Fundamentals of Managerial Economics (Economic Applications Access)

696 Pages·2005·11.62 MB·English

by  Mark Hirschey

1
CHAPTER ONE
Introduction
W
arren E. Buffett, the celebrated chairman and chief executive officer
of Omaha, Nebraska–based Berkshire Hathaway, Inc., started an
investment partnership with $100 in 1956 and has gone on to accumulate a
personal net worth in excess of $30 billion. As both a manager and an investor,
Buffett is renowned for focusing on the economics of businesses.
Berkshire’s collection of operating businesses, including the GEICO
Insurance Company, International Dairy Queen, Inc., the Nebraska Furniture
Mart, and See’s Candies, commonly earn 30 percent to 50 percent per year on
invested capital. This is astonishingly good performance in light of the 10
percent to 12 percent return typical of industry in general. A second and
equally important contributor to Berkshire’s outstanding performance is a
handful of substantial holdings in publicly traded common stocks, such as
The American Express Company, The Coca-Cola Company, and The
Washington Post Company, among others. As both manager and investor,
Buffett looks for “wonderful businesses” with outstanding economic charac-
teristics: high rates of return on invested capital, substantial profit margins on
sales, and consistent earnings growth. Complicated businesses that face
fierce competition or require large capital investment are shunned.1
Buffett’s success is powerful testimony to the practical usefulness of man-
agerial economics. Managerial economics answers fundamental questions.
When is the market for a product so attractive that entry or expansion
becomes appealing? When is exit preferable to continued operation? Why do
some professions pay well, while others offer only meager pay? Successful
managers make good decisions, and one of their most useful tools is the
methodology of managerial economics.
1 Information about Warren Buffett's investment philosophy and Berkshire Hathaway, Inc.,
2 can be found on the Internet (http://www.berkshirehathaway.com).
1
2 Introduction
Chapter One Introduction 3
HOW IS MANAGERIAL ECONOMICS USEFUL?
managerial Managerial economics applies economic theory and methods to business and administrative
economics decision making. Managerial economics prescribes rules for improving managerial decisions.
Applies economic tools Managerial economics also helps managers recognize how economic forces affect organiza-
and techniques to
tions and describes the economic consequences of managerial behavior. It links economic
business and adminis-
concepts with quantitative methods to develop vital tools for managerial decision making.
trative decision making
This process is illustrated in Figure 1.1.
Evaluating Choice Alternatives
Managerial economics identifies ways to efficiently achieve goals. For example, suppose a
small business seeks rapid growth to reach a size that permits efficient use of national media
advertising. Managerial economics can be used to identify pricing and production strategies
to help meet this short-run objective quickly and effectively. Similarly, managerial economics
provides production and marketing rules that permit the company to maximize net profits
once it has achieved growth or market share objectives.
FIGURE 1.1
Managerial Economics Is a Tool for Improving Management Decision Making
Managerial economics uses economic concepts and quantitative methods to solve managerial problems.
Management Decision Problems
¥ ProductSelection,Output,andPricing
¥ InternetStrategy
¥ OrganizationDesign
¥ ProductDevelopmentandPromotion(cid:3)
Strategy
¥ WorkerHiringandTraining
¥ InvestmentandFinancing
Economic Concepts Quantitative Methods
¥ MarginalAnalysis ¥ NumericalAnalysis
¥ TheoryofConsumerDemand ¥ StatisticalEstimation
¥ TheoryoftheFirm ¥ ForecastingProcedures
¥ IndustrialOrganizationandFirm(cid:3) ¥ GameTheoryConcepts
Behavior ¥ OptimizationTechniques
¥ PublicChoiceTheory ¥ InformationSystems
Managerial Economics
Managerial Economics
UseofEconomicConceptsand
QuantitativeMethodstoSolve(cid:3)
ManagementDecisionProblems
OptimalSolutionstoManagement
DecisionProblems
Introduction 3
4 Part One Overview of Managerial Economics
MANAGERIAL APPLICATION 1.1
Managerial Ethics
In The Wall Street Journal, it is not hard to find evidence • Stick by your principles. Principles are not for sale at
of unscrupulous business behavior. However, unethical any price.
