CHAPTER 9 Perfect Competition and Monopoly  A variation of the MR=MC rule for those firms

Contribution Margin operating in perfectly competitive markets.

 The amount of revenue that a firm earns above its total  In such markets, firms are price takers. Thus, the price
variable cost. they must deal with is in fact the same as a firm’s
 A firm experiencing a loss may continue operating in the marginal revenue.
short run if it has a positive contribution margin.
 A firm experiencing a negative contribution margin Perfect Competition
must shut down its operations because its revenue  A market with four main characteristics
cannot even cover its variable costs of operations. (1) Very large number of relatively small buyers and
sellers
Economic Cost (2) A standardized product
 All cost incurred to attract resources into a company’s (3) Easy entry and exit
employ. (4) Complete information by all market participants
 Includes explicit cost as well as opportunity cost. about the market price.
Firms in this type of market have absolutely no control over the
Economic Loss price
 When a firm’s revenues cannot cover its accounting
cost as well as its opportunity cost of production. Price makers
 Firms that exercise market power through product
Economic Profit differentiation or by being dominant players in their
 Total revenue minus total economic cost. markets.
 An amount of profit earned in a particular endeavor Price Takers
above the amount of profit that the firm could be  Firms that operate in perfectly competitive markets.
earning in its next-best alternative activity.
 Also referred to as abnormal profit or above-normal Pricing for Profit
profit.  The method pricing that follows the MR=MC rule.

Long run (market analysis) Pricing for revenue

 Firms are expected to enter a market in which sellers  The pricing of a product to maximize a firm’s revenue.
are earning economic profit.  Assuming that the firm faces a linear demand curve, the
 Expected to leave a market in which sellers are price it establishes to maximize revenue would be
incurring economic losses. lower than the price that would maximize its profit.

Market Power Shutdown point

 The power to establish the market price.  The point at which the firm must consider ceasing its
production activity because the short-run loss suffered
Market Structure by operating would be equal to the short-run loss
 Number and relative sizes of the buyers and sellers in a suffered by not operating.
particular market.
A competitive market structure implies that the number of  *The Meaning of Competition*
buyers and sellers in a market is large enough that it is difficult, if - In economic analysis, the most important indicator of the degree
not impossible, for any one buyer or seller to determine the of competition is the ability of firms to control the price and use it
market price. as a competitive weapon.
- The extreme form of competition is perfect competition. Firms
Monopoly in this type of market are all price takers.
 A market in which there is only one seller for a
particular good or service. CHAPTER 10 MONOPOLISTIC COMPETITION AND OLIGOPOLY
 There may be legal barriers to entry into this type of Five Forces Model
market. - Developed by Michael Porter that shows the key factors
that affect the ability of a firm to earn an economic
MR=MC rule profit:
 a rule that states that if a firm desires to maximize its (1) Potential entrants;
economic profit, it must produce an amount of output (2) Bargaining power of suppliers;
whereby the marginal revenue received at this (3) Bargaining power of buyers;
particular level is equal to marginal cost. (4) Threat of substitute products or services; and
(5) Intra market rivalry.
Normal profit - Also referred to as the Porter Competitive Framework.
 An amount of profit earned in a particular endeavor
that is just equal to the profit that could be earned in a Game Theory
firm’s next-best alternative activity. - Formal mathematical approach to the study of how
 When a firm earns normal profit, its revenue is just individuals make decisions when they are aware that
enough to cover both its accounting cost and its their actions affect each other and each individuals
opportunity cost. takes this into account.

P= MC rule Kinked Demand

 - Theoretical construction that attempts to explain price - a collusive arrangement in oligopolistic markets.
rigidities (inflexibility) in oligopolistic markets. - Producers agree on unified pricing and production
actions to maximize profits and eliminate the rigors of
Monopolistic Competition competition.
- A market distinguished from perfect competition in that *Cartels may not flourish in all oligopolistic markets.*
each seller attempts to differentiate its product from Conditions that influences the formation of cartels:
those of its competitors. (1) The existence of a small number of large firms
- Example: can be found in small businesses, particularly facilitates the policing of a collusive agreement.
those in retail trade. (2) Geographical proximity of the firms is favorable
*It is a market in which there are many firms and relatively easy (3) Homogeneity of the products makes it impossible for
entry.* cartel participants to cheat on one another by
emphasizing product difference.
Mutual Interdependence (4) The role of general business conditions presents
- A situation in which each firm in the market sets a price somewhat contradictory arguments
based on its costs, price elasticity, and anticipated (5) Entry into the industry must be difficult.
reactions of its competitors. (6) If cost conditions for the cartel members are similar and
- This type of pricing situation prevails in oligopolistic profitability thus will not differ greatly among
markets. members, cartels will be easier to maintain.

