Managerial Economics

Managerial Economics Lecture Three: Other theories of price & competition The Entrepreneurial Role

Recap • Blinder’s research • 90% of firms have constant or falling marginal cost • Therefore price must be above marginal (and variable) cost for firms to be profitable. • Don’t think in terms of marginal revenue, cost • 50% of firms change prices only once or less a year • 70% of sales to other businesses & 85% to repeat customers • 70% have inelastic demand • So “[a good deal of microeconomic theory] is called into question…” (p. 302) • Confirms over 140 similar previous surveys • So conventional (neoclassical) micro can’t explain output and pricing decisions of firms

Other theories of pricing • If rising costs of production & falling don’t determine how much firms produce, what does? • According to some economists, things conventional (neoclassical) theory of firm omits: • Product differentiation • Theory assumes firms compete only on price • Uncertainty • Theory assumes costs, demand, etc., known by firms • Also probably no “one size fits all” pricing model • Different price models needed for different • Industries (Ag & Mining vs Manufacturing) • Products (established vs new) • Uses (consumables vs assets [houses, shares, etc.])

Manufacturing: Operation within capacity • Alternative theories of manufacturing pricing emphasise: • Uncertainty • Can’t know future • Excess capacity gives room to react to unforeseeable events • Rivalry with other producers • Output not homogeneous • Firms compete on product differentiation • Try to “steal” market share from competitors by non-price competition • Extra sales profitable because • “Marginal revenue” high: Price doesn’t have to drop when non-price competition expands sales • “Marginal cost” low & fixed costs high

Segmented demand heterogeneous goods • Not a “demand curve” for a homogeneous commodity, but segmented markets for related but very different products • Product made & priced for one target income group/taste pattern; very hard to shift demand. • Can’t do it just by reducing price… Luxury Price Sports Midrange Standard Economy Quantity

Manufacturing: Operation within capacity • Product differentiation limits sales because… • “Business men, who regard themselves as being subject to competitive conditions, would consider absurd the assertion that the limit to their production is to be found in the internal conditions of production in their firm, which do not permit of the production of a greater quantity without an increase in cost. The chief obstacle against which they have to contend … does not lie in the cost of production—which, indeed, generally favours them in that direction—but in the difficulty of selling the larger quantity of goods without reducing the price, or without having to face increased marketing expenses.” (Sraffa 1926) • Main constraint on sales not “conditions of supply” but “conditions of demand”:

Manufacturing: Operation within capacity • Neoclassical model of capitalism “supply constrained” • “Unlimited wants” • “Scarce resources” • Post-Keynesian economist Janos Kornai argues modern capitalism “demand constrained” • Excess capacity the rule • Not “waste” but “opportunity” • In growing economy, new factory must have much more capacity than needed now; • In uncertain world, excess capacity needed to react to opportunities • E.g., 2001 recall of “Firestone” tyres in USA

Firestone recall • Bridgestone’s (Japan) “Firestone” tyres supplied with Ford Explorers The night before... • Several deaths due to blowouts • Recall 6.5 million tyres in 2000/2001 • Goodyear (US ) 31% of market; Bridgestone 23%; Michelin (French) 23% • Big consumer shift from Bridgestone to Goodyear • How would “supply & demand economics” analyse this? The morning after...

Price Quantity Firestone recall • Fall in supply (Bridgestone temporarily out of market) • Rise in demand (normal demand plus refit of 6.5 million tyres)… Supply • Price should rise, not much change in output… Pe • What actually happened? • Much more complex: case study in • Actual competitive dynamics; and • What not to do! Demand Qe

