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Microeconomics for Managers

Textbook for Managerial Economics and Business Strategy

Economics 3551

Winter Quarter 2013

By

David J. St. Clair

Professor Department of Economics

California State University, East Bay

© 2013

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Table of Contents Chapter 1 – Introduction: Economics and Decision Making ………… 3 Chapter 2 – The Goal of the Firm and its Environment ………..…… 35

Chapter 3 – The Many Faces of Competition ………………………. 49 Chapter 4 - The Firm’s Vertical and Conglomerate Boundaries …. 64 Chapter 5 - Demand and Elasticity ………………………………….. 91 Chapter 6 - Price Discrimination …………………………………..... 126 Chapter 7 – Horizontal Issues: Costs in the Short Run ……….…. 137 Chapter 8 - Market Structure Analysis ……………………………... 147 Chapter 9 - Barriers to Entry ………………………………………... 171 Chapter 10 - Unit Costs in the Long Run …………………...……… 188 Chapter 11 - Searching for Economies of Scale ………………….. 195 Chapter 12 - Countering Diseconomies of Scale …………………. 210 Chapter 13 - A Final Look at Competition: Antitrust Policies …..… 226

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David J. St. Clair Microeconomics for Managers

Chapter 1

Introduction: Economics and Decision Making

Economics is a social science concerned with how people go about providing for their material well-being. As such, economics often focuses on business activity. Indeed, economists were studying business activity decades before the study of business (and business schools) emerged as a separate academic inquiry. The systematic study of economics began in the 18th century under the term “political economy.” This name was changed to “economics” in the late nineteenth century in order to distinguish the field from Marxist political economy. Today, the term “political economy” continues to be associated with Marxism; unless you are a comrade-in-training, it is probably best to stick with the new name.

After the 1930s, economics split into two distinct (but still related) fields of study: microeconomics and macroeconomics. Macroeconomics grew out of the crippling impact of the Great Depression of the 1930s. In macroeconomics, the focus is on how the overall (or aggregate) economy functions. Do we have full employment or do we have unemployment? Are prices stable, or do we have inflation? Are we growing or stagnating? Do non-market economic systems perform better or worse than market economic systems? These are all primarily macroeconomic questions. Microeconomics is the branch of economics that focuses on how individuals and business firms make decisions in markets. Microeconomics attempts to explain how markets work, and why they might not work so well. Microeconomics, like economics in general, has usually been policy-oriented, that is, the emphasis has usually been on analyzing market outcomes with an eye toward formulating the firm’s business strategy and/or public policies. For example, should markets be allowed to function free of government control, or should markets be closely regulated by government? Managerial Economics and Business Strategy is a course in microeconomics taught with the business manager in mind. As such, it should seek to present microeconomic concepts and analysis in a manner most useful for business professionals.

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A Few Words about the Structure and Format of this Course This course and text will probably look a bit different from the economic courses and texts that you have been used to seeing; there are few graphs, equations, models, or derivations. This is not an oversight or omission – it is by design. This course will primarily feature microeconomic concepts presented in a narrative format and supplemented with short real world cases and examples.

This approach was developed in response to one paramount question: What do business men and women need to know about microeconomics? This is actually a variation on a more fundamental question that should underlie all courses: What should students know about a subject and how should they know it? My answer to this question is multi-facetted. First, this course never forgets that it is designed for business students. Microeconomic theories and concepts will be presented in a manner that is most useful to those who will primarily be users of microeconomics rather than practitioners. This certainly includes most managers and business people. (This should also include most economics majors, including those destined for graduate school in economics; tragically, too many economics majors end up mastering only stylized or abstract theoretical economic models.

Second, this course is built on the premise that how you know microeconomics is just as important as what you know. What kind of microeconomics will be most useful for business managers and owners? Unfortunately, stylized and abstract models seldom have much relevance to managers and overly formal models and graphs are often more distracting than helpful. For business people, models, graphs, and rigorous proofs are not very useful on the job. Your colleagues on the trading floor or in a business meeting are going to laugh or get angry if you start drawing graphs or lecturing about models. To be sure, models, graphs, and proofs have their place in academic economics, but they are not very useful here. We will go to great lengths to avoid this problem. If you have found graphs and formal models confusing, take heart in the knowledge that there is nothing in a graph that cannot be readily communicated in straight-forward narrative English. (However, the converse is often not the case.) This text embraces this approach. The focus is on a rigorous narrative exposition of economic concepts and issues that will hopefully be most useful to business managers. This does not mean that the material presented in this manner is any less rigorous; it simply means that there is a different emphasis. There will be less derivation, less model building, and less graphs. There will be more emphasis on practical microeconomic policy issues and solid narrative exposition. Most important, all of the assignments and exams feature the same approach. Assignments and exams will test your microeconomic knowledge in a narrative format without the need for graphs, formal proofs, formal derivations, or elaborate model building.

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Finally, the class and text seek to illustrate economic concepts with short examples and cases. It is usually easier to understand a concept when it is grounded in a real-world example. However, we will avoid long case studies because these often obscure the point rather than highlight it. If the point of an example or mini case is not readily apparent, you have either missed something, or I have not done my job well. A Simple Suggestion for Testing Your Knowledge The approach described above lends itself to a very simple way of testing your knowledge of applied microeconomics. To see if you have acquired the microeconomic understanding needed to excel in the business world, try this simple test: Say it. Say it out loud. Shout it or whisper it. Tell it to a classmate or tell it to yourself or tell it to a friend or lover (but be careful, you can lose friends and lovers this way). The point is that microeconomics in the business world will only be useful if you can verbalize it. If you cannot verbalize it, you can not use it or access it when it counts. To me, this means that you do not really know it. The reason why this is such a good test of your knowledge stems from a curious fact of human nature. When you read something and encounter a word or concept that you do not understand, your mind can simply skip over it. This is also true of concepts that you know something about, but are still a bit vague or fuzzy on. For example, you may read something that seems reasonable, but you are still not completely sure about it. The mind will move on and most people will be content with this vague understanding. But do you know it? The answer to this question is a resounding no; you do not know it and you will quickly discover this when you try to say it. Reading and listening are passive, but speaking is not - speech does not come when the concept is vague or fuzzy. When you don’t know it but try to say it, you stop; speech won’t jump over the fuzzy part. This is why saying it is such a good test of your understanding and why saying it is the ultimate study tip.

Getting Started: Centuries of Human History in a Few Paragraphs Discussions without a bit of background and context are seldom productive. What follows in this section is a very brief look at the (not-so) good old days. The goal is to put the modern economy and economics in context.

Before the capitalist era, economies all around the world were overwhelmingly agrarian. Most people tilled the soil and the economy was usually organized around the village. The village economy was in turn structured according to tradition. Tradition was the time-honored way of doing things that had been passed on through the generations. Tradition dictated who did what

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and when, as well as who got what and why. People were seldom asked to make choices, but they were constantly required to conform to tradition.