Oligopoly Cost-plus pricing

- A market in which there is a small number of relatively - Also called full-cost pricing
large sellers. - A practice in which prices are calculated by adding a
- Pricing in this type of market is mutual markup to total cost.
interdependence among the sellers.
- Products may either be standardized or differentiated. Dominant Price Leadership
*Oligopoly firms have a more challenging task because of mutual - In an oligopolistic industry, a firm, usually the largest in
interdependence. However, if oligopoly firms are of sufficient size the industry, sets a price at which it will maximize its
or are very effective in differentiating their products, they may profits, allowing other firms to sell as much as they
not have as much competition from new entrants as those firms wish at that price.
operating in monopolistic competition.* *when an industry contains one company distinguished by its size
and economic power relative to other firms, the dominant price
Strategy leadership model emerges.*
- The means by which an organization uses its scarce
resources to relate to the competitive environment in a Multiproduct pricing
manner that is expected to achieve superior business - Pricing that reflects the interrelationship among
performance over the long run. multiple products of a firm that are substitutes or
complements.
Structure-Conduct-Performance (S-C-P) paradigm
- an approach to studying industrial economics that states Penetration pricing
that an industry’s structure determines an industry’s - A company charges a lower price than indicated by
conduct, which in turn affects the industry’s economic analysis in order to gain a foothold in the
performance. market.
- Key factors that shape industry structure are number of
firms in the industry, the conditions of entry and exit, Prestige pricing
and product differentiation. - A perception that charging a higher price will increase
quantity sold because of the prestige obtained by the
*The Reality of Monopolistic Competition and Oligopoly: buyer.
“Imperfect” Competition*
- In theory, the essential difference between monopolistic Price discrimination
competition and oligopoly are the ease of entry into the market, - A situation in which an identical product is sold in
the relative sizes of the sellers, and the presence of mutual different markets at different prices.
interdependence in the pricing of products. - Means one of the following:
(1) Products with identical costs are sold in different
Chapter 11 SPECIAL PRICING markets at different prices.
Barometric Price Leadership (2) The ration of price to marginal cost differs for similar
- In an oligopolistic industry, a situation in which one products.
firm, perceiving that demand and supply conditions *First-degree discrimination – exists when the seller can identify
warrant it, announces a price change, expecting that where each buyer lies on the demand curve and can charge each
other firms will follow. buyer the price he is willing to pay.

Baumol Model *Second-degree discrimination – although encountered

- a model hypothesizing that firms seek to maximize their somewhat more frequently than first degree, also is not
revenue subject to some minimum profit requirement. commonplace in real life. It involves differential prices charged
by blocks of services.
Cartel
*Third-degree discrimination – by far the most frequently
encountered. In this case, the monopolists segregates the Cost of capital
customers into different markets and charges different prices in - Also often referred to as the required rate of return, the
each. hurdle rate, or the cut-off rate
- The rate of return a company must earn on its assets to
Price Leadership justify the using and acquiring of funds.
- One company in an oligopolistic industry establishes the Cost of Debt
price, and the other companies follow. - Interest rate that must be paid on the debt.
- There is no formal or tacit agreement among the
oligopolists to keep prices at the same level or change Discount rate
them by the same amount. - Rate at which cash flows are discounted
- Two types of price leadership: barometric and - The required rate of return or cost of capital
dominant.
*When collusive agreement are not easily achieved, this practice Dividend growth model
will occur.* - A method to arrive at the value of a security
- Given the prize of the security, it calculates the
Price Skimming company’s cost of equity as the dividend divided by the
- The practice of charging a higher price than indicated by current stock price plus the growth rate in dividends
economic analysis when a company introduces a new - Alternative method to CAPM in calculating the equity
product and competition is weak. cost of capital

Psychological Pricing Free cash flow

- The practice of charging, for example, $9.95 rather than - Funds that are available for distribution to investors
$10 for a product in the belief that such pricing will - Includes operating cash flow after taxes minus (plus)
create the illusion of significantly lower price to the increases (decreases) in operating working capital and
consumer. fixed assets investment.

