1. 1 Welcome to EC 209: Managerial Economics- Group A By: Dr. Jacqueline Khorassani Week Eight

2. 2 Managerial Economics Week Eight- Class 1 Monday, October 22 11:10-12:00 Fottrell (AM) 11:10-12:00 Fottrell (AM)

3. 3 This week’s Aplia Assignment IS DUE BEFORE 5:00 PM Tomoorow

4. 4 I received a question Just wondering if you could show me how to determine the marginal product of capital when given the production function and a value for both capital and labour. Just wondering if you could show me how to determine the marginal product of capital when given the production function and a value for both capital and labour.

5. 5 Sure, example 1 Suppose production function is Q = 5K + 10L. What is the marginal product of capital when 3 units of capital and 5 units of labor are employed? Suppose production function is Q = 5K + 10L. What is the marginal product of capital when 3 units of capital and 5 units of labor are employed? MP k = dQ/dK (holding labor constant) MP k = dQ/dK (holding labor constant) MP k = dQ/dK = 5 MP k = dQ/dK = 5

6. 6 Another example Suppose production function is Q = 5K 2 L 3. What is the marginal product of capital when 3 units of capital and 5 units of labor are employed? Suppose production function is Q = 5K 2 L 3. What is the marginal product of capital when 3 units of capital and 5 units of labor are employed? MP k = dQ/dK (holding labor constant) MP k = dQ/dK (holding labor constant) MP k = 5L 3 K= 5 * (5) 3 * (3)= 1875 MP k = 5L 3 K= 5 * (5) 3 * (3)= 1875

7. 7 Last time we talked about 4 types of specialized investments. What are they? 1. Site specificity. 2. Physical-asset specificity. 3. Dedicated assets. 4. Human capital

8. 8 Specialized Investments lead to higher transaction costs 1. Costly bargaining How much should you charge for the pasta that is unique? How much should you charge for the pasta that is unique? 2. Underinvestment I don’t want to learn how operate a machine that only one pasta factory uses (Underinvestment in human capital) I don’t want to learn how operate a machine that only one pasta factory uses (Underinvestment in human capital)

9. 9 Specialized Investments lead to higher transaction costs 3. Opportunism and the hold-up problem –The market price of this special pasta is €20/pound. –The restaurant spends €100 to test the pasta of your factory. –Once you know that your pasta has met their standard, you will ask for a price of €21/pound for the 50 pounds of pasta. –The manager of the restaurant may take this deal because the alternative is to spend another €100 to test some other factory’s pasta –Sunk cost becomes relevant.

10. 10 Specialized Investments and Contract Length MB 0 3yr € Contract Length 0 5yr MC MB 1 Longer Contract Due to greater need for specialized investments As the need for specialized investment increases, it is more beneficial to sign longer term contracts MB 0 is the marginal benefit of a non- specialized labor to pasta factory MB 1 is the marginal benefit of a specialized labor to pasta factory MC is marginal cost of labor to pasta factory

11. 11 Optimal Input Procurement Substantial specialized investments relative to contracting costs? Spot Exchange No Complex contracting environment relative to costs of integration? Yes Vertical Integration Yes Contract No

12. 12 Oliver Williamson’s Analysis Williamson identified and explored the impact of various factors on transaction costs and the boundaries of the firm. Williamson identified and explored the impact of various factors on transaction costs and the boundaries of the firm. Transaction cost economics views firms and markets as alternative governance structures designed to manage transactions. Transaction cost economics views firms and markets as alternative governance structures designed to manage transactions.

13. 13 Oliver Williamson’s Analysis 1. Market transactions will be avoided when the potential for opportunistic behaviour is greatest. If the pasta factory would want to charge much higher price  The restaurant should get its own pasta machine If the pasta factory would want to charge much higher price  The restaurant should get its own pasta machine 2. Markets rely on formal contracts but formal contracts are typically incomplete What if the pasta machine breaks down? What if the pasta machine breaks down? 3. Firms may rely on relational contracts (informal agreements not adjudicated by courts – social capital) Somehow we will deal with it later Somehow we will deal with it later

14. 14 The Principal-Agent Problem Occurs when the principal cannot observe the effort of the agent. Occurs when the principal cannot observe the effort of the agent. –Example: Shareholders (principal) cannot observe the effort of the manager (agent). –Example: Manager (principal) cannot observe the effort of workers (agents).

