Managerial Economics - Budi Hermana

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Managerial Economics
Pricing
Introduction
Invest.&Budgeting
Product&Strategy
Cases
The Firm
Production&Cost
Consumer
Research Question
Demand
The Market
MANAGERIAL
ECONOMICS
An Analysis of Business Issues
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-1
Managerial Economics
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Introduction
Invest.&Budgeting
Product&Strategy
Cases
The Firm
Production&Cost
Consumer
Research Question
Demand
The Market
Douglas - “Managerial economics is .. the application of economic
principles and methodologies to the decision-making process within
the firm or organization.”
Pappas & Hirschey - “Managerial economics applies economic
theory and methods to business and administrative decisionmaking.”
Salvatore - “Managerial economics refers to the application of
economic theory and the tools of analysis of decision science to
examine how an organisation can achieve its objectives most
effectively.”
Howard Davies and Pun-Lee Lam - “It is the application of economic
analysis to business problems; it has its origin in theoretical
microeconomics.”
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-2
Managerial Economics
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Introduction
Invest.&Budgeting
Product&Strategy
Cases
The Firm
Production&Cost
Consumer
Research Question
Demand
The Market
• A powerful “analytical engine”.
• A broader perspective on the firm.
• what is a firm?
• what are the firm’s overall objectives?
• what pressures drive the firm towards profit
and away from profit
• The basis for some of the more rigourous
analysis of issues in Marketing and
Strategic Management.
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-3
Managerial Economics
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Introduction
Invest.&Budgeting
Product&Strategy
Cases
The Firm
Production&Cost
Consumer
Research Question
Demand
The Market
 How do markets work?
 How do customers value products?
 What are the relevant production and cost measures for
decision making?
 How does competition affect business decisions in different
market structures?
 What prices should be set?
 What would be the impact of changes in interest rates on
costs, accounting, or capital budgeting?
 How important to managerial and marketing decisions are
changes, in foreign exchange rates, in technology, in
incomes, in government regulations, in sources of energy,
in the balance of payments?
Questions
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-4
Managerial Economics
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Introduction
Invest.&Budgeting
Product&Strategy
Cases
The Firm
Production&Cost
Consumer
Research Question
Demand
The Market
Competition,
structures and
decisions
Pricing
practices
Production and Costs
Demand analysis
and estimation
Basic economics principles:
demand and supply.
market
business
strategies
and
Business and Government.
Managerial
Economics
Capital budgeting
Research question
Business
and
economic situation.
current
Introduction. The nature of
managerial economic decision
making
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Managerial Economics
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Introduction
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The Firm
Production&Cost
Consumer
Research Question
Demand
The Market
For the academic economist: to understand, to make
predictions about firm’s behavior. The “positive” approach to
theory: What is?
For the businessperson: “to assist decision-making”, to
provide decision-rules which can be applied
The “normative”
approach to theory: What should be?
These purposes are different, they can lead to misunderstanding,
and economists are not always honest about the limitations of their
approach for practical purposes.
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Managerial Economics
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The Firm
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How Can
ManagerialAdopt a general perspective,
not a sample of one
EconomicsSimple
Assist models provide
stepping
stone
to
more
Decision-Making?
complexity and realism
Thinking logically has value
itself and can expose sloppy
thinking
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Managerial Economics
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The Firm
Production&Cost
Consumer
Research Question
Demand
The Market
In managerial economics, the emphasis is upon
the firm, the environment in which the firm
finds itself, and the decisions which individual
firms have to take.
In industrial economics (or industrial
organization), the emphasis is (or was) upon the
behavior of the whole industry, in which the
firm is simply a component.
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-8
Managerial Economics
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The Firm
Production&Cost
Consumer
Research Question
Demand
The Market
Basic Conditions: factors which shape the market of the industry,
e.g. demand, supply, political factors
Structure: attributes which give definition to the supply-side of
the market, e.g. economies of scale, barriers to entry, industry
concentration, product differentiation, vertical integration.
Conduct: the behavior of firms in the market, e.g. pricing behavior
advertising, innovation.
Performance: a judgement about the results of market
behaviour, e.g. efficiency, profitability, fairness/income
distribution, economic growth.
How can the government improve the performance in an industry?
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Managerial Economics
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The Firm
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Consumer
Research Question
Demand
The Market
Managerial economics: is often concerned with
finding optimal solutions to decision problems.However,
the primary purpose of using models is to predict how
firms will behave, not to advise them what ought to do.
Managers are assumed to find the optimal solutions for
themselves and that is how predictions are made.
Management science: is essentially concerned with
techniques for the improvement of decision-making and
hence it is essentially normative;firms are not assumed to
find the optimal solutions for themselves. They are found
by the researchers who then present them as prescriptions
for what the firm should do.
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Managerial Economics
Invest.&Budgeting
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The Firm
Production&Cost
Consumer
The nature of
managerial economic
decision making
Pricing
Introduction
Research Question
Demand
The Market
Managerial economic
as an economics
discipline
The role of managerial
economics in
managerial decision
making
Economic
optimisation
The value of firm
Economic constraints
The basic economic
variables
Demand
Supply
Costs
Revenue
Profit
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Managerial Economics
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The Firm
Production&Cost
Consumer
Research Question
Demand
The Market
Economics
Macroeconomics
Money, finance, banking
Microeconomics
“Sector” economics
Labor economics
Environmental
economics
Managerial economics
International Economics
Regional Economics
Economics development
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Managerial Economics
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Introduction
Invest.&Budgeting
Product&Strategy
Cases
The Firm
Production&Cost
Consumer
Research Question
Demand
The Market
Managerial decision problems
Product price and output
Make or buy
Production technique
Internet strategy
Advertising media and intensity
Investment and financing
Economic concepts
Decision making tools
Theory of consumer behaviour
Numerical analysis
Theory of firm
Statistical analysis
Theory of market structure and
pricing
Forecasting
Game theory
Optimisation
Managerial Economics
Use of economics concepts and
decision making tools to solve
managerial decision problems
Optimal solutions
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Managerial Economics
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Cases
The Firm
Production&Cost
Consumer
Research Question
Demand
The Market
Choose alternative
that produces a result the most
consistent
with managerial objective
What is the primary
managerial objective?
It depends upon the property structure
Profit maximisation?
Sales/revenue maximisation?
The value of firm
maximisation?
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Managerial Economics
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The Firm
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Consumer
Research Question
Demand
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Profitt N Total revenue  Total cos tt
Value  

