Wednesday, January 11, 2006

Market Structure

Monopolies, Oligopolies and Perfect Competition

A monopoly is a market structure in which there is only one producer/seller for a product. In other words, the single business is the industry. Entry into such a market is restricted due to high costs or other impediments, which may be economic, social or political. For instance, a government can create a monopoly over an industry that it wants to control, such as electricity. Another reason for the barriers against entry into a monopolistic industry is that oftentimes, one entity has the exclusive rights to a natural resource. For example, in Saudi Arabia the government has sole control over the oil industry. A monopoly may also form when a company has a copyright or patent that prevents others from entering the market. Pfizer, for instance, had a patent on Viagra.

In an oligopoly, there are only a few firms that make up an industry. This select group of firms has control over the price and, like a monopoly, an oligopoly has high barriers to entry. The products that the oligopolistic firms produce are often nearly identical and, therefore, the companies, which are competing for market share, are interdependent as a result of market forces. Assume, for example, that an economy needs only 100 widgets. Company X produces 50 widgets and its competitor, Company Y, produces the other 50. The prices of the two brands will be interdependent and, therefore, similar. So, if Company X starts selling the widgets at a lower price, it will get a greater market share, thereby forcing Company Y to lower its prices as well.

There are two extreme forms of market structure: monopoly and, its opposite, perfect competition. Perfect competition is characterized by many buyers and sellers, many products that are similar in nature and, as a result, many substitutes. Perfect competition means there are few, if any, barriers to entry for new companies, and prices are determined by supply and demand. Thus, producers in a perfectly competitive market are subject to the prices determined by the market and do not have any leverage. For example, in a perfectly competitive market, should a single firm decide to increase its selling price of a good, the consumers can just turn to the nearest competitor for a better price, causing any firm that increases its prices to lose market share and profits.

Supply and Demand

Supply and demand analysis tries to explain how prices and quantities work in markets.

Supply and Demand Equilibruim

Suppliers - those who sell goods in a market

Demanders - those who buy goods in a market

Market Equilibruim - a situation in which demanders can buy the quantities they want and suppliers can sell the quantities they want at the prevailing price. This price is the equilibruim price, and the total quantity bought and sold at that price is the equilibruim quantity.

Supply and demand is perhaps one of the most fundamental concepts of economics and it is the backbone of a market economy. Demand refers to how much (quantity) of a product or service is desired by buyers. The quantity demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and quantity demanded is known as the demand relationship. Supply represents how much the market can offer. The quantity supplied refers to the amount of a certain good producers are willing to supply when receiving a certain price. The correlation between price and how much of a good or service is supplied to the market is known as the supply relationship. Price, therefore, is a reflection of supply and demand.

A. The Law of Demand The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more. The chart below shows that the curve is a downward slope.

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A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation between quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and the price will be P1, and so on. The demand relationship curve illustrates the negative relationship between price and quantity demanded. The higher the price of a good the lower the quantity demanded (A), and the lower the price, the more the good will be in demand (C).

B. The Law of Supply
Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue.

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A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation between quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2, and so on.

Time and Supply
Unlike the demand relationship, however, the supply relationship is a factor of time. Time is important to supply because suppliers must, but cannot always, react quickly to a change in demand or price. So it is important to try and determine whether a price change that is caused by demand will be temporary or permanent.

Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy season; suppliers may simply accommodate demand by using their production equipment more intensively. If, however, there is a climate change, and the population will need umbrellas year-round, the change in demand and price will be expected to be long term; suppliers will have to change their equipment and production facilities in order to meet the long-term levels of demand.

C. Supply and Demand Relationship
Now that we know the laws of supply and demand, let's turn to an example to show how supply and demand affect price.

Imagine that a special edition CD of your favorite band is released for $20. Because the record company's previous analysis showed that consumers will not demand CDs at a price higher than $20, only ten CDs were released because the opportunity cost is too high for suppliers to produce more. If, however, the ten CDs are demanded by 20 people, the price will subsequently rise because, according to the demand relationship, as demand increases, so does the price. Consequently, the rise in price should prompt more CDs to be supplied as the supply relationship shows that the higher the price, the higher the quantity supplied.

If, however, there are 30 CDs produced and demand is still at 20, the price will not be pushed up because the supply more than accommodates demand. In fact after the 20 consumers have been satisfied with their CD purchases, the price of the leftover CDs may drop as CD producers attempt to sell the remaining ten CDs. The lower price will then make the CD more available to people who had previously decided that the opportunity cost of buying the CD at $20 was too high.

D. Equilibrium
When supply and demand are equal (i.e. when the supply function and demand function intersect) the economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient because the amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given price, suppliers are selling all the goods that they have produced and consumers are getting all the goods that they are demanding.

