Economics 600 Handout 1 Professor Tom K.

Lee

Section I: Basic economics

Part 1: Introduction
(Introduction)
Three implications of Economic Darwinism
-successful firms in an industry are not random but due to hardworking & planning (Apple).
-firms’ success is not absolute but relative to competitors & business environment (GM).
-to remain successful a firm must adapt to new technology (Kodak photographic imaging),
competition (Pepsi vs Coke), or regulation (United Airline).
Benchmarking is identifying the best firm in an industry or the best business unit in a
firm & imitating it, e.g. Wal-Mart & Target.
Maslow’s hierarchy of needs (Theory Z: situation guides, reason motivates & social belonging
adheres people):
1) Basic survival needs (physiological, e.g. food, clothing & transportation)
2) Safety needs (e.g. housing, banking, security & protection)
3) Social needs (sense of belonging & love, e.g. clubs, restaurants & churches)
4) Esteem needs (self-esteem, recognition & status, e.g. Lexus, diamonds, designer goods)
5) Self-actualization needs (self-development & realization, e.g. meditation, peace corp.)

Part 2: Basic economic principles

(CHs 1, 2, 9, 13, 14)
Basic economic principles
-people are non-satiated (in quality, performance & features), self interest and smart.
-resources (raw material, financial capital & management time) are limited.
- demand, supply, social surplus & value creation
-prices economize on the cost of transferring information to coordinate decisions.
-people do tradeoff, e.g. monetary and non-monetary rewards are both important.
-people react to incentive & do cost-benefit analysis.
-own- (cross-) price demand (supply) elasticity, the definition of a market, mark-up pricing
& percentage-of-sales method to set advertising budget
-marginal analysis: MR=MC, MR=P[1+1/e] & inverse demand elasticity rule
-opportunity cost (comparative advantage) is the best feasible alternative foregone.
-fixed cost: economy of scale & economy of scope (horizontal & conglomerate boundary)
-information is costly, imperfect & asymmetric leading to adverse selection and moral hazard.
-rational expectation, risk averse & diversify; but don’t diversify for the sake of diversification
-time value of money, the Fisherian theory of interest rate & life cycle theory of consumption
-voting with your feet: Tiebout location equilibrium for consumers and producers
-Free Rider Problem
-rent-seeking behavior
-network effect
-learning curve effect and cumulative output
-Coase Theorem, property rights and Common Pool Problem
-Transaction costs dictate business practices, strategies, communications & signaling.
-three elements of decision theory (objective, optimal information & control variables)
 Economics 600 Handout 2 Professor Tom K. Lee

-five elements of game theory {# of players, preferences of players, information sets of players
(SWOT/PEST analyses), strategy sets of players & equilibrium concept}; Prisoners’ Dilemma
Game, Battle-of-the-Sexes Game, subgame perfectness & first (second) mover advantage
-fairness: efficiency versus equity

Part 3: What is a firm, why it exists and why firms cluster?

(CHs 5, 6)
Economic transactions involve transaction costs, including search, information, bargaining,
decision, monitoring & enforcement costs. The optimal method of organizing an economic
transaction is the one that minimizes transaction costs.
A firm is a focal point of a set of implicit and explicit contracts.
A contract is an agreement to facilitate deferred exchange & define the conditions of exchange.
Implicit contracts are not enforceable in a court of law but explicit (legal) contracts are.
Costs of contracts -legal costs for writing, interpreting, monitoring & enforcing contracts
-information cost and contingencies
-uncertainty and incomplete contracts
-contract negotiation & renegotiation
Pre-contracting informational asymmetries can cause bargaining failure (e.g. strikes) and
adverse selection.
Adverse selection is the tendency of an individual with superior information over a
potential trading partner to extend an offer that would be detrimental to that trading
partner.
Solutions to adverse selection
-reduce or remove information asymmetry
-introduce deductibles and co-payments
-introduce variety of contracts to sort out trading partners with different private
information.
-allow trading partners to signal their private information.
Post contract problems –agency (moral hazard) problems (one solution is bonding)
-information cost, e.g. monitoring cost
-enforcement cost
-legal cost of recourse
If contract costs are too high, backward & forward vertical integration is a solution.
Firms exist -to minimize transaction costs and to achieve information specialization e.g. Dell
-to enjoy economies of scale (e.g. GM) & scope (e.g. GE & McDonald)
-to diversify risk (e.g. conglomerates & multinationals)
-to solve coordination problem of specific assets (e.g. Alcoa)
-to pose bond to trading partners through reputation (e.g. Goldman Sachs)
Specific assets are assets that are worth more in their joint operation than alternative operation.
Firms cluster -to share intermediate inputs e.g. dressmakers cluster around button-makers
-to share labor pool e.g. Silicon Valley
-to better job-worker matching e.g. financial service industry on Wall Street
-start-up firms cluster around research universities for knowledge spillovers
e.g. analytical instrument firms in Boston
Economics 600 Handout 3 Professor Tom K. Lee