t
t
(1

i
)
(1

i
)
t 1
t 1
N
N
I
Profitt
(1  i )t
– firm’s life time
- discount rate
- current value of the
profit earned in t years
time
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Managerial Economics
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The Firm
Production&Cost
Consumer
Research Question
Demand
The Market
Model
MNE
This means that the model is an ‘optimising’ model: the firm
attempts to achieve the best possible performance, rather than
simply seeking “feasible” performance which meets some set of
minimum criteria
Merger
The firm is a profit-maximiser: it is assumed to make as much
profit as possible.
Nature
1. The firm is a profit-maximiser - it optimises
2. The firm can be treated in a holistic way
It is a holistic model: the firm is a single entity which has
objectives of its own and which can be said to take decisions
3. There is perfect certainty
It assumes perfect certainty. Cost and demand conditions are
perfectly known
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Managerial Economics
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The Firm
Production&Cost
Consumer
Research Question
Demand
The Market
Marginal Cost
Nature
$
Model
The firm aims to maximise profit by choosing the level of output
which gives the biggest difference between revenue and costs
$
Demand: Average Revenue
Demand: Average Revenue
MNE
P2
Merger
P1
Q1
Q2
Quantity
Produced
$
Profit maximising
output
$
Demand: Average Revenue
Quantity
Produced
Marginal
Revenue
Marginal Cost
Average Cost
Demand: Average
Revenue
Marginal Revenue
Quantity
Produced
Profit maximising output
Marginal Revenue
Quantity
Produced
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Managerial Economics
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The Firm
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Consumer
Research Question
Demand
The Market
MNE
• When demand increases?
• When costs rise?
• When a fixed cost increases?
Merger
– begin with an initial equilibrium position - the starting point
– change something
– identify the new equilibrium, e.g:
Nature
• Comparative Statics
Model
What Can We Do With This Model?
– This is the main purpose of the model -what it was designed to do
• Normative prescriptions
– it will cost me $30 per unit to supply something which will give
me $20 per unit in revenue- should I do it?
– I must pay $20 billion to set up in my industry. Should I charge
higher prices to get that money back?
• Positive and Normative are linked by “if?” IF the aim of
the firm is to maximise profit what will it do/what should it do?
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Managerial Economics
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Cases
The Firm
Production&Cost
Consumer
Research Question
Demand
The Market
Model
“Managerial” Criticisms of the Profit-Maximising Model
Berle and Means (1932)
The Managerial School argues that:
Ownership and control are in the hands of different groups of
people.
2.
The interests of owners
(managers) are different.
3.
Managers have the power to let their interests over-ride those of
the shareholders.
4.
Therefore firms are run in the interests of the managers.
(shareholders)
and
MNE
1.
Merger
firms are owned by shareholders but controlled by managers
owners’ and managers’ interests are different
managers have discretion to use the firm’s resources in their own interests
Nature
–
–
–
Controllers
In place of the profit-maximising model, the managerial school
substitute a variety of alternatives - sometimes referred to as
managerial discretion models:

Sales-revenue maximising (Baumol)

Managerial utility maximising (Williamson)
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Managerial Economics
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Introduction
Invest.&Budgeting
Product&Strategy
Cases
The Firm
Production&Cost
Consumer
Research Question
Demand
The Market
Merger
MNE






Nature
 If all aspirations are being met - everyone is satisfied - do nothing
 BUT then aspiration levels will rise until someone is not satisfied
 THEN rules of thumb used to find solutions to “the problem”
Model
 Organisations do not have objectives, only people have objectives
 The firm does not exist - it is a set of shifting coalitions of individuals
 Individuals and groups do not maximise - they satisfice
 Information about the environment is very limited
Aspiration levels, which adjust according to experience
Problem-oriented ‘rules of thumb’ based on past experience
A dynamic model
not “holistic”
not “deterministic”
not optimising
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Managerial Economics
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Introduction
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Cases
The Firm
Production&Cost
Consumer
Research Question
Demand
The Market
Nature
Merger
MNE
 Behavioural approach is a more accurate description of what happens INSIDE
the firm.
 BUT it tells us almost nothing about how the firm will respond to changes in
the environment.
 To use it to make predictions about how the firm will react to changes in the
environment we need to know everything about the individual firm.
 However, if shareholders are a powerful group and their aspiration level
requires making maximum profit the firm will again behave in the same way as a
profit-maximiser.
Model
Which Approach is Most Useful?
In Conclusion?
The behavioural approach is a useful complement to the
profit-maximising and managerial approaches, not
a substitute for them
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Managerial Economics
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Introduction
Invest.&Budgeting
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Cases
The Firm
Production&Cost
Consumer
Research Question
Demand
The Market
MNE
Why Do Firms Exist?
Merger
a transaction takes place whenever a good or a service is transferred from one
party to another
Nature
a set of transactions* coordinated by authority instead of by
the market
Model
What is a Firm?




Some transactions are co-ordinated by markets
Some transactions take place inside firms
The firm is the supersession of the market mechanism
The firm is that set of transactions which is coordinated by managerial authority instead of the market
 Why does this happen?
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Managerial Economics
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Merger
MNE
 Produce ouput y, which it can sell for price p(y)
 From quantities of input (factors): X1, X2, …
 Input costr (per unit): w1, w2, …
Nature
 A Firm
Model
The Setup
 How Can this firm produce
 Technology
 How Should this firm produce
 Cost minimitation
 How much should this firm produce
 Profit maximization
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Managerial Economics
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The Firm
Production&Cost
Consumer
Research Question
Demand
The Market
Model
Transactions inside a firm
Nature
Product
Market
Merger
Factor
Market
MNE
Product
Factor of
Production
Consumers
FIRM
Entrepreneur
(Goods &
Services) e.g. a
shirt
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Demand
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Transaction cost problem; firm supersedes market
2.
Transactions are “normally” done through markets; market is
the default
3.
Some transactions are done inside firms
4.
Transactions are done in a firm when the costs of transacting on
the market is higher than costs of transacting in the firm
MNE
1.
Merger
The “Coasian”Analysis
Nature
Transaction Cost Analysis
Model
Why Firm Exists?
What decides whether a transaction takes place
through the market or inside a firm?
Answer:
TRANSACTIONS COSTS
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Managerial Economics
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The Firm
Production&Cost
Consumer
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Demand
The Market
MNE
locating buyers and sellers
acquiring information about their availability, quality, reliability and prices
negotiating, re-negotiating and concluding contracts
co-ordinating the agreed actions of the parties
monitoring performance with respect to fulfilment of contracts
taking action to correct any failure to perform
Merger
•
•
•
•
•
•
Nature
 A transaction takes place when a good or a service is transferred from one party to
another
 Direct costs arise in respect of:
Model
What Are Transactions Costs?
 Opportunity costs arise in respect of:
• inefficiencies if inappropriate equipment used
• failure to adapt to changing conditions
Transaction costs include:
 information and measurement costs
 negotiation costs
 contracting costs (ink costs, legal costs)
 monitoring and enforcing costs, etc.
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Demand
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Merger
MNE
As firm becomes larger marginal cost of transacting increases
managerial diseconomies arise
larger firms may pay more for resources
physical distance
dissimilarity of transactions
rapidly changing environment
Nature






Model
The costs of transacting inside firm rise with:
Transactions will be organised in the least-cost way
Limitations of Transaction Cost Analysis?
 So flexible it explains everything after the event, but can it really predict much before
the event?
 Transaction costs not directly observable, so empirical work must be indirect
 May be many efficient solutions, so which one will occur?
 Is opportunism really universal? Should it be something we explain instead of an
assumption?
 Ghoshal and Moran (1996) - teaching it is bad for business!!!
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Managerial Economics
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The Firm
Production&Cost
Consumer
Research Question
Demand
The Market
Merger
MNE
 Diversification will be efficient if there is SYNERGY
 SYNERGY can come from
– economies of scope
– exploitation of specific assets
– reduction of risk and uncertainty
 BUT DOES IT REALLY EXIST IN PRACTICE?
Nature
What factors determine the extent to which a firm diversifies across different
industries?
Model
The Extent of Diversification
The history of diversification is not good
 In the 1960s and 1970s the “conglomerate” was a favourite form of business
 Although the purchased firms were usually good performers, the merged firm
tended to have poor performance
 It became clear in the 1980s and 90s that there is a “diversification discount” of
about 15% on average
 WHY?
 Firms seemed to not understand the
sectors they entered
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Managerial Economics
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Research Question
Demand
The Market
Model
Nature
If there is a diversification discount
why did firms do it?
Merger
MNE
 Perhaps the discount only emerged in the 80s
 some studies suggest it was not evident in the 70s
 Mergers were to satisfy the managers, not
the
shareholders
 With more liberalized and efficient financial markets,
“focus” has been the trend for some time now
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Vertical:
with suppliers or customers
with unrelated firms
MNE
Conglomerate:
Merger
 Horizontal:
with competitors
Nature
1. Alternative forms of of merger
Model
Mergers and Take-overs
2. Mergers in a perfect world
 All managers are efficient;they work in the interests of shareholders; stock
markets price shared efficiently;no uncertainty; everyone uses the same
discount rate
 In that situation there are only two reasons for mergers to take place:
 SYNERGY: 2+2>4; economies of scope or scale, joint use of key
resources or capabilities
 MARKET POWER: merger gives some degree of monopoly power
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Managerial Economics
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The Firm
Production&Cost
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Research Question
Demand
The Market
Merger
MNE
If a firm is run inefficiently, share price will be low
The firm will be purchased by someone who installs better managers
Share price rises
BUT IF THIS WERE TRUE PERFORMANCE WOULD BE
BETTER AFTER MERGERS!
Nature




