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BUSINESSECONOMICS ANDMANAGERIALDECISION MAKINGTrefor JonesManchester School of ManagementUMISTTeAMYYePGDigitally signed by TeAMYYePGDN: cn=TeAM YYePG,c=US, o=TeAM YYePG,ou=TeAM YYePG,firstname.lastname@example.orgReason: I attest to theaccuracy and integrity ofthis documentDate: 2005.04.2019:31:36 +08'00' read more..
INTRODUCTIONFirms are major economic institutions in market economies. They come in all shapesand sizes, but have the following common characteristics:gOwners.gManagers.gObjectives.gApoolofresources (labour,physicalcapital,¢nancialcapitalandlearnedskillsandcompetences) to be allocated roles by managers.gAdministrative or organizational structures through which production isorganized.gPerformance assessment by owners, managers and other stakeholders.Whatever its size, a ¢rm is owned by someone read more..
primary group but employees’ interests are also served. These types of companiesare commonly found in France and Germany.gPluralistic ^ where the company serves the interests of stakeholders in the companyand not just shareholders. Employee and supplier interests may be paramount.Such companies are found in Japan.Since Yoshimori’s study some commentators have argued that there has been somedegree of convergence between European and Anglo-American forms of corporateorganizations because of read more..
The key features are:gThe largest group of domestic owners of company shares are ¢nancial institutions.gFinancial institutions’ share of ownership increased between 1963 and 1997, butfell to 50% in 2001.gIndividual ownership of shares has been in long-term decline and fell to 14.8% in2001.gOverseas ownership of UK companies has increased and stood at 31.9% in 2001.This trend re£ects the growing internationalisation of the asset portfolios held by¢nancial institutions.Shareholding in read more..
and a signi¢cant proportion is owned by non-bank ¢nancial institutions. The board ofdirectors typically own a tiny proportion of the shares, often much less than 0.5%.Thus, managers rather than owners control many medium and large-sized companiesand set the ¢rm’s objectives. In France and Germany shareholding tends to be moreconcentrated with greater blocks of shares held by companies and banks. According toDenis and McConnell (2003) concentrated ownership structures are more likely to read more..
gthe willingness of other shareholders to be active and to vote against the controllinggroup.Case Study 1.1Manchester United – owner ormanagerially controlled?Manchester United epitomizes the conflicts between commercialization and the influenceof supporters. The club’s origins lie in the formation of a football team by the workers of theYorkshire and Lancashire Railway Company. It joined the Football League in 1892 in itsfourth year of existence. The club finished bottom in their first two read more..
%Cubic Expression Ltd23.2(J.P. McManus and John Magnier, Irishbusinessmen)Malcolm Glazer8.9(Tampa Bay Buccaneers, USA owner)Mountbarrow Investment6.5(Harry Dobson, Canadian-basedScottish businessman)UBS5.9(Financial institution)Talpa Capital4.1(John de Moi, Dutch television tycoon)Landsdowne Partners3.7(Financial institution)Legal and General3.3(Financial institution)E.M. Watkins2.3(United director)Amvesscap1.8(Financial institution)Dermot Desmond1.6(Glasgow Celtic, dominant read more..
following a hostile bid. These characteristics, it is argued, lead to more active ownerparticipation. Owners and other stakeholders are represented on the boards ofcompanies, and there is active investor participation in controlling the company; thisminimizes external in£uences in the control of the company. Ownership lies within thecorporate sector rather than with a multiplicity of individual shareholders. Directorsare representatives of other companies and interest groups, while a two-tier read more..
Outsider systemsOutsider systems are characterized by dispersed share ownership, with the dominantowners being nonbank ¢nancial institutions and private individuals. Owners andother stakeholders are not represented on the boards of companies. Shareholders areseen as passive investors who only rarely question the way in which a company isbeing operated. Shares are easily sold and tend to be held for investment purposes, aspart of a diversi¢ed portfolio, rather than for control purposes; this read more..
In outsider systems, external control is exercised mainly through the workings of thestock market rather than voting. In the stock market, shares are continuously tradedand the price re£ects the relative numbers of buyers and sellers and their willingnessto buy or sell. The in£uence of the workings of the stock market on managerialdiscretion assumes that a fall in the share price will make management morevulnerable to shareholder activism either in selling shares or in voting at read more..
the company. These include employees of the ¢rm as well as customers, suppliers,lenders and the local community. They may do this by expressing their criticisms/concerns either directly to the executives or indirectly by informing shareholders, themedia and outside experts or commentators. Investment banks and stockbrokers o¡eradvice to shareholders on the potential future earnings of the company, and suchcomments may help to in£uence attitudes toward incumbent managers.Aligning the interests read more..
corporate governance is about ensuring accountability in the exercise of power and¢nancial responsibility, while not discouraging ¢rms from being enterprising and risktaking.Across the world, many countries have developed voluntary codes of practiceto encourage good corporate practice. The website of the European CorporateGovernance Network in August 2000 listed codes for 19 countries together with thoseagreed by the OECD (Organization for Economic Cooperation and Development) andvarious read more..
gDirectors should receive appropriate training to carry out their duties.gThe majority of non-executive directors should be independent, and boards shoulddisclose in their annual report which of the non-executive directors are consideredto be independentgThe roles of chairman and chief executive should normally be separated, andcompanies should justify a decision to combine the roles.gThe names of directors submitted for re-election should be accompanied bybiographical details, and directors who read more..
16 PART I g COR POR ATE GOVERN ANCE AND BUSINESS O B JECTIVESCase Study 1.2Ownership and governance structuresin UK retailingThe ideal board would under the various codes (pre-Higgs) have the following compositionand duties:gA part-time chairman who is not involved in the day-to-day running of thebusiness, thinks strategically, ensures directors are aware of their obligations to share-holders and makes sure non-executive directors are properly briefed.gExecutive directors who manage the company read more..
who with another three individuals own 39.7%. In both these companies the largest share-holders are members of the Morrison and Sainsbury families. Somerfield, Debenhams andSafeway have a significant single institutional shareholder owning more than 12% of allshares, while the first two companies have a small group of significant shareholderscontrolling more than 30% of the total. Marks & Spencer, Kingfisher and Boots also haveinstitutional shareholders as their largest single shareholder, read more..
gOwners of private clubs might be interested in minimizing losses, relative footballsuccess (e.g., avoiding relegation) and keeping fans happy.gIn a mutual, or fan-controlled, club the controllers/owners might seek to avoid losses,relative football success and low admission prices.gManager and players, given their abilities, are also interested in maximizing theirearnings and football success, though their commitment to any one club might befor a short period only.gFans are interested in read more..
CHAPTER SUMMARYIn this chapter we explored issues relating to the ownership and control of the ¢rm. Todo this we analysed:gThe ownership structures of ¢rms and the pattern of shareholdings in di¡erentcountries.gThe divorce between ownership and control led to the distinction between ownercontrolled and managerially controlled enterprises.gThe nature of control in di¡erent countries was examined. In the UK and the USA,where share ownership is widely dispersed, there are outsider systems of read more..
Discussion questions1 What is understood by the terms ownership and control?2 What do you understand by the term ‘‘divorce between ownership and control’’?3 What size of ownership stake makes for control? How do we divide companies intomanagerial or owner-controlled? Is the use of a simple percentage cut-o¡ rule toosimplistic?4 How does the growth of institutional shareholdings in£uence the way managersrun a company? Would we expect them to adopt a passive or active role in monitor-ing read more..
Denis, D.K. and J.J. McConnell (2003) International corporate governance. Journal of Financial andQualitative Analysis,38(1), 1^36Douma, S (1997) The two-tier system of corporate governance. Long Range Planning,30(4),612^614.Franks, J. and C. Meyer (1990) Corporate ownership and corporate control: A study of France,Germany and the UK. Economic Policy,100, 189^232.Franks, J. and C. Meyer (1992) Corporate Control: A Synthesis of the International Experience(Working paper). London Business read more..
2 BUSINESS OBJECTIVES ANDTHEORIES OF THE FIRMCHAPTER OUTLINEChapter objectivesIntroductionPro¢t maximizationSales revenue maximizationWilliamson’s managerial utility modelBehavioural modelsComparison of behavioural and traditional theoriesCorporate social responsibilityOwners, managers and performanceCase Study 2.1Objectives in company annual reportsChapter summaryReview questionsReferences and further readingCHAPTER OBJECTIVESThis chapter aims to discuss the alternative objectives of the read more..
INTRODUCTIONThe objective of this chapter is to explore how economists have developed models of the¢rm based on control by owners and managers. Traditionally, it has been assumedthat owners set the goal of pro¢t maximization and that managers make decisions inpursuit of that goal. However, the divorce between ownership and control has led tothe development of theories that emphasize the maximization of managerial objectives.The chapter also explores the notion that ¢rms pursue multiple read more..
Criticisms of pro¢t maximizationCriticisms of pro¢t maximization as capturing the essence of a ¢rm’s objectives havecome from empirical and theoretical perspectives.CHAPTER 2 g BUSINESS OBJECTIVES AND THEORIES OF THE F IRM25OQpQC QSOutputProfitTotal revenueTotal costTotal £pCWTMBDAEQAFigure 2.1Pro¢t maximization with total revenue and total cost curvesPrice/CostsOMRARACMCFEDABAPpPCPSQpQC QSQAQuantityFigure 2.2Pro¢t maximization with average revenue as well as marginal revenue and costs read more..
Empirical studies of the motives of ¢rms, often associated with studies of pricing,tend to suggest that ¢rms do not maximize pro¢ts. Two such studies of the UK are byShipley (1981) and Hornby (1995). Shipley (1981) studied a sample of 728 UK ¢rmsusing a questionnaire. He found that 47.7% of respondents said they tried to maximizepro¢ts and the remainder to make satisfactory pro¢ts. In response to a second questionabout the relative importance of pro¢t maximization compared with other read more..
Defence of pro¢t maximizationMachlup (1967) has argued that pro¢t maximization is not a hypothesis that can betested, but a paradigm that is not itself testable; yet, the paradigm allows a set ofpossible hypotheses to be de¢ned for subsequent validation. He argues that ¢rms donot need accurate knowledge to maximize pro¢ts. Marginal revenue and marginal costare subjective concepts, and their use by managers is not deliberate but done in anautomatic way. It has been likened to overtaking when read more..
gIncreasing sales and, hence, the size of the ¢rm makes it easier to manage, becauseit creates an environment in which everyone believes the ¢rm is successful. A ¢rmfacing falling sales will be seen as failing and lead to calls for managers toreappraise their policies.The static single-period sales maximization modelThe static model assumes that:gThe ¢rm produces a single product and has non-linear total cost and revenuefunctions.gThe ¢rm makes its price/output decision without taking read more..
maximizing output is greater than the pro¢t-maximizing output, the ¢rm will alwayscharge a lower price (i.e.,OPC will be less thanOP).In the short run, if the ¢rm assumes it faces linear total cost and total revenuecurves, then sales revenue maximization implies selling all the output the ¢rm canproduce. In Figure 2.3 the ¢rm will break even, where total cost is equal to totalrevenue at pointE selling outputOQ1. The ¢rm will meet its pro¢t constraint (OC)selling outputOQC, but will read more..
compared with the curve in Figure 2.1. The level of advertising expenditure thatmaximizes pro¢t isOA while the level of advertising that maximizes sales revenuesubject to a pro¢t constraint isOAC. The sales maximizer will therefore spend more onadvertising than a pro¢t maximizer. The price charged by a sales-maximizing ¢rm isagain lower than that charged by a pro¢t maximizing enterprise.The relationships as postulated by Baumol between sales revenue and advertising,on the one hand, and read more..
gAssuming advertising expenditure is increased in discrete steps.gAssuming each level of advertising generates a unique sales revenue curve (anddemand curve) that recognizes that revenue eventually decreases as prices fall.The minimum pro¢t constraint and advertising expenditure are measured on thevertical axis and output or sales on the horizontal axis. The linesAC1 þ representthe combined levels of the minimum pro¢t constraint and advertising expenditureassociated with total revenue read more..
Q3 and an increase in price. This helps to explain price increases, following increases in¢xed costs or lump sum taxes, such as tobacco duty, which are observed in the realworld.An increase in variable costs (or a sales tax), which shifts the pro¢t curve to the leftas well as downward (from1 to2), leads both the pro¢t maximizer and the salesmaximizer to reduce their output. This can be observed in Figure 2.6(b) where thepro¢t maximizer reduces output fromQ2 toQ1 and the sales maximizer read more..
important, have power to make decisions and receive professional and publicrecognition. Of these, only salary is directly measurable in monetary terms, but theother non-pecuniary bene¢ts are related to expenditures on:gSta¡ (S), the more sta¡ employed the more important the manager.gManagerial emoluments or fringe bene¢ts (M) are rewards over and above thosenecessary to secure the managers services and are received in the form of freecars, expense accounts, luxurious o⁄ces, etc. and are read more..
BEHAVIOURAL MODELSBehavioural theories of the ¢rm, while based on the divorce between ownership andcontrol, also postulate that the internal structures of a ¢rm and how various groupsinteract could in£uence a ¢rm’s objectives. Behavioural theories set out to analyse theprocess by which ¢rms decide on their objectives, which are assumed to be multiplerather than singular in nature. The complexity of large modern enterprises means thatthe ¢rm is made up of a number of separate groups, each read more..
He argues that the overriding objective of the ¢rm is survival rather than the maximiza-tion of pro¢t or sales. Survival is achieved if the performance of the ¢rm is satisfactoryand satis¢es the various interest groups in the ¢rm, including the owners. Galbraith(1974, p. 175) argued that ‘‘for any organisation, as for any organism, the goal orobjective that has a natural assumption of pre-eminence is the organisation’s ownsurvival.’’ Simon argued that a ¢rm’s goal is unlikely read more..
sales maximization. This would appear to make the construction of a predictivebehavioural theory rather di⁄cult. Nevertheless, Cyert and March (1963) developedsuch a model. They identify the various groups or coalitions which exist within the¢rm, de¢ning a coalition as any group that shares a consensus on the goals to bepursued. The ¢rm is seen as a collection of interest groups or stakeholders, each ofwhich may be able to in£uence the set of objectives eventually agreed. The agreedgoals read more..
individuals happy with any agreement. These are not paid directly to individualsbut enhance the work or importance of the group.Once goals are agreed, the problem is then to set the level of prices, advertising and soon so that the goals can be achieved. Generally, rules of thumb are used to guide suchdecisions.COMPARISON OF BEHAVIOURAL AND TRADITIONAL THEORIESThe behavioural model has been extensively criticized by economists. A summary of theassumptions of the model and those of read more..
all. Contrary to this view, Matthews (1981) argued that the ‘‘the main-spring of thesystem appears to be a standard of behaviour, which, in a non-economic contextwould be regarded as deplorable.’’ Self-interest in both business and social contexts isnot always in the interest of the wider community.Economics identi¢es various market failures that make the community worse o¡(see Chapter 23). It also identi¢es various actions by ¢rms which have adverseexternal impacts on others and on read more..
environment in which managers, who negotiate between themselves, are at the centreof a¡airs but need to keep various stakeholders happy. The managerial group in some¢rms will take into account the role of stakeholders in formulating their objectives,because, individually, they might have a signi¢cant impact on whether the ¢rm issuccessful or not: for example, employees and customers are important to the successof the ¢rm. Unhappy customers or workers can adversely a¡ect the sales and costs read more..
(1985) correlated SCR and share price, where SCR was measured by asking a sample ofbusinessmen to rank companies according to their perceptions of their performance.They found no statistically signi¢cant relationships between a strong orientation tosocial responsibility and ¢nancial performance (Aupperle et al. 1985, p. 459). Theyconcluded that it was, ‘‘neither bene¢cial or harmful for a ¢rm to ful¢l a socialcontract.’’ Another study by McGuire et al. (1988) found a signi¢cant read more..
correlation between SCR and return on assets (R2 ¼ 0.47) but no signi¢cant correlationbetween social spending and stock market prices.The pressure on companies to modify their goals beyond those that maximize ormake satisfactory returns to shareholders and managers varies at di¡erent times andfrom country to country. In the 1980s and 1990s the ‘‘right of management tomanage’’, irrespective of the social consequences, was reasserted. However, the impactof business decisions in pursuit read more..
to attract more people on to our services – and to maximize the use of publictransport systems to bring about environmental and social beneﬁts to thecommunities we serve. Our 30,000 employees are dedicated to improving continu-ously the quality, value for money and, above all our services for our passengers.’’gThe Skansa Group of Sweden in its 1998 annual report states that its goal is to be aworld leader, and that it aims to achieve an annual growth of net sales of 12%, whileits proﬁt read more..
cDecide whether it is trying to maximize pro¢ts or not.dIdentify whether the ¢rm has reported any social responsibility concerns and theextent of them.Discussion Questions1 What rules must a ¢rm follow to maximize pro¢ts?2 What are the main criticisms of the pro¢t maximization hypothesis? Can it be de-fended as a reasonable description of the behaviour of ¢rms?3 What are the main assumptions about objectives in the managerial theory ofBaumol?4 How does the price^output combination di¡er read more..
Gri⁄ths, A. and S. Wall (1996) Firm objectives and ¢rm behaviour. Intermediate Microeconomics(Chapter 5). Longman, London,Holl, P. (1975) E¡ects of control type on the performance of the ¢rm in the UK. Journal of IndustrialEconomics,23(4), 257^271.Hornby, W. (1995) The theory of the ¢rm revisited: A Scottish perspective. Management Decision,33(1), 33^41.Jones, T.T. and J.F. Pickering (1984) The ¢rm and its social environment. In: J.F. Pickering andT.A.C. Cockerill (eds), The Economic read more..
3 RISK AND UNCERTAINTYCHAPTER OUTLINEChapter objectivesIntroductionRisk versus uncertaintySources of uncertaintyIncorporating time and uncertainty into decision makingDecision treesAttitudes to risk and uncertaintyCase Study 3.1UK Lottery and risk-loving behaviourIndi¡erence curve analysis of risk and returnDecision making and attitudes to riskLimiting the impact of uncertaintyCase Study 3.2Uncertainty and business decisions: buses andpharmaceuticalsChapter summaryReview questionsReferences and read more..
INTRODUCTIONThe models of the theory of the ¢rm discussed in Chapter 2 have tended to assumecertainty of information, and no attempt was made to include time or uncertainty inthe analysis. In this chapter we explore ways in which economists have incorporatedrisk, uncertainty and the time value of money into decision making and objectivesetting. To do this, it is necessary to think in terms of the expected values of variables ^expected in the sense that uncertainty may alter the certain read more..
1Changing market demandThe nature of demand can change as consumer tastes and incomes evolve. Some ofthese changes may be predictable, while others may be unforeseen and take suppliersby surprise. An individual enterprise, for example, can misunderstand the changestaking place. For example, a company might introduce a new, larger, more luxuriouscarintheexpectationthat, asconsumersbecomebettero¡, theirtasteswillchange inthat direction. In practice, they may ¢nd that, when the new model is read more..
4Macroeconomic risksMacroeconomic risks are linked not to changes in the market but to the economy as awhole. Economic activity at the aggregate level tends to be cyclical with periods ofgrowth followed by periods of decline. Timing the launch of a new product to takeplace in a slump will be harmful for sales, while launching in a boom will be bene¢cial.5Political changeUncertainty may be associated with political change. Changes of government, even bydemocratic means, may lead to adverse read more..
whereS ¼ slump,N ¼ normal andB ¼ boom:EVA¼ð4;000 Ã 0:1Þþð5;000 Ã 0:8Þþð6;000 Ã 0:1Þ¼ 5; 000Thus the expected value of decisionA is 5,000, decisionB is 5,000 and decisionC is105,000.Coe⁄cient of variationAlthough decisionsA andB have the same expected pro¢ts, we cannot ascertain whichof the projects is the more uncertain. To measure the degree of uncertainty or riskassociated with each decision, it is usual to measure variance, standard deviation andthe coe⁄cient of read more..
coe⁄cient of variation is calculated: that is, the standard deviation divided by theexpected value, or column 7, divided by column 2.The standard deviation and the coe⁄cient of variation calculated in columns 7 and8 can be used by decision makers to obtain an indication of the dispersion of the likelyoutcomes for each project given the risks. If the standard deviation is used, then thedecision with the lowest standard deviation is considered the least risky of the three,because any outcome read more..
Time and discountingTime is accounted for in economics by discounting future bene¢ts by an appropriatediscount rate (see Chapter 12 on investment appraisal) to measure the net presentvalue. The logic of this process is that:gMoney earned in future time periods has di¡erent values in the current period.g»1 now is worth »1 þ r in one year’s time, or »1.10, ifr is 10% (or 0.10 in decimalterms).g»1 in one year’s time is worth »1=ð1 þ rÞ, or »0.91 now, ifr is 10%.g»1 in two years’ read more..
Let us assume the ¢rm currently makes pro¢ts of »400. It reviews its prices and hasto decide whether to increase, hold or decrease its price. The outcome of either policydepends on the reaction of rivals. Therefore, the ¢rm has to estimate the likelihood ofrivals holding or altering their prices. If there is a 50% chance that they will hold theirprices, a 40% chance that they will cut their price and a 10% chance that they willincrease their prices, then the expected value of an increased read more..
same as the previous one then there is constant marginal utility of money, while if thevalue of the additional unit is greater than the previous one then there is increasingmarginal utility of money.These relationships are illustrated in Figure 3.2. Utility is measured on the verticalaxis and money income on the horizontal axis. The marginal utility of income forindividualA decreases with additional increments; such individuals are described asrisk averse. The marginal utility of money is read more..
than from losing (KL). Such an individual will tend to be risk-averse because the gain inutility will decrease as income increases. An individual with a utility functionexhibiting increasing marginal utility of income will gain more utility (FG)fromwinning than from losing (EF). Such individuals will be risk-loving becauseincrements of income will bring increasing increments of utility. An individual with autility function exhibiting constant returns to income will be indi¡erent between read more..
CHAPTER 3 g RI SK AND UNCER TAINTY55expected utility from winning the lottery is greater than implied by the simple expectedvalue.The willingness to buy a lottery ticket despite the unlikely chance of winning thejackpot prize reflects the lack of opportunities the vast majority of the population have toacquire such large single sums of money. For them the prize of more than £2 million, ismore than their lifetime earnings.Therefore, buyers of lottery tickets value them more highly than the read more..
INDIFFERENCE CURVE ANALYSIS OF RISK AND RETURNThe choice between expected returns can be analysed using indi¡erence curves. InFigure 3.3, riskiness is measured on the horizontal axis and expected return on thevertical axis. Thus, any point within the diagram shows the level of expected returnand the risk attached.We have argued that di¡erent individuals have di¡erent attitudes to risk anduncertainty. These attitudes can be represented by indi¡erence curves. They show thedi¡erent read more..
Further, indi¡erence curveI2 represents a superior position to curveI1, so that higherreturns for any given level of risk will be preferred to lower rates. For any given levelof return a less risky position will be preferred to a riskier one.Risk-neutral individuals would have horizontal indi¡erence curves because risk oruncertainty do not in£uence their choices. Such a set is shown in Figure 3.3(a).Higher expected returns are preferred irrespective of the associated risks.Risk-loving read more..
Table 3.5. This presents returns for three projects depending on the state of theeconomy. The ¢nal two columns show the minimum and the maximum return foreach project.Maxi-min decision criterionThe ¢rst of these is the maxi-min criterion; this is a risk-averse test, because theindividual identi¢es the worst possible outcome for each course of action beingconsidered. He then selects the project with the highest value from the list of leastvalues. By choosing the best of the worst, the decision read more..
analyse the gains and losses associated with a correct or incorrect decision. A regretmatrix may be devised for the projects in Table 3.5 as follows. If we consider projectA,then assuming recession prevails it would earn »12,000 compared with the bestoutcome, which is »13,000. The regret of having chosen the wrong project istherefore »1,000. The regret for each project can be calculated for each state of theworld and is shown in the ¢nal column of Table 3.6. If projectA had been chosen,then read more..
Hurwicz’s alpha decision criterionThe Hurwicz alpha decision test is used to select the project with the highest weightedaverage, where the average is made up of the maximum and minimum outcomes; thisis illustrated by reference to Table 3.8, where the maximum outcome is given alikelihood outcome value of 0.7 and the minimum outcomes at 0.3. The results showthat project C would be chosen. The assignment of likelihood or expected probabilityvalues could re£ect expectations about how the economy read more..
routines to cope with the aftermath of the attacks on the World Trade Center on11 September 2001.When a ¢rm faces uncertainty in some aspect of its market and industry, it mayseek to gain some degree of control over the source of the uncertainty. For example, a¢rm facing uncertainty over the supply of components might attempt to eliminatesome part of the uncertainty by buying a supplier and bringing the activity within theenterprise. Alternatively, the ¢rm might seek to sign a heavily read more..
gAfter licensing for use the drug may produce unexpected side effects and have itslicence withdrawn.To bring a new drug successfully to market is estimated to take 8–12 years – taking upmany of the maximum number of years offered by patent protection. The profit record ofpharmaceutical companies therefore exhibits a high expected return and a high coefficientof variation compared with the less innovative and stable sector.Companies seeking to increase the size of the firm may have a number read more..
CHAPTER SUMMARYIn this chapter we examined brie£y some of the techniques for coping with uncertaintyin decision making. To do this we analysed:gMainly the techniques for weighting outcomes in line with subjective likelihoods ofoutcomes. The decision maker can then behave in a rational way and choosebetween projects with di¡erent degrees of uncertainty attached.gThe choice of project, which depends on the attitude of the decision maker to riskand uncertainty.gVarious formal rules.gFirms that read more..