conduct is neither consistent with value maximization
Does the “high road” lead to corporate success? Consider
nor with the enlightened self-interest of management
the experience of one of America’s most famous winners—
and other employees. If honesty did not pervade corpo-
Omaha billionaire Warren E. Buffett, chairman of
rate America, the ability to conduct business would col-
Berkshire Hathaway, Inc. Buffett and Charlie Munger, the
lapse. Eventually, the truth always comes out, and when
number-two man at Berkshire, are famous for doing
it does the unscrupulous lose out. For better or worse,
multimillion-dollar deals on the basis of a simple hand-
we are known by the standards we adopt.
shake. At Berkshire, management relies upon the charac-
To become successful in business, everyone must
ter of the people that they are dealing with rather than
adopt a set of principles. Ethical rules to keep in mind
expensive accounting audits, detailed legal opinions, or
when conducting business include the following:
liability insurance coverage. Buffett says that after some
• Above all else, keep your word. Say what you mean, early mistakes, he learned to go into business only with
and mean what you say. people whom he likes, trusts, and admires. Although a
company will not necessarily prosper because its man-
• Do the right thing. Ahandshake with an honorable
agers display admirable qualities, Buffett says he has
person is worth more than a ton of legal documents
never made a good deal with a bad person.
from a corrupt individual.
Doing the right thing not only makes sense from an
• Accept responsibility for your mistakes, and fix
ethical perspective, but it makes business $ense, too!
them. Be quick to share credit for success.
• Leave something on the table. Profit withyour cus-
See: Emelie Rutherford, “Lawmakers Involved with Enron Probe Had
tomer, not offyour customer. Personal Stake in the Company,” The Wall Street Journal Online, March 4,
2002 (http://online.wsj.com).
Managerial economics has applications in both profit and not-for-profit sectors. For
example, an administrator of a nonprofit hospital strives to provide the best medical care
possible given limited medical staff, equipment, and related resources. Using the tools and
concepts of managerial economics, the administrator can determine the optimal allocation
of these limited resources. In short, managerial economics helps managers arrive at a set of
operating rules that aid in the efficient use of scarce human and capital resources. By fol-
lowing these rules, businesses, nonprofit organizations, and government agencies are able
to meet objectives efficiently.
Making the Best Decision
To establish appropriate decision rules, managers must understand the economic environ-
ment in which they operate. For example, a grocery retailer may offer consumers a highly
price-sensitive product, such as milk, at an extremely low markup over cost—say, 1 percent
to 2 percent—while offering less price-sensitive products, such as nonprescription drugs, at
markups of as high as 40 percent over cost. Managerial economics describes the logic of this
pricing practice with respect to the goal of profit maximization. Similarly, managerial eco-
nomics reveals that auto import quotas reduce the availability of substitutes for domestically
produced cars, raise auto prices, and create the possibility of monopoly profits for domestic
manufacturers. It does not explain whether imposing quotas is good public policy; that is a
decision involving broader political considerations. Managerial economics only describes the
predictable economic consequences of such actions.
Managerial economics offers a comprehensive application of economic theory and method-
ology to management decision making. It is as relevant to the management of government
agencies, cooperatives, schools, hospitals, museums, and similar not-for-profit institutions as it
4 Introduction
Chapter One Introduction 5
is to the management of profit-oriented businesses. Although this text focuses primarily on
business applications, it also includes examples and problems from the government and non-
profit sectors to illustrate the broad relevance of managerial economics.
THEORY OF THE FIRM
At its simplest level, a business enterprise represents a series of contractual relationships that
specify the rights and responsibilities of various parties (see Figure 1.2). People directly involved
include customers, stockholders, management, employees, and suppliers. Society is also
involved because businesses use scarce resources, pay taxes, provide employment opportunities,
and produce much of society’s material and services output. Firms are a useful device for pro-
ducing and distributing goods and services. They are economic entities and are best analyzed in
the context of an economic model.
