UC The Advice of Increasing the Product Value Discussion

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Assigned Readings:
Chapter 8. Understanding Markets and Industry Changes.
Chapter 9. Market Structure and Long-Run Equilibrium.
Chapter 10. Strategy: The Quest to Keep Profit from Eroding.
Initial Postings: Read and reflect on the assigned readings for the week. Then post what you thought was the most important concept(s), method(s), term(s), and/or any other thing that you felt was worthy of your understanding in each assigned textbook chapter.Your initial post should be based upon the assigned reading for the week, so the textbook should be a source listed in your reference section and cited within the body of the text. Other sources are not required but feel free to use them if they aid in your discussion.
Also, provide a graduate-level response to each of the following questions:

To increase a company’s performance, a manager suggests that the company needs to increase the value of its product to customers. Describe three ways in which this advice might be incorrect (Hint: Think about what else might or might not change that affects profit.)

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CHAPTER
8
Understanding
Markets and
Industry Changes
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? A market has a product, geographic, and time dimension.
Define the market before using supply–demand analysis.
? Market demand describes buyer behavior; market supply
describes seller behavior in a competitive market.
? If price changes, quantity demanded increases or
decreases (represented by a movement along the
demand curve).
? If a factor other than price (like income) changes, we say
that demand curve increases or decreases (a shift of
demand curve).
? Supply curves describe the behavior of sellers and tell
you how much will be sold at a given price.
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2
• continued
? Market equilibrium is the price at which quantity
supplied equals quantity demanded. If price is above
the equilibrium price, there are too many sellers,
forcing price down, and vice versa.
? Prices are a primary way that market participants
communicate with one another. High prices tell
consumers to consume less, and suppliers to supply
more, and vice-versa.
? Making a market is costly, and competition between
market makers forces the bid–ask spread down to the
costs of making a market. If the costs of making a
market are large, then the equilibrium price may be
better viewed as a spread rather than a single price.
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3
Y2K and Generator Sales
? From 1990-98, sales of portable generators grew 2%
yearly.
? In 1999, public anticipation of Y2K power outages
increased demand for generators
• AMP invested to increase capacity in anticipation of this
demand growth – they vertically integrated their company
to increase capacity and reduce variable costs
• Demand grew as expected – Industry shipments increased
by 87%. Prices also increased by an average of 21%
• The following year – a bust! Demand fell, and AMP’s Y2K
strategy to increase production led it to bankruptcy in 2000.
? Lesson: AMP could have anticipated this.
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4
Which Industry or Market?
? Setting a single price for a single product of a single firm is
referred to as a “monopoly” model of pricing
? This chapter focuses on the “market” setting, showing how
prices are determined in an industry where many sellers and
many buyers come together (still a single price for a single
product)
? Caution: Do not use demand and supply analysis for an
individual firm
• Example: You would talk about changes to the “smart phone”
industry, not the “demand and supply of iPhones because there
is only one seller of iPhones
? The behavior of sellers is determined by a “supply” curve
? The behavior of buyers is determined by a “demand” curve
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5
Which Industry or Market? (cont.)
? Before you begin analyzing an industry, you must consider
what you want to learn from analysis
? Usually this yields a particular market definition
? Each market (or industry) has a time, product, and geographic
dimension
? For example: The yearly market for portable generators in the
U.S.
• Time: annual
• Product: portable generators
• Geography: US
? When analyzing a problem, or investment opportunity, first
define the time, product and geographic dimensions of the
market in question
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6
Shifts in the Demand Curve
? Movement along the demand curve, i.e. a change in
price leads to a change in the “quantity demanded”
? Shifts in demand curve can occur for multiple
reasons
• Uncontrollable factor – something that affects demand
that a company cannot control
• Income, weather, interest rates, and prices of substitute and
complementary products owned by other companies.
• Controllable factor – something that affects demand
that a company can control
• Price, advertising, warranties, product quality, distribution
speed, service quality, and prices of substitute or
complementary products also owned by the company
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7
Microsoft
In the late 1970s, Microsoft developed DOS, an operating system
to control IBM computers
? The price for DOS depended on the price and availability of computers
that could run it and the applications that ran under
it as well as the price of DOS itself
? To increase demand for DOS Microsoft:
• Licensed its operating system to other computer manufacturers so
that competition would reduce price of a crucial complement
• Developed its own versions of complimentary software
• Kept the price of DOS low, to increase share to encourage
complementary software development
? Discussion: How did Microsoft control demand using these factors?
How did competitors (Apple, for example) operate differently?
• HINT: this was Steve Jobs’s biggest mistake
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8
Demand Increase
? At a given price, more quantity demanded = shift of
the demand curve
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otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images
9
Supply Curves
? Definition: Supply curves describe the behavior of a group of
sellers and tell you how much will be sold at a given price
? Supply curves slope upward g the higher the price, the higher
the quantity supplied
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otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images
10
Market Equilibrium
? Definition: Market equilibrium is the price at which
quantity supplied equals quantity demanded
? At the equilibrium price, there is no pressure for the
price to change because the number of sellers equals
the number of buyers (quantity demanded = quantity
supplied)
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11
Market Equilibrium (cont.)
? Proposition: In a competitive equilibrium there are
no unconsummated wealth-creating transactions
RIDDLE: How many economists does it take to change a light bulb?
ANSWER: None. The market will do it.
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12
Using Supply and Demand
? Supply and demand curves can be used to describe
changes that occur at the industry level