If you had traveled around in the pre-capitalist world, you would have encountered societies with very different traditions, languages, costumes, diets, religions, and customs. But while these societies may have all looked very different on the surface, at their cores, they were all quite similar - tradition ruled in each. In addition, all traditional economies have had remarkably similar structures and features. The following have been typical of just about all traditional economies:

1. Agriculture predominated

Through history, village economies have conformed to what economic historian Carlo Cipolla termed “The 90 – 10 Rule.” According to Cipolla, village societies always had about ninety percent of the population directly employed in agriculture. The vast majority of workers had to work in agriculture due to their very low (by modern standards) productivity. It took ninety percent of workers tilling the soil in order to grow food for themselves as well as for the 10 percent “crust” that worked outside of agriculture. The 10% crust included the educated, well-fed, upper classes as well as craftsmen, merchants, soldiers, government officials and members of the clergy. And the crust was quite thin; these city-dwellers were little more than small scattered islands in a sea of peasants

2. Short, but not Sweet The village economy was usually a place of too little – too little food, too little shelter, too little clothes (and no underwear), and too little years. In the not-so-good-old days, men usually had a life expectancy in their mid-thirties; women lived much shorter lives (child bearing took a terrible toll). The masses were skinny and the rich were fat; fat was beautiful and the upper classes took great care to differentiate themselves from the great unwashed through fashions such as ridiculously long finger nails (i.e., proof that one never touched manual labor). 3. Markets were Few and Far Between Tradition ruled the lives of peasants and markets were limited to the cities and towns scattered across the sea of peasants. Most peasants might engage in only a few market transactions during their lives; many none at all. And where markets functioned, they were usually tightly regulated by suspicious officials. In addition, merchants were not tradition-bound and were sometimes very upwardly mobile. This drew the ire of the upper classes and put them in an awkward

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position; the upper classes enjoyed the products and variety that markets brought them, but it was difficult for them to watch uppity merchants getting richer than their social superiors. Distrust of markets and merchants has usually been a feature of pre-capitalist economies (and many capitalist economies as well). 4. Stability, not Growth Traditional economies and societies were structured for stability and survival, not change and development. Equally important, people were not accustomed to economic progress, nor did they expect economic progress. In fact, the notion of a "good life” to a peasant usually meant an absence of any change (i.e., a good life was a life where nothing bad happened). In this world, one generation took over from another, doing essentially the same things that their parents did. They in turn sought to pass on their traditional lifestyle to the next generation. Outside of the upper ranks of the nobility, people in traditional economies seem to never have embraced the idea that things could get better for themselves or for future generations; maintaining the status quo was thought to be as good as it gets. 5. A World without Economists In traditional economies, there was no systematic economic inquiry, nor much interest in economic topics. The reasons for this largely reflect the features discussed above; there was little need for or interest in economics because: First, with little or no market activity, there was little need to understand markets. Second, with tradition governing these economies, their workings were fairly obvious. A casual observer spending a few days in a village could easily understand the workings of the village economy. However, this has never been the case with markets. Markets have always confused people, both educated as well as uneducated. Markets have been so confusing because on first inspection, it always appears that no one (or nothing) is in control. Market activity appears to be chaotic, free, unstructured, unregulated, unplanned, and selfish. Markets have been especially confusing to religious and secular authorities, and what people do not understand, they mistrust. Third, since nothing much changed for the better in traditional economies, there appeared to be little need for an economic development strategy. Fourth, educated people in the crust went to great lengths to separate themselves from the great unwashed masses and took virtually no interest in the affairs of working people. For all of these reasons, a systematic study of economics was inconceivable. The Emergence of Markets and Economics

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In the 18th century, Great Britain became the first country to break the “90-10” rule. This resulted from a revolution in agriculture that began in the 17th century which dramatically increased productivity. The Agricultural Revolution was followed by a further quickening of economic activity in the British Industrial Revolution after 1750. As agricultural output increased dramatically, the share of agricultural output and employment in agriculture began a relentless decline. Today, agriculture employs less than 2 percent of workers in most developed economies.

At the same time, markets expanded, industrial output surged, urban areas grew, and the population exploded. From Britain, industrialization spread to Western Europe and to areas of European settlement. On the other hand, traditional village economies (or hybrid village economies) continued to persist in most of the underdeveloped parts of the world today, with a large development gap opening between the developed and underdeveloped parts of the world. Today, some underdeveloped economies are in the midst of similar rapid transformations; others however, are virtually dead in the water (i.e., they are undeveloped and not going any where). The successes of European economies lead to the development of economics as a systematic science. The creation of economics was primarily driven by the need to explain how markets worked, and by growing dissatisfaction with mercantilist economic development policies. In 1776, Adam Smith published An Inquiry into the Nature and Causes of the Wealth of Nations. (Abbreviated title: The Wealth of Nations.) This was one of the first books devoted to systematic economic inquiry and it established the field of economics. It offered the reader a scathing criticism of mercantilism and made the case for laissez-faire. Laissez-faire was a French term adopted by Smith to describe an economic policy of limited government interference in markets. When Smith began the study of economics, there was no division of economics into microeconomics vs. macroeconomics. Smith and those who followed him were primarily interested in policies that related to how markets worked (microeconomics) and to in long term economic growth (microeconomics and macroeconomics). Inquiry into business cycles (a part of macroeconomics) largely developed as a sub-field of economics in the 19th century. What was New about Smith’s Approach?

Adam Smith was interested in explaining how people make economic decisions in markets. Why did decision makers do what they did? What motivated their decisions and what were the economic and social consequences of their actions?

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While this may seem very simple and basic, it was actually quite new at the time. As noted above, pre-capitalist economies used markets sparingly and references to economic issues were only scattered in among the writings of scholars who were primarily concerned with ethics, politics, philosophy, or theology.

In addition, these scattered discussions of economic issues found in the writings of pre-capitalist scholars tended to deal entirely with economics from a moral or ethical perspective. Most involved discussions of what people ought to do, rather than what they actually did. Economists call this kind of ethics-oriented discussion normative analysis. On the other hand, discussions about what people actually do, and how the economy actually works, fall within the bounds of positive analysis. It is fair to say that most (if not all) economic analysis before the advent of market economies was normative.

For example, when it came to matters involving prices, pre-capitalist scholars provided very little analysis of what actually determined market prices. However, they got into heated discussion about what prices ought to be. In Europe, these scholars usually argued that prices should be "just." In traditional economies, prices were considered just when they served to maintain the correct social order. Everyone, it was argued, had their correct place in society and market transactions should not disrupt this order. When market prices were unjust, they were too low or too high and people therefore fell or rose in rank as a consequence. The doctrine of "Just Price" (and the numerous laws that it gave rise to) were intended to protect society from unjust markets.

Profit and profit seeking were treated in similar fashion. St. Augustine, an early leader of the Christian Church in Europe, condemned profit as sin because making a profit was tantamount to theft. Augustine argued that profit was the result of buying at one price and selling at another price. But, he reasoned, a product could never have two different just prices. Consequently, the man who earned a profit was a thief who had either paid too little for the product initially, or had subsequently sold it too high. In the first case, he had stolen from the person that he had bought it from; in the second case, he had stolen from his buyer. For Augustine, the only interesting question about profit was the identity of the injured party.

Notice that these discussions of prices and profits do not display any real interest in explaining the process of price formation or the role of prices or profits in economic activity. The analysis is normative, not positive, and served primarily to restrict and condemn market transactions. This disapproval, or at least distrust, of markets and merchants has been very common around the world in pre-market societies. Merchants were usually relegated to the fringes of societies or confined to lower social classes. For example, Aristotle argued that pirating was a more honorable occupation than being a merchant. Similarly, in Japan, merchants were at the bottom of the social order, one level above untouchables.

It was not until the thirteenth century that church scholars came to grips with St. Augustine's condemnation of profits and market activity. The person

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most responsible for exonerating profits and profit making was St. Thomas Aquinas. Aquinas argued that profits were not necessarily sinful provided they were not excessive and if the proceeds were put to a just purpose such as supporting one’s family, community, and church. (It is amazing how many cathedrals can be financed from the offerings of merchants anxious about their souls.) We will not go further into the details of this revolution in economic thought. Suffice it to note here that Aquinas legitimized markets and profit making, but he still offered little insight into how markets actually worked.

But European economies were developing through market activity and the growing use of markets created a need to understand how markets actually worked, not just how they ought to work. While not the first to wrestle with this task, Adam Smith’s Wealth of Nations was the most successful and firmly grounded economics in positive analysis. To be sure, there was still plenty of room for policy discussions and normative analysis, but following Smith, the positive inquiry came first.

Smith dispensed with the normative-analysis-only perspective and boldly proclaimed that people acted out of self-interest. People do things because they figure that it is in their self-interest to undertake that action. Smith went on to argue that markets channeled self-interest into actions that produced benefits for society as a whole. Smith then returned to the normative issue and argued that the pursuit of self interest was in fact good for society. Markets allowed people to pursue their self-interest and channeled this selfish behavior into activities that made society better off.

