managerial economics lecture firm alternative

8/8/2019 Managerial Economics Lecture Firm Alternative

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Managerial Economics

Lecture Four:

Alternative theories of thefirm, pricing, & profits



Recap

Last week

² Institutional (Galbraith), Post Keynesian, Sraffiantheories of price

² Schumpeter·s model Accepts (wrongly) absence of profit in equilibrium

Builds model of disequilibrium source of entrepreneurialprofit from² New goods² New production methods² New markets

² New raw materials² New industrial combinations Assumes (1) not done by existing firms; (2) uses existing

resources (labour & capital)



Schumpeter·s model

First stage:

² To innovate, need concept and resources to put it into effect² But new firm has no retained earnings from which to buy them² Hence new firm needs credit«

Second Stage:² ´To provide this credit is clearly the function of that category of

individuals which we call "capitalists".µ (69) We would call these ´venture capitalistsµ today² OR ´the creation of purchasing power by banks « It is always a

question, not of transforming purchasing power which alreadyexists in someone's possession, but of the creation of newpurchasing power out of nothing « which is added to the existing

circulation. And this is the source from which new combinationsare often financed«µ (73) ¶The banker« has himself become the capitalist par

excellence«· (1936: 74)



Schumpeter·s model

´The carrying out of new combinations we call "enterprise"; the

individuals whose function it is to carry them out we call"entrepreneurs."µ (74)

² Not the same as managers of firms in static theory:

´The tendency is for the entrepreneur to make neither profitnor loss in the circular flow - that is he has no function of a

special kind there, he simply does not exist; but in his stead,there are heads of firms or business managers of a differenttype which we had better not designate by the same term«the Marshallian definition of the entrepreneur, which simplytreats the entrepreneurial function as "management" in thewidest meaning, will naturally appeal to most of us. We do not

accept it, simply because it does not bring out what weconsider to be the salient point and the only one whichspecifically distinguishes entrepreneurial from otheractivities.µ (76-77)

Entrepreneurial decision-making fundamentally different to

neoclassical vision of profit-maximising decision-making



Schumpeter·s model

Conventional economic ´profit maximisationµ emphasises

rational calculation² Thomas & Maurice 2003, Managerial Economics, p. 450

´a manager must answer two questions « Produce aslong as the market price is greater than « minimumaverage variable cost « Produce the output at which

market price (which is marginal revenue) equalsmarginal costµ Not possible for entrepreneurial decisions:

² ´What has been done already has the sharp-edgedreality of all the things which we have seen andexperienced; the new is only the figment of ourimagination. Carrying out a new plan and actingaccording to a customary one are things asdifferent as making a road and walking along it.µ(p.85)

Empirically &Empirically &theoretically wrongtheoretically wrong

anyway« seeanyway« seeprevious lectures!previous lectures!



Technological innovation

Innovations revolutionise production in waysInnovations revolutionise production in ways

even innovators can·t foresee«even innovators can·t foresee«²² 19541954 expertexpert vision of 2004 ´home computerµvision of 2004 ´home computerµ



Schumpeter·s model

Future impact of new product fundamentally uncertain

´Rational calculationµ (e.g., assessing NPV) hardly possible& maybe counterproductive² ´Of course he must still foresee and estimate on the

basis of his experience. But many things must remainuncertain, still others are only ascertainable withinwide limits, some can perhaps only be "guessed." «Thorough preparatory work, and special knowledge,breadth of intellectual understanding, talent forlogical analysis, may under certain circumstances besources of failure.µ (85)

Very similar to Keynes·s ´animal spiritsµ Given 1st 3 stages fulfilled: (1) concept backed by (2)

credit, (3) carried to fruition by entrepreneur; we get acyclical economic process«



Schumpeter·s model

Cycles considered later in economy section of subject

Here the pricing/strategy issue² How can entrepreneur borrow money, produce new

commodity/new production method etc., and still makea profit?

Essential ́ systemicµ reason: creation of new credit byloan from bank/[venture] capitalist affects economicsystem. Injection of new spending power will, amongstother things, ´affect the price levelµ (74)

Technological innovation gives innovator cost advantageover incumbents«



Schumpeter·s model

Éntrepreneurial profit is a surplus over costs. From the

standpoint of the entrepreneur, it is the differencebetween receipts and outlay in a business.µ (128)² Schumpeter argues this does not exist in equilibrium in

the ćircular flowµ: ín the circular flow the totalreceipts of a business³abstracting from monopoly³

are just big enough to cover outlays. In it there areonly producers who neither make profits nor sufferlosses and whose income is sufficiently characterisedby the phrase "wages of management."µ (129)

But entrepreneur (if successful!) uses technologies etc.

that are s uperior to those in ćircular flowµ; ´since thenew combinations « are necessarily more advantageousthan the old, total receipts mus t in this case be grea ter than total cos ts .µ (129)



Schumpeter·s model

Schumpeter·s example: the powerloom

² 1st major step in automation of industry: replacinghand weaving with mechanised production of cloth

² Has taken many forms over the years« From the original design

And the original sweatshops«



Technological innovation

To the more advanced

And its sweatshop«

To today·s ´high techµ

And «

And what tomorrow:bioengineering? nanotech?