-for economies of scale in local public goods (education, sports & utilities) &
social opportunities e.g. Scottsdale, Arizona
-to reduce transportation cost e.g. bauxite mine & smelting plant
-to form network organization to enjoy (avoid) (dis-) economies of scale & scope
e.g. hospitality & tourism in Las Vegas & shopping malls
Spectrum of market structure: perfect & monopolistic competition, oligopoly, monopoly & HHI

Section II: Organizational theory of the firm

Part 4: Micro-Microeconomic Theory of the Firm

(CH 3)
Facts of a firm
-There are many decision makers within a firm.
-The primary objective of most decision makers is not to maximize the value of a firm.
-Firms often use internal pricing and market to allocate internal resources.
Separation of ownership and management
Principal Agent Problem involves a principal who wants an agent to exert effort to
benefit the principal, and how the principal design an incentive and risk sharing
compensation to induce the agent to exert an optimal level of effort.
Seven sources of conflict between shareholders and managers
-Efforts are costly to managers (Theory X) but increase the value of a firm.
-Once compensation package is given to managers, they try to increase perquisites
which are costly to a firm but tax-free to the managers.
-Managers typically have substantial human and financial capital invested in the firm
that they might be excessively risk averse.
-Managers might involve with self-dealing to enrich themselves at the expense of the general
shareholders through hidden actions.
-Horizon problem: Managers’ tenure with a firm has a finite horizon & hidden information but
a firm presumably has an infinite horizon.
-Managers bear personal cost of decision-making but not the firm leading to oversizing.
-Members of a firm are grouped to form teams leading to free rider problem.
Shareholders might enrich themselves at the expense of bondholders & vice versa.
Large shareholders might enrich themselves at the expense of small shareholders.

Part 5: Organization architecture: solution to principal agent problem

Organizational architecture is an important set of constraints and incentives to

limit or resolve incentive conflicts and a risk sharing plan.
The primary goal of an economic organization is to produce & sell to customers what
they want at the lowest cost of production & to extract the consumers’ value as profit.
Three important aspects of organizational architecture of a firm
-the assignment of decision rights within the firm (administrative decisions versus
transfer prices) & an information system to transfer the right info to the right person.
-the design of reward system of members of the firm for incentive & risk sharing
Economics 600 Handout 4 Professor Tom K. Lee

-the design of performance monitor/evaluation system of members/business units of the firm

The challenge is how to get the relevant information from so many different members of
the firm to the right person to make the right decisions and to provide the incentive for
the right person to use the information productively.
Organizational change should be undertaken only if expected marginal benefit exceeds
expected marginal cost.
Three costs of changing organizational architecture
-direct costs of informing the members of the firm of the change
-indirect costs of redistributing wealth within the firm thus generating proponents and
opponents within the firm for the change
-frequent changes can backfire by shortening decision horizon of members of the firm
leading to less incentive to acquire specific human capital, to devise more efficient
production process, and to develop effective relations with coworkers.
Corporate culture is the passing of practices from one generation of owner &
employees to those in the next generation such as the way job are assigned, decision
rights are assigned, the way members of the firm are rewarded and controlled, and
organizational features such as customs, taboos, company slogans, heroes, public
recognition and social rituals. It is important to plan for succession of firm members.

Business environment: technology, markets & regulation

Business strategy -----------> Value of the firm

Organizational architecture: decision (info & structure), incentive & control

Part 6: assigning decision rights & decision making process

Decisions are made at the top management level –if firms are small,
-if market shares of firms are stable.
Decisions are decentralized –if firms are large,
-if market shares of firms experience rapid changes
in business environment, new product and/or market
expansion and introduction of new product varieties.
Benefits of decision decentralization
-effective use of local knowledge (McDonald’ filet-o-fish & Walmart China live fish)
-conserve top management time & reduce middle management for less info processing
-attract talents to junior management positions in business units to prune for future
senior management positions in corporate headquarters (GM’s Daewoo Motors)
-successful use of local knowledge in one business unit might be transfer to other
business units leading to new process and/or new products (Wendy’s salad)
-reduce rent-seeking costs within the firm
Costs of decision decentralization
-incentive conflicts increase as decision rights are delegated to lower level of the firm (GM)
-coordination costs and failure, e.g. airline hub-and-spoke organization
Economics 600 Handout 5 Professor Tom K. Lee