Positive vs. Normative Analysis Economists continue to stress the difference between positive and normative analysis and you need to be able to distinguish between the two. Positive analysis attempts to analyze how the world works. Disputes in positive analysis can (at least conceptually) be resolved by appeal to empirical evidence (that is, the facts). "An increase in the supply of money will produce inflation" is a positive statement. Proponents and critics may argue about the validity of the point and appeal to the historical record and/or economic models to support their views. However, the important point is that it should be (subject to data limitations) possible to resolve this issue. In contrast, normative analysis always introduces ethical and moral criteria into the discussion. Normative analysis may appeal to positive theory, but it always brings a standard of ethics, morality, or value judgments to the issue. "Income is distributed unequally" is a positive statement. "Income should be distributed more equally" is a normative statement. It introduces the notion of good and bad. More equal is good; less equal is bad. All normative analysis is

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readily identifiable by the use of such terms as "good," "bad," "should," "ought to," "better," etc. The critical point to note about the distinction between positive and normative analysis is that good and bad are ethical terms, not economic terms. There is nothing in economics that supports, defends, or rejects any ethical position. Economists argue that people make rational decisions within their ethical systems. It does not, and cannot, address the rationality or morality of those beliefs. There are some ethical propositions that have a rather large following and are often assumed to be generally valid. For example, economists will often proceed on the basis of a value judgment that more material goods is better than less material goods. While most people have little trouble accepting this, there is a counter perspective. If one believes that material possessions corrupt the soul, then more material goods may lead one further from God. Therefore, less material goods would be better than more material goods. Who is right? You will have to decide this one for yourself - but the main point is that the battle must be waged in the realm of religion, ethics, and value judgments, not economics. Economic analysis cannot resolve this dispute and attempts to resolve any normative question apart from its ethical underpinnings is doomed to failure. Positive vs. Normative: A Ridiculous Example to make an Important Point Consider the following statement: “If you had an infinite amount of time and an infinite number of monkeys working on an infinite number of typewriters (yes, typewriters), one of them would eventually write Hamlet.”

This is a ridiculous proposition and people who spend too much time on it should make you nervous. However, let’s consider this extreme proposition to make a point: Positive statements are at least theoretically verifiable and they do not involve value judgments. By this criterion, this is a positive statement. First, there is no value judgment (no one is saying monkeys banging away on typewriters are either good or bad). And if we could observe infinity, we could probably resolve the question. Even though “infinity” is involved, this remains the appropriate criteria for distinguishing between positive and normative statements. (As for the actual monkey question at hand, I think it is rather absurd and unlikely - I would expect something like: “To be or not to pee …..” Doh! – monkey starts over).

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The Economic Approach: Rational Choice

Adam Smith argued that people tend to look out for themselves. They weigh the cost of doing something against the expected benefit and end up doing things that bring more benefit than cost. Economists call this rational behavior. By this, they mean that people weigh the benefits of an action (as they see them) against the costs of an action (as they see them) and then act in a manner consistent with their best interests. The critical juncture in the argument is the "as they see them" part. "As they see them" means that benefits and costs are subjective. In other words, there is no objective assessment of rationality.

Economists run into a lot of misinterpretation on this point. In other disciplines, rationality usually means that one's perceptions of the world are valid. In economics, rationality means that people take actions based on the world as they see it. They may or may not be rational in the psychological sense, but they are always rational in the economic sense. For example, if you actually thought that you were Napoleon, psychiatrists would say that you were irrational. However, economists would argue that you are still acting in a completely rational manner when you kept looking over your shoulder, on guard against your next encounter with the Duke of Wellington. (Recall that it was the Duke of Wellington who defeated Napoleon at Waterloo, thus ending his comeback and condemning him to exile on a rocky island in the middle of the Atlantic for the rest of his life – definitely a bummer.)

It is also important to note that rationality does not mean that people never make mistakes. People make mistakes all the time. When they do, they usually pay a price. At other times, dumb luck may intervene on their behalf. Rationality explains the basis for a decision, not the wisdom of the undertaking or its necessary outcome. A Case Study in Error: Why was Columbus out in the Atlantic?

This last point can be illustrated by the case of Christopher Columbus. Contrary to popular belief, Columbus was not the originator of the idea of sailing west across the Atlantic to circumnavigate the globe in order to reach Asia. The Garibaldi Brothers from Genoa had sailed out into the Atlantic with this goal in the thirteenth century - unfortunately, they never came back.

In Columbus’s day, virtually all educated people, and certainly all men with sailing experience, knew that the world was round. What they were unsure of was how far it was to Asia and how to keep from getting lost at sea with the very rudimentary navigation techniques of their day.

In 1474, Paolo Toscanelli popularized the idea that the distance from Europe to Asia was much smaller than had been previously thought. King

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Manuel of Portugal sent out an expedition based on Toscanelli’s theory that same year, but it failed to find Asia. The Portuguese soon concluded that Toscanelli’s calculations were simply wrong. And most other European officials and scholars involved with exploration had come to the same conclusion about Toscanelli’s numbers.

However, some ten years later, Columbus came up with his own plan based on Toscanelli’s calculations. He figured that he could reach Japan by sailing west for 2,400 miles. He would then sail another 1,150 miles to reach Hang Chou, China.

Columbus was wrong - the correct distances to Japan and China were 10,600 miles and 1,166 miles respectively. Since most advisors to European governments were aware of Toscanelli’s error, Portugal, Spain, and England all rejected Columbus’ plan as being infeasible due to his underestimation of the distances involved. However, a fourth try at selling the idea to the Queen of Spain proved successful and Columbus made his voyage in 1492.

It is important to point out that both Columbus and Queen Isabella were wrong. However, they were rational, undertaking the voyage because the benefits (as they perceived them) exceeded the costs (as they perceived them). The mission also failed to attain its objective - Columbus never did find Asia and, in fact, never even realized his error. But he was elevated to the rank of Admiral of the Seas and richly rewarded. For Spain, the mistake led to the colonization of the New World and to the discovery of vast quantities of gold and silver that would finance a century and a half of Spanish empire-building.

In a fair and just world, people who make terrible mistakes are not rewarded - but this is not always a fair and just world. The voyages of Columbus are a case in point; despite making a huge error, Columbus and Spain both prospered from their mistake. (Perhaps the holiday on October 12 ought to be re-named or at least subtitled: Fools-Sometimes-Get-Lucky Day.) But whether Columbus got his just reward is not the point; the important point is that Columbus’ decision was rational because it was predicated on his weighing of the costs and the benefits. In that weighing, he was rational - and wrong. The Nature of Costs and Benefits

The topic of costs and benefits will come up often in this course. A few words about these terms are in order here.

Benefits are something positive that accrue as the result of a decision. Costs are something lost or given up as a result of a decision. Economists argue that the basis for all cost is lost opportunity. Lost opportunity means that something is given up, lost, or foregone as a direct consequence of undertaking an action. In the economic discussion of costs and benefits, the emphasis is on decision making and it is forward looking. In many respects, accounting is the

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opposite of economics. In economics, one is interested in how anticipated benefits and costs relate to actions undertaken; in accounting, one tracks past performance; that is, one accounts for what has happened. Accounting is inherently backward looking (backward looking, not backward). This is not a matter of which discipline is doing it right; it is instead a question of what one wants to do.

In economics, benefits and opportunity costs are:

1. Subjective

2. Both explicit and implicit

3. Ex Ante, rather than ex post

4. Based on an honest assessment of the value of the next-best alternative foregone (This applies to costs only, not benefits.)

