Managerial Notes For All Chapters

CHAPTER
1 Introduction:
What This Book is About
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SUMMARY OF MAIN POINTS
● Problem solving requires two steps:

1) figure out what’s causing the problem
2) figure out how to fix it
● For both steps, predict how people behave
● rational-actor paradigm: assumes that people act
rationally, optimally, and self-interestedly.
● Simply put, people respond to incentives.
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● Good incentives come from rewarding good
performance.
• Ex: commission on sales
● A well-designed organization aligns employee
incentives with organizational goals.
● Specifically, employees have enough information to
make good decisions, and the incentive to do so.
● Three questions to find the source of the problem:
1) Who is making the bad decision?
2) Does the decision maker have enough information
to make a good decision?
3) Does the decision maker have the incentive to make
a good decision?
● Answers to these questions will suggest solutions:
1) Letting someone with better information or
incentives make the decision
2) Giving the decision maker more information
3) Changing the decision maker’s incentives.
Problem: Over-bidding OVI gas tract
● A young geologist was preparing a bid

recommendation for an oil tract in the Gulf of
Mexico.
● The geologist knew the productivity of nearby
tracts also owned by the company.
● Knowing this, he recommended a bid of $5 million.
● Senior management bid $20 million – far over the
next highest bid of $750,000.
● What, if anything, is wrong?
Problem solving
● The goal of this text is to provide tools to help

identify and solve problems like this.
● Two distinct steps:
1) Figure out what’s wrong
• i.e., why overbidding occurred
2) Figure out how to fix it
Model of Behavior
● Both steps require a model of behavior

• Why are people making mistakes?
• What can we do to make them change?
● Economists use the rational-actor paradigm to model
behavior.
● The rational actor paradigm states:
• People act rationally, optimally, self-interestedly
• Meaning, they respond to incentives – to change
behavior you must change incentives.
Answer to Overbidding Problem
● Answer the three questions:

1) Senior management made the bad decision to overbid.
2) They had enough information to make the right
decision.
3) They didn’t have the incentive to do so.
● A bonus system created incentives to over-bid.
• Senior managers were rewarded for acquiring reserves
regardless of their profitabilit.y
• They had the young geologist “do what he could” to
increase the size of estimated reserves.
• Bonuses also created an incentive to manipulate the
reserve estimate.
Solution to Overbidding Problem
Now that we know what is wrong, how do we fix it?

● Let someone else decide? NO
● Change information flow? NO
● Change incentives? YES
• Change performance evaluation metric
• Ex: Increased profitability as measurement of success instead of
increased acquired reserves
• Reward scheme
• Ex: Make bonuses tied to profitability, not acquired reserves
NAR Problem
● In 2006, a TV reporter was sent into a National

Auto Repair (NAR) shop with a perfectly good
car
● The reporter came out with a new muffler and
transmission – and a bill for over $8,000
● The news story badly hurt NAR’s profits
● How do you solve this problem?
Problem-Solving Algorithm

• The mechanic recommended unnecessary repairs.
2) Does the decision maker have enough information to
make a good decision?
• Yes, in fact, the mechanic is the only one with enough
information to know whether repairs are necessary.
Problem-Solving Algorithm
3) Does the decision maker have the incentive to

make a good decision?
• No, the mechanic is evaluated based on the amount
of repair work he does, and receives bonuses or
commissions tied to the amount of repair work.
NAR Solution
● There was an incentive issue

● NAR tried two solutions
1) reorganized into two division – led to colluding
2) adopted flat pay – led to less incentive to work hard
● Suggested resolution: add an additional performance
evaluation metric to original commission scheme
• Ex: Sporadically send in “secret shoppers” like the
news reporter
● This shows the trade-offs you face when creating
solutions
Ethics and Economics
● The rational-actor paradigm can make students

uncomfortable
• It seems to disregard personal ethics the guide
behavior.
● You have to understand why unethical behavior
occurs to fix it though
• Be able to anticipate opportunistic behavior to know
how to avoid it
Value System
● Debates about ethics and economics really are

about different value systems
● Deontologists: actions are good or ethical if they
conform to a set of principles (ex: The Golden
Rule)
● Consequentialists: actions are judged based on
whether they lead to a good consequence
● Economics is more consequentialist
• Uses analysis to understand the consequences of
different solutions
CHAPTER
2 The One Lesson
of Business
● Voluntary transactions create wealth by moving assets from
lower- to higher-valued uses.
● Anything that impedes the movement of assets to higher-
valued uses, like taxes, subsidies, or price controls, destroys
wealth.
● Economic analysis is useful to business for identifying assets
in lower-valued uses.
● The art of business consists of identifying assets in low-
valued uses and devising ways to profitably move them to
higher-valued ones.
● A company can be thought of as a series of transactions.
A well-designed organization rewards employees who
identify and consummate profitable transactions or who stop
2
unprofitable ones
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Kidney Transplants
● Two prominent hospitals recently refused patients for

kidney transplants because the organs were from
“directed donations.”
• The kidneys were meant for specific people
● Demand for organs is high – far exceeding supply –
and many never receive them.
● Despite high demand and low supply, buying and
selling organs is illegal.
● Why?
Apartments
Suppose you want to move from Detroit to Nashville
● First, you would try a two-way trade Detroit Nashville
● Failing that, you’d try a three-way Detroit Nashville

connection with another city Los Angeles
● Need to find correct trades with

correct timing = difficult!
● Like with kidney transplants, compatibility problems

lead to inefficiency
Capitalism 101
To identify money-making opportunities,

you must first understand how wealth is created
(and sometimes destroyed).
● Key note: Wealth is created when assets are moved
from lower to higher-valued uses
● Definition: Value = willingness to pay
Desire + Income = You want something + you can pay for it
● Key note: Voluntary transactions, between individuals

or firms, create wealth.
• Meaning, people create wealth by pursuing self-interest.
Housing Example
A house is for sale:

● The buyer values the house at $130,000
• This is the buyer’s top dollar – willingness to pay
● The seller values the house at $120,000
• This is the seller’s bottom line – won’t accept less
The buyer and seller must agree to a price that “splits”
surplus between buyer and seller. Here, $128,000.
Surplus
The buyer and seller both benefit from this transaction:

● Buyer surplus = buyer’s value minus the price
$130,000 ‐ $128,000 = $2,000 buyer surplus
● Seller surplus = the price minus the seller’s value

$128,000 ‐ $120,000 = $8,000 seller surplus
● Total surplus = buyer + seller surplus = difference in

values
$2,000 + $8,000 = $10,000  $130,000 ‐ $120,000 = $10,000
$10,000 are the gains from trade
Wealth-Creating Transactions
● Which assets do these transactions move to higher-

valued uses?
• Factory Owners • Corporate Raiders
• Real Estate Agents • Insurance Salesman
• Investment Bankers
● Discussion: How does eBay create wealth?
● Discussion: Which individual has created the most
wealth during your lifetime?
● Discussion: How do you create wealth?
Do Mergers Create Wealth?
● Do mergers follow the wealth-creating engine of

capitalism? Do they move assets to a higher-valued use?
• Our largest and most valuable assets are corporations.
● Ex: Dell-Alienware merger:
• In 2006, Dell purchased Alienware, a manufacturer of
high-end gaming computers.
• Dell left design, marketing, sales and support in
Alienware’s hands.
• Dell took over manufacturing though, using its expertise
to build Alienware’s computers at a much lower cost.
Do Mergers Create Wealth?
● However, many mergers and acquisitions do not

create value
• If they do, value creation is rarely so clear
● To create value, the assets of the acquired firm

must be more valuable to the buyer than to the
seller
Does Government Create Wealth?
● Discussion: What’s the government’s role is wealth creation?

• Enforcing property rights and contracts legal tools that
facilitate wealth creating transactions
• Ensures that buyers and sellers keep gains from trade
● Discussion: Why are some countries so poor?
• No property rights
• No rule of law
● Discussion: Much of the justification for government
intervention comes from the assertion that markets have
failed. One money manager scoffed at this idea. “The markets
are working fine, but they’re giving people answers that they
don’t like, so people cry market failure.”
The One Lesson of Economics
● Definition: An economy is efficient if all assets are employed in

their highest-valued assets.
• This is an unattainable, but useful benchmark
● The One Lesson of Economics: The art of economics consists in

looking not merely at the immediate but at the longer effects of any
act or policy; it consists in tracing the consequences of that policy
not merely for one group but for all groups.
● Must look at the intended and unintended effects of policies to
understand their efficiency
● The economist’s solution to inefficient outcomes is to argue for a
change in public policy.
● Business person’s solution is to try to make money on the
inefficiency
The One Lesson of Business
● Definition: Inefficiency implies the existence of

unconsummated, wealth-creating transactions
● The One Lesson of Business: The art of business
consists of identifying assets in lower valued uses
and devising ways to profitably moving them to
higher valued uses.
● In other words, make money by identifying
unconsummated wealth-creating transactions and
devise ways to profitably consummate them.
Destroying Wealth
Anything that stops assets from moving to higher

valued uses is destroying wealth.
• Taxes Destroy Wealth:
• By deterring wealth-creating transactions – when the tax is
larger than the surplus for a transaction.
• Subsidies Destroy Wealth:
• Example: flood insurance encourages people to build in areas
that they otherwise wouldn’t
• Price Controls Destroy Wealth:
• Example: rent control (price ceiling) in New York City
deters transactions between owners and renters
● Which assets end up in lower-valued uses?

Profiting from Inefficiency
● Taxes create a profit opportunity

• Discussion: 1983 Sweden tax
● Subsidies create opportunity

• Discussion: health insurance
● Price-controls create opportunity

• Discussion: Regulation Q. & euro dollars
• Discussion: What about ethics?
Wealth Creation in Organizations
● Companies = a collection of transactions

● They buy raw materials (capital, labor, etc.) and create
and sell higher-valued goods and services
● Can equate market-level problems (taxes, subsidies
and price controls) with organization-level goal
alignment problems
• Ex: The overbidding from the oil company = “subsidy”
paid to management for acquiring oil reserves
● Allows us to use the same analysis
CHAPTER
3 Benefits, Costs,
and Decisions
● Costs are associated with decisions, not activities.
● The opportunity cost of an alternative is the profit
you give up to pursue it.
● In computing costs and benefits, consider all costs
and benefits that vary with the consequences of a
decision and only those costs and benefits that vary
with the consequences of the decision. These are the
relevant costs and benefits of a decision.
● Fixed costs do not vary with the amount of output.
Variable costs change as output changes. Decisions
that change output will change only variable costs.
• continued
● Accounting profit does not necessarily correspond to

real or economic profit.
● The fixed-cost fallacy or sunk-cost fallacy means
that you consider irrelevant costs. A common fixed-
cost fallacy is to let overhead or depreciation costs
influence short-run decisions.
● The hidden-cost fallacy occurs when you ignore
relevant costs. A common hidden-cost fallacy is to
ignore the opportunity cost of capital when making
investment or shutdown decisions.
• continued
● EVA® is a measure of financial performance that

makes visible the hidden cost of capital.
● Rewarding managers for increasing economic profit
increases profitability, but evidence suggests that
economic performance plans work no better than
traditional incentive compensation schemes based on
accounting measures.
Big Coal Power Company
Big Coal Power Co. switched to a 8400 coal when the

price fell 5% below the price of 8800 coal
• 8400 coal generates 5% less power than 8800
• The manager was compensated based on the average
cost of electricity, and expected this move to save money
• Instead – company profit reduced
● Why? What happened?
● Discussion: Diagnose the problem.
● Discussion: Come up with a proposal to fix it.
Big Coal Solution
Use our three questions for analysis

• The plant manager made the switch to the lower-priced
8400 coal.
2) Did he have enough information to make a good
decision?
• Yes, presumably he knew that this would reduce his output.
3) Did he have the incentive to make a good decision?
• No, because he was evaluated based on the average cost of
electricity produced at his plant.
Lesson From Coal Problem
● The plant manager should have considered all the

costs of switching to the lower Btu coal
• Namely, the lost electricity
● Average costs can be a poor measure of plant
performance
● Need to align incentives of a business unit with the
goals of the parent company
Background: Types of Costs
● Definition: Fixed costs do not vary with the amount

of output.
● Definition: Variable costs change as output changes.
FIGURE 3.1 Cost Curves

Example: A Candy Factory
● The cost of the factory is fixed.

● Employee pay and cost of ingredients are variable costs.
TABLE 3.1 Candy Factory Costs
Your Turn
Are these costs fixed or variable?

● Payments to your accountants to prepare your
tax returns.
● Electricity to run the candy making machines.
● Fees to design the packaging of your candy bar.
● Costs of material for packaging.
Real Example: Cadbury (Bombay)
● Beginning in 1978, Cadbury offered managers free housing in

company owned flats to offset the high cost of living.
● In 1991, Cadbury added low-interest housing loans to its
benefits package. Managers moved out of the company
housing and purchased houses. The empty company flats
remained on Cadbury’s balance sheet for 6 years.
● In 1997, Cadbury adopted Economic Value Added (EVA)®
• Charges each division within a firm for the amount of capital it uses
• Provides an incentive for management to reduce capital expenditures if
they do not cover costs
● Senior managers then decided to sell the unused apartments

after seeing the implicit cost of capital.
Accounting Costs for Cadbury
TABLE 3.2 Cadbury Income Statement

Cadbury Accounting Profit
● Accounting profit recognizes only explicit costs

● Typical income statements include explicit costs:
• Costs paid to its suppliers for product inputs
• General operating expenses, like salaries to factory
managers and marketing expenses
• Depreciation expenses related to investments in
buildings and equipment
• Interest payments on borrowed funds
Cadbury Accounting Profit vs. Economic Profit
● What’s missing from Cadbury’s statements are

implicit costs:
• Payments to other capital suppliers (stockholders)
• Stockholders expect a certain return on their money
(they could have invested elsewhere)
• “Profit” should recognize whether firm is generating a
return beyond shareholders expected return
● Economic profit recognizes these implicit costs;
accounting profit recognizes only explicit costs
Opportunity Costs & Decisions
Definition: the opportunity cost of an action is what

you give up (forgone profit) to pursue it.
● Costs imply decision-making rules and vice-versa
● The goal is to make decisions that increase profit
● If the profit of an action is greater than the
alternative, pursue it.
Identifying Costs
● Whenever you get confused by costs, step back and

ask, “What decision am I trying to make?”
• If you start with costs, you will always get confused
• If you start with a decision, you will never get
confused
● Apply it to Cadbury:
• The cost of the company of holding onto the
apartments was the forgone opportunity to invest
capital in the company’s organization to earn a higher
return.
Cadbury’s Costs
● Holding on to the flats cost the company £600,000

each year.
● Unless the benefits to the company of holding onto
the apartments were at least £600,000, the capital
was not employed in its highest-valued use.
● The cost of the company of holding onto the
apartments was the forgone opportunity to invest
capital in the company’s organization to earn a
higher return.
● By selling the flats, the company moved the capital
to a higher-valued use.
Relevant Costs and Benefits
● When making decisions, you should consider all costs

and benefits that vary with the consequence of a decision
and only costs and benefits that vary with the decision.
● These are the relevant costs and relevant benefits of a
decision.
● You can make only two mistakes
• You can consider irrelevant costs
• You can ignore relevant ones
● Definition: The fixed-cost/sunk-cost fallacy means you

make decisions using irrelevant costs and benefits
Fixed-Cost/Sunk-Cost Fallacy Examples
Football game:
● You pay $20 for a ticket. At halftime, you’re team is losing by 56 points.
● You say you’ll stay to get your money’s worth, but you can’t get your
money’s worth!
● The ticket price does not vary whether you stay or leave – it’s a sunk
cost and irrelevant.
Launching a new product:

● You are in a new products division and will be able to distribute a new
product through your existing sales force
● You will be forced to pay for a portion of the sales force
● If you believe this “overhead” is big enough to deter an otherwise
profitable product launch, then you’ve committed the sunk-cost fallacy
Hidden-Cost Fallacy
Definition: ignoring relevant costs (costs that vary with the

consequences of your decision) when making a decision
Example: Football game (again)
● You buy a ticket for $20
● Scalpers are selling tickets for $50 because your team is playing
cross-state rivals
● You go to the game, saying, “These tickets cost me only $20.”
WRONG
● The tickets really cost you $50 because you give up the
opportunity to scalp them by going
● Unless you value them at $50, you are sitting on an
unconsummated wealth-creating transaction
Example: Should You Fire an Employee?
● The revenue he provides to the company is $2,500
per month
● His wages are $1,900 per month
● His office could be rented out $800 per month
● YES, you are only making $600 a month from this
employee but could make $800 a month from renting
his office
Subprime Mortgages
● The subprime mortgage crisis of 2008 is a good example

of the hidden-cost fallacy.
● Credit-rating agencies failed to recognize the higher costs
of loans made by dubious lenders.
• Example: Long Beach Financial
• Gave loans out to homeowners with bad credit, asked for no
proof of income, deferred interest payments as long as possible.
● Credit ratings didnt reflect the hidden costs of risky loans
● As a result, many Wall Street investors purchased packaged
risky loans and eventually went bankrupt when the debtors
defaulted.
Hidden cost of capital
● Recall that accounting profit does not necessarily

correspond to economic profit.
● Discussion: Economic Value Added
• EVA®= net operating profit after taxes minus the cost of
capital times the amount of capital utilized
• Makes visible the hidden cost of capital
● The major benefit of EVA is identifying costs.
If you cannot measure something, you cannot control
it.
• Those who control costs should be responsible for them.
Incentives and EVA®
● Goal alignment: “By taking all capital costs into

account, including the cost of equity, EVA shows the
dollar amount of wealth a business has created or
destroyed in each reporting period.
… EVA is profit the way shareholders define it.”
● Discussion: can you make mistakes using EVA?
• Does it help avoid the hidden cost fallacy?
• Does it help avoid the fixed cost fallacy?
Does EVA® work?
● Adopting companies of EPP’s (+ four years)

• ROA from 3.5 to 4.7%
• operating income/assets from 15.8 to 16.7%
● Indistinguishable from non-adopters
• Bonuses increase 39.1% for EVA® firms
• But 37.4% for control group
● Interpretations
• Selection bias?
• NO, cheaper to use existing plans
• Goal alignment, YES.
● EVA® is no better or worse
• Rival EPP’s
• Bonus plans
• Discussion: WHY?
Psychological Biases
● Not enough information or bad incentives are not the only

causes for business mistakes. Often psychological biases get in
the way of rational decision making.
● Definition: the endowment effect means that taking ownership
of item causes owner to increase value she places on the item.
● Definition: loss aversion – individuals would pay more to
avoid loss than to realize gains.
● Definition: confirmation bias – a tendency to gather
information that confirms your prior beliefs, and to ignore
information that contradicts them.
● Definition: anchoring bias – relates the effects of how
information is presented or “framed”
● Definition: overconfidence bias – the tendency to place too
much confidence in the accuracy of your analysis
In class problem (1)
You won a free ticket to see an Eric Clapton concert

(which has no resale value). Bob Dylan is performing
on the same night and is your next-best alternative
activity. Tickets to see Dylan cost $40. On any given
day, you would be willing to pay up to $50 to see
Dylan. Assume there are no other costs of seeing either
performer. Based on this information, what is the
opportunity cost of seeing Eric Clapton?
A. $0 B. $10 C. $40 D. $50
In class problem (2)
You won a free ticket to see an Eric Clapton concert

(which has no resale value). Bob Dylan is performing
on the same night and is your next-best alternative
activity. Tickets to see Dylan cost $40. On any given
day, you would be willing to pay up to $50 to see
Dylan. Assume there are no other costs of seeing either
performer. Based on this information, what is the
minimum amount (in dollars) you would have to
value seeing Eric Clapton for you to choose his
concert?
A. $0 B. $10 C. $40 D. $50
Alternate intro anecdote
● Coca-Cola in the 1980s had very little debt, preferring to raise

equity capital from its stockholders
● The company had a diversified product line, including products
like aquaculture and wine. These other businesses generated
positive profits, earning a ten percent return on capital invested.
● The company, however, decided to sell off these “under-
performing businesses”
● Why?
• At the time, soft drink division was earning 16 percent return on capital
• The “opportunity cost” of investing in aquaculture and wine is the
foregone profit that could have been earned by investing in soft drinks
• A dollar invested in aquaculture and wine is a dollar that was not invested
in soft drinks
• Divisions sold off and proceeds invested in core soft drink business
CHAPTER 4 Extent
(How Much)
Decisions
Do not confuse average and marginal costs.
● Average cost (AC) is total cost (fixed and variable)
divided by total units produced.
• Average cost is irrelevant to an extent decision.
● Marginal cost (MC) is the additional cost incurred by
producing and selling one more unit.
● Marginal revenue (MR) is the additional
revenue gained from selling one more unit.
● Sell more if MR > MC; sell less if MR < MC. If
MR = MC, you are selling the right amount
(maximizing profit!).
• continued
● The relevant costs and benefits of an extent decision

are marginal costs and marginal revenue. If the
marginal revenue of an activity is larger than the
marginal cost, then do more of it.
● An incentive compensation scheme that increases
marginal revenue or reduces marginal cost will
increase effort. Fixed fees have no effects on effort.
● A good incentive compensation scheme links pay to
performance measures that reflect effort.
US Financial Crisis
● The financial crisis began in the subprime housing market,

where government policies encouraged lenders to extend
credit to low-income borrowers (by lowering lending
standards)
● These high-risk loans, or mortgages, were being packaged
into securities by lenders and sold to investors.
● If the risk had been recognized investor demand would
have been low, but rating agencies were too liberal with
AAA ratings, increasing demand for loans.
● The result? A credit “bubble”
● How did this lending crisis arise?
Average Cost Caution!
● Memorial Hospital’s CEO conducted performance reviews of

the hospital departments.
● During this process, the chief of obstetrics proposed an
increase in the number of babies being delivered in his
department.
● The CEO wondered why since the cost of delivering babies
was higher than the revenues brought in.
● The CEO’s mistake: He began with the costs instead of the
decision.
• He committed the fixed-cost fallacy by looking at average cost,
which include costs that do not vary with the decision.
• If he had ignored fixed costs, he would have seen that increasing
the number of deliveries would increase profit.
Background: Average Cost
● Definition: Average cost (AC) is simply the total

cost (TC) of production divided by the number of
units produced (Q).
• AC = TC/Q
● Average costs often decrease as quantity increases
due to presence of fixed costs (FC)
• AC = (VC + FC)/Q
• FC does not change as Q increases
● Key note: Average costs are not relevant to extent
decisions
Background: Average Cost (cont.)
FIGURE 4.1 Average Cost Curve
Memorial Hospital Revisited
● Memorial made 500 deliveries originally

• Fixed cost: $1,000,000
• Variable cost: $3,000/delivery
• Total cost: $1,000,000 + ($3,000 x 500)
• Average cost: total costs/# of deliveries
● Average costs fall as you increase output, but the
variable costs remain constant
● Marginal cost is only $3,000 at Memorial Hospital
Marginal Cost & Marginal Revenue
● Definition: Marginal cost is the additional cost to

make and sell one additional unit of output (Q)
MC = TCQ+1 – TCQ
● Marginal cost is often lower than average cost (due to
fixed costs) but not always
● Marginal costs are what matter in extent decisions
● Definition: Marginal revenue (MR) is the additional
revenue gained from producing and selling one more
unit.
Extent Decisions
● Examples of extent decisions:

• Should you change the level of advertising?
• Should you increase the quality of service?
• Is your staff big enough, or too big?
• How many parking spaces should you lease?
● For extent decisions, we break the decision into
small steps
• If taking a step provides more benefit than cost, take a
step forward
• If not, step backward
Extent (How Much?) Decisions
● This analysis tells you direction of change but not the

distance.
• You can only measure MR and MC at the current level
of output – make a change and re-measure
● If the benefits of selling another unit (MR) are bigger
than the costs (MC), then sell another unit.
● Maxim:
• Produce more when MR>MC
• Produce less when MR<MC
• Profits are maximized when MR=MC
Memorial Hospital Marginal Analysis
● As we mentioned, the MC of a delivery was $3,000