Expected Value Maximization
theory of the firm The model of business is called the theory of the firm. In its simplest version, the firm is
Basic model of business thought to have profit maximization as its primary goal. The firm’s owner-manager is assumed
to be working to maximize the firm’s short-run profits. Today, the emphasis on profits has been
expected value
maximization broadened to encompass uncertainty and the time value of money. In this more complete model,
Optimization of profits the primary goal of the firm is long-term expected value maximization.
in light of uncertainty The value of the firmis the present value of the firm’s expected future net cash flows. If
and the time value of
cash flows are equated to profits for simplicity, the value of the firm today, or its present value,
money
value of the firm
FIGURE 1.2
Present value of the
firm’s expected
The Corporation Is a Legal Device
future net cash flows
The firm can be viewed as a confluence of contractual relationships that connect suppliers, investors,
present value
workers, and management in a joint effort to serve customers.
Worth in current
dollars
Society
Suppliers Investors
Firm
Management Employees
Customers
Introduction 5
6 Part One Overview of Managerial Economics
is the value of expected profits or cash flows, discounted back to the present at an appropriate
interest rate.2
This model can be expressed as follows:
Value of the Firm = Present Value of Expected Future Profits
π π π
= 1 + 2 + • • • + n
(1 + i)1 (1 + i)2 (1 + i)n
(1.1)
n π
∑ t
=
(1 + i)t
t= 1
Here, π , π , . . . π represent expected profits in each year, t, and iis the appropriate interest,
1 2 n
or discount, rate. The final form for Equation 1.1 is simply a shorthand expression in which
sigma (∑) stands for “sum up” or “add together.” The term
n
∑
t=1
means, “Add together as tgoes from 1 to nthe values of the term on the right.” For Equation
1.1, the process is as follows: Let t= 1 and find the value of the term π /(1 + i)1, the present
1
value of year 1 profit; then let t= 2 and calculate π /(1 + i)2, the present value of year 2 profit;
2
continue until t = n, the last year included in the analysis; then add up these present-value
equivalents of yearly profits to find the current or present value of the firm.
Because profits (π) are equal to total revenues (TR) minus total costs (TC), Equation 1.1
can be rewritten as
∑n TR – TC
(1.2) Value = t t
(1+ i)t
t= 1
This expanded equation can be used to examine how the expected value maximization
model relates to a firm’s various functional departments. The marketing department often
has primary responsibility for product promotion and sales (TR); the production department
has primary responsibility for product development costs (TC); and the finance department
has primary responsibility for acquiring capital and, hence, for the discount factor (i) in the
denominator. Important overlaps exist among these functional areas. The marketing
department can help reduce costs associated with a given level of output by influencing
customer order size and timing. The production department can stimulate sales by improv-
ing quality. Other departments, for example, accounting, human resources, transportation, and
engineering, provide information and services vital to sales growth and cost control. The
determination of TRand TCis a complex task that requires recognizing important interrelations
among the various areas of firm activity. An important concept in managerial economics is
that managerial decisions should be analyzed in terms of their effects on value, as expressed
in Equations 1.1 and 1.2.
2 Discounting is required because profits obtained in the future are less valuable than profits earned presently.
To understand this concept, one needs to recognize that $1 in hand today is worth more than $1 to be received
a year from now, because $1 today can be invested and, with interest, grow to a larger amount by the end of
the year. If we had $1 and invested it at 10 percent interest, it would grow to $1.10 in one year. Thus, $1 is
defined as the present value of $1.10 due in 1 year when the appropriate interest rate is 10 percent.
6 Introduction
Chapter One Introduction 7
Constraints and the Theory of the Firm
Managerial decisions are often made in light of constraints imposed by technology, resource
scarcity, contractual obligations, laws, and regulations. To make decisions that maximize
value, managers must consider how external constraints affect their ability to achieve organ-
ization objectives.
Organizations frequently face limited availability of essential inputs, such as skilled labor,
raw materials, energy, specialized machinery, and warehouse space. Managers often face lim-
itations on the amount of investment funds available for a particular project or activity.
Decisions can also be constrained by contractual requirements. For example, labor contracts
limit flexibility in worker scheduling and job assignments. Contracts sometimes require that
a minimum level of output be produced to meet delivery requirements. In most instances,
output must also meet quality requirements. Some common examples of output quality con-
straints are nutritional requirements for feed mixtures, audience exposure requirements for
marketing promotions, reliability requirements for electronic products, and customer service
requirements for minimum satisfaction levels.