5. Relevant

We will briefly look at each of these in turn. Economic Benefits and Costs are Subjective

Point #1 says that the actual weighing of costs and benefits is always up to the individual decision-maker. What matters is how that person subjectively sees it. Another way of saying this is to say that there is no objective, external criteria that determines what is or is not an opportunity cost. Outside observers can understand and estimate subjective costs incurred by decision-makers by trying to see the world as the decision maker sees it. But one must always keep the perspective of the decision-maker, not the outside observer. Economic Benefits and Costs are both Explicit and Implicit Point #2 says that financial costs are part of opportunity costs (explicit), but so are non-financial costs (implicit). These implicit costs include waiting costs, time costs, aggravation costs, foreclosed-option costs, and costs that stem from exposure to the risk of injury or loss. For example, lost sleep could be a cost of attending early morning classes.

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Economic analysis, with its assumption of rationality and benefit/cost comparisons, has often given people the mistaken impression that only material benefits and costs are weighed. What about ethics and morality? What about unselfish acts of kindness and charity?

There is nothing in economic analysis that precludes decision-makers from valuing love, peace, virtue, honesty, and charity (or counting the loss of any of these as a cost). For many, acting in a moral fashion has great value and it would be impossible to understand their actions without appreciating how these factors influence their weighing of costs and benefits. Economic Benefits and Costs must be evaluated Ex Ante

Point #3 says that costs (and benefits) must be evaluated ex ante, not ex post. This simply means that you weigh the consequences of a decision before you know the outcome. Ex ante means “before the fact,” while ex post means “after the fact.” The need for ex ante rather than ex post weighing of costs and benefits in decision-making can be illustrated with one of Will Roger's famous quotes. Will Rogers (1879-1935) was one of the first American comedians and political commentators to gain a national following. Rogers once told his audience that making money in the stock market was easy: All one had to do was to buy stocks low and then sell them when they went up. And if they don’t go up, then you don’t buy them! Whether an audience today would find this funny is debatable, but the joke was based on a deliberate confusing of ex post with ex ante.

Exposure to the possibility of injury or loss is also an implicit cost. This cost is called “risk,” and it is an opportunity cost provided that it is considered ex ante. In other words, your decision to fly or not to fly on an airline probably weighed the risk involved. You probably looked at this as a matter of probability. Of course, the issue would not arise if you knew the plane was going to crash (or not crash). You would never fly if you knew that the plane was going to crash (or at least we hope not) and you would not hesitate to fly if you knew it was not going to crash. But that is the point - risk is an ex ante opportunity cost. If an airplane does crash, accountants will have to deal with the ex post costs. But accountants are not decision makers and they deal with loss, not risk. This distinction lies at the heart of the distinction between ex ante and ex post.

When assessing risk, it is important to keep in mind that decision-makers often use subjective criteria. For example, Lotto players usually use very subjective probabilities in deciding to play. In other words, they pay little attention to the mathematical probabilities, preferring instead to concentrate on their own view of the odds (and joy) of winning. For example, you have a greater statistical likelihood of being struck by lightening than winning the Lotto, yet Lotto players do play and they seldom concern themselves about thunderstorms.

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It is always important to understand the distinction between subjective versus objective probabilities in decision making. All casinos profit from huge discrepancies between true odds and subjective odds. As a case in point, consider Keno, a game usually played by the bored and/or the criminally stupid. Despite the dismal true odds, Keno players feel confident of their chances. Worse, discussions of the true odds usually do little to dissuade people with strong subjective views of the likelihood of outcomes. The point here is that the subjective probabilities, even when grossly wrong, are relevant in decision making.

The importance of the distinction between true odds and subjective odds can also be seen in the air travel industry. Fear of flying is a real concern among some and this impacts the demand for air travel, especially following an air disaster. Yet all of the statistics confirm that flying is the safest means of travel. The mathematical probability of dying on your next airline flight is one in seven million. (Notice that the odds of winning the jackpot in the California Lotto are closer to one in 45 million.) To put this in further perspective, a person flying everyday can expect to die every 19,000 years. While shorter commuter flights are three to four times as dangerous as flights on major airlines, a person actually faces a far greater chance of dying of a heart attack while waiting for his bags at the luggage carousel than of dying on one of these “dangerous” flights.

The gap between objective probabilities versus subjective probabilities can be large and important. No airline can ignore perceptions of air safety and lotteries only work because of greatly exaggerated subjective probabilities. Decision-making is clearly dependent on subjective perspective. Economic Cost is an Opportunity Cost

Point #4 says that lost opportunity must be measured as the value of what is actually foregone in the next-best alternative. Obviously, this must be based on an ex ante consideration. For example, if you go to class instead of going to the race track to bet on the horses, you lose the opportunity to bet on races (but before you know who wins). It is the probability of winning (and losing) that is foregone. One should also note that this is a legitimate opportunity cost only if you would have actually gone to the horse track if you had not been in class. On the other hand, if you would have been sitting with your friends in the cafeteria instead of going to class, then that would be your next best alternative. Note that evaluating lost opportunity gives you a wonderful chance to lie to yourself - if I don’t go to class, then I would be writing a best selling novel. This is only true if it is actually your next-best alternative activity.

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Economic Benefits and Costs are Relevant Benefits and Cost

Point #5 requires that all costs and benefits must be relevant. In economics, we define relevant costs and relevant benefits as costs and benefits that will be impacted by a decision. On the other hand, irrelevant costs and irrelevant benefits are costs and benefits that will not be impacted by a decision. The most important point here is to distinguish between sunken benefits and costs versus incremental or marginal benefits and costs. In decision making, sunken costs are usually irrelevant because they are not affected by the decision. For example, if you are thinking about dropping a class late in the quarter, your tuition fees become irrelevant because tuition fees will not be returned regardless of whether you drop or stay.

Incremental essentially means “additional” and the term “marginal” should always be translated as the impact of one more or one less. At this point, we will treat the two as virtually synonymous. Most importantly, marginal or incremental costs and benefits are usually relevant costs in decision making because they quantify the additional benefits and costs that result from a decision. One Final Point: The Choice Field

An additional point about rationality and weighing costs against benefits is in order. While economists feel comfortable about explaining how choices stem from the subjective assessment of relevant costs and benefits, they cannot explain which options people are willing or unwilling to put in the choice field in the first place. What are you willing to do? For example, if you were not a student, would you be a drug dealer? (If you are a dealer, you may skip the next question.) Are you not currently dealing in cocaine simply because you are afraid of getting caught? If so, you have made a benefit/cost comparison. On the other hand, you might find the idea of dealing in drugs to be morally unacceptable and not a relevant choice consideration. This removes the option from the choice field and your decision is not based on a benefit/cost comparison.

Or consider another example: Have you ever considered cannibalism as an alternative to the high cost of beef? (This is a rhetorical question, not an invitation to confess.) For most, this choice option is unacceptable and not subject to benefit/cost evaluation. In any case, the decision to include cannibal dishes on the menu is a moral and ethical determination, not an economic choice.

To illustrate this point with a more serious example, consider the question of slavery in the American South before the Civil War. Why did slavery become

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entrenched in the southern English colonies? At different times, slavery has been practiced all around the world. However, while England had a long feudal history, slavery was almost unknown in recent times. It is commonly argued that southern plantation owners (or soon-to-be plantation owners) resorted to slavery in order to overcome a severe labor shortage. There is some truth in this claim; the benefits and costs of slave labor were weighed and slavery was adopted. But one must be careful to keep the issues separate. In weighing the costs versus the benefits of slavery, Southerners were rational, but this is not an excuse or even an adequate explanation. The real question is why was slavery considered in the first place? That is not an economic question - it is an ethical matter.