Profits from innovation if« ´If anyone in « the textile industry « with hand labor sees the

possibility of « powerlooms,... borrows « from a bank andcreates his business... If a worker « is now in a position toproduce six times as much as a hand-worker in a day, « giventhree conditions the business must yield a surplus over costs

First, the price of the product must not fall when the newsupply appears, or else not fall to such an extent that thegreater product per worker brings no greater receipts now «

Secondly, the costs of the powerloom per day must « remainbelow the daily wages of the five workers dispensed with «

The third condition ... If his demand is [not] relatively small «then the prices of « labor and land rise because of the newdemand. ... therefore the businessman, « must add an

appropriate amount, so that yet a third item must bededucted. Only if the receipts exceed outlays after allowing for all three

sets of changes is there a surplus over costs.µ (129-130)



Profits from innovation if«

Process: Current production requires 6 workers costing

$100 per day + machine depreciation $100 per day

New machine reduces labourneed to one

² But bids wages up $1/day

² $100 rise in depreciation

Extra supplier drives price down (say $1/days output) Surplus ($398) minus interest payments is entrepreneur·s

profit

² Profit falls as more producers adopt new technology«



Schumpeter·s model

Evolutionary basis to thinking:

² ¶the evolutionary idea is now discredited in our field«with all the hasty generalisations in which the word´evolutionµ plays a part, many of us have lost patience.We must get away from such things« then two factsstill remain:

first the fact of historical change... [and that] These changes constitute neither a circular process nor

pendulum movements about a centre.· (1936: 57-58) Economic evolution & hence development is

² ¶spontaneous and discontinuous changespontaneous and discontinuous change in the channelsof the flow, disturbance of equilibrium, which foreveralters and displaces the equilibrium state previouslyexisting.' (1936: 64)



Schumpeter·s model

Entrepreneur as agent of evolutionary change:

² ¶The carrying out of new combinations we call´enterpriseµ; the individuals whose function it is tocarry them out we call ´entrepreneursµ.· (1936: 74)

Net profit emanates from development² ´he has, if everything has gone according to

expectations, enriched the social stream with goodswhose total price is greater than the credit receivedand than the total price of the goods directly andindirectly used up by him...

² Furthermore, the entrepreneur can now repay his debt(amount credited plus interest) at his bank, andnormally still retain a credit balance (=entrepreneurialprofit) that is withdrawn from the purchasing powerof the circular flow.µ (110-111)



Schumpeter·s model

Net credit (credit in excess of asset backing) arises

from development:² ´money, and « other means of payment « perform an

essential function, «

² processes in terms of means of payment are not

merely reflexes of processes in terms of goods« (95)«² in real life total credit must be greater than it could

be if there were only fully covered credit«µ (101) Contra standard neoclassical ´money as veil over barterµ

conclusion solely because dynamic, disequilibrium analysisvs conventional static equilibrium thinking

Disruption to equilibrium, net entrepreneurial profit, netcredit, leading ultimately to a new equilibrium:



Schumpeter·s model

´But now comes the second part of the drama. The spell

is broken and new businesses are continually arising underthe impulse of the alluring profit. A completereorganisation of the industry occurs, with its increasesin production, its competitive struggle, its supercessionof obsolete businesses, its possible dismissal of workers,

and so forth« the final result must be a new equilibriumposition« Consequently, the surplus of the entrepreneur in question

and his immediate followers disappears « Nevertheless, the surplus is realised « And their profit,

the surplus, to which no liability corresponds, is anentrepreneurial profit.µ (131-132)² This process occurs in cycles: considered in later

lectures



Schumpeter·s model

Power loom example ́ cost-cuttingµ

² Same product produced more cheaply Much innovation develops new product³category 1 of

Schumpeter·s means to make entrepreneurial profit

² New product steals demand from predecessors

Price can be significantly higher than old rivals² ´Early adoptersµ: willing to pay ´almost anyµ price to

secure product

Price drops significantly as product becomes standard

Continuous development needed to maintain marketshare

² Process called ́ creative destructionµ by Schumpeter:



Schumpeter·s model

Innovation ´incessantly revolutionizes the economic

structure from within, incessantly destroying the old one,incessantly creating a new one. This process of C rea tiv e D es tr uction is the essential fact about capitalism."(Schumpeter, Capitalism, Socialism, and Democracy, p.83.)

