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Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market MANAGERIAL ECONOMICS An Analysis of Business Issues Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-1 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Douglas - “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 decisionmaking.” 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.” Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-2 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market • 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. Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-3 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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? Questions Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-4 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Competition, structures and decisions Pricing practices Production and Costs Demand analysis and estimation Basic economics principles: demand and supply. market business strategies and Business and Government. Managerial Economics Capital budgeting Research question Business and economic situation. current Introduction. The nature of managerial economic decision making Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-5 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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. Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-6 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market How Can ManagerialAdopt a general perspective, not a sample of one EconomicsSimple Assist models provide stepping stone to more Decision-Making? complexity and realism Thinking logically has value itself and can expose sloppy thinking Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-7 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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. 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. Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-8 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Basic 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? Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-9 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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. Management 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. Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-10 Managerial Economics Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer The nature of managerial economic decision making Pricing Introduction Research Question Demand The Market Managerial economic as an economics discipline The role of managerial economics in managerial decision making Economic optimisation The value of firm Economic constraints The basic economic variables Demand Supply Costs Revenue Profit Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-11 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Economics Macroeconomics Money, finance, banking Microeconomics “Sector” economics Labor economics Environmental economics Managerial economics International Economics Regional Economics Economics development Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-12 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Managerial decision problems Product price and output Make or buy Production technique Internet strategy Advertising media and intensity Investment and financing Economic concepts Decision making tools Theory of consumer behaviour Numerical analysis Theory of firm Statistical analysis Theory of market structure and pricing Forecasting Game theory Optimisation Managerial Economics Use of economics concepts and decision making tools to solve managerial decision problems Optimal solutions Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-13 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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? Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-14 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Profitt N Total revenue Total cos tt Value t t (1 i ) (1 i ) t 1 t 1 N N I – firm’s life time - discount rate Profitt - current value of the t (1 i ) profit earned in t years time Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-15 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Model MNE 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 Merger The firm is a profit-maximiser: it is assumed to make as much profit as possible. Nature 1. The firm is a profit-maximiser - it optimises 2. The firm can be treated in a holistic way 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 3. There is perfect certainty It assumes perfect certainty. Cost and demand conditions are perfectly known Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-16 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Marginal Cost Nature $ Model The firm aims to maximise profit by choosing the level of output which gives the biggest difference between revenue and costs $ Demand: Average Revenue Demand: Average Revenue MNE P2 Merger P1 Q1 Q2 Quantity Produced $ Profit maximising output $ Demand: Average Revenue Quantity Produced Marginal Revenue Marginal Cost Average Cost Demand: Average Revenue Marginal Revenue Quantity Produced Profit maximising output Marginal Revenue Quantity Produced Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-17 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market MNE • When demand increases? • When costs rise? • When a fixed cost increases? Merger – begin with an initial equilibrium position - the starting point – change something – identify the new equilibrium, e.g: Nature • Comparative Statics Model What Can We Do With This Model? – 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? Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-18 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Model “Managerial” Criticisms of the Profit-Maximising Model Berle and Means (1932) The Managerial School argues that: Ownership and control are in the hands of different groups of people. 2. The interests of owners (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. (shareholders) and MNE 1. Merger 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 Nature – – – Controllers 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) Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-19 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Merger MNE Nature 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” Model 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 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-20 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Nature Merger MNE 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. Model Which Approach is Most Useful? In Conclusion? The behavioural approach is a useful complement to the profit-maximising and managerial approaches, not a substitute for them Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-21 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market MNE Why Do Firms Exist? Merger a transaction takes place whenever a good or a service is transferred from one party to another Nature a set of transactions* coordinated by authority instead of by the market Model What is a Firm? 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 coordinated by managerial authority instead of the market Why does this happen? Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-22 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Merger MNE Produce ouput y, which it can sell for price p(y) From quantities of input (factors): X1, X2, … Input costr (per unit): w1, w2, … Nature A Firm Model The Setup How Can this firm produce Technology How Should this firm produce Cost minimitation How much should this firm produce Profit maximization Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-23 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Model Transactions inside a firm Nature Product Market Merger Factor Market MNE Product Factor of Production Consumers FIRM Entrepreneur (Goods & Services) e.g. a shirt Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-24 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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 MNE 1. Merger The “Coasian”Analysis Nature Transaction Cost Analysis Model Why Firm Exists? What decides whether a transaction takes place through the market or inside a firm? Answer: TRANSACTIONS COSTS Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-25 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market MNE 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 Merger • • • • • • Nature A transaction takes place when a good or a service is transferred from one party to another Direct costs arise in respect of: Model What Are Transactions Costs? Opportunity costs arise in respect of: • inefficiencies if inappropriate equipment used • failure to adapt to changing conditions Transaction costs include: information and measurement costs negotiation costs contracting costs (ink costs, legal costs) monitoring and enforcing costs, etc. Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-26 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Merger MNE 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 Nature Model The costs of transacting inside firm rise with: Transactions will be organised in the least-cost way 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!!! Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-27 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Merger MNE 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? Nature What factors determine the extent to which a firm diversifies across different industries? Model The Extent of Diversification 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-28 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Model Nature If there is a diversification discount why did firms do it? Merger MNE 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-29 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Vertical: with suppliers or customers with unrelated firms MNE Conglomerate: Merger Horizontal: with competitors Nature 1. Alternative forms of of merger Model Mergers and Take-overs 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-30 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Merger MNE 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! Nature Model 3. Mergers as the transfer of resources to better managers 4. Mergers as the result of manipulation or 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-31 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Merger MNE 6. Are mergers really for managers? Nature 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! Model 5. The performance consequences of mergers 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 CEOs Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-32 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Model Nature Merger MNE “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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-33 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Model Nature Early 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. Merger In the 1920s and 1930s: MNE 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. Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-34 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 0A MNE 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 Rate of Return (%) to Merger diminishing returns capital investment Nature Equi-marginal productivity of capital Model Economic theory and the multinational MP MP B A Capital 0B 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) Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-35 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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. not produce in home country and export the goods? Locational theory 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 MNE But why Merger Nature 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. The “eclectic” framework: O L I Model The Hymer-Kindleberger proposition Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-36 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Model Internalization Location Nature Ownership Merger FDI MNE Exporting Licensing From the viewpoint of the MNE: What are the advantages of foreign direct investment (MNE) over exporting and licensing? Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-37 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Effects on competitive structure and performance MNE Effects of sovereignty and local autonomy Merger Trade and balance of payments effects Nature Resource transfer and technology transfer effects Model The Impact of the Multinational on Host Economies The impact of the MNE on its home country Some concerns: Balance of payments effects Employment effects The loss of technological lead Tax avoidance and loss of sovereignty Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-38 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-39 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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 If (a+b) > 1; economies of scale If (a+b) < 1; diseconomies of scale If (a+b) = 1; constant returns to scale Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-40 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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 = f(x1, x2) x1 = f1(x1, x2o) Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-41 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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 x2 An isoquant is the locus of all input combination that yield the sama level of output x1 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-42 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Technical 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 : Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-43 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market From Production Functions to Cost Curves 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 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-44 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Average & Marginal Cost Production&Cost Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-45 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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; Program Pascasarjana, Universitas Gunadarma, that is, the LTC curve is convex. Magister Management , Budi Hermana-46 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market The Main Approaches Utility Theory Indifference Analysis