-less effective use of central information (solution: rapid response team)

Lowering information cost eliminates middle management for controlling information
flow.
New roles of middle management include identifying and assembling a team, helping
subordinates to design winning strategies, and providing motivation to members of the
firm.
Firms grant decision rights to teams for four reasons
-to manage a project (space program)
-to design and make a new product (state-of-the-art jet fighter)
-to study a problem and to recommend actions (Social Security Commission)
-to transfer wealth among team members
Benefits of team decision-making
-improve use of disperse specific knowledge
-broaden the support base among employees for changes
Costs of team decision-making
-costs of arriving a consensus or a rational decision (Arrow’s Impossibility Theorem)
-free rider problem increases with team size.
Optimal team size is between two to twenty five, preferably in odd number of team members.
Two determinants of team size -purpose of the team
-complexity of the problem
Collective decision-making(decision-making cost vs external cost); cyclical preference, voting
rules, agenda manipulation, power of a committee chair; and power of the purse.
Four steps of decision-making process
-initiation: proposal of decision initiatives
-ratification: choice of alternative decision initiatives
-implementation: execution of ratified decision initiative
-monitoring: measure performance of executed decision and allocate rewards
Decision management refers to initiation and implementation and is executed at a lower
level of the firm.
Decision control refers to ratification and monitoring and is executed at a higher level of
the firm.
Whenever there is principal-agent relationship, separating decision management and
decision control limits conflict of interest, e.g. 150-year old Barings Bank in London failed.
In large corporations, decision management are done by managers while decision control
is done by the board of directors, who in turn is monitored by large shareholders and
takeover specialists. In some cases an empowered employee might have explicit rights
to initiate & implement decisions, but managers will ratify and monitor the decisions.

Part 7: Structural forms of organization

(CH 17)
Four structural forms of organization
-Unitary form (U form) is to group jobs by functional specialty, e.g. CSUN Business College.
-Multidivisional form (M form) is to group jobs into a collection of business units
based on product or geographic area, e.g. CSUN campus & CSU system.
Economics 600 Handout 6 Professor Tom K. Lee

-Matrix organization has employees from different functional departments assigned to

product or geographical area teams on temporarily basis, e.g. defense, construction and
management consulting. Employees report to both a functional manager and a business
unit manager. In-fights & rent seeking among functional groups are more intense.
-Network organization has an affiliation of independent subsidiaries that together
enjoy economies of scale & scope but separately avoid diseconomies of scale &
scope, e.g. Disneyland theme park, hotels, restaurants and transportation from LAX.
Benefits of U form organization
-it promotes functional expertise
-it incurs lower costs to recruit, retain and evaluate functional members.
-there are lower costs of communicating and share results among members of the same
functional specialty.
-there is well defined promotion path for employees.
Costs of U form organization
-higher senior management costs of coordinating functions
-higher communicating costs across functional departments
-too much functional expertise and not overall customer satisfaction
-in-fights among functional groups
U form organization works best in small firms with homogeneous products and markets,
and more stable technological environment.
Benefits of M form organization
-in a dynamic environment, it is best to have decentralized decision making.
-it frees up managerial time for higher level decision making.
-it encourages system (supply chain) thinking in a business unit.
-in a dynamic environment, different business units can experiment alternative
organizational architectural or product changes.
Costs of M form organization
-if there are interdependence of business units, there may be decision conflicts across
business units to the extent lowering overall value of the firm.
-business unit managers need cross functional training
Large multinational corporations tend to organize their international divisions around the
matrix concept, but to organize their domestic divisions around U form or M form.
Corporations are moving towards product-oriented organizations with caseworkers with
broad decision authority and multiple task assignment and away from functional
subunits.

Part 8: Attracting and retaining qualified employees

In a perfectly competitive labor market, a competitive firm will hire workers until wage
equals to their value marginal product of labor, and a monopolistic firm will hire
workers until wage equals to their marginal revenue product of labor.
Marginal product is incremental output due to the last unit of an input.
Value marginal product is competitive price of a product time marginal product.
Marginal revenue product is marginal revenue of a product time marginal product.
Economics 600 Handout 7 Professor Tom K. Lee

