Week 1 - Introduction: Strategy and Economics Flashcards
(37 cards)
What 4 crucial elements do economic models feature?
- Decision makers
- Goals
- Choices
- Relationship between choices and outcomes
What are the main topics studied in this unit?
- Economic foundations of strategy
- Boundaries of the firm
- Market and competitive analysis
- Strategy dynamics
- Internal organisation
What does the following topic consist of: economic foundations of strategy?
- Cost and revenue functions
- Profit maximisation
- Pricing and output decisions
- Game theory
What does the following topic consist of: boundaries of the firm?
- Historical perspective
- Horizontal boundaries of the firm
o Australia’s chicken meat industry - Integration and its alternatives
o Pepsi, Disney and Pixar, KFC
What does the following topic consist of: market and competitive analysis?
- Market structure and competition o Retail petrol market in Australia o Airbus and Boeing - Entry and exit o Victoria taxi industry - Dynamic competition o Target, Bunnings, Tesla - Industry analysis o Australia’s banking industry
What does the following topic consist of: strategy dynamics?
- Strategic positioning o U.S. airline industry o Qantas, Virgin and the Dark Knight - Sustaining competitive advantage o Coke and Pepsi; FedEx and UPS
What does the following topic consist of: internal organisation?
- Performance measurement and incentives
o Australia’s sugar industry
What is a firm’s ultimate objective?
To maximise profits.
Calculation of a firm’s profit:
Profit = Revenue – Costs. Pi(Q) = TR(Q) – TC(Q)
Pi(Q): firm’s profit function
TR(Q): total revenue function
TC(Q): total cost function
Why is profit maximisation an important concept in understanding the formation of business strategies?
Because it helps a firm make a better decision in several dimensions, such as:
- Whether to take a specific marketing strategy or not
- When to expand the production capacity
- When to trigger a price war with competitors
- How to make a trade-off between long-term benefits and short-term losses.
What does the total cost function represent?
TC(Q) represents the relationship between a firm’s total costs and the total amount of output it produces in a given time period, denoted by Q.
What are the 2 components of the total cost function?
- Fixed costs = remain constant as output increases
o E.g. General and administrative expenses, property taxes - Variable costs = increase as output increases
o E.g. direct labour and commission to salespeople
What is the average cost function?
It describes how the firm’s average or per-unit-of-output costs vary with the amount of output it produces.
AC(Q) = TC(Q)/Q
If total costs were directly proportional to output, then average costs would be constant.
- However, often average cost will vary with output.
Average cost and economies of scale:
- When AC decreases as output increases = economics of scale
- When AC increases as output increases = diseconomies of scale
- When AC remains unchanged with respect to output = constant returns to scale.
What is the marginal cost function?
This describes the rate of change of TC with respect to output (AKA the cost of producing one additional unit of output).
MC(Q) = Change in TC(Q)/Change in Q MC(Q) = TC(Q + ΔQ) – TC(Q)/ΔQ
Relationship between AC and MC:
- When average cost is decreasing in output, marginal cost is less than average cost
- When average cost is increasing in output, marginal cost is greater than average cost
- When average cost is constant or at a minimum point, marginal cost is equal to average cost
What does the demand function describe?
It describes the relationship between the quantity of product that the firm is able to sell and all the variables that influence that quantity.
What factors affect demand?
- Price
o This is the main factor that determines demand of a product - Income
- Substitutes and complements (the prices of related produces)
o E.g. Australia’s declining taste for beef and growing appetite for chicken (beef is more expensive) - Consumer tastes/preferences
o E.g. soft drinks - Quality of the product
- Market structure and competition
- Government policy
o E.g. Netflix tax
The relationship between quantity and price:
The demand curve demand curve is downward sloping:
- the lower the price, the greater the quantity demanded
- the higher the price, the smaller the quantity demanded
This inverse relationship is called the law of demand.
What does the total revenue function describe?
It describes the relationship between total revenue and output. In other words, it indicates how the firm’s sales revenues vary as a function of how much product it sells.
TR(Q) = P(Q) x Q
What does the marginal revenue function describe?
It describes the rate of change of total revenue with respect to output.
MR(Q) = ΔTR(Q)/ΔQ
What is price elasticity of demand?
It is commonly denoted by η (n with long tail) and is the percentage change in quantity brought about by a 1% change in price.
It measures the sensitivity of quantity demanded to price. As a result, it alters the shape of the demand curve, which strongly affects the success of the firm’s pricing strategy.
η = ΔQ/Q0/ΔP/P0
- If elasticity of demand (η) is less than 1 === demand is inelastic
- If elasticity of demand is greater than 1 === demand is elastic
Elasticity of demand example:
Formula:
η = ΔQ/Q0/ΔP/P0
Example:
Original price = $5, corresponding demand= 1000 units
If the price rises to $5.75, the Q demanded would fall to 800 units. Then:
η = 800 – 1000/1000 / 5.75 – 5/5
η = -0.2/0.15
η = -1.33
Relationship between MR and price elasticity of demand:
MR(Q) = p(Q) x (1 – (1/η))
- When demand is elastic (n > 1), then MR > 0
o The increase in output brought about by a reduction n price will raise total sales revenue. - When demand is inelastic (n < 1), then MR < 0
o The increase in output brought about by a reduction in price will lower total sales revenues.
Example: If n = 0.75 and p = 15, then MR = 15 x (1 – (1/0.75) MR = 15 X (1 – 1.33) MR = 15 x -0.333 MR = -4.99 = -5