Model
3. Mergers as the transfer of resources to better
managers
4. Mergers as the result of manipulation
or valuation discrepancies
 Manipulation: planting rumours, “bootstrapping”
– my P/E is 15: 1. If I buy a firm whose ratio is 10:1 its share price
will rise until the P/E is 15:1
 Valuation discrepancies
– when there is a lot of “turbulence” in the environment, different
people will make different judgements. Some will think a firm is
worth more than the market valuation
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Production&Cost
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Demand
The Market
Merger
MNE
6. Are mergers really for managers?
Nature
 Shareholders of the acquired firms gain because the acquiring firm pays a premium
 The pattern of results for the acquiring firm is
very mixed with values tending to fall, not rise!
Model
5. The performance consequences of mergers
 CEOs and senior managers like mergers
larger firms involve more prestige and often more
pay
larger and more diverse firms reduce risk for
managers (but not for shareholders who could do it
another way)
publicity is welcomed by many CEOs
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Demand
The Market
Model
Nature
Merger
MNE
“An enterprise that controls and manages
production establishments - plants - located
in at least two countries.” (Caves, 1996)
Note that the MNE is involved in Foreign
Direct Investment, not simply Portfolio
Investment
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Demand
The Market
Model
Nature
Early 19th century:
Almost all European-based (e.g. British American Tobacco, Lever Brothers,
Michelin and Nestle), reflected distribution of colonial influence and most were
involved in backward integration into agriculture and minerals in the colonies.
Merger
In the 1920s and 1930s:
MNE
Establishment of international cartels in many industries for global competition.
From the 1950s to the early 1970s:
Led by American firms moving into the European market (The American
Challenge); research-intensive manufacturing industries.
In the 1970s, 1980s and 1990s:
Emergence of the Japanese multinationals, “export-platform” activities in the
newly-industrializing countries. More diversity; more host countries; more home
countries; more in and out.
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Demand
The Market
0A
MNE
 capital will flow from
countries (B) with lower
rates of returns to those
with higher rates of returns
(A) until rates of return are
equal
Rate of Return (%)
to
Merger
 diminishing returns
capital investment
Nature
Equi-marginal productivity of capital
Model
Economic theory and the multinational
MP
MP
B
A
Capital
0B
 but this does not explain the MNE:owners of capital can
simply invest in portfolios (buying shares and bonds), no
need for foreign direct investment (setting up
offices/subsidiaries, involving management and control)
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Demand
The Market

The host countries possess some locational advantages, otherwise the firm would
simply operate in a single location
e.g. some countries have cheap resources: cheap and abundant supply of land and
labour; some are close to the customers.
not produce in home country and export the goods?
Locational theory


But why
not license the competitive advantage of multinationals?
Internalization and transaction cost theory


High transaction costs involved in using marketing transactions; e.g. costs in enforcing
licensing agreements.
Buckley and Casson’s analysis: five advantages that an internalised transaction over the
market:

increased ability to control and plan

the opportunity for discriminatory pricing

avoidance of bilateral monopoly

reduction of uncertainty

avoidance of government intervention
MNE
But why
Merger

Nature

multinationals must face some disadvantages relative to incumbents
they must possess some form of offsetting competitive advantage over the incumbents;
these advantages can be exploited by producing in overseas markets.
Competitive advantages of multinationals: technology, capital, management sills, etc.
The “eclectic” framework:
O
L
I


Model
The Hymer-Kindleberger proposition
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Model
Internalization
Location
Nature
Ownership
Merger
FDI
MNE
Exporting
Licensing
From the viewpoint of the MNE:
What are the advantages of foreign direct investment
(MNE) over exporting and licensing?
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Effects on competitive structure and performance
MNE
Effects of sovereignty and local autonomy
Merger
Trade and balance of payments effects
Nature
Resource transfer and technology transfer effects
Model
The Impact of the Multinational on Host Economies
The impact of the MNE on its home country
Some concerns:
Balance of payments effects
Employment effects
The loss of technological lead
Tax avoidance and loss of sovereignty
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The Relationship Between Inputs and Outputs
 The fundamental relationship is that between inputs and
outputs - expressed as the production function
 This can be examined at a number of levels
the economy as a whole
the industry
the firm
 A number of different mathematical forms can be used to
model the relationship
Cobb-Douglas: Q = aKaLb
translog production function
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The Cobb-Douglas
 Q = aKaLb : Where K= capital; L = Labour
 As each individual input (K,L) is increased, output
increases, but at a decreasing rate - the principle of
diminishing returns - one of the most fundamental
economic ideas
 A production function identifies many different techniques
within the same technology
If (a+b) > 1; economies of scale
If (a+b) < 1; diseconomies of scale
If (a+b) = 1; constant returns to scale
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Production Function

A Production function tells you how much output (at most) you can get from given
quantities of inputs (factors)
 Example (Cobb-Douglas)
y= f(x1, x2) = X1 0,5 X2 0,5
Short-Run Production Function

In the short-run, not all input can be varied: at least one input is fixed
 Suppose input 2 is fixed at x2 = x2 : y = f(x1, x2)
Marginal Product

Suppose input 2 is held constant: How does output change as we change input 1?
 The Marginal Product (MP) of input 1 is the partial derivative of the
production function with respect to input 1
MP1 =
 f(x1, x2)
 x1
= f1(x1, x2o)
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 What is the marginal product of input 1 of the Cobb-Douglass
production function

f(x1, x2) = x1 0,5 x2 0,5 ?
 Does the marginal product increase or decrease as the firm uses
more of input 1 ?
Answer :
Isoquants
x2
 An isoquant is the locus of all
input combination that yield
the sama level of output
x1
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Technical Rate of Substituion
 The technical rate of substitution (RTS) is the slope of and isoquant at
a point
 That is, holding total output constant (remaining on the same
isoquant), at wahta rate can we exchange input 2 for input 1 ?
RTS =
 x2
 x1
f1
=
f2
 What is the technical rate of substitution (slope of the isoquant)
for the Cobb-Douglass production function