● The MR was $5,000
● Therefore, MR>MC so the hospital was not
delivering enough babies
● This explains why the CEO was wrong
Advertising Extent Decision Example
Answering the “How much advertising?” question

● A $50,000 increase in the TV ad budget brings in
1,000 new customers
● Estimated MCTV is $50 (the cost to get one more
customer)
$50,000 / 1,000 = $50
● If the marginal revenue generated by this customer is
greater than $50, do more advertising.
Advertising Extent Decision Example (cont.)
● You know the direction (do more), but you do

not know how far to go
● You have to take a step and re-compute marginal cost
and benefit to see if you should continue in the
direction your analysis originally pointed
you in
● Also, even if we do not know the marginal revenue,
we can still use marginal analysis to make extent
decisions
• by comparing marginal effectiveness of different media
Competing Strategies & Marginal Analysis
● Example: Compare TV advertising to telephone solicitation

• The opportunity cost of spending one more $ on TV
advertising is the forgone opportunity to spend $ on telephone
solicitation
• Say you recently cut telephone (PH) budget by $10,000 and
lost 100 customers
Estimated MCPH = $100= ($10,000 / 100)
• So, to get one more customer costs $50 for TV and $100 for
phone
MCPH > MCTV so shift ad dollars from phone to TV
● Advice: make changes one-at-a-time to gather valuable

information about marginal effectiveness of each medium
Textile Production Example
● A textile company with manufacturing plants in Latin

America uses SAH=“Standard Absorbed Hours” a measure
of textile factory output
• Allows managers to compare factories making different items,
e.g. t-shirt = 1 SAH while dress=3 SAH
● Suppose Factory A has costs of $30 per SAH while Factory B
has cost of $20 per SAH. How can you profitably use this
information?
● Should you move production to cheaper factory?
• Make sure you are not including fixed costs in the analysis
• Marginal costs matter, not average costs!
• If the $20 and $30 rates are good MC proxies, shift some
production from Factory A to Factory B
Incentive Pay
● Discussion: Royalty rates vs. fixed fee contracts

● How hard to work is an extent decision so you can
design incentives to encourage hard work by using
marginal analysis
● Example: You receive two bids to harvest 100 trees on
your land
• $150/tree or $15,000 for the right to harvest all the trees.
• On your tract there are pines (worth $200) and fir (worth
$100).
• Which offer should you accept?
• Hint: consider the effects of the two bids on the incentives of the
logger.
Tree Harvesting Answer
● The bids have the same face value, but are very
different in terms of logger’s incentives
• Fixed fee: the logger will ignore the $15,000 because it
doesn’t vary with the decision to cut down trees.
• The logger will end up cutting down all trees that are profitable to
cut down, MR>MC
• Royalty Rate: The logger will only cut down trees trees that
generate profit of $150, MR>MC+150
• Mix of $200- and $100-value trees – logger will harvest only the $200
• The landowner receives less money since the logger only harvests one
type of tree
• Royalties deter some wealth-creating transactions as fir trees are not
harvested
Sales Commission Example
Motivating salespeople:
● Expected sales level: 100 units @ $10,000/unit=$1M
• Option 1: 10% commission
• Option 2: 5% commission + $50,000 salary
• Hint: consider incentives for salespeople
● Use Option 1 because MR=$1000/sale > $500/sale,

the MR under Option 2
● The sales force responds to larger marginal benefits
of selling with more effort
• Lower sales effort under option 2 is called “shirking”
Tie Pay to Performance
● A consulting firm COO received a flat salary of

$75,000
• After learning about the benefits of incentive pay
in class, the CEO changed COO compensation to
$50K + (1/3)* (Profits-$150K)
• Profits increased 74% to $1.2 M
• Compensation increased $75K$177K
● Discussion: What are the disadvantages to incentive
pay?
Title?
● American Express offers a Platinum Card to affluent customers

● In 2001, there were approximately 2,000 Platinum cardholders in the
Japanese market. Numbers had been limited to ensure high quality
customer service
● With customer service technology advances, the company considered
expanding number of card holders
● How many more should be added?
• As more members are acquired, average spending per card member decreases
because the financial threshold for membership is lowered
• Costs of customer service rise for each additional member added, and growing
beyond a certain point would require building and operating an additional call
center
• After analyzing the costs and benefits, American Express realized that it should
expand its offering to only 15,000 more Platinum Card members
● We call this an “extent” decision, because the company needed to decide
“how many” platinum cards to provide. In this chapter, we show you how
to make profitable extent decisions.
CHAPTER 5 Investment
Decisions:
Look Ahead and Reason
Back
● Investments imply willingness to trade dollars in the present for dollars in the
future. Wealth-creating transactions occur when individuals with low discount
rates (rate at which they value future vs. current dollars) lend to those with high
discount rates.
● Companies, like individuals, have different discount rates, determined by their
cost of capital. They invest only in projects that earn a return higher than the cost
of capital.
● The NPV rule states that if the present value of the net cash flow of a project is
larger than zero, the project earns economic profit (i.e., the investment earns more
than the cost of capital).
● Although NPV is the correct way to analyze investments, not all companies use it.
Instead, they use break-even analysis because it is easier and more intuitive.
● Break-even quantity is equal to fixed cost divided by the contribution margin. If
you expect to sell more than the break-even quantity, then your investment is
profitable.
• continued
● Avoidable costs can be recovered by shutting down. If the

benefits of shutting down (you recover your avoidable costs)
are larger than the costs (you forgo revenue), then shut down.
The break-even price is average avoidable cost.
● If you incur sunk costs, you are vulnerable to post-investment
hold-up. Anticipate hold-up and choose contracts or
organizational forms that minimize the costs of hold-up.
● Once relationship-specific investments are made, parties are
locked into a trading relationship with each other, and can be
held up by their trading partners. Anticipate hold-up and
choose organizational or contractual forms to give each party
both the incentive to make relationship-specific investments
and to trade after these investments are made.
Title?
● In summer 2007, Bert Matthews was contemplating purchasing a 48-unit

apartment building.
• The building was 95% occupied and generated $550,000 in annual profit.
• Investors expected a 15% return on their capital
• The bank offered to loan Mr. Matthews 80% of the purchase price at a rate
of 5.5%
● Mr. Matthews computed the cost of capital as a weighted average
of equity and debt.
.2*(15%) + .8*(5.5%) = 7.4%
• Mr. Matthews could pay no more than $550,000/7.4% = $7.4 million and still
break even.
● Mr. Matthews decided not to buy the building. A good decision – one year
later, the cost of capital was 10.125% and Mr. Matthews could offer only
$5.4 million for the building.
● This story illustrates both the effect of the bursting credit bubble on real
estate valuations and, more importantly, the relevant costs and benefits of
investment decisions.
Background: Investment Profitability
● All investments represent a trade-off between

possible future gain and current sacrifice.
● Willingness to invest in projects with a low rate of
return, indicates a willingness to trade current dollars
for future dollars at a relatively low rate.
• This is also known as having a low discount rate (r).
• Individuals with low discount rates would willingly
lend to those with higher discount rates.
• Discounting helps you figure out if future gains are
larger than current sacrifice.
Compounding
● To understand discounting, let’s first look at

compounding:
(future value, k periods in the future) = (present value) x (1 + r)K
● Example: If you invest $1 (present value) today at a

10% (r), then you would expect to have $1.10 in one
year.
• In two years, $1 becomes $1.21 = $1.10 x (1+.1)
● A good compounding rule of thumb:
“Rule of 72”: If you invest at a rate of return r,
divide 72 by r to get the number of years it takes to
double your money
Discounting
● Discounting (the inverse of compounding):

Present value = (future value, k periods in the future)
(1 + r)k
● Example: At a 10% r, $1 is worth:
• Next year: ($1)/1.1 = $0.91
• Two years: ($0.91)/1.1 =$0.83
● Discussion: If my discount rate is 10%, would I lend
to or borrow from someone with a discount rate of
15%?
• What does this say about behavior?
Example: Nashville Pension Obligations
● The city of Nashville uses discounting to decide how

much to save for future pension obligations.
● For a pension that pays out $100,000 in 20 years,
with a discount rate of 8.25% Nashville must save:
• $100,000/(1.0825)20 =$20,485
• If the city invests the $20,485 and earns 8.25%, then the
savings will compound in 20 years – unrealistic!
• Somewhat of high savings rate that may not be returned;
however, a high savings rate means less current spending,
which is politically popular
• A more realistic (but less popular) discount rate would be
6.5%, which would lead to saving $28,380 now.
Determining the Profitability of Investments
● Remember the simple rule: discount the future benefits of

an investment, and compare them to the current cost.
● Companies use discount rates, which are determined by
cost of capital.
• A company’s cost of capital is a blend of debt and equity, its
“weighted average cost of capital” or WACC
● Time is a critical element in investment decisions
• Cash flows to be received in the future need to be
discounted to present value using the cost of capital
● The NPV Rule: if the present value of the net cash flows
is larger than zero, then the project earns more than the
cost of capital.
The NPV Rule In Action
● Consider two projects that each require an initial

investment of $100
• Project 1 returns $115 at the end of the first year
• Project 2 returns $60 at the end of the first, and $60 at the
end of the second
• The company’s cost of capital is 14%
• Project 1 earns more than the cost of capital. Project 2 does not.
NPV and Economic Profit
● Projects with a positive NPV create economic profit.

● Only positive NPV projects earn a return higher than
the company’s cost of capital.
● Projects with negative NPV may create accounting
profits, but not economic profit.
● In making investment decisions, choose only projects
with a positive NPV.
Another Method: Break-Even Quantities
● The break-even quantity is the amount you need to

sell to just cover your costs
• At this sales level, profit is zero.
● The break-even quantity is:
Q=FC/(P‐MC)
FC: fixed costs P: price MC:marginal cost
• (P-MC) is the “contribution margin” – what’s left

after marginal cost to “contribute” to covering fixed
costs
Break-Even Example: Nissan Truck
● Nissan’s popular truck model, the Titan, had only two years
remaining on its production cycle. Redesigning the “Titan” would
cost $400M.
• Cost of capital was 12%, implying annual fixed cost of $48M
• Contribution margin on each truck is $1,500
• Break-even quantity is 32,000 trucks
• The decision to redesign or not came down to a break-even analysis
● Nissan had a 3% share of the market, implying only 12,000 Titan
sales per year – not enough to break even.
● Instead they decided to license the Dodge Ram Truck, which
would reduce the fixed cost of redesign, and a lower break-even
point.
● After the Government took over Chrysler, Nissan reconsidered.
Deciding Between Two Technologies
● In 1983, John Deere was in the midst of building a

Henry-Ford-style production line factory for large 4WD
tractors
• Unexpectedly, wheat prices fell dramatically reducing
demand for large tractors
● Deere decided to abandon the new factory and instead
purchased Versatile, a company that assembled tractors
in a garage using off-the-shelf components
● Deere chose one manufacturing technology over another
• A discrete investment decision – the factory had big FC and
small MC, Versatile had small FC but bigger MC
John Deere: Right Decision?
● Was purchasing Versatile the right choice?

● It depends… on how much John Deere expected to sell.
• Suppose the capital-intensive technology would
involve $100 FC and $10 MC
• Suppose Versatile’s technology had $50 FC and $20 MC
• To determine break-even quantity (point of indifference),
solve for the quantity that equates the costs: $150 for 5
units
• If you expect to sell less than 5 units, choose the
low-MC technology
• If you expect to sell more than 5 units, choose the
low-FC technology
John Deere Lesson
● John Deere made the right decision by acquiring

Versatile; however, the Antitrust Division of he U.S.
Department of Justice challenged the acquisition as
anticompetitive.
● John Deere and Versatile were only two of 4 firms
selling 4WD tractors in North America.
Break-Even Advice
● Remember this advice: Do not invoke break-even

analysis to justify higher prices or greater output.
● Managers sometimes believe they must raise prices
to cover fixed costs or they must sell as much as
possible to make average costs lower
● These are extent decisions though!
• They require marginal analysis, not break-even
The Decision to Shut-Down
● Shut-down decisions are made using break-even

prices rather than quantities.
• The break-even price is the average avoidable cost
per unit
• Profit = (Rev-Cost)= (P-AC)(Q)
● If you shut down, you lose your revenue, but you get
back your avoidable cost.
• If average avoidable cost is less than price, shut down.
● Determining avoidable costs can be difficult.
• To identify avoidable costs firms use Cost Taxonomy
Cost Taxonomy
● Example: FC=$100, MC=$5, and you produce 100 units/year

● How low of a price before you shut down? IT DEPENDS
● It depends on which costs are avoidable
• Long-run: fixed costs become avoidable so they are included
in the shutdown price
• Short run: they are unavoidable and should not be included
in the shutdown price Costs
Avoidable Unavoidable
Costs or “Sunk” Costs
Fixed Costs Variable Costs
(avoidable in long run) (avoidable in short run)
Sunk Costs and Post-Investment Hold Up
● Always remember the business maxim “look ahead

and reason back.” This can help you avoid potential
hold up.
● Before making a sunk cost investment, ask what you
will do if you are held up.
● What would you do to address hold up?
Sunk Costs and Post-Investment Hold Up Example
● National Geographic can reduce shipping costs by

printing with regional printers.
• To print a high quality magazine, the printer must buy a
$12 million printing press.
• Each magazine has a MC of $1 and the printer would print
12 million copies over two years.
• The break-even cost/average cost is $7 = ($12M / 2M
copies) + $1/copy
• BUT once the press is purchased, the cost is sunk and the
break-even price changes.
• Because of this the magazine can hold up the printer by
renegotiating the terms of the deal – because the price of
the press is unavoidable, and sunk, the break-even price
falls to $1, the marginal cost.
Vertical Integration
● One possible solution to post-investment hold-up is

vertical integration.
● Example: Bauxite mine and alumina refinery
• Refineries are tailored to specific qualities of ore
• The transaction options are:
• Spot-market transactions
• Long-term contracts
• Vertical integration
– Vertical integration refers to the common ownership of two firms in
separate stages of the vertical supply chain that connects raw
materials to finished goods
• Discussion: How is vertical integration a solution to hold up?
● Contractual view of marriage
• Long-term contracts induce higher levels of relationship-
specific investment
CHAPTER
6 Simple Pricing
● Aggregate demand or market demand is the total number of
units that will be purchased by a group of consumers at a
given price.
● Pricing is an extent decision. Reduce price (increase quantity)
if MR > MC. Increase price (reduce quantity) if MR < MC.
The optimal price is where MR = MC.
● Price elasticity of demand: e = (% change in quantity
demanded) ÷ (% change in price)
• Estimated price elasticity is used to estimate demand from a
price and quantity change.
[(Q1 ‐ Q2)/(Q1 + Q2)] ÷ [(P1 ‐ P2)/(P1 + P2)]
• If |e| > 1, demand is elastic; if |e| < 1, demand is inelastic.
• continued
● %ΔRevenue ≈ %ΔPrice + %ΔQuantity

• Elastic Demand (|e| > 1): Quantity changes more than price.
• Inelastic Demand (|e| < 1): Quantity changes less than price.
● MR > MC implies that (P - MC)/P > 1/|e|; in words, if the
actual margin is bigger than the desired margin, reduce
price
• Equivalently, sell more
● Four factors make demand more elastic:
1) Products with close substitutes (or distant complements) have
more elastic demand.
2) Demand for brands is more elastic than industry demand.
3) In the long run, demand becomes more elastic.
4) As price increases, demand becomes more elastic.
• continued
● Income elasticity, cross-price elasticity, and

advertising elasticity are measures of how changes
in these other factors affect demand.
● It is possible to use elasticity to forecast changes in
demand:
• %ΔQuantity ≈ (factor elasticity)*(%ΔFactor).
● Stay-even analysis can be used to determine the
volume required to offset a change in costs or prices,
which is how businesses often implement marginal
analysis.
Hot Wheels
● Mattel introduced Hot Wheels in 1968

● They kept price below $1.00 for 40 years, even as
production costs rose
● Finally tested a price increase, experienced profit
increase of 20%
• Why? Profit=(P-C)xQ
• Businesses tend to focus on C and Q, neglect P
● In many instances, companies can make money by
simply raising price
Simple Pricing
In this chapter, we consider “simple pricing”:

● A single firm selling a single product at a single price
● Most firms sell: in competition with rivals; multiple
products, and at different prices, so this is rare
● Important to understand simple pricing first though
● Simple pricing has become part of business
vernacular
• When your boss says that “demand is elastic,” she often
means that price is too high.
Background: Consumer Surplus and Demand Curves
● First Law of Demand - consumers demand more

(purchase more) as price falls, assuming other factors are
held constant.
● Consumers make consumption decisions using marginal
analysis, consume more if marginal value > price
● But, the marginal value of consuming each subsequent
unit diminishes the more you consume.
● Consumer surplus = value to consumer - price paid
● Definition: Demand curves are functions that relate the
price of a product to the quantity demanded by consumers
Consumer Surplus and Demand Curves Example
Pizza consumer
● Values first slice at $5, next at $4 . . . fifth at $1
Pizza Demand Schedule
● Note that if pizza slice price is $3, consumer will

purchase 3 slices
Pizza Example (cont.)
● For the first slice, the total and marginal value are the
same at $5
● For the second, the marginal value is $4, while the
total value is $9 = $5 + $4
Pizza Value Table
Background: Aggregate Demand
● Aggregate Demand: the buying behavior of a group of

consumers; a total of all the individual demand curves.
● To construct demand, sort by value.
Pizza Consumer Surplus
Aggregate Demand (cont.)
● Demand curves describe buyer behavior and tell you how

much they will buy at a given price.
● If something other than price causes an increase in demand, we

say that “demand shifts” to the right or “demand increases” such
that consumers purchase more at the same prices
Pricing Trade-Off
● Pricing is an extent decision

● Profit= Revenue - Cost
● Demand curves turn pricing decisions into quantity
decisions:
• “what price should I charge?” is equivalent to “how much
should I sell?”
● Fundamental tradeoff:
• Lower price sell more, but earn less on each unit sold
• Higher price sell less, but earn more on each unit sold
● Tradeoff created by downward sloping demand
Marginal analysis of pricing
● Marginal analysis finds the profit increasing

solution to the pricing tradeoff.
• It tells you which direction to go (to raise or lower
price), but not how far to go.
● Definition: marginal revenue (MR) is change in
total revenue from selling another unit.
● If MR>0, then total revenue will increase if you sell
one more.
● If MR>MC, then total profit will increase if you sell
one more.
● Proposition: Profit is maximized when MR = MC
Example: Find the Optimal Price
● Once you reach the 4th unit, total profit decreases by

%0.50 because the MR from the 4th unit is only $1,
which is less than $1.50 MC
● Therefore, the profit maximizing quantity is 3 and
we see that the price is $5.00 for 3 units to be sold
Optimal Price
How Do We Estimate MR?
● Price elasticity allows us to calculate MR.

● Definition: price elasticity of demand (e)
(%change in quantity demanded)
(%change in price)
• If |e| is less than one, demand is said to be inelastic.
• If |e| is greater than one, demand is said to be elastic.
Mistake in 3rd Edition
● The Correct Answer

• Elastic Demand implies |e|>1
• Inelastic Demand implies |e|<1
● The following figures are mis-labled (The inequality
in parentheses should be reversed)
Elastic Demand [|e| < 1]
Inelastic Demand [|e| > 1]
Price Elasticity Example
● Mayor Marion Barry increased taxes on gasoline

sales in DC by 6%.
● Before the tax, gas station predicted that the increase
in a sales tax would reduce quantity demanded by
40%.
● The gas station owners were indirectly arguing that
gasoline revenue, and the taxes collected out of
revenues, would decline because gasoline sales in
DC has a very elastic demand.
Estimating elasticities
● Definition: Arc (price) elasticity=

[(q1‐q2)/(q1+q2)]
[(p1‐p2)/(p1+p2)]
• Discussion: Compute elasticity, when price changes
from $10 to $8, and quantity changes from 1 to 2?
● Example: On a promotion week for Vlasic, the price
of Vlasic pickles drops by 25% and quantity
increases by 300%.
• Is the price elasticity of demand -12?
• HINT: could something other than price be changing?
Intuition: MR and Price Elasticity
● Revenue and price elasticity are related by the

following approximation.
% Rev ≈ % P + % Q
● Elasticity tells you the size of |% P| relative to |% Q|

● If demand is elastic
• If Pthen Rev • If Pthen Rev
● If demand is inelastic
• If Pthen Rev • If Pthen Rev
Formula: Elasticity and MR
● Proposition: MR = P(1-1/|e|)
• If |e|>1, MR>0.
• If |e|<1, MR<0.
● Discussion: If demand for Nike sneakers is inelastic,
should Nike raise or lower price?
● Discussion: If demand for Nike sneakers is elastic,
should Nike raise or lower price?
Elasticity and Pricing
● MR>MC is equivalent to
• P(1-1/|e|)>MC
• P>MC/(1-1/|e|)
• (P-MC)/P>1/|e|
● MR > MC means that (P-MC)/P > 1/|e|
● The left side of the expression is the current margin = (P-MC)/P
● The right side is the desired margin, or the inverse elasticity = 1/|e|
● If the current margin is greater than the desired margin, reduce the
price because MR>MC and vice versa.
● Intuition: the more elastic demand becomes (1/|e| becomes smaller),
the less you can raise price over MC because you lose too many
customers
What Makes Demand More Elastic?
5 factors that affect demand elasticity and optimal

pricing:
1) Products with close substitutes have elastic demand.
2) Demand for an individual brand is more elastic than
industry aggregate demand.
3) Products with many complements have less elastic
demand.
4) In the long run, demand curves become more elastic.
5) As price increases, demand becomes more elastic.
Factor 1
1. Products with close substitutes have elastic

demand.
● Consumers respond to a price increase by switching
to their next-best alternative.
● If their next-best alternative is a very close substitute,
then it doesn’t take much change in price for them to
switch.
● When Mayor Barry raised the price of gasoline, DC
commuters began buying gasoline in nearby Virginia
and Maryland.
Factor 2
2. Demand for an individual brand is more elastic

than industry aggregate demand.
● Rough rule of thumb: brand price elasticity is
approximately equal to industry price elasticity divided
by brand share
● Example:
• elasticity of demand for all running shoes = -0.4
• Market share of Nike running shoes is 20%
• Price elasticity of demand for Nike running shoes is -0.4/.20 = -2
• Using our optimal pricing formula, this would give Nike a desired
margin of 50%
Factor 3
3. Products with many complements have less

elastic demand.
● Products that are consumed as a larger bundle of
complementary goods have less elastic demand.
● Example: iPhones have less elastic demand because
of the number of apps run on them
• If the price of an iPhone increases, you are less likely
to substitute to another product due to the
complementary apps
Factor 4
4. In the long run, demand curves become

more elastic.
● This can also be explain by the speed at which price
information is spread; or the ability of consumers to
find more substitutes in the long run.
● Example: ATM fees
• At a selected number of ATMs, a bank raised user fees from
$1.50 to $2.00.
• When informed of the fee increase, users typically
completed the current transaction but avoided the higher-
priced ATMs in the future.
Factor 5
5. As price increases, demand becomes

more elastic.
● Example: high-fructose corn syrup (HFCS)
• Primary use is a caloric sweetener in soft drinks
• Sugar is the perfect substitute for HCFS
• Import quotas and sugar price supports have raised the
US domestic price of sugar about twice that of HFCS.
• Bottlers have shifted to HFCS.
• Bottlers have no close substitute for low-priced HFCS,
although as the price of HFCS approaches that of sugar,
demand for HFCS becomes very elastic.
Other Elasticities
● Definition: income elasticity measures the change in

demand arising from a change in income
(%change in quantity demanded) (%change in income)
• Inferior goods (negative): as income increases, demand declines
• normal goods (positive): as income increases, demand increases
● Definition: cross-price elasticity of good one with

respect to the price of good two
(%change in quantity of good one) (%change in price of good two)
• Substitute (positive): as the price of a substitute increases,
demand increases
• Complement (negative): as the price of a complement increase,
demand decreases
Stay-Even Analysis
● Stay-even analysis tells you how many sales you need

when changing price to maintain the same profit level
• How to implement marginal analysis of pricing using
stay-even quantity:
%ΔQ = (%ΔP)
(%ΔP + margin)
● Margin=40%, %ΔP=5%, then %ΔQ = 11.1%

