Managerial Economics and Organisational Architecture - Assignment Example

Managerial Economics and Organisational Architecture Demand and supply Price elasti generally affects demand and revenue in two different ways; it is observed that price increases may lead to lower quantities in a normal market due to the fact that demand has a negative slope. This fall in quantity demanded therefore consequently leads to lower revenue. Similarly when the demand is inelastic, meaning that it does not change significantly over time, price increases may lead to a reduction in quantities demanded. However, in the second case there will still be an increase in revenue because of the price increase. This scenario can be explained by considering a company; in conditions of inelastic demand, greater demand for the company’s output at lower prices still gets the company increased revenue because more people are buying. On the other hand, in elastic conditions, increase in prices reduces demands for goods, which outweighs increase in price thus decreasing the revenue (Beggs, 2008). The inverse elasticity rule indicates that marginal revenue is supposed to be equal to marginal cost for the company to be operating at optimum market conditions. This would imply that a company needs to adjust output so as to strike the balance whenever marginal revenue is lower than marginal cost or the other way round. In an oligopolistic market, this rule is less applicable because of other factors that affect pricing, e.g. competitive pricing by market rivals that seeks to maximize profits as well as market share. However, in monopolistic markets, the inverse elasticity rule plays a significant role because the company can segment the market and keep prices constant so as to maintain its market share; this enables it to vary output in the different segments depending on demand while maintaining profits. Profit can only be maximized through maximization of revenue and minimization of costs. Thus as has been explained above, marginal revenue must be equal to marginal cost at optimum conditions, at this level profit will also be maximized because the difference between MR and MC is zero. Thus as long as a company can set up prices to obey the inverse elasticity rule, demand will always be elastic and thus profits will be maximized. On the other hand, if the demand is inelastic profits can only be maximized through price increases, something that is not sustainable in a competitive market (Dobbs, 2000). 2. Demand Analysis Econometric analysis mainly involves statistical analysis aiming at explaining economic relationships. Econometrics applies statistical and mathematical theories in its analysis and economists mainly use it in either testing hypotheses about observations that have been made or predicting future economic trends (Brickley, Zimmerman, and Smith, 2008). Many economic models are presented both theoretically and mathematically, econometrics puts those models to test by utilizing statistical methods to manipulate past data to get answers which are then tested by comparing them to real examples. Two major forms of econometrics exist, including theoretical and applied econometrics. While the former category of econometrics aims to explain economic models using statistical theory and formulae, applied econometric actually utilizes real statistics to come up with answers. Although econometrics involves a large variety of computation methods that are commonly used to obtain estimations for different economic parameters, the most commonly applied technique is multiple regression. Researchers or companies have to go out and collect data for econometric analysis. Various methods of obtaining data for econometric analysis exist and each of them has its own merits and demerits. The first method is ‘gut feelings’ whereby a decision-maker, because of lack of proper statistical knowledge just observes market conditions and makes estimates through guesswork (Dobbs, 2000). While this can be able to provide correct results over a short period of time when the person has sufficient market experience, it is a crude method of economic estimation and can fail at any time because the decision lacks a strong statistical basis. The next method is survey or interview; here the decision-maker seeks public opinion through interviews with a sample of buyers. The results are then extrapolated to a whole population (Dobbs, 2000). The advantage of this method is that it provides accurate data from customers, the disadvantages involved include the fact that the accuracy or quality of the estimates is limited to the size of the sample. A larger sample may be more accurate but also expensive. Another disadvantage is that respondents cannot be trusted to give accurate answers or even tell the truth, customers are known to twist their answers in the hope of an outcome that favours them. 3. Pricing and Market Structure Price discrimination is perceived in various different ways, it can simply be viewed as charging customers different prices for the same product depending on their characteristics or more specifically charging prices that are different irrespective of the average cost of delivering the items to the various different customers. While the customers would like their welfare to be taken care of in pricing, probably through state intervention, companies carry out price discrimination specifically to try and maximize their profits (Begg et al., 2011). There are three main degrees of price discrimination. First degree price discrimination, also known as ‘perfect’ discrimination involve offers where the seller sets a fixed price that customers can either buy the goods at or leave them. This kind of discrimination may also include price reductions at particular times but the price remains fixed even when it is reduced. This is not quite different from providing a single price, it main issue is that it is largely non-responsive to market changes and the inflexibility limits company profits particularly when competitors’ prices are flexible to market conditions. However, this type of price discrimination also safeguards company profits in cases where certain types of products are involved. Products such as technology and machinery do dot experience significant market price fluctuations dictated by demand, thus a company that offers quality goods may utilize perfect price discrimination and still assure itself of profits in the short and long-term. Second degree discrimination involves non-linear price schedules that depend on the products being sold. For example multi-part tariffs are applied by telecom and electricity companies where there is continuous flow of the product to the customers. Here the company can be able to manipulate