Mini Cases and Applications

The remainder of this chapter is devoted to mini cases and examples where the economic approach developed above is applied to specific situations. A Case of Lost Opportunity: ‘Normal’ Profit as a Cost There are many differences in how economists and accountants treat costs. Perhaps the biggest difference can be found in the willingness of economists to treat a ‘normal’ accounting rate of return as an opportunity cost. In accounting, costs are restricted to explicit costs compiled according to rules acceptable to the accounting profession and tax authorities. Implicit and subjective costs have no place in the business of accounting. This is as it should be; the different treatment of costs by economists is not a criticism of accounting – it is simply a look at costs from a different perspective, i.e., from a decision-making perspective. Economists argue that a normal accounting profit is a relevant and necessary cost of production. Normal profit is the income that the firm could be earning in its next-best alternative and is therefore a relevant opportunity cost to the firm. This is in danger of becoming a bit abstract, so let’s make the point a different way. Both accountants and economists agree that wages are a cost of production. Workers must be paid. If wages are not paid, workers stop working. Economists argue that a normal profit is no different. If a firm cannot earn at least a normal profit in an activity, it stops that activity and pursues its next-best alternative. Unlike wages, normal profits are not an explicit cost, however, they still need to be earned (and paid to the owners) if production is to continue. Resource holders simply will not continue to keep resources committed to activities that they feel will not give them a return that is readily available elsewhere.

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In all of the discussion of costs that follow in this course, we will assume that a normal profit is an opportunity cost that is always a part of rational decision making.

An Application of Relevant Costs and Benefits: To Call or Fold in Poker Suppose that you are playing Texas Hold’em poker and you are on the last round of betting (on the river if you play). Two other players have raised and you must decide whether to call (i.e., match) the raise or drop out of the hand (we will assume you are not going to raise). The bet is $1,000, but you have already put $5,000 of your money into the pot. What are the relevant costs and benefits of calling?

The relevant cost is the incremental or marginal cost, that is, $1,000. The $5,000 that you have already put in the game is a sunken cost and is therefore irrelevant. This is not a relevant cost because there is no decision that you can make that will affect the $5,000 already committed. (Note: don’t try to just reach in and take your money out – it is amazing how upset people will get.) Note that the size of the pot (including your contribution) is a relevant benefit that must be factored into your decision. Your decision requires that you weigh the relevant cost (i.e., $1,000) against the probability of winning the entire pot. This example also illustrates a significant difference between business and economics. In economics, we can easily frame the issue, but success in business often rests on the art of application, that is, the key to business success is to be able to act and apply concepts in a very chaotic and uncertain world. Likewise, a big part of success poker stems from your ability to think logically in a very stressful situation – you have to get your brain to ignore the $5,000 while your gut is screaming that it’s your money in there! An Example of Relevant versus Irrelevant Costs: On the Perils of Getting it Wrong

In the early 1970s, Franklin National Bank, with headquarters in Franklin Square, New York, was the nation’s 20th largest bank and was doing a robust loan business. Customers were lined up for loans because the bank was charging interest rates well below the rates offered by its competitors. Life was good at Franklin; there is nothing like a long line of customers to make the suits happy. However, on October 8, 1974, Franklin Bank became the nation’s largest bank failure in history to date and was taken over by the Federal Deposit Insurance Corporation. What went wrong?

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There are quite a few things that one could say about Franklin National. On the positive side, the bank was a pioneer in developing the drive-up teller window in 1950; it was an early issuer of bank credit cards in 1951; it was one of the first banks to initiate a no-smoking policy in 1958; and it was a pioneer in introducing outdoor teller machines at its branch banks in 1968. On the negative side, there were persistent rumors linking the bank with the Mafia. However, none of these allegations had much to do with the collapse; the demise of the bank can be traced to a fundamental mistake in its lending policies.

Franklin’s lending strategy was simple: offer interest rates to borrowers that were at least 1 percent above the average cost of the bank’s funds. It is hard to see why a bank that charges more to lenders than it pays to its depositors and creditors can go wrong, but a closer examination reveals the crucial error.

Like most banks at the time, Franklin got its money from four sources: 1) invested capital; 2) demand deposits (that is, checking accounts) in the bank; 3) savings deposits in the bank; and 4) funds borrowed in the federal funds market. The first, capital invested, was rather small and often had to be retained to satisfy reserve and capital requirements. The bulk of the funds for lending therefore came from the other three sources.

In 1974, Franklin had demand deposits of about $2 billion and these accounts cost the bank about 2.25%. Franklin’s savings accounts in 1974 totaled about $1 billion dollars and cost the bank about 4% annually. Both of these deposit sources were relatively low-cost sources of funds, but they were rather inflexible. The bank’s deposits were already invested and additional funds from these sources were limited to the growth of deposits.

The fourth source of funding was the federal funds market. This was a market where banks lent and borrowed money on a very short term basis. The federal funds market got its name from the practice of banks lending out their excess funds (i.e., funds above their federal reserve requirements) to banks that needed borrowed funds to meet their federal reserve requirements. Unlike savings and checking deposits, federal funds market money was usually readily available, but at much higher interest rates. In 1973 and 1974, Franklin Bank was paying between 6% and 11% for these funds. In 1974, Franklin had acquired about $1.7 billion from the federal funds market at these higher interest rates. On average, these funds cost the bank about 10% during this period.

Using these figures, we can compute Franklin’s weighted average cost of

funds in 1974: The weighted average cost of funds was: $2 billion @ 2.25% + $1 billion @ 4% + $1.7 billion @ 10% = 5.42% $4.7 billion

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On average, funds cost the bank 5.42%. Franklin then lent these funds out at an average interest rate of about 6.5%. Other banks were generally charging more than 10% to loan customers - no wonder customers were lined up for loans at Franklin.

The problem with this strategy can be seen in the equation above. While the average cost of funds was 5.42%, this rate only covered the funds obtained from deposits. But all new loans had to be funded with money acquired in the federal funds market. The interest rate for these funds was 10%, well above the rate that the bank was charging its borrowers. Franklin was losing money on all of these loans. Worse, while it was losing money, bank executives were happy because they thought they were making money. (There is nothing worse than being stupid with a dumb grin on your face.)

The bank’s error can be described in the terms introduced earlier in this chapter: Franklin Bank was losing money because it did not recognize that the relevant cost of funds was the marginal cost, not the average cost. In economics and business, marginal always means the next one, or the last one, or the incremental one, etc. In decision making (e.g., the decision to make a loan) the relevant cost is usually the marginal or incremental cost.

In the case of Franklin, the next loan was going to be funded with money from the federal funds market that cost about 10%. This was the marginal cost of funds and the marginal cost of funds should have been the relevant cost for the bank’s lending decisions. The average cost of bank funds (5.42%) was irrelevant because the next loan was not going to be funded with deposit funds. Franklin would have been on sound footing if it had lent money at interest rates 1% above its marginal cost of funds rather than its average costs. When Franklin borrowed money at 10% in order to fund a loan made to a customer at a 6.5% interest rate, the bank lost money. More than a third of the bank’s loans were made where the marginal cost of funds exceeded the interest rates charged to the bank’s customers. You cannot make money this way. In addition, every loan made under these terms further weakened the bank.

In the real world, there is no big neon sign that lights-up to announce that you have made a mistake and are about to pay for it. Instead, when a problem arises, you are usually drained trying to figure out what is wrong. Unfortunately, Franklin never did figure it out. They were making loans, but not money, and could not figure out why.

In addition, as the bank grew weaker and weaker, management became ever more desperate. As a consequence, the bank began to pursue greater returns, but only at the cost of assuming greater risks. Franklin began to speculate in risky foreign exchange markets. When these positions turned sour, the bank went into bankruptcy. However, while the risky investments in the foreign exchange market were the immediate cause of the bank’s demise, the real cause was the bank’s fatal error in not understanding that it was marginal costs - not average costs - that were relevant. (In an interesting parallel, the investment banks that failed in 2008 – Bear Sterns, Lehman Brothers, and Merrill

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Lynch – all seem to have resorted to similar speculative “Hail Mary” strategies just prior to their demise. But in these cases as well, the final desperate speculation was more consequence than cause.)

In the discussion of Columbus, we noted that some mistakes do in fact pay off – Columbus and Isabel never got nailed for screwing up. In the case of Franklin, we return to the norm – the mistake ended up bankrupting the bank. One can only hope that the six-figure executives who made the mistake received their fair share of pain and suffering.

