Chapter 7 Firm Organization and Market Structure

Transcription

1 Chapter 7 Firm Organization and Market Structure SOLUTIONS TO END-OF-CHAPTER QUESTIONS OWNERSHIP AND GOVERNANCE OF FIRMS 1.1 The private sector has three main types of organizations: the sole proprietorship, the partnership, and the corporation (which is owned by shareholders). The private sector is sometimes referred to as the for-profit sector. The nonprofit sector consists of organizations that are neither government-owned nor intended to earn a profit but typically pursue social or public interest objectives. 1.2 A publicly traded corporation is a corporation with shares that can be readily bought and sold by the general public. The shares of most publicly traded corporations trade on major organized stock exchanges, such as the New York Stock Exchange (NYSE). In making the transition from privately held to publicly traded status, a closely held firm will make an initial public offering (IPO) of its shares on an organized stock exchange. The IPO is a way to raise money for the firm. The ability to raise money by issuing stock is one major advantage of going public. In addition, the owners of a corporation are not personally liable for the firm s debts; they have limited liability. However, a major disadvantage from the point of view of the original owners is that ownership of the firm becomes broadly distributed, possibly causing the original owners to lose control of the firm. 1.3 Traditionally, the owners of sole proprietorships and partnerships were fully liable, individually and collectively, for any debts of the firm. In contrast, the owners of a corporation are not personally liable for the firm s debts; they have limited liability: The personal assets of the corporate owners cannot be taken to pay a corporation s debts even if it goes into bankruptcy. 1.4 Yes, today only 5% of firms are owned by the government in China. However, it should be noted that this relatively small number of state-owned firms still controls 40% of assets, so the small number of firms still under state control does not tell the whole story. 163

2 164 Perloff/Brander, Managerial Economics and Strategy, Second Edition PROFIT MAXIMIZATION 2.1 Joshua is correct. A firm s marginal costs are always avoidable: The firm only pays the variable costs such as marginal costs if it operates. In contrast, the firm s short-run fixed cost is usually unavoidable: the firm incurs the fixed cost whether or not it shuts down. Therefore, the firm should ignore the plant s fixed cost. Instead, it should move production to the plant to avoid paying the higher marginal cost at the other plants. 2.2 A firm sets its output where its marginal profit is zero: Marginal profit() = MR() MC() = 0, where MR is marginal revenue and MC is marginal cost. Marginal revenue is Marginal cost is MC = 10. MR = Therefore, the firm maximizes profit by producing MR() MC() = 0 MR() = MC() = = 6 = 15 units. Profit euals revenue, R(), minus the cost of production, C(): Profit = R() C() Profit = 100(15) 3(15) (15) Profit = $1, Economic profit is business profits (revenue minus explicit costs) minus the excess profits that could be realized from alternative uses of the company s resources (implicit cost). Even if a company is making a negative economic profit, it may continue to produce as long as it is making positive business profits. However, it should move to the alternative use, which will mean making a positive economic profit and more business profit. 2.4 Only $200 of the fixed cost is sunk. The firm should shut down if its revenue is less than the avoidable cost. Avoidable cost in this case is $1,100, and revenue is $1,000. As revenue is less than the avoidable cost, the firm should shut down. Shutdown rule 1: The firm shuts down only if it can reduce its loss by doing so.

3 Solutions Manual Chapter 7/Firm Organization and Market Structure A firm sets its output where its marginal profit is zero. With a 25 percent tax on revenue, this is where Marginal profit() = (1 0.25)MR() MC() = 0, where MR is marginal revenue and MC is marginal cost. 2.6 Unfortunately, owners and managers have conflicting objectives in some firms. A manager is especially likely to pursue an objective other than profit if the manager s compensation system rewards the manager for something other than maximizing profit. For example, if the manager can allocate reported costs to a future year, then the manager can increase reported profit this year. If shareholders care only about the value of the company in the present period, then acsoi is not an appropriate measure because marketing and acuisition expenses are marginal costs and affect profits in the current period. 2.7 The investment will increase the present value of the company if the present value of the revenue it generates is greater than its cost. The cost of the investment is the opportunity cost of $800,000. That is, the firm could invest $800,000 at an interest rate of r% and receive interest of r% multiplied by $800,000 per period. This will be less than the revenue generated by the investment if OWNERS VERSUS MANAGERS OBJECTIVES 50,000 (r%)800,000 r 6.25%. 3.1 At every possible uantity of output, Anne s earnings are eual to half the firm s profits minus $50,000. That is, Anne s earnings curve is eual to half the firm s profit curve shifted down by $50,000. As a result, the firm s profits and Anne s earnings are maximized at the same level of output. Because she has no incentive to behave differently (e.g., to produce a level of output that does not maximize profits), Anne will act in a manner that maximizes the store s total profit. 3.2 Revenue is maximized where marginal revenue euals zero. Maximizing ar() implies the same level of output,, as maximizing R() because which euals zero where euals zero: d( ar( )) dr( ) MR a d d, dr( ) MR d

