managerial economics 2.pptx

1: Production Functions
A firm uses a technology or production process to
transform inputs or factors of production into
outputs.
The output can be a service, such as an automobile
tune-up by a mechanic, or a physical product, such
as a computer chip or a potato chip.

The various ways in which inputs can be
transformed into output are summarized in the
production function: the relationship between
the quantities of inputs used and the maximum
quantity of output that can be produced, given
current knowledge about technology and
organization.

 The production function for a firm that uses only labor
and capital is:
q = f(L, K)
 where q units of output (such as wrapped candy bars)
are produced using L units of labor services (such as
hours of work by assembly-line workers) and K units of
capital (such as the number of conveyor belts).

2: Short Run Production
The short run is a time frame in which the
quantity of one or more resources used in
production is fixed.
For most firms, the capital, called the firm’s
plant, is fixed in the short run.
Other resources used by the firm (such as labor,
raw materials, and energy) can be changed in the
short run.

To increase output in the short run, a firm must
increase the amount of labor employed.
Three concepts describe the relationship between
output and the quantity of labor employed:
1. Total product
2. Marginal product
3. Average product

Product Schedules
Total product is the total output produced in a given period. It
is the maximum output that a given quantity of labor can
produce
The marginal product of labor is the change in total product
that results from a one-unit increase in the quantity of labor
employed, with all other inputs remaining the same.
The average product of labor is equal to total product divided
by the quantity of labor employed.

 (a) The total product of labor curve shows how many computers,
q, can be assembled with eight fully equipped workbenches and
a varying number of workers, L, who work eight-hour days.
 (b) Where the marginal product of labor (MPL) curve is above
the average product of labor (APL) curve, the APL must rise.
Similarly, if the MPL curve is below the APL curve, the APL must
fall.
 Thus, the MPL curve intersects the APL curve at the peak of the
APL curve, point b, where the firm uses 6 workers.

The law of diminishing returns
The law of diminishing returns states that:
 If a firm keeps increasing an input, holding all other inputs
and technology constant, the corresponding increases in
output will eventually become smaller (diminish).
 Increasing marginal returns arise from increased
specialization and division of labor.
 Diminishing marginal returns arises because each
additional worker has less access to capital and less space
in which to work.

Land
Labor
Total
Product
Marginal
Product
Average
Product
2
1
8
-
-
2
2
-
-
10
2
3
-
-
12
2
4
-
24
-
2
5
90
-
-
2
6
-
-
18
2
7
-
4
-
2
8
112
-
-
2
9
-
-
12
2
10
100
-
-
2
11
-
-12
-

Land
Labor
Total Product
Marginal
Product
Average
Product
2
1
8
8
8
2
2
20
12
10
2
3
36
16
12
2
4
60
24
15
2
5
90
30
18
2
6
108
18
18
2
7
112
4
16
2
8
112
0
14
2
9
108
-4
12
2
10
100
-8
10
2
11
88
-12
8

The law of diminishing returns
 Thomas Malthus predicted that population would grow
more rapidly (a diminishing marginal product of
labor) than food production because the quantity of
land was fixed.
 Today the earth supports a population about seven
times as large as when Malthus made his predictions.
 Typical agricultural worker produces vastly more food
today than was possible when Malthus was alive.
 Green Revolution, which included development of
drought- and insect-resistant crop varieties, improved
irrigation, better use of fertilizer and pesticides, and
improved equipment.
Malthus and the Green
Revolution

3: Long Run Production
 The long run is a time frame in which the quantities of
all resources—including the plant size—can be varied.
With all factors variable, a firm can usually produce a
given level of output by using a great deal of labor and
very little capital, a great deal of capital and very little
labor, or moderate amounts of both.

Isoquant: is a curve that shows the efficient
combinations of labor and capital that can produce
the same (iso) level of output (quantity).
The Isoquant shows the smallest amounts of
inputs that will produce a given amount of output.
That is, if a firm reduced either input, it could not
produce as much output.

If the production function is q = f(L, K), then the
equation for an Isoquant where output is held
constant at q is:
An Isoquant shows the flexibility that a firm has in
producing a given level of output.

Isoquant
These isoquants show the combinations of labor and
capital that produce 14, 24, or 35 units of output, q.
Isoquants farther from the origin correspond to
higher levels of output. Points a, b, c, and d are
various combinations of labor and capital the firm
can use to produce q = 24 units of output.

Isoquant
If the firm holds capital constant at 2 and
increases labor from 1 (point e on the q = 14
Isoquant) to 3 (c), its output increases to q = 24
Isoquant.
If the firm then increases labor to 6 (f ), its output
rises to q = 35.