● In other words, a 5% price increase would be
profitable if quantity went down by less than 11.1%.
● Use elasticity estimates or marketing surveys to
determine whether quantity would go down by 11.1%.
Cost-Based Pricing
● Our expression for optimal pricing, MR=MC or (P-

MC)/P= 1/|e|, takes into account the firm’s cost
structure and its consumer demand
● Often, the consumer side is ignored in pricing
decisions, leading to cost-based pricing. Why?
● Often, firms do not have the demand picture
● They need to invest in a market research division to
take profitability seriously
Extra: Quick and Dirty estimators
● Linear Demand Curve Formula:

e= p / (pmax‐p)
● Discussion: How high would the price of the brand
have to go before you would switch to another
brand of running shoes?
● Discussion: How high would the price of all running
shoes have to go before you should switch to a
different type of shoe?
Extra: Market Share Formula
● Proposition: The individual brand demand elasticity

is approximately equal to the industry elasticity
divided by the brand share.
• Discussion: Suppose that the elasticity of demand for
running shoes is –0.4 and the market share of a
Saucony brand running shoe is 20%. What is the price
elasticity of demand for Saucony running shoes?
● Proposition: Demand for aggregate categories is
less-elastic than demand for the individual brands in
aggregate.
Title?
● In 1994, the peso devalued by 40% in Mexico

• Interest rates and unemployment shot up
• Overall economy slowed dramatically and consumer income fell
● Concurrently, demand for Sara Lee hot dogs declined
• This surprised managers because they thought demand would
hold steady, or even increase, since hot dogs were more of a
consumer staple than a luxury item.
• Surveys revealed the decline was mostly confined to premium
hot dogs
• And, consumers were using creative substitutes
• Lower priced brands did take off but were priced too low.
● Failure to understand demand and to price accordingly was
costly.
CHAPTER
7 Economies of
Scale and Scope
● The law of diminishing marginal returns states that as you
expand output, your marginal productivity (the extra output
associated with extra inputs) eventually declines.
● Increasing marginal costs eventually cause increasing average costs
and make it more difficult to compute break-even prices. When
negotiating contracts, it is important to know what your costs
curves look like; otherwise, you could end up accepting contracts
with unprofitable prices.
● If average cost falls with output, then you have increasing returns
to scale. In this case you want to focus strategy on securing sales
that enable you to realize lower costs. Alternatively, if you offer
suppliers big orders that allow them to realize economies of scale,
try to share in their profit by demanding lower prices.
• continued
● If your average costs are constant with respect to output, then

you have constant returns to scale. If average costs rise with
output, you have decreasing returns to scale or
diseconomies of scale.
● Learning curves mean that current production lowers future
costs. It’s important to look over the life cycle of a product
when working with products characterized by learning curves.
● If the cost of producing two outputs jointly is less than the
cost of producing them separately — that is
Cost(Q1,Q2) < Cost(Q1) + Cost(Q20)
— then there are economies of scope between the two
products. This can be an important source of competitive
advantage and shape acquisition strategy.
Rayovac Company
● Founded in 1906, three entrepreneurs started a battery production

company that grew to rival Energizer and Duracell.
● In 1996, The Thomas H. Lee Company acquired Rayovac – taking
advantage of easy credit availability the company then bought many other
battery production companies as well. A move the company said they
made to take advantage of efficiencies and economies of scale.
• They expected that as they produced more of the same good, average costs
would fall.
● The company also bought many unrelated companies at the same time as
the battery binge – the reasoning being that because of synergies, if they
centralized the production of many different goods the costs of production
would be lower.
● By February 2009 the new conglomerate was bankrupt
● Moral of the story? In business investments if you hear the words
“efficiency” or “synergy,” hold on to your money.
Increasing Marginal Costs
● Definition: The law of diminishing marginal returns: as

you try to expand output marginal productivity (the extra
output associated with extra inputs) eventually declines.
• Diminishing marginal returns  marginal productivity
declines
• Diminishing marginal productivity  increasing marginal
costs
• Increasing marginal costs eventually lead to increasing
average costs
● Some causes of diminishing marginal returns
• Difficulty of monitoring and motivating a large work force
• Increasing complexity of a large system
• The “fixity” of some factor, like testing capacity
Graph 1: Marginal Cost
Graph 2: Marginal vs. Average Cost
When marginal cost rises above average,

the average rises.
Increasing Marginal Cost (cont.)
● Example: Akio Morita and the Sony Transistor radio

• In 1955, Akio Morita found a retailer that would sell his
$29.95 transistor radio under his “Sony” brand name
• The problem: the retailer wanted to buy 100,000 for its 150
stores, 10 times more than Mr. Morita’s capacity.
• Mr. Morita had to turn down the offer
• He knew that he would lose money producing 100,000 units
because increasing output would require hiring/training more
workers and an expansion of facilities
• This would raise his average costs.
• The retailer agreed to settle for 10,000 units, the rest is
history
• Lesson: know what your costs look like!
Economies of Scale
● Definition: short run “fixity” vs. long run

“flexibility”
• i.e. factors that are fixed costs in the SR but become
variable in the long run
● If long-run average costs are constant with respect to
output, then you have constant returns to scale.
● If long run average costs rise with output, you have
decreasing returns to scale or diseconomies of
scale.
● If average costs fall with output, you have
increasing returns to scale or economies of scale.
Example: Poultry Industry
● In 1967 in the US, a total of 2.6 billion chicken and

turkeys were processed
● By 1992, that number was almost 7 billion BUT the
number of processing facilities dropped from 215 to
174
● The share of shipment plants with over 400
employees grew immensely
● The shift in the structure of the industry was due
largely to changes in technology, which reduced cost
of processing poultry in larger plants
Learning Curves
● Learning curve: when you produce more, you

learn from the experience so that you produce at a
lower cost in the future
● Use the maxim “Look ahead and reason back”
● Example: Every time an airplane manufacturer
doubles production, marginal cost decreases
by 20%
Airplane Learning Curve
● American Airline negotiates with Boeing to purchase planes

● Boeing sees a big order from the world’s largest airline as a
chance to “walk down its learning curve”
Airplane Manufacturing Costs
Airplane Learning Curve (cont’d)
● American knows its order will allow Boeing to reduce costs for
future sales, they want to capture some of Boeing’s profit
● If American could know how many planes Boeing would make
over the lifetime of the plane, they could offer Boeing’s
average cost
Airplane Learning Curve (cont’d)
What actually happened with American and Boeing:

● American offered to purchase planes exclusively
from Boeing over the next 30 years
● This provided Boeing with a big chunk of demand
that would lower costs
● In exchange, Boeing offered a discounted price
Guitar Fingerboards
● Firm X produces guitar fingerboards

• Rosewood is used for budget guitars
• Ebony is used for high-end guitars
● However, there is a decreasing supply streak-free
of ebony
• Brown streaks in ebony are seen as a blemish for high-end
guitars, but a step up from rosewood.
● The streaked ebony can be used on budget guitars
• Better than rosewood cost and quality advantage
● Therefore, there are economies of scope between
production of high-end and low-end guitars.
Economies of Scope
● If the cost of producing two products jointly is less than

the cost of producing those two products separately then
there are economies of scope between the two products
Cost(Q1, Q2) < Cost(Q1) + Cost(Q2)
● You want to exploit economies of scale by producing

both Q1 and Q2
● Major cause of mergers
● Example: Kraft, Sara Lee and ConAgra sell a variety of
meat products, hot dogs, sausage, and lunchmeats
because they can derive economies of scope by
distributing these products together
Diseconomies of Scope
● Production can also exhibit diseconomies of scope

when the cost of producing two products together is
higher than the cost of separate production.
Pet Food Production
● AnimalSnax, a pet food company has 2,500 products (SKU’s)

with 200 different formulas
● They receive a lot of pressure from large customers like
Wal-Mart to reduce prices
● These requests worry the firm because of the so-called 80/20
rule (80% of a firm’s profit comes from 20% of its customers)
● To respond to Wal-Mart, the company shrinks it product
offerings
• AnimalSnax reduced its product offerings to 70 SKUs using only 13
different formulas AND it began offering price discounts for larger orders.
• The company could consolidate small orders into large ones to
reduce setup costs.
Pet Food Production Graph
● Typical savings for one extruder line are illustrated below

● Under the new approach, the same amount of pet food could be
produced faster
● This led to a 25% savings for the company because of reduced
production costs (see graph)
Sample Question
● Learning curves: every time you double production,

your costs decrease by 50%. The first unit costs you
$64 to produce. On a project for 4 units, what is your
break-even price?
● You can win another project for 2 more units.
What is your break-even price for those units?
Answer
Q MC TC AC
1 $64 $64 $64
2 $32 $96 $48
3 $21 $117 $39
4 $16 $133 $33
5 $13 $146 $29
6 $11 $157 $26
● The break-even price for 4 units is $33.

● The extra costs for the fifth and sixth units is only
$24, so break-even is $12/unit for those two.
● If the project were for six units total, break-even
would be $26/unit for those six.
CHAPTER
8 Understanding
Markets and
Industry Changes
● A market has a product, geographic, and time dimension.
Define the market before using supply–demand analysis.
● Market demand describes buyer behavior; market supply
describes seller behavior in a competitive market.
● If price changes, quantity demanded increases or
decreases (represented by a movement along the
demand curve).
● If a factor other than price (like income) changes, we say
that demand curve increases or decreases (a shift of
demand curve).
● Supply curves describe the behavior of sellers and tell
you how much will be sold at a given price.
• continued
● Market equilibrium is the price at which quantity

supplied equals quantity demanded. If price is above
the equilibrium price, there are too many sellers,
forcing price down, and vice versa.
● Prices are a primary way that market participants
communicate with one another. High prices tell
consumers to consume less, and suppliers to supply
more, and vice-versa.
● Making a market is costly, and competition between
market makers forces the bid–ask spread down to the
costs of making a market. If the costs of making a
market are large, then the equilibrium price may be
better viewed as a spread rather than a single price.
3
Y2K and Generator Sales
● From 1990-98, sales of portable generators grew 2%

yearly.
● In 1999, public anticipation of Y2K power outages
increased demand for generators
• AMP invested to increase capacity in anticipation of this
demand growth – they vertically integrated their company
to increase capacity and reduce variable costs
• Demand grew as expected – Industry shipments increased
by 87%. Prices also increased by an average of 21%
• The following year – a bust! Demand fell, and AMP’s Y2K
strategy to increase production led it to bankruptcy in 2000.
● Lesson: AMP could have anticipated this.
Which Industry or Market?
● Setting a single price for a single product of a single firm is

referred to as a “monopoly” model of pricing
● This chapter focuses on the “market” setting, showing how
prices are determined in an industry where many sellers and
many buyers come together (still a single price for a single
product)
● Caution: Do not use demand and supply analysis for an
individual firm
• Example: You would talk about changes to the “smart phone”
industry, not the “demand and supply of iPhones because there
is only one seller of iPhones
● The behavior of sellers is determined by a “supply” curve
● The behavior of buyers is determined by a “demand” curve
Which Industry or Market? (cont.)
● Before you begin analyzing an industry, you must consider

what you want to learn from analysis
● Usually this yields a particular market definition
● Each market (or industry) has a time, product, and geographic
dimension
● For example: The yearly market for portable generators in the
U.S.
• Time: annual
• Product: portable generators
• Geography: US
● When analyzing a problem, or investment opportunity, first
define the time, product and geographic dimensions of the
market in question
Shifts in the Demand Curve
● Movement along the demand curve, i.e. a change in

price leads to a change in the “quantity demanded”
● Shifts in demand curve can occur for multiple
reasons
• Uncontrollable factor – something that affects demand
that a company cannot control
• Income, weather, interest rates, and prices of substitute and
complementary products owned by other companies.
• Controllable factor – something that affects demand
that a company can control
• Price, advertising, warranties, product quality, distribution
speed, service quality, and prices of substitute or
complementary products also owned by the company
Microsoft
In the late 1970s, Microsoft developed DOS, an operating system

to control IBM computers
● The price for DOS depended on the price and availability of computers
that could run it and the applications that ran under
it as well as the price of DOS itself
● To increase demand for DOS Microsoft:
• Licensed its operating system to other computer manufacturers so
that competition would reduce price of a crucial complement
• Developed its own versions of complimentary software
• Kept the price of DOS low, to increase share to encourage
complementary software development
● Discussion: How did Microsoft control demand using these factors?
How did competitors (Apple, for example) operate differently?
• HINT: this was Steve Jobs’s biggest mistake
Demand Increase
● At a given price, more quantity demanded = shift of

the demand curve
Supply Curves
● Definition: Supply curves describe the behavior of a group of

sellers and tell you how much will be sold at a given price
● Supply curves slope upward  the higher the price, the higher
the quantity supplied
Market Equilibrium
● Definition: Market equilibrium is the price at which

quantity supplied equals quantity demanded
● At the equilibrium price, there is no pressure for the
price to change because the number of sellers equals
the number of buyers (quantity demanded = quantity
supplied)
Market Equilibrium (cont.)
● Proposition: In a competitive equilibrium there are

no unconsummated wealth-creating transactions
RIDDLE: How many economists does it take to change a light bulb?

ANSWER: None. The market will do it.
Using Supply and Demand
● Supply and demand curves can be used to describe

changes that occur at the industry level
● Here, initial equilibrium is $8. After a demand shift, the
new equilibrium is $10
Market Equilibrium Analysis
Using Supply and Demand (cont.)
● Again: the mechanism driving price to the new

equilibrium is competition
● At the old price of $8, there is excess demand (9-5=4
more buyers than sellers), which puts upward pressure
on price until it settles at the new $10 equilibrium
Portable Generator Market Revisited
● Return to the electric generator industry:

• 1997– Stable industry sales with intense competition
(2% avg. sales growth)
• 1997– Industry anticipates record demand will occur in 1999
• 1998 – Massive capital expenses throughout industry on
vertical integration projects
AB demand
(anticipation) and
supply (investment)
increased
BC price dropped

but quantity stayed
above the 1998 level
Using Supply and Demand (cont.)
● Example: model the Increase in quantity of mobile

phones and the decline in the price over the past decade
● Use a graph to explain two points
• Shift of the supply curve – that’s it!
• Shows the increase in supply (Q0Q1) and the decrease in
price (P0P1)
Prices Convey Information
● Prices are a primary way that market participants

communicate with one another
● Buyers signal their willingness to pay
● Sellers signal their willingness to sell with prices
● Price information especially important in financial
markets
Prices Convey Information (cont.)
● Example: Gas pipeline burst between Tucson and

Phoenix
Prices Convey Information (cont.)
● Tucson-Phoenix pipeline break reduced supply

to Phoenix which raised price in Phoenix.
● High prices in Phoenix conveyed information to
sellers so they diverted tanker trucks from Tucson to
Phoenix.
• There was a limit to how many tanker trucks could
fill up at the “rack” in Tuscon, so some Tuscon
tanker trucks were displaced by the tanker trucks
going to Phoenix.
● The results was a reduction of supply in Tucson,
resulting in a price increase in Tuscon.
Market Making
● A “market maker” makes a market – by buying low and

selling high.
● A single (monopoly) market maker does not want to have too
much or hold too much inventory  She has to pick prices
that equalize quantity supplied and demanded.
Market Makers (cont.)
● If the market maker bought and sold at the competitive price

($8), she would earn zero profit
● To earn more, she must buy low and sell high and can do that
with varying numbers of transactions
● She should either buy at $6/sell at $10, or buy at $5/sell at $11
since both earn a profit of $12
● Competition between market makers will force the bid-ask
spread down to the cost of making a market
Optimal Spread in Market Making
Title?
● Video enhancement products are state-of-the-art graphics

systems that capture, analyze, enhance, and edit all major
video formats without altering underlying footage
● In 1998, this market consisted of a small number of
companies, and demand was relatively light due to the
extremely high price of the technology (prices ranged
between $45,000 and $80,000)
● In 2000, Intergraph entered the market at a price of
$25,000, attempting to quickly capture a major share of
the market. Intergraph produced a product at a
substantially lower cost than the competition
Title continued?
● What happened?
• Entry caused an increase in supply and a strong downward
pressure on price (average pricing fell to around $40,000)
• A number of firms exited and prices rose back to around
$45,000
● Later, the events of 9/11/01 caused demand to spike
● What happened?
• In the short run, average prices shot up.
• Higher prices eventually attracted more entrants,
increasing supply. Pricing fell back down to an average
level of around $30,000
CHAPTER
9 Relationships
Between Industries:
The Forces Moving Us Toward
Long-Run Equilibrium
● 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).
• continued
● The difference between stock returns and bond yields

includes 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.
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 (this will be discussed in
this chapter)
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 = marginal revenue
• so if P>MC, produce more and if P<MC, produce less
Competitive Firms (cont.)
● Perfect competition is a theoretical benchmark

• No industry is perfectly competitive, but many industries
come close to it
• The benchmark is valuable to expose the forces that move
prices and firm profit in the long run

profit, but only in the short-run. In the long run:
• Positive profit (P>AC) leads to entry, decreasing price and profit
• Negative profit (P<AC) leads to exit, increasing price and profit
● In the long-run, competitive firms are condemned

to earn only an average rate of return.
Competitive Firms in the Long Run
● Proposition: In equilibrium, capital is indifferent

between entering one industry or any other, because
P=AC (economic profit is zero)
• In the short run, a price increase that leads to a profit
increase attracts capital to existing firms or new entrants
come into the industry.
• This increases supply, which leads to a decrease in price
until firms are no longer earning above-average profit, so
capital flow stops = long-run equilibrium
profit in the short run but only entry and exit occurs.
In the long run, competitive firms earn only an
average rate of return.
“Mean Reversion” of Profits
● Asset flows (entry and exit) force price to average

cost
• e.g. even with demand and supply shocks that result in
short-run price increases/decreases, economic profit
will always revert back to zero
• We say that “profits exhibit mean reversion”
● Silver lining to dark cloud (low profit will increase as
firms exit the industry)
● Reversion speed is 38% per year
• So, if profits are 20% above the mean one year, in the
next year they will be only 12.4% above the mean, on
average
“Mean Reversion” of Profits (cont.)
● An analysis of over 700 business units found the 90% of both

above-average and below-average profitability differentials
disappeared over a 10-year period
● Return on investment reverted back to the mean level of
approximately 20% for both over- and underperformers (shown
below)
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
● Indifference principle: 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
● Labor and capital are generally highly mobile assets
• They flow into an industry when profits are high and
out of an industry when profits are negative
Indifference Principle Example
● Suppose San Diego, CA is more attractive to live in

than Nashville, TN
● If labor is mobile, people will move from Nashville
to San Diego
• This will increase demand for housing  housing
prices will increase to a point where San Diego
becomes as unattractive as Nashville  migration to
San Diego will stop  long run equilibrium!
Compensating Wage Differentials
● Wages adjust to restore equilibrium

• The indifference principle tells us that in long-run
equilibrium, all professions should be equally
attractive, provided labor is mobile
• Once long-run equilibrium is reached, differences in
wages are “compensating wage differentials”
● Compensating wage differentials reflect
differences in the inherent attractiveness of various
professions
• Example: embalmers make 30% more than
rehabilitation counselors because it is considered a
relatively unattractive profession
Finance: Risk vs. Return
● Can apply long-run analysis to fundamental relationships

in finance
• Investors prefer higher returns and lower risk if two investment options
have the same return and one is less risky, the less risky one will be
chosen and it will bid up the price of the less risky investment
• The higher price decreases the investment’s expected rage of return
• Therefore, n 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
Stock Volatility and Returns
● CBOE Volatility Index (VIX) against the price of the S&P 500 stock index
(GSPC)
● From Fall of 2008 through the Spring of 2009, the stock market declined
by about 50% while the volatility index increased by about 100%
● Greater volatility reduced stock prices, increased expected returns to
compensate investors for bearing more risk
Change since Jan. 2008 (%)
Historical Equity Risk Premium
● Government bonds are considered risk-free, they returned 1.7% over the
last 80 years while stocks returned 6.9%.
● The difference is a risk premium that compensates investors for holding
the more risky stocks
● The equity risk premium of stocks over bonds (in the graph below) has
varied over time, from 0% to 9%
Monopoly-Different Story, Same Ending
● Monopoly firms have attributes that protect them from the

forces of competition:
• They produce a product or service with no close substitutes
• they have no rivals
• 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 though
• Entry makes demand more elastic (P-MC)/P=1/|e|, which forces
price back down towards MC
• Example: In Oct. 2001, Apple released the iPod, which was a
unique, user-friendly product with low elasticity of demand and
high margins. Rivals began producing competing music players,
which made demand for iPods more elastic. This reduced price-
cost margins and lowered profit for Apple.
Title?
● 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.
Title continued?
● 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.
CHAPTER
10 Strategy:
The Quest to Keep
Profit from Eroding
● Strategy is simple―to increase economic
performance, figure out a way to increase P (price) or
reduce C (cost)
● The industrial organization economics (IO)
perspective assumes that the industry structure is the
most important determinant of long-run profitability
● The Five Forces model is a framework for analyzing
the attractiveness of an industry. Attractive industries
have low supplier power, low buyer power, high
entry barriers, low threat of substitutes, and low
rivalry
• And cooperation from complements (The force that
• continued
● According to the resource-based view (RBV),

individual firms may exhibit sustained performance
advantages due to their superior resources. To be the
source of sustainable competitive advantage, those
resources should be valuable, rare, and difficult to
imitate/substitute
● Strategy is the art of matching the resources and
capabilities of a firm to the opportunities and risks in
its external environment for the purpose of
developing a sustainable competitive advantage
● Be wary of any advice you read that claims to
identify best practices, critical resources or
capabilities that successful companies have to
develop in order to gain a competitive advantage.
This is the fundamental error of attribution
● To stay one step ahead of the forces of competition, a
firm can adopt one of three strategies: cost reduction,
product differentiation, or reduction in the intensity
of competition
● In 1971, three partners opened a coffee shop in Seattle
named Peaquod, after the ship from Moby Dick
● The company enjoyed mild growth until 1988 when the
partners agreed to sell the company to their former
director of retail operations and marketing
● Over the next 20+ years, that director has overseen a
global expansion of the company and billions of dollars of
revenue
● Yes, Starbucks was the first mate on the Peaquod and that
former director of retail operations is Howard Schultz, the
current CEO of Starbucks
Sustainable Competitive Advantage (SCA)
● Warren Buffett was once asked what his most important

investment criterion is. Without hesitation, he replied,
“Sustainable competitive advantage”
● Succeeding in a competitive market requires a company
to find an advantage, and then protect that 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
Strategy
● Strategy = trying to slow erosion

● Firms have a competitive advantage when they can:
a) Deliver the same product or service benefits as
competitors at a lower cost OR…
b) …they can deliver superior product or service
benefits at a similar cost
● Strategy is about raising price or reducing cost
• Really successful firms manage to do both
• Extremely successful firms (like Starbucks) do it over a
long period of time, creating sustainable competitive
advantage
Strategy (cont.)
● Strategy is all
about how to
increase the size of
the profit box
Sources of Economic Profit
● What is the key to competitive advantage and

positive economic profit?
● Two schools of thought:
1) Industrial organization (IO) economics
• Locates the source of advantage at the industry level
2) Resource-based view (RBV) – build the right firm
• Locates the source of advantage at the individual firm level
Industry (IO) View of Strategy
● Industry is the key issue