While we have emphasized that average cost were not relevant to Franklin’s business model, it should be pointed out that its average cost were perfectly relevant to another question, that is, the accounting question. To determine profits, one could look at the average cost of funds and then at the interest rates charged in order to determine a profit margin. This could then be multiplied by the amount of funds lent in order to calculate total profits.

This calculation would be relevant for accounting purposes, but it is definitely not relevant for determining how much to charge for your next loan. In decision-making, marginal costs are usually the only costs that matter. [Source note: Some data cited above was obtained from: Robert Thomas, Microeconomic Applications: Understanding the American Economy (Belmont, CA: Wadsworth, 1981): 87-91.]

An Example of Implicit Benefits: Biore Strips Biore Strips are used to remove blackheads from the skin on the nose. You moisten a plastic strip coated with an adhesive, apply, wait, and then remove. The strip pulls away all of those blackheads that have been clogging your pores. What are the benefits and costs that explain why this product sells well (let alone why it exists in the first place)? To understand the success of the product, one must understand how implicit benefits are just as important as explicit benefits.

As for costs, the price that you pay for Biore Strips pretty much captures all of the relevant costs. But what about the benefits? Clean nose skin is certainly the primary explicit benefit, but this is still a very limited benefit since the product cannot be used anywhere else on the face. If you think about it, a clean nose on a dirty face is not all that great.

Arguably, a good loofa sponge or face scrubber might be more effective, but neither has the unique benefit of the Biore strip. The real benefit of the strip is an implicit benefit that is deeply rooted in human nature. What do you do when you take the strip off? (Those who have used the product know; those who haven’t used it will have to figure it out or guess). Answer: You look at it. There is

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something quite appealing to seeing what just came out of those dirty pores. In fact, if your friends are around, what will you do? That is right, you will show them – this is too good not to be shared. This is an implicit, subjective benefit that is at the heart of the company’s business model (I assure you, there is someone at Biore right now who is working on how to promote “strip-viewing parties” or some such devises).

Now that we have taken care of hygiene, let’s consider a case where a failure to distinguish relevant from irrelevant costs led to some unwarranted criticism. Application: Did NASA really deserve another one of “Those” Awards? The Hubble Telescope was launched into orbit in 1990. Unfortunately, just after the launch, scientists discovered that the Hubble Telescope had a problem. There had been a mistake in grinding the telescope’s mirror that left the telescope unable to focus correctly. In essence, the telescope was nearsighted. Now a nearsighted telescope is truly a sad thing to behold and scientists devised a correction for the error (sort of like fitting it with corrective glasses). However, the fix had to be made in space and the scientists turned to NASA (the National Atmospheric and Space Administration) to use the space shuttle for a mission to fix the Hubble Telescope. NASA agreed to charge the Hubble Project $378 million for the use of the space shuttle to fix the telescope. The Hubble Project agreed to the price and, in 1993, the mission was undertaken and the telescope fixed. This might have been the happy ending to the story of the little telescope that needed glasses were it not for critics who quickly complained that NASA had grossly wasted taxpayer money on the Hubble launch. The critics wanted to know: Where were the Golden Fleece Awards when you needed them most? Golden Fleece Awards had been awarded by Sen. William Proxmire (D-Wis) from 1975 through 1988. Sen. Proxmire had gained a reputation as a crusader against waste in government and had hit upon the award as a clever gimmick to shame wasteful government agencies; he awarded Golden Fleece Awards to government agencies with the most egregious waste. He got the idea from Laugh In, a 1960s television show that awarded Flying Fickle Finger of Fate Awards to people or organizations that screwed up. Some of Proxmire’s more memorable Golden Fleece Awards went to:

• the National Science Foundation for spending $84,000 on a study of why people fall in love

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• the Justice Department for conducting a study on why prisoners wanted to get out of jail

• the National Institute of Mental Health for funding a study of a Peruvian

brothel. (The project reportedly paid for numerous trips to brothels to gather data.)

• the Federal Aviation Agency (FAA) for funding a studying of the

physical measurements of 432 airline stewardesses, with special attention paid to the “length of the buttocks”

• NASA in 1978 for funding the Search for Extra-Terrestrial Intelligence

Project (SETI Project) to look for intelligent life in other worlds. Sen. Proxmire followed up the award with efforts to kill funding for SETI in 1981, but his efforts failed.

While many award recipients certainly deserved the ridicule, Sen. Proxmire was sometimes accused of lambasting projects that had led to important findings or breakthroughs. The Senator did in fact later apologize for a few of the awards, including the award that he had given to NASA for its SETI Project. But in most cases, a Golden Fleece Award stuck and the award was credited with killing some of the worst pork barrel projects. When Sen. Proxmire left the Senate in 1989, the awards stopped. But NASA’s critics demanded that the awards be revived with NASA as its first new recipient. The critics argued that NASA had only charged $378 million for the use of the space shuttle, a figure that was a mere fraction of the cost of the launch. The critics pointed out that the Space Shuttle Program at NASA had an annual budget of $4.6 billion and was averaging four launches per year. Simple division put the average cost of a space shuttle launch at $1.15 billion. What kind of fools at NASA charged $378 million for a space shuttle launch that cost $1.15 billion? NASA responded by pointing out that while its budget was $4.6 billion per year, $4 billion of this was for fixed costs. If a shuttle mission was not undertaken, NASA could avoid $44 million in launch and mission costs. Based on this information, there are number of interesting questions in this case:

1. Was the $1.15 billion the relevant accounting cost per flight? 2. Was the $1.15 billion the relevant economic cost per flight? 3. What was the incremental economic profit or loss to NASA of the

Hubble launch?

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4. Were the critics correct in calling for a Golden Fleece Award for NASA? Why or why not?

5. When would the $4.6 billion annual Space Shuttle budget be a

relevant economic cost? 6. Suppose that a space shuttle launch had already been scheduled

and was going to take place regardless of whether the Hubble “fix” was aboard. What would be the relevant shuttle cost in the decision to accept (and price) the Hubble launch?

7. Suppose the scenario in # 6 above applies except that undertaking

the Hubble project on this flight would require not undertaking another science project that NASA was charging $35 million for? What would the relevant economic costs be of undertaking the Hubble project on this launch?

8. Note that the critics never raised the issue as to whether the

Hubble project might have been willing (or forced) to pay more than $378 million because NASA was the only space launch available (that is, there was no other game in town). Might this have been a relevant opportunity cost and a legitimate criticism?

Application: Why do Airlines Discount Tickets? Airlines have substantial costs. Their planes are expensive, they are expensive to maintain, their business operations require a large skilled workforce, and the airlines consume enormous quantities of fuel. When a scheduled airline (that is, an airline that has a scheduled flight, as opposed to a charter operation) has unsold seats, it will often discount tickets in order to fill these empty seats. The discounts are often substantial; discounted tickets often sell for a small fraction of the full-fare ticket price. Why do the airlines offer such huge discounts when they have such large costs to contend with? We will use the concepts of relevant costs and incremental costs to explain the airlines’ discounting policies. First, if we were talking about accounting for airline operations (that is, doing the books) all of the costs described above would be relevant. They are relevant accounting costs because they are all legitimate costs that must be accounted for. However, this is not the case when we are talking about the airlines’ decision to offer steep discounts. For this question, most airline costs are irrelevant because they are sunken costs. From a decision-making perspective, sunken costs are usually irrelevant.

