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Economic Concepts For
Strategy
Besanko, Dranove, and Shanley
Primer Chapter
1
Agenda





Strategy Defined
Review the Concepts Related to Costs
Profitability, Revenue, and Demand
Pricing and Output Decisions
Game Theory
2
Perspective 1 of Strategy
Taken From Besanko

“the determination of the basic longterm goals and objectives of an
enterprise, and the adoption of courses
of action and the allocation of resources
necessary for carrying out these goals.”
–Alfred Chandler
3
Perspective 2 of Strategy
Taken From Besanko

“the pattern of objectives, purposes or
goals, and the major policies and plans
for achieving these goals, stated in such
a way as to define what business the
company is in or should be in and the
kind of company it is or should be.”
–Kenneth Andrews
4
Perspective 3 of Strategy
Taken From Besanko

“what determines the framework of a
firm’s business activities and provides
guidelines for coordinating activities so
that the firm can cope with and
influence the changing environment.
Strategy articulates the firm’s preferred
environment and the type of
organization it is striving to become.”
–Hiroyuki Itami
5
Key Points of Strategy



Strategy focuses on long-term goals
and objectives.
Strategy develops action plans.
In essence, strategy can be defined as
the action plans that move the company
towards its long-term goals and
objectives within a particular
environment.
6
Benchmarking Versus
Principles

Benchmarking is where you examine
how successful companies operate and
attempt to imitate them.


It assumes that the keys to success can be
measured and are knowable.
Principles, as related to strategy, are a
set of guidelines that work across time
in many differing environments.
7
Besanko’s Framework for
Strategy

Boundaries of the firm

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What should the firm do and how large
should it be?
Market and competitive analysis

What is the nature of the markets and the
interaction between firms?
8
Besanko’s Framework for
Strategy Cont.

Position and dynamics

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How and on what basis does the firm
compete?
Internal organization

How should the firm be internally
organized and managed?
9
Total Cost Function


The total cost function is the
summation of all fixed (including sunk)
and variable costs.
It is usually represented as the
following: TC(Q) = VC(Q) + FC(Q)


Where VC(Q) denotes the variable costs
Where FC(Q) denotes the fixed costs
10
Graphical Depiction of the
Total Cost Function
Total Cost
TC(Q)
Output (Q)
11
Variable and Fixed Costs

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A variable cost is a cost that is zero if
no production occurs.
A fixed cost is a cost that exists
whether production occurs or not.

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Fixed costs can be broken down further
into sunk costs.
There tends to be more fixed costs in the
short-run compared to the long-run.
12
Sunk Costs

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A sunk cost is a cost that cannot be
recovered.
A sunk cost is always considered a fixed
cost, but a fixed cost does not
necessarily imply being sunk.
Sunk costs can have a significant
impact on how you choose strategies.
13
Strategy and the Cost
Function

The types of strategies you have as a
firm can be dictated by your present
and future cost functions.

Why?
14
Average and Marginal Costs


Average cost can be
defined as the total
cost divided by
output.
Marginal cost is the
change in total cost
divided by the
change in output.
AC (Q) 
TC (Q)
Q
MC (Q) 
TC (Q  Q)  TC (Q)
Q
15
Relationship Between Average
and Marginal Cost

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If marginal cost is below average cost
then average cost is decreasing.
When average and marginal cost are
equal, then marginal cost is at a
minimum.
When marginal cost is above average
cost, the average costs are increasing
16
Graphical Depiction of Average
and Marginal Costs
$
MC
AC
Q
17
Long-Run Average Cost Curve

The long-run average cost curve can be
defined as the envelope of all possible
short-run average cost curves.

By envelope we mean the minimum
amount that can occur given a particular
level of output.
18
Scale of Economics


When examining the long-run average
cost curve, the economics of scale
examines what happens to average cost
as output is increased.
There are three general types of scale:


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Economies of scale
Minimum efficient scale
Diseconomies of scale
19
Economies of Scale

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Economies of scale are said to exist
when by increasing output, the long-run
average costs decrease.
This implies that AC(Q1) > AC(Q2) when
Q1 < Q2 and you move from Q1 to Q2.
20
Minimum Efficient Scale


Minimum efficient scale is said to exist
when by increasing output, the long-run
average costs does not change.
This implies that AC(Q1) = AC(Q2) when
Q1 < Q2 and you move from Q1 to Q2.
21
Diseconomies of Scale


Diseconomies of scale are said to exist
when by increasing output, the long-run
average costs increase.
This implies that AC(Q1) < AC(Q2) when
Q1 < Q2 and you move from Q1 to Q2.
22
Short-Run Average Costs for
Differing Firms
SRAC1
SRAC5
SRAC2
SRAC3
LRAC
SRAC4
Q
23
A Possible LRAC
$/per unit
LRAC
Note: The section of output
between A and B is known
as the minimum efficient
scale.
A
B
Y
24
Profit


There are two ways to define profits.
In general, profit is defined as total
revenue minus total costs.


