EAP MBA50 Vol.2 PDF

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ECONOMICS FOR MANAGERS
Managerial Economics
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Managerial Economics
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H E L L E N I C O P E N U N I V E R S I T Y
SCHOOL OF SOCIAL SCIENCES
PROGRAM OF STUDIES
Masters in Business Administration
MODULE
Economics for Managers
VOLUME 2
MANAGERIAL ECONOMICS
PATRAS 2005
CONTENTS
Preface 23
CHAPTER 1
Economic behavior 25
The Scope of the Chapter ..................................................................................................25
Learning Objectives............................................................................................................25
Key Words ...........................................................................................................................25
Introductory Comments .....................................................................................................26
1.1 Organizational problems and managerial economics ....................................27

1.1.1 Organizational architecture .........................................................................27
1.1.2 Economic analysis.........................................................................................27
1.2 Darwinism and economics ..................................................................................29

1.2.1 The fittest survives........................................................................................29
1.2.2 Benchmarking may prove unsuccessful ......................................................29
1.3 The economics approach to organizations .......................................................30
1.4 Economic behavior...............................................................................................31

1.4.1 Economic choice...........................................................................................31
1.4.2 Marginal analysis and opportunity costs ....................................................31
1.5 Graphical analysis ...............................................................................................32

1.5.1 Objectives ......................................................................................................32
7
1.5.2 Indifference curves .......................................................................................32
1.5.3 Constraints.....................................................................................................33
1.5.4 Optimal choice ..............................................................................................34
1.6 Managerial implications .....................................................................................36

1.6.1 Structuring the terms of choice to motivate desired action .....................36
1.6.2 An application...............................................................................................36
1.7 Uncertainty............................................................................................................38
Synopsis – Conclusions .............................................................................................39
Appendix ......................................................................................................................40
Bibliography.................................................................................................................41
Recommended Reading .............................................................................................41
CHAPTER 2
The market system and the role of knowledge 43
The Scope of the Chapter..................................................................................................43
Key Words ...........................................................................................................................43
2.1 Property rights and market exchange ...................................................44

2.1.1 Goals of economic entities and economic systems ........................44
2.1.2 Trading property rights .....................................................................44
2.1.3 The price mechanism ........................................................................45
2.2 The Coase Theorem .............................................................................................48
2.3 The market system versus the system of central planning ............................50
2.3.1 Specific knowledge and the allocation of resources..................................50
2.3.2 Contracting costs as a reason for the existence of firms...........................51
Appendix ......................................................................................................................53
Bibliography.................................................................................................................55
8
CHAPTER 3
Analysis of demand 57
Key Words ...........................................................................................................................57
3.1 Product demand ...................................................................................................59

3.1.1 Demand functions and curves .....................................................................59
3.1.2 The law of demand, elasticities and marginal revenue.............................60
3.2 Defining and estimating demand.......................................................................64

3.2.1 Industry demand, network effects, product attributes and life cycles ....64
3.2.2 Demand estimation ......................................................................................65
Appendix ......................................................................................................................68
Bibliography.................................................................................................................69
CHAPTER 4
Theory of production and costs 71
Key Words ...........................................................................................................................71
4.1 Production functions ...........................................................................................72

4.1.1 Returns to scale and factor returns ............................................................72
4.1.2 Input substitutability and isoquants............................................................73
9
4.2 Minimization of costs ..........................................................................................75
4.2.1 Isocost lines and the optimal input mix......................................................75
4.2.2 Cost curves ...................................................................................................76
4.2.3 Profit maximization, factor demand, and cost estimation........................79
Appendix ......................................................................................................................82
Bibliography.................................................................................................................83
CHAPTER 5
Market structure 85
Key Words ...........................................................................................................................85
5.1 Markets, competitive markets and competitive equilibrium.........................86
5.2 Barriers to entry, monopoly, and monopolistic competition .........................89

5.2.1 Barriers to entry............................................................................................89
5.2.2 Monopoly ......................................................................................................90
5.2.3 Monopolistic competition ............................................................................90
5.3 Oligopoly, Nash equilibrium and collusion .....................................................92

5.3.1 Cournot-Nash equilibrium...........................................................................92
5.3.2 Collusion and the “Prisoners’ Dilemma”...................................................94
Appendix ......................................................................................................................96
Bibliography.................................................................................................................97
10
CHAPTER 6
Market power 99
Key Words ...........................................................................................................................99
6.1 Single pricing......................................................................................................100

6.1.1 Sensitivity of demand and optimal markup .............................................100
6.1.2 Estimation of the profit-maximizing price ...............................................101
6.2 Potential for higher profits and price discrimination ..................................103

6.2.1 Homogenous consumers ............................................................................103
6.2.2 Heterogeneous consumers.........................................................................104
Synopsis – Conclusions ...........................................................................................106
Appendix ....................................................................................................................107
Bibliography...............................................................................................................108
Recommended Reading ...........................................................................................108
CHAPTER 7
Creating and capturing value by firms 109
The Scope of the Chapter................................................................................................109
Learning Objectives..........................................................................................................109
Key Words .........................................................................................................................109
Introductory Comments ...................................................................................................109
7.1 The strategy of firms..........................................................................................110

7.1.1 Value creation by firms ..............................................................................110
7.1.2 Reducing production costs ........................................................................111
7.1.3 Reducing consumer transaction costs ......................................................111
7.1.4 Increasing demand ....................................................................................111
11
7.1.5 The introduction of new products and services.......................................113
7.1.6 Cooperation to increase value...................................................................113
7.1.7 Converting organizational knowledge into value ....................................113
7.1.8 Creating value .............................................................................................114
7.2 Capturing value..................................................................................................115

7.2.1 Market power..............................................................................................115
7.2.2 Important factors of production................................................................116
7.2.3 A successful example..................................................................................118
7.2.4 All good things must end ...........................................................................118
7.3 Diversification ....................................................................................................119

7.3.1 Benefits associated with diversification....................................................119
7.3.2 Costs associated with diversification.........................................................119
7.3.3 Management implications..........................................................................119
7.4 Strategy formulation..........................................................................................121

7.4.1 Combining environmental and internal analyses ....................................121
7.4.2 Strategy and organizational architecture .................................................121
Appendix ....................................................................................................................123
Bibliography...............................................................................................................124
CHAPTER 8
An introduction to game theory 125
Key Words .........................................................................................................................125
8.1 Game theory........................................................................................................126
12
8.1.1 The concept of Nash equilibrium..............................................................127
8.1.2 Competition vs coordination .....................................................................128
8.1.3 Equilibria in mixed strategies ....................................................................129
8.2 Sequential interactions .....................................................................................131

Appendix ....................................................................................................................134
Bibliography...............................................................................................................135
CHAPTER 9
Resolving incentive conflicts 137
Key Words .........................................................................................................................137
9.1 Firms as contracts .............................................................................................138

9.1.1 Incentive conflicts within firms .................................................................138
9.1.2 Incentive problems through contracts ......................................................138
9.1.3 Costly contracting .......................................................................................139
9.1.4 Post-contractual information problems....................................................139
9.1.5 Information problems ................................................................................141
9.2 Problems with implicit contracts.....................................................................143

Appendix ....................................................................................................................145
Bibliography...............................................................................................................146
13
C H A P T E R 10
The organizational architecture of firms 147
Key Words .........................................................................................................................147
10.1 The main problem............................................................................................148

10.1.1 The architecture of firms .........................................................................148
10.1.2 Architectural determinants......................................................................149
10.2 Corporate culture.............................................................................................150

10.2.1 Inappropriate architecture.......................................................................150
10.2.2 Benchmarks ...............................................................................................150
Appendix ....................................................................................................................152
Bibliography...............................................................................................................153
C H A P T E R 11
Decision rights I 155
Key Words .........................................................................................................................155
11.1 Tasks and decision rights ...............................................................................156

11.1.1 Centralization versus decentralization ...................................................156
11.1.2 An example................................................................................................157
11.2 Determinants of the optimal level of decentralization ...............................160
14
11.2.1 Recent trends ............................................................................................160
11.2.2 Assigning decision rights to teams ..........................................................161
11.2.3 Decision management and control .........................................................162
11.2.4 Decision right assignment and knowledge creation..............................162
11.2.5 Influence costs...........................................................................................163
Appendix ....................................................................................................................164
Bibliography...............................................................................................................165
C H A P T E R 12
Decision rights II 167
Key Words .........................................................................................................................167
12.1 Bundling tasks into jobs .................................................................................168
12.2 Bundling of jobs ...............................................................................................170

12.2.1 Matrix organization ..................................................................................172
Synopsis – Conclusions .........................................................................................174
Appendix ....................................................................................................................175
Bibliography...............................................................................................................176
C H A P T E R 13
Qualified employment 177
Key Words .........................................................................................................................177
15
13.1 Contracting objectives.....................................................................................178

13.1.1 The competitive model of employment and compensation .................178
13.2 Internal labor markets: a description...........................................................181

13.2.1 Pay in internal labor markets ..................................................................182
13.3 The salary-fringe benefit mix .........................................................................184

Appendix ....................................................................................................................188
Bibliography...............................................................................................................189
C H A P T E R 14
The economics of incentive compensation 191
Key Words .........................................................................................................................191
14.1 The basic model................................................................................................192

14.1.1 The basic incentive problem....................................................................194
14.2 Optimal risk sharing .......................................................................................196
14.3 Effective incentive contracts...........................................................................198

14.3.1 The principal-agent model.......................................................................198
14.3.2 The informativeness principle .................................................................200
14.3.3 Group incentive pay .................................................................................200
14.3.4 Multi-task principal-agent problems.......................................................200
14.3.5 Forms of incentive pay .............................................................................201
14.3.6 Incentive compensation and information revelation ............................201
16
14.4 Does incentive pay work?................................................................................203
Appendix ....................................................................................................................205
Bibliography...............................................................................................................207
C H A P T E R 15
Performance evaluation 209
Key Words .........................................................................................................................209
15.1 Performance benchmarks ...............................................................................210

15.1.1 Measurement costs ...................................................................................211
15.1.2 Opportunism .............................................................................................211
15.1.3 Relative performance evaluation ............................................................212
15.2 Subjective performance evaluation ...............................................................213

15.2.1 Multiple tasks and unbalanced effort .....................................................213
15.2.2 Multiple subjective evaluation methods.................................................213
15.2.3 Problems with subjective performance evaluations ..............................214
15.2.4 Combining objective and subjective performance measures ...............214
15.3 Team performance ...........................................................................................216

15.3.1 Evaluating teams.......................................................................................216
Appendix ....................................................................................................................219
Bibliography...............................................................................................................220
17
C H A P T E R 16
Evaluation of divisional performance 221
Key Words .........................................................................................................................221
16.1 Divisional performance ...................................................................................222

16.1.1 Cost centers ...............................................................................................222
16.1.2 Expense centers .......................................................................................223
16.1.3 Revenue centers........................................................................................223
16.1.4 Profit centers .............................................................................................223
16.1.5 Investment centers....................................................................................224
16.2 Transfer pricing ...............................................................................................225

16.2.1 The economics of transfer pricing ..........................................................225
16.2.2 Common transfer-pricing methods.........................................................226
16.3 Internal accounting system ............................................................................228

Appendix ....................................................................................................................229
Bibliography...............................................................................................................230
C H A P T E R 17
Alternative legal forms of organization 231
Key Words .........................................................................................................................231
18
17.1 A menu of alternative legal forms ................................................................232
17.1.1 For-profit versus non-profit.....................................................................232
17.1.2 For-profit organizations ...........................................................................232
17.2 Analyzing choices over legal organizational forms .....................................234

17.2.1 Choosing the profit status........................................................................234
17.2.2 Alternative for-profit organizational forms ...........................................235
17.3 Mechanisms to achieve governance in PTCs ...............................................237

17.3.1 Internal mechanisms.................................................................................237
17.3.2 External mechanisms................................................................................238
Appendix ....................................................................................................................240
Bibliography...............................................................................................................241
C H A P T E R 18
Vertical integration versus outsourcing 243
Key Words .........................................................................................................................243
18.1 Buying in competitive markets and reasons

for non-market transactions .........................................................................245
18.1.1 Benefits from purchases from competitive markets .............................245
18.1.2 Turning to non-market transactions .......................................................245
18.2 Long-term contracts ........................................................................................249
18.3 Distribution contracts .....................................................................................251

Appendix ....................................................................................................................254
19
Bibliography...............................................................................................................255
C H A P T E R 19
Leadership and organizational change 257
Key Words .........................................................................................................................257
19.1 Leadership and firm decision making ..........................................................258

19.1.1 Setting the plan and motivating individuals...........................................258
19.1.2 Incentive problems ..................................................................................258
19.2 Leadership power ............................................................................................263

19.2.1 Sources of leadership power....................................................................263
19.2.2 Logrolling ..................................................................................................264
Appendix ....................................................................................................................266
Bibliography...............................................................................................................267
C H A P T E R 20
Government intervention and regulation 269
Key Words .........................................................................................................................269
20.1 The economic reasoning for government intervention ...............................270
20.2 The economics of regulation...........................................................................273
20
20.3 Opting for government regulation.................................................................276
Appendix ....................................................................................................................279
Bibliography...............................................................................................................280
C H A P T E R 21
Business ethics and management innovations 281
Key Words .........................................................................................................................281
21.1 Ethics and corporate aims..............................................................................283
21.2 Ethics and incentive problems .......................................................................283
21.3 Demand for management innovations..........................................................284
21.4 Reasons for innovation failure.......................................................................284

Bibliography...............................................................................................................287
21
PREFACE
This volume provides a modern economic framework in which to analyze a

variety of problems that managers regularly face in today’s business environment.
In particular, it focuses on topics which are most important to managers, like:
ñ Traditional Microeconomics (e.g. demand, supply, and pricing)
ñ Game Theory (e.g. strategic interaction, Nash equilibrium, credibility)
ñ Corporate Governance (e.g. assigning decision-making authority, measuring
and rewarding performance, outsourcing, and transfer pricing)
Effectively, while the text covers the standard problems of managerial economics
(e.g., pricing and production), it pays special attention to organizational problems.
Thus, this book builds a comprehensive approach to both managerial and
organizational issues, which any firm has to cope with, and the reader is guided –
step by step – to an understanding of:
ñ How the business environment (technology, the status of competition, and
regulation in input/output markets) affects a firm’s choice of strategy.
ñ How strategy and the business environment together drive the firm’s choice
of organizational design (organizational architecture).
Students, particularly those already possessing an in-field business
background, presumably want to develop skills that will make them more effective
managers in everyday business practices. They need, further, to be adequately
equipped in order to promote organizational changes within their business units.
We expect that the curriculum of this volume, as well as the style in which it is
written, will encourage students to coherently deal with critical business concepts
arising from various sources. To this end, we also provide a number of activities
(structured across chapters/learning objectives) along with their answers (given at
the end of each chapter). Last, but not least, we suggest that students should
further advance their study by means of the recommended reading in each chapter.
Minas Vlassis
23
CHAPTER 1
ECONOMIC BEHAVIOR
The scope of Chapter 1 is to provide a comprehensive summary of the The Scope
framework that economists use to examine individual behavior, along with some of of the Chapter
the analytical and graphical tools employed.
After completing the study of Chapter 1, the reader will: Learning

ñ be familiar with the fundamental issues arising in the closely related fields Objectives
of managerial economics and organizational architecture
ñ have some basic insight into how real-life business problems can be
approached, using the concepts and tools of economic analysis
ñ have a basic understanding of how individuals make choices between
alternatives when they face constraints
ñ be familiar with the meaning and use of the basic graphical tools of this
analysis
ñ be able to “translate” real-life circumstances that an individual faces into
objectives and constraints so that predictions about individual choices, as
well as about changes in choices (when circumstances change), can be
consistently made.
ñ Methodology Key Words

