Strategic Management II (2017)Apunte Inglés
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Strategic Management II
1. Introduction - Chapter 1
A firm’s profit equals its revenues minus its costs.
Cost functions: - Total costs: Shows the total costs that the firm would incur for a level of output Q.
The total cost function is an efficiency relationship in that it shows the lowest possible total cost the firm would incur to produce a level of output, given the firm’s technological capabilities and the prices of factors of production, such as labor and capital. We stress that the total cost function reflects the current capabilities of the firm. If the firm is producing as efficiently as it know how, the slope must be upward (the only way to achieve more output is using more factors of productions, such as labor or machinery, which in turn increases total costs.
- Variable costs: Increase as output increases, such as direct labor or commissions to salespeople. But the line between fixed and variable is not clear at all (depending on the time period in which decisions regarding output are contemplated, some variable costs can be thought as fixed ones).
- Fixed costs: Remain the same even when output increases, such as administrative expenses and property taxes.
- Average costs: Describes how the firm’s per-unit-of-output costs vary the amount of output it produces.
If total costs were directly proportional to output, average cost would be a constant.
However, average cost will vary with output (it may rise, fall o remains constant as output increases). So, AC are not necessarily the same at each level of output. If: - AC increases as output increases: diseconomies of scale - AC remain constant as output increases: constant returns to scale - AC decreases as output increases: economies of scale As you can see here, the smallest output level at which economies of scale are exhausted is Q’. This point is known as the minimum efficient scale. In addition, the unit after Q’’ is creating diseconomies of scale, because that extra unit leads to an increase in AC.
- Marginal costs: Refers to the rate of change of total cost with respect to output. Marginal cost may be thought of 1 as the incremental cost of producing exactly one more unit of output.
Marginal costs often depend on the total volume of output.
At low levels of output, an extra unit from Q’ doesn’t change total cost much, as reflected by the low marginal cost. Otherwise, at high levels of output we see that the MC is higher, so, this cost varies depending on the level of output. Because the total cost function becomes steeper as Q gets larger, the marginal cost curve must increase in output.
It’s usually confused both costs, average and marginal, but they are different generally. The exception is when total costs vary in direct proportion to output, TC(Q)=cQ. In this case: This result reflects a more general relationship between marginal and average cost: - When AC is a decreasing function of output, MC is less than AC.
- When AC neither increases nor decreases in output (because it’s either constant or at a minimum point), MC is equal to AC.
- When AC is an increasing function of output, MC is greater than AC.
Graphically: 2 The Importance of the Time Period: Short-Run vs Long-Run Cost Functions The period of time in which the firm cannot adjust the size of its production facilities is known as the short run. If a firm knows how much output plans to produce before building the production facility, then to minimize the cost, it should choose the plant size that results in the lowest short-run average cost for that desired output.
It’s often useful to express short-run average costs as the sum of average fixed costs and average variable costs: SAC(Q)=AFC(Q)+AVC(Q) Note that as the volume of output increases, AFC become smaller, which tends to pull down SAC (they are being spread). Otherwise, AVC rise with output, which pulls SAC upward. The net effect of these forces creates the U-shaped SAC curve.
- - Sunk costs: Those costs that must be incurred no matter what the decision is and thus cannot be avoided. When we make decisions, we should ignore them. They are important in analyzing rivalry among firms, entry and exit decisions and decisions to adopt new technologies.
Avoidable costs: These costs can be avoided if certain choices are made.
Economic Costs and Profitability Economic vs Accounting Costs The accounting numbers must be objective and verifiable, because are designed to serve an audience outside the firm. However, this costs are not necessarily appropriate for decision making inside a firm. Business decisions require the measurement of economics costs, which are based on the concept of opportunity cost, which says that the economic cost of deploying resources in a particular activity is the value of the best foregone alternative use of those resources.
Demand and Revenues 3 Demand Curve The demand function describes the relationship between the quantity of product that the firm is able to sell and all the variables that influence that quantity. These variables include the price of the product, the prices of related products, the incomes and tastes of consumers, the quality of the product, advertising…etc.