Innovation then alters system of production/consumption

² ´Logistic diffusion processµ: Low rate of initial adoption (´early adoptersµ)

Accelerated take-up by mass market (´take-offµ)

Final ceiling reached

² ´Market saturationµ; or

² Product overtaken by new one before maturity



Computer industry³Schumpeterian example

Computers classic case of Schumpeterian

process with new products rather thancost cutting

1935 IBM introduces

² 601 multiplying punch-card machine

Allows accounting to be done by lessskilled personnel

² electric typewriter Pushes previous manual typewriters

into ´old hatµ bin

² New innovation (manual/electronicoffice machines) allows rise of majorcompany (IBM)



Computer industry

New product (computers)

² Originated in UK as part of WWII² Traded with USA in return for

nuclear technology

² UK rapidly loses dominance in

computers« (Another bad trade deal with

USA«)

² IBM becomes dominant company in computers too« Produces ´mainframeµ computers

² Very big

² Very expensive

² But best way to do complex calculations, manage

large business

December 1943, UK:December 1943, UK:´Colossusµ, first all´Colossusµ, first all--electronicelectronic

(vacuum tube) computer(vacuum tube) computer



Computer industry

In 1953 IBM introduces the ́ 650µ ́ Magnetic Drum

Calculatorµ: world·s first mass-produced computer.

Component manufacturing becomesmajor IBM advantage

² If component fails, can be´unpluggedµ & replacementinstalled

² Computer continues to operatewhile problem diagnosed/fixed at

IBM factory² But opens up opportunity for

other firms to profit: ´plugcompatibilityµ«



Computer industry

Five main (but much smaller) rivals: ´the BUNCHµ

² Burroughs² Unisys² NCR (National Cash Register)² Control Data

² Honeywell Ever heard of these companies??? BUNCH ́ competesµ by producing plug compatible

components for IBM computers at lower cost² Also sometimes try producing lower performance/cost

rival computers IBM responds by making each new generation computer

incompatible with previous plug-in components



Computer industry

IBM outfoxes Bunch, but

² New rivals arise Not competing in mainframe

market but ´miniµ computers Smaller size (physical and

memory/processing power)

But cheaper, better interface,lower maintenance

First DEC (Digital EquipmentCorporation) PDP-1 in 1960

1

st

computer with keyboard & monitor input Previous magnetic, paper tape, punch cardinputs, teletype output² Remember RAND corporation 1954 vision

of ´home computerµ in 2004?



Computer industry

IBM continues to innovate in mainframes

² System/360 computer seen as 3rd generation: Magnetic storage

Terminal input (multiple terminals per computer)

Mini-computer rivals continue

to innovate² DEC PDP-8 first to use

transistors in modules

´Plug and playµ reaches newlevels«



Computer industry

Innovation also by ́ BUNCHµ

² Burroughs first to use integrated circuits in 1968² 1968 Control Data produces first supercomputer

(designed by Seymour Cray)

² But BUNCH continues to play second fiddle to IBM in

business machines IBM marketing ´No-one ever got sacked for purchasing

IBMµ dominates technical advances of rivals

IBM gradually incorporates rival advances into ownmachines

² BUT competition in innovation continues from´newcomersµ

1968: Intel formed as 3 person company«



Computer industry

1972: Intel produce 8008 ´microprocessorµ: computer on

a chip² 8 bit processor

1975: first ´microcomputerµ developed

² Altair 8800 (using successor chip to Intel 8008)

² Kit computer: components purchased by user andassembled

Major technologies now beingproduced outside ´monopolistµ IBM

IBM continues to dominatemainframes, but mainframes losingmarket share to minis and micros«



Computer industry

1976 Steve Jobs and Steve Wozniak design and build the

Apple I:

1977: Apple II debuts and becomes industry standardfor microcomputers

And also in 1977«



Computer industry

As or more important: software development

² 1979: First ´killer applicationµ the spreadsheetdeveloped on and for microcomputers: Visicalc

Ran on CP/M andeventually Apple PCs

No comparable product onmainframes/minis

Legitimises PCs in eyes ofbusiness«

IBM is in trouble So« if you can·t beat

them, join them!