Properties of Isoquant
 First, the farther an Isoquant is from the origin, the greater the
level of output. That is, the more inputs a firm uses, the more
output it gets if it produces efficiently.
 Second, Isoquant do not cross. Such intersections are
inconsistent with the requirement that the firm always produces
efficiently.
 For example, if the q = 15 and q = 20 Isoquant crossed, the firm
could produce at either output level with the same combination
of labor and capital. The firm must be producing inefficiently if it
produces q = 15 when it could produce q = 20. Thus, efficiency
requires that Isoquant do not cross.

Properties of Isoquant
Third, Isoquant slope downward or is negatively
sloped. This means that the same level of production
only occurs when increasing units of input are offset
with lesser units of another input factor.
As an example, the same level of output could be
achieved by a company when capital inputs
increase, but labor inputs decrease.

4: Returns to Scale
 We now turn to the question of how much output changes
if a firm increases all its inputs proportionately. The
answer helps a firm determine its scale or size in the long
run.
 In the long run, a firm can increase its output by building
a second plant and staffing it with the same number of
workers as in the first one.

4: Returns to Scale
Whether the firm chooses to do so depends in part
on whether its output increases less than in
proportion, in proportion, or more than in
proportion to its inputs.

4: Returns to Scale
 Constant returns to scale:
If, when all inputs are increased by a certain proportion,
output increases by that same proportion, the production
function is said to exhibit constant returns to scale.
If a firm doubles its inputs—by, for example, building an
identical second plant and using the same amount of labor
and equipment as in the first plant—it doubles its output,
then it exhibits constant return to scale.

4: Returns to Scale
 Increasing returns to scale:
If output rises more than in proportion to an equal
proportional increase in all inputs, the production function
is said to exhibit increasing returns to scale.
A technology exhibits increasing returns to scale if
doubling inputs more than doubles the output.

4: Returns to Scale
 Decreasing returns to scale:
If output rises less than in proportion to an equal
proportional increase in all inputs, the production function
exhibits decreasing returns to scale.
 A technology exhibits decreasing returns to scale if doubling
inputs causes output to rise less than in proportion. (An
owner may be able to manage one plant well but may have
trouble running two plants).

The Nature of Costs
 To produce a particular amount of output, a firm incurs costs
for the required inputs such as labor, capital, energy, and
materials.
 If workers earn $20 per hour and the firm hires 100 hours of
labor per day, then the firm’s cost of labor is $20 * 100 =
$2,000 per day.
 The manager can easily calculate these explicit costs, which
are payments for inputs to its production process during a
given time period.

The Nature of Costs
 While calculating explicit costs is straightforward, some
costs are implicit in that they reflect only a foregone
opportunity rather than explicit, current expenditure.
 A fundamental principle of managerial decision making is
that managers should focus on opportunity costs.
 The opportunity cost of a resource is the value of the
best alternative use of that resource.

The Nature of Costs
 Opportunity costs represent the benefits an individual,
investor or business misses out on when choosing one
alternative over another.
Opportunity Cost = FO – CO
where: FO = Return on best foregone option
: CO = Return on chosen option
 Opportunity cost is not an accounting concept, and so does
not appear in the financial records of an entity. It is strictly a
financial analysis concept.

The Nature of Costs
 Assume the expected return on investment in the stock
market is 12 percent over the next year, and your
company expects the equipment update to generate a
10 percent return over the same period. The opportunity
cost of choosing the equipment over the stock market is
(12% - 10%), which equals two percentage points. In
other words, by investing in the business, you would
forgo the opportunity to earn a higher return.

The Nature of Costs
 Let's say you have $15,000 and your choice is to either
buy shares of Company XYZ or leave the money in a CD
(certificate of deposit) that earns only 5% per year. If the
Company XYZ stock returns 10%, you've benefited from
your decision because the alternative would have been
less profitable. However, if Company XYZ returns 2%
when you could have had 5% from the CD, then your
opportunity cost is (5% - 2% = 3%).

The Nature of Costs
 You decide to spend $80 on some great shoes and do
not pay your electric bill. The opportunity cost is having
the electricity turned off, having to pay an activation fee
and late charges. You might also have food in the fridge
that gets ruined and that would add to the total cost.
 As a consultant, you get $75 an hour. Instead of working
one night, you go to a concert that costs $25 and lasts
two hours. The opportunity cost of the concert is $150 for
two hours of work.

Short-Run Cost
To produce more output in the short run, the firm must
employ more labor, which means that it must increase its
costs.
 Three cost concepts and three types of cost curves are
 Total cost
 Marginal cost
 Average cost

Short-Run Cost
Total Cost:
A firm’s total cost (TC) is the cost of all resources used.
Total fixed cost (TFC) is the cost of the firm’s fixed
inputs. Fixed costs do not change with output.
Total variable cost (TVC) is the cost of the firm’s variable
inputs. Variable costs do change with output.
Total cost equals total fixed cost plus total variable cost.
That is:
TC = TFC + TVC

Short-Run Cost
Figure 5.1 shows a firm’s total
cost curves.
Total fixed cost is the same at
each output level.
Total variable cost increases as
output increases.
Total cost, which is the sum of
TFC and TVC also increases as
output increases.

