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Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-1
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
MANAGERIAL ECONOMICSAn Analysis of Business Issues
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-2
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
Intr
odu
ctio
n
Definitio
nDouglas - “Managerial economics is .. the application of economic principles and methodologies to the decision-making process within the firm or organization.”
Pappas & Hirschey - “Managerial economics applies economic theory and methods to business and administrative decision-making.”
Salvatore - “Managerial economics refers to the application of economic theory and the tools of analysis of decision science to examine how an organisation can achieve its objectives most effectively.”
Howard Davies and Pun-Lee Lam - “It is the application of economic analysis to business problems; it has its origin in theoretical microeconomics.”
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-3
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
Why Managerial
Economics?• A powerful “analytical engine”.
• A broader perspective on the firm.• what is a firm?• what are the firm’s overall objectives?• what pressures drive the firm towards profit
and away from profit
• The basis for some of the more rigourous analysis of issues in Marketing and Strategic Management.Intr
odu
ctio
n
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-4
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
Questions How do markets work? How do customers value products? What are the relevant production and cost measures for
decision making? How does competition affect business decisions in
different market structures? What prices should be set? What would be the impact of changes in interest rates on
costs, accounting, or capital budgeting? How important to managerial and marketing decisions
are changes, in foreign exchange rates, in technology, in incomes, in government regulations, in sources of energy, in the balance of payments?
Intr
odu
ctio
n
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-5
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
Intr
odu
ctio
n
Content
StructureCompetition, market structures and business decisions
Competition, market structures and business decisions
ManagerialEconomics
ManagerialEconomics
Production and CostsProduction and Costs
Basic economics principles: demand and supply.
Basic economics principles: demand and supply.
Introduction. The nature of managerial economic decision making
Introduction. The nature of managerial economic decision making
Pricing strategies and practices
Pricing strategies and practices
Business and Government.Business and Government.
Capital budgetingCapital budgeting
Research question
Business and current economic situation.
Research question
Business and current economic situation.
Demand analysis and estimation
Demand analysis and estimation
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-6
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
Intr
odu
ctio
nWhat is the purpose of economic analysis?
Why do we want to apply economic analysis to business problems?
For the academic economist: to understand, to make
predictions about firm’s behavior. The “positive” approach to theory: What is?
For the businessperson: “to assist decision-making”, to provide decision-rules which can be applied The “normative” approach to theory: What should be?
These purposes are different, they can lead to misunderstanding, and economists are not always honest about the limitations of their approach for practical purposes.
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-7
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
How Can Managerial Economics Assist Decision-Making?
Adopt a general perspective, not a sample of one
Simple models provide stepping stone to more complexity and realism
Thinking logically has value itself and can expose sloppy thinkingIn
trod
uct
ion
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-8
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
Intr
odu
ctio
n
Managerial Economics
&Industrial Economics
In industrial economics (or industrial organization), the emphasis is (or was) upon the behavior of the whole industry, in which the firm is simply a component.
In managerial economics, the emphasis is upon the firm, the environment in which the firm finds itself, and the decisions which individual firms have to take.
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-9
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
Intr
odu
ctio
n
The Structure-Conduct-
Performance ParadigmBasic Conditions: factors which shape the market of the industry, e.g. demand, supply, political factors
Structure: attributes which give definition to the supply-side of the market, e.g. economies of scale, barriers to entry, industry concentration, product differentiation, vertical integration.
Conduct: the behavior of firms in the market, e.g. pricing behavior advertising, innovation.
Performance: a judgement about the results of market behaviour, e.g. efficiency, profitability, fairness/income distribution, economic growth.
How can the government improve the performance in an industry?
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-10
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
Managerial
Economics &
Management
ScienceManagement science: is essentially concerned with techniques for the improvement of decision-making and hence it is essentially normative;firms are not assumed to find the optimal solutions for themselves. They are found by the researchers who then present them as prescriptions for what the firm should do.
Managerial economics: is often concerned with finding optimal solutions to decision problems.However, the primary purpose of using models is to predict how firms will behave, not to advise them what ought to do. Managers are assumed to find the optimal solutions for themselves and that is how predictions are made.
Intr
odu
ctio
n
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-11
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
Th
e n
atu
re o
f m
anag
eria
l eco
no
mic
d
ecis
ion
mak
ing
Economic optimisation
Economic optimisation
The value of firm The value of firm
Economic constraints Economic constraints
The basic economic variables
The basic economic variables
DemandDemand
SupplySupply
CostsCosts
RevenueRevenue
ProfitProfit
The role of managerial economics in
managerial decision making
The role of managerial economics in
managerial decision making
Managerial economic as an economics
discipline
Managerial economic as an economics
discipline
Intr
odu
ctio
n
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-12
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
Man
ager
ial
eco
no
mic
as
an
eco
no
mic
s d
isci
plin
e
Macroeconomics
Economics
Microeconomics
International Economics
Regional Economics
Money, finance, banking “Sector” economics
Labor economics
Environmental economics
Managerial economics
Economics development
Intr
odu
ctio
n
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-13
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
Intr
odu
ctio
n
The role of
managerial e
conomics in
managerial d
ecision
making
Managerial decision problems
Product price and output
Make or buy
Production technique
Internet strategy
Advertising media and intensity
Investment and financing
Managerial decision problems
Product price and output
Make or buy
Production technique
Internet strategy
Advertising media and intensity
Investment and financing
Economic concepts
Theory of consumer behaviour
Theory of firm
Theory of market structure and pricing
Economic concepts
Theory of consumer behaviour
Theory of firm
Theory of market structure and pricing
Decision making tools
Numerical analysis
Statistical analysis
Forecasting
Game theory
Optimisation
Decision making tools
Numerical analysis
Statistical analysis
Forecasting
Game theory
Optimisation
Managerial Economics
Use of economics concepts and decision making tools to solve managerial decision problems
Managerial Economics
Use of economics concepts and decision making tools to solve managerial decision problems
Optimal solutions Optimal solutions
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-14
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
Choose alternative that produces a result the most
consistent
with managerial objective
Choose alternative that produces a result the most
consistent
with managerial objective
What is the primary managerial objective?
It depends upon the property structure
Profit maximisation?
Sales/revenue maximisation?
The value of firm maximisation?
Intr
odu
ctio
nE
con
om
ic o
pti
mis
atio
n
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-15
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
1 1
cos
(1 ) (1 )
N Nt tt t
t t
Profit Total revenue Total tValue
i i
N – firm’s life timeI - discount rate
- current value of the profit earned in t years time
N – firm’s life timeI - discount rate
- current value of the profit earned in t years time
(1 )tt
Profit
i
Intr
odu
ctio
nTh
e va
lue
of
firm
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-16
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
Short-run & Long-run
Th
e F
irm
1. The firm is a profit-maximiser - it optimises
2. The firm can be treated in a holistic way
3. There is perfect certainty
Mod
e l o
f th
e F
irm
-Neo
cla s
sica
l
The firm is a profit-maximiser: it is assumed to make as much profit as possible.
This means that the model is an ‘optimising’ model: the firm attempts to achieve the best possible performance, rather than simply seeking “feasible” performance which meets some set of minimum criteria
It is a holistic model: the firm is a single entity which has objectives of its own and which can be said to take decisions
It assumes perfect certainty. Cost and demand conditions are perfectly known
Model
Natu
reM
ergerM
NE
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-17
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
Th
e F
irm
Demand: Average Revenue$
Quantity Produced
P1
P2
Q1 Q2
Quantity Produced
Demand: Average Revenue
Marginal Revenue
$
Demand: Average Revenue
Marginal Revenue
Marginal Cost$
Quantity Produced
Profit maximising output
Pro
fit
max
i mi s
ingp
r ice
QuantityProduced
Demand: Average
Revenue
Marginal Revenue
Marginal Cost$
Profit maximising output
Pro
fit m
axim
isin
g pr
ice
Average Cost
The firm aims to maximise profit by choosing the level of output which gives the biggest difference between revenue and costs
Mod
e l o
f th
e F
irm
-Neo
cla s
sica
l
Model
Natu
reM
ergerM
NE
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-18
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
• Comparative Statics– begin with an initial equilibrium position - the starting point
– change something
– identify the new equilibrium, e.g:• When demand increases?