Responds with

development of IBM PC Doesn·t have operating

system, so sub-contractsto«

² Microsoft



Computer industry

´Street credµ of IBM with business means IBM PCs wipe

out competitors even though many technically superior² IBM PC had 8-bit processor (8088)

Osborne had 16-bit (8086)

² IBM operating system single-user/single-tasking

Osborne used MP/M, multi-user/multi-tasking Customers· pre-existing knowledge of IBM meant technical

advantages of rivals weren·t enough for survival

1983: ´Killer Appµ introduced for IBM PC:

Lotus 123² Adds graphics to Visicalc·s tables² Starts trend of software being written

just for IBM hardware (bypassoperating system for faster processing

speed)



Computer industry

Many important competitive issues apparent here:

² Existence of ´monopolyµ doesn·t stifle innovation² But innovation often comes from new or peripheral

firms² Cooperation important as well as competition

Software company produces operating system, programstailored for particular computer hardware

Standards evolve for cross-compatibility of commoncomponents (e.g., parallel interface for printers; thenUSB; in future WSB)

² Costs would be dramatically higher (& thereforehigher prices for consumers) without this cross-competitor cooperation

² Competition still fierce, but mainly in productinnovation rather than price«




However price benefits also exist:

² US Price of desktop microcomputers fairly constantover time«

Desktop Computer Average Price

0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

1975 1980 1985 1990 1995 2000

US$

Y E a r




But ́ bang for buckµ

rising dramatically² Price per

megabyte of RAMplummets from

almost $200,000to only $10 in 25 years«

² Exponentialincrease in

storage capacityof standardcomputer

Price in $ per Meg RAM

0

50000

100000

150000

200000

250000

1970 1975 1980 1985 1990 1995 2000 2005

Year

U

$

¡

r ¢

ce¢

£

$ per ¤

eg¥

¦

¤

1

10

100

1000

10000

100000

1000000

1970 1975 1980 1985 1990 1995 2000 2005

Year

U

$




Price per megahertz

processing power alsoplummets from $1000per megahertz in 1975to less than $10 permegahertz in 1999«

Pr § ¨ © § n $ © r MHz

0

200

400

600

800

1000

1200

1400

1600

1970 1975 1980 1985 1990 1995 2000 2005

Year

U S

$

r

e in $ per M

1

10

100

1000

10000

1970 1975 1980 1985 1990 1995 2000 2005

Year

U S

$

Competitive process hasone technology dominant(mainframes), dominantfirm arises (IBM), but

then new product(minicomputer) from newrival (DEC) undercutsmarket«

Is there a pattern?...



Schumpeter·s model: addendum

Schumpeter mainly considered innovation process itself

Other issue: ´market penetration processµ² Once innovation developed & produced, over time

becomes ́ standardµ According to Schumpeter, becomes part of Walrasian

system of general equilibrium³no profit According to Sraffa/Post-Keynesians, becomes part of

input-output system (remember Blinder·s 70% of outputpurchased by other firms?)

² Priced according to needs of production system

Cost of production times markup² Quantity and price dynamics of market penetration

follow ´logistic diffusion processµ



Schumpeter·s model: addendum Market penetration question: how fast will sales of new product

grow?

² Simplest growth process exponential: ´grows at y per cent per annumµ

² Successful new product must grow faster than economy(say x% p.a.)

Impossibility of sustained c onstant growth rate

Time (Years)

0 25 50 75 100 125 150 175 200 225 250

R e a l O u t p u t P r e d i c t i o n s

0

2000000000

4000000000

6000000000

8000000000

10000000000

12000000000

14000000000

16000000000

18000000000

20000000000

22000000000

24000000000

26000000000

28000000000

30000000000Entire economy

Widgets (new product)

Can·t be sustained indefinitely² With y>x, ́ growth modelµ

predicts output of newcommodity will exceed sizeof economy!

² Modified model needed² Most accepted: logistic

diffusion Product·s success slows

its own growth

ProductDiffusion01.vsm




Logistic model based on idea of overcrowding from

population growth:² New animal in ecosystem grows exponentially to begin

with (e.g., cane toads)

² If successful, reaches ´carrying capacityµ of

ecosystem Population stops growing

Basic equation of exponential growth of widget sales is

1 d

Widgets yWidgets dt

!

Logistic equation is 1 d

Widgets y b WidgetsWidgets dt

! v




Logistic predicts

some ceiling value ofnew product sales

² Can be modified topredict (say) valuewidget sales as %of total economy

Most successfulproducts followapproximation to this

² But are thenundercut by new,rival product

Logistic growth curve

Time (Years)

0 50 100 150 200 250 300 350 400 450 500

R e a l O u t p u t P r e d i c t i o n s

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000Widgets (new product)

P odu

Di u ion02"

#

As seen with computers




So is computer industry ´competitiveµ?

² By microeconomics standards, NO Dominant company IBM

² Remember 2004 Fortune 500 listing from lastlecture?

² IBM 9th largest company in USA still Microsoft only 47th with sales of US$32

billion versus IBM at US$89 billion² Anti-competitive practices (plug incompatibility

tricks etc.)

² By consumer/other business user standards, YES Dramatic rate of development Dramatic fall in cost, rise in convenience

² So what is competition, really?

² Next week·s lecture

managerial economics lecture firm alternative

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