General human capital is training and education that are of general value to many firms.
Specific human capital is training and education that are of value to a particular firm.
In general employees pay for general human capital, & firms pay for specific human capital.
General knowledge is free to transfer, while specific knowledge is expensive to transfer,
e.g. idiosyncratic knowledge of particular circumstances, scientific knowledge and
knowledge from learning-by-doing.
Firms are constantly taking ideas & specific knowledge of their employees that are their
“wetware” (ideas) & converting them into general knowledge that is “software”
(instructions and formula) that can be employed to produce products & services.
Jobs differ according to skill and education training, quality of work environment,
geographical location, length of commute, risk of injury and death, characteristics of
coworkers, and degree of monotony associated with the tasks.
Compensation wage differential is the extra wage that is paid to attract a worker to a
less desirable job. This is how unpleasant jobs got filled. It also shows that it pays for a
firm to invest to improve non-wage attractiveness of a job.
Why different industries have different period of probation for new hires?
Why some industries offer life time employment and others don’t?
Job satisfaction at a firm is indicated by -number of new qualified applicants
-the quit rate of existing employees
Firms have to tradeoff between incremental compensation and turnover costs of workers.
Sometimes employees leaving a firm take customers and knowledge to competing firm,
e.g. high tech firms in Silicon Valley.
Matching all outside offers generates incentive for employees to take time and effort to
generate outside offers, but discretionary matching generates rent-seeking.
An internal labor market exists in a firm when outside hiring focuses primarily on
filling entry-level jobs and most other jobs in the firm are filled from within the firm.
Firms can have multiple internal labor markets, e.g. white-collar & blue-collar workers.
Firms are more likely to use internal labor markets where specific training of & trust among
employees are important, e.g. steel, petroleum, chemical industries, firemen & police force.
Benefits of an internal labor market
-increase incentive to invest in specific human capital
-better align employees’ interest with interest of owners of the firm
-over time more information of employees’ skill, capability, attitude, intelligence are
revealed to employers.
-reduce turnover costs
-establish career paths and the prospect of promotions for employees
-provide job stability to employees through long-term relationships
Costs of an internal labor market
-may not get the best person for the job
-pay, job assignment and promotions are determined by administrative decisions
- increase rent-seeking cost in influencing decisions
Efficiency wage is a wage premium above market rate for two reasons: to reduce
incentive to shirk by employees and to reduce turnover costs, e.g. Henry Ford.
Firms are typically partitioned into hierarchical levels, with a higher pay limit at each
Economics 600 Handout 8 Professor Tom K. Lee

higher level in the job hierarchy. Promotion is the only way to move up the job
hierarchy. Promotions can be viewed as contests or tournaments among employees
who exert extra efforts if they perceive close chances of promotion.
Costs of contest and tournament
-undermine workers cooperation
-less flexible compared to bonus pay, pay raise or profit sharing
-Peter Principle: employees keep getting promotion until they reach a job that they
cannot handle.
-employees value more than just promotion and higher pay, e.g. job security
-intensify rent-seeking costs
-if workers don’t perceive a chance of winning, they maximize shirking.
Job seniority and pay are usually positively correlated because of learning-by-doing.
Wage Compression is the situation when new hires are paid more than experienced
workers. One explanation is that new hires bring in new ideas that are potentially
valuable, while on-going workers on routine tasks gain minimal value from experience.
Back-loaded compensation is when compensation increases faster than productivity as
an employee ages, for example, professional services such as law & accounting firms.
Workers choose back-loaded compensation jobs as bonding and signaling.
Firms offer back-loaded compensation if productivity of workers increases rapidly over
time but with uncertainty.
Firms frequently offer attractive retirement packages to encourage older employees to
retire and often have mandatory retirement age.
A typical American worker receives 75% of total compensation in the form of pay for
work and 25 % in fringe benefits. The most important fringe benefits are medical
insurance and pension plans.
Different workers have different preferences in the tradeoff of pay versus fringe benefits.
In designing compensation package, management should consider the total tax bill for the
employee and the firm.
Fringe benefits such as sick leave and disability insurance can be costly to the firm
beyond direct cost of insurance premium, e.g. absenteeism.

