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ECONOMICS 3200M

Winter 2011

Professor LazarN205J Schulichflazar@yorku.ca416-736-5068

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ECONOMICS 3200MLecture 1

January 5, 2011

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Course Requirements

• Three tests

• February 16 @ 14:30; March 16 @ 14:30; Exam period in April

• 30%, 30%, 40%

• Format: 3 questions of 6 – short essays

• Open book: No cell phones, no wireless communication devices

• No excuses for missing first two tests

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Other Ground Rules

• No taping of lectures

• No cell phones in class, including text messaging!

• Responsible for all chapters in text except chapter 18

• Listen before you write

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Office Hours

• Wednesdays: 11:30-14:00

• N205J, Schulich

• Phone: 736-5068

• Email: flazar@yorku.ca

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Objectives

• Focus of the course: Examine real-world competitive behaviour, and highlight the theoretical limitations of traditional microeconomic theories

• Study different market structures – Consider how these structures develop and evolve over time

– Implications for competitive behaviour

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Disclosure: Personal Bias

• Theoretical underpinnings of competition policy and competition law have not yet incorporated the work of Professor Michael Porter

• Porter’s work, which builds upon that of Joseph Schumpeter emphasizes that companies strive to create a competitive advantage – Those that succeed outperform their competitors and are most likely to

dominate their markets

– The laggards eventually exit the industry

• Competition policy tends to inhibit companies from freely developing competitive advantages because the successful companies are likely to be constrained in their ability to exploit their advantages – The long-run consequences of this are much more significant than the

supposed loses in consumer welfare resulting from a reduction in the number of unsuccessful “competitors”

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Disclosure: Personal Bias

• According to Schumpeter, the competitive gales of creative destruction, the product of entrepreneurs, drive the capitalist system forward and produce the dramatic improvements in standards of living.

• If one were to compare the top 25-100 companies on the Fortune 500 list in 1970 and the list in 2009, one would find that there has been a dramatic turnover in the list – And in 35 years’ time the list will be much different yet.

– All of these changes have taken place and will take place without the intervention of competition policy

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Creative Destruction

Schumpeter on capitalism• “This process of creative destruction is the essential fact

about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in.”

• “The function of entrepreneurs is to reform or revolutionize the pattern of production by exploiting an invention or more generally an untried technological possibility for producing a new commodity or producing an old one in a new way.”

• “The essential point to grasp is that in dealing with capitalism we are dealing with an evolutionary process.”

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Top 15 Fortune 500 Companies (Sales)

20061. Exxon-Mobil2. Wal-Mart3. GM4. Chevron5. Ford6. Conoco Phillips7. GE8. IBM9. HP10. Home Depot11. Valero Energy12. McKesson13. Verizon14. Cardinal Health15. Altria Group

19701. GM2. Exxon3. Ford4. GE5. IBM6. Chrysler7. Mobil8. Texaco9. ITT Industries10. Gulf Oil11. AT&T12. US Steel13. Chevron14. LTV15. DuPont

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Top 30 Global Companies (Market Value)

20061. Exxon-Mobil2. GE3. Microsoft4. Citigroup5. AT&T6. Bank of America7. Toyota (Japan)8. Gazprom (Russia)9. Petro China (China)10. Royal Dutch Shell (Netherlands)11. HSBC (UK)12. Wal-Mart13. P&G14. BP (UK)15. China Mobile (China)

16. Johnson & Johnson17. Pfizer18. Altria Group19. ICBC (China)20. AIG21. JP Morgan Chase 22. Berkshire Hathaway23. Glaxo Smith Kline (UK)24. Cisco Systems25. Roche Holdings (Switzerland)26. Total (France)27. Chevron28. Vodafone (UK)29. Bank of China (China)30. Nestle (Switzerland)

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Largest Canadian Companies (Market Value)

2006• Royal Bank• Manulife Financial• Bank of Nova Scotia• TD Bank• EnCana• Suncor Energy• Bank of Montreal• CIBC• Husky Energy• Canadian Natural Resources• RIM• Thomson• Barrick Gold• Sun Life Financial• CNR

• Brookfield Asset Management• BCE• Rogers Communications• Alcan• Goldcorp• Talisman Energy • Petro Canada• Potash of Saskatchewan• Telus• Trans Canada• Teck Cominco• Nexen• Power Corp• Cameco• Nortel• Enbridge

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Introduction

• Decision making– Objectives – Information – Constraints– Trade-offs– Time horizons

• Scarcity• Distributional issues – equity, fairness

– Generally ignored

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Introduction

Decision making– Forward looking: Information requirements and

uncertainty– Time horizon: short run vs. long run

– Adam Smith: individuals pursuing their own self interest will collectively produce the greatest good Greed is good, Economics 101

• Importance of incentives: individuals motivated by personal well-being

• Explain increasing concern with global warming?

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Introduction

• From here to there– Defining here

– Choosing among all possible theres

– Choosing the path to get there• Options created/foregone along each path

• How long to get there along each path

– What if “there” chosen proves to be the wrong one?• How do you find out?

– Role of milestones and contingency planning

– Accountability

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Introduction

Decision making– Objectives: constrained maximization

• Maximization of what?

