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Welcome to
EC 209: Managerial
Economics- Group A
By: Dr. Jacqueline Khorassani
Week Eight
1
Managerial Economics
Week Eight- Class 1
Monday, October 22
11:10-12:00
Fottrell (AM)
2
This week’s Aplia
Assignment
IS DUE BEFORE 5:00 PM Tomoorow
3
I received a question

Just wondering if you could show me
how to determine the marginal
product of capital when given the
production function and a value for
both capital and labour.
4
Sure, example 1



Suppose production function is Q = 5K
+ 10L. What is the marginal product
of capital when 3 units of capital and 5
units of labor are employed?
MPk = dQ/dK (holding labor constant)
MPk = dQ/dK = 5
5
Another example



Suppose production function is Q =
5K2L3. What is the marginal product of
capital when 3 units of capital and 5
units of labor are employed?
MPk = dQ/dK (holding labor constant)
MPk = 5L3K= 5 * (5)3 * (3)= 1875
6
Last time we talked about 4
types of specialized
investments. What are they?
1. Site specificity.
2. Physical-asset specificity.
3. Dedicated assets.
4. Human capital
7
Specialized Investments
lead to higher transaction
costs
1.
Costly bargaining
 How much should you charge for
the pasta that is unique?
2.
Underinvestment
 I don’t want to learn how operate
a machine that only one pasta
factory uses (Underinvestment in
human capital)
8
Specialized Investments
lead to higher transaction
costs
3. Opportunism and the hold-up problem
– The market price of this special pasta is
€20/pound.
– The restaurant spends €100 to test the pasta of
your factory.
– Once you know that your pasta has met their
standard, you will ask for a price of €21/pound
for the 50 pounds of pasta.
– The manager of the restaurant may take this
deal because the alternative is to spend another
€100 to test some other factory’s pasta
– Sunk cost becomes relevant.
9
Specialized Investments
and Contract Length MB is the
1
MB0
is the
marginal benefit
of a nonspecialized labor
to pasta factory
MC is
marginal cost
of labor to
pasta factory
€
MC
marginal benefit
of a specialized
labor to pasta
factory
MB1
Due to greater need for
specialized investments
As the need for
specialized
investment increases,
it is more beneficial to
sign longer term
contracts
MB0
Longer Contract
0
3yr
5yr
Contract
Length
10
Optimal Input
Procurement
No
Substantial
specialized
investments
relative to
contracting costs?
Yes
No
Contract
Spot Exchange
Complex contracting
environment relative to
costs of integration?
Yes
Vertical
Integration
11
Oliver Williamson’s
Analysis


Williamson identified and explored
the impact of various factors on
transaction costs and the boundaries
of the firm.
Transaction cost economics views
firms and markets as alternative
governance structures designed to
manage transactions.
12
Oliver Williamson’s
Analysis
1.
Market transactions will be avoided when the
potential for opportunistic behaviour is greatest.

2.
Markets rely on formal contracts but formal
contracts are typically incomplete

3.
If the pasta factory would want to charge much higher
price The restaurant should get its own pasta
machine
What if the pasta machine breaks down?
Firms may rely on relational contracts
(informal agreements not adjudicated by courts –
social capital)

Somehow we will deal with it later
13
The Principal-Agent
Problem

Occurs when the principal cannot observe the
effort of the agent.
– Example: Shareholders (principal)
cannot observe the effort of the
manager (agent).
– Example: Manager (principal) cannot
observe the effort of workers (agents).
14
The Principal-Agent
Problem

Problem
– Principal cannot determine whether a bad
outcome was the result of the agent’s low effort
or due to bad luck.


Managers must recognize the existence of
the principal-agent problem and devise
plans to align the interests of workers with
that of the firm.
Shareholders must create plans to align the
interest of the manager with those of the
shareholders.
15
Solving the Problem
Between Owners and
Managers
1.
Internal incentives
– Stock options, year-end bonuses.
2.
External incentives
– Personal reputation.
– Potential for takeover.
16
Managerial EconomicsGroup A

Week Eight - Class 2
– Tuesday, October 16
– Cairnes
– 15:10-16:00

Aplia assignment is due before 5PM
today
17
Last time we talked about


The Principal-Agent Problem
Let’s see it graphically
18
Indifference Curve Approach
to Managerial Incentives
(Appendix of Chapter 6)



The indifference curve shows
different combinations of
income and leisure on the job
that satisfy the manager the
same.
Suppose manager’s salary is
€50,000 and it is fixed
Will he shirk 5 hours or 8
hours a day?
– 8 hours a day, if he shirks 5
hours a day he will be on a
lower indifference curve
income
II
I
C
€50,000
5
A
8
Shirking (leisure
on the job) 19

