MANAGERIAL ECONOMICS:
A PROBLEM-SOLVING APPROACH
3RD EDITION
INSTRUCTOR GUIDE
SECTION 0 – GUIDE TO THIS TEACHER’S GUIDE .............................................................................. 1
0. CHAPTER HEADINGS OF THE TEXT ............................................................................................ 1
Main Points of the Chapter ................................................................................................................... 1
Supplementary Material ........................................................................................................................ 1
Teaching Note ....................................................................................................................................... 1
In-class Problems .................................................................................................................................. 2
Additional Anecdotes not in text .......................................................................................................... 2
SECTION I – PROBLEM SOLVING AND DECISION MAKING ........................................................... 4
1. INTRODUCTION: WHAT THIS BOOK IS ABOUT ....................................................................... 4
Main Points ........................................................................................................................................... 4
Supplementary Material ........................................................................................................................ 4
Teaching Note ....................................................................................................................................... 5
In-class Problem.................................................................................................................................... 6
Additional Anecdotes: Sears Automotive and Kidder-Peabody ........................................................... 6
2. THE ONE LESSON OF BUSINESS................................................................................................... 9
Main Points ........................................................................................................................................... 9
Supplementary Material ........................................................................................................................ 9
Teaching Note ..................................................................................................................................... 10
In-class Problem.................................................................................................................................. 11
Additional Anecdote: Zimbabwe ........................................................................................................ 11
3. BENEFITS, COSTS, AND DECISIONS .......................................................................................... 12
Main Points ......................................................................................................................................... 12
Supplementary Material ...................................................................................................................... 12
Teaching Note ..................................................................................................................................... 13
In-class Problem.................................................................................................................................. 14
Additional Anecdote: Coca-Cola ........................................................................................................ 14
4. EXTENT (HOW MUCH) DECISIONS ............................................................................................ 15
Main Points ......................................................................................................................................... 15
Supplementary Material ...................................................................................................................... 15
Teaching Note ..................................................................................................................................... 16
In-class Problem.................................................................................................................................. 17
Additional Anecdotes: Truck Leasing and American Express ........................................................... 17
5. INVESTMENT DECISIONS: LOOK AHEAD AND REASON BACK ........................................ 19
Main Points ......................................................................................................................................... 19
Supplementary Material ...................................................................................................................... 19
Teaching Note ..................................................................................................................................... 20
In-class Problem.................................................................................................................................. 21
Additional Anecdote: John Deere ....................................................................................................... 21
SECTION II – PRICING, COSTS, AND PROFITS .................................................................................. 22
6. SIMPLE PRICING ............................................................................................................................ 22
Main Points ......................................................................................................................................... 22
Supplementary Material ...................................................................................................................... 23
Teaching Note ..................................................................................................................................... 23
In-class Problem.................................................................................................................................. 25
Additional Anecdote: Mars (Snickers) & Sara Lee (hot dogs) ........................................................... 25
7. ECONOMIES OF SCALE AND SCOPE ......................................................................................... 27
Main Points ......................................................................................................................................... 27
Supplementary Material ...................................................................................................................... 27
Teaching Note ..................................................................................................................................... 28
In-class Problem.................................................................................................................................. 29
Additional Anecdotes: Electrical Equipment Manufacturer & Department Store Sign Production ... 29
8. UNDERSTANDING MARKETS AND INDUSTRY CHANGES ................................................... 32
Main Points ......................................................................................................................................... 32
Supplementary Material ...................................................................................................................... 32
Teaching Note ..................................................................................................................................... 33
In-class Problem.................................................................................................................................. 34
Additional Anecdote: Video Enhancement Market ............................................................................ 34
9. RELATIONSHIPS BETWEEN INDUSTRIES: THE FORCES MOVING US TOWARD LONGRUN EQUILIBRIUM ............................................................................................................................. 36
Main Points ......................................................................................................................................... 36
Supplementary Material ...................................................................................................................... 36
Teaching Note ..................................................................................................................................... 36
In-class Problem.................................................................................................................................. 37
Additional Anecdote: Will wages adjust to offset new tax progressivity? ......................................... 38
10. STRATEGY―THE QUEST TO KEEP PROFIT FROM ERODING ............................................ 39
Main Points ......................................................................................................................................... 39
Supplementary Material ...................................................................................................................... 39
Teaching Note ..................................................................................................................................... 40
In-class Problem.................................................................................................................................. 40
Additional Anecdote: Kleenex ............................................................................................................ 41
11. USING SUPPLY AND DEMAND: TRADE, BUBBLES, AND MARKET-MAKING ................ 42
Main Points ......................................................................................................................................... 42
Supplementary Material ...................................................................................................................... 42
Teaching Note ..................................................................................................................................... 42
In-class Problem.................................................................................................................................. 44
Additional Anecdote: Video Enhancement Market ............................................................................ 44
SECTION III – PRICING FOR GREATER PROFIT ................................................................................ 45
12. MORE REALISTIC AND COMPLEX PRICING .......................................................................... 45
Main Points ......................................................................................................................................... 45
Supplementary Material ...................................................................................................................... 45
Teaching Note ..................................................................................................................................... 46
In-class Problem.................................................................................................................................. 48
Additional Anecdote: American Airlines............................................................................................ 48
13. DIRECT PRICE DISCRIMINATION............................................................................................. 50
Main Points ......................................................................................................................................... 50
Supplementary Material ...................................................................................................................... 50
Teaching Note ..................................................................................................................................... 51
In-class Problem.................................................................................................................................. 52
Additional Anecdotes: Medical Device Company & Grey Market for iPhones ................................. 53
14. INDIRECT PRICE DISCRIMINATION ........................................................................................ 55
Main Points ......................................................................................................................................... 55
Supplementary Material ...................................................................................................................... 55
Teaching Note ..................................................................................................................................... 56
In-class Problem.................................................................................................................................. 57
Additional Anecdote: Trip Insurance .................................................................................................. 58
SECTION IV – STRATEGIC DECISION MAKING................................................................................ 59
15. STRATEGIC GAMES..................................................................................................................... 59
Main Points ......................................................................................................................................... 59
Supplementary Material ...................................................................................................................... 59
Teaching Note ..................................................................................................................................... 60
In-class Problem.................................................................................................................................. 62
Additional Anecdote: American Airlines & Chinese Banks ............................................................... 62
16. BARGAINING ................................................................................................................................ 64
Main Points ......................................................................................................................................... 64
Supplementary Material ...................................................................................................................... 64
Teaching Note ..................................................................................................................................... 65
In-class Problem.................................................................................................................................. 65
Additional Anecdote: CHAOS at Midwest Express ........................................................................... 66
SECTION V – UNCERTAINTY ............................................................................................................... 67
17. MAKING DECISIONS WITH UNCERTAINTY........................................................................... 67
Main Points ......................................................................................................................................... 67
Supplementary Material ...................................................................................................................... 67
Teaching Note ..................................................................................................................................... 67
In-class Problem.................................................................................................................................. 68
Additional Anecdotes: Global Warming & Banning speculators ....................................................... 69
18. AUCTIONS ..................................................................................................................................... 70
Main Points ......................................................................................................................................... 70
Supplementary Material ...................................................................................................................... 70
Teaching Note ..................................................................................................................................... 70
In-class Problem.................................................................................................................................. 72
Additional Anecdotes: FCC Auctions & Car Bargains....................................................................... 72
19. THE PROBLEM OF ADVERSE SELECTION .............................................................................. 74
Main Points ......................................................................................................................................... 74
Supplementary Material ...................................................................................................................... 74
Teaching Note ..................................................................................................................................... 75
In-class Problem.................................................................................................................................. 76
Additional Anecdotes: Manufacturing Firm Hiring & Disability Insurance Company ...................... 76
20. THE PROBLEM OF MORAL HAZARD ....................................................................................... 78
Main Points ......................................................................................................................................... 78
Supplementary Material ...................................................................................................................... 78
Teaching Note ..................................................................................................................................... 78
In-class Problem.................................................................................................................................. 79
Additional Anecdote: Regional Phone Company ............................................................................... 80
SECTION VI – ORGANIZATIONAL DESIGN ....................................................................................... 81
21. GETTING EMPLOYEES TO WORK IN THE BEST INTERESTS OF THE FIRM .................... 81
Main Points ......................................................................................................................................... 81
Supplementary Material ...................................................................................................................... 81
Teaching Note ..................................................................................................................................... 82
In-class Problems ................................................................................................................................ 83
Additional Anecdote: Whaling Industry ............................................................................................. 83
22. GETTING DIVISIONS TO WORK IN THE BEST INTERESTS OF THE FIRM ....................... 85
Main Points ......................................................................................................................................... 85
Supplementary Material ...................................................................................................................... 85
Teaching Note ..................................................................................................................................... 85
In-class Problem.................................................................................................................................. 87
Additional Anecdotes: Toner Supplier, Sears Auto Repair, & Functionally Organized Banks.......... 87
23. MANAGING VERTICAL RELATIONSHIPS ................................................................................ 89
Main Points ......................................................................................................................................... 89
Supplementary Material ...................................................................................................................... 89
Teaching Note ..................................................................................................................................... 89
In-class Problem.................................................................................................................................. 90
Additional Anecdotes: Alcoa & TicketMaster / Live Nation ............................................................. 90
SECTION VII – WRAPPING UP .............................................................................................................. 92
24. YOU BE THE CONSULTANT ...................................................................................................... 92
Supplementary Material ...................................................................................................................... 92
Teaching Note ..................................................................................................................................... 92
SECTION 0 – GUIDE TO THIS TEACHER’S GUIDE
0. CHAPTER HEADINGS OF THE TEXT
SUB-SECTION 1
SUB-HEADING 2
SUB-HEADING 3
Main Points of the Chapter

The summary points of at the end of each chapter in the book are reproduced here.
Supplementary Material
These are Supplementary Materials that complement the material in the text.
Be sure to go to http://www.ManagerialEcon.com and click on the chapter headings for up-to-date
supplementary material.
Teaching Note
This note describes how Professor Froeb teaches the specific chapter material to his MBA classes. Each
lecture has the same outline:
I.
Review of last lecture’s main ideas, with a problem, if possible. Make them “solve” a
business problem that illustrates the main idea from last lecture and then pull out the main
themes of the class
II.
Write down the main ideas you want to cover (usually 3-4 main points in a 60 minute
lecture). Writing down the themes on the board will help you stay on track, as I tend to give
up a lot of control to the students during class time. Before the class go over the chapter, and
pick out 3 or 4 examples that you can use to illustrate the themes. Think of ways to use the
examples to force students to participate. For example, in the “supply-demand” chapter, the
three ideas I want to cover are (i) that markets have a product, geographic and time
dimension, chosen to help answer the question that motivated the supply-demand analysis;
(ii) you should be able to use supply-demand analysis to “explain” past movements in price
and quantity. For example, the drop in price and increase in quantity of MP3 players sold in
the US over the past five years can be explained by a increase in supply; and (iii) be able to
use supply-demand analysis to “predict” future changes, like what would happen to the price
and quantity of diesel engines sold in the US if the EPA mandated a change to high cost, low
mileage but cleaner engines. I pose these kinds of questions in class and make the students
answer them.
III.
Be prepared for the students to lose interest. When this happens, show a video clip (YouTube
or Stossel in the Classroom). Choose one or two videos in advance that speak to the themes
of the chapter. Make sure to debrief the video to make sure the students understand the link
to the chapter. Ask students to draw the link to the book.
IV.
For executive MBA classes, I reserve time for about an hour of student presentations of the
group problems at the end of each chapter. Presentations (no more than 3 slides) should take
5-7 minutes with 5 minutes of discussion. You will hear some good stories from the exec
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MBA students. For the regular MBA’s, I ask them to prepared and answer to the one of the
questions at the end of the chapter (e.g., be prepared to discuss a sunk or hidden-cost fallacy).
If their experience is not rich enough to yield an answer, take one from the class blog
http://managerialEcon.com instead.
I rarely use slides as they cause me to commit what I like to think of as “the fundamental error of
teaching,” which is to try to cover the material regardless of whether it is sinking in. FORGET ABOUT
COVERING THE MATERIAL. Instead, tell the stories and engage the students. If you find yourself
worried about finishing on time, you are already committing this error. Instead slow down. Teaching a
few things well is much better than trying to cover the material. The students can do this on their own.
I have found that there are several big decisions that affect how I teach. The first is how to engage the
class. As I have gotten older, my teaching has evolved towards more engagement, i.e., from straight
lecture to posing questions and calling on those who raise their hands; to posing questions and cold
calling.
If you are lucky enough to get a question from a student, one thing I have learned is to NEVER answer a
student’s question directly. Instead ask another student what they think the answer is. You can keep
going until you get the right answer. If you want to “steer” the discussion in another direction pose a
follow-on question to the student who originally asked the question.
I find value in cold calling. Students have rated my course the “most valuable” one in the core, but written
comments indicate that there are a big group of students who really dislike cold calling. When I am
particularly aggressive in cold calling and will not accept “I don’t know” for an answer, class can be
intimidating for students. But ultimately they will appreciate that you are giving them tools to think on
their feet. Cold calling encourages them to come to class prepared. Students seem to recognize its value,
while simultaneously disliking it.
In-class Problems
One of the best ways to engage the class is by posing in-class problem. I pose the question to the
students, give them five minutes to do it; and then I ask them to turn to the person sitting next to them and
explain the answer. I tell them that the two best ways to learn economics are doing problems and verbally
explaining the answers to someone else. When enough time has elapsed and you want to move on, tell
the students to “stop learning.”
Additional Anecdotes not in text
There is a tradeoff between repeating the anecdotes of the book in class and using new applications. The
benefit of repetition is that it helps the weaker students. The cost is that the best students may become
bored. Better students would benefit more from different applications. If you do not require students to
read the material ahead of class, I would repeat the material in the book. If you do require students to
come to class prepared and enforce the requirement with cold calling, I would use new anecdotes.
In telling the anecdote, I typically give students just enough information to recognize that there is a
problem. For example, in the first chapter additional anecdote about John Jett and Kidder Peabody,
describe Jett’s success, and ask if there is anything you be worried about if you were Jett’s boss. I play
“20 questions” with the students where they have to ask me yes-or-no questions until they figure out what
the problem is; and then I ask them how to fix it. Students will unconsciously begin using the rational
actor paradigm. After you get the right answer, summarize the analysis for them to reinforce the benefits
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of using the rational actor paradigm to diagnose and solve problems: My own “spin” on how to use the
rational actor paradigm is that any problem can be analyzed by asking three questions:
1. Who is making the bad decision;
2. Do they have enough information to make a good decision; and
3. The incentive to do so?
I tell students that incentives have two pieces, a performance evaluation scheme and a link between
compensation and performance.
Answers to the questions will suggest solutions centered on:
1. Changing decision rights (letting someone else make the decision);
2. Changing the information flow; or
3. Changing incentives (performance evaluation+compensation).
I tell them that the art of business is figuring out the costs and benefits of each solution. I can teach them
only to recognize the tradeoffs; they have to figure out which solution is most profitable by balancing the
costs against the benefits.
Note that this is related to Michael Jensen’s famous 3-legged stool, popularized by Brickley, Smith, and
Zimmerman in their textbook. I typically assign a shorter version of their approach (THIS IS HARD TO
FIND, SO E MAIL ME IF YOU ARE HAVING TROUBLE, luke.froeb@owen.vanderbilt.edu) as
outside reading James Brickley, Clifford Smith, Jerold Zimmerman, “The Economics of Organizations,”
Journal of Financial Economics, Vol. 8:2 (Summer, 1995) pp. 19-31. The difference is that Brickley, et
al. focus on (i) Decision rights, (ii) Performance evaluation, and (iii) Compensation schemes.
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SECTION I – PROBLEM SOLVING AND DECISION MAKING
1. INTRODUCTION: WHAT THIS BOOK IS ABOUT
Problem Solving
Ethics and Economics
Economics in Job Interviews
Main Points






Problem solving requires two steps: First, figure out why mistakes are being made; and then
figure out how to make them stop.
The rational-actor paradigm assumes that people act rationally, optimally, and self-interestedly.
To change behavior, you have to change incentives.
Good incentives are created by rewarding good performance.
A well-designed organization is one in which employee incentives are aligned with organizational
goals. By this we mean that employees have enough information to make good decisions, and the
incentive to do so.
It follows that you can analyze problems by asking three questions: (1) Who is making the bad
decision?; (2) Does the decision maker have enough information to make a good decision?; and
(3) the incentive to do so?
Answers to these questions will suggest solutions centered on (1) letting someone else make the
decision, someone with better information or incentives; (2) giving the decision maker more
information; or (3) changing the decision maker’s incentives.
Supplementary Material
ManagerialEcon.com (Chapter 1)
John Stossel’s Video “GREED,” by ABC News.
This is a provocative 45-minute video that covers several topics and gets students thinking about
how people respond to incentives and how markets turn self interested behavior to the benefit of
consumers. Make sure you get the OLD “greed” the NEW version has been sanitized, and it is not
nearly as hard hitting. [e-mail me if you have trouble finding this, luke.froeb@owen.vanderbilt.edu]
James Brickley, Clifford Smith, Jerold Zimmerman, “The Economics of Organizations,” Journal of
Financial Economics, Vol. 8:2 (Summer, 1995) pp. 19-31.
This article provides the basis for our study of behavior within organizations. The authors
present a methodology for diagnosing and repairing problems within an organization. Their
take on the rational actor paradigm is slightly different than mine: They would diagnose
problems by asking three questions:
i.
ii.
iii.
Who is making the bad decision?;
How are they evaluated?; and
How are they compensated?
Answers to these questions will suggest solutions to the problem centered on:
i.
ii.
iii.
Re-assigning decision rights;
Changing evaluation schemes; and/or
Changing compensation schemes.
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This is very similar to my approach. But I group evaluation and compensation schemes into
“incentives” and ask explicitly about information.
Good very short story illustrating how markets turn self interest (greed) into group
interest:
Doti, Capitalism & Greed, This is a great very short story of two stores during a Chicago snow
storm: one kept prices low and ran out of goods while the other doubled prices and was able to
keep operating, even inducing kids to bring produce from the farmers markets on their sleds.
Makes students think.
Short Videos:
7-minute video: Problem Solving with Economics
3-minute video : Friedman v. Donohue on Greed
The first video is an edited lecture by Froeb, with sound, illustrating the idea of chapter 1 with the
TVA barge example from chapter 24. The second is a great defense of capitalism by Uncle
Milton.
Teaching Note
I open with a business problem, like the over-bidding in the introduction, the Kidder-Peabody anecdote,
or any of the anecdotes in the concluding chapter “you be the consultant,” and then ask the students to
assume that they are a consultant brought in to the company to figure out what is wrong. Play 20
questions, and make them ask questions that have “yes” or “no” answers until they figure out what is
wrong. Students will invariably use the rational actor paradigm to do this. Point this out to them. Tell
them that this class is trying to show them how to use this paradigm more formally.
At the beginning of each of my lectures, I reinforce their problem solving skills by asking them to solve a
specific problem. The trick is to dribble out the information, bit by bit, to engage the students and keep
them guessing what the problem is.
Note that some students will typically define the problem as the lack of a particular solution. When this
happens, use the opportunity to point out how this approach locks you into a particular solution. Show
them how not to do this.
I then formally introduce the rational actor paradigm and show how it can be used to both identify why
problems occur and what can be done to change behavior. I tell them that the key step in solving
problems is to bring it down to an individual decision level. First, find out who made a bad decision.
Under the rational actor paradigm there are only two reasons for making mistakes: not enough
information or bad incentives. Find out which it is. Bottom line is that problems can be identified by
asking three questions:
1. Who made the bad decision?
2. Did they have enough information to make a good decision?
3. Did they have the incentive to make a good decision?
I then tell them that incentives have two pieces: a performance evaluation metric and a way to reward
good performance, or punish bad performance. The Brickley, Smith, and Zimmerman article is a good
reference for this. Various solutions to the problem will likewise center on:
1. Changing decision rights (letting someone else make the decision);
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2. Changing information flows; or
3. Changing incentives
i. Performance evaluation
ii. Compensation linking performance to rewards.
I tell them the “goal” is to align the incentives of employees with the goals of the organization. After
giving students this paradigm, I then ask them to fix the problem. Solicit suggestions, and ask other
students what they like or don’t like about the various proposed solutions. The message is that there are
only tradeoffs and no universal solutions, i.e., the answer to every question is “it depends.” The point of
the class is to teach your students to recognize and evaluate the tradeoffs.
If you want to focus on information rather than incentives, use the Sears automotive example in the
“additional anecdote” below (What do tonsillectomies have in common with auto repair?). This is a
particularly good example for teaching the lesson, “there are no solutions, only tradeoffs.” None of the
three solutions is very good: (1) If you leave the decision making with the mechanics, you have to make
sure they don’t recommend needless repairs; (2) if you change their incentives to flat salary, you can
expect shirking; and (3) giving the decision making to someone else results in costly duplication. Be sure
to draw the analogy to the current health care debate. It will shake your students up when they realize the
dreary choices in front of them.
In-class Problem
If you do not assign it, the following question (Individual HW Chapter 2) is a good one to motivate
problem solving. Tell them to put themselves in the role of the newly hired manager. Ask them what the
problem is; and then how to solve it.
Goal Alignment at a Small Manufacturing Concern
The owners of a small manufacturing concern have hired a manager to run the company with the
expectation that he will buy the company after five years. Compensation of the new vice president is a flat
salary plus 75% of first $150,000 of profit, and then 10% of profit over $150,000. Purchase price for the
company is set as 4½ times earnings (profit), computed as average annual profitability over the next five
years. Does this contract align the incentives of the new vice president with the goals of the owners?
Answer:
No. Both the purchase price and the profit sharing create perverse incentives. The VP keeps $0.75 of
each dollar earned up to $150,000, but only $0.10 of each dollar earned after $150K. Since earning more
requires more effort (increasing marginal effort), the VP has little incentive to earn more than $150,000.
And every dollar the VP earns raises the price that he will eventually pay for the company by $4.50,
effectively penalizing him for increasing company profitability.
Additional Anecdotes: Sears Automotive and Kidder-Peabody
SEARS AUTOMOTIVE: What do tonsillectomies have in common with auto repair?
In 1992 charges were brought against Sears whose mechanics were recommending unnecessary auto
repairs. The problem was traced to the incentive system used by Sears (and others in the industry):
“[the] use of quotas, commissions, or similar compensation may provide incentives for sales personnel to
sell unnecessary auto repair services in order to meet quotas or receive larger commissions.”
Sears tried to fix the problem by re-organizing into two divisions, one responsible for recommending
repairs; and the other responsible for doing them. Rather than solving the problem, however, the two
divisions got together and began colluding. In exchange for recommending unnecessary repairs, the
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service division paid the recommending division for recommending them. Sears finally adopted flat pay
for the mechanics, which led to shirking.
I used this example in Vanderbilt's MMHC class (syllabus) to illustrate the difficulties of aligning the
incentives of providers with the goals of payers. President Obama tried to make the same point when he
accused physicians of performing unnecessary tonsillectomies. However, as the Sears example suggests,
there are no "fixes" to the problem, only tradeoffs:
Incentives matter, yet maybe the truth is that medicine is a highly complex science in which the
evidence changes rapidly and constantly. That’s one reason tonsillectomies are so much rarer now
than they were in the 1970s and 1980s—but still better for some patients over others. As the
American Academy of Otolaryngology put it in a press release responding to Mr. Obama’s
commentary, clinical guidelines suggest that “In many cases, tonsillectomy may be a more effective
treatment, and less costly, than prolonged or repeated treatments for an infected throat.”
Mr. Obama seems to think that such judgments are easy. “If there’s a blue pill and a red pill and the
blue pill is half the price of the red pill and works just as well,” he asked, “why not pay half price for
the thing that’s going to make you well?” But usually the red and blue treatments are available—as
well as the green, yellow, etc.—because of the variability of disease, human biology and patient
preference. And the really hard cases, especially when government is paying for health care, are those
for which there’s only a red pill and it happens to be very expensive.
KIDDER-PEABODY:
In 1992 Joseph Jett became a star bond trader for Kidder-Peabody, earning a two-million-dollar bonus.
As his monthly profits grew, he was allowed to risk more and more capital in his trading portfolio, and
was eventually promoted to head of the Government Trading Desk. By the end of 1993, Jett had been
promoted to managing director. He also received the “Chairman’s Award” for outstanding performance,
in addition to a $9 million year-end bonus.
Joseph Jett traded “strips,” which involved separating the interest payments from the principal on a
government bond. He specialized in putting interest payments back together with the stripped bonds, thus
reconstructing original bond. This activity earns profits by taking advantage of yield differences between
zero-coupon bonds (no interest payments) and interest-bearing bonds.
However, at Kidder-Peabody, this activity seemed to earn profits—even in the absence of any yield
differences. The antiquated information system at Kidder-Peabody tracked zero-coupon bonds by price
instead of yield, which overstated their value once they entered the system. The information system
rewarded Jett contemporaneously for sales of five-day forward contracts on reconstructed bonds. This
allowed Jett to realize contemporaneous profits that would disappear in five days, when the computer
recorded the future reconstruction. However, by rolling the contracts forward, Jett was able to keep these
profits on the books. In order to make this work, Jett had to continuously increase the size of his
portfolio.
Early in 1994, the information system at Kidder began having trouble keeping up with Jett’s trading
activity. From 1992-1994, Jett had traded about $1.7 trillion in government securities, about half of all
outstanding government debt. When the source of the profits was uncovered, Kidder liquidated Jett’s
positions, and the company was sold to Paine-Webber for under-performing the market.
Joseph Jett was fired for refusing to cooperate with the resulting internal investigation but was cleared of
criminal fraud charges in 1996. Kidder’s civil suit to collect $9 million from Jett was rejected by the
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NASD (National Association of Securities Dealers). He was fined by an SEC administrative judge but
was allowed to keep $3.7 million in compensation earned while at Kidder.
Jett’s boss, Edward Cerullo, was forced to resign in 1994. The Securities and Exchange Commission
charged him with failing to supervise Jett’s trading activities. He was suspended from working in the
industry for one year, but walked away with $9 million in severance pay and deferred compensation.
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2. THE ONE LESSON OF BUSINESS
Capitalism & Wealth
Do Mergers Move Assets to Higher-Valued Uses?
Does the Government Create Wealth?
Economics versus Business
Wealth Creation in Organizations
Main Points
•
•
•
•
Voluntary transactions create wealth by moving assets from lower- to higher-valued uses.
Anything that impedes the movement of assets to higher-valued uses, like taxes, subsidies, or
price controls, destroys wealth.
The art of business consists of identifying assets in low-valued uses and devising ways to
profitably move them to higher-valued ones.
A company can be thought of as a series of transactions. A well-designed organization rewards
employees who identify and consummate profitable transactions or who stop unprofitable ones.
Supplementary Material
ManagerialEcon.com (Chapter 2)
Steven Landsburg, “The Iowa Car Crop,” The Armchair Economist, (New York: The Free Press, 1993)
pp. 197-202.
This reading illustrates the idea that “voluntary transactions create wealth” by making the case for
international trade.
Steven Landsburg, “Why Taxes are Bad: The Logic of Efficiency,” The Armchair Economist, (New
York: The Free Press, 1993) pp. 60-72.
This reading illustrates the concept of efficiency and shows how taxes cause inefficiency.
MBAprimer.com, Managerial Economics Module, Section 1. “Using Economics in Management
Decisions.” http://mbaprimer.com
This interactive, online hypertext motivates the study of economics for MBA’s. At the end of the
text there is a short, five question quiz so that the students can “self test.” I give a very similar five
question quiz to make sure that the students learn this material well.
Frédéric Bastiat, “Candlemakers’ Petition.” (http://bastiat.org/en/petition.html)
One of the most famous documents in the history of free-trade literature is Bastiat’s famous parody,
in which he imagined the makers of candles and street lamps petitioning the French Chamber of
Deputies for protection from a most dastardly foreign competitor, the sun.
Example of how taxes destroy wealth; but they also create opportunities for those know how to evade
them
A [Massachusetts] lawmaker who voted to hike the state sales and alcohol taxes was spotted
brazenly piling booze in his car - adorned with his State House license plate - in the parking lot of
a tax-free New Hampshire liquor store
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Short Videos:
7-minute video : The One Lesson of Business
7-minute video : Larry the Liquidator on “other people’s money”
The first is an animated lecture by Froeb; and the second is a famous scene of a vulture capitalist
addressing a shareholders’ meeting of a company considering his offer to buy up the company
and liquidate it.
Milton Friedman, “The Social Responsibility of Business is to Increase its Profits,” The New York Times
Magazine, (Sept. 13, 1970).
A clear articulation of what my colleagues in the Divinity School refer to as the “Andrew Carnegie
Dichotomy,” a company should make as much money for its shareholders as possible in order to let
them do “good” with the money, should they choose.
Teaching Note
I often begin with a brief overview of “where have we been, where are we going, and how are we going
to get there?” Students like this, as it puts what we are doing into perspective. In this case, I remind them
in the first chapter we showed students how to align the incentives of individuals with the goals of an
organization (give them enough information to make good decisions and the incentive to do so); in this
chapter we show them how to identify profitable decisions.
We start out talking about the wealth creating mechanism of capitalism is the movement of assets to
higher valued uses, and that taxes, price controls, and subsidies slow down the movement of assets, or
encourage assets to move in the wrong direction. I then remind them that decision making in firms can
either move assets to higher valued uses, or not, and that the point of this lecture is to show them how to
make profitable decisions by learning how to compute the benefits and costs of a decision.
The main point of this chapter is to introduce the metaphor that ties all the business problems together:
Identifying assets in lower valued uses, and then figuring out how to profitably move them to higher
valued uses. Get them thinking about how to use this metaphor to help identify problems (which assets
are in lower valued uses) as well as how to solve them (how do we profitably move them to a higher
valued use?).
I open this class by asking students how wealth is created (by moving assets to higher valued uses). If
the student answers correctly, ask the respondent what they mean by “value” (ability to pay). If you get
another correct answer, confront the student by asking “do you mean that a poor student, growing up in
poverty, does NOT value education?” (Yes, that is correct.). With executive MBA’s, you might want to
ask students how they, or their company, create wealth. Relate it back to moving assets to higher valued
uses.
The “one lesson of business” is to find assets in lower valued uses and find a way to profitably move
them to a higher valued use. Alternatively, the lesson can be rephrased as seeking out unconsummated
wealth creating transactions and finding ways to profitably consummate them. This theme will tie all the
book chapters together.
Many students have taken a microeconomics class, and then I use a “compare and contrast” approach to
explain how micro differs from managerial. Several points to reinforce:
 Economists are concerned with public policy; MBA’s with making money.
10