ñ Conceptual framework
ñ Economic analysis
ñ Managerial economics
ñ Organizational problems
ñ Effective (efficient) organizational architecture
ñ Decision rights
ñ Performance evaluation systems
ñ Rewarding methods
ñ Marginal benefit
ñ Marginal cost
ñ Opportunity cost
ñ Objectives
ñ Indifference curves
25
ñ Constraints
ñ Trade-off
ñ Optimal choice
ñ Risk aversion
ñ Certainty equivalent
ñ Risk premium
Introductory This book aims to guide the reader in first, viewing various problems arising in
Comments real business life as standard issues of managerial economics and organizational
nature; and second, applying the framework of economic analysis in order to get
important insights into how resolutions can thus be obtained. To this end, Chapter
1 plays a tutorial role as regards the methods and tools used for the systematic
study and understanding of the issues covered in the chapters to follow. Therefore
it is crucial at this point that the reader reproduce on his or her own, and thus
grasp the content and meaning of, all graphs and solutions in the chapter.
26
CHAPTER 1
1.1 ORGANIZATIONAL PROBLEMS

AND MANAGERIAL ECONOMICS
A poorly designed organization of a firm, or an inefficient organizational

architecture, may result in serious problems and even in the firm’s failure. Hence,
while standard managerial economics addresses and examines various issues which
are important for business success (such as which markets will the firm enter, or
what may be the response of the firm’s competitors to its pricing policy and
product offerings), a broader framework is needed for studying internal
organizational problems as well.
1.1.1 Organizational architecture

The book provides a systematic framework which can be consistently applied in
addressing and resolving organizational problems. This framework identifies three
critical organizational aspects of any modern corporation, which are:
ñ The assignment of decision rights (to individuals and/or groups) within the
firm
ñ The methods of rewarding individuals
ñ The structure of systems to evaluate (individual and/or group) performance
The above can be considered as the building blocks of any organizational
architecture. However, for the latter to be efficient, these aspects must be properly
tailored and coordinated at any particular instance. This task relies to a major
extent on the application of the basic principles of economics.
1.1.2 Economic analysis

Essentially, economics provide models to explain the way individuals make
choices which are optimal to themselves, under various circumstances. Therefore,
one can use economics to examine how managers can (re)design organizations
(organizational “circumstances” within a firm) in order to motivate individuals to
27
make optimal choices which will increase the firm’s value as well.
In sum, Section 1.1 justifies the necessity for an integrative framework to
address problems and obtain resolutions, which would coherently link managerial
economics with organizational architecture. The theoretical background of such a
framework is economic analysis.
28
CHAPTER 1
1.2 DARWINISM AND ECONOMICS
1.2.1 The fittest survives

Competition among firms in an industry implies that (at least in the long run)
only those firms with low costs will survive (survival of the fittest). This is the
meaning of Economic Darwinism. If a firm adopts and insists on an inefficient,
high-cost policy, including an inefficient organizational architecture, it will
eventually be wiped out of the industry by its efficient, low-cost competitors.
1.2.2 Benchmarking may prove unsuccessful

The meaning of benchmarking is to emulate successful companies, hoping that
by copying their methods and organization, the imitator will also reach success.
However, random (uncritical) mutation, as in the biological systems that Darwin
analyzed, may expose a firm to a high risk of failure. Before adopting a particular
method or organizational structure, a manager must have a good understanding of
why and how a successful firm arrived at its existing status. More generally,
business executives must develop a broader perspective of why specific types of
organizations work well in particular settings.
In sum, Section 1.2 suggests that Economic Darwinism differs significantly
from Darwinism in nature, since for a firm to survive in a competitive environment
it needs to follow the “right model”. Hence, while occasionally this may happen
simply by pure luck, managers should rely on elaborated case studies rather than
on mutation.
29
1.3 THE ECONOMICS APPROACH TO
ORGANIZATIONS
Based on the principles of economic analysis, this book’s approach to studying

organizations is briefly as follows. Individuals act in their own interest and they do
not all share the same information. This, in turn, suggests that successful
organizations (efficient organization architectures) should, in principle:
ñ Assign decision rights so that decision making is linked with the information
to make good decisions.
ñ Develop reward and performance-evaluation systems that provide decision
makers with the appropriate incentives to make decisions which are optimal
for their organizations.
Activity 1/Chapter 1
In the event of rising oil prices, the method of contacting potential customers in person
becomes relatively more expensive than contacting them by phone or mail. How, in this
instance, should an efficient organizational architecture of a firm be structured?
The answer can be found in the Appendix at the end of this chapter.
30
CHAPTER 1
1.4 ECONOMIC BEHAVIOR
1.4.1 Economic choice
Individuals have unlimited wants. However, the resources available to satisfy

their wants are limited. Therefore, they should always assign priorities and choose
the most preferred among the alternative options. Of course, individuals do not
always choose the best among feasible alternatives. The reason is that they are not
always endowed with perfect knowledge and foresight. In addition information is
costly. Hence, they do their best (make their choice) facing imperfect knowledge
(decision making under uncertainty) while they may also “learn by doing.”
1.4.2 Marginal analysis and opportunity costs

Marginal analysis and opportunity costs are the cornerstones of economic
analysis. Since resources are limited, individuals are always facing trade-offs: for
instance, to marginally increase (say, by an hour) the time devoted to work, an
individual must marginally decrease the time devoted to leisure (or to another
activity). Then, the choice to increase work time, up to a certain number of hours,
is optimal so long as the value assigned to the last hour devoted to work (e.g. the
marginal benefit of work) is equal to the value assigned to the last hour devoted to
leisure (e.g. the marginal benefit of leisure). Hence, the latter (forgone value) is the
marginal (opportunity) cost of work. However, the fixed (sunk) benefits and costs
related to those alternative activities are irrelevant to the ongoing decision of
whether to increase work time at the expense of leisure time.
Individuals are quite creative in minimizing the effects of constraints (in the
above instance, the time available for work or leisure), by adjusting their choice
whenever the ingredients of constraints change. This has important managerial
implications: if per hour leisure is taxed, the marginal (opportunity) cost of work
decreases, hence, the individual should be expected to increase working hours.
In sum, Section 1.4 introduces the fundamental economic rationale: to find the
optimal level of an activity (among all possible alternative activities constrained by
limited resources), one has to compare, step by step, its marginal benefit with its
marginal (opportunity) cost and increase (decrease) the activity so long as the
former exceeds (falls short of) the latter, until the two are found to be equal and,
also, resources have been exhausted.
31
1.5 GRAPHICAL ANALYSIS
1.5.1 Objectives
According to the hypothesis of economic behavior, an individual acquires
goods, services, or even intangibles, in order to maximize his/her utility function,
given his/her resource constraints (in the case of goods or services, his/her limited
income). Utility functions subjectively rank the personal happiness (or
satisfaction) derived from any combination (bundle) of goods and/or services,
without indicating how much one bundle is preferred to another bundle.
1.5.2 Indifference curves

An indifference curve is defined by all combinations (bundles), and only those,
that yield the same utility to an individual. In Figure 1, two such indifference
curves are depicted, out of the many possible (one, and only one, passing through
each point) in the Furniture, Clothing space.
Figure 1: Indifference Curves
32
CHAPTER 1
A higher indifference curve contains bundles which are preferred to all bundles
on a lower indifference curve. At any point on an indifference curve, the willingness
to substitute a unit of Clothing for some units of Furniture is measured by its slope
at that point. Indifference curves are convex to the origin (their slope decreases as
Furniture is given up for Clothing), at each point, since the less Furniture an
individual possesses, the fewer units of it he/she is willing to give up for an extra
unit of Clothing.
1.5.3 Constraints
Given the goods’ prices, the individual’s choice is constrained by his/her
income. If he/she is willing and able to spend I monetary units for Furniture and/or
Clothing, costing Pf and Pc per unit respectively, his/her budget constraint: I = Pf F
+ PcC (the straight line depicted in Figure 2) allows a maximum of F units
purchase equal to I / Pf (when the C purchase is zero) or, alternatively, a maximum
of C units purchase equal to I / Pc (when the F purchase is zero).
l Combinations above line

Pf are unaffordable
Pc Combinations on/below line

- are affordable
Pf
C
l
Pc
Figure 2: Income Constraint
Then, the ratio Pc / Pf (the relative price of Clothing), calculated by dividing

I / Pf by I / Pc, effectively represents the ability to substitute Clothing for Furniture.
That is, how many units of Furniture must be given up to acquire one more unit of
Clothing. Therefore, Pc / Pf (the slope of the budget line) is effectively the
opportunity cost of Clothing, in terms of forgone Furniture. The reader can easily,
on his/her own, check that:
1. Increases (decreases) in I, whilst Pf and Pc (and, hence, their ratio) remain
the same, result in outward (inward) parallel shifts of the budget line.
33
2. Changes in either Pf or Pc, whilst I remains the same, rotate the budget
line. For instance, as only Pc decreases (increases), I / Pc increases
(decreases) and the budget line rotates outward (inward), since its vertical
intercept (I / Pf) is kept constant.
1.5.4 Optimal choice

As Figure 3 depicts, at the optimal bundle (point a), i.e. the one belonging to
the highest possible indifference curve and, hence, maximizing utility given the
budget constraint, the willingness to substitute C for F (measured by the slope of the
indifference curve) must be equal to the ability for such a substitution (measured by
the slope of the budget line). In graphical terms, point a is a point of tangency of an
indifference curve with the budget line.
Figure 3: Optimal Choice
Is the bundle at point a optimal according to the fundamental economic rationale? Why?
As, in turn, Figure 4 suggests, the optimal bundle will change if, given I, relative
prices change: a rise in Pf (and, hence, an increase in the relative price of F)
decreases I / Pf and thus rotates the budget line inward (since I / Pc remains
34
CHAPTER 1
unchanged). Here, the new point of tangency results in a decrease in the F

purchase (while the C purchase remains unchanged). Note, however, that this
prediction (or the one that can be made when a change in I is considered) is based
on the assumption that the individual’s utility ranking (and, hence, the place and
curvature of any indifference curve) remains unchanged.
Original constraint
Constraint after increase in price of food
F0*
F1*
C
C*
Figure 4: Price Change and Change in Choice
In Figure 4, draw a new budget line, parallel to the original and tangential to the lower
indifference curve. Does the optimal bundle change? How do you interpret this result in
comparison to the previous one (when Pf increases)?
35
1.6 MANAGERIAL IMPLICATIONS
1.6.1 Structuring the terms of choice to motivate

desired action
The economic approach to individual behavior has important managerial
implications. Since individuals make economic choices (i.e. choices maximizing
their own utility under constraints), a manager can establish incentives which, by
appropriately structuring the specific terms of such a choice (an individual makes
within his/her firm), will motivate desired action. It should be noted, however, that
the focus of economists is on “average” behavior (that is, on what the typical
individual is expected to do) under certain circumstances. Hence, their model is
expected to work well for a manager too if the latter is interested in structuring an
organizational architecture that does not depend on specific people filling
particular jobs. Typically, nonetheless, managers are interested in resolving
organizational problems of this nature.
1.6.2 An application
A typical stock analyst values (enjoys utility from) two “goods:” Money Income
($) and Honesty (H). Currently, his/her firm pays its analysts an annual bonus that
is based on their contribution to the firm’s investment banking revenue. Hence,
the analyst faces a trade-off: the more honest he/she is (H increases), the more
probable it is to rate a given company as a poor investment (so long as it is so). In
turn, however, the more probable it is that the given company will take its
investment banking business away, hence reducing the stock analyst’s annual
bonus ($). As a result (see Case 1 in Figure 5), the typical analyst is expected to
choose a low level of Honesty and, thus, his/her firm runs a high risk of
accumulating poor investments. Still, the firm’s management can motivate honesty
on the part of its typical analyst, by changing the slope of the constraint the latter
faces within the firm. If, for instance, bonuses are not based on the volume of
investment banking business, but rather on the quality of investment advice, the
relative price (or, opportunity cost) of H (in terms of forgone $) effectively decreases
36
CHAPTER 1
for the typical analyst (i.e. the constraint becomes flatter). As a result, less risky
investment advice may emerge, but along with a lower volume of business (see
Case 2 in Figure 5).
$1
$2
Case 2
Case 1
H
H1 H2
Figure 5: The Analyst’s Optimal Choice under Two Different Bonus Schemes
37
1.7 UNCERTAINTY
So far, complete certainty about the choice variables has been presumed. The
analysis of optimal choice can, nonetheless, be extended to incorporate
uncertainty. For that to happen, it is necessary for:
1. Uncertain items to be expressed in expected terms. The expected value of
an uncertain payoff is the weighted average of all possible outcomes, with
weights being the probability for each particular outcome to emerge.
2. The analysis to incorporate individual attitude toward risk. For equal
expected payoffs, risk averse individuals always prefer the outcome with
the lowest variability. The latter can be measured by standard deviation, i.e.
the square root of variance, which is the expected value of the payoff’s
squared difference from its expected value. The evaluation of uncertain
outcomes can then be made by means of each outcome’s certainty
equivalent and risk premium.
In sum, section 1.7 suggests that a risk-averse individual is willing to undertake

more risk and still enjoy the same utility, only as long as the risky outcome’s
expected value (payoff) increases. Hence, in problems of optimal choice under
uncertainty, the general formula for an indifference curve (defined in the Expected
Value, Standard Deviation space) is Expected Value = Certainty Equivalent + Risk
Premium, where risk premium is typically an increasing function of the standard
deviation. By that means, the certainty equivalent of an uncertain outcome can be
calculated.
38
CHAPTER 1
Synopsis – Conclusions
This book develops an integrative framework by means of which problems of
both a managerial and an organizational nature can be addressed and analyzed.
This framework builds upon the principles of economics: individuals have
unlimited wants, while the resources available to satisfy their wants are limited.
Therefore, possessing a preference (utility) ordering, individuals always choose
the most preferred among the alternative feasible options (optimal choice). This
economic approach to individual behavior has important managerial
implications. A manager can establish incentives which, by appropriately
structuring the specific terms under which individual choice is made within the
firm, will motivate desired action. Therefore, most managerial and/or
organizational problems can be viewed and structured as: finding how
individual (or group) optimal choice can be properly affected.
39
APPENDIX
Answers to Activities
Activity 1
An efficient organizational architecture should in this instance effectively transfer total

responsibility for the sales promotion costs to the firm’s salespeople, instead of
reimbursing all those costs by itself. In terms of its critical organizational aspects, this
means that:
ñ The firm must assign decision rights to its salespeople as regards the choice of
method to contact potential customers.
ñ Along with issuing a volume of sales bonus to reward its salespeople, the firm
must also issue a negative bonus (penalty), per contacted customer, to punish
those who exceed least-cost sales promotion.
ñ By the above means, the firm would be in a position to evaluate individual (as well
as group) performance on the basis of both costs and revenues, and hence,
profits that accrue to the firm from the sales promotion activity of its salespeople.
Activity 2
By its definition, the slope of the indifference curve at any point (bundle) effectively
measures the relative benefit of an extra unit of C purchased instead of some units of F. At
point b (Figure 3), this slope exceeds the opportunity cost of making that purchase (the
slope of the budget line). Hence, the individual will go on across the budget line,
substituting C for F, until the relative benefit of the last unit of C purchased becomes equal
to its opportunity cost (Pc / Pf), at point a. In contrast, at all points to the right of a (like at
point c), the slope of the indifference curve falls short of the slope of the budget line, hence,
the individual has now an opposite incentive: to substitute F for C, until the relative benefit
of the last unit of F purchased becomes equal to its opportunity cost (Pf / Pc), at point a.
Activity 3
Both the quantity of C and the quantity of F purchased now decrease, due to the decrease
in I. In the previous instance the ability to buy C or F has also decreased, due to the
decrease in I / Pf . Nonetheless, Pc / Pf was then decreased, hence the ability to buy more
of C (F) by economizing on F (C) has been increased (decreased). Therefore, in that
instance the individual had an incentive to economize more on F than on C and, given
his/her utility ordering (defined by the particular indifference map), to decrease only his/her
F purchases.
40
CHAPTER 1
BIBLIOGRAPHY
Brickley J., Smith C., Zimmerman J., Managerial Economics and Organizational
Architecture, Third Edition, McGraw-Hill/Irwin, New York 2004, pp. 1-41.
RECOMMENDED READING
Coase R., “The Nature of the Firm”, Economica, 4, 1937, pp. 386-405.
Becker G., “Nobel lecture: The Economic Way of Looking at Behavior”, Journal
of Political Economy, 101, 1993, pp. 385-409.
41
CHAPTER 2
THE MARKET SYSTEM

AND THE ROLE OF KNOWLEDGE
The scope of Chapter 2 is to provide answers to three important questions. The Scope
First, how do economic systems, primarily relying on the operation of markets, of the Chapter
work? Second, what are the advantages of those systems relative to systems of
central economic planning? Third, why, in market economies, are firms the
prominent institution to organize economic activity?