Short-Run Cost
The AVC curve gets its shape
from the TP curve.
Notice that the TP curve
becomes steeper at low output
levels and then less steep at
high output levels.
In contrast, the TVC curve
becomes less steep at low output
levels and steeper at high output
levels.

Short-Run Cost
To see the relationship between
the TVC curve and the TP curve,
lets look again at the TP curve.
But let us add a second
x-axis to measure total variable
cost.
1 worker costs $25;
2 workers cost $50; and so on,
so the two x-axes line up.

Short-Run Cost
We can replace the quantity of
labor on the x-axis with total
variable cost.
When we do that, we must
change the name of the curve.
It is now the TVC curve.
But it is graphed with cost on
the x-axis and output on the y-
axis.

Short-Run Cost
Redraw the graph with cost
on the y-axis and output on
the x-axis, and you’ve got the
TVC curve drawn the usual
way.
Put the TFC curve back in the
figure,
and add TFC to TVC, and
you’ve got the TC curve.

Short-Run Cost
Marginal Cost:
Marginal cost (MC) is the increase in total cost that
results from a one-unit increase in total product.
 increasing marginal returns, marginal cost falls as
output increases.
 diminishing marginal returns, marginal cost rises as
output increases.

Short-Run Cost
Average Cost:
Average cost measures can be derived from each of the
total cost measures:
Average fixed cost (AFC) is total fixed cost per unit of
output.
Average variable cost (AVC) is total variable cost per unit
of output.
Average total cost (ATC) is total cost per unit of output.
ATC = AFC + AVC.

Short-Run Cost
This Figure shows the MC, AFC,
AVC, and ATC curves.
The AFC curve shows that
average fixed cost falls as output
increases.
The AVC curve is U-shaped. As
output increases, average
variable cost falls to a minimum
and then increases.

Short-Run Cost
The ATC curve is also U-shaped.
The MC curve is very special.
For outputs over which AVC is
falling, MC is below AVC.
For outputs over which AVC is
rising, MC is above AVC.
For the output at minimum AVC, MC
equals AVC.

Similarly, for the outputs over
which ATC is falling, MC is
below ATC.
For the outputs over which ATC
is rising, MC is above ATC.
For the output at minimum ATC,
MC equals ATC.
Short-Run Cost

Short-Run Cost
The AVC curve is U-shaped because:
Initially, MP exceeds AP, which brings rising AP and
falling AVC.
Eventually, MP falls below AP, which brings falling AP
and rising AVC.
The ATC curve is U-shaped for the same reasons.
In addition, ATC falls at low output levels because AFC
is falling quickly.

Short-Run Cost
Why the Average Total Cost Curve Is U-Shaped:
The ATC curve is the vertical sum of the AFC curve and the
AVC curve.
The U-shape of the ATC curve arises from the influence of two
opposing forces:
1. Spreading total fixed cost over a larger output—AFC curve
slopes downward as output increases.
2. Eventually diminishing returns—the AVC curve slopes upward
and AVC increases more quickly than AFC is decreasing.

Short-Run Cost
Cost Curves and Product Curves:
The shapes of a firm’s cost curves are determined by
the technology it uses.
We’ll look first at the link between total cost and total
product and then …
at the links between the average and marginal product
and cost curves.

Short-Run Cost
Total Product and Total
Variable Cost
This Figure shows when
output is plotted against
labor, the curve is the TP
curve.
When output is plotted
against variable cost, the
curve is the TVC curve …
but it is flipped over.

Short-Run Cost
Average and Marginal Product and Cost
The firm’s cost curves and product curves are linked:
 MC is at its minimum at the same output level at
which MP is at its maximum.
 When MP is rising, MC is falling.
 AVC is at its minimum at the same output level at
which AP is at its maximum.
 When AP is rising, AVC is falling.

Short-Run Cost
This Figure shows these
relationships.

Short-Run Cost
The optimum volume of production in the short run:
 The optimum output size is determined when the
marginal cost curve intersects the average total cost
curve at its lowest point in the short term.

Production
Fixed costs
Variable costs
1
100
20
2
100
38
3
100
51
4
100
62
5
100
75
6
100
90
7
100
110
8
100
134
9
100
163
10
100
200

Calculate the total, marginal, average fixed,
average variable, average total cost.
Then draw the curves.

Short-Run Cost
Shifts in the Cost Curves
The position of a firm’s cost curves depends on
two factors:
- Capital
-Technology
-Prices of factors of production

Short-Run Cost
Technology
Technological change influences both the product curves
and the cost curves.
An increase in productivity shifts the product curves
upward and the cost curves downward.
If a technological advance results in the firm using more
capital and less labor, fixed costs increase and variable
costs decrease.
In this case, average total cost increases at low output
levels and decreases at high output levels.