Part 9: Incentive compensation

(CH 16)
Examples of incentive compensation -piece rate and commission
-bonuses or promotion for good performance
-prizes for winning contests, e.g. a free vacation
-stock option and profit sharing plans
-demotion and firing upon poor performance
Incentive conflicts are not a problem when efforts of employees are observable and
verifiable, i.e. efforts are contractible.
In some cases, incentive conflicts can be resolved even when efforts are not observable.
-one way is profit sharing with employees so that both benefits and costs are
internalized by employees and thus employees will choose the optimal efforts.
Economics 600 Handout 9 Professor Tom K. Lee

Three important factors that limit the use of ownership to resolve incentive problems
-employees have limited wealth to buy a significant share of the company
-uncontrollable random events and employee risk aversion towards ownership
-team production and free rider problem
From risk sharing standpoint it is better to pay employees fixed salaries and let the total
risk of random income flows be borne by the shareholders.
From incentive standpoint it is better to tie pay to performance, e.g. stock option.
An optimal compensation contract must strike a balance between these two standpoints.
By offering a menu of incentive compensation contract for employees to choose from can
induce employees to reveal private information.
Group incentive plans are incentive pay to an employee based on group performance,
such as overall profitability of a firm as reflected by stock prices.
Benefits of group incentive plans
-group performance measure is less costly than individual performance measure
-encourage cooperation and teamwork
-motivate mutual monitoring and enforcement among employees
A problem with group incentive plans is the free rider problem.

Part 10: Performance Evaluation

(CH 16)
Employee performance is evaluated
-to provide employees with feedback on job achievement to improve performance
-to determine rewards & sanctions
Informativeness Principle states that improvement in the precision of measuring
employees’ effort by incorporating more information of employees’ effort reduces the
cost of inefficient risk sharing and leads to a more efficient effort choice by employees.
The informativeness principle implies that information about other employees’ effort
and/or output should be included in an incentive compensation contract, i.e. a relative
performance evaluation, which makes sense if common random factors affect the
performance of different employees. It also implies that there is a tradeoff between the costs of
developing and implementing better performance measures, and the benefits of
improving effort motivation and more effective risk sharing.
Shortcomings of relative performance evaluation
-collusion to under-perform
-electing a poor performer as the standard
-sabotage coworkers’ work performance
-admit low quality new hires
When objective performance leads employees to exert effort on measurable performance
attributes and de-emphasize on non-measurable performance attributes, subjective performance
evaluation is supplemented to yield a comprehensive performance evaluation.
Two subjective performance evaluation methods
-standard rating scale system rank employee on a number of different performance
factors using a five point scale to size up the shortcomings of an employee,
Economics 600 Handout 10 Professor Tom K. Lee

-goal based system requires employees to set goals for the year and the supervisor
evaluates the extent to which each goal has been met at the end of the year, after which
the employees have a chance to respond.
Specific, measurable, agreed-upon, realistic, and time-bound (SMART) goals
Problems of subjective performance evaluation
-shirking among evaluators leading to ratings compression, Los Angeles County court.
-rent-seeking to influence decision
Ratchet effect refers to basing next year’s target performance on this year’s actual
performance leading to a perverse incentive for employees not to exceed this year’s
target performance to avoid raising next year’s target performance, e.g. communist China.
Methods to reduce the ratchet effect
-set next year’s target based on this year’s peer actual performance
-introduce more frequent job rotation at the cost of losing learning curve effect
-make a commitment not to change next year’s target
Opportunism is the non- or counter-productive activities to seek private gain at the expense of
the greater good leading to gaming & horizon problem.
Gaming occurs when employees are rewarded according to some measured output & yet
measured output is not perfectly correlated with firm value leading employees to engage in
dysfunctional activities to improve their performance evaluations, e.g. Lincoln Electric.
Horizon problem: short-run, objective performance measures can cause employees
(especially those about to change jobs or retire) to concentrate their efforts on
producing results to reap short term benefits at the expense of sacrificing long term
profit of the firm, e.g. Pfizer.
Federal & state legislation requires employers to document their compensation and
promotion decisions to demonstrate their actions are related to performance and are not
related to race, sex, age, physical handicap, religion and national origin.

Part 11: Pricing

(CHs 10, 8, 11)
Cost center for example: manufacturing units.
Optimality condition for output-constrained cost minimization:
Incremental cost due to the last unit of output through the usage of any input should be
the same across all inputs.
Expense Center for example: personnel, accounting, marketing & research centers.
Revenue Center, for example: retail and wholesale units.
Optimality condition for cost-constrained revenue maximization given product price:
Incremental revenue due to the last dollar spent on each promotion activity should be
the same across all promotion activities.
Profit center e.g. Cadillac division of GM. Profit center consists of revenue, cost & expense
centers.
Profit maximization requires marginal revenue equals marginal cost. For the special case
of a competitive firm, price is equal to marginal revenue. For firms with market power,
price is greater than marginal revenue.
Investment center consists of several profit centers, e.g. GM & its many divisions.
Economics 600 Handout 11 Professor Tom K. Lee