• When costs rise?
• When a fixed cost increases?
– This is the main purpose of the model -what it was designed to do
• Normative prescriptions– it will cost me $30 per unit to supply something which will give
me $20 per unit in revenue- should I do it?
– I must pay $20 billion to set up in my industry. Should I charge higher prices to get that money back?
• Positive and Normative are linked by “if?” IF the aim of the firm is to maximise profit what will it do/what should it do?
Th
e F
irm
Mod
e l o
f th
e F
irm
-Neo
cla s
sica
l
Model
Natu
reM
ergerM
NE
What Can We Do With This Model?
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-19
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
The Managerial School argues that:
1. Ownership and control are in the hands of different groups of people.
2. The interests of owners (shareholders) and Controllers (managers) are different.
3. Managers have the power to let their interests over-ride those of the shareholders.
4. Therefore firms are run in the interests of the managers.
In place of the profit-maximising model, the managerial school substitute a variety of alternatives - sometimes referred to as managerial discretion models:
Sales-revenue maximising (Baumol)
Managerial utility maximising (Williamson)
“Managerial” Criticisms of the Profit-Maximising ModelBerle and Means (1932)– firms are owned by shareholders but controlled by managers
– owners’ and managers’ interests are different
– managers have discretion to use the firm’s resources in their own interests
Th
e F
irm
Mod
e l o
f th
e F
irm
-Ma n
a ger
ial S
c hoo
l
Model
Natu
reM
ergerM
NE
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-20
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
Th
e F
irm
Mod
e l o
f th
e F
irm
-Beh
avio
ura
l Ap p
roac
h Organisations do not have objectives, only people have objectives The firm does not exist - it is a set of shifting coalitions of individuals Individuals and groups do not maximise - they satisfice
Information about the environment is very limited
If all aspirations are being met - everyone is satisfied - do nothing BUT then aspiration levels will rise until someone is not satisfied THEN rules of thumb used to find solutions to “the problem”
Aspiration levels, which adjust according to experience Problem-oriented ‘rules of thumb’ based on past experience A dynamic model not “holistic” not “deterministic” not optimising
Model
Natu
reM
ergerM
NE
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-21
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
Behavioural approach is a more accurate description of what happens INSIDE the firm.
BUT it tells us almost nothing about how the firm will respond to changes in the environment.
To use it to make predictions about how the firm will react to changes in the environment we need to know everything about the individual firm.
However, if shareholders are a powerful group and their aspiration level requires making maximum profit the firm will again behave in the same way as a profit-maximiser.
Th
e F
irm
Mo d
el o
f th
e F
irm
In Conclusion?The behavioural approach is a useful complement to the profit-maximising and managerial approaches, not a substitute for them
Model
Natu
reM
ergerM
NE
Which Approach is Most Useful?
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-22
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The MarketT
he
Nat
ure
of
the
Fir
mT
he
Fir
mWhat is a Firm?
a set of transactions* coordinated by authority instead of by the market
a transaction takes place whenever a good or a service is transferred from one party to another
Why Do Firms Exist? Some transactions are co-ordinated by markets Some transactions take place inside firms The firm is the supersession of the market mechanism The firm is that set of transactions which is co-
ordinated by managerial authority instead of the market
Why does this happen?
Model
Natu
reM
ergerM
NE
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-23
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The MarketT
he
Nat
ure
of
the
Fir
mT
he
Fir
m
The SetupA Firm
Produce ouput y, which it can sell for price p(y) From quantities of input (factors): X1, X2, … Input costr (per unit): w1, w2, …
How Can this firm produce Technology
How Should this firm produce Cost minimitation
How much should this firm produce Profit maximization
Model
Natu
reM
ergerM
NE
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-24
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
Transactions inside a firmTransactions inside a firm
Factor Market
Product Market
FIRMEntrepreneur
Factor of Production
Product
(Goods & Services) e.g. a shirt
Consumers
Th
e N
atu
re o
f th
e F
irm
Th
e F
irm
Model
Natu
reM
ergerM
NE
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-25
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
The “Coasian”Analysis
1. Transaction cost problem; firm supersedes market
2. Transactions are “normally” done through markets; market is the default
3. Some transactions are done inside firms
4. Transactions are done in a firm when the costs of transacting on the market is higher than costs of transacting in the firm
Why Firm Exists?Transaction Cost
Analysis
Th
e N
atu
re o
f th
e F
irm
Th
e F
irm
What decides whether a transaction takes place through the market or inside a firm?
Answer: TRANSACTIONS COSTSTRANSACTIONS COSTS
Model
Natu
reM
ergerM
NE
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-26
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
What Are Transactions Costs? A transaction takes place when a good or a service is transferred from one party to
another Direct costs arise in respect of:
• locating buyers and sellers• acquiring information about their availability, quality, reliability and prices• negotiating, re-negotiating and concluding contracts • co-ordinating the agreed actions of the parties • monitoring performance with respect to fulfilment of contracts• taking action to correct any failure to perform
Opportunity costs arise in respect of:• inefficiencies if inappropriate equipment used• failure to adapt to changing conditions
Th
e N
atu
re o
f th
e F
irm
Th
e F
irm
Transaction costs include: information and measurement costs
negotiation costs
contracting costs (ink costs, legal costs)
monitoring and enforcing costs, etc.
Model
Natu
reM
ergerM
NE
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-27
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
As firm becomes larger marginal cost of transacting increases managerial diseconomies arise larger firms may pay more for resources physical distance dissimilarity of transactions rapidly changing environment
Transactions will be organised in the least-cost way
Th
e N
atu
re o
f th
e F
irm
Th
e F
irm
Limitations of Transaction Cost Analysis? So flexible it explains everything after the event, but can it really predict much before
the event? Transaction costs not directly observable, so empirical work must be indirect May be many efficient solutions, so which one will occur? Is opportunism really universal? Should it be something we explain instead of an
assumption? Ghoshal and Moran (1996) - teaching it is bad for business!!!
Model
Natu
reM
ergerM
NE
The costs of transacting inside firm rise with:
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-28
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
The Extent of DiversificationWhat factors determine the extent to which a firm diversifies across different industries? Diversification will be efficient if there is SYNERGY SYNERGY can come from
– economies of scope
– exploitation of specific assets
– reduction of risk and uncertainty BUT DOES IT REALLY EXIST IN PRACTICE?
Div
ersi
fica
tion
&M
erge
rT
he
Fir
m
The history of diversification is not good In the 1960s and 1970s the “conglomerate” was a favourite form of business Although the purchased firms were usually good performers, the merged firm
tended to have poor performance It became clear in the 1980s and 90s that there is a “diversification discount” of
about 15% on average WHY?
Firms seemed to not understand the sectors they entered
Model
Natu
reM
ergerM
NE
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-29
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The MarketD
iver
sifi
cati
on&
Mer
ger
Th
e F
irm
If there is a diversification discount why did firms do it?