Short-Run Cost
Prices of Factors of Production
An increase in the price of a factor of production increases
costs and shifts the cost curves.
An increase in a fixed cost shifts the total cost (TC ) and
average total cost (ATC ) curves upward but does not shift
the marginal cost (MC ) curve.
An increase in a variable cost shifts the total cost (TC ),
average total cost (ATC ), and marginal cost (MC ) curves
upward.

Long‐Run Costs
 In the long run, the firm adjusts all its inputs so that its cost of
production is as low as possible. The firm can change its plant
size, design and build new machines, and otherwise adjust
inputs that were fixed in the short run.
 To produce a given quantity of output at minimum cost, our firm
uses information about its production function and the price of
labor and capital. In the long run when capital is variable, the
firm chooses how much labor and capital to use; in the short run
when capital is fixed, the firm chooses only how much labor to
use.

Long‐Run Costs
 A firm can produce a given level of output using many different
technically efficient combinations of inputs, as summarized by an
isoquant (Chapter 4).
 The Isocost Line. The cost of producing a given level of
output depends on the price of labor and capital.
 The firm hires L hours of labor services at a constant wage of w
per hour, so its labor cost is wL. The firm rents K hours of machine
services at a constant rental rate of r per hour, so its capital cost is
rK. The firm’s total cost is the sum of its labor and capital costs:
C = wL + rK.

Long‐Run Costs
 Suppose that the wage rate, w, is $10 an hour and the rental rate
of capital, r, is $20. Five of the many combinations of labor and
capital that the firm can use that cost $200 are listed in the
following table.
 These combinations of labor and capital are plotted on an isocost
line, which represents all the combinations of inputs that
have the same (iso-) total cost.
 Figure 5.3 shows three isocost lines. The $200 isocost line
represents all the combinations of labor and capital that the firm
can buy for $200, including the combinations a through e in Table
5.2.

Combining Cost and Production Information
 By combining the information about costs contained in the
isocost lines with information about efficient production
summarized by an isoquant, a firm chooses the lowest-cost way
to produce a given level of output.
 The firm minimizes its cost by using the combination of inputs
on the isoquant that is on the lowest isocost line that touches
the isoquant.
 Figure 6.4 shows the isoquant for 100 units of output and the
isocost lines for which the rental rate of a unit of capital is $8 per
hour and the wage rate is $24 per hour.

Long‐Run Costs
 Long‐run average total cost curve. In the long‐run, all
factors of production are variable, and hence, all costs
are variable. The long‐run average total cost curve
(LATC) is found by varying the amount of all factors of
production. However, because each SATC corresponds
to a different level of the fixed factors of production,
the LATC can be constructed by taking the “lower
envelope” of all the SATCs, as is illustrated in Figure .

Long‐Run Costs
 The LATC is shown to be tangent to each of five
different SATCs, labeled SATC 1 through SATC 5 .
 In general, there will be a large number of SATCs, each
of which corresponds to a different level of the fixed
factors the firm can employ in the short‐run. Because
there is such a large number of SATCs—more than just
the five illustrated in Figure —the lower envelope of all
the SATCs, which makes up the LATC, can be
approximated by a smooth, U‐shaped curve.

Long‐Run Costs
 Economies of scale:
 The U‐shape of the LATC reflects the changing costs of
production that the firm faces in the long‐run as it varies
the level of its factors of production and hence the level
of its output. At low levels of output, a firm can usually
increase its output at a rate that exceeds the rate at
which it increases its factor inputs. When this situation
occurs, the firm's average total costs are falling, and the
firm is said to be experiencing economies of scale.

Long‐Run Costs
 At higher levels of output, the firm may find that its output
increases at the same rate at which it increases its factor
inputs. In this case, the firm's average total costs remain
constant, and the firm is said to experience constant
returns to scale.

Long‐Run Costs
 At even higher output levels, the firm's output will tend to
increase at a rate that is below the rate at which it increases
its factor inputs. In this situation, average total costs are
rising, and the firm is said to experience diseconomies of
scale.
 The firm's minimum efficient scale is the level of output at
which economies of scale end and constant returns to scale
begin. The minimum efficient scale is indicated in Figure .

* ECONOMIES OF SCALE:-
 What Are Economies of Scale?
 Economies of scale are cost advantages reaped by companies
when production becomes efficient. Companies can achieve
economies of scale by increasing production and lowering costs.
This happens because costs are spread over a larger number of
goods. Costs can be both fixed and variable.
 Economies of scale are the advantages that can sometimes occur
as a result of increasing the size of a business. For example, a
business might enjoy an economy of scale concerning its bulk
purchasing. By buying a large number of products at once, it could
negotiate a lower price per unit than its competitors.