ñ have a good understanding of whether, why, and how markets and firms Objectives
within market economies work efficiently (i.e., their operation is
advantageous relative to central planning)
ñ understand how appropriate resolutions can be found to relevant business
issues, such as which decision rights should be decentralized to the
employees of a firm, whether to make or alternatively buy the firm’s
inputs, and so forth.
ñ Pareto efficiency Key Words

ñ Property rights
ñ Supply and demand
ñ Market equilibrium
ñ Market-clearing (equilibrium) price
ñ Externalities
ñ Creation (and transfer) of knowledge
ñ Contracting (and bargaining) costs
Chapter 2 provides the theoretical background on the operation of markets and Introductory
of firms within markets. In doing so, it familiarizes the reader with the concepts of Comments
exchange and equilibrium regarding all possible items of trade. Moreover, this
chapter introduces the reader to the systematic study of managerial decision
making that is based on the notion of efficiency.
43
2.1 PROPERTY RIGHTS
AND MARKET EXCHANGE
2.1.1 Goals of economic entities and economic

systems
Any economic entity – such as a national economy, a firm, or a household – at
any point in time, has to decide upon what to produce, how to produce it, and how
to allocate the final output. To resolve those issues, economic entities can be
organized in alternative ways (economic systems): firms can use decentralized, or
centralized, decision making, while national economies can analogously rely on the
operation of markets, or adopt central planning. The criterion used by economists
to compare alternative systems is that of Pareto efficiency: an allocation of
resources into production (that is, what and how), as well as an allocation of the
final output among the individuals that make up the entity, is said to be Pareto
efficient if there exists no other allocation that improves the well-being of some
individuals while keeping all others’ well-being at least the same. Otherwise, an
alternative allocation of resources (hence, an alternative system) has to be found,
in order for the economic entity’s well-being to improve.
2.1.2 Trading property rights

A property right is the right to select the uses of an economic good (for whose
production resources are limited). In market economies property rights are, in
principle, private, while the government (by means of the courts and the police)
maintains their enforcement. Private property rights can be transferred to
individuals other than the original owner. However, there may be legal restrictions
on that alienability (no legal market for human kidneys exists). To understand how
a market economy works, and why it may achieve Pareto efficiency, one must
understand the motives for trading (buying and selling) property rights.
Within the economics framework, trade takes place so long as a buyer places a
higher value on the item than the seller, that is, so long as an individual (the buyer)
is willing to pay a higher price for a good (in order to acquire its property right)
44
CHAPTER 2
than it is worth to its current owner (the seller). In equilibrium (i.e. when the
trading process ends), trade makes both individuals better off. For instance, if you
are willing to sell your car for no less than $5,000 and somebody is willing to pay
up to $8,000 for it, trade is mutually advantageous: if, in equilibrium the car is sold
at $6,500, both you and the buyer gain $1,500. In effect, trade creates value and
moves resources (goods) to more productive (valuable) uses. To illustrate this,
substitute the car with a land tractor. The reason why the buyer paid a higher price
for that item than the (minimum) price you were prepared to accept, is probably
that he/she is more able than you to make productive use of it in land farming.
Moreover, in the absence of complications (see, later on, externalities and/or
market power), any allocation of resources resulting from trade is Pareto efficient.
Assume that a central planner has rated your tractor at $4,500. Then trade does
not materialize, hence both you and the potential buyer lose the opportunity to
gain 0 < $ < {(8,000 – 5,000) =} 3,000.
2.1.3 The price mechanism

As the previous example suggests, in market economies prices play the role of
social coordinators. In each market, price restricts the amount demanded to the
amount supplied, so that equilibrium emerges at the price at which the amount
buyers are willing to buy is equal to the amount sellers are willing to sell.
Figure 1: Equilibrium in the DVD Industry
In Figure 1, the demand curve depicts how many DVD players consumers are
45
willing to buy at each price, while the supply curve depicts how many DVD players
producers are willing to sell. This market is assumed to be competitive, in the sense
that no one consumer or producer can individually affect the price (individual
producers and/or consumers have no market power). At the market-clearing price
P*, the amount of DVDs demanded (Q*) equals the amount supplied (Q*), hence,
at this price there is no shortage or surplus of DVDs: the market is in equilibrium.
In contrast, at a price P’ consumers are willing to buy more of Q than producers
are willing to sell. Hence, a shortage of DVDs emerges that motivates consumers
to bid up the price in order to induce more Q supplied. Therefore, P’ increases
approaching P*, until shortages no longer exist (when the number of demanded
and supplied DVDs is equal to Q*). On the other hand, at a price consumers are
willing to buy less of Q than producers are willing to sell. Hence, a surplus of
DVDs emerges that motivates producers to lower the price in order to induce
more Q demanded. Therefore, P” decreases approaching P*, until surpluses no
longer exist (when the number of demanded and supplied DVDs is equal to Q*).
The supply and demand curves may shift, due to changes in circumstances
(parameters) that fix their position and, hence, determine how much of Q is
supplied or demanded at any certain price. These shifts are in turn expected to
alter the equilibrium levels of P* and/or Q*.
To summarize and check what the reader should have learned from Section 2.1,
assume that the supply and demand functions for DVDs respectively are: Qs = 300
+ 0.2P - 15w ; Qd = 200 - P / 3 + 0.02 I , where w stands for the hourly wage paid
to workers and I stands for the per capita income of the consumers of the DVDs.
The latter arguments act as shift parameters of the demand and supply functions
(curves). To see this, first assume that currently w is $20 and I is $10,000. Hence
Qs = 0.2 P ; Qd = 400 - P / 3. Setting Qs = Qd , the equilibrium price (P0*) of a
DVD player is currently $750 (i.e., given that w is $20 and I is $10,000). Hence
(substituting that price into the demand or supply function), the current
equilibrium quantity (Q0*) of DVDs sold is 150. Next, assume that tomorrow the
hourly wage decreases to $15. Then the supply function for DVDs shifts to the
right, Qs = 75 + 0.2 P, and, as shown in Figure 2, the equilibrium price of DVDs
decreases to P1*= $609, while the equilibrium quantity of DVDs sold increases to
Q1*= 197. Conversely, assume that the hourly wage increases to $25. Then the
supply function for DVDs shifts to the left, Qs = -75 + 0.2P, and, as shown in
Figure 2, the equilibrium price of DVDs increases to P1*= $891, while the
equilibrium quantity of DVDs sold decreases to Q1*= 103.
46
CHAPTER 2
Figure 2: Shift in Supply and the Equilibrium Price and Quantity of DVDs
Assume that while w = $20, the per capita income of the consumers of DVDs increases to
$15,000. Does the number of DVDs sold increase or decrease? Does their price increase
or decrease? Now assume that while w = $20, the per capita income of the consumers of
DVDs decreases to $5,000. Does the number of DVDs sold increase or decrease? Does
their price increase or decrease?
47
2.2 THE COASE THEOREM
An externality arises when the action of one party (consumer or producer)

affects the well-being of another party (consumer or producer), while the action
considered is not an exchange between the two parties. Traditional economics
used to think that externalities always prevent a market system from reaching an
efficient allocation of resources (through exchange) and, hence, government
intervention, through taxes or subsidies, is always needed in externality situations.
In 1960 R. Coase argued that, so long as the property rights have been clearly
assigned, the parties involved in an externality may have incentives to rearrange
these rights, by trading them. Economic efficiency may thus be feasible without
government intervention. Nonetheless, in many arrangements of that kind,
especially when the entities involved in an externality are numerous, there often
arise substantial contracting costs which may prevent an efficient outcome from
occurring. As an example, suppose that a firm has the legal right to pollute its
neighbors. However, the latter can bribe the firm to reduce its pollution level and,
therefore, the firm will go on polluting only until its benefit from the last unit of
pollution equals the opportunity cost of not receiving compensation to avoid it,
which, in turn, must be equal to the neighbors’ cost from the last unit of pollution.
Hence, since in equilibrium total pollution would be worth more to the firm than
it costs to the neighbors, the efficient level of pollution may emerge without any
pollution tax. If, however, the neighbors’/firm’s contracting and bargaining costs
are significant, they can prevent an agreement, and hence the efficient level of
pollution, from being reached.
What Coase suggested has important managerial implications. In sum, even if
a manager does not have all the property rights which are necessary to undertake
a project, the project can still be undertaken so long as it would create enough
value. Then, the project can still be profitable as the manager acquires the missing
property rights from their owners. Since, however, high contracting costs may
prevent such a scenario, organizational considerations are very important.
48
CHAPTER 2
There is a laundry A earning $50,000 per year from servicing 1,000 citizens living close to
a polluting firm B, and pollution is illegal. Assume that firm B’s annual earnings are
$100,000, while the earnings of A will be reduced to $40,000 if firm B suspends operation
(due to less need for washing clothing). What is the efficient resolution? How is it possible
for it to emerge without government intervention?
49
2.3 THE MARKET SYSTEM VERSUS THE
SYSTEM OF CENTRAL PLANNING
There are two key reasons why the market system, relative to the system of
central planning, behaves more efficiently (i.e., it produces highly valued products
and avoids shortages or surpluses).
1. The market system motivates better use of knowledge and information in
decision making.
2. The market system provides stronger incentives for individuals to make
productive decisions.
2.3.1 Specific knowledge and the allocation of

resources
While in principle the cost of information-acquisition, which transfers
knowledge from the sender to the receiver, increases as knowledge becomes more
specific, specific knowledge is critical in properly allocating resources.
There is a convincing argument (Hayek, 1945) that market economies are more
likely than centrally planned economies to incorporate specific knowledge in
decision making. By default, such knowledge is not given to any one individual. It
is rather distributed among many. Therefore, it is quite probable for a central
planner to ignore important specific knowledge in his/her economic decisions. In
contrast, in a market system economic decisions are decentralized to individuals
who are likely to have the relevant specific knowledge, while their activities are
coordinated by the price mechanism. In effect, prices economize on the costs of
transferring information to coordinate decisions. For instance, an increase in the
wage rate (determined in the labor market) signals to producers that labor is in
short supply and should be conserved. The latter is done without firms knowing
why labor costs have increased, as they respond to higher wages by using less labor.
On the other hand, private property rights make an economy work because
they provide strong incentives for decision makers to act on their specific
information. If somebody owns a piece of property, he/she has an incentive to
50
CHAPTER 2
make the most productive use of it, as he/she will keep the profits. In contrast, a
central planner may allocate this property to a less productive use, since any profits
will go to the state.
2.3.2 Contracting costs as a reason for the

existence of firms
The foregoing analysis implies that firms do not have to exist as separate
entities. All production and exchange could be carried out by market transactions
(DVD consumers could alone buy all separate parts and pay somebody to
assembly them). Why, then, in market economies, are resources, to a great extent,
allocated by managerial decision making within firms? The reason is provided by
Coase’s approach to economic transactions. Since economic transactions involve
contracting costs, the optimal method of organizing an economic transaction is the
one that minimizes these costs. In some cases, this method will be market
exchange. In others, contracting costs are minimized when transactions are
internalized within firms. To this end, nonetheless, the organizational architecture
of a firm is quite important. For example, as firms become larger it is increasingly
difficult for managers to take efficient decisions: it is more likely to make errors
and be less responsive to changing circumstances.
In sum, Section 2.3 suggests that in order for firms to efficiently internalize
economic transactions and thus advance their survival prospects in a market
economy, they must be structured in ways that:
1. Promote the use of the relevant specific knowledge in making decisions.
2. Economize on the costs of organizing transactions.
3. Establish appropriate incentives so that their employees act in a
productive manner.
51
An important feature of a market economy is private property rights. A
private property right is a legally enforced right to select the use of a good.
Private property rights are frequently exchanged, so long as there are mutual
benefits from a market exchange, with prices playing the role of social
coordinators of individual actions. A market is in equilibrium when, at a certain
(equilibrium) price, the quantity demanded equals the quantity supplied.
Equilibrium prices and quantities change with changes in the demand and/or
supply relationships (functions). The latter changes are due to changes in the
market parameters which determine how much of the good is demanded and/or
supplied at any certain price. In the presence of externalities, the ultimate
resource allocation can still be efficient, through market exchange of private
property rights, so long as contracting costs are sufficiently low. Specific
knowledge is quite important in economic decision making; however, it is
expensive to transfer. Therefore, central planning, as a substitute for the market
system, typically fails since important specific knowledge is not likely to be
incorporated in the planning process. In contrast, prices convey knowledge that
efficiently coordinates individual decision making. Resource allocation failure
may nonetheless still evolve in market economies, as decision making within
firms often substitutes market transactions, while organizational architecture is
poor. In effect, since individuals always have incentives to organize transactions
in the most efficient manner, economic activity organization will remain within
firms only so long as the cost of doing so is lower than that of using markets.
52
CHAPTER 2
APPENDIX
Activity 1
$ Initial demand
S0
Price (in dollars)
P1*
P0* P0* Initial demand

P2*
D1
D0 D0
D2
Q Q
Q0* Q1* Q2* Q0*
Quantity of DVDs Quantity of DVDs
Increase in demand Decrease in demand
Figure 3: Shifts in Demand and the Equilibrium Price and Quantity of DVDs
As I increases to $15,000, the demand function shifts to the right, becoming Qd = 500 - P
/ 3, while as w remains equal to $20, the supply function remains Qs = 0.2P. As a result,
since in equilibrium the quantity demanded and supplied is equal, the equilibrium price P1*
increases to $938, while by substituting P1* into the demand (or the supply) function,
Q1*(i.e. the quantity of DVDs sold in equilibrium) increases to 188. In contrast, as I
decreases to $5,000, the demand function shifts to the left, becoming Qd = 300 - P / 3,
while as w remains equal to $20, the supply function remains Qs = 0.2P. As a result, since
in equilibrium the quantity demanded and supplied is equal, the equilibrium price P2*
decreases to $563, while by substituting P2* into the demand (or the supply) function, the
quantity of DVDs sold in equilibrium Q2* decreases to 113.
Activity 2
The efficient resolution is for firm B to maintain business despite pollution being illegal,
because the social well-being is then increased by $100,000 {= $100,000 (accruing to firm
53
B) + $10,000 (accruing to firm A) – $10,000 (the citizens’ extra cleaning-up costs)}. This
resolution may emerge if firms B and A agree to bribe citizens (to give up their right to close
B down) by an amount, respectively, equal to x: $10,000 < x < $(100,000 – z), and z: $0
< z < $10,000. In practice, given that A and B reach an agreement on x and z, each citizen
can be induced to trade his/her property right by receiving a per year laundry discount
equal to d: $(50,000 – 40,000)/1,000 <d < (x + z)/1,000.
54
CHAPTER 2
BIBLIOGRAPHY
Hayek E., “The Use of Knowledge in Society”, American Economic Review, 35,
1945, pp. 519-530.
RECOMMENDED READING
Coase R., The Firm, the Market, and the Law, The University of Chicago Press,
Chicago 1988.
Hayek E., “The Use of Knowledge in Society”, American Economic Review, 35,
1945, pp. 519-530.
55
CHAPTER 3
ANALYSIS OF DEMAND
The scope of Chapter 3 is to provide an extensive analysis of the demand The Scope
relationship. Important topics include demand functions and curves, industry of the Chapter
versus firm-level demand, demand for product attributes, demand estimation,
price elasticity of demand, and marginal revenue.