Perhaps the discount only emerged in the 80s some studies suggest it was not evident in the 70s
Mergers were to satisfy the managers, not the shareholders
With more liberalized and efficient financial markets, “focus” has been the trend for some time now
Model
Natu
reM
ergerM
NE
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-30
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The MarketD
iver
sifi
cati
on&
Mer
ger
Th
e F
irmMergers and Take-overs
Horizontal:with competitors
Vertical:with suppliers or customers
Conglomerate:with unrelated firms
1. Alternative forms of of merger
2. Mergers in a perfect world All managers are efficient;they work in the interests of shareholders; stock
markets price shared efficiently;no uncertainty; everyone uses the same discount rate
In that situation there are only two reasons for mergers to take place: SYNERGY: 2+2>4; economies of scope or scale, joint use of key
resources or capabilities MARKET POWER: merger gives some degree of monopoly power
Model
Natu
reM
ergerM
NE
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-31
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
3. Mergers as the transfer of resources to better managers If a firm is run inefficiently, share price will be low The firm will be purchased by someone who installs better managers Share price rises BUT IF THIS WERE TRUE PERFORMANCE WOULD BE
BETTER AFTER MERGERS!
Div
ersi
fica
tion
&M
erge
rT
he
Fir
m
4. Mergers as the result of manipulationor valuation discrepancies Manipulation: planting rumours, “bootstrapping”
– my P/E is 15: 1. If I buy a firm whose ratio is 10:1 its share price will rise until the P/E is 15:1
Valuation discrepancies– when there is a lot of “turbulence” in the environment, different
people will make different judgements. Some will think a firm is worth more than the market valuation
Model
Natu
reM
ergerM
NE
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-32
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
5. The performance consequences of mergers Shareholders of the acquired firms gain -
because the acquiring firm pays a premium The pattern of results for the acquiring firm is
very mixed with values tending to fall, not rise!
6. Are mergers really for managers? CEOs and senior managers like mergers
larger firms involve more prestige and often more pay
larger and more diverse firms reduce risk for managers (but not for shareholders who could do it another way)
publicity is welcomed by many CEOsDiv
ersi
fica
tion
&M
erge
rT
he
Fir
mM
odelN
ature
Merger
MN
E
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-33
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
Definition
Th
e M
ult
inat
ion
al E
nte
rpri
seT
he
Fir
m
“An enterprise that controls and manages production establishments - plants - located in at least two countries.” (Caves, 1996)
Note that the MNE is involved in Foreign Direct Investment, not simply Portfolio Investment
Model
Natu
reM
ergerM
NE
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-34
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The MarketT
he
Mu
ltin
atio
nal
En
terp
rise
Th
e F
irm
A history
of the M
NE’sEarly 19th century:
Almost all European-based (e.g. British American Tobacco, Lever Brothers, Michelin and Nestle), reflected distribution of colonial influence and most were involved in backward integration into agriculture and minerals in the colonies.
In the 1920s and 1930s:
Establishment of international cartels in many industries for global competition.
From the 1950s to the early 1970s:
Led by American firms moving into the European market (The American Challenge); research-intensive manufacturing industries.
In the 1970s, 1980s and 1990s:
Emergence of the Japanese multinationals, “export-platform” activities in the newly-industrializing countries. More diversity; more host countries; more home countries; more in and out.
Model
Natu
reM
ergerM
NE
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-35
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
Economic theory and the multinationalEqui-marginal productivity of capital
Th
e M
ult
inat
ion
al E
nte
rpri
seT
he
Fir
m
MPB MP
A
0A 0B
Rat
e of
Ret
urn
(%
)
Capital
diminishing returns to capital investment
capital will flow from countries (B) with lower rates of returns to those with higher rates of returns (A) until rates of return are equal
but this does not explain the MNE:owners of capital can simply invest in portfolios (buying shares and bonds), no need for foreign direct investment (setting up offices/subsidiaries, involving management and control)
Model
Natu
reM
ergerM
NE
Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-36
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The MarketT
he
Mu
ltin
atio
nal
En
terp
rise
Th
e F
irm
The Hymer-Kindleberger proposition multinationals must face some disadvantages relative to incumbents they must possess some form of offsetting competitive advantage over the incumbents;
these advantages can be exploited by producing in overseas markets. Competitive advantages of multinationals: technology, capital, management sills, etc.
But why not produce in home country and export the goods?
Locational theory The host countries possess some locational advantages, otherwise the firm would
simply operate in a single location e.g. some countries have cheap resources: cheap and abundant supply of land and
labour; some are close to the customers.
But why not license the competitive advantage of multinationals?
Internalization and transaction cost theory High transaction costs involved in using marketing transactions; e.g. costs in enforcing
licensing agreements. Buckley and Casson’s analysis: five advantages that an internalised transaction over
the market: increased ability to control and plan the opportunity for discriminatory pricing avoidance of bilateral monopoly reduction of uncertainty avoidance of government intervention
Th
e “eclectic” framew
ork:O
L I
Model
Natu
reM
ergerM
NE
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he
Mu
ltin
atio
nal
En
terp
rise
Th
e F
irm
Licensing
Exporting
FDI
Ownership Internalization Location
From the viewpoint of the MNE:
What are the advantages of foreign direct investment (MNE) over exporting and licensing?
Model
Natu
reM
ergerM
NE
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he
Mu
ltin
atio
nal
En
terp
rise
Th
e F
irm
The Impact of the Multinational on Host EconomiesResource transfer and technology transfer effects
Trade and balance of payments effects
Effects on competitive structure and performance
Effects of sovereignty and local autonomy
Some concerns:
Balance of payments effects
Employment effects
The loss of technological lead
Tax avoidance and loss of sovereignty
The impact of the MNE on its home country
Model
Natu
reM
ergerM
NE
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Pr o
duct
ion
&C
ost The Relationship Between Inputs and Outputs
The fundamental relationship is that between inputs and outputs - expressed as the production function
This can be examined at a number of levels the economy as a whole the industry the firm
A number of different mathematical forms can be used to model the relationship Cobb-Douglas: Q = aKaLb
translog production function
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The Cobb-Douglas Q = aKaLb : Where K= capital; L = Labour
As each individual input (K,L) is increased, output increases, but at a decreasing rate - the principle of diminishing returns - one of the most fundamental economic ideas
A production function identifies many different techniques within the same technology
Pr o
duct
ion
&C
ost
If (a+b) > 1; economies of scale If (a+b) < 1; diseconomies of scale
If (a+b) = 1; constant returns to scale
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&C
ost Production Function
A Production function tells you how much output (at most) you can get from given quantities of inputs (factors) Example (Cobb-Douglas) y= f(x1, x2) = X1 0,5 X2 0,5
Short-Run Production Function In the short-run, not all input can be varied: at least one input is fixed
Suppose input 2 is fixed at x2 = x2 : y = f(x1, x2)
Marginal Product Suppose input 2 is held constant: How does output change as we change input 1?
The Marginal Product (MP) of input 1 is the partial derivative of the production function with respect to input 1
MP1 = = f1(x1, x2o)
f(x1, x2)
x1
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Pr o
duct
ion
&C
ost What is the marginal product of input 1 of the Cobb-Douglass
production function
f(x1, x2) = x1 0,5 x2 0,5 ?
Does the marginal product increase or decrease as the firm uses more of input 1 ?
Answer :
Isoquants An isoquant is the locus of
all input combination that yield the sama level of output
x1
x2
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&C
ostTechnical Rate of Substituion
The technical rate of substitution (RTS) is the slope of and isoquant at a point
That is, holding total output constant (remaining on the same isoquant), at wahta rate can we exchange input 2 for input 1 ?
RTS = = x2
x1
f1
f2
What is the technical rate of substitution (slope of the isoquant) for the Cobb-Douglass production function
f(x1, x2) = x1 0,5 x2 0,5 ?