f(x1, x2) = x1 0,5 x2 0,5 ?
 …… at the point x1 = x2 = 2 ?
 …… at the point x1 = 4, x2 = 1 ?
Answer :
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From Production Functions to Cost Curves
 Short run - some inputs are fixed. (K). The firm is restricted to a fixed
set of plant and equipment
– capacity utilisation decisions
 Long run - both inputs are variable. (K,L). The firm can choose the set
of plant and equipment it wants
– investment decisions
 Short run cost curves
•
•
•
•
each short run curve shows costs for a specific set of plant and equipment
AFC declines
Average variable cost rises after some point
AC is U-shaped
 Long run cost curves
• the firm can choose from all of the known sets of plant and equipment
• the shape of the curve depends upon economies or diseconomies of scale
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Average & Marginal Cost
Production&Cost
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If a production function exhibits constant returns to scale, a doubling of
all inputs results in a doubling of output. If you double all inputs, long-run total cost
doubles:
LTC = r · k + w · l;
r·2k + w·2l = 2LTC
So: a production process exhibits constant returns to scale if a doubling of output
results in a doubling of cost, that is, if the LTC curve is a straight line.
If a production function exhibits increasing returns to scale, a
proportional change in all inputs results in more than a proportional change in
output. If you change all inputs by a factor of t, long-run total cost changes by a
factor of t:
LTC = r · k + w · l;
r·tk + w·tl = tLTC
So: a production process exhibits increasing returns to scale if a change in output
(by a factor of t) results in a change in long-run total cost of less than a factor t;
that is, the LTC curve is concave.
If a production function exhibits decreasing returns to scale, a
proportional change in all inputs results in less than a proportional change in
output. If you change all inputs by a factor of t, long-run total cost changes by a
factor of t:
LTC = r · k + w · l;
r·tk + w·tl = tLTC
So: a production process exhibits decreasing returns to scale if a change in output
(by a factor of t) results in a change in long-run total cost of more than a factor t;
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The Main Approaches
Utility Theory
Indifference Analysis
Revealed Preference
The Characteristics Approach
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Utility Theory
 Consumers seek to maximise their UTILITY, which increases as
they consumer more ‘goods’ and decreases as they consumer
more ‘bads’
 As a consumer has more of a ‘good’, the extra (marginal) utility
they enjoy from each successive extra unit of the good declines
 the principle of diminishing marginal utiity
 A utility-maximising consumer will purchase a combination of
goods such that the extra utility acquired per $ or cent, £ or
penny, is the same for every good OR:
 the ratio of the marginal utilities is equal to the ratio of the
prices
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Utility Theory and Falling Prices
 If a consumer has a fixed income and begins in
equilibrium:
 MUapples/Papples = MUpears/Ppears
 Then the price of apples falls
 Left-hand side of the equation> Right-hand side
 There is an opportunity to increase UTILITY- how to
do it?
 Shift spending from pears to apples - WHY DOES
THIS WORK?
 Because each extra penny spent on apples gives more
additional utility than each extra penny spent on pears
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 UTILITY theory requires us to think in terms of a cardinally
measurable unobservable concept, which is rather ‘heroic’
 INDIFFERENCE ANALYSIS explains consumer behaviour on the
basis of less restrictive assumptions (tho’ the logic is very similar)
 The following assumptions are made about ‘rational’ consumers
– they know when they prefer one bundle of goods to another or are
indifferent between them - their preferences are complete
– Preferences are symmetric. If I prefer A to B, I cannot prefer B to A.
– Preferences are transitive. If I prefer A to B and B to C I must prefer A to
C.
(These are not as unproblematic as they may
seem)
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•
Good A
•
Research Question
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Good A
All combinations of A
and B for which the
consumer is indifferent
Slopes show relative
preferences for A and B
AN
INDIFFERENCE
CURVE
Good B
Good B
An A-lover
•
•
Good A
Good A
More B is bought
and (in this
example only)
the same amount
of A
Budget
Line
Good B
Optimal Combination of A&B
Budget
Line
Good B
If the Price of B Falls
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 Assume that the utility function is U = q1q2, that p1 = 2
dollars, p2 = 5 dollars, and that the consumer’s income
for the period is 100 dollars. The budget constraint is
 100 – 2q1 – 5q2 = 0
At the utility maximum level:
 q1 = ……?
 q2 = ……?
Answer :
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Revealed Preference
Less restrictive assumptions - consumers are
consistent in their choices
A budget line is constructed and the consumer’s
choice observed
When price of one good falls, a new choice is
made
The new choice cannot involve less of the good
whose price has fallen
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Revealed Preference
• Why?
Apples
If combination X is the original choice and Z is the new
choice (after the price of oranges falls), X to Z is the price
effect. The broken line shows the goods which could be
bought if income remained at the level requiredto buy the
original basket of goods, but the new price ratio held. We
don’t know exactly where the consumer would choose to be,
but they cannot be to the left of X because they have already
rejected superior combinations in favour of X
Z
X
Oranges
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The Characteristics Approach
 Lancaster 1966
 Consumers do
‘characteristics’
not
desire
‘goods’
but
bundles
of
– not a computer but
•
•
•
•
processing speed
memory
storage
functions
 Different brands offer different combinations of
characteristics. Combining brands may allow other
combinations to be achieved
 Desirable mixes of characteristics might be identified
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The Determinants of Demand
 Demand is the quantity of a product that purchasers are
willing and able to purchase in a specified period
 It is determined by
– Own Price - Po
– Price of other products, especially close substitutes and
complements, Pc,s
– Consumers’ disposable incomes, Yd
– Consumers’ tastes, T
– The amount spent on advertising the product, Ao
– The amount spent on advertising complements and substitutes, A
c,s
– Interest rates (i) and credit availability (C)
– Expectations of future prices and supply conditions(E)
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These Relationships May be
Represented As:
A ‘demand function’ - the general
mathematical form
• Qd = f(Po,Po,Ps,Yd,Ao,Ac,As,I,C,E)
A ‘demand curve’
Price
The demand curve shows the quantity that would
be bought at each price, for some fixed
combination of all other factors
Quantity Demanded
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Concepts of Elasticity
 Own price elasticity is:
– percentage change in quantity demanded, divided by percentage change
in price:
increases with lower prices.
If demand is price-inelastic, revenue decreases with lower prices
Cross-price elasticity of demand between substitutes is positive
 If demand is price-elastic, revenue