Economics tools help you spot assets in lower valued uses and to design public policy to facilitate
the movement of assets to higher valued uses. MBA’s use economics to spot assets in lower
valued uses so they can buy them, and profitably move them to a higher valued use.
Economists see inefficiency as something to be eliminated; MBA’s as something to be exploited.
Elimination of inefficiency is a by-product of their effort to exploit it.
I illustrate the difference between micro and managerial by looking at the effects of three policies on
marginal transactions: price controls (prevent some voluntary wealth creating transactions); taxes (deter
movement of some assets to higher valued uses), and subsidies (move some assets to lower valued uses).
Then, after you have identified assets in lower valued uses, ask what an economist would do (change
policy) and what an MBA would do (buy the asset, and sell it to someone who valued it more highly.) I
focus only on the “marginal” transactions that are affected by the policies.
You may also want to talk about the role of government in facilitating wealth creating transactions.
Compare and contrast countries, like Zimbabwe, with those of Hong Kong or the US (PJ O’Rourke’s
book, Eat the Rich, is great on this account). The paradox is that there is more wealth creating potential
in countries like these because the government’s rules have put assets in lower valued uses, but the same
government rules make it difficult to move them to higher valued uses.
I close the lecture by noting that organizations have trouble creating wealth for analogous reasons:
internal taxes, subsidies, or price controls that impede the movement of assets to higher valued uses
within the organization. Use an example, (my favorite is Phycor, a physician management company that
purchased physician practices with stock, and this reduced the incentive of physicians to work hard,
essentially by turning owner/managers into stockholders of a larger entity), or refer back to the two stories
in the first chapter.
In-class Problem
Ask a student for an example of a price control, tax, or subsidy, and then ask them which assets end up in
lower valued uses. Ask someone else if they can figure out a way to make money from the inefficiency?
If you get no volunteers, ask someone to analyze the effects of the minimum wage. Do this without
supply and demand; instead talk about the transactions that are deterred by the regulation (employers
willing to hire at a wage below the minimum wage and those willing to work at below the minimum wage
are deterred from transacting). Ask if there is a way to make money by consummating these transactions
(outsourcing, start a temp agency, etc.).
Additional Anecdote: Zimbabwe
Discuss the following article
“Mugabe should heed the warnings of Hayek,” by Marian Tupy, Financial Times, Copyright
2005 The Financial Times Limited, Published: July 27 2005
Available online at http://www.ft.com/cms/s/939cb766-fe3c-11d9-a289-00000e2511c8.html
The article summarizes the negative economic consequences associated with the expropriation of private
property of (white) commercial farmers in Zimbabwe in 2000.
11
3. BENEFITS, COSTS, AND DECISIONS
Background: Variable, Fixed and Total Costs
Background: Accounting vs. Economic Profit
Costs Are What You Give Up
Fixed- or Sunk-Cost Fallacy
Hidden-Cost Fallacy
Economic Value Added®
Does EVA® work?
Psychological Biases and Decision-Making
Main Points
•
•
•
•
•
•
•
•
•
Costs are associated with decisions, not activities.
The opportunity cost of an alternative is the profit you give up to pursue it.
In computing costs and benefits, consider all costs and benefits that vary with the consequences
of a decision and only those costs and benefits that vary with the consequences of the decision.
These are the relevant costs and benefits of a decision.
Fixed costs do not vary with the amount of output. Variable costs change as output changes.
Decisions that change output will change only variable costs.
Accounting profit does not necessarily correspond to real or economic profit.
The fixed-cost fallacy or sunk-cost fallacy means that you consider irrelevant costs. A common
fixed-cost fallacy is to let overhead or depreciation costs influence short-run decisions.
The hidden-cost fallacy occurs when you ignore relevant costs. A common hidden-cost fallacy is
to ignore the opportunity cost of capital when making investment or shutdown decisions.
EVA® is a measure of financial performance that makes visible the hidden cost of capital.
Rewarding managers for increasing economic profit increases profitability, but evidence suggests
that economic performance plans work no better than traditional incentive compensation schemes
based on accounting measures.
Supplementary Material
ManagerialEcon.com (Chapter 3)
MBAprimer.com, Managerial Economics Module, Section 2. “Understanding the Seller’s Cost”
http://mbaprimer.com
This interactive, online hypertext includes a short, five question quiz so that the students can “self
test.” I give a very similar five question quiz to make sure that the students learn this material well.
Samuel L. Baker, Economics Interactive Tutorials,
http://hspm.sph.sc.edu/COURSES/ECON/Tutorials2.html
1. Total Cost, Variable Cost, and Marginal Cost
Similar to the MBA Primer but with less attention to the graphic design aspects.
Harvard Business School Note: “Relevant Costs and Revenues,” HBS 9-892-010
This reading illustrates the idea that the relevant costs and revenues are those that vary with the
consequence of the decision. It goes through a couple of different decisions and identifies which
accounting costs are relevant, and which are not.
12
Teaching Note
The main point of this lecture is to get students to understand that costs and decisions are intrinsically
related to one another. I illustrate this with a simple decision tree, choosing between two mutually
exclusive alternatives, and the profit associated with each alternative. The benefit of each alternative is
the profit associated with the alternative, and the cost is the forgone profit of the alternative not chosen.
Benefit-cost analysis is easy in principle, but difficult in practice (which is why business school costs so
much). I remind them that whenever they get confused about applying benefit-cost analysis, step back
and recall what decision you are trying to make. Then compute the profit of each alternative, and choose
the one with the highest profit.
Drill this last point home: “if you start your analysis by looking at costs, you will always become
confused; if you start your analysis with a question, you will never get confused.” CONSIDER ALL
COSTS THAT VARY WITH THE CONSEQUENCES OF A DECISION; BUT ONLY COSTS THAT
VARY WITH THE CONSEQUENCE OF A DECISION.
I then sometimes bait the students by looking at one and asking where she works and asking what are the
costs of her division. If she “bites” and start listing the costs, I yell at her and say “HAVEN’T YOU
BEEN PAYING ATTENTION?” Costs are defined ONLY by the decision you are trying to make. For
example, the costs associated with a pricing decision are very different than the costs associated with a
decision to outsource production.
I then tell them that there are only two mistakes they can make: ignoring relevant costs (the hidden-cost
fallacy) and taking into account irrelevant costs (the sunk- or fixed-cost fallacy). I illustrate the costs with
a football game. Going to a game because you purchased the ticket cheaply even though you can scalp it
for much more (the hidden-cost fallacy); or staying past half time even though your team is losing badly
because you want to get your money’s worth (sunk-cost fallacy).
TABLE 3-2 Outsourcing a Washing Machine Agitator
The second point of the lecture is to get students to understand the accounting costs are not economic
costs. I make fun of accountants as “bean counters.” In business the biggest sunk-cost fallacy is
associated with depreciation, and I tell them the story in the text of a GE profitable outsourcing
opportunity that was NOT realized (see table above) because the accountants decided to dump the undepreciated tooling costs onto the manager’s income statement should he decide to outsource, which
meant that the manager would forgo a $40,000 bonus, tied to division income. I said that the accountants
13
were just following GAAP procedures (If you pronounce it as G-ah-ah-P, to make it sound like a sheep,
students will laugh).
You can have a lot of fun with this anecdote. Ask students how to fix this problem. Most will say that
they should not penalize the division manager for doing the right thing, and say that senior management
should step in to re-adjust his bonus? I then ask them what kind of incentive that this creates for division
managers (they will complain to senior management about every decision that is not properly recognized
and rewarded).
You can also shorten the depreciation time. Ask student if they still think this is a problem if the same
manager was the one who incurred the tooling costs 6 years ago? What about 1 year ago? (un-depreciated
assets of $900K.) They should come to the realization that if the division manager could have foreseen
that outsourcing would become profitable, then you should penalize him for making the wrong decision.
But this also gives managers an incentive to ignore profitable outsourcing opportunities after they have
made investment decisions.
You can also have an interesting discussion about ethics. Compare and contrast the behavior of the
washing machine plant manager who decided not to outsource even though outsourcing was more
profitable alternative for GE, to the behavior of the oil company executives who deliberately overbid for
the oil in Chapter 1. Ask students what the difference is. Stake out a position that they were both doing
what the company asked them to do through the incentives set up by the company. (Point out that this is
a version of the Adolf Eichmann defense “I was just following orders”).
You can also ask for examples of the sunk cost fallacy in class. Corporate overhead often comes up.
The biggest hidden cost fallacy is the hidden cost of capital (it does not appear in accounting statements).
Here I like to talk about EVA® as making visible the hidden cost of capital. Success stories can be
downloaded from the Stern Stewart web site (http://www.sternstewart.com/), although I tell them that
Stern Stewart “oversells” their program. All it does is make visible the hidden cost of capital.
In-class Problem
Tell students that GM or Chysler is losing money, and ask a student if they would recommend shutting
down. Ask them how much money GM would save by shutting down.
Additional Anecdote: Coca-Cola
As an example of a company that did not ignore its cost of capital, consider Coca-Cola in the 1980s. It
had very little debt because it preferred to raise equity capital from its stockholders. It also had a
diversified product line, including products like aquaculture and wine. But none of these activities earned
as much as its soft drink division. The opportunity cost of investing in these unrelated businesses was the
forgone opportunity to expand the soft drink division, which at the time was earning a 16 percent return
on capital. Although these other businesses were earning a positive 10 percent rate of return on capital,
the opportunity cost of that capital was 16 percent. CEO Robert Goizueta correctly decided to sell off
these under-performing divisions and invest the capital in its soft drink division. By making decisions
whose benefits were greater than their costs, the topic of this chapter, Coca-Cola increased its
profitability.
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4. EXTENT (HOW MUCH) DECISIONS
Background: Average and Marginal Costs
Marginal Analysis
Incentive Pay
Tie Pay to Performance Measures that Reflect Effort
If Incentive Pay is So Good, Why Don’t More Companies Use it?
Main Points









Do not confuse average and marginal costs.
Average cost (AC) is total cost (fixed and variable) divided by total units produced.
Average cost is irrelevant to an extent decision.
Marginal cost (MC) is the additional cost incurred by producing and selling one more unit.
Marginal revenue (MR) is the additional revenue gained from selling one more unit.
Sell more if MR > MC; sell less if MR < MC. If MR = MC, you are selling the right amount
(maximizing profit).
The relevant costs and benefits of an extent decision are marginal costs and marginal revenue. If
the marginal revenue of an activity is larger than the marginal cost, then do more of it.
An incentive compensation scheme that increases marginal revenue or reduces marginal cost will
increase effort. Fixed fees have no effects on effort.
A good incentive compensation scheme links pay to performance measures that reflect effort.
Supplementary Material
ManagerialEcon.com (Chapter 4)
MBAprimer.com, Managerial Economics Module, Section 2. “Understanding Sellers’ Costs.”
http://mbaprimer.com
Interactive, online hypertext covers same material. At the end of the text there is a short, five
question quiz so that the students can “self test.” I give a very similar five question quiz to make
sure that the students learn this material well.
Samuel L. Baker, Economics Interactive Tutorials,
http://hspm.sph.sc.edu/COURSES/ECON/Tutorials2.html
2. Marginal Cost and the Price-Taking Firm's Optimal Output Rate
4. Demand
5. Elasticity
6. Elasticity II
Similar to the MBA Primer but with less attention to the graphic design aspects.
Harvard Business School Note: "Basic Quantitative Analysis for Marketing", HBS 9-584-149.
Break even quantities, prices, and relevant costs for marketing decisions.
Harvard Business School Note: "A Note on Microeconomics for Strategists" pp 1-9, HBS 9-799-128.
15
Summarizes the core ideas about the microeconomics of markets that are most relevant to business
strategy.
Teaching Note
I begin with the anecdote of the truck leasing company leasing too many trucks (see the additional
anecdote for this chapter) and note that this is an extent decision (“how much”). Who made the bad
decision? Did they have enough information to make a good decision; and the incentive to do so?
Depending on whether they have read the book, follow up with the anecdote of the hospital obstetrics
department whose head wanted to expand operations because the MR>MC. But the OB department lost
$700 on each patient so the CEO was reluctant to expand. It illustrates the basic idea of the chapter, that
the relevant costs and benefits of the decision are not average costs but rather the marginal costs.
Shutting down the OB department was not an option due to community pressure. After students get the
right answer, I remind them that whenever they get confused, go back to the decision they are trying to
make. Then the benefit cost analysis will be clear.
I tell them that marginal analysis is simple—you break up the extent decision into tiny steps and take
another step if the benefits of taking another step are bigger than the costs of taking another step.
Marginal analysis can tell you ONLY which direction to step; it cannot tell you how far to step.
Then go through a simple example, like the long distance phone company increasing TV advertising by
$50,000 and this yielded 1,000 new customers; the cost of another customer is $50 (sometimes called
“customer acquisition cost”). If the benefit of another customer is greater than $50, then do more
advertising; if it is less, do less advertising. Stress that the informational requirements: marginal analysis
tells you only which direction to go, it does not tell you how far to go. Get there by taking steps, and
recomputing marginal costs and benefits.
I then compare two alternate ways of acquiring customers: TV advertising vs. phone solicitation. If you
recently cut back on phone solicitation expenditures by $10,000 and this lost you 100 customers, then
customer acquisition costs by phone solicitation are $100/customer. So cut back further on phone
solicitation and use the savings to finance more TV advertising. Again, marginal analysis tells you only
which direction to move, not how far to move. When you make these changes, make them one at a time
so that you can gather information on the marginal effectiveness of each medium.
Now that they think they understand this logic ask them the logging question: which bid should you
accept for a tract of timber containing 100 trees. One bid is for $150/tree, and the other bid is for $15,000
for the right to harvest all the trees. If the forest is a mix of fir (worth $50/tree) and pine worth
($150/tree) the logger will harvest only the pine. The second contract is essentially a fixed cost with
respect to the decision of how many trees to cut down, so the logger ignores it and cuts down all the trees.
The decision of how hard to work is an extent decision and is governed by the logic of marginal analysis.
Segue to the example of which incentive compensation to use: a ten percent commission rate
($1000/sale) or a five percent ($500/sale) commission rate plus a $50,000/year flat salary. Each year you
expect the salesperson to sell 100 units at a price of $10,000 per unit. If some sales are easy to make (cost
less than $500 of effort to make) and some sales are hard to make (cost more than $500 if effort) the sales
person will make only the easy sales under this weaker incentive compensation. Make the analogy: just
as the higher MC of cutting trees reduced the incentive to cut, so too does the lower commission rate
reduce the marginal benefit of making sales. Economists call this “shirking.”
16
If you want to have fun, re-ask the “ethics” question: what is the difference between the sales person on
5% commission who doesn’t make the hard sales and the senior management at the gas company who
over bid deliberately for the offshore oil tract. Insist that there is none.
I close with the story that shows the practical difficulties of instituting incentive pay (tie pay to
performance measures that reflect effort). A consulting firm instituted incentive pay by moving the COO
from a $75K flat salary to a $50K salary plus 1/3 of every dollar his office earned over $150K. Ask
someone why only earnings over $150K? (Because the first $150K would be earned with little or no
effort). Earnings for the incentive compensation contract were defined as the revenues minus the costs
over which the COO had control. Reinforce the point that accounting earnings are NOT related to the
relevant marginal costs of effort. A separate set of books was kept that reflected employee effort. Ask
students if they discovered the separate set of books, whether they would be suspicious that something
illegal was going on.
In-class Problem
QUESTION: A firm recently spent $100 on Google Adwords and generated 100 extra visits to the firm’s
web site, 5 of which resulted in a purchase. To pay for the change, they dropped the banner advertising
on ESPN.com, saving $1000, but which also reduced the number of visits to their web site by 500, and 20
fewer sales. Sales from visitors from ESPN.com were, on average, 25% higher than sales from visitors
from Googel Adwords. Evaluate the decision to shift advertising money from ESPN.com to Google
Adwords.
ANSWER: On Google Adwords, the marginal effectiveness of advertising is 1 sale for $20 dollars
($100/5); while the marginal benefit of advertising on ESPN is 1 sale for $50 ($1000/20). But since a
sale from ESPN is more valuable than a sale on Google Adwords, 20 sales from ESPN.com is “equivalent
to” 25 sales from Google Adwords, thus the marginal effectiveness of ESPN.com advertising is $1000/25
or 1 sale for $40.
Additional Anecdotes: Truck Leasing and American Express
Leasing companies purchase capital equipment, like airplanes or trucks, and then lease the equipment to
the firms that actually use them. On its face, it is hard to see why this is a wealth-creating transaction
since the end-users could borrow money and purchase the equipment themselves. The answer is that
banks, due to the way they are regulated, are more willing to lend to companies with less debt. By leasing
equipment, a company moves debt, albeit with assets, off its balance sheet, which makes it easier to
borrow more heavily. The enhanced borrowing ability of low-debt companies makes leasing more
valuable than owning.
In the fall of 2000, one such truck leasing company was having trouble making money. The company
purchased over-the-road trucks for $92,000 and then leased them to various transport companies, ranging
from small owner-operators to large publicly owned firms with fleets of over a hundred trucks.
The problem could be traced to incentives of the sales force. Salespeople who negotiated the leases were
paid a commission equal to $2,000 for each truck they leased, regardless of the profitability of the lease.
Sales people responded to this incentive by leasing as many trucks as they could. The easiest way to do
this was to charge low rates, which resulted in low profits for the leasing company.
We call this an “extent” decision, because the company implicitly decided “how many” trucks to lease
through its compensation scheme. In this chapter, we show how to identify and implement profitable
extent decisions.
17
American Express offers its Platinum Card to an affluent customer segment whose annual income is
above $100,000 USD. In 2001, there were approximately 2,000 Platinum cardholders in the Japanese
market. To further its goal of delivering the most customer-oriented service among credit card providers
in Japan, the company set a limit on the number of the Platinum cardholders. With technology advancing,
however, the company began to consider whether it could expand the membership of the Platinum
Cardholders without sacrificing the quality of service, thus increasing market share and profits.
In order to maximize its profit, American Express needed to determine how many more members it
should acquire. As more members are acquired, average spending per card member decreases because
the financial threshold for membership is lowered. At the same time, costs of customer service rise for
each additional platinum member added. Growing beyond a certain point would require building and
operating an additional call center. After analyzing the costs and benefits, American Express realized that
it should expand its offering to acquire a total of 15,000 Platinum Card members to maximize its profits.
We call this an “extent” decision, because the company needed to decide “how many” platinum cards to
provide. In this chapter, we show you how to make profitable extent decisions.
18
5. INVESTMENT DECISIONS: LOOK AHEAD AND REASON BACK
How to Determine whether Investments are Profitable
Break-Even Analysis
Choosing the Right Manufacturing Technology
Shutdown Decisions and Break-Even Prices
Sunk Costs and Post-investment Hold-Up
Solutions to the Hold-Up Problem
Main Points
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






