Managerial Economics

A Strategic Approach

Robert Waschik, Tim Fisher, David Prentice

• Publisher: Routledge
• Year: 2010
• ISBN:
  9781135154950
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Traditional microeconomic theory has much to offer a manager. It suggests ways to increase profits by setting prices and packaging services, using advertising to increase demand and shows how internet auction sites like eBay affect competition and profitability. By using game theory to present and solve a manager's decision-making problems and by focusing on the strategic nature of these problems, this text makes microeconomic theory much more intuitive and relevant for the business student.

The text is separated into four sections:

• basic microeconomic theory of the firm and the basic tools of game theory
• problems related to the strategic interaction between firms, including price and quantity competition and product differentiation
• issues arising from strategic interactions within the firm, including vertical and horizontal integration, training and motivating workers, and labour unions
• marketing economics including information problems, advertising, durable goods and the product life cycle.

This book will be suitable for any student with a background of introductory economics. The authors include a variety of international examples and case studies from the business world to expand and illustrate key concepts, and provide end-of-chapter exercises to test students' grasp of the material. An online supplement comprising of problems and solutions as well as PowerPoint slides is available for lecturers.

1
Introduction

On Thursday, 19 March 2009, Southwest Airlines announced it was reducing fares across its travel network. Fares on flights from Los Angeles to San Francisco fell to as low as US$49 one-way, and from West Palm Beach in Florida to Chicago to US$69 one-way. This was obviously a boon to travellers. But imagine what the situation was like at Southwest’s main rivals: American Airlines, United Airlines and Delta Air Lines. The cut in fares was significant and Southwest had advertised that it was going to last for travel up to 14 August 2009, over most of the summer holiday travel period. The other airlines had to react quickly or risk losing business to Southwest. In fact, within hours, the rival airlines matched Southwest’s fares on most of the routes flown by Southwest. Given the dramatic reduction in travel demand due to the onset of recession in the United States and the global financial crisis of late 2008, it is probably not overstating the case too much to say that a quick and sensible reaction to Southwest’s fare-cutting was vital to the profitability of the other airlines.

Moreover, imagine the situation at Southwest when someone first came up with the idea of a fare cut. One of their main concerns would have been: how are the other airlines going to react? Because Southwest’s managers are well aware that the other airlines are operating on the brink of profitability, they must have expected that American, United and Delta were going to react to the fare reductions offered by Southwest. Thus, when deciding to cut fares, Southwest’s managers also must have taken into consideration how rival airlines would react.

There is nothing particularly special about this example. It merely serves to illustrate a central theme of this book: planning ahead and anticipating how rivals might react – in other words strategy – is a vital component of business. Anyone who plays a sport or takes part in a competition intuitively knows strategy is important. Business is no different. How firms react to things their rivals do is a critical part of decision-making within any firm.

A more common-place example takes place in almost every major city on every continent several times a year: gasoline price wars. If you drive a car, you will be especially aware of the price of gasoline and you will have noticed how the price fluctuates from one week to the next. For example, in Sydney, Australia, the price of petrol may vary by up to 20 per cent in any given month. It is unlikely that the underlying cost of drilling, transporting, refining and distributing the product varies by anything like as much as 20 per cent a month. The price changes are much more likely to be the result of competition between firms for market share.

But the same underlying forces are at work here as in the air fares example. Each time a firm decides to cut (or raise) its price, it has to take into account how its competitors are going to react to its decisions; as a result, firms have to come up with ways of dealing with their competitors’ reaction. Put another way: strategy is vital to firms in a competitive business environment.

Both examples presented so far have been about the strategic aspects of pricing. But strategic issues are not confined to decisions about prices. Advertising is used heavily in some industries, especially beer and detergent retailing. We shall see that advertising plays a strategic role in positioning a firms product relative to rival products. Investment, too, has a strategic element. Toyota Canada recently completed construction on a C$500 million expansion to its Cambridge, Ontario, factory where the Corolla model is produced. This signals to Toyota’s competitors that the firm is committed to producing more Canadian-built cars in the foreseeable future, which has implications for pricing and production levels for any firm that produces a product to rival the Toyota Corolla. Mergers and acquisitions have a strategic element as well, as do research and development (R&D). All these strategic issues are discussed in various chapters of this book.

1.1 The use of game theory

Any student of economics knows about the demand and supply model. This simple yet remarkably powerful set of tools describes how markets made up of participants acting purely in their own self interest determine overall prices and production levels. On the demand side of the market, consumers make decisions about how to allocate a fixed set of resources to consume goods and services to make themselves as well off as possible. On the supply side of the market, firms produce goods and services. Firms are assumed to minimize costs and maximize profits, given the structure of competition. The simplest markets describe firms with no market power (perfect competition) or one firm with complete market power (monopoly).

But very few firms fit this description of the supply side of the market. It is certainly not the case that Southwest Airlines or United Airlines, Shell or BP, or Toyota or General Motors operate in a market where they have either no market power or complete market power. If we want to describe how decisions made by managers to maximize profits or minimize costs in any of these companies are made, we need to expand our demand and supply model to allow us to consider the strategic effect that decisions made by managers have on the market. The missing element from the simple demand and supply model is the fact that what a manager in one firm does will affect the behaviour of other managers in the same market. All managers know this. Managers at Southwest know that managers at United and other airlines will respond to their pricing strategy, and an important part of their job is understanding how United will respond to their pricing strategy.

We have argued that strategy is at the centre of important business decisions. Now you might think that there are probably as many strategies as there are business situations. This, after all, is the implicit view of case study analysis employed by many business schools. A case study is deliberately anecdotal: cases tell a story, and every story is different. Since every story is different it might seem very difficult to come up with any general system of analysing business situations.

But this is precisely what we will attempt to accomplish through the use of game theory, the mathematical science of conflict and cooperation. We will show that many business situations can be deconstructed to a few basic conditions that can be systematically analysed. We will also see how it is possible to break down strategy into component parts and analyse the role played by each part. Thus, through game theory we will develop a general approach to understanding what strategy is and how choices of strategy affect the outcome of certain situations. Theoretical analysis is all very well in the classroom, but it will never completely take the place of experience. That is why each chapter in the book contains several cases to illustrate and expand on the theoretical material and to tie it in to the real world.

1.2 Traditional managerial economics

What is so special about our approach to managerial economics? The answer is simple: the focus on strategy. Traditionally, managerial economics has simply been treated as intermediate microeconomics adapted for business students. This approach does not take into account a major development in economics that has taken place since the late 1970s: the use of game theory.

Ignoring game theory in economics is a bit like analysing a successful professional sports team and focusing on the physical fitness of the athletes. Certainly, physical fitness is an important element of success in sport. But in the modern era where each team has the ability to ensure all its players are at the peak of their physical condition, physical fitness surely is not the key to the difference between winning and losing. Successful teams are those that have the best strategies, whether it be a strategy for getting players, a strategy for trading players, or strategy (tactics) employed, during the game. Sir Alex Ferguson of Manchester United and José Mourinho, currently at Inter Milan, do not command the highest salaries because they know how to get their soccer players into shape. They are well paid because their strategies for success have been shown to work.

1.3 Overview of the book

This book is divided into four parts: basic theory, applications of game theory to interactions between firms, applications of game theory to interactions within the firm, and applications relevant to marketing economics. Part I, comprising Chapters 1 to 5, covers the basic economic tools of the firm, and introduces game t...

Table of contents

• Contents
• Preface
• 1 Introduction
• Part I Theory
• Part II Strategic interaction between firms
• Part III Strategic interaction within firms
• Part IV Marketing economics
• Answers to odd-numbered problems
• Index