…… at the point x1 = x2 = 2 ?
…… at the point x1 = 4, x2 = 1 ?
Answer :
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Pr o
duct
ion
&C
ost From Production Functions to Cost Curves
Short run cost curves• each short run curve shows costs for a specific set of plant and equipment
• AFC declines
• Average variable cost rises after some point
• AC is U-shaped
Long run cost curves• the firm can choose from all of the known sets of plant and equipment
• the shape of the curve depends upon economies or diseconomies of scale
Short run - some inputs are fixed. (K). The firm is restricted to a fixed set of plant and equipment
– capacity utilisation decisions
Long run - both inputs are variable. (K,L). The firm can choose the set of plant and equipment it wants
– investment decisions
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Pr o
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ion
&C
ost
Production&Cost
Average & Marginal CostS
hor
t R
un
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Pr o
duct
ion
&C
ost If a production function exhibits constant returns to scale, a doubling of
all inputs results in a doubling of output. If you double all inputs, long-run total cost doubles:
LTC = r · k + w · l;
r·2k + w·2l = 2LTC
So: a production process exhibits constant returns to scale if a doubling of output results in a doubling of cost, that is, if the LTC curve is a straight line.
If a production function exhibits increasing returns to scale, a proportional change in all inputs results in more than a proportional change in output. If you change all inputs by a factor of t, long-run total cost changes by a factor of t:
LTC = r · k + w · l;
r·tk + w·tl = tLTC
So: a production process exhibits increasing returns to scale if a change in output (by a factor of t) results in a change in long-run total cost of less than a factor t; that is, the LTC curve is concave.
If a production function exhibits decreasing returns to scale, a proportional change in all inputs results in less than a proportional change in output. If you change all inputs by a factor of t, long-run total cost changes by a factor of t:
LTC = r · k + w · l;
r·tk + w·tl = tLTC
So: a production process exhibits decreasing returns to scale if a change in output (by a factor of t) results in a change in long-run total cost of more than a factor t; that is, the LTC curve is convex.
Lon
g R
un
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onsu
mer
Beh
aviu
or T
heo
ryC
onsu
mer
The Main ApproachesUtility TheoryIndifference AnalysisRevealed PreferenceThe Characteristics Approach
Character.RevealedIndifferenceUtility
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ehav
iuor
Th
eory
Con
sum
erUtility Theory Consumers seek to maximise their UTILITY, which increases as
they consumer more ‘goods’ and decreases as they consumer more ‘bads’
As a consumer has more of a ‘good’, the extra (marginal) utility they enjoy from each successive extra unit of the good declines the principle of diminishing marginal utiity
A utility-maximising consumer will purchase a combination of goods such that the extra utility acquired per $ or cent, £ or penny, is the same for every good OR:
the ratio of the marginal utilities is equal to the ratio of the prices
Character.RevealedIndifferenceUtility
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Con
sum
erUtility Theory and Falling Prices If a consumer has a fixed income and begins in
equilibrium:
MUapples/Papples = MUpears/Ppears
Then the price of apples falls Left-hand side of the equation> Right-hand side There is an opportunity to increase UTILITY- how to
do it? Shift spending from pears to apples - WHY DOES
THIS WORK? Because each extra penny spent on apples gives more
additional utility than each extra penny spent on pears
Beh
aviu
or T
heo
ry
Character.RevealedIndifferenceUtility
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diff
eren
ce A
nal
ysis
Con
sum
er
UTILITY theory requires us to think in terms of a cardinally measurable unobservable concept, which is rather ‘heroic’
INDIFFERENCE ANALYSIS explains consumer behaviour on the basis of less restrictive assumptions (tho’ the logic is very similar)
The following assumptions are made about ‘rational’ consumers– they know when they prefer one bundle of goods to another or are
indifferent between them - their preferences are complete
– Preferences are symmetric. If I prefer A to B, I cannot prefer B to A.
– Preferences are transitive. If I prefer A to B and B to C I must prefer A to C.
(These are not as unproblematic as they may seem)
Character.RevealedIndifferenceUtility
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dif
fere
nce
An
alys
isC
onsu
mer
• Good A
Good B
All combinations of A and B for which the consumer is indifferent
AN INDIFFERENCE CURVE
• Good A
Good B
Slopes show relative preferences for A and B
An A-lover
• Good A
Good BBudget Line
• Good A
Good BBudget Line
More B is bought and (in this example only) the same amount of A
If the Price of B FallsOptimal Combination of A&B
Character.RevealedIndifferenceUtility
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er
Assume that the utility function is U = q1q2, that p1 = 2 dollars, p2 = 5 dollars, and that the consumer’s income for the period is 100 dollars. The budget constraint is
100 – 2q1 – 5q2 = 0
At the utility maximum level:
q1 = ……?
q2 = ……?
Answer :
Character.RevealedIndifferenceUtility
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Revealed PreferenceLess restrictive assumptions - consumers are
consistent in their choicesA budget line is constructed and the consumer’s
choice observedWhen price of one good falls, a new choice is
madeThe new choice cannot involve less of the good
whose price has fallen
Character.RevealedIndifferenceUtility
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Con
sum
erRevealed Preference
Apples
Oranges
• Why?
XZ
If combination X is the original choice and Z is the new choice (after the price of oranges falls), X to Z is the price effect. The broken line shows the goods which could be bought if income remained at the level requiredto buy the original basket of goods, but the new price ratio held. We don’t know exactly where the consumer would choose to be, but they cannot be to the left of X because they have already rejected superior combinations in favour of X
Character.RevealedIndifferenceUtility
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Con
sum
erThe Characteristics Approach Lancaster 1966 Consumers do not desire ‘goods’ but bundles of
‘characteristics’– not a computer but
• processing speed
• memory
• storage
• functions
Different brands offer different combinations of characteristics. Combining brands may allow other combinations to be achieved
Desirable mixes of characteristics might be identified
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Dem
and
The Determinants of Demand Demand is the quantity of a product that purchasers are
willing and able to purchase in a specified period It is determined by
– Own Price - Po
– Price of other products, especially close substitutes and complements, Pc,s
– Consumers’ disposable incomes, Yd
– Consumers’ tastes, T
– The amount spent on advertising the product, Ao
– The amount spent on advertising complements and substitutes, A
c,s
– Interest rates (i) and credit availability (C)
– Expectations of future prices and supply conditions(E)
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and
These Relationships May be Represented As:A ‘demand function’ - the general
mathematical form• Qd = f(Po,Po,Ps,Yd,Ao,Ac,As,I,C,E)
A ‘demand curve’Price
Quantity Demanded
The demand curve shows the quantity that would be bought at each price, for some fixed combination of all other factors
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and
Concepts of Elasticity Own price elasticity is:
– percentage change in quantity demanded, divided by percentage change in price:
If demand is price-elastic, revenue increases with lower prices.
If demand is price-inelastic, revenue decreases with lower prices
Cross-price elasticity of demand between substitutes is positive Income-elasticity determines how demand changes with customers’
incomes. For most goods income-elasticity is positive. Advertising elasticity is important in deciding on advertising budgets. It is
positive. As the level of advertising increases, we would expect
advertising elasticity to fall.
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and
Zero-elasticity at all prices
Price
Quantity
Ed = 0
Infinite elasticity at all pricesPrice
Quantity
Ed =
Unitary elasticity at all pricesPrice
Quantity
Ed = -1This curve is a ‘rectangular hyperbola’ such that price x quantity is a constan
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Dem
and
Price
Quantity
1
2
p0
q0
p1
q1
12 >
If demand is price-elastic, decrease the price to gaining higher revenue
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Dem
and
Price
Quantity
1
2
p0
q0
p1
q1
12 <
If demand is price-inelastic, lower
prices will decreases revenue
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and
Determinants of Own-price Elasticity Substitutes: how close and at what prices?