Profit sharing scheme
Now Suppose the owner
offers the manager a fixed
salary of €50,000 plus a
bonus of 1% of profits.
– Suppose
1. If manager does not shirk,
profits will be €3,000,000
–
income
€ 80,000
B
€72,500
III
II
Manager’s
opp set
manager can earn up to
€80,000
2. Every hour that he does not
shirk, he can earn €3750 extra
6
– Shirking declined by ________
hours
A
€50,000
2
8
Slope =
3750
Shirking (leisure
on the job) 20
Solving the Problem
Between Managers and
Workers
1.
2.
3.
Profit sharing
Revenue sharing
Piece rates
 Wage rate is not per hour it is per unit
of production
4.
Time clocks and spot checks
21
Managerial incentive schemes
(Jensen’s paper on balckboard)

Ok then to increase manager’s productivity
we must
– tie the compensation of the top managers of a
firm to the share price of the firm thereby
aligning the interests of the top managers with
those of the equity holders.
– Stock options are used because the market price
of shares accurately captures how the firm is
doing. Market prices are set by rational investors
interested in predicting the future value of the
firm.
22
But the idea that the market
price of equity reflects the true
value of the firm is flawed



The market price of a firm’s equity reflects
the information that equity markets possess.
Equity is overvalued when the a firm’s
share price is higher than its underlying
value. A firm’s share price should reflect the
present value of future earnings.
Top managers can manipulate financial
statements and, for a while at least, share
prices.
23
How?


Various ways in which earnings can be
managed. For example, revenues that are
expected to accrue in future years could be
counted in the current year.
Problem is that once this starts it is hard to
stop.
– One reason is that so much weight is put on
meeting market expectations. Negative earnings
surprises typically lead to falls in share prices. A
manager who manipulates data to meet or
exceed market expectations in one year will have
to continue to lie in future years if s/he wants to 24
avoid disappointing market expectations.
Jensen estimates


that Enron was actually worth $30bn when it was
valued $70bn.
The efforts of managers to defend the $40bn of
excess valuation effectively destroyed the $30bn
core value.
– One of the ways this was done was through acquisitions of
other companies for more than these companies were in
fact worth.

Management makes acquisitions to con the market
into believing that the company is growing in true
value.
– Between 1997 and 2001, Nortel acquired 19 companies for
more than $33bn. When Nortel’s share price fell by 95%,
Nortel closed down many of these acquisitions.
25
Chapter 7 of Baye

Market structure: A set of variables that affect managerial conducts
1.
2.
3.
4.
5.

Conduct: Behavior that affects performance
1.
2.
3.
4.

Number and size of firms.
Industry concentration.
Technological and cost conditions.
Demand conditions.
Ease of entry and exit.
Pricing.
Advertising.
R&D.
Merger activity.
Performance: Result
1. Profitability.
2. Social welfare.
26
Approaches to Studying
Industry
• The Structure-Conduct-Performance (SCP) Paradigm:
Causal View
Market
Structure

Conduct
Performance
The Feedback Critique
– No one-way causal link.
– Conduct can affect market
structure.
– Market performance can affect
conduct as well as market
structure.
27
Managerial EconomicsGroup A

Week Eight- Class 3
– Thursday, October 25
– 15:10-16:00
– Tyndall


Next Aplia Assignment is due before 5
PM on Wednesday, October 31
No Class on Monday, October 29
28
Industry Concentration

Four-Firm Concentration Ratio
– The sum of the market shares of the top four firms in
the defined industry.
Si
C4  w1  w2  w3  w4 , where w1 
ST
The Four Firm concentration ratio can
take a value between 0 to 1
The closer C4 to 1, the _______
closer
industry is to a monopoly
Si denotes
sales for firm
i and ST
denotes total
industry sales
29
Example 1

There are five banks competing in a local
market. Their market shares are 50%,
20%, 10%. 10% and 10%. What is the
four-firm concentration ratio?
C4  0.5  0.2  0.1  0.1  09
90 percent of total output is
produced by the top 4 firms in the
industry.
30
Example 2

There are five banks competing in a local
market. Their market shares are 30%,
30%, 20%. 10% and 10%. What is the
four-firm concentration ratio?
C4  0.3  0.3  0.2  0.1  0.9
90 percent of total output is
produced by the top 4 firms in the
industry.
31
Is Concentration the
same in both cases?


No, it is higher in case 1
C4 does not catch this
32
Herfindahl-Hirschman Index
(HHI)

The sum of the squared market shares of all
firms in a given industry, multiplied by
10,000:
–
–
–
–

HHI = 10,000  S wi2, where wi = Si/ST.
HHI can take a value between 0 to 10,0000
HHI  zero competitive market
HHI 10,000  monopoly
HHI is preferred to C4 because it gives more
weight to firms with higher market share
33
Example 1

There are five banks competing in a local
market. Their market shares are 50%, 20%,
10%. 10% and 10%. What is HHI?