When it comes to investment center with several profit centers competing for investment
funds, a portfolio approach might prove to be useful. One should diversify into a
portfolio of profit centers to maximize expected investment returns subject to a level of
risk tolerance. Diversification reduces the importance of variance risk and increase the
prominence of covariance risk.
There are four general pricing approaches:
1) Mark-up pricing is to have a fixed mark-up on the cost of the product to set the
price, e.g. retail stores.
2) Value-based pricing ( demand –based pricing) is setting price based on buyers’
perceptions of value independent of cost, e.g. Louis Voitton & Rolex for signaling.
3) Value pricing is offering the right combination of quality & good service at a fair price,
e.g. value meal menu.
4) Competition-based pricing is to set price following that of the industry leader, e.g.
breakfast cereal pricing according to Kellogg prices.
There are four product-quality pricing strategies:
1) Market-skimming pricing sets a high price to a low quality product to reap maximum
revenues step by step from the market segments, e.g. new high tech products.
2) Market penetration pricing sets a low price for a high quality product to attract a large
number of customers & a large market share to enjoy network effect, e.g. Microsoft.
3) Economy pricing is to set a low price for a low quality product to maximize sale volumne,
e.g. 99cents Store.
4) Premiun pricing (prestige pricing) is to set high price to a high quality product, e.g. Cunard
cruises. Godilocks pricing is to provide a “gold-plated” version of a product in order to
make the next lower priced option look more reasonably priced, e.g. comic books and sport
collectible cards.
There are five product-mix pricing strategies:
1) Product line pricing is to set price steps between various products in a product line based
on cost differences between products, customer evaluations of different features, and
competitors’ prices, e.g. Sony TVs.
2) Optional product pricing is pricing optional or accessory products along with a main
product, e.g. Toyota cars.
3) Captive-product pricing is to set a price for products that must be used with a main
product, e.g. blades for razor & video games for Sony PS3.
4) By-product pricing is to set a price for by-products in order to make the main product
price more competitive, e.g. cocoa bean shells from chocolate candy making are sold as
mulch for gardening.
5) Product bundle pricing is to set a price of a group of products and/or services that is less
than the sum of the individual product/service prices, e.g. two-movie package, value meal
in fast food restaurant & season tickets.
Market (monopoly) power is the ability of a seller (buyer) to set the market price.
Five sources of market power -essential inputs (strategic assets)
-economies of scale and scope & learning curve effect
-product differentiation: quality, warranty, brand name (marketing advantage)
-government regulation
Economics 600 Handout 12 Professor Tom K. Lee

-entry barrier (limit pricing vs predatory pricing, raising rival’s cost & excess capacity)
Third degree price discrimination is the situation where a firm can sell to different
consumers (possibly in different markets) at different prices. Profit maximization
requires marginal revenue in each market equals to marginal cost. This leads to the
inverse demand elasticity rule, for example, movie ticket prices, dry cleaners, best price
policy, coupons, and senior citizen, student and group discount.
Inverse demand elasticity rule requires a firm to sell a product to consumers with
higher own-price demand elasticity at a lower price and to consumers with lower
own-price demand elasticity at a higher price.
There are three examples where firms with market power can lead to efficient outcome by
extracting all consumer surpluses to become monopoly profits:
-first degree price discriminating monopolist: every unit at a different price
-two-part tariff monopolist: membership fee plus price per unit
-all-or-nothing contract monopolist: fixed quantity plus price per unit
Second degree price discrimination is selling different blocks of units to the same
consumer at different prices.
Fourth degree price discrimination is selling to different consumers at the same price
but the cost of providing the product to different consumers are different.
Peak-load pricing is selling to a customer at different prices at different times for the same
quality product.
There are five forms of pricing:
1) Discount pricing is a straight reduction in price on purchase in a specified period of time,
e.g. cash discount, coupon rebate, cumulative quantity discount, functional discount
(trade discount, e.g. airfare special for travel agents) & seasonal discount, e.g. cruises.
Allowance pricing is giving promotional money by manufacturers to retailers in return for
an agreement to feature the manufacturer’s products in some way. The effective price is
the price of a seller receives less discounts, promotion & other incentives.
2) Segmented pricing is selling a product or service at two or more prices, where the
difference prices are independent in costs: customer-segment pricing, e.g. textbook &
movie ticket prices, location pricing, e.g. airport fast food prices, and yield management.
Yield management (revenue management) is the process of understanding, anticipating &
reacting to customer behavior in order to maximize profits, e.g. Las Vegas hotel room
rates & airline ticket prices.
3) Psychological pricing is to set price of a product according to the beliefs of customers,
e.g. higher price means higher quality. Reference prices are prices that customers carry in
their minds & compare to when contemplate buying a product.
4) Promotional pricing is temporarily set the price of a product below the list price, and
sometimes even below cost (loss leader), or low-interest financing & extended warranties
to increase short-run sale to clear inventory for a new model or to attract customers, e.g.
GM employee discount and white sale after Christmas.
5) Geographical pricing: FOB(free on board)-origin pricing is pricing a product at the point
of sale and customers have to pay the freight from the point of sale to the destination of
the customers. Uniform-delivered pricing (freight absorption pricing) is to set the same
Economics 600 Handout 13 Professor Tom K. Lee