Understanding Economies of Scale
 The size of the business generally matters when it comes to
economies of scale. The larger the business, the more the cost
savings. Economies of scale can be both internal and external.
Internal economies of scale are based on management decisions,
while external ones have to do with outside factors.
 Internal functions include accounting, information technology, and
marketing, which are also considered operational efficiencies and
synergies.

 Economies of scale are an important concept for any business in
any industry and represent the cost-savings and competitive
advantages larger businesses have over smaller ones.
 Most consumers don't understand why a smaller business charges
more for a similar product sold by a larger company. That's
because the cost per unit depends on how much the company
produces. Larger companies can produce more by spreading the
cost of production over a larger amount of goods. An industry may
also be able to dictate the cost of a product if several different
companies are producing similar goods within that industry.

 There are several reasons why economies of scale give rise to
lower per-unit costs. First, specialization of labor and more
integrated technology boost production volumes. Second, lower
per-unit costs can come from bulk orders from suppliers, larger
advertising buys, or lower costs of capital. Third, spreading
internal function costs across more units produced and sold
helps to reduce costs.

Internal vs. External Economies of Scale

Internal vs. External Economies of Scale
 Internal economies of scale:
 Originate within the company, due to changes in how that
company functions or produces goods.
 External economies of scale:
 Based on factors that affect the entire industry, rather than a
single company.

Internal Economies of Scale
 Internal economies of scale happen when a company cuts costs
internally, so they're unique to that particular firm. This may be the
result of the sheer size of a company or because of decisions from
the firm's management. There are different kinds of internal
economies of scale. These include:
 Technical: large-scale machines or production processes that
increase productivity.
 Purchasing: discounts on cost due to purchasing in bulk.

 Managerial: employing specialists to oversee and improve different
parts of the production process
 Risk-Bearing: spreading risks out across multiple investors
 Financial: higher creditworthiness, which increases access to
capital and more favorable interest rates
 Marketing: more advertising power spread out across a larger
market, as well as a position in the market to negotiate
 Larger companies are often able to achieve internal economies of
scale—lowering their costs and raising their production levels—
because they can, for example, buy resources in bulk, have a
patent or special technology, or access more capital.

External Economies of Scale
 External economies of scale, on the other hand, are achieved
because of external factors, or factors that affect an entire
industry. That means no one company controls costs on its own.
These occur when there is a highly-skilled labor pool, subsidies
and/or tax reductions, and partnerships and joint ventures—
anything that can cut down on costs to many companies in a
specific industry.

Limits to Economies of Scale
 The economies of scale concept has an upper limit. A business
will find that it must incur additional fixed costs as its sales
increase beyond a certain point, due to additional complexities
inherent in operating a very large business. For example, a
business may find that additional sales require it to distribute
goods into distant regions, which increases its transport costs.
This means that the cost per unit will begin to increase after a
certain point, which is referred to as diseconomies of scale.

Why Are Economies of Scale Important?
 Economies of scale are important because they can help provide
businesses with a competitive advantage in their industry.
Companies will therefore try to realize economies of scale
wherever possible, just as investors will try to identify economies
of scale when selecting investments. One particularly famous
example of an economy of scale is known as the network effect.

What are Mergers & Acquisitions (M&A)?
 Mergers and acquisitions (M&A) refer to transactions between two
companies combining in some form. Although mergers and
acquisitions (M&A) are used interchangeably, they come with
different legal meanings. In a merger, two companies of similar size
combine to form a new single entity.
 On the other hand, an acquisition is when a larger company
acquires a smaller company, thereby absorbing the business of the
smaller company. M&A deals can be friendly or hostile, depending
on the approval of the target company’s board.

Mergers and Acquisitions (M&A)
Transactions – Types

 1. Horizontal
 A horizontal merger happens between two companies that operate in similar
industries that may or may not be direct competitors.
 2. Vertical
 A vertical merger takes place between a company and its supplier or a customer
along its supply chain. The company aims to move up or down along its supply
chain, thus consolidating its position in the industry.
 3. Conglomerate
 This type of transaction is usually done for diversification reasons and is
between companies in unrelated industries.

 1. Statutory
 Statutory mergers usually occur when the acquirer is much larger than the
target and acquires the target’s assets and liabilities. After the deal, the target
company ceases to exist as a separate entity.
 2. Subsidiary
 In a subsidiary merger, the target becomes a subsidiary of the acquirer but
continues to maintain its business.
 3. Consolidation
 In a consolidation, both companies in the transaction cease to exist after the
deal, and a completely new entity is formed.

Reasons for Mergers and Acquisitions (M&A)
Activity
 Mergers and acquisitions (M&A) can take place for various reasons, such
as:
 1. Unlocking synergies
 The common rationale for mergers and acquisitions (M&A) is to create
synergies in which the combined company is worth more than the two
companies individually. Synergies can be due to cost reduction or higher
revenues.
 Cost synergies are created due to economies of scale, while revenue
synergies are typically created by cross-selling, increasing market share, or
higher prices. Of the two, cost synergies can be easily quantified and
calculated.