ProjectOutcomeProbabilityA2000.24000.62000.2BÀ2000.36000.51,2000.2C1000.15000.71,0000.25Distinguish between and explain the di¡erences between maxi-min, maxi-max andmini-max regret decision criteria. Using the following information identify whichproject a decision maker using each of these criteria would select:State of the economyööööööööööööööööööööööööööLowExistingHighProjectdemanddemanddemandA8,00012,0002,0000B10,00017,0002,3000C4,00016,0002,50006 The read more..
PARTIIKNOWING THEMARKET4 Consumer behaviour675 Demand analysis856 Estimation of demand functions103 read more..
4 CONSUMER BEHAVIOURCHAPTER OUTLINEChapter objectivesIntroductionIndi¡erence curve analysisCharacteristics approach to consumer behaviourCase Study 4.1The characteristics approach and the provision of airlineservicesHedonic pricesCase Study 4.2Estimating and using hedonic prices: cars and wineBehavioural approach to consumer behaviourChapter summaryReview questionsReferences and further readingCHAPTER OBJECTIVESThis chapter aims to explore the nature of consumer choice and use di¡erenteconomic read more..
INTRODUCTIONFirms undertake the production of goods and services in anticipation of consumerswishing to purchase them in su⁄cient quantity for the ¢rm to make a pro¢t. Thischapter focuses on the managerial problem of identifying the characteristics ofconsumer behaviour and the possibility of reshaping or altering products to alignthem more closely with the preferences of consumers. Understanding consumerbehaviour is an important task for the business enterprise. Economists assume read more..
slope of the indi¡erence curve depends on the willingness of the consumer to substituteone good for the other. When the consumer moves down an indi¡erence curve (e.g.,fromD toE on indi¡erence curveI1) the number of units ofX in each bundleincreases, while the number ofY decreases. Conversely, if a consumer moves left upan indi¡erence curve, each bundle contains more ofY and less ofX. Indi¡erencecurves are therefore said to exhibit a diminishing marginal rate of substitutionbetween the two read more..
level of money income (M) and known prices ofX (PX)and Y (PY), the budget line canbe determined. If all income is spent on goodY, then the consumer will be able to buyM=PY units of the good (orQY). However, if all income is spent onX, then theconsumer will buyM=PX units of the good (orQX). These points are represented bypointsJ andK in Figure 4.1. The lineJK is the budget constraint, and the consumer isable to purchase any of these bundles of goods on or within the line. However, anypoint beyond read more..
purchase the original bundle of goods, thus allowing the consumer to purchase more ofboth goods, if that increases satisfaction.The reaction of a rational consumer to a price change is illustrated in Figure 4.2.The consumer is initially at point E on indi¡erence curve I1 and budget line JK.Iftheprice of X falls, then the new budget constraint in the line JL allows the consumer tomove to point F on the preferred indi¡erence curve I2. The move from E to F has twocomponents: the substitution and read more..
not make marginal calculations explicitly in practice, they make such estimates inmaking such decisions.Fourth, consumers are not su⁄ciently well informed to be able to make reasonableestimates of the bene¢ts they expect to receive from a purchase nor to make rationalchoices between products.Fifth, the ordering of preferences by individuals is a purely utility-driven processand takes no account of moral preferences or the notion of a hierarchy of needs withsome being more important than read more..
gEach product will have more than one characteristic.gEach product will have a mix of characteristics that will vary by brand.gCharacteristics are measurable objectively.gProducts are divisible and do not have to be purchased in whole units.gProducts (or brands) are substitutes for each other despite containing di¡ering com-binations of characteristics.The nature of the choice process can be illustrated with a simple arithmetic andgraphical example. Suppose the desirable characteristics of read more..
product II, while a consumer preferring maturity over texture would get better valuefrom product I. A consumer who might prefer better texture and maturity in the sameproduct is not satis¢ed by either of the existing products. However, given that cheeseis a divisible product, the consumer could buy varying quantities of the two brands toobtain the desired combination of characteristics. If we join points AIand AII,thenwecan derive the e⁄ciency frontier that represents the choices available read more..
(point e) are revealed to be inside the frontier and, therefore, are poor buys because »1buys fewer units of characteristics than in the other three brands.Consumer 1 with a set of indi¡erence curves, of which IA is representative, wouldchoose to be at point d,purchasingbrandIV.Consumer2withaset ofindi¡erencecurves,ofwhich IB is representative, would prefer to be at a point h between brands IIIand IV.Price changes will shift the frontier. For example, if the price of all brands were todouble read more..
introduction of brands II, IV and V ¢lls the gap between the two initial products andwould satisfy consumers wanting a product with a more equal balance of the two char-acteristics. Thus, if producers can identify such gaps, then they may ¢nd it worthwhileto di¡erentiate their product in terms of the relative proportions of characteristics thatthe product contains. Consumers will only switch to the new product if it is priced insuch a way that it either appears on the existing e⁄ciency read more..
The no-frills airlines also offer lower prices than traditional carriers. The impact of theintroduction of new products at lower prices is shown by changes in the efficiency frontier.Initially, the consumer is limited to choices on efficiency frontierEF. With the introduction ofthe low-fare, no-frills alternative the efficiency frontier moves fromEF toHF, with pointEbecoming an inefficient point. The consumer with the preference function shown in thefigure will move fromE toF, which is on a read more..
HEDONIC PRICESThe characteristics approach has been used to estimate hedonic (or pleasure) prices. Ifwe assume that there are many brands available of the same product (e.g., toothpasteor cars) which can be purchased at di¡erent prices, then the hedonic price approachmeasures the implied price for each characteristic in each product available.The hedonic prices approach postulates that price di¡erences between brandsre£ect di¡erences in the bene¢ts or value to the consumer of the various read more..
such as the vineyard and vintage year, are more precisely measured. In studies where theprice of wine is a function of quality, reputation and objective characteristics the researchershave found all to be important, but reputation to be economically more important thanquality (Landon and Smith 1997, 1998).Oczkowski has used the notion of hedonic price to develop the Australian Wine PriceCalculator (available at http://athene.riv.csu.edu.au/~eoczkows/winestart.htm).The potential buyer enters read more..
Behavioural theories tend to be inductive in nature in that they study and observethe decision making processes used by consumers and deduce the decision rules used.Theconsumerisviewedasfollowingaprocessthatinvolvescollectinginformation,processing information, comparing and eliminating products and ¢nally making achoice. Of particular interest are the rules and routines used in processing informationas well as in eliminating and selecting products for further consideration. For example,a read more..
The application of the rules is demonstrated with the use of the simple arithmeticexample found in Table 4.4. The consumer is assumed to have narrowed the choice ofproducts to four on the basis of a preferred price range and to have assessed each ofthe products for four key characteristics labelledCA, CB, CC andCD,eachofwhichare marked out of ten. In addition, the ¢nal row shows the weight attached to eachcharacteristic.CHA PTER 4 g CONSUM ER BEHAVIO UR81Table 4.3Decision-making rulesChoice read more..
The choice of product using the di¡erent rules is shown in the ¢nal column of Table4.3. The weighted and unweighted average scores lead to the choice of productC andD, respectively. The additive di¡erences rule examines pairs of products and comparesscores allocated for each characteristic: the one with the biggest di¡erence is selectedand compared with other products until one emerges as the best buy. If we compareproductsA andB,then A scores better for characteristicA only, while read more..
REVIEW QUESTIONSExerciseVisit the websites of a number of airlines, including low cost and full service ones,which £y a similar route between Britain and continental Europe. Find for a givenservice on the same day:aThe fare.bThe restrictions on ticket use.cThe cabin services provided.dThe distance of the airport from the city centre.Can the services o¡ered by the di¡erent airlines be distinguished in terms of their char-acteristics? If they can, then plot the products in characteristic space, read more..
^ What additional information is required to determine an optimal position for aconsumer?^ Given the data above, suppose PA rises to »12. What happens to the e⁄ciencyfrontier?^ What are the similarities and di¡erences between traditional and characteristicmodels in the optimal position of a consumer?^ A new brand of shirt (F) is introduced. If the shirt possesses 40 units of S and 30units of Cm and is priced at »10, what happens to the e⁄ciency frontier?7 What advantage does the read more..
5 DEMAND ANALYSISCHAPTER OUTLINEChapter objectivesIntroductionThe demand functionThe demand curveMarket demandDemand and revenueElasticity and revenueOwn price elasticityOwn price elasticity and marginal revenueCase Study 5.1Own price elasticity and railway pricingFactors a¡ecting the own price elasticity of demandIncome elasticityAdvertising elasticity of demandCross elasticity of demandCase Study 5.2Estimating elasticities of demand for petrolDemand elasticities and businessChapter read more..
INTRODUCTIONThe decision by a ¢rm to produce any particular good or service is based up theexistence of adequate demand for that product. In this chapter we are interested incombining all the individual demand curves obtained from individual preferencefunctions to derive an aggregate or market demand curve; this is a function that everyenterprise needs to know and understand, usually before engaging in production. It isimportant because it sums together all the individual demand curves of all read more..
things being constant. The shape of the individual demand curve is based on the propo-sitions that:gThe marginal utility gained from the purchase of additional quantities of a good willdiminish, so that the consumer will pay a lower price for each additional unitbought.gThe substitution e¡ect of a fall in price is positive, which means a consumer willswitch to purchase more of a cheaper good compared with more expensivesubstitutes.gThe income e¡ect of a fall in price makes the consumer better read more..
It can also be expressed by rearrangement as a price equation:PX¼ 10À 2QXð5:2ÞThen, using equation (5.2) the major co-ordinates of the demand or average revenuecurve (AR) are derived as follows:gThe vertical intercept, or maximum price, is found where QX¼ 0and PX¼ a or 10.gThe horizontal intercept, or maximum quantity, is given where PX¼ 0andQX¼ 20 or aÃ 1=b.gThe slope of the demand curve is given by the change in quantity for each unitchange in price (DQX=DPX)or Àb or 2.DEMAND AND read more..
gTotal revenue (PXQX) is calculated by multiplying the output sold by the priceobtained.gAverage revenue (PX) is calculated by dividing total revenue by the quantity sold.gMarginal revenue (MRX) is the addition to total revenue by selling an additionalunit of output.Using the example above, where the estimated relationship is:PX¼ 10À 12 QXTotal revenue can be obtained by multiplying equation (5.1) by Q to give:PXQX¼ aQXÀ bQ2orPXQX¼ 10QXÀ 12 Q2Xð5:3ÞThe total revenue curve (TR) for this read more..
many extra units the ¢rm will sell in response to any change in the price of the good. Ifthe ¢rm is interested in nothing more than predicting the number of additional unitsthat can be sold by changing price, then the slope of the demand curveDQX=DPX willsu⁄ce. However, if the ¢rm is concerned about the additional revenue generated bylowering the price, then the slope of the demand curve alone is an inadequateindicator; this is because the slope of a linear demand curve never changes and read more..
ties greater than 1 (by convention in economics the minus signs are usually ignoredwhen discussing own price elasticity, thus an elasticity of -4 is described as beinggreater thanÀ1).gThe lower portion of the demand curve, from price OP to O (5 to 0), is the inelasticrange. It is associated with negative marginal revenues and an own priceelasticity less than 1.gAt the midpoint on the linear demand curve at price OP (5), elasticity is 1 andmarginal revenue is 0.In the elastic range of the demand read more..
the reciprocal of the slope of the demand curve: that is, 1=ðDQX=DPXÞ.Thus:QX¼ aÀðDQX=DPXÞPXLet own price elasticity of demand be termed e,then:e¼ðPX=QXÞÃ ðDQX=DPXÞBy rearranging we obtain:QX¼ aÀ eQXDividing both sides by QX we obtain:1¼ a=QX À eore¼ðQX À aÞ=Qð5:4ÞBy substituting in equation (5.4) for quantity we obtain:e¼ða=2 À aÞa=2Using the equation QX¼ 20À 2PX we then get:e¼ðð20=2ÞÀ 20ÞÞ=ð20=2Þ¼ À10=10 ¼À1Thus, at an output of 10, the midpoint output, read more..
increase total revenue by raising its price. If it were operating on the portion of thedemand curve where price elasticity is greater than 1 (i.e., marginal revenue ispositive), then it would increase its total revenue by lowering its price.Case Study 5.1Own price elasticity and railtravel pricingEconomists have measured the price elasticities of demand for railway journeys and foundthat for peak travel they are less than 1 and for off-peak travel they are greater than 1 (seeOum et al, 1992 and read more..
The substitution e¡ect depends on the availability of substitutes, so that the demandfor a commodity is more elastic if there are close substitutes available. The degree ofsubstitutability for any product will vary from consumer to consumer, depending onthe nature of the need satis¢ed by the good, with necessities tending to have inelasticdemands because of a lack of substitutes, while non-necessity goods are more price-elastic.The time period is also important. Demand tends to be more read more..
curves. However, we have observed that for any given price change the responsivenessin quantity demanded will be greater for an elastic than an inelastic demand curve(i.e., the percentage increase in sales for a given price fall will always be greater forone demand curve than another). In practice, when ¢rms wish to equate marginalcost with marginal revenue, they will con¢ne themselves to operate where themarginal revenue curve is positive and the relevant portion of the demand curve hasan own read more..
gPositive income elasticities of less than 1 imply that as income increases thedemand for the product will increase at a slower rate.gNegative income elasticities of less than 1 imply that the demand for the productwill decline at a lower rate than the increase in income.gNegative income elasticities of greater than 1 imply that the demand for the productwill decline at a faster than the increase in income.The ¢rm would prefer to produce goods with positive income elasticities, as it can read more..
size of such an e¡ect is the advertising elasticity of demand.Thisisde¢nedastheratioofthe percentage change in quantity demanded (QX) to the percentage increase inadvertising expenditure (AX), or symbolically as:ðDQX=QXÞ=ðDAX=AXÞorðQX=AXÞðDAX=DQXÞThe resulting value for the elasticity of advertising can be either positive or negative,close to 1 or much larger or smaller. The impact of advertising on consumer spendingwill depend on its nature and the susceptibility of the consumer to read more..
substitute in the eyes of readers of The Guardian but a better substitute for readers of TheIndependent.Case Study 5.2Estimating elasticities for petrolEstimates of elasticities of demand are generally derived from modelling demand usingregression analysis. These methods are discussed in Chapter 6, but an example of theoutcomes for such studies is given below using petrol as its subject.Companies make estimates of own price elasticities of demand for their products.Likewise, academic economists read more..
CHAPTER SUMMARYIn this chapter we examined the nature of the demand function for the products of a¢rm. In doing this we analysed:gThe demand curve and its associated marginal revenue curve.gVarious elasticity concepts, including own price elasticity, income, advertising andcross-price elasticities of demand; these are important to the ¢rm because theyin£uence the pricing and advertising strategies of the ¢rm.In the next chapter the empirical estimation of demand functions will be read more..
aDraw a diagram showing how average revenue and marginal cost vary withquantity. Plot the given price and quantity data on the diagram.bSuppose that the ¢rm wished to maximize sales revenue. Can we say without doingany calculations whether price would need to be higher or lower than the pro¢t-maximizing price. Why?cDerive equations for total revenue and marginal revenue and determine therevenue maximizing price and quantity. Draw the marginal revenue line on yourearlier diagram.dExplain the read more..
11 The estimated own price elasticities for rail travel are as follows:First classÀ0.5CommutingÀ0.4BusinessÀ0.2PersonalÀ1.0LeisureÀ1.4^ Suggest reasons why elasticities for business travel are lower than those forcommuting and leisure travel.^ Which of the existing prices are at levels set either to maximize pro¢t or salesrevenue? Which prices should be increased and which lowered to maximizerevenue?REFERENCES AND FURTHER READINGBaumol, W.J. (1961) Theory of demand. Economic Theory and read more..
6 ESTIMATION OF DEMANDFUNCTIONSCHAPTER OUTLINEChapter objectivesIntroductionEstimating demand functionsInterviews and survey methodsQuestionnairesConsumer experimentsMarket studiesStatistical analysisPitfalls using regression analysisThe economic veri¢cation of regression modelsStatistical veri¢cation of regression modelsEconometric veri¢cation of regression estimatesCase Study 6.1The demand for alcoholic drinkChapter summaryReview questionsReferences and further readingCHAPTER OBJECTIVESThis read more..
INTRODUCTIONKnowledge of the market demand function and of the key factors in£uencing futurechanges in demand is important for the management of the ¢rm, not only for settingprices but also for planning production capacity and the choice of goods or services toproduce. The purpose of this chapter is to discuss aspects of the empirical estimation ofdemand functions including:gMethods of data collection.gInterview and survey analysis.gRegression methods for analysing the data and obtaining read more..
This chapter will now examine, in a non-technical manner, survey and statisticalmethods to estimate demand functions.INTERVIEWS AND SURVEY METHODSThe most obvious way to try to identify the relationships important in a demandfunction is simply to ask actual or potential buyers. Thus, you could ask a group ofbuyers how they might react to price changes, product re-speci¢cation and cheapercredit. Collating the results of the study should then give some indication to the ¢rm ofthe likely read more..
respondto apricecutatthetimeofthesurvey,theymaynotdosoatthetimeoftheactual price change. In a similar way, consumers asked to classify themselves intoincome or social groups may either overestimate or underestimate their actualincome or social class.4A fourth relates to face-to-face interview, as the answers may be in£uenced by theinterviewer. The attitude and personality of the interviewer may in£uence theanswers of respondents who may be unwilling to give answers which may betruthful but read more..
level. At a price of »10, for example, the quantity demanded (DQ) is the sum of theanticipated volume of sales to each group of respondents given their responses, or:DQ¼ð425 Ã 0:0Þþ 225Ã 0:25 þ 175Ã 0:5 þ 125Ã 0:75 þ 50Ã 1:0 ¼ 287:5The anticipated values for the other prices can be calculated in a similar way. Theresults show that demand increases as the price falls. This information can be plottedin a price quantity diagram to form an anticipated demand curve for the samplesshown read more..
6.1 indicate an inverse relationship between price and quantity demanded. A simpleregression line can be estimated between quantity demanded and price. The resultobtainedisasfollows:Q¼ 1315:7 À 103.9PðÀ31:5ÞR2¼ 0:995where the t statistic is in parentheses. This linear regression would give a quantityintercept of 1,315.7 and a price intercept of 12.6. The estimation of linear regressionrelationships is discussed later in this chapter. The equation can be used to predictdemand at any price. read more..
rather than their own true views. Nevertheless, they may provide useful information,particularly about product characteristics and the combinations of characteristics thatconsumers prefer.The Gabor^Granger Test is used to test the potential of new products by comparinga new product with an existing one: Half the group are shown the new product andasked whether they would buy it at various prices on a random price list. They arethen shown the existing product. The other half are shown the read more..
The typical form of such a linear demand equation for cars using more than oneindependent variable would be:Qc¼ aþ b1Pcþ b2Pyþ b3Yþ b4Aþ bnXnwhere Qc¼ quantity demanded, Pc¼ price of the product, Py¼ the price of otherproducts, Y¼ income, A¼ advertising expenditure and Xn¼ all the other variablesthat might be included in the model.If the equation for the demand for cars is recast logarithmically, then we have:log Qc¼ aþ bi log Pcþ b2 log Pyþ b3 log Yþ b4 log Aþ bn log XnThe read more..
taneous relationship between quantity demanded and consumer income, which wasnot included in the model.The problem is illustrated in Figure 6.3, where cross-sectional data collection yieldsthe three combinations of quantity and price, labelled A to C representing price^quantity combinations P1Q1, P2Q2 and P3Q3. These points joined together show that afall in price leads to an increase in the quantity demanded. This relationship suggestsan upward rather than a downward-sloping demand curve, which read more..
suggests that for a normal good the own price elasticity of demand should have anegative sign, the cross-price elasticity of demand should have a negative sign and theincome elasticity of demand should be positive. While contrary signs are notnecessarily wrong they indicate that one should proceed with caution. Likewise, if themagnitude of the estimated variables is outside the expected range, then again oneshould proceed with caution. In Table 6.2 there are a number of results contrary read more..
group of independent variables. The test itself is based either on accepting or rejectingthe null hypothesis that there is no signi¢cant statistical relationship between thedependent and independent variables as a group. The test proceeds by comparing theF-value estimated when measuring the regression relationship and the benchmarkvalue obtained from F distribution statistical tables. The benchmark values are afunction of the degrees of freedom of the denominator, the degrees of freedom for read more..
Standard error of estimateThe standard error of estimate is used to check whether the relationship between anindependent and dependent variable is signi¢cant. It measures the degree of dispersionof the data around the estimated value for the variable. It can then be used to indicatethe degree of con¢dence that the value of the variable will fall within the measuredlimits. The general rules for using the standard error are that there is:gA 68% probability that actual values will fall within read more..
may be to accept a model as a good ¢t when the result is dependent on autocorrelation.The test for autocorrelation relies on a comparison between the Durbin^WatsonStatistic and an upper and lower value derived from statistical tables. The Durbin^Watson Test checks to see whether null hypothesis holds and that there is no autocorre-lation present in the model. For the 5% level of signi¢cance with 25 data observationsand 3 independent variables, the lower limit is 1.12 and the upper limit is read more..
In Table 6.2 the following information is reported for the log-linear demand functions foreach product:gConstant term.gReal price of the good.gReal price of all other goods.gReal income.gThe coefﬁcient of determination, or adjustedR2.gCoefﬁcients for each independent variable.gt-ratios for each variable.gThe Durbin–Watson Statistic.The significant results found by Duffy (1983) include the following:gChanges in real income are signiﬁcant for all three products and measured read more..
identi¢ed, it is imperative for the ¢rm to discover the nature of the demand functions forits products and the variables in£uencing demand.Knowing the size of the elasticities for price, income and advertising can shape notonly the pricing and sales strategies of ¢rms but also the long-term growth of sales.REVIEW QUESTIONS1In what circumstances should a company employ survey methods to obtain moreinformation on the demand for its product and the relative merits of its productcompared with read more..
Du¡y, M. (1987) Advertising and the inter-product distribution of demand: A Rotterdam modelapproach. European Economic Review,31, 1051^1070.Green, P.E. and D.S. Tull (1988) Research for Marketing Decisions (5th edn). Prentice Hall,Englewood Cli¡s, NJ.Gri⁄ths, A. and S. Wall (1996) Market demand. Intermediate Micro-economics (Chapter 2).Longman, London.Hill, S. (1989) Demand theory and estimation. Managerial Economics (Chapter 5). Macmillan,Basingstoke, UK.Judge,G.(2000) Computing Skills for read more..
PARTIIIUNDERSTANDINGPRODUCTIONAND COSTS7 Production and e⁄ciency1218 Costs145 read more..
PRODUCTION ANDEFFICIENCYCHAPTER OUTLINEChapter objectivesIntroductionProduction functionsIsoquant analysisOptimal choice of factorsTechnical progress and the shape of isoquantsLaws of productionTotal, average and marginal product curvesEmpirical production functionsCase Study 7.1Production function for a retail chainMeasuring productivityRelative measures of e⁄ciencyCase Study 7.2Measuring relative e⁄ciencyProductivity di¡erencesCase Study 7.3Explaining productivity di¡erences in read more..
INTRODUCTIONThe production of goods and services is one of the key activities of any ¢rm. Thetechnology chosen to produce its goods and services helps determine the capital andlabour to be employed, the e⁄ciency of the ¢rm and the costs incurred. In this chapterwe will examine:gThe nature of the production function.gIsoquant analysis.gTechnical progress.gMeasurement of e⁄ciency and productivity.gThe use of productivity as a performance indicator.PRODUCTION FUNCTIONSProduction is concerned read more..
speci¢ed and, for any given quantity of the factors K, L and E, the total output of Q couldbe calculated. Three possible situations are illustrated in Table 7.1:gConstant returns to scale areillustratedin Table7.1(1). Thesumof thepowers(bþ cþ d) adds to 1 and gives an initial output of 42.426. If the volume of factorsis doubled, then output also doubles to 84.852 The ratio of Q2 to Q1 is 2.gIncreasing returns to scale are illustrated in Table 7.1(2). The sum of the exponents(bþ cþ d) adds read more..
level of output will be represented by a separate isoquant. If we assume that there aretwo factors of production ^ capital (K) and Labour (L) ^ then Figure 7.1 shows anisoquant map for three levels of output: namely, Q1, Q2 and Q3. A move along the rayOT sees output increase, because OT represents a greater output than OS and OSrepresents a greater output than OR.Each isoquant is drawn convex to the origin, re£ecting the diminishing e¡ective-ness of substituting one factor for the other in the read more..
divided by the change in labour, orDK=DL. At any point on the isoquant the MRTS isgiven by the slope of a line drawn tangential to the isoquant.A reduction in the use of capital as a consequence of a move along an isoquantinvolves a reduction in output. To remain on the same isoquant this loss of output iscompensated for by employing more labour. Thus, the reduction in capital multipliedby the marginal product of capital (ÀDK Ã MPK) is compensated by an increase inlabour multiplied by the read more..
Alternatively, we can obtain an expression forL:X¼ wLþ rKwL¼ XÀ rKL¼ X=w Àðr=wÞKThe K intercept in Figure 7.2, assuming L¼ 0, is given by X=r and the L intercept,assuming K¼ 0, is given by X=w. The slope of the isocost curveDK=DL is equal to(Àw=r) or the relative prices of the factors. Thus, an initial isocost curve for the ¢rmmight be the line AB in Figure 7.2. A higher level of expenditure or total cost incurredwill move the isocost curve to the right of the isocost curve AB, while read more..
from E to F, substituting capital for labour, because capital is now relatively cheaperthan labour. Changes in the relative prices of the factors will lead the ¢rm to choose adi¡erent labour capital mix to produce output Q1.TECHNICAL PROGRESS AND THE SHAPE OF ISOQUANTSTechnical progress in the production process is important for the ¢rm in that it enablesfewer factors to be used and cost savings to be made. Technical progress results ineither more output being produced by the same quantities read more..
move fromB toF along a rayOB holds the capital^labour ratio constant. AtF theslope of the isoquant become steeper, so that the MRTS increases and:^ The marginal product of labour relative to capital increases.^ Labour is substituted for capital with production becoming more labour-intensive: for example, a move from B to F.LAWS OF PRODUCTIONSo far, we have concentrated largely on either one or two isoquants. We now need topay attention to the complete set of production possibilities open to the read more..