price including freight to all customers irrespective of distance to destination of

customers. Zone pricing is for the seller to set two or more zones with all customers pay
the same price within a zone, but the more distant the zone, the higher the price. Basing-
point pricing is for a seller to designate a city (where demand is more elastic) as a basing
point and charges all customers the freight cost as if the shipping is from that city, hence
phantom freight charge.
Transfer Pricing is the pricing of an intermediate good sold from one division of a firm
to another division of the firm.
From the managerial point of view, transfer price should be set to the competitive market
price of the intermediate good if a competitive market for the product exists, or to the
marginal cost of producing the intermediate good by the firm so as to clear the internal
market for the intermediate good if a competitive market for the product does not exist.
Foreign exchange rate is the rate of conversion of one national currency for another national
currency, e.g. Yens/USD & USD/Euro.
The Law of One Price
Purchasing Power Parity
Long-run determinants of foreign exchange rates
-domestic vs foreign prices
-tariffs & quotas
-preferences of domestic vs foreign goods & services
-domestic vs foreign productivity growth rates
Covered Interest Rate Parity
Open Interest Rate Parity assumes risk neutrality & rational expectations
Short-run determinants of foreign exchange rates
-domestic vs foreign interest rates
-expected future foreign exchange rate
-gov’t intervention

Part 12: Legal forms of Organization

There are two legal forms of organization: nonprofit and for-profit.

A nonprofit organization prohibits persons who control the organization from receiving
the organization’s residual profits. Residual profits must be used for the arts, education,
or charity. Nonprofit organizations are private and self-governing. They are exempted
from federal, state, and local taxes. They must be financed through debt, internally
generated funds, and donations. Nonprofit organizations cannot pay top managers
equity-based compensation. Board members are typically community leaders and major
donors.
For-profit organizations have owners to receive the residual profits. Advantages of
for-profit organizations are that they can gain access to capital funds from publicly
traded equity markets and use equity based compensation to motivate workers.
Nonprofit and for-profit organizations co-exist in certain sectors of an economy, such as
hospital, nursing homes, and education.
Economics 600 Handout 14 Professor Tom K. Lee

Part 13: Markets for Corporate Control

(CH 7)
Downsizing (reengineering) refers to divesting unrelated businesses to focus on the core
business. Since the early 1990s, downsizing is common business policy. Downsizing
means job cutting especially middle management jobs, partly due to technological
change. However majority of firms that went downsizing enjoyed an initial drop in
accounting cost but in six months to a year accounting cost went up. The explanation is
that work from the dismissed employees are piled up on the remaining employees
causing lower productivity and decline in morale.
Divestiture means selling a segment of a firm to a third party.
Spin-off means distributing on a pro rata basis all the shares a firm owns in a subsidiary
to its shareholders, e.g. Tyco International spin-off to three distinct companies.
Equity carve-out means distributing on a pro rata basis some of the shares a firm owns
in a subsidiary to its shareholders while the rest of the shares are sold to the general
public to raise cash to the parent firm, e.g. Altria equity carve-out Kraft Food.
Split-off means some parent firm shareholders receive the subsidiaries shares in return
for relinquishing their parent firm shares.
Outsourcing is the switching from make to buy parts and services. The most common
outsourcing activities are information system, pension management and facility
management.
Supply chain management ensures that each transaction in the process of producing a
product from raw materials to the final product is efficient. It requires the exchange of
technical and managerial knowledge between upstream and downstream firms. It may
also require coordination to achieve just-in-time inventory control. Since 1990s three
successful cases standout in the application of the concept, for example, Dell, Baxter,
and Proctor and Gamble.
Strategic alliance refers to two or more firms that share common interest in expanding
into new products, services and/or markets to avoid duplication of efforts.
-product/service alliance, e.g. Dell & Intel.
-promotional alliance, e.g. trade shows.
-logistics alliance, e.g. Shanghai Airline teams up with local airlines for cargo shipping to
compete with UPS & FedEx.
-pricing alliances, e.g. CVS & Rite Aid.
Joint ventures are entities created out of the cooperative efforts of a small part of two or
more corporations for a limited time period, for example, joint contract bidding,
research and development, and new market penetration. (GM-Toyota’s NUMMI)
Shares of closely held corporations are held by a few shareholders and are not freely
traded, while shares of publicly traded corporations are held by the general public
and are exchange traded. Reorganization of publicly traded corporations to closely held
corporations typically enjoy positive stock returns upon the announcement. Such
reorganization initiated by the existing management is called management buy-out
(MBO), and if it is financed by debt it is called a leverage buy-out (LBO). Kohlberg,
Kravis, Roberts & Co. is an example of buy-out specialist.
Economics 600 Handout 15 Professor Tom K. Lee