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As you can see on the chart, equilibrium occurs at the intersection of the demand and supply curve, which indicates no allocative inefficiency. At this point, the price of the goods will be P* and the quantity will be Q*. These figures are referred to as equilibrium price and quantity.

In the real market place equilibrium can only ever be reached in theory, so the prices of goods and services are constantly changing in relation to fluctuations in demand and supply.

Strategic and Tactical Decision Making

Strategic management is concerned with the fundamental direction of the organization's activity, i.e., the businesses that the organization intends to pursue and desired levels of achievement in those lines of business. Such decisions, by their very natures, must be made at the highest policy making level of the organization. The time frame is from the present to as far into the future as the organization's time horizon. The organization's time horizon is limited to that of its least visionary policy maker who constrains the enthusiasm of its would-be innovators.

By virtue of the fact that such directional decision making covers the long run and is laden with risk, it should be understood to be entrepreneurial rather than managerial in nature. Although the language of the business administration literature stresses strategic management, it should be more properly understood to be stragetic entrepreneurship. In the late twentieth century, the term "entrepreneurship" has come to be associated with new, small, "start-up" business ventures that are highly risky. Entrepreneurship often is not perceived to occur in established or "going" concerns, especially if they have attained large size in terms of assets, employment, market share, or volume of sales.

Strategic entrepreneurship may occur at any level in any organization, whether a new local venture or a well-established multinational enterprise. In a new venture, entrepreneurship is exercised by the founder of the firm. To the extent that fundamental change is initiated at the board room level of an established enterprise, the function of the governing board is almost purely entrepreneurial since the board must assume the risks of its innovational decisions. If proposals for change are devised at lower levels in the administrative organization and only submitted to the governing board for approval, it is the site of the innovative proposal that is the true locus of entrepreneurship. However, in its approval the governing board assumes a substantial portion of the risk of the proposed innovation, and in effect shares risk with the proposer of the strategic change.

There is some confusion over the meanings of the terms "goals" and "objectives." We shall take the term goal to refer to an ultimate end that the organization at its highest policy making level determines to try to achieve. The term objective is taken to refer to desirable intermediate situations or levels of performance to be achieved in pursuit of the ultimate goals of the organization. By their nature then, goals are long-term and strategic in orientation, whereas objectives are more short-term, immediate, and partial in nature.

In military parlance, the term "tactic" is usually juxtaposed to "strategy" in referring to an action that is taken "in the field" by a specific unit to accomplish a limited objective in pursuit of a strategic goal of the organization. The term "tactic" and its various derivative forms are rarely used in discussions of strategic management. However, decisions taken at various levels in the administrative organization to implement an approved strategic change are oriented toward specific objectives (such as a target volume of sales or share of the market) rather than ultimate goals (such as a required return on investment in a particular line of business), and are thus essentially tactical in nature. In a new venture, goals and objectives may coincide, and strategic and tactical decision making may converge in the mind of the founding entrepreneur.

In the established enterprise, tactical decision making at various administrative levels must confront choices that involve risks. A modicum of entrepreneurship may therefore be exercised by the mid-level manager in the tactical decisions that must be made. However, tactical decisions that involve simply deciding upon increases or decreases in activities already in progress belong to the realm of managerial decision making. It is possible that nearly all of the decisions that must be made in a new business venture are strategic and entrepreneurial rather than tactical and managerial.

A prime example of strategic decision making is found in the international business arena. It is not uncommon for corporations to engage in international transactions or operations, but proprietorships and partnerships may do so as well. By its very nature, much of the business decision making concerning the international realm is entrepreneurial because of the inherent risks attendant upon extending operations into other countries. But once international operations have become established, tactical managerial decision making is required to adjust levels and rates of operations.

The Nature of the Decision Problem
Managers may make a myriad of decisions every day. Some of the decisions are trivial in the sense that the consequences of them do not matter very much. The consequences of other decisions, for example, what employee health insurance plan to adopt or whether to add or drop a product line from the company's product mix, may be monumental.

We shall assume as an operating premise that human beings are basically interested in their own welfare. Rational human behavior consists of trying to maximize the value of some positive quantity, or to minimize the value of something perceived as having negative connotations. Although human nature is culturally influenced, we shall also presume that human beings are more-or-less materialistic, i.e., more is better than less, and hedonistic, i.e., that pain and displeasure are to be avoided or minimized. We consider in Chapter A2 whether these behavior premises truly are viable foundations upon which to erect models of managerial decision making.

Human approaches to decisions may be categorized as capriciousness, conditioned response, and deliberate, reasoned choice. The more trivial the consequences of the decision, the less time and effort are devoted to the decision process. Sometimes people seem to act without engaging in any apparent decision-making process. The choices underlying such actions may have been nearly automatic, based upon an implicit summing-up of the current circumstance compared with the decision maker's accumulated stock of past experiences under similar circumstances. Occasionally, however, human beings indulge themselves in a capricious action (an act without deliberate choice), even when the consequences may be non-trivial. If a capricious action constitutes a "bad" decision, the actor must suffer the consequences.