 Income-elasticity determines how demand changes with customers’
incomes. For most goods income-elasticity is positive.
 Advertising elasticity is important in deciding on advertising budgets. It is
positive. As the level of advertising increases, we would expect
advertising elasticity to fall.
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Zero-elasticity at all prices
Infinite elasticity at all prices
Price
Price
Ed = 0
Ed = 
Quantity
Quantity
Unitary elasticity at all prices
Price
Ed = -1
This curve is a ‘rectangular
hyperbola’ such that price x
quantity is a constan
Quantity
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Price
p0
p1
1
2
q0
q1
Quantity
2 > 1
If demand is price-elastic, decrease
the price to gaining higher revenue
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Price
p0
p1
1
2
q0 q1
Quantity
2 < 1
If demand is price-inelastic, lower prices
will decreases revenue
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Determinants of Own-price Elasticity
 Substitutes: how close and at what prices?
– How narrowly defined is the product? The more narrowly defined the more close
substitutes
 Proportion of consumers’ income spent on the product (or % of industrial
buyers’ costs accounted for)
 Time. Demand is more elastic over longer periods of time
Determinants of Other Elasticities
 Income Elasticity
– Type of good
• necessities - salt, drinking water, zero elasticity
• luxuries, zero at low levels of income then high when income thresholds
exceeded
• inferior goods - negative, purchase less as income rises - bus travel, low-grade
margarine, paraffin
 Cross-price elasticity
– substitutes or complements,and how close?
– An industry is a group of firms producing products with high positive
cross-elasticities
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Estimation
Estimation attempts to quantify the links between the
level of demand for a product and the variables which
determine it.
 The demand for hotel rooms depends upon:
 their price
 the price of bed and breakfast accommodation
 household incomes in visitors’ home countries
 natural events (the weather, foot-and-mouth disease)
Forecasting
Forecasting simply attempts to predict the level of sales
at some future date
 How many Japanese tourists will visit Hong Kong in 2000?
 How many delegates will attend conferences in London in 2001?
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Econometric Estimation
 Qd = f(Po, Pc, Ps, Yd, T, Ao, Ac, As, I. C, E)
– THE GENERAL FORM OF THE DEMAND FUNCTION
– (CANNOT BE ESTIMATED BY THE USUAL METHODS UNTIL A
PARTICULAR LINEAR FORM IS CHOSEN)
 Qd = a + b1Po+b2Pc+b3 Ps+b4 Yd+b5T +b6Ao +b7Ac+b8As+b9 I+b10C+b11E
– THE SIMPLE LINEAR FORM
 Qd= Poa.Pcb,.Psc Ydd Te.Aof Acg Ash Ii. Cj, Ek
– THE EXPONENTIAL FORM
 log Qd= alogPo+blogPc+clogPs+dlogYd+elogT+flogAo+glog Ac
+hlogAs+ilogI+jlog C+klogE
– THE LOGLINEAR FORM
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Forecasting Demand
• Simplest Method is EXTRAPOLATION
 The DECOMPOSITION METHOD
 Etc
•
•
•
•
•
•
How To Evaluate the
Forecast?
Objectivity. Does the result depend on the data or on the person making the forecast?
Validity. How closely does a series of forecast estimates correlate with the actual time
series, for the time period used to make the forecast?
Reliability. If we take different starting points for the forecast, do the results stay
approximately the same?
Accuracy.How close are the forecasts to the actual figures, for the period outside that
used to generate the forecast?
Confidence. Is there are high probability that we can accept the results?
Sensitivity.If we use the method to make forecasts using data with very different
patterns, do we get very different results?
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What Other Methods are
Available?
Barometric forecasting - leading indicators are used: variables
which change in advance of the variable you wish to predict
Market Surveys,
Sales Force Opinion
Expert Opinion ‘Delphi’ approach
Market Testing
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Which Technique Is Best For
Each Product?
 An industrial product with a
limited market
 Time-series analysis
 Expert opinion
 A consumer good which has
been on sales for many years
 A new product whose full scale
launch will be very expensive
 A technically very complex
product, to be sold in a very
wide market
 Market testing
 Survey of buyer’s intentions
•
THIS ISJUST ONE POSSIBLE
ANSWER . YOU MAY BE ABLE
TO JUSTIFY OTHERS
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Formal Textbook Models
Economic analysis identifies four types of market structure
 PERFECT COMPETITION
 MONOPOLY
 OLIGOPOLY
 MONOPOLISTIC COMPETITION
The
basis
for
the
STRUCTURE-CONDUCTPERFORMANCE approach to industrial organization.
– Structure determines prices and profitability
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Perfect Competition
 Large No of Small Firms, (i.e.No Economies of Scale), Identical
Products, Free Entry to the Industry, Perfect Knowledge of market
Opportunities
 SHORT RUN
–
–
–
–
price is determined at industry level by supply and demand
each firm has a horizontal demand curve at the market price
demand and marginal revenue curve are the same
MR = P = MC
 LONG RUN
– entry takes place, shifting supply curve to the right and price down
– super-normal profits are competed away, P= minimum LAC
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Perfect Competition:
Short Run
• Industry
P
Firm
S
SMC
P
P2
P1
D=AR=MR
P
D
Q
q0
q
q
1
2
Q
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The Firm in More Detail
SMC
SAC
P = AR =MR
AC
LAC
q
SAC
PL is the only possible
long run price
P = AR =MR
PL
q
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Monopoly
 One firm, no entry is possible - ‘pure monopoly’
 Firm’s demand-curve is industry’s demand curve
 Price >Marginal Cost - economic inefficiency. Superprofits can be made in the long run. The firm does not
necessarily use the plant which gives lowest cost
 Most countries have some kind of anti-monopoly policy
– note that the economic rationale for monopoly policy is P>MC not P>AC
– the problem is inefficiency not inequity
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Monopoly
• A monopolist produces less and charges a higher price,
relative to the socially optimal
MC
Pmonopoly
Psocially
optimal
Demand
Qmonopoly
Qsocially optimal
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Monopolistic Competition
• Many firms, free entry, differentiated products
• Downward-sloping demand-curves
• In the long-run Price = Average Cost. Firms have
plants which are too small to take full advantage
of scale economies. (But there is only an
equilibrium in this market structure if heroic and
perhaps contradictory assumptions made)
– when new firms enter, they take customers in equal proportions
from all old firms
– all firms have same cost and demand curves, while producing
different products
– will new firms not imitate successful old ones?
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Monopolistic Competition
•
The ‘excess capacity’ result: but which firm is shown here? ALLOF THEM?
Differentiated products but identical cost and demand conditions?
MC
AC
Demand = AR
MR
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Oligopoly
 Competition amongst the Few
 Key feature is interdependence and rivalry
 Small number of firms (2 = duopoly)
 Condition of Entry may vary
 Product differentiation may vary
 Possible outcomes include:
– co-operation and collusion - the monopoly price
– price war - the perfectly competitive price
 The modern approach to oligopoly is through game
theory
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What Do These Models Tell Us
About the Impact of Structure?
Entry
Conditions are Important: They affect whether high
profits can be maintained in the long run.
The
Number of Competitors and their Behaviour is
Important. A few co-operating “competitors” can lead to
monopoly-type profits
Product
Differentiation is Important. Without it all firms
must charge the same price in a competitive market
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Features of the four market
structures
Type of
market
Number
of firms
Freedom of
entry
Perfect
competition
Very
many
Monopolistic
competition
Many /
several
Oligopoly
Monopoly
Few
One
Nature of product
Examples
Implications for demand
curve
faced by firm
Unrestricted
Homogeneous
(undifferentiated)
Cabbages,
carrots
(approximately)
Horizontal:
firm is a price taker
Unrestricted
Differentiated
Plumbers,
restaurants
Downward sloping,
but relatively elastic
Undifferentiated
Cement
or differentiated
cars, electrical
appliances
Downward sloping.
Relatively inelastic
(shape depends on
reactions of rivals)
Restricted
Restricted or
completely
blocked
Unique
Local water
Downward sloping: more
company, gas
inelastic than oligopoly.
and electricity in Firm has considerable
many countries
control over price
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The Basic Rule for Profit-Maximization
•
•
•
(Price - Marginal Cost)/Price = 1/-Ed
Not an operational decision rule - a statement of the condition required for maximum
profit
Can be re-stated in an “average cost plus margin” format
Pricing and Market Structures
•
•
•
Under perfect competition, firms are price-takers
Under monopoly, firms are price-makers (but still constrained by the requirement to
make maximum profit)
Under monopolistic competition, prices settle at the ‘excess capacity’ level where P=AC
Price Discrimination
•
•
Price discrimination exists when the same product is sold for different prices, that are
not attributable to differences in the cost of supply
Two conditions are needed:
– the market must be divisible into sub-markets between which there cannot be any
arbitrage
– demand conditions (elasticity) must be different in the sub-markets
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Third Degree Price Discrimination
•
•
A number of sub-markets, each containing a number of potential customers
These markets may be separated by:
– distance ( car prices differ between Europe and the UK - but is it really price
discrimination?)
– time (for non-storable commodities) - peak versus off-peak journeys
– age and status - Student Railcards, Old Person Railcards
Second Degree Price Discrimination
•
Customers are charged one price for the first block of units they purchase, then
a different price for the second block
– electricity, water, gas tariffs
– the producer appropriates part of the consumer surplus
First Degree Price Discrimination
•
•
•
Every buyer is charged the maximum they are willing to pay (the demand
curve becomes the marginal revenue curve)
Can be difficult to evaluate willingness to pay but first degree discrimination
may be possible in personal, household or commercial services
Note that the socially optimal level of output will be produced but all the
surplus accrues to the producer
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Pricing and the Product Life Cycle
.
Maturity
Decline
Sales
Volume
Growth
Introduction
Time
What Happens to Elasticity of Demand
and Marginal Cost Over the Product Life Cycle?
 Introduction
- product is new. Elasticity may be low because there are no
substitutes or high if buyers need to be persuaded to try the new product. Marginal cost
is relatively high. Appropriate price will reflect high MC combined with high/low
elasticity
 Growth
- imitation begins, and learning takes place. Elasticity rises, MC falls. Price
falls?
 Maturity
- competition from many locations, substitutes and next-generation
products have been invented, elasticity high, MC low
 Decline - fierce competition for a declining market, very low margins
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Pricing
New
Products
•
For new products, there is a significant amount of uncertainty about demand conditions. Two
•
strategies have been suggested (Dean 1950)
SKIMMING - set an initially high price. IF that produces a high level of profits, leave the price high
until conditions change and demand becomes more elastic. Do this when:
–
–
–
–
•
there is a significant group of buyers prepared to pay high prices
when demand is inelastic
when the high price will not induce entry
when the cost penalty for low volume is small
PENETRATION - set a low price from the beginning in order to build a large market share quickly.
Do this when:
–
–
–
demand is elastic
low volume is very high cost
entry is a major danger
Is Skimming v Penetration Just an Application of the
Simple Model?
•
•
YES - set a high price when elasticity is low and MC is high, set a low price when the opposite is true
BUT –
–
–
skimming may have another benefit. If experience shows it is the wrong strategy, the price can be cut without
much customer resistance. If the penetration approach is used but it becomes clear that skimming would be
better, it is more difficult to raise price than to lower it
skimming may provide a means of price discrimination through time. If a market contains a group of
‘trendsetters’ or ‘first-adopters’ who must have, or like to have, a product first and are willing to pay more for it.
Skimming allows them to be charged a higher price.
E.g new major dictionaries, new types of mobile phone
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Pricing Objectives
 The central objective of pricing is PROFIT MAXIMIZATION
 Companies may either express this in a different way, or have
intermediate level objectives for pricing.
 Those intermediate level objectives may or may not be consistent
with profit-max
 achieve a target rate of return: might be the maximum, might be a
‘satisficing objective, might be to deter entry
 target market share: might be the share which is consistent with profitmaximisation or it might be a managers’ target
 stabilize output - keep the factory running and the workers employed
 match the competition
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A Good Example of the Theory/Practice
Relationship
•
•
•
•
A simplistic interpretation of the Oxford findings is that the economic model
of pricing is incorrect
– it is clear from the evidence that managers do not describe their pricing practices
in marginalist terms, in terms of MC=MR or in terms of elasticity and MC
– some analysts (including the original researchers and many accountants) have
concluded that the MC=MR model is therefore incorrect
However, the conclusion that the evidence on cost-plus pricing invalidates the
profit-maxing model is a misunderstanding of the relationship between models and
practice.
This is very important for general understanding and can be approached in a
number of ways
First
–
–
–
the profit-maxing model can be re-written in cost-plus form
(P-MC) = 1 is the same as P = MC . (Ed)
P
Ed
(Ed -1)
If average variable cost is constant (which is often assumed in management accounting) then
AVC = MC
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The Marginal Pricing Model is Equivalent to a
Cost-Plus Model in Many Common
Circumstances
 If AVC is constant , therefore = MC the profit-max model can be
re-written:
 P = AVC. (Ed)
Average cost plus a margin