ñ have acquired comprehension of the product demand function Objectives
ñ understand the problems that often arise in trying to get information
about this key economic relationship.
ñ Demand function Key Words

ñ Demand curve
ñ Changes in quantity demanded
ñ Changes in demand
ñ The law of demand
ñ Price elasticity of demand
ñ Cross elasticity of demand
ñ Marginal revenue
ñ Income elasticity of demand
ñ Substitutes
ñ Complements
ñ Normal and inferior goods
ñ Network effect
ñ Product attributes
ñ Demand estimation
The learning material of this chapter provides basic instruction about one of Introductory
the three major cornerstones – demand, production and costs, and market Comments
structure – on which managerial/business economics is based. Therefore, the
comprehension of this chapter is necessary in order for the reader to be able to
cope later on with significant issues of managerial decision making, such as which
markets the firm will enter, what may be the effect on the firm’s profitability of its
competitors’ output and pricing decisions, what should the firm’s optimal scale of
57
output be when demand conditions change, or when changes are made in the tax
regime.
58
CHAPTER 3
3.1 PRODUCT DEMAND
3.1.1 Demand functions and curves

In order to make sound decisions on pricing, output, capital and other strategic
issues, managers require knowledge about the factors that influence the demand
for their firm’s product. A demand function Q = f(X1, X2, ...Xn) is a mathematical
representation of the relationship (f) that exists between the quantity demanded of
the product (Q), which is the dependent variable; and all factors that influence it
(X1, X2, ...Xn), which are the independent variables. This chapter focuses on three
particularly important variables: the price of the product (Pi), the prices of related
products (Pj), and the (average) income of potential customers (I). For instance, a
theater company may, on any given night, face the following demand function for
tickets (Qi):
Qi = 117 - 6.6Pi + 1.66Ps - 3.3Pr + 0.0066I, where P(j=s) is the ticket price at a
nearby symphony hall, which potential customers may find as a substitute to theater
entertainment, and P(j=r) is the average meal price at nearby restaurants, which
potential customers may choose as a complement to either i or s entertainment.
Hence, if on any particular night: P(j=s)= $50, P(j=r)= $40, I = $50,000, the
demand function which the theater company faces on that particular night
(roughly) reduces to Qi = 400 - 6.6Pi .
In inverse format, this function becomes Pi = 60 - 0.15Qi , and it is depicted as
a demand curve in the left panel of Figure 1.
$ $
Income = $51,000
61
Ticket price (in dollars)
60 60
Income = $50,000
D1
D
D0
Q Q
400 400 406.6
Quantity of tickets Quantity of tickets
Figure 1: Demand Curve for Theater Tickets
59
Note that in a typical demand curve, like the one in Figure 1, the horizontal axis
measures the dependent variable Q (quantity of a good demanded) and the
vertical axis measures the independent variable P (the price of the good). Hence,
movements along the demand curve, resulting in changes in the quantity demanded,
reflect changes in the price of the good. For instance as Pi increases from $40 to
$50, Qi (i.e., the number of tickets demanded) decreases from 136 to 70, while the
other independent variables act as shift parameters of the entire demand curve,
and are referred to as changes in demand. For instance (see right panel of Figure
1), as I increases by $1,000 the demand curve shifts to the right, now intercepting
the Qi axis at 406.6. Therefore, at any price, 6.6 more tickets are now demanded.
What change in Ps or Pr would cause the same effect (on Qi demanded) as a change in I
like the above? How would you graphically depict and interpret your findings?
3.1.2 The law of demand, elasticities and

marginal revenue
The theater company’s demand curve has a slope of -0.15 (e.g., the inverse of
the slope of the demand function, ¢Qi / ¢Pi = -6.6). Hence, its manager can safely
assume that, as regards the number of tickets demanded, the law of demand holds
true: it varies inversely with price. Nonetheless, how sensitive is the number of
tickets demanded to a change in the ticket price? Information on this sensitivity is
critically important for managerial decision making. For instance, as the price
decreases the quantity demanded may increase relatively more, or less, than the
price decrease. Hence, total revenue may increase or decrease. The absolute value
of the price elasticity of demand measures the percentage change in quantity
demanded relative to a certain percentage price change. It is, thus, defined as:
(¢Qi / Qi)
Ë=- = - {(¢Qi / ¢Pi)(Pi / Qi)}.
(¢Pi / Pi)
The elasticity of demand between any two points along a demand curve can then
be approximated using the arc elasticity formula: - {(¢Qi / ¢Pi)[(Pi1 / Pi2) / (Qi1 /
Qi2)]}. As shown in Figure 2, this elasticity is 1.4. That means that, over the
particular region of the demand curve, for every 1% decrease (increase) in the
price, the number of tickets demanded increases (decreases) by 1.4% and, hence,
the theater company’s total revenue increases (decreases) as price decreases
(increases); demand is elastic (Ë > 1) In contrast, whenever Ë < 1 demand is
60
CHAPTER 3
inelastic, while if demand elasticity is unitary (Ë = 1), total revenues are unaffected
by price changes.
Figure 2: Elasticity of Demand
Price elasticities may lie between zero and infinity (see Figure 3). For instance,
a small farmer might not be able to sell any of his/her product if he/she charges a
price above the prevailing market price; he/she faces a perfectly elastic demand
curve (Ë = ∞). In contrast an individual’s demand for salt may be perfectly inelastic
(Ë = 0), since salt has no close substitutes and the percentage income spent on salt
purchases is very small, and thus a rise in its price would bring no effect to the
quantity demanded.
$ $
D(η = 0)
Price (in dollars)
D(η = ∞)
Price (in dollars)
Q Q
Quantity Quantity
Figure 3: Perfectly Inelastic/Elastic Demand
In general, the price elasticity of demand of a particular product tends to be

high as:
61
ñ ∆he number of close substitutes for the product is high.
ñ ∆he relative importance of the product in the consumers’ budgets is high.
ñ ∆he period to which the demand curve pertains is long (hence, there is
time for consumers to identify and/or search for substitutes).
Nonetheless, recall that the demand for a product can be affected by the prices
of related products, which can in turn be substitutes or complements with the
particular product. One frequently used measure of the degree of substitution
between two products X, Y, is the cross elasticity of demand which, analogously to
the price elasticity of demand, is defined as:
(¢Qy / Qy)
Ëyx = = {(¢Qy / ¢Px)(Px / Qy)}.
(¢Px / Px)
Note that here the interest is not only in the absolute value; a positive
(negative) cross elasticity means that the products X, Y, are substitutes
(complements). For instance, Pepsi and Coke would be expected to have a large
positive cross elasticity, at least for some consumers who consider them close
substitutes. In the theater company example, a $10 increase in Pr will result in 33
fewer tickets demanded, and (applying the arc formula of Ëyx) Ëir = -0.81. Last but
not least, since the demand for a product is affected by the consumers’ average
income, the sensitivity of demand to income is measured by:
(¢Qi / Qi)
ËI = = {(¢Qi / ¢I)(I / Qi)}.
(¢I / I)
This income elasticity of demand is positive for normal goods and negative for
inferior goods and its value is quite important for managerial decisions. For
instance, the theater company has a relatively high income elasticity of demand
(above 1.6). This has probably motivated the company to locate in a community
with a high per capita income. On the other hand, unlike food products, firms
producing services (like the theater company) probably face high fluctuations in
demand over the business cycle.
An important concept in economics is marginal revenue (MR), defined as the
change in a firm’s total revenue (TR) per unit of change in quantity. For the theater
company, MR = ¢TR / ¢Qi = ¢{(60 - 1.5Qi} / ¢Qi = 60 - 0.3Qi. Since changes in
the quantity demanded are brought about by changes in the product price, the
behaviour of a firm’s total revenue along the demand curve can then be easily
related to the value of the price elasticity of demand, at least for linear demand
curves. This is depicted, for the theater company example, in Figure 4. While MR
decreases as Pi decreases and, hence, Qi increases, note that, as should be
expected, TR increases (decreases) so long as Ë > 1 (Ë <1). Hence, if all the
theater company’s costs are fixed, its profits as well as its revenues are maximized
at a price of $30. Note that at this price MR = 0.
62
CHAPTER 3
60
Elastic Demand (η > 1)
Ticket price (in dollars)
30 (η = 1)
Inelastic Demand (η < 1)
D
MR
Q
$
Total revenue (in dollars)
6,000
Q
200
Quantity of tickets
Figure 4: Demand, Total Revenue, and Marginal Revenue
As I increases by $1,000, find the price Pi at which the theater company’s total revenues
and profits are maximized.
In sum, Section 3.1 provides the basic information needed to understand the
factors that may affect the demand for a firm’s product, as well as the response in
demand as (some of) these factors change.
63
3.2 DEFINING AND ESTIMATING DEMAND
3.2.1 Industry demand, network effects, product

attributes and life cycles
Demand functions and curves may, beyond the firm-level, be defined for entire
industries. Managers are often interested in industry demand because it provides
important information about the size of their potential markets and the trends that
affect them. To this end, an important note about industry versus firm demand is
that the firms’ products within an industry are quite likely to be close substitutes,
while the overall industry is less likely to have close substitutes. Therefore, firm-
level demand tends to be more price elastic than the industry-level demand. On
the other hand, one problem that managers face is defining their firms’ relevant
industry and market area: is the theater company competing in the live theater
industry, or in a more broadly-defined entertainment industry? Also, the manager
of the theater company must define the relevant geographical area of the theater
company’s marketplace. Cross elasticities of demand may help to answer these
types of questions.
For some products, demand depends on the number (network) of users. For
instance, consumers were reluctant to buy DVD players until they became
convinced that this product had the potential for widespread use and, hence, that
DVD movies would be produced in high volumes and at attractive prices. In
general, products where these network concerns are important often have
relatively elastic demands, because of a network effect: as more consumers “join the
network,” there is an externality effect on the rest of the consumers that further
stimulates overall demand. While, thus, network considerations of demand play an
important role in the design and pricing of a product, the same is true with regard
to understanding the specific product attributes that are important to customers. In
the theater company example, an anticipated decrease in the demand for tickets,
because of an increase in the price of (the complement) restaurant meals, could be
offset if the management delays the starting time of plays so as to give people more
time to eat at home before going to the play. Managers should, therefore,
constantly seek to develop new and better ways to identify and respond to
consumer demands, while recognizing that market demand for a new product is
64
CHAPTER 3
unlikely to remain constant over time. To this end, the product-life-cycle hypothesis
suggests that the demand for a product can be categorized into four main phases:
1. Introduction
2. Growth
3. Maturity
4. Decline
3.2.2 Demand estimation

Unlike in the theater company example, in real life a firm’s (or an industry’s)
demand function is not known; managers must estimate it. There are, in general,
three methods used in estimating demand:
ñ Interviews
ñ Price experimentation
ñ Statistical analysis
Interviews attempt to estimate demand through customer surveys,
questionnaires, and focus groups. These techniques try to extract information
about the demand relationship by simply “asking consumers.” This is quite
unreliable though, since the sample is rarely representative and people often have
incentives to be untruthful. However, they may provide important information
about which product attributes are most valued by potential customers.
Price experimentation faces three limitations. First, the response in demand can
differ, depending on whether customers anticipate that the price change is
temporary or permanent. Second, they are not controlled experiments, hence,
various other changes may occur simultaneously (for instance, a change in the
price of a related good). Third, an experimental temporary price increase (or
decrease) may be risky, insofar as it may result into a permanent loss in sales.
Statistical (regression) analysis is the most sophisticated and reliable method
used to estimate demand: by virtue of statistical techniques the effects of specific
factors can often be isolated, while the use of large samples of actual market data
would typically result in more reliable findings. Yet, there are three major
problems often encountered: omission of important variables, multicollinearity, and
identification. To illustrate the first two, suppose that A denotes advertising
expenditures and the actual demand function for a company is Q = 120 - 2P + 8A
+ 0.041 I. Assume that a manager ignores I and, if P does not vary over the sample,
instead of a shift in the true demand relationship, the manager estimates a
relationship between Q and A. Then, standard regression would yield the following
estimated equation: Q = 140 + 48A, which overstates the true influence of
advertising on demand. The reason is that the omitted variable I is positively
correlated with A. Nonetheless, even if I has not been omitted from the estimated
relationship, the fact that I and A are correlated (multicollinearity) would also lead
to biased estimates of the I and A individual coefficients, and hence, to misleading
65
information about their effects on demand. To illustrate the identification
problem, suppose that in a three-year period the following sales and price
combinations have been observed: (10,$10), (12,$8), (14,$6). Is it valid to connect
these three points as an estimate of a demand curve? Since, each of those three
sets of data should reflect an intersection of the demand and supply curve for each
year, unless information is provided about the factors (other than the price) which
determine the quantity demanded and/or supplied, the answer is generally no (see
Figure 5).
Price (in dollars) $
S1
D1 S2
P1
P2 D2 S3
P3 D3
Estimated demand
Q
Q1 Q2 Q3
Quantity
Figure 5: Identification Problem
In sum, Section 3.2 addresses important structural considerations, and

reservations that need to be overcome, before one can draw conclusions about a
firm’s or an industry’s demand relationship.
66
CHAPTER 3
A demand function is a mathematical representation of the relationship that
exists between the quantity of a product demanded over a specific period and the
various factors that may influence this quantity. A demand curve is the
graphical representation of this relationship. Movements along this curve
reflect the response of the quantity demanded to a change in price, holding all
other factors fixed. As some of these factors change, they result in a shift of the
entire curve, thus influencing the quantity demanded at any price. Demand
curves vary in the sensitivity of the quantity demanded to price and income
changes. This sensitivity is measured by the elasticity of demand (properly
defined). Substitute goods have positive, while complement goods have negative,
price elasticities of demand. While marginal revenue decreases as price
decreases, total revenue increases (decreases) insofar as demand is elastic
(inelastic). Demand relationships can be defined for individual firms or entire
industries. Information about possible network effects, as well as of the product
attributes, on consumer demand is important in the design of products. The
most reliable method of estimating demand is statistical (regression) analysis.
Yet, it can also suffer from serious problems whose consideration can make
managers more intelligent producers and users of demand estimates.
67
APPENDIX
Activity 1
From the demand function Qi = 117 - 6.6Pi + 1.66Ps - 3.3Pr + 0.0066I, it is easily derived
that ¢Qi = 1.66¢Ps ; ¢Qi = - 3.3¢Pr. Therefore, setting ¢Qi = 6.6, we conclude that an
outward shift of the demand function by 6.6 (like in Figure 1) can alternatively be brought
about by: first, an increase in the price of the substitute good s: ¢Ps = 3.97, and second,
a decrease in the price of the complement good r: ¢Pr = -2.
Activity 2
An increase in I equal to $1,000 results in an outward shift of the demand curve (see Figure
1) so that Qi= 406.6 - 6.6Pi, or equivalently, Pi = 61 - 0.15Qi. Hence, the equation for the
theater company’s marginal revenue becomes MR = 61 - 0.30Qi. Therefore, for profit
maximization: MR = 0 ⇔ Qi = 203 ⇒ Pi = 30.5.
68
CHAPTER 3
BIBLIOGRAPHY
RECOMMENDED READING
Baumol W., Economic Theory and Operations Analysis, Englewood Cliffs, NJ 1977.
Stigler G., The Theory of Price, Macmillan, New York 1987, Chapter 3.
69
CHAPTER 4
THEORY OF PRODUCTION
AND COSTS
The scope of Chapter 4 is to provide the basic theory regarding production and The Scope
costs. Major topics include production and cost functions, the choice of optimal of the Chapter
input mix, profit maximization, cost estimation, and factor (input) demand curves.
After completing the study of Chapter 4, the reader will be able to analyze how Learning
cost minimization and the optimal choice of inputs lead a firm to optimal output Objectives
choice and to profit maximization.
ñ Production function Key Words

ñ Fixed and variable costs
ñ Cost curves
ñ Returns to scale
ñ Returns to a factor
ñ Production isoquants
ñ Isocost lines
ñ Cost minimization
ñ Minimum efficient scale
ñ Economies of scope
The learning material of this chapter provides basic instruction regarding the Introductory
second major cornerstone on which managerial/business economics is based: Comments
production and cost. Its comprehension is necessary in order for the reader to get
answers to critical inquiries arising in managerial decision making. For example,
how do firms choose among inputs to be used in their production process, how
does the optimal input mix change with changes in the input prices, and how do
changes in input prices affect the output choices of firms?
71
4.1 PRODUCTION FUNCTIONS
4.1.1 Returns to scale and factor returns