Legal restrictions, which affect both production and marketing activities, can also play an
important role in managerial decisions. Laws that define minimum wages, health and safety
standards, pollution emission standards, fuel efficiency requirements, and fair pricing and
marketing practices all limit managerial flexibility.
The role that constraints play in managerial decisions makes the topic of constrained opti-
mization a basic element of managerial economics. Later chapters consider important eco-
nomic implications of self-imposed and social constraints. This analysis is important because
value maximization and allocative efficiency in society depend on the efficient use of scarce
economic resources.
Limitations of the Theory of the Firm
Some critics question why the value maximization criterion is used as a foundation for study-
optimize ing firm behavior. Do managers try to optimize (seek the best result) or merely satisfice
Seek the best solution (seek satisfactory rather than optimal results)? Do managers seek the sharpest needle in a
haystack (optimize), or do they stop after finding one sharp enough for sewing (satisfice)?
satisfice
Seek satisfactory rather How can one tell whether company support of the United Way, for example, leads to long-run
than optimal results value maximization? Are generous salaries and stock options necessary to attract and retain
managers who can keep the firm ahead of the competition? When a risky venture is turned
down, is this inefficient risk avoidance? Or does it reflect an appropriate decision from the
standpoint of value maximization?
It is impossible to give definitive answers to questions like these, and this dilemma has led to
the development of alternative theories of firm behavior. Some of the more prominent alterna-
tives are models in which size or growth maximization is the assumed primary objective of man-
agement, models that argue that managers are most concerned with their own personal utility
or welfare maximization, and models that treat the firm as a collection of individuals with wide-
ly divergent goals rather than as a single, identifiable unit. These alternative theories, or models,
of managerial behavior have added to our understanding of the firm. Still, none can supplant the
basic value maximization model as a foundation for analyzing managerial decisions. Examining
why provides additional insight into the value of studying managerial economics.
Research shows that vigorous competition in markets for most goods and services typical-
ly forces managers to seek value maximization in their operating decisions. Competition in the
capital markets forces managers to seek value maximization in their financing decisions as
well. Stockholders are, of course, interested in value maximization because it affects their rates
of return on common stock investments. Managers who pursue their own interests instead of
stockholders’ interests run the risk of losing their job. Buyout pressure from unfriendly firms
Introduction 7
8 Part One Overview of Managerial Economics
MANAGERIAL APPLICATION 1.2
The World Is Turning to Capitalism and Democracy
Capitalism and democracy are mutually reinforcing. Competition is a fundamentally attractive feature of
Some philosophers have gone so far as to say that capi- the capitalistic system because it keeps costs and prices
talism and democracy are intertwined. Without capital- as low as possible. By operating efficiently, firms are able
ism, democracy may be impossible. Without democracy, to produce the maximum quantity and quality of goods
capitalism may fail. At a minimum, freely competitive and services possible. Mass production is, by definition,
markets give consumers broad choices and reinforce the production for the masses. Competition also limits con-
individual freedoms protected in a democratic society. centration of economic and political power. Similarly,
In democracy, government does not grant individual the democratic form of government is inconsistent with
freedom. Instead, the political power of government consolidated economic influence and decision making.
emanates from the people. Similarly, the flow of eco- Totalitarian forms of government are in retreat. China
nomic resources originates with the individual cus- has experienced violent upheaval as the country embarks
tomer in a capitalistic system. It is not centrally directed on much-needed economic and political reforms. In the
by government. former Soviet Union, Eastern Europe, India, and Latin
Capitalism is socially desirable because of its decen- America, years of economic failure forced governments to
tralized and customer-oriented nature. The menu of dismantle entrenched bureaucracy and install economic
products to be produced is derived from market price incentives. Rising living standards and political freedom
and output signals originating in competitive markets, have made life in the West the envy of the world.
not from the output schedules of a centralized planning Against this backdrop, the future is bright for capitalism
agency. Resources and products are also allocated through and democracy!
market forces. They are not earmarked on the basis of
favoritism or social status. Through their purchase deci-
See: Karen Richardson, “China and India Could Lead Asia in
sions, customers dictate the quantity and quality of
Technology Spending,” The Wall Street Journal Online, March 4, 2002
products brought to market. (http://online.wsj.com).
