BUS7500 Managerial Economics

1. BUS7500Managerial Economics Week 4 Dr. Jenne Meyer

2. Naked Economics • Chapter 3: Government and the Economy • Chapter 4: Government and the Economy II • Chapter 5: Economics of Information • Key learnings/take-aways?

3. Chapter 9Relationships Between Industries: The forces moving us towards long-run equilibrium

4. Chapter 9 – Summary of main points • A competitive firm can earn positive or negative profit in the short run until entry or exit occurs. In the long run, competitive firms are condemned to earn only an average rate of return. • Profit exhibits what is called mean reversion, or “regression toward the mean.” • If an asset is mobile, then in equilibrium the asset will be indifferent about where it is used (i.e., it will make the same profit no matter where it goes). This implies that unattractive jobs will pay compensating wage differentials, and risky investments will pay compensating risk differentials (or a risk premium).

5. Summary of main points (cont.) • The difference between stock returns and bond yields is a compensating risk premium. When risk premia become too small, some investors view this as a time to get out of risky assets because the market may be ignoring risk in pursuit of higher returns. • Monopoly firms can earn positive profit for a longer period of time than competitive firms, but entry and imitation eventually erode their profit as well.

6. Introductory Anecdote: Good to Great • In 2001, Jim Collin published Good to Great, a book detailing how 11 companies used management principals to go from “good” to “great” • By 2009 many of these same companies were bankrupt – they had done amazingly well during the research period but failed to outperform the market after the book’s publication. Why? • Mr. Collin’s made two fatal errors • The “fundamental error of attribution” • Successful firms aren’t necessarily successful because of their observed behavior. (this will be discusses in a later chapter) • Ignoring long-run forces that erode profit. • Competition erodes above-average profit

7. Competitive firms • Definition: A competitive firm is one that cannot affect price. • They produce a product or service with very close substitutes so they have very elastic demand. • They have many rivals and no cost advantage over them. • The industry has no barriers to entry or exit. • Competitive firms, • cannot affect price; they can choose only how much to produce • Can sell all they want at the competitive price, so the marginal revenue of another unit is equal to the price (sometimes called “price taking” behavior). • For competitive firms price equals marginal revenue, so if P>MC, produce more and if P<MC, produce less

8. Mean reversion of profits

9. Indifference principle • The ability of assets to move from lower- to higher-valued uses is the force that moves an industry toward long-run equilibrium. • Definition: If an asset is mobile, then in long-run equilibrium, the asset will be indifferent about where it is used; that is, it will make the same profit no matter where it goes. • Discussion: Suppose that San Diego is a lot more attractive than Nashville. What will happen? • Discussion: Michael Porter has tried to convince businesses to re-locate in the inner city. Is this a good idea?

10. Finance: risk vs. return • Proposition: In equilibrium, differences in the rate of return reflect differences in the riskiness of the investment, e.g. risk premium • Expected return = (E[Pt+1] - Pt)/Pt • The higher return on a risky stock is known as the risk premium • In equilibrium, differences in the rate of return reflect differences in the riskiness of an investment. • Risk premia are analogous to compensating wage differentials: just as workers are compensated for unpleasant work, so too are investors compensated for bearing risk

11. Monopoly (different story, same ending) • Definition: A monopoly firm is one that faces a downward sloping demand curve. • They produce a product or service with no close substitutes; they have no rivals; and there are barriers to entry, so no other firms can enter the industry. • Proposition: In the very long run, monopoly profits are driven to zero by the same competitive forces. • Entry makes demand more elastic (P-MC)/P=1/|e|, which forces price back down towards MC. • Example: 1983 Macintosh was priced very high when it first appeared. Eventually, though, Windows copied the OS, and price was forced back down.

12. Alternate intro anecdote • In 1924, Kleenex tissue was invented as a means to remove cold cream. • After studying customer usage habits, however, the manufacturer (Kimberly-Clark) realized that many customers were using the product as a disposable handkerchief. The company switched its advertising focus, and sales more than doubled. • Kimberly-Clark built a leadership position by creating an innovative use for a relatively common product.

