The Economics of Business

The Economics of Business Class 12 Outline Harvard Extension School Instructor: Bob Wayland Teaching Assistant: Natasha Wambebe

In Previous Episodes of E1600 How did Frank Knight distinguish risk and uncertainty? Is profit the reward for bearing risk? If people have to make decisions under uncertainty, how does Simon suggest they proceed (i.e. what are the essential simplifications)? How does Nelson and Winter’s notion of the competency puzzle relate to Simon’s bounded rationality If you are familiar with Bayesian statistical analysis, how would you connect it with the sort of judgment defined by Knight and the acquisition of expertise described by Simon? Thorstein Veblen said, “The addiction to sports, therefore, in a peculiar degree marks an arrested development in man’s moral nature.” Is this consistent with neoclassical utility theory? Why would anyone listen to this man? incomplete w/o oral accompaniment

Veblen on Advertising… Veblen also said, “Advertising is competitive; the greater part of it aims to divert purchases, etc., from one channel to another channel of the same general class. And to the extent to which the efforts of advertising in all its branches are spent on this competitive disturbance of trade, they are, on the whole, of slight if any immediate service to the community.Such advertising, however, is indispensable to most branches of modern industry; but the necessity of most of the advertising is not due to its serving the needs of the community nor to any aggregate advantage accruing to the concerts which advertise, but to the fact that a business concern which falls short in advertising fails to get its share of trade.Each [business] concern must advertise, chiefly because the others do.” How might Lancaster respond? How might Stigler respond? incomplete w/o oral accompaniment

Information Costs Recall Coase’s argument for transactions costs, in particular identifying sellers and prices, as a cost of using the market Alchian and Demsetz, emphasized the metering costs of using resources in cooperative production Simon emphasized the difficulty of finding and using information relevant to decisions Stigler noted that buyers and sellers are searching for one another and that contrary to the classical model of one, uniform, market clearing price there is usually a distribution (dispersion) of prices incomplete w/o oral accompaniment

George Stigler and The Economics of Information Information “occupies a slum dwelling in the town of economics” Price dispersion is a manifestation and measure “of ignorance in the market” Some dispersion is the result of heterogeneity (recall Lancaster multi-attribute goods) but some is ignorance Transactions costs e.g. re-labeling all goods, comparing all rivals, seeking all prices inhibit price uniformity At any time, a distribution (probably skewed right) prevails for prices incomplete w/o oral accompaniment

Sampling and Searching Stigler’s marketplace is similar to a jar with equal numbers of black ($3) and white ($2) marbles. The probability of drawing a white or a black ball is .5. therefore the expected first draw value is: E(P) = .5($3) + .5($2) =$2.50 First draw is for maximum or minimum value; continue the experiment, our expected minimum price observation converges on the real minimum of $2.00. Chances of drawing a $3 or a $2 ball on the second try is still .5 but, the chances of drawing the same value ball as from the first draw is only .5 * .5 or .25 Chance of drawing a white ($2) ball after three draws is same as one minus chance of drawing 3 black balls: 1- (.5*.5*.5) = 1 - .12.5 = .875 Now the expected minimum price is .875*($2) + .125*($3) = $2.125 incomplete w/o oral accompaniment

Sampling and Searching continued incomplete w/o oral accompaniment

Expected Incremental Minimum Price incomplete w/o oral accompaniment

Introduce the Search Costs to Find Optimal As always we equate the marginal or incremental return to the marginal cost. Assume a $.10 constant search cost: incomplete w/o oral accompaniment

Search and Recurrent Purchase Stigler ignores the second term which he believes is usually minor That may not be the case, especially for recurrent purchases or contracts. The demand curve below shows increase in one consumer’s purchase program as she discovers the lower prices available. (q = 30 – 2p). incomplete w/o oral accompaniment

Uniform Distribution of Prices • In a uniform distribution (sometimes called a rectangular distribution) the frequency or probability of every value is the same. Flipping a coin, tossing a die… • Normalized by dividing all values by the maximum value, resulting in distribution from 0 to 1. • Normalized form of the uniform distribution properties: • The distribution of minimum prices with n searches is: • The average minimum price is: • Finally, the variance of the average minimum price is: incomplete w/o oral accompaniment

Search and Sampling As you increase number of searches, your chances of finding a representative from the lower end increase: incomplete w/o oral accompaniment

Expected Savings for Incremental Searches • Ceteris paribus: expected net savings of an incremental search will be influenced by: • Greater the higher the expenditure on the commodity. You will search longer and harder for a car than for a popsicle. • The larger the fraction of the buyer’s expenditures represented by the commodity, the greater the potential savings and hence the greater the amount of search. • Greater the dispersion of the prices. If prices are all over the place, you will sense that looking further may well pay off. • The greater the geographicalextentof the market the larger will be the cost of search and therefore less will be undertaken. • Smaller the higher the cost per search. If sellers are widely separated or it is difficult to compare quality or other factors, you will settle sooner. Conversely, if search is facilitated by the Internet, Consumer Reports, or other agents, you can search more extensively. incomplete w/o oral accompaniment