 = TR - TC
The two ways of defining profits are:

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Accounting Profit
Economic Profit
25
Accounting and Economic
Profit

Accounting profit can be defined as
sales revenue minus accounting costs.

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Accounting costs do not usually take into
account opportunity costs.
Economic profit can be defined as sales
revenue minus economic costs.

Economic costs are equal to accounting
costs plus all opportunity costs.
26
Present Value


When you want to know what the value
of something in the future is worth to
you today, you can use the idea of
present value.
Present value takes a value in the
future and converts it to what it is
worth to you today.
27
Present Value Cont.
C
(1  i )t
Where C is the cash flow received in year t
Where i is the interest rate or discountin g factor you have due to time
PV 
28
Net Present Value


When you want to know what the value
of a set of income streams is worth to
you today, you can use the idea of net
present value.
Net present value takes a set of income
streams in the future and converts it to
what it is worth to you today.
29
Net Present Value Cont.
PV 
C1
C2
CT


...

(1  i )1 (1  i ) 2
(1  i )T
T
Ct
t
t 1 (1  i )
Where C is the cash flow received in year t, and T is the terminal year
Where i is the interest rate or discountin g factor you have due to time
PV  
30
Demand Function

The demand function is a function that gives
the relationship between quantity demanded
and all the variables that affect that quantity
demanded.

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The demand function usually examines the
relationship between price and quantity.
The Law of Demand states that there is an inverse
relationship between price and quantity demanded
holding all other variables fixed.
31
Price Elasticity of Demand

This measures the sensitivity of quantity
demanded due to a change in price.
Q
 Q P0 
 Q P0 
Q0
  (1) *
 
*   
* 
P
 P Q0 
 P Q0 
P0
Where Q is related to quantity demanded
and P is related to price
32
Price Elasticity of Demand
Cont.

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When  > 1, then demand is said to be
elastic.
When  = 1, then demand is said to be
unitary elastic.
When  < 1, then demand is said to be
inelastic.
33
Price Elasticity of Demand
Cont.

There is a relationship between
revenue, elasticity, and price.

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When  > 1, then revenue can be
increased by decreasing price.
When  < 1, then revenue can be
increased by increasing price.
When  = 1, then revenue is maximized
for the given price.
34
Causes of Price Sensitivity
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The commodity is consider
homogeneous or near homogenous to
its rival products.
The price of the product is a large
proportion of the buyer’s expenditure.
The product is an input of a very elastic
product.
35
Causes of Price Insensitivity

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Very few or no substitute products.
A substitute product is much more
costly.
There are incentives that reduce the
effective price of the product.
The product is a complementary
product to a product that is highly
inelastic.
36
Total and Marginal Revenue

Total revenue is defined as price times
quantity where price is a function of
quantity.


TR = P(Q)*Q
Marginal Revenue is the change in total
revenue due to a change in quantity.
TR TR
MR 

Q
Q
37
Relationship Between Elasticity
and Marginal Revenue
1
MR  P(1  )



When demand is elastic, i.e.,  > 1, then
marginal revenue is positive when quantity is
increased.
When demand is elastic, i.e.,  < 1, then
marginal revenue is negative when quantity is
increased.
38
Pricing and Output Decisions

Change in profit () can be defined as the
change in quantity times the difference
between marginal revenue and marginal cost,
i.e.,  = (MR-MC)*Q.



When MR > MC, the firm can increase profits by
decreasing price and selling more.
When MR < MC, the firm can increase profits by
increasing price and selling less.
When MR = MC, the firm cannot increase profits.
39
Price Elasticity and the Output
Decision

The following relationships can be
derived:


MR – MC > 0, when PCM > 1 / .
MR – MC < 0, when PCM < 1 / .

Where PCM, the percentage contribution
margin, is defined as (P – c) / P.

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P is the price of the product.
c is the marginal cost.
40
Price Elasticity and the Output
Decision Cont.


When the percentage contribution margin is
greater than the reciprocal of the price
elasticity of demand, then prices should be
decreased to increase profitability.
When the percentage contribution margin is
less than the reciprocal of the price elasticity
of demand, then prices should be increased
to increase profitability.
41
Game Theory

Game theory is the study of a set of
tools that can be used to analyze
decision-making by a set of players who
interact with each other through a set
of strategies.
42
Tools Used in Game Theory

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Matrix Form of a Game
Dominant Strategy
Dominated Strategy
Nash Equilibrium
Game Trees
Subgame Perfection
43
Matrix Form of the Game

The matrix form of a game represents
the strategies and payoff of those
strategies in a matrix.