– How narrowly defined is the product? The more narrowly defined the more close substitutes
Proportion of consumers’ income spent on the product (or % of industrial buyers’ costs accounted for)
Time. Demand is more elastic over longer periods of time
Determinants of Other Elasticities Income Elasticity
– Type of good• necessities - salt, drinking water, zero elasticity• luxuries, zero at low levels of income then high when income thresholds
exceeded• inferior goods - negative, purchase less as income rises - bus travel, low-grade
margarine, paraffin
Cross-price elasticity– substitutes or complements,and how close?– An industry is a group of firms producing products with high positive
cross-elasticities
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and
EstimationEstimation attempts to quantify the links between the
level of demand for a product and the variables which determine it.
The demand for hotel rooms depends upon: their price the price of bed and breakfast accommodation household incomes in visitors’ home countries natural events (the weather, foot-and-mouth disease)
ForecastingForecasting simply attempts to predict the level of sales
at some future date How many Japanese tourists will visit Hong Kong in 2000? How many delegates will attend conferences in London in 2001?
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Dem
and
Econometric Estimation Qd = f(Po, Pc, Ps, Yd, T, Ao, Ac, As, I. C, E)
– THE GENERAL FORM OF THE DEMAND FUNCTION– (CANNOT BE ESTIMATED BY THE USUAL METHODS UNTIL A
PARTICULAR LINEAR FORM IS CHOSEN)
Qd = a + b1Po+b2Pc+b3 Ps+b4 Yd+b5T +b6Ao +b7Ac+b8As+b9 I+b10C+b11E
– THE SIMPLE LINEAR FORM
Qd= Poa.Pc
b,.Ps
c Ydd Te.Ao
f Acg As
h Ii. Cj, Ek
– THE EXPONENTIAL FORM log Qd= alogPo+blogPc+clogPs+dlogYd+elogT+flogAo+glog Ac
+hlogAs+ilogI+jlog C+klogE– THE LOGLINEAR FORM
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and
• Simplest Method is EXTRAPOLATIONForecasting Demand
The DECOMPOSITION METHOD
How To Evaluate the Forecast?
• Objectivity. Does the result depend on the data or on the person making the forecast?
• Validity. How closely does a series of forecast estimates correlate with the actual time series, for the time period used to make the forecast?
• Reliability. If we take different starting points for the forecast, do the results stay approximately the same?
• Accuracy.How close are the forecasts to the actual figures, for the period outside that used to generate the forecast?
• Confidence. Is there are high probability that we can accept the results?
• Sensitivity.If we use the method to make forecasts using data with very different patterns, do we get very different results?
Etc
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and
What Other Methods are Available?
Barometric forecasting - leading indicators are used: variables which change in advance of the variable you wish to predict
Market Surveys,
Sales Force Opinion
Expert Opinion ‘Delphi’ approach
Market Testing
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and
Which Technique Is Best For Each Product? An industrial product with a
limited market
A consumer good which has been on sales for many years
A new product whose full scale launch will be very expensive
A technically very complex product, to be sold in a very wide market
Time-series analysis
Expert opinion
Market testing
Survey of buyer’s intentions
• THIS ISJUST ONE POSSIBLE ANSWER . YOU MAY BE ABLE TO JUSTIFY OTHERS
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e M
arke
t
Formal Textbook ModelsEconomic analysis identifies four types of market structure PERFECT COMPETITION MONOPOLY OLIGOPOLY MONOPOLISTIC COMPETITION
The basis for the STRUCTURE-CONDUCT-PERFORMANCE approach to industrial organization.
– Structure determines prices and profitability
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t Perfect Competition Large No of Small Firms, (i.e.No Economies of Scale), Identical
Products, Free Entry to the Industry, Perfect Knowledge of market Opportunities
SHORT RUN– price is determined at industry level by supply and demand
– each firm has a horizontal demand curve at the market price
– demand and marginal revenue curve are the same
– MR = P = MC
LONG RUN– entry takes place, shifting supply curve to the right and price down
– super-normal profits are competed away, P= minimum LAC
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arke
tPerfect Competition: Short Run
• Industry Firm
P P
Q Q
D
S
P
q0 q1 q2
P2
P1 D=AR=MR
SMC
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tThe Firm in More DetailSMC
SAC
P = AR =MR
q
AC
PL is the only possible long run price
SAC
P = AR =MR
q
PL
LAC
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tMonopoly One firm, no entry is possible - ‘pure monopoly’
Firm’s demand-curve is industry’s demand curve
Price >Marginal Cost - economic inefficiency. Super-profits can be made in the long run. The firm does not necessarily use the plant which gives lowest cost
Most countries have some kind of anti-monopoly policy– note that the economic rationale for monopoly policy is P>MC not P>AC
– the problem is inefficiency not inequity
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t
Monopoly• A monopolist produces less and charges a higher price,
relative to the socially optimal
Pmonopoly
Qmonopoly
Psocially
optimal
Qsocially optimal
MC
Demand
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tMonopolistic Competition
• Many firms, free entry, differentiated products• Downward-sloping demand-curves• In the long-run Price = Average Cost. Firms have
plants which are too small to take full advantage of scale economies. (But there is only an equilibrium in this market structure if heroic and perhaps contradictory assumptions made)– when new firms enter, they take customers in equal proportions
from all old firms– all firms have same cost and demand curves, while producing
different products– will new firms not imitate successful old ones?
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tMonopolistic Competition• The ‘excess capacity’ result: but which firm is shown here? ALLOF THEM?
Differentiated products but identical cost and demand conditions?
MC
AC
Demand = AR
MR
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tOligopoly Competition amongst the Few
Key feature is interdependence and rivalry Small number of firms (2 = duopoly) Condition of Entry may vary Product differentiation may vary Possible outcomes include:
– co-operation and collusion - the monopoly price
– price war - the perfectly competitive price
The modern approach to oligopoly is through game theory
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tWhat Do These Models Tell Us About the Impact of Structure?
Entry Conditions are Important: They affect whether high profits can be maintained in the long run.
The Number of Competitors and their Behaviour is Important. A few co-operating “competitors” can lead to monopoly-type profits
Product Differentiation is Important. Without it all firms must charge the same price in a competitive market
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tFeatures of the four market Features of the four market structuresstructuresFeatures of the four market Features of the four market structuresstructures
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gThe Basic Rule for Profit-Maximization• (Price - Marginal Cost)/Price = 1/-Ed
• Not an operational decision rule - a statement of the condition required for maximum profit
• Can be re-stated in an “average cost plus margin” format
Pricing and Market Structures• Under perfect competition, firms are price-takers
• Under monopoly, firms are price-makers (but still constrained by the requirement to make maximum profit)
• Under monopolistic competition, prices settle at the ‘excess capacity’ level where P=AC
Price Discrimination• Price discrimination exists when the same product is sold for different prices, that are
not attributable to differences in the cost of supply
• Two conditions are needed:
– the market must be divisible into sub-markets between which there cannot be any arbitrage
– demand conditions (elasticity) must be different in the sub-markets
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Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
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gThird Degree Price Discrimination• A number of sub-markets, each containing a number of potential customers• These markets may be separated by:
– distance ( car prices differ between Europe and the UK - but is it really price discrimination?)
