MBA Class of 2002
Micro-Economics
October-November 2000
Peter Swann
MANCHESTER BUSINESS SCHOOL
Lectures 9 and 10: Strategy
• Have learned about several economic tools
• How can we use these to explore the effects of
several aspects of strategy:
– on cost conditions?
– on demand conditions?
– on the competitive context?
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Lecture 9: Strategy Part I
Changing Costs and Preferences
• R&D, Investment, Process Innovation
– to reduce costs
– to replace labour intensive by capital intensive
– to increase economies of scope
• Product Innovation
– to increase demand
– to increase market share
– to increase market segmentation
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Lecture 9: Strategy Part I
Changing Costs and Preferences, cont...
• Advertising
– to increase demand
– to “reposition” product or service
– to signal commitment
• Building Switching Costs
– to lock in customers
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R&D, Process and Product Innovation
• Some definitions:
– Research
• Basic and Applied
– Development
– Invention
• Patents
– Innovation
• Process
• Product/Service
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R&D, Investment and Process Innovations
Reduce Costs
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Total Cost
Original Cost Curves (1)
Total Cost
Variable Cost
Fixed Cost
0
Quantity Produced
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Total Cost
Reduction in Fixed Costs
Total Cost
Variable Cost
Fixed Cost
0
Quantity Produced
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Total Cost
Original Cost Curves
Total Cost
Variable Cost
Fixed Cost
0
Quantity Produced
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Total Cost
Reduction in Marginal Costs
Total Cost
Variable Cost
Fixed Cost
0
Quantity Produced
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Unit Cost
Original Cost Curves (2)
Marginal Cost
[MC]
[AC]
Average Cost
0
Quantity Produced
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Unit Cost
Reduction in Fixed Costs
Marginal Cost
[MC]
[AC]
Average Cost
0
Quantity Produced
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Unit Cost
Original Cost Curves (2)
Marginal Cost
[MC]
[AC]
Average Cost
0
Quantity Produced
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Unit Cost
Reduction in Marginal Costs
Marginal Cost
[MC]
[AC]
Average Cost
0
Quantity Produced
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Product Choice By The Producer
Cost
Willingness To Pay
P2
0
Q1
Q2
Q3
Characteristic Score
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Reduction in Cost of Quality
Willingness To Pay
Cost
0
Characteristic Score
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Price
Demand and Supply
S
D
0
Quantity
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Price
Cost Reductions Shift Supply Curve Down
and to the Right
S
D
0
Quantity
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Replace Labour Intensive Process by Capital
Intensive Process
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Total Cost
Original Cost Curves (1)
Total Cost
Variable Cost
Fixed Cost
0
Quantity Produced
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Total Cost
Higher Fixed Costs - Lower Marginal Cost
Total Cost
Fixed Cost
Variable Cost
0
Quantity Produced
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Unit Cost
Original Cost Curves (2)
Marginal Cost
[MC]
[AC]
Average Cost
0
Quantity Produced
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Unit Cost
Higher Fixed Cost - Lower Marginal Cost
Marginal Cost
[MC]
[AC]
Average Cost
0
Quantity Produced
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Revenue, Cost, Profit
Original Diagram Showing Profit
Maximisation
Cost
Maximum Profit
Profit
0
Revenue
Quantity
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Revenue, Cost, Profit
Higher Fixed Cost - Lower Marginal Cost
Maximum Profit
Revenue
Cost
Profit
0
Quantity
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Price
Profit Maximisation
MR
Demand or AR
MC
0
Quantity
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Price
Reduction in Marginal Cost - Regardless of
Changes to Fixed Cost
MR
Demand or AR
MC
0
Quantity
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Price
Aggregate Supply Curve
Inelastic
Moderately
Elastic
Replacing labour
intensive by capital
intensive makes
supply more elastic
Very Elastic
0
Quantity
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Process Innovations to Increase Economies
of Scope
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Producer's Choice of Number of Brands
Costs And Revenues
Costs
Revenues
0
20
40
60
80
100
Number Of Brands
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Costs And Revenues
Increased Economies of Scope
Revenues
Costs
0
20
40
60
80
100
Number Of Brands
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Product Innovation to Increase Demand
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Price
Profit Maximisation
MR
Demand or AR
MC
0
Quantity
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Price
Product Innovation and Increased Demand
Demand or AR
MR
MC
0
Quantity
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Price
Price Elasticities of Demand
Very Elastic
Product Innovation
will sometimes also
make demand less
elastic
0
Moderately
Elastic
Inelastic
Quantity
Product Innovation to Increase Market Share
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Price and Willingness To Pay
Characteristics Diagram 2
C
B
A
Product
Innovation
Characteristic Score
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Product “Territories”:
Which Customers buy which products?
