Summary ICAS
Chapter 0. Economics Primer: Basic Principles
0.1 Costs
A company has no direct control over its profit, market share etc. Marketing, production and
administrative decisions determine a competitive position and ultimate profitability.
Cost Functions
Profit = revenue – costs
Total costs (TC) = Total costs firm has for Quantity produced. Reflects current capabilities. TC
is always an upwards slope as the more Q, the more costs.
Fixed costs = remain constant as quantity changes. Invariant to firm’s output so a horizontal
slope.
Variable costs = costs increase as quantity increase so upward slope.
Semifixed = fixed over certain ranges of output but variable over other ranges.
Average cost function: AC(Q) = describes how firm’s average/per-unit-of-output costs vary with the amount of output
it produces. AC(Q) = TC(Q)/Q
AC(Q) decreases as output increases? Economies of Scale > Opposite = diseconomies of scale.
AC(Q) remains unchanged, therefore is constant? Constant returns to scale.
Minimum efficient scale = output Q at which economies of scale is exhausted (€ low as possible).
Marginal cost function: MC(Q) = rate of change of total costs TC compared to output Q. Basically, the incremental
cost of producing exactly one more Q.
TC ( Q+ ΔQ ) – TC ( Q )
MC (Q )=
ΔQ
Often depends on total volume of output.
When AC neither increases/nor decreases, because it’s constant or at a minimum point, MC = AC.
When AC increases with increase of 1 unit, this must be because the ‘MC’, is greater than the AC. Conversely, if AC
decreases, it must be the MC is less than the average costs.
Importance of Time period: Long-Run versus Short-Run Cost Functions
SACs(Q), SACm(Q) and SACl(Q) are short-run average cost functions for
small, medium and large plants. The long-run average cost is the lower
envelope, in bold. Curve shows the lowest attainable average cost for any Q.
Includes fixed & variable costs.
Large plant is e.g. more expensive at Q1 since it has higher fixed costs, but
also needs to utilize more labor to assure materials flow in the large facility.
This shows economies of scale don’t always work, only when there’s
throughput: there needs to be sufficient input for production & distribution.
Short-run average costs = Average fixed costs (AFC) + Average variable costs (AVC)
Since it’s average, both are expressed per-unit-of-output basis.
U-shape is created as the AVC rises with output, which pulls the SAC upward. Net effect offsetting AFC decreases.
Sunk costs = are incurred no matter what the decision is, cannot be avoided.
Avoidable costs = costs that can be avoided if certain choices are made.
0.2. Economic Costs and Profitability
Economic versus Accounting Costs
Accounting costs = emphasizes historical costs, serves an audience outside the firm. Must be objective and verifiable.
Economic cost = based on opportunity costs, costs associated with costs that are missed because of an opportunity.
Economic costs provide the best basis for good economic decisions. With strategy we’re interested in
distinguishing good from bad decisions, given the opportunities and constraints firms face.
Economic Profit versus Accounting Profit
Accounting profit = sales revenue – accounting cost
Economic profit = sales revenue – economic cost
= Sales Revenue – (Economic cost – Accounting cost)
0.3. Demand and Revenues
Demand Curve
,A demand function describes relationship between Q sold and all the variables that influence Q like price, price-
related products, incomes, tastes consumers, quality product, advertising etc.
Law of demand = the lower the price, the more consumers will purchase the product. May not hold if high prices
confer prestige or enhance product’s image. Horizontal = Q, Vertical = P.
The Price Elasticity of Demand
Price elasticity of demand η = strength between price & quantity purchased, % change in quantity bought, by a 1%
change in price.
− ΔQ ∕ Q 0
η= Both new-old/old
Δρ ∕ ρ0
If η < 1, demand is inelastic (Da), if η > 1, demand is elastic (Db)
A steep line (Da) means not very sensitive to price (small decrease Q) inelastic &
Higher price would lead to increase sales revenue.
A flatter line (Db) is very sensitive to price (large drop in Q) elastic, higher price
would lead to decrease sales revenue.
Things that make demand for firm more sensitive to price are:
- Product has few unique features that differentiate from competitors, buyers are aware
of this.