– time (for non-storable commodities) - peak versus off-peak journeys– age and status - Student Railcards, Old Person Railcards
Second Degree Price Discrimination• Customers are charged one price for the first block of units they purchase, then
a different price for the second block– electricity, water, gas tariffs– the producer appropriates part of the consumer surplus
First Degree Price Discrimination• Every buyer is charged the maximum they are willing to pay (the demand
curve becomes the marginal revenue curve)• Can be difficult to evaluate willingness to pay but first degree discrimination
may be possible in personal, household or commercial services • Note that the socially optimal level of output will be produced but all the
surplus accrues to the producer
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gPricing and the Product Life Cycle
.
IntroductionGrowth
Maturity Decline
Time
Sales
Volume
What Happens to Elasticity of Demandand Marginal Cost Over the Product Life Cycle? Introduction - product is new. Elasticity may be low because there are no
substitutes or high if buyers need to be persuaded to try the new product. Marginal cost is relatively high. Appropriate price will reflect high MC combined with high/low elasticity
Growth - imitation begins, and learning takes place. Elasticity rises, MC falls. Price falls?
Maturity - competition from many locations, substitutes and next-generation products have been invented, elasticity high, MC low
Decline - fierce competition for a declining market, very low margins
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g1Pricing New Products
• For new products, there is a significant amount of uncertainty about demand conditions. Two strategies have been suggested (Dean 1950)
• SKIMMING - set an initially high price. IF that produces a high level of profits, leave the price high until conditions change and demand becomes more elastic. Do this when:
– there is a significant group of buyers prepared to pay high prices– when demand is inelastic– when the high price will not induce entry– when the cost penalty for low volume is small
• PENETRATION - set a low price from the beginning in order to build a large market share quickly. Do this when:
– demand is elastic– low volume is very high cost– entry is a major danger
Is Skimming v Penetration Just an Application of the Simple Model?• YES - set a high price when elasticity is low and MC is high, set a low price when the opposite is true• BUT -
– skimming may have another benefit. If experience shows it is the wrong strategy, the price can be cut without much customer resistance. If the penetration approach is used but it becomes clear that skimming would be better, it is more difficult to raise price than to lower it
– skimming may provide a means of price discrimination through time. If a market contains a group of ‘trendsetters’ or ‘first-adopters’ who must have, or like to have, a product first and are willing to pay more for it. Skimming allows them to be charged a higher price.
– E.g new major dictionaries, new types of mobile phone
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Pricing Objectives The central objective of pricing is PROFIT MAXIMIZATION Companies may either express this in a different way, or have
intermediate level objectives for pricing. Those intermediate level objectives may or may not be consistent
with profit-max achieve a target rate of return: might be the maximum, might be a
‘satisficing objective, might be to deter entry target market share: might be the share which is consistent with profit-
maximisation or it might be a managers’ target stabilize output - keep the factory running and the workers employed match the competition
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gA Good Example of the Theory/Practice Relationship• A simplistic interpretation of the Oxford findings is that the economic model
of pricing is incorrect– it is clear from the evidence that managers do not describe their pricing practices in
marginalist terms, in terms of MC=MR or in terms of elasticity and MC
– some analysts (including the original researchers and many accountants) have concluded that the MC=MR model is therefore incorrect
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• However, the conclusion that the evidence on cost-plus pricing invalidates the profit-maxing model is a misunderstanding of the relationship between models and practice.
• This is very important for general understanding and can be approached in a number of ways
• First– the profit-maxing model can be re-written in cost-plus form
(P-MC) = 1 is the same as P = MC . (Ed)
– P Ed (Ed -1)
– If average variable cost is constant (which is often assumed in management accounting) then AVC = MC
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The Marginal Pricing Model is Equivalent to a Cost-Plus Model in Many Common Circumstances
If AVC is constant , therefore = MC the profit-max model can be re-written:
P = AVC. (Ed) Average cost plus a margin
(Ed -1)
Calculate the margin when elasticity takes the following values• 1.2 P = AVC.1.2/.2 = AVCx6 Margin
= 600%
• 2.5 P = AVC.2.5/1.5 = AVCx1.66 - Margin = 66%
• 3 P = AVC.3/2 = AVCx1.5 Margin = 50%
• 10 P = AVC 10/9 = AVCx 1.11 Margin = 11%
(Why can we not find a value if elasticity is less than 1?) If managers use margins which are consistent with these values,
they are profit-maximising
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But That Is Not the Most Important Point• Close examination shows that
– rigid cost plus pricing must lead to irrational results. Managers would be stupid to use it
– in practice, firms do take other factors into account, which allows them to approximate the profit-maxing solution
Why Is Rigid Cost-plus Pricing Irrational?
• There is a circularity problem. In many circumstances cost per unit depends on the volume of output sold. But the volume of output sold depends upon the price!.
– Unless cost is constant over a very wide range of output a firm does not know its cost per unit until it knows the price !
• Cost-plus pricing completely ignores the demand side and the behaviour of customers and competitors For instance:
– if my competitors lower their prices, how would a cost-plus price change?
– if demand increases how will my cost plus price change?
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Why Is Rigid Cost-plus Pricing Irrational?• If my competitors lower their prices, my sales volume will fall. That will
increase my cost per unit.
• IF I USE COST-PLUS PRICING, I WILL RAISE MY PRICE!
• If demand increases and my sales volume increases, my costs will usually fall.
• IF I USE COST-PLUS PRICING I WILL LOWER MY PRICE!
• NOTICE THAT THE PROFIT-MAXING, MC=MR MODEL GIVES MUCH BETTER PREDICTIONS OF FIRMS’ BEHAVIOUR THAN A COST-PLUS ‘MODEL’ OF PRICING!
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What Can We Conclude on the Cost-Plus Practice Versus MC=MR Theory? The theory is not supposed to describe pricing practices. It
should be no surprise that it does not.
The purpose of the MC=MR theory is to predict how firms will change their prices when cost and demand conditions change. The predictions make more sense, and are more accurate than those derived from a ‘cost-plus’ theory of price.
Managers are not dumb. They do not use cost-plus in a rigid way and they do not have the accurate information needed to do an MC= MR calculation. They feed their experience and knowledge into a complex decision-making process and in the end often behave ‘as if’ they were fully-informed maximisers.
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Pricing Methods II:Other Approaches• Target return pricing - identify target profit and set the margin
equal to that required to provide the target profit
• Going rate pricing - behave as a price-taker
• Sealed bids - for auctions
Transfer Pricing• How to set prices for internal transfers so that divisions taking their
own decisions will bring maximum profit to the firm as a whole?– If there is no external market for the intermediate product the amount
of that product that the final producing division wishes to purchase must correspond to the profit-maxing output for the firm as a whole
– if there is an intermediate market for the product the final production division can buy on the open market as well as acquire in-house. Transfer price is the market price
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Pricing in Public Enterprise The basic rule? Set price equal to marginal cost? But which marginal cost - long-run or short-run? It doesn’t matter if you have the appropriate set of plant and equipment
because in that case SMC =LMC
What about surpluses or deficits?– If there are scale economies at the optimal level of output, MC pricing must lead to
losses (and vice versa for diseconomies)
– Some planning theorists hoped that losses and gains would just balance out!
– If a public enterprise makes losses it might be because of the pricing rule, or it might be due to inefficiency - difficult to tell the difference
• The second-best problem - if there are ‘n’ conditions for an optimum and 1 cannot be achieved - the others may be redundant
If MC pricing in all industries is optimal but it is impossible in one industry - MC pricing may not be optimal in the others - VERY DESTRUCTIVE OF THE PRICING RULE
But a partial approach may be possible. If the price of oil is too high, oil output will be too low and coal and gas output will be too high. Therefore ‘lean’ against the distortion by also raising their prices>MC
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Investment TheoryInvestment is the change in capital stock during a period.