Revealed Preference The Characteristics Approach Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-47 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Utility 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-48 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Utility 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-49 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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) Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-50 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer • Good A • Research Question Demand The Market Good A All combinations of A and B for which the consumer is indifferent Slopes show relative preferences for A and B AN INDIFFERENCE CURVE Good B Good B An A-lover • • Good A Good A More B is bought and (in this example only) the same amount of A Budget Line Good B Optimal Combination of A&B Budget Line Good B If the Price of B Falls Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-51 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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 : Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-52 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Revealed Preference Less restrictive assumptions - consumers are consistent in their choices A budget line is constructed and the consumer’s choice observed When price of one good falls, a new choice is made The new choice cannot involve less of the good whose price has fallen Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-53 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Revealed Preference • Why? Apples 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 Z X Oranges Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-54 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market The Characteristics Approach Lancaster 1966 Consumers do ‘characteristics’ not desire ‘goods’ but bundles of – 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-55 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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) Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-56 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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 The demand curve shows the quantity that would be bought at each price, for some fixed combination of all other factors Quantity Demanded Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-57 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Concepts of Elasticity Own price elasticity is: – percentage change in quantity demanded, divided by percentage change in price: increases with lower prices. If demand is price-inelastic, revenue decreases with lower prices Cross-price elasticity of demand between substitutes is positive If demand is price-elastic, revenue 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. Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-58 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Zero-elasticity at all prices Infinite elasticity at all prices Price Price Ed = 0 Ed = Quantity Quantity Unitary elasticity at all prices Price Ed = -1 This curve is a ‘rectangular hyperbola’ such that price x quantity is a constan Quantity Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-59 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Price p0 p1 1 2 q0 q1 Quantity 2 > 1 If demand is price-elastic, decrease the price to gaining higher revenue Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-60 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Price p0 p1 1 2 q0 q1 Quantity 2 < 1 If demand is price-inelastic, lower prices will decreases revenue Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-61 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-62 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Estimation Estimation 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) Forecasting Forecasting 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? Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-63 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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.Pcb,.Psc Ydd Te.Aof Acg Ash Ii. Cj, Ek – THE EXPONENTIAL FORM log Qd= alogPo+blogPc+clogPs+dlogYd+elogT+flogAo+glog Ac +hlogAs+ilogI+jlog C+klogE – THE LOGLINEAR FORM Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-64 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Forecasting Demand • Simplest Method is EXTRAPOLATION The DECOMPOSITION METHOD Etc • • • • • • 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? Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-65 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-66 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Which Technique Is Best For Each Product? An industrial product with a limited market Time-series analysis Expert opinion 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 Market testing Survey of buyer’s intentions • THIS ISJUST ONE POSSIBLE ANSWER . YOU MAY BE ABLE TO JUSTIFY OTHERS Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-67 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Formal Textbook Models Economic analysis identifies four types of market structure PERFECT COMPETITION MONOPOLY OLIGOPOLY MONOPOLISTIC COMPETITION The basis for the STRUCTURE-CONDUCTPERFORMANCE approach to industrial organization. – Structure determines prices and profitability Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-68 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-69 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Perfect Competition: Short Run • Industry P Firm S SMC P P2 P1 D=AR=MR P D Q q0 q q 1 2 Q Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-70 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market The Firm in More Detail SMC SAC P = AR =MR AC LAC q SAC PL is the only possible long run price P = AR =MR PL q Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-71 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Monopoly One firm, no entry is possible - ‘pure monopoly’ Firm’s demand-curve is industry’s demand curve Price >Marginal Cost - economic inefficiency. Superprofits 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-72 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Monopoly • A monopolist produces less and charges a higher price, relative to the socially optimal MC Pmonopoly Psocially optimal Demand Qmonopoly Qsocially optimal Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-73 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Monopolistic 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? Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-74 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Monopolistic 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-75 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Oligopoly 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-76 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market What 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-77 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Features of the four market structures Type of market Number of firms Freedom of entry Perfect competition Very many Monopolistic competition Many / several Oligopoly Monopoly Few One Nature of product Examples Implications for demand curve faced by firm Unrestricted Homogeneous (undifferentiated) Cabbages, carrots (approximately) Horizontal: firm is a price taker Unrestricted Differentiated Plumbers, restaurants Downward sloping, but relatively elastic Undifferentiated Cement or differentiated cars, electrical appliances Downward sloping. Relatively inelastic (shape depends on reactions of rivals) Restricted Restricted or completely blocked Unique Local water Downward sloping: more company, gas inelastic than oligopoly. and electricity in Firm has considerable many countries control over price Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-78 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market The 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-79 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Third 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-80 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Pricing and the Product Life Cycle . Maturity Decline Sales Volume Growth Introduction Time What Happens to Elasticity of Demand and 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-81 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Pricing 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-82 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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 profitmaximisation or it might be a managers’ target stabilize output - keep the factory running and the workers employed match the competition Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-83 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market A 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 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-84 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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 2.5 3 10 P = AVC.1.2/.2 = AVCx6 P = AVC.2.5/1.5 = AVCx1.66 P = AVC.3/2 = AVCx1.5 P = AVC 10/9 = AVCx 1.11 Margin = 600% Margin = 66% Margin = 50% 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-85 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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? Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-86 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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! Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-87 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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. Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-88 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-89 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-90 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Investment Theory Investment 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-91 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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. Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-92 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Three Reasons for Investing Why invest ??? People invest to … supplement their income earn capital gains Appreciation is an increase in the value of an investment. experience the excitement of the investment process Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-93 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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. Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-94 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Empirical research uses actual market data rather than mathematical models. An anomaly is an observed result that defies explanation within the known theoretical framework. The Academic Study of Investments vs. Professors Practitioners 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. Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-95 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Risk&Return The Relationship between Risk and Return Riskier securities have higher expected returns. Expected Return Risk-free Return Risk Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-96 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Risk&Return The Relationship between Risk and Return Empirical financial research reveals clear evidence of the direct relationship between systematic risk and expected return. Expected Return T-bills Large Company Stocks Small Company Stocks Long-term Corporate Bonds Long-term Government Bonds Inflation Risk Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-97 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Risk&Return The simplest measure of return is the holding period return. Buy 100 shares at $25 per share Holding period return = Holding period = return Ending _ value Dividend of $0.10 per share Beginning + Income value Beginning value Sell the shares at $30 per share $30 - $25 + $0.10 = 20.4% $25 Time Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-98 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Risk&Return 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-99 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Risk&Return Expected Monetary Values (EMV) In a situation of RISK we could use Expected Monetary Values (EMV) to take a decision EMV = SpiVi Where: pi = probability of the i’th outcome Vi = value of the i’th outcome Example: Weather Probability Takings Sunny 0.2 $500 Cloudy 0.4 $300 Raining 0.4 $100 EMV = ? Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-100 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Risk&Return EMV- 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-101 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Risk&Return EMV- Limitations of EMV How 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 A Risk-Lover Utility Utility Income Income Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-102 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Risk&Return Decision-makers Are Usually Assumed to be Risk-averse • • Instead of using EMV, use Expected Utility (EU) EU = SpiUi Where: – pi = probability of the i’th outcome – Ui = utility of the i’th outcome 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-103 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Risk&Return Minimax Criterion Actions States of Nature A B C 1 20 40 180 2 -40 100 220 3 60 70 90 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-104 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Investment Alternatives Assets financial assets e.g. bond, stock real assets e.g. land Assets are things that people own. Financial assets have a corresponding liability, while real assets do not. Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-105 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Investment Alternatives 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. Securitization is the process of converting an asset or collection of assets into a more marketable form. Securities Equity Securities e.g. common stock Fixed Income Securities e.g. bonds, preferred stock Derivative Assets e.g. futures, options Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-106 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Investment Alternatives Major Classes of Financial Securities Markets and Instruments Debt Money Market Money market instruments Debt Instruments Bonds Derivatives Common stock Capital Market Preferred stock Bonds Derivative securities Equity Derivatives Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-107 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Investment Alternatives Money Market Instruments Capital Market: Equity Treasury bills Common stock Certificates of deposit Residual claim Commercial Paper Limited liability Bankers Acceptances Preferred stock Eurodollars Fixed dividends - limited Repurchase Agreements (RPs) and Reverse Priority over common Tax treatment RPs Federal Funds Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-108 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Investment Management TRADITIONAL ORGANIZATIONS INVESTMENT MANAGEMNT – 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 FIVE STEP PROCEDURE: – – – – – SETTING INVESTMENT POLICY PERFORMING SECURITY ANALYSIS CONSTRUCTING A PORTFOLIO REVISING THE PORTFOLIO EVALUATING THE PORTFOLIO Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-109 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Investment Management SETTING 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 • Series Average Standard Annual Return Deviation 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 – 90% Distribution 0% + 90% 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-110 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Investment Management REVISING THE PORTFOLIO Use 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: Equity The Agreement » one party agrees to pay the other a variable-sized cash payment » the other party agrees to a fixed-sized cash payment Results in a restructured portfolio without incurring any transaction costs Interest Rate The 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 Agreement Results in a restructured portfolio without incurring any transaction costs Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-111 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Common Methods of Appraisal The common methods are: • PAYBACK • DISCOUNTED PAYBACK • RETURN ON INVESTMENT • INTERNAL RATE OF RETURN • NET PRESENT VALUE Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-112 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market •PAYBACK Payback 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: Cash flow: $10 million $2 million per year Payback-period? Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-113 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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 cutoff rate Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-114 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market INTERNAL RATE OF RETURN 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. • 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-115 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 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 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: PV= I (1+r)n Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-116 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market NET PRESENT VALUE NPV = -P + I0 + I1 (1+r) I2 In + (1+r)2 + … + (1+r)n or 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-117 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Foreign Direct Investment 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) Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-118 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Foreign Direct Investment 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-119 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Foreign Direct Investment FDI Requirements Factors 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. FDI Today: The differences The 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 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-120 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Foreign Direct Investment Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-121 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Foreign Direct Investment OECD Survey, 1999 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-122 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Foreign Direct Investment OECD Survey, 1999 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-123 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Foreign Direct Investment FDI & Competition FDI & Economic Growth OECD Survey, 1999 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-124 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Foreign Direct Investment The impact of FDI on ASEAN4 development 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 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. 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. OECD Survey, 1999 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-125 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Foreign Direct Investment Total FDI inflows by country, 1990-97 Thailand 17 177 Philippines 8 379 OECD Survey, 1999 Indonesia 23 684 Malaysia 35 177 Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-126 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer 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 Research Question Demand The Market What Is Strategy? Strategy as a: Plan Ploy Pattern Position Perspective Henry Mintzburg Howard Davies and Pun-Lee Lam Jeffrey Kaufmann: Strategy is a deliberate search for a plan of action that will develop a business’s competitive advantage and compound it Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-127 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Elements of Competitive Advantage Performance Outcomes Sources of Advantage •Superior Resources •Superior Capabilities Positional Advantages •Superior Cust. Value •Lower Relative Cost •Customer Satisfaction •Customer Loyalty •Market Share •Profitability Investment to Sustain Competitive Advantage Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-128 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Your Competitive Positioning A Positioning • Who are your competitors? Statement • Are you 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? - • If not, how can you become the market leader? • If yes, how do you remain the market leader? Harry Beckwith Selling the Invisible Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-129 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Postioning Template For Who Our Product That Provides Unlike Our Product (Target Customers) (Have a Problem) (Is a new Category) (Breakthrough Results) (Reference Competitor) (Key Differentiators) Geoff Moore Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-130 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market 5 Generic Competitive Strategies TYPE OF COMPETITIVE ADVANTAGE BEING PURSUED Lower Cost Broad buyer segment Differentiation OVERALL COST LEADERSHIP STRATEGY MARKET TARGET Narrow buyer segment FOCUSED LOW-COST STRATEGY BEST COST PROVIDER STRATEGY BROAD DIFFERENTIATION STRATEGY FOCUSED DIFF. STRATEGY PORTER, 1980. Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-131 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Peter Duncan (2001) Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-132 Managerial Economics Pricing Introduction Invest.&Budgeting Product&Strategy Cases The Firm Production&Cost Consumer Research Question Demand The Market Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-133