Some corporations have dual-class voting shares, where one class of share has primary
claim to the residual profits and few voting rights, while the other class of share has
smaller claim to the residual profits but retains more of the voting rights, e.g. Google.
Typical limited voting right stock sells at a discount of over five percent relative to its
superior voting right counterpart.
Corporate governance refers to organization structure of a firm to monitor and direct
the performance of the firm.
There are five important internal control mechanisms to limit agency problems in
publicly traded corporations: large shareholders (blockholders), shareholder voting
(proxy contest), board of directors with outsiders, management compensation where
straight salary account for only twenty percent of total compensation , and (internal &
external) auditing.
In a proxy contest, an outside group seeks to obtain representation on the firm’s board of
directors. Proxy contest are usually directed against the existing management.
There are three important external control mechanisms to limit agency problems in
publicly traded corporations: market of corporate control (takeovers of poorly managed
firms), managerial labor market (track record of managers affecting future executive
income and employment), and product market competition (Economic Darwinism).
In a tender offer, an outside group request existing shareholders of a corporation to sell
their shares to the outside group at a pre-set tender price to gain control of the
corporate management.
A bear hug is a tender offer where the outside group first seek approval from the
corporate management and board of directors.
A hostile takeover is a tender offer where the corporate management and board of
directors reject the offer but the outside group continue to proceed with the tender offer
to win corporate control.
A greenmail is a premium repurchase of stocks owned by the takeover party to prevent a
takeover usually with an agreement from the takeover party not to pursue another
takeover of the corporation in the future, e.g. Occidental Petroleum paid greenmail to
David Murdoch $60 million in 1984 and Goodyear Tire and Rubber Company paid Sir James
Goldsmith $93 million in 1986.
A white knight is a third party sought by the corporate management and board of
directors to take over the corporation that is subject to a hostile takeover, e.g. Nissin
paid $314m to buy Myoto Foods after US hedge fund Steel Partners wanted a hostile
takeover.
A poison pill is restructuring by a corporation subject to a hostile takeover to reduce
the attractiveness of the takeover.
Examples of poison pill (anti-takeover defenses):
-an immediate large cash dividend financed by debt,
-a cash refund to customers in the event of a takeover, e.g. Peoplesoft against Oracle,
-golden parachutes: to award large severance pay to existing management if a takeover
is successful and the existing management are terminated, e.g. Robert Nardelli walked
away with $210 million to resign as chairman and CEO of Home Depot in 2007,
Economics 600 Handout 16 Professor Tom K. Lee

-poison put allows bondholders to sell bonds back to the firm at a premium in the event
of a takeover of the firm, e.g. a note issued by Grumman Corporation that mature in
1999,
-poison call allows management to buy back bonds of the firm at a premium in the
event of a takeover of the firm, e.g. a $ 300 million note issued by Mesa. LP in May 1989,
-move the corporate headquarters to a state with strong anti-takeover laws, e.g.
Delaware,
-change corporate governance to require absolute majority to approve a takeover vote
In general, defensive strategies of existing management lead to lower stock returns.
Fifty percent of top management of target firms are gone within three years of takeover.
Organization capital comes from three sources:
-learning by doing: production, management, customer/government relations &
research/innovation.

-learning by matching: workers to job, workers to team

-learning by cooperating: team work
Other corporate capital -liquid assets, e.g. cash and money market instruments (Microsoft),
-real assets, e.g. real estate (K-mart) and expensive equipment (GM),
-patents, trademark, copyrights, e.g. Pfizer, MacDonald, Capital Records
-reputation: with consumers (Nordstrom), suppliers (Toyota),
workers (Google), and gov’t (Northrop Grumman)
-earning power, e.g. telecommunication & cable companies
-market access, e.g. Walmart
-funds access, e.g. GE Capital