A production function Q = f (x1, x2, .... , xn) specifies the maximum feasible
output (Q) that can be produced for given amounts of the inputs (x1, x2, .... , xn)
used in the production process. As an illustration, suppose that a pharmaceutical
product Q (measured in units) is produced from just two inputs, A and S, which
are active substances measured in mgs, through the following production function:
Q = Só Aó. Therefore, 100 mgs of S and 100 mgs of A will produce 100 units of
the pharmaceutical product Q. This is an example of a production function which
is characterized by constant returns to scale: a change in all inputs by 1% will result
in a 1% change in output. In contrast, if the production function were Q = S . A,
it would be characterized by increasing returns to scale: if both inputs are doubled,
four times more units of Q will be produced. On the other hand, if a change in all
inputs by 1% results in a less than 1% change in output, the pharmaceutical
production function would be characterized by decreasing returns to scale (for
instance, Q = S1/3 A1/3). Yet, production functions may vary in returns to scale over
the range of output. Typically, production functions have increasing (decreasing)
returns to scale when output is relatively low (high), while returns to scale can be
constant over a medium range of output.
The term returns to a factor (or factor returns) refers to the relation between
output produced and a single input, holding all other inputs fixed.
Factor returns can be expressed in total, marginal, and average terms,
respectively termed as: total product (TPi ), marginal product (MPi ), and average
product (APi ) of the variable input (i). To illustrate, consider once more the
production function Q = Só Aó. Then, if A is fixed, the total, marginal and average
returns to the factor S typically behave as in Figure 1.
72
CHAPTER 4
Q/S
Q
Total
product
Average
product
Marginal
product
S S
S1 S2
Q/S
Figure 1: Factor Returns
The reader can easily trace this common pattern by noting the following. First,
by definition (MPS = ∂TP / ∂S), that is, the MP of S is (at any level of S) measured
by the slope of the TPS curve. Second, also by definition (APS = TP / S), that is, the
AP of S is the slope of the line connecting the origin and the TPS curve (at any level
of S). Then, the behavior of MPi (as well as of the APi) reflects the law of
diminishing marginal product, stating that the increase in production brought about
by a variable input (factor) i will eventually decline whilst increases of that input
beyond a certain level, holding all other inputs fixed, will result in a decrease in
production (i.e. MPi will be negative).
To produce beans on a small farm, three factors of production are needed: labor, seed and
water. If the law of diminishing marginal product were not true, which (funny, still true)
economic proposition could you make?
4.1.2 Input substitutability and isoquants

Most production technologies allow substitution among inputs. In the
pharmaceutical product example, production function Q = Só Aó implies that
there may be many different combinations of S and A that yield a particular
amount of Q. Each isoquant in Figure 2 displays all the possible combinations of
inputs A and S that can be used to produce a certain number of Q units.
73
A
300
200
100
S
Figure 2: Isoquants
Normally, as pictured in Figure 2 and in the center panel of Figure 3, isoquants

are convex to the origin, implying that the substitutability of one input for another
is imperfect, i.e. it declines as more of the second input is used. Hence, the amount
(mgs) of S that it is possible to sacrifice and still produce the same amount of Q
decreases per mg of A used instead, and this is due to the law of diminishing
marginal product. However, in some production processes input substitutability is
impossible and the factors of production must always be used in fixed proportions.
The isoquants are then right angles (see Figure 3, left panel) because, given the
analogy of S and A needed to produce (certain units of) Q, more A (or S) is useless.
In contrast, if the production technology of Q allowed perfect substitutability among
A and S, the isoquants would be straight lines (see Figure 3, right panel).
A A A
S S S
Figure 3: Isoquants for Different Production Technologies
In sum, Section 4.1 addresses, and outlines the linkages among, the main
ingredients of the theory of production: production function, returns to scale,
returns to an input, and input substitutability.
74
CHAPTER 4
4.2 MINIMIZATION OF COSTS
4.2.1 Isocost lines and the optimal input mix

Given that the production technology allows some substitutability among
inputs, how do firms choose their optimal input mix? The answer depends on
inputs prices. For instance, in the pharmaceutical product example, first suppose
that the input prices are PA = $1 ; PS = $0.50. Then, for any amount the firm has
decided to spend for both inputs (for instance $100), an isocost line can be defined
by the equation: Total Costs (TC) (= $100) = $0.5S + $A. Obviously (see Figure
4), this line has a slope -1/2 = -PS / PA. Moreover note that as the price of S
increases, for instance to $1, this slope becomes -1 and, given the same input
budget (TC = $100), the isocost line rotates inward.
A
100
Ps=$1.00 Ps=$.50
per pound per pound
S
100 200
Figure 4: Isocost Lines
Next, assume that the firm has decided to produce Q* (see Figure 5). Which input
mix will minimize total costs? Obviously, TC minimization occurs at (S*, A*), that
is, at the point of tangency between the isoquant for Q* and the lowest possible
isocost line. The reason is that, only there does the slope of the isoquant, which is
always expressed as -MPS / MPA, equal the slope of the isocost line (that is, -PS /
PA) and, hence, (MPS / PS)=(MPA/PA). In terms of the fundamental economic
rationale (discussed in Section 1.4), only at (S*, A*) does the marginal benefit per
75
$ spent on S (and not on A), which is measured by MPS, equal its marginal
opportunity cost, which is measured by the forgone MPA. It should be clear then
that, as PS and PA change so that (as shown in Figure 5) the active substance S
becomes relatively more expensive (i.e., its relative price PS / PA increases), the
optimal input mix changes since the firm substitutes A for S along the Q* isoquant.
Q*
A2*
A1*
S
S2* S1*
Figure 5: Change in Input Prices and Change in the Optimal Input Mix
Given the production function Q = Só Aó, and that the firm has a fixed $200 budget to
produce Q, find the optimal input mix when: (i) PA = $1, PS = $0.5; (ii) PA = $1, PS = $1.
Does the firm remain on the same isoquant as PS increases? How do you interpret your
findings?
4.2.2 Cost curves

The analysis so far can be extended to focus on the behavior of costs as
different levels of output are produced. The long-run total cost curve depicts this
relationship, given that the firm always produces with an optimal cost-minimizing
input mix. Then, marginal cost is the change in the minimum possible total cost per
unit of change in output (MC = ¢TC / ¢Q), while the average cost is the minimum
possible total cost per unit of output (AC = TC / Q). Hence, at any output level,
the MC curve reflects the slope of the TC curve, while the AC curve reflects the
76
CHAPTER 4
slope of the line that connects the origin with the TC curve (at the particular
output level). The typical pattern of behavior of those cost curves, shown in Figure
6, is generated by the varying returns to scale over the range of output.
Total costs (in dollars) $
Total cost
Marginal cost
Cost per unit of output
(in dollars)
Average cost
Q
Q1 Q2
Quantity of output
Figure 6: Long-Run Cost Curves
However, as shown in Figure 7, in the short run the typical pattern of behavior
of the relevant cost curves is slightly different, while it evolves so for quite different
reasons. In the short run firms are unable to adjust their plant sizes. Whenever
they need to increase their output they can do so only by increasing their variable
inputs. Therefore, due to the law of diminishing marginal returns of a single
(variable) input, and given the input price, the behavior of the short-run MC and
AC curves is simply “the mirror image” of the behavior of the MP and AP curves
shown in Figure 1. To interpret the (fixed cost) gap between total and variable
costs, note that in the short run, regardless of how much they produce, firms
cannot avoid standard payments associated with their fixed plants; in average
terms, however, these payments decrease (increase) as output increases
(decreases).
77
$
Total cost
Total costs (in dollars)

Total
variable cost
$ Average
total cost
Marginal cost
Average
variable cost
(in dollars)
Average
fixed cost
Q
Q1 Q2 Q3
Quantity of output
Figure 7: Short-Run Cost Curves
It must be further noted that, by definition, a typical long-run AC curve (like

the one in Figure 6) effectively is an “envelope” curve comprised of all possible
short-run AC curves, each corresponding to the optimal (cost-minimizing) plant
size given the output level. Hence, the minimum efficient scale can be defined as
that plant size at which the long-run AC reaches its minimum. Obviously, achieving
the minimum efficient scale depends on the firm’s projected demand, while its
magnitude may in turn affect the level of competition in an industry; if it is small,
relative to the total industry demand, the number of competitors will be large and,
thus, competition more vigorous.
Last, but not least, economies of scale, or returns to scale, must be
distinguished from economies of scope. The latter concept denotes cost savings that
may result from joint production (giving rise to multi-product firms), while the
former involves efficiency gained from producing higher volumes of a certain
product. The first is possible without the second, and vice versa. Moreover, the
long-run average cost of producing a given level of output may, due to a learning
effect, decline as the firm gains production experience. Effectively this would result
in a downward shift in the entire long-run AC curve, as the cumulative volume of
production increases.
78
CHAPTER 4

(in dollars)
Learning effect
Average cost with low

cumulative volume
Average cost with high

cumulative volume
Q
Quantity of output
Figure 8: Economies of Scale and Learning Effects
4.2.3 Profit maximization, factor demand, and

cost estimation
Given a firm’s cost behavior, what output level should a manager choose in
order to maximize the firm’s profits? The answer can once more be
straightforwardly given by means of the fundamental economic rationale. Since
each extra unit of output produced results in an incremental benefit (measured by
MR), as well as in an incremental cost (measured by MC), for the firm, for the last
unit of output produced the following condition must hold: MR = MC. Note that,
as shown in Chapter 3, MR depends on the firm’s demand curve. This demand
curve, in turn, depends on the degree of competition, or the structure, of the
product market. Therefore, as it will be shown later on (in Chapter 6), the output
decisions of firms will typically vary across different market structures.
On the other hand, recall that the optimal input mix (regarding any inputs i and
j) is obtained insofar as (MPi / Pi) = (MPj / Pj). Then, by its definition, MC can be
effectively measured by the reciprocal of any of these ratios: each reflects the cost
of incremental output, the latter obtained by an incremental change in any input
holding the other input constant. Hence, since moreover MR = MC must hold for
profit maximization, the firm’s demand curve for factor (input) i can be defined as
Pi = MR . MPi. Then, assuming that the quantity of the other input j is adjusted so
that the input mix is kept optimal, at any given price Pi* the firm must use Qi* units
of the input i in order to achieve maximum profits (see Figure 9).
79
$
Cost /revenue per unit of input

(in dollars)
Pi*
MRPi
Q
Qi*
Quantity of input i
Figure 9: Factor Demand and Profit Maximization
As should already be clear, cost curves play an important role in managerial

decision making. However, when using regression analysis to get estimates of cost
(as well as of demand) curves, similar problems arise. For instance, problems
arising from omitted or correlated explanatory variables. Nonetheless, further
complications arise in cost estimation. One of the most serious is due to the fact
that firms often produce multiple products, the latter typically being produced in
the same plant because of economies of scope. Then, total and average costs for
each product can be estimated only by allocating fixed costs across products. This
calculation, however, is complicated by the existence of joint costs, and it is often
arbitrary.
In sum, Section 4.2 shows that the profit-maximizing output level and the
optimal use of inputs, so that cost minimization occurs, are two directly linked
decisions.
80
CHAPTER 4
Most production functions allow some substitution of inputs. Isoquants
display all possible input combinations that produce a particular level of output.
The optimal input mix results in cost minimization for production of a
particular level of output. This input mix occurs where, given the input prices,
the isoquant is tangent to the isocost line. Short-run and long-run cost curves
can be subsequently derived from the isoquant/isocost analysis, and they play an
extremely important role in managerial decision making: when the marginal
revenue is above (below) the short-run marginal cost of production, profits
expand by expanding (reducing) production. The behavior of the average long-
run cost, in turn, determines the optimal plant size for any (predicted) demand
conditions. Given the latter, profit-maximizing firms always choose the output
where marginal revenue equals marginal cost, and adjust their inputs so that
the price of each is equal to its marginal revenue product.
81
APPENDIX
Activity 1
If the law of diminishing marginal product were not true, then a small farm could always
cover the world’s needs for beans! How? By increasing output, so that it always matched
the world demand for beans, by simply increasing the amounts of the variable inputs (i.e.
labor, water and seed) used in bean production!
Activity 2
(i) The condition for optimal input mix is: MPS / MPA (= A/S) = PS / PA (=0.5/1). Hence, since
TC (=$200) = $0.5S + $A, S = 200; A = 100. Therefore, Q = 141.
(ii) The condition for optimal input mix is: MPS / MPA (= A/S) = PS / PA (=1/1) Hence, since
TC (=$200) = $S + $A, S = 100; A = 100. Therefore, Q = 100.
Obviously, in (ii) relative to (i) the firm’s output level is depicted by a lower isoquant. The
reason is that, as PS increases, the firm uses less S without substituting more A for less S.
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CHAPTER 4
BIBLIOGRAPHY
RECOMMENDED READING
Alchian A., “Costs and Outputs”, in The Allocation of Economic Resources, by M.
Abramovitz et al., Stanford University Press, Palo Alto, CA 1959, pp. 23-40.
Stigler G., The Theory of Price, Macmillan, New York 1987, Chapters 6-10.
83
CHAPTER 5
MARKET STRUCTURE
The scope of Chapter 5 is to outline the theory regarding the pricing and output The Scope
behavior of firms operating within different market structures. The topics covered of the Chapter
include perfect competition, monopoly, monopolistic competition, and oligopoly.
After completing the study of Chapter 5, the reader will understand how a
firm’s optimal output and pricing decisions depend on the market structure within Learning
which the firm operates. Objectives
ñ Incumbent firms
ñ Potential entrants Key Words
ñ Economic profit
ñ Competitive equilibrium
ñ Market power
ñ Barriers to entry
ñ Monopoly
ñ Monopolistic competition
ñ Oligopoly
ñ Credible threat
ñ Nash equilibrium
ñ Output competition
ñ Price competition
ñ Collusion and “Prisoners’ Dilemma”
Chapter 5 exploits the material covered in Chapters 3 and 4 so as to provide

basic instruction about the firm’s optimal choice under alternative market Introductory
structures. Therefore, comprehension of the topics covered in this chapter is a Comments
prerequisite in order for the reader to eventually grasp how a firm’s strategy and
organizational architecture can be successfully designed, depending on the firm’s
market environment.
85
5.1 MARKETS, COMPETITIVE MARKETS
AND COMPETITIVE EQUILIBRIUM
A market (or alternatively, an industry or a sector) consists of all sellers and

buyers of a particular product, including those currently engaged in buying and
selling as well as potential entrants. The latter are all firms and individuals that
pose a sufficiently credible threat of market entry to affect the behavior of
incumbent firms. Products with high cross elasticities can, though differentiated
across firms, be considered to be in the same market since they are close
substitutes. A market structure refers to the following basic characteristics: (1) the
number and size of buyers, sellers and potential entrants; (2) the degree of product
differentiation; (3) the amount and cost of information about product and quality;
and (4) the conditions for entry and exit.
A competitive market is characterized by:
1. Large numbers and small individual size.
2. Product homogeneity.
3. Rapid dissemination of accurate information at low cost.
4. Free (e.g., costless) entry and exit.
In competitive markets individual firms take the market price for the product
as given because, if a firm charges more than the market price, buyers will simply
purchase the product from another firm, while no firm has an incentive to charge
less. Hence, any firm i always views its demand curve as a horizontal at the market
price, with MRi thus always being equal to the market price (see Figure 1).
$ $
S
Price (in dollars)
P* P* Di = MRi = ARi
D
Q Qi
Quantity (market) Quantity (firm i)
Figure 1: Individual and Market Demand in Perfect Competition
86
CHAPTER 5
As shown in Section 4.2, a firm’s profit is maximized at the level of output