15. 15 The Principal-Agent Problem Problem Problem –Principal cannot determine whether a bad outcome was the result of the agent’s low effort or due to bad luck. Managers must recognize the existence of the principal-agent problem and devise plans to align the interests of workers with that of the firm. Managers must recognize the existence of the principal-agent problem and devise plans to align the interests of workers with that of the firm. Shareholders must create plans to align the interest of the manager with those of the shareholders. Shareholders must create plans to align the interest of the manager with those of the shareholders.

16. 16 Solving the Problem Between Owners and Managers 1. Internal incentives –Stock options, year-end bonuses. 2. External incentives –Personal reputation. –Potential for takeover.

17. 17 Managerial Economics- Group A Week Eight - Class 2 Week Eight - Class 2 –Tuesday, October 16 –Cairnes –15:10-16:00 Aplia assignment is due before 5PM today Aplia assignment is due before 5PM today

18. 18 Last time we talked about The Principal-Agent Problem The Principal-Agent Problem Let’s see it graphically Let’s see it graphically

19. 19 Indifference Curve Approach to Managerial Incentives (Appendix of Chapter 6) The indifference curve shows different combinations of income and leisure on the job that satisfy the manager the same. The indifference curve shows different combinations of income and leisure on the job that satisfy the manager the same. Suppose manager’s salary is €50,000 and it is fixed Suppose manager’s salary is €50,000 and it is fixed Will he shirk 5 hours or 8 hours a day? Will he shirk 5 hours or 8 hours a day? –8 hours a day, if he shirks 5 hours a day he will be on a lower indifference curve income Shirking (leisure on the job) I II 8 5 €50,000 A C

20. 20 Profit sharing scheme Now Suppose the owner offers the manager a fixed salary of €50,000 plus a bonus of 1% of profits. Now Suppose the owner offers the manager a fixed salary of €50,000 plus a bonus of 1% of profits. –Suppose 1.If manager does not shirk, profits will be €3,000,000 – manager can earn up to €80,000 2.Every hour that he does not shirk, he can earn €3750 extra –Shirking declined by ________ hours income Shirking (leisure on the job) II 8 2 €50,000 III € 80,000 Manager’s opp set Slope = 3750 €72,500 A B 6

21. 21 Solving the Problem Between Managers and Workers 1. Profit sharing 2. Revenue sharing 3. Piece rates Wage rate is not per hour it is per unit of production Wage rate is not per hour it is per unit of production 4. Time clocks and spot checks

22. 22 Managerial incentive schemes (Jensen’s paper on balckboard) Ok then to increase manager’s productivity we must Ok then to increase manager’s productivity we must –tie the compensation of the top managers of a firm to the share price of the firm thereby aligning the interests of the top managers with those of the equity holders. –Stock options are used because the market price of shares accurately captures how the firm is doing. Market prices are set by rational investors interested in predicting the future value of the firm.

23. 23 But the idea that the market price of equity reflects the true value of the firm is flawed The market price of a firm’s equity reflects the information that equity markets possess. The market price of a firm’s equity reflects the information that equity markets possess. Equity is overvalued when the a firm’s share price is higher than its underlying value. A firm’s share price should reflect the present value of future earnings. Equity is overvalued when the a firm’s share price is higher than its underlying value. A firm’s share price should reflect the present value of future earnings. Top managers can manipulate financial statements and, for a while at least, share prices. Top managers can manipulate financial statements and, for a while at least, share prices.

24. 24 How? Various ways in which earnings can be managed. For example, revenues that are expected to accrue in future years could be counted in the current year. Various ways in which earnings can be managed. For example, revenues that are expected to accrue in future years could be counted in the current year. Problem is that once this starts it is hard to stop. Problem is that once this starts it is hard to stop. –One reason is that so much weight is put on meeting market expectations. Negative earnings surprises typically lead to falls in share prices. A manager who manipulates data to meet or exceed market expectations in one year will have to continue to lie in future years if s/he wants to avoid disappointing market expectations.

25. 25 Jensen estimates that Enron was actually worth $30bn when it was valued $70bn. that Enron was actually worth $30bn when it was valued $70bn. The efforts of managers to defend the $40bn of excess valuation effectively destroyed the $30bn core value. The efforts of managers to defend the $40bn of excess valuation effectively destroyed the $30bn core value. –One of the ways this was done was through acquisitions of other companies for more than these companies were in fact worth. Management makes acquisitions to con the market into believing that the company is growing in true value. Management makes acquisitions to con the market into believing that the company is growing in true value. –Between 1997 and 2001, Nortel acquired 19 companies for more than $33bn. When Nortel’s share price fell by 95%, Nortel closed down many of these acquisitions.