HHI  10,000 .5  .2  .1  .1  .1  3,200
2
2
2
2
2
34
Example 2

There are five banks competing in a local
market. Their market shares are 30%, 30%,
20%. 10% and 10%. What is the four-firm
concentration ratio?


HHI  10,000 0.3  (0.3) 2  0.2  0.1  0.1  2,400
2
2
2
2
Note: HHI is this case lower than
Example 1
35
Limitation of Concentration
Measures




Market Definition: National, regional, or local?
Excludes foreign producers
Industry definition and product classes.
Recent study on Concentration in Irish Industry
by Patrick McCloughan in the Economic and
Social Review (www.esr.ie)
– Data limitations: He could only estimate 5 firm
concentration ratios for net output for broad
industrial categories.
36
Concentration in Irish Industry
Industry
5 firm
concentration
ratio
% net output
% gross output
by foreign firms exported
Leather
products
.68
0
89
Pharmaceuticals
.44
98
98
Dairy products
.35
0
56
Paper products
.34
49
47
Meat
products
.20
0
49
Office machinery
& computers
.63
95
93
37
Concentration in Irish
Industry: Conclusions from
recent study




Aggregate concentration is high in Ireland.
The 100 largest manufacturing firms
account for over half of all manufacturing
industry.
Data suggests that the very largest
industrial enterprises tend to operate large
single plants rather than multi-plant
operations.
Substantial variation in concentration across
industries.
Typically it is the largest and second largest
firms in an industry that determine industrial
concentration.
38
Concentration in Irish
Industry: Conclusions from
recent study



No link between the level of
concentration and the extent of
foreign ownership or export activity in
Irish industry.
No overall trend in concentration
between 1991 and 2001.
International comparisons suggest
that Irish industry is comparably
concentrated.
39
Measuring Demand and Market
Conditions

The Rothschild Index (R) measures the
elasticity of industry demand for a product
relative to that of an individual firm:
R = ET / EF .
– ET = elasticity of demand for the total market.
– EF = elasticity of demand for the product of an individual
firm.


If there is only one firm in the market ET = EF R
=1
As the number of firms in the industry goes up EF
goes up  R0 .
40
Market Entry and Exit
Conditions

Barriers to entry
1.
2.
3.
4.
Capital requirements.
Patents and copyrights.
Economies of scale.
Economies of scope.
41
Conduct: Pricing Behavior

The Lerner Index
L = (P - MC) / P
– A measure of the difference between price
and marginal cost as a fraction of the
product’s price.
– The index ranges from 0 to 1.


When P = MC, the Lerner Index is zero; the firm
has no market power.
A Lerner Index closer to 1 indicates relatively weak
price competition; the firm has market power.
42
Markup Factor

From the Lerner Index, the firm can determine
the factor by which it should cover MC.
Rearranging the Lerner Index
 1 
P
 MC
1 L 

The markup factor is 1/(1-L).
– When the Lerner Index is zero (L = 0), the markup factor is 1
and P = MC.
– When the Lerner Index is 0.20 (L = 0.20), the markup factor is
1.25 and the firm charges a price that is 1.25 times marginal
cost.
43
Integration and Merger
Activity

Vertical Integration
– The Italian Restaurant buys the Pasta
factory.

Horizontal Integration
– The Italian Restaurant buys another
restaurant.

Conglomerate Mergers
– The Italian Restaurant buys a child care
facility.
44
Horizontal Merger Guidelines (The
Competition Authority, Ireland)




See Notice in Respect of Guidelines for Merger
Analysis from The Competition Authority
Use both an SLC (Substantial lessening of
competition) test and a HHI test.
SLC test is interpreted in terms of consumer
welfare. This in turn is based on whether the price
is expected to rise.
Mergers are analysed by looking at
–
–
–
–
Relevant geographic or product markets
Effect on market structure
Effect on rivalry in the industry
Effect on potential entrants
45
Horizontal Merger Guidelines (The
Competition Authority, Ireland)




Use of HHI
Both the level and change of HHI are
examined
HHI above 1800 are likely to raise
competitive concerns.
HHI between 1000 and 1800 that
involves a change in the HHI of more
than 100 may raise competitive
concerns.
46
Performance


Performance refers to the profits and
social welfare that result in a given
industry.
Social Welfare = CS + PS
– Dansby-Willig Performance Index measure
by how much social welfare would improve
if firms in an industry expanded output in a
socially efficient manner.
47