Managerial Economics

Managerial Economics Lecture Four: Alternative theories of the firm, pricing, & profits

Recap • Last week • Institutional (Galbraith), Post Keynesian, Sraffian theories of price • Schumpeter’s model • Accepts (wrongly) absence of profit in equilibrium • Builds model of disequilibrium source of entrepreneurial profit from • New goods • New production methods • New markets • New raw materials • New industrial combinations • Assumes (1) not done by existing firms; (2) uses existing resources (labour & capital)

Schumpeter’s model • First stage: • To innovate, need concept and resources to put it into effect • But new firm has no retained earnings from which to buy them • Hence new firm needs credit… • Second Stage: • “To provide this credit is clearly the function of that category of individuals which we call "capitalists".” (69) • We would call these “venture capitalists” today • OR “the creation of purchasing power by banks … It is always a question, not of transforming purchasing power which already exists in someone's possession, but of the creation of new purchasing power out of nothing … which is added to the existing circulation. And this is the source from which new combinations are often financed…” (73) • ‘The banker… has himself become the capitalist par excellence…’ (1936: 74)

Schumpeter’s model • Net creation of new money thus essential step: • “The banker, therefore, is not so much primarily a middleman in the commodity "purchasing power" as a producer of this commodity.” (74) • Overturns conventional economic argument about “money illusion”. • Money plays essential role in profit process (according to Schumpeter) • Economists instead suffer from “barter illusion” that only applies to existing products • Third stage: • With credit & purchased resources, innovator combines them to revolutionise production in some way • Process fundamentally different to “management”…

Schumpeter’s model • “The carrying out of new combinations we call "enterprise"; the individuals whose function it is to carry them out we call "entrepreneurs."” (74) • Not the same as managers of firms in static theory: • “The tendency is for the entrepreneur to make neither profit nor loss in the circular flow - that is he has no function of a special kind there, he simply does not exist; but in his stead, there are heads of firms or business managers of a different type which we had better not designate by the same term… the Marshallian definition of the entrepreneur, which simply treats the entrepreneurial function as "management" in the widest meaning, will naturally appeal to most of us. We do not accept it, simply because it does not bring out what we consider to be the salient point and the only one which specifically distinguishes entrepreneurial from other activities.” (76-77) • Entrepreneurial decision-making fundamentally different to neoclassical vision of profit-maximising decision-making

Schumpeter’s model Empirically & theoretically wrong anyway… see previous lectures! • Conventional economic “profit maximisation” emphasises rational calculation • Thomas & Maurice 2003, Managerial Economics, p. 450 “a manager must answer two questions … Produce as long as the market price is greater than … minimum average variable cost … Produce the output at which market price (which is marginal revenue) equals marginal cost” • Not possible for entrepreneurial decisions: • “What has been done already has the sharp-edged reality of all the things which we have seen and experienced; the new is only the figment of our imagination. Carrying out a new plan and acting according to a customary one are things as different as making a road and walking along it.” (p.85)

Technological innovation • Innovations revolutionise production in ways even innovators can’t foresee… • 1954 expert vision of 2004 “home computer”

Schumpeter’s model • Future impact of new product fundamentally uncertain • “Rational calculation” (e.g., assessing NPV) hardly possible & maybe counterproductive • “Of course he must still foresee and estimate on the basis of his experience. But many things must remain uncertain, still others are only ascertainable within wide limits, some can perhaps only be "guessed." … Thorough preparatory work, and special knowledge, breadth of intellectual understanding, talent for logical analysis, may under certain circumstances be sources of failure.” (85) • Very similar to Keynes’s “animal spirits” • Given 1st 3 stages fulfilled: (1) concept backed by (2) credit, (3) carried to fruition by entrepreneur; we get a cyclical economic process…

Schumpeter’s model • Cycles considered later in economy section of subject • Here the pricing/strategy issue • How can entrepreneur borrow money, produce new commodity/new production method etc., and still make a profit? • Essential “systemic” reason: creation of new credit by loan from bank/[venture] capitalist affects economic system. Injection of new spending power will, amongst other things, “affect the price level” (74) • Technological innovation gives innovator cost advantage over incumbents…