 2. Higher growth
 Inorganic growth through mergers and acquisitions (M&A) is
usually a faster way for a company to achieve higher revenues
as compared to growing organically. A company can gain by
acquiring or merging with a company with the latest capabilities
without having to take the risk of developing the same internally.

 3. Stronger market power
 In a horizontal merger, the resulting entity will attain a higher market
share and will gain the power to influence prices. Vertical mergers
also lead to higher market power, as the company will be more in
control of its supply chain, thus avoiding external shocks in supply

 4. Diversification
 Companies that operate in cyclical industries feel the need to
diversify their cash flows to avoid significant losses during a
slowdown in their industry. Acquiring a target in a non-cyclical
industry enables a company to diversify and reduce its market
risk.

 5. Tax benefits
 Tax benefits are looked into where one company realizes significant
taxable income while another incurs tax loss carryforwards. Acquiring
the company with the tax losses enables the acquirer to use the tax
losses to lower its tax liability. However, mergers are not usually done
just to avoid taxes.

Forms of Acquisition
 There are two basic forms of mergers and acquisitions (M&A):
 1. Stock purchase
 In a stock purchase, the acquirer pays the target firm’s shareholders cash
and/or shares in exchange for shares of the target company. Here, the target’s
shareholders receive compensation and not the target. There are certain
aspects to be considered in a stock purchase:
 The acquirer absorbs all the assets and liabilities of the target – even those
that are not on the balance sheet.
 To receive the compensation by the acquirer, the target’s shareholders must
approve the transaction through a majority vote, which can be a long process.
 Shareholders bear the tax liability as they receive the compensation directly.

 2. Asset purchase
 In an asset purchase, the acquirer purchases the target’s assets and pays
the target directly. There are certain aspects to be considered in an asset
purchase, such as:
 Since the acquirer purchases only the assets, it will avoid assuming any of
the target’s liabilities.
 As the payment is made directly to the target, generally, no shareholder
approval is required unless the assets are significant (e.g., greater than
50% of the company).
 The compensation received is taxed at the corporate level as capital gains
by the target.

Ch 6: Market structure & Global business

To reap the gains from trade, the choices of individuals
must be coordinated.
To make coordination work, four complimentary social
institutions have evolved over the centuries:
 Firms
 Markets
 Property rights
 Money
Economic Coordination

A firm is an economic unit that hires factors of production and
organizes those factors to produce and sell goods and
services.
A market is any arrangement that enables buyers and sellers
to get information and do business with each other.
Property rights are the social arrangements that govern
ownership, use, and disposal of resources, goods or services.
Money is any commodity or token that is generally acceptable
as a means of payment.

Circular Flows Through
Markets
This figure illustrates how
households and firms
interact in the market
economy.
Factors of production,
and …
goods and services flow
in one direction.
Money flows in the
opposite direction.

Coordinating Decisions:
Markets coordinate
individual decisions
through price
adjustments.

Market type
Perfect competition
market
Monopolistic
competition
market
Oligopolistic
market
Monopoly
market
The degree of competition decreases
The degree of competition increases

Market type
1) Perfect Competition Market:
 It is a market with a large number of buyers and sellers,
each dealing in a very specific size of the total quantity of
goods produced.
The most important characteristics of this market:
1- The large number of sellers and buyers.
2- Freedom to enter and exit the market.

Market type
3 - The lack of agreements between the sellers and each
other or buyers and each other or between sellers and
buyers.
4 - Full knowledge of market conditions.
5 -The complete homogeneity of the units of the commodity
dealt with (identical).
6 - There is one prevailing market price.

Market type
 Agricultural markets: In some cases, there are several
farmers selling identical products to the market, and many
buyers. At the market, it is easy to compare prices. Therefore,
agricultural markets often get close to perfect competition.
 Internet related industries: The internet has made many
markets closer to perfect competition because the internet has
made it very easy to compare prices, quickly and efficiently
(perfect information). Also, the internet has made barriers to
entry lower.

Market type
2) Monopolistic Competition Market:
 It is a market where a large number of projects produce and
sell a particular good or service, but each offers its own special
type of good or service (similar but not identical).
1. The number of competing monopolists is large, but each
distinguishes its goods from others.
2. Lack of full knowledge of market conditions.
3- Barriers to entry and exit are low.

Market type
4- Discrimination in products.
5- Different market prices.
6- The prices that prevail in this market in the long term are
higher than those prevailing in the market of perfect
competition.
Restaurants – restaurants compete on quality of food as much as
price. Product differentiation is a key element of the business.
There are relatively low barriers to entry in setting up a new
restaurant.