The ¢rm could choose any point within the map, depending on the output it wishes toproduce and the relative prices of labour and capital.The isoquant map also shows that the production possibilities initially exhibitincreasing returns to scale and then decreasing returns to scale. Changes in scaleresult from movements from one isoquant to another rather than from movementsalong a particular isoquant. If the ¢rm moves from isoquant Q1 to isoquant Q4,thenthe ¢rm is able to increase output from read more..
is measured on the vertical axis and the variable factor labour on the horizontal axis.The total product curve plots the output produced on each isoquant, together with theunits of labour used. The total product curve in the ¢gure is drawn so that totaloutput declines after a certain quantity of labour has been used. The total productcurve shows initially increasing returns to labour with output peaking at output levelOQ, utilizing labour input OL2 with a given ¢xed quantity of capital. The read more..
product curve is total output divided by the units of labour employed, and the marginalproduct curve measures the change in output resulting from the employment of anextra unit of labour.Given the production function the total product curve for either one or morevariable factors represents the maximum output that can be obtained. Points beyondthe total product curve are not attainable, while those on or below the curve are.Points inside the frontier are ine⁄cient in that the ¢rm is not read more..
The result shows that labour was the dominant factor and that the sum of the labour andcapital (sales area) coefficients adds to 1.04, which indicates very weak increasing returnsto scale; this meant that small shops were not at a significant disadvantage compared withlarger shops. However, the results were derived from the existing stock of stores, andobservation showed that other chains operated larger units, indicating that the consensus inthe industry favoured larger units.MEASURING read more..
gTotal factor productivity is output Q1 divided by the amount of both capital andlabour employed: that is, OKG plus OLG.Partial or single-factor measures of productivity give di¡erent results for each point onan isoquant. On isoquant Qt labour productivity is greater at F than at G and greaterat G than at H. Capital productivity has a reverse order, so that at H capital productivityis greater than at G and greater at G than at F. Total factor productivity avoids theseproblems, because output is read more..
This second technique is illustrated in Figure 7.8, where the labour and capital require-ments per unit of output of existing plants are plotted. A best practice isoquant is ¢ttedusing the innermost points available and passes through points A, B, C, D and E,repre-senting the most e⁄cient plants. Finding the best practice frontier can be done usingdata envelopment analysis which utilizes linear programming techniques.In Figure 7.9 the best practice production isoquant for the industry read more..
costs of production than the most e⁄cient ¢rm D. The degree of cost-ine⁄ciencyincurred by ¢rm A is measured by the ratio OC=OB.The cost levelat C is thesameasat D.Firm B is on a higher isocost line ST and ¢rm A is on an even higher isocost lineUV, making both higher cost producers than ¢rm D.If¢rm A was to becometechnically e⁄cient by moving to B, it would still be cost-ine⁄cient because it is notusing the optimal capital^labour ratio, given current factor prices.These two measures read more..
Case Study 7.2Measuring relative efﬁciencyFarrell’s Efficiency concepts have been widely used by economists to measure the extentof inefficiency in various industrial sectors. Todd (1985) used the technique to measureefficiency in UK and German industry, while Forsund and Hjalmarsson (1979) used it toexplore efficiency in the Swedish dairy industry. Pickering (1983) applied the technique to adepartment store group. The two key factors identified by Pickering were capital (in termsof retail read more..
gLabour inputs: theory assumes that all units of labour are homogeneous both interms of ability and e¡ort supplied. However, workers will not have identical skilland application levels, but accounting for the homogeneity of labour units may beextremely di⁄cult in practice. Workers may also work di¡erent lengths of time ina week, so that comparisons should be made per similar time period, such as perhour. Work practices, training and many other factors might also account for onegroup of read more..
Case Study 7.3Explaining productivity differences inthe biscuit industryOne way of accounting for productivity differences between plants and countries is toundertake detailed studies of individual industries, using matched samples of plants; onesuch study has been of the biscuit industry: first, in Europe and, then, between Europe andthe USA (Mason et al., 1994; Mason and Finegold, 1997).The study estimated productivity per hour, with output measured by the tonnage ofbiscuits produced; tonnage read more..
CHAPTER 7 g PRODUCTIO N AND EFFI CIENCY139departments. The process and engineering skills of UK and US process workers weredeemed to be at a semi-skilled level, with no externally validated vocational training. Incontrast, in continental Europe a highly significant proportion of workers possessedvocational qualifications. Many were trained as craft bakers and had greater formal qualifica-tions and on-the-job training. In the UK on-the-job training was limited to a few months andwas given in a read more..
COUNTRY DIFFERENCES IN PRODUCTIVITYThere have been a number of studies of productivity di¡erences between countries,which usually put the USA at the top of the table and the UK at or near the bottom ofthe group of countries compared. One such study was that by the McKinsey GlobalInstitute (1998). Table 7.5 summarizes the results of a comparison between the UK,France, West Germany and the USA, using labour, capital and total factor productivity.In terms of labour productivity the UK is not only read more..
lower labour productivity, a lack of investment in training labour and poormanagement. This report di¡ers from conventional wisdom in that capital investment,although a contributory factor, was not identi¢ed as a primary cause of poorperformance.CHAPTER SUMMARYIn this chapter we explored the economics of production by primarily using isoquantanalysis. In doing this we analysed:gThe relative performance of plants and ¢rms.gProductivity to measure relative performance.gThe shortcomings of using read more..
Services (%)Manufacturing (%)Labour2.2À2.1Capital5.51.3Total inputs3.1À1.5Output4.13.7Total factor productivity1.05.2Capital productivityÀ1.45.2Labour productivity1.95.6^ Do these changes represent unequivocal increases in e⁄ciency in both manufac-turing and services?^ Is production becoming more or less capital-intensive?^ Are ¢rms using capital e⁄ciently?^ Demonstrate the relative changes in the two sectors using isoquant analysis.9 Historically, the UK has a poor comparative record in read more..
14 The following function was estimated for the bus industry:Q¼À1:80ðÀ2:4Þþ 0:21Bð2:0Þþ 0:41Fð3:3Þþ 0:37Lð3:2Þadjusted R2¼ 0:97Explain the role and function of the exponents in the multiplicative productionfunction. Does the estimated production function indicate that there areeconomies of scale?REFERENCES AND FURTHER READINGCharnes, A., W.W. Cooper and E. Rhodes (1978) Measuring the e⁄ciency of decision makingunits. European Journal of Operations Research,2, 429^444.Cubbin, J., read more..
8 COSTSCHAPTER OUTLINEChapter objectivesIntroductionShort-run cost curvesLong-run cost curvesCosts and the multi-product ¢rmEconomics versus accounting cost conceptsEmpirical cost analysisCase Study 8.1Estimating cost functions for hospitalsCost concepts and strategic advantageCase Study 8.2Economies of scope in car productionCase Study 8.3Economies of scale in building societies and insuranceManagement of costsChapter summaryAppendixStatistical cost functionsReview questionsReferences and read more..
INTRODUCTIONThe objective of this chapter is to explore the nature of costs, their importance indecision making and in gaining a competitive advantage. The main topics covered inthe chapter include:gEconomic concepts of costs in the short and long run.gCost concepts used by managers.gEmpirical procedures for estimating cost functions.gEconomies of scale, economies of scope and economies of learning.gCosts and competitive advantage.SHORT-RUN COST CURVESIn the short run, economic analysis assumes read more..
never touching the average ¢xed cost curve, while in Figure 8.2(b), ATC2 slopesinitially downward and then upward, being described as U-shaped.gMarginal costs (MCs): these are the addition to total costs by producing anadditional unit of output. Since ¢xed costs do not vary with output, the marginalcost curve is the increment in total variable costs, as a result of producing anextra unit of output. In Figure 8.2(a), average variable costs and marginal costsare identical, but in Figure 8.2(b) read more..
Mathematically, the relationships can be expressed using a cost function. If Q is thequantity produced, then the cost function can take the quadratic form:Total cost¼ aþ bQþ cQ2Average variable cost¼ bþ cQAverage total cost¼ a=Q þ bþ cQorAFCþ AVCMarginal cost¼ TC=QorTVC=Q ¼ bþ 2cQ148 PA RT III g UNDERSTAN DING P RODUC TIO N AND CO ST SCostsCostsATC1AFCMCATC2AVC2AFC2AVC1 = MCOQuantity(a) Constant variable costsOQQuantity(b) U-shaped variable costsFigure 8.2Average and marginal cost read more..
The marginal cost curve will rise as a constant function of output, where the costfunction takes the cubic form:Total cost¼ aþ bQþ cQ2þ dQ3Average variable cost¼ bþ cQþ dQ2Average total cost¼ a=Q þ bþ cQþ dQ2orAFCþ AVCMarginal cost¼ TC=QorTVC=Q ¼ bþ 2cQþ 3dQ2The average total cost and marginal cost curves will be U-shaped with the marginal costcurve intersecting the average total cost and average variable cost curves at theirlowest point and from below, as in Figure read more..
A small selection of three potential plant sizes is shown in Figure 8.3, but keep inmind that theoretically there is an almost in¢nite number of plants, all of slightlydi¡erent sizes. Each individual plant is characterized by a U-shaped short-run averagecost curve. Joining the outer points of successive short-run cost curves (e.g., D, E andF)gives the long-run average cost curve (LRAC). Such a curve is shown in Figure 8.3and is described as an envelope curve enclosing the myriad of short-run read more..
which can be rearranged to give:ECQ¼ðDTC=DQÞ=ðTC=QÞor marginal cost divided by average cost, or MC=AC. From this ¢nal ratio we have thefollowing relationships:1If ECQ is less than 1, then the marginal cost is less than average cost and, therefore,the cost function exhibits economies of scale.2If ECQ is greater than 1, then the marginal cost is greater than average cost and,therefore, the cost function exhibits diseconomies of scale.3If ECQ is equal to 1, then the marginal cost is equal to read more..
The average cost of production of each product can only be calculated if there isagreement on how ¢xed costs should be allocated between the two products. Typicalmethods of allocating ¢xed costs are:gTo allocate all ¢xed costs to one product, because it is regarded as the main productof the ¢rm.gTo allocate ¢xed costs between the two products on the relative use made of the¢xed factors by both products, measured by time used or output produced.gTo allocate ¢xed costs on an arbitrary read more..
then any cost incurred by increasing the output of product 2 can be attributed toproduct 2 and be regarded as the marginal cost of that product.ECONOMICS VERSUS ACCOUNTING COST CONCEPTSThe economist’s concepts of costs do not necessarily coincide with the cost conceptsused by businesses or accountants: for accounting, costs are only incurred where aledger entry is required because money has been spent; and for economists, the mainconcept is that of opportunity cost. The cost of any input in read more..
Replacement and historic costsAnother distinction is made between replacement and historic costs. Historic costs arethose paid at the time of purchase, while current or replacement costs re£ect thecurrent price or cost of buying or replacing the input now, which, better re£ects theopportunity cost of employing equipment or other resources that may have been instock for some time.Sunk and non-sunk costsSunk costs are those incurred in buying assets, such as plant or machinery, or spendingon read more..
resources, while normal pro¢t needs to be modi¢ed to account for the varying degrees ofrisk involved in di¡erent activities.EMPIRICAL COST ANALYSISIdentifying the shape and nature of the cost function is important for many decisions.Economists view short-run cost curves as being U-shaped, while accountants see therelevant costs as being constant per unit. The two views are reconciled in the shortrun by proposing a bath-shaped cost curve (see Figure 8.4), with a signi¢canthorizontal section read more..
the data. Generally, several di¡erent models are ¢tted to the data to see which is statis-tically the more appropriate.Time series regression is the most popular method for estimating the short-runvariable cost function. The model to be estimated, as long as the relationship isassumed to be linear, is TVC¼ aþ bQ,where a and b are the parameters to beestimated. Theintercept mayhavelittlemeaningas itlies well outsidetherangeofobservations. The parameter b measures the variable cost function read more..
by using the linear model. Koot and Walker (1970) estimate cost functions for a plasticcontainer manufacturer and found evidence of linear average variable costs. Recentstudies of hospitals ¢nd that short-run variable costs of hospitals are constant (Aletras1999). The empirical evidence tends to suggest that short-run average variable costsare constant over the range of outputs the ¢rm is most likely to produce.Long-run statistical cost estimationIn the long run, all inputs are variable and read more..
Engineering approachBecause of the di⁄culties with statistical studies, economists have sometimes used anengineering approach. The technique consists of developing the physical productionfunction, or isoquant map, that exists between inputs and output and, then, attachingcost values to obtain a total cost function for producing a di¡erent output level: forexample, in producing ethylene or cars, in plants of di¡erent sizes, the capital costscan be estimated by calculating the size and type of read more..
The long-run model found costs increased by 8.28% when output increases by 10%;this was a statistically significant result and indicates that there are economies of scaleavailable to Greek hospitals.Economies of scale for general hospitals have been examined extensively. Studieshave found that economies of scale are fully exploited in hospitals that have roughly 200beds and that larger hospitals with 400 or more beds are at best no more efficient thansmaller units; this suggests that long-run read more..
are that it is more e⁄cient to produce a number of products within the same plant. Thesource of economies of scope may not only be found in manufacturing but also in suchareas as marketing: for example, it may be cheaper to market di¡erent ¢nancialservices from the same premises, a strategy adopted by banks, building societies andinsurance companies.Case Study 8.2Economies of scope in car productionIn a multi-product industry, such as motor cars, a firm can gain cost advantages from read more..
area and, therefore, the material required to make it. Because volume increases by r3andareaor costsby r2 in process industries, such as oil re¢ning, this has led to theadoption of the 0.6 rule: a general rule of thumb that says doubling the size of a plantraises capital costs by only 60%. Haldi and Whitcomb (1967) estimated scale coe⁄-cients for 687 types of basic equipment. Fitting the function C¼ aQb,where C¼ costs,Q¼ output capacity and a, b¼ constants, they found in 90% of cases that read more..
by substantial economies of scale, particularly for larger societies. The results are similar toHardwick’s estimates for smaller societies, but not for larger societies.Hardwick (1993) undertook a survey of managers of life insurance companies todiscover the sources of economies of scale. Respondents considered the main sourcesof economies of scale, in terms of the number of respondents agreeing:gMore efﬁcient use of computers 75%.gName awareness 68%.gMore cost-effective advertising read more..
output increases at the outset and then eventually diminishes and becomes insigni¢-cant. In practice, separating learning e¡ects from other causes of cost reductions, suchas economies of scale, may be di⁄cult and make empirical estimation harder.Many e¡orts have been made to measure the learning curve (see Baden-Fuller1983). An early example identi¢ed by Abernethy and Wayne (1974) was the Model TFord. Over a period of 16 years the price of the car fell from $4,500 to $950 as read more..
Learning e¡ects are thought to be most signi¢cant in activities using advancedtechnology and where capital input dominates the production function. However,learning e¡ects are not con¢ned to assembly operations and can occur in any part ofthe business where repetition gives rise to knowledge-based e¡ects. Knowledge of thelearning curve is important to managers in assessing their cost advantages over rivals.It gives early starters a cost advantage that later entrants cannot match for some read more..
Simplistic, across-the-board cost cutting, however, should be avoided, because of theknock-on e¡ect on other costs and revenue: for example, ceasing the production of oneproduct may have adverse e¡ects on the costs of another because of economies ofscope. The price^cost margin may not be restored if revenue is adversely a¡ected bycost cutting: for example, if the quality of the product or after-sales service is reduced,consumers may switch to alternative suppliers. Likewise, cutting the read more..
where a, b, c, d¼ are positive constants; this converts into a linear relationship in logs:log TC¼ log aþ b log Qþ c log wþ d log rThe constant b is the output elasticity of total cost, while c and d are the positiveelasticities of long-run total cost in relation to the prices of inputs. An increase in pricewill increase total cost.REVIEW QUESTIONS1 Distinguish between ¢xed and variable costs. Comment on which potential costsources are truly variable and those that are wholly or partially read more..
REFERENCES AND FURTHER READINGAbernethy, W.J. and K. Wayne (1974) Limits of the learning curve. Harvard Business Review,September/October,52, 109^119.Aletras, V.H. (1999) A comparison of hospital scale e¡ects in short-run and long-run costfunctions. Health Economics,8, 521^530.Baden-Fuller, C. (1983) The implications of the learning curve for ¢rm strategy and public policy.Applied Economics,15, 541^551.Bailey, E.E. and A. D. Friedlander (1982) Market structure and multiproduct industries, read more..
PARTIVPRICING,PROMOTIONALAND INVESTMENTPOLICIES9Pricing and market structure: theoreticalconsiderations17110Pricing in practice19711Advertising21912Investment appraisal241 read more..
PRICING AND MARKETSTRUCTURE:THEORETICALCONSIDERATIONSCHAPTER OUTLINEChapter objectivesIntroductionPerfect competitionMonopolistic competitionOliogopolyKinked demand curve modelBertrand oligopolyCournot oligopolyCollusion and cheatingGame theoryNon-zero sum gamePrice stickinessCollusive oligopolyCartelsCase Study 9.1The vitamin cartel and the EUTacit collusionCase Study 9.2Price leadership in the salt industryCase Study 9.3UK digital televisionChapter summaryReview questionsReferences and further read more..
ability of a ¢rm to make its own prices. At the end of the chapter you should beable to:t Identify the main characteristics of perfect competition, monopolistic competitionand the implications for the pricing behaviour of individual ¢rms.t Understand the nature of interdependence of ¢rms in oligopolistic markets and theuse of reaction curves.t Explain the insights of the kinked demand curve model and the concept of pricestickiness.t Analyse the equilibrium outcomes of the Bertrand and Cournot read more..
gFirms can enter and leave the market freely.gFirms are owned and managed by individual entrepreneurs.gDecision makers are unboundedly rational and perfectly informed.gOwners seek to maximize pro¢ts.gConsumers seek to maximize utility.As a result the market price is determined by the interplay of rivalry between suppliersand consumers. Given the market price, all controllers select an output for their ¢rmthat will maximize pro¢ts; this is illustrated in Figure 9.1. The demand curve for read more..
MONOPOLISTIC COMPETITIONChamberlain (1933) and Robinson (1933) developed models of monopolistic andimperfect competition, respectively, in which the ¢rm has some degree of marketpower. The key assumptions for a market to be described as monopolisticallycompetitive include:gLarge numbers of small ¢rms and consumers.gEach ¢rm produces a di¡erentiated product.gFirms can freely enter and leave the market.gFirms are owned and managed by an owner entrepreneur.gDecision makers are unboundedly read more..
InterdependenceOligopolists are signi¢cant players in a market. Any action they take to alter price oroutput will have some impact on their competitors. In deciding what price to chargethe ¢rm must consider the potential reaction of other ¢rms in the market. Forexample, if ¢rm 1 were to lower its price how would ¢rm 2 react? If its product isCHAPTER 9 g P RICI NG AND MA RKET STRU CTU RE175AP1Q1MR1AR1QCOPrice/CostABP2OPrice/CostOutputMCBDEAC(a) Supernormal profitsQ2AR1MR1QOutput(b) Normal read more..
strongly di¡erentiated from that of its rival, then it may ignore the price cuts andcontinue charging the same price. If its product is weakly di¡erentiated, then itsconsumers may purchase the cheaper alternative. To discourage them, ¢rm 2 maylower its price and match the price cut of ¢rm 1.By varying supply to a market an oligopolist can also in£uence price. Thus, in theinternational oil industry the withdrawal of supply by the larger producers, such asSaudi Arabia, can signi¢cantly read more..
selling OQ units of output. If ¢rm 1 considers reducing price to sell more products, thenit must be aware of the reaction of its rivals. If no other ¢rm follows its move, then¢rm 1 will expect to move along the demand curve AR2 from B toward point K,signi¢cantly increasing its market share. If rivals lower their prices in response to theprice cut, then ¢rm 1 will expect to move along demand curve BH from B toward J.Price increase: if ¢rm 1 were to increase its price, then all other ¢rms read more..
demand elasticity was found to be greater for upward than for downward pricemovements, in line with the conjectures of kinked demand theory. This double-kinkeddemand curve is illustrated in Figure 9.4, with kinks at B and C. The reasons for thelack of initial response to a price change may be consumer loyalty to the product, thesearch costs of identifying alternatives, the costs of switching to a new supplier andthe lack of reaction from rivals because of the costs of changing price.BERTRAND read more..
gIf ¢rm 2 has the lower price, then it captures the whole market and ¢rm 1 suppliesnothing.gIf both ¢rms set the same price, then they are assumed to each supply half themarket.The optimal price for ¢rm 1 depends on its conjectures about what ¢rm 1 will do. If ¢rm1 expects ¢rm 2 to set the monopoly price, then by slightly undercutting this price¢rm 2 would capture the entire market and make pro¢ts close to the monopoly ormaximum level, while ¢rm 1 would sell nothing. Firm 1’s optimal read more..
market will set those prices equal to marginal cost that would prevail in a competitivemarket.If the market demand curve is given by P¼ 100À Q and marginal cost is 10, thenthe monopoly price and output would be 55 and 45, respectively, and the competitiveprice and output would be 10 and 90, respectively. To be able to meet all the demandgenerated, each ¢rm would require a capacity of 90. Thus, if ¢rm 1 were to charge themonopoly price of 55, then ¢rm 2 could supply the whole market by read more..
Both ¢rms charge price OP3, and total supply to the market is two-thirds thecompetitive level of sales.Assuming a market demand curve of P¼ 100À Q and a constant marginal cost of10, the competitive output will be 90 and the monopoly output 45. In a Cournotoligopoly, convergence of the sales of both ¢rms is shown in Table 9.1, for ¢ve rounds.Firm 1 initially sets the monopoly price and makes pro¢ts of »2,025. The sales of ¢rm1 reduce from the monopoly output of 45 toward 30, and the sales read more..
function, for ¢rm 1 de¢nes the pro¢t-maximizing output for ¢rm 1, given the output of¢rm 2. Given that ¢rm 2 sells Q2 units of output, ¢rm 1’s output can be expressed asQ1¼ R1ðQ2Þ. For ¢rm 2 the reaction function is given by Q2¼ R2ðQ1Þ.Reaction functions for a duopoly are shown in Figure 9.7, where ¢rm 1’s sales aremeasured on the horizontal axis and ¢rm 2’s on the vertical axis. The horizontalintercept of ¢rm 1’s reaction curve QM1 assumes that ¢rm 2 sells nothing and read more..
Since marginal cost is equal to 10, marginal revenue equal to marginal cost can beexpressed as:100À 2Q1À Q2¼ 10orQ1¼ fðQ2Þ¼½ð90 À Q2Þ=2¼ 45À 12 Q2Q2¼ fðQ1Þ¼½ð90 À Q1Þ=2¼ 45À 12 Q1If ¢rm 2 sells 40 units, then ¢rm 1 would choose to produce½ð90 À 40Þ=2,or25. If¢rm2 produces 30, then ¢rm 1 would produce½ð90 À 30Þ=2, or 30. The equilibriumoutput is to be found at point E in Figure 9.6. At this point, both ¢rms make pro¢ts of»900, which is derived by read more..
Likewise, ¢rm 2 has the same incentive to cheat: if ¢rm 1 increases its output by 1 to23.5 while ¢rm 2 continues to produce 22.5, then ¢rm 1 can increase its pro¢ts by»21.5 to »1,034 at the expense of ¢rm 2, whose pro¢ts are reduced by »22.5 to »990.Overall, joint industry pro¢ts fall by »1 to »2,024. Firm 2’s incentive to cheat isexactly the same as that for ¢rm 1; these outcomes are found in Table 9.1. Thus,Cournot equilibrium may or may not be a stable position, depending on read more..
make pro¢ts of »120, and combined industry pro¢ts are »240. If both select a strategyof low price, then they each make pro¢ts of »80 and combined industry pro¢ts are»160. If one ¢rm chooses a high-price strategy and the other a low-price strategy,then the low-price ¢rm makes »150 and the high price ¢rm makes »20, indicating adegree of product di¡erentiation because sales of the higher priced product do not fallto zero.The strategic options facing ¢rm 2, which are dependent on the read more..
Theoretical explanation of price stickiness can be found in the kinked demandmodel and in game theory. The behavioural conjectures in the kinked demand curvemodel (i.e., that rivals will match price cuts but not price increases) reinforces the stick-ability of the existing price. The danger in price cutting is that rivals may overreact,not just matching price cuts but imposing bigger cuts leading to a damaging pricewar. The price stickiness e¡ect may also be reinforced by uncertainty about how read more..
cost-based pricing, price changes only occur when there are signi¢cant moves in prices,wages and/or raw materials (see Chapter 10). Co-ordination failure refers to the unwill-ingness of a ¢rm to be ¢rst to change its prices, while non-price elements refer to rigidprices accompanied by quality or quantity changes. In these circumstances a ¢rm mayprefer to reduce the number of biscuits in a pack rather than raise the price.COLLUSIVE OLIGOPOLYThe theory of oligopoly stresses the di⁄culty that read more..
homogeneous the product the smaller the room for independent action. Frequent smallorders tend to facilitate co-ordination, whereas infrequent large orders will tend tolead ¢rms to compete vigorously. Where ¢xed costs are a high proportion of totalcosts, an individual ¢rm will strive to maintain the maximum level of output to keepaverage ¢xed costs to a minimum. A fall in demand tends to an increase in the degreeof competition. Price ¢xing is also easier in an industry where there is little read more..
level of marginal cost the output of both ¢rms is summed. Thus,at marginal cost OC1,¢rm 1’s output C1E plus ¢rm 2’s output of C1F gives the industry output CMG and apoint on the market’s marginal cost curve. The portion of the market marginal costcurve LM is made up only of the initial portion of ¢rm 1’s marginal cost curve. Abovepoint M its position is determined by the marginal cost curves of both ¢rms.The cartel’s total output is determined where the industry marginal cost is read more..