• Focus 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
• the number and size distribution of firms
IO View of Strategy (cont.)
● 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
Using Five Forces
● Definition: An industry is comprised of a group of firms

producing products that are close substitutes to each
other to serve each other
• Note: For a multi-product company, industry analysis may
need to be done on a product-by-product basis
● To use the Five Forces model, one must consider “value
capture”
• Just because you are in an industry that creates value
doesn’t mean that you are going to capture it
• Value is created in each industry and distributed across
suppliers, industry rivals, and buyers
• The Five Forces model helps you think about how much of
the industry value your firm is likely to capture
Five Forces (cont.): Buyers and Suppliers
● Suppliers
• are the providers of any input to the product or service
• power tends to be higher when the inputs provided are critical
inputs or highly differentiated
• Concentration among suppliers gives suppliers power because a
firm will have fewer bargaining options
• Even if many suppliers exist, power may still be high if there are
significant costs to switching between suppliers
● Buyers
• If buyers are concentrated or if it is easy for buyers to switch
from firm to firm, buyer power will tend to be higher.
• More power means these buyers will find it easier to capture
value, taking it away from your firm.
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
Five Forces (cont.): Rivalry
● Rivalry is the force most directly related to our

typical view of “competition”
● If a large number of firms compete in an industry
with high fixed costs and slow industry growth,
rivalry is likely to be quite high
● Rivalry also tends to be higher when products are not
very well differentiated and buyers find it easy to
switch back and forth
Support for the IO View
● Profitability differences do exist across industries
Using Industry Analysis Creatively
● What if you don’t have the ability to choose a new

industry?
● You can use industry analysis too
1) Move beyond a historical analysis of your industry
to think about how the five force might change in
the future
2) Think about what actions you can take to make
your current industry position more attractive
• Ex/ How can you reduce supplier power?
• Increase rivalry among your suppliers
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
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 was priced high - forgot about the
value of the Macintosh platform.
• In contrast, Microsoft recognized the value of the DOS platform.
Platform Strategy
● If you decide on a platform strategy, there are two

recommended strategies
1) “Coring” - using a set of techniques to create a
platform by making a technology “core” to a
particular technological system and market
• Examples of successful coring include Google Inc. in
Internet search and Qualcomm Inc. in wireless technology.
2) “Tipping” - the set of activities that helps a company
“tip” a market toward its platform rather than some
other potential one
• Examples of tipping include Linux’s growth in the market for
Web server operating systems
The Resource-Based View
● According to the resource-based view (RBV), individual

firms may exhibit sustained performance advantages due
to the superiority of their resources (internal focus)
● Definition: Resources are defined as “the tangible and
intangible assets firms use to conceive of and implement
their strategies”
● Two primary assumptions underlie the RBV:
1) resource heterogeneity - firms possess different bundles of
resources
2) resource immobility - since resources can be immobile,
these resource differences may persist
The Resource-Based View (cont.)
● If a resource is both valuable and rare, it can lead to at

least a temporary competitive advantage over rivals
● A valuable resource must allow a business to
conceive of and implement strategies that improve its
efficiency or effectiveness
• Ex/ resources that let a firm operate at lower costs than
its rivals or charge higher prices to its customers
● For a resource to be rare, it must not be
simultaneously available to a large number of
competitors
● 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
1) Resources that flow from a firm’s unique historical conditions
will be difficult for competitors to match
2) If the link between resources and advantage is ambiguous,
then competitors will have a hard time trying to re-create the
advantage
3) If a resource is socially complex (e.g., organizational culture),
rivals will find it difficult to duplicate the resource
● So from the resource based view perspective, resources

and capabilities that are valuable, relatively rare, and
difficult to successfully imitate/substitute are at the core
of sustained, excellent firm performance
● These resources and capabilities may include:
• technology
• physical capital
• intellectual assets
• human capital
• financial resources
• organizational excellence
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
• ex/ 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?
• Your competitor heard about the CMEO “secret” as well and hired
one too. Now that everyone knows about it, no advantage is
possible. Competitive advantage flows from having something that
competitors cant easily duplicate
Generic Strategies
● There are three basic strategies a firm can follow to

generate better economic performance and keep ahead of
competitors
1) Reduce costs
2) Reduce intensity of competition
3) Differentiate product
• Example: Perdue Chicken – successful differentiation
– Frank Perdue took an essentially homogenous product – chicken –
and turned it into a branded product by exercising quality control
over the entire supply chain. Consumers perceive his branded
chickens to be of higher quality.
• Example: Prelude Lobster – fruitless attempt at differentiation
– Tried to adopt Perdue’s strategy, but consumers correctly
perceived that the supply chain for lobsters is largely
uncontrollable.
Title?
● 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.
Title continued?
● 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
CHAPTER 11 Foreign Exchange,
Trade, and Bubbles
● 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
• continued
● 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.
Iceland
● In 2003, Iceland’s three banks borrowed from other banks and

began investing in foreign assets.
• Icelandic banks borrowed as much as they could, as fast as they
could – and used the money to buy as much as they could
● By 2006 it was becoming difficult for Icelandic banks to
borrow. So they began accepting internet deposits – essentially
borrowing money from British residents.
• They offered the highest interest rate available and British
consumers sold pounds to buy krona to deposit in Icelandic
banks.
● The expansion of the financial sector created a domestic
consumption spree – mostly of imports.
• And if Icelandic citizens didn’t have the cash to buy goods, they
simply borrowed (from foreign banks because foreign interest
rates were 3% versus domestic rates of 15.5%)
Iceland (continued)
● Normally, gov’t insurance prevents bank runs, but in this

case, Iceland’s deposit guarantees were several times
greater than its entire national income.
● When the British depositors finally became concerned
about repayment, the resulting bank run devastated the
country.
• The krona fell dramatically in value and domestic prices
soared.
• Today, Iceland is broke. Consumer debt is 8x the national
income, and because the krona has depreciated, paying
back foreign loans will be difficult for Iceland’s citizens.
● This chapter develops tools to allow us to understand
what happened in Iceland.
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
Exchange rate
● Example: price of a British pound measured in krona, i.e., how

many krona are needed to buy one pound. The appreciation of
the pound is equivalent to a devaluation of the krona.
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?
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
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
Effects of a currency devaluation
● Example: golf in Tijuana and San Diego (sister towns on

either side of the Mexico/US border – making golf in one city
a substitute for golf in the other)
• Demand for golf in Mexico:
• Two sets of consumers: American and Mexicans
• When the peso devalues, demand for golf in Mexico increases
for both groups.
– Mexicans see an increase in price of golf in the US, it takes
more pesos to buy one dollar
– Americans see a decrease in the price of golf in Mexico,
one dollar can buy more pesos
● 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.
Effects of a dollar appreciation on golf markets in
Tijuana and San Diego
Currency appreciation
● Example: Icelandic fish

• There are two sets of consumers:
• Domestic buyers and exporters
– total demand = domestic demand + export demand
• When the pound appreciates, export demand increases –
fewer pounds can now buy more krona which equals more
fish.
• Total demand increases, so the price of fish in Iceland rises.
• Icelandic producers benefit because fish are cheaper in the
foreign currency (representing an increase in demand for
Icelandic fish), but Icelandic consumers are hurt because
fish are more expensive in the domestic currency.
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.
Bubbles (cont.)
Bubbles (cont.)
● When buyers expect prices to increase faster than the interest rate,
it makes sense to borrow money to expand buying now in order to
sell in the future.
• This contributes to the demand increase.
● There are certain features of bubbles that economists have
documented.
• Bubbles emerge at times when investors disagree about the significance
of a big economic development. Because it's more costly to bet on
prices going down than up, the bullish investors dominate.
• Financial bubbles are marked by huge increases in trading
● Bubbles persist because no one has the firepower to successfully
attack them. Only when skeptical investors act simultaneously ―a
moment impossible to predict― does the bubble pop.
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
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.
US housing (cont.)
● In the end, Professor Shiller was right – prices

peaked in 2006 then fell dramatically
Popping bubbles
● Why did the housing bubble pop?

• If you believe the bubble-ologists, because there were enough
skeptical investors who, like Professor Shiller, started betting on
house prices to fall.
• But the truth is that we don’t know.
● Professor Shiller also predicted the internet/tech bubble in
2000
• He identified the bubble by looking at the long-run equilibrium
relationship between stock prices and earnings (profit). If prices
are rational, then they should equal the discounted flow of future
earnings.
• Obviously, we cannot observe future earnings, so Professor
Shiller plotted current stock prices against a 10-year trailing
average of past earnings. We update his analysis using a 10-year
trailing average of earnings.
Stock price/Earnings ratio
Price/Earnings Ratio of U.S. Stocks, 1881–2008

(Using 10-Year, Inflation-Adjusted Earnings)
50
45
40
35
30
P/E
25
20
Average: 16.3
15
10
5
0
81
86
92
97
03
08
14
19
25
30
36
41
47
52
58
63
69
74
80
85
91
96
02
07
18
18
18
18
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
20
Year
Data and concept: Professor Robert J. Shiller, http://www.econ.yale.edu/~shiller/data.htm. Graph suggested by
Shayne & Co., LLC. The graph shows the monthly value of the U.S. stock market as measured by the S&P 500 (and
comparable predecessor indices) divided by the average of the earnings per share for the prior ten years. Graph
ends at December 2008.
Back to Iceland
● Looking at Shiller’s graph, we see that from 2003–2007,

the stock market was very expensive.
• There are only two other episodes in history where stock
prices have been this high, 1929 and 2000. In both of these
cases, prices crashed after reaching these heights.
● Shiller’s methodology says that Icelandic banks began
borrowing to invest when asset prices were very
expensive.
● Once the asset prices began to come down, depositors
lost faith in the banks’ ability to pay them back, leading
to the run on the banks.
● This caused the depreciation of the krona
CHAPTER
12 More Realistic and
Complex Pricing
● After acquiring a substitute product,
• raise price on both products to eliminate price
competition between them.
• raise price more on the low-margin
(more price elastic demand) product.
• reposition the products so that there is less
substitutability between them.
● After acquiring a complementary product, reduce
price on both products to increase demand for both
products.
● If fixed costs are large relative to marginal costs,
capacity is fixed, and MR > MC at capacity, then set
2
price to fill available capacity

● If demand is unknown, and the costs of underpricing
are smaller than the costs of over-pricing, then
underprice, on average, and vice-versa.
● If promotional expenditures make demand more
elastic, then reduce price when you promote the
product, and vice-versa.
● Psychological biases suggests “framing” price
changes as gains rather than as losses.
Harry Potter
● When Scholastic Publishing released the final Harry

Potter, sales expectations were through the roof – the
previous HP had sold over 7M copies in the first 24
hours alone.
• Scholastics suggested selling price was $34.99, and they
sold the book to wholesale retailers for $18.99
• Instead of following the advice in chapter six and pricing
the book at the point where the markup equals the inverse
demand elasticity (P-MC)/P = 1/|e|, Barnes and Noble,
Amazon, Costco, and Walmart all priced the book at less
than $20
• These retailers are clearly interested in maximizing profit,
so why were prices so low?
Realistic Pricing
● In this chapter, we move beyond the simple, single-

product analysis of Chapter 6 to more realistic
settings. In fact, the MR=MC pricing rule applies
only to a single-product firm setting a single price.
For firms that sell multiple products, or those who
use low prices to win new customers, the rule does
not hold.
Pricing schemes
● We have seen this kind of pricing before, the low price for 3-liter Coke
used merely to attract customers to a grocery store. Whatever the grocery
store lost on 3-liter Cokes, it made up in sales on other items.
● Amazon was following a similar tactic. By pricing low, Amazon sold over
two million copies of HP.
• Some were new customers, who would purchase books from Amazon in the
future; and some purchased additional items at the same time they purchased
The Deathly Hallows.
• In fact, Amazon estimates that about 1% of its $2.89 billion second-quarter
revenue was due to added sales from customers who also purchased The
Deathly Hallows.
● Both the grocery store and the bookstore were pricing where MR < MC,
or equivalently where (P-MC)/P < 1/|e|. They did so because they were
trying to maximize total profit, not profit on their individual product lines.
Pricing commonly owned substitutes
● To price commonly owned products, use marginal analysis

● Discussion: Purchasing a nearby, rival video store
• How does this change the price of video rentals at each store?
• If there were only one store, marginal analysis finds the point where
MR=MC to maximize profits, BUT common ownership of two
substitutes changes the calculation
• Reducing price at one store steals sales from the other
(reduces MR at both)
• To counter the falling MR, raise prices at both stores to
maximize profits
● Consider your product portfolio as a “bundle” of goods
• Demand for a bundle of substitutes is less elastic than demand for the
individual products - less elastic demand implies a higher optimal price
• Raise the price more on the more elastic product (try to push price-
sensitive customers to the higher-margin product)
Another option for substitutes
● After acquiring a substitute product, you can

reposition the products so they don’t directly
compete with each other.
● For example, you might want to stock multiple
copies of the most popular videos at one of the stores
(add depth) but stock a wider range of titles (add
breadth) at the other.
● Moving the products farther apart can further
increase profit after acquiring a substitute product.
Pricing commonly owned complements
● Again, use marginal analysis to determine pricing.

● Discussion: Purchasing a parking lot adjacent to video store
• Common ownership means pricing decisions must consider
the effects on movie rentals as well as parking lot use.
• Reducing price at one increases demand at the other, i.e.,
common ownership increases MR at both
● With bigger MR, reduce price (sell more) to maximize
profits
● Again, consider your product portfolio as a “bundle” of goods
• Demand for a bundle of complements is more elastic than
demand for the individual products
• More elastic demand implies a lower optimal price
Revenue or yield management
● Products such as cruise ships, hotels, stadiums, commercial

parking lots, etc. have similar characteristics.
• The costs of building capacity are mostly fixed or sunk
• And, these businesses face capacity constraints
● The first decision for these firms is how much capacity to
build – because this is an extent decision, marginal analysis
can be used.
• Keep adding capacity until LRMR = LRMC
● Once capacity is built, firms make pricing decisions, ignoring
the sunk or fixed costs of building capacity.
• Relevant costs are now short-run MR and MC
• If MR>MC at capacity, price to fill available capacity – because
the capacity is fixed the firm cannot sell more by reducing price.
Revenue management example
● Example: designing a new hotel

• keep adding rooms to the design plan, as long as LRMR > LRMC
• Suppose that the optimal size is 300 rooms. At the optimal size, annualized
LRMC of building, cleaning, and heating the room is about $400 per day.
● Once the rooms are built/the costs have been sunk, the hotel’s owners must
decide what to charge for the rooms. Suppose that 90% of the annualized
LRMC are fixed or sunk and that the relevant marginal cost is just $40 per
day.
● Since capacity decisions are determined by all costs, and the pricing
decision only by short-run MC, it ’s likely that MR > MC at the capacity of
the hotel. If so, then the hotel’s owner should price to fill capacity (sell all
available rooms).
● Choose a price that matches expected demand to capacity
• In some industries, like parking lots, stable demand and the daily observation of
realized demand make this relatively easy to do
• In other industries, like cruise ships, this is much more difficult
Revenue or yield management (cont.)
● When demand is difficult to predict, pricing to fill

capacity is also difficult.
● To maximize profits, balance the cost of over-pricing
(lost profit on unsold capacity) against the cost of under-
pricing (lower margins on capacity sold)
● Optimal price minimizes the expected costs of these two
mistakes.
● In general, if the lost profit from over-pricing (unused
capacity) is bigger than the lost profit from under-pricing
(lower margins), then price lower than would fill
capacity, and vice-versa.
Advertising and promotional pricing
● Combines two of the “Four P’s of marketing,” Pricing and

Promotion
● Promotional spending affects demand in different ways
• Price-related promotions (coupons, end-of-aisle displays, etc.)
tend to make demand more elastic
• If promotion makes demand more elastic, it makes sense to
reduce price concurrently
● Product-related promotions (quality advertising, celebrity
endorsements, etc.) tend to make demand less elastic
• If promotions make demand less elastic, it makes sense to raise
price concurrently
● Caveat: Prices can affect customer perception of quality – i.e.
higher price equals higher quality in the mind of the consumer
Psychological Pricing
● Biases can affect optimal pricing decisions.

• Example: Airline snacks
• In 2008, some airlines began charging for snacks
• It seems like a good idea because those who value an in-flight
snack could buy one and those who didn’t didn’t have to buy.
• Many passengers, though, viewed the change negatively and
changed airlines as a result.
● Research in the field of behavioral economics

says that this reaction was predictable using “prospect
theory”
• The way a decision is framed matters a great deal to the
decisions that consumers make, i.e. consumers feel losses
more than gains – so decisions should be framed in such a
way to highlight a gain not the loss of an in-flight snacks.
Psychological pricing (cont.)
● Consumers are also very sensitive to fairness.

● Many retailers make deliberate pricing decisions so as not to appear
unfair
• Home Depot didn’t raise prices after Katrina, though demand did
increase; hardware stores don’t increase the price on snow shovels
following a big winter blizzard
• In 2008, when gas prices rose to meet consumer demand, many US
citizens were outraged and heavily criticized oil companies for
profiting “unfairly.”
● To avoid looking unfair, companies must come up with creative
solutions.
• In the music industry, performers set concert ticket prices below the
market price. People buy up the low priced tickets and sell them on
secondary markets, which consumers don’t subject to rules of fairness.
• Often, artists also sell tickets on secondary sites, sharing in the profits
but avoiding the label of “unfair”
Title?
● American Airlines pioneered the development of

sophisticated reservation management systems, launching
SABRE in 1968
● Without overbooking practices like those instituted through
SABRE, AA estimates that 15% of the seats on sold out
flights would be unused.
● This overbooking process was the first element in
developing a “yield management” system.
● With additional industry changes in the 1970’s, AA moved
to develop a yield management system with the goal of
“selling the right seat to the right customer at the right
time.”
Title continued?
● The yield management system helps determine

• How many seats to allocate initially to each fare category
• How to dynamically adjust this allocation as reservations
come in and the date of the flight approaches.
• Accurate forecast of demand and cancellations are critical
● The complexity of the problem eventually led to the
development in 1988 of an automated system for yield
management, DINAMO. The system's net impact was
estimated be $1.4 billion in additional revenues over a
three year period.
Las Vegas Casinos
● Las Vegas Casinos

• Offer both hotel rooms and gaming
• Prices on rooms are often set at “sub-optimal” levels
• Casinos plan to more than make up for the room profit
shortfall with gaming profits
● Similar to grocery store loss leader concept
• Get people in the door
● Goal is to maximize total profit, not individual
product profit
CHAPTER
14 Indirect Price
Discrimination
● When a seller cannot identify low- and high-value consumers
or cannot prevent arbitrage between two groups, it can still
discriminate, but only indirectly, by designing products or
services that appeal to groups with different price elasticities
of demand, who identify themselves based on their
purchasing behavior.
● Metering is a type of indirect discrimination that identifies
high-value consumers by how intensely they use a product
(e.g., by how many cartridges they buy). In this case, charge a
big markup on the cartridges and a lower markup on the
printer.
● If you offer a low-value product that is attractive to high-
value consumers, you may cannibalize sales of your high-
price product.
• continued
● When pricing for an individual customer, do not

bargain over unit price. Instead, you should
• Offer volume discounts;
• Use two-part pricing; or
• Offer a bundle containing a number of units.
● Bundling different goods together can allow a seller
to extract more consumer surplus if willingness to
pay for the bundle is more homogeneous than
willingness to pay for the separate items in the
bundle.
Airlines
● Airlines cater to both business and leisure travelers

● Business travelers have less elastic demand
• Don’t pay for own ticket, more time sensitivity
● Airlines can’t determine between these two groups
of customers, but can analyze their buying habits
• Leisure= vacation, planned well in advance
• Business= last-minute, often on short notice
● Airlines price tickets higher as the date of travel
gets closer
● How could businesses take advantage of this?
Hewlett-Packard printers
● HP identifies high- and low-value consumer groups by

the number of ink cartridges purchased
● To charge high-value customers higher prices, HP
charges a 50% markup over MC on ink cartridges while
only charging a 15% markup on printers.
● In 2003, HP sold $10 billion worth of printers and $12
billion in ink cartridge sales, HP’s actual profit off of ink
cartridges was three times greater than the profit from
printer sales.
● The low margin on printers and high margin on ink
cartridges is similar to pricing schemes used for many
complementary products: razor blades and razors,
movies and popcorn, etc.
Complementary pricing
Low-Value Consumers High-Value Consumers Total

$100 value, 1 cartridge $200 value, 2 cartridges Revenue
Strategy 1: $100 $150 $250

$50 printer +
$50 cartridge
Strategy 2: $0 $100 $200 $300
printer + $100
cartridge
● This strategy works because high-value costumers

use more cartridges than low-value costumers.
● “Metering” schemes, such as this, are used to
identify high-value consumers and allow for indirect
price discrimination.
Indirect price discrimination
● When arbitrage cannot be prevented; OR when high- and

low-value groups cannot be identified, sellers can still
use price discrimination by designing products or
services that appeal to different consumer groups.
• Discount coupons: grocery stores allow more price
sensitive consumers (shoppers with a lower income) to use
coupons to receive lower prices, high-income/value
shoppers are less price sensitive and less likely to clip
coupons.
• This pricing scheme can be dangerous, though. High-value
customers have the option of clipping coupons, and if too
many do the scheme will become unprofitable.
• A second risk is creating profitable entry opportunities for
rivals. For example, HP’s ink cartridges, unless HP can
prevent rivals from selling lower-priced ink cartridges or
refills, HP will lose sales.
Indirect price discrimination (cont’d)
● In some cases, businesses can increase profit by

“tying” the sales of one product to another, e.g., new
ink cartridges to sale of printers.
• BUT such ties may violate antitrust laws.
● In fact, a former antitrust prosecutor advises:
• “Do not tie the sale of one product to another. Such
arrangements are only legal in a few rare instances—
to ensure effective functioning of complicated
equipment, to name one. But they are generally
against the law.”
Price discrimination in software
● Software manufacturers discriminate between high- and low-

value consumers by offering different versions of software
designed, and priced, to appeal to different groups.
● For example, the software MINITAB, sold an “academic”
version (aimed at students) for $50 in March 2009, while
selling a full-featured model (aimed at businesses) for $1,195.
• Here the threat of cannibalization is clear and to avoid losing money
the manufacturer must price and/or design the two versions so that
high-value customers really do prefer the more expensive version.
• For MINITAB this meant putting limits on the number of observations

and omitting some statistical tests in the academic version
Price discrimination in software (cont’d)
Software Version Home Users Commercial Users

Full-featured version $175 $500
Disabled version $150 $200
Strategy Implementation Total Profit
1. Sell only to Price full-featured version at $500

commercial users at a $500, do not sell home
single high price. version
2. Sell to all users at a Price full-featured version at $175 + $175 = $300
single low price. $175.
3. Price discriminate: Price disabled version at $150 + $449 = $599
Price high to the $150; price full-featured
commercial users; price version at $449.
low to the home users
More pricing schemes
● In 1990, IBM released the LaserPrinter E – a lower-price

alternative to the popular LaserPrinter
• The LaserPrinter E printed at a speed of 5 pages per minute while the
LaserPrinter could print at 10 ppm.
• IBM added chips to the LaserPrinter E (increasing the MC) to slow the
printing speed and ensure the LaserPrint was still the preferred model.
• This pricing scheme is known as the “damaged goods” strategy
● Frequently, successful price discrimination attracts competition.
• Between 1997 and 2005 competition drove United Airlines to
reduce prices on its business class tickets on the Philadelphia
to Chicago flight.
• In 1997, the highest-priced tickets were 3 times higher than the
lowest priced tickets. By 2005, the highest-price was less than
twice the low price.
UA: PHX to ORD
Volume discounts
● Volume of purchase can also be used to

discriminate between buyers.
● For example: a single customer willing to pay $7
for the first unit purchased, $6 for the second, $5
for the third, etc.
• A price of $7 means the consumer will buy only one
unit. But a price of $6 means the consumer will buy
two units.
• The price represents the value the consumer places
on each unit consumed. This is known as an
individual demand curve.
Volume discounts (cont’d)
● If a seller sets a single price, she will sell all units

where MR > MC.
• For this example, 3 units at a price of $5 – but if MC is
just $1.50 this leaves unconsummated wealth-creating
transactions (the remaining three units valued at $4,
$3, and $2).
• To increase profitability the seller must find a way to
sell the additional units at a lower price without
lowering the price of the first three units sold.
Volume discounts (cont’d)
This can be done in a number of ways:

● Offer volume discounts; for example, price the first good at $7, the
second at $6, the third at $5, and so on.
● Use two-part pricing (fixed price plus a per-unit price). Charge a
per-unit price low enough to consummate all wealth-creating
transactions (set it at MC ¼ $1.50).
• The consumer’s total value for six units is $27 ( ¼ $7 þ $6 þ $5 þ $4 þ
$3 þ $2), and six units cost just $9 (¼ 6*$1.50) to produce. Bargain
over how to split the remaining surplus ($18 ¼ $27 – $9) created by the
transaction. This is the “fixed price” part of the transaction.
● Bundle the goods. The consumer’s total value for six units is $27.
With enough bargaining power, the entire consumer surplus can be
capture, if not, then bargain over how to split it.
Bundling
● When selling bundled goods don’t forget: When bargaining

with a customer, do not bargain over unit price; instead,
bargain over the bundled price.
● Sellers can bundle like items where consumer value decreases
with each additional unit OR sellers can bundle different
items with different consumer demands.
• For example: a movie theatre – two group of customers prefer
two different types of film (romantic comedy and SciFi). The
theatre owner cannot directly price discriminate but in bundling
the two picture together into a double feature, the problem is
avoidable.
• Suppose there are 50 customers willing to pay $3 for the SciFi
film but only $2 for the romantic comedy, and 50 willing to pay
$3 for the chick flick but only $2 for the SciFi.
Bundling (cont’d)
● If the theatre sets a single price for a ticket to any movie, it must
face the pricing trade-off – sell to all consumers at $2 (total revenue
$200 per film) or sell to half the movie goers at $3 (total revenue
$150 per film). Pricing low is more profitable, earning $400 on the
two films combined.
● BUT if the theatre combines the movies into a double feature it can
sell to all customers at a price of $5 increasing total revenue for the
two films to $500
● Bundling in this way makes consumers more homogeneous (both
consumer groups are now willing to pay the same price).
● This also allows sellers to earn more if willingness to pay is more
homogeneous for the bundled good than separate goods
• For cable TV, providers make 65% more selling bundled packages than
if each channel were sold separately.
CHAPTER
15 Strategic Games
PowerPoint Slides
© Luke M. Froeb,
Vanderbilt 2014
● A Nash equilibrium is a pair of strategies, one for each player,
in which each strategy is a best response against the other.
● When players act rationally, optimally, and in their own self-
interest, it’s possible to compute the likely outcomes
(equilibria) of games. By studying games, we learn not only
where our strategies are likely to take us, but also how to
modify the rules of the game to our own advantage.
● Equilibria of sequential games, where players take turns
moving, are influenced by who moves first (a potential first-
mover advantage, or disadvantage), and who can commit to a
future course of action. Credible commitments are difficult to
make because they require that players threaten to act in an
unprofitable way—against their self-interest.
● In simultaneous-move games, players move at the same time.
• continued
● In the prisoners’ dilemma, conflict and cooperation are in

tension—self-interest leads to outcomes that reduce both
players’ payoffs. Cooperation can improve both players’
payoffs.
● In a repeated prisoners’ dilemma, it is easier for players to
learn to cooperate. Here are some general rules of thumb:
• Be nice: No first strikes.
• Be easily provoked: Respond immediately to rivals.
• Be forgiving: Don’t try to punish competitors too much.
• Don’t be envious: Focus on your own slice of the profit pie,
not on your competitor’s.
• Be clear: Make sure your competitors can easily interpret
your actions.
Blu-ray
● In February 2002, nine electronics companies, led by Sony,

announced plans for the next big video recording format: Blu-Ray
● By August of that same year, Toshiba and NEC announced plans
for a rival technology: HD-DVD
● A common standard among all competitors (rather than two rival
technologies) would have best benefited consumers.
• With a common standard, demand for the new technology would have
grown more rapidly and all producers would have benefitted.
• But some producers would benefitted more than others: Sony would
have profited from the choice of Blu-ray while Toshiba would have
preferred HD-DVD.
● Both sides waged a “standards” war, recruiting big name
entertainment groups (such as Disney, Paramount Pictures, HBO,
etc.) to take sides. In the end, Blu-Ray won after Walmart
announced it would sell only Blu-Ray disc players.
Blu-ray (cont’d)
● In a standards war, the profit of one firm depends on

the actions of other firms, rivals, consumers, and
suppliers.
● This type of interdependence is characteristic of
games, and we analyze it using game theory.
● A “game,” has three elements: players,
options/moves available and the payoffs resulting
from each combination of moves.
● Assuming that each player acts optimally, rationally
and selfishly, the likely outcomes, or equilibria, of
the game can be computed.
Introduction: Game theory
● Aside from telling firms where competition is likely to lead

them, game theory can also offer advice to change the rules of
the game to one or both player’s advantage.
● For Sony and Toshiba, both realized there were two potential
equilibria to their game (Blu-ray vs. HD-DVD):
• Consumers, retailers, manufacturers, content providers, etc.
would coordinate on one of these standards
• The standards war was the result of each firm attempting to
convince the market participants and public that their respective
technology would become the standard (competition “for the
market”)
● Game theory also suggest strategies to reduce competitive
intensity to increase profit (“strategy” from ch. 11)
Sequential-move games
● In game theory, there are two types of games. The first of

which is known as sequential-move games.
• For a sequential-move game, players take turns.
• Each competitor is given the opportunity to evaluate their
rival’s move before selecting how to proceed.
● To analyze sequential games, use the “extensive-” or
“tree-form” of a game, and look ahead and reason back.
• For example, a two-move, two-player game. Player One
(moving first) must anticipate the reaction of Player Two to
each of One’s possible moves to determine One’s best move
• Equilibrium is when each player chooses a best available
move, anticipating how the other will react.
Nash Equilibria
● Named for John Nash, mathematician and Nobel

laureate in economics.
• Nash is known as the “father” of non-cooperative game
theory
• He proved the existence of equilibrium in all well-defined
games in his doctoral dissertation at Princeton.
● Definition
• A set of strategies, one for each player, such that no player
has incentive to unilaterally change her action.
• Players are in an equilibrium if a change in strategies by
any one of them would lead that player to earn less than if
she remained with her current strategy.
Entry “game”
● Suppose a potential entrant is deciding whether to

enter an industry in competition with an incumbent
firm/monopoly.
● If the entrant decides to enter the industry, the
incumbent has two paths of action:
• Accommodate the entry; or
• Fight the entry.
● By modeling the situation using game theory, we
find that accommodating an entrant leads to profits
while fighting an entrant leads to losses.
Modeling entry decision
Modeling entry decision (cont’d.)
● To find the best strategy in a sequential game put two

lines through the paths that present suboptimal
choices.
● In this game, equilibrium is {In, Acc}:
Deterring Entry
● Part of game theory is figuring out how to change the game to

your own advantage.
• In the current game, if the incumbent firm can deter entry, it
would earn $10 profit, instead of only $5.
● One way of deterring entry is to threaten (in such a manner as
to be truly believable) to “commit” to fight the entry and price
low.
• To model this commitment, take away one of the incumbent’s
options, the ability to accommodate entry.
● By committing to fight entry, the incumbent can benefit, even
though the incumbent would be worse off if entry did occur,
and the incumbent had to fight.
• In other words, the best threat is one you do not have to use.
Types of games: Simultaneous-move
● The second type of game is simultaneous-move. In

this type of game players move simultaneously.
• This does not literally require players moving at same
time, just that each player plans a move without
knowing the other player’s move in advance
● To analyze a simultaneous-move game we use a
matrix or “reduced-form” of the game.
● Again the likely outcomes are Nash equlibria, where
no player has an incentive to change, i.e., each player
is doing the best they can.
Simultaneous-move games (cont’d.)
● In a two-player game, each player’s payoffs can be

modeled in a table/matrix by assigning player One to
choose row strategies and player Two to choose column
strategies.
● If player one’s strategy payoffs are in rows 1,2,3,4,5 and
player two’s strategy payoffs are in columns A,B,C,D,E
then the actual payoff can be found by locating the cell in
which the two strategy decisions (row, column) meet.
● Compute Nash Equilibrium by finding pairs of strategies
where both players are choosing the best possible
response to their competitor’s strategy
Modeling simultaneous-move games
Player Two
A B C D E
P O 1 9, 9 7, 1 5, 6 3, 4 1, 1
l n
a e 2 7, 8 5, 2 3, 6 1, 4 3, 3
y
3 5, 6 3, 3 1, 8 9, 7 1, 5
e
r
4 3, 9 1, 9 9, 4 7, 9 5, 9
5 1, 2 9, 8 7, 7 5, 6 3, 7
Analyzing simultaneous-move games
● For player one:

• For each of player Two’s strategies (each column), select the row
(underline it) that maximizes One’s profits.
• For example if Two plays column A, One would do best to use strategy
1, which earns a nine dollar payoff. For each column underline player
one’s best response.
● For player two:
• Examine each of player One’s strategies (each row) and select the
column strategy that maximizes player Two’s profits
• For example on row 4, player Two would be indifferent between A,B,D,
and E because each earns a $9 payoff. Underline all four best
responses.
● To find the game equilibria, locate the cell (or cells) in which both
numbers have been underlined—these are best responses to each
other.
Finding Equilibria
Player Two
A B C D E
1 9, 9 7, 1 5, 6 3, 4 1, 1
P O
2 7, 8 5, 2 3, 6 1, 4 3, 3
l n
a e 3 5, 6 3, 3 1, 8 9, 7 1, 5
y
e 4 3, 9 1, 9 9, 4 7, 9 5, 9
r
5 1, 2 9, 8 7, 7 5, 6 3, 7
● This game has three equilbria, where each player is

responding optimally to their rival, i.e., neither
player has incentive to change strategy
The prisoners’ dilemma game
● The police suspect that Frank and Jesse robbed a bank,

but they have no direct evidence. They picked them up in
their car, a parole violation which carries a sentence of
two years. The US attorney offers both the same deal:
• If only one confesses, the one who confesses goes free, while
the other one receives ten years in jail.
• If they both confess, each receives five years in jail.
• If neither confesses, they both serve two years for violating
parole.
Frank
J s e Confess Say nothing
e sConfess -5 , -5 0 , -10
Say nothing -10 , 0 -2 , -2
Why the PD is interesting
● The only equilibrium is for both to confess and serve

five years
● But BOTH would be better off if neither confessed
● By following self interest, the players thus make the
group worse off
● The tension between conflict (self interest) and
cooperation (group interest) is inherent in the prisoners’
dilemma game.
● If the players/prisoners could cooperate, they make
themselves better off.
• Prosecutors separate defendants for precisely this reason,
i.e., to make cooperation more difficult.
The Prisoners’ Dilemma in business
● A pricing dilemma frequently faced by businesses

selling substitute products has the same logical
structure as the prisoners’ dilemma
• Two competing firms would both be better off if they
could price high
• BUT that outcome is not an equilibrium
• If the competing firms could “coordinate” pricing,
they would make themselves better off.
• BUT beware of violating antitrust laws
Don’t break the antitrust laws
● Advice from an antitrust prosecutor:

• Do not discuss prices with your competitors. That is one of those
“black-and-white,” areas. The enforcement authorities can be counted
on to bring a criminal prosecution if they learn that you have met with
you competitors to fix prices or any other terms of sale. Jail time is
increasingly common.
● Other illegal solutions to the prisoners’ dilemma are

to allocate customers, rig bids, or agree not to
compete in each other’s areas. Again the advice is:
• Do not agree with your competitor to stay out of each other’s markets.
It may be tempting to seek freedom of action in one part of the country
by agreeing with a competitor not to go west if he will not come east.
Avoid that temptation. The consequences of the discovery of such
behavior by the enforcement authorities are likely to be the same as the
unearthing of a price-fixing conspiracy.
A (potentially) legal solution
● One way to break the prisoners’ dilemma pricing (low, low)

is for the two competing firms to merge.
● HOWEVER, if the only incentive to merge is to eliminate
competition, the merger may violate antitrust laws.
● The Clayton Act outlaws any merger that substantially lessens
competition, and a merger to get firms out of a prisoners’
dilemma could be viewed as anticompetitive.
● Rule of thumb: Your merger is not likely to be challenged by
the competition agencies if (i) there is a pro-competitive
justification for it; (ii) if it is not likely to result in higher
prices; and (iii) if customers are not complaining about its
anticompetitive effects
The price discrimination dilemma
● Price discrimination by one firm is always profitable.

However, when competing against other firms, price
discrimination sometimes becomes a prisoners’
dilemma
● Example
• Supermarkets and pizza delivery joints will circulate
coupons to customers who live close to their competitors.
Many other businesses use similar techniques
• In each case, rivals would likely react by offering lower
prices to the customers living near rivals, and the resulting
price is much lower than if they had not begun to
discriminate in the first place
Price discrimination dilemma (cont’d.)
● This table shows the resulting equilibrium between

two competing grocery stores that are discriminating
by geography (offering discounts to consumers who
live near rivals).
● The Nash equilibrium {price discriminate, price
discriminate} is for both to earn zero.
Advertising dilemma
● In advertising too, there is a dilemma firms face that

can be modeled after the prisoners’ dilemma.
● For these two cigarette companies, both could make
more money by not advertising, BUT given the
share-stealing nature of the advertisements
(structured to steal market share from rivals rather
than increase demand) the {don’t advertise, don’t
advertise} cell is not an equilibrium – either firm
does better by advertising
The free-riding dilemma
● An MBA study group is assigned a project. Each

member can work hard or shirk. If both work hard,
they get A’s; if both shirk they get C’s; if only one
works hard they both get B’s.
● Suppose their preferences are identical:
1) Shirk and a B is preferred to
2) Work and an A which is preferred to
3) Shirk and a C, which is preferred to
4) Work and a B.
The free-riding dilemma (cont’d.)
● Given the preferences of each student, we see that this game has the
same logical structure as a prisoners’ dilemma.
● The Nash equilibrium is (shirk, shirk) – BUT, as any student will

verify, this outcome is inefficient, the students would jointly prefer
{work, work} outcome (and the resulting “A”).
● This outcome is not an equilibrium though, once your partner is
working hard, the best response is to shirk.
● A successful study group finds a way to manage this conflict and
avoid the {shirk, shirk} equilibrium
Lessons of Prisoners’ Dilemma
1 Don’t get caught in one

• Change the payoff structure of game so your profits are not dependent
on others’ actions
• Differentiate the product so that it can’t be easily imitated
• Find a way to lower cost
2 How to get out of repeated one (based on Axelrod’s Tournament)

• Be nice: no first strikes
• Be forgiving: don’t punish competitors too much if they defect from
the cooperative outcome
• Be easily provoked: respond immediately to rivals.
• Don’t be envious: focus on your strategy and market share
• Be clear: make sure your competitor can easily interpret your actions.
3 Control competition LEGALLY!!
The game of chicken
● The classic game of “chicken” has two equilibria:
● Dean can make himself better off by committing

to going straight (which changes a simultaneous-
move game into a sequential move game with a
first-mover advantage).
● Coordination is REALLY important in this game.
Game of Chicken (cont’d.)
● By committing to going straight, Dean exploits the

inherent first-mover advantage. If James moves first
and selects “straight,” Dean is forced to swerve.
● But convincing your competitor that you have
committed to a position can be difficult
● Do you have to hit him to convince him you are
going straight?
The game of chicken in business
● In 2000, a company (A) was deciding between Italy and

South Africa as locations for which to develop a new
strain of hybrid grapes.
● The Italian market was bigger so A preferred Italy as a
growing site, but A’s only competitor (B) was facing the
same choice for the same strain of grapes.
● Both would prefer to be the sole entrant, and both would
prefer Italy to South Africa.
● This is essentially a game of chicken.
Growing grapes (cont’d.)
● If A can find a way to move first and go into Italy, B

will choose S. Africa
Firm A
S. Africa Italy
Firm B
Italy S. Africa Italy S. Africa
50 , 100 -50 , -50 0,0 100 , 50

The dating game
● The dating game is motivated by the following story: Sally

likes ballet. Joe likes wrestling. They both like each other.
They would prefer to be together regardless of event. But the
equilibrium is for them to attend separate events
● To increase payoffs, Sally and Joe could agree to rotate event

attendance. Ballet one week, wrestling the next – this would
allow for a higher group payoff (sum of their individual
payoffs), but this solution is possible only if the game is
repeated.
The dating game (cont’d)
● Using the dating game firms can also analyze the tension
between different divisions of a corporation.
● For example: Saturn and Cadillac, both divisions under
General Motors.
● Both receive a volume discount when buying tires from a
single supplier. BUT each has their own preference: Saturn,
Goodyear tires; Cadillac, Michelin. This conflict will end up
negatively affecting the entire corporation and will be re-
examined later (in a chapter devoted to divisions of firms)
Shirking/Monitoring Game
● How to manage workers can be seen as a game between the

employer and employee.
● This game has no equilibrium in “pure strategies”

• Instead, players randomly choose actions, called “mixing”
• Idea is to keep your opponent guessing
• The employer could combine random monitoring with an incentive
based compensation scheme – such as rewarding the employee with a
bonus when/if the employer finds her hard at work.
• Or if found shirking, the employer could dismiss, demote or fine the
employee
Title?
● In 1992, America Airlines (AA) announced a new pricing strategy - Value

Pricing.
• American narrowed the number of fares possible from 500,000 to 70,000 by
classifying each into one of four classes (first class, coach, discounted 7 and 21
day purchase) and began pricing based on flight length.
• Changes resulted in lower list prices for both business and leisure travelers.
● According to AA, Value Pricing was to create “simplicity, equity, and
value” in their prices
● Company expectations
• Demand would be stimulated
• Volume on AA planes would increase
• Overall growth in market share and profitability would follow
● What really happened??
• Competitors responded aggressively by cutting prices
• Industry profits plummeted
• Value Pricing initiative abandoned within months of its launch
CHAPTER 16 Bargaining
PowerPoint Slides
© Luke M. Froeb,
Vanderbilt 2014
● Strategic view of bargaining: model as either a
simultaneous-move or sequential-move game.
● A player can gain bigger share of the \“pie” by
• changing a simultaneous-move game into a sequential-
move game with a first-mover advantage;
or by
• committing to a position.
● Credible commitments (threats) are difficult to make
because they require players to commit to a course of
action against their self-interest. Thus, the best threat
is one you never have to use.
• continued
● The strategic view of bargaining focuses on how the

outcome of bargaining games depends on who moves
first and who can commit to a bargaining position, as
well as whether the other player can make a counteroffer.
● The non-strategic view of bargaining focuses on the
gains and alternatives to agreement to determine the
outcome of barganing.
• Main insight: The gains from agreement relative to the
alternatives to agreement determine the terms of any
agreement.
• Anything you can do to increase your opponent’s relative
gains from reaching agreement or to decrease your own
will improve your bargaining position.
1: NBA
• In summer 2011, National Basketball Assc. owners were negotiating
with the players’ union over how to split revenues
• Union wanted 57%, owners only offered 50%
• Owners locked out the players, cancelling the start of the season
• After months of legal threats and lost revenue, players finally
accepted owners’ initial offer
4
2: Texaco
• In 1985, Texaco was found guilty by a Texas jury for interfering with
Pennzoil’s attempt to buy Getty Oil.
• Texaco was fined $10.5 billion, but appealed the verdict and began negotiating
with Pennzoil.
• In 1987, Texaco filed for bankruptcy. Pennzoil was then unable to seize
control of Texaco’s assets.
• Texaco was also freed from the responsibility to pay interest and dividends.
• One year later Texaco and Pennzoil settled the case, with Texaco having
to pay only $3 billion. Texaco successfully used bankruptcy to reduce its
liability by over 70%
• This chapter examines bargaining, and strategies to improve your
bargaining position, like those used by Bear Stearns and Texaco .
5
Introduction: Bargaining
• There are two complementary ways to look at bargaining:
• the strategic view analyzes bargaining using the tools of game theory (ch 15).
Bargaining can be viewed as either a simultaneous‐move game with two
equilibria or a sequential‐move game, where one player gains an advantage by
committing to a position.
• the non‐strategic view acknowledges that real life negotiations don’t have fixed
rules as formal games do. This view postulates that the alternatives to
agreement determine the terms of agreement, regardless of the rules of the
negotiating game.
• If you can increase your opponent’s relative gain, or decrease your own, you can gain a
bigger share of the pie.
• By declaring (or threatening) bankruptcy, Bear Stearns and Texaco were able to improve their
bargaining “position”, i.e., by changing the alternatives to agreement, they changed the
terms of agreement.
6
Bargaining: a simultaneous‐move game
• Example: Wage negotiations
• Management and labor are bargaining over a fixed sum of $200 million
• Two possible strategies are available to each player: “bargain hard” or
“accommodate.”
• If both bargain hard, no deal is reached. Neither side gains.
• If both accommodate, they split the gains from trade.
• If one player bargains hard and the other accommodates, then the player
who bargains hard takes 75% of the “pie”
7
Bargaining: a simultaneous game (cont.)
• There are two equilibria for this game
• Management prefers the lower‐left equilibrium
• Labor prefers the upper‐right.
• This bargaining game has the same structure as a game of “chicken”
• Each party can gain by committing to a position, which turns it into a sequential
game
8
Bargaining: a sequential‐move game
• In sequential‐move bargaining the first “player” makes an
offer that the second “player” can accept or refuse.
• Again to analyze a sequential‐move game look ahead and
reason back.
• The first‐mover “looks ahead and reasons back” to determine the
how her rival will react to each possible move. Then the first‐mover
can determine the consequences of each possible move.
• In this case, the sequential‐move games present a “first‐
mover advantage,” i.e., by moving first a player can gain an
advantage.
• Using the same wage negotiation example, we can look at
sequential‐move bargaining and first‐mover advantage.
9
Bargaining game: first‐mover advantage
• Management “wins” by moving first and making a low offer
Management
low offer generous offer
Union
strike accept strike accept
0,0 150 , 50 0,0 50 , 150

10
Bargaining game: first‐mover advantage
• Union can change the outcome by credibly committing to strike if a
low offer is made
Management
low offer generous offer
Union
strike strike accept
0,0 0,0 50 , 150