? Here, initial equilibrium is $8. After a demand shift, the
new equilibrium is $10
Market Equilibrium Analysis
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13
Using Supply and Demand (cont.)
? Again: the mechanism driving price to the new
equilibrium is competition
? At the old price of $8, there is excess demand (9-5=4
more buyers than sellers), which puts upward pressure
on price until it settles at the new $10 equilibrium
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otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images
14
Portable Generator Market Revisited
? Return to the electric generator industry:
• 1997– Stable industry sales with intense competition
(2% avg. sales growth)
• 1997– Industry anticipates record demand will occur in 1999
• 1998 – Massive capital expenses throughout industry on
vertical integration projects
A?B demand
(anticipation) and
supply (investment)
increased
B?C price dropped
but quantity stayed
above the 1998 level
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15
Using Supply and Demand (cont.)
? Example: model the Increase in quantity of mobile
phones and the decline in the price over the past decade
? Use a graph to explain two points
• Shift of the supply curve – that’s it!
• Shows the increase in supply (Q0Q1) and the decrease in
price (P0P1)
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16
Prices Convey Information
? Prices are a primary way that market participants
communicate with one another
? Buyers signal their willingness to pay
? Sellers signal their willingness to sell with prices
? Price information especially important in financial
markets
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17
Prices Convey Information (cont.)
? Example: Gas pipeline burst between Tucson and
Phoenix
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18
Prices Convey Information (cont.)
? Tucson-Phoenix pipeline break reduced supply
to Phoenix which raised price in Phoenix.
? High prices in Phoenix conveyed information to
sellers so they diverted tanker trucks from Tucson to
Phoenix.
• There was a limit to how many tanker trucks could
fill up at the “rack” in Tuscon, so some Tuscon
tanker trucks were displaced by the tanker trucks
going to Phoenix.
? The results was a reduction of supply in Tucson,
resulting in a price increase in Tuscon.
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19
Market Making
? A “market maker” makes a market – by buying low and
selling high.
? A single (monopoly) market maker does not want to have too
much or hold too much inventory g She has to pick prices
that equalize quantity supplied and demanded.
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20
Market Makers (cont.)
? If the market maker bought and sold at the competitive price
($8), she would earn zero profit
? To earn more, she must buy low and sell high and can do that
with varying numbers of transactions
? She should either buy at $6/sell at $10, or buy at $5/sell at $11
since both earn a profit of $12
? Competition between market makers will force the bid-ask
spread down to the cost of making a market
Optimal Spread in Market Making
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21
Title?
? Video enhancement products are state-of-the-art graphics
systems that capture, analyze, enhance, and edit all major
video formats without altering underlying footage
? In 1998, this market consisted of a small number of
companies, and demand was relatively light due to the
extremely high price of the technology (prices ranged
between $45,000 and $80,000)
? In 2000, Intergraph entered the market at a price of
$25,000, attempting to quickly capture a major share of
the market. Intergraph produced a product at a
substantially lower cost than the competition
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otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images
22
Title continued?
? What happened?
• Entry caused an increase in supply and a strong downward
pressure on price (average pricing fell to around $40,000)
• A number of firms exited and prices rose back to around
$45,000
? Later, the events of 9/11/01 caused demand to spike
? What happened?
• In the short run, average prices shot up.
• Higher prices eventually attracted more entrants,
increasing supply. Pricing fell back down to an average
level of around $30,000
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23
CHAPTER
9
Relationships
Between Industries:
The Forces Moving Us Toward
Long-Run Equilibrium
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? A competitive firm can earn positive or negative
profit in the short run until entry or exit occurs. In
the long run, competitive firms are condemned to
earn only an average rate of return.
? Profit exhibits what is called mean reversion, or
“regression toward the mean.”
? If an asset is mobile, then in equilibrium the asset
will be indifferent about where it is used (i.e., it will
make the same profit no matter where it goes). This
implies that unattractive jobs will pay compensating
wage differentials, and risky investments will pay
compensating risk differentials (or a risk premium).
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2
• continued
? The difference between stock returns and bond yields
includes a compensating risk premium. When risk
premia become too small, some investors view this
as a time to get out of risky assets because the market
may be ignoring risk in pursuit of higher returns.
? Monopoly firms can earn positive profit for a longer
period of time than competitive firms, but entry and
imitation eventually erode their profit as well.
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otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images
3
Good to Great
? In 2001, Jim Collin published Good to Great, a book
detailing how 11 companies used management principals
to go from “good” to “great”
• By 2009 many of these same companies were bankrupt –
they had done amazingly well during the research period
but failed to outperform the market after the book’s
publication. Why?
? Mr. Collin’s made two fatal errors
• The “fundamental error of attribution”
• Successful firms aren’t necessarily successful because of their
observed behavior (this will be discusses in a later chapter)
• Ignoring long-run forces that erode profit
• Competition erodes above-average profit (this will be discussed in
this chapter)
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otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images
4
Competitive Firms
? Definition: A competitive firm is one that cannot affect
price.
• They produce a product or service with very close substitutes
so they have very elastic demand
• They have many rivals and no cost advantage over them
• The industry has no barriers to entry or exit
? Competitive firms,
• cannot affect price; they can choose only how much to produce
• can sell all they want at the competitive price, so the marginal
revenue of another unit is equal to the price (sometimes called
“price taking” behavior).
? For competitive firms price = marginal revenue
• so if P>MC, produce more and if PAC) leads to entry, decreasing price and profit
• Negative profit (P
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market structure

Industry Changes

LongRun Equilibrium

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