4 166 Perloff/Brander, Managerial Economics and Strategy, Second Edition dr() a 0 d dr() 0. d The manager will only maximize profit if he receives a share (a) of profit because maximizing results in him setting output such that A[R() C()] a[mr() MC()] = 0 MR() MC() = 0, which is the same output level as that which maximizes profit for the firm, but if he receives only a share of revenue (and does not bear any costs), then he sets output such that amr() = 0 MR() = 0, which is occurs at a different (higher) level of output. 3.3 A firm s profit is maximized where its marginal profit is zero: Marginal profit() = MR() MC() = 0. This occurs at the output level corresponding to the top of the profit curve (point a). Revenue is maximized where marginal revenue euals zero: MR = 0. This occurs at the top of the revenue curve (point b). Labor is maximized when revenue euals zero (point c). Thus, Firm 3 produces the most, then Firm 2, and Firm 1 the least.

5 Solutions Manual Chapter 7/Firm Organization and Market Structure For Firm 1, profit is maximized where marginal profit is zero: Marginal profit() = MR() MC() = = = 4 = 20 units. The manager of Firm 2 will maximize revenue. Revenue is maximized where marginal revenue euals zero: MR = = = 4 = 25 units. Labor is maximized when revenue euals zero (point c). Thus, Firm 3 will produce such that = 0 (100 2) = = = 2 = 50 units.

6 168 Perloff/Brander, Managerial Economics and Strategy, Second Edition 3.5 Assume Michael, with the bonus, can receive a maximum salary of X if he receives no compensation in the form of peruisites. Michael receives at least a salary of M. The maximum amount of peruisites Michael can receive is B. Thus, the point (M, B) is on his budget constraint. Thereafter, he can trade peruisites for salary bonus, up to the point where peruisites eual 0 and his salary plus bonuses euals X. The point (X, 0) is also on his budget constraint. 3.6 No, not at all. Support of the Ronald McDonald House, in addition to providing many benefits to the families that use the facility, also serves to show community involvement on the part of McDonald s. If customers (and potential customers) value this involvement, then it will help increase visits and sales to McDonald s restaurants and thereby increase firm profit. 3.7 If a firm s owner s and manager s objectives conflict, the owner may try to monitor or control the manager s behavior. However, the cost of monitoring the manager s effort is sometimes prohibitively high. Usually the owner does not want to have to shadow the manager all day to ensure that the manager is working hard. To minimize these agency costs, most corporations include on their boards outside directors, who are not the firm s managers, to improve corporate governance. For example, outside directors might help determine the salaries of senior executives.

7 Solutions Manual Chapter 7/Firm Organization and Market Structure Many corporate managers, in the face of a hostile takeover, will construct a takeover defense. Common defenses include a shareholder rights plan, which is better known as a poison pill. A poison pill is a provision that a corporate board adds to its bylaws or charter that makes the firm a less attractive takeover target. That is, poison pills are designed to combat hostile takeovers with pyrrhic activity, where the firm damages itself and stockholders, to make it a less attractive takeover target. For example, in the face of a hostile takeover, Yahoo s management created a huge incentive for a massive employee walkout in the aftermath of a change in control by providing generous termination benefits. 3.9 Managers can be disciplined through the market for corporate control, where outside investors use the stock market, buying enough shares to take over control of an underperforming publicly traded firm. A profit opportunity exists to seize control of a company where the current managers are doing a poor job, undertaking unprofitable projects, and spending money on their own comfort and compensation, with little profit going to the shareholders in the form of dividends or capital gains. If the acuiring firm can convince enough shareholders that profit will rise after a takeover, the shareholders can vote out the existing board and management and vote in the one the acuiring firm recommends For the poison pill to make firm T unattractive, it must make firm T s value to firm A negative (or eual to zero). Thus, the poison pill must reduce the value of firm T by at least $100 million. Absent the poison pill, the value of firm T is $20 million more if taken over by firm A (from a value of $100 million if taken over minus a value of $80 million if not taken over). Thus, the cost of the poison pill to shareholders of firm A and firm T is $20 million. THE MAKE OR BUY DECISION 4.1 The present value (PV) to Campbell s from acuiring Bolthouse Farms is the $75 million annual value of the produce plus the $10 million annual savings in searching and negotiating costs received indefinitely minus one-time current-period costs of $1.55 billion for the acuisition and $50 million in transaction costs: PV = , PV = $100.