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For example, while an airline flight will consume a lot of fuel and incur a rather hefty fuel bill, the only relevant part of this cost to the discounting issue is the incremental fuel cost. The incremental fuel cost is the extra fuel needed to carry an additional passenger in that empty seat. How much do you think that is? You are correct - it is next to nothing. In other words, the accounting fuel costs are very high, but the relevant incremental costs are very low. What about the flight crew costs? The airlines have to pay for a pilot and a co-pilot (and perhaps a third navigator on some flights). This is a substantial labor cost. However, while it is relevant to accounting, it is completely irrelevant to the discounting decision because the crew is going (and going to be paid) regardless of whether there is a passenger sitting in a seat. Cabin personnel costs (that is flight attendants, etc.) are similar. Most flight attendant costs are sunken and therefore irrelevant (the flight attendants are going anyway, regardless of the number of passengers). The only relevant incremental flight attendant costs would be the costs associated with bringing another flight attendant in to handle a very booked flight (in other words, if the discounting is very successful in filling the plane). What about relevant food costs? The additional cost of an in-flight meal and beverage would be a relevant incremental cost. How much is that? If you have eaten airplane food, you know it isn’t much. (On Southwest Airlines, incremental food costs are a soft drink and a bag of peanuts – two bags if you are lucky.) And what about landing fees? Most landing fees are based on the type of plane. In this case, there are no relevant incremental landing fees. If landing fees are based on passenger count, then the incremental landing fee cost is the extra fees due because the seat is occupied. The same analysis applies to the other costs associated with discounting tickets: incremental risk costs, incremental baggage handling costs, incremental overhead and administration costs, etc. are all ridiculously small. Is it any wonder that airlines can offer such step discounts when the relevant costs are so low? Of course not. About fifteen years ago, I had a student in this class who worked for American Airlines. At the time, the CEO of American Airlines had announced that American was going to stop the practice of discounting. I offered that it was not going to happen because the benefit/cost scenario overwhelmingly favored discounting; she insisted that the company was serious about ending the practice. After great fanfare, American’s no-discounting policy was quietly abandoned. This description of the relevant costs of ticket discounting is incomplete. In fact, we have not brought up the only significant cost of discounting – lost full-fare ticket sales. This is an opportunity cost that is measured by the lost revenue that occurs when a customer who would have otherwise paid full-fare manages to purchase a discounted ticket instead.

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Airlines recognize that this is virtually the only significant cost of discounting and they take extra precautions to minimize this cost. We will look at what the airlines do to minimize this cost later when we look at price discrimination in the airline industry. An Example of Relevant Costs: Acquisition Costs

What does it cost you to acquire a commodity, a product, or an asset? In accounting, the cost of acquiring an item would be the purchase price. While one can bring in additional dimensions to this accounting question (e.g., buying in installments, multi-period analysis, financing, etc.) the basic proposition holds - the cost of acquiring something is measured by the price that is paid for it.

For accounting purposes, this is the correct relevant cost. However, economics is more concerned with decision making than with accounting and uses the concept of actual lost opportunity for a different take on acquisition cost. The relevant economic cost of acquiring is limited to the actual lost opportunity arising from the decision to purchase. For this purpose, the price paid is simply not a good measure of lost opportunity.

Instead, economists offer the following as a better measure of the relevant economic costs of acquiring a product or asset:

Acquisition cost = Purchase price - Immediate resale value

The rationale here is that the decision to buy only commits the buyer to

that part of an expenditure that is irrevocably lost. We will define “irrevocably lost” as that part of the expended funds that cannot be immediately recovered by resale. In the extreme, if you could immediately resell at full-price (or return for a full refund), there would be zero acquisition cost. At the other extreme, the purchase price of the product would be the acquisition cost only if there was no opportunity of re-selling (or returning for refund).

Again, this is not an accounting-versus-economics issue; it is a matter of choosing the relevant cost. In accounting, purchase price is relevant; in economics, the acquisition cost formula above is relevant.

The economic concept of acquisition cost is often encountered in the real world. For example, suppose that you buy a new car and drive it off the showroom floor. What is the acquisition cost? Any car that leaves the showroom immediately becomes a used car and will have lost value. In economics, this loss in value is the relevant acquisition cost.

This distinction has also served as the basis for advertising strategies. Car makers such as Mercedes Benz and BMW have, over the years, tried to use this distinction to make the case that while their cars have high prices, they have

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lower acquisition costs. These firms have had advertising campaigns that point out that their cars retain their value very well, thus reducing their acquisition costs.

If you shop at stores with liberal return policies, you are probably already aware of the point that economists are trying to make here. Exchange and refund policies certainly impact acquisition costs, but customers need to pay particular attention to how a refund or return or buy-back guarantee is worded. For example, a number of years ago, the Avis Car Rental Company was selling its surplus car rentals as used cars with a full-price buy back guarantee. A buyer could buy an Avis car and then return it within three days for a full-price buy back. However, note that a guaranteed full-price buy-back is very different from a full-refund return. With a refund, sales tax is returned to the buyer. However, a buy-back constitutes a separate transaction in which the purchase price is returned, but the sales taxes paid are not refunded.

Avis chose to do a buy-back rather than a refund. Why? The answer is: making the guarantee a buy-back rather than a refund significantly raised the acquisition cost and reduced the number of returns. Avis could advertise a money-back guarantee while simultaneously minimizing the number of customers who might actually return their vehicles. Of course, this strategy was clearly predicated on the assumption that buyers would not understand the distinction up front. The economic definition of acquisition costs can also be used to explain how goods with identical prices can have very different acquisition costs. For example, products that are special ordered are likely to have higher acquisition costs compared to in-stock products with the same price. The difference stems from the likely re-sale scenario. Estimating an immediate re-sale value for special order products requires that you consider the likelihood of connecting with two very different types of buyers: a) connecting with a buyer who, like you, is interested in the special features, or b) connecting with one of the more numerous buyers that is more interested in the non-customized product. Since you are anticipating the future, your determination is both subjective and risky. In this case, the acquisition cost of a special-order product would be: Acquisition cost Spec = Purchase price - [(Pgen buyer ) (general re-sale value)

+ (Pspecial buyer ) (special buyer re-sale value)]

In the formula above, “P” represents the probability of connecting with each type of buyer (i.e., a special buyer or a general buyer).

As an example, consider the acquisition cost of ordering a black wedding dress. We won’t ask why you want one - our task is to only note the difference in acquisition costs. First, let’s agree that you are not going to be able to return this dress to a traditional bridal store. (It might be a different story if you bought it at

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Goths-R-Us Bridal Boutique, but let’s not go there.) To estimate the immediate re-sale value, you would need to determine the different types of buyers who might be interested in buying a black wedding dress. In addition, you would need to estimate prices that each group might be willing to pay as well as the probability of finding different types of buyers.

I can think of three types of buyers: a) people who want a black wedding dress; b) people who would not be caught dead in a black wedding dress, and; c) people who might buy the dress to go to a funeral.

The first group would probably be very excited about the dress and would be willing to pay quite a bit for it. However, I suspect that the probability of finding such a person is very low. The second group is very numerous and the probability of finding one of these buyers is very high, however, they will probably pay next to nothing for it. As for the third group, I suspect that they are not very numerous and that they would not pay very much for the dress. (Funerals are not really fashion events and a black wedding dress might be over-dressing.)

I do not have actual probabilities or re-sale values, but I would confidently estimate that the combined resale value would be quite low and the acquisition cost correspondingly high. An Application of Acquisition Cost: Capital Specificity and Barriers to Entry Barriers to entry are factors that shield the firm from new firms entering industry and taking business from them. You have probably encountered this term before and you will certainly see it featured in subsequent discussions. For example, in Chapter 8, we will highlight the role of barriers to entry in our discussion of market structures. In Chapter 9, we will devote a full chapter to describing common sources of barriers to entry. For now, let’s link the concept of acquisition cost to a common barrier to entry – large capital costs that must be incurred by firms seeking to enter an industry. There is no such thing as costless entry into a new industry, so the concept of large or heavy capital costs as a barrier to entry is obviously a matter of degree.

It is also easy to see that the mere size of the capital requirement (i.e., a large dollar cost) may be sufficient to deter newcomers. However, the mere size of the capital requirement may not be as significant as the capital specificity of the investment. The concept of acquisition costs can illustrate this important distinction. Capital specificity refers to the easy with which capital assets can be used for alternative purposes. When other uses are limited, we refer to these assets as being specific assets. When alternative uses are readily available, we refer to

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these assets as non-specific assets. Obviously, asset specificity runs the full spectrum from highly specific assets to completely general or non-specific. Why would assets be specific? We can identify the following factors affecting the degree to which assets might be specific to a particular deployment:

• Assets may be task specific – Specialized equipment is often more productive than general-purpose equipment because it is specifically tailored or calibrated for a narrow task, However, this specialization often reduces its productivity when employed for purposes for which it was not specifically designed.