(“raiders”) has been considerable during recent years. Unfriendly takeovers are especially hos-
tile to inefficient management that is replaced. Further, because recent studies show a strong
correlation between firm profits and managerial compensation, managers have strong eco-
nomic incentives to pursue value maximization through their decisions.
It is also sometimes overlooked that managers must fully consider costs and benefits before
they can make reasoned decisions. Would it be wise to seek the best technical solution to a
problem if the costs of finding this solution greatly exceed resulting benefits? Of course not.
What often appears to be satisficing on the part of management can be interpreted as value-
maximizing behavior once the costs of information gathering and analysis are considered.
Similarly, short-run growth maximization strategies are often consistent with long-run value
maximization when the production, distribution, or promotional advantages of large firm
size are better understood.
Finally, the value maximization model also offers insight into a firm’s voluntary “socially
responsible” behavior. The criticism that the traditional theory of the firm emphasizes profits
and value maximization while ignoring the issue of social responsibility is important and will
be discussed later in the chapter. For now, it will prove useful to examine the concept of prof-
its, which is central to the theory of the firm.
PROFIT MEASUREMENT
The free enterprise system would fail without profits and the profit motive. Even in planned
economies, where state ownership rather than private enterprise is typical, the profit motive
is increasingly used to spur efficient resource use. In the former Eastern Bloc countries, the
8 Introduction
Chapter One Introduction 9
former Soviet Union, China, and other nations, new profit incentives for managers and employ-
ees have led to higher product quality and cost efficiency. Thus, profits and the profit motive
play a growing role in the efficient allocation of economic resources worldwide.
Business Versus Economic Profit
The general public and the business community typically define profit as the residual of sales
revenue minus the explicit costs of doing business. It is the amount available to fund equity
capital after payment for all other resources used by the firm. This definition of profit is
business profit accounting profit, orbusiness profit.
Residual of sales rev- The economist also defines profit as the excess of revenues over costs. However, inputs
enue minus the explicit provided by owners, including entrepreneurial effort and capital, are resources that must be
accounting costs of
compensated. The economist includes a normal rate of return on equity capital plus an oppor-
doing business
tunity cost for the effort of the owner-entrepreneur as costs of doing business, just as the
interest paid on debt and the wages are costs in calculating business profit. The risk-adjusted
normal rate of normal rate of return on capital is the minimum return necessary to attract and retain
return investment. Similarly, the opportunity cost of owner effort is determined by the value that
Average profit necessary could be received in alternative employment. In economic terms, profit is business profit
to attract and retain
minus the implicit (noncash) costs of capital and other owner-provided inputs used by the
investment
firm. This profit concept is frequently referred to as economic profit.
economic profit The concepts of business profit and economic profit can be used to explain the role of
Business profit minus
profits in a free enterprise economy. Anormal rate of return, or profit, is necessary to induce
the implicit costs of
individuals to invest funds rather than spend them for current consumption. Normal profit
capital and any other
owner-provided inputs is simply a cost for capital; it is no different from the cost of other resources, such as labor,
materials, and energy. Asimilar price exists for the entrepreneurial effort of a firm’s owner-
manager and for other resources that owners bring to the firm. These opportunity costs for
owner-provided inputs offer a primary explanation for the existence of business profits, espe-
cially among small businesses.
Variability of Business Profits
In practice, reported profits fluctuate widely. Table 1.1 shows business profits for a well-known
sample of 30 industrial giants: those companies that comprise the Dow Jones Industrial
Average. Business profit is often measured in dollar terms or as a percentage of sales revenue,
profit margin called profit margin, as in Table 1.1. The economist’s concept of a normal rate of profit is typ-
Accounting net income ically assessed in terms of the realized rate of return on stockholders’equity (ROE). Return
divided by sales on stockholders’ equity is defined as accounting net income divided by the book value of the
return on stock- firm. As seen in Table 1.1, the average ROE for industrial giants found in the Dow Jones
holders’equity Industrial Average falls in a broad range of around 15 percent to 25 percent per year. Although
Accounting net income an average annual ROE of roughly 10 percent can be regarded as a typical or normal rate of
divided by the book
return in the United States and Canada, this standard is routinely exceeded by companies such
value of total assets
as Coca-Cola, which has consistently earned a ROE in excess of 35 percent per year. It is a stan-
minus total liabilities
dard seldom met by International Paper, a company that has suffered massive losses in an
attempt to cut costs and increase product quality in the face of tough environmental regulations
and foreign competition.