Expected Savings Per Incremental Search, continued • The higher the positive correlation of prices over successive searches, the less investment in search in subsequent periods. If buyer finds that repeated searches reveal the same results, he is likely to reduce or eliminate searches for that product • Gives rise to reputational advantages, or a form of brand equity, • Stigler suggests that goodwill can be defined as the propensity to purchase without significant re-searching • Tendency to “lock-in” perceptions formed by multiple searches explains why Wal-Mart seeks to be identified as the low cost supplier and maintain an everyday low price policy (“sales” are a form of search-provoking tactic). • Explains why bad reputations are so hard to shed – people have to go back to searching and must have a strong incentive to do so. Hyundai, for example, had to introduce exceptional warranties to offset the bad taste left by their earlier low quality. • Explains why tourists, without accumulated knowledge of prices, pay more than locals • The need for search never goes completely away; there will always be some price dispersion: • Information becomes obsolete with shifting supply and demand patterns. • Retailers change strategies, some are slower to re-price than others, • Local conditions may diverge from regional or national norms. incomplete w/o oral accompaniment

Advertising • Stigler, like Lancaster, takes a kinder view of advertising than did (do) many economists, • Advertising providesinformation for buyers • Advertising for buyers reduces the search cost of buyers • In its absence (especially price advertising), buyers would have to spend more to find the best price and therefore would succeed less often with the result that less would be purchased. incomplete w/o oral accompaniment

Advertising, continued Consider advertising a way to inform N customers where c=g(a) is the proportion reached, a is the volume of advertising. Generally assume diminishing returns at some point What about viral advertising? incomplete w/o oral accompaniment

Advertising, continued • Let N be total of potential customers • Let b equal the number of new customers who are born or die each period then the • Path of informed customers will be • cN in the first period • In the second period cN(1-b) customers will still be informed and cbN new potential customers will be reached while c[(1-b)N – cN(1-b)] of the old potential customers not reached the first time will now be informed. • Total is now: cN[1+ (1-b)(1-c)] incomplete w/o oral accompaniment

Advertising • You can generalize this sequence into an infinite series over k periods and then find the limit as k gets large as: cN/1-(1-c)(1-b) =N • The proportion of buyers informed, , thus depends on c and b. As c and/or b are large relative to 1 (as proportions both must be less than or equal to 1) then  will become larger • If there are r sellers advertising, then  is the probability of any one of them reaching any particular customer and the number of sellers therefore known to an average buyer is between 0 and r with a mean of r and variance r(1-). • The more advertising and by more sellers, the larger the number of sellers known to each buyer and the lower the variance in knowledge among buyers. • Sellers will invest in marketing so long as the incremental revenue from more contacts, which requires an estimate of propensity to buy for each new contact, is greater than or equal to the cost of reaching an incremental prospect. incomplete w/o oral accompaniment

Brokers as Information Appliances • Advertising is less effective when there are relatively few buyers as a percentage of the medium’s circulation or viewership. Specialized dealers (brokers) arise in this situation. • My friend Larry Rayman, president of GTI Power, is a specialist in quickly finding and delivering aircraft components which he can do by knowing a vast multitude of operators and suppliers. • Operators, distributors, and manufacturers contact him about needs and availability of parts. • Larry is essentially an information appliance. • Efforts to computerize the market haven’t worked so far. • Why do you think Larry has not been digitally displaced? incomplete w/o oral accompaniment

Advertising, continued • Advertising mediums have to attract potential buyers in order to offer value to sellers. • The creation of newspaper or television program can be viewed as a device to assemble potential buyers for the advertisers. • Hence concern about ratings and demographics. • In conclusion, Stigler notes that ignorance is like sub-zero weather (recall that he taught at the University of Chicago). We can spend to reduce its effects and even achieve a degree of comfort but it is uneconomic to eliminate all of its effects. So too we can neither eliminate nor ignore the cold winds of ignorance. incomplete w/o oral accompaniment

Thoughts for Discussion Stigler, like Simon, does not assume hyper-rationality (e.g. omniscience on market prices) on the parts of buyers and sellers. Is his model of search a form of bounded rationality? Stigler describes search costs and investment in them as part of the product transaction. Does this anticipate Williamson’s notion of transactions costs as an element to be considered in choosing among governance or contracting relationships? Does Stigler’s treatment of search costs comport with Coase’s notion of costs to use the market? incomplete w/o oral accompaniment

The Economics of Business