Investments imply willingness to trade dollars in the present for dollars in the future. Wealthcreating transactions occur when individuals with low discount rates (rate at which they value
future vs current dollars) lend to those with high discount rates.
Companies, like individuals, have different discount rates, determined by their cost of capital.
They invest only in projects that earn a return higher than the cost of capital.
The NPV rule states that if the present value of the net cash flow of a project is larger than zero,
the project earns economic profit (i.e., the investment earns more than the cost of capital).
Although NPV is the correct way to analyze investments, not all companies use it. Instead, they
use break-even analysis because it is easier and more intuitive.
Break-even quantity is equal to fixed cost divided by the contribution margin. If you expect to
sell more than the break-even quantity, then your investment is profitable.
Avoidable costs can be recovered by shutting down. If the benefits of shutting down (you recover
your avoidable costs) are larger than the costs (you forgo revenue), then shut down. The breakeven price is average avoidable cost.
If you incur sunk costs, you are vulnerable to post-investment hold-up. Anticipate hold-up and
choose contracts or organizational forms that minimize the costs of hold-up.
Once relationship-specific investments are made, parties are locked into a trading relationship
with each other, and can be held up by their trading partners. Anticipate hold-up and choose
organizational or contractual forms to give each party both the incentive to make relationshipspecific investments and to trade after these investments are made.
Supplementary Material
ManagerialEcon.com (Chapter 5)
MBAprimer.com, Managerial Economics Module, Section 3. “Understanding Sellers’ Costs.”
http://mbaprimer.com
Interactive, online hypertext covers same material. At the end of the text there is a short, five
question quiz so that the students can “self test.” I give a very similar five question quiz to make
sure that the students learn this material well.
Samuel L. Baker, Economics Interactive Tutorials,
http://hspm.sph.sc.edu/COURSES/ECON/Tutorials2.html
3. Average Cost and the Break-Even Output Rate
9. Discounting Future Income
19
Similar to the MBA Primer but with less attention to the graphic design aspects.
Harvard Business School Note: "Basic Quantitative Analysis for Marketing", HBS 9-584-149.
Break even quantities, prices, and relevant costs for marketing decisions.
Teaching Note
Continuing with the theme that costs are related to decisions, this chapter identifies the relevant benefits
and costs of investment decisions. I begin with the anecdote of how TVA “held up” Mobil Oil after they
made a three month investment in an engineering audit of TVA’s lubrication needs, and tell students
Mobil did not “look ahead and reason back”, one of the main lessons of the chapter (this anecdote is at the
beginning of the Sunk Costs and Post-Investment Hold-Up section of the chapter).
I start by talking about NPV analysis as an “if and only if” proposition. Investments cover the (hidden?)
cost of capital if and only if they have a positive NPV. To set this up, talk about compounding and
discounting as the inverse of compounding. Talk about behavior of people with high discount rates
(smoking, uneducated, over weight), i.e., unwilling to undertake investments unless they return a lot of
money.
I then talk about entry decisions, introduce break even quantities, and give an example. Then I tell the
story of John Deere abandoning its large fixed cost but low MC factory in favor of buying Versatile, a
company that assembled off-the-shelf components in a large garage (low fixed cost, but high MC). If
expected sales were low, then this was a good decision. Get them to think of costs as related to the
underlying technology.
I then introduce break-even prices and give an example of how they are used in shut down decisions. Use
the cost taxonomy (long run: avoidable vs. unavoidable; short run: fixed vs. variable). Give an in-class
example, with fixed costs of $100/year, expected production of 100/year, and MC of $5. Ask them how
low price can go before they shut down. The answer is “it depends” on whether the fixed costs are
avoidable (long run) or not (short run).
I ask them what they would do if their firm received an RFP (request for proposal) on a wire harness from
GM with fixed costs of $1 million and MC of $1 with expected sales of 1 million units. The break even
price is $2. GM agrees to the price, and then hands you with a PO (purchase order) for .5 million units,
what do you say? Students will usually see the problem. Ask students whether this behavior is ethical? I
then tell them to anticipate self-interested behavior.
Go through the printer example to make them understand the importance of fixed vs. sunk (relationshipspecific) costs. Talk about the problem is that the investment will NOT be made unless the parties can
solve the hold-up problem. Ask how to do this. They will usually come up with the “rental” solution (the
magazine buys the printer, and rents it to the printing company).
I talk a little about contracts, hostage exchange, or vertical integration as a solution to the hold-up
problem, and then talk about hold-up problem in marriage but only with the older (executive) MBA
students. The younger students will not relate to a marriage example. I like to talk about Patent Ambush
as an example of post investment hold up. In 2003, the FTC sued Unocal for illegally obtaining market
power by suggesting the California Air Resources Board (CARB) adopt its formula for cleaner burning
fuel. After the oil refiners had sunk billions of dollars into modifying their refineries to produce the new
formula announced that it owned a patent on the formula that would cost them five cents/gallon to use.
20
When Chevron purchased Unocal, the FTC made them stop charging royalties on CARB gasoline.
In-class Problem
In the teaching notes below, I pose several different in-class problems, repeated here for convenience.
QUESTION 1: With fixed costs of $100/year, expected production of 100/year, and MC of $5. What is
shut down price?
ANSWER 1: Depends on which costs are avoidable. If fixed costs are avoidable, then shut down price is
$6, if they are not, then it is $5.
QUESTION 2: Your firm received an RFP (request for proposal) on a wire harness from GM with fixed
costs of $1 million and MC of $1 with expected sales of 1 million units. What is break-even price?
ANSWER 2: Break even price is $2.
QUESTION 3: GM agrees to the price, and then hands you with a PO (purchase order) for .5 million
units, what do you say?
ANSWER 3: Students will usually see the problem. You say “no” or quote them a higher break even
price on first 0.5 million ($3) with a promise that the second 0.5 million will be cheaper ($1).
Additional Anecdote: John Deere
In 1986, John Deere was in the middle of building a capital-intensive Henry-Ford-style factory to produce
large four-wheel-drive farm tractors, when the price of wheat dropped dramatically. This reduced
demand for the large tractors, which were primarily used for harvesting wheat. John Deere abandoned
construction of the factory and purchased Versatile, a Canadian company that assembled tractors in a big
garage using off-the-shelf components. The decision meant that the company could reach profitability
sooner, with fewer sales, than if they had built their own factory. John Deere’s decision to abandon a
capital-intensive production technology in favor of one with lower capital requirements is an example of a
“discrete” or all-or-nothing decision.
21
SECTION II – PRICING, COSTS, AND PROFITS
6. SIMPLE PRICING
Background: Consumer Surplus and Demand Curves
Marginal Analysis of Pricing
Price Elasticity and Marginal Revenue
What Makes Demand More Elastic?
Forecasting Demand Using Elasticity
Stay-Even Analysis, Pricing and Elasticity
Main Points

Aggregate demand or market demand is the total number of units that will be purchased by a
group of consumers at a given price.

Pricing is an extent decision. Reduce price (increase quantity) if MR > MC. Increase price
(reduce quantity) if MR < MC. The optimal price is where MR = MC.

Price elasticity of demand, e = (% change in quantity demanded)  (% change in price)
o Estimated price elasticity = [(Q1 – Q2)/(Q1 + Q2)]  [(P1 – P2)/(P1 + P2)] is used to estimate
demand from a price and quantity change.
o If |e| > 1, demand is elastic; if |e| < 1, demand is inelastic.

%Revenue  %Price + %Quantity

Elastic Demand (|e| > 1): Quantity changes more than price.
Revenue
Price ↑
–
Price ↓
+

Inelastic Demand (|e| < 1): Quantity changes less than price.
Revenue
Price ↑
+
Price ↓
–

MR > MC implies that (P - MC)/P > 1/|e|; that is, the more elastic demand is, the lower the price
o

Four factors make demand more elastic:
o Products with close substitutes (or distant complements) have more elastic demand.
o Demand for brands is more elastic than industry demand.
o In the long run, demand becomes more elastic.
o As price increases, demand becomes more elastic.

Income elasticity, cross-price elasticity, and advertising elasticity are measures of how changes
in these other factors affect demand.
22

It is possible to use elasticity to forecast changes in demand: %ΔQuantity ≈ (factor
elasticity)*(%ΔFactor).

Stay-even analysis can be used to determine the quantity change required to offset a price
change. The stay-even quantity is %ΔQ=%ΔP/(%ΔP+margin)
Supplementary Material
ManagerialEcon.com (Chapter 6)
MBAprimer.com, Managerial Economics Module, Section 3. “Understanding Buyer’s Demand.”
http://mbaprimer.com
Interactive, online hypertext covers same material. At the end of the text there is a short, five
question quiz so that the students can “self test.” I give a very similar five question quiz to make
sure that the students learn this material well.
Samuel L. Baker, Economics Interactive Tutorials,
http://hspm.sph.sc.edu/COURSES/ECON/Tutorials2.html
8. Monopoly: Marginal Revenue and the Profit-Maximizing Price and Output Rate
Similar to the MBA Primer but with less attention to the graphic design aspects.
Teaching Note
I begin with an anecdote to motivate the pricing chapter, and tell them that simple pricing (a uniform
price to all customers) is an extent decision that should be made using marginal analysis. Simple pricing
can be converted into a quantity decision (how much to sell) by the demand curve and that is why we
study demand curves. If the MR from selling another unit is more than the MC, then sell more, and you
do this by reducing price.
Go through the derivation of a simple aggregate demand curve to illustrate this point, seven individuals
who each want a single unit of a good. Line them up by what they are willing to pay. At a price of $7,
one customer buys, at a price of $6, two, and so on. Then compute the revenue, and then the MR, and
illustrate the basics of marginal analysis. Ask them should you sell the first unit? If they say “yes,” tell
them NO!—the right answer is “it depends”—in this case on the MC. For a MC of $1.50, the optimal
quantity is 3, at a price of $5.
Now, pick out a student and ask him if he understands the analysis. Then ask him what he is going to do
when his boss asks him why he is leaving $3.50 on the table (at optimum, price is $5, MC is $1.50).
Challenge his analysis, and ask whether he wants to change his mind. Try to talk him out of his analysis.
Then make the point that MR<Price.
After showing students how to use marginal analysis, I then ask if there are any engineers in the class.
Ask them why not just write down the implied profit function, differentiate it and set the first derivative
equal to zero. The reason is that they will never “see” a demand curve. Usually, the only information
you will have is what your current price is and what you current quantity is. This leads naturally to the
next question, and cold call another student and ask “if we don’t know what demand looks like, how do
we know what the MR is?”
23
Tell them if they get any info about demand it is likely to be in the form of an elasticity. Define price,
cross-price elasticity, income elasticity, and advertising elasticity. Tell them that elasticity is related to
MR. Use the approximation (pct. change in REV.)=(pct change in Q) + (pct. Change in P) to illustrate the
relationship between price changes and revenue changes and elasticity, e.g., for an elastic demand, an
increase in price results in a bigger decrease in quantity, and the net result is that revenue declines. Draw
arrows on the board to derive the relationships (elastic, inelastic) X (price increase, price decrease). Tell
the students to work this out for themselves and that they will not understand it today, but they should be
able to derive it. Give an example of the District of Columbia trying to raise the price of gasoline. Relate
it to the Laffer curve.
Tell them the exact relationship is MR=P(1-1/|e|) and that substitutes into the usual pricing analysis
MR>MC iff (P-MC)/P>1/|e|, or the “actual markup”>”desired” (or “target”) markup. Reduce price (or
sell more) if MR>MC or if the actual markup is greater than the target markup. Test their understanding
by giving them a numerical question, e=-2, P=10, MC=8. Here the desired markup is 50%, but the actual
markup is 20%. Raise price. Here is another example:
Cheaper iPhones are being introduced by Apple:
Citing a firm survey of consumers, Morgan Stanley analyst Kathryn Huberty said that a $50 price
cut (25%) could increase demand by 50 per cent and a $100 cut by 100 per cent. This implies an
elasticity of demand for iPhones of -2. The cut will increases profit if the margin, (P-MC)/P,
greater than 50%.
At this point I like to go to the Whole Foods merger case and describe that the FTC wanted to define a
PNOS product market (Premium Natural and Organic Supermarket) and their evidence was statements by
John Mackay that acquiring Wild Oats would remove the last viable competitor and evidence that when
Wild Oats shut down in Boulder Colorado, most of its customers went to Whole Foods.
On the other side of the case, Economist David Scheffman used a marginal analysis of the PNOS market,
saying essentially that the P-MC/P > 1/|e| where the margin was 40% and he argued qualitatively that
since consumers who shop at Whole Foods also shop at other grocery stores it was likely that that demand
elasticity was bigger than -2. Below we explain that he used what is known as “critical loss” analysis.
Instead of asking whether it would be profitable for all the stores in the PNOS segment to raise price, he
instead argued that a 5% price increase would be unprofitable because the firm would lose more than the
“critical” or “break even” quantity of 11.1%. The judge, who shopped at both Safeway and Whole Foods
agreed with Professor Scheffman, and allowed the merger to go through, reasoning that the actual loss
(i.e., elastic demand) would be bigger than 11.1%.
Economics in the Whole Foods merger case
Last week, a federal judge refused to grant a preliminary injunction against the Whole Foods
acquisition of Wild Oats (FTC website; testimony: day1 am, day1 pm, day2 am). He ruled that
"premium, natural and organic supermarkets" was a not a "relevant product market." A relevant
market is one in which a hypothetical, multi-store monopolist, owning all stores in the category
(and eliminating competition among them), would raise price.
In his decision, the Judge cited a break-even analysis (sometimes called "critical loss") that asks
how much quantity a monopolist could afford to lose and still want to raise price. With retail
margins of 40% (FTC complaint, p.21), a 5% price increase would require a quantity loss of no
more than 11.1% to be profitable [11.1%=5%/(5%+40%)]. Citing marketing studies showing that
customers shopped at Whole Foods as well as other grocery stores, former FTC Chief Economist
and colleague David Scheffman argued that the actual quantity lost would be greater than 11.1%,
24
presumably
to
stores
outside
the
category.
University of Chicago economist Kevin Murphy criticized the break-even analysis by focusing on
the incentive of the merged firm to raise price. From my favorite textbook,
When you price commonly owned products, ... your concern changes from earning profit
on an individual product to earning profit on both products ... Aggregate demand for a
group of substitute goods is less elastic than the individual demand for the goods that
comprise the group. And with a less elastic aggregate demand, the merged firm wants to
raise price.
The closer substitutes the two stores are, the bigger incentive the merged has to raise price
(Murphy rebuttal report).
The heavily redacted court documents refer to entry "experiments" to determine the degree of
substitution between the two merging stores. We found the following on the Whole Foods
website,
If we [close the Wild Oats Store right across the street], we believe approximately 50% of
the volume their store does will transfer to our store, with the other 50% migrating to our
other competitors (these estimates are based on our past experience with similar
situations).
It is hard to believe that the diversion ratio is this big. But even at half the size, simple models of
competition would predict a big enough post-merger price increase to put the two stores into a
relevant market by themselves.
Finally, tell them what makes demand more elastic, and relate it to strategy (Microsoft created cheap
complementary software and complementary computers to increase demand for its operating system;
while Apple decided to price high for its computers and charge a lot for complementary products, e.g.,
they charged developers a lot to buy the software development tools to write applications for the
Macintosh. Tell that that it was one of the biggest mistakes in modern business history).
In-class Problem
This is described in the teaching note below, I repeat it here for convenience. Given seven consumers,
each of whom wants one unit of a good at {$7, $6, $5, $4, $3, $2, $1}, compute the price that maximizes
revenue. Then compute the price that maximizes profit if MC=$1.50.
Price
7
6
5
4
3
2
1
Quantity
1
2
3
4
5
6
7
Rev
7
12
15
16
15
12
7
MR
7
5
3
1
-1
-3
-5
MC
1.5
1.5
1.5
1.5
1.5
1.5
1.5
Additional Anecdote: Mars (Snickers) & Sara Lee (hot dogs)
SNICKERS: In 1993, Mars began exporting its popular Snickers chocolate bar to Russia. They had no
experience in Russia, so they based the Russian price on the price in Great Britain. One local distributor
began selling the candy to retailers for much higher prices—and pocketed the difference. Some months
after her misdeeds were discovered, Mars did a demand study that verified what the distributor already
25
knew—that customers were willing to pay six times the amount charged in Great Britain due to the
novelty of the bars and the fact that they were the first western-style candy bar in Russia. Unfortunately,
by the time the mistake was discovered, foreign competitors had already entered the market and the
demand for Snickers dramatically declined.
The purpose of this chapter is to teach you how to price products and to avoid mistakes like this. We
introduce demand curves as a way to describe consumer behavior for the purpose of making profitable
pricing decisions. Profits are equal to revenue minus costs. To understand the determinants of revenue,
we use demand curves to model consumer behavior.
HOT DOGS: Between December 20, 1994 and February 1, 1995, the Mexican peso fell by 40 percent
against the dollar. In response, interest rates rose sharply, business activity slowed, and unemployment
increased dramatically. All of these changes resulted in a big decline in consumer income, and Sara Lee
saw Mexican consumption of its hot dogs decline by thirty-five percent. This was surprising to the
company's management because they considered hot dogs to be consumer staples whose consumption
would hold steady, or perhaps even rise, as income fell.
Sara Lee did a survey and found that many of their customers had turned to a cheaper source of protein-cat food mixed with eggs, rolled up in a tortilla. Further analysis showed that the decline was limited to
Sara Lee’s premium brands. The lower-priced brands took off with double-digit volume increases.
Unfortunately for Sara Lee, the lower-end brands were priced too low and lost money.
Sara Lee would have profited from a better understanding of demand for its products and how to set
prices, the topic of this chapter.
26
7. ECONOMIES OF SCALE AND SCOPE
Increasing Marginal Cost
Economies of Scale
Learning Curves
Economies of Scope
Diseconomies of Scope
Main Points
•
The law of diminishing marginal returns states that as you try to expand output, your marginal
productivity (the extra output associated with extra inputs) eventually declines.
•
Increasing marginal costs eventually cause increasing average costs and make it more difficult to
compute break-even prices. When negotiating contracts, it is important to know what your costs
curves look like; otherwise, you could end up accepting contracts with unprofitable prices.
•
If average cost falls with output, then you have increasing returns to scale. In this case you want
to focus strategy on securing sales that enable you to realize lower costs. Alternatively, if you
offer suppliers big orders that allow them to realize economies of scale, try to share in their profit
by demanding lower prices.
•
If your average costs are constant with respect to output, then you have constant returns to
scale. If average costs rise with output, you have decreasing returns to scale or diseconomies of
scale.
•
Learning curves mean that current production lowers future costs. It’s important to look over the
life cycle of a product when working with products characterized by learning curves.
•
If the cost of producing two outputs jointly is less than the cost of producing them separately—
that is, Cost(Q1,Q2) < Cost(Q1) + Cost(Q2) — then there are economies of scope between the two
products. This can be an important source of competitive advantage and shape acquisition
strategy.
Supplementary Material
ManagerialEcon.com (Chapter 7)
MBAprimer.com, Managerial Economics Module, Section 3. “Understanding Sellers’ Costs.”
http://mbaprimer.com
Interactive, online hypertext covers same material. At the end of the text there is a short, five
question quiz so that the students can “self test.” I give a very similar five question quiz to make
sure that the students learn this material well.
Shlomo Maital, "Tales of scale and scope," Barron's (Feb., 13, 1995) p. 54
27
Teaching Note
I begin by reminding students that we are continuing with our discussion of costs and decisions, and we
are going to talk about how decisions are affected by costs that go up or down with output (economies or
diseconomies of scale), or that go up or down with joint production of other products (economies of
scope). Each of the main points is illustrated with an anecdote. I start with the story of the electrical
equipment manufacturer under a hiring freeze because they were taken over by an investment banking
firm that wanted to reduce costs (see additional introductory anecdote for this chapter). As a
consequence, they created a bottleneck when no one hired a tester to test the increased number of units
that were shipped. This represents a firm with increasing MC or diseconomies of scale.
I also tell the story of Wal-Mart pressuring a pet food manufacturer for lower prices, and the change that
it made in reducing the number of SKU’s and recipes. This is a good time to ask about whether this kind
of pressure that Wal-Mart puts on its suppliers is good.
I tell the story about how Akio Morita came to the US as detailed in his biography to illustrate break even
pricing with a U-shaped cost curve. Moral of the story: know what your costs look like.
I also tell students that upward sloping marginal costs are rare. In my ten years at FTC and DOJ
investigating mergers, we always asked nonmerging firms whether they could double output at the same
MC in the event of a post-merger price increase, and they invariably said “yes.” So I think the scope of
firms is limited NOT by upward sloping MC, which economists love because it allows them to interpret
supply curves as MC, but rather by downward sloping MR. For this reason, I give short shrift to the
competitive model in the chapters that follow.
I next tell the story of Bruce Henderson, founder of BCG, one of the first strategy consulting firms, and
the discovery of learning curves in airplane production during WWII. He correctly predicted that the
Lockheed transport plane, the L1011, would bankrupt the company because it was introduced at the end
of the Vietnam war when demand was declining. They never sold enough to break even. I have heard it
said that this was the birth of the modern (quantitative/economic) consulting.
I go through the derivation of the average cost (AC) and show that MC falls by 20% with each doubling
of production. I then ask them to consider the decision of American Airlines (AA) to purchase the new
Boeing 777. Suppose AA wants five planes. How much should it offer for the planes? The answer is to
look ahead over the lifetime production of the planes, and offer the AC. Do NOT buy the first five at AC
of the first five because you are paying Boeing to learn how to produce planes more cheaply for your
competitors.
I close with a discussion of a regional breakfast sausage manufacturer. Tennessee Pride sells a single
product, breakfast sausage, with a big seasonal peak in demand during November and December. The
company competes with Con Agra and Kraft, firms that sell a whole portfolio of processed meat, with
summer seasonal peaks. As a consequence, Con Agra and Kraft have cheaper distribution costs.
Tennessee Pride sold its trucking fleet, and then was held up by its distributor.
I ask them what they should have done to exploit these economies of scope—the answer I like best is to
sell the brand or the company to Con Agra or Kraft. The scope economies make the acquired asset worth
more to the buying firm than to the selling firm.
28
In-class Problem
You can derive a simple 80% learning curve, i.e., when you double production, marginal cost goes down
by 20%. Click on the formulas in the spread sheet to “see” how to derive the formula Y=A+X^B.
Q
1
2
3
4
5
6
7
8
9
10
MC
100.0
80.0
70.2
64.0
59.6
56.2
53.4
51.2
49.3
47.7
Total
Cost
100.0
180.0
250.2
314.2
373.8
429.9
483.4
534.6
583.9
631.5
AC
100.0
90.0
83.4
78.6
74.8
71.7
69.1
66.8
64.9
63.2
Typically, I will put the learning curve on the board, and then ask them to assume the role of either buyer
or seller, and figure out how to profitably transact when costs look like this. Ask for several different
scenarios. They will come up with 1. rebates to the first buyer if the seller sells more; 2. stock options to
the first buyer who will benefit from reducing costs to subsequent buyers; 3. price at AC over the
expected lifetime production.
Additional Anecdotes: Electrical Equipment Manufacturer & Department
Store Sign Production
Electrical Equipment Manufacturer: In 2004, managers at Zimmerman, Adams, and Plover (ZAP), Inc,
an electrical equipment manufacturer, thought the firm was having a banner year. Sales (revenue) had
risen to nearly $40 million from $30 million the previous year. But total costs had risen together with
revenues. As a consequence, profit—the difference between revenue and cost—had not changed. We
can see ZAP’s monthly revenue, profit and sales for the years 2003 and 2004 in Error! Reference source
not found..
Figure 1: Company X Performance
29
40,000
Dollars (000s)
35,000
30,000
25,000
20,000
15,000
10,000
Sales
Cost
Ja
n04
M
ar
-0
4
M
ay
-0
4
Ju
l- 0
4
Ja
n03
M
ar
-0
3
M
ay
-0
3
Ju
l- 0
3
Se
p03
No
v03
5,000
Gross Profit
As Error! Reference source not found. shows, costs as a percentage of revenue rose from 64% in 2003
to 76% in 2004. Raw materials costs remained constant, so labor costs accounted for almost all of the
12% increase.
Further investigation revealed that longer production times created most of the increase in labor cost.
Each unit produced had to be tested, and the company employed just two testers, each of whom had a
capacity of just 600 units per year. Thus, when 2004 production rose above 1,200 units, the testers began
holding up the rest of the production line because QC took a constant amount of time per unit. The result
was idle production workers, who were being paid to wait for the testers.
When a private equity group bought ZAP, the new owners brought in new management, who immediately
identified the problem. They hired another tester for $125,000. This simple action removed the production
bottleneck, reducing production time per worker and reducing costs by more than $3 million.
In many production processes, especially those involving large fixed assets, average costs fall as
production increases. These types of processes exhibit economies of scale. In contrast, our electrical
equipment manufacturer’s process exhibited diseconomies of scale, in which average costs increased with
output, until the quality control bottleneck was resolved.
Department Store Sign Production: As part of its promotional efforts, Department Store X utilizes
small-scale promotional signs at its retail stores. At each of the 75 store locations, the company produces
an estimated 100 promotional signs per month. Each small “sign shop” operates as its own unit, and each
location incurs the same variable costs to use the machines. Installation costs, those incurred to set up the
machine for printing, printing costs (paper, ink, etc.), and maintenance costs comprise total production
costs. On average, monthly production costs are estimated to be $5,000 per machine: $1,000 for
installation, $3,000 for printing, and $1,000 for maintenance is incurred at each location. Therefore, the
total production of these signs costs the company approximately $375,000 per month.
Department Store X would benefit by consolidating this operation and taking advantage of the reduced
costs that come from centralized production. The company estimates that total production costs for
printing the signs in one location would be approximately $231,000 per month. Installation costs for the
single machine will be $1,000. This is the area in which the largest savings can be recognized. Printing
costs will remain the same, $225,000 for 75 stores. Maintenance costs will increase slightly to $5,000 per
month, because of the increased production on the single machine. However, savings are recognized here
as well, because fewer machines will need to be maintained. Therefore, by moving the printing
30
operations to one central location and taking advantage of the economies of scale, Department Store X
saves over $1.5 million per year.
31
8. UNDERSTANDING MARKETS AND INDUSTRY CHANGES
Which Industry or Market?
Shifts in Demand
Shifts in Supply
Market Equilibrium
Predicting Industry Changes Using Supply and Demand
Explaining Industry Changes Using Supply and Demand
Prices Convey Valuable Information
Market Making
Main Points
•
A market has a product, geographic, and time dimension. Define the market before using supply–
demand analysis.
•
Market demand describes buyer behavior; market supply describes seller behavior in a
competitive market.
•
If price changes, quantity demanded increases or decreases (represented by a movement along
the demand curve).
•
If a factor other than price (like income) changes, we say that demand curve increases or
decreases (a shift of demand curve).
•
Supply curves describe the behavior of sellers and tell you how much will be sold at a given
price.
•
Market equilibrium is the price at which quantity supplied equals quantity demanded. If price is
above the equilibrium price, there are too many sellers, forcing price down, and vice versa.
•
Prices convey valuable information; high prices tell buyers to conserve and sellers to increase
supply..
•
Making a market is costly, and competition between market makers forces the bid–ask spread
down to the costs of making a market. If the costs of making a market are large, then the
equilibrium price may be better viewed as a spread rather than a single price.
Supplementary Material
ManagerialEcon.com (Chapter 8)
MBAprimer.com, Managerial Economics Module, Section 4. “4: Understanding Markets and Profit
Maximizing.” http://mbaprimer.com
Interactive, online hypertext covers same material. At the end of the text there is a short, five
question quiz so that the students can “self test.” I give a very similar five question quiz to make
sure that the students learn this material well.
32
Samuel L. Baker, Economics Interactive Tutorials,
http://hspm.sph.sc.edu/COURSES/ECON/Tutorials2.html
7. Supply, Demand, and Equilibrium
Similar to the MBA Primer but with less attention to the graphic design aspects.
Steven Landsburg, “The Indifference Principle: Who Cares if the Air is Clean?” The Armchair
Economist, (New York: The Free Press, 1993) pp. 60-72.
This is an elegant illustration of competitive equilibrium.
Harvard Business School Note: "A Note on Microeconomics for Strategists" pp 10-19, HBS 9-799-128.
Summarizes the core ideas about the microeconomics of markets that are most relevant to business
strategy.
Teaching Note
Before starting this section, I warn my students that this analysis is appropriate ONLY at the industry, not
the firm level. I tell them that someone will flunk the class because they turn in a paper or write on an
exam that applies supply and demand analysis at the firm level. I explain that there is no such thing as a
supply curve at the firm level—how much the firm produces depends both on MR (demand) and MC—
whereas at the industry level, industry supply can be modeled as depending only on price due to
competition among firms.
In chapter 6, we constructed demand curves by assuming that each person wanted only one unit and
arranged consumers by their values (highest to lowest) to derive demand. We construct supply curves
similarly, assuming that sellers have one unit to sell and arrange them by their values, or their bottom line
(from lowest to highest).
I try to do is explain market equilibrium pretty quickly, and then get the students to
1. Shift demand and supply, i.e., tell them to forecast what will happen when demand, supply, or both
shift, e.g., what will happen to the housing market following an increase in interest rates; AND
THEN
2. Get students to describe real phenomenon using shifts in demand and supply (start with data, then
ask them to explain what happened, e.g., why does the daily price of gasoline increase in the
summer and decrease in the winter?)
The second step is much harder than the first, but it is the difference between understanding how the
model works and understanding how to use the model to solve problems.
I like to tell the story of the pipeline break from Tucson to Phoenix to illustrate how well markets work.
In Phoenix, the supply decreased causing price to increase and quantity to decrease. Curiously, price also
increased in Tucson because tanker trucks found it more profitable to drive to Phoenix than to deliver gas
to Tucson. The capacity constraint at the Tucson “rack” (where tanker trucks fill up with gasoline) is also
necessary to explain why price increased in Tucson.
I end up showing students how financial markets work by talking about market making activity. I show
student how to compute the optimal bid ask spread. If I get time, I will talk about the Nasdaq price fixing
conspiracy and how the rules of the exchange work (e.g., if you offer a better bid or ask, you don’t
necessarily get the trade because your dealer has only to match the trade).
33
I illustrate what a bid-ask spread looks like by going to www.intrade.com and looking at the political
futures prices and show them that the bid-ask spreads are biggest when the markets are thinnest. I also
like to talk about how companies are setting up prediction markets internally, and getting their sales
people to trade on them to get better forecasts of demand than can be made by marketing departments.
See http://www.businessweek.com/technology/content/aug2006/tc20060803_012437.htm?chan=search
In-class Problem
I have used two approaches. If you have time, you can run some supply-demand “experiments” as in
Theodore Bergstrom and John Miller, Experiments with Economic Principles, New York: McGraw-Hill,
1997. The simplest is to deal out a deck of cards and have all the red numbers represent seller values
(bottom line), while all the black numbers represent buyer values (top dollar). Give students 5 minutes to
transact in a trading pit. Record all the “deals” as they are reached. Then add a “tax” to the sellers,
telling them that they have to pay a $4 sales tax. See how the equilibrium changes. If you have never
done this, I would recommend it as a learning experience for the professor.
The other problem I have used in class is to make them construct demand and supply curves from raw
data, e.g., 10 sellers with values {3,4,5,6,7,8,9,10,11,12} and ten buyers with values
{12,11,10,9,8,7,6,5,4,3}. Ask students to compute equilibrium. The easiest way to do this is to match up
the high value buyers with the low value sellers, and see how many transactions you can consummate (5
transactions, equilibrium price is between $7 and $8). Then ask them to imagine a single market maker
and compute the profit maximizing bid-ask spread.
Bid
3
4
5
6
7
8
Ask
12
11
10
9
8
7
# Transactions
1
2
3
4
5
6
Profit
9
14
15
12
5
-6
Additional Anecdote: Video Enhancement Market
The video enhancement market is relatively new in the United States—offering commercial products
only since around 1998. Video enhancement products are state-of-the-art graphics systems that capture,
analyze, enhance, and edit all major video formats without altering underlying footage. In 1998, this
market consisted of a small number of companies who extended their primary business of broadcast video
production systems to include video enhancement products. Demand was relatively light due to the
extremely high price of the technology and the lack of product awareness with prices ranging between
$45,000 and $80,000.
In 2000, Intergraph entered the market at a price of $25,000, attempting to quickly capture a major share
of the market. Intergraph produced a product at a substantially lower cost than the competition. This entry
caused an increase in supply and a strong downward pressure on price, dropping average pricing to
around $40,000. This hostile environment led to a number of firms exiting and prices rising back to
around $45,000.
The events of 9/11/01 had a further dramatic effect on the supply and demand of video enhancement
services. Concern over terrorist activities caused demand to spike. Videotapes from airports, border
34
crossings, convenience stores, parking lots, and the like became much more important. Soon there were
more tapes needing analysis than there were people or machines available, and price was no longer a
critical issue. In the short run, average pricing shot up. These higher prices attracted more companies to
the market thereby increasing supply, and drove pricing back down to an average level of around
$30,000.
Being able to forecast and interpret these industry-level changes requires an understanding of both
aggregate consumer behavior (demand) and aggregate seller behavior (supply), the topic of this chapter.
35
9. RELATIONSHIPS BETWEEN INDUSTRIES: THE FORCES MOVING
US TOWARD LONG-RUN EQUILIBRIUM
Competitive Industries
The Indifference Principle
Monopoly
Main Points