13. Alternate intro anecdote (cont.) • As others saw the profits, however, they moved into the market. • The managers of the company maintained profitability through a continuing stream of innovations and investment in advertising/promotion • Printed tissue in the 1930’s • Eyeglass tissue in the 1940’s • Space-saving packaging in the 1960’s • Lotion-filled tissue in the 1980’s. • Without this continuing stream of innovations and brand support, the product’s profits would have been slowly eroded away by the forces of competition.

14. Chapter 10Strategy – The Quest to Keep Profit from Eroding

15. NetFlix • How the company currently makes money? • Will this strategy will make money in five years? • You’re the CEO, what would you do?

16. Classroom Exercise • 4 teams • You all make textbooks. Current price of manufacturing 250pp textbook is $25.00 • You are working on your 5 year strategic plan. • What is your plan to compete?

17. Introductory anecdote • In 1964, an MIT professor founded a technology company. • One year later, the company launched it’s first product – a loudspeaker with excellent technological performance. • Regardless, the loudspeaker was a complete failure in the market. No one liked the design of it and turned to complimentary products. • Four years later the company produced another loudspeaker. The company was forced to rely on door-to-door sales to convince consumer’s of the quality of the product. • Baring the rocky start, the company stuck with it and continued to produce innovative products. Now annual revenues have grown to $2 billion and the company employs over 9,000 people.

18. Introductory anecdote (cont.): The key to success • In 2006, a survey of American households found that consumers voted this company the most trusted technology brand. • How did they achieve this success? • According to the company’s former president: “'Our challenge is to prod people into being innovative and using their creativity to do something that's better. In the long run, this is the source of sustainable advantage over our competition.” • The continuous stream of product innovations coupled with aggressive marketing and innovative control of its supply chain created a competitive advantage that rivals found difficult to match

19. Sustainable Competitive Advantage • Succeeding in a competitive market requires a company to find and protect an advantage. • Warren Buffett’s most important investment criterion: “sustainable competitive advantage." • SCA creates a “moat” around the company to help protect its profits from the forces of competition. • A company's prosperity is driven by how powerful and enduring its competitive advantages are. • Stock price = discounted flow of future profits • The challenge is to keep profits from eroding

20. Strategy – Trying to Slow Erosion • Firms have a competitive advantage when • They can price lower than competitors • Or they can offer a superior product at a similar price to competitors • Strategy is about raising price or reducing cost. Really successful firms manage to do both.

21. Sources of economic profit • What is the key to competitive advantage and positive economic profit? • Two schools of thought • Industrial organization (IO) economics – choose the right industry. • Resource-based view (RBV) – build the right firm.

22. Industry (IO) view of strategy • Industry is the key issue – focuses on the external environment. • Industry structure determines the conduct of firms, which in turn determines their performance. • Typical structural characteristics that are of interest to IO researchers include barriers to entry, product differentiation among firms, and the number and size distribution of firms. • The key to generating economic profit for a business is its selection of industry. According to the Five Forces model of Michael Porter, the best industries are characterized by: • High barriers to entry, Low buyer power, Low supplier power, Low threat from substitutes, Low levels of rivalry between existing firms, (Cooperation from complementary products) • So, the advice is to pick a good industry and work to make it even more attractive. • For a multi-product company industry analysis may need to be done on a product-by-product basis.

23. Five Forces (cont.): Entrants • Economic profits tend to draw new entrants • Entrants erode the profit of an industry, so barriers are made to prevent, or slow, their entry. Some barriers are, • government protection (e.g., patents or licensing requirements) • proprietary products • strong brands • high capital requirements for entry • lower costs driven by economies of scale. • Substitute products can still erode a firm’s ability to capture value even if barriers to entry are high. • http://www.youtube.com/watch?v=mYF2_FBCvXw

24. Support for the IO View • Profitability differences do exist across industries

25. Limitations of Five Forces • This view portrays an industry as a zero-sum game. • i.e., the way you get a bigger piece of the pie is to take it from one of the other participants in the industry • Although this is one way to view competition, companies can also work with other industry participants to try to build a larger pie. • With a larger pie, everyone’s slice grows bigger • Some economists recommend that as a complement to a Five Forces analysis, which focuses on threats in the industry, that firms also evaluate the Value Net of the industry for cooperative opportunities.