Schumpeter’s model • “Entrepreneurial profit is a surplus over costs. From the standpoint of the entrepreneur, it is the difference between receipts and outlay in a business.” (128) • Schumpeter argues this does not exist in equilibrium in the “circular flow”: “in the circular flow the total receipts of a business—abstracting from monopoly—are just big enough to cover outlays. In it there are only producers who neither make profits nor suffer losses and whose income is sufficiently characterised by the phrase "wages of management."” (129) • But entrepreneur (if successful!) uses technologies etc. that are superior to those in “circular flow”; “since the new combinations … are necessarily more advantageous than the old, total receipts must in this case be greater than total costs.” (129)

Schumpeter’s model • Schumpeter’s example: the powerloom • 1st major step in automation of industry: replacing hand weaving with mechanised production of cloth • Has taken many forms over the years… • From the original design • And the original sweatshops…

Technological innovation • To the more advanced • And its sweatshop… • To today’s “high tech” • And … • And what tomorrow: bioengineering? nanotech?

Profits from innovation if… • “If anyone in … the textile industry … with hand labor sees the possibility of … powerlooms,... borrows … from a bank and creates his business... If a worker … is now in a position to produce six times as much as a hand-worker in a day, … given three conditions the business must yield a surplus over costs • First, the price of the product must not fall when the new supply appears, or else not fall to such an extent that the greater product per worker brings no greater receipts now … • Secondly, the costs of the powerloom per day must … remain below the daily wages of the five workers dispensed with … • The third condition ... If his demand is [not] relatively small … then the prices of … labor and land rise because of the new demand. ... therefore the businessman, … must add an appropriate amount, so that yet a third item must be deducted. • Only if the receipts exceed outlays after allowing for all three sets of changes is there a surplus over costs.” (129-130)

$100 $100 $100 $100 $100 $200 p.d. depreciation $100 p.d. depreciation Profits from innovation if… • Process: Current production requires 6 workers costing $100 per day + machine depreciation $100 per day $101 $100 • New machine reduces labour need to one • But bids wages up $1/day • $100 rise in depreciation • Extra supplier drives price down (say $1/days output) • Surplus ($398) minus interest payments is entrepreneur’s profit • Profit falls as more producers adopt new technology…

Schumpeter’s model • Evolutionary basis to thinking: • ‘the evolutionary idea is now discredited in our field… with all the hasty generalisations in which the word “evolution” plays a part, many of us have lost patience. We must get away from such things… then two facts still remain: • first the fact of historical change... [and that] • These changes constitute neither a circular process nor pendulum movements about a centre.’ (1936: 57-58) • Economic evolution & hence development is • ‘spontaneous and discontinuous change in the channels of the flow, disturbance of equilibrium, which forever alters and displaces the equilibrium state previously existing.' (1936: 64)

Schumpeter’s model • Entrepreneur as agent of evolutionary change: • ‘The carrying out of new combinations we call “enterprise”; the individuals whose function it is to carry them out we call “entrepreneurs”.’ (1936: 74) • Net profit emanates from development • “he has, if everything has gone according to expectations, enriched the social stream with goods whose total price is greater than the credit received and than the total price of the goods directly and indirectly used up by him... • Furthermore, the entrepreneur can now repay his debt (amount credited plus interest) at his bank, and normally still retain a credit balance (=entrepreneurial profit) that is withdrawn from the purchasing power of the circular flow.” (110-111)

Schumpeter’s model • Net credit (credit in excess of asset backing) arises from development: • “money, and … other means of payment … perform an essential function, … • processes in terms of means of payment are not merely reflexes of processes in terms of goods… (95)… • in real life total credit must be greater than it could be if there were only fully covered credit…” (101) • Contra standard neoclassical “money as veil over barter” conclusion solely because dynamic, disequilibrium analysis vs conventional static equilibrium thinking • Disruption to equilibrium, net entrepreneurial profit, net credit, leading ultimately to a new equilibrium:

Schumpeter’s model • “But now comes the second part of the drama. The spell is broken and new businesses are continually arising under the impulse of the alluring profit. A complete reorganisation of the industry occurs, with its increases in production, its competitive struggle, its supercession of obsolete businesses, its possible dismissal of workers, and so forth… the final result must be a new equilibrium position… • Consequently, the surplus of the entrepreneur in question and his immediate followers disappears … • Nevertheless, the surplus is realised … And their profit, the surplus, to which no liability corresponds, is an entrepreneurial profit.” (131-132) • This process occurs in cycles: considered in later lectures

Schumpeter’s model • Power loom example “cost-cutting” • Same product produced more cheaply • Much innovation develops new product—category 1 of Schumpeter’s means to make entrepreneurial profit • New product steals demand from predecessors • Price can be significantly higher than old rivals • “Early adopters”: willing to pay “almost any” price to secure product • Price drops significantly as product becomes standard • Continuous development needed to maintain market share • Process called “creative destruction” by Schumpeter:

Schumpeter’s model • Innovation “incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism." (Schumpeter, Capitalism, Socialism, and Democracy, p. 83.) • Innovation then alters system of production/consumption • “Logistic diffusion process”: • Low rate of initial adoption (“early adopters”) • Accelerated take-up by mass market (“take-off”) • Final ceiling reached • “Market saturation”; or • Product overtaken by new one before maturity

Computer industry—Schumpeterian example • Computers classic case of Schumpeterian process with new products rather than cost cutting • 1935 IBM introduces • 601 multiplying punch-card machine • Allows accounting to be done by less skilled personnel • electric typewriter • Pushes previous manual typewriters into “old hat” bin • New innovation (manual/electronic office machines) allows rise of major company (IBM)

Computer industry • New product (computers) • Originated in UK as part of WWII • Traded with USA in return for nuclear technology • UK rapidly loses dominance in computers… • (Another bad trade deal with USA…) December 1943, UK: “Colossus”, first all-electronic (vacuum tube) computer • IBM becomes dominant company in computers too… • Produces “mainframe” computers • Very big • Very expensive • But best way to do complex calculations, manage large business

Computer industry • In 1953 IBM introduces the “650” “Magnetic Drum Calculator”: world’s first mass-produced computer. • Component manufacturing becomes major IBM advantage • If component fails, can be “unplugged” & replacement installed • Computer continues to operate while problem diagnosed/fixed at IBM factory • But opens up opportunity for other firms to profit: “plug compatibility”…

Computer industry • Five main (but much smaller) rivals: “the BUNCH” • Burroughs • Unisys • NCR (National Cash Register) • Control Data • Honeywell • Ever heard of these companies??? • BUNCH “competes” by producing plug compatible components for IBM computers at lower cost • Also sometimes try producing lower performance/cost rival computers • IBM responds by making each new generation computer incompatible with previous plug-in components

Computer industry • IBM outfoxes Bunch, but • New rivals arise • Not competing in mainframe market but “mini” computers • Smaller size (physical and memory/processing power) • But cheaper, better interface, lower maintenance • First DEC (Digital Equipment Corporation) PDP-1 in 1960 • 1st computer with keyboard & monitor input • Previous magnetic, paper tape, punch card inputs, teletype output • Remember RAND corporation 1954 vision of “home computer” in 2004?

Computer industry • IBM continues to innovate in mainframes • System/360 computer seen as 3rd generation: • Magnetic storage • Terminal input (multiple terminals per computer) • Mini-computer rivals continue to innovate • DEC PDP-8 first to use transistors in modules • “Plug and play” reaches new levels…

Computer industry • Innovation also by “BUNCH” • Burroughs first to use integrated circuits in 1968 • 1968 Control Data produces first supercomputer (designed by Seymour Cray) • But BUNCH continues to play second fiddle to IBM in business machines • IBM marketing “No-one ever got sacked for purchasing IBM” dominates technical advances of rivals • IBM gradually incorporates rival advances into own machines • BUT competition in innovation continues from “newcomers” • 1968: Intel formed as 3 person company…

Computer industry • 1972: Intel produce 8008 “microprocessor”: computer on a chip • 8 bit processor • 1975: first “microcomputer” developed • Altair 8800 (using successor chip to Intel 8008) • Kit computer: components purchased by user and assembled • Major technologies now being produced outside “monopolist” IBM • IBM continues to dominate mainframes, but mainframes losing market share to minis and micros…

Computer industry • 1976 Steve Jobs and Steve Wozniak design and build the Apple I: • 1977: Apple II debuts and becomes industry standard for microcomputers • And also in 1977…

Computer industry • Microsoft formed… • Would you buy an operating system from these people? • Flurry of microcomputer innovations: • Microcomputer operating system developed: CP/M • Microsoft develops rival MS-DOS • Small/Portable microcomputers developed • Commodore “PET”, Tandy TRS-80… • CP/M compatible “portable” Osborne Osborne Portable.Weight: 11 kilos

Computer industry • As or more important: software development • 1979: First “killer application” the spreadsheet developed on and for microcomputers: Visicalc • Ran on CP/M and eventually Apple PCs • No comparable product on mainframes/minis • Legitimises PCs in eyes of business… • IBM is in trouble • So… if you can’t beat them, join them! • Responds with development of IBM PC • Doesn’t have operating system, so sub-contracts to… • Microsoft