A competitive firm can earn positive or negative profit in the short run until entry or exit occurs.
In the long run, competitive firms are condemned to earn only an average rate of return.

Profit exhibits what is called mean reversion, or “regression toward the mean.”.

If an asset is mobile, then in equilibrium the asset will be indifferent about where it is used (i.e., it
will make the same profit no matter where it goes). This implies that unattractive jobs will pay
compensating wage differentials, and risky investments will pay compensating risk differentials
(or a risk premium).

The difference between stock returns and bond yields includes a compensating risk premium.
When risk premia become too small, some investors view this as a time to get out of risky assets
because the market may be ignoring risk in pursuit of higher returns.

Monopoly firms can earn positive profit for a longer period of time than competitive firms, but
entry and imitation eventually erode their profit as well.
Supplementary Material
ManagerialEcon.com (Chapter 9)
Steven Landsburg, “The Indifference Principle: Who Cares if the Air is Clean?” The Armchair
Economist, (New York: The Free Press, 1993) pp. 60-72.
MBAprimer.com, Managerial Economics Module, Section 5. “Wrapping Up.”
http://mbaprimer.com
This is a summary of sections 1-4 with a summary question quiz so that the students can “self test.”
I give a very similar summary question quiz to make sure that the students learn this material well.
Teaching Note
I again open by warning students to not get confused between chapters 8 (short run analysis of price and
quantity changes) and chapter 9 (long run analysis of industry profit). I tell them that someone will fail
the class because they write on an exam that “supply creates its own demand.” I tell them that the
hallmark of supply-demand analysis is the separation of producer and consumer behavior. Do not
confuse them.
36
I explain long run competitive equilibrium using Steven Landsburg’s “the indifference principle”—in
equilibrium, a mobile asset will be indifferent as to where it is used. If not, it will move to a higher
valued use.
I illustrate the indifference principle two ways:
1. Tracing through the long run analysis of a competitive industry responding to a demand shift
(price goes up, existing firms earn above average profit, new assets are drawn into the industry.
Depending on the age of the class, I sometimes use an example of a fad, like leg warmers
(suddenly popular in the early 1980’s following release of the movie “Flashdance”).
2. Talking about compensating wage differentials or compensating house price differentials, or
about the risk-return relationship in finance. I sometimes joke that I am going to teach them the
most important theorem in finance. Ask a student what will happen if two assets are earning the
same expected return, but one is more risky than the other. (ANSWER: investors sell the risky
asset, driving down its price and increasing its expected return. Expected return will keep going
up until investors are just indifferent between the risky stock and the less risky stock.)
In-class Problem
In 2006, Bill Spitz, Treasurer of Vanderbilt gave this talk, saying that risk premia had gotten very small
on all kinds of investments: stocks vs. bonds, foreign vs. domestic, and on emerging market vs.
developed. Go through the talk and then ask them if they should follow Spitz’s advice and move assets
into less risky investments.
ANSWER: Print out the VIX index (a measure of riskiness), and the S&P returns and ask what changes
would we expect to see as risk returned to the market.
37
Additional Anecdote: Will wages adjust to offset new tax progressivity?
QUESTION: In equilibrium, we know that workers must be compensated for jobs that require higher
levels of investment in human capital, like physicians. If not, people would exit these professions into
those that require fewer investments. Likewise, if we increase the progressivity of the tax system, we
should expect a compensating wage increase.
ANSWER: Evidence that this happened in Canada in 1967.
...our results suggest that the progressivity of the Canadian income tax system significantly affected
wage settlements and that the implicit tax increases attributable to this progressivity were at least
partially forward shifted into higher wage rates.
38
10. STRATEGY―THE QUEST TO KEEP PROFIT FROM ERODING
Strategy Is Simple
Sources of Economic Profit
The Three Basic Strategies
Main Points
•
Strategy is simple―to increase economic performance, figure out a way to increase P (price) or
reduce C (cost).
•
The industrial organization economics (IO) perspective assumes that the industry structure is the
most important determinant of long-run profitability.
•
The Five Forces model is a framework for analyzing the attractiveness of an industry. Attractive
industries have low supplier power, low buyer power, high entry barriers, low threat of
substitutes, and low rivalry.
•
According to the resource-based view (RBV), individual firms may exhibit sustained
performance advantages due to their superior resources. To be the source of sustainable
competitive advantage, those resources should be valuable, rare, and difficult to
imitate/substitute.
•
Strategy is the art of matching the resources and capabilities of a firm to the opportunities and
risks in its external environment for the purpose of developing a sustainable competitive
advantage.
•
Be wary of any advice you read that claims to identify critical resources or capabilities that
successful companies have to develop in order to gain a competitive advantage.
•
To stay one step ahead of the forces of competition, a firm can adopt one of three strategies: cost
reduction, product differentiation, or reduction in the intensity of competition.
Supplementary Material
ManagerialEcon.com (Chapter 10)
Porter M. 2008. The five competitive forces that shape strategy. Harvard Business Review, 86(1): 78-93.
If you would like to delve more deeply into industry analysis and the Five Forces framework, this is
a very good article to assign. You can also access a video of Michael Porter discussing the Five
Forces framework at http://www.youtube.com/watch?v=mYF2_FBCvXw (or in a number of other
locations; search Google for “the five competitive forces that shape strategy” video)
Barney, J. 1991. Firm resources and sustained competitive advantage. Journal of Management 17: 99–
120.
This is the article in which Barney lays out the aspects of firm resources that are consistent with
competitive advantage (value, rareness, inimitability, non-substitutability)
39
Teaching Note
I open by linking this chapter back to Chapter 9. One of the main points of that chapter was that longterm forces constantly push industries toward equilibrium in which competitive firms will only earn an
average rate of return. Strategy is the attempt to deal with those long-term forces by building a
sustainable competitive advantage to earn positive economic profits.
I also try to tell them why strategy is the capstone course of our MBA curriculum—it brings together all
of the functional disciplines (accounting, finance, marketing, economics, operations) and answers the kind
of questions that are likely to be asked of senior management and are likely to have cross functional
answers.
With that introduction, the first goal I have is to explain to students that profit is typically increased in one
of two fashions – either prices increase or costs get lowered. If you like, you can dig more deeply into
this idea by noting that strategy is about trade-offs. Typically, if a firm wants to increase the value of its
product (and one would hope the price as well), it is costly to create this extra value. Profits will only be
increased if the dollars generated from the increased price are greater than the extra costs incurred.
Similarly, if a firm reduces the value of a product to cut costs, the cost savings need to be greater than the
lost revenue from reducing price in order for the move to be profitable. I end by saying to them that
strategy is all about making the box bigger (note: if you have any particularly sharp students, they may
notice that the “profit” box might be increased horizontally rather than only vertically. So, for example, a
firm might reduce price to capture greater volume. The vertical size of the box would decrease while it
expands horizontally. This is a fair point but emphasize that the horizontal increase has to be larger than
the vertical decrease to make the move profitable).
I think the best way to illustrate the ideas of sustainable competitive advantage is through examples. At
the industry level, the students are likely to easily relate to the idea that pharmaceutical companies are
more profitable than airlines. This can then be tied to the Five Forces to explain those differences. You
may also consider assigning an industry analysis before class, which can serve as a topic of discussion.
Transition to the resource-based view by noting that there are still differences within industries (example:
Southwest’s performance in the airline industry). Students will likely be able to identify a number of
companies that they believe have an advantage. Push them to identify the resources that support that
advantage and discuss how those resources link to competitive advantage (using the Value, Rare,
Inimitable, Non-Substitutable characteristics).
The final section should also be easy to relate to student experiences. All of them should be able to come
up with examples of companies that compete more based on lower costs (e.g., Walmart) vs. companies
that compete on differentiation (e.g., Rolex or any other high-end product).
In-class Problem
I typically begin this class by asking how many students subscribe to Netflix. Then ask one student how
the company currently makes money. Then ask another student whether this strategy will make money in
five years. Most will correctly predict that the idea of selling DVD’s by mail will become obsolete as
movies will be more commonly purchased over the internet or through your cable TV (or through kiosks
at local fast-food restaurants). Then ask students to put themselves in the place of the CEO and ask what
you should do. Someone will naturally say “sell out” to a rival, and this naturally brings up the resource
based view of the firm. Which assets are valuable? The firm has a good distribution system (able to
deliver movies within two days, a six million person subscriber base, a nice website that tracks users’
tastes, and brand name recognition). The firm is trying to develop an online presence using its web
portal, brand name, and subscriber base. Will it be successful? Who else is out there doing the same
40
thing? Tell students that these are the questions of strategy. They concern the senior management of the
company and the ability to create and sustain a competitive advantage.
Additional Anecdote: Kleenex
In 1924, Kleenex tissue was invented as a means to remove cold cream. The product was initially backed
by a series of advertisements that included endorsements from the era’s Hollywood stars, like Helen
Hayes and Jean Harlow. After studying customer usage habits, however, the manufacturer (KimberlyClark) realized that many customers were using the product as a disposable handkerchief. The company
switched its advertising focus, and sales more than doubled.
Kimberly-Clark faced a significant challenge in trying to grow and defend its new product. At its core,
Kleenex is simply tissue paper, a product that is not particularly difficult to replicate. As others in the
consumer packaged goods industry saw the profits available from producing disposable handkerchiefs,
they moved into the market. The managers of Kimberly-Clark applied many of the lessons of this chapter
to defend against these new entrants and maintain Kleenex’s leadership position.
To defend a leadership position, Kimberly-Clark had to first build that position. And, the company did so
by creating an innovative use for a relatively common product. The managers of the company maintained
profitability through a continuing stream of innovations from the introduction of printed tissue in the
1930’s, eyeglass tissue in the 1940’s, space-saving packaging in the 1960’s, and lotion-filled tissue in the
1980’s. All during this time, the company invested in advertising and promotion, building a brand whose
name became synonymous with disposable tissues. Without this continuing stream of innovations and
brand support, the product’s profits would have been slowly eroded away by the forces of competition.
41
11. USING SUPPLY AND DEMAND: TRADE, BUBBLES, AND MARKETMAKING
The Market for Foreign Exchange
Purchasing Power Parity
The Effects of a Currency Devaluation
Bubbles: Past Performance is No Guarantee of Future Success
Main Points
•
In the market for foreign exchange, the supply of pounds includes everyone in Britain who wants
to sell pounds to buy krona in order to buy Icelandic goods, or invest in Iceland. The supply of
pounds is also equal to the demand for krona.
•
In the market for foreign exchange, the demand for pounds includes everyone in Iceland who
wants to sell krona to buy pounds in order to buy British goods, or invest in Britain. The demand
for pounds is also equal to the supply of krona.
•
The so-called “carry trade,” borrowing in foreign currencies to spend or invest domestically,
increases demand for the domestic currency, appreciating the domestic currency. However,
borrowing in foreign currency to buy imports or invest in a foreign country does not affect the
exchange rates.
•
Currency devaluations help suppliers because they make exports less expensive in the foreign
currency; but they hurt consumers because they make imports more expensive in the domestic
currency.
•
Once started, expectations about the future play a role in keeping bubbles going. If buyers expect
a future price increase, they will accelerate their purchases to avoid it. Similarly, sellers will delay
selling to take advantage of it.
•
You can potentially identify bubbles by using the “indifference principle” of Chapter 9 to tell you
when market prices move away from their long-run equilibrium relationships.
Supplementary Material
ManagerialEcon.com (Chapter 11)
Teaching Note
I try to get four ideas across:
 Use demand/supply analysis to explain exchange rate shifts
 Use demand/supply analysis to explain demand for imports and exports
 Use demand/supply analysis to describe bubbles
 Use demand/supply analysis to describe market making
Market for foreign exchange: I talk about who wants to “sell pounds to buy krona” and who wants to sell
krona to buy pounds.” Talk about the Icelandic example, and how the high Icelandic interest rates
attracted British deposits (selling pounds to buy krona to deposit in Icelandic banks) would have normally
strengthened the krona, but much of the investment went right back into Britain (to buy soccer teams, the
Icelandic banks had to sell krona to buy pounds, i.e. two offsetting trades).
42
I then switch to Mexico/US and ask students how changes in exchange rates affect demand for imports
and exports. You can do this by choosing border towns and ask what happens to each city economy when
the exchange rate changes (El Paso and Juarez; San Diego and Tijuana). A devaluation of the dollar
increases demand for exports and decreases demand for imports; likewise it helps US producers and
retailers and hurts Mexican producers and retailers. Important thing to tell them is to compute the
changes from the point of view of the domestic economy, i.e., when talking about changes in Mexico,
denominate prices in pesos and quantity demanded and supplied of Mexican goods. I use this as an
opportunity to reinforce the “Which market” idea—define a market based on what you want to use it for
with a time, geographic, and product dimension, i.e. monthly market for golf rounds in Tijuana.
I illustrate bubbles by setting up the feedback mechanism (if traders see price going up, they often form
expectations that it will continue to go up) by talking about the day trading I saw at Owen in 1999/2000.
Day trading is back
If you buy a stock, sell it, and earn money on the trade, you might mistakenly infer that you have
above-average stock-picking ability. So you try it again. And as long as the market keeps rising, you
will be successful, more often than not. This is the kind of feedback loop that leads to bubbles:
Trading volume surged 14% or more last month from July at online brokerage firms Charles
Schwab Corp., TD Ameritrade Holding Corp. and E*Trade Financial Corp. Electronic trader
Knight Capital Group Inc. also posted a 7.7% increase.
What causes bubbles?
In the second edition of our textbook, we discuss the feedback mechanism that causes asset
bubbles: when price goes up (or down) in one period, expectations form that price will continue up
(or down) next period. In today's NY Times, Bubbleologist Robert Shiller looks at the mechanics
behind these feedback loops
A downward movement in stock prices, for example, generates chatter and media response, and
reminds people of longstanding pessimistic stories and theories. These stories, newly prominent
in their minds, incline them toward gloomy intuitive assessments. As a result, the downward
spiral can continue: declining prices cause the stories to spread, causingstill more price declines
and further reinforcement of the stories.
I then ask students how they would change behavior if they expected price to go up next period?
ANSWER: accelerate purchases and delay sales, which causes an increase in demand and a decrease in
supply, or a self fulfilling prophecy.
I tell students that they may be able to recognize bubbles by using the long run equilibrium relationships
of chapter 9 and illustrate this in the real estate market (Shiller recognized “bubble” by looking at the
increasing price of buying relative to renting) and the stock market (Shiller recognized a bubble by
looking a the P/E ratios).
I end up showing students how financial markets work by talking about market making activity. I show
student how to compute the optimal bid ask spread. If I get time, I will talk about the Nasdaq price fixing
conspiracy (odd eighth avoidance) and how the rules of the exchange work supported the conspiracy (e.g.,
if you offer a better bid or ask, you don’t necessarily get the trade because your dealer has only to match
the trade).
I illustrate what a bid-ask spread looks like by going to www.intrade.com and looking at the political
futures prices and show them that the bid-ask spreads are biggest when the markets are thinnest. I also
like to talk about how companies are setting up prediction markets internally, and getting their sales
43
people to trade on them to get better forecasts of demand than can be made by marketing departments.
See http://www.businessweek.com/technology/content/aug2006/tc20060803_012437.htm?chan=search
In-class Problem
The other problem I have used in class is to make them construct demand and supply curves from raw
data, e.g, 10 sellers with values {3,4,5,6,7,8,9,10,11,12} and ten buyers with values
{12,11,10,9,8,7,6,5,4,3}. Ask students to compute equilibrium. The easiest way to do this is to match up
the high value buyers with the low value sellers, and see how many transactions you can consummate (5
transactions, equilibrium price is between $7 and $8). Then ask them to imagine a single market maker
and compute the profit maximizing bid-ask spread.
Bid
3
4
5
6
7
8
Ask
12
11
10
9
8
7
# Transactions
1
2
3
4
5
6
Profit
9
14
15
12
5
-6
Additional Anecdote: Video Enhancement Market
Why is the Peso falling?
Answer: [as of Nov, 14, 2008] The price of a peso has fallen from about $0.10 to $0.07 in the last two
months. Falling US demand for Mexican exports to the US means a lower demand for Pesos. As demand
for pesos falls, the price of a peso drops.
44
SECTION III – PRICING FOR GREATER PROFIT
12. MORE REALISTIC AND COMPLEX PRICING
Pricing Commonly Owned Products
Revenue or Yield Management
Advertising and Promotional Pricing
Psychological Pricing
Main Points
•
After acquiring a substitute product,
• raise price on both products to eliminate price competition between them.
• raise price more on the low-margin (more price elastic demand) product.
• reposition the products so that there is less substitutability between them.
•
After acquiring a complementary product, reduce price on both products to increase demand for
both products.
•
If fixed costs are large relative to marginal costs, capacity is fixed, and MR > MC at capacity,
then set price to fill available capacity.
•
If demand is unknown, and the costs of underpricing are smaller than the costs of over-pricing,
then underprice, on average, and vice-versa.
•
If promotional expenditures make demand more elastic, then reduce price when you promote the
product, and vice-versa.
•
Psychological biases suggests “framing” price changes as gains rather than as losses.
Supplementary Material
ManagerialEcon.com (Chapter 12)
Wii shortage: poor forecasting or marketing ploy?
In the past, we have talked about deliberately under-priced products. Business Week has a story on
the Wii:
The growing popularity of online shopping has created a booming secondary market in which
individuals profit from shortages by snapping up supply and reselling at a premium. A search of
eBay's (EBAY) U.S. site pulls up thousands of listings for new Wii consoles, with bidding well
above the suggested retail price. Nintendo isn't pocketing any of that extra cash, but it's collecting
a dividend in the form of free hype. That has allowed the company to hold fast on the price even
as Sony (SNE) and Microsoft (MSFT), maker of the Xbox, have started discounting their newest
machines to spur demand.
So it looks as if there's little incentive for Nintendo to crank up production. "You can extend the
technology cycle of the product by sitting just below the demand curve and creating a sense of
excitement. It's something they've done very cleverly in the past year," says Laurence Knight, a
45
partner at marketing innovation consultant Fletcher Knight. The risk is that consumers may be turned
off if they begin to feel manipulated.
Teaching Note
I begin by reminding students that in Chapter 6, “Simple Pricing” we used marginal analysis to figure out
how to set a uniform price, for a single good, owned by a one-product firm. In this chapter and the next,
we relax these assumptions to make pricing more realistic. I tell students that we can use the same
marginal analysis to derive simple pricing rules, even in these complex environments. In the price
discrimination chapters (13 and 14) we relax the assumption of a uniform price; in this chapter, we
consider pricing jointly owned goods; revenue or yield management (pricing in presence of capacity
constraints); pricing when advertising or promotional expenditures affect demand; and psychological
pricing.
I first go through the marginal analysis of pricing jointly owned substitute products (when I increase
output of one, it “steals” output from the other, which reduces the perceived marginal revenue, which
causes me to raise price). Tell the students they will see this result in the chapter on game theory (the
“horizontal pricing dilemma”), and they will see it again in Chapter 23, as the “double markup” or
“double marginalization” problem between two producers at different stages in the same vertical supply
chain. I then turn to a student and told him that the FTC blocked the merger of Blockbuster and
Hollywood Video using this theory of the case. The parties argued that the external environment had
grown more competitive (Netflix, Wal-Mart sales of DVD’s, and movies On Demand through cable TV)
so the merger was no longer anticompetitive. I put a student on the spot and ask whether the FTC did the
right thing. The resulting discussion, brings out the importance of the “extent” to which the merger
reduces MR.
When talking about commonly owned complements, keep a parallel construction between the analysis of
jointly owned substitutes and jointly owned complements (increasing output of one raises the MR of the
other) and talk about antitrust treatment of mergers between substitutes (if MC reduces more than MR
increases, then the merger is pro-competitive because it results in price decrease), and mergers among
complements (generally viewed as beneficial in the US but not so in the rest of the world; see GE-Hughes
which was blocked by EC); or Microsoft acquiring Quicken (US blocked this merger because they
thought that it would likely lead to higher prices and lessened innovation in that market).
For revenue management, I tell the story of two industries: parking lots and cruise lines. I talk about the
long-run (LR) extent decision to build capacity where LRMR=LRMC. But once the capacity is built, the
pricing calculus changes. The relevant costs for pricing become SRMR and SRMC, which we denote
MR and MC. So at capacity MR>MC, so they price to fill the ship.
For parking lots, this is simple to do: raise price if the lot is filled before 9am; reduce price otherwise.
The daily realization of demand means that there is relatively little uncertainty about optimal pricing. For
cruise ships, demand is less certain, so they do extensive research on how best to fill the ships.
Uncertainty means errors, and I introduce type I (unsold capacity) and type II errors (excess demand at
capacity). Overshoot or undershoot depending on the costs of the two types of errors. This is especially
important for students who play the CapStone® strategy game, as forecasting demand for their products is
hard. If you are going to err on the side of over or under pricing, first look at the costs of over or under
pricing.
46
Two mergers I worked on (Central Parking acquiring Allright; and Princess acquiring Carnival) were in
these industries. Again, I ask students whether we should block these mergers. I tell them that the MR
and MC change, but not enough so that the companies were not still trying to fill the ships or parking lots.
If they price to fill parking lots before the merger and price to fill parking lots after the merger, then the
merger has no effect.
To set up promotional pricing, I remind them that in their marketing class, they learn that there are four
dimensions to competition, the “Four P’s” of marketing, Price, Product, Place, Promotion. I tell them we
are going to study how to price in the presence of promotional expenditures. I tell them there are two
kinds of promotional expenditure: those that make demand less elastic and those that make demand more
elastic. Obviously reduce price if demand becomes more elastic; raise it if it becomes less.
For promotional pricing, I ask them why, on Columbus Day in NY, do grocery stores reduce the price of
spaghetti? Why do they reduce the price of pumpkin pie and Turkey on Thanksgiving Day? Make
students come up with at least three answers: Loss leader (to get customers into the store); price
discrimination ( those who purchase these items are likely to purchase a lot of other items as well); or my
favorite explanation, that those who buy these items are very price elastic, and they are drawn into the
market on the holidays. The third explanation has empirical support.
This graph shows the more elastic demand for super-premium ice cream sold on promotion
Tenn, Steven, Luke Froeb, and Steven Tschantz, Merger Effects When Firms Compete by Choosing
Both Price and Advertising, Owen Working paper (2007). Available at SSRN:
http://ssrn.com/abstract=980941
47
I close by noting that the pricing strategies we have discussed so far assume that consumers behave
rationally, optimally, and self-interestedly. A lot of research, however, indicates that consumers don’t act
in this way, and there are a number of pricing strategies that are designed to take advantage of consumer
decision-making biases.
In-class Problem
Ask students why concert prices have doubled in the last five years. Give them some time to think about
it, then ask for answers. Do not respond yourself—instead ask other students to comment specifically on
the answers of their classmates. The answer that I think is correct is that music piracy has reduced the
“promotional” motive to give concerts. It used to be that the only way to sell recorded music was to give
concerts, i.e., they were complements. Now reducing the price of a complement (concerts) increases
demand for illegal, as well as legal downloads. In other words, relative to the “before piracy” period, the
marginal benefit of selling more concert tickets is reduced, so concert price is increased.
Additional Anecdote: American Airlines
Discuss the following article
Barry C. Smith, John F. Leimkuhler, and Ross M. Darrow, (1992) “Yield Management at
American Airlines,” Interfaces, 22:1 (8-31)
[High-level summary from the article]
DINAMO Yield Management at American Airlines has $1.4 Billion Impact
Barry C. Smith, John F. Leimkuhler, and Ross M. Darrow, (1992) “Yield Management at American
Airlines,” Interfaces, 22:1 (8-31)
American Airlines pioneered the development of sophisticated reservation management systems. In 1968
American Airlines launched the SABRE computerized reservation system that linked all of the
reservation agents around the country. This enabled the company to gather consistent and timely data
about reservations. By 1968, American launched it first version (that has since been refined several times)
of an automated overbooking process. Without overbooking, American estimates that 15% of the seats on
sold out flights would be unused. This overbooking process was the first element in developing a yield
management system.
Managing ticket sales increased in complexity when American introduced super saver discount fares in
1977 and when the airline industry's schedules and fare structure were deregulated in 1979. With these
changes American Airlines moved to develop a yield management system with the goal of "selling the
right seat to the right customer at the right time." The yield management system helps determine how
many seats to allocate initially to each fare category and how to dynamically adjust this allocation as
reservations come in and the date of the flight approaches. One key to maximizing an airline's revenue is
to keep the right number seats available for the full-fare customer (often a business person) who makes
reservations relatively close to the departure date.
De-regulation of the airline industry triggered a major restructuring of flight schedules that further
complicated seat allocation. Under de-regulation the airlines moved to develop a hub and spoke system
that often had passengers flying into a hub on their way to their final destination. As a result, the yield
management system must take into account that some seats on flights between cities must be reserved for
connecting flights. An important building block is the forecasting model that estimates demand and
cancellation rates.
48
The complexity of the problem eventually led to the development in 1988 of an automated system for
yield management, DINAMO. The system's net impact was estimated be $1.4 billion in additional
revenues over a three year period. It also increased the productivity per analyst by 30%. Lastly, the
system enabled American Airlines to evaluate the potential of Ultimate Super Saver fares that were priced
so low that they could stimulate additional traffic.
49
13. DIRECT PRICE DISCRIMINATION
Introduction
Why (Price) Discriminate?
Direct Price Discrimination
Robinson-Patman Act
Implementing Price Discrimination Schemes
Only Schmucks Pay Retail
Main Points
•
If a seller can identify two groups of consumers with different demand elasticities, and it can
prevent arbitrage between two groups, it can increase profit by charging a higher price to group
with the less-elastic demand.
•
Price discrimination is the practice of charging different people or groups of people different
prices that are not cost-justified. Typically more people are served under price discrimination than
under a uniform price.
•
Arbitrage can defeat a price discrimination scheme if enough of those who purchase at low
prices re-sell to high-value consumers. This can force a seller to go back to a uniform price.
•
A direct price discrimination scheme is one in which we can identify members of the low-value
(more price elastic) group, charge them a lower price, and prevent them from re-selling their
lower- priced goods to the higher-value group.
•
It can be illegal for business to price discriminate when selling goods (not services) to other
businesses unless
• price discounts are cost-justified, or
• discounts are offered to meet competitors’ prices.
•
Price discrimination schemes may annoy customers who know they’re paying more than others
and can make them less willing to buy because they know someone else is getting a better price.
If you can, keep them secret.
Supplementary Material
ManagerialEcon.com (Chapter 13)
Harvard Business School Note: "Price Discrimination", HBS 9-191-105
This note, which is introductory in nature, provides a classification scheme for some of the more
common examples of price discrimination. For each case that is discussed, the note characterizes the
appropriate market segments, the alternative product "versions," and the differences in the firm's
economics from one version to another.
Only Schmucks Pay Retail
Ordinarily, price discrimination is profitable if firms can segment consumers by how much they are
willing to pay. By offering discounts to low-value consumers, firms profit because they can increase
sales to low-value consumers without cannibalizing (losing) sales to high-value ones.
50
However, recent research by colleagues Mike Shor and Rich Oliver showed that this intuition does
not always hold . They studied the use of "promotional codes" on websites, an online analog to
discount coupons. They found that the click-through rates on real websites that had boxes for
promotional codes were so much lower as to render the promotional discounts unprofitable. They
conclude that "Web sites prompting [high-value] customers to enter a 'promotion code,' ...may
unwittingly be losing customers who otherwise would be willing to purchase."
Apparently, no one wants to be a schmuck.(1)
----------------------------------------------------(1) Schmuck also shmuck: n. Slang; a clumsy or stupid person; an oaf.
Teaching Note
I abandon the traditional type I, II, III taxonomy for describing price discrimination and limit myself to
two groups of consumers with different demands. “Direct” discrimination means that you can identify
individuals in the two groups, set different prices to them, and prevent arbitrage. “Indirect” means that
you cannot distinguish individuals in the two groups, or you cannot prevent arbitrage. We talk about
volume discounts, two part pricing, and bundling in later chapters.
I typically begin by asking all students to construct a demand curve from ten individuals with values
{$10, $9, $8, $7, $6, $5,$4,$3,$2,$1}, tell me what the optimal price is if $MC=$1.50. Give them five
minutes to do this on their own, and after 3 minutes draw the following table on the board.
Price
10
9
8
7
6
5
4
3
2
1
Q
1
2
3
4
5
6
7
8
9
10
Rev
10
18
24
28
30
30
28
24
18
10
MR
10
8
6
4
2
0
-2
-4
-6
-8
The optimal single price is $6, with a quantity of 5, revenue of $30, and profit of $22.50. I then ask them
to notice that there are still four consumers, those who value the good at {$5,$4,$3,$2}, a price above its
MC, and that the one lesson of business tells us to try to consummate these wealth creating transactions.
I then bait the students and ask them how many think that movie theaters are being “nice” to old people
by offering them a discount? I then say imagine that our example is a movie theater and that your
marketing department has done a survey of potential demand and figured out that the low value
consumers are over age 65. I then ask students what they should charge to the senior citizens. Give them
five minutes to come up with an answer, and at minute 3, begin writing a second table on the board.
Price
5
4
3
2
Q
1
2
3
4
Rev
5
8
9
8
MR
5
3
1
-3
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1
5
5
-5
They should be able to figure out that the optimal price for the senior citizens is $4, and the movie theater
sells two extra tickets and earns $5 extra dollars. I tell them that this is the reason for price
discrimination—it is always profitable.
I then ask for a show of hands of those who think it is unfair that Canadian citizens pay less for drugs than
the US. I tell them to imagine that Canadian citizens are the low value purchasers of drugs and that the
drug companies price discriminate exactly as above. I ask them what would happen if the US allows