Figure 9.9 is selling its cartel-determined output OQ1 at the cartel’s set price OPC,thenitwill be making pro¢ts of PCASC. If the ¢rm increases its output to the point wheremarginal cost is equal to the cartel-set price, then it would make additional pro¢tsequal to the triangle AVS by producing output OQ2: hence, the incentive to increaseoutput.However, if an increase in output by one ¢rm reduces the price below that set by thecartel, then the impact on pro¢ts depends on the elasticity of read more..
their own output and so ensure a greater fall in price than expected by the cheating ¢rmthat increases output.Case Study 9.1The vitamin cartel and the EUIn both the EC and the UK all cartels are illegal, and firms participating in them are subject tofines of up to 10% of their turnover in the appropriate market. Each year a number of cartelsare identified. One of the most significant in recent years was a ‘‘vitamin cartel’’ of 13companies that engaged in a series of agreements to read more..
commonly identi¢ed forms of price leadership including dominant-¢rm price leadershipand barometric price leadership.Evidence of price co-ordination in the UK was found by Domberger and Fiebig(1993). They studied 80 industries between 1974 and 1985 and found that the moreoligopolistic an industry the more symmetrical were price changes: that is, theytended to be in the same direction, to be of similar size and to occur in a relativelyshort period of time.Dominant-¢rm price read more..
supply at any price set by the dominant ¢rm. If the dominant ¢rm sets a price of OC,then the fringe will supply nothing because the market price is equal to its marginalcost. Thus, he dominant ¢rm supplies the whole market. If the dominant ¢rm sets aprice at PH, then at this point the fringe’s marginal cost curve cuts the industrydemand curve, with the result that the fringe would, theoretically at least, supply theentire industry output. The residual demand curve for the dominant ¢rm is read more..
between January 1974 and January 1984, which were initiated by either firm and alwaysfollowed more or less exactly by the other. The leader would normally inform the follower ofits planned price change four weeks before it was to be implemented. The follower wouldconsider the proposals and make identical changes within that period. One of the reasonsfirms co-ordinate their activities is the fear of the consequences of being out of line andbeing caught in a low-price market and, thus, of losing read more..
CHAPTER SUMMARYIn this chapter we examined the in£uence of market structure on the price-settingbehaviour of ¢rms. In doing this we analysed:gOligopolistic market structures in which ¢rms have a degree of independence insetting prices and need to be aware of moves by their rivals. In oligopolisticmarkets, ¢rms co-ordinate their activities by using speci¢c or tacit collusion.gThe dominant ¢rm, which has more control over price than its smaller rivals,obliging them to be price followers.gHow read more..
9 Consider the usefulness of the ‘‘prisoner’s dilemma’’ model in explaining thedilemma of ¢rms trying to decide whether they should collude or act independently.10 What factors facilitate the formation of cartels and, once formed, what factors makethem unstable?11 What do you understand by the term ‘‘price stickiness’’? Why are prices sticky inoligopolistic industries?12 Why do duopoly markets not result in prices being set at competitive lewels.REFERENCES AND FURTHER read more..
10 PRICING IN PRACTICECHAPTER OUTLINEChapter objectivesIntroductionThe nature of priceDominant-¢rm pricing and consumer surplusPrice discriminationCase Study 10.1 Licence auction: third-generation mobile phonesTwo-part tari¡sPeak load pricingCase Study 10.2 British Telecom’s pricing structurePricing in imperfect marketsStudies of pricingAnalytics of average cost pricingOther considerations in setting priceChapter summaryReview questionsReferences and further readingCHAPTER OBJECTIVESThis read more..
INTRODUCTIONSetting a price is one of the major decisions that a ¢rm has to take. In most marketstructures the ¢rm has the ability to make prices, though it may be severely limited bythe structure of the market it operates in. In the most competitive markets, ¢rms willhave to accept the market price and be price takers. In setting a price a ¢rm will haveto consider both demand factors and costs. In some circumstances, demand factorswill be the dominant in£uence in setting a price; in read more..
buyers are consumers or industrial users, whether products are singly or jointlyproduced and the age and utilization of productive capacity.DOMINANT-FIRM PRICING AND CONSUMER SURPLUSA dominant ¢rm acting as a monopolist, aiming to maximize pro¢ts and using a singleprice will equate marginal revenue to marginal cost and set the appropriate price forthat output. The ¢rm will be able to earn supernormal pro¢ts in the long run, since itfaces no competition. In Figure 10.1 the ¢rm faces a read more..
PRICE DISCRIMINATIONPrice discrimination involves exploiting demand characteristics that allow the sameproduct to be sold at various prices unrelated to the cost of supply. In practice a singleconsumer may be charged di¡erent prices for di¡erent units of a good bought ordi¡erent consumers may be charged di¡erent prices for the same product or service.Economists distinguish between three types of price discrimination.1First degree price discriminationFirst-degree price discrimination occurs read more..
bidders were left – each holding a licence. By round 106, 5 companies had withdrawn. Inthe final round, only one company NTL was eligible to bid against the existing highestbidders, but chose not to do so and withdrew. The winners of the licences after 150rounds are shown in Table 10.1. The newcomer’s licence went to TIW of Canada, whosubsequently sold its licence to Hutchinson Communications, after they had sold Orange toMannesman. The other four licences went to the existing operators. The read more..
di¡erent price for the same product. To be able to achieve such market separation, theremust exist some barriers to prevent consumers moving from the expensive to thecheaper market, as well as to prevent customers in the cheaper market selling toconsumers in the more expensive one. In addition, the price elasticity of demand mustbe di¡erent for each group of customers, so that market separation is pro¢table.In Figure 10.3 the monopolist is able to split demand into two separate markets read more..
The implication of third-degree price discrimination is a higher price in the marketwith less elastic demand and a lower price in the market with more elastic demand.We know that MR¼ Pð1 þ 1=eÞ,where P¼ price, MR¼ marginal revenue ande¼ price elasticity of demand (see Chapter 5). Pro¢t maximization requires theequality of marginal revenue in both markets with combined marginal cost. Thus, wecan equate P1ð1 þ 1=e1Þ¼ P2ð1 þ 1=e2Þ.If e is lower in market 1 than market 2, then1=e is read more..
204 PA RT IV g PRIC ING, P ROMO TIONA L AND INVESTMENT POLICI ESSolving these equations gives the following values for quantity and price in each market:Market 1Q1¼ 10andP1¼ 20Market 2Q2¼ 15andP2¼ 25We can also calculate the price elasticity of demand for both P1 and P2. The formula forpoint elasticity isðP=QÞÃðDQ=DPÞ, so that the price elasticity for P1 is given by½ð20=10ÞÃÀ1,or À2. Price elasticity for P2 is given by½ð25=15ÞÃÀ1Þ,or À1:66.We can also verify the read more..
CHAPTER 10 g PRICIN G I N P RA CTICE205MR1¼ 30À 12:5MR1¼ 17:5MR2¼ 40À 22:5MR2¼ 17:5Since marginal revenue is equal to marginal cost, it must be equal to 17.5, or Q1þ Q2,which is equal to 11:25 þ 6:25, or 17.5.We can also calculate the price elasticity of demand for both P1 and P2. The formulafor price elasticity isðP=QÞÃðDQ=DPÞ, so that price elasticity for P1 is given by½ð23:75=6:25ÞÃÀ1; orÀ3:8, and for P2 is given by½ð28:75=11:25ÞÃÀ1,or À2:6.We can also verify the read more..
A two-part tari¡ pricing strategy has been employed in utility industries where the¢xed charge is designed to recover ¢xed costs and the variable element is intended tore£ect more closely the marginal cost of consumption; this encourages additionalconsumption, particularly in industries with high ¢xed cost, declining average costsand excess capacity. However, while the marginal price might more closely re£ect themarginal cost of supply, the method has adverse distributional consequences read more..
that the peak price is not explicitly related to costs. The hairdresser is also exploitingdi¡erences in the willingness of individual consumers to pay higher prices on peak days.Assume a ¢rm has two separate and independent demand curves for its services,separated by time of the week. Its short-run marginal cost curve increases with thequantity sold to capacity, at which point it rises vertically. The short-run average costcurve is shown as falling to capacity output QC and then increasing; read more..
Time-of-day pricing in electricity at both peak and o¡-peak can be justi¢ed by costvariations because electricity is produced by power stations whose costs are higher atpeak than at o¡-peak. Railway pricing tends to be similar to that of the hairdresser,with higher prices at morning peak to restrict demand and lower prices o¡-peak toencourage greater usage of unused capacity. In the electricity industry, pricedi¡erences are justi¢ed by cost di¡erences and are not regarded as price read more..
PRICING IN IMPERFECT MARKETSIn imperfect markets where there are a small number of competitors producing di¡eren-tiated products the ¢rm has a degree of £exibility to make its own prices, tempered byconcern for the pricing behaviour of rivals. Economics suggests two competing meth-odologies for price setting. First, a ¢rm can relate prices to costs of production. At itssimplest this represents a desire on the part of a ¢rm to ensure that revenues covercosts and allow the ¢rm to make a read more..
4Prices are set equal to direct costs plus a ¢xed percentage mark-up (17%).5Prices are set by customers or buyers (5%).6Prices are set by regulators (2%).The survey showed that 64% of ¢rst preferences said they used the market-basedprocess in setting their prices compared with 37% that used cost-plus pricingprocedures. Cost-plus mark-up pricing tended to be more important for smallcompanies than for medium and large ones. The report suggests that the cost mark-uprule of thumb is more suitable read more..
leads to a contribution approach, in that products are given a share of ¢xed costs andpro¢ts they are expected to contribute.In Figure 10.7 the full cost price maker chooses a normal output QN and then addsaverage variable costs, average ¢xed costs and pro¢t to obtain the full cost price ofOPF.Ifsaleswere less than Q1, then the ¢rm would start making losses becauseaverage total cost exceeds average revenue OPF.In Figure 10.8, a ¢rm, using mark-up pricing, estimates average variable costs read more..
212 PA RT IV g PRIC ING, P ROMO TIONA L AND INVESTMENT POLICI ESAVC+ AFC+ ΠAVC+ AFCAVCHGFEDCBAQ1PFOQNQuantityCostsQ2Figure 10.7Full cost pricingBMRQNPNQuantityPrice/CostOAARSRMCSRAVCFigure 10.8Mark-up pricing read more..
this can be rearranged as:P¼ AVCþðÀ1=ðe þ 1ÞÞAVCwhere the second term represents the mark-up on average variable costs (see Douglas1992, pp. 425^426). Thus, if the price elasticity of demand isÀ3and AVC¼ 10, thenthe mark-up can be calculated as follows:P¼ 10þðÀ1=ðÀ3 þ 1ÞÞ Ã 10P¼ 10þð1=2ÞÃ 10P¼ 10þ 5¼ 15a mark-up of 50%. A price elasticity ofÀ2 would give a mark-up of 100%, a priceelasticity ofÀ4 would give a mark-up of 33.3% and a price elasticity ofÀ5 would givea read more..
industries, such as brick making and cement, when price changes were monitored andregulated in the 1970s.Reconciling cost-plus pricing and marginalismWhen investigating pricing behaviour, economists have looked for evidence thatmanagers make use of the marginalist framework. Instead, they ¢nd that price makersmake use of rules of thumb to guide them in their making of prices rather thanequating marginal revenue with marginal cost. Rules of thumb are important becausemanagers are not unboundedly read more..
Typical examples include biscuit manufacturers that may adjust the number of biscuitsin a packet or make each biscuit smaller. Clearly, such adjustments are not possible inall circumstances, and the ¢rm may have to accept a cut in its pro¢t margin.Relative pricingFirms may attempt to position the price of their product relative to a similar but di¡erentproduct. If the product has a number of characteristics that consumers ¢nd attractive,then the ¢rm may be able to establish a higher price read more..
purchased, consumers will repeat the exercise even at higher prices. Larger sales mayalso lead to cost advantages as plants are more fully utilized.Predatory pricingIn certain circumstances a ¢rm may set a price below that of its rival to win increasingmarket share with the added strategic motive of driving a rival from the market. Theaggressive price cutter will probably argue that its costs are lower and re£ect lowercosts of production. However, if prices are set at less than average read more..
REVIEW QUESTIONSExercise1Visit the websites of a number of airlines, choose a £ight and obtain a price for:^ Flights at di¡erent times of the day.^ Flights on di¡erent days of the week.^ Flights one week, one month and three months ahead.What pricing patterns emerge?How does the economics of pricing help to explain your observations?2Observe the pricing of petrol on your route to college:^ What pricing patterns emerge?^ Do they all charge the same price?^ If the price of petrol increases, do read more..
REFERENCES AND FURTHER READINGAlfred, A.M. (1972) Company pricing policy. Journal of Industrial Economics,21,1^16.Andrews, P.W.S. (1949) Manufacturing Business. Macmillan, London.Andrews, P.W.S. and E. Brunner (1975) Studies in Pricing. Manufacturing Business, Oxford, UK.Atkin, B. and R. Skinner (1975) How British Industry Prices. Industrial Market Research, London.Atkinson, B., F. Livesey and B. Millward (1998) Applied Economics. Macmillan, Basingstoke, UK.Barback, R.H. (1964) The Pricing of read more..
11 ADVERTISINGCHAPTER OUTLINEChapter objectivesIntroductionRoles of advertisingAdvertising and changing consumer preferencesAdvertising: price and demandAdvertising and costsSales and advertisingOptimal level of advertisingWhich products do ¢rms advertise?Advertising and market structureAdvertising as investmentBrandingCase Study 11.1 Cigarette advertisingChapter summaryReview questionsReferences and further readingCHAPTER OBJECTIVESThis chapter aims to examine issues surrounding the level of read more..
INTRODUCTIONThe term ‘‘advertising’’ is generally taken to mean expenditure undertaken by a ¢rm topromote the sales of its products or services. The most visible form of advertising ispaid-for space in print, radio or television media. Advertising also includespromotional activity for a product, such as special displays, o¡ers in shops or atcommercial shows. Advertising is intended to in£uence consumer choice in favour ofthe advertiser’s product or service. In this chapter we will read more..
ADVERTISING AND CHANGING CONSUMER PREFERENCESAdvertising is designed to alter the consumer’s preferences in favour of advertisedproducts and against non-advertised products. In Figure 11.1 a consumer’s preferencebetween two goods A and B is shown in the form of an indi¡erence curve map. Thepre-advertising indi¡erence curve is labelled IC1. With budget line DE, the consumer isin equilibrium at point K on indi¡erence curve IC1. The consumer buys OA1 of good Aand OB1 of good B. In read more..
advertising campaign the greater the increase in the marginal rate of substitutionbetween A and B.ADVERTISING: PRICE AND DEMANDAdvertising is often the principal method employed by ¢rms to increase perceiveddi¡erences between products among consumers and to create brand loyalty. Therefore,advertising is a major competitive tool, especially when used in combination withother competitive weapons, such as price. In some oligopolistic markets, such aswashing powders in the UK, variations in read more..
new demand curve D2D3, which is to the right of the existing demand curve, so that atevery price the quantity demanded has increased. Alternatively, a new demand curveD2D1 may be generated with a higher price intercept and the same quantity intercept.In Table 11.1 these demand curves are expressed in quantitative terms and theimpact of advertising on quantities and price elasticity is calculated. If the existingprice of the product is 12, then the ¢rm will sell 8 units when the relevant read more..
OQ2, will experience a fall in average production costs from OC1 to OC3.If the¢rmisalso on the downward portion of its long-run average cost curve, then signi¢cantincreases in sales could lead to larger production facilities being constructed andfurther falls in average production costs.Advertising is also an expense, and the average unit expenditure on advertisingmay more than o¡set the reductions in production costs achieved by selling more. Ifthe costs of an advertising campaign are read more..
always positive and greater than 1; this assumption means that all advertisingcampaigns are successful. In practice, advertising campaigns can be unsuccessful; thisis indicated in two ways: ¢rst, a positive advertising-to-sales ratio of less than 1 wouldindicate that sales revenue had increased by less than the increase in advertisingexpenditure; and, second, a negative sales-to-advertising ratio would indicate that anincrease in advertising expenditure had led to a decline in sales.It is read more..
226 PA RT IV g PRIC ING, P ROMO TIONA L AND INVESTMENT POLICI ESMCP +ADEMRGQQuantityARFACP +AACPACAPHOPrice/CostsFigure 11.4Pro¢t maximizing with advertisingQ1QuantityPrice/CostsP2P1OQ2EGHFKAMRAMCAARAACFigure 11.5Optimal price and advertising read more..
the marginal increase in costs of advertising are equal to the marginal increase inrevenue; this is achieved at point K where the ¢rm charges price OP2, sells quantityOQ2 and incurs average advertising costs of Q2H.This approach to optimal advertising has certain advantages and limitations. Itallows the myriad individual combinations of advertising and price outcomes to becombined into the AAR and AMR curves to demonstrate the incremental or marginalnature of the process. Its shortcomings are read more..
the objectives of advertising is to reduce the elasticity of demand for a product and topromote brand loyalty. Cause and e¡ect are therefore intertwined.Advertising-to-sales ratios in the UKData on advertising-to-sales ratios for 190 selected products in the UK for 1997 can befoundinTable11.2.Ofthese,84productshaveratios oflessthan1%, 12 productshave ratios in excess of 10% and only 4 have ratios in excess of 20%; these 4 werevitamins, hair colourants, indigestion remedies and shampoos. read more..
Consumer goods and advertisingThe level of advertising intensity may vary by type of consumer product or service beingsold.Durable/Non-durable goodsDurable goods, such as washing machines andrefrigerators, generally have lower advertising-to-sales ratios than non-durable goods,such as chocolate bars. Given the high price of durable products, it is argued thatconsumers will undertake more detailed searches of the products available and thecharacteristics and attributes of each using the read more..
Evidence to support the notion that experience goods will be more heavilyadvertised than search goods is found in a study by Davis et al. (1991). In ascendingorder of advertising-to-sales ratios for 1989 they found that:1Search goods had the lowest ratio of 0.4%.2Goods where experience is of little value had the second lowest ratio of 1.8%.3Short-term experience goods had an average ratio of 3.6%.4Long-term experience goods had the highest ratio of 5.0%.They also found:gThe highest read more..
a signi¢cant competitive weapon will be those ranging from monopolistic competitionto duopoly where products are di¡erentiated and there are relatively few competitors.In monopolistically competitive markets, products are di¡erentiated; this meansthat, although there are large numbers of competitors, each ¢rm’s product is not aperfect substitute for the products of other suppliers. The demand for each ¢rm’sproduct tends to be more price-inelastic than in more competitive markets read more..
campaign. Similar advantages may be gained by changing the speci¢cations of aproduct in ways that cannot easily be copied by rivals.The smaller the number of ¢rms competing with each other the greater theincentive for an individual ¢rm to pursue policies that will take sales from its rivals. Inoligopolies there is both an incentive to compete and an incentive to collude eitherexplicitly or implicitly. The incentive to advertise is to gain market share, while thedisincentive is the cost of an read more..
Advertising and barriers to entryIf a ¢rm gains an increased market share in a rapidly expanding market by advertising,then it will experience growth. It will also gain market power and be expected to havea higher price^cost margin. Thus, larger ¢rms will have higher pro¢t rates thansmaller ¢rms. Having achieved higher pro¢ts through increasing its advertising-to-sales ratio, the ¢rm may continue to increase its ratio because it makes life di⁄cult forits less successful rivals to read more..
name of the company and of a diverse range of products from airlines and trains to¢nancial services and mobile telephones.Doyle (1989) identi¢ed four factors that can determine brand performance: quality,innovation, superior service and di¡erentiation. Each of these factors is interrelated.For example, quality embodies features like reputation, performance and durabilityand is itself a function of process and product innovation as well as pre and after-salesservice activity. E¡ective read more..
Table 11.4Cigarette statisticsYearPercentage of adult smokersAverageConsumerReal priceNumberweeklyexpenditure2indexsmoked———————————————expenditure1per weekAllMenWomen(£)(£m)(men)19784044367.0016,41512519883132305.9012,22010011919982728265.308,022158100Notes1 Average weekly expenditure 1998/9 prices2 Consumer expenditure at 1985 pricesSourceBased on data extracted from DOH (2000)In a declining market, tobacco companies might be expected to advertise to:gEncourage read more..
smoking-related cancer and respiratory diseases. Health concerns also apply to the effectson children of smoking during pregnancy. Passive smokers are also likely to be affected bysmoky environments.The main measures to discourage smoking in the UK have been tax increases ensuringcigarette prices increase in real terms and health promotion. In addition, the growingconcern of non-smokers who become passive smokers has led to smoking bans in theworkplace and public places of entertainment. While read more..
CHAPTER SUMMARYIn this chapter we explored the nature and role of advertising as a means of competingwith rivals. In doing this we showed how:gAdvertising can be used to change consumer preferences so as to increase demandand make demand less price-sensitive.gExpenditure on advertising is a cost incurred to increase sales. The relationshipbetween incremental advertising expenditure and incremental sales is importantin determining the optimal level of advertising expenditure.gAdvertising read more..
2 What are the Dorfman^Steiner conditions for optimal advertising? If theadvertising-to-sales ratio is currently 1/10, the elasticity of advertising 0.2 andprice elasticityÀ2:0, what are the consequences for the advertising-to-sales ratio ifthe price elasticity of demand is 1?3 Using diagrams explain the derivation of the LAAC and LAR curves and explain therelationship between sales and advertising. Where will the equilibrium level ofadvertising be?4 Compare and contrast the relative advantages read more..
Doyle, P. (1989) Building successful brands: The strategic options. Journal of MarketingManagement,5(1), 77^95.Du¡y, M. (1994) Advertising and Cigarette Demand in the UK. UMIST School of Management,Manchester.High,H.(1999) Does Advertising Increase Smoking? Institute of Economic A¡airs, London.Nelson, P. (1974) Advertising as information. Journal of Political Economy,82(4), 729^754.Porter, M. (1980) Competitive Strategy: Techniques for Analysing Industries and Competitors.FreePress, New read more..
12 INVESTMENT APPRAISALCHAPTER OUTLINEChapter objectivesIntroductionBasic steps in investment appraisalEstimating cash £owsTime and the value of moneyDiscounting and present valueRanking of projects and the capital-spending planNon-discounting methods of investment appraisalCapital rationing and the capital-spending planIncorporating risk and uncertaintyCoping with uncertaintyThe cost of capitalThe risk premium and the discount rate for capital investmentCapital budgeting in large British read more..
INTRODUCTIONInvestment is undertaken by every ¢rm. Without investment in capital the ¢rm’sproduction facilities will slowly become outdated, depreciate and eventually cease tofunction. To be competitive in terms of costs and quality of product, the ¢rm mustfrom time to time spend money on new plant and equipment, either to replace existingequipment or add to the ¢rm’s stock of capital. In economics, investment is de¢ned asthe setting aside of current resources to produce a stream of read more..
Identifying the costs, bene¢ts, timing and uncertainties of each optionOnce each option has been identi¢ed, it is necessary to quantify the timing and size ofthe streams of costs, as well as the revenues accruing as a consequence of the project.For each year of the project, a schedule should be constructed showing theexpenditure and expected income. The initial costs of the project may be known withcertainty, but the net revenue stream will depend on future economic conditions. Itmay be read more..
ESTIMATING CASH FLOWSFor example, if an electricity supplier has decided to build a new power station to meetan expected growth in demand, then the steps outlined above could be implemented asfollows. Initially, the alternative technologies available should be considered forsimilar sized increments in capacity. The costs of undertaking each alternative planshould then be estimated. Once operational, the variable costs of producing electricityincluding fuel, labour, and management should be read more..
plus »10 of interest). If the money is kept in the account, then at the end of year 2 thesum would have increased to »121 (i.e., the »110 plus another »11 of interestpayments). This kind of accumulation is termed compound interest. It can beexpressed as follows:gAt the start of year 0 a deposit D of »100 is made.gAfter 1 year the terminal value T will be T¼ 100Ãð1 þ 0:1Þ or T¼ Dð1 þ rÞ,where the interest rate r is expressed as a decimal.gAfter2yearstheterminalvaluewouldbe100Ãð1 read more..