8 170 Perloff/Brander, Managerial Economics and Strategy, Second Edition 4.2 For vertical integration to be profitable, the resulting average cost of uilts must be less than $100, which is the cost (on average) of purchasing uilts from the producer. The average cost (AC) of producing uilts if vertically integrated is AC = C AC = 10, AC = 10, This is less than $100 when 100 > 50 > 10,000 10, > 10,000 > 200 uilts A firm that participates in more than one successive stage of the production or distribution of goods or services is vertically integrated. The alternative to a firm producing an input or activity itself is to buy it. Probably the most important reason to integrate is to reduce transaction costs. Firms may also vertically integrate to avoid government price controls, taxes, and regulations. Thus, if the government begins taxing ink, then the ballpoint pen company will be more likely to integrate vertically to avoid paying taxes on ink. This will decrease its cost of production. 4.4 No, the primary advantage to Zara is the ability to move uickly to catch rising fashion trends. Work clothes and uniforms are not nearly as affected by the whims of the fashion police and, therefore, the firms that produce them would not realize the same competitive advantage from vertical integration. 4.5 Adam Smith, writing in Scotland at the time of the American Revolution, gave an example of a pin factory to illustrate how the division of labor can have important advantages in manufacturing. In particular, he showed that workers commonly engage in highly specialized activities to divide production processes into several, more efficient, small steps. However, the division of labor is limited by the extent of the market. That is, a firm can take advantage of specialization and economies of scale only if it produces a

9 Solutions Manual Chapter 7/Firm Organization and Market Structure 171 sufficiently large amount of output, which it produces only if there are enough consumers willing to buy it. When an industry is small, it does not pay for a firm to specialize. As the industry grows, firms vertically disintegrate (specialize). This has happened in the market for education over time. Teachers are becoming increasingly likely to teach only one subject to one grade to specialize as the market for education has become larger. 4.6 Firms vertically integrate for a number of reasons. First, it may help firms avoid possible government intervention (such as price controls and various kinds of taxes). It may also give them the ability to control the supply of valuable inputs. Finally, vertical integration may help the firm avoid possible opportunistic behavior on the part of upstream and downstream partners. Vertical integration, however, is not without costs most notably, the cost of controlling and directing a larger and larger organization. In the end, the firm must balance out the costs and benefits of vertical integration in order to find the right level in a particular market. MARKET STRUCTURE 5.1 A competitive market structure is one in which many firms produce identical products and firms can easily enter and exit the market. Because each firm produces a small share of the total market output and its product is identical to that of other firms, each firm is a price taker, meaning that the firm cannot raise its price above the market price. A monopoly is the only supplier of a good for which there is no close substitutes. An oligopoly is a market with only a few firms and with substantial barriers to entry. Because relatively few firms compete in such a market, each can influence the price, and hence each affects rival firms. Monopolistic competition is a market structure in which firms have market power (the ability to raise price profitably above marginal cost) but no additional firm can enter an earn positive profits. Monopolistically competitive firms sell products differentiated, often by brand. Airline manufacturing is an oligopoly because airline manufacturers are few and it has entry barriers. The market for electrical work in a small town is monopolistically competitive because electrical work may be differentiated and individual electricians have some ability to set price, particularly in a small town. The market for cable television in a city is a monopoly because there is only one cable supplier. Further, barriers to entry prevent new suppliers from competing. The market for tomatoes is perfectly competitive because the many tomato farmers are selling a homogeneous product. None of the tomato farmers has any market power, and tomato farmers may enter and exit the market easily.

10 172 Perloff/Brander, Managerial Economics and Strategy, Second Edition 5.2 It is safe to say that the growth of the Internet has substantially increased the degree of competitiveness in many markets and has made the study of perfect competition more relevant over time. The availability of product and price information has increased dramatically, and for the most part, search costs have declined. This is not to say that searches are always easy online or that no additional new costs are associated with this way of doing business (shipping, not being able to see an item in person, etc.), but the overall effect has almost certainly been to increase competition. MANAGERIAL PROBLEM 6.1 If Angelo loans to the riskier group in Year 1, then he will receive $3 million (from $30 million multiplied by 10 percent) and then be fired. If he loans to the safer group in both years, then he will receive $2 million (from $10 million multiplied by 10 percent for two years). If he loans to the safer group in Year 1 and the riskier group in Year 2, then he will receive $4 million (from $1 million from the safer group in Year 1 plus $3 million from the riskier group in Year 2). Thus, he will loan to the safer group in Year 1 and the riskier group in Year 2. In this instance, Angelo prefers to loan to the riskier group in Year 2 than to the safer group. This is because he is happy earning a larger amount in the second year because being fired thereafter imposes no penalty (since this is a two-period model). This management problem can be avoided if his compensation were based on profit over a longer period, where he had less incentive to loan to the bad risks. Evaluating a manager s performance over a longer period could lead to better management. Otherwise, managers may increase this year s profit even though doing so lowers profit in later years. Many firms pay a bonus on a positive profit but do not impose fines or penalties (negative bonuses) in bad years. In an extreme case, a manager engages in reckless behavior that increases this year s profit but bankrupts the firm next year. The manager plans to grab this year s bonus and then disappear. However, if the bonus is calculated over two years, the manager would receive no bonus in either year. A firm could achieve a similar effect by allowing for a bonus given in one year to be clawed back if the firm does badly in subseuent years. SPREADSHEET EXERCISES See the associated Excel files.