We would expect the demand curve to be downward sloping: the lower the price, the greater the quantity demanded, and the opposite. This is called the law of demand. But sometimes, the demand is upward sloping (giffen goods, conspicuous consumption…).
The Price Elasticity of Demand The firm understands that according to the law of demand, the increase in price will result in the loss of some sales. This may be acceptable if the loss in sales is not “too large”. If sales don’t suffer much, the firm may actually increase its sales revenue when it raises its price. If sales drop substantially, however, sales revenues may decline, and the firm could be worse off.
When the demand curve is DA, a change in price has a small effect in the quantity demanded (and increase sales revenues). When it’s DB, the change in price results in a large drop in quantity demanded (and decrease sales revenues).
The concept of the price elasticity summarizes this effect by measuring the sensitivity of quantity demanded to price. Concretely, it’s the percentage change in quantity brought about by a 1 percent change in price.
⁄ ⁄ The price elasticity might be less than 1 or greater than 1: - If 𝜼 is less than 1: Inelastic - If 𝜼is greater than 1: Elastic Among the factors that make it more sensitive (elastic): - The product has few unique features that differentiate it from rival products.
- Buyers’ expenditures on the product are a large fraction of their total expenditures.
- The product is an input that buyers use to produce a final good whose demand is sensitive to price.
- When search costs are low.
4 Among the factors that make it less sensitive (inelastic): - Comparisons among substitute product are difficult.
- Because of tax deductions or insurance, buyers pay only a fraction of the full price of the product.
- A buyer would incur significant costs if it switched to a substitute product.
- The product is used in conjunction with another product that buyers have committed themselves to.
While demand can be inelastic at the industry level, it can be highly elastic at the brand level.
- If firm’s rivals match price changes by one firm, then industry level elasticity is relevant.
- If rivals don’t match price changes the firm’s demand elasticity will be relevant.
Total Revenue and Marginal Revenue Functions A firm’s total revenue function indicates how the firm’s sales revenues vary as a function of how much product it sells.
TR(Q)=P(Q)Q MR(Q) represents the rate of change in total revenue that results from the sale of additional units of output: Q In general, whether MR is positive or negative depends on the price elasticity of demand.
( - ) When demand is elastic (𝜼>1): MR>0. The increase in output brought about by a reduction in price will raise total sales revenues.
When demand is inelastic (𝜼<1): MR<0. The increase in output brought about by a reduction in price will lower total sales revenues.
This implies that MR<P. Because of this, MR curve must lie everywhere below the demand curve, except at a quantity of zero. At some point, it will shift from being positive to negative.
Theory of the Firm: Pricing and Output Decisions 5 The firm would like to increase profits, thus: MR must be equal MC. The firm cannot increase profits by either increasing or decreasing output, so it must be at their optimal level of output and price.
An alternative relation would be: ( ) In addition, given the percentage contribution margin (PCM): And Which implies that: - - A firm should lower its price whenever the price elasticity of demand exceeds the reciprocal of the percentage contribution margin on the additional units it would sell by lowering its price.
A firm should raise its price when the price elasticity of demand is less than the reciprocal of the percentage contribution margin of the units it would not sell by raising its price.
Perfect Competition Consists on an industry with many firms producing identical products (so costumers make choices based on prices) and where firms can enter or exit the industry at will. The price they charge is a market price given, any individual firm has the control. Here, the competitive firm’s demand curve is perfectly horizontal at the market price, even though the industry demand curve is downward sloping (the firm-level price elasticity of demand facing a perfect competitor is infinite, even though the industry-level price elasticity is finite). Industry supply is more elastic than individual firm’s supply (MC).
At the price P* (determined by industry supply and demand), each firm is producing the optimal output.
In addition, each firm is 6 earning a positive profit because at q*, the price P* exceeds AC(q*), resulting in a profit on every unit sold. Thus, new firms would like to enter this industry.
As new entrants come in, the industry’s supply curve shifts to the right. Entry ceases when firms make zero profit, so price equals AC. Firms are thus at the minimum point on their AC function.
This theory implies that free entry exhausts all opportunities for making profits.