Consequently, unlike capital, investment is a flow term and not a stock term
Capital is the stock of assets that will generate a flow of income in the future.
Capital budgeting is the planning process for allocating all expenditures that will have an expected benefit to the firm for more than one year.
The investment flow at time period t can be defined as
It = Kt – Kt-1
Kt is the stock of capital at the end of
period t and Kt-1 is the stock of capital at
the end of period t-1
Theory
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Investing Defined
?
??To consume, to save, or to invest
a dollar that is earned ?
Both saving and investing amount to consumption shifting through time.However, investing is risky, saving is not.
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Criterion
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Three Reasons for Investing
Why invest ???
People invest to …
supplement their income
earn capital gainsAppreciation is an increase in the value of an investment.
experience the excitement of the investment process
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Criterion
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The Academic Study of Investments
Theoretical research builds mathematical models and proposes pricing relationships rather than studying actual market data.
E.g. arbitrage relationships, impact of stock splits and cash dividends on investors
Theoretical models are tested by conducting empirical research.
Theory
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An anomaly is an observed result that defies explanation within the known theoretical framework.
Empirical research uses actual market data rather than mathematical models.
The Academic Study of Investments
The investment community can learn much from both rigorous academic research and from the life experiences of people on the
front lines of the marketplace.
vs.
Professors Practitioners
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Risk&ReturnThe Relationship between Risk and Return
ExpectedReturn
RiskRisk-free Return
Riskier securities have higher expected returns.
Theory
Risk&Return
Alternatives
Criterion
Management
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Risk&ReturnThe Relationship between Risk and Return
Empirical financial research reveals clear evidence of the direct relationship between systematic risk and expected return.
ExpectedReturn
Risk
SmallCompany Stocks
LargeCompany Stocks
Long-term Government BondsT-bills
Inflation
Long-term Corporate Bonds
Theory
Risk&Return
Alternatives
Criterion
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Risk&ReturnHolding period = return
Ending Beginning value value Income
Beginning value
_+
The simplest measure of return is the holding period return.
Buy 100 shares at $25 per share
Time
Dividend of $0.10 per share
Sell the sharesat $30 per share
Holding period return = = 20.4%$30 - $25 + $0.10
$25
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Criterion
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Alternative States of Information
Certainty: we have perfect information about future outcomes
Risk: we know what future outcomes are possible and we can attach probabilities to each outcome
Uncertainty: we do not know the precise nature of the outcomes or their probabilities
Risk&ReturnTheory
Risk&Return
Alternatives
Criterion
Management
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Risk&ReturnExpected Monetary Values (EMV) In a situation of RISK we could use Expected Monetary
Values (EMV) to take a decision EMV = piVi Where:
pi = probability of the i’th outcome
Vi = value of the i’th outcome
Weather Probability Takings
Sunny 0.2 $500
Cloudy 0.4 $300
Raining 0.4 $100
EMV = ?
Example:
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Criterion
Management
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Risk&ReturnEMV- Limitations of EMV Will you accept a 50/50 bet for $5? Probably YES Will you accept a 50/50 bet for $5m? Probably NO BUT BOTH HAVE AN EMV = 0! In some way you ‘care’ more about losing $5m than winning
$5m Your house is worth $200,000 The probability of destruction by fire is 1/10,000 EMV of the loss = $20 So $20 is the most you will pay for insurance? NO, YOU CARE MORE ABOUT THE CHANCE OF LOSING
YOUR HOUSE
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Risk&ReturnEMV- Limitations of EMVHow to Take This Into Account Decision-makers have different ‘attitudes to risk’ RISK NEUTRAL - values gains and losses equally RISK AVERSE - values losses more highly than gains RISK LOVER - values gains more than losses
A Risk-Averse Person
Utility
Income
• A Risk-Neutral Person
Income
Utility Utility
Income
A Risk-Lover
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Risk&Return
Alternatives
Criterion
Management
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Decision-makers Are Usually Assumed to be Risk-averse • Instead of using EMV, use Expected Utility (EU)
• EU = piUi Where:
– pi = probability of the i’th outcome
– Ui = utility of the i’th outcome
Risk&Return
The Expected Value of Information• EVPI = difference between the expected value of future actions, given the information
currently available, and the expected value of future action, if perfect advance state revelation were available
Techniques for Coping with Uncertainty
• If we do not know the possible outcomes, there is little we can do
• If we know the possible outcomes, but not their probabilities, a number of techniques are possible
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Risk&ReturnMinimax CriterionActions States of Nature
A B C
1 20 40 180
2 -40 100 220
3 60 70 90
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Investment AlternativesAssets
financial assets real assets e.g. bond, stock e.g. land
Assets are things that people own.Financial assets have a corresponding liability, while real assets do not.
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Criterion
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Securities
Derivative Assetse.g. futures, options
Fixed IncomeSecurities
e.g. bonds,preferred stock
EquitySecurities
e.g. common stockInve
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Investment Alternatives
Securitization is the process of converting an asset or collection of assets into a more marketable form.
A security is a legal document that shows an ownership interest.
Securities are historically associated with financial assets, but are also applicable to real assets.
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Investment AlternativesMajor Classes of Financial Securities
Debt
Money market instruments
Bonds
Common stock
Preferred stock
Derivative securities
Markets and Instruments
Money Market
Debt Instruments
Derivatives
Capital Market
Bonds
Equity
Derivatives
Theory
Risk&Return
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Investment AlternativesMoney Market Instruments
Treasury bills
Certificates of deposit
Commercial Paper
Bankers Acceptances
Eurodollars
Repurchase Agreements (RPs) and Reverse
RPs
Federal Funds
Capital Market: Equity
Common stock
Residual claim
Limited liability
Preferred stock
Fixed dividends - limited
Priority over common
Tax treatment
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Risk&Return
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Investment Management
FIVE STEP PROCEDURE:– SETTING INVESTMENT POLICY
– PERFORMING SECURITY ANALYSIS
– CONSTRUCTING A PORTFOLIO
– REVISING THE PORTFOLIO
– EVALUATING THE PORTFOLIO
TRADITIONAL INVESTMENT MANAGEMNT ORGANIZATIONS– Security Analysts play a key role and rely upon information and reports
from• economists
• technicians
• market experts
– Investment Committee is advised by the analyst to create
– An Approved List of Securities
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Investment ManagementSETTING INVESTMENT POLICY DETERMINE THE INVESTMENT OBJECTIVE
estimate the client’s level of risk tolerance
PERFORMING SECURITY ANALYSIS Security Selection: A 2 Stage Procedure
STAGE I: forecast• expected returns• standard deviation• covariances• identify optimal portfolio
STAGE II: Asset Allocation• strategic
– refers to how a portfolio’s funds would be divided, given the manager’s long-term forecasts from Stage I
• tactical– given short-term forecasts, who will assets be allocated at any one time
– 90% + 90%0%
Average Standard
Series Annual Return Deviation Distribution
Large Company Stocks 13.0% 20.3%
Small Company Stocks 17.7 33.9
Long-Term Corporate Bonds 6.1 8.7
Long-Term Government Bonds 5.6 9.2
U.S. Treasury Bills 3.8 3.2
Inflation 3.2 4.5
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Investment ManagementREVISING THE PORTFOLIOUse Cost-Benefit Analysis transaction costs should be examined since they complicate the management decision portfolio revisions must be weighed against the cost of revision particularly with regard
to transaction costs
Swap Methodology a cost saving method which involves exchanges of assets rather than purchases or sales TYPES OF SWAPS:
EquityThe Agreement» one party agrees to pay the other a variable-sized cash payment» the other party agrees to a fixed-sized cash paymentResults in a restructured portfolio without incurring any transaction costs
Interest RateThe Agreement» one party pays the second a variable-sized stream of cash based on the current level of
an agreed-upon interest rate (e.g. LIBOR)» second party pays the first a fixed-sized payment stream based on the interest rate at
the time of the AgreementResults in a restructured portfolio without incurring any transaction costs
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Common Methods of Appraisal
The common methods are:
• PAYBACK
• DISCOUNTED PAYBACK
• RETURN ON INVESTMENT
• INTERNAL RATE OF RETURN
• NET PRESENT VALUE
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•PAYBACKPayback period is the amount of time sufficient to cover the initial cost of an investment.