Canadian pharmacies to re-import drugs into the US. I tell them that if the low value consumers could
purchase drugs at $4 and sell them to the US for $6, the US drug manufacturers would be back to setting a
uniform price. I tell them that Canada should be against re-importation because it will result in higher
prices for Canadian citizens. I tell them that in each country around the world drugs are sold at prices
roughly proportional to income. The US pays the most, Africa the least, with other countries ranked
according to their incomes. There is one country, however, that pays more for drugs than would be
predicted by their income. I ask them to guess which country and why. The answer is Mexico and the
reason is that lots of US consumers go across the border to buy drugs.
I then ask them to imagine that these are AIDS drugs and that the low value consumers live in Africa. I
ask for a show of another show of hands of those who think re-importation is a good idea.
I then talk about the Robinson Patman Act. I tell the story about how it started (mom and pop grocery
stores were facing pressure from A&P, the first modern, low cost, grocery store), and how the act has
been used to go after Wal-Mart (sued by mom and pop pharmacies), Borders and Barnes & Noble (sued
by mom and pop book stores). Look up any Robinson-Patman suit and you can tell a story how it
discourages discounting. In an oligopoly context, it may even facilitate collusion, as it raises the cost of
cheating on the cartel. Talk about the two defenses: cost justification or done to meet the competition.
I like the story of Mike Shor’s research “Only Schmuck’s Pay Retail” about how knowing that others are
getting a discount makes it less likely that an online customer will “click through” to the sale.
If there is time, I set up the next section by talking about the difference between direct and indirect
discrimination, like software pricing for Minitab (it is about half price for a disabled version).
In-class Problem
This is repeated for convenience from the teaching notes. I typically begin by asking all students to
construct a demand curve from ten individuals with values {$10, $9, $8, $7, $6, $5,$4,$3,$2,$1}, tell me
what the optimal price is if $MC=$1.50. Give them five minutes to do this on their own, and after 3
minutes draw the following table on the board.
Price
10
9
8
7
6
5
4
3
Q
1
2
3
4
5
6
7
8
Rev
10
18
24
28
30
30
28
24
MR
10
8
6
4
2
0
-2
-4
52
2
1
9
10
18
10
-6
-8
The optimal single price is $6, with a quantity of 5, revenue of $30, and profit of $22.50. I then ask them
to notice that there are still four consumers, those who value the good at {$5,$4,$3,$2}, a price above its
MC, and that the one lesson of business tells us to try to consummate these wealth creating transactions.
Additional Anecdotes: Medical Device Company & Grey Market for iPhones
MEDICAL DEVICES IN EUROPE: Firm X sells medical measurement devices in Germany, Holland
and the Scandinavia for $25. A box of 50 test strips sells for $22. The test strips measure various
chemicals in blood and urine when they are inserted into measurement machines. Prices for strips and
machines are dictated by reimbursement policies established through negotiation with insurance
companies. In countries such as Italy and Spain, insurance companies’ reimbursement rates are 50%
lower than in the north. Firm X has not tried to sell their products in southern Europe because they fear
that wholesalers in northern Europe would buy lower-priced products from wholesalers in southern
Europe.
They currently produce 12 million boxes of test strips, and have the capacity to produce an additional 6
million boxes of test strips per year at the same marginal cost of $5 per box. The southern European
market for test strips is $200 million per year. Assuming they would acquire 30% of the market, the
opportunity cost of not entering the southern markets is about $60 million in revenue. If Firm X could
find a way to sell to the two different markets at two different prices while preventing resale (a price
discrimination approach), its profits would increase markedly.
Implementing the Scheme
To implement a price discrimination scheme, Firm X could price test strips in southern Europe at $11 per
box and the measurement devices at $12.50. This is the maximum cost that the insurance companies in
southern Europe will reimburse.
To prevent the resale of the lower price strips in northern Europe, Firm X could make them incompatible
with the higher-priced measurement devices. They can do this by reprogramming the ROM key that ships
with each box of test strips. Currently, users plug the key into the measurement device before using the
strips in a new box. The ROM key is also used to calibrate the device. By programming the ROM key to
communicate the origin of the test strip to the device, it is possible to prevent devices sold in the North
from reading test strips sold in the South.
In order to comply with EC antitrust laws preventing discrimination, they can reduce the measurement
speed of the devices sold in southern Europe from 11 to 25 seconds. It is important that these slower
devices cost less, so that the price difference has some cost justification.
Grey Market: 1.3 million i Phones smuggled out of US
In past, we have blogged about Apple's attempt to control the distribution of its popular iPhone. It is
apparently losing the "war" to smuggling, from the US back to China.
There the phones’ digital locks are broken so they can work on local cellular networks, and they
are outfitted with localized software, essentially undermining Apple’s effort to introduce the
phone with exclusive partnership deals, similar to its primary partnership agreement with AT&T
in the United States.
53
This kind of smuggling is called a "grey market," where consumers circumvent the attempt of a
private company to control pricing or distribution, to distinguish it from a "black market," where
consumers circumvent governments attempt to control pricing or distribution of a product.
54
14. INDIRECT PRICE DISCRIMINATION
Indirect Price Discrimination
Volume Discounts as Discrimination
Bundling Different Goods Together
Main Points
•
When a seller cannot identify low- and high-value consumers or cannot prevent arbitrage between
two groups, it can still discriminate, but only indirectly, by designing products or services that
appeal to groups with different price elasticities of demand, who identify themselves based on
their purchasing behavior.
•
Metering is a type of indirect discrimination that identifies high-value consumers by how
intensely they use a product (e.g., by how many cartridges they buy). In this case, charge a big
markup on the cartridges and a lower markup on the printer.
•
If you offer a low-value product that is attractive to high-value consumers, you may cannibalize
sales of your high-price product.
•
When pricing for an individual customer, do not bargain over unit price. Instead, you should
• Offer volume discounts;
• Use two-part pricing; or
• Offer a bundle containing a number of units.
•
Bundling different goods together can allow a seller to extract more consumer surplus if
willingness to pay for the bundle is more homogeneous than willingness to pay for the separate
items in the bundle.
Supplementary Material
ManagerialEcon.com (Chapter 14)
Steven Landsburg, “Why Popcorn costs More at the Movies and Why the Obvious Answer is Wrong,”
The Armchair Economist, (New York: The Free Press, 1993) pp. 157-167.
MICHAEL WARD’s NIFTY PRICING EXERCISE
This is an exercise on how to construct a demand curve from survey data. By asking consumers how
much they pay for each song, you can construct an aggregate demand curve by first constructing a
demand curve for each song (rank consumers by what they are willing to pay); and then sum across all 25
songs to get an aggregate demand curve.
These questions are based on the survey responses you gave to the online Music Survey at
<http://www3.uta.edu/faculty/mikeward/Music/survey.htm>. To answer these questions, you must
download the spreadsheet of data from <http://www3.uta.edu/faculty/mikeward/Music/musicsurvey.xls>.
This spreadsheet contains the willingness-to-pay "wtp" data for each of 25 songs and 25 surveyed
students.
55
1. You are operating an online music shop and the data are representative of your
customers. Suppose marginal cost of a download is zero. If you charged a single price to all
customers for any song, what would be the profit maximizing price? How much revenue would
you generate? Indicate your answer on the "Question1" tab of the spreadsheet.
2. Suppose you were able to distinguish customers into two groups, those who are "high" demanders
and those who are "low" demanders. If you were able to price discriminate between these two
groups but still had to charge the same price per song, what prices would you charge the two
groups? How much revenue would you generate? Indicate your answer on the "Question2" tab
of the spreadsheet.
3. Suppose, instead, you were able to distinguish songs into three groups, those you know will have
"high" demand, "medium" demand and low" demand. If you were able to price discriminate for
these three groups of songs but still had to charge the same price per song within a group, what
prices would you charge? How much revenue would you generate? Indicate your answer on the
"Question3" tab of the spreadsheet.
4. Suppose you bundled all 25 songs into a package. What price would you charge for the bundle?
How much revenue would you generate? Indicate your answer on the "Question4" tab of the
spreadsheet.
[Answers]
Teaching Note
There is always a tradeoff between using new stories and anecdotes in class or going over the anecdotes
and stories in the book. This material is particularly hard for the students to figure out, so I typically go
over all the examples in the text. Then modify the examples and give the students time to figure out how
the answer changes. In my experience, less than half the class understands the software pricing example
so I always go over it in class.
The other thing to keep in mind is that the direct and indirect price discrimination will play a role when
we talk about adverse selection and moral hazard. Screening is analogous to price discrimination; the
difference is that it is cost justified.
The last thing I try to underscore is the link between marketing and pricing. In their marketing classes
they will spend a lot of time talking about various kinds of consumer behavior and how it varies across
different kinds of consumers. I tell them pricing tells you what to do with the information. And I begin
the examples in class by saying “your marketing department has conducted a survey of likely consumers
and this is what they found.”
To underscore this link you might want to tell them that the marketing department has discovered four
type of consumers: those unwilling to purchase at any price; baby boomers willing to pay $7; generation
X’ers willing to pay $4, and generation Y’ers willing to pay $3. If the marginal cost is zero and the
proportion of potential customers in each group is (30,10,20,40) [NOTE: when you get to uncertainty,
you can replace these numbers with probabilities] what is the optimal price? Then say that you have
found a way to offer discounts to Gen X’ers and Gen Y’ers. What discounts would you offer? How
much profit would you make?
Answer:
Price Q Rev
$7
10 $70
Average MR
$7
56
$4
$3
30 $120 $2.50
70 $210 $2.11
The four examples (printers and cartridges, software pricing, bundling, volume discounts) are pretty
straightforward. The most difficult to understand is the software pricing. I typically change the numbers
in the table, change the number of high and low value customers and ask them to compute the optimal
pricing strategy.
Some Professors might want to also cover “mixed bundling,” offering the goods for sale individually as
well as in a bundle. Here in an individual HW question that has as the right answer a mixed bundle. You
can go over this example.
Mixed Bundling Problem
At the 8:10 café, there are equal numbers of two types of customers with the following values.
The café owner cannot distinguish between the two types of students because many students
without early classes arrive early anyway (that is she cannot price discriminate).
Students with
early classes
Coffee
Banana
Students without
early classes
70
50
60
100
The MC of coffee is 10. The MC of a banana is 40. Is bundling more profitable than selling
separately? HINT: if you sell the bundle, can you make more by offering coffee separately?
If so, what price should be charged for the bundle? (show calculations)
Answer:
Mixed bundling is more profitable than only selling separately…
Price bundle at 160, earn 160-50=110; price coffee at 70, earn 70-10=60. Total Profit is 170.
Price separately only: price coffee at 60, earn a 120-20=100; price bananas at 100, earn 10040=60 Total profit is 160.
Bundle only: coffee + banana at 120, earn 240 – 100 = 140; Total profit is 140.
In-class Problem
There are two in-class problems in the teaching notes above. A third in class problem would be to modify
the software pricing example by changing the number of consumers in the high and low value groups; or
by changing the amount that each consumer type is willing to pay for each version of the software.
57
Additional Anecdote: Trip Insurance
International Expeditions, Inc. (IEI) provides trip cancellation insurance for international travelers. Trip
cancellation insurance provides reimbursement of prepaid trip costs to travelers in the event of
involuntary cancellation by the customer. Claims are subject to specific catastrophic events such as death,
sickness, loss of home, or other circumstance beyond the insured’s control. Since January of 2002, there
has been a marked increase in the number of claims against these insurance policies. In response to these
claims, the insurance companies have raised premiums. Consequently, the number of travelers selecting
this insurance is decreasing, with customers choosing to bear the risk instead.
IEI currently utilizes uniform pricing based on the trip duration. With this pricing strategy, they can not
differentiate between high and low risk travelers. In the current pricing environment, low risk travelers
are declining insurance cutting off a profitable stream of business from the company. If IEI could
discover a way to price policies separately to high and low risk clients, it could restore this profit stream.
IEI can not, however, simply ask whether travelers are high or low risk since the higher risk travelers
would assign themselves to the low risk category to get lower rates. By studying its customer histories,
the company found that frequent international travelers have greater experience with travel and are less
likely to file claims against trip insurance (low-risk traveler).
By offering a frequent traveler discount, where frequency is determined by the number of policies
previously purchased with IEI, the company gets travelers to identify themselves by their purchasing
activities. A high-risk traveler will be unable to profitably mimic the low-risk traveler with this program.
With low risk customers restoring their purchases through the frequent traveler program, IEI was able to
successfully price discriminate. This scheme helped drive a nearly 100% revenue increase in 2003.
58
SECTION IV – STRATEGIC DECISION MAKING
15. STRATEGIC GAMES
Sequential Move Games
Simultaneous Move Games
What Can I Learn from Studying Games Like the Prisoners’ Dilemma?
Other Games
Main Points
•
A Nash equilibrium is a pair of strategies, one for each player, in which each strategy is a best
response against the other.
•
When players act rationally, optimally, and in their own self-interest, it’s possible to compute the
likely outcomes of games. By studying games, we learn where the pitfalls are and how to avoid
them.
•
Sequential games include a potential first-mover advantage, or disadvantage, and players can
change the outcome by committing to a future course of action.. Credible commitments are
difficult to make because they require that players threaten to act in an unprofitable way—against
their self-interest.
•
In simultaneous-move games, players move at the same time.
•
In the prisoners’ dilemma, conflict and cooperation are in tension—self-interest leads to
outcomes that no one likes. Studying the games can help you figure a way to avoid these bad
outcomes.
•
In repeated games, it is much easier to get out of bad situations. Here are some general rules of
thumb:
• Be nice: No first strikes.
• Be easily provoked: Respond immediately to rivals.
• Be forgiving: Don’t try to punish competitors too much.
• Don’t be envious: Focus on your own slice of the profit pie, not on your competitor’s.
• Be clear: Make sure your competitors can easily interpret your actions.
Supplementary Material
ManagerialEcon.com (Chapter 15)
Mike Shor, GameTheory.net
Simultaneous game self test
http://www2.owen.vanderbilt.edu/mike.shor/Courses/game-theory/quiz/quiz1.html
Sequential game self test
http://www2.owen.vanderbilt.edu/mike.shor/Courses/game-theory/quiz/quiz4.html
Play the repeated prisoners' dilemma
http://www.gametheory.net/Mike/applets/PDilemma/
59
These first two applications are self guided tests that students should take to learn how to compute
equilibria in sequential games (“roll back”) and simultaneous games (best-response equilibria). The
third allows the students to play the prisoner’s dilemma against five different personality “types.”
Robert A. Garda and Michael V. Marn, “Price Wars”, The McKinsey Quarterly, 1993, number 3, pp. 87100
Never start a land war in Asia; never start a price war.
Courtney, H., “Games Managers Should Play”, The McKinsey Quarterly, 2000 Number 3.
Game theory helps business predict the likely outcome (equilibrium), but more importantly it shows
you how to manipulate the game to your advantage.
Steven Landsburg, “Courtship and Collusion: The Mating Game,” The Armchair Economist, (New York:
The Free Press, 1993) pp. 168-173.
Very funny, but politically incorrect interpretation of NOW’s opposition to breast implants.
Individually, it makes no sense to limit the choices of women, but collectively, if NOW can eliminate
competition amongst women for men (by eliminating cosmetic surgery), then they can make the
group better off.
What happened after BluRay won the standards war?
We have been following the standards war between HD DVD and BluRay. At week 10 below,
Toshiba conceded and Wal-Mart went exclusive with BluRay. Predictably, price of BluRay players
increased realtive to both HD DVD and to Dual players (both formats).
The Price Premium over HD DVD players increased by about 50%; and the price discount realtive to
Dual players (that can play both formats) decreased by about 50%.
Teaching Note
To place this topic in perspective, I tell my students that in the previous chapters, we have shown them
how to do benefit-cost analysis for a variety of decisions. We study game theory and bargaining to show
you how to make decisions in cases where your profit depends on rivals’ actions, in addition to your own
actions. Game theory is used both to tell you what is likely outcome of the game, but also shows you how
to change the payoffs or rules of the game to your advantage.
60
I also tell students that the only way to learn this material is by doing problems and tell them that the
individual HW will be simple if they answer they spend an hour on these three sites. Typically I bring
these up in class and “do” the first questions in each to give them a push.
Simultaneous game self test
http://www2.owen.vanderbilt.edu/mike.shor/Courses/game-theory/quiz/quiz1.html
Sequential game self test
http://www2.owen.vanderbilt.edu/mike.shor/Courses/game-theory/quiz/quiz4.html
Play the repeated prisoners' dilemma
http://www.gametheory.net/Mike/applets/PDilemma/
After defining a game and describing how to compute equilibria, I talk a little about John Nash. They are
very interested in Nash, as many have seen the movie “A Beautiful Mind.” Tell a little bit about him and
schizophrenia (strikes in your 20’s or 30’s but many grow out of it in your 50’s or 60’s).
The prisoner’s dilemma is used to illustrate the tension between individual and group interest. I tell them
stories about my time at Justice putting price fixing conspirators in a prisoners’ dilemma because the only
way to get evidence that an agreement was reached is to get one of them to confess. We had indirect
evidence that they conspired (usually phone records) but no direct evidence without a confession. I talk
about the standard of proof in criminal (beyond all reasonable doubt) and civil (preponderance of the
evidence). For criminal prosecutions, a confession is typically needed. I tell them about Grand Juries,
designed to prevent malicious prosecution by the US Attorneys by making sure that there is really
evidence that a crime has been committed but have evolved into evidence gathering mechanism.
I ask them how we find out about most conspiracies: from disgruntled employees, cartel members who
didn’t think they got a “fair” share of the profit, but mostly from disgruntled ex-spouses going through a
divorce. I joke that you shouldn’t fix prices if you have a shaky marriage; but if you are going to fix
prices, don’t use the phone.
I tell them about various conspiracies: The airline computerized reservation service conspiracy where, for
example, airline A would offer a low fare into B’s hub, and B would respond by offering a special low
fare into A’s hub, that was “visible” but not available until some future date. The fare had two letters
“FU” after it to indicate B’s displeasure with A’s fare. The settlement required airlines to offer tickets at
every fare. If you can gain access to them, you might also show the famous FBI tapes of the ADM
conspiracy where the US cartel organizer was meeting in Japan. Here is a description of the Lysine
conspiracy: http://everything2.com/index.pl?node_id=963023
Talk about the prisoners’ dilemma as a metaphor for the antitrust laws. Collusion is an attempt to move
from the Nash equilibrium in the upper left to the lower right cell that maximizes collective profit.
Merger law attempts to prevent the same movement.
Then talk about Axelrod’s repeated dilemma strategy as a way to get out of the dilemma. Might want to
play the repeated game in class (http://www.gametheory.net/Mike/applets/PDilemma/) and draw
Axelrod’s lessons from it. But if you can get the student’s to do this on their own, it is much better. In
the longer run, tell them to avoid getting caught in a dilemma by differentiating your product or do
something that makes your profit less dependent on your rivals’ actions.
Finally go through the game of chicken and show how you turn the game with two equilbria into a
sequential game with a first mover advantage by committing to a course of action so that your opponent
61
moves “second.” Remind them that this illustrates the entire point of studying game theory, to model the
game so you can figure out what is likely to occur; and then, if you don’t like the equilibrium, try to
change the structure to your advantage.
In-class Problem
I also tell students that the only way to learn this material is by doing problems and tell them that the
individual HW will be simple if they answer they spend an hour on these three sites. Typically I bring
these up in class and “do” the first questions in each to give them a push.
Simultaneous game self test
http://www2.owen.vanderbilt.edu/mike.shor/Courses/game-theory/quiz/quiz1.html
Sequential game self test
http://www2.owen.vanderbilt.edu/mike.shor/Courses/game-theory/quiz/quiz4.html
Play the repeated prisoners' dilemma
http://www.gametheory.net/Mike/applets/PDilemma/
In this game, I play against only the first “type” and leave it to the students to play against the rest on their
own.
Additional Anecdote: American Airlines & Chinese Banks
AMERICAN AIRLINES: In 1992, America Airlines (AA), the market share leader in the airline
industry, announced a new pricing strategy - Value Pricing. AA believed Value Pricing would address
customer complaints and help reverse operating losses by stimulating demand, increasing market share,
and reducing costs. American narrowed the number of fares possible from 500,000 to 70,000 by
classifying each into one of four classes (first class, coach, discounted 7 and 21 day purchase) and began
pricing based on flight length. These changes resulted in lower list prices for both business and leisure
travelers.
According to AA, Value Pricing was to create “simplicity, equity, and value” in their prices. By
simplifying their pricing structure, AA was stabilizing price fluctuations as well as establishing a price
floor. The new system set firm prices based on restrictions and miles flown, and eliminated any corporate
discount programs. Most importantly, American believed the new fare structure created through Value
Pricing would increase volume on their planes (raising load factors) by making the industry “pie” larger
and by gaining AA a larger share of that pie. AA believed Value Pricing would drive an increase in
overall demand through its effort to stimulate travel and economic activity. American also believed these
prices would allow AA to increase its market share.
What AA failed to fully anticipate was its competitors’ reactions to this new pricing plan. Business is not
a static environment, and AA did a poor job of projecting the response of the other players in the dynamic
game of air travel. Had Robert Crandall, the CEO of AA at the time, used the lessons of this chapter, a
devastating industry price war might have been avoided. Instead, AA pushed forward, competitors
responded aggressively, and industry profits plummeted. The Value Pricing initiative was abandoned
within months of its launch.
CHINESE BANKS: In 1995, in Sanya City, China, the Rural Credit Union raised interest rates from
9.2% to 10.8% on one-year savings accounts, hoping to attract new deposits to the bank. Instead of
attracting deposits, however, the change provoked its principal competitor, the Hainan Development
62
Bank, to increase deposit rates as well. As a result, capital costs increased at both banks, without a
corresponding increase in deposits, and profits declined. In 1996, the Central Bank of China ended this
“excessive” competition for deposits by mandating a uniform (and low) interest rate throughout the
country. Although we don’t know what motivated the Central Bank policy, it is likely that the competing
banks asked them to reduce the intensity of the competition between them.
The anecdote shows what can happen when the profits of one firm depend on the actions of another. To
analyze this interdependence, we use what is known as “game theory." In a game, we identify the
players, the options or moves available to them, and the payoffs associated with combinations of moves.
If each player acts optimally, rationally, and selfishly, we can compute the likely outcome or
“equilibrium” of the game.
The point of studying game theory is not just to figure out what is likely to happen, but also to give you
some guidance about how to change the game to your advantage. For example, in the story above, it is
likely that the banks realized that neither of them could stop the competition for depositors, so they asked
the government to step in and control it.1
Another way to think about this topic is to relate it back to the three generic strategies: reducing costs;
differentiating your product; and controlling the intensity of competition. Game theory helps you
understand the third of these options. In this chapter, we partition our study of games into three areas:
sequential-move games, simultaneous-move games, and repeated games.
1 This is very similar to what the Federal Reserve did in the 1970’s with its Regulation Q, fixing deposit rates at 5¼ %. As happened in the United States, we would
expect non-price competition for deposits, and competition from foreign banks not subject to Chinese regulation.
63
16. BARGAINING
Bargaining as a Game of Chicken
How to Improve Your Bargaining Position
Main Points
•
Bargaining can be modeled as either a simultaneous-move or sequential-move game.
•
A player can gain an advantage by 1) turning a simultaneous-move game into a sequential move
game with a first-mover advantage; or by 2) committing to a position.
•
Credible commitments are difficult to make because they require players to commit to a course of
action against their self-interest. Thus, the best threat is one you never have to use.
•
The strategic view of bargaining focuses on how the outcome of bargaining games depends on
who moves first and who can commit to a bargaining position, as well as whether the other player
can make a counteroffer.
•
The non-strategic view of bargaining does not focus on the explicit rules of the game to
understand the likely outcome of the bargaining. This view focuses on the gains from bargaining
relative to alternatives.
•
The gains from agreement relative to the alternatives to agreement determine the terms of any
agreement.
•
Anything you can do to increase your opponent’s gains from reaching agreement or to decrease
your own will improve your bargaining position.
Supplementary Material
ManagerialEcon.com (Chapter 16)
Schelling, T.C. 1960. The strategy of conflict. Harvard University Press. Chapters 2 “An essay on
bargaining” (pp. 21-52) and chapter 5 “Enforcement, communication, and strategic moves” (pp. 119161).
The alternatives to agreement...
...determine the terms of agreement. Thanks to a Toyota dealer in Kenosha who is also CarMax
dealer, consumers have a good "outside" option to use when they bargain with their local Toyota
dealers. The Kenosha dealer lists all their inventory on the CarMax website, priced at about 90%
of MSRP, which is about where dealer cost should be (according to Consumer Reports). If your
local dealer doesn't come down to that price, take a road trip to Kenosha. Online buyers seem
excited:
Has anyone from Il-Chicago bought a brand new Toyota at CarMax,Kenosha WI ? They
advertise brand new HL below MSRP. From the numbers I have seen, better deal than
local Toyota dealerships. I am not sure how it all works out in terms of registering the car
in IL, warranty and taxes. Anyone has any idea ?
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Teaching Note
The main point of this lecture is to illustrate to the students the two different ways of looking at
bargaining: the strategic and the axiomatic.
Strategic view of bargaining:
I often begin by offering to bargain with a student over how to split a $20 bill. I put the bill on her desk
and then outline the rules of the game: “You have to play optimally, selfishly, and rationally. I am going
to make you a take it or leave it offer, and you can either accept or reject my offer. If you reject it, the
$20 goes to <<pick another student in the class>>, and remind the student that no side payments are
allowed. Are you ready?” I then offer her a quarter from my pocket. If she plays rationally, she takes the
quarter.
I will then segue to the normal form game of bargaining, where there are two equilibria, and then ask
them how they can “steer” the game to their preferred equilibrium. They often say “move first” or
“commit” to rejecting any but a low offer. I then diagram these two outcomes in an extensive form. I
then diagram the extensive form game with a first mover advantage. I show how commitment can change
the equilibrium of the game.
I then ask them how they are going to commit, and tell them the story of Mike Shor’s dad, who buys a car
by first test driving the model he wants. Then, he writes the number that he wants to pay (way below list
price) on a sheet of paper and gives it to the salesman. He says that that only word he wants to hear out of
the salesman’s mouth is “yes” or “no.” If the salesman tries to bargain, he leaves, making sure that the
salesperson has his phone number. If he can commit to a take-it-or-leave-it strategy, and the salesman
believes him, then the salesman will accept the price, as long as it is above his reservation value.
Nonstrategic view of bargaining:
In the strategic view of bargaining the timing of moves, the ability to make a counter offer, and the ability
to commit to a position can change the outcome. But the sensitivity of strategic bargaining games to
mostly unobservable assumptions frustrated John Nash and led him to develop an axiomatic approach to
bargaining where the parties split the surplus created by agreement. The surplus is measured relative to
the alternatives to agreement, which implies a different approach to bargaining. If you can increase your
opponent’s gain to agreement, it makes him more eager to reach agreement. His eagerness to reach
agreement makes him a weaker bargainer, and Nash’s theory predicts a weaker price.
I illustrate this with the story of Mr. Smith, who always went to buy a new car on Christmas Eve, when
there were no other shoppers to compete for the attention of the car dealer and because it was near the end
of the month when the sales people were paid (both factors increased their gains to reaching agreement
with Mr. Smith were larger).
I then explain how merger among competing hospitals can increase the gains to reaching agreement by
the insurance company because now the alternatives to agreement with the two hospitals are agreement
with more distant, less desirable hospitals. I tell them this was the FTC’s theory in their challenge to the
consummated Evanston-Highland Park hospital merger. The FTC won by showing that the hospitals
planned to increase bargaining position by merging, and if they were successful, raising price relative to a
control group of non merging hospitals).
In-class Problem
I start by demonstrating that a take-it-or-leave-it offer can capture all the gains from trade. Use a ten
dollar bill to demonstrate. Then I ask students what would happen in a three-offer game A—B—A.
Using backwards induction, or as students like to think of it, “look ahead and reason back,” I show that
65
whoever makes the last offer, A, gets all the gains from trade, so the second offer, B, must get nothing,
and the first offer, A, gets everything. Since the parties can “see” this solution, the trade occurs in period
one.
Then I modify the three offer game by saying that the pie shrinks every period by $2. By backwards
induction, in period 3, A gets the entire pie, which is $6. So in period 2, B must offer $6 to A, keeps $2
for himself. Finally, in period 1, A must offer $2 to B keeps $8 for himself. Trade occurs in period 1.
The shrinking pie gives B some bargaining power as now he can threaten to delay.
Additional Anecdote: CHAOS at Midwest Express
In 2002, the Association of Flight Attendants (AFA) announced plans to attempt to create CHAOS for
Midwest Express, a regional air carrier based in Milwaukee. Under the CHAOS (Create Havoc Around
Our System) plan, flight attendants threatened to either stage a mass walkout for a few days to a week or
to strike individual flights, with no advance warning to either customers or management.
Midwest Express flight attendants began their CHAOS campaign after contract negotiations broke down
between the union and company management. CHAOS was first tested in a strike campaign the flight
attendants waged against Alaska Airlines in 1993. Six weeks after announcing the plan, attendants struck
the first flight; over the course of the following six months, they struck only seven times. But the
continuing threat helped scare customers away from the airline.
To prepare itself to weather CHAOS, Midwest Express cancelled all flight attendant vacations and
threatened to lock out any employee who participated in the strike effort. To back up its commitment, the
AFA promised funding from its strike fund to support any attendant who ended up locked out. Each of
the participants tried to bolster its bargaining position by making their threats as credible as possible.
The biggest strength of the union’s threat, however, was that it could be effective without full
implementation. The mere threat of random strikes was enough to push passengers to other airlines.
Within 30 days of announcing implementation of CHAOS, the union successfully negotiated a new
contract that received 95 percent approval from its membership. Mastering bargaining tactics like
effective threats backed by credible commitments, one of the subjects of this chapter, allowed the flight
attendants to successfully negotiate a favorable labor agreement.
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SECTION V – UNCERTAINTY
17. MAKING DECISIONS WITH UNCERTAINTY
Random Variables
Uncertainty in Pricing
Run Natural Experiments to Reduce Uncertainty
Minimizing Expected Error Costs
Risk versus Uncertainty
Main Points