Not Quality
Conscious
A
0
B
C
D
E
F
G
Quality
Conscious
H
I
Slope of Customer’s WTP Line/Curve
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New Product “Territories”:
After Innovation in Product B
Not Quality
Conscious
A
0
B
C
B cuts deep into
C’s territory, but
only makes a
modest intrusion
into A’s territory
D
E
F
G
Quality
Conscious
H
I
Slope of Customer’s WTP Line/Curve
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Product Innovation to Increase Market
Segmentation
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Price
I
H
G
F
WTP
E
A
B
C
D
Quality
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Product “Territories”:
Which Customers buy which products?
Not Quality
Conscious
A
0
B
C
D
E
F
G
Quality
Conscious
H
I
Slope of Customer’s WTP Line/Curve
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Product Innovation / Proliferation to
Increase Segmentation
Not Quality
Conscious
0
Quality
Conscious
Slope of Customer’s WTP Line/Curve
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Price
Second Degree Price Discrimination
MC=AC
D=AR
0
Quantity
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Advertising: Some Definitions
• Informative
– Latent Demand - depends on consumers being
informed
• “Transformative” - Persuasive
– changes preferences
– changes perceived “position”
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Advertising to Increase Demand
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Price
Profit Maximisation
MR
Demand or AR
MC
0
Quantity
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Price
Advertising and Increased Demand
Demand or AR
MR
MC
0
Quantity
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Price
Price Elasticities of Demand
Very Elastic
Advertising can
sometimes also
make demand less
elastic
0
Moderately
Elastic
Inelastic
Quantity
Advertising to “Reposition” Product or
Service
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Consumption
of Product Y
Indifference Curves
When product Y is repositioned,
it takes less of Product Y to
deliver the same degree of
consumer satisfaction
Consumption
of Product X
Price and Willingness To Pay
Characteristics Diagram 2
C
B
A
Advertising to
Reposition
Product
Characteristic Score
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Advertising to Reposition Product
Network Externalities
Product 1
Increase perceived
network externalities
Product 2
0
Quality
Increase
perceived
quality
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Advertising to Signal Commitment
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Advertising to Signal Commitment
Perceived/Expected
Network Externalities
Product 1
Increase perceived
network externalities
Product 2
0
Quality
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Building Switching Costs to Lock in
Customers
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Price and Willingness To Pay
Characteristics Diagram 2
WTP before
C
B
A
WTP after
Switching costs
mean that changes
in the product or
service consumed
reduce utility
Characteristic Score
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Network Externalities
Switching Costs
Indifference
curve after
Product 1
Indifference
curve before
Product 2
0
Quality
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End of Lecture 9
•
•
•
•
Changing Costs and Preferences:
R&D, Investment, Process Innovation
Product Innovation
Advertising
Building Switching Costs
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Exercises on Strategy Topics
[for discussion at next session]
•
•
•
•
Advertising
Switching Costs
Innovative Pioneers
Product Proliferation and Entry Barriers
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Exercises from Last Session
[for discussion today]
• Repeated Games
• Cartels
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