Computer industry • 1981: IBM PC introduced • Has Intel 8088 chip • First machines have no floppy disk: • IBM PC Basic (written by Bill Gates as uni student) on ROM • Data stored on cassette tape • Later machine has • 160K floppy disk • IBM PC-DOS (written by Microsoft) boots from floppy

Computer industry • “Street cred” of IBM with business means IBM PCs wipe out competitors even though many technically superior • IBM PC had 8-bit processor (8088) • Osborne had 16-bit (8086) • IBM operating system single-user/single-tasking • Osborne used MP/M, multi-user/multi-tasking • Customers’ pre-existing knowledge of IBM meant technical advantages of rivals weren’t enough for survival • 1983: “Killer App” introduced for IBM PC: Lotus 123 • Adds graphics to Visicalc’s tables • Starts trend of software being written just for IBM hardware (bypass operating system for faster processing speed)

Computer industry • Many important competitive issues apparent here: • Existence of “monopoly” doesn’t stifle innovation • But innovation often comes from new or peripheral firms • Cooperation important as well as competition • Software company produces operating system, programs tailored for particular computer hardware • Standards evolve for cross-compatibility of common components (e.g., parallel interface for printers; then USB; in future WSB) • Costs would be dramatically higher (& therefore higher prices for consumers) without this cross-competitor cooperation • Competition still fierce, but mainly in product innovation rather than price…

Computer industry—Schumpeterian example • However price benefits also exist: • US Price of desktop microcomputers fairly constant over time…

Computer industry—Schumpeterian example • But “bang for buck” rising dramatically • Price per megabyte of RAM plummets from almost $200,000 to only $10 in 25 years… • Exponential increase in storage capacity of standard computer

Computer industry—Schumpeterian example • Price per megahertz processing power also plummets from $1000 per megahertz in 1975 to less than $10 per megahertz in 1999… • Competitive process has one technology dominant (mainframes), dominant firm arises (IBM), but then new product (minicomputer) from new rival (DEC) undercuts market… • Is there a pattern?...

Schumpeter’s model: addendum • Schumpeter sees innovation as main source of growth • Over time, innovations become dominant source of demand too • Figures from Japan: • Goods invented before 1950 constituted less than 20% of total demand by 1990!

Schumpeter’s model: addendum • Previous graph in tabular form: • Need dynamic/evolutionary model of feedback between producer (innovator) and consumer to explain level of consumption today • Static “supply/demand” model not enough

Schumpeter’s model: addendum • Schumpeter mainly considered innovation process itself • Other issue: “market penetration process” • Once innovation developed & produced, over time becomes “standard” • According to Schumpeter, becomes part of Walrasian system of general equilibrium—no profit • According to Sraffa/Post-Keynesians, becomes part of input-output system (remember Blinder’s 70% of output purchased by other firms?) • Priced according to needs of production system • Cost of production times markup • Quantity and price dynamics of market penetration follow “logistic diffusion process”

Schumpeter’s model: addendum • Market penetration question: how fast will sales of new product grow? • Simplest growth process exponential: • “grows at y per cent per annum” • Successful new product must grow faster than economy (say x% p.a.) • Can’t be sustained indefinitely • With y>x, “growth model” predicts output of new commodity will exceed size of economy! • Modified model needed • Most accepted: logistic diffusion • Product’s success slows its own growth

Schumpeter’s model: addendum • Logistic model based on idea of overcrowding from population growth: • New animal in ecosystem grows exponentially to begin with (e.g., cane toads) • If successful, reaches “carrying capacity” of ecosystem • Population stops growing • Basic equation of exponential growth of widget sales is • Logistic equation is

Schumpeter’s model: addendum • Logistic predicts some ceiling value of new product sales • Can be modified to predict (say) value widget sales as % of total economy • Most successful products follow approximation to this • But are then undercut by new, rival product • As seen with computers

Schumpeter’s model: addendum • So is computer industry “competitive”? • By microeconomics standards, NO • Dominant company IBM • Remember 2004 Fortune 500 listing from last lecture? • IBM 9th largest company in USA still • Microsoft only 47th with sales of US$32 billion versus IBM at US$89 billion • Anti-competitive practices (plug incompatibility tricks etc.) • By consumer/other business user standards, YES • Dramatic rate of development • Dramatic fall in cost, rise in convenience • So what is competition, really? • Next week’s lecture…

Managerial Economics