When you’re uncertain about the costs or benefits of a decision, assign a simple probability
distribution to the variable and compute expected costs and benefits.

When customers have unknown values, you face a familiar trade-off: Price high and sell only to
high-value customers, or price low and sell to all customers.

If you can identify high-value and low-value customers, you can price discriminate and avoid the
trade-off. To avoid being discriminated against, high-value customers will try to mimic the
behavior and appearance of low-value customers.

Difference-in-difference estimators are a good way to gather information about the benefits and
costs of a decision. The first difference is before versus after the decision or event. The second
difference is the difference between a control and an experimental group.

If you are facing a decision in which one of your alternatives would work well in one state of the
world, and you are uncertain about which state of the world you are in, think about how to
minimize expected error costs.
Supplementary Material
ManagerialEcon.com (Chapter 17)
Teaching Note
To place this topic in perspective, I tell my students that in the previous chapters, we have shown them
how to do benefit-cost analysis for a variety of decisions. When we studied game theory and bargaining,
we introduced a complication to the simple benefit-cost analysis and showed how to make decisions when
profit depends on rivals’ actions, in addition to your own actions. In this section, we introduce another
complication: what if you don’t know the costs and benefits. In this case, you replace the unknown
variables with random variables and compute expected costs and benefits. Not only does this allow you
to make better decisions, but it also points out the value of gathering additional information and may
show you how to mitigate the risk. Point out the parallel of studying uncertainty to studying game theory.
Game theory is used both to tell you what is likely outcome of the game, but it also shows you how to
change the payoffs or rules of the game to your advantage.
67
I then go into the dilemma faced by Northern Telecom (called TeleSwitch in the text, but students like it
when you tell them the name of the companies) of deciding whether to deal directly with big customers,
and risk losing their dealers, or do nothing and risk losing their big customers. The cost of losing dealers
is bigger, but the probability that they will leave is lower.
I then describe binomial and trinomial random variables and show them how to compute expected value.
I make the point that this is also called “sensitivity analysis,” where you try different values and see how
sensitive your analysis is to various assumptions.
I then model the decision faced by Northern Telecom and compute the expected profit of each alternative.
I then ask students what they should do. Someone will take the bait and say “sell only through dealers”
because $112>$110. I then point out that the difference in expected profit is less than two percent, and
ask them where the probabilities came from. The answer is that they estimated (or guessed). I tell them
that doing this kind of analysis should tell you that you need more information to make a decision.
Alternatively, talk to the Dealers or talk to the Big phone companies (the big customers) to ask if their
concerns could be addressed by, for example, putting a technical representative on site to keep them
apprised of new technology.
I tell a story of a relative who wanted me to invest in a residential real estate deal. Reading the prospectus
made it seem very profitable. But once I varied the assumptions about interest rates and about the price at
which the houses would sell, the deal looked very risky. Moreover, my relative did well regardless of
how well I did (his incentives were not aligned with my goals).
I go through entry deterrence, and show how to model uncertainty about how rivals will react to you. I go
through pricing with uncertainty, and tell them that this is the kind of information that they are likely to
get from their marketing group, segmenting the population into groups with information about what they
are willing to pay. Show them how to construct a demand curve from this information. If 50% of the
population is willing to pay $8; and the other 50% of is willing to pay $5, then at a price of 8, 50%
purchase; and at a price of $5, everyone purchases. Compute the expected profit of pricing at $8 and the
expected profit of pricing at $5. Compute the expected profit of price discrimination.
I remind them that price discrimination requires being able to identify high and low value customers, set
different prices to each, and prevent arbitrage. Car sales people identify high and low value buyers
according to how long they are willing to wait at the dealer; low value sellers have low opportunity cost
of time so a policy of reducing price every half hour or so will “screen” out the high value sellers who
will purchase before the price reduces too much.
In-class Problem
QUESTION: your marketing department has identified the following customer demographics in the
following table. Tell students to construct a demand curve and determine the profit maximizing price as
well as the expected profit if MC=$1. The number of customers in the target population is 10,000.
Group
Baby boomers
Generation X
Generation Y
`Tweeners
Seniors
Others
Value
$5
$4
$3
$2
$2
$0
Frequency
20%
10%
10%
10%
10%
40%
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ANSWER:
Price
$5
$4
$3
$2
$0
Freq
20%
30%
40%
60%
100%
Q
2000
3000
4000
5000
10000
E[Rev]
$10,000
$12,000
$12,000
$12,000
$0
E[MR]
$5
$2
$0
$0
($2.40)
MC
$1
$1
$1
$1
$1
Point out to students that the demand curve is “lumpy”, so the MR calculation is a little different.
Additional Anecdotes: Global Warming & Banning speculators
GLOBAL WARMING: The analytics of the decision are pretty simple, once you model the uncertainty.
Take action
Don’t take action
Global warming is real (p)
0
p*(Error Cost II)
Global warming is not real (1-p) (1-p)*(Error Cost I) 0
To
minimize
expected
error
costs,
take
action
if
and
only
if
(1-p)*(Error Cost I) < p*(Error Cost II). Most of the policy debate concerns the probability that Global
warming will occur, p, and the size of the Error Costs. Since the costs of taking action are incurred in the
present; and the costs of inaction are incurred only in the future, benefit-cost analysis requires a discount
rate. A small discount rate favors action. A big discount rate favors inaction.
BANNING SPECULATORS: As Congress contemplates banning speculators from trading oil contracts,
it should study its past efforts to rein in speculation:
In 1958, Congress officially banned all futures trading in the fresh onion market. Growers blamed
"moneyed interests" at the Chicago Mercantile Exchange for major price movements, which could
sink so low that the sack would be worth more than the onions inside, then drive back up during other
seasons or even month to month. Championed by a rookie Republican Congressman named Gerald
Ford, the Onion Futures Act was the first (and only) time that futures trading in a specific commodity
was prohibited, and the law is still on the books.
Even after the nefarious speculator had been banned, the volatility of onion prices remained high.
Ironically, growers now want the speculators back.
69
18. AUCTIONS
Oral Auctions
Second-Price Auctions
First-Price Auctions
Bid Rigging
Common-Value Auctions
Main Points
•
In oral or English auctions, the highest bidder wins by outbidding the second- highest bidder.
Losing bidders determine the price.
•
A Vickrey or second-price auction is a sealed-bid auction in which the high bidder wins but
pays only the second-highest bid. These auctions are well suited for use on the Internet.
•
In a sealed-bid first-price auction, the high bidder wins and pays his value. Bidders must
balance the probability of winning against the profit they will make if they do win. Optimal bids
are less than bidders’ private values.
•
Bidders can increase their profit by agreeing not to bid against one another. Such collusion or bid
rigging is more likely to occur in open auctions and in small, frequent auctions. If collusion is
suspected,
• do not hold open auctions;
• do not hold small and frequent auctions;
• do not disclose information to bidders—do not announce who the winners are, who else
may be bidding, or what the winning bids were.
•
In a common-value auction, bidders bid below their estimates to avoid the winner’s curse. Oral
auctions return higher prices in common-value auctions because they release more information.
Supplementary Material
ManagerialEcon.com (Chapter 18)
Luke Froeb & Mikhael Shor, Auctions, Evidence, and Antitrust, in Econometrics: Legal Practical and
Technical Issues, John Harkrider (ed.), ABA Section on Antitrust Law, 2005. (with Mikhael
Shor). link
Steven Landsburg, "Cursed Winners and Glum Losers,” The Armchair Economist, (New York: The Free
Press, 1993) pp. 157-167.
Teaching Note
I begin with a simple English, private-values auction. Start with the simple example of five bidders with
values {$1,$2,$3,$4,$5}. Show that high value bidder wins (efficiency), and price is determined by the
maximum of the losers’ values and that the bidder surplus is the difference between the first and second
highest values. Change the $4 to a $3, and ask them what the new price is. Change the $4 to a $5 and ask
them what the new winning price is.
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I tell them that economists love auctions because they identify the high value user and set a price. I tell
that that concerts used to set posted prices but faced a very complex revenue management problem (price
too high and leave unsold seats or price too low and have excess demand). eBay has given them a way to
auction off the tickets and replace posted prices with auctions—no more mispricing.
To link this chapter to the previous one, tell students that you have one item for sale in your store, MC=$3
and the probability of getting a high value customer who is willing to pay $8 is 50% and the probability
of getting a low value customer willing to pay $5 is 50%. Ask them to compute the expected profit under
two different scenarios:
i. posted price profit is .5*($8-$3)=$2.50
ii. an auction when two people show up, auction profit is .25*$8 + .75*$5 -$3=$5.75-$3=$2.75
{$8, $8}, winning price is $8
{$8, $5}, winning price is $5
{$5, $8}, winning price is $5
{$5, $5}, winning price is $5
You can also ask them to compute auction prices with three bidders and you can change the probability
distribution.
I then move on to the examples showing that more bidders raise price because the expected maximum
losing value is higher. Note the result that 3-day eBay auctions return 42% less than 10-day eBay
auctions.
I then introduce second price private value auctions with the same {$1,$2,$3,$4,$5} example, and show
that the outcome is identical to an English auction. Note how second price auctions are well suited to the
Internet (asynchronous) and you can tell the computer what your value is and go home (no need to keep
logging on and upping your bid).
Talk about sealed bid, first price auctions, and the bidding tradeoff: higher bid raises probability of
winning but also reduces profit if you do win. The tradeoff can be learned only through experience. Tell
a story of a friend who bought timber for International Paper who had two bids in his brief case. If the
competition was strong, he would submit the aggressive bid; if weak, the less aggressive bid.
To illustrate bid rigging, go back to the {$1,$2,$3,$4,$5} example and ask what happens if the $4 and $5
bidders form a cartel. Price reduces from $4 to $3, so the cartel “earns” a dollar. A cartel must solve four
problems: whom to admit to the cartel, how to suppress competition, how to divide cartel profit, and how
to punish cheaters. For example antique dealers show up at estate sales together and “express interest” in
certain items, which is really a way to organize a bid rotation scheme where members refrain from
bidding on certain items in exchange for the same consideration. This is easiest to do for something like
timber auctions where distant mills do not bid aggressively in exchange for the same consideration for
auctions that are close to them. The Justice Department has prosecuted cartels where a single bidder bid
for everyone in the group and then the cartel members held “knockout auctions” after the real auction to
allocate the items to the highest bidder in the cartel. The difference between what the item went for in the
first auction and the knockout auction is profit to the cartel and is split among the cartel members.
I ask students whether they think collusion is more likely in an English or sealed bid auction. ANSWER:
open auctions because there is no opportunity to cheat on the cartel. Once cartel members see someone in
the cartel bidding aggressively, they know the agreement to suppress competition has been abandoned.
The last auction I worked on was the frozen fish conspiracy. The government is a frequent victim of
bidding cartels. Learn from their mistakes:
71





Do not entangle purchasing agents with masses of red tape. Instead, permit them to negotiate—to
bargain with the bidders if they suspect bid-rigging.
Do not rely on purchasing agents who have little interest in buying at a low price. Reward agents
only for making good (high-quality and low-price) purchases.
Do not use the procurement process to further a social agenda (small business set-asides, public lands,
national defense, etc.) that is irrelevant to purchasing goods at low prices.
Keep information away from any potential cartel.
If you suspect collusion,
o do not hold open auctions.
o do not hold small and frequent auctions.
o do not disclose information to bidders: Do not announce who the other bidders are, who
the winners are, or what the winning bids are.
For common value auctions, if you have time, auction off a jar of coins. Experience has shown that the
winning bid is about 25% too high. You will make money. The easiest way to describe the basic adverse
selection in a common value auction is by telling the story of bidding against a firm that has a nearby
offshore oil tract with good seismic data on what the formation looks like. Since they have a better
estimate of how much oil is in the tract than you do, you will win only if you bid too much. Extend the
logic to the case of many bidders who collectively have information that you do not. When you win, you
learn that their information was worse than yours, so you must bid as if your information is the most
optimistic by shading what you think the item is worth.
In-class Problem
QUESTION: What is the merger effect in a three bidder private values auction with three bidders whose
values are {$5, $8} with probabilities {.5, .5}, if bidders 1 and 2 agree to not compete against each other.
ANSWER:
{$8, $8, $8} pre-merger price is $8; post-merger price is $8
{$5, $8, $8} pre-merger price is $8; post-merger price is $8
{$8, $5, $8} pre-merger price is $8; post-merger price is $8
{$8, $8, $5} pre-merger price is $8; post-merger price is $5 [only case with an effect]
{$5, $5, $8} pre-merger price is $5; post-merger price is $5
{$5, $8, $5} pre-merger price is $5; post-merger price is $5
{$8, $5, $5} pre-merger price is $5; post-merger price is $5
{$5, $5, $5} pre-merger price is $5; post-merger price is $5
Note that only when the merging bidders draw the two highest values is there a merger effect. Price
increases from $8 to $5 and this occurs 1/8 of the time. Expected merger effect is $3*(1/8)
EXPERIMENT: [common value auction] Auction off a jar of coins, using either a second-price or firstprice sealed bid auction. On average, winning bids will be around 25% too high because students do not
correct for the winners’ curse.
Additional Anecdotes: FCC Auctions & Car Bargains
FCC AUCTIONS: Since 1994, the Federal Communications Commission (FCC) has conducted auctions
of licenses for electromagnetic spectrum. These auctions are open to any eligible company or individual
that submits an application and upfront payment, and is found to be a qualified bidder by the
Commission.
72
FCC auctions are conducted electronically and are accessible over the Internet. Thus, qualified bidders
can place bids from the comfort of their home or office. Further, anyone with access to a computer with a
web browser can follow the progress of an auction and view the results of each round.
In 1993 Congress passed the Omnibus Budget Reconciliation Act, which gave the Commission authority
to use competitive bidding to choose from among two or more mutually exclusive applications for an
initial license. Prior to this historic legislation, the Commission mainly relied upon comparative hearings
and lotteries to select a single licensee from a pool of mutually exclusive applicants for a license. The
Commission has found that spectrum auctions more effectively assign licenses than either comparative
hearings or lotteries. The auction approach is intended to award the licenses to those who will use them
most effectively. Additionally, by using auctions, the Commission has reduced the average time from
initial application to license grant to less than one year, and the public is now receiving the direct
financial benefit from the award of licenses.
(from http://wireless.fcc.gov/auctions/default.htm?job=about_auctions)
The FCC’s decision to use auctions illustrates the uncertainty surrounding all significant business
decisions. Businesses never have perfect information, especially about the customers who wish to
purchase their goods and the values those customers place on those goods. In this section, we show you
how to “quantify” uncertainty so that you can make better weigh the benefits of a decision against its
costs. In particular, we model missing pieces of information as random variables so that we can compute
the expected costs and expected benefits of various decisions. We also discuss ways to extract the most
value from potential purchasers with uncertain values.
CAR BARGAINS:
A student tells me about CarBargains:
The service costs a couple of hundred dollars and organizes a sealed-bid auction among local car
dealers. In my case, they got 6 dealers to bid, and the prices ranged from $1500 over factory invoice
to $100 over invoice. The dealer who had the exact car (options, color, etc.) I wanted actually came in
with the worst bid, but when I went to their sales manager with the $100 bid from another dealer, and
explained to them I would prefer to buy from him but only if he matched the best offer, he instantly
agreed and took care of the deal himself. This cut out the salesman saving the dealership the
commission and saved me the time and hassle of dealing with a car salesman. Well worth the $190
the service cost. (at least as far as I was concerned)
73
19. THE PROBLEM OF ADVERSE SELECTION
Insurance and Risk
Anticipating Adverse Selection
Screening
Signaling
Adverse Selection and Internet Sales
Main Points

Insurance is a wealth-creating transaction that moves risk from those who don’t want it to those
who are willing to bear it for a fee.

Adverse selection is a problem that arises from information asymmetry—anticipate it, and, if you
can, figure out how to consummate the unconsummated wealth-creating transaction (e.g.,
between a low-risk customer and an insurance company).

The adverse selection problem disappears if the asymmetry of information disappears.

Screening is an uninformed party’s effort to learn the information that the more informed party
has. Successful screens have the characteristic that it is unprofitable for bad “types” to mimic the
behavior of good types.

Signaling is an informed party’s effort to communicate her information to the less in- formed
party. Every successful screen can also be used as a signal.

Online auction and sales sites, like eBay, address the adverse selection problem with
authentication and escrow services, insurance, and on-line reputations.
Supplementary Material
ManagerialEcon.com (Chapter 19)
Steven Landsburg, “Rational Riddles: Why the Rolling Stones Sell Out,” The Armchair Economist, (New
York: The Free Press, 1993) pp. 10-19.
Comment: Selling out is a form of signaling that the concert is high quality. It is too costly for
lower quality groups to mimic this signal.
Samuel L. Baker, Economics Interactive Tutorials,
http://hspm.sph.sc.edu/COURSES/ECON/Tutorials2.html
12. Risk
13. Risk Aversion and Insurance
Similar to the MBA Primer but with less attention to the graphic design aspects.
74
Teaching Note
I begin this class with the story of a South Carolina manufacturing firm that used an “orientation” classes
as a screen (see the additional intro anecdote at the end of this section of the manual; the Zappos story in
the text is a very similar example). If job candidates missed one of the orientation periods, they were told
to go home as they would not be getting job offers. Ask the students why the company was doing this.
Ask students if it was unethical? Ask students if it was unethical for shirkers to misrepresent themselves
to companies trying to hire them.
To formally model adverse selection, first describe risk aversion as the unwillingness to pay expected
value for a lottery. Ask whether individuals are risk averse. Ask how we know this. Then describe how
insurance moves risk from those who don’t want it to those who don’t mind it. Go through a simple
example of a bike owner willing to pay $25 to insure a risk of a 20% probability of getting his bike stolen,
which costs $100 to replace.
Ask a student whether “speculators” harm ordinary investors. Ask a student to explain how futures
contracts moves risk from those who don’t want it to those who don’t mind it. Tell them they play the
same role as insurance companies.
Then complicate the example by telling students that your marketing department has identified two risk
types (20% and 40%), each facing a probability of a $100 loss. Tell them each is willing to pay $5 more
than expected value to get rid of the expected loss, and tell them that the two risk types are equally
represented in the area.
Tell them that if you can identify the two types, you can charge two different prices ($25 and $45) for the
insurance. Note the analogy to price discrimination, but it is not discrimination because the high price
reflects the expected costs of providing insurance.
Then tell them that you cannot tell the types apart, and ask what price maximizes profit. Show that
charging $30 is unprofitable. The only profitable price is $45 selling to the high risk types. At any other
price, the insurance company loses money because the good types (low risks) do not buy. Explain that
the problem is caused by the information asymmetry.
Get rid of the asymmetry by gathering
information, charge two different prices and the problem disappears.
There are two lessons from this example:
1. Anticipate adverse selection (anticipate that only the high risks will buy); and