Dimensions of the Decision Problem

Multiple Goals. The decision maker may be confronted with a multiplicity of goals. Since it is technically not possible to try to maximize simultaneously the values of multiple conflicting goals, the decision maker has to choose one of the goals for primary pursuit. The other goals, expressed as minimum or maximum acceptable values, can then be regarded as constraints on the pursuit of the primary goal. The object of the decision is to maximize the value of the primary goal, subject to realization of satisfactory levels of subordinate goals. The mathematical modeling problems and possibilities with respect to multiple goals are elaborated in Chapter B2.

Multiple Strategies. With respect to any single goal, a decision involves multiple possible courses of action, or strategies. If there were no alternatives, no decision would be required other than selecting the goal for pursuit. The deliberate approach to decision making involves the identification of all possible courses of action and the benefits and costs likely to result from each of the alternatives. The rational choice is the alternative that yields the greatest relative positives or the largest sum of net benefits (positives less negatives), given the decision maker's set of preferences.

Marginal Changes. In many cases, the choices are not mutually-exclusive alternative courses of action; rather they involve more or less of the same course of action. The range of possible alternatives includes larger or smaller quantities to be selected. Typically, the decision problem is to select some quantity that is an alternative to the present one. Assuming that the alternative quantities are arrayed from smallest to largest, or vice-versa, choosing to shift from one to another involves additions to or subtractions from benefits or costs. Economists speak of such additions and subtractions as incremental changes, or marginal changes if they are the smallest possible changes that can be made. The rational choice in such cases is to make a quantitative change that will yield the greatest marginal benefit relative to marginal cost. The application of the calculus to marginal analysis is the subject of Chapter B2.

Multiple Outcomes. Often the possible alternative courses of action can be identified, but each decision alternative may have several outcome possibilities. If the decision maker can in some meaningful sense assess the probability, p, of the occurrence of each possible outcome, V, for each of the alternative courses of action, he may then compute the expected value of each alternative. The expected value is a probability-weighted average of the possible outcomes for each decision alternative,

(1) EV = p1V1 + p2V2 + ... + pkVk,


(1') EV = Sj=1,k (pjVj),

where EV is the expected value of the alternative, p is the probability of the outcome V for each of the k possible outcomes of the alternative. The presumption here is that the sum of the probabilities of the possible outcomes is 1.0. Each outcome may itself be a net difference between benefit (b) and cost (c), or V = b - c. Other things remaining the same, the rational decision then is the choice of the alternative that promises the largest expected value of possible outcomes.

An extension of the expected value concept may be employed in decision situations that unfold in stages such that subsequent stages depend upon what happens in previous stages. In such cases, the probability of occurrence of an ultimate outcome is a conditional probability, i.e., the product of the probabilities of the final outcome and all prior stages. Such a situation can best be visualized with a "decision tree," an example of which is illustrated in Figure A1-1. In this hypothetical situation the decision maker has to decide whether to develop a major shopping center anchored by two department stores, or a small strip shopping center with no department stores. In Figure A1-1, the decision point is represented by the box on the left side of the tree. The circles in the diagram indicate non-decision outcome branches. There is a 60 percent chance that if a major center is built, the county will construct a 4-lane approach road to the center, but a 40 percent chance that the existing 2-lane road will have to do. But if a small strip is constructed, there is only a 20 percent chance of construction of a 4-lane. Beyond the estimated completion of the project, there is a 20 percent chance that the economy will boom, a 50 percent chance of normal economic conditions, and a 30 percent chance of recession.

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Introduction to Economics and Managerial Decision Making


Managerial economics is about the criteria for rational decision making by managers of business enterprises. The criteria elaborated here for business enterprises can also be applied to non-commercial decision settings, including government agencies, eleemosynary institutions, the home, and one's personal life. Before we proceed to an examination of these decision criteria, we shall review the essential economic nature of decision making in order to establish the fundamental principles upon which decision criteria may be based.

As noted in a first Principles of Economics course, the world is characterized by scarcity rather than abundance. Human beings need certain things for survival, and they want to possess or consume a much larger variety of amenities. If all of these things were abundantly available, each person could simply gather as much as he or she wished, and still leave enough for everyone else to do likewise. Managerial decision making would require little more than determining the time sequence of acquisition.

In regard to most of the things that humans consume, scarcity is the rule and abundance is the exception. A scarcity of something means that the total of human wants for it exceeds the quantity of it available for human consumption. As a result, one person simply cannot take all that he or she might want without consequences for other persons. Something may be said to be scarce when its price exceeds zero (P greater than 0). The price may be expressed and paid in non-pecuniary terms as well as in money. There are a few things that have essentially zero prices, e.g., common air and the water available from a water fountain.