- Buyers expenses on the product are a large faction of their total expenses.
Things that make demand for firm less sensitive to price are:
- Comparisons among substitutes are difficult to find.
- Because of tax deductions/insurance.
- Significantly costly to switch to a substitute product.
- Product is used in conjunction with another product to which buyers have committed themselves.
However, there’s also brand-level versus industry-level elasticities. An industry can be very price inelastic, but if 1
company changes its’ prices, the market can react elastic to that company. It’s wise to pay attention to competitors and
match them.
0.4. Total Revenue and Marginal Revenue functions
Total Revenue TR(Q) = P(Q) x Q
TR ( Q+ ΔQ )−TR (Q)
Marginal revenue MR(Q) = = rate of change in TR from change Q.
ΔQ
Revenue Destruction = Revenue must lower price to sell more. Generate revenue on extra Q
from lower price, but losing revenue on units that would’ve been sold at a higher price.
MR(Q) = P ¿)
MR represents marginal revenue curve with demand curve D. MR < P, so MR curve most lie
below demand curve except at Q = 0. MR is negative for quantities in excess of Q’.
When η > 1, demand is elastic, it follows that MR > 0: Increase Q brought about by reduction
in price will raise total sales revenues.
When η < 1, demand is inelastic, it follows that MR < 0: Increase Q brought about by reduction in price will lower
total sales revenues.
0.5. Theory of the Firm: Pricing and Output Decisions
Theory of the firm = theory of how firms choose their P & Q. Explanatory & prescriptive
usefulness. Sheds light on how prices are established & how to make pricing decisions.
Assumes ultimate objective is to maximize profit.
Change in Total Revenue = MR x ΔQ
Change in Total Cost = MC x ΔQ
Change in Total Profit = (MR – MC) x ΔQ
If MR > MC, firm can increase profit by selling more, so it should lower prices.
If MR < MC, firm can increase profit by selling less, so it should raise prices.
If MR = MC, profit and quantity is optimal as there’s no better strategy (Q*).
,When firm’s total variable costs is proportional to output, so MC = AVC, the PCM on additional units sold is the ratio
of profit per unit to revenue per unit. PCM = (P – AVC) / P, which following establishes:
MR – MC > 0 as η > 1/PCM (Percentage Contribution Margin)
MR – MC < 0 as η < 1/PCM
Implies that a firm should lower its price when price elasticity of demand exceeds the reciprocal of PCM on the
additional units it would sell by lowering the price.
A firm should raise its price when the price elasticity of demand is less than the reciprocal of the PCM of the units
it would not sell by raising its price.
0.6. Perfect Competition
Theory of perfect competition = market forces shape and constrain a firm’s behaviour;
interact with the firm’s decisions to determine profitability. A perfectly competitive
firm’s demand curve is horizontal at market price price = MR curve (>). Supply curve
= Shows Q a perfect competitive firm would sell at various market prices. In a perfect
competitive market supply curve = MC function. An industry supply curve = all supply
curves added, determines market price. Positive profit is achieved when P exceeds
average cost AC(q) > New firms would enter industry (<). Market equilibrium = No
pressure on price to change > demand equals quantity supplied by industry.
In the figures below you see profit exceeds AC > new firms enter
> supply curve shifts outwards SS’. Quantity supplied exceeds
demand, prices will fall > until no addition entry occurs > market
price = AVC > Equilibrium P** = minimum level of AVC as firms
produce at minimum efficient scale. Suppose demand suddenly
falls: D0 > D1 > Price to P’ > below AC > industry shakeout, exits
> supply curve shifts to the left SS1 > prices rise, reach P** >
optimizing output, earning 0 profit/0 economic profit.
0 economic profit≠ 0 accounting profit, investors are earning
returns which can be used for next opportunity.
Free entry decreases economic profit so for firms it’s important to
focus strategy on difficulty to imitate skills/resources. Risky for forces highlighted by theory of perfect competition.