But it ignores any returns accrue after the pay-back period; ignores the pattern of returns; ignores the time value (time cost) of money.
Example:
Initial investment: $10 millionCash flow: $2 million per year
Payback-period?
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RETURN ON INVESTMENT• Accept a project of the Return on Investment is greater than an agreed
target return
• Note that there is no economically defensible way to estimate the cut-off rate
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INTERNAL RATE OF RETURN
• Accept a project of the Internal Rate of Return exceeds the opportunity cost of capital
• Note that the opportunity cost of capital is economically defensible because it relates to the risk of the project
Internal rate of return (IRR) is the rate of return that will equate the present value of a multi-year cash flow with the cost of investing in a project.
Using the NPV equation: the IRR is the discount rate that renders the NPV of the project equal to zero.
Theory
Risk&Return
Alternatives
Criterion
Management
FDI
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NET PRESENT VALUE• Accept a project if the NPV is greater than zero when discounted at
the opportunity cost of capital
• Note that the NPV is economically defensible because it uses the opportunity cost of capital
The present value of a single future amountThe present value of a single future amount
In general, present value (PV) refers to the value now of payments to be received in the future (I). The present value of I after n year at r is:
I
(1+r)nPV=
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Risk&Return
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Criterion
Management
FDI
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NET PRESENT VALUE
NPV = -P + I0 +I1
(1+r)
I2
(1+r)2+ … ++
In
(1+r)n
NPV = -P +I
r
where:
P: =capital cost, accruing in full at the beginning of the project
I1,2,…n =net cash flows arising from the project in years 1 to n
r =the opportunity cost of capital
or
Theory
Risk&Return
Alternatives
Criterion
Management
FDI
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Foreign Direct InvestmentTheory
Risk&Return
Alternatives
Criterion
Management
FDI What is FDI?FDI (Foreign Direct Investment):
• « Direct investment is the category of international investment that reflects the objective of obtaining a lasting interest by a resident entity in one economy (the direct investor) in an enterprise (foreign direct investment enterprise) resident in another economy. » (IMF)
• « Foreign direct investment (FDI) occurs when a foreign investor develops a long term relationship with a domestic enterprise and owns enough of the equity of the enterprise to exercise a significant degree of influence on the management of the enterprise » (IMF)
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Foreign Direct InvestmentTheory
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Criterion
Management
FDI
Meaning of Foreign Direct Investment (FDI)Concept of control Control must accompany the investment 100 percent share does not guarantee control
government intervenes in company operations Direct investment usually implies an ownership share of 10 – 25 %
Concern about control Government concern—when foreign investors control a company,
decisions of national importance may be made abroad Investor concern—transfer of resources to acquiring company
appropriability theory—company receiving resources may undermine the competitive position of the transfer company
Internalization—control by self-handling of foreign operations, usually down the supply chain
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Management
FDI
FDI Today: The differencesThe new determinants of FDI location: Policy liberalization Rapid technical progress New management and organizational techniques
Yesterday: Economic factors were critical
Today : New variables increase the complexity of FDI
FDI RequirementsFactors of decision: Large domestic markets Abundance of natural resources Cheap labour
These conditions are required to make a FDI in a host country.
However, these motivations belong to the Old Economy.
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Criterion
Management
FDI
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Foreign Direct InvestmentTheory
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Management
FDI
OECD Survey, 1999
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FDI
OECD Survey, 1999
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FDIFDI & Competition
FDI & Economic Growth
OECD Survey, 1999
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FDI
Technology transfers
The most enduring potential benefit to developing countries from inward direct investment is the transfer of technology. Exports can drive rapid economic growth over long period, but technology transfers can do much more to promote sustainable development by enhancing indigenous capabilities. In this area, the record from decades of FDI in the ASEAN4 is not encouraging. Possible remedies for this situation will be discussed later.
FDI and exports
The experience of successful ASEAN countries amply demonstrates how FDI can play a leading role in bringing about rapid, export-led growth. Rapidly rising exports have fuelled the world’s fastest growth rates in some of these economies which, until recently, had made them the envy of the developing world. But economic development is more than growth, as the crisis has made abundantly clear.
FDI as a form of development finance
The crisis has brought into relief the importance of FDI as a stable source of finance for development compared to other forms of international capital flows. Foreign direct investment in Asia has so far held up very well, in spite of the crisis, while other capital flows have reversed themselves
The impact of FDI on ASEAN4 development
OECD Survey, 1999
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FDI
Thailand 17 177
Malaysia 35 177
Indonesia 23 684
Philippines 8 379
OECD Survey, 1999
Total FDI inflows by country, 1990-97
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Pro
d uct
Qu
a lit
y &
Com
peti
tive
Str
ateg
yWhat Is Strategy?
Strategy as purposive action – the resource allocations that firms plan and implement in order to position themselves in markets and to compete with other
Strategy as the ‘fit’ between a firm’s use of resources and its environment
Strategy as an ongoing, unplanned and ‘unintended’ process of interaction between the firm’s internal structures and its environment
Strategy is a deliberate search for a plan of action that will develop a business’s competitive advantage and
compound it
Strategy as a:
Plan
Ploy
Pattern
Position
Perspective
Strategy as a:
Plan
Ploy
Pattern
Position
PerspectiveHenry Mintzburg
Jeffrey Kaufmann:
Howard Davies and Pun-Lee Lam
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Elements of Competitive Advantage
Sources of Advantage
•Superior Resources•Superior Capabilities
Positional Advantages
•Superior Cust. Value•Lower Relative Cost
Performance Outcomes
•Customer Satisfaction•Customer Loyalty•Market Share•Profitability
Investment to Sustain Competitive Advantage
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d uct
Qu
a lit
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Com
peti
tive
Str
ateg
y Your Competitive Positioning
• Who are your competitors?
• Are you the market leader?
• If not, how can you become the market leader?
• If yes, how do you remain the market leader?
• Who: Who are you?• What: What business are you in?• For whom: What people do you serve?• What need: What are the special needs
of the people you serve?• Against whom: With whom are you
competing?• What’s different: What makes you
different from those competitors?• So: What’s the benefit? What unique
benefit does a client derive from your product?
- Harry BeckwithSelling the Invisible
A PositioningStatement
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Pro
d uct
Qu
a lit
y &
Com
peti
tive
Str
ateg
y Postioning TemplateFor (Target Customers)Who (Have a Problem)Our Product (Is a new Category)That Provides (Breakthrough Results)Unlike (Reference
Competitor)Our Product (Key Differentiators)
Geoff Moore
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Str
ateg
y 5 Generic Competitive Strategies
OVERALL COSTLEADERSHIPSTRATEGY
FOCUSEDLOW-COSTSTRATEGY
FOCUSEDDIFF.
STRATEGY
BROAD DIFFERENTIATION
STRATEGYBESTCOST
PROVIDERSTRATEGY
TYPE OF COMPETITIVE ADVANTAGE BEING PURSUED
Lower Cost Differentiation
MARKET TARGET
Broad buyersegment
Narrow buyer segment
PORTER, 1980.
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Peter Duncan (2001)
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