2. Sometimes, you can consummate the unconsummated wealth creating transaction with the low risk
types. Do this by price discriminating directly (by gathering information about individuals), or
indirectly (by designing products that appeal to each risk type).
Go through the health insurance example, the used car example, small IPO example (for IPO’s, investors
do NOT anticipate adverse selection) and bank loans. In each ask where the information asymmetry is
and what is likely to happen (only those with HIV purchase insurance; only those with lemons sell them;
only low value companies sell to the public).
Define screening and then discuss how to design screens, both those that are analogous to direct and
indirect price discrimination. Explain that a policy with a deductible can be used to sell partial insurance
to the low risk types. The policy will “work” if it is unattractive to high risk types (they prefer full
insurance at $45 to insurance with a 50% deductible priced at $15; the partial insurance is priced at $15 to
cover the 20% chance of a $50 loss from low-risk types plus the $5 risk premium). Explain that this is
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analogous to the indirect price discrimination scheme used by the software company—the scheme worked
as long as the high value customers preferred the full-featured software to the disabled software.
Ask students which health care plan they would purchase: one with a $1,000 deductible, or one with no
deductible. The answer depends on whether they expect to use the insurance. If they choose the high
deductible, they will be “grouped” with other low risk types and be able to buy it very cheaply. If they
choose the low deductible, they are grouped with the high risk types and pay a very high price. So buy
the insurance that “fits” your type.
I like the Louisiana choice of “covenant” vs. “light” marriage as a screen. Covenant marriages are more
costly to get into and to get out of. Both men and women want to screen out partners likely to divorce
them after they have made relationship specific investments. You learn that your partner is a “bad type”
if he or she rejects a covenant marriage; however, the screen only works if it is too costly for the bad
types to mimic the good type behavior.
I also like to ask students why they can get a car insurance quote by calling up GEICO and giving them
permission to look at their credit record. Turns out that your credit score is the best predictor of your
expected car insurance costs that the industry has. Ask them why. Tell them that three states, CA, HI,
and MA, prohibit the use of credit scores. What would you expect to happen in those states? Since
insurance is mandatory, you don’t have adverse selection, but good drivers end up subsidizing bad
drivers. Also when insurance companies have less information, it gives them an incentive to use other
types of information, like race or gender to predict expected insurance costs.
In-class Problem
QUESTION: your marketing department has identified the following risk groups and their expected costs
for health insurance. How should you price insurance 1. if you can discriminate; and 2. if you cannot
discriminate?
Group
Cost of Claims Probability of filing Claim
Smokers
$500
50%
Non-smokers $400
10%
ANSWER:
Group
Cost of Claims Probability of filing Claim E[Cost]
Smokers
$500
50%
$250
Non-smokers $400
10%
$40
If you can discriminate, offer the insurance for $250 to smokers; and $40 to non smokers (plus a
reasonable premium). If you cannot, then offer the insurance for $250.
Additional Anecdotes: Manufacturing Firm Hiring & Disability Insurance
Company
Manufacturing Firm Hiring
When a manufacturing firm in South Carolina, Rivets & Bolts, Inc. (R&B), hires assembly workers, it
wants employees whose work ethic is strong. Because work ethic is an intangible that is difficult to
measure, firms like R&B often mistakenly hire workers whom we can best describe as “shirkers.”
Shirkers are difficult to manage and have high absentee rates. Shirkers also reduce worker morale and
ultimately raise production costs.
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To improve the quality of its workforce, R&B devised a clever plan. R&B’s Human Resources managers
asked candidates to go through a pre-hire process (24 hours of classes over eight days during a four-week
period). The HR managers told potential employees that this process would be the final step before fulltime employment, and that candidates would receive no pay for attending these classes. The candidates
thought the pre-hire classes served as an orientation to the company; however, the firm used the classes to
weed out less-motivated candidates. Candidates who missed a class—or showed up late—were sent
home and not allowed to return. On average, R&B’s managers dismissed two in each class of thirty
people for not coming in on time. This pre-hire screening has been very successful; just 10 of the 1,300
workers hired under the program have exhibited significant attendance problems. The program reduced
the rate of bad hires from about 8 percent to less than 1 percent. R&B’s screening process may also be
illegal if, for example, it has a discriminatory impact. Before trying something like it, you may want to
consult an attorney to ensure that you are in full compliance with all labor laws.
This story illustrates the problem known as adverse selection. Adverse selection arises when one party to
a transaction is better informed than another—in this case, workers know more about their work habits
than does their employer. Unless employers can distinguish good from bad workers, they end up hiring
both.
In general, adverse selection arises in any transaction in which one party to a transaction has better
information than the other . In this chapter we show you how to anticipate the adverse selection problem,
protect yourself from its consequences, and, in some cases, how to solve it.
Disability Insurance Company
Insurance Company X provides group disability insurance products to businesses, who in turn offer the
product to their employees. Pricing policies to prevent a loss is difficult. Since it is difficult to know
exactly which employees are more prone to file claims, it is hard to price policies accurately. If policies
are priced too low, high-risk clients will be attracted and losses incurred. If policies are priced too high,
not enough clients will be attracted. Compounding this factor is the fact that companies are motivated to
exaggerate their safety in order to negotiate a lower price.
To improve the profitability of its pricing decisions, the insurance company turned to its historical data.
By using available geographic and industry experience information as a screening tool, the company was
able to identify groups prone to higher risks and to price those policies appropriately.
As an example, the company found that companies in Miami, Florida had (on average) higher long-term
disability claims while companies in Washington, D.C. had lower long-term disability claims. Prices for
Miami companies were increased while prices for D.C. companies were dropped. Insurance Company X
also discovered that different industry groups had different claim patterns. For example, while short term
disability for a teacher might cost 18% more than the base cost, the same policy for a group of automotive
exhaust repairers would cost 107% more than the base.
This story illustrates a solution to the problem known as “adverse selection.” It arises when one party to a
transaction is better-informed than another – in this case companies know more about their risk profile
than does the insurance company. Unless insurance companies can distinguish low from high risk
companies, they can not profitably write policies.
In general, the problem arises in any transaction where one party to a transaction is better informed than
the other. In this chapter we show you how to anticipate the adverse selection problem, protect yourself
from its consequences, and, in some cases, how to solve it.
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20. THE PROBLEM OF MORAL HAZARD
Insurance
Moral Hazard versus Adverse Selection
Shirking
Moral Hazard in Lending
Moral Hazard and the 2008 Financial Crisis
Main Points
•
Moral hazard refers to the reduced incentive to exercise care once you purchase insurance.
•
Moral hazard occurs in a variety of circumstances: Anticipate it, and (if you can) figure out how
to consummate the implied wealth-creating transaction (i.e., ensuring that consumers continue to
take care when the benefits of doing so exceed the costs).
•
Moral hazard can look very similar to adverse selection—both arise from information asymmetry.
Adverse selection arises from hidden information about the type of individual you’re dealing
with; moral hazard arises from hidden actions.
•
Solutions to the problem of moral hazard center on efforts to eliminate the information
asymmetry (e.g., by monitoring or by changing the incentives of individuals).
•
Shirking is a form of moral hazard.
•
Borrowers prefer riskier investments because they get more of the upside while the lender bears
more of the downside. Borrowers who have nothing to lose exacerbate this moral hazard problem.
Supplementary Material
ManagerialEcon.com (Chapter 20)
Steven Landsburg, “The Power of Incentives: How Seat Belts Kill,” The Armchair Economist, (New
York: The Free Press, 1993) pp. 3-9.
This reading illustrates moral hazard associated with seat belt use.
Teaching Note
I often teach this in the same 90 minute class as the adverse selection lecture. I open with an anecdote
about the truck driver who was having an affair (see additional introductory anecdote) and say that it
illustrates the problem of moral hazard. The GPS illustrates the solution.
I then go through the insurance example, saying that there is now something that bicycle owners can do to
reduce the risk of theft by 10%, like buy a lock that costs $5. This is a wealth creating transaction
because the benefit of buying a lock (10%)*$100=$10 is greater than the cost, $5. But once the consumer
purchases insurance, the benefit disappears because the insurance compensates him for the lock. So the
probability of a theft increases from 30% to 40%.
Two lessons of moral hazard:
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1. Anticipate it. If your marketing department observes a 30% chance of bicycle theft in an
uninsured population, anticipate that once you sell insurance the probability will rise to 40%. Sell
insurance for $45.
2. There may be ways to consummate the unconsummated wealth creating transaction (inducing
customers to use the lock). You could buy it for them. This is analogous to the health and
wellness programs adopted by companies to get employees to take better care of themselves and
reduce expected insurance costs.
Tell students that moral hazard is similar to adverse selection in that it is caused by information
asymmetry. The difference is that moral hazard is a post-contractual change in behavior caused by
hidden actions; adverse selection is a pre-contractual problem caused by hidden information. Ask
students for a moral hazard explanation and an adverse selection explanation of the fact that cars with air
bags are more likely to get into accidents; that Volvo’s are less likely to stop at stop signs; that on all-youcan-eat nights, restaurants sell more food per person.
Then go through the two examples of moral hazard in lending and “shirking” as moral hazard. These are
subtle and take a while to get through. The lending example is that the bank lends at expected cost of
borrowing and is willing to lend $30 to the entrepreneur, but demand $60 if the investment pays off. The
expected payoff is (50%)*$60, the exact amount the entrepreneur borrowed. However, once the loan is
made, the borrower finds a much riskier investment with the same expected value (5%)$1000=(50%)100.
But in this case, the payoff to the bank is only (5%)$60=$3. Ask students how to control this behavior.
Relate the shirking example to the creation of incentives. In the sales example, the performance
evaluation metric is very noisy (if the sales person works hard, it raises the probability of a sale by only
25%). So the expected benefit of working hard is the higher probability of a commission times the
commission. If working hard “costs” the salesperson $100, then the commission has to be at least $400 to
get him to exert effort. Ask students what to do if the contribution margin on the product is only $300.
They will have a very hard time understanding that it is better to let the salesperson shirk. Remind them
that if there is no solution, there is no problem. Also relate to CEO performance. If we have only very
noisy metrics of CEO performance, we have to pay them a lot in order to induce high effort.
Then segue to the next topic; the problems of designing an organization are two:
1. Whom to hire (adverse selection); and
2. Once hired, how to make them exert effort (moral hazard)
Incentive pay potentially solves both problems but may be very difficult to implement without a good
performance evaluation metric.
In-class Problem
QUESTION: your marketing department has identified the following risk groups and their expected costs
for auto insurance. How should you price insurance?
Group
Cost of Claims Probability of filing Claim
Uninsured motorists $500
50%
Insured motorists
$400
10%
ANSWER:
Group
Cost of Claims Probability of filing Claim E[Cost]
Uninsured motorists $500
50%
$250
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Insured motorists
$400
10%
$40
Offer the insurance for $250 (plus a reasonable premium).
Additional Anecdote: Regional Phone Company
A regional phone company, BonaComm, has installed GPS (global positioning satellite) locators on its
repair trucks to track the location of each truck in its repair fleet. Every 15 minutes, the GPS sends the
company the location (latitude and longitude) of each truck so the BonaComm dispatchers can more
effectively position the fleet. This information, constantly refreshed, is particularly helpful in response to
emergencies, like those caused by storms or other system-wide disasters.
The system also had an unexpected side benefit. In response to complaints about a repairman’s slow
response times, BonaComm managers were able to plot the movement of his truck. They found that the
driver made long side trips to the same house at roughly the same time each day. It turned out he was
visiting a woman (with whom he’d begun an affair) when he was supposed to be repairing phones. The
company fired him for violating the firm’s work rules.
This story illustrates a solution to a problem that economists call moral hazard. The name refers not to
the affair, but rather to the fact that the repairman was using company time to conduct it. Closely related
to the problem of adverse selection, moral hazard has similar causes and solutions. Again, these problems
arise in situations characterized by information asymmetry, in which one party has more information than
the other.
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SECTION VI – ORGANIZATIONAL DESIGN
21. GETTING EMPLOYEES TO WORK IN THE BEST INTERESTS OF
THE FIRM
Principal-Agent Relationships
Principles for Controlling Incentive Conflict
Marketing versus Sales
Franchising
A Framework for Diagnosing and Solving Problems
Main Points
•
Principals want agents to work for their (the principals’) best interests, but agents typically have
different goals than do principals. This is called incentive conflict.
•
Incentive conflict leads to moral hazard and adverse selection problems when agents have better
information than principals.
•
Three approaches to controlling incentive conflict are
• Fixed payment and monitoring (shirking, adverse selection, and monitoring costs),
• incentive pay and no monitoring (must compensate agents for bearing risk), or
• sharing contracts and some monitoring (some shirking and some risk compensation).
•
In a well-run organization, decision makers have (1) the information necessary to make good
decisions and (2) the incentive to do so.
•
If you decentralize decision-making authority, you should strengthen incentive compensation
schemes.
•
If you centralize decision-making authority, you should make sure to transfer needed information
to the decision makers.
•
To analyze principal–agent conflicts, focus on three questions:
• Who is making the (bad) decisions?
• Does the employee have enough information to make good decisions?
• Does the employee have the incentive to make good decisions?
•
Alternatives for controlling principal–agent conflicts center on one of the following:
• Reassigning decision rights
• Transferring information
• Changing incentives
Supplementary Material
ManagerialEcon.com (Chapter 21)
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James Brickley, Clifford Smith, Jerold Zimmerman, “The Economics of Organizations,” Journal of
Financial Economics, Vol. 8:2 (Summer, 1995) pp. 19-31.
I not only want you to be able to identify profitable decisions using benefit-cost analysis (the
main thrust of the course as reflected in course goals), but I also want to make sure that you
can implement them within your organization. Identifying profitable decisions without being
able to implement them, or implementing decisions without knowing whether they are
profitable, are both fruitless exercises. This article provides the basis for our study of
behavior within organizations. The authors present a methodology for diagnosing and
repairing problems within an organization. To implement it, you need to ask three questions:
i.
ii.
iv.
Who is making the decision?;
How are they evaluated?; and
How are they compensated?
Answers to these questions will suggest solutions to the problem centered on:
i.
ii.
iii.
Re-assigning decision rights;
Changing evaluation schemes; and/or
Changing compensation schemes.
We will use this methodology throughout the course to analyze why business
mistakes are made, so it is important to read this article right away and begin using it
to diagnose and correct mistakes.
Teaching Note
The main point of class time is to
1. Explain the link between the problems of moral hazard (how to motivate employees) and adverse
selection (whom to hire), and the principal-agent problem.
2. Teach the tradeoffs inherent in various solutions to principal-agent problems (risk vs. incentive
pay)
3. Get students to understand how the problem-solving framework introduced in the opening chapter
is based on principal-agent analysis (who is making the bad decision; do they have enough
information to make a good decision; and the incentive to do so)
The slides explain the theory using the auction house story to illustrate the theory, and they follow the
book fairly closely. I find that it helps to bring up other principal-agent problems and ask students how to
align the incentives of the agent with the goals of the principal. Then ask questions about which of
various solutions reduces agency costs.
I sometimes bring up the classic landowner-tenant farmer principal-agent problem. Weather is the source
of risk, and the landowner cannot observe how much effort the farmer is putting out. Tell them that the
problem is the low output of the farm, and ask them how to solve the problem. Students often find this
anachronistic, so in the text, I use the more complicated McDonald’s franchisee and the parent company
(more sources of incentive conflict about maintaining the quality of the brand). Ask them what the
principal agent incentive conflict is and how to solve it.
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An alternate route to take is to assume that students have read the chapter, and then present a series of
principal agent problems and ask them to: 1. figure out what’s wrong and 2. how to fix it. Play 20
questions (make them ask you yes or no questions until they figure out what the problem is; and then ask
how to fix it.) Be sure to ask them questions about proposed solutions that illustrate the principal-agent
tradeoff. Remind them that there are costs and benefits to any solution.
The stories in the last chapter, “You be the consultant” can be used for this as it is not a chapter that
requires a lecture to go with it.
In-class Problems
QUESTION: One fun question to use is the story from the old Alchian-Allen textbook: “in the early 20th
century, a woman takes a ride on a boat and is shocked to see the oarsmen being whipped by an
overseer.” What is the principal-agent problem the whipping is supposed to solve? Play twenty questions
and make students guess the answer.
ANSWER: The oarsmen collectively own the boat and hire the overseer to whip them in order to solve
the free riding problem.
QUESTION: A company-owned McDonald’s located on the NJ turnpike has low output, much less than
a franchisee owned store in the nearest town. Why?
HINT: Step back and ask students why the company owns stores on the freeway and franchisees own
stores in town.
ANSWER: Repeat customers give franchisees incentive to keep quality high in town. On freeways
(where repeat business is lower), franchisee can shirk on quality.
QUESTION: What is the principal agent conflict between shareholders and managers and how does it get
solved?
ANSWER: Examples of potential solutions include incentive pay with stock options; monitoring by
outside directors; concentrated stock ownership.
Additional Anecdote: Whaling Industry
Discuss the following article
Incentives in Corporations: Evidence from the American Whaling Industry
Eric Hilt
NBER Working Paper No. 10403
March 2004
JEL No. N5, L2, G3
Whaling ventures in the 1800s were managed by agents, who would purchase supplies, hire a captain and
crew, and plan the voyage on behalf of the investors. The agent’s performance, however, was difficult for
investors to observe or evaluate. The actions of crew members on multi-year voyages were even more
difficult to evaluate.
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Contracts and organizational forms century evolved in response to these problems. Most whaling
enterprises were closely held by a small number of local investors, and ownership rights were allocated to
create powerful incentives for their managers. Agents usually held substantial ownership shares in their
ventures
Attempting to run these ventures via corporation form in the 1830s and 1840s failed. They paid their
crews the same ways, used similar vessels, and employed agents with similar responsibilities. The only
main difference was in ownership structures and hierarchical governance. They were unable to create the
incentives requisite for success in the industry. The managers of these corporations, who did not hold
significant ownership stakes, did not perform as well as their peers in unincorporated ventures.
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22. GETTING DIVISIONS TO WORK IN THE BEST INTERESTS OF
THE FIRM
Incentive Conflict between Divisions
Transfer Pricing
Functional Silos versus Process Teams
Budget Games: Paying People to Lie
Main Points