Therefore, money has a time value with an exchange rate between money now andmoney in the future. Thus, in our simple example, money now is worth »121 in twoyears’ time or, alternatively, »121 in two years’ time is worth »100 now. If a ¢rm isconsidering borrowing to ¢nance an investment, then it can obtain money now bypaying an interest rate of r% per annum and paying it back out of future earnings. Atthe end of year 1 the borrower would have to pay back the sum borrowed plus read more..
net present value of »41.04m and project B of »112.46m. Thus, project B has a highernet present value than project A and is therefore a more highly rated project.The present value of the two projects will vary with the discount rate used; this isillustrated in Figure 12.1, where the discount rate is plotted on the horizontal axis andthe net present value on the vertical axis. Line PA shows the net present value ofproject A at a range of discount rates from 0 to 36%. At discount rates up to 15% read more..
years of the project’s life and, consequently, become more important the higher the rateof discount used.Internal rate of return (IRR)An alternative discounting procedure is to use the internal rate of return; this is the rateof discount that makes the net present value of the cash £ow of a project equal to zero.Projects with higher internal rates of return are preferred to projects with lowerinternal rates of return. Thus, the internal rate of return for project A is 15% and forproject B it read more..
individual projects; this is illustrated in Table 12.3 when comparing project E withproject F.Using theinternalrateofreturn, project F is preferred to project E;but,using the net present value, project E is preferred to project F.A second problem with the internal rate of return is that certain cash £ow streamsgenerate two values; this may occur where the £ows are initially negative, thenpositive and then negative again. Thus, the preferred method for ranking projects isthe net present value read more..
with a payback period less than the norm will be accepted, while projects with apayback period longer than the norm are rejected.The main criticisms of the payback method are that it ignores all bene¢ts beyondthe payback period and does not discount the cash £ows. If the payback period is veryshort, such as 2 years, discounting may have little e¡ect on the discounted cash valuesand cause very few changes in decisions. The more serious criticism is that it ignoresall returns after the payback read more..
value; this would rank the projects in the order J, G and H.To undertake all theseprojects would require a total expenditure of »400m. With a budget restricted to»200m, all three projects could not be undertaken. The recommended procedure is torank projects in order of net present value divided by capital outlay; this gives aranking of H, G and J. The ¢rm then proceeds down the new rankings until the budgetis exhausted. Thus, in Table 12.4 the ¢rm undertakes projects H and G and thenexhausts read more..
COPING WITH UNCERTAINTYThe impact of uncertainty on an investment project can be dealt with in two ways:adjusting the net bene¢ts or the discount rate.Adjusting net bene¢ts or expected net present valueAlthough we are dealing with uncertainty the decision maker could decide which of thepotential outcomes are most likely or least likely to occur; this calls for decisionmakers to attach not probabilities but estimates of likelihoods to future events; theseare not objective, like probabilities read more..
include price, sales, labour and raw material costs. For example, when oil prices arehigh there is increasing interest in the potential of alternative energy sources. Theprice of oil is a critical variable in assessing the value of energy from biomass. Low oilprices would threaten the viability of a biomass project, while high prices wouldenhance it. The solution is to identify a range of values for key variables and thencalculate the outcomes for all combinations of inputs and outputs. read more..
Simulation of returnsSimulation models attempt to assess the impact of changes in key variables. Combina-tions of price and cost are randomly made to produce net revenue data. Withlikelihoods attached to the possibility of each price or cost occurring, a distribution ofpossible outcomes is generated (Hertz 1964). These data can then be used to generatea range of potential cash £ows with associated likelihoods. Expected values, varianceand standard deviation can then be measured for any project. read more..
CHAPTER 12 g INVESTMENT APPR AISAL255Table 12.7Simulation model of pro¢tability(a) Matrix of price, cost, likelihoods and pro¢t marginsCostPrice102030400.10.40.40.1Pro¢t marginsöööööööööööööööööööööööööööööööö100.10102030150.4À551525200.4À1001020250.1À15À5515(b) Pro¢t outcomes and likelihoodsLikelihoodPriceCostPro¢t per unitSalesTotal read more..
pro¢ts of »1,000 are expected to occur. Overall losses will occur 13 times in 100occasions, and positive pro¢ts will occur 70 times in every 100. The mean is »687.5and the standard deviation is 918.9.Adjusted discount rateA third method posited to account for uncertainty is to adjust the discount rate. Thegreater the uncertainty the higher the discount rate. Higher discount rates discriminateagainst more distant cash £ows and favour earlier cash £ows, as they give greaterweight to early read more..
funds set aside to meet depreciation charges. Such sources have no direct or accountingcost attached to them, but it is important that the opportunity cost of these sourcesshould be estimated. External sources of funds include debt capital or bonds, equity orshare capital and bank or other loans, such as from government agencies. Externalsources generally have an interest rate attached to their use, though this is not strictlytrue of equity capital where the payment of dividends depends on the read more..
Cost of equity (RE)If the ¢rm raises funds through the issue of new equity capital, then the purchaser ofthe equity will expect to receive dividends equivalent to the risk-free rate of interestplus a risk premium. The current price of equity will re£ect the discounted value offuture dividends.The risk-free rate of interest plus a risk premium is justi¢ed as follows. A lenderrequires a rate of return to compensate for the loss of consumption foregone byinvesting in equity (RF). Since equities read more..
If we assume an investor holds a portfolio of ¢nancial assets, then one consisting ofone equity holding is riskier than one consisting of two equity holdings, as thevolatility of returns to one share may be o¡set by the returns to another. An individualcould lower company-speci¢c risks by purchasing a diversi¢ed portfolio of shares, eventhough the overall equity market risk still exists.The risk of holding equity can be broken into two elements of risk: company andmarket- related. read more..
¢nance represented by debt, RD¼ the cost of debt, WE¼ the proportion of ¢nancerepresented by equity and RE¼ the cost of equity.Thus, if the ratio between internal funding, debt and equity is 20: 20: 60 and thecomparative cost of each source of capital is 8, 10 and 15%, then the weightedaverage cost of capital would be:ð0:08 Ã 0:2Þþð0:10 Ã 0:20Þþð0:15 Ã 0:6Þ¼ 0:126or12:6%The optimal choice of capital structure to fund an investment depends on marketconditions and the degree of read more..
expected cost and revenue flows over the life of the project. Concorde was not a purelycommercial proposition and had the support, financially and politically, of the British andFrench governments. In addition the major players were state-owned enterprises.CostsThe development of a new aeroplane involves incurring research and development costs aswell as production costs. Henderson (1977) estimated the expenditure on developmentbetween 1962 and 1976 to be £496m and production/launch costs read more..
Therefore, as a commercial project Concorde looked to be high-risk. It went ahead onlybecause of the support of the French and British governments who envisaged widerbenefits to their economies from the project (see Chapter 25 for a discussion of cost–benefit analysis and Woolley 1972).Concorde in practiceThe negative expectations when the decision to go ahead was taken were confirmed bylater events. Although the aircraft was widely admired for its looks and gracefulness andwas a success in read more..
given situation. In practice, it is important to use the correct method, to make thebest estimates of future net cash £ows and to be aware of the uncertaintiesattached to them.REVIEW QUESTIONS1 Explain the notion of the ‘‘time value’’ of money. Why does it lead to thediscounting of future cash £ows?2 Explain the concepts of net present value and the internal rate of return of a seriesof net cash £ows. Demonstrate their calculation. Which technique should be thepreferred methodology read more..
REFERENCES AND FURTHER READINGAllen, D. (1991) Economic Evaluation of Projects (3rd edn). Institution of Chemical Engineers,London.Brewster, D. (1997) Investment and ¢nancing decisions. Business Economics (Chapter 12). DrydenPress, London.Bromwich,M.(1976) The Economics of Capital Budgeting. Penguin, Harmondsworth, UK.Dimson, E. (1995) The capital asset pricing model. Financial Times, Mastering Management Part4, 7^8.Douglas, E.J. (1992) Capital budgeting and investment decisions. Managerial read more..
PARTVSTRATEGICDECISIONS: THEGROWTH ANDDEVELOPMENT OFTHE FIRM13The entrepreneur and the development ofthe ¢rm26714The boundaries of the ¢rm28515The growth of the ¢rm30316Changing the boundaries of the ¢rm:vertical integration32317Changing the boundaries of the ¢rm:diversi¢cation34118Changing the boundaries of the ¢rm:divestment and exit36119Changing the boundaries of the ¢rm:mergers37920Organizational issues and structures39921The growth and development of the ¢rm:Stagecoach Buses423 read more..
THE ENTREPRENEUR ANDTHE DEVELOPMENTOF THE FIRMCHAPTER OUTLINEChapter objectivesIntroductionEntrepreneurshipEconomic developmentsA behavioural explanation of entrepreneurshipEntrepreneurship and the development of the ¢rmThebirthof the¢rmCharacteristics of new-¢rm foundersThe formation of new ¢rms in the UKCase Study 13.1Sir Richard Branson and the Virgin GroupChapter summaryReview questionsReferences and further readingCHAPTER OBJECTIVESThis chapter aims to explore the nature and role of read more..
INTRODUCTIONAlthough the ¢rm is the central focus of this book, little has been said of how ¢rms arecreated, why they exist and what factors determine their boundaries. In the neoclassi-cal economic theories of the ¢rm, examined in earlier chapters, the ¢rm is essentiallyconceived as a production system and the role of owner-controllers is to makedecisions that maximize the owner’s pro¢ts. In these models the decision maker of the¢rmispresumedalsotobeanentrepreneurinthe read more..
The study of entrepreneurship in the economy has been mainly the preserve ofeconomists operating outside the main neoclassical school; this is explained partly bythe fact that these traditional models assume certainty of information and rationaldecision making. In such static models, decision makers respond to freely availableprice signals and are sometimes described as being entrepreneurless because of theabsence of uncertainty. Economists have identi¢ed and emphasized various aspects ofthe read more..
entrepreneur to have a vision of the new market, including the number of potentialcustomers and their willingness to buy at di¡erent prices. Entrepreneurs makedecisions on the basis of their assumed conditions prevailing. If they do, then thedecision is seen to be successful and pro¢table; if not then it is seen to be unsuccessfuland possibly loss-making.Casson (1982) introduced the concept of entrepreneurial judgement, ‘‘An entre-preneur is de¢ned as someone who specialises in taking read more..
A BEHAVIOURAL EXPLANATION OF ENTREPRENEURSHIPIf we examine entrepreneurship in a sequential way, then the processes of decisionmaking will consist of a series of successive activities with an individual having todecide at the end of each stage whether or not to continue to the next; this isdependent, as discussed in Chapter 2, on whether the goals set have been satisfactorilyachieved. If they have been met, then the decision maker will proceed to the nextstage; if not, then the activity may read more..
potentially successful project. The outcome of the search process is either theproduction of an idea or a plan for future evaluation of the idea. If the objective is notmet, then the potential entrepreneur either gives up or goes back to box 1 and startsthe process again.If the objective is met, then the individual proceeds to box 2, when the idea isdeveloped to the point where it can be put into practice. If the objective is met, thenthe individual can proceed to box 3. If the objective is not read more..
and suppliers of other resources. If their support is to the entrepreneur’s satisfaction,then a move can be made to stage II. If the entrepreneur fails to establish the viabilityof the project and to ¢nd the necessary funding, then the process ends or starts again.Stage IIThe entrepreneur creates a new organization to bring the innovation to fruition; thisrequires the co-ordination of the various factors required for manufacturing a productor providing a service, such as ¢nance, specialist read more..
individual. Entrepreneurship may be subdivided into specialist activities. One individualmay have ideas, while another may be better at evaluating them and yet another maybring them to fruition. It might also be easier for those not involved with the originalideas to abandon them. While usually considered an individual activity, entrepreneur-ship can therefore also be considered a team activity.Entrepreneurship can also take place within existing ¢rms. At this point theclassical entrepreneur read more..
are more likely to establish their own businesses if they have worked previously insmaller entrepreneurial ¢rms and gained experience of a wider range of business roles.The opposite is true in larger organizations where individuals are con¢ned to specialistfunctions. Such experience, together with the examples set by the owner managers ofsuch enterprises, gives individuals the vision to want to be entrepreneurs. Such peopledisplay lower relative risk aversion against entrepreneurship than read more..
forminganew ¢rm. In thistheymaybehelpedbyhavingaredundancypaymenttopartially or wholly ¢nance their venture. In the UK many new trading enterprisesstart up as a single-person organization and may operate initially as labour-onlycontractors in industries, such as construction. Many of these ‘‘enterprises’’ nevermove beyond this stage, but some may develop into conventional ¢rms employingcapital and other employees.Another push factor is brought about by individual enterprises read more..
overcome this aspect of market failure by o¡ering ¢nancial support to encourage new-¢rm formation.The ¢nding of suitable and a¡ordable premises is often a stumbling block; if the ¢rmcannot be started in the garden shed or garage, then commercial premises arerequired. Another problem for small ¢rms is the lack of managerial and/or technicalskills of thefounders. Whiletheyhavethedrivetocreatethe¢rm, theymaynotactually have the skills to run the ¢rm and prevent it from an early death. Help read more..
gNecessity (35%).gAmbition (48%).gIdenti¢cation of a market gap (46%).gChance (10%).gFamily event (6%).gGovernment enterprise allowance (2%).THE FORMATION OF NEW FIRMS IN THE UKStatistics on new-¢rm formation in the UK come from registrations for the payment ofvalue-added tax (VAT), which is compulsory if turnover exceeds a minimum threshold(»51,000 in 1999). These data do not include ¢rms below the threshold. Figure 13.2shows the total numbers of ¢rms registering and deregistering for VAT read more..
regions. Generally, the further north and west a region is from London the lower are therates of new-¢rm formation. Standardizing this for the population, in 2000 the rate ofnew-¢rm formation per 10,000 adults was: London 65, the east of England 43,Scotland 28 and the north-east of England 21 (Small Business Service 2001).If these ratios are taken as being indicative of a region having a dynamic economyand a culture conducive to entrepreneurship, then generally the older heavy industrialareas read more..
date of company incorporation and its death by withdrawal from the registration. Thedata show the death rate of companies in 1996 and the year in which they were incor-porated. Thus, ¢rms registered in 1994 which were 2 years old had a death rate of26.8%, while ¢rms registered in 1980 had a death rate of 8.6%. The death rate tendsto decline as the ¢rm gets older, and the third year is the most dangerous in a new¢rm’s existence.Holmes et al. (2000) estimated ¢rm hazard functions using data read more..
gIntroduce new methods of production.gCreate new markets and extend others by bringing in new consumers.gWilling to bear risk and uncertainty.gAn agent for change.CHAPTER SUMMARYThis chapter examined the concept of entrepreneurship. In doing this we analysed:gThe main characteristics of entrepreneurial activity; these include a willingness totake decisions in conditions of uncertainty and to start new ventures based onimagined future outcomes.gA behavioural model of entrepreneurship showing both read more..
2Distinguish between management and the entrepreneurial functions within a ¢rm.3Which of the following activities might be described as entrepreneurial and giveyour reasons?:^ Introducing a new product that meets previously unful¢lled demand (e.g., the¢rst electronic calculator).^ Introducing a product similar to those already existing but with superiorperformance.^ Introducing a product similar to those already existing but with no advantages.^ Inventingaproduct.^ Reallocating resources in read more..
Hart,P.E.and N.Oulton (1998) Job Creation and Destruction in the Corporate Sector: The RelativeImportance of Births, Deaths and Survivors (NIESR Discussion Paper No. 134). NationalInstitute of Economic and Social Research, London.Holmes, P., I. Stone and P. Braidford (2000) New Firm Survival: An Analysis of UK Firms Using aHazard Function (Working paper). University of Durham, UK.Hyrsky, K. (2000) Entrepreneurial metaphors and concepts: An exploratory study. InternationalSmall Business read more..
14 THE BOUNDARIES OFTHE FIRMCHAPTER OUTLINEChapter objectivesIntroductionTransaction costsInformation, imperfect markets and transaction costsWilliamson’s analysisKnowledge-based theory of the ¢rmThe ¢rm as a teamThe ¢rm as a nexus of contractsCase Study 14.1The changing distribution of ¢zzy drinks: a transactioncosts explanationChapter summaryReview questionsReferences and further readingCHAPTER OBJECTIVESThis chapter aims to explore the reasons why ¢rms exist. At the end of thechapter read more..
INTRODUCTIONThe purpose of this chapter is to explain the existence of ¢rms and the boundaries theythemselves put on their activities. Initial observations show that ¢rms vary in terms ofsize, the number of products produced, the range of markets served, their ownershipand organizational structures and management cultures. Whatever their current size,status and structure, at some point in the past all ¢rms were created as a result of adecision by one or more individuals, with either a short read more..
An entrepreneur wishing to organize the production of a product has a choicebetween co-ordinating its procurement in the market by contracting others toundertake the necessary tasks or to undertake some or all of these within a ¢rmcreatedtoproducethe¢nalproduct.Inmakingthisdecisionforanygiven activity,theentrepreneur will compare the marginal costs of making market transactions withthose of doing it within the ¢rm. Thus, one activity may be undertaken in the marketand others within the ¢rm, read more..
For example, workers agree to sell their labour in exchange for a payment, whileconsumers agree a payment in return for receiving a desirable commodity or service.For the producer, transaction costs include discovering the range of potentialsuppliers, the speci¢cations of the products and their prices, negotiating contractterms, monitoring performance and enforcing the terms of the agreement. The costsarising from organizing the same transaction within the ¢rm might be termed read more..
may wish to act rationally but their ability to do so is limited because they have alimited ability to absorb and handle information.In imperfect markets a decision maker may not be fully informed or may only haveavailable part of the information required to make a decision. Unfortunately, thedecision maker will not know the quality of the information he does have nor theimportance of the information he does not have. In addition, some information may bedi⁄cult to acquire and be known to only read more..
are willing to pay »700 for a low-quality motor vehicle and »1,500 for a high-qualitycar. Buyers will have to estimate how much they are willing to o¡er for a second-handcar, without knowing which car is the good one and which is the bad one. If weassume that the probability of obtaining a high or low-quality car is equal, then theexpected value of any car to a buyer is given by the weighted average of the twovalues multiplied by the probability ratio. Thus, the expected value is equal read more..
transactions: in short, self-interested behaviour to deny the other party of the agreedbene¢ts. Individuals may behave deceitfully and misrepresent the quality of a product.A ¢rm may have contracted for the supply of ¢rst-grade coal, but actually be suppliedwith a lower grade; this might be di⁄cult for the purchaser to observe. Such di⁄cultiesare less likely when input is purchased frequently, but is more likely when there isonly one supplier, when swapping suppliers is more di⁄cult and read more..
Economies of scope arise from producing two or more goods using common inputs.Thus, if a ¢rm requires a single input that bene¢ts from joint production, then againthe ¢rm would ¢nd the market the more e⁄cient outcome. For example, supermarketsthat sell own brand products ¢nd the preferred method of sourcing these goods is byusing an outside supplier who bene¢ts from both economies of scale and scope, ratherthan making the goods themselves.BNumber of ¢rmsEconomists de¢ne market read more..
where within the enterprise these will operate and the costs of incentives to ensure theallotted tasks are carried out. Management costs are a function of the e¡ectiveness ofan organization in getting members of the ¢rm to work together e⁄ciently with theavailable capital. Thus, management costs will be greater:gThe higher the costs of incentives required to generate acceptable performance fromsta¡.gThe higher the costs of sanctions required to discipline inappropriate sta¡behaviour.gThe read more..
other product. The most extreme type of asset speci¢city is where the only alternativeuseisasscrap.Asset speci¢city is a key concept in organizational economics and can be appliedto any form of asset, human or non-human, dedicated to ful¢lling a particulartransaction. Human asset speci¢city arises where individuals develop skills for aspeci¢c process or service. These skills are acquired by specialist training and on-the-job experience and are not easily transferable. Other forms of read more..
of organizing that transaction in a market or in another ¢rm. However, the role ofindividual factors will lead di¡erent ¢rms to adopt di¡erent attitudes to particularissues. In the UK bus industry, most companies own and operate their own vehicles.However, National Express, which operates a national network of long-distance coachservices, hires all their vehicles from local suppliers. The di¡erence in approach cannotbe explained by the asset speci¢city of buses and coaches; it may have read more..
the ownership of knowledge. If it is created within a ¢rm does it belong to the ¢rmor the individual or is there some type of joint ownership? This becomes aparticular issue if an individual moves to another ¢rm and takes signi¢cant tacitknowledge with them; this may give the ¢rm that has acquired the individualaccess to information it did not previously have. The ¢rm that sees the knowledgetransferred will ¢nd it di⁄cult to receive compensation.gSpecialization in knowledge acquisition: read more..
the market. Instead, they develop their own theory to explain the existence of ¢rmsbased on team production and monitoring.Team production is de¢ned as a way of organizing production requiring the simul-taneous e¡orts of more than one individual. Identifying and measuring the e¡ort of anindividual working in a team, as opposed to the team as a whole, is di⁄cult. Thus, anindividual has an incentive to cheat, shirk or not to pull his weight. If the reducede¡ort of one member is not replaced read more..
within a ¢rm and those between ¢rms. Rather both categories of transactions are part ofa continuum of types of contractual relations with di¡erent types of organisationsrepresenting di¡erent points on this continuum’’ (Hart 1990 p. 10).Contracts are the cornerstone of the ‘‘new’’ theories of the ¢rm. In a world of perfectinformation and unbounded rationality, comprehensive contracts can be written tocover every eventuality since the future can be foreseen at the time of the read more..
Case Study 14.1The changing distribution ofCoca-Cola and Pepsi: a transaction cost explanationMuris et al. (1992) applied the transaction cost framework to the changing pattern ofproduction and distribution adopted by the major cola producers in the USA. Thedominant cola firms, Coca-Cola and Pepsi-Cola, moved the distribution of their drinksfrom a network of independent bottlers to captive bottling subsidiaries because ofchanges in the economic environment which had led to increasing transaction read more..
Muris et al. also carried out empirical studies to show that the change in strategy wasdriven by the need to reduce transaction costs. They compared the centralized distributionsystem of Coca-Cola and the local system of Pepsi-Cola to on-tap, or draught, users in thecatering trade, where the product is distributed in glasses rather than bottles or cans. Theresults showed that the captive system had lower costs and thus supported the moregeneral move to ownership of bottling and distribution read more..
3Explain the concepts of bounded rationality and asymmetric information and theirrole in determining the boundary between the market and the ¢rm.4What is the importance of asset speci¢city in encouraging the avoidance of themarket?5Explain the concepts of adverse selection and moral hazard.6Many ¢rms contract out services and o¡er their suppliers long-term contracts.What factors would encourage the ¢rm to acquire its supplier?7In the analysis of incomplete contracts what advantages does read more..
15 THE GROWTH OF THE FIRMCHAPTER OUTLINEChapter objectivesIntroductionMotives for growthAsimplegrowthmodelBaumol’s dynamic sales growth modelMarris’smodelofmanagerialenterpriseDiversi¢cation and the growth of the ¢rmEndogenous growth theory of the ¢rmLimits to growthLimits to growth: empirical evidenceResources and competencesCase Study 15.1Stagecoach: core competencesThe development of the ¢rmChapter summaryReview questionsReferences and further readingCHAPTER OBJECTIVESThis read more..
INTRODUCTIONIn Chapter 2 the objectives of the ¢rm were analysed in terms of a single-period, orstatic, model. The main motives analysed were pro¢t, sales and managerial utility max-imization. The missing element in these models is the consideration of time; and how¢rms will behave when the future of the ¢rm is considered. In the future the ¢rm cangrow or decline or stay the same, and become larger or smaller or static in terms ofoutput, sales or assets. In this chapter we will examine:gThe read more..
t time periods, the revenues earned in years 0 to t can be considered. To convert therevenue stream to present values the annual revenue sums are discounted at the costof capital of the ¢rm. The discounted present value of revenue (PVR) would then be:R¼½Rð1 þ gÞ=ð1 þ iÞ þ ½Rð1 þ gÞ2=ð1 þ gÞ2 þ ÁÁÁ þ ½Rð1 þ gÞt=ð1 þ gÞtorPVR¼Xnt¼0Rð1 þ gÞt=ð1 þ iÞtThe net present value of the stream of costs (PVC) is calculated in a similar fashion,giving:PVC¼Xnt¼0Cð1 read more..
trade-o¡ between growth and revenue and the ¢rm will choose to be on the highestfeasible iso-present value curve; this is at point E,with GE and RE being the level ofgrowth and sales revenue that maximizes the present value of future sales revenue.MARRIS’S MODEL OF MANAGERIAL ENTERPRISEMarris (1964) developed a managerial theory of the growth of the ¢rm. It assumes thatthe owners and managers have di¡erent objectives: owners maximizing pro¢t andmanagers growth. Purchasing a share, or read more..
pursue growth opportunities. Thus, there is a trade-o¡ between the retention or distri-bution of dividends and the growth rate that the ¢rm can achieve; this is illustrated inFigure 15.2(a). On the vertical axis is measured the proportion of pro¢t paid asdividends and on the horizontal axis the growth rate. Thus, if OA% of pro¢ts are paidas dividends, then proportion AT is retained by the ¢rm to ¢nance growth. Thus, witha distribution ratio of OA the achievable growth rate is GA. If the read more..
while if the proportion of pro¢ts paid out as dividends is less than OA, the achievablegrowth rate is greater.The managerial pursuit of growth is restricted by the need to pay dividends toshareholders, limiting the proportion of pro¢ts that can be retained to ¢nance growth.If shareholders view the proportion of dividends retained adversely, they may seek tochange the company’s policy or sell their shares. Thus, managers can only pursuegrowth, as long as they keep shareholders happy, if they read more..
position, because its market value is less than the value of the assets it is using. If thevaluation ratio is greater than 1, then the market value is greater than the book valueof the assets used. If the ¢rm’s valuation ratio is greater than a value thought by themarket to be appropriate for that sector, then the ¢rm is in a strong ¢nancial positionand its management is considered to be doing a good job. If the ¢rm’s valuation ratiofalls below the expected value for the sector, then the read more..