26. 26 Chapter 7 of Baye Market structure: A set of variables that affect managerial conducts Market structure: A set of variables that affect managerial conducts 1.Number and size of firms. 2.Industry concentration. 3.Technological and cost conditions. 4.Demand conditions. 5.Ease of entry and exit. Conduct: Behavior that affects performance Conduct: Behavior that affects performance 1.Pricing. 2.Advertising. 3.R&D. 4.Merger activity. Performance: Result Performance: Result 1.Profitability. 2.Social welfare.

27. 27 Approaches to Studying Industry The Structure-Conduct-Performance (SCP) Paradigm: Causal View Market Structure ConductPerformance The Feedback Critique The Feedback Critique –No one-way causal link. –Conduct can affect market structure. –Market performance can affect conduct as well as market structure.

28. 28 Managerial Economics- Group A Week Eight- Class 3 Week Eight- Class 3 –Thursday, October 25 –15:10-16:00 –Tyndall Next Aplia Assignment is due before 5 PM on Wednesday, October 31 Next Aplia Assignment is due before 5 PM on Wednesday, October 31 No Class on Monday, October 29 No Class on Monday, October 29

29. 29 Industry Concentration Four-Firm Concentration Ratio Four-Firm Concentration Ratio –The sum of the market shares of the top four firms in the defined industry. The Four Firm concentration ratio can take a value between 0 to 1 The closer C 4 to 1, the _______ industry is to a monopoly S i denotes sales for firm i and S T denotes total industry sales closer

30. 30 Example 1 There are five banks competing in a local market. Their market shares are 50%, 20%, 10%. 10% and 10%. What is the four-firm concentration ratio? There are five banks competing in a local market. Their market shares are 50%, 20%, 10%. 10% and 10%. What is the four-firm concentration ratio? 90 percent of total output is produced by the top 4 firms in the industry.

31. 31 Example 2 There are five banks competing in a local market. Their market shares are 30%, 30%, 20%. 10% and 10%. What is the four-firm concentration ratio? There are five banks competing in a local market. Their market shares are 30%, 30%, 20%. 10% and 10%. What is the four-firm concentration ratio? 90 percent of total output is produced by the top 4 firms in the industry.

32. 32 Is Concentration the same in both cases? No, it is higher in case 1 No, it is higher in case 1 C 4 does not catch this C 4 does not catch this

33. 33 Herfindahl-Hirschman Index (HHI) The sum of the squared market shares of all firms in a given industry, multiplied by 10,000: The sum of the squared market shares of all firms in a given industry, multiplied by 10,000: –HHI = 10,000   w i 2, where w i = S i /S T. –HHI can take a value between 0 to 10,0000 –HHI  zero  competitive market –HHI  10,000  monopoly HHI is preferred to C 4 because it gives more weight to firms with higher market share HHI is preferred to C 4 because it gives more weight to firms with higher market share

34. 34 Example 1 There are five banks competing in a local market. Their market shares are 50%, 20%, 10%. 10% and 10%. What is HHI? There are five banks competing in a local market. Their market shares are 50%, 20%, 10%. 10% and 10%. What is HHI?

35. 35 Example 2 There are five banks competing in a local market. Their market shares are 30%, 30%, 20%. 10% and 10%. What is the four-firm concentration ratio? There are five banks competing in a local market. Their market shares are 30%, 30%, 20%. 10% and 10%. What is the four-firm concentration ratio? Note: HHI is this case lower than Example 1

36. 36 Limitation of Concentration Measures Market Definition: National, regional, or local? Market Definition: National, regional, or local? Excludes foreign producers Excludes foreign producers Industry definition and product classes. Industry definition and product classes. Recent study on Concentration in Irish Industry by Patrick McCloughan in the Economic and Social Review (www.esr.ie) Recent study on Concentration in Irish Industry by Patrick McCloughan in the Economic and Social Review (www.esr.ie)www.esr.ie –Data limitations: He could only estimate 5 firm concentration ratios for net output for broad industrial categories.

37. 37 Concentration in Irish Industry Industry 5 firm concentration ratio % net output by foreign firms % gross output exported Leather products.68089 Pharmaceuticals.449898 Dairy products.35056 Paper products.344947 Meat products.20049 Office machinery & computers.639593

38. 38 Concentration in Irish Industry: Conclusions from recent study Aggregate concentration is high in Ireland. The 100 largest manufacturing firms account for over half of all manufacturing industry. Aggregate concentration is high in Ireland. The 100 largest manufacturing firms account for over half of all manufacturing industry. Data suggests that the very largest industrial enterprises tend to operate large single plants rather than multi-plant operations. Data suggests that the very largest industrial enterprises tend to operate large single plants rather than multi-plant operations. Substantial variation in concentration across industries. Substantial variation in concentration across industries. Typically it is the largest and second largest firms in an industry that determine industrial concentration. Typically it is the largest and second largest firms in an industry that determine industrial concentration.