26. The force that Porter forgot • Preston McAfee was the first to realize that Michael Porter's famous industry analysis leaves out one crucial force: cooperation from complements. • A company must decide whether to pursue a "product" or a "platform" strategy: • “Put simply, a product is largely proprietary and under one company’s control, whereas an industry platform ... requires complementary innovations to be useful, and…is no longer under the full control of the originator..” • One of the biggest mistakes a company can make is to pursue a product strategy and fail to recognize the platform value of their product. • E.g., 1983 Macintosh computer price product high; forgot about the value of the Macintosh platform. In contrast, MSFT recognized the value of the DOS platform.

27. The Resource-Based View • According to the resource-based view, individual firms may exhibit sustained performance advantages due to the superiority of their resources (internal focus) • Resources are defined as “the tangible and intangible assets firms use to conceive of and implement their strategies” • Two primary assumptions underlie the RBV: • resource heterogeneity (firms possess different bundles of resources); • resource immobility (since resources can be immobile, these resource differences may persist). • If a resource is both valuable and rare, it can lead to at least a temporary competitive advantage over rivals.

28. The Resource-Based View (cont.) • Resources that may generate temporary competitive advantage do not necessarily lead to a sustainable competitive advantage. • SCA requires that resources must be difficult to imitate or substitute. • Some conditions that make a resource hard to imitate are, • Resources that flow from a firm’s unique historical conditions will be difficult for competitors to match. • If the link between resources and advantage is ambiguous, then competitors will have a hard time trying to re-create the advantage. • If a resource is socially complex (e.g., organizational culture), rivals will find it difficult to duplicate the resource. • These resources and capabilities may include: • Technology, physical capital, intellectual assets, human capital, financial resources, organizational excellence

29. Some advice you can follow • Be wary of any advice that claims to identify critical resources or capabilities that successful companies have to develop in order to gain a competitive advantage. • explanations such as these often mistakenly conclude a causal relationship when only a correlation exists. • Publicly available knowledge is not going to help you create a competitive advantage. • For example, you read that having a CMEO (Chief Managerial Economics Officer) in your company leads to a competitive advantage. You decide to hire a CMEO for your business and no competitive advantage follows. What happened?

30. Generic Strategies • There are three basic strategies a firm can follow to generate better economic performance and keep ahead of competitors. • Reduce costs • Reduce intensity of competition • Differentiate product • Example: Perdue Chicken – successful differentiation • Example: Prelude Lobster – fruitless attempt at differentiation

31. Chapter 11Using Supply and Demand: Trade, Bubbles, and Market Making

32. Summary of main points • In the market for foreign exchange, the supply of pounds includes everyone in Britain who wants to buy Icelandic goods, or invest in Iceland. To do so, they must “sell pounds to buy krona.” The supply of pounds is also equal to the demand for krona. • In the market for foreign exchange, the demand for pounds includes everyone in Iceland who wants to buy British goods, or invest in Britain. To do so, they must “sell krona to buy pounds.” The demand for pounds is also equal to the supply of krona. • The so-called “carry trade,” borrowing in foreign currencies to spend or invest domestically, increases demand for the domestic currency, appreciating the domestic currency. However, borrowing in foreign currency to buy imports or invest in a foreign country does not affect the exchange rates.

33. Summary of main points (cont.) • Currency devaluations help suppliers because they make exports less expensive in the foreign currency; but they hurt consumers because they make imports more expensive in the domestic currency. • Once started, expectations about the future play a role in keeping bubbles going. If buyers expect a future price increase, they will accelerate their purchases to avoid it. Similarly, sellers will delay selling to take advantage of it. • You can potentially identify bubbles by using the “indifference principle” of Chapter 9 to tell you when market prices move away from their long-run equilibrium relationships.

