Essay: Managerial Economics

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¶ … Finite World," a column by Paul Krugman that appeared in the New York Times on December 26, 2010. The article discusses the recent run-up in commodities prices, which has included metals, energy and food. The article also relates commodities prices to inflation, industrial production and the implications for monetary policy. There is one line, however, that hints at some implications for managerial economics in particular: "(rising commodities prices) will require that we gradually change the way we live, adapting our economy and our lifestyles to the reality of more expensive resources."

At the core of Krugman's argument is that rising commodities prices reflects a long-term story, one that is increasingly focused on growth in emerging economies. While he warns that policymakers should not be tempted to attribute these price increases on domestic demand and the same can apply to domestic corporations. Firms need to understand how global economic shifts are going to impact their businesses. With specific respect to managerial economics, this means firms need to adjust to changes in price elasticity as consumers adjust spending patterns and they need to minimize the risk associated with volatile commodities markets.

Krugman notes that economic adjustment to reflect a world of consistently higher commodities prices is inevitable, and that this will impact on purchasing decisions. Firms will need to understand the implications for their own products of shifts in purchasing behavior on the part of consumers. As prices increase, substitutes are more likely to emerge and consumption of goods that become too expensive is likely to decline. Consider the example of food prices. Some foods are relatively price inelastic with respect to demand. A staple such as wheat will be consumed in most countries by anybody who can afford bread. Should the price of wheat increase to the point where substitutes become cheaper, however, the elasticity curve will become steeper. Within the range where substitutes are not a viable option, there will be little to no change in the price elasticity of demand for bread. When the price of bread is such that a substitute such as rice becomes cheaper, people in most cultures will begin to substitute rice for bread -- at this point there is greater price elasticity of demand for wheat than when the price was out of range of substitutes.

For firms, it is essential to understand where their price elasticities lie and what substitutes may arise if the price of key inputs (and be extension prices to consumers). Attention paid to broad trends in the macroeconomic environment can help managers to make decisions both in the long and short run about the risks they face as well. Firms can institute commodities hedging strategies if the inputs are important enough to the cost structure (such as airlines with jet fuel) or make decisions to substitute inputs before high commodities prices drive consumers away.

This article is a good example of the concept of price elasticity of demand in particular because it shows how macro-level trends can impact a business, and highlights the need for managers to understand how elasticity in their industry works so that they can make better decisions with respect to managing risk, in particular in response to rising commodities prices. In a world where resources are finite, this issue will become increasing important in coming decades.

The second article is "Platform Competition under Asymmetric Information" by Hanna Halaburda and Yahon Yehezkel, published as a working paper by the Harvard Business School. This article discusses the impact on business strategy of asymmetric information and uncertainty with respect to market outcome of new technology. The authors conclude that the "incumbent dominates the market by setting the welfare-maximizing quantity when the difference in the degree of asymmetric information between buyers and sellers is significant."

This article illustrates some of the impacts of asymmetric information. The authors note that technological innovation often comes from new entrants rather than established, incumbent competitors. The new entrants, however, do not have sufficient market power to maximize welfare. Considerable risk arises from this asymmetric information for the market incumbent, but it is the incumbent that has the power to set output levels. This creates a balance by which the incumbent is able to make up for its relative lack of technological capability. The incumbent, despite being as a competitive disadvantage technologically, can use its market muscle to either extract key technology from the innovator or to imitate the innovator and continue to set output at the welfare-maximizing level.

New entrants often rely on technological innovation as a means to enter a market. For incumbents, new entrants and consumers this creates a situation characterized by asymmetric information. In this scenario, the authors find that trade is less efficient than it would be under a monopoly. Consumers may be either wary of the new technology or they find the new platform more difficult to acquire than the old platform. In either case, the market does not return to full efficiency until either the new entrant becomes the incumbent or the incumbent closes the technology gap, or leverages its size to acquire the technology from the upstart.

For firms, this article has implications for strategy, in particular with respect to technological innovation and market entry. Firms in the new entrant category must devise strategies that will maintain the asymmetry of information long enough to overtake the incumbent in size in order to bring the market to an efficient state. An example of this would be the iPhone. Smartphones effectively represented a new technology that overtook handheld computers. Palm was unable to close the technological gap with Apple, allowing the latter to gain substantial size in the industry. Blackberry maintained its size by rapidly closing the technological gap. That market is still not in a state of efficiency because of new entrants, but Apple knocking out Palm was an example of the dynamics created by technological innovation and asymmetry -- the incumbent firm must close the asymmetry gap in order that its existing size remains a source of competitive advantage.

This article effectively provides a real world example of how firms should behave in markets characterized by asymmetry of information, a strong incumbent, and a technologically superior upstart. This situation has become commonplace in the past couple of decades, so that the authors have added to our understanding of this particular situational dynamic is valuable for managers, investors and even consumers seeking to understand the markets for their favorite products better.

The third article is "New York Times paywall goes live today" by Allan Chernoff of CNN. This article discusses the decision by the New York Times to charge money for online access to its content. The Times is charging for access but the system has a number of different loopholes that will allow users to find the content they want through back doors. The article is important for its discussion of the microeconomics behind the pricing decision.

A number of factors that went into the pricing decision are discussed. Among them are the prices charged by competitors, the usage statistics for the website and the price elasticity of demand. It is believed, for example, that heavier users are willing to pay, while casual users are not. In addition, there is the consideration of advertising revenue. The fees may decrease site usage, which will decrease advertising revenue. The Times needs to set its pricing policy based on its determination of the optimal balance of revenue streams.

It is also worth considering that there is asymmetric information involved. The Times has some data with respect to usage but it does not know what the response will be to its new pricing plan. It can only estimate at the price elasticity of demand at this point. With this asymmetric information, the Times must close the information gap quickly in order to determine the point of maximum economic efficiency.

The article illustrates the complexity of pricing decisions for Internet sites. Substitutes -- however imperfect -- are often free, which creates a unique situation in which an operator trying to charge money is competing against those giving it away for free. For the Times, there is significant risk associated with its strategy. This risk reflects who little it knows not only about its own price elasticity of demand but also the cross-price elasticity of demand for competing products.

The Times agonized over its pricing decision, and it took at least a year for the company to bring this to fruition. It attempted to draw on research it had gathered, on the experiences of its competitors and on past experience in the industry in order to mitigate some of the risks. It is likely that a substantial amount of quantitative analysis went into the decisions that underlie the announcement -- both in terms of the price charged and the limits that the Times has set on quantity of articles.

This article is a great illustration of the some of the factors that influence pricing decisions. In this case, the cost… [END OF PREVIEW]

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