39. 39 Concentration in Irish Industry: Conclusions from recent study No link between the level of concentration and the extent of foreign ownership or export activity in Irish industry. No link between the level of concentration and the extent of foreign ownership or export activity in Irish industry. No overall trend in concentration between 1991 and 2001. No overall trend in concentration between 1991 and 2001. International comparisons suggest that Irish industry is comparably concentrated. International comparisons suggest that Irish industry is comparably concentrated.

40. 40 Measuring Demand and Market Conditions The Rothschild Index (R) measures the elasticity of industry demand for a product relative to that of an individual firm: The Rothschild Index (R) measures the elasticity of industry demand for a product relative to that of an individual firm: R = E T / E F. –E T = elasticity of demand for the total market. –E F = elasticity of demand for the product of an individual firm. If there is only one firm in the market  E T = E F  R = 1 If there is only one firm in the market  E T = E F  R = 1 As the number of firms in the industry goes up  E F goes up  R  0. As the number of firms in the industry goes up  E F goes up  R  0.

41. 41 Market Entry and Exit Conditions Barriers to entry Barriers to entry 1.Capital requirements. 2.Patents and copyrights. 3.Economies of scale. 4.Economies of scope.

42. 42 Conduct: Pricing Behavior The Lerner Index The Lerner Index L = (P - MC) / P –A measure of the difference between price and marginal cost as a fraction of the product’s price. –The index ranges from 0 to 1. When P = MC, the Lerner Index is zero; the firm has no market power. When P = MC, the Lerner Index is zero; the firm has no market power. A Lerner Index closer to 1 indicates relatively weak price competition; the firm has market power. A Lerner Index closer to 1 indicates relatively weak price competition; the firm has market power.

43. 43 Markup Factor From the Lerner Index, the firm can determine the factor by which it should cover MC. Rearranging the Lerner Index From the Lerner Index, the firm can determine the factor by which it should cover MC. Rearranging the Lerner Index The markup factor is 1/(1-L). The markup factor is 1/(1-L). –When the Lerner Index is zero (L = 0), the markup factor is 1 and P = MC. –When the Lerner Index is 0.20 (L = 0.20), the markup factor is 1.25 and the firm charges a price that is 1.25 times marginal cost.

44. 44 Integration and Merger Activity Vertical Integration Vertical Integration –The Italian Restaurant buys the Pasta factory. Horizontal Integration Horizontal Integration –The Italian Restaurant buys another restaurant. Conglomerate Mergers Conglomerate Mergers –The Italian Restaurant buys a child care facility.

45. 45 Horizontal Merger Guidelines (The Competition Authority, Ireland) See Notice in Respect of Guidelines for Merger Analysis from The Competition Authority See Notice in Respect of Guidelines for Merger Analysis from The Competition Authority Use both an SLC (Substantial lessening of competition) test and a HHI test. Use both an SLC (Substantial lessening of competition) test and a HHI test. SLC test is interpreted in terms of consumer welfare. This in turn is based on whether the price is expected to rise. SLC test is interpreted in terms of consumer welfare. This in turn is based on whether the price is expected to rise. Mergers are analysed by looking at Mergers are analysed by looking at –Relevant geographic or product markets –Effect on market structure –Effect on rivalry in the industry –Effect on potential entrants

46. 46 Horizontal Merger Guidelines (The Competition Authority, Ireland) Use of HHI Use of HHI Both the level and change of HHI are examined Both the level and change of HHI are examined HHI above 1800 are likely to raise competitive concerns. HHI above 1800 are likely to raise competitive concerns. HHI between 1000 and 1800 that involves a change in the HHI of more than 100 may raise competitive concerns. HHI between 1000 and 1800 that involves a change in the HHI of more than 100 may raise competitive concerns.

47. 47 Performance Performance refers to the profits and social welfare that result in a given industry. Performance refers to the profits and social welfare that result in a given industry. Social Welfare = CS + PS Social Welfare = CS + PS –Dansby-Willig Performance Index measure by how much social welfare would improve if firms in an industry expanded output in a socially efficient manner.