Some of the variation in ROE depicted in Table 1.1 represents the influence of differential
risk premiums. In the pharmaceuticals industry, for example, hoped-for discoveries of effec-
tive therapies for important diseases are often a long shot at best. Thus, profit rates reported
by Merck and other leading pharmaceutical companies overstate the relative profitability of
the drug industry; it could be cut by one-half with proper risk adjustment. Similarly, reported
profit rates can overstate differences in economic profits if accounting error or bias causes
Introduction 9
10 Part One Overview of Managerial Economics
TABLE 1.1
The Profitability of Industrial Giants Included in the Dow Jones Industrial Average
Return Return
Net Income Sales Net Worth on Sales on Equity
Company Name Industry ($ Millions) ($ Millions) ($ Millions) (Margin) (ROE)
Alcoa Inc. Metals and Mining (Div.) 1,489 22,936 11,422 6.5% 13.0%
American Express Financial Services (Div.) 2,810 23,675 11,684 11.9% 24.0%
AT&TCorp. Telecom. Services 6,630 65,981 107,908 10.0% 6.1%
Boeing Aerospace/Defense 2,511 51,321 11,020 4.9% 22.8%
Caterpillar Inc. Machinery 1,053 20,175 5,600 5.2% 18.8%
Citigroup Inc. Financial Services (Div.) 13,519 n.a. 66,206 n.a. 20.4%
Coca-Cola Beverage (Soft Drink) 3,669 20,458 9,316 17.9% 39.4%
Disney (Walt) Entertainment 1,892 25,020 24,100 7.6% 7.8%
DuPont Chemical (Basic) 2,884 28,268 13,299 10.2% 21.7%
Eastman Kodak Precision Instrument 1,441 13,994 3,428 10.3% 42.0%
Exxon Mobil Corp. Petroleum (Integrated) 16,910 206,083 70,757 8.2% 23.9%
General Electric Electrical Equipment 12,735 63,807 50,492 20.0% 25.2%
General Motors Auto and Truck 5,472 184,632 30,175 3.0% 18.1%
Hewlett-Packard Computer and Peripherals 3,561 48,782 14,209 7.3% 25.1%
Home Depot Retail Building Supply 2,581 45,738 15,004 5.6% 17.2%
Honeywell International Diversified Co. 2,293 25,023 9,707 9.2% 23.6%
Intel Corp. Semiconductor 10,669 33,726 37,322 31.6% 28.6%
International Business Computer and Peripherals 8,093 88,396 20,624 9.2% 39.2%
Machine
International Paper Paper and Forest Products 969 28,180 12,034 3.4% 8.1%
Johnson & Johnson Medical Supplies 4,800 29,139 18,808 16.5% 25.5%
McDonald’s Corp. Restaurant 1,977 14,243 9,204 13.9% 21.5%
Merck & Co. Drug 6,822 40,363 14,832 16.9% 46.0%
Microsoft Corp. Computer Software and Services 10,003 25,296 47,289 39.5% 21.2%
Minnesota Mining Chemical (Diversified) 1,857 16,724 6,531 11.1% 28.4%
Morgan (J.P.) Chase Bank 5,727 n.a. 42,338 n.a. 13.5%
Philip Morris Tobacco 8,510 80,356 15,005 10.6% 56.7%
Procter & Gamble Household Products 4,397 39,244 12,010 11.2% 36.6%
SBC Communications Telecom. Services 7,746 53,313 31,463 14.5% 24.6%
United Technologies Diversified Co. 1,808 26,583 8,094 6.8% 22.3%
Wal-Mart Stores Retail Store 6,295 191,329 31,343 3.3% 20.1%
Averages 5,371 54,028 25,374 9.9% 21.2%
n.a. means “not applicable.”