0.7. Game Theory
Games in Matrix Form and the Concept of Nash Equilibrium
Key strategic challenge of a perfectly competitive firm is to anticipate future path prices in industry, and maximize
against it. Game theory = analysis of optimal decision making when all decision makers are rational, attempting to
anticipate the actions & reactions of competitors. Nash Equilibrium = each player is doing the best, given the
strategies of the other player. Prisoner’s dilemma = in pursuing self-interest, each party imposes a cost on the other
that it doesn’t take into account.
since you don’t want to be the ‘loser’ it’s always better to e.g. admit your wrong.
A dominant strategy occurs when one choice is most logical in all scenarios, must also be in the Nash Equilibrium.
Nash equilibrium isn’t necessarily the outcome that maximizes aggregate profit. Rational pursuit of self-interest
ultimately is detrimental to their collective interest.
Game Trees and Subgame Perfection
Matrix form is convenient when parties move simultaneously. However, often decisions happen sequentuial, so
therefore game tree is easier to use.
Subgame perfect Nash equilibrium (SPNE) = each player chooses optimal action at each stage with the thought the
other players will behave the same.
, Outcome can be very different than Game matrix, as firm’s decisions are linked through time: you can see what the
other is doing.
Chapter 1. The Power of Principles: an Historical Perspective
Demonstrate value of principles by examining how the scale & scope of the firm has evolved. Dates are
milestones in evolution for the business environment.
1.1. Before 1840:
Business environment was constrained by lack of information. Selling was informal, firms were often small. Factors
were sellers, agents were buyers – rarely dealt with each other. Brokers served as matchmakers, possessing specialized
knowledge of market conditions. Lack of economic knowledge and associated risk led to uncertainty. Limited
infrastructure (communication, structure and finance). Market conditions made other systems impractical.
Infrastructure = assets that assist in production or distribution of goods and services, a firm itself can’t easily provide.
Facilitates transportation, communication and financing. Government key role > affects conditions under which firms
may do business, often supply infrastructure investments.
Transportation
Transportation by waterways was dominant, but time-consuming and risky as well. Waterway routes were limited.
Few steam-run trains and railroads, too fragmented to foster growth of markets, not integrated (different wagons,
schedules seldom coordinated), took time to develop.
Communication
Poor communication; Major means of long-distance communication was the public mail, later made faster by mail
trains. High postage rates, therefore mail was often hand-carried brought. Volume increased when prices were lowered
(1845/1851). First modern form communication: Telegraph, was invented but took long to spread. It was expensive so
was only used for time-sensitive messages.
Finance
Financial markets = bring together providers and users of capital – enabling smoothing out of cash flows and reduce
risk of price fluctuation. Given the business nature of uncertainty about prices, banks were unwilling to finance
business expansion > underdeveloped capital markets. Long-term debts were not known and high investment projects
were hard to finance. Most capital was private, based on personal relationships, done informally. Trading stocks only
regionally. High investment risks and low protection of investors > patterns of boom and bust, major depressions. No
institutional mechanisms that reduced risk of price fluctuation > need for creation of future markets. Individuals
purchase right to buy and sell goods on a specified date for a predetermined price. Requires verification characteristics
product, requires one party to bear the risk that the price may differ between transactions.
Production Technology
Relatively undeveloped and inefficient > manufacturing through use of interchangeable parts was only just beginning.
Government
Governments were not much involved, except for few public projects (rails).
Summay: Lack of modern infrastructure limited economic activity. Firms were generally small, informal and
operating in local markets. Technology prevented production. No professional managers. Limited transportation &
communication made investments in large-scale too risky. Market demand & technology development was needed.
There were forces that were changing conditions under which business operated.
1.2. Doing Business in 1910
Changes in infrastructure & technology resulted in more modern business practices. The concepts of mass production
technology (reduced costs production) and mass distribution (better infrastructure transport, communication,
investment needed) dominated the economy. This led to the combination of scale economies and throughput as basic
determining factors. Infrastructure was improved accordingly to serve the high trade volume.
Both horizontal integration = acquiring/merging with competitors and vertical integration = when firm expands into
another production stage (e.g. acquiring supplier, distributor). Reduced number of firms in industries, danger of
monopolies (restrict competition, increase profits > new laws). Standardization (and specialization) of processes,
tasks, job definitions and whole organizations > monitoring and appraising job performance, test and train employees,