The preferences of managers are represented in Figure 15.3(b) in the form of a set ofindi¡erence curves (M1, M2, etc.) which show preferences between the growth rateand the valuation ratio. Utility will be maximized at point EM, the point of tangencybetween the managerial indi¡erence curve M2 and the valuation curve. Managers arepresumed to favour a higher growth rate than owners, so that the preferred growth310 PA RT V g STRATEGIC DECISIONSOGFGrowth rateProfit rateValuation ratio(a) Owner's read more..
rates GM and GO do not coincide. However, they will do so if the only secure position forthe managers is at the maximum point on the valuation curve.DIVERSIFICATION AND THE GROWTH OF THE FIRMThe rate of growth of demand for existing products is a constraint on the growth of the¢rm. This constraint can be overcome if the ¢rm diversi¢es into new products that arebeing sold in faster growing markets. Marris analysed the optimal or balanced growthposition for a ¢rm in terms of diversi¢cation, read more..
rate of growth of consumer demand. Thus, with a given rate of diversi¢cation and agiven price of the product, the pro¢t margin will be lower if the expenditure requiredto sell the new products is larger.Figure 15.5 shows the growth of supply curves S that plot the relationshipbetween the rate of diversi¢cation and the rate of growth of supply. The growth in thesupply of resources in diversi¢cation projects is a function of the ratio of dividendsretained or distributed. The higher the rate of read more..
within the ¢rm, it is known as an endogenous growth theory. Firms consist ofresources, and it is the growth and changing abilities of these that enables a ¢rm tocontinually increase its productive capacity.Tangible and intangible resourcesThe resources of the ¢rm are both tangible and intangible. Tangible resources includephysical assets, such as plant, equipment and physical labour, while intangibleresources include skills and knowledge about productive and managerial processes.These read more..
capital and cannot be so easily purchased because they are acquired from training andexperience within the ¢rm and may only be valuable within its speci¢c structuresdespite residing within individuals who can be hired or ¢red. Such considerations mayapply to management resources, in particular. Managers plan and co-ordinate theoperation of the ¢rm using ¢rm-speci¢c structures and routines. Individual members ofa management team are skilled in the ways of the ¢rm as well as their read more..
bManagerial specialization and experience meansanincreaseintheir capacity andthe emergence of unused resources that can be devoted to expansion.Thus, underutilized managerial resources become available to the entrepreneurialfunction, which can use them in existing or new ventures to expand the ¢rm.LIMITS TO GROWTHThe Penrose e¡ect or managerial constraintPenrose (1959) and Richardson (1964) identify management as the main constraint onthe growth of the ¢rm. This constraint has been termed the read more..
On the horizontal axis is measured the growth rate of the ¢rm and on the vertical axisthe growth rate of the managerial team. Curve GM shows a positive relationshipbetween the growth of the managerial team and the growth of the ¢rm. The startingpoint of the curve on the horizontal axis is at G because OG istherateofgrowtha¢rmcan achieve with a stationary managerial team. The slope of the curve also re£ects thediminishing returns to a higher growth of management, re£ecting that expansion read more..
operating companies in the UK were forced to cancel services in 2001 and limit growthbecause of a shortage of train drivers. Becoming a train driver requires training andthe learning of routes and safety procedures, all of which takes time and assumes thatsu⁄cient people are willing to train at the going wage rate. If such problems can arisein traditional skill areas such as train driving, it is safe to assume they will arise in thenew skill areas of computation and information technology. read more..
Available opportunitiesEconomic models tend to assume that the management of an enterprise will have a hostof projects to choose from in developing the ¢rm. In practice, management may beunable to identify suitable opportunities that may be pro¢table for an enterprise, givenits resources and competences; this may be reinforced by a cautious management whoonly see future di⁄culties rather than future opportunities.LIMITS TO GROWTH: EMPIRICAL EVIDENCERichardson (1964) along with Leyland (1964) read more..
involves the creation of a new organizational architecture. Firms undertake change inthe expectation that it will be more e⁄cient in the long run (i.e., expected bene¢tsexceed the costs) and that growth will lead to lower costs and improved businessperformance.RESOURCES AND COMPETENCESAccording to Kay (1993a) the main elements of the resource or competence-basedtheory of the ¢rm are that:gFirms are essentially collections of capabilities.gThe e¡ectiveness of a ¢rm depends on the match read more..
importantly, to ensure the rents are long-lived (i.e., the competitive advantage is long-lasting).The success of ¢rms is generally based on the identi¢cation and exploitation ofdistinctive capabilities ^ factors that one company enjoys and other companies areunable to emulate, even after having recognized them. The ownership of distinctivecapabilities is attributed to the ability of the ¢rm to innovate to create new processes,products and managerial methods (Grant 1995).Case Study read more..
Internal growth is where the company uses its existing capabilities, resources and¢nances to expand the business. The growth is entirely endogenous, but may besupported by external ¢nance. The alternative external route is to grow by acquisitionof existing companies. These issues will be discussed in the Chapters 16^19.CHAPTER SUMMARYIn this chapter we reviewed various theories of growth including those of Baumol,Marris and Penrose. They all suggest that the key objective of ¢rms is growth. read more..
REFERENCES AND FURTHER READINGBaumol, W.J. (1958) Business Behaviour, Value and Growth. Macmillan, New York.Baumol, W.J. (1962) On the theory of expansion of the ¢rm. American Economic Review,52,1078^1087.Devine, P.J., R.M. Jones, N. Lee and W.J. Tyson (1974) Corporate growth. An Introduction toIndustrial Economics (Chapter 4). Allen & Unwin, London.Foss, N.J. and C. Knudsen (1996) Towards a Competence Theory of the Firm (Chapters 1 and 2).Routledge, London.Grant, R.M. (1995) Contemporary read more..
16 CHANGING THEBOUNDARIES OF THE FIRM:VERTICAL INTEGRATIONCHAPTER OUTLINEChapter objectivesIntroductionConcept of vertical integrationCase Study 16.1Production linkages in the oil industryMotivation to vertically integrateTraditional explanationsUncertainty and security of supplyAlternative explanations of vertical integrationCase Study 16.2Kuwait National Oil CompanyCase Study 16.3Fisher Body and General MotorsVertical integration and pro¢tabilityChapter summaryReview questionsReferences and read more..
INTRODUCTIONVertical integration involves joining together under common ownership a series ofseparate but linked production processes. Such a strategy is used by many enterprisesto widen the boundaries of the ¢rm and to enlarge its size. In this chapter we willexamine:gThe concept and dimensions of vertical integration.gThe motivation for pursuing vertical integration.gTraditional economic explanations of the advantages of vertical integration.gTransaction cost explanations.CONCEPT OF VERTICAL read more..
Case Study 16.1Production linkages in the oil industryThe stages of the production process through which a firm may integrate depend verymuch on the technological and production functions of the industry concerned.Figure 16.1 presents a simplified vertical chain for the oil industry, from oil production/extraction to the point where the product is sold to another user. For the retailing ofpetrol, the supply of heavy fuel oil for the generation of electricity and feedstocks for thechemical read more..
products to meet all their needs. Thus, not all firms will necessarily be fully integrated: forexample, a firm may only own crude oil and refineries and purchase transport, such aspipelines or tankers, to move its crude oil. Other firms may only own a refinery and apetrochemical plant thereby making a lateral move into another vertical chain. (Forexamples in the petrochemical industry see Burgess 1984). Firms may be fully involvedat various stages and only partially involved at other stages. read more..
TRADITIONAL EXPLANATIONSTechnical e⁄ciency and production cost savingsIn Chapter 7 the traditional concept of the production function was explored for a singleproduct using two inputs in a single time period. The objective of the ¢rm was toachieve minimum costs. A real ¢rm would want to use or move toward least costproduction methods. In the discussion of vertical integration the notion of theproduction function is more complex than the simple format presented earlier. Notonly does it read more..
will have to renegotiate or enforce contractual terms. By avoiding the market, theintegrated ¢rm can avoid market transaction costs but does incur additional costs formanaging a larger ¢rm. Thus, the costs of the combined management functionsrequired for the single enterprise are expected to be lower than for two independententerprises linked by market transactions. On the other hand, the increasedcomplexity of the ¢rm may increase management costs compared with separatelyowned operations. read more..
Market powerA traditional argument for vertical integration is to increase monopoly power. Marketpower enables the ¢rm to raise prices above competitive levels in product markets. Insome sense the vertical integration of two stages of production does nothing to alterthe number of ¢rms operating at each stage and, therefore, appears to have littleimpact on the degree of monopoly at each stage. However, it may change relationshipsbetween ¢rms, in that a previously independent supplier may now read more..
stages are competitive, then it will not be in the interest of either buyer or seller tointegrate into the other stage because the buyer will not be able to achieve a lowerprice for the input with its own production facilities. Likewise, a seller could notachieve a higher price for the ¢nal product if there is e¡ective competition. Therefore,there would be no incentive to alter the structure and to integrate the stages. Threatsto withhold supplies would also not be relevant.Market structure 2: read more..
combinations. The shape of the isoquant shows that inputs can be substituted inresponse to changes in relative prices of the inputs. The budget line that faces thebuyer if both sectors are competitive is C1C2 and ML if sector A is a monopoly. Thus, ifthe buyer faces price line ML, then the monopoly price restricts the use of input A andthe cost-minimizing equilibrium position is at point E compared with point F ifcompetition prevailed in both sectors. Since the price lines are also cost ratios, read more..
gMarket structure 2: where the seller is a monopolist and there are competitivebuyers. The price of the stage II product is »70, which is the price of the input plusthe marginal cost of stage II production, giving a monopoly pro¢t in stage I andnormal pro¢t in stage II.gMarket structure 3: where the seller is competitive and the buyer is a monopolist.The price of the stage II product is »80; this is the sum of the marginal cost instage I plus the monopoly price in stage II; a normal pro¢t read more..
gSavings in transaction costs by not using the market, whereas buying through themarket involves: incurring costs in searching for suppliers, discovering prices;writing, agreeing and monitoring contracts. Contracting costs are avoided.gIncreasingmanagementcostsbecauseinternalizedactivitieswillrequiresupervision and co-ordination.Thus, the increase in management cost has to be less than the savings in transactioncosts to justify vertical integration.Integration also avoids problems associated read more..
greater asset speci¢city the scale and scope-based advantages of outside suppliers arelikely to be weaker.The curveDG re£ects di¡erences in agency e⁄ciency. It measures di¡erences intransaction costs when the item is produced internally (Gi) and when it is purchasedfrom an outside supplier (Gm) in an arm’s length transaction. When the item ispurchased from an outside supplier, these costs comprise the direct costs of negotiatingthe transaction, the costs of writing and enforcing read more..
costs of using the market are more than o¡set by the production costs savings. The¢rm will be located to the right of point K*.Thus:gMarket exchange is preferred when asset speci¢city is low (i.e., K is less than K*).gVertical integration is preferred when asset speci¢city is high (i.e., K is greater thanK*).Vertical integration becomes increasingly attractive as economies of scale become morepronounced. The position of theDC curve re£ects the ability of the independentproducer to achieve read more..
signi¢cant e¡ects on the vertical structure of production. This is especially remarkablewhen compared to the dearth of evidence on market power explanations forintegration’’ (p. 344). Grossman and Hart (1986) focused their analysis on theimportance of asset ownership and control.Case Study 16.2Kuwait National Oil CompanyThe traditional importance of vertical integration in the oil industry is illustrated by thestrategies pursued by the state oil companies of the major oil producing read more..
Case Study 16.3Fisher Body and General MotorsA case study that has been much studied by American economists was the relationshipbetween Fisher Body and General Motors (GM) in the 1920s (Klein 1991). General Motorsassembled motor cars and Fisher Body was geared up to manufacture pressed metalbodies to replace the traditional wood and metal bodies. In 1919, Fisher signed a long-term (10-year) exclusive contract with GM for the supply of car bodies. Fisher made thenecessary investment in capital read more..
the corporate parent’s in£uence on the acquired business. For this to be a positivein£uence:1The acquired business must have the potential to improve its performance indepen-dently of its relationships with other divisions or business units within thecompany.2The parent company must have the skills or resources necessary to help thebusiness. In practice, they may not have the skills, and the methods chosen tointegrate the company may cause more problems than they solve.3The parent company read more..
REVIEW QUESTIONSExerciseTry to identify from your reading of current events an instance of a ¢rm seeking tovertically integrate either by acquisition or by organic expansion. In addition, try toidentify the motives and advantages claimed for such a development.Discussion questions1 What do you understand by the term ‘‘vertical integration’’?2 Explain and evaluate the saving of production costs argument for verticalintegration.3 How does vertical integration reduce costs?4 Explain and read more..
Klein, B. (1991) Vertical integration as organisational ownership: The Fisher Body^GeneralMotors relationship revisited. In: O.E. Williamson and S.G. Winter (eds), The Nature of theFirm: Origins, Evolution and Development. Oxford University Press, New York.Krickx, G. (1995) Vertical integration in the computer mainframe industry: A transaction costinterpretation. Journal of Economic Behaviour and Organisation,26, 75^91.MMC (1988) The Government of Kuwait and the British Petroleum Company plc read more..
17 CHANGING THEBOUNDARIES OF THE FIRM:DIVERSIFICATIONCHAPTER OUTLINEChapter objectivesIntroductionDirections of diversi¢cationRelated and unrelated diversi¢cationThe ¢rm’s portfolio of activitiesEconomic arguments for diversi¢cationBene¢tsandcostsofdiversi¢cationThe performance of diversi¢ed ¢rmsCase Study 17.1Virgin Group ^ diversi¢cation and brandingCase Study 17.2US oil industry: related and unrelated diversi¢cationCase Study 17.3Hanson Trust: its rise and dismembermentChapter read more..
INTRODUCTIONThe typical unit of analysis in microeconomic theory is a single-product, single-plant¢rm serving a single market. In practice, however, many ¢rms produce a range ofproducts and serve a number of markets. Such companies are described as diversi¢edor as conglomerates. Diversi¢cation occurs when a single-product ¢rm changes itselfinto a multi-product ¢rm. Most diversi¢cation ¢rms get involved in products that arerelated to their initial activity; this gives a diversi¢ed ¢rm a read more..
To overcome this constraint the ¢rm can diversify. Diversi¢cation can take anumber of directions. One form of diversi¢cation is moving from box 1 to box 4: thatis, supplying new products or services to new product markets or to new geographicalmarkets (box 8). However, existing products can be sold in new product markets (box2) or new geographical markets (box 6). A good example of selling an existing productin a new market is the ¢zzy soft drink Ir’n Brew; this was marketed in Glasgow at read more..
making bricks and processing frozen chickens has neither markets nor productiontechniques that overlap, except in the very broadest sense. Companies engaged inunrelated diversi¢cation are further subdivided into:gManagerial enterprises in which a managerial team provides general services to allthe operating divisions within the company and decides which activities orproducts to add to or delete from the ¢rm’s portfolio.gFinancial or holding companies where the relationship between the core read more..
resources in box 9 products and withdraw from box 1. Boxes 3 and 6 represent high-growth sectors where the ¢rm is not strongly competitive. Decisions should be made asto whether a strongly competitive position can be attained and, if not, whetherresources should be moved to alternative uses. In low-growth sectors represented byboxes 1, 4 and 7, the ¢rm should consider its position in boxes 1 and 4, but stay in thelow-growth market (box 7) where the ¢rm is strongly competitive. In general, read more..
is the spur to considering a diversi¢cation strategy. Thus, the adoption of a diversi¢ca-tion strategy may be driven by a number of push factors arising from the currentposition of the ¢rm. Push factors may include: the limited size of the existing market;the existence of underutilized assets that might be used to produce new products ormanage new activities; and surplus investment resources that could be used to ¢nancenew activities.There may also be a number of pull factors, or incentives, read more..
gThe distribution and logistics system by distributing related goods to the sameoutlets.gThe marketing department to advertise and promote the new product using itsaccumulated knowledge and expertise of particular markets and customers.gThe brand name to sell new products using the goodwill built up for its existingbranded products.gRetained earnings that are not required to develop current activities can be used forinvestment in new activities rather than keeping them in the non-interest read more..
more cheaply together than separately. These bene¢ts are not available to single-product ¢rms.The increase in size of the ¢rm that comes with diversi¢cation may also produceeconomies of size. For example, an increase in size, might mean that larger ¢rms maybe able to use its buying power to obtain lower cost inputs. The extent to which this ispossible may depend on the degree of relatedness between the various activities of the¢rm. Economies arising from buying power may only be achieved read more..
whose cycles lag behind other products and reach their peak at di¡erent times.Together, the di¡erence between highs and lows in overall sales can be reduced.Likewise, shifts toward new geographical markets may o¡set £uctuations in sales. Ifthe economic cycle in one economy is out of step, then variations in sales will likewisebe reduced. For example, it is argued that the economic cycle in the UK follows adi¡erent time path from that of continental European economies. Having a read more..
Shareholders and stock markets appear to have little con¢dence in the ability ofdiversi¢ed ¢rms to use available resources e¡ectively. A noted feature of diversi¢ed¢rms is that they trade at a lower price, given their earnings, than focused ¢rms. Thisdi¡erence, which has been noted in the UK and the USA, is known as the ‘‘diversi¢ca-tion discount’’.Managerial risks and rewardsThe senior managers of a company, unlike their shareholders, cannot diversify theiremployment risks. If read more..
compared with the alternative of using the market. Only if the gains from utilizingunused resources internally exceed the gains made by arranging to sell the use of theresources to third parties can the e⁄ciency arguments for diversi¢cation hold. Grant(1995) argues that, ‘‘for diversi¢cation to yield competitive advantage requires notonly the existence of economies of scope in common resources but also the presence oftransaction costs that discourage them from selling or renting the use read more..
A diversi¢ed ¢rm can engage in practices unavailable to single-product enterprises.It might engage in predatory pricing to make life di⁄cult for competitors and possiblydrive them from the market. A predatory price is generally perceived to be one thatdoes not cover its variable costs in the short run and average variable and ¢xed costsin the long run; this may be di⁄cult to prove since the allocation of joint overheadcosts is generally based on arbitrary rules. Although price cutting may read more..
distortion and control loss and is similar to the relationship postulated by Marris whichwe discussed in Chapter 15.Managerial assets that can initially cope with diversi¢cation may be less able to doso the more diversi¢ed the ¢rm becomes. The competences and skills of the managerialteam may become less appropriate the farther away the new activities are from theoriginal ones of the ¢rm. For example, techniques appropriate to managing oilre¢neries may not be appropriate to managing read more..
split its Woolworth variety store business from its DIY and electrical businesses; and in2001, British Telecom divested itself of its mobile phone operation.THE PERFORMANCE OF DIVERSIFIED FIRMSOur previous discussion suggests that if diversi¢ed ¢rms are more e¡ective at utilizingresources than single-product ¢rms, then they might be expected to earn a higher rateof pro¢tability. If they are not, then we might expect single-product ¢rms to be morepro¢table. Studies of the impact of read more..
enterprises, came to a similar conclusion. Rumelt also found evidence that ¢rms thatdiversi¢ed into related activities were more pro¢table than ¢rms engaged in unrelateddiversi¢cation.Financial studies using stock market data have been more conclusive. Markides(1992) found that announcements of refocusing by diversi¢ed enterprises led tosigni¢cant upward movements in share prices. Pandya and Rao (1998) suggestedthat, ‘‘while management and marketing disciplines favour related read more..
Case Study 17.2US oil industry: related andunrelated diversiﬁcationA study by Ollinger (1994) of the US oil industry examined the success or failure ofalternative strategies for changing the boundaries of 19 major oil firms and the limits tothe transferability of firm-specific skills in the growth process.The study evaluated the success of horizontal growth, vertical integration and relatedand unrelated diversification between 1930 and 1990.First, oil companies grew by transferring skills from read more..
inefficient companies that were asset-rich but undervalued by the stock market. Suchcompanies were judged to be able to benefit from the Hanson treatment and releasesignificant value to the acquirers, so that the purchase price was recovered by disposalof assets. The target companies were characterized as being in low-technology, low-risk,basic industries, with not much competition and little or no government interference.Essentially, Hanson purchased underperforming companies, sold their read more..
gEmpirical studies, which are inconclusive in terms of determining whether diversi¢-cation is always successful. The strongest conclusion for companies is summed upin the phrase ‘‘diversify with care’’.REVIEW QUESTIONSExerciseaSelect a company, read its annual report and determine its degree of diversi¢cation.bFrom your reading of the business pages identify a company that has made a moveto diversify either by organic change or by acquisition. Try to ascertain themotivation and read more..
REFERENCES AND FURTHER READINGBosworth, D., P. Dawkins, M. Harris and S. Kells (1997) Diversi¢cation and the Performance ofAustralian Enterprises (Working Paper No. 28/97). Melbourne Institute.Bower, T. (2001) Branson. Fourth Estate, London.Bruce-Gardyne, T. (2002) Och aye the Bru. Financial Times Magazine, 9 February, p. 23.Feeny, S. and M. Rogers (1999) Market Share, Concentration and Diversi¢cation in Firm Pro¢tability(Working Paper No. 29/99) Melbourne Institute.Grant, R.M. (1995) read more..
18 CHANGING THEBOUNDARIES OF THE FIRM:DIVESTMENT AND EXITCHAPTER OUTLINEChapter objectivesIntroductionExit decisions in competitive marketsExit decisions in oligopolistic marketsFactors encouraging exitFactors keeping the ¢rm in the market: exit barriersBankruptcyCase Study 18.1ITV Digital terrestrial serviceChapter summaryReview questionsReferences and further readingsCHAPTER OBJECTIVESThis chapter aims to examine the issues surrounding decisions to make the¢rm smaller rather than larger and read more..
INTRODUCTIONSo far in this book, we have analysed the growth and diversity of the ¢rm. However,¢rms that grow can also decline, ¢rms that diversify can refocus their activities on anarrower range of activities and ¢rms that invest in growth can also divest themselvesof activities in search of greater pro¢tability. Thus, the withdrawal, or exit, frommarkets or ceasing to undertake an activity is as much part of the development of the¢rm as growth: put another way, the opposite of the read more..
it should exit the market as soon as possible. Firms making the greatest losses areexpected to exit ¢rst. However, a ¢rm ^ even one not covering its variable costs ^ maystay in the market if it is awaiting the decisions of other loss-making rivals. If su⁄cientcapacity is retired by its competitors, then the ¢rm may be able to return to a positionof earning a normal pro¢t as prices rise through the reduction in supply and the ¢rmcuts its costs.EXIT DECISIONS IN OLIGOPOLISTIC MARKETSFirms read more..
everyone expects demand to pick up in the near future, then adjustment will also bedelayed.These problems can be illustrated using game theory. Let us consider a duopolywith the pay-o¡s shown in Table 18.1. Here ¢rm A is assumed to be more e⁄cientthan ¢rm B and each ¢rm has a choice of exiting or staying in the market. If bothcompetitors remain in the industry, then they both lose money: ¢rm AÀ»100 and¢rm BÀ»150. If both exit, then neither makes pro¢ts nor losses. If competitor A read more..
the pattern of exit, with the result that closure patterns were ine⁄cient in economicterms.The author ( Jones 1994) in a study of the adjustment process in the West Europeanoil-re¢ning industry between 1976 and 1992 found signi¢cant variation in theclosure pattern in terms of ¢rm size and plant size. In the period under study re¢ningcapacity was reduced by 53%. The breakdown was as follows:gOf the three largest companies, BP closed 60%, Shell 57% and Esso 43% of theircapacity.gChemical read more..
acquire a workforce and make a product or service to be o¡ered to consumers. Once inthe market the ¢rm has then to compete with any rivals to persuade su⁄cientconsumers to buy its o¡ering rather than those o¡ered by competitors.Conversely a ¢rm will be motivated to leave or exit a market where:gDemand is static or declining.gEnterprises are earning below-normal pro¢ts or making losses in the activityconcerned.gEnterprises face cash £ow problems and are unable to pay their read more..
in£uencing both the nature of competition and the timing of exit. When all companiesare fairly con¢dent about the rate at which demand will continue to fall, reductions incapacity are likely to be orderly; whereas, if some ¢rms believe that demand growthwill be resumed, then they may attempt to hold onto their positions, perpetuating over-capacity and intense competition.Some industries are characterized by product di¡erentiation: for example, whilelong-term demand is in decline, some read more..
combined e¡ect of declining margins and falling output reduces pro¢tability and maylead to losses being made.Matching supply and demand within a ¢rm is a key managerial function. However,some ¢rms will ¢nd a declining market more hostile and less pro¢table than other¢rms who may ¢nd a declining market pro¢table, particularly if they can maintainsales and price competition is absent.Excessive diversi¢cationAnother reason for divesting activities is that the ¢rm believes that it has read more..
where the existing management of an unwanted division believes that they can makethe division more pro¢table than under the benign neglect of the parent company. Forexample, British Airways developed a low-cost, or budget, airline to compete withcompanies like Ryanair and easyJet in the European market. However, in 2001, BAdecided to revise its strategy and to concentrate on those things it did best: providinghigh-quality air services to customers willing to pay higher prices. Consequently, read more..
gA high-quality image created by previous expenditure on R and D, production andadvertising.gFacilities shared with other products that are pro¢table.gCompany recognition generated by previous advertising.gBusinesses that are of strategic importance to the ¢rm.gThe potential damage in other markets of upset customers with signi¢cant buyerpower.Porter (1980) argued that a signi¢cant factor to come out of case studies was that exitfor a single-product ¢rm meant managers losing their jobs, read more..
pro¢table product and the viability of the supply division. Therefore, the ¢rm maydecide to maintain production of the less pro¢table product, providing it covers itsvariable costs. However, it may be cheaper to close the component supply divisionand buy the inputs in the market. If the two products use the same facilities intheir production this option may not be available.gVertical integration: vertical linkages raise similar issues to those of shared facilities.It may be di⁄cult to close read more..