Firestone recall • “The Firestone recall briefly swamped Goodyear with more business than it could handle. It also convinced Goodyear executives that their brand carried … a reassurance of safety for which Americans would pay a premium price… But once the Firestone recall fell out of the headlines, the public did what it has increasingly been doing: buying whatever was on sale. • Goodyear's sales deflated… Its North American market share fell last year to 28.4% from nearly 31% in 2001. Japan's Bridgestone Corp., whose market share slipped only about two percentage points to 21% as a consequence of the recall, managed to stem a further decline… in part by launching a massive advertising campaign under the slogan "Making It Right." …” (Wall Street Journal 19th February 2003)

Firestone recall • No “diminishing marginal productivity” rise in cost of production • Goodyear simply increased output to capacity • But firm tried to profit from Firestone recall by increasing its markup • Rivals (including Firestone) fought back with non-price competition • Goodyear lost market share • Analysts argued worst mistake was increasing price

Firestone recall • “Goodyear's biggest mistake appears to be its effort to capitalize on the Firestone recall by raising its prices. Starting in January 2001, Goodyear boosted prices on its passenger and light-truck tires up to 7%, and followed up with another hefty increase the following June. Partly, the company saw itself asserting its right to charge prices closer to those of Michelin, which generally had the highest in the market. • But in the eyes of many customers, Goodyear failed to justify the increases. To charge a premium, a tire maker has to offer some advantage, even if it's just an aura of quality—which Michelin has historically promoted.” (Wall Street Journal 19th February 2003)

Firestone recall • Price response with no matching non-price compensation brought Goodyear undone despite windfall from Firestone • Strategic responses of rivals not on price but design, image, availability • “In the tire industry, innovations are quickly copied, so it's hard to retain a genuine edge for long. But Goodyear has underspent its rivals on research and development. Goodyear spent $376 million on R&D in 2001, while Bridgestone spent $476 million and Michelin spent about $645 million. • In years past, Goodyear made up for that through muscular sales and marketing and a network of dealers that pushed its products with near-religious zeal. [But] Goodyear's price changes came at a time when dealers were already in near-rebellion over a host of other complaints.” (Wall Street Journal 19th February 2003) • Need model of manufacturing competition that fits situations like these:

Alternative models of firm behaviour • In manufacturing • Few very large firms • Differentiated products: quality and feature variation • Competition mainly on product development, marketing, services (availability, after-sales support) • Price “banding”: price reflects quality so market segmented • Product diversity & non-price competition limit output, not costs • Income distribution also limits potential sales • Main problem not producing with “DMP”, but selling output given constrained effective demand

Alternative models of firm behaviour • Conventional economic supply & demand model based on small, “price taking” firms • Model doesn’t fit data; any alternative model must! • Basic fact: wide dispersion of firm sizes, but • Most industries dominated by few large firms • E.g., US industry aggregate data: • Let’s break that down by percentages:

Alternative models of firm behaviour • 95% of firms earn less than $5 million; • Less than 1 in 400 earns more than $100 million; but… • Bottom 95% of firms responsible for only 25% of salaries & 15% of sales • Top 0.25% responsible for 51%+ of salaries and 62%+ of sales • It’s a big world out there… Model of “big” pricing needed

Galbraith & Institutional Analysis • One alternative: “Institutional economics” view • Focuses on institutions of society • Sees dominant institution as large manufacturing firm • Some competition good & necessary • Restrains prices (e.g., Goodyear’s experience) • Encourages innovation (Apple v IBM v Dell) • But small firms/“competitive industries” not automatically superior to concentrated industries • Too small scale of operation • Inability to plan for technology/market • Institutionally inferior to large firms because less effective manager of vagaries of market

Galbraith & Institutional Analysis • Focus of Galbraith’s “institutional” analysis of firms: • “Nothing so characterizes the industrial system as the scale of the modern corporate enterprise. In 1969, the five largest industrial corporations, with combined assets of $59 billion, had just under 11 per cent of all assets used in manufacturing. The 50 largest manufacturing corporations had 38 per cent of all assets. The 500 largest had 74 per cent…” (89) • Companies achieve scale because it facilitates planning of technology, and “control” of the market:

Galbraith & Institutional Analysis • “The firm must be large enough to carry large capital commitments of modern technology. It must also be large enough to control its markets. But the present view also explains what the older explanations don't explain. That is, why General Motors is not only large enough to afford the best size of automobile plant but is large enough to afford a dozen or more of the best size; and why it is large enough to produce things as diverse as aircraft engines and refrigerators, which cannot be explained by the economies of scale; and why, though it is large enough to have the market power associated with monopoly, consumers do not seriously complain of exploitation. The size of General Motors is in the service not of monopoly or the economies of scale but of planning. And for this planning - control of supply, control of demand, provision of capital, minimization of risk - there is no clear upper limit to the desirable size. It could be that the bigger the better. The corporate form accommodates to this need. Quite clearly it allows the firm to be very, very large.” (91) • How large? Check Fortune 500 list of America’s top companies

Fortune 500 Top 26…

Post Keynesian Price Theory • Post Keynesian School focuses on • Manufacturing prices for established products • Input prices: raw materials, agriculture • Several variants, but basic ideas: • Manufacturing prices = average cost at target output + a markup • Target: historic market share + growth objective • Markup: reflects degree of competition in industry • Manufacturing supply flexible: • Production well within capacity • Subject to constant/falling marginal costs • Demand fluctuations covered mainly by changes in stocks

Post Keynesian Price Theory • Prices set by markup on input costs: • “[P]rice is set by adding together direct material and labor costs per unit output, plus overhead costs determined at standard volume output, plus a predetermined (conventional) profit margin. Because the pricing procedure is not explicitly designed to maximize profits, the full cost price is no a profit maximizing price or, in fact, a price that maximizes anything. Rather the pricing procedure is designed to enable the firm to reproduce itself and grow.” (Lee 1984: 1108)

Post Keynesian Price Theory • View of firms costs: • Based on empirical data; • High fixed costs • Constant variable costs • Costs fall to full capacity • Planned output within capacity: Andrews 1950: 61 • Emphasis on realism • Post Keynesians often stunned that model not accepted by economists:

Post Keynesian Price Theory • “Granted that the principle is so generally adhered to in manufacture, the mystery is that it has not yet emerged as a postulate of economic analysis. It should obviously be an accepted principle in pricing-theory. Those economists who have thought about it have been too concerned with trying to explain it on the basis of the existing theory, instead of accepting it… Scientific method would suggest that the right thing to do at the existing state of knowledge would be at least to accept the principle as a basis for further theory in its own field—the analysis of price-policy.” (Andrews 1950: 82) • Main danger for firm is that target sales will not be met • If sales below target then costs (including debt servicing) can exceed revenue • Sales above target greatly increase profit

Post Keynesian Price Theory • Main focus of competition between firms then non-price • Attempt to alter profile of demand towards own product and away from competitors • Hence advertising, marketing, etc. • Attempt to lower/control costs & increase quality • Research & development key focus of firm • Non-manufacturing prices quite different • Minerals, foodstuffs etc. subject to very different dynamics • Products much more homogeneous than manufactures • Supply less under control of producer (esp. agriculture) • Often more difficult to stockpile • Productive capacity more difficult to alter

Post Keynesian Price Theory • As a result, manufacturing prices “administered” while minerals/agriculture “market” • Administered: • Price set by firm on target output costs plus markup • Changed rarely • Changes in demand met by changes in output • Increase in output can allow drop in markup • Market • Price set by some market mechanism, mainly demand-determined • Changed often • Changes in demand initially met by change in price • Change in supply only after sustained change in demand • Prices will rise & fall with the trade cycle

Post Keynesian Price Theory • In PK theory, volatile market prices tend to rise in boom, fall in slump relative to stable administered prices • Distinction between “administered” and “market” prices set by frequency of price changes • 1935 study (Means) • “Administered” < 3 changes/year or less • “Market” ≈ 1 change/month or more • On this basis, following classification of administered vs market prices by industry:

Post Keynesian Price Theory • Means concluded majority of prices were administered • Manufactured goods account for 85% of turnover, so majority of most important prices administered

Post Keynesian Price Theory • Empirically valid theory but… • Limited model of how markups etc. set • Limited development of implications • makes some predictions re inflation, cycles • Increase in administered prices mainly reflects • Changes in distribution of income (higher wages passed on in higher prices): increase during booms • Change in cost of raw materials inputs: increase during booms • Change in economic activity (increase means lower markups needed for same profit): fall during booms • Market prices take brunt of fall during slumps • But lacks real theory of interaction between different prices, etc.

Post Keynesian Price Theory • Interesting example of ideas from recent newspaper: • The 71.5 per cent price rise achieved by iron ore producers this week ... the rest of us should be bracing for a dose of cost-of-living reality as those prices flow through the production chain. Everything ... will be affected. Or, at least, they would be affected if the price rises were passed down the chain.

Post Keynesian Price Theory • The iron ore producers and steel makers can raise prices almost at will. But the story is different as the metal gets closer to the price-sensitive customer. Here price rises can become more a dream than a reality... • The price rises reflected a world shortage ... Steel prices have been jumping at an alarming rate, with the most common industrial feedstock, ... rising from $US330 to $US630 a tonne in the past 14 months. • The pain has been obvious during this profit season. At least it was if companies could secure steel supplies… • "We have all been struggling, not just with prices, but a lack of availability," … "The problem was a lack of notice from BlueScope Steel. There is a three-month lag for us to recover steel price rises." And that's only if Hills can raise prices. "There is a fine line between recovering prices and being able to retain the business," Mr Simmons said. "If you raise the price, a retailer is just as likely to say `Well, we'll get it offshore'."

Post Keynesian Price Theory • Post Keynesian Price Theory • Similar to institutional in that emphasises decision-making power of firm • Firm sets markup & thus price • With some constraint from “degree of monopoly” • Different to neoclassical • Argues market sets price, argues decision-making power of firm limited to non-existent • But theory flawed and empirically invalid • Another pricing theory “Sraffian” or “Classical” • Similar to Post Keynesian in that empirically valid (constant marginal costs) • Similar to neoclassical in that argues prices set by markup

“Sraffian” Price Theory • Based on work of Piero Sraffa • Sraffa used model to critique neoclassical price theory • Followers extend model to alternative theory of price, output • Prices based on • Cost of production (input costs) • Markup (like Post Keynesian) but • In equilibrium, markup • Constant across industries (uniform rate of profit) • Constrained by need to enable each industry to “reproduce itself” • “Reproduce”: Sell output at price that lets it buy inputs and make uniform rate of profit

“Sraffian” Price Theory • Basic idea • In equilibrium, price of output must equal price of inputs times a profit margin: • Equation expressed using Matrix notation • P vector of prices: one for each commodity in economy • Q matrix: each element shows fraction of one input needed to produce one unit of relevant output • Mathematics puts limits on “markup” (profit rate) • Generalised to include Labour inputs needed: • Labour needed also vector: labour-time needed to produce one unit of each commodity in economy

“Sraffian” Price Theory • Many “macroeconomic” ideas extracted from model • One crucial idea: distribution of income (between wages and profits) affects prices • Model rejects neoclassical argument that wage equals “marginal product of labour” • “Marginal product” theory key link between neoclassical micro and macroeconomics • Undermined already by empirical finding that marginal product constant for vast majority of firms • Instead see wage/profit split reflecting relative political strength of workers vs capitalists • Sees legitimate role to industrial relations, etc.