• Nature of constraints

– Competitors’ strategies

– Company history – core competencies, reputation, resources

– Resource constraints – short-run/long run (i.e. availability of resources, quality)

– Financial capital constraints – short-run/long run (are there capital constraints or investment opportunity constraints?)

– Laws, regulations

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Introduction

• Time horizon– Longer the time horizon – fewer constraints,

more uncertainty• Temporal interdependence among decisions made

at different points in time

• Increasing complexity

– Shorter time horizon• Tradeoffs

• Rash behavior

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Introduction

Markets and players– What is a market? – Rules and regulations: role of governments

• Ex ante vs. ex post rule making – political risk• Ability to influence rule makers

– Market boundaries: Who’s in, who’s out?• Who’s waiting to get in?• Are the boundaries shifting?

– Interaction between/among competitors; interaction between competitors and suppliers; interaction between competitors and customers; interaction between markets

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Introduction

Teams

• Creation of clubs/teams– Reinforce early success

– Limit competition among members

– Economies of scale

– Solution to imperfect information, absence of trust

– Enhance benefits for all members

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Introduction

Firms• Collection of people working as team• Existence of firms

– What does a “firm” maximize?

– Who makes the key decisions and why?• Separation of ownership and control

– How is accountability managed within the firm?

– How are they/how should they be organized?

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Introduction

• Economic paradigms:– Perfect competition – many firms, homogeneous products

– Monopoly – one firm

– Oligopoly – small numbers

– Monopolistic competition – many, heterogeneous products

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Introduction

• Theory: If, then– If perfect competition, then P=MC

– If monopoly, then, P>AC

– If no entry barriers and zero exit costs, then markets contestable and P=AC

– If economies of scale to Q0 and diseconomies of scale beyond Q0 , then AC curve is U-shaped

– If oligopoly, then ???

– If heterogenous product, then monopolistic competition

– If economic profits, then entry occurs

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Introduction

• Common shortcomings– Time: short run vs. long run

– Market/industry boundaries

– Competitive behavior – competitive strategies, competitive advantage

– First entrant

– Evolution of technology

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Introduction

• Problem: Many paths to the “if”, thus many paths for “then”

• Example: Monopoly– How was monopoly created?

• Government, natural monopoly, successful strategies, superior management, luck

– Entry barriers created as part of process?• Depends on how monopoly created

– Strategies to sustain monopoly?• Rent seeking – public vs.private sector

• Sustainability

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Introduction

• Problem: Competition

• Passive/active?

• Rivalry – “the goal of competition is to kill your competitors”– Compare to concept of competition in perfect competition model

• Michael Porter: Determinants of rivalry– Concentration and balance (Herfindahl-Hirschman index, concentration

ratios) – facilitate collusive behaviour, deter entry, dominant firm

– Threat of entry, exit barriers

– Product differentiation – brand identity, switching costs, reputation

– Informational complexity

– Intermittent overcapacity – airlines, steel

– Bargaining power of buyers

– Industry growth

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Introduction

• Michael Porter: Competitive strategy– Establish profitable and sustainable position factoring in

bargaining power of suppliers and buyers, threat of entry, threat of substitutes, intensity of rivalry

• Strategies for achieving competitive advantage– Cost leadership

– Differentiation– Niche

• Role of management and luck– Gamblers’ ruin and industry concentration

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Introduction

• Sustainability of competitive advantage– Barriers to imitation not insurmountable, thus firm

must create moving target by investing to continually improve position

– Well executed offensive strategy best defense against attack by challenger

– Role remains for defensive strategy – increase structural barriers to entry, increase probability of retaliation; retaliate when entry attempted

– Deeper pockets– Risk-taking vs. risk aversion – role of regulations, fear

of liabilities

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Introduction

• Problem: Market definition

• Identification of buyers, sellers – potential entrants, potential sources of supply

• Geographic scope

– Local, regional, national, international

– Trade barriers, information

• What constitutes a substitute product?– Cross-price elasticities – measurement, critical values

– MR>0: elastic range of demand curve, thus high degree of substitutability with products that are not included in market

– Substitutability over time – alternative energy sources

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Introduction

• Entry barriers – ease, speed of entry– Entry by outsiders (who are they?); entry by insiders– Height, perception of entry barriers –

reputation,economies of scale/scope, learning curves, access to distribution networks, switching costs, firm specific capital (patents, trade secrets, management skills, location)

– Strategic behaviour of incumbents – entry accommodation or deterrence

• Time period for defining markets – time required for adjustments in buyer/seller behaviour in response to certain size price change

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Introduction

• Problem: Information• What do buyers know about availabilities, prices, quality?

– Search costs– Uncertainties re. quality – signals by firms for quality (advertising,

warranties, investments in creating brand names)– Limited search enhances market power of each firm– Impact of Internet – search sites

• What do suppliers know about technologies (product, production), consumer tastes, price elasticity, number and location of buyers, number and competencies of rivals, cost structures of rivals, strategies of rivals– Role of B2B – impact on relative bargaining advantages

• What do potential entrants know?– Impact of Internet

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Introduction

• Are suppliers/competitors (including potential entrants) equally well-informed?– Perfect information?

– Role of Internet, B2B, B2C

– Implications for stability of entry/exit process

– Implications for innovation