(Ed -1)
 Calculate the margin when elasticity takes the following values
•
•
•
•
1.2
2.5
3
10
P = AVC.1.2/.2 = AVCx6
P = AVC.2.5/1.5 = AVCx1.66 P = AVC.3/2 = AVCx1.5
P = AVC 10/9 = AVCx 1.11
Margin = 600%
Margin = 66%
Margin = 50%
Margin = 11%
 (Why can we not find a value if elasticity is less than 1?)
 If managers use margins which are consistent with these values,
they are profit-maximising
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But That Is Not the Most Important Point
•
Close examination shows that
–
rigid cost plus pricing must lead to irrational results. Managers would be stupid to use it
–
in practice, firms do take other factors into account, which allows them to approximate the
profit-maxing solution
Why Is Rigid Cost-plus Pricing
Irrational?
•
There is a circularity problem. In many circumstances cost per unit depends on the volume of output
sold. But the volume of output sold depends upon the price!.
–
•
Unless cost is constant over a very wide range of output a firm does not know its cost per unit until it
knows the price !
Cost-plus pricing completely ignores the demand side and the behaviour of customers and
competitors For instance:
–
–
if my competitors lower their prices, how would a cost-plus price change?
if demand increases how will my cost plus price change?
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Why Is Rigid Cost-plus Pricing
Irrational?
•
If my competitors lower their prices, my sales volume will fall. That will
increase my cost per unit.
•
IF I USE COST-PLUS PRICING, I WILL RAISE MY PRICE!
•
If demand increases and my sales volume increases, my costs will usually fall.
•
IF I USE COST-PLUS PRICING I WILL LOWER MY PRICE!
•
NOTICE THAT THE PROFIT-MAXING, MC=MR MODEL GIVES
MUCH BETTER PREDICTIONS OF FIRMS’ BEHAVIOUR THAN A
COST-PLUS ‘MODEL’ OF PRICING!
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What Can We Conclude on the Cost-Plus
Practice Versus MC=MR Theory?
 The theory is not supposed to describe pricing practices. It
should be no surprise that it does not.
 The purpose of the MC=MR theory is to predict how firms will
change their prices when cost and demand conditions change.
The predictions make more sense, and are more accurate than
those derived from a ‘cost-plus’ theory of price.
 Managers are not dumb. They do not use cost-plus in a rigid
way and they do not have the accurate information needed to do
an MC= MR calculation. They feed their experience and
knowledge into a complex decision-making process and in the
end often behave ‘as if’ they were fully-informed maximisers.
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Pricing Methods II:Other Approaches
• Target return pricing - identify target profit and set the margin
equal to that required to provide the target profit
• Going rate pricing - behave as a price-taker
• Sealed bids - for auctions
Transfer Pricing
• How to set prices for internal transfers so that divisions taking their
own decisions will bring maximum profit to the firm as a whole?
– If there is no external market for the intermediate product the amount
of that product that the final producing division wishes to purchase
must correspond to the profit-maxing output for the firm as a whole
– if there is an intermediate market for the product the final production
division can buy on the open market as well as acquire in-house.
Transfer price is the market price
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Pricing in Public Enterprise
 The basic rule? Set price equal to marginal cost?
 But which marginal cost - long-run or short-run?
 It doesn’t matter if you have the appropriate set of plant and equipment
because in that case SMC =LMC
 What about surpluses or deficits?
– If there are scale economies at the optimal level of output, MC pricing must lead to
losses (and vice versa for diseconomies)
– Some planning theorists hoped that losses and gains would just balance out!
– If a public enterprise makes losses it might be because of the pricing rule, or it
might be due to inefficiency - difficult to tell the difference
•
The second-best problem - if there are ‘n’ conditions for an optimum and 1 cannot
be achieved - the others may be redundant
 If MC pricing in all industries is optimal but it is impossible in one industry - MC
pricing may not be optimal in the others - VERY DESTRUCTIVE OF THE PRICING
RULE
 But a partial approach may be possible. If the price of oil is too high, oil output will be
too low and coal and gas output will be too high. Therefore ‘lean’ against the distortion
by also raising their prices>MC
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Investment Theory
Investment is the change in capital stock during a period.
Consequently, unlike capital, investment is a flow term and
not a stock term
Capital is the stock of
assets that will generate
a flow of income in the
future.
Capital budgeting is the planning process
for allocating all expenditures that will
have an expected benefit to the firm for
more than one year.
The investment flow at time period t can be
defined as
It = Kt – Kt-1
Kt is the stock of capital at the end of
period t and Kt-1 is the stock of capital at
the end of period t-1
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Investing Defined
?
To consume, to save, or to invest
a dollar that is earned ?
?
?
Both saving and investing amount to
consumption shifting through time.
However, investing is risky,
saving is not.
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Three Reasons for Investing
Why invest ???
People invest to …
 supplement
their income
 earn capital gains
Appreciation is an increase in the
value of an investment.
 experience the excitement of the
investment process
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The Academic Study of Investments
Theoretical research builds
mathematical models and
proposes pricing relationships
rather than studying actual
market data.
E.g. arbitrage relationships,
impact of stock splits and
cash dividends on investors
Theoretical models are tested by
conducting empirical research.
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Empirical research uses actual market
data rather than mathematical models.
An anomaly is an observed result that
defies explanation within the known
theoretical framework.
The Academic Study
of Investments
vs.
Professors
Practitioners
The investment community can learn much from both rigorous
academic research and from the life experiences of people on the
front lines of the marketplace.
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Risk&Return
The Relationship between Risk and Return
Riskier securities have higher expected returns.
Expected
Return
Risk-free
Return
Risk
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The Relationship between Risk and Return
Empirical financial research reveals clear evidence of the direct
relationship between systematic risk and expected return.
Expected
Return
T-bills
Large
Company
Stocks
Small
Company
Stocks
Long-term Corporate Bonds
Long-term Government Bonds
Inflation
Risk
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The simplest measure
of return is the holding
period return.
Buy 100 shares
at $25 per share
Holding period return =
Holding
period =
return
Ending _
value
Dividend of
$0.10 per share
Beginning
+ Income
value
Beginning value
Sell the shares
at $30 per share
$30 - $25 + $0.10
= 20.4%
$25
Time
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Alternative States of Information
Certainty:
we have perfect information about
future outcomes
Risk:
we know what future outcomes are
possible and we can attach probabilities to each
outcome
Uncertainty: we do not know the precise nature
of the outcomes or their probabilities
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Expected Monetary Values (EMV)
 In a situation of RISK we could use Expected Monetary
Values (EMV) to take a decision
 EMV = SpiVi
Where:
 pi = probability of the i’th outcome
 Vi = value of the i’th outcome
Example:
Weather
Probability
Takings
Sunny
0.2
$500
Cloudy
0.4
$300
Raining
0.4
$100
EMV = ?
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EMV- Limitations of EMV