Data source: Value Line Investment Survey, March 4, 2002 (http://www.valueline.com).
Reproduced with the permission of Value Line Publishing, Inc.
investments with long-term benefits to be omitted from the balance sheet. For example, current
accounting practice often fails to consider advertising or research and development expendi-
tures as intangible investments with long-term benefits. Because advertising and research and
development expenditures are immediately expensed rather than capitalized and written off
over their useful lives, intangible assets can be grossly understated for certain companies. The
balance sheet of Coca-Cola does not reflect the hundreds of millions of dollars spent to estab-
lish and maintain the brand-name recognition of Coca-Cola, just as Merck’s balance sheet fails
to reflect research dollars spent to develop important product names like Vasotec(for the treat-
10 Introduction
Chapter One Introduction 11
ment of high blood pressure), Zocor(an antiarthritic drug), and Singulair(asthma medication).
As a result, business profit rates for both Coca-Cola and Merck overstate each company’s true
economic performance.
WHY DO PROFITS VARY AMONG FIRMS?
Even after risk adjustment and modification to account for the effects of accounting error and
bias, ROE numbers reflect significant variation in economic profits. Many firms earn significant
economic profits or experience meaningful economic losses at any given point. To better under-
stand real-world differences in profit rates, it is necessary to examine theories used to explain
profit variations.
Frictional Theory of Economic Profits
frictional profit One explanation of economic profits or losses isfrictional profit theory. It states that markets
theory are sometimes in disequilibrium because of unanticipated changes in demand or cost condi-
Abnormal profits tions. Unanticipated shocks produce positive or negative economic profits for some firms.
observed following
For example, automated teller machines (ATMs) make it possible for customers of financial
unanticipated changes
institutions to easily obtain cash, enter deposits, and make loan payments. ATMs render obsolete
in demand or cost
conditions many of the functions that used to be carried out at branch offices and foster ongoing consoli-
dation in the industry. Similarly, new user-friendly software increases demand for high-powered
personal computers (PCs) and boosts returns for efficient PC manufacturers. Alternatively, a rise
in the use of plastics and aluminum in automobiles drives down the profits of steel manufactur-
ers. Over time, barring impassable barriers to entry and exit, resources flow into or out of finan-
cial institutions, computer manufacturers, and steel manufacturers, thus driving rates of return
back to normal levels. During interim periods, profits might be above or below normal because
of frictional factors that prevent instantaneous adjustment to new market conditions.
Monopoly Theory of Economic Profits
monopoly profit Afurther explanation of above-normal profits, monopoly profit theory, is an extension of fric-
theory tional profit theory. This theory asserts that some firms are sheltered from competition by high
Above-normal profits barriers to entry. Economies of scale, high capital requirements, patents, or import protection
caused by barriers to
enable some firms to build monopoly positions that allow above-normal profits for extended
entry that limit
periods. Monopoly profits can even arise because of luck or happenstance (being in the right
competition
industry at the right time) or from anticompetitive behavior. Unlike other potential sources of
above-normal profits, monopoly profits are often seen as unwarranted. Thus, monopoly profits
are usually taxed or otherwise regulated. Chapters 10, 11, and 13 consider the causes and con-
sequences of monopoly and how society attempts to mitigate its potential costs.
Innovation Theory of Economic Profits
innovation profit An additional theory of economic profits, innovation profit theory, describes the above-normal
theory profits that arise following successful invention or modernization. For example, innovation
Above-normal profits profit theory suggests that Microsoft Corporation has earned superior rates of return because it
that follow successful
successfully developed, introduced, and marketed the Graphical User Interface, a superior image-
invention or modern-
based rather than command-based approach to computer software instructions. Microsoft has
ization
continued to earn above-normal returns as other firms scramble to offer a wide variety of “user
friendly” software for personal and business applications. Only after competitorshave intro-
duced and successfully saturated the market for user-friendly software will Microsoft profits
be driven down to normal levels. Similarly, McDonald’s Corporation earned above-normal
rates of return as an early innovator in the fast-food business. With increased competition from
Burger King, Wendy’s, and a host of national and regional competitors, McDonald’s, like