managerial economics pricing program pascasarjana, universitas gunadarma, magister management, budi...

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





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.”





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





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





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





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.





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





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.





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

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





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





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





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


Use of economics concepts and decision making tools to solve managerial decision problems


Use of economics concepts and decision making tools to solve managerial decision problems

Optimal solutions Optimal solutions





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





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





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





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





• 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?





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

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ergerM

NE





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

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NE





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

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ergerM

NE

Which Approach is Most Useful?




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

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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

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NE





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





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

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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

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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

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NE

The costs of transacting inside firm rise with:





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

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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

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NE




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

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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

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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





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

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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

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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

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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

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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

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ergerM

NE





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

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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





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





Pr o

duct

ion

&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





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





Pr o

duct

ion

&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 :





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





Pr o

duct

ion

&C

ost

Production&Cost

Average & Marginal CostS

hor

t R

un





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




Introduction The Firm ConsumerProduction&Cost Demand The MarketC

onsu

mer

Beh

aviu

or T

heo

ryC

onsu

mer

The Main ApproachesUtility TheoryIndifference AnalysisRevealed PreferenceThe Characteristics Approach

Character.RevealedIndifferenceUtility




Introduction The Firm ConsumerProduction&Cost Demand The MarketB

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






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





Introduction The Firm ConsumerProduction&Cost Demand The MarketIn

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)





Introduction The Firm ConsumerProduction&Cost Demand The MarketIn

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






Con

sum

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 :






Con

sum

er

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






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






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






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)





Dem

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





Dem

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.





Dem

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





Dem

and

Price

Quantity

1

2

p0

q0

p1

q1

12 >

If demand is price-elastic, decrease the price to gaining higher revenue





Dem

and

Price

Quantity

1

2

p0

q0

p1

q1

12 <

If demand is price-inelastic, lower

prices will decreases revenue





Dem

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





Dem

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?





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





Dem

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





Dem

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





Dem

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





Th

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





Th

e M

arke

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





Th

e M

arke

tPerfect Competition: Short Run

• Industry Firm

P P

Q Q

D

S

P

q0 q1 q2

P2

P1 D=AR=MR

SMC





Th

e M

arke

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





Th

e M

arke

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





Th

e M

arke

t

Monopoly• A monopolist produces less and charges a higher price,

relative to the socially optimal

Pmonopoly

Qmonopoly

Psocially

optimal

Qsocially optimal

MC

Demand





Th

e M

arke

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?





Th

e M

arke

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





Th

e M

arke

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





Th

e M

arke

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





Th

e M

arke

tFeatures of the four market Features of the four market structuresstructuresFeatures of the four market Features of the four market structuresstructures





Pr i

cin

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





Pr i

cin

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





Pr i

cin

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





Pr i

cin

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





Pr i

cin

gP

rici

ng

in P

ract

ice

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





Pr i

cin

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

Pri

cin

g in

Pra

ctic

e

• 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





Pr i

cin

gP

rici

ng

in P

ract

ice

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





Pr i

cin

gP

rici

ng

in P

ract

ice

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?





Pr i

cin

gP

rici

ng

in P

ract

ice

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!





Pr i

cin

gP

rici

ng

in P

ract

ice

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.





Pr i

cin

gP

rici

ng

in P

ract

ice

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





Pr i

cin

gP

rici

ng

in P

ract

ice

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





Inve

stm

ent

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

Risk&Return

Alternatives

Criterion

Management

FDI





Inve

stm

ent

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.

Theory

Risk&Return

Alternatives

Criterion

Management

FDI





Inve

stm

ent

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

Theory

Risk&Return

Alternatives

Criterion

Management

FDI





Inve

stm

ent

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

Risk&Return

Alternatives

Criterion

Management

FDI





Inve

stm

ent

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

Theory

Risk&Return

Alternatives

Criterion

Management

FDI





Inve

stm

ent

Risk&ReturnThe Relationship between Risk and Return

ExpectedReturn

RiskRisk-free Return

Riskier securities have higher expected returns.

Theory

Risk&Return

Alternatives

Criterion

Management

FDI





Inve

stm

ent

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

Management

FDI





Inve

stm

ent

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

Theory

Risk&Return

Alternatives

Criterion

Management

FDI





Inve

stm

ent

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

FDI





Inve

stm

ent

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:

Theory

Risk&Return

Alternatives

Criterion

Management

FDI





Inve

stm

ent

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

Theory

Risk&Return

Alternatives

Criterion

Management

FDI





Inve

stm

ent

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

Theory

Risk&Return

Alternatives

Criterion

Management

FDI





Inve

stm

ent

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

Theory

Risk&Return

Alternatives

Criterion

Management

FDI





Inve

stm

ent

Risk&ReturnMinimax CriterionActions States of Nature

A B C

1 20 40 180

2 -40 100 220

3 60 70 90

Theory

Risk&Return

Alternatives

Criterion

Management

FDI





Inve

stm

ent

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.

Theory

Risk&Return

Alternatives

Criterion

Management

FDI





Securities

Derivative Assetse.g. futures, options

Fixed IncomeSecurities

e.g. bonds,preferred stock

EquitySecurities

e.g. common stockInve

stm

ent

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.

Theory

Risk&Return

Alternatives

Criterion

Management

FDI





Inve

stm

ent

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

Alternatives

Criterion

Management

FDI





Inve

stm

ent

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

Theory

Risk&Return

Alternatives

Criterion

Management

FDI





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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

Theory

Risk&Return

Alternatives

Criterion

Management

FDI





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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

Theory

Risk&Return

Alternatives

Criterion

Management

FDI





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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

Theory

Risk&Return

Alternatives

Criterion

Management

FDI





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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

Theory

Risk&Return

Alternatives

Criterion

Management

FDI





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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?

Theory

Risk&Return

Alternatives

Criterion

Management

FDI





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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

Theory

Risk&Return

Alternatives

Criterion

Management

FDI





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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=

Theory

Risk&Return

Alternatives

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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Risk&Return

Alternatives

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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Risk&Return

Alternatives

Criterion

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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Risk&Return

Alternatives

Criterion

Management

FDI





Inve

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Risk&Return

Alternatives

Criterion

Management

FDI

OECD Survey, 1999





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Risk&Return

Alternatives

Criterion

Management

FDIFDI & Competition

FDI & Economic Growth

OECD Survey, 1999





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Risk&Return

Alternatives

Criterion

Management

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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Risk&Return

Alternatives

Criterion

Management

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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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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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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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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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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