BANKRUPTCYSingle product or multi-product ¢rms may cease to exist if they become ¢nanciallyunviable. When this happens a ¢rm is described as being bankrupt (i.e., it hasinsu⁄cient assets to meet its debts). Many countries have bankruptcy procedureseither to restructure ¢nancially distressed companies to prevent bankruptcy or,ultimately, to liquidate them.Bankruptcy procedures are required when a ¢rm cannot pay its debts to ensure fairtreatment of all creditors by the bankrupt ¢rm. In the read more..
asymmetry of information between managers and outsiders, on the other, outsidersystems will be less aware of an oncoming ¢nancial crisis.Using the data in Table 18.2 we can compare the average rate of bankruptcy inEnglish and non-English-speaking countries, which roughly coincides with thedistinction between outsider and insider systems of corporate governance. It is higherin the USA, Canada, Ireland, Australia and New Zealand (3.15%) than in continentalEurope and Japan (1.13%). However, the read more..
determined by a majority of each claimant class or group. Once agreed a new plancannot be put forward for at least 180 days.Chapter 11 has been criticized for leaving the managers who have brought aboutthe ¢nancial crisis in charge, of being too friendly to debtors, of being costly and time-consuming. Hart (2000) argues that there are two fundamental problems withChapter 11 in that it is a structured bargaining process that: ‘‘tries to make twodecisions at once: what to do with the ¢rm, read more..
gThe management of the new venture had no experience of pay TV and thought thattheir experience of operating terrestrial services could be transferred to the newformat.gThe strategy of styling itself as a mini-Sky TV, but without the ﬁnancial resources orthe management. Sky TV was judged to have been successful because of itspremium sports channels and, particularly, the showing of Premier League soccer.ON digital decided to launch a sports channels with the highlight being FootballLeague read more..
were made to keep the ¢rm operating or to sell it to new owners. Or did it just ceaseto exist?Discussion questions1What factors might explain why a ¢rm ceases to be viable?2Explain the concept of barriers to exit. How do they explain the reluctance of ¢rmsto leave industries or markets?3How might game theory help to explain the reluctance of ¢rms to exit markets?4Can a ¢rm overdiversify?5Explain the terms ‘‘manager-friendly’’ and ‘‘investor-friendly’’ used in read more..
Jones, T.T. (1979) Oil re¢ning: An EEC and UK problem of excess capacity. National WestminsterQuarterly Review, May, 34–42.Jones, T.T. (1994) Exit from the West European Oil Re¢ning Industry. School of Management,UMIST, Manchester.Klapper, L. (2001) Bankruptcy around the World(Working paper for World Development Report).World Bank, Washington, DC.Lowes, B., C. Pass and S. Sanderson (1994) Market entry and exit. Companies and Markets(Chapter 7). Blackwell, Oxford, UK.Penrose, E. (1959) The read more..
19 CHANGING THEBOUNDARIES OF THE FIRM:MERGERSCHAPTER OUTLINEChapter objectivesIntroductionMergers, acquisitions and takeoversTypes of mergersNumber of mergers in the UKMotives for mergingCase Study 19.1Ford’s acquisition of Kwik-Fit ^ a corporate error?The merger processIndicators of the success or failure of mergersCase Study 19.2Granada^Forte takeover battle 1995^1996Chapter summaryReview questionsReferences and further readingCHAPTER OBJECTIVESThis chapter aims to discuss the use of mergers read more..
INTRODUCTIONIn this chapterwewill lookatmergers as astrategytogrowanddevelopthe¢rm.Mergers remain a frequent strategic choice of many ¢rms. They involve the acquisitionand incorporation of another enterprise into the acquiring ¢rm; this may be motivatedby reasons of market power, related or unrelated diversi¢cation or vertical integration.In this chapter we will examine:gThe nature and process of merging.gThe motivation for engaging in merger activities.gThe costs and bene¢ts of read more..
production process merge. Vertical mergersaredescribedaseitherbringingaboutbackward or forward integration. Backward integration involves a ¢rm movingcloser to the raw material source and forward integration a ¢rm moving closer tothe market (see Chapter 16).gConglomerate mergers occur when two ¢rms producing independent products fordi¡erent markets merge. Conglomerate mergers create larger diversi¢ed ¢rms.Although these do not generate concerns about market dominance, there areconcerns read more..
382 PA RT V g STRATEGIC DECISIONS19651967196919711973197519771979198119831985198719891991199319951997199920012,0001,5001,0005000Figure 19.1Number of mergers in the UK (1965^2001)Source: National Statistics1965196719691971197319751977197919811983198519871989199119931995199719992001706050403020100£ bnFigure 19.2Value of mergers in the UK (1965^2001) (»bn January 1987 prices)Source: National Statistics read more..
the EU, 114 in the USA, 52 in other developed countries and 59 in developingcountries. In the same year 227 UK businesses were acquired by overseas enterprises.MOTIVES FOR MERGINGThe motives for merging are di¡erent in managerial and owner-controlled ¢rms: theformer may be more concerned with increasing the growth rate of the ¢rm, whileowners are presumed to be more concerned with increasing pro¢ts or shareholdervalue. The main sources of economic gain which enable ¢rms to achieve read more..
way of achieving greater size and a higher growth rate than pursuing internal ororganic growth.Mergers and market powerMarket power arises from a ¢rm having a signi¢cant presence in a market. Greatermarket power can be achieved by increasing market share at the expense of rivals.Competing away the market share of rivals requires the ¢rm be in a relatively strongercompetitive position than its rivals; this may be achieved by having superior products,lower costs and better distribution systems. read more..
Case Study 19.1Ford’s acquisition of Kwik-Fit – acorporate error?In 1999 the Ford Motor Company, the world’s second largest maker of cars, acquired Kwik-Fit, a UK-based firm specializing in the fast replacement of car components, such asexhausts, shock absorbers and tyres. Three years later Ford sold it at a substantial loss.Kwik-Fit was founded in Edinburgh by entrepreneur Sir Tom Farmer in 1971. His firsttyre business was started in 1964, but was sold 4 years later. Returning from read more..
Chapter 15, may include knowledge of a particular market, or of a particulartechnology, or a strong reputation for product quality. Such knowledge is embedded inindividuals and the architecture of the ¢rm; this means that these resources can beutilized within the ¢rm at a constant or declining marginal cost and have high markettransaction costs, so that the most pro¢table way to exploit them is within the ¢rmand the only way to acquire them is through acquisition. It is these competences read more..
the growth prospects of the ¢rm and keep shareholders happy because of their dislike ofexcessive non-working assets.Changes in the economyMergers are sometimes motivated by general changes in an industry, such as changesin demand and technology, and trends in the economy as a whole, such as globaliza-tion. For example, declining demand in the defence sector following the end of the coldwar led to mergers of defence companies and consolidation of the industry.The general state of the economy may read more..
For vertical mergers there may be cost savings where two technologically linkedstages of a production chain are joined together under common ownership. Such alink avoids recourse to market transactions and avoids transaction costs; however,these may be o¡set by increases in governance costs. For conglomerate mergerswhere the activities are unrelated, the cost savings may arise from more e⁄cientmanagement, from a lower cost of capital for market funding and from operating aninternal capital read more..
existing shareholders. A low valuation ratio should also encourage the existingmanagement to take actions to restore the fortunes of the ¢rm to raise the valuationratio.The market for corporate control, or the buying and selling of companies, operateson the basis that buyers who value companies more highly than the existing share-holders will try to acquire them. To encourage shareholders to sell their shares,potential buyers will o¡er a premium over the present share price. Clearly, the read more..
growth, rationalization and synergies. Diversi¢cation was much less important andre£ects the changing strategies of companies.A questionnaire study by Ingham et al. (1992) asked managers to rank up to 10motives that best described their company’s merger policy. Based on 146 returns fromthe top 500 companies the average scores out of ten were:Increased pro¢tability7.656Pursuit of market power6.708Marketing economies of scale3.568Risk spreading2.885Acquisition of management2.698Cost read more..
bidder o¡ers 110 pence, then the bidder is said to o¡er a 10% premium to encourage theshareholder to sell. Alternatively, the o¡er may be in terms of shares in the bidding¢rm; this makes valuing the o¡er more di⁄cult because it is a function of the currentand future share price of the bidder: for example, one share in the bidding companymay be o¡ered for two in the target company. In some instances the bid may be acombination of cash and shares.Having decided on the nature of the o¡er read more..
INDICATORSOFTHESUCCESSOR FAILUREOFMERGERSThe merger as a strategy is intended to improve the performance of the bidding ¢rm.When two ¢rms merge the expectation is that the combined ¢rm will be greater thanthe sum of its parts. The success or failure of mergers can be measured using some orall of the following criteria:gThe pro¢tability of the combined enterprise, which would be expected to haveincreased when measured absolutely or relative to capital employed.gE⁄ciency gains measured by read more..
shareholders improved in the period immediately after the merger, but this superiorperformance was not maintained beyond 3 years; this is not unexpected because if themerged ¢rm becomes more competitive, then competitors can either lose market shareor improve their own operation and become more e⁄cient and competitive. Thealternative explanation is that the stimulus of the merger to superior performance islost with the passage of time.Studies of the stock market e¡ects of UK mergers agree read more..
identi¢ed three main factors explaining failure. First, when the target company put up agood defence; this requires the management of the target company to obtain thesupport of their shareholders and persuade them not to sell their shares. Managementmust demonstrate that their chosen strategy will be more bene¢cial to them than thealternative strategy of the acquirer. Second, when the bidding company makesmistakes in handling the bid or there are adverse movements in their own share priceas a read more..
particular activities in pursuit of rationalization. Rationalization requires the closure ofplants, o⁄ces, etc. and the making of managers and workers redundant. Mergers, atbest, create uncertainty for the sta¡ of both companies and, at worst, discontent anddeclining productivity.Cultural di¡erences may be more signi¢cant if the merger is one of equals ratherthan atakeover. In atakeover thewinner’sculture is morelikelytobe imposed.Combining cultures in a merger of equals may be more read more..
disposed of in due course. Granada argued that its management were superior and couldmake more effective use of the assets than the existing management.The bid for Forte was launched on 22 November 1995 when its share price was 260p.The offer was 4 new shares plus £23.25 cash for every 15 Forte shares or a full cash offer of321.67p; this valued Forte at £3.3bn which was described as hugely inadequate by SirRocco Forte who resolved to oppose the bid and maintain the independence of thecompany. read more..
Discussion questions1 Why should the management of a ¢rm prefer:^ Internal growth to external growth through mergers?^ Growth through mergers to internal growth by organic expansion?2 Distinguish between horizontal, vertical and conglomerate mergers and giveexamples of each.3 For what reasons would a ¢rm seek to be taken over?4 What reasons motivate a ¢rm to acquire another?5 What are the anti-e⁄ciency arguments against mergers?6 What are the pro-e⁄ciency arguments in favour of mergers?7 read more..
Kennedy, V.A. and R.J. Limmack (1996) Takeover activity, CEO return and the market forcorporate control. Journal of Business Finance and Accounting,23(2), 267^285.KMPG (1999) Mergers and acquisitions: A global research report: Unlocking shareholder value:The keys to success. Available at http://www.kmpg.comKnowles-Cutler, A. and R. Bradbury (2002) Why mergers are not for amateurs? Financial Times(12 February).Komoto,K.(1999) The E¡ect of Mergers on Corporate Performance and Stock Prices (Paper read more..
20 ORGANIZATIONAL ISSUESAND STRUCTURESCHAPTER OUTLINEChapter objectivesIntroductionPrincipal^agent analysisE¡ort, outcomes and rewardsCase Study 20.1Sliding-scale payments in coal miningCase Study 20.2Managerial incentive schemesOrganizational structuresU-form organizationsM-form organizationsCase Study 20.3Organizational form ^ empirical studiesLimits to growth and size of the ¢rmChapter summaryReview questionsReferences and further readingCHAPTER OBJECTIVESThis chapter aims to explore the read more..
INTRODUCTIONA key characteristic of the modern ¢rm, identi¢ed in Chapter 1, is the divorce betweenownership and control. The implications of the distinction were then discussed in thecontext of corporate governance and the consequences for the performance of a ¢rm ofdi¡erences in the objectives of owners and managers. In this chapter we propose tofurther that discussion by examining the implications for management costs and limitsto the size of the ¢rm; this will be achieved by read more..
terms discretionary spending, or non-pecuniary bene¢ts, or on on-the-job consumption.Such things might include spending on a luxury company car or an aeroplane, golfclub membership and the time o¡ to play. These expenditures add to the owner-manager’s personal satisfaction and personal prestige but at the expense of the valueof the ¢rm. These extra costs imposed on the ¢rm by unnecessary expenditure aretermed agency costs.Jensen and Meckling (1976) developed a simple model to explain the read more..
If the owner decides to sell 60% of the company to outside shareholders, then theowner is left with a 40% stake and managerial control, while the outside shareholdershold 60% of the value of the ¢rm. If the outside shareholders pay 60% of the value ofthe ¢rm (OV1) for their stake, then they do so on the assumption that the managercontinues to receive OP1 in non-pecuniary bene¢ts and that the future value of the¢rm will continue to be OV1. However, in the new situation the manager might read more..
managerbyonly40pence andtothe outsideownersby60pence.Hence,the slopeofthe value constraint (E1E2D) for the manager is given by the fact that the managercan trade »1 of perquisites for 40 pence of personal wealth, giving a slope ofÀ0:4.With a given preference function the new equilibrium position is at E2,where theindi¡erence curve I3 is tangential to the line E1E2D. If the manager increasesexpenditure on perquisites to OP2, then the value of the ¢rm is reduced to OV2 ^theloss to the manager read more..
EFFORT, OUTCOMES AND REWARDSA further problem may relate to how far an outcome is a function of the e¡ort of theagent and how far is it dependent on factors outside his control. First, if e¡ort andoutcomes can be perfectly observed (i.e., there is perfect knowledge), then both theoutcome (Q)ande¡ort(E) can be fully observed. Thus, Q is a function of E,orQ¼ fðEÞ. The agent can be paid either on the basis of the observed e¡ort or on thebasis of the observed outcome.Second, if we assume that read more..
gIf interest rates fall to the medium level and the agent takes the easy e¡ort option,then sales of »2,000 are generated and the principal now receives »1,500. If theagent were to choose the hard e¡ort option, then the principal would receive anincreased surplus of »2,500 while the agent still receives »500. In these circum-stances the agent has no incentive to increase e¡ort because he does not share inthe higher revenue. To achieve higher sales the principal would have to inducethe read more..
rewards would vary with e¡ort and risks would be shared. The numbers in parenthesisin Table 20.2 show the proportion of total revenue going to the agent.Risk sharing: symmetric informationThe principles involved in risk sharing and devising incentive schemes can beillustrated diagrammatically. If we initially assume symmetric information so thate¡ort can be fully observed, then the compensation of the agent can be explained withthe help of Figure 20.3. On the horizontal axis is measured the read more..
minimum OE1 of e¡ort (with no reward for any less or any greater e¡ort). Analternative would be to o¡er the agent the reward structure represented by the lineAW. To obtain the highest utility level achievable under this reward structure theagent would choose e¡ort level OE1 where the wage function is tangential to the indif-ference curve and receive payment of W1E1. Thus, because the principal can observethe exact e¡ort of the agent he can select the appropriate reward for the agent read more..
This pattern of a risk-neutral principal and a risk-averse agent is to some extentmirrored in the relationship between shareholders and executives. The former can beregarded as risk-neutral as they hold diversi¢ed portfolios whereas executive managersare tied to the enterprise and failure may well result in them losing their positions.Thus, we would expect to ¢nd top managers being rewarded by performance-relatedschemes.Reward schemesTo align the interests of owners and managers more closely read more..
Besides monetary incentives to compensate for extra e¡ort, there may also be non-monetary factors at work, such as being part of a team where peer group pressuremay bring out the best in everyone. Such a strategy is in the agent’s interest becauseit may lead to: glowing references were he to apply for another job; getting promotion;and protecting his position if dismissals are considered. The management/ownersmight also encourage the workers to have an ownership stake in the company, eitherby read more..
stock market return of the company and the sample as a whole. The relationship betweensize, ownership and performance was analysed using variance analysis and the resultssuggested that both size and ownership are statistically significant explanatory factors indetermining firm performance, as measured by excess returns. The results support thehypothesis of a significant relationship between ownership and performance, even aftercontrolling for size differences. The results showed higher excess read more..
depending on organizational form. Therefore, there is a need for organizationalstructure to be seen as an independent variable in explaining behaviour and constrain-ing or expediting growth. He has also argued that, ‘‘the modern corporation is mainlyto be understood as the product of a series of organisational innovations that havehad the purpose of and e¡ect of economising on transaction costs’’ (Williamson, 1985,p. 273).The two organizational types compared and contrasted by read more..
U-FORM ORGANIZATIONSThe U-form ¢rm emerged during the development of the American railways in thesecond half of the 19th century. The growth in size of the network together with thegrowth in tra⁄c led to the creation of an administrative structure, the appointment ofspecialist managers, the development of internal accounting and control policies andto what is now termed the ‘‘unitary structure’’ of the ¢rm; these incorporated ‘‘decen-tralized line and sta¡ organization’’ read more..
would increase the number of supervisors to 15 and the number of tiers to 5. Increasingthe span of control would clearly reduce the number of managers and tiers in an organ-ization. With a span of control of 10, 1,000 workers could be supervised by 111managers and the organization would have only 4 tiers. With a span of control of 2,the organization employing 1,024 operatives would require 11 tiers and 1,023managers.Increasing the span of control of supervisors or managers can therefore o¡set read more..
Increasing span of controlOne way of limiting the number of levels in the hierarchyas the organization grows is to increase the span of control. However, this means thata manager has less time to address any particular problem and to deal with individualsta¡, so that the outcome is likely to be poorer decision making and greater opportu-nities among sta¡ to behave opportunistically.Principal^agent analysis suggests that there is greater opportunity for opportunis-tic behaviour by agents if the read more..
The simple U-form organization is considered appropriate for small and medium-sized ¢rms since it generates e⁄ciency from specialization of functions. It appears to beless e⁄cient as size and complexity increase, particularly if the ¢rm grows throughproduct or market diversi¢cation; this is supported by empirical studies, which areconsidered in Case Study 20.3. However, there comes a point where the U-formstructure begins to constrain the growth of a ¢rm; this occurs when read more..
appear to have few motives to behave opportunistically and distort the allocation ofresources, though they might desire the number of sta¡ and the functions of headquar-ters to increase in size.A key feature of the M-form structure is that divisions remit ¢nancial surpluses toheadquarters who in turn allocate resources to divisions on the basis of the greatestcontribution to pro¢tability. The operation of this internal capital market is the respon-sibility of headquarters. One of the read more..
Divisions can also be easily added with little or no impact on the other divisions.The M-form structure facilitates the growth of diversi¢ed enterprises because eachdivision is in some senses an independent business. The limit to the number ofdivisions depends on the ability of central management to be able to control theinformation £ows from individual divisions.The advantages of the M-form structure lies in the control of divisions by a head-quarters dedicated to improving the pro¢tability read more..
non-M-form organizations, providing a distinction is made between pure M-form firms anddivisionalization (Hill, 1984, 1985a). He concluded that the pure M-form with its internalcapital market produced greater profitability than mere divisionalization.Hill (1988), using a sample of 156 large UK firms, investigated the relationship betweencontrol systems and performance and proposed that the control systems necessary torealize the economic benefits from related diversification are incompatible read more..
Of those firms allocating resources to activities with the highest returns, 53% achievedabove-average profits and 47% below-average profits. Of those achieving above-averagereturns, 26% were allocated by greatest profit (i.e., pure M-form), while 23% of under-performing firms also used greatest profit as the main criteria. Thus, Weir argued that therelationship between the internal resource allocation model and performance is complexand probably reflects inadequate investment appraisal within read more..
Galbraith (1967) in the New Industrial State envisaged consumers as totallymalleable at the hands of dominant producers who had totally eroded the notion ofconsumer sovereignty. While ¢rms take decisions on what to produce based on theirunderstanding of consumer preferences, they do not have to buy what is on o¡er fromdominant companies. If goods go unsold, then clearly the consumer prefers somethingelse. If consumers want products that are di¡erentiated, then there may be more roomfor small, read more..
REFERENCES AND FURTHER READINGBartlett, C.A. and S. Ghoshal (1993) Beyond the M-form: Toward a managerial theory of the ¢rm.Strategic Management Journal,14, 23^46.Bruce, A. and T. Buck (1997) Executive reward and corporate governance. In: K. Keasey, S.Thompson and M. Wright (eds), Corporate Governance. Oxford University Press, Oxford, UK.Cable, J.R. (1988) Organisational form and economic performance. In: S. Thompson and M.Wright (eds), Internal Organisation, E⁄ciency and Pro¢t. Philip read more..
21 THE GROWTH ANDDEVELOPMENT OF THEFIRM: STAGECOACHGROUP PLCCHAPTER OUTLINEChapter objectivesIntroductionThe bus industryGovernment policy changes in the bus industry – creating opportunitiesStagecoach start-upStagecoach: growth and developmentStagecoach in 2003Chapter summaryReview questionsReferences and further readingCHAPTER OBJECTIVESThis chapter aims to use the experience of Stagecoach in starting, growingand developing a business, to illustrate the themes explored in earlierchapters. At read more..
INTRODUCTIONStagecoach was started in 1980 and grew in 20 years to be one of the largest buscompanies, not just in the UK but in the world. It was founded by a brother and sister,Brian Souter and Ann Gloag, in their home town of Perth with a couple of second-handbuses that they used to run the first service from Dundee to London on 11 October 1980,two days after the deregulation of coach services (Sharkey and Gallagher 1995).In 1980 the bus industry was heavily regulated and had experienced a read more..
The demand function for bus transport for local journeys is dependent on suchvariables as bus fares, the price of other forms of transport, income and the availability ofsubstitutes, particularly cars. Other factors include the necessity of making the journey, thequality of the journey and the length of time it takes. The latter is related to the length ofjourney and the level of road congestion on the route.The demand curve for local bus journeys on individual routes is seen to be read more..
The function estimated was:logB ¼ a logF þ b logY þ c logMwhereY ¼ millions of bus journeys per annum,F ¼ real bus fares,Y ¼ real disposableincome andM ¼ real motoring costs. The reason this is in log form is to give directestimates of the elasticities (as explained in Chapters 5 and 6). The estimated equationusing least squares (witht-ratios in parentheses) is:B ¼ 5.903ð15:6ÞÀ 0:812FðÀ6:54ÞÀ 0:495YðÀ6:52Þþ 0:318Mð1:86ÞR2 ¼ 0:985; F ¼ 528:86Own price elasticity and income read more..
Production and costsThe production function of the bus industry includes the following capital and labour inputs:gBus stock.gTerminal, garaging and maintenance facilities.gPlatform staff (i.e., drivers and conductors).gMaintenance staff.gSupervisory and management staff.gFuel.gRoad use charges.Output is bus kilometres. Each bus kilometre provides a number of bus seats per kilometredepending on the size of the bus, but can provide a much larger journey capacity dependingon whether passengers read more..
firms operating larger fleets of buses, not from operating costs but from cost savings incovering for bus failure, maintenance and bus purchase. In addition, there may bemanagerial and financial advantages. Another advantage of size is the ability to offer asystem of bus services or routes which allows passengers to make separate but linkedjourneys. These advantages generate economies of scope and greater revenue. Economiesof scale arising from operating on a larger scale may therefore be of read more..
16%, a fall in costs per passenger journey of 7%, an increase in fares per passenger journeyof 20% and a decline in subsidies per journey by 5%. Overall, total revenue remainedunchanged in real terms over the 10-year period.The attractiveness of the bus industryAs was shown earlier, the bus industry has attractions in terms of its inelastic demandcurve; this gives opportunities to make excess profits in the absence of competition, acharacteristic that has led buses to be described as, ‘‘cash read more..
than the industry that is important in determining profitability. In any declining industry theremay be significant opportunities for growth and expansion for an entrant willing to questionthe prevailing ethos and traditional ways of its incumbent enterprises. However, entry wasnot possible under the old regulatory regime in the industry.In general terms the bus industry appeared in the early 1980s to be characterized by:gDeclining demand.gExcess capacity.gHigh costs.gInappropriately sized read more..
gAny new route or service could be started, but 42 days’ notice of entry was required.subsidies were to be awarded on a route basis by competitive tender.gThe industry became subject to competition law.To facilitate the privatization of the National Bus Company and to encourage new entry andcompetition, the company was split into 73 subsidiaries and offered for sale to the highestbidders. No bidder was allowed to acquire more than three geographically disperseddivisions. The first subsidiary read more..
were linked not only to the spotting of a business opportunity but also to his sister’sinvolvement in the industry and the low costs of entry.STAGECOACH: GROWTH AND DEVELOPMENTStage 1: ﬁrst movesThe deregulation of long-distance services came into force on 9 October 1980. Thefounders of Stagecoach were ready to take advantage of this change. They decided thatthe market for intercity coaches was underdeveloped in Scotland and offered real oppor-tunities for development. The Scottish Bus read more..
is, it was low cost and posed only a limited threat to the existing state-owned operators.The Glasgow market was attractive to many operators and as a result the city centrebecame flooded with buses causing significant congestion. The very competitive natureof the market resulting from new entry also led to price reductions, and what came to beknown as ‘‘bus wars’’ erupted in many cities.Stage 3: privatization and external growthAnother major decision was to bid to acquire subsidiaries read more..
of around 16–18%, and at the same time one of the world’s largest bus companies.Between 1992 and 1996, 23 full and 2 partial acquisitions were completed in the UK.Stage 5: diversiﬁcationThe major decision to diversify away from buses came with the privatization of British Rail.In 1992, Stagecoach had started running a railway service from Aberdeen to London bynegotiating the attachment of coaches to the night sleeper train; this did not provesuccessful. However, the privatization of read more..
to the replacement of management and the resignation of Stagecoach’s managing directorin July 2002.DisposalsIn line with the behaviour of companies that grow by acquisition, Stagecoach has bothacquired and disposed of companies and assets. An early disposal was the sale of thecompany’s long-distance coaches in 1989 to National Express for £1.6m; these formed 5%of the business at the time of the sale but had been 95% in 1985, before the major moveinto local services. Disposals have included read more..
gAdopting an M-form organizational structure, with a small head ofﬁce employing 30people.gHandling ﬁnance centrally with loans being made to subsidiaries.gChanging route patterns in line with current and potential market demand.gIntroducing a variety of bus sizes more suitable for existing and new services.gInvesting heavily in new buses and reaping the beneﬁts of buying in bulk.gReducing maintenance costs on vehicles and cost of spares.gSelling unwanted property to ﬁnance read more..
own fleet of vehicles; it does not hire them though the market. In the train industry, rollingstock and maintenance are hired through the market as a consequence of the UK privatiza-tion scheme that split the industry into track authorities, train operators, vehicle providersand maintenance firms. The company did own Porterbrook, a vehicle-leasing company, butdecided it did not have the necessary competences or resources to operate it and disposedof it to Abbey National.Stagecoach has stuck to read more..