11
Sequential‐move bargaining (cont.)
• Because the management has the first‐mover
advantage, it is in their best interest to make a low offer,
and it is in the union’s best interest to accept that offer.
• However, if the union can effectively threaten to strike
(in such a way that the management believes them)
they can change the outcome of the game despite
management’s first‐mover advantage.
• Credible threats are hard to make because they require the
union act against its self interest.
• If management doesn’t believe the threat, the union might
actually have to follow through on the threat.
• So, again, the best threat is one you never have to use.
12
Non‐strategic View of Bargaining
• The outcome in strategic bargaining “games” is dependent
on the rules of the game, but in real life, the rules are not
always clear.
• John Nash proved that any reasonable outcome to a bargain
would maximize the product of the bargainers’ surplus.
• This is known as an “axiomatic” or “non‐strategic” view of
bargaining.
• In this view, the gains from bargaining relative to the alternatives
to bargaining, determine the terms of any bargain.
• This view also teaches that to increase your bargaining power,
• you can increase your opponent’s gain from reaching agreement or decrease
your own.
• If your rival has more to gain by agreeing, he becomes more eager to reach
agreement, and accepts a smaller share of the surplus.
13
Non‐strategic view (cont.)
• Nash’s axiomatic approach:
• [ S1(z) – D1 ] x [ (S2(z) – D2 ] , where:
• z is the agreement
• S1(z) is the value of the agreement to player 1 (sub 2 for player two)
• D1 is “disagreement value,” or pay‐off if no agreement is reached, for player 1
(sub 2 for player two)
• So player 1’s gain from agreement is (S1(z) – D1)
14
Non‐strategic view (cont.)
• For example, two brothers are bargaining over a dollar.
• If no agreement is reached, neither participant gains.
• If they reach an agreement (z)
• Player one, the older brother, has a surplus of z
• Player two, the younger brother, has a surplus of 1 – z
• Nash’s solution is for them to “split” the gains from trade, i.e., {½, ½} is the axiomatic
solution.
• But, now the older brother receives a $0.50 bonus for “sharing nicely,” and the
total gain rises from $1.00 to $1.50
• The Nash bargaining outcome is for the brothers to split to total gains – each receiving
$0.75, meaning the older brother effectively shares half of his bonus.
• By increasing the first player’s gain to reaching agreement, he becomes more eager to reach
agreement, and “shares” his gain with his brother.
15
Bonuses for agreement
• Giving a bonus for reaching agreement is similar to incentive
compensation schemes used by many companies.
• When salespeople are offered bonuses it increases their eagerness to
reach agreement and this induces them to accept “weaker”
agreements.
• So giving salespeople such a bonus driven incentive will lead to lower prices
when they negotiate with customers.
• (This concept will be further addressed in chapter 20)
16
Alternatives to agreement
• Nash’s bargaining solution incorporates the effect of alternatives to
agreement on the agreement itself. This creates some sound
bargaining advice:
• To improve your own bargaining position, increase your opponent’s gain
from reaching agreement, S2(z) – D2, or reduce your own gain from reaching
agreement, S1(z) – D1.
• When you increase your opponent’s gain in agreement, you make him more
willing to agree.
• Reducing your own gain makes you less willing to compromise and helps to
improve your position.
17
How Nash’s view differs from strategic
• The strategic view of bargaining places a greater emphasis on timing
and commitment in determining the outcome of the game.
• With the labor/management example, the union’s commitment to strike,
or management making the first move, changes the equilibrium of the
game.
• But neither action changes the gains of the agreement so neither would
affect the Nash bargaining outcome.
• The Nash bargaining outcome incorporates the idea that if you
decrease your own gain to agreement you become a better
bargainer.
• EXAMPLE: the best time to ask for a raise is when you have another
attractive offer waiting for you, you have less to gain by reaching
agreement. Your bargaining position improves.
• This is similar to the idea of “opportunity cost.” The opportunity cost of
staying at your current job is giving up the new offer; if the new job pays
more, you’re costs (bottom line) go up.
18
Improving a Bargaining Position
• Discussion Question: When is the best time to buy a car?
• Hint: Remember, car salesmen are generally paid a commission for the sales
they make.
• Discussion Question: How can mergers or acquisitions improve
bargaining power?
19
Merger bargaining example
• A Managed Care Organization (MCO) markets its network to
an employer
• Network value is $100 if it contains either one of two local hospitals
• But the value rises to $120 if it contains both
• And there is no value without at least one of the hospitals
• The gain to the MCO from adding either of the hospitals to
its network when it already has the other is $20
• Nash bargaining solution predicts this is evenly split
• So, each hospital gets $10 for joining the MCO
• But if the hospitals merge and bargain together,
• The MCO can no longer drop one of the hospitals, so the gain from striking a
bargain with the merged hospital is the full $120
• The gain is evenly split in the Nash bargaining solution
• The merged hospitals thus receive $60, a post‐merger gain of $40
20
Health care mergers
• In Rhode Island in 2003, Blue Cross Blue Shield (BCBS, the health
insurance company covering state employees) hired PharmaCare to
provide pharmaceutical services.
• PharmaCare created a network of retail pharmacies willing to sell drugs
to state employees at discounted rates.
• The previous contract had allowed employees to buy from any pharmacy but
was considerably more expensive.
• In the new PharmaCare contract, 4 retail pharmacies were excluded from the
plan. These 4 firms lobbied RI legislature to include them in the new plan and
offered to provide the same discounted price but PharmCare declined their
request to join.
• Pharmacare maintained that allowing the other stores to join would
eliminate the savings generated by having a restricted network.
PharmaCare’s bargaining position would deteriorate.
• Many politicians, though, like “freedom‐of‐choice” bills that would open any
pharmacy willing to meet the negotiated prices.
21
Title?
• Under the 2002 CHAOS (Create Havoc Around Our System) plan, flight
attendants threatened to either stage a mass walkout for several days
or to strike individual flights of Midwest Express, with no advance
warning to either customers or management.
• Midwest Express reacted by cancelling all flight attendant vacation,
and threatened to lock out any employee who participated in the
strike
• Flight attendant union promised funding from its strike fund to
support any attendant who ended up locked out.
• The biggest strength of the union’s threat was that it could be
effective without full implementation.
• The threat of random strikes was enough to push passengers to other
airlines.
• After 30 days of CHAOS, the union successfully negotiated a new
contract.
22
CHAPTER
17 Making Decisions
with Uncertainty
● When you’re uncertain about the costs or benefits of
a decision, replace numbers with random variables
and compute expected costs and benefits.
● Uncertainty in pricing: When customers have
unknown values, you face a familiar trade-off: Price
high and sell only to high-value customers, or price
low and sell to all customers.
● If you can identify high-value and low-value
customers, you can price discriminate and avoid the
trade-off. To avoid being discriminated against, high-
value customers will try to mimic the behavior and
appearance of low-value customers.
• continued
● Difference-in-difference estimators are a good way

to gather information about the benefits and costs of
a decision. The first difference is before versus after
the decision or event. The second difference is the
difference between a control and an experimental
group.
● If you are facing a decision in which one of your
alternatives would work well in one state of the
world, and you are uncertain about which state of the
world you are in, think about how to minimize
expected error costs.
TeleSwitch
● A large telecom supplier, TeleSwitch, sold its product

only through distributors.
● In 2000, their largest clients wanted to deal directly with
TeleSwitch – and avoid the middle man distributor.
TeleSwitch was unsure what to do.
• They might lose large customers if they didn’t switch.
• But, they might lose distributors (and their small
customers) if they did.
• There is a lower probability of losing dealers (because they
would have to incur costs to change suppliers)
• But this would have a much larger impact on profit.
● How should we analyze decisions like this??

Introduction: Undertainty
● This problem illustrates the type of uncertainty that

exist in most business decisions.
● This chapter looks at ways to help deal with
uncertainty and arrive at decisions that will best
profit your firm.
● By modeling uncertainty, you can:
• Learn to make better decisions
• Identify the source(s) of risk in a decisions
• Compute the value of collecting more information.
Modeling Uncertainty
● To model uncertainty we use random variables to

compute the expected costs and benefits of a decision.
● Definition: a random variable is simply a way of
representing numerical outcomes that occur with
different probabilities.
● To represent values that are uncertain,
• list the possible values the variable could take,
• assign a probability to each value, and
• compute the expected values (average outcomes) by
calculating a weighted average using the probabilities
as the weights.
Random variables
● Definition: a binomial random variable, X, can

have two values, x1 or x2, with probabilities, p and 1-
p. The expected value (mean) for a binomial random
variable is:
E[X]=p*x1+(1‐p)x2
● Definition: a trinomial random variable, X, can
have three values, x1, x2, or x3, with probabilities p1,
p2, and 1-p1–p2. The mean for a trinomial random
variable is:
E[X]= p1*x1+ p2*x2+(1‐ p1‐p2) x3
How to model uncertainty
● “Wheel of Cash” example:

• The carnival game wheel is divided like a pie into thirds, with
values of $100, $75, and $5 painted on each of the slices
• The cost to play is $50.00
• Should you play the game?
• Three possible outcomes: $100, $75, and $5 with equal
probability of occurring (assuming the wheel is “fair”)
• Expected value of playing the game is
1/3 ($100) + 1/3 ($75) + 1/3 ($5) = $60
• But, if the wheel is biased toward the $5 outcome, the
expected value is
1/6 ($100) + 1/6 ($75) + 2/3 ($5) = $32.50
TeleSwitch’s Decision Tree
● The probability of losing customers is 0.6

● The probability of losing distributors is 0.2
Telecom Firm
Sell directly to large customers Sell only through dealers
(.20) × $30 + (.80) × $130 = $110 (.60) × $100 + (.40) × $130 = $112
Distributors leave Distributors stay Large customers leave Large customers stay
(probability = .20) (probability = .80) (probability = .60) (probability = .40)

Firm profit = $30 Firm profit = $130 Firm profit = $100 Firm profit = $130
Entry Decision with Uncertainty
● The probability of retaliation (no accommodation) to an entry

decision (as modeled in ch 15) is 0.5
Entrant
Enter Stay Out
(.50) × $60 + (.50) × $-40 = $10 (.50) × $0 + (.50) × $0 = $0
Incumbent prices high Incumbent prices low Incumbent prices high Incumbent prices low

Entrant profit = $60 Entrant profit = $-40 Entrant profit = $0 Entrant profit = $0
Dealing with uncertainty
● Discussion: How do you respond to an invitation from a

friend to invest in a real estate venture that depends on
uncertain future demand and interest rates?
• Calculate the potential gains and loses based on different
combinations of high and low interest rates and high and
low demand
• Whoever proposed the venture probably presented the best
case scenario (low interest rates and high demand) – and
that is the only combination (of four possible outcomes)
under which you will do well.
• Either don’t invest or find a way that aligns your friend’s
incentives with your own, i.e., he gets a payoff only if the
venture does well.
Uncertainty in Pricing
● Uncertainty in pricing arises when the demand for a

product is unknown.
● To model this uncertainty, classify the number and type
of potential customers. For example:
• High-value consumers willing to pay $8
• Low-value consumers willing to pay $5
• Suppose there are equal numbers of each consumer group
● Discussion: If MC= $3, what is optimal price?
• By pricing high, you would earn $5 per sale each time a
high-value costumer shops – or %50 of the time
• By pricing low, you would earn $2 per sale but would be
able to sell to both high- and low-value costumers – 100%
of the time.
Uncertainty in Pricing (cont’d.)
● Answer: Price High
Pricing Decision
Price High Price Low
(.50) × $5 + (.50) × $0 = $2.50 (.50) × $2 + (.50) × $2 = $2
Get high-value customer Get low-value customer Get high-value customer Get low-value customer

Profit = $5 Profit = $0 Profit = $2 Profit = $2
Price Discrimination Opportunity
● If you can identify the two types of customers, set

different prices to each group, and prevent arbitrage
between them, then you can price discriminate.
• Price of $8 to the high-value customers
• Price of $5 to the low-value customers.
● Discussion: When buying a new car, sales people
discriminate between high- and low-value customers.
How do they do this?
● Discussion: What can you do to defeat this?
Natural experiments
● To gather information about the benefits and costs of

a decision you can run natural experiments.
● Natural experiment example: A national restaurant
chain
• A regional manager wanted to test the profitability of a
special holiday menu
• To do this, the menu was introduced in half the restaurants
in her region.
• In comparing sales between the new menu locations and
the regular menu locations (the control group) the manager
hoped to isolate the effect of the holiday menu on profit.
Natural experiments (cont’d.)
● This is a difference-in-difference estimator. The first

difference is before vs. after the introduction of the menu; the
second difference is the experimental vs. control groups
● Difference-in-difference controls for unobserved factors that
can influence changes
● The manager found that sales jumped during the holiday
season – but the increase was seen both in the control and
experimental groups—both increased by the same amount.
● The manager concluded that the holiday menu’s popularity
came at the expense of the regular menu. So the holiday menu
only cannibalized the regular menu’s demand and didn’t
attract new customers to the restaurant.
Natural experiments (cont’d.)
● Natural experiments can be useful in many different

contexts.
● When the FTC looked back at a 1998 gasoline
merger in Louisville, they used their own version of
a difference-in-difference estimator.
• Three control cities (Chicago, Houston, and Arlington)
were used to control for demand and supply shocks that
could affect price.
• The first difference was before vs. after the merger; the
second difference was Louisville prices vs. prices in control
cities– this allowed the FTC to isolate the effects of the
merger and determine its effect
1998 LouisGasoline Merger
Minimizing expected error costs
● Sometimes, when faced with a decision, instead of

focusing on maximizing expected profits (benefits minus
costs) it can be useful to think about minimizing
expected “error costs.”
● This approach is helpful when one alternative would
work well only under certain conditions, and you are
uncertain about whether the conditions hold.
• For example, “should we impose a carbon tax?”
• If global warming is caused by human activity then a carbon tax
will help reduce it.
• But if global warming is not caused by human activity, then a
carbon tax would only reduce economic activity and would not
cool the Earth.
Error costs (cont’d.)
● The two global warming alternatives can be modeled by:

Carbon Tax No Tax
GW is caused by human activity (p) 0 (p) x (error cost II)
GW is not caused by human (1-p) x (error cost I) 0

activity (1-p)
• Type I error is the failure to tax when global warming (GW) is caused by human activity.
• The Type II error is the implementation of a carbon tax when global warming (GW) is
not caused by human activity.
• The optimal decision is the one with the smaller expected error costs, i.e. Tax if (1-
p)*Cost(Type I) < p*Cost(Type II)
• This type of analysis is especially useful for balancing the risks associated with pricing
errors (over- v. under-), e.g., for airlines, hotels, cruise ships; as well as production
errors (over v. under)
Risk versus uncertainty
● Risk is how we characterize uncertainty about values that

are variable.
• Risk is modeled using random variables.
● Uncertainty is uncertainty about the about the
distribution of the random variables.
• E.g., which probabilities should be assigned to the various
values the random variables can take?
● This difference is critical in financial markets. Risk can be
predicted, priced and traded – people are comfortable with
risk. Dealing with uncertainty is much more difficult.
● Mistaking risk for uncertainty can be a costly mistake
IndyMac: Risk vs. Uncertainty
● Risk never went away,

investors were just
ignoring it
● Black Swans & fat tails
I have nothing against
economists: you should let them
entertain each others with their
theories and elegant mathematics,
[But]…do not give any of them
risk-management responsibilities.
—Nassim Nicholas Taleb
Dealing with uncertainty
● Uncertainty is unavoidable. So to cope with uncertainty

in decision making, gather more or better information.
• Best Buy has used dispersed sets of non-experts to predict
future variables, such as a holiday sales rate.
• Google uses internal prediction markets to generate
demand and usage forecasting.
● The US Marines advise:
• Because we can never eliminate uncertainty, we must learn
to fight effectively despite it. We can do this by developing
simple, flexible plans; planning for likely contingencies;
developing standing operating procedures; and fostering
initiative among subordinates.
Risk versus uncertainty
● Part of the housing crisis can be attributed to an error in translating

uncertainty to risk through a mathematical formula created by
David Li.
• The formula was designed to measure the correlation between returns
of various assets that made up collateralized debt obligations (CDOs).
• But there was uncertainty about how one asset’s failure would related
to that of another asset. There was also a lack of historical data about
relationships among the underlying assets.
● Li’s solution was to use past credit default swap (CDS) prices as an
indication of correlation returns (clever but imperfect).
• CDS data came from a time when housing prices were on the rise, and
the correlation changed during a period of decreasing prices.
• Nearly everyone was using this formula, and… we’ve seen how it all
turned out
CHAPTER
18 Auctions
● In oral or English auctions, the highest bidder wins by
outbidding the second- highest bidder. This means that
the second-highest bidders’ value determines the price.
● A Vickrey or second-price auction is a sealed-bid auction
in which the high bidder wins but pays only the second-
highest bid. These auctions are equivalent to oral
auctions and are well suited for use on the Internet.
● In a sealed-bid first-price auction, the high bidder wins
and pays his value. Bidders must balance the benefits of
bidding higher (a higher probability of winning) against
the costs of bidding higher (reduced margin if they do
win). Optimal bids are less than bidders’ private values.
• continued
● Bidders can increase their profit by agreeing not to bid

against one another. Such collusion or bid rigging is
more likely to occur in open auctions and in small,
frequent auctions. If collusion is suspected,
• do not hold open auctions;
• do not hold small and frequent auctions;
• do not disclose information to bidders—do not announce
who the winners are, who else may be bidding, or what the
winning bids were.
● In a common-value auction, bidders bid below their
estimates to avoid the winner’s curse. Oral auctions
return higher prices in common-value auctions because
they release more information than sealed-bid auctions.
Bell Telephone
● In 1885, Bell Telephone Company of Canada

established Northern Electric to manufacture its
telephone equipment.
• By 2000, the company (now Nortel) had a market share of
over $200 Billion
• Decade of bad investments, declared bankruptcy in 2011
● Nortel approved for sale by bankruptcy court
• The court was unsure of the value of some of the company’s
assets, such as the 6000 patents, and decided to sell these
assets with an auction.
• The bidding started at $900 million but was pushed up to
$4.5 billion after successive rounds of bidding.
Introduction: Auctions
● Auctions are simply another form of competition, like

price competition or bargaining.
● CarBargains is one company that uses auctions to help
car buyers.
• In these auctions, though, sellers not buyers are competing.
• Local car dealers offer prices to a single consumer in a sealed-
bid auction.
● Auctions set a price and identify the high-value buyer or
low-cost seller.
● Auctions are often used in combination with bargaining,
e.g., first an auction is used to identify the high-value
buyers and then there is a negotiation over the final price.
Oral Auctions
● Definition: In an oral or English auction, bidders submit

increasing bids until only one bidder remains. The item is
awarded to this last remaining bidder.
● Example: Suppose there are five bidders with values equal to
{$5, $4, $3, $2, $1}.
• The $5 bidder will win the auction, and bids only slightly over $4
to do so.
• The “price” or winning bid is $4, or slightly above.
• The winning bidder is willing to pay $5 but doesn’t have to, so
the losing bidders determine the price in oral auctions.
● Auctions identify the high-value bidder (“efficiency”) and set
a price for an item, with no negotiating necessary. For these
reasons, economists love auctions.
Benefits of auctions
● Example: auction vs. posted-price

• A retail store is unsure whether they should price high ($8) or
low ($5) for a certain item.
• If the store prices high, they sell to only high-value buyers (half
the time). If the store prices low, they sell to all customers at a
lower price.
• If MC = $3, then pricing high is preferable
(.5)($8‐$3) = $2.50 [versus (1.0)($5‐$3) = $2.00]
● If the store uses an auction instead, and two bidders show
up with values $8 and $5 – meaning there is again a .5
chance of selling to a high-value costumer – what will
the revenue of the sale be?
Oral Auctions (cont’d)
Bidder 1 Bidder 2 Probability Winning bid

$5 $5 .25 $5
Bidder 1 Bidder 2 $5 $8 Bidder 3
.25 $5 Probability Winning bid
$8 $5 .25 $5
$5 $5 $8 $8 $5
.25 $8 .125 $5
$5 $5 $8 .125 $5
$5 $8 $5 .125 $5
$8 $5 $5 .125 $5
$5 $8 $8 .125 $8
$8 $5 $8 .125 $8
$8 $8 $5 .125 $8
$8 $8 $8 .125 $8
Second-Price Auctions
● Definition: A Vickrey or second-price auction is a

sealed-bid auction in which the item is awarded to
the highest bidder, but the winner pays only the
second-highest bid.
• This at first seems counterintuitive – why leave money
on the table? But second-price auctions encourage
bidders to bid more aggressively.
• William Vickrey and James A. Mirrlees shared the
1996 Nobel Prize in Economics for their work
inventing the Vickrey auction and establishing that
there is no difference in outcome between an oral and
second-price auction.
Second-price auctions (cont’d)
● Because the winning bidder pays the price of the second-

highest bid, bidders are willing to bid up to their values,
so the outcome is the same as an oral auction.
● Second-price auctions are easier to run than oral auctions
because the bidders can bid in remotely, and
asychronously (at different places and times).
● Discussion: Why are eBay auctions equivalent to
second-price auctions?
● Discussion: Why does eBay use second-price auctions?
Sealed-Bid Auctions
● Definition: In a sealed-bid first-price auction, the highest

bidder gets the item at a price equal to the highest bid.
● These auctions present a difficult trade-off for bidders:
• A higher bid reduces the profit if you win, but
• Also raises probability of winning
● Bidders balance these two effects by bidding below their
values (“shading”).
● Experience and knowing the competing bidders are the
keys to these auctions, but in general, bid more
aggressively – shade less – if the competition is strong.
Bid Rigging or Collusion
● Example: an oral auction with bidder values of {$5, $4,

$3, $2, $1}.
• Suppose that in this auction the two high-value bidders have
formed a bidding ring (also known as a cartel).
• The two decide NOT to bid against each other, so the cartel wins
the item by outbidding the non-cartel members, i.e., price= $3.
The cartel makes a profit of $1 which typically is split evenly
between members.
● Bid-rigging is a criminal violation of antitrust laws in the
US and many other countries.
● In one type of bid-rigging, cartel members re-auction the
items won in a second-auction to cartel members in a
second or “knockout” auction.
Bid-rigging / Collusion (cont’d)
● Another type of collusion is known as a bid-rotation

scheme. This scheme uses quid pro quo bidding
behavior.
● Bidders in these cartels submit weak bids or refrain from
bidding against each other until it is their turn to “win.”
● In a bid-rotation scheme each cartel member must wait
for his turn to win – a weakness that leaves these
schemes vulnerable to cheating.
● Proposition: Collusion is more likely in oral auctions.
● Proposition: Collusion is more likely in small, frequent
auctions.
Bid-rigging: Frozen Fish Conspiracy
● After this cartel was broken the price of fish dropped 23%
● Investigators backcast from the competition period into the
collusive period to determine the cartel’s effect, i.e., what the
price would have been, “but for” the conspiracy.
Reacting to bid-rigging
● The government is frequently the victim of bid-rigging

schemes.
● Learning from the government’s experience, some tips to
avoid collusion:
• Do not rely on purchasing agents (those running the auction)
who have little interest in buying at a low price. Instead, reward
agents for making good (high-quality and low-price) purchases.
• Do not entangle purchasing agents with masses of red tape.
Instead, permit them to negotiate (e.g., to bargain with the
bidders) if they suspect bid rigging.
• But beware of patronage
• Do not use the procurement process to further a social agenda
(small business set-asides, public lands, national defense, etc.)
that is irrelevant to the goal of purchasing goods at low prices.
Avoiding collusion (cont’d)
● Keep cartels in the dark, so it is difficult for them to

organize and to punish cheaters.
• do not hold open auctions;
• do not hold small and frequent auctions;
• do not disclose information to bidders—do not
announce who the other bidders are, who the winners
are, or what the winning bids are.
Common-Value Auctions
● Definition: In a common-value auction, the value is the same

for each bidder, but no one knows what it is. Each bidder has
only an estimate of the value.
● Be careful in these auctions lest you suffer the “winner’s
curse”
• If you win, you learn that you were the one who had the highest
and most optimistic estimate of the unknown value of the item
• Bidders should reduce their value estimates to protect against this.
• If you are the auctioneer, release info to mitigate winners’ curse.
● Winner’s curse is worse when
• More bidders
• Other bidders have better information
Common-Value Auctions (cont’d)
● To avoid the winner’s curse bid less aggressively as

the number of bidders increases.
● In common-value settings, oral auctions return
higher prices than sealed-bid auctions because oral
bids reveal information.
• But oral auctions are more vulnerable to collusion.
● Discussion: Why do bidders wait until the last
minute of the auction to submit bids on eBay?
CHAPTER
19 The Problem of
Adverse Selection
● Insurance is a wealth-creating transaction that moves
risk from those who don’t want it to those who are
willing to bear it for a fee.
● Adverse selection is a problem that arises from
information asymmetry—anticipate it, and, if you
can, figure out how to consummate the
unconsummated wealth-creating transaction (e.g.,
between a low-risk customer and an insurance
company).
● The adverse selection problem disappears if the
asymmetry of information disappears.
• continued
● Screening is an uninformed party’s effort to learn the

information that the more informed party has.
Successful screens have the characteristic that it is
unprofitable for bad “types” to mimic the behavior of
good types.
● Signaling is an informed party’s effort to
communicate her information to the less informed
party. Every successful screen can also be used as a
signal.
● Online auction and sales sites, like eBay, address the
adverse selection problem with authentication and
escrow services, insurance, and on-line reputations.
Zappos
● Zappos.com is an online shoe retailer that depends heavily on