Market type
3) The oligopolistic market (oligopoly):
 An oligopoly consists of a select few companies having
significant influence over an industry. Oligopolies are
noticeable in a multitude of markets (communications).
 While these companies are considered competitors within
the specific market, they tend to cooperate with each other
to benefit as a whole, which can lead to higher prices for
consumers.

Market type
1 - An industry which is dominated by a few firms.
2 - Differentiated products – in an oligopoly, firms often compete
on non-price competition. This makes advertising and the quality
of the product are often important..
3 - Interdependence of firms – companies will be affected by how
other firms set price and output.
4 - Barriers to entry – in an oligopoly, there must be some barriers to
entry to enable firms to gain a significant market share. These
barriers to entry may include brand loyalty or economies of scale.

Market type
 Apple iOS and Google Android dominate smart phone
operating systems, while computer operating systems are
overshadowed by Apple and Windows.
 Pharmaceutical industry.
 wireless cell phone service industry.

Market type
Monopoly market:
 It is the market in which a single enterprise produces a commodity
that does not have strong alternatives to compete with, i.e. the only
productive enterprise in the market.
 There is no competition from any one of the market.
 The monopolist's production represents the total supply in the
market.
 The monopolist can make an extraordinary profit even in the long
run.

Market type
 The monopoly that sets the price and supply of a good or service is
called the price maker.
 There are typically high barriers to entry, which are obstacles that prevent
a company from entering into a market.
Most utilities today operate as government-licensed monopolies
(electricity/ Railways/ Water Facility/ tobacco/……..).
Microsoft is a Computer and software manufacturing Company. It
holds more than 75% market share and is the market leader.
Google: The biggest web searcher with their secret algorithm
controls more than 70% market share.

Profit Maximization
 Most owners of private-sector firms want to maximize
their profits, which is the reason why private-sector firms
are called for-profit businesses.
 A firm’s profit, π, is the difference between a firm’s
revenues, R, and its cost, C:
π = R - C.
 If profit is negative, π < 0, the firm makes a loss.

Profit Maximization
 Because both the firm’s revenue and cost vary with its output, q,
the firm’s profit also varies with output:
π(q) = R(q) - C(q)
 where R(q) is its revenue function and C(q) is its cost function. A
firm decides how much output to sell to maximize its profit. To
maximize its profit, any firm must answer two questions:
◗ Output decision: If the firm produces, what output level, q,
maximizes its profit?
◗ Shutdown decision: Is it more profitable to produce q or to
shut down and produce no output?

Profit Maximization
Output Rules:
 Output Rule 1: A firm sets its output where its marginal profit is
zero.
Marginal profit (q) = MR(q) - MC(q).
Marginal profit (q) = 0
 Output Rule 2: A firm sets its output where its marginal revenue
equals its marginal cost:
MR(q) = MC(q).

Profit Maximization
 A firm’s marginal cost (MC) is the amount by which a
firm’s cost changes if it produces one more unit of
output: MC = ΔC/Δq, where ΔC is the change in cost
when Δq = 1.
 Similarly, a firm’s marginal revenue (MR) is the change
in revenue it gets from selling one more unit of output:
ΔR/Δq, where ΔR is the change in revenue when Δq = 1.

Owners’ Versus Managers’ Objectives
 A conflict may arise between owners who want to maximize profit
and managers interested in pursuing other goals, such as
maximizing their incomes or traveling in a company jet. A conflict
between an owner (a principal) and a manager (an agent) may
impose costs on the firm—agency costs—that result in lower profit
for the firm.
 However, owners can take steps to minimize these conflicts, and
market forces reduce the likelihood that a firm will deviate
substantially from trying to maximize profit.

 Profit Sharing. If profit is easily observed by the
owner and the manager and both want to maximize
their own earnings, the agency problems can be avoided
by paying the manager a share of the firm’s profit.

 If the manager gets a third of the total profit, 1/3 π, then
the manager sets output at q*, which maximizes the
manager’s share of profit. The firm’s owners receive 2/3
π, which is the vertical difference between the total profit
curve and the agent’s earnings at each output. Both total
profit and the owner’s share of profit are also maximized
at q*.

Reasons for International Trade
 Many of the national economies that have shown the most
rapid growth in the last few decades—for example, Japan,
South Korea, China, and India—have done so by
dramatically orienting their economies toward international
trade.
 There is no modern example of a country that has shut itself
off from world trade and yet prospered. To understand the
benefits of trade, or why we trade in the first place, we need
to understand the concepts of comparative and absolute
advantage.

 Adam Smith argued that specialization and free trade benefit all
trading partners, even those that may be relatively inefficient.
 A country has an absolute advantage in producing a good over
another country if it uses fewer resources to produce that good.
 Absolute advantage can be the result of a country’s natural
endowment.
 Absolute advantage looks at the efficiency of producing a single
product.