Management constraintThe Penrose (1959) view of management is that initially it facilitates growth as its capacityto manage grows. However, the capacity of management eventually becomes a constrainton growth as new managers have to be recruited and trained in the ways of the company.Stagecoach successfully coped with growth and adding new acquisitions up to 2000, whichsuggests that the management team coped with these changes. However, the acquisitionof Coach USA and the difficulties faced in read more..
STAGECOACH IN 2003Stagecoach in 2003 is the result of the imagination of its founders, the seeking out ofopportunities, the availability of finance, the employment of good managers who havemade the best use of the company’s assets with the exception of the setback of CoachUSA. The pattern of development is summarized in Table 21.3; this shows expansionclassified by internal and external expansion, on the one hand, and domestic and inter-national change, on the other, in the same industry and read more..
gAspects of costs and demand, as well as the demand function for bus travel,conﬁrming the industry to be a hostile environment in which to pursue a growthstrategy, because of the negative income elasticity of demand and the absence ofeconomies of scale.gHow the company survived many early difﬁculties to emerge as one of the largestbus companies in the world, in an essentially declining and fragmented industry.gHow the company’s objectives to grow and achieve high proﬁt margins were read more..
Davies, S. (1994) Fleets of cash boxes on wheels.Financial Times (16, November, p. 22).de Jong, G. and H. Gunn (2001) Recent evidence on car cost and time elasticities of travel demand inEurope.Journal of Transport Economics and Policy, 35(2), 137–160.DoT (1999)Annual Abstracts of Transport Statistics (Department of Transport). HMSO, London.DoT (2001)Annual Abstracts of Transport Statistics (Department of Transport). HMSO, London.DoT (2002)Annual Abstracts of Transport Statistics (Department read more..
PARTVIDECISION MAKINGIN THEREGULATED ANDPUBLIC SECTORS22Decision making in regulated businesses44523Public sector production46924Quasi-markets and the non-market publicsector49125Investment appraisal in the public sector:cost^bene¢t analysis509 read more..
DECISION MAKING INREGULATED BUSINESSESCHAPTER OUTLINEChapter objectivesIntroductionWhat is regulation?Regulatory tools for promoting the public interestCase Study 22.1Regulating British TelecomCompetition policyAnti-competitive behaviour, or what ¢rms cannot doMethodology of competition policyCompetition policy in the EUCase Study 22.2Airtours and First Choice ^ a rejected mergerUK competition policyCase Study 22.3Interbrew and the UK competition regulatorsChapter summaryReview read more..
INTRODUCTIONOne of the roles of government in a market economy is to regulate private sectorenterprises, ensuring that the unbridled pursuit of pro¢t does not lead to a seriousmisallocation of resources and to outcomes that are unfair to consumers. Governmentregulation of business is all-pervasive in that there are rules governing the establish-ment of limited liability companies and rules about publishing annual reports andaccounts which apply to all enterprises. In addition, there are read more..
gThe setting of standards and licensing activities that may be applied by law orvoluntarily by business.gThe control of pricing and investment.gThe holding of competitions or auctions for the right to supply a service togovernment speci¢cation.These instruments have been used to deal with a number of problems including:gControl of entry to ensure only reputable or ¢nancially sound enterprises supply aparticular product or service (e.g., cinemas and banks).gSetting of prices for certain read more..
social surplus is reduced to the area AKLC. This new position generates a net welfareloss of KBL. Under monopoly the social surplus AKLC is now distributed in favour ofthe producer. Producer surplus is now equal to area PMKLC, which compared withPCBC is a net gain of PMKJPC,lessthe area JBL.Withtheloss of area PMKJPC,whichbecomes producer surplus, consumer surplus is now AKPM and KBJ becomes the lostsurplus, or the deadweight loss to consumers.As has been shown, the arguments for regulation are read more..
Besides higher prices and lower output, a government might also be concerned with thedistribution of gains and losses that might be considered politically unacceptable. Inthis case the government may act to correct the unfair distribution.Another argument for regulation is the consequences of destructive competition.Competition is deemed to be excessive when it leads to excess capacity, unreliableservice to consumers and the failure of companies when prices fail to cover costs. Inthe UK, read more..
gCosts and their minimization.gDemand ^ its level and growth.gInvestment requirements to maintain or expand capacity.gPrice^cost relationship to prevent excessive pro¢ts being made.g‘‘Fair’’ level of pro¢t to ensure the company can remain in business and ¢nanceexpansion.Essentially, the regulator has to decide whether there is a need to control price or pro¢tby setting levels for either that do not threaten the ¢nancial viability of the ¢rm or thedisruption of supply.Marginal cost read more..
then the price will be OPM and quantity OQM. However, charging the marginal costprice means that ¢xed costs are not recovered and the enterprise makes a loss ofPMLMN. The problem for the regulator and government is how to cover the losses ifprices are set equal to marginal cost; this can be achieved by paying the ¢rm a subsidyor, so that the ¢rm remains ¢nancially viable, allowing it to use average cost pricing,two-part pricing or price discrimination.SubsidiesIf the government wishes to read more..
prices it chooses, providing its pro¢ts do not exceed the regulatory rate of return. Incost-plus pricing terms the ¢rm should cover its variable costs and make su⁄cientpro¢t to cover the costs of capital and make a pro¢t.The rate of return on capital set by the regulator has to be a ‘‘fair’’ one, not too highto be ‘‘unfair’’ to consumers nor too low to be ‘‘unfair’’ to the ¢rm. It is also expectedto be in line with the risk/return conditions in more competitive read more..
allowed to earn. However, if the regulated ¢rm increases its capital employed it canincrease its absolute level of pro¢ts. If it increases it to the point where the allowedregulatory pro¢ts are equal to the pro¢ts given by the pro¢t function, then it canincrease its absolute pro¢t from O1 to O2. Thus, the ¢rm employs capital of OK2,rather than OK1; this e¡ect of employing too much capital is termed the Averch^Johnson e¡ect (1962).Incentive schemesTo overcome the problems and read more..
in price and pro¢t.The mechanism also creates an incentive for the ¢rm to reduce average costs belowcost curve AC1 to prevent the eradication of supernormal pro¢ts. If the ¢rm isine⁄cient, then becoming more e⁄cient will reduce average costs. If the ¢rm isproducing at the minimum cost level, then the ¢rm will have to innovate and improveproductivity. If cost levels can be reduced to AC2 in period 2, then the ¢rm willincrease its pro¢ts, given the price set for that period. However, read more..
prices by up to 2%. In real terms the price charged is lower in each successive period,thereby forcing the ¢rm in successive periods to lower its unit costs if pro¢ts are to bemaintained.The formulaissetfora periodof3to 5 yearsandischangedafterdiscussion between the regulator and the regulated enterprise. The value put on X iscrucial to the working of the scheme, as the higher its value the greater the pressureput on the ¢rm to be e⁄cient.Once its price cap has been set the ¢rm can choose read more..
456 PA RT VI g DECISION M AKING IN THE REGULATED A ND P UBLIC SECTO RSTable 22.1BT regulatory formula and price changesYear toChange in retailX factorAllowed priceTelephoneRetail priceRate of returnAugustprice indexchangeprice indexindexon read more..
telephone price index shown in column 4 would have stood at 83.3 in 2001, whereas itactually stood at 81.5. From the beginning the result has been declining prices in real termsand latterly in absolute terms. The changes in cost and efficiency levels are partly due tomore efficient working methods and advances in telephone technology. Their adoption andimplementation might be attributed to the incentive effects of the regulatory regime.The impact on profitability is plotted in Figure 22.7, where read more..
good); this was discussed in Chapter 9. In a competitive market there is a generalexpectation that one price will prevail for undi¡erentiated goods and, where productsare di¡erentiated, those of a similar quality will have similar prices. Thus, the concernto competition regulators is whether the same products are sold at di¡erent prices todi¡erent buyers for reasons unrelated to cost: for example, the European Commissionhas investigated the variation in car prices between member states in read more..
at the same time. This practice, known as bundling, has been used by Microsoft amongothers. The company was investigated by the US competition authorities for o¡ering aweb browser with its Windows operating system at no extra cost, making life di⁄cultfor Netscape whose major product was adversely a¡ected. Microsoft was eventuallyfound to have behaved anti-competitively after a series of appeals in 2001.Another problem that can arise in the relationship between sellers and buyersinvolves read more..
De¢ning the relevant marketAnother important aspect of competition policy is the de¢nition of the market. Whetherthe market is de¢ned widely or narrowly, it clearly in£uences the measured marketshares, for it is these that determine whether the ¢rm has a dominant position.Markets are normally de¢ned in terms of substitution. On the demand side, crosselasticity can be estimated to draw a market boundary. On the supply side, a similarconcept can be used to try to measure whether an increase read more..
The Commission takes a harsh view of cartels and ¢rms found to have participatedin a cartel can be ¢ned up to 10% of their turnover: for example, eight companies were¢ned a total ofc¼855.22m in 2001 for participating in eight distinct, secret, market-sharing and price-¢xing cartels that were involved in the production of vitamins (seeCase Study 9.1). Firms found guilty by the Commission can appeal to the courts: forexample, in the wood pulp cartel case of 1984, ¢rms were found guilty but read more..
with the policy. These latter decisions increased the number of rejected mergers from 13in the previous 10 years to 18 in total. Rejected mergers included that betweenAirtours and First Choice.Another element in the policy is the approval of mergers subject to the disposal ofcertain assets, which lowers the potential level of dominance: for example, Nestle¤’s bidfor Perrier in 1992 was approved by the Commission on condition that Nestle¤ sellcertain of Perrier’s brands. Nestle¤ sold read more..
not based on the creation of a dominant position, the test in the regulation, but collectivedominance. The Court did not reject the notion of collective dominance, but did not accept itwould have the direct effect of enabling the merged firm and its competitors to adoptcommon policies to impede competition. To prove collective dominance the Commissionwould have to show that each member of the oligopoly knew how the others would behave(e.g., when setting price); there must be no incentive for a read more..
Rome. The objective was to overcome the limitations of previous legislation, to attackcollusive practices and create a more competitive economy. Other aspects of policy,such as monopoly and merger policy, remained unchanged and are still based on theFair Trading Act 1973.The competition authorities in the UK comprise:gThe O⁄ce of Fair Trading (OFT) is a quasi-autonomous body that polices the state ofmarkets, enforces and investigates cases arising under the 1998 legislation. It hasto be read more..
g4 cases were found not to be against the public interest and were allowed toproceed;g2 cases were declared to be against the public interest;g4 cases were abandoned because the proposed merger was abandoned.Case Study 22.3Interbrew and the UK’scompetition regulatorsIn May 2000, Interbrew – a Belgian brewer – proposed buying Whitbread’s brewinginterests in the UK. The proposal was approved by the OFT and a decision made not torefer it to the Competition Commission because:gThe market read more..
gHow regulation by government can prevent ¢rms from pursuing policies theyotherwise would have done.gThe need for regulation to stop ¢rms acting collectively to co-ordinate markets bylimiting competition and, thereby adding to their own pro¢tability.gTwo types of policy: the ¢rst type is aimed at regulating natural monopolies andutilities (which in recent experience in the UK followed privatization); this remainsan ongoing problem unless competitive markets are developed. The second type read more..
OFT (2002) Annual Report 2001(O⁄ce of Fair Trading Cmnd 773). HMSO, London.Papaionnou, A., U. Diez, S. Ryan and D. Sjoblom (2002) Green paper on the review of the mergerregulation. Competition Policy Newsletter,1, February, 65^68.Train, K.E. (1991) Optimal Regulation: The Economic Theory of Natural Monopoly.MIT Press,Cambridge, MA.Viscusi, W.K., J.M Vernon and J.E. Harrington (1995) Economics of Regulation and Antitrust (2ndedn). MIT Press, Cambridge, MA.Vogelsang, I. and J. Finsinger (1979) A read more..
23 PUBLIC SECTOR PRODUCTIONCHAPTER OUTLINEChapter objectivesIntroductionWhy public sector production?ExternalitiesCharacteristics of goods: excludability and rivalryProvision of goods by the public and private sectorArguments for public productionOrganizational issuesProperty rights approachIncentives and monitoringPublic enterprisePublic enterprise versus private enterprise performance comparedCase Study 23.1The postal serviceChapter summaryReview questionsReferences and further readingsCHAPTER read more..
INTRODUCTIONA common feature of most economies is that some activities are undertaken not byprivate pro¢t-seeking enterprises but by state-owned organizations, voluntary organ-izations and mutually owned organizations, whose prime objective is the service of thecommunity or its members. In the UK these three types of organizations undertake arange of activities that is sometimes in competition with private operators. The mainpurpose of this chapter is to explore why public sector or read more..
for other producers or consumers. Acid rain produced by electricity generators in theUK is delivered free of charge to Scandinavian countries by the prevailing westerlywinds where it pollutes many lakes and has adverse e¡ects on the environment.Theoretically, externalities can be imposed by either a consumer or a producer andbe received by either a consumer or producer. There are four possible relationships,and these are shown in Table 23.1. Producer^producer and producer^consumer arethe two of read more..
472 PA RT VI g DECISION M AKING IN THE REGULATED A ND P UBLIC SECTO RSMCSCSCPLKMCPP2FP1HGOQ2Q1Quantity(a) Private benefits and private and social cost of supplyBenefit/CostsGEP3P1GOQ1Q2Quantity(b) Private costs of supply and private and social benefitsBenefit/CostsFADPDSMCPBFigure 23.1Externalities: demand and cost curves read more..
In Figure 23.1(b), social bene¢ts and private costs are considered, with no external-ities in production. In this case, society would wish to see output OQ2 produced, wheremarginal social bene¢ts are equal to marginal private costs. However, if left to themarket, then only OQ1 is supplied, where marginal private bene¢ts are equal tomarginal private costs. If the desired output of OQ2 were to be supplied, then the ¢rmwould require compensation of Q3B. On the basis of their private bene¢ts, read more..
provided by products and on the horizontal axis are di¡erent types of goods. Thus, forgood 1 all the bene¢ts are private, for good 2 the bene¢ts are 50% private and 50%external and for good 3 the bene¢ts are 100% external with no private bene¢tswhatsoever. In a market economy the majority of products are presumed to providewholly private bene¢ts and any element of external bene¢ts can be safely ignored, butthere are others where the social element cannot be ignored.Property rights and read more..
Merit and bad goodsParticipation in the market by consumers is a function of individual preferences andincome. If the community believes that society is underconsuming or overconsumingcertain goods because of their mix of social/private bene¢ts and costs, thengovernment may try to rectify this position. Such goods are termed merit goods ifthere are substantial social bene¢ts associated with consumption and bad goods (orbads) if there are substantial social costs; for example, education and read more..
amount available for others. Typical examples of such situations are common land,public beaches and ¢sheries. Everyone has the right to catch ¢sh, but doing sodeprives others of catching the same ¢sh. Over¢shing leads to a reduction in ¢shstocks, but it is in no one’s interest to stop ¢shing unless ownership rights are declaredand limits put on ¢shing and depleting stocks. These goods can be: produced by theprivate sector and ¢nanced by user charges; supplied by the public sector at a read more..
demand curves horizontally they are summed vertically to see whether total willingnessto pay justi¢es the provision of the service. The individual demand curves AQA andBQB are added vertically to give total willingness to pay and a community demandcurve of DGHQB. Thus, the total willingness to pay is the area under this curve(namely, ODHQB). With a given marginal social cost curve of CMCS the optimalquantity to be supplied is OQ3.Ifonly A’s preferences were revealed, then only OQ1would be read more..
two options in terms of pricing (namely, charging a price or making the serviceavailable free), then we can identify four options:AGoods produced by the public sector, but sold at a price normally set to recovervariable and ¢xed costs.BGoods produced by the public sector, but supplied ‘‘free’’ or at a nominal charge ^costs are met from the public purse.CGoods produced in the private sector, but sold at a price normally set to recovercosts and make a pro¢t.DGoods produced in the private read more..
ARGUMENTS FOR PUBLIC PRODUCTIONProduction of goods by organizations and agencies owned and controlled by the statemay be preferred for a host of reasons. In the inter-war and post-war years,governments throughout Europe generally increased their control of the economythrough nationalization, because of the failures of the market economy and disadvan-tages of private ownership. However, since 1980 the same countries have reduced thelevel of state control though policies of privatization and read more..
increase in premiums was attributed to the increasing cost of claims; many of thoseinsured were becoming elderly and making more expensive claims. Those who cannota¡ord the higher premiums tend to be the elderly and the newly retired. Thus, whenpeople become increasingly in need of health care they ¢nd that they can no longera¡ord the cover they expected and are forced to leave the private sector and becomedependent on the state (Papworth, 2000).Decreasing cost industriesAnother argument used read more..
instead, to restrictions on foreign ownership of certain industries, such as broadcastingand airlines.Enterprise and managerial failureIn practice, many decisions to pursue public ownership are a response to a particularproblem rather than to an ideological commitment. Public ownership has been used torescue bankrupt companies, to solve industrial relations problems, to replacemanagement, to prevent foreign ownership or to start enterprises when the privatesector appears unwilling to take the read more..
independent agencies and independent public corporations. Some of the factorsin£uencing that choice include:gOwnership: public activities are normally wholly owned by the state; but, in someinstances, ownership may be shared with private owners. In these cases, the statehas a choice of being a passive partner (British Petroleum from the First WorldWar until 1990) or an active partner controlling objectives and the appointmentof managers.gFunction: this can vary from o¡ering advice to read more..
PUBLIC ENTERPRISEHistorically, the concept of the public enterprise in the UK was one where politicians setthe long-term objectives and management were responsible for day-to-day decisions.The aim was to combine the notion of publicness with the concept of enterprise toserve the public interest. The concept of publicness implies serving the interests of thecommunity as a whole rather than the private interests of the owners of capital. Thegovernment sets objectives that are ful¢lled by managers read more..
in the latter they are shareholders. Typically, the former will be a much larger groupthan the latter and, in practice, will look to the elected politicians to set objectives andto civil servants or audit agencies to measure performance. The citizen owners of thepublic enterprise are unable to exercise any ownership rights except via the ballot box,which is a somewhat indirect method.In private sector organizations the owners or shareholders are able to use theirownership rights to in£uence the read more..
preventing targets being achieved. However, politicians can overcome these problemsby setting hard budget constraints and forcing managers to live within their budgetswithout any bailing out. However, their willingness to stick to hard budget constraintsis always in doubt if the political consequences are serious.Ine⁄ciencies of public sector organizationsPublic sector organizations, in a similar way to private enterprises, have had a wholerange of criticisms levelled against them, generally read more..
performance at a particular point in time and the indicators used to measureperformance, given the di¡ering objectives of public and private enterprises. Typicalindicators have included pro¢tability, productivity and unit cost.Millward (1982) in a major survey of the evidence concluded that there appeared tobe no general ground for believing that managerial e⁄ciency was lower in public¢rms. Vickers and Yarrow (1988) suggested, ‘‘that privately owned ¢rms tend, onaverage, to be more read more..
Case Study 23.1The postal serviceHistorically, the postal service has been seen as a public sector activity. Postal servicesworldwide have been organized either as government departments or as public corpora-tions. However, in the 1990s a number of post offices were wholly or partially privatized,most notably in Holland, Germany and New Zealand. In the UK the Post Office wasconverted to a private company to give it greater commercial freedom, with thegovernment owning all the shares.The postal read more..
gLicences are being issued to private ﬁrms to compete with the Post Ofﬁce incollecting and delivering commercial mail and in bulk delivery.gThe closure of socially unnecessary local post ofﬁcesThe government hopes the result will be a more efficient postal service with commercialfreedom to compete with its continental rivals; this may mean higher prices and cuts inservices. However, if the universal system of delivery is threatened, particularly in ruralareas, then the voters may become read more..
8 Why are clearly speci¢ed property rights important in determining the performanceof a public enterprise?9 Is it possible to reconcile the concepts of ‘‘public’’ and ‘‘enterprise’’ in a singleorganization?10 Explain why economists suggest that a bureaucrat’s utility function can be summedinto one that maximizes his budget. What are the implications or the size of theorganization?11 What objectives should a government set for a public enterprise selling a product orservice read more..
24 QUASI-MARKETS AND THENON-MARKET PUBLIC SECTORCHAPTER OUTLINEChapter objectivesIntroductionDecision making in the absence of pricesSupply: economic analysis of bureaucracyDemand: merit and public goodsCollective decision makingExit, voice, loyaltyConsumer di⁄culties with public supplyTheory of quasi, or internal, marketsCase Study 24.1Health reform: the quasi-market approachChapter summaryReview questionsReferences and further readingCHAPTER OBJECTIVESThis Chapter aims to examine decision read more..
INTRODUCTIONThe goods and services the public sector produces can be divided into two categories:gThose goods and services produced by public enterprises and sold at a priceintended to cover costs.gAnd those goods and services produced by public agencies that are supplied toconsumers either ‘‘free’’ or at nominal charges not intended to cover costs.In this chapter we will examine the problems associated with the second categorywhere price is not used and monopoly supply is the normal read more..
be organized as part of local or central government with politicians ultimately incontrol of setting objectives and assessing performance. Such organizational forms arepart of the state bureaucracy and described as bureaucratic, which is taken to meanine⁄cient. The reasons are to be found in the objectives of senior bureaucrats, themonopoly relationship with government, excessive layers in the organization,narrowly compartmentalized jobs, the absence of consumer preferences and read more..
equate marginal bene¢ts with marginal cost, the equilibrium size of the agency wouldbe at OA1. However, the agency will be able to push the budget to the point wheretotal bene¢ts are equal to total costs (i.e., to agency size OA2,where ODFA2 is equal toOHGA2). If the budget is pushed to OA3 where marginal bene¢ts from the activity arezero, then total cost would exceed total bene¢t. The agency is able to push the budgetto OA2 because it has information not available to the purchasing body read more..
be done is to make the service available ‘‘free of charge’’ and leave the choice of howmuch to consume to the individual or to compel individuals to consume.However, the government has to decide how much to supply whichever method isused, given that consumer preferences and willingness to buy will not determine theoutcome. Likewise, goods that are characterized by an inability to exclude people fromconsuming them generate similar problems because it is not in the interests ofindividuals read more..
community will pay to implement such decisions there should, it is argued, be asigni¢cant and not just a bare majority in favour.Simple questions put to the vote do not allow individuals to express theirpreferences fully or their total willingness to pay: one individual may be very keen onpublic lighting while others are less keen; some will favour a large number of high-quality lights whereas others will favour a minimalist system. To achieve a greaterexpression of preferences a whole range of read more..
to infer that the group would prefer high to low spending. However, if a vote were heldbetween high and low spending, then the result would favour low spending. Thus, inthis case voting produces an inconsistent set of preferences for the community and theoutcome would depend on the order in which the votes are taken: if high versus lowwere voted ¢rst, low would win; if medium versus low followed, then medium wouldbe the preferred outcome. See Brown and Jackson (1990) for a more read more..
consumers of food). This outcome is explained by the degree of expected net gain or lossof individual voters. The average voter gains or loses little by marginal changes in thesupply of public or merit goods. A small number of voters stand to lose or gainsigni¢cantly from policy shifts. Therefore, they are strongly motivated to in£uence the498 PA RT VI g DECISION M AKING IN THE REGULATED A ND P UBLIC SECTO RSSAOSBLowHighPublic spending(a) Normal distributionNumber of votersSAOSHSBLowHighPublic read more..
political outcome in their favour and to convince politicians and voters of theworthiness of their cause. They may have signi¢cant resources to spend on formingpressure groups, supporting political parties and propagating their viewpoint. Largegroups in which individual gains are small will be unable to attract mass resources toform pressure groups to in£uence the outcome. The average voter is also poorlyinformed and can be in£uenced by the information made available by special read more..
similar options available to them as private consumers. Since many public and meritgoods are supplied by local political entities a satis¢ed citizen-consumer remains aloyal resident, while dissatis¢ed ones can move to another area or voice theirdiscontent. The ability to leave one authority for another does however depend on theability to meet the transaction costs of the exit decision.In the UK, parents seeking the best state education for their children seek out thebest schools and try to read more..
Politicians may view the problem of lack of supply as the result of the ine⁄cient useof resources by the agency. The suppliers of funds may view the agency as ine⁄cient,disinterested in its clients or customers and more interested in pursuing the self-interest of its managers and employees. To bring about more e⁄cient operation,changed work practices and better use of facilities, the politicians or budget suppliershave a number of options. First, they can use budgetary pressure to force read more..
on the producer. Increasing the diversity of supply may be an option for some services,butwillbe afunction of thesizeofthecommunityandthee⁄cientsizeofsupplyunits. In large cities it may be possible to have competing suppliers but not in rural orless sparsely populated areas.Fourth, it might be possible to decentralize political decision making, facilitating themovement of citizen-consumers between jurisdictions; this enables di¡erent budgetaryauthorities and supply agencies to use di¡erent read more..
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