customer service – a key differentiator for Zappos.
● As part of the hiring process, Zappos recruits are required to
complete a four-week training process.
• Zappos discovered that training alone could not imbue
employees with the attitude and personality required to maintain
Zappos’ reputation for customer service.
• Specifically, Zappos was having trouble measure such intangible
qualities and devised a system to get the employees with these
qualities to identify themselves.
● After one week of training, Zappos offers $2000 to any
person who will quit on the spot.
• About 3% of employees take this offer, and the remaining group
generally deliver the quality of service Zappos desires.
Introduction: adverse selection
● The problem Zappos faces is known as adverse selection. Zappos

want to hire only good employees, but cannot distinguish the good
from the bad.
• For Zappos, the employees known whether they are hard workers with
the attitude and personality that Zappos seeks, but Zappos does not
know which employees possess those attributes.
● When one party in a transaction has more or better information than
the other, adverse selection is a problem.
• Low-quality employees generally have more incentive to accept an
offer of employment (they might not get another), which exacerbates
the problem of adverse selection.
● Employers need to find a way to distinguish the high- from the
low-quality workers. Zappos $2000 offer is one way to “screen”
out the low-quality applicants, and is a solution to the adverse
selection problem.
Insurance and risk
● The problem of adverse selection is easily illustrated in the market

for insurance.
● The demand for insurance comes from consumers who do not like
risk. We model risk as a lottery – a random variable with a payment
attached to each outcome.
• A risk-neutral consumer values a lottery at its expected value.
• A risk-averse consumer values a lottery at less than its expected value.
● For example, flipping a fair coin. If the coin lands on heads the
payoff is $100; on tails, $0. A risk-adverse consumer would value
the lottery at $40, while a risk-neutral consumer would value it at
%50.
● Insurance moves “risk” from the risk adverse consumer (lower
value) to a risk neutral insurance company (high value).
Insurance and risk (cont’d)
● Insurance is also a wealth creating transaction, except that it moves

a “bad” from someone who doesn’t want it (risk averse consumer)
to someone who willing to accept the risk for a fee (insurance
company).
● Numerical example: Rachel owns a bicycle valued at $100.
• The bike has a possibility of being stolen, meaning Rachel’s ownership
is like a lottery: lose $100 if it’s stolen, lose $0 if it isn’t.
• If the probability of theft is 20%, then the expected cost of the lottery is
(0.2)($100) = ($20).
• If Rachel buys a bike insurance policy that will reimburse her for the
value of the bike if stolen for $25, she eliminates the risk of owning a
bike.
• Both insurance company and Rachel are better off with this policy. The
company earns $5 ($25-$20), on average, and Rachel can stop
worrying about bike theft, i.e., she “pays” the insurance company $25
each year so she doesn’t have to face the risk of bike theft.
Insurance and risk (cont’d)
● It’s important to note, the insurance company never

actually earns $5. Either the company loses $75 if the
bike is stolen, or earns $25 if it’s not.
● The expected value of offering insurance,
though, is $5
0.2 x ($75) + 0.8 x ($25) = $5
● One main function of the financial industry is also the
allocation of risk, moving risk from lower- to higher-
valued uses.
● Discussion: Describe precisely how a futures contract
transfers risk from the seller of the contract to the buyer
of the contract.
The first lesson of adverse selection
● To explain on adverse selection, we modify the bike example. Now

suppose that there are two equally sized risk-adverse consumer
groups:
• Group 1 with a probability of theft of 0.2
• Group 2 with a probability of theft of 0.4
● What happens when you try to sell insurance at a price of $35?
• HINT: do NOT assume that both groups will purchase at this price
● Because only high-risk consumers would be willing to pay the
higher price, the company would consistently be paying out
policies.
● So, anticipate adverse selection and protect yourself against it.
● This means anticipate that only the high-risk types will buy, so
price the insurance at $45
The first lesson (cont’d)
● In 1986, D.C. passed the Prohibition of Discrimination in the

Provision of Insurance Act outlawing HIV testing by health
insurance companies.
● As a result many insurance companies left D.C.
● The companies were unable to distinguish the low-risk from the
high-risk consumers. If the companies sold only to HIV-positive
consumers they would lose money.
● In 1989, the law was repealed, and the adverse selection problem
disappeared. Companies could once again differentiate between
high- and low-risk consumers and offered two differently priced
policies to cover each group.
● By eliminating asymmetry of information (insurance companies
could tell who was high-risk and who was low-risk) the problem of
adverse selection was solved.
Anticipating adverse selection (cont’d)
● In financial markets, adverse selection becomes a

problem when the owners of a company want to sell
shares to the public but know more information about the
prospects of the company than potential investors.
● Potential investors should thus anticipate that companies
with poor prospects are most likely to sell to the public.
● For example, small initial public offerings (IPOs) of less
than $100 million lose money, on average, whereas large
IPOs have “normal” returns.
● The winner’s curse of common-value auctions is also a
type of adverse selection.
The second lesson of adverse selection
● In the bicycle example, if the insurance company sells

policies at $45, low-risk consumers wont buy (because
with their lower risk, their cost is only $35)
• But these consumers would be willing to pay $25, which is still
more than the cost to the company of insuring the bike ($20).
● This means the low-risk consumers are not served
because it is difficult to profitably transact with them.
● The problem of adverse selection presents many
potentially profitable (unconsummated) wealth-creating
transactions.
● Using screening or signaling helps overcome the adverse
selection problem so that low-risk individuals can be
transacted with profitably.
Screening
● One simple solution to adverse selection is to gather enough

information to distinguish high-risk from low-risk consumers.
● But this can be difficult and costly to do.
• Privacy and anti-discrimination laws frequently prevent
insurance agencies, and other companies, from gathering or
using certain information (race, gender, credit scores).
● To solve this problem more indirect methods can be used to

identify individual risk. Screening is an effort by the less-
informed party to induce of consumers to reveal their types.
• Information may be gathered indirectly by offering consumers a
menu of choices, and consumers reveal information about their
risks by the choices they make.
Screening (cont’d)
● Screening is frequently used in the insurance market.

● Suppose high-risk individuals prefer full insurance at
$45, to partial insurance (for instance receiving only
$50 if your bike is stolen) at $15.
• For a successful screen, it must not be profitable for
the high-risk consumers to mimic the choice of the
low-risk consumers.
• Using a screening method allows companies to
consummate the unconsummated wealth-creating
transactions by eliminating information asymmetry.
Car Buying Screen
● In the used car market, adverse selection is known as the

lemons problem.
● On a car lot there are bad cars (“lemons”) worth $2000 and
good cars (“cherries”) worth $4000.
• Sellers know which cars are cherries and which are lemons.
● So, if an uninformed buyer walks onto the lot and offers to
buy a car for $3000, only the lemons owner would sell.
• The result is that the buyer overpays by $1000 for a bad car.
● But if the buyer offers to pay $4000, both lemons owners and
cherry owners will sell. However, the expected value of the
car in both cases will be $3000, so again the buyer overpays.
● Anticipating adverse selection, the buyer will offer only
$2,000, ensuring a lemon, but at least he won’t overpay.
Car buying (cont’d)
● Owners of good cars are analogous to low-risk

insurance consumers – they are unable to transact.
● How can this unconsummated wealth-creating
transaction be consummated? In other words, how
can you design a screen for those who want to buy a
cherry, and not a lemon?
● One option is to offer to buy a car for $4000 and
demand a money-back guarantee.
● If the car is really worth $4000, the cherry owner
knows that it won’t be returned.
● But the lemons owner will refuse the offer.
Marriage screen
● Discussion: Louisiana offers a choice between two

marriage contracts: a covenant contract which makes
divorce expensive; and a regular contract which makes
divorce relatively cheap. How does Louisiana marriage
law function as a screen?
• HINT: What is adverse selection problem in marriage?
● Screening is also useful as implemented by Zappos to
identify high- from low-quality employees.
• Zappos made it profitable for low-quality employees to
identify themselves by offering the $2000 payment to quit.
● Incentive compensation is another tool companies use to
identify low-quality workers.
Incentive compensation as a screen
● When hiring sales people there are hard workers, who will sell 100 units
per week, and lazy workers, who will sell only 50 units per week.
● Asymmetric information means only workers known if they’re lazy or
hard working.
● A Straight salary leads to adverse selection.
• Because both types of employee will accept an offer of $800/week, you will
attract a mix of lazy and hard workers.
● Incentive pay ($10 per sale) solves the problem: hard workers earn $1000
and lazy workers will reject the offer (they expect to earn only $500).
• Incentive pay imposes risk on the workers – some sales factors are out of their
control.
● Another screen with less risk: offer a base salary of $500 plus $10 per sale
for every unit above 50 sales.
Signaling
● Definition: Signaling describes the efforts of the more

informed party (consumers) to reveal information about
themselves to the less informed party (the insurance
company). A successful signal is one that bad types will
not mimic.
● Proposition: Any successful screen can also be used as a
signal
• Low-risk consumers could offer to buy insurance with a big
deductible, good employees could offer to work on commission,
and sellers with good cars could include a warranty with the
purchase.
● The crucial element of a successful signal is that it must
not be profitable for the bad-types to mimic the signaling
behavior of the good-types.
Signaling (cont’d)
● Some of the value of education is in its signaling value.

• Students can signal employers that they’re hardworking, quick-
learning, dedicated, etc. by spending the time and money
necessary to pursue an education.
● Firms brand and advertise products to signal quality to
consumers.
● As a result, most consumers are now willing to pay more for
branded and advertised goods.
● Low-quality firms wont find it profitable to advertise because
once consumers use the product and notice the difference,
they will switch brands and the firm will have wasted money
on the advertising.
• (Note that some states prohibit advertising, e.g., for financial
advisors, that would serve as a signal of quality.)
Adverse Selection on eBay
● Sellers have better information than buyers about the quality of

goods being offered for sale.
● Anticipating adverse selection leads buyers to offer less, which
makes sellers less willing to sell high quality goods.
● Consummated transactions are more likely to leave buyers
disappointed in the quality (“lemons”).
● How does eBay try to solve this problem?
• By providing:
• Escrow services
• Fraud insurance
• Seller ratings – provided by past buyers
● eBay’s ability to address the adverse selection problem has allowed
them to begin selling more expensive items, like cars, where the
problem can result in much bigger losses.
Title?
● Insurance Company X provides group disability insurance products to

businesses, who in turn offer the product to their employees
● Pricing policies to prevent a loss is difficult since the company does not
know which customers are high-risk (likely to file a claim)
• If policies are priced at the average risk, only high risk consumer will purchase.
• If policies are priced at low risk, both high and low-risk consumers purchase,
leading to expected costs above price.
• By using available geographic and industry experience information as a
screening tool, the company was able to identify groups prone to higher risks
and to price those policies appropriately
• Companies in Miami, Florida had (on average) higher long-term disability
claims while companies in Washington, D.C. had lower long-term disability
claims
• Short term disability for a teacher might cost 18% more than the base cost; the
same policy for a group of automotive exhaust repairers would cost 107% more
than the base.
Pre-Hire “Training”
● South Carolina manufacturing firm hiring new employees

• Requires 24 unpaid classroom hours over 8 days in 4 week
period
• Final step before full-time employment
• If candidate is tardy, he/she is sent home and not allowed to
return
● Results
• Of 30 people, two candidates are sent home
• Only ten of the 1,300 workers hired under the program have
had significant attendance issues
• Program reduced the rate of bad hires from about eight
percent to less than one percent
CHAPTER
20 The Problem
of Moral Hazard
● Moral hazard refers to the reduced incentive to
exercise care once you purchase insurance.
● Moral hazard occurs in a variety of circumstances:
Anticipate it, and (if you can) figure out how to
consummate the implied wealth-creating transaction
(i.e., ensuring that consumers continue to take care
when the benefits of doing so exceed the costs).
● Moral hazard can look very similar to adverse
selection—both arise from information asymmetry.
Adverse selection arises from hidden information
about the type of individual you’re dealing with;
moral hazard arises from hidden actions.
• continued
● Solutions to the problem of moral hazard center on

efforts to eliminate the information asymmetry (e.g.,
by monitoring or by changing the incentives of
individuals).
● Shirking is a form of moral hazard.
● Moral hazard in loans: Borrowers prefer riskier
investments because they get more of the upside
while the lender bears more of the downside. The
problem is worse for borrowers who have nothing to
lose.
TripSense
● In 2004, the Progressive Direct Group of Insurance Companies

introduced TripSense – a service that provided a free device to
record mileage, speeds and times driven in a vehicle.
• Progressive then used this information to offer discounted renewal
policies to customers who drove fewer miles at slower speeds during
non-peak hours.
● This helps the insurance company solve two problems. Adverse
selection, from the last chapter, and moral hazard, the focus of this
chapter.
• The decision of how frequently, how far, or how fast to drive is
equivalent to choosing your probability of having an accident.
• The cost of having an accident goes down when you buy insurance.
● Drivers respond to this reduced cost by “choosing” to have more
accidents. This is called “moral hazard.”
Introduction: Moral hazard
● Once you have insurance, the cost of an accident is

reduced, which also reduces the cost of the risky
behavior.
● This is the problem of “moral hazard” and exists in many
contexts, not just in the market for insurance.
● Moral hazard and adverse selection are closely related
problems. Both,
• are caused by information asymmetry:  moral hazard results
from hidden actions; while adverse selection results from hidden
information
● The cost of managing both problems can be reduced by
reducing uncertainty (gathering more information).
Moral Hazard in Insurance
● To illustrate moral hazard, lets return to the bicycle

insurance example of chapter 19.
• Suppose that bike owners stand a 40% chance of theft when
parking their bike on the street overnight. However, if the bike
owner exercises care (locks the bike), the chance of theft is
reduced to 30%.
• Suppose the cost of taking care (buying a lock) is $5.
• For uninsured bike owners, the benefit of exercising care is
(0.40 - 0.30)($100) = $10 and is greater than the costs of
exercising care, $5.
• Moral hazard suggests that once customers purchase
insurance, they exercise less care because there is less
incentive to do so.
• Is this really the case?
Moral Hazard in Insurance (cont’d)
● In our example,
• The cost of bike theft is reduced when an insurance
policy is purchased.
• Sp, the consumer stops taking the extra time to lock up
the bicycle every night once she buys insurance.
• The probability of theft then increases from thirty back
to forty percent.
• The insurance company anticipates this moral hazard, and now
charges $45 for every policy it sells.
● If you do NOT anticipate that the probability of theft will
increase from 30% to 40%, you will lose money on the
insurance you sell.
● In other words, anticipate moral hazard and protect
yourself against it.
Creating wealth with moral hazard
● Moral hazard can also represent an unconsummated

wealth-creating transaction.
• This opportunity exists because the benefits of taking care
are bigger than the costs of taking care.
● But how can the insurance company induce the bike
owner to take care?
• If the insurance company could observe whether the
customer was exercising care, then it could lower the price
of insurance to those taking care.
• This is exactly what Progressive’s MyRate/TripSense system
tries to do.
• It could also purchase the lock for the bike owner.
• Note that these kinds of prevention and wellness programs do NOT
reduce health care costs.
Moral Hazard or Adverse Selection?
● To distinguish between moral hazard and adverse

selection, ask whether:
• Information is hidden (adverse selection) or the action is
hidden (moral hazard)
• The problem arises before a transaction (adverse selection)
or after (moral hazard)
● Discussion: Give a moral hazard and an adverse
selection explanation for each the following:
• Drivers with air bags are more likely to get into traffic
accidents.
• Volvo drivers are more likely to run stop signs.
• At all-you-can-eat restaurants, customers eat more food.
Shirking as moral hazard
● Because it’s difficult to monitor an employee’s actions after

they are hired, employers anticipate shirking.
● Problem: What commission rate is required to induce hard
work?
• Suppose the benefit of working hard is the higher probability of
making a sale, e.g., probability of a sale rises from 50% to 75%.
• The cost of working hard is $100
• To induce hard work, (0.25) x (Commission) > $100, i.e., the
commission must be bigger than $400
• Unless the contribution margin on the item is at least $400, you
can’t afford to pay a $400 commission. You make more money by
letting the salesman shirk, i.e., it doesn’t pay to address the
moral hazard problem.
● If there is no solution, there is no problem!
Shirking as Moral Hazard (decision tree)
Salesperson
Shirk (cost = $0) Work Hard (cost = $100)
EV = [.5C + .5 × $0] – $0 = .5C EV = [.75C + .25 × $0] – $100 = .75C – $100
Make sale No sale Make sale No sale

Earn commission = C Earn commission = $0 Earn commission = C Earn commission = $0
Shirking (cont’d)
● Another potential solution is to try to get a better indicator of

effort than sales.
• Suppose that by incurring costs of $50, you could observe
whether the sale person was working hard.
• Would it be profitable to hire someone to monitor the
salesperson’s behavior?
• Expected benefit of inducing hard work is the increased probability of
making a sale (twenty-five percent) times the margin.
• If the item’s margin is at least $200, then it pays to monitor the worker.
● The company could also pay $50 more for a worker that has a
reputation for working hard, whether or not she is being
monitored.
• Remember: A reputation for working hard without monitoring is
valuable to both companies and workers.
Shirking (cont’d)
● Moral hazard injures both parties to a transaction.

● If firms anticipate moral hazard, they will be less
willing to transact; or put a lower value on the
transaction.
● Example: A consulting firm is paid on an hourly rate.
• Given the rate structure, and the inability of the client to
monitor what the consultant is doing, the client expects the
consultant to shirk by billing more hours than the client
would prefer, or by working on projects that are valuable to
the consultant but not the client.
● Are there solutions to this problem?
Moral Hazard in Lending
● Banks face a moral hazard in loans: borrowers who are least likely
to repay loans are the most likely to apply for them.
● Example: a $30 investment opportunity arises. The investment has
a 50% chance of a $100 payoff and a 50% chance of a $0 payoff
● The bank offers a $30 loan at 100% interest based on the expected
value of the investment.
● If the investment pays off, then the bank gets $60, if the
investment fails the bank gets $0.
Moral Hazard in Lending (cont’d)
● However, after the loan is made, the borrower “discovers” a

different investment.
● This second investment pays off $1000 but only has a 5%
probability of succeeding.
● Here the borrower receives more if the investment pays off, so the
bank receives a smaller payoff, $3 = (.05)($60) + (.95)($0)
● The lender prefers the less risky investment because she receives a
higher expected payoff. But, the borrower prefers the riskier
investment.
Moral Hazard in Lending (cont’d)
● Moral hazard is a problem for both the lender and the borrower in
this situation.
• If the bank anticipates moral hazard they will be less willing to lend, or
demand a higher interest rate.
● This incentive conflict is only made worse when the borrower can
put other people’s money at risk.
• Borrowers take bigger risks with other people’s money than they would
with their own.
● To control this, lenders must find ways to better align the incentives
of borrowers with the goals of lenders.
• Banks sometimes do this by requiring borrowers to put some of  their
own money at risk.
• This is why banks are much more willing to lend to borrowers who put a
great deal of their own money at risk, but it also leads to the complaint
that banks lend money only to those who don’t need it.
Moral hazard in financial crisis
● Regulators try to reduce the costs of moral hazard by requiring banks

to keep about 10% of their equity in case depositors want their
money back.
• But when the value of assets fall by more than 10%, (as they did in 2008)
banks become insolvent and the risk of moral hazard increases.
● In late 2008, the US treasury guaranteed short-term loans to help
banks make riskier loans – if loans payoff, the bank profits; but if
they fail, taxpayers cover the loss.
• A better solution may have been to simply give the banks more equity.
The govt. would own equity and thus share in the upside gain, i.e., should
the loans payoff.
● Companies that are “too big to fail,” such as AIG, take bigger risks
because they know the government will bail them out.
Moral hazard in 2008 (cont’d)
● Bailing out homeowners also causes moral hazard.

Foreclosure bailouts helps irresponsible homeowners
who made risky investments that they couldn’t afford;
responsible borrowers wouldn’t need the bailout
assistance.
● The bailouts end up hurting responsible borrowers.
• Those who were less cautious are now getting to keep their risky
investment while taxpayers (including those cautious borrowers)
pay for the bailouts.
• AND, the new rules favoring borrowers increase the cost of
making loans. So responsible borrowers who had no part in the
real estate collapse pay the higher loan rates caused by new
regulations; AND pay for the bailout.
Driver Tracking
● Regional phone company using GPS to track

driver location
• Designed to deploy repairmen more efficiently.
• Used to investigate slow response time
• Led to surprising conclusions on source of problem
(drivers having extra marital affairs)
● Example of moral hazard
• Similar to adverse selection (but post-contractual
or “hidden action”)
• Caused by same information asymmetry
CHAPTER
21 Getting Employees
to Work in the
Firm’s Best Interest
● Principals want agents to work for their (the principals’) best
interests, but agents typically have different goals than do
principals. This is called incentive conflict.
● Incentive conflict leads to adverse selection (“which agent do I
hire?”) and moral hazard (“how do I motivate agents?”) when
agents have better information than principals.
● Three approaches to controlling incentive conflict are
• Fixed payment and monitoring (shirking, adverse selection, and
monitoring costs),
• incentive pay and no monitoring (must compensate agents for
bearing risk with a risk premium), or
• sharing contracts and some monitoring (some shirking and some
risk sharing which leads to lower risk premium).
• continued
● In a well-run organization, decision makers have

1) the information necessary to make good
decisions and
2) the incentive to do so.
● If you decentralize decision-making authority, you
should strengthen incentive compensation schemes.
● If you centralize decision-making authority, you
should make sure to transfer specific knowledge
(information) to the decision makers.
• continued
● To analyze principal–agent conflicts, focus on three questions:

• Who is making the (bad) decisions?
• Does the employee have enough information to
make good decisions?
• Does the employee have the incentive (performance evaluation +
reward system) to make good decisions?
● Alternatives for controlling principal–agent conflicts center
on one of the following:
• Reassigning decision rights (to someone with better incentives or
information)
• Transferring information
• Changing incentives (performance eval. + reward system)
ASI
● Auction Service International (ASI) employed art experts to

convince owners of valuable art to use auction services to sell
their artwork.
• The auction house profited by charging the art owners a
percentage of the sell price at auction.
• This percentage was negotiated by the young art experts.
● A problem arose, the negotiated prices (“commissions” to the
auction house), which were supposed to be between 10 and
30%, were consistently low, near 10%.
● The CEO of ASI began investigating this phenomenon and
found that the art experts were “trading” low prices for
kickbacks from the art owner.
● Discussion: What are two possible solutions for this problem?
Principal-Agent Relationships
● When studying firm-employee relationships we use

principal-agent models.
● Definition: A principal wants an agent to act on her
behalf. But agents often have different goals and
preferences than do principals.
• The auction house is a principal;
the art expert is an agent.
Note: for convenience only, we adopt the linguistic convention
of referring to principals as female and agents as male.
Incentive Conflict
● Because the agent has different incentives than the principal,

the principal must manage the incentive conflict, which
comes down to two problems with which you should by now
be familiar:
• Adverse selection: the principal has to decide which
agent to hire
• Moral hazard: once hired, the principal must find a way to
motivate the agent.
• Both problems are caused by asymmetric information: adverse
selection implies that only the agent knows his “type”; while
moral hazard means that only the agent knows how much effort
he is exerting.
● The costs of addressing moral hazard and adverse selection
are known as agency costs, because they are often analyzed
by principal-agent models.
Agency Costs
● A principal can reduce agency costs if she gathers

information (reduces information asymmetry)
• about the agent’s type (adverse selection); or
• about the agent’s actions (moral hazard).
● Information gathering:
• To mitigate adverse selection problems, firms can run
background checks on agents before they are hired.
• To mitigate moral hazard problems, firms can monitor
an agent’s behavior while working.
• This difference in timing leads to the characterization
that adverse selection is a pre-contractual problem,
while moral hazard is a post-contractual problem.
Incentive Pay vs. Risk
● Incentive pay can help align the incentives of employees

(agents) with the goals of the organization (principal).
• For example, if harder work leads to higher sales, then create
incentives by tying the employee’s reward to sales performance,
e.g., with a sales commission.
● But incentive pay also imposes risk on agents.
• Commissions mean a portion of an agent’s compensation is
dependent on factors beyond the agent’s control, e.g., weather.
• Agents must be compensated for taking on this additional risk.
● So, incentive compensation represents a tradeoff:
• Does the benefit (harder work by agent) outweigh the cost
(extra compensation for bearing risk)?
Controlling incentive conflict
● In an ideal organization
• Decision-makers have all the information necessary
to make profitable decisions; and
• The incentive to do so.
● When designing an organization, you should consider how to
structure the following three items.
• Decision rights: who should make the decisions?
• Information: is the decision-maker provided with enough
information to make a good decision?
• Incentives: does the decision-maker have the incentive to do so.
Incentives are created by linking performance evaluation and
reward systems (rewarding good performance).
Decision Rights and Information
● Who should make decisions?