34. Foreign Exchange • Why trade one currency for another? • To invest in a foreign country, or to buy exports from a foreign country. • This increases demand for the foreign currency. • British consumers “sold pounds to buy krona” so they could deposit krona in Icelandic banks. • Example: An Icelander buys American real estate. The krona used to purchase the house must be exchanged for dollars in order to complete the transaction • An easier way to think of this is that foreign goods can be bought only with foreign currency. The buyer must sell krona to buy dollars in order to buy the house. • Model this as an increase in Icelandic demand for dollars. • The exchange rate of krona to dollars is an equilibrium price set so that the supply of dollars equals the demand for dollars

35. Carry trade • The Carry trade: (from Iceland’s point of view) Icelanders borrow pounds in order to invest domestically. • Why? • When the cost of borrowing domestically (domestic interest rates) increases, Icelanders find a cheaper source of funds – they borrow from foreign countries with lower interest rates. • They then sell the borrowed pounds to buy krona • The supply of pounds in Iceland increases, and the pound depreciates. • Looking back at the graph though, the pound never fell versus the krona. • Why not?

36. Krona vs. Pound • The missing piece: Iceland’s foreign borrowing was occurring at the same time as increased import consumption. • To consume imports, Icelanders sold krona to buy pounds. • The exchange rates did not change because demand for the pound was increasing at the same time supply was increasing. • The fall: In 2008, however, after the run on the Icelandic banks, many investors sold krona to buy pounds. • Demand for pounds increased – an increase in demand leads to higher prices – the pound appreciated

37. The long-run: purchasing power parity • Definition: purchasing power parity means that exchange rates and/or prices adjust so that tradable goods cost the same everywhere. • If they didn’t, there would be a higher-valued use for the good, i.e., importers could make money by buying the good in one country and selling it in another. An act sometimes referred to as arbitrage. • The Economist’s Big Mac index: In July 2007, a big mac cost $7.61 in Iceland, $3.41 in the US, and $1.45 in China. • The theory of purchasing power parity says these prices should move closer together. • Here is the mechanism: to buy Chinese Big Macs, US consumers would sell dollars to buy yuan. The yuan appreciates, and it would then take more dollars to buy a Big Mac in China. • The index thus shows which currencies are over- or under-valued relative to the dollar

38. Inflation from devalution • As the krona fell in value relative to the pound, inflation in Iceland rose dramatically

39. Bubbles • Definition: bubbles (if they exist) are prices that cannot be explained by normal economic forces. • Here is what economists think they know about bubbles: • expectations about the future play a role in keeping bubbles going: • If buyers expect a future price increase, they will accelerate their purchases to avoid it. • Sellers will delay selling to take advantage of it. • Both changes increase price. • In this sense, expectations are self-fulfilling.

40. Bubble example: US housing • In 1993, government policies began encouraging low-income citizens to buy houses – by reducing qualifications for home borrowing from government-sponsored lenders like Fannie Mae. • This led to an increase in demand for houses – the “big economic development” that started the bubble

41. US housing (cont.) • Housing prices increased dramatically, especially where supply was limited. • Frequently in areas with strict zoning - zoning laws make supply less elastic (a steeper supply curve) which exacerbates price increases when demand increases • Many investors expected prices to continue to rise– buying continued and lenders did not seem concerned. • Two well-known economists disagreed about the existence of a housing bubble: • David Lereah believed the house price increase could be explained rationally - low inventories, low mortgage rates, and favorable demographics caused by a big increase in boomers and retirees, who often buy second homes. • Robert Shiller was wary of a bubble. He identified the bubble by noting that house prices were becoming very expensive relative to rents. In long-run equilibrium, homeowners should be indifferent between renting and buying.

42. US housing (cont.) • In the end, Professor Shiller was right – prices peaked in 2006 then fell dramatically

43. Discussion • Key learnings? • Next weeks assignments.