where MR = MC. Hence, in a perfectly competitive industry, the relevant
condition for profit maximization in the short run is P* = SRMC, where SRMC
stands for the firm’s short-run marginal cost, taking the firm’s plant size (and
possibly other inputs) as given. If, however, the market price is insufficient to cover
the firm’s average variable cost (AVC) (Figure 7 in Chapter 4), that is if P* < AVC
the firm is better off if it ceases production. By doing so the firm will minimize its
loss, since it will then have to incur only its fixed cost. Hence, in the short run the
competitive firm’s supply curve is the portion of its SRMC curve which is above
AVC; a firm can lose money and still find it optimal to stay in business (see Figure
2).
$
ATCi
SRMCi
AVCi
Costs per unit of output
(in dollars)
Qi
Quantity (firm i)
Figure 2: Short-Run Supply Curve
If, however, a loss persists in the long run, despite the fact that the firm has
optimally adjusted its plant size in order to achieve minimum costs, the firm will
leave the market. Hence, for the competitive firm to exit the market in the long
run, it must face P* < LRAC, where LRAC stands for the firm’s long-run average
cost (Figure 6 in Chapter 4).
The competitive equilibrium, in the short and the long run, is then determined
by the intersection of the industry demand and supply curves, where (as was
already explained in Chapter 3) the industry demand curve depicts total quantities
demanded in the particular market, at each price, and the industry supply curve
aggregates the supply decisions of all individual firms, taken as shown above. The
long-run competitive equilibrium is determined as follows. If, as shown in Figure
3, at time t = 0 the typical incumbent firm i enjoys an economic profit of (P0* -
LRACi)Qi0*, this will motivate other firms to enter the industry. Hence, the
87
industry supply curve will shift to the right, pulling the market price down until
economic profits and, hence, entry incentives no longer exist. Therefore, since at
time t=1 : P1* = LRACi, the typical firm will only earn a normal rate of profit, which
is incorporated into the LRAC. Note that in this long-run, competitive equilibri-
um, firms always produce at the minimum of their LRAC. Thus, this equilibrium
is associated with efficient production.
$ $
Price and dost per unit of output
LRMCi S0
LRACi
(in dollars)
P0* P0*
S1
P1* P1*
D0
Qi Q
Qi1* Qi0* Q0* Q1*
Quantity (firm i) Quantity
Figure 3: Firm and Market Equilibrium in a Competitive Industry
In sum, Section 5.1 defines the notion of market (industry) structure and
explains how the short-run as well as the long-run equilibrium is determined, at the
firm and at the industry level, in the context of perfectly competitive markets.
Suppose that, in a perfectly competitive industry, the typical firm suffers a short-run loss.
Explain if, and how, efficient production will be achieved in the long-run equilibrium.
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CHAPTER 5
5.2 BARRIERS TO ENTRY, MONOPOLY,

AND MONOPOLISTIC COMPETITION
5.2.1 Barriers to entry

The competitive model is an ideal market structure. However, it can only be
considered as an approximation in markets where there are strong competitive
forces that reduce economic profits over time. In many industries, nonetheless,
firms maintain notable market power, that is, their individual output decisions have
a noticeable impact on prices. A necessary condition for market power to exist is
that there be effective barriers to entry into the industry. Effective barriers to entry
may be associated with:
1. The incumbent firms’ (possible) reactions to potential entry.
2. The existence of incumbent firms’ specific advantages over potential
entrants.
3. The existence of exit costs.
Each of those sources of barriers to entry is briefly outlined as follows.
1. (i) Incumbents who have heavily invested in assets which are specialized to the
industry are more likely to fight hard to maintain their position in the market.
(ii) The existence of significant economies of scale implies that a new entrant
must produce at high volume to be cost effective and, hence, entry would
trigger vigorous price competition from incumbents.
(iii) Incumbents may react aggressively in order to build a reputation for
future entry deterrence.
(iv) The existence of incumbents’ excess capacity may lead them to a more
aggressive reaction in the event of entry.
2. (i) Incumbent firms may have long-term contracts that limit the opportunities
for customers and suppliers to switch to new entrants.
(ii) Entry is sometimes limited by licensing requirements and patents.
(iii) Learning-effects can result in new rivals having a cost disadvantage
relative to incumbents.
(iv) In some industries customers are reluctant to switch brands, even if the
price of the new product is substantially lower, and this entails extra costs (in
experience goods) for the entrant.
89
3. In some industries it is impossible to “hit and run:” firms bear significant costs,
such as moving employees to new locations and liquidating plants and other
assets, when they decide to exit, and this may deter initial entry.
5.2.2 Monopoly
Effective barriers to entry may occasionally sustain only one firm in an industry.
In this – monopoly – case, the industry and firm demand curves are one and the
same. Then, if the monopolist is unable to prevent resale among customers, a
single price must be charged so that profits are maximized. Equivalently, the
monopolist’s profit-maximizing output (Q*) occurs where MR = MC and the
optimal price (P*) can then be found along the demand curve. For instance, if the
(inverse) demand curve is P = 200 - Q, and MC = AC = $10, then (since MR =
200 - 2Q) Q* = 95 ; P*=105. Hence, as depicted in Figure 4, the monopolist earns
an economic profit abcd = $9,025, while if the industry were perfectly competitive,
the market price would be $10 and the quantity sold 190, with zero economic
profits. Note also that, due to monopoly, there is a loss in potential gains from
trade, cde, which is incurred by consumers along the ce segment of the demand
curve.
$
Price and cost per unit of output
P*=
105 b c
a d e
MC = AC
Q
Q* = 95
MR
Quantity
Figure 4: Monopoly
5.2.3 Monopolistic competition

Monopolistic competition is a hybrid market structure between perfect
competition and monopoly. Though there exist multiple firms and free exit and
entry in the industry, market power is not eliminated, because firms sell
90
CHAPTER 5
differentiated products. Hence, this market structure is similar to monopoly in that

firms face downward-sloping demand curves: a firm can raise its price without
losing all sales and, therefore, each firm strives to select the price-quantity
combination that maximizes its profits. That is, it chooses the level of output
where MR =MC and then finds the optimal price along the firm’s individual
demand curve. The difference is that in monopolistic competition, economic
profits invite entry which is more or less costless. Therefore, entry will shift the
original firm’s demand curve to the left, until economic profits are typically
exhausted in the long run (see Figure 5). Of course, some firms can be more
attractive to consumers (and/or more cost-effective) than others, retrieving some
economics profits, at least for a period of time.
LRACi
Price and cost per unit of output
LRMCi
(in dollars)
P*i
Di
Qi
Q*i MRi
Quantity (firm i)
Figure 5: Monopolistic Competition
In sum, Section 5.2 suggests that, insofar as some barriers to entry and/or pro-
duct differentiation in a particular industry exist, at least some market power will
be sustained by incumbent firms; in the extreme instance the industry will consist
of only one firm which always enjoys economic profits (monopoly).
91
5.3 OLIGOPOLY, NASH EQUILIBRIUM AND
COLLUSION
5.3.1 Cournot-Nash equilibrium

In oligopolistic markets, only a few firms produce most of the output. These
industries are typically characterized by scale economies and other barriers to
entry, while the individual firms’ products may or may not be differentiated. In any
instance, due to large individual size, firm-level decision making requires strategic
thinking: firms always place themselves in their rivals’ positions and consider how
they might react to their own decisions. In such an environment, the principle used
to define an equilibrium is that firms always do the best they can, given what their
rivals are doing (Nash solution concept). Actions determined in that manner are
noncooperative in that each firm is doing the best it can, given the actions of its
rivals. As an illustration, consider a simple duopoly, where two firms, let’s say ACo
and BCo, produce an identical product and each firm may charge either a high or
a low price. Given the expected payoffs (profits) for each choice (see Figure 6), the
Nash equilibrium is for ACo to charge a high price and BCo to charge a low price.
Any other combination is unstable, in that each firm has an incentive to alter its price
given the other firm’s choice.
Figure 6: Nash Equilibrium
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CHAPTER 5
The original oligopoly model, which still possesses substantial explanatory

power, is the Cournot duopoly. Two firms i ≡ A and j ≡ B, facing zero marginal cost,
compete in a homogenous product industry by adjusting their output, while the
industry demand is P = 100 - (Qi - Qj). Therefore, for any output choice of its rival
firm (Qj(i)), the anticipated demand for firm i(j) is P = 100 - Qj(i) - Qi(j). Using the
Nash principle, in equilibrium neither firm must have an incentive to change its
output level, given the other firm’s choice. This of course happens when MRj(i) =
(100 - Qj(i)) - 2Qi(j) = MCi(j) = 0. Hence, each firm’s reaction curve (indicating its
optimal output given its rival’s output choice) is Qi(j) = 50 - 0.5Qj(i) = and the
equilibrium occurs where the two reaction curves cross (see Figure 7).
QB
100
Firm A’s reaction curve
a = Competitive equilibrium
b = Cournot equilibrium
c = Collusive (monopoly)
Quantity of output by Firm B
equilibrium
aa
50
b
33.33
c
25
Firm B’s reaction curve
QA
25 33.33 50 100
Quantity of output by Firm A
Figure 7: Cournot-Nash Equilibrium
Note that the total output level in this Cournot-Nash equilibrium is lower
(higher) than the one that would have been produced under perfectly competitive
(monopoly) conditions. More importantly, note that in the Cournot-Nash
equilibrium, each firm enjoys an economic profit of $1,110.89, whilst if firms could
informally agree (which would be collusion) to produce the monopoly output 50
(each producing half of it and splitting the joint profits), the economic profit of
each firm would rise to $1,250. This analysis can be easily extended when marginal
costs are positive and/or there are more than two firms in the industry: as the
number of firms increases, total output increases (as marginal costs increase total
output decreases).
93
5.3.2 Collusion and the “Prisoners’ Dilemma”
Firms trying, even through formal agreements (such as cartels), to maximize
profits by restricting output and, thus, increase the price level, would typically face
a “Prisoners’ Dilemma” type of problem: so long as all other firms restrict their
output, any individual firm has an incentive to cheat, since the price will not be
significantly affected by the extra output of only one firm. However, as all firms
cheat, by increasing their output in the Nash equilibrium, the price decreases and
the cartel breaks down. As shown in Figure 8, the reason is that cheating is the
dominant strategy for any single firm, i.e., whatever choice is made by BCo (ACo),
the profit of ACo (BCo) increases as it increases its own output.
ACo-High output
$200
$200
BCo-High output
Figure 8: Cartel’s (Prisoners’) Dilemma
The same problem arises if firms focus on choosing their prices, rather than
their output level (Bertrand Oligopoly). Here, nonetheless, in the Nash equilibrium
firms would choose a price equal to the marginal cost, i.e., the perfectly
competitive outcome would emerge even though there are only two firms!
In sum, Section 5.3 outlines the way in which the Nash solution concept can be
used to determine the equilibrium in oligopolistic markets and, by this token,
explains why it is difficult for the monopoly outcome to emerge in such markets.
Properly changing the pay-offs depicted in Figure 6, explain why ∞Co and BCo would not
cooperate (collude) in the Betrand-Nash equilibrium.
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CHAPTER 5
In perfectly competitive industries:
ñ Firms determine their output by equating the market price, which is
beyond their control, with their marginal cost.
ñ Firms stay in business so long as they enjoy at least a normal rate of
profit.
ñ In the short run, firms may either enjoy economic profits, or suffer a
loss, which, however, cannot persist in the long run where efficient
production is achieved.
Yet, even if the number of firms is large and entry is free, product
differentiation may sustain some economic profits, however only for a short
period of time (e.g., the monopolistic competition case).
On the other hand, if there are barriers to entry, at least some market power
will be sustained to incumbent firms. Hence:
ñ In the extreme monopoly case, the industry will consist of only one firm
which will always enjoy economic profits by charging a price above
marginal cost.
ñ In oligopolistic industries, the Nash equilibrium is determined through
strategic interaction among a few large firms, where the output and
pricing decisions of each firm is optimally taken given the actions of its
rival firms. However, the economic profits of those firms are not as large
as would be if they could effectively collude and jointly post the
monopoly price and output.
95
APPENDIX
Activity 1
If the typical firm i adjusts its plant size (so as to achieve the min LRAC) and still suffers a
loss: (LRACi - P*)Qi*, then (at least) the less efficient firms will eventually leave the industry.
Hence, the industry supply curve will shift to the left, pushing the market price up, until the
normal rate of profit is achieved at the efficient scale of production; hence, exit incentives
will no longer exist.
Activity 2
Since firms compete in prices, if (for instance) BCo charges PT > MC (“high price), then
ACo may profitably capture all industry sales by slightly lowering its price, while this
opportunity does not exist if PT = MC (“low price”). Hence, the (clockwise) pay-offs in
Figure 6 become: (0,0), ( >>0,<0), (>0,>0), (<0,>>0). Then, it is easy to check why “low
price” is the dominant strategy for both firms and, hence, collusion (“high price,” “high
price”) cannot emerge in the Bertrand-Nash equilibrium.
96
CHAPTER 5
BIBLIOGRAPHY
RECOMMENDED READING
Dixit A., Nalebuff B., Thinking Strategically, Norton, New York 1991.
Stigler G., The Theory of Price, Macmillan, New York 1987, Chapter 3.
97
CHAPTER 6
MARKET POWER
Chapter 6 presents the basic analysis of pricing with market power, that is, of the The Scope
various pricing decisions of firms facing downward-sloping demand curves. The of the Chapter
major topics covered include markup and cost-plus pricing, two-part tariffs, and
price discrimination.
After completing the study of Chapter 6, the reader will be able to analyze how Learning
a firm’s pricing decisions can be optimally taken: Objectives
ñ given the firm’s demand and cost structure
ñ assuming that the prices of its competitors (if any) are held constant.
ñ Consumer surplus Key Words

ñ Markup
ñ Price discrimination
ñ Cost-plus pricing
ñ Block pricing
ñ Two-part tariff
ñ Personalized pricing
ñ Bundling
Using the basic tools of economics to provide a rationale of many observed Introductory
pricing policies, this chapter is an introduction to product pricing. The analysis Comments
identifies several key features in the business environment that can affect pricing
decisions, such as the nature of the customer base and the type of relevant
information retained. However, the actual implementation of a pricing strategy is
further complicated by legal and/or strategic issues, which are also considered later
on in the book.
99
6.1 SINGLE PRICING
6.1.1 Sensitivity of demand and optimal markup

So long as firms retain some individual market power (i.e., they face an
individual downward-sloping demand curve, like the one in Figure 1), they can
raise price without losing all customers to competitors. Hence, if in addition the
business setting is expected to be stationary, in any single period the managers
must choose a pricing policy that maximizes the firm’s current profits. Then, since
the demand curve at any point measures what consumers are willing to pay for the
product, if the firm were to sell the product at MC, consumers would enjoy all
gains from trade in the form of consumer surplus (the shaded area in Figure 1).
$
Price (in dollars)
Demand
MC
Q
Quantity
Figure 1: Selecting a Pricing Policy
In principle, therefore, managers must devise a pricing policy that instead

captures as much of that surplus as possible in the form of company profits.
The benchmark pricing policy is single pricing, i.e. the firm charges all customers
the same price. If, for example, the firm’s inverse demand curve is P = 85 - 0.5Q
and MC = $10, applying the MR = MC principle, its profits are maximized at P*
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CHAPTER 6
= $47.50 and the quantity produced and sold at that price (Q*) is 75. Hence, since
it can be easily shown that MR = P(1-1/Ë) the optimal markup $37.50 (calculated
[P*-MC] = MC[ 1/Ë ] from the formula decreases with the sensitivity of the firm’s
(1-1/Ë)
demand to price changes, measured by the price elasticity of demand Ë. For
instance, if the firm’s demand curve were instead P = 42.50 - 0.25Q the optimal
markup would be $16.25 (see Figure 2 and note that the price elasticities of the
inverse demand schedules under consideration are 1.27 and 1.62 respectively).
$ $
85.00 85.00
P*=
47.50 Demand 42.50
P*= Demand
26.25
10.00 MC 10.00 MC
MR MR
Q Q
Q* = 75 170 Q* = 65 170
Figure 2: Sensitivity of Demand and Optimal Markup
6.1.2 Estimation of the profit-maximizing price