Transfer Pricing Types of Cash Flows:

- A method to correctly price a product as it is (1) Initial Cash Flows – cash flows occur at the inception of
transferred form one stage of production to the next. the project
(2) Operating Cash Flows – when a new project goes on
CHAPTER 13 CAPITAL BUDGETING line, it begins to generate cash inflows (revenue). Of
Accounting rate of return course, it also generates cash outflows (expenses and
- Also known as return on investment (ROI) or return on costs)
assets (ROA)
- a method for evaluating capital projects. Independent projects
- Obtained by dividing the average annual profit by - A situation in which the acceptance of one capital
average investment. project does not preclude the acceptance of another
project
Capital asset pricing model (CAPM)
- A financial model specifying relationships between risk Internal rate of return (IRR)
and return. - One method of evaluating capital projects by
- An important part of the CAPM is the development of discounting cash flows
beta, which measures the market risk of a security and - The interest rate that equates the present value of
is a necessary ingredient in determining a stock’s inflows with the present value of outflows, or, in other
required rate of return. words, causes the net present value of the project to
equal zero.
Capital budgeting
- An area of business decision making that concerns Mutually exclusive project
undertakings whose receipts and expenses continue - A situation in which the acceptance of one project
over a significant period of time. precludes the acceptance of another
Types of capital budgeting decisions:
(1) expansion of facilities Net present value (NPV)
(2) New or improved products - A method of evaluating capital projects in which all cash
(3) Replacement flows are discounted at the cost of capital to the
(4) Lease or buy present and the present value of all outflows is
(5) Make or buy subtracted from the present value of all inflows

Capital rationings Noncash investment

- The practice of restricting capital expenditures to a - Sometimes a new project involves an investment that
certain amount, possibly resulting in the rejection of does not require a cash flow.
projects that have a positive net present value and
should be accepted to maximize the company’s value. Payback
- A method of evaluating capital projects in which the
original investment is divided by the annual cash flow.
 - Tells management how many years it will take for a
project’s cash inflows to repay the original investment
Sensitivity analysis
Time value of money - a method for estimating project risk that involves
- means that a dollar today is worth more than a dollar identifying the key variables that affect results and then
tomorrow, because today’s dollar will earn interest and changing each variable to measure the impact.
increase in value
Simulation analysis
CHAPTER 14 CONCEPTS IN RISK AND UNCERTAINTY - a method that assigns a probability distribution to each
Certainty equivalent of the key variables and uses random numbers to
- a certain (risk-free) cash flow that would be acceptable simulate a set of possible outcomes to arrive at an
as opposed to the expected value of risky cash flow expected value or dispersion.

Coefficient of variation Standard deviation

- measure of risk relative to expected value that is used - the degree of dispersion of possible outcomes around
to compare standard deviations of projects with the mean outcome or expected value
unequal expected values - the square root of the weighted average of the squared
deviations of all possible outcomes from the expected
Decision tree value.
- a method used with sequential decision making in
which a diagram points out graphically the order in Uncertainty
which decisions must be made and compares the value - a situation in which there is no viable method of
of the various actions that can be undertaken. assigning probabilities to a future random events.

Expected value
- an average of all possible outcomes weighted by their
respective probabilities

Political risk
- an action by a foreign government that is detrimental to
the firm.
4 types of such action:
(1) Regulation – includes changes in taxes, labor law rules,
minimum wages, and price controls
(2) Discrimination – restrictions on the repatriation of
dividends, special labor conditions, tariff and nontariff
barriers, and imposition
(3) Expropriation – a government takes over foreign
property
(4) Wars and disorders – destruction of a firm’s property.

Probability
- an expression of the chance that a particular event will
occur

Probability distribution
- a distribution indicating that chances of all possible
occurrences.

Real option
- an opportunity to make adjustments in a capital
budgeting in response to changing circumstances
potentially resulting in improved results.

Risk
- a situation in which possible future events can be
defined and probabilities assigned.

Risk-adjusted discount rate (RADR)

- a value equal to the riskless (risk-free) interest rate plus
a risk premium
- the risk- free rate ideally is the pure time value of
money, and the risk premium represents a judgement
as to the additional return necessary to compensate for
additional risk.