Will you accept a 50/50 bet for $5? Probably YES
Will you accept a 50/50 bet for $5m? Probably NO
BUT BOTH HAVE AN EMV = 0!
In some way you ‘care’ more about losing $5m than winning
$5m





Your house is worth $200,000
The probability of destruction by fire is 1/10,000
EMV of the loss = $20
So $20 is the most you will pay for insurance?
NO, YOU CARE MORE ABOUT THE CHANCE OF LOSING
YOUR HOUSE
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EMV- Limitations of EMV
How to Take This Into Account




Decision-makers have different ‘attitudes to risk’
RISK NEUTRAL - values gains and losses equally
RISK AVERSE - values losses more highly than gains
RISK LOVER - values gains more than losses
A Risk-Averse Person
Utility
Income
•
A Risk-Neutral Person
A Risk-Lover
Utility
Utility
Income
Income
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Decision-makers Are Usually Assumed to be Risk-averse
•
•
Instead of using EMV, use Expected Utility (EU)
EU = SpiUi
Where:
– pi = probability of the i’th outcome
– Ui = utility of the i’th outcome
The Expected Value of Information
•
EVPI = difference between the expected value of future actions, given the information
currently available, and the expected value of future action, if perfect advance state
revelation were available
Techniques for Coping with Uncertainty
•
•
If we do not know the possible outcomes, there is little we can do
If we know the possible outcomes, but not their probabilities, a number of techniques
are possible
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Minimax Criterion
Actions
States of Nature
A
B
C
1
20
40
180
2
-40
100
220
3
60
70
90
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Investment Alternatives
Assets
financial assets
e.g. bond, stock
real assets
e.g. land
Assets are things that people own.
Financial assets have a
corresponding liability,
while real assets do not.
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A security is a legal document that
shows an ownership interest.
Securities
are
historically
associated with financial assets,
but are also applicable to real
assets.
Securitization is the process of
converting an asset or collection
of assets into a more marketable
form.
Securities
Equity
Securities
e.g. common
stock
Fixed Income
Securities
e.g. bonds,
preferred stock
Derivative Assets
e.g. futures,
options
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Major Classes of Financial Securities
Markets and Instruments
Debt
Money Market
Money market instruments
Debt Instruments
Bonds
Derivatives
Common stock
Capital Market
Preferred stock
Bonds
Derivative securities
Equity
Derivatives
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Money Market Instruments
Capital Market: Equity
Treasury bills
Common stock
Certificates of deposit
Residual claim
Commercial Paper
Limited liability
Bankers Acceptances
Preferred stock
Eurodollars
Fixed dividends - limited
Repurchase Agreements (RPs) and
Reverse
Priority over common
Tax treatment
RPs
Federal Funds
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Investment Management
 TRADITIONAL
ORGANIZATIONS
INVESTMENT
MANAGEMNT
– Security Analysts play a key role and rely upon information and reports
from
• economists
• technicians
• market experts
– Investment Committee is advised by the analyst to create
– An Approved List of Securities
 FIVE STEP PROCEDURE:
–
–
–
–
–
SETTING INVESTMENT POLICY
PERFORMING SECURITY ANALYSIS
CONSTRUCTING A PORTFOLIO
REVISING THE PORTFOLIO
EVALUATING THE PORTFOLIO
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SETTING INVESTMENT POLICY
 DETERMINE THE INVESTMENT OBJECTIVE
 estimate the client’s level of risk tolerance
PERFORMING SECURITY ANALYSIS
 Security Selection: A 2 Stage Procedure
 STAGE I: forecast
•
•
•
•
expected returns
standard deviation
covariances
identify optimal portfolio
 STAGE II: Asset Allocation
•
Series
Average
Standard
Annual Return Deviation
Large Company Stocks
13.0%
20.3%
Small Company Stocks
17.7
33.9
Long-Term Corporate Bonds
6.1
8.7
Long-Term Government Bonds
5.6
9.2
U.S. Treasury Bills
3.8
3.2
Inflation
3.2
4.5
– 90%
Distribution
0%
+ 90%
strategic
– refers to how a portfolio’s funds would be divided, given the manager’s long-term
forecasts from Stage I
•
tactical
– given short-term forecasts, who will assets be allocated at any one time
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REVISING THE PORTFOLIO
Use Cost-Benefit Analysis


transaction costs should be examined since they complicate the management decision
portfolio revisions must be weighed against the cost of revision particularly with
regard to transaction costs
Swap Methodology


a cost saving method which involves exchanges of assets rather than purchases or sales
TYPES OF SWAPS:

Equity
The Agreement
»
one party agrees to pay the other a variable-sized cash payment
»
the other party agrees to a fixed-sized cash payment
Results in a restructured portfolio without incurring any transaction costs

Interest Rate
The Agreement
»
one party pays the second a variable-sized stream of cash based on the current level of
an agreed-upon interest rate (e.g. LIBOR)
»
second party pays the first a fixed-sized payment stream based on the interest rate at
the time of the Agreement
Results in a restructured portfolio without incurring any transaction costs
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Common Methods of Appraisal
The common methods are:
• PAYBACK
• DISCOUNTED PAYBACK
• RETURN ON INVESTMENT
• INTERNAL RATE OF RETURN
• NET PRESENT VALUE
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•PAYBACK
Payback period is the amount of time sufficient to cover the initial cost of an investment.
But it ignores any returns accrue after the pay-back period; ignores the pattern of returns;
ignores the time value (time cost) of money.
Example:
Initial investment:
Cash flow:
$10 million
$2 million per year
Payback-period?
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RETURN ON INVESTMENT
• Accept a project of the Return on Investment is greater than an agreed
target return
• Note that there is no economically defensible way to estimate the cutoff rate
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INTERNAL RATE OF RETURN
Internal rate of return (IRR) is the rate of return that will
equate the present value of a multi-year cash flow with the cost
of investing in a project.
Using the NPV equation: the IRR is the discount rate that
renders the NPV of the project equal to zero.
• Accept a project of the Internal Rate of Return exceeds the
opportunity cost of capital
• Note that the opportunity cost of capital is economically
defensible because it relates to the risk of the project
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NET PRESENT VALUE
• Accept a project if the NPV is greater than zero when discounted at the
opportunity cost of capital
• Note that the NPV is economically defensible because it uses the
opportunity cost of capital
The present value of a single future amount
In general, present value (PV) refers to the value now of payments to be
received in the future (I). The present value of I after n year at r is:
PV=
I
(1+r)n
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NET PRESENT VALUE
NPV = -P + I0 +
I1
(1+r)
I2
In
+ (1+r)2 + … + (1+r)n
or
NPV = -P +
I
r
where:
P:
=capital cost, accruing in full at the beginning of the project
I1,2,…n
=net cash flows arising from the project in years 1 to n
r
=the opportunity cost of capital
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Foreign Direct Investment
What is FDI?
FDI (Foreign Direct Investment):
• « Direct investment is the category of international investment
that reflects the objective of obtaining a lasting interest by a
resident entity in one economy (the direct investor) in an
enterprise (foreign direct investment enterprise) resident in
another economy. » (IMF)
• « Foreign direct investment (FDI) occurs when a foreign
investor develops a long term relationship with a
domestic enterprise and owns enough of the equity of the
enterprise to exercise a significant degree of influence on the
management of the enterprise » (IMF)
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Foreign Direct Investment
Meaning of Foreign Direct Investment (FDI)
Concept of control



Control must accompany the investment
100 percent share does not guarantee control
 government intervenes in company operations
Direct investment usually implies an ownership share of 10 – 25 %
Concern about control

Government concern—when foreign investors control a company,
decisions of national importance may be made abroad

Investor concern—transfer of resources to acquiring company
 appropriability theory—company receiving resources may
undermine the competitive position of the transfer company
 Internalization—control by self-handling of foreign operations,
usually down the supply chain
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Foreign Direct Investment
FDI Requirements
Factors of decision:
 Large domestic markets
 Abundance of natural resources
 Cheap labour
These conditions are required to make a FDI in a host country.
However, these motivations belong to the Old Economy.
FDI Today: The differences
The new determinants of FDI location:
 Policy liberalization

Rapid technical progress
 New management and organizational techniques
Yesterday: Economic factors were critical
Today : New variables increase the complexity of FDI
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OECD Survey, 1999
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OECD Survey, 1999
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FDI & Competition
FDI & Economic Growth
OECD Survey, 1999
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The impact of FDI on ASEAN4 development
FDI as a form of development finance
The crisis has brought into relief the importance of FDI as a stable source of finance for
development compared to other forms of international capital flows. Foreign direct investment
in Asia has so far held up very well, in spite of the crisis, while other capital flows have
reversed themselves
FDI and exports
The experience of successful ASEAN countries amply demonstrates how FDI can play a leading
role in bringing about rapid, export-led growth. Rapidly rising exports have fuelled the world’s
fastest growth rates in some of these economies which, until recently, had made them the envy of
the developing world. But economic development is more than growth, as the crisis has made
abundantly clear.
Technology transfers
The most enduring potential benefit to developing countries from inward direct investment is the
transfer of technology. Exports can drive rapid economic growth over long period, but technology
transfers can do much more to promote sustainable development by enhancing indigenous
capabilities. In this area, the record from decades of FDI in the ASEAN4 is not encouraging.
Possible remedies for this situation will be discussed later.
OECD Survey, 1999
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Foreign Direct Investment
Total FDI inflows by country, 1990-97
Thailand 17 177
Philippines 8 379
OECD Survey, 1999
Indonesia 23 684
Malaysia 35 177
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 Strategy as purposive action – the
resource allocations that firms plan
and implement in order to position
themselves in markets and to
compete with other
 Strategy as the ‘fit’ between a firm’s
use of resources and its environment
 Strategy as an ongoing, unplanned
and
‘unintended’ process
of
interaction between the firm’s
internal
structures
and
its
environment
Research Question
Demand
The Market
What Is Strategy?
Strategy as a:
Plan
Ploy
Pattern
Position
Perspective
Henry Mintzburg
Howard Davies and Pun-Lee Lam
Jeffrey Kaufmann:
Strategy is a deliberate search for a plan of action that
will develop a business’s competitive advantage and
compound it
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Elements of Competitive
Advantage
Performance Outcomes
Sources of Advantage
•Superior Resources
•Superior Capabilities
Positional Advantages
•Superior Cust. Value
•Lower Relative Cost
•Customer Satisfaction
•Customer Loyalty
•Market Share
•Profitability
Investment to Sustain Competitive Advantage
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Your Competitive
Positioning
A Positioning
• Who are your competitors?
Statement
• Are you the market leader?
•
•
•
•
•
•
•
Who: Who are you?
What: What business are you in?
For whom: What people do you serve?
What need: What are the special needs
of the people you serve?
Against whom: With whom are you
competing?
What’s different: What makes you
different from those competitors?
So: What’s the benefit? What unique
benefit does a client derive from your
product?
-
• If not, how can you become
the market leader?
• If yes, how do you remain
the market leader?
Harry Beckwith
Selling the Invisible
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Postioning Template
For
Who
Our Product
That Provides
Unlike
Our Product
(Target Customers)
(Have a Problem)
(Is a new Category)
(Breakthrough Results)
(Reference Competitor)
(Key Differentiators)
Geoff Moore
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5 Generic Competitive Strategies
TYPE OF COMPETITIVE ADVANTAGE
BEING PURSUED
Lower Cost
Broad buyer
segment
Differentiation
OVERALL COST
LEADERSHIP
STRATEGY
MARKET
TARGET
Narrow buyer
segment
FOCUSED
LOW-COST
STRATEGY
BEST
COST
PROVIDER
STRATEGY
BROAD
DIFFERENTIATION
STRATEGY
FOCUSED
DIFF.
STRATEGY
PORTER, 1980.
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Peter Duncan (2001)
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