Under single pricing, one practical problem (in applying the MR = MC rule for
profit maximization) is that managers often do not have precise information about
their firms’ demand curves. Yet, a technique to overcome this problem is linear
approximation. For that technique, information must be available, at least about
the current price (say $70) and quantity sold (say 30), as well as about the quantity
sold (say 40) if the price is changed (say lowered) by a certain amount (say $5). A
manager can then approximate the slope (b = {¢P / ¢Q} = -0.5 as well as the
intercept (· = {70 + 0.5(30)} = 85) of his/her firm’s inverse demand curve, as the
latter can be reasonably approximated by the linear equation P = · + bQ.
Alternatively, assuming that the price elasticity of demand Ë is constant along
the entire demand curve (or, at least, across a range of values on the demand
curve), so long as a current estimate of Ë is available, the profit-maximizing price
can easily be approximated using the optimal markup formula
[P* - MC] = MC[ 1/Ë ]
(1-1/Ë)
Finally, one of the more common single-pricing methods used is cost-plus
pricing. For that method, a targeted percentage return on sales (s) is needed, and
101
the price which would yield this return is simply found from the formula P = ATC
1-s
However, this approach ignores two fundamental economic considerations: (1)
to determine the equilibrium output, only the incremental (e.g., variable) costs
matter; and (2) to determine the equilibrium price, the customers’ response to
price changes, the sensitivity of which is measured by Ë, also matters.
In sum, Section 6.1 provides the reasoning for the alternative methods which a
firm possessing market power may employ to determine a single profit-maximizing
price for its product. Yet all those methods assume, rather than test, current
demand circumstances, and ignore future demand as well as strategic interaction
among rival firms.
If your firm’s assumed (inverse) demand curve is P = · / Q which would be the most
convenient method to estimate the profit-maximizing price? Explain.
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CHAPTER 6
6.2 POTENTIAL FOR HIGHER PROFITS

AND PRICE DISCRIMINATION
As Figure 3 depicts, by means of single pricing the firm captures some (e.g. the
shaded rectangle), but not all, of the potential gains from trade; the value of the
triangle abc still accrues to consumers who buy Q*, while the value of the triangle
edf is simply lost. Are there other pricing strategies that would allow the firm to
capture at least a part of those values?
P* a c
e
Demand
d f
MC
MR
Q
Q*
Figure 3: Capturing More Profits
6.2.1 Homogenous consumers

Assume that consumers are homogenous, that is, all potential customers have
quite similar individual demand curves. In effect, all of them are willing to pay the
same maximum price for the product; in many instances this is reasonable. Then,
since the marginal value that the representative consumer places on each
additional unit declines as purchases increase, the firm could in principle capture
all potential gains from trade by charging a price equal to the marginal value of
103
each unit. In practice this policy can be approximated via a block pricing scheme:
the firm charges a high price for the first purchase block and declining prices for
subsequent blocks.
A special case of the block pricing scheme (yet, widely used in real life) is the
two-part tariff. As an example, consider a tennis club where the consumer pays a
fee to join the club, and then so much per play. Suppose that the representative
consumer’s inverse demand function is P = 10 - Q while MC = $1. As shown in
Figure 4, the club could then capture all gains from trade by charging an up-front
fee equal to $40.50 and a per-play price covering MC (e.g., equal to $1). In
contrast, under the MR = MC single pricing rule, leading to no fee and a $4.50 per-
play price, the club’s profits would only be $20.25.
10
Price (in dollars)
Demand
P* MC
=1 MR
Q
Q* = 9
Quantity
Figure 4: A Two-Part Tariff Pricing Scheme
6.2.2 Heterogeneous consumers

As is implied above, a firm facing homogenous consumers may increase its
profits by varying prices across blocks of its product (second-degree price
discrimination). When potential customers vary in their willingness to pay for the
product (e.g. consumers are heterogeneous), price discrimination across customers
may raise the firm’s profits, provided that market segmentation is possible. For
that to happen:
1. The different price elasticities of demand, across submarkets, must be
identified.
2. Speculative transfers among consumers, across submarkets (arbitrage),
must be effectively restricted.
Then, the optimal markup rule dictates that higher prices must be charged to
those (segments of) consumers with lower price elasticities of demand.
In its extreme version, this policy implies personalized pricing (or first-degree
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CHAPTER 6
price discrimination): each customer is charged exactly the price that she/he is
willing to pay for the product unit according to the marginal utility she/he obtains.
Obviously, the firm can then extract all potential gains from trade, by charging a
different price for each unit of its product (and, thus, producing the perfectly
competitive output). Though it seems quite unrealistic, companies selling over the
Internet can approximate this rule.
Using the example depicted in Figure 4, explain the difference/similarity between two-part
tariff and personalized pricing.
More plausibly, group pricing (or third-degree price discrimination), results when
a firm effectively separates its customers into several groups and sets a different
price for each group, following the optimal markup rule. As an illustration
consider the “Delphi Ski Resort” company, facing a MC of servicing a skier equal
to $10, which, however, can separate its overall demand into: (1) local skiers’ Q1 =
500 - 20P; and (2) out-of-town skiers’ Q0 = 500 - 10P. Then, the optimal prices are
found by setting MR1 = MC ; MR0 = MC. As depicted in Figure 5, in this way the
company obtains the optimal markups, by charging a higher (lower) price to the
group whose elasticity of demand is lower (higher), and, thus, enjoys an overall
profit of $5,125. In contrast, if the company applies a single (MR = MC) pricing
rule, by considering the overall demand Q = Q1 + Q0 = 1,000 - 30P, its profit
would be $4,081. Of course, for price discrimination to be effective, a prerequisite
is that it would in some way be impossible for local skiers to resell their (low-cost)
access rights at a price less than $30.
$ $
50.00 50.00
Ë* = 1.50
P* = 30.00
25.00 Ë* = 2.33
P* = 17.50
10.00 MC 10.00 MC
MR MR
Q0 Q1
Q* = 200 Q* = 150
Figure 5: Third-Degree Price Discrimination

In sum, Section 6.2 outlines the techniques used to increase a firm’s profits, by
capturing at least part of the gains of trade which are lost under single pricing. The
principle on which these techniques are based is that of price discrimination,
across consumers and/or product quantities, according to the differential
willingness to pay.
105
So long as a firm (i) retains some market power, (ii) does not consider the
rival firms’ (if any) reactions to its pricing policy, and (iii) gets some reasonable
estimate of its demand conditions:
ñ The single-pricing (MR = MC) rule is plausible, yet unable to lead the
firm in capturing the overall gains from trade.
ñ The firm can do better with price discrimination. In fact, single pricing is
just a special case of a two-part tariff, while block pricing is the general
method of price discrimination across output quantities, when
consumers are (more or less) homogenous.
ñ When consumers are heterogeneous and effective market segmentation
is possible, price discrimination across groups of consumers will lead
the firm to profit maximization, as it obtains the optimal markup for
each particular group.
Other considerations must also be taken into account when a firm decides
about its pricing policy:
ñ A multiple-product firm may extract additional profits from a customer
base with heterogeneous product demands by bundling its products
(selling them at a price below the sum of the individual prices).
ñ A firm may offer “free samples,” or charge the product below marginal
cost, in order to create lock-in-effects and profit from future demand.
ñ A firm may produce high volumes (and, hence, sell at a low price) in
order to take advantage of learning effects in the future.
106
CHAPTER 6
APPENDIX
Activity 1
Since the firm’s demand curve is Q = · / P it can be easily checked that the price elasticity
of demand: Ë = -1 along the entire demand curve. Therefore, by straightforwardly applying
the optimal markup formula
[P* - MC] = MC[ 1/Ë ], we find that P* = 3MC.

(1 - 1/Ë) 2
Then, whenever the MC changes,we can easily adjust the firm’s profit-maximizing price.
Activity 2
As can be easily grasped by inspecting Figure 4, the similarity between a two-part tariff and
personalized pricing is that, under both techniques, the different prices charged reflect the
consumers’ different willingness to pay, rather than going without the particular amount of
the product. However, there is a significant difference: under a two-part tariff, the same
representative consumer is charged two different prices – one for a block of the product
and another per unit; while under personalized pricing, prices are differentiated across
consumers, each buying only a few units of the good. Hence, for the latter technique to be
plausible, much larger and more specific information is needed. Nonetheless, with
personalized pricing the firm is more able to enlarge its gains from trade.
107
BIBLIOGRAPHY
RECOMMENDED READING
Nagel T., The Strategy and Tactics of Pricing: A Guide to Profitable Decision Making,
Second Edition, Prentice Hall, Englewood Cliffs, NJ 1994.
Oi W., “A Disneyland Dilemma: Two-Part Tariffs for a Mickey Mouse Monopo-
ly”, Quarterly Journal of Economics, February 1971, pp. 77-96.
108
CHAPTER 7
CREATING AND CAPTURING

VALUE BY FIRMS
The scope of Chapter 7 is to analyze the policies that managers adopt for their The Scope
firms to realize sustained profits. Firms do not operate alone. They act within an of the Chapter
industry and interact with other firms. They need to develop the appropriate
strategies in order to create and capture value.

ñ be familiar with the actions that managers take to improve the profitability Objectives
of their firms when they act in an industry
ñ understand the methods firms use to create and capture value.
ñ Strategy Key Words

ñ Creating value
ñ Capturing value
ñ Hardware
ñ Wetware
ñ Software
ñ Market power
ñ Team production capabilities
ñ Economies of scope
ñ Economics of diversification
ñ Organizational architecture
In previous chapters, the focus was on the actions taken by the managers to Introductory
create value through input, output and pricing policies. In this chapter value Comments
creation is considered within a given industry. A firm can create value by lowering
its cost of production and /or increasing the demand for its products. It is easier for
the firm to capture the value it creates when it has market power.
109
7.1 THE STRATEGY OF FIRMS
Strategy has to do with the actions that managers take to increase the value of
their enterprise. These actions do not refer to the details of the operation of the
firm, but rather to the actions that the firm has to take with respect to a broad
number of issues. Strategy is a key determinant of the success or failure of the
enterprise.
7.1.1 Value creation by firms

The supply and demand curves for an industry are shown in Figure 1. Managers
can increase value either: (1) by reducing transaction or production costs that shift
the supply curve to the right (dotted line supply curve), or (2) by increasing the
demand for the product that shifts the demand curve to the right (dotted line
demand curve). Examples of transaction costs are the cost of searching for a new
product, the cost for learning the quality and the characteristics of a product, and
so forth.
$
a
Co
nsu
me
r-b Effective supply given
orn
e
tra transaction costs
nsa
ctio Potential supply if no
nc
ost transaction costs
s
Consumer surplus
P*
ts
Producer surplus cos
action
ans Potential demand if no
e tr
r-born transaction costs
e
duc
b Pro Effective demand
after transaction costs
Q
Q*
Figure 1: Creating Value
110
CHAPTER 7
The sum of producer and consumer surplus is called the total value created by the
industry.
Managers can take four types of actions to create value:
ñ Actions that reduce the production or transaction cost
ñ Actions that reduce the consumer transaction cost
ñ Actions that increase consumer demand
ñ Introduction of new products
7.1.2 Reducing production costs

Managers discover new technological opportunities to reduce production costs
and increase value. They also devise ways to lower the cost of transacting with
consumers and suppliers. In the personal computers industry there has been a
considerable decrease in the cost of production over the last few years. Computer
manufacturers have reduced the cost of transacting with suppliers and customers
through direct computer links with major suppliers.
7.1.3 Reducing consumer transaction costs

This refers to ways to reduce the cost that consumers incur when making their
purchases. Early Wal-Marts, for example, were established in small rural towns.
This reduced the travel time that consumers of these towns had to spend for a
large part of their shopping.
7.1.4 Increasing demand

Managers can increase the effective demand for their products by enhancing
the expected quality of their products, by decreasing the price of the complements
and by increasing the price of the substitutes.
Product Quality
An improvement in the quality of a product may increase its demand. When the
associated increase in the production cost is smaller than the increase in the
demand, we have value creation in this industry.
Prices of Complements
An increase in the demand for the products of a firm may come from a decrease
in the price of its complement products. For example, IBM produces personal
computers and HP produces printers. Here, we assume that consumers always buy
a printer when they buy a personal computer (the two products are strong
111
complements). Let the price of an IBM computer be Pc and the price of a HP
printer be Pp. Let the demand for each product be:
Q = 12 – (Pc + Pp)
where Q is the price of the (computer and printer) bundle. It is easy to notice that
demand is zero when Pc + Pp is not less than 12 and positive otherwise. Let also
the marginal cost for each product be zero. We further assume that the two firms
do not cooperate, therefore each firm maximizes its profits given its expectation of
the other firm’s price. The demand curves for IBM and HP are:
Pc = 12 – Q – Pp
and
Pp = 12 – Q – Pc
respectively, where, Pp and Pc give the expectations about the other firm’s price.
By setting MR = MC = 0 we have:
Pc = 12 – 2Q
and
Pp = 12 – 2Q.
These give:
Pp = 12 – 2Pc
and
Pc = 12 – 2Pp.
The equilibrium prices Pp* and Pc* simultaneously solve the above equations.
Pp
12
IBM’s reaction curve

in choosing Pc
Price of HP printers
Pp* = 4
HP’s reaction curve
in choosing Pp
Pc
Pc* = 4 6 12
Price of IBM computers
Figure 2: Noncooperative Pricing for IBM and HP
In equilibrium each firm chooses a price of 4. Each firm sells 4 units and the profits
for each firm are 16. Combined profits are 32.
112
CHAPTER 7
Prices of Substitutes
When managers can affect the price of substitutes, they create value for their
firms. This is because low-priced substitutes reduce the demand for their products.
In the above example, what is the outcome if the two firms create a joint venture and act
as one firm by coordinating their prices? What are the total profits of the two firms in this
case?
7.1.5 The introduction of new products and

services
The introduction of new products that incorporate better technology also
creates value for a firm. Digital cameras and digital video displays (DVDs) are
such examples.
7.1.6 Cooperation to increase value

Cooperation of firms that produce complementary products can increase value.
In many cases, competitors increase value by cooperating. This happens, for
example, when they create joint ventures to share the cost of research and
development for the production of a new product.
7.1.7 Converting organizational knowledge into

value
Managers should use all the available assets to increase value. These include
the enterprise’s hardware, that is, its physical assets like its location. They also
include its software, that is, patents and recipes that it may possess. Finally, they
include its wetware, that is, the brainpower of its employees. Managers must find
ways to convert the knowledge and the ideas the employees may have into
software.
113
7.1.8 Creating value
An important factor that increases the value of a firm is the more efficient use
of its resources. Better use of the existing technology, new methods of organizing
the production, and so on, allow firms to produce improved products at a lower
cost. Furthermore, the use of new developments in information, communication
and production technologies considerably increases the opportunities for value
creation.
In sum, Section 7.1 describes the ways in which a firm can create value. This can
be done either by lowering the cost of production or by increasing the demand for
the products of the firm.
114
CHAPTER 7
7.2 CAPTURING VALUE
Value creation does not necessarily imply more profits. A firm should have
market power to capture the value that it has created. Otherwise, the competition
might decrease profits. As Figure 3 shows, only firms with market power are able
to capture a portion of their producer surplus as economic profit.
$ $ $
Producer surplus
S
P* Dj P*
Di
D
Qi Qj Q
Q*
Figure 3: A Firm with Market Power versus a Firm in a Competitive Industry
7.2.1 Market power

Entry barriers increase market power. Entry barriers are all the things (such as
patents and brand names) that make it difficult for a potential entrant to replicate
the position of a firm that already exists. There is empirical evidence of a positive
relation between profits and entry barriers. However, entry barriers alone do not
guarantee the existence of economic profits. The following factors are also
important for the existence of economic profits.
The degree of rivalry is related to the number and the relative size of the
competitors in an industry. When the degree of rivalry is high, competition is
strong and profits are low even if there are entry barriers.
The threat of subsidies is another factor. Firms face much more severe
competition when their products have many substitutes. Profits can again be low
even if there are entry barriers.
115
Profits are also low when there are only a few large customers. In such a case
they will use their buying power to extract lower prices. The same happens when
there are only a few key suppliers that provide an important raw material to an
industry.
In many cases firms try to decrease competition by acting strategically. Thus,
they can create entry barriers, reduce intra-industry rivalry, and so on, in an effort
to increase their market power. They can, for example, lobby for taxes or
restrictions on imports in an effort to decrease competition from abroad.
7.2.2 Important factors of production