• Decentralize decision making: move decision rights
down in the hierarchy, closer to those with better
information; or
• Centralize decision making: move decision rights up
in the hierarchy, closer to those with better incentives.
● If you decentralize decision-making authority, you
should also strengthen incentive-compensation
schemes.
● If you centralize decision-making, find a way to
transfer information to those making decisions.
Incentives (performance + reward)
● Performance evaluation
• Informal: using subjective performance evaluation, or
• Formal: using objective measures such as sales or
accounting profit, stock price, relative performance
metrics.
● Rewards: Decide how compensation is tied to
performance evaluation.
• Reward good performance and/or penalize
bad performance.
• Examples: bonus, increased probability
of promotion, faster promotion.
Example: Marketing vs. Sales
● Sales and marketing divisions often have incentive conflict

• Sales wants to maximize revenue, i.e., make all sales
where MR > 0
• Marketing wants to maximize profit, i.e., make all
sales where MR > MC.
• In other words, sales prefers a higher level of sales and a lower
price than does marketing.
● For example, a large telecommunications equipment company
that serves government agencies that buys telecom equipment.
• Sales people want to bid more aggressively to make sure that they
win the contract (they care about maximizing sales)
• Marketing wants the sales agents to bid less aggressively, so that
when they do win, the contracts are more profitable (they care
about maximizing profit).
Marketing vs. Sales (cont’d)
● Two solutions:
• Centralize bidding decisions to marketing; and try to transfer
enough information to marketing managers so they know how
aggressively to bid.
• Decentralize bidding decisions (keep decision rights with the sales
people) and change incentives – Instead of a 10% commission on
revenue, give sales people a 20% commission on profit, (revenue
neutral if the contribution margin is 50%)
● Discussion: How well do threshold compensation schemes
work, e.g., a bonus if you open hit a target sales number.
● Discussion: How well do high-powered sales commissions
work, e.g., 5% commission for sales of $1M; 10% commission
on sales of $2M, work?
Example: Franchising
● Incentive conflict exists between franchisors (McDonalds) and

its franchisees. McDonalds wants big franchise fees and high
quality at franchisees to protect its reputation. Franchisees want
smaller fees and lower quality (cheaper).
● McDonalds has both company owned stores and franchisees.
• In a company-owned store, both adverse selection and moral
hazard are concerns – managers don’t work as hard as they would
if they owned the restaurant, and a salaried manager position
might attract lazy workers.
• Franchisees have bigger incentive to work hard (because they are
the “residual claimants” of profit), but they are also exposed to
more risk. Franchisees have to be compensated (lower franchise
fees) for bearing risk.
Franchising (cont.)
● Another option is to use a sharing contract: instead of

a fixed franchise fee, the franchisor might demand a
percentage of the revenue or profit of the restaurant.
• This arrangement reduces franchisee risk by reducing
the amount the franchisee pays to the franchisor when
the store does poorly.
• Sharing contracts may also encourage shirking because
the franchisee no longer keeps every dollar he earns.
● Discussion: Why does McDonalds use company-
owned stores along freeways, but franchises in towns?
Diagnosing and solving problems
● To analyze principal-agent problems, begin with the bad

decision that is causing the problem, and then ask three
questions.
1) Who is making the (bad) decision?
2) Did agent have enough information to make a good
decision?
3) Did agent have the incentive to do so, i.e., how is the
employee evaluated and compensated?
● Answers to these questions generally suggest alternatives
for reducing agency costs. You can,
• Let someone else make the decision, or
• Change the information flow, or
• Change the incentives.
Example: Declining Store Profits
● The CEO of a large retail chain of “general stores” that target

low-income customers has noticed that newly opened stores
are not meeting sales projections.
● What is the problem here? And how can it be fixed?
● Some helpful information about the stores is,
• The company uses development agents to find new store locations
and negotiate the leases with property owners – the company
rewards these agents with generous bonuses (stock options) if
they open fifty new stores in a single year.
• Agents are supposed to open new stores only if their sales
potential is at least one million dollars per year, but recently
opened stores earn half this much.
● What is the problem; and what is the solution?
Title?
● Whaling ventures in the 1800s were managed by agents,

who would purchase supplies, hire a captain and crew, and
plan the voyage on behalf of the investors.
• Agent’s performance difficult for investors to observe or
evaluate
• Actions of crew on multi-year voyages even more difficult to
evaluate
● Contracts and organizational forms century evolved in
response to these problems
• Most whaling enterprises were closely held by a small
number of local investors
• Ownership rights were allocated to create powerful
incentives for their managers
• Agents usually held substantial ownership shares
in their ventures
Title continued?
● Attempting to run these ventures via corporation

form in the 1830s and 1840s failed
• They paid their crews the same ways, used similar
vessels, and employed agents with similar
responsibilities
• Only main difference was in ownership structures and
hierarchical governance
• They were unable to create the incentives requisite for
success in the industry. The managers of these
corporations, who did not hold significant ownership
stakes, did not perform as well as their peers in
unincorporated ventures.
CHAPTER
22 Getting Divisions to
Work in the Firm’s
Best Interest
● Companies are “principals” who try to align the
incentives of divisions (“agents”) with the goals of
the parent company.
● Transfer pricing is a big source of conflict between
divisions because they transfer profit from one
division to another; they can also result in too few
goods being transferred. Transfer prices should be set
equal to the opportunity cost of the transferred asset.
● A profit center on top of another profit center can
result in too few goods being sold; one common way
of addressing this problem is to change one of the
profit centers into a cost center. This eliminates the
incentive conflict (about price) between the
2
divisions
• continued
● Companies with functional divisions share functional

expertise within a division and can more easily evaluate
and reward division employees. However, change is
costly, and senior management must coordinate the
activities of the various divisions to ensure they work
towards a common goal.
● Process teams are built around a multi-function task and
are evaluated based on the success of the task.
● When divisions are rewarded for reaching a budget
threshold, they have an incentive to lie to make the
threshold as low as possible, to make the threshold easier
to reach. In addition, they will pull sales into the present,
and push costs into the future, to make sure they reach the
threshold. A simple linear compensation scheme eliminate
this incentive conflict.
Acme
● The by-product of producing Acme paper is “black liquor

soap” that is converted into “crude tall oil” used in resin
manufacturing.
• The Paper division at Acme sold it’s soap to the Resin company
at a transfer price set by senior management.
● But both divisions fought over the transfer price.
• The Resin division wanted a low transfer price
• The Paper division wanted a high price
● The corporate parent company “gave” the Resin department a
very low transfer prices. As a result, the Paper division began
burning the soap as a fuel instead
of selling it to Resin.
• The soap’s value as a fuel was below its value as an input into
resin manufacturing.
Incentive Conflicts between Divisions
● In a multi-divisional company, transactions between

divisions can create incentive conflicts.
● In these transactions the company is the principal and
divisions are the agents.
● To understand the source of conflicts that arise between
divisions, personify the divisions and consider each to be
a rational actor. Then ask the same three questions
1) Which division is making the bad decision?
2) Does the division have enough info. to make a good
decision
3) Does it have the incentive to do so?
● Without proper control, these conflicts can deter
profitable transactions from occurring.
Incentive conflicts (cont’d)
● Again the answers suggest three possible solutions

• Change the division that does the decision making,
• Change the flow of information, or
• Change a division’s evaluation and compensation schemes
● Often, parent companies organize so that each
division is an autonomous, and separate profit center.
● Definition: A profit center is a division that is
evaluated based on the profit it earns.
● The benefit of a profit center is that they are easy to
evaluate (and manage); the cost is that they are
concerned only with their own division profit.
Analyzing Black Liquor Soap Problem
● Who is making the bad decision? The Paper Division

made the bad decision to burn the soap for fuel instead of
transferring it to the Resins Division.
● Did they have enough information to make a good
decision? The Paper Division had enough information to
know that the soap’s value as a fuel was below its value as
an input to resin manufacturing.
● And the incentive to do so? The Paper Division was
rewarded for increasing its own profit, not that of the Resin
Division.
Transfer Pricing
● One common belief is that transfer pricing just shifts

profits between divisions & doesn’t affect firm profits.
• THIS IS A MYTH.
• Sometimes they move assets to lower valued uses, i.e. the
“black liquor soap” incident.
● Transfer pricing is always a problem between two profit
centers because they “fight” over the transfer price.
• You can get rid of the conflict by turning one division into a
cost center.
• A cost center is rewarded for reducing the cost of
producing a specified output. (but remember, cost centers
can come with problems of their own.)
● Discussion: Are your transfer prices set equal to the
opportunity cost of the product? If not, why not?
Paper Company
● A company can transfer paper from its upstream Paper

division to its downstream Cardboard Box division.
● The company set a transfer price to guarantee a
contribution margin of 25% to the Paper division.
• So, if the Paper MC is $100, the transfer price would
be $125
● The Box Division considers the transfer price to be its
MC, and then marks up the cost again.
• The Box division makes all sales where MR > MC, but
now the MC is overstated (because of the included
contribution margin of the Paper division).
● Discussion: Solution?
Paper company (cont’d)
● The analysis makes clear that the conflict arises

because two profit centers are each trying to extract
profit from a single product.
● This creates a “double markup” problem.
● One way to solve the problem is to make the Paper
division a cost center.
● Cost centers are not evaluated based on the profit
they earn, and so don’t care about the transfer price.
● Once the Paper division began transferring at MC the
Box division began winning more jobs from its
rivals.
Organizational options: U-form
● Functional (U-form): A functionally organized firm is

one in which various divisions perform separate tasks,
such as production and sales.
● Example of functional organization are Henry Ford’s
automobile assembly line, or Adam Smith’s pin factory.
● Advantages:
• Workers develop high functional expertise.
• Information can be shared easily within a division.
• It’s easier to tie pay to performance because performance
is easily measured.
● Disadvantages:
• Each division must coordinate with each other, a burden
that falls on management; and change is costly.
Banking Coordination Problem
● Banks have many different divisions, all of which must

work together for the bank to create profits.
● The Loan Origination Division (think of them as
“mortgage brokers”) identifies potential borrowers, lends
money to them, and then hands them over to
● The Loan Servicing Division, which collects interest on
the loan and makes sure that borrowers repay the loans
when they come due.
● For the bank in question, there was an unusually high
number of defaulted loans.
● What caused this to occur, and how can it be fixed?
Banking problem (cont’d)
● Three questions:
1) Who is making the bad decision?  The Loan
Origination Division was making risky loans.
2) Did the Division have enough information to make a
good decision?  The Division could have easily
verified the credit status of the borrowers.
3) And the incentive to do so?  Like many sales
organizations, the Loan Origination Division (“mortgage
brokers”) were evaluated based on the amount of money
they were able to lend, regardless of the credit
worthiness of borrowers.
Organizational options: M-form
● M-Form: An M-form firm is one whose divisions

perform all the tasks necessary to serve customers of a
particular product or in a particular region.
● Advantages:
• Divisions can respond more easily to change.
• Easier to establish customer relationships because one
person can serve each customer’s needs
● Disadvantages:
• Individual workers develop less functional expertise.
● Example: re-organize a bank into “home” and “business”
loans, where both divisions originate and service loans.
This reduces incentive to make bad loans.
Corporate Budgeting: Paying People to Lie
● A toy company’s Marketing Division creates sale

projections for each season. The Manufacturing Division
uses the forecast to plan production.
● Problem: There was excess inventory at the individual
business units within the toy company.
• HINT: each business unit is rewarded with a big bonus if it
meets budget.
● This system created incentives for business units to set
low budgets.
• The CEO knew this and “stretched” each budget goal, even
though he lacked specific information about business unit.
• When the goals were set too high, the inventory was not
sold and accumulated; if too low, stock-outs occurred.
Corporate Budgeting: Paying People to Lie (cont’d)
● Once budget goals were reached, there was no

incentive to exceed them. (“shirking”)
● Also, there are incentives to “game” the system
• Accelerate sales or delay costs if just short of target
• Delay sales or accelerate costs if target already met to
make next year’s goals easier to reach
• Accelerating or delaying sales can be costly, e.g.,
discounts offered to customers to delay or accelerate
demand.
● Discussion: How should it be fixed?
Corporate Budgeting: Typical Problem
$115,000
Total Compensation
Compensation depends on
realizing a minimum profit
level. Managers have an
$95,000
incentive to game the
system to reach the $4
million level. Also,
$75,000 managers have no
additional incentives once
profit has reached $6
million.
$4 million $5 million $6 million Profit

(Target)
● This threshold compensation scheme creates

incentives to lie
Corporate Budgeting: solution
Compensation no longer
Total Compensation
depends on realizing a
Compensation minimum profit level. With
Level
no incentive to game the
system (pay is the same
whether profit was targeted
at $4 million or at $6
million), budgets will be
more accurate and useful
in the planning process.
$4 million Realized $6 million Profit

Profit
Performance
● Adopting a linear compensation scheme solves

problem
Title?
● Company X, one of the world’s largest suppliers of

supplies for printers, copiers, and fax machines,
included two separate divisions.
• Toner Division produced toner, which it sold to the
Cartridge Division and to the external market.
• The Cartridge Division integrated the toner into
cartridges sold to original equipment manufacturers
and consumers.
● Company management allowed the two divisions to
negotiate the transfer price of toner and evaluated
each division on its profitability.
Title continued?
● After negotiations were unsuccessful, both divisions elected not to

transact.
• Toner Division continued to sell to the external market at its customary
price
• Cartridge Division elected to buy toner from an external supplier.
● The Cartridge Division ended up buying its toner from the exact
same supplier to whom the Toner Division was selling.
• Rather than paying one markup to the Toner Division, the Cartridge
Division ended up paying that markup plus an additional margin to the
external supplier
• Price was 38 percent higher cost than originally proposed in
negotiations
• External supplier’s shipment arrived at Company X’s docks with the
products still emblazoned with Company X’s logo. CEO noticed this.
CHAPTER
23 Managing Vertical
Relationships
● Do not purchase a customer or supplier merely because
that customer or supplier is profitable. There must be a
synergy that makes them more valuable to you than they
are to their current owners. And do not overpay.
● If unrealized profit exists at one stage of the vertical
supply chain — as often happens when regulations limit
profit — a firm can capture some of the unrealized profit
by vertical integration, by tying, by bundling, or by
excluding competitors.
● The double-markup problem occurs when
complementary products compete with one another.
Setting prices jointly eliminates the double-markup
problem and is often a motive for vertical integration or
maximum price contracts between a manufacturer and
2
retailer
• continued
● Restrictions on intra-brand competition like minimum

resale price maintenance or exclusive territories provide
retailers with higher profit, giving them incentives to
provide demand-enhancing services to customers.
● If a product has two retail uses, a manufacturer may find
it profitable to integrate downstream so that the firm can
capture the profit through price discrimination. Vertical
integration stops arbitrage between the two products,
which allows price discrimination.
● Outsource an activity if the outsourcer can perform the
activity better or more cheaply than you can.
UC Power & Light
● UC P & L sells electricity to customers at rates regulated by the

state Public Utility Commission.
• UC P & L is allowed to earn a nine percent return on invested capital.
● The UC decided to buy the mine that supplies them with coal.
• They formed a multi-divisional company, a regulated Power division,
and an unregulated Coal mine.
• By raising the transfer price of coal sold to the Power Division, they
Coal division evade the regulation that limits profit for the Power
division.
● An increase in the price of coal raises the marginal cost of

producing electricity (and Coal profit).
• Under the profit regulation, this allows the Power Division to raise
electricity prices.
UC Power & Light (cont’d)
● As a result, Coal earns more on the coal it sells; and Power is

allowed to raise the regulated price of electricity so that its
profit does not fall.
● In other words, the Coal Mine is more valuable as a sister
division to the Power Company than it is as an independent
company.
● This chapter looks at vertical relationships (merger, or
contracts) between upstream suppliers and downstream
customers in same vertical supply chain.
● Vertical relationships can increase profit by giving firms a
way to evade regulation, eliminate the double-markup
problem, better align the incentives of manufacturers and
retailers, and price discriminate.
Caveat: Beware Acquisitions
● Do NOT buy a customer or supplier simply because

they are profitable
• Purchasing a profitable upstream supplier or downstream
customer will not necessarily increase your profit.
● Without some kind of synergy, the value of the
upstream supplier or competitor is exactly equal to
the size of its profit stream – not moving assets to
higher value uses.
● Discussion: In 1999 AT&T bought TCI’s cable TV
assets for $97 B; then in 2002, they sold the cable
assets to Comcast for $60 B.
Evading Regulation
● One of the simplest and easiest-to-understand reasons for

vertical integration is to evade regulation.
● If unrealized profit exists at one stage of the vertical
supply chain — as often happens when regulations limit
profit — a firm can capture some of the unrealized profit
by integrating vertically, by tying, by bundling, or by
excluding competitors.
● Discussion: How can you evade Rent Control (HINT:
Tying, bundling, or exclusion)
● Discussion: How can Multi-National companies evade
national taxes using transfer pricing?
Solving the Double-Markup Problem
● Discussion: Gasoline refiners selling branded gasoline

• This problem can be analyzed more generally as a
prisoners’ dilemma faced by any two firms in the same
vertical supply chain or by any two firms selling
complementary goods.
• In this case, consumers demand the gas, as well as the
retail outlet that dispenses it.
• When firms selling complementary products compete with
each other, they price too high.
● The double-markup problem occurs when firms selling
complementary products set price in competition with
each other.
• Vertical integration is one way of addressing the double
marginalization problem – commonly owned firms can
coordinate more easily on lower prices to raise profit.
Aligning Retailer Incentives with Manufacturer Goals
● Discussion: Getting retailers to invest in demand-enhancing

services
• With a smaller profit slice, retailers may under-invest in services
that help enhance a brand name.
• Intra-brand competition can be controlled by means such as
granting exclusive territories, or setting minimum retail prices.
• This guarantees retailers a higher profit level creates incentive
to provide demand-increasing services
● Can you think of examples of this?
● Limiting intra-brand competition also helps reduce free-
riding, e.g., PING golf clubs require custom fitting and are
not sold over the Internet.
● BUT, many of these tactics may be illegal under antitrust laws
• Especially for companies with dominant market shares
Aligning incentives (cont’d)
● Frequently, practices that limit distribution in an attempt to

enhance demand for a brand may violate anti-trust laws.
• For example, European authorities have prohibited Coke
from purchasing refrigerators for retail outlets because the
practice may unfairly exclude rival soft drink manufacturers
from retail outlets.
● In Europe this is known as “abuse of dominance” and in
the US as “monopolization” or anticompetitive
“exclusion.”
• To avoid this, remember: If you have significant market
power, you should consider the effect any planned action
will have on competitors.
Price Discrimination
● Vertical integration of downstream products can make it

easier to price discriminate.
• When there are two separate consumer groups who use the
same product in different manners, buying a retailer can
make it easier to price discriminate in a way that wont be
defeated by arbitrage.
● Example: Herbicide users
• Home gardeners are willing to pay $5 per liter for
herbicide.
• Farmers are willing to pay $3 per liter.
• Vertical integration solves the pricing dilemma by
preventing farm retailers from selling to home gardeners.
● Price discrimination at the consumer level is legal; but at
wholesale level is more difficult (and may be illegal).
Outsourcing
● While technically the opposite of vertical integration,

decisions to outsource should employ the same logic as
decisions to vertically integrate.
• Outsource an activity to an upstream supplier or
downstream customer if they can do it more profitably.
● The typical reason to outsource is to gain advantages of
economies of scale or scope.
● Remember to consider whether you are sacrificing any
integration benefits before you decide to outsource.
• Outsourcing takes away control of upstream manufacturing
processes or downstream distributors and retailers.
• It may also create a double-markup problem; you may find
it difficult to motivate your downstream customers or
upstream suppliers to invest in activities that benefit you;
and you may find it more difficult to price discriminate.
Title?
● The Aluminum Company of America (Alcoa) was the

only domestic supplier of aluminum ingots prior to 1930,
which were used for a variety of purposes
• An addition to the production process in the iron and steel
industry, used to improve the quality of the final product.
• Manufacture of cooking utensils
• Production of electric cable
• Automobile and aircraft parts constituted the final two end
markets.
● Consumers in these diverse markets varied widely in their
willingness to pay for aluminum ingots.
• Demand for aluminum in the iron/steel industry and in the
aircraft industry was relatively inelastic
• In the other three industries, demand was much more elastic
Title (cont’d)
● The potential for arbitrage created a barrier to

implementing a scheme to increase prices to
iron/steel and aircraft consumers while generally
reducing price to the other three markets.
● To successfully implement its price discrimination
scheme, Alcoa was forced to forward integrate into
the three relatively elastic markets.
● By moving into the cookware, electric cable, and
automotive parts markets, Alcoa prevented potential
re-sale of aluminum ingot and was able to maintain
high prices to the iron/steel and aircraft parts
markets.

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CHAPTER

● Problem solving requires two steps:

● A young geologist was preparing a bid

● The goal of this text is to provide tools to help

● Both steps require a model of behavior

● Answer the three questions:

Now that we know what is wrong, how do we fix it?

● In 2006, a TV reporter was sent into a National

1) Who is making the bad decision?

3) Does the decision maker have the incentive to

● There was an incentive issue

● The rational-actor paradigm can make students

● Debates about ethics and economics really are

● Two prominent hospitals recently refused patients for

Suppose you want to move from Detroit to Nashville

● First, you would try a two-way trade Detroit Nashville

● Failing that, you’d try a three-way Detroit Nashville

● Need to find correct trades with

● Like with kidney transplants, compatibility problems

To identify money-making opportunities,

● Key note: Voluntary transactions, between individuals

A house is for sale:

The buyer and seller both benefit from this transaction:

● Seller surplus = the price minus the seller’s value

● Total surplus = buyer + seller surplus = difference in

● Which assets do these transactions move to higher-

● Do mergers follow the wealth-creating engine of

● However, many mergers and acquisitions do not

● To create value, the assets of the acquired firm

● Discussion: What’s the government’s role is wealth creation?

● Definition: An economy is efficient if all assets are employed in

● The One Lesson of Economics: The art of economics consists in

● Definition: Inefficiency implies the existence of

Anything that stops assets from moving to higher

● Which assets end up in lower-valued uses?

● Taxes create a profit opportunity

● Subsidies create opportunity

● Price-controls create opportunity

● Companies = a collection of transactions

● Accounting profit does not necessarily correspond to

● EVA® is a measure of financial performance that

Big Coal Power Co. switched to a 8400 coal when the

Use our three questions for analysis

● The plant manager should have considered all the

● Definition: Fixed costs do not vary with the amount

FIGURE 3.1 Cost Curves

● The cost of the factory is fixed.

TABLE 3.1 Candy Factory Costs

Are these costs fixed or variable?

● Beginning in 1978, Cadbury offered managers free housing in

● Senior managers then decided to sell the unused apartments

TABLE 3.2 Cadbury Income Statement

● Accounting profit recognizes only explicit costs

● What’s missing from Cadbury’s statements are

Definition: the opportunity cost of an action is what

● Whenever you get confused by costs, step back and

● Holding on to the flats cost the company £600,000

● When making decisions, you should consider all costs

● Definition: The fixed-cost/sunk-cost fallacy means you

Launching a new product:

Definition: ignoring relevant costs (costs that vary with the

● The subprime mortgage crisis of 2008 is a good example

● Recall that accounting profit does not necessarily