Companies are principals trying to get their divisions (agents) to work profitably in the interests
of the parent company.

Transfer pricing does not merely transfer profit from one division to another; it can result in
moving assets to lower-value uses. Efficient transfer prices are set equal to the opportunity cost of
the asset being transferred.

A profit center on top of another profit center can result in too few goods being sold; one
common way of addressing this problem is to change one of the profit centers into a cost center.
This eliminates the incentive conflict (about price) between the divisions.

Companies with functional divisions share functional expertise within a division and can more
easily evaluate and reward division employees. However, change is costly, and senior
management must coordinate the activities of the various divisions to ensure they work towards a
common goal.

Process teams are built around a multi-function task and are evaluated based on the success of the
project on which they are working.

When divisions are rewarded for reaching a budget threshold, they have an incentive to lie to
make the threshold as low as possible, thus ensuring they get their bonuses. In addition, they will
pull sales into the present, and push costs into the future, to make sure they reach the threshold. A
simple linear compensation scheme solves this problem.
Supplementary Material
ManagerialEcon.com (Chapter 22)
Michael Jensen, “Corporate Budgeting Is Broken, Let’s Fix It,” Harvard Business Review (November
2001).
Froeb, Luke, Paul Pautler, and Lars-Hendrik Roeller, The Economics of Organizing Economists, (July,
2008). Available at SSRN: http://ssrn.com/abstract=1155237
Note: this is an analysis of the tradeoff between a functional organization (economists in their own
division) and a divisional organization (attorneys and economists in same division).
Teaching Note
There are four main points I want to get across in class:
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1. The analytic tools of principal-agent analysis can be applied to company-division analysis
Since this topic uses analytic tools very similar to the principal-agent problems of the previous
chapter, I want to give students practice in solving real problems. I would describe the toner pricing
problem from the additional introductory anecdote, (that the cartridge division ended up buying toner
from an external supplier who had bought it from the same company’s toner division, marked it up,
and sold it back to the same company). Ask students if they can figure out what is wrong by asking
yes or no questions. Steer them towards the same the three questions we have been using all along,
except “personify” the Division (which division is making the bad decision; do they have enough
information to make a good decision; and the incentive to do so).
Once they figure it out, ask them how to fix it. Steer them towards the same three solutions (change
decision rights; change information flows; change incentives). Identify at least three solutions (senior
management mandates a transfer price; change upstream toner division into a cost center; and “do
nothing”); and then ask the students what are the advantages and disadvantages of each. If the
upstream toner division sells a significant amount of product to the outside market, then it may be
best to “do nothing” because the magnitude of the problem is relatively small and implementing the
other solutions would require significant organizational change.
2. Transfer pricing
I forgo the double marginalization analysis, and just tell them that any transfer price greater than MC
will result in a price that is too high to maximize parent company profit. Draw a vertical supply chain
on the board, and show explicitly how this works. Make them aware that this is the same problem as
competition between complements (Chapter 15) and pricing jointly owned complementary products
(Chapter 12). In general, tell them that there are lots of incentive conflicts between divisions or firms
in the same vertical supply chain, the subject of the next chapter. Make the link to the problem of
incentive conflict between sales and marketing, where you have, effectively, a transfer price that is set
too low (at zero) because the salespeople are compensated based on revenue.
3. Functional silos vs. process teams
There are lots of good stories you can use to tell this story (banks, jet engine). If students have NOT
read the chapter in advance, describe the problem of Pratt & Whitney designing an engine that cost
more than anyone was willing to pay for it. Let them guess the problem using “yes or no” questions.
If you want to hit close to home talk about the problem with MBA programs designed around
functional areas. Each professor becomes a narrow academic expert in his or her field and ends up
producing knowledge that is useful to the narrow functional discipline but problems don’t lie in
narrow functional disciplines.
4. Corporate budgeting.
Michael Jensen’s article is terrific. Even more than transfer pricing, this is an area in which every
business has problems. Begin with the problem, not enough toys, or too many toys produced for the
holidays. Let students try to figure out what is wrong.
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In-class Problem
QUESTION: Oracle notices that its sales of its enterprise software are concentrated at the beginning of
each quarter and at the end of each quarter, with fewer any sales in the middle. The sales at the beginning
of the quarter and at the end of the quarter have much lower prices, about 7% lower than earlier sales.
Why?
ANSWER: Salespeople are compensated with strong incentive packages that increase dramatically once
a salesperson reaches his “goal.” This gives sales people an incentive to push sales forward to the
beginning of next period; or pull sales back from the next period to the present in order to reach goals.
The discounts reflect the gains to the salesperson (remember the non strategic view of bargaining) as there
is more potential gain to the salespeople.
Additional Anecdotes: Toner Supplier, Sears Auto Repair, & Functionally
Organized Banks
TONER SUPPLIER: Company X, one of the world’s largest suppliers of supplies for printers, copiers,
and fax machines, included two separate divisions. The Toner Division produced toner, which it sold to
the Cartridge Division and to the external market. The Cartridge Division integrated the toner into
cartridges sold to original equipment manufacturers and consumers. Company management allowed the
two divisions to negotiate the transfer price of toner and evaluated each division on its profitability. Since
a lower transfer price raised the profit of the buying division while simultaneously reducing the profit of
the selling division, each division spent a considerable amount of time trying to obtain the most favorable
transfer price.
The Toner Division wanted to sell toner at its customary external market price while the Cartridge
Division argued for a price much nearer the Toner Division’s cost. After negotiations were unsuccessful
in reaching any agreement, both divisions elected not to transact. The Toner Division continued to sell to
the external market at its customary price, while the Cartridge Division elected to buy toner from an
external supplier.
An astute aficionado of irony might predict where this story ended up. The Cartridge Division ended up
buying its toner from the exact same supplier to whom the Toner Division was selling. But, rather than
paying one markup to the Toner Division, the Cartridge Division ended up paying that markup plus an
additional margin to the external supplier (a 38 percent higher cost than originally proposed in
negotiations). The problem became especially apparent to senior management, as the external supplier’s
shipment arrived at Company X’s docks with the products still emblazoned with Company X’s logo.
Senior management stepped in and mandated a transfer price.
In this chapter, we apply the lessons of the last chapter, showing how to control the incentive conflict
between a principal and an agent, to the problem of controlling incentive conflict between a company and
its various divisions.
SEARS AUTO REPAIR: In 1992 charges were brought against Sears whose mechanics were
recommending unnecessary auto repairs. The problem was traced to the incentive system used by Sears
(and others in the industry),
[the] use of quotas, commissions, or similar compensation may provide incentives for sales
personnel to sell unnecessary auto repair services in order to meet quotas or receive larger
commissions.
Sears tried to fix the problem by re-organizing into two divisions, one responsible for
recommending repairs; and the other responsible for doing them. Rather than solving the
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problem, however, the two divisions got together and began colluding. In exchange for
recommending unnecessary repairs, the service division paid the recommending division for
recommending them. Sears finally adopted flat pay for the mechanics, which led to shirking.
I used this example in Vanderbilt's MMHC class (syllabus) to illustrate the difficulties of aligning the
incentives of providers with the goals of payers. President Obama tried to make the same point when he
accused physicians of performing unnecessary tonsillectomies. However, as the Sears example suggests,
there are no "fixes" to the problem, only tradeoffs:
Incentives matter, yet maybe the truth is that medicine is a highly complex science in which the
evidence changes rapidly and constantly. That’s one reason tonsillectomies are so much rarer now
than they were in the 1970s and 1980s—but still better for some patients over others. As the
American Academy of Otolaryngology put it in a press release responding to Mr. Obama’s
commentary, clinical guidelines suggest that “In many cases, tonsillectomy may be a more effective
treatment, and less costly, than prolonged or repeated treatments for an infected throat.”
Mr. Obama seems to think that such judgments are easy. “If there’s a blue pill and a red pill and the
blue pill is half the price of the red pill and works just as well,” he asked, “why not pay half price for
the thing that’s going to make you well?” But usually the red and blue treatments are available—as
well as the green, yellow, etc.—because of the variability of disease, human biology and patient
preference. And the really hard cases, especially when government is paying for health care, are those
for which there’s only a red pill and it happens to be very expensive.
FUNCTIONALLY ORGANIZED BANKS:
Managers of a functionally organized firm must coordinate the activities of each division. Otherwise, the
divisions may end up working at cross purposes.
The incentive conflict between bank deposit and lending divisions is a classic example. The S&L crisis of
the early 1980's was caused, in part, by the behavior of S&L's which borrowed short (deposits) and lent
long (home mortgages). When interest rates skyrocketed in the early 1980's, S&L borrowing costs
increased dramatically as depositors demanded higher rates, but revenue did not change on the 30-year,
fixed-rate mortgages. Good managers would recognize the mismatch between deposit and loan maturities
and use financial markets to offload some of the risk.
It seems as if something similar may be going on in today's banks. The loan originators and (mortgage
brokers) are compensated mainly on volume, but not the quality of the loans they make. This leads to
risky loans that may not be recognized as risky until housing prices start falling, and borrowers find it
more profitable to forfeit the house to the bank. Again, good managers will recognize the incentive
conflict between loan origination and servicing, and try to control it.
In an earlier post, we suggested that investors ignored risk in search of higher returns as they drove risk
premia on all kinds of exotic and risky investments down to historic lows. It may be that functional
specialization has been partly responsible for the failure of subprime lenders to recognize risk. When loan
originators make loans that no investor wants to fund, lenders go bankrupt.
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23. MANAGING VERTICAL RELATIONSHIPS
Do Not Buy a Customer or Supplier Simply Because They Are Profitable
Evading Regulation, Bundling, Tying, and Exclusion
Eliminate the Double Markup
Aligning Retailer Incentives with the Goals of Manufacturers
Price Discrimination
Outsourcing
Main Points
•
Do not purchase a customer or supplier merely because that customer or supplier is profitable.
There must be a synergy that makes them more valuable to you than they are to their current
owners. And do not overpay.
•
If unrealized profit exists at one stage of the vertical supply chain — as often happens when
regulations limit profit — a firm can capture some of the unrealized profit by vertical integration,
by tying, by bundling, or by excluding competitors.
•
The double-markup problem occurs when complementary products compete with one another.
Setting prices jointly eliminates the double-markup problem and is often a motive for vertical
integration or maximum price contracts between a manufacturer and retailer.
•
Restrictions on intra-brand competition like minimum resale price maintenance or exclusive
territories provide retailers with higher profit, giving them incentives to provide demandenhancing services to customers.
•
If a product has two retail uses, a manufacturer may find it profitable to integrate downstream so
that the firm can capture the profit through price discrimination. Vertical integration stops
arbitrage between the two products, which allows price discrimination.
•
Outsource an activity if the outsourcer can perform the activity better or more cheaply than you
can.
Supplementary Material
ManagerialEcon.com (Chapter 23)
Written Testimony of Luke Froeb before the House Subcommittee on Courts and Competition Policy on
the Ticketmaster/Live Nation Proposed Merger, 26 February 2009, link.
HBS Case 9-403-080, Gary Rodkin at Pepsi-Cola North America (A).
This case is a good illustration of the principal-agent problems created when Pepsi-Cola North
America spun off its bottling unit, Pepsi Bottling Group, into a separate entity. Incentive conflicts
between the bottler ad the manufacturer about new products, pricing, and promotion lead to profit
and personnel problems.
Teaching Note
Begin by drawing the link between the previous chapter and this one. Just as there is incentive conflict
between sister divisions of the same firm, so too is there incentive conflict between a firm and its
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upstream suppliers or between a firm and its downstream customers. Think of the firm as a principal, and
its upstream supplier or downstream customer as an agent. Figuring out how to minimize the agency
costs inherent in the vertical supply chain is the point of the chapter.
The opening anecdote is a regulatory evasion story, and I use it because it clearly illustrates why the coal
company is more valuable to the power company than it is to its current owners. The general idea is that
corporations are assets and for vertical integration, there has to be a synergy that makes the acquired firm
more valuable to the acquiring firm; otherwise, the acquisition makes no sense. In general, anytime there
is an incentive conflict in the vertical supply chain, and you can control the conflict better, faster, or more
cheaply than your rivals, then you have a reason to acquire the asset.
One thing that I do NOT cover in the chapter is the exclusionary, or anticompetitive, reasons for vertical
integration. This is mostly because the magnitude of the problem appears small (very little empirical
support). If you want to emphasize the anticompetitive reasons for vertical integration, you might want
to talk about Kodak and its suppliers (Supreme Court ruled that they could not deny crash parts to its
suppliers); Dentsply getting sued by its rivals; 3M getting sued by LePages for offering “loyalty” or “all
units discounts;” or about Coke being sued by the European Commission for giving away refrigerators to
retail outlets. All of these cases are described on the web. Start a debate and then ask who is correct.
Make sure to cover the incentive conflict in the vertical supply chain:
1. Pricing conflict (double marginalization);
2. Advertising conflict (retailer prefers lower level of promotional activity than manufacturer).
3. Investment conflict (retailer, or manufacturer, reluctant to make relationship specific
investments for fear of post-investment hold up)
4. Price discrimination conflict (sell this as a conflict in that the upstream manufacturer wants to
prevent arbitrage between retailers that sell to high value customers and retailers that sell to
low value customers, i.e., there is nothing to prevent retailers that buy at a low price from
entering the high-priced market segment and undercutting sales by the high priced retailers).
Again, I find the most effective way to teach this material is to pose a problem, let the students try to
figure out what is wrong by asking yes or no questions, and then suggest solutions.
In-class Problem
QUESTION: In May, 2006, new financial instruments, the S&P CME Housing Futures, began trading on
a single exchange, the Chicago Mercantile Exchange. Institutional investors can hedge against a fall in
the price of housing. Why would the owners of the index license it to trade on only one exchange?
ANSWER: The owners of the index want to give an incentive to the exchange to educate traders, and
promote trading in the new instruments. Without the protection of exclusivity, the exchange would not
devote as much effort to educating traders about the instruments because they could move their trades to
other exchanges. Exclusivity may also mean more order flow to a single exchange which increases
liquidity, the number of traders trading on the index.
Additional Anecdotes: Alcoa & TicketMaster / Live Nation
ALCOA:
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Based on Perry, Martin K., “Forward Integration by Alcoa: 1888-1930,” Journal of Industrial Economics,
Sep80, Vol. 29 Issue 1, p37-53.
Before 1930, the Aluminum Company of America (Alcoa) was the only domestic supplier of aluminum
ingots. Aluminum ingots were used for a variety of purposes
 An addition to the production process in the iron and steel industry (utilized to improve quality of
the final product)
 Manufacture of cooking utensils
 Production of electric cable
 Automobile parts
 Aircraft parts
Consumers in these diverse markets varied widely in their willingness to pay for aluminum ingots.
Demand for aluminum in the iron/steel industry and in the aircraft industry was relatively inelastic, that is,
customers were less sensitive to price changes. In the other three industries, demand was much more
elastic. In response to price changes, customers might cancel orders or move to substitute products.
Given this situation, Alcoa’s preference would have been to increase prices to iron/steel and aircraft
consumers while generally reducing price to the other three markets. The potential for arbitrage,
however, created a barrier to implementing this scheme. With wide price differences, nothing would
prevent a cookware purchaser from undercutting Alcoa and reselling aluminum to an aircraft parts
consumer.
To successfully implement its price discrimination scheme, Alcoa was forced to forward integrate into the
three relatively elastic markets. By moving into the cookware, electric cable, and automotive parts
markets, Alcoa gained control over potential resales of aluminum ingot and was able to maintain high
prices to the iron/steel and aircraft parts markets.
TICKETMASTER/LIVENATION;
Representative Conyers is holding hearings on the Ticketmaster/Live Nation proposed merger. An
obscure Vanderbilt professor is scheduled to testify:
Ticketmaster and Live Nation are both part of the vertical supply chain that delivers live
performances to fans.The “price” of this service is the difference or “wedge” between what
consumers pay and what performers receive. At one end of this chain are firms that interact directly
with artists, such as Live Nation. At the other end are firms that interact directly with fans, such as
ticketing firms like Ticketmaster who sell tickets on behalf of venues.
The merger is interesting because it raises both horizontal (Live Nation has begun ticketing its own
events) and vertical (Live Nation is Ticketmaster's largest customer) issues. The potential horizontal costs
of the merger will have to be weighed against the potential vertical benefits, including increased
coordination across the supply chain.
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SECTION VII – WRAPPING UP
24. YOU BE THE CONSULTANT
Excess Inventory of Prosthetic Heart Valves
High Transportation Costs at a Coal-Burning Utility
Overpaying for Acquired Hospitals
Large E&O Claims at an Insurance Company
Losing Money on Homeowner’s Insurance
Quantity Discounts on Hip Replacements
What You Should Have Learned
Supplementary Material
Epilog to the text
Teaching Note
I go through an overview of the material: where have we been; what have we learned and preview the
exam. Also give a summary of the final exam—I give them the formulas in advance, and give them a
description of the test.
Summary of things they should now be able to do:
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Use the rational-actor paradigm, identify problems, and then fix them;
Use benefit–cost analysis to evaluate decisions;
Use marginal analysis to make extent (how much) decisions;
Compute break-even quantities to make investment decisions;
Compute break-even price to make shut-down and pricing decisions;
Set optimal prices and price-discriminate’
Predict industry-level changes using demand/supply analysis;
Understand the long-run forces that erode profitability
Develop long-run strategies to increase firm value;
Predict how your own actions will influence others’ actions;
Bargain effectively;
Make decisions in uncertain environments;
Solve the problems caused by moral hazard and adverse selection;
Motivate employees to work in the firm’s best interests;
Motivate divisions to work in the best interest of the parent company, and
Manage vertical relationships with upstream suppliers or downstream customers.
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