Very often the success of a firm depends upon the use of a specific important
factor. For instance, a gasoline station might be very profitable if it is on a busy
highway. In a case like that other firms will compete for this location. If
competition works, the gains from the use of this specific factor (i.e. privileged
location) will eventually accrue to the owner of the specific factor, and the rents
will eventually go to the owner of the land where the gasoline station is located. As
regards important factors of production, the following are typically involved.
Producer Surplus Captured by Superior Assets
In cases where the firm owns the superior asset, its value (and thus the
opportunity cost of continuing to use it) will be bid up. The firm pays the rent to
itself for its continued use of the asset. Figure 4 provides a graphical analysis of the
above.
$ LRAC1
$
LRMC
LRAC0 S
Per unit cost
P1*
P0*
D0 D1
Qi Q
Q0* Q1* Q0* Q1*
Firm i Market
Figure 4: Producer Surplus Created and Captured by Superior Assets
The graph on the right shows the conditions (supply and demand) in the market
and the graph on the left shows the cost curves of a typical firm in the industry. The
116
CHAPTER 7
initial price is P* and the firm does not make any economic profits (P*0 = LRAC0).
If there is an increase in the demand for the product, the new equilibrium price
becomes P1*. At the new price, the firm makes an economic profit. However,
competitors and new entrants will compete for the factor that allows the firm to
produce at an average cost below P1*. As a result, the price for this factor will
increase. In the new equilibrium, the new long-run average cost curve will be equal
to the new equilibrium price (P1* = LRAC1). The firm does not have any
economic profit. The extra revenues of the firm due to the higher price will be paid
to the factor responsible for the increase in the price of the product.
Table 1 gives another example.
Table 1: Opportunity Costs of Delta
Profits $400,000 $300,000
Profits $0 ($100,000)
In this example the following assumptions have been made: Delta’s cost of
extracting enough oil to make a gallon of gasoline is $0.10. This oil can be sold for
$0.50. It costs another $0.50 to refine the oil into gasoline. Delta produces 1
million gallons of gasoline every month. These are the only relevant costs or
revenues. The top part of the table shows Delta’s income statement by using
standard accounting techniques assuming gasoline prices are either $1 or $0.90.
Recall the production cost for oil is $0.10 per gallon. Delta reports positive profits
at both prices ($400,000 and $300,000 respectively).
However, the above analysis ignores the opportunity cost of the oil, that is, the
market price. Taking the market price into account, the company breaks even
when the price is $1.00 and suffers losses when the price is $0.90. In the second
case it is better for the company to get out of the production of gasoline and enter
the open market to sell the oil.
Second-Price Auctions
When competition takes the form of a second-price auction, each buyer
submits a bid. The buyer who offers the highest bid obtains the asset and pays the
bid of the second-highest buyer. It can be shown that in a case like that, each
bidder submits a bid equal to his/her true valuation.
117
Show that in a second-price auction each buyer bids his/her true valuation.
In such a case, the producer surplus by the winning bidder is limited to the
difference between the asset’s first and second-highest valued uses. The rest of the
value will be reflected in the price of the superior asset.
Team Production Capabilities
The various factors of production do not act independently in a firm. They
cooperate, and the increase in the value of the firm is often the result of the good
cooperation between these factors. For this reason, it is possible for the overall
firm to be more valuable than the sum of its parts. In this case the firm has team
production capabilities. It is difficult for the team production capabilities of a firm
to be duplicated by other firms. This is because it is very difficult for those outside
the firm to find the exact source of the synergies within a team.
7.2.3 A successful example

Wal-Mart’s stores created value by effectively using entry barriers to get market
power. Their success was also based on team production capabilities. Wal-Mart’s
stores were first established in small towns. As the number of stores increased, the
firm designed an efficient system to distribute its products to the distant Wal-Mart
stores. This strategy was very successful. Other competitors could not mimic Wal-
Mart (by establishing stores in the same towns) since the size of these towns was
small. In this way Wal-Mart created a successful entry barrier and market power.
Wal-Mart also created team production capabilities as the success of the stores
was not only due to the location of the stores but also to the efficient distribution
system of its products.
7.2.4 All good things must end

The creation of value is the result of a continuous effort. A firm that is
successful today may not continue creating value in the future. Wal-Mart’s growth
slowed significantly during the late 1990s. And this is not the only example. Many
successful firms from yesteryear have gone out of existence. At the same time,
none of today’s top firms existed 50 years ago. New technological innovations,
changes in consumer tastes, new competitors either from the same country or
abroad may result in the decline of the profits of a firm. In such an environment a
firm should always try to find a succession of new value-increasing strategies.
In sum, Section 7.2 describes how the firm can capture the value it creates.
When a firm has market power, it is easier for it to capture the value it creates.
118
CHAPTER 7
7.3 DIVERSIFICATION
Today, only a very small number of firms produce a single product. Most firms
produce a large variety of products, that is, they are diversified. Is corporate
diversification a good strategy to create and capture value? In this section we are
going to analyze the costs and benefits of this strategy.
7.3.1 Benefits associated with diversification

The most important benefit from diversification is the existence of economies
of scope. A firm benefits from economies of scope when it can produce more than
one product at a lower cost than separate firms could produce the same products.
For example, when the firm uses the same input for the production of more than
one product, it can buy larger quantities of the input at lower prices.
Another benefit from diversification is the supply of complementary products.
Car producers have historically entered the consumer credit business. They
offered low-interest-rate loans in an effort to increase demand for their cars.
7.3.2 Costs associated with diversification

On the other hand diversification may have costs. The costs of diversification
are associated with the problems that arise as the firm grows. Usually when a firm
grows it becomes more bureaucratic and its ability to take decisions fast declines
more and more. The cost of management also increases. Furthermore, since
managers do not have the same incentives as the owners of a firm (to increase the
value of their firms), firms do not have the same ability to create and capture value
as they had before.
7.3.3 Management implications

A firm may enter into the production of more than one product to reduce the
volatility of its earnings. However, this might not increase the value of the firm
119
since it is possible that the firm might not be as successful in the production of all
its products. It would be better if shareholders diversified within their own
investment portfolios, as they can do that at lower cost.
Diversification creates value when the business serves common markets or uses
related technologies. It is more effective in cases where it effectively takes
advantage of economies of scope and promotes complement products.
In sum Section 7.3 provides an analysis of the benefits a firm has through
diversification. Diversification can be beneficial if the firm takes advantage of
economies of scope.
120
CHAPTER 7
7.4 STRATEGY FORMULATION
An effective strategy of a firm is related both to the internal resources and

capabilities of the firm and to its external environment. The firm’s internal
resources and capabilities include its physical, human, and organizational capital
and its team production capabilities. It is also important to know the opportunity
cost of its resources since it may be profitable to sell these resources to other firms.
The firm’s external environment includes the markets of its inputs and its
products, the available technology, and government regulation.
7.4.1 Combining environmental and internal

analyses
Managers should combine environmental and internal analyses to be able to
create value. They need to know the capabilities and weaknesses of their business.
They also need to know the opportunities technology provides. Their success very
much depends on their ability to use the opportunities that the environment
provides to strengthen the capabilities of their firm, thus improving the
performance of their business. They also need to be aware of the developments
that occur in the business environment and to adapt their strategy accordingly.
7.4.2 Strategy and organizational architecture

Another very important factor in the firm’s value is its organizational
architecture. Managers will not be able to implement their strategy unless the
business has the appropriate structure. For example, it needs to have a
decentralized decision system if it chooses to react quickly to changes in consumer
demands. Sometimes, it is the firm’s structure that influences its strategy. If, for
example, the firm has an effective decentralized decision-making system, it might
decide to enter a market for which this type of organizational design is well suited.
In sum, Section 7.4 provides a description of the determining factors of a firm’s
strategy. Any strategy should take into account both the internal resources and
capabilities of the firm as well as its external environment. A successful manager
121
uses the opportunities in the external environment to increase the value of the
firm.
A firm’s strategy aims to create and capture value. This can be achieved by
exploiting the opportunities to decrease its cost of production and to increase
demand. The potential a firm has to capture value increases with market power.
A firm’s strategy is successful when it takes into account the external
environment and uses the opportunities technology provides to strengthen its
capabilities.
122
CHAPTER 7
APPENDIX
Activity 1
In this case, the joint venture sets a price:

P = Pc + PP.
We have P = 12 – Q. The marginal revenues for the joint venture are 12 – 2Q. The marginal
cost is again zero. The joint venture produces Q = 6 to maximize its joint profits. The price
for both products is P = 12 – 6 = 6, and the combined profits are P x Q = 6(6) = 36.
Activity 2
Assume there is a buyer who has a value of $10 for the asset. This buyer will never bid
above $10, (say $11) because it is possible that he/she may be the buyer who wins the
asset, and if the second-highest buyer also bids above $10 (say $10.50), he/she will have
to pay a price above $10 (i.e. P = $10.50) and to suffer a loss of $0.50.
The buyer will never bid below $10 (say $9). If he/she does so, he/she just increases the
chances that he/she will not be the winning buyer, i.e. someone else may bid above $9
(say $9.50), and he/she can win the asset at a price less than $9.50.
The buyer will bid $10. This is how he/she maximizes the probability that he/she will be the
highest bidder.
123
BIBLIOGRAPHY
RECOMMENDED READING
Jarrell G., Brickley J., Netter J., “The Market for Corporate Control: The
Empirical Evidence since 1980”, Journal of Economic Perspectives, 2, 1988, pp. 49-
68.
Porter M., Competitive Strategy, Free Press, New York 1980.
124
APPENDIX
137
APPENDIX
138
Answers to Self Assessment Exercises
Chapter 1
1. b
2. b
3. e
4. a
5. c
6. a
7. Facilitating organizational competitiveness; enhancing productivity and quality;
complying with legal and social obligations; promoting individual growth and
development,
8. b.
9. b.
10. Adopting a strategic perspective; understanding the environmental context;
staffing the organization; enhancing motivation and performance of
employees; conducting the ongoing management of the existing workforce;
meeting other arising or new challenges.
Chapter 2
1. a
2. b
3. b
4. b
5. a
6. a
7. b
8. b
9. b
10. a
Chapter 3
1. c
2. a
3. a
4. b
5. b
6. c
7. a
8. b
139
APPENDIX
9. ∞ needs analysis is the assessment of the organization’s job-related needs and

the capabilities of the current work.
10. b
Chapter 4
1. b
2. a
3. b
4. b
5. a
6. a
7. b
8. Job ranking
9. Job evaluation
10. Reinforcement theory
Chapter 5
1. c
2. b
3. c
4. a
5. d
6. a
7. b
8. c
9. b
10. e
140
APPENDIX
George Agiomirgianakis is Associate Professor at the Business School of the Hellenic

Open University and holds a Senior Research Fellowship at City University of London.
He is also the Secretary General of the European Economics and Finance Society
(EEFS). He has 20 years teaching experience in higher education, both in Greece and
in Britain. From 1997 to 2001 he taught at City University of London. His research
interests lie in the areas of International Economics, Macroeconomic Policy Games,
Labour Economics, International Migration, Human Capital, Economic Growth,
SMEs and Foreign Direct Investment. He has served as guest editor for the following
journals: Policy Modelling, Applied Economics, International Journal of Economic
Research, International Journal of Financial Management Services, International
Review of Economics and Finance, International Journal of Finance and Economics
and the Journal of Economic Integration. He has published three books: a) The
Macroeconomics of Open Economies Under Labour Mobility (1999), Ashgate
Publishing UK, b) European Integration (November 2004), with A. Zervoyianni and
G. Argyros, Macmillan (Palgrave),UK and c) Aspects Of Globalisation:
Macroeconomic and Capital Market Linkages In The Integrated World Economy
(December 2003), with C. Tsoukis and T. Biswas, Kluwer, USA.
Athanassios N. Mihiotis graduated in 1987 from the National Technical University of

Athens in Greece, Department of Mechanical Engineering, where he completed his
studies in Industrial Management. He holds a Ph.D. degree since 1993 from the NTU
of Athens and his research interests are Operations Management and Logistics. Dr.
Mihiotis has more than 15 years of teaching experience as Research Fellow at the NTU
of Athens and at the University of Piraeus in Greece, where he has taught ‘Production
and Operations Management’, ‘Project Management’ and ‘Operations Research’ in
both undergraduate and postgraduate courses. He was recently appointed Assistant
Professor in the Hellenic Open University School of Social Sciences, responsible for
the Postgraduate Course of Business Administration (MBA). He has in the past
worked as Planning and Logistics Director for multinational and domestic companies
and has served as Member of Project Teams in the Greek Public Sector.
141
APPENDIX
142
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PREPARATION OF THE TEACHING MATERIAL

Author Scientific Reviewer

Supervision of the Methodology of Distance Learning

Coordination of the development of the educational material

SCHOOL OF SOCIAL SCIENCES

Masters in Business Administration

1.1 Organizational problems and managerial economics ....................................27

1.2 Darwinism and economics ..................................................................................29

1.3 The economics approach to organizations .......................................................30

1.4 Economic behavior...............................................................................................31

1.5 Graphical analysis ...............................................................................................32

1.6 Managerial implications .....................................................................................36

2.1 Property rights and market exchange ...................................................44

2.2 The Coase Theorem .............................................................................................48

3.1 Product demand ...................................................................................................59

3.2 Defining and estimating demand.......................................................................64

4.1 Production functions ...........................................................................................72

5.1 Markets, competitive markets and competitive equilibrium.........................86

5.2 Barriers to entry, monopoly, and monopolistic competition .........................89

5.3 Oligopoly, Nash equilibrium and collusion .....................................................92

6.1 Single pricing......................................................................................................100

6.2 Potential for higher profits and price discrimination ..................................103

7.1 The strategy of firms..........................................................................................110

7.2 Capturing value..................................................................................................115

7.3 Diversification ....................................................................................................119

7.4 Strategy formulation..........................................................................................121

8.1 Game theory........................................................................................................126

8.2 Sequential interactions .....................................................................................131

9.1 Firms as contracts .............................................................................................138

9.2 Problems with implicit contracts.....................................................................143

10.1 The main problem............................................................................................148

10.2 Corporate culture.............................................................................................150

11.1 Tasks and decision rights ...............................................................................156

11.2 Determinants of the optimal level of decentralization ...............................160

12.1 Bundling tasks into jobs .................................................................................168

12.2 Bundling of jobs ...............................................................................................170

13.1 Contracting objectives.....................................................................................178

13.2 Internal labor markets: a description...........................................................181

13.3 The salary-fringe benefit mix .........................................................................184

14.1 The basic model................................................................................................192

14.2 Optimal risk sharing .......................................................................................196

14.3 Effective incentive contracts...........................................................................198

15.1 Performance benchmarks ...............................................................................210

15.2 Subjective performance evaluation ...............................................................213

15.3 Team performance ...........................................................................................216

16.1 Divisional performance ...................................................................................222

16.2 Transfer pricing ...............................................................................................225

16.3 Internal accounting system ............................................................................228

17.2 Analyzing choices over legal organizational forms .....................................234

17.3 Mechanisms to achieve governance in PTCs ...............................................237

18.1 Buying in competitive markets and reasons

18.2 Long-term contracts ........................................................................................249

18.3 Distribution contracts .....................................................................................251

19.1 Leadership and firm decision making ..........................................................258

19.2 Leadership power ............................................................................................263

20.1 The economic reasoning for government intervention ...............................270

20.2 The economics of regulation...........................................................................273

21.1 Ethics and corporate aims..............................................................................283

21.2 Ethics and incentive problems .......................................................................283

21.3 Demand for management innovations..........................................................284

21.4 Reasons for innovation failure.......................................................................284

This volume provides a modern economic framework in which to analyze a