 For example, extracting oil in Saudi Arabia is pretty much just a
matter of “drilling a hole.” Producing oil in other countries can require
considerable exploration and costly technologies for drilling and
extraction—if indeed they have any oil at all.
 The United States has some of the richest farmland in the world,
making it easier to grow corn and wheat than in many other
countries.
 Colombia have climates especially suited for growing coffee. Chile
and Zambia have some of the world’s richest copper mines.
Zambia will provide copper and Colombia will produce coffee,
and they will trade.

 However, thinking about trade just in terms of absolute advantage is
incomplete. Trade really occurs because of comparative
advantage.
 According to the principle of comparative advantage (David
Ricardo), a country exports goods it can produce at relatively low
cost and imports goods that are relatively costly to produce
domestically.
 A country has a comparative advantage when a good can be
produced at a lower cost in terms of other goods.
 comparative advantage: the ability to produce a good or service at
lower opportunity cost than other countries.

Gains from Trade Between Countries:
 Consider a hypothetical world with two countries, Saudi Arabia and
the United States, and two products, oil and corn. Saudi Arabia can
produce oil with fewer resources, while the United States can produce
corn with fewer resources.

 Saudi Arabia has an absolute advantage in the production of oil
because it only takes an hour to produce a barrel of oil
compared to two hours in the United States. The United States
has an absolute advantage in the production of corn.
 let’s say that Saudi Arabia and the United States each have 100
worker hours We illustrate what each country is capable of
producing on its own using a production possibility frontier
(PPF) graph

100/1=100 b/h 100/4=25 b/h
100/2=50 b/h 100/1=100 b/h

 Arguably Saudi and U.S. consumers desire both oil and corn to live.
Let’s say that before trade occurs, both countries produce and
consume at point C or C’.
 Thus, before trade, the Saudi Arabian economy will devote 60 worker
hours to produce oil. This choice implies that it produces/consumes
60 barrels of oil. With the remaining 40 worker hours, since it needs
four hours to produce a bushel of corn, it can produce only 10
bushels.
 To be at point C’, the U.S. economy devotes 40 worker hours to
produce 20 barrels of oil and the remaining worker hours can be
allocated to produce 60 bushels of corn.

Gains from Intra-firm Trade:
 This basic idea of comparative advantage also works for intra-firm
trade—where a single firm is on both sides of an international
transaction—exporting the output from its operation in one country to
an affiliated business unit in another country.
 Suppose that General Electric (GE) has production facilities in many
countries, including Hungary and Romania, to produce a refrigerator,
GE must manufacture the basic parts or components and assemble
those components into a finished product.

 a Hungarian worker can produce enough components (parts) for four
refrigerators per day or can assemble four refrigerators in a day. A
Romanian worker can produce enough parts for two refrigerators per
day or can assemble one refrigerator per day.
opportunity cost = what is lost / what is gained

 If a Romanian worker assembles one refrigerator, that worker does
not have the time to produce two sets of parts, so the opportunity
cost of assembling a refrigerator is the value of the labor it takes to
produce two sets of parts. In contrast, if a Hungarian assembles one
refrigerator, the opportunity cost is that the worker does not produce
one set of parts.
Opportunity cost Components Assembly
Hungary 1/1=1 1/1=1
Romania ½=0.5 2/1=2

 Suppose that GE has 120 workers in its Hungarian plant and
240 in its Romanian plant. If GE cannot lay off any workers in
the short run, how should GE allocate activities in Hungary and
Romania to maximize total output?

 The Hungarian plant allocates 60 workers to parts and 60 to
assembly. Because a component worker produces 4 sets of parts per
day, these workers produce 4 * 60 = 240 sets of parts. The 60
Hungarian assembly workers can assemble all 240 sets of parts
because each worker can assemble 4 refrigerators per day. This
allocation of workers to tasks yields 240 refrigerators per day in
Hungary. Any other allocation would yield less output.
 In Romania, 80 workers work on parts and 160 on assembly, yielding
an output of 160 refrigerators per day. Thus, the two plants working
independently can produce 400 refrigerators per day—240 in
Hungary and 160 in Romania.

 A better alternative is to have Romania specialize in
producing parts and Hungary specialize in production. If all
240 workers in Romania produced parts, they could
manufacture enough for 480 refrigerators each day.
 If these parts were then sent to Hungary, the 120 Hungarian
workers could assemble all 480 refrigerators in a day. This
allocation of labor, involving specialization and trade,
maximizes output. The gain from trade is 80 refrigerators.

 If the Romanian plant specializes in assembly and the
Hungarian plant in producing components, what is the largest
number of refrigerators that GE can produce per day?
 The Romanian workers can assemble 240 refrigerators a day.
To keep all the Romanian workers busy, only 60 Hungarian
workers are needed to make 240 sets of parts each day.
 The remaining 60 Hungarian workers can produce the largest
number of refrigerators by having 30 workers each producing 4
sets of components a day and 30 assembling 4 refrigerators per
day, thereby producing an additional 120 refrigerators.

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