The key components of this is the players,
the strategies, and the payoffs of the
strategies.
The matrix form is a useful tool when
the players of the game must move
simultaneously.
44
Matrix Form of the Game
Cont.
Player 2
Strategy 1
Strategy 2
Strategy 1
(Player 1 payoff, (Player 1 payoff,
Player 2 payoff) Player 2 payoff)
Strategy 2
(Player 1 payoff, (Player 1 payoff,
Player 2 payoff) Player 2 payoff)
Player 1
45
Matrix Form Example


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Suppose there were two producers of
hogs, Farmer A and Farmer B.
Assume that there are two strategies
that each farmer can do: be large or be
small.
If each farmer chooses the same size,
they will split the demand for there
product evenly.
46
Matrix Form Example Cont.


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If both producers are small, then the market
is worth $100.
If both producers are large, then the market
is worth $80.
If one chooses to be large and the other
chooses to be small, then the market is worth
$90.
When one farmer is small and the other is
large, the large producer obtains 2/3 of the
market leaving the rest to the small farmer.
47
Matrix Form Example Cont.

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Players: Farmer A, Farmer B
Strategies: Large, Small
Payoffs:



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Large, Large implies (40, 40)
Large, Small implies (60, 30)
Small, Small implies (50, 50)
Small, Large implies (30, 60)
48
Matrix Form Example
Farmer B
Large
Small
(40, 40)
(60, 30)
(30, 60)
(50, 50)
Large
Farmer A
Small
49
Dominant and Dominated
Strategies

Dominant Strategy


Given a set of strategies, a dominant
strategy is one that is better than all other
strategies in that set.
Dominated Strategy

Given a set of strategies, a dominated
strategy is one that is worse than all other
strategies in that set.
50
Nash Equilibrium

A Nash Equilibrium is said to occur
when given the strategies of the other
players are held constant, there is no
incentive for a player to change his
strategy to get a higher payoff.

In essence, a Nash Equilibrium occurs
when all players in the game do not want
to change their strategies given the other
players’ strategies.
51
Nash Equilibrium Cont.


A Nash Equilibrium will be in a
Dominant Strategy.
A Nash Equilibrium will never be in a
dominated strategy.
52
Matrix Form Example with
Nash Equilibrium
Farmer B
Large
Large
Farmer A
Small
(40, 40)
Nash
Equilibrium
(60, 30)
(30, 60)
(50, 50)
Small
53
Prisoners’ Dilemma

A Prisoners’ Dilemma occurs when all parties
through noncooperative strategies obtain a
less than optimal solution due to their self
interest.

In the previous example, the Nash Equilibrium
occurred at a sub-optimal solution for the game
where both farmers chose large.

They both would have been better off by choosing small.
54
Game Trees


A Game Tree is a way of representing a
sequential move game.
There are four components to a Game Tree.



Players
Payoffs
Nodes


A node represents a position within the game.
Actions

An action is a move that moves from one node to the
next.
55
Representation of Game Tree
Player 2
Player 1 Payoff, Player 2 Payoff
Action 3
Player 1
Action 1
Action 4
Player 1 Payoff, Player 2 Payoff
Player 1 Payoff, Player 2 Payoff
Action 2
Action 5
Action 6
Player 1 Payoff, Player 2 Payoff
56
Game Tree Representation Using Previous
Example Assuming Farmer A Moves First
Farmer B
40, 40
Large
Farmer A
Large
Small
60, 30
30, 60
Small
Large
Small
50, 50
57
Subgame Perfection


When working with a Game Tree, an
important equilibrium concept is the Subgame
Perfect Nash Equilibrium (SPNE).
A SPNE is said to exist if “each player chooses
an optimal action at each stage in the game
that it might conceivably reach and believes
that all other players will behave in the same
way.” (Besanko)
58
Subgame Perfection Cont.

Subgame Perfection can be found by
using a method called the fold-back
method.

In the fold-back method, you start at the
end of the tree and work your way back to
find the best strategies for each node.
59
Subgame Perfection Example
2
Farmer B
Large
Medium
Small
Farmer A
Large
Large
Medium
Medium
Small
Small
Large
Medium
Small
50, 50
65, 55
100, 60 SPNE
55, 65
90, 90
120, 70
60, 100
70, 120
110, 110
60
Subgame Perfection Example
2



The SPNE is where Farmer A becomes
large and Farmer B becomes small.
This gives a payoff of 100 to Farmer A
and a payoff of 60 to Farmer B.
If this was a simultaneous move game,
what would the outcome had been?
61