“Sraffian” Price Theory • Neoclassical theory • only one set of relative prices will clear market • wage rate simply another price, as is rate of profit • Sraffian: • Income distribution not determined by market but by social/political forces • Except that productivity of economy sets maximum feasible rate of profit • Many different sets of relative prices will clear market • One for each feasible distribution of income

Summing up alternatives • Some guidance from Post Keynesians & Sraffians re pricing for managers • “Supply & demand” can’t explain 95% of prices • In general, prices set by markup on costs • Markup constrained by • Competitive pressures • Productivity of industry • Minerals/agriculture largely demand-determined prices • But theories don’t explain all prices • Pricing theory for new products • Pricing theory for assets (Finance section of subject)

New products • Doesn’t fit Post Keynesian or Sraffian models because • Both refer to established products • Sraffian (in particular) considers equilibrium positions • Can’t fit into neoclassical model either • Model flawed for all products • More importantly, even if model was OK • Model fits equilibrium only when new products are “disequilibrium” phenomena • In equilibrium, profits are zero • Best understood by “Austrian” school of economics • In particular, Joseph Schumpeter: “in an exchange economy … the prices of all products must, under free competition, be equal to the prices of the services of labor and nature embodied in them…” (30)

New products • Schumpeter accepted neoclassical “general equilibrium” as accurate model of unchanging economy • Defines profit as surplus of receipts over cost • In equilibrium, receipts exactly equal cost in all industries • All products sold at marginal cost (assuming rising MC) • Wages equal marginal product of labour • Return to capital equals marginal product of capital • But “capital” (machinery) itself an assembly of products • All paid for at marginal cost • Hence profit zero

New products • “The businessman considers as his costs those sums of money which he must pay to other individuals, in order to procure his wares or the means of producing them, that is his expenses of production. We complete his calculation in that we also include in costs the money value of his personal efforts. Then costs are in their essence price totals of the services of labor and of nature. And these price totals must always equal the receipts obtained for the products. To this extent, therefore, production must flow on essentially profitless.” (31) • But profit the driving motive of production in capitalist economy! • Yes, but not in equilibrium (argues Schumpeter)

New products • In Schumpeter’s vision, profit arises out of change • Conventional (neoclassical) economic model describes system in static equilibrium • Describes state of rest given one set of data • Ignores process of change to new state of rest after change • Schumpeter argues profit arises in the process of change from one state of rest to another • Hence conventional economics unable to understand profit • Also unable to understand pricing or strategy • Need model of discontinuous change that disturbs equilibrium

New products • Neoclassical economics “ describes economic life from the standpoint of the economic system's tendency towards an equilibrium position, which tendency gives us the means of determining prices and quantities of goods, and may be described as an adaptation to data existing at any time… These tools only fail … where economic life itself changes its own data by fits and starts. “Static" analysis is not only unable to predict the consequences of discontinuous changes in the traditional way of doing things; it can neither explain the occurrence of such productive revolutions nor the phenomena which accompany them. It can only investigate the new equilibrium position after the changes have occurred.” (62-63)

New products • Schumpeter builds model of economic development that • Uses neoclassical as description of equilibrium • Adds process of qualitative change • Explains profit as outcome of one of 5 types of qualitative change caused by entrepreneurial activity • “(1) The introduction of a new good … • (2) The introduction of a new method of production… • (3) The opening of a new market… • (4) The conquest of a new source of supply of raw materials or half-manufactured goods… • (5) The carrying out of the new organisation of any industry” (66) • Explains introduction (& pricing) of new products • In doing so, overturns many conventional economic beliefs not as false, but as only applying in equilibrium

Schumpeter’s model • Simplifying assumptions • All innovation done by new firms • “it is not essential to the matter - though it may happen - that the new combinations should be carried out by the same people who control the productive or commercial process which is to be displaced by the new.” (66) • All resources (land, labour, machinery) currently fully employed • “we must never assume that the carrying out of new combinations takes place by employing means of production which happen to be unused. In practical life, this is very often the case... This certainly is … a favorable condition ... [But] as a rule the new combinations must draw the necessary means of production from some old combinations … we shall assume that they always do so.” (67-68)

Managerial Economics