• Assets may be dedicated – Facilities may be created to serve a specific

use or a specific customer in an area where there are no other customers or activities. This might be viewed as an especially extreme version of task specificity.

• Assets may be location specific – A facility built to serve a specific site

might dramatically reduce transportation costs, particularly if the site is not adequately served by general transportation networks. However, this scenario means that the relatively remote location of the facility diminishes its use for other activities that are not close by.

• Assets may be worker specific – We usually think of machinery when we

consider assets and capital, but the term human capital should be a reminder that workers and worker skills can be viewed assets as well. When worker skills are specific to a particular task or location, the firm’s commitment to employing those workers tends to create asset specificity. The more unique and specialized the worker skills, the greater the specificity is likely to be.

Specific versus non-specific assets can be illustrated with an example: Suppose you needed to purchase a fleet of delivery trucks in order to enter an industry. The trucks were more or less standard delivery trucks suitable to most delivery purposes. We would refer to these trucks as limited-specificity capital. That being the case, you would expect to pay less for general purpose trucks than for specialty trucks. Equally important, should things go wrong and the venture fail, your resale prices on non-specialized trucks would likely be much higher than for specialized trucks. In fact, if we leave trucks aside and go to very specialized capital equipment specifically created for the task at hand, the resale price may be little more than the scrape price.

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To illustrate how this affects the size of the capital requirement and therefore the size of the barrier to entry, consider the following extreme example: Suppose one industry requires a capital commitment of $5 million while a second industry requires a capital commitment of only $3 million. It looks like the first industry might have the higher barriers to entry because the capital requirement to enter is 67% higher. However, the relevant cost ought t be the acquisition cost rather that prices of the capital because acquisition costs are better measures of what the new entrants actually are risking in their attempt to enter. Suppose the first industry with the $5 million capital costs entails investments that are very non-specific. Suppose that immediate re-sale could recover 80% of the initial cost. This means that entrants into the first entry would be committing to a potential loss of $1 million (i.e., $5 million - $4 million).

Suppose the second industry with the $3 million capital requirement must be spent on highly specific investments. In this case, resale is restricted and the firm can only expect to recover 30% of its initial investment on resale. In this case, the firms acquisition cost will be $2.1 million (i.e., $3 million - $900,000).

While capital requirements for an entering firm are much lower in the second industry, highly-specific capital actually creates a much higher acquisition costs and therefore a greater barrier to entry. Indeed, capital specificity is quite often more important than the size of the capital requirement in creating a barrier to entry. Application: Business Models and Relevant Benefits - Broadcast TV versus HBO In decision making, relevant costs and benefits are confined to actual costs and benefits that accrue as the result of a decision. Business organization and institutions often determine these relevant costs and benefits. For example, consider how the costs and benefits that accrue to HBO differ from those that accrue to broadcast television broadcasters. HBO provides television content to cable and satellite TV providers. Its business model is very different from traditional television broadcasters and production companies. Most broadcast television networks and stations make money by selling advertisement. Content providers create shows that these television stations buy. They are looking for shows that deliver viewers because the price of advertising on television depends on the number of people watching the show (and therefore the commercials). This is why advertising on the Super Bowl is so expensive. This is an over-simplified description of the broadcast television business model, but it will do. The point is to note what the relevant benefits are, and how these benefits impact content. The broadcast TV model wants viewers who can be sold to advertisers. Suppose that television tastes were normally distributed (i.e., the tastes of viewers can be represented by the bell curve). What part of the

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bell curve would TV content providers aim for? Of course, they aim for the middle where the bulk of the viewers are. Do you think they would have an interest in a show that might be very different and innovative and appealing to the fringes? The answer is ‘no’ because the numbers are not on the fringes. As a consequence, broadcast TV content tends to gravitate to the bland middle – the shows all seem pretty similar. HBO makes money when cable and satellite providers carry HBO programming. Cable and satellite providers will subscribe to HBO if HBO brings them cable and satellite TV subscribers. Note that HBO is not looking for a large viewing audience as much as it is looking for people who want to subscribe to HBO (via a cable or satellite subscription). For simplicity, we are ignoring the possibility that the cable station might sell advertisement around HBO content. Again, this is an oversimplified description of the HBO model, but it is sufficient to make the connection between content and programming. Rather than shoot for a larger viewing audience for a show, HBO wants to appeal to the largest group of potential subscribers. The best way to appeal to a potential subscriber is to offer something on HBO that they will not find elsewhere. This has lead HBO to seek out different types of programming to appeal to a broad spectrum of tastes. The key point here is that they do not have to appeal to viewers on a per show basis, but rather on a combined programming basis. Not everyone likes the Sopranos or Six Feet Under or boxing matches. But HBO does not have to get everyone to like all of its shows; it just has to get you passionately involved in any one of them to make you a subscriber. As a consequence, HBO programming has been bold, innovative, and deliberately diverse. This has been reflected in Emmy Awards. HBO and similar providers have routinely won more awards for their shows than their broadcast television counterparts. The difference is not a matter of talent as much as it is a matter of different relevant benefits in different business models. Application: The Costs and Benefits of DeBeers’ Unique Diamond Distribution

The DeBeers Group started out as a South African diamond mining firm that until recently had a near-monopoly on the gem-quality diamond market. It attained its monopoly by controlling access to South African diamond mines, long one of the few places in the world where gem-quality diamonds could be economically recovered. For decades, DeBeers was also able to come to terms with its primary competitor, the Soviet Union. It seems that monopolists and Bolsheviks need not be such strange bedfellows. But DeBeers’ monopoly is not the topic here; its very unique (and strange) distribution practices are. DeBeers currently produces about 40 percent of the world’s raw diamonds and is responsible for marketing another 30 percent. With

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its marketing of almost three-quarters of the world’s raw diamonds, it is not a monopoly, but certainly the major player in the market. The Diamond Trading Company of London (usually referred to simply as DTC) is the unit of DeBeers that handles the wholesaling of raw diamonds to diamond cutters and jewelers. DTC schedules a “sight” for buyers every five weeks. At a sight, a very select group of sightholders – about 100 diamond wholesalers – go to DTC to purchase raw diamonds. The sightholders had previously submitted their specifications – weight, shape, and color – for diamonds that they want to purchase from DTC. In turn, DTC has selected the stones to fill the sightholder orders, boxed the stones, set a price for the lot, and then stored them until the sight.

At the sight, the sightholders pay for the box of diamonds in advance, sight-unseen. There is no bargaining or haggling and the stones are not individually returnable; the sightholder can only refuse the box, but cannot refuse individual stones. If a sightholder refuses a box, the buyer will be refunded the purchase price, but will not be invited to future sights and will no longer be a sightholder.

This is a rather strange arrangement and one that most people do not expect to encounter in such a prestigious market. It also seems to work well. The primary criterion for saying that the arrangement works well is its longevity. The practice persists; but why?

Some might simply conclude that DeBeers uses its monopoly power to force sightholders to pay in advance on a take-it-or-leave-it basis. However, while market power might play a part, it is probably a small part. Understanding this practice requires an understanding of its costs and benefits.

See if you can explain why the sight practice persists by addressing the following questions:

1. What is the advantage to DeBeers of using this arrangement to

distribute diamonds? 2. What is the cost to a sightholder of refusing a DTC box? 3. What is the benefit to sightholders of having DTC select the

diamonds that meet the sightholders specifications? 4. What are the costs to sightholders of having DTC select the

diamonds that meet the sightholders specifications? 5. By all accounts, DTC has an excellent track record of matching

diamonds to sightholder specifications. How does this impact the benefit/cost trade-off of this arrangement for sightholders? If DTC

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was less proficient at matching specifications to stones, how would this impact the persistence of the sight system?