tariffs by differentiating the service into categories that ensure it gets profits from all tariffs. From a profit point of view this makes sense as most customers will be satisfied with one tariff or another. Another example of second degree discrimination is block tariffs. Quantity discounts are also used as part of second degree price discrimination because they make greater profit sense while keeping demand high. While customers are offered discounts for bulk purchases, this does not necessarily mean that prices are lowered, on the contrary they buy more products at the same price for small discounts and the company gets same profits (Begg et al., 2011). Block tariffs in second degree discrimination refer to the situation whereby the customers purchase allocated “blocks” of goods or services at progressively declining prices. For example the first bulk purchase will be at a higher price but the second bulk purchase comes at a lower tariff and so on. However as the unit price for each tariff reduces progressively, the size of the block increases so that customers are encouraged every time to buy more in order to enjoy the discount. In essence, giving small discounts for different ‘blocks’ of products enables the firm to maximize demand. Second degree price discrimination is most effective when a product can be well differentiated to offer a menu of two part tariffs whereby even when prices are higher on one tariff, the other one remains uniform and therefore demand is maintained. The firm also needs to be a market leader or price maker for it to be more effective. Finally, the third degree price discrimination involves a delicate balance between marginal revenue and marginal cost. This discrimination utilizes the classic laws of demand and supply, leading to the inverse elasticity rule. The discrimination makes greater profit sense because prices are fixed over various segments; therefore profits can be increased simply by transferring product output from markets with lower marginal returns to those with greater marginal returns (Begg, 2008). Two part tariffs, block tariffs, and discount quantities are essentially equivalent because they all attempt to manipulate the demand curve so as to maintain profits without having to raise prices. The first, second, and third degree tariffs help firms to increase their profits while maintaining stable prices because they enable them to present their products in various different offerings that attract customers and maintain or increase demand. These tariffs always give the customers an impression that by going for the cheaper option, they have an advantage but in reality what they pay is just the original optimum price that ensures the firm gets profit. In the case of third degree discrimination, the State may prevent firms from practicing using legislation and other forms of regulation. This kind of action can be justified by arguing that transferring units of output from market segment to another not only destabilizes particular market segments especially in sensitive industries where companies need stability to offer essential products to society. On the other hand this may also negatively harm customers who depend on essential products through causing artificial shortages in particular market segments that make it similar to hoarding. On the other hand the State would be unfair to intervene in this way because it is paramount to hindering company strategy and thus denying a company profits that are essential for giving investors their returns. This kind of interference also gives competitors with different strategies advantage in the market. 4. Oligopoly The kinked demand curve is based on the assumptions that competitors in a market are more concerned with price reductions than price increases by their fellow competitors. It is assumed that all firms try to maintain maximum profits and larger market shares, therefore competitors are unlikely to follow price increases by one of them because the action would increase demand elasticity meaning that if a firm follows suit to increase prices then its total revenue may be harmed. On the other hand the rivals in the market will definitely try to match a price reduction by a competitor because they would want to avoid loss of their market share. This would lead to greater inelasticity of demand this leading a fall in total revenue. The implication of this is that for price reductions, the demand curve is commonly steeper than for price increases (Begg et al., 2011). In oligopolistic markets, competition is normal and while it is advantageous for customers (mainly because of the greater incentive to reduce prices rather than increase them), it harms firm profits significantly. However, the extent to which a company’s profits may be harmed or may benefit depends on the choices that are made by the firm from a set of choices. This situation is explained by the game theories, these mainly present various options a company may chose from and the advantages and disadvantages of each. One such theory is the prisoner’s dilemma. In the case of price determination, this theory explains that each company has some incentive to cheat on the agreed cartel or ‘market’ price so as to gain a market advantage. The company therefore is presented with a variety of outcomes that may result from its cheating, it therefore has to choose a dominant strategy for its pricing (Brickley, Zimmerman, and Smith, 2008). When a competitor decides to cheat in the market, it should be with clear consideration of the outcome and therefore a good strategy that balances advertising wit price reduction has to be selected. The same goes to all the other competitors because demand will be affected. The most important factor about the game theory and the ensuing incentive to cheat is that the actions of one firm definitely affects the rest and may significantly affect the market characteristics. Therefore, firms revert to ‘cheap talk’, this is where they can be able to discuss and come up with non-binding agreements about pricing strategy so as to reduce cheating. However, such agreements are not binding contracts because cartels are illegal in all markets, as a result a firm is always likely to get an incentive to cheat to its own advantage even when the overall effect to the market is negative (Begg et al., 2011). References Begg, D., 2008. Economics. New York: McGraw Hill. Begg, D., Vernasca, G., Fischer, S., and Dornbusch, R., 2011. Economics, 10th ed. New York: McGraw Hill. Brickley, J., Zimmerman, J., Smith, C.W., 2008. Managerial Economics & Organizational Architecture, 5th ed. New York: McGraw Hill. Dobbs, I., 2000. Managerial Economics: Firms, Markets and Business Decisions. Oxford: Oxford University Press. Read More