Econ 106I (Galles) – Lecture 3 (January 26^th, 2005)

Game theory only works in simple situations with few variables.

Alchian likes game theory because it formalizes the idea of “it depends” as an answer to general questions.

Profit maximization does not make sense

Every form of maximization does not make sense under uncertainty

Luck versus skill

(p 27) Alchian’s approach is more powerful

Everything you could really do with standard approaches, you can still do

Now you know what you can and cannot do

It is consistent with evidence in the real world

Is the standard approach of profit maximization consistent with the fact that there is disagreement among managers? No. Alchian’s approach is, however.

Is random behavior consistent with Alchian’s model? Yes. Is it consistent with the standard model? No.

(pp 28-29) What replaces profit maximization? What is a necessary condition to survive? Positive profits. Is it an equilibrium condition? Not necessarily. It might be impossible to achieve positive profits.

What replaces the equilibrium condition? Modes of behavior.

Policy equilibria – want to maintain superiority and prevent inferiority by imitating that which others do better.

Pay attention to the alertness requirement to do this. This is why managers are required.

Management books – what might I lose by NOT purchasing these books? Others might become more competitive if they read it and I don’t.

Why do they fall out of favor quickly? They do not have any real content.

When are they published? At the pinnacle of the manager’s success. But the same thing that works for the author might not work elsewhere.

Managers are paid for judgment, not for being right.

What variable do firms pick in the standard model? Only quantity. Price is magically generated.

Can your firm control how much it successfully sells? No, unless you are on an organized exchange, in which case you can pick Q.

You need to construct policies for pricing, delivery terms, financing, quality, marketing, labor policy, reputation.

(p 42) Footnote 5: Assumption of perfect market. Assumption of organized exchange with everything standardized.

Paul the king of big screen – biggest seller of big screen Mitsubishi TVs.

Delivery policy: Free delivery for Southern California within four hours

Who buys them? Men

When do they buy them? Right before big games.

Would this work for 13” black and white TVs? Probably not.

Paul must have low prices in order to be able to compete and be able to pay for his 44 person shipping crew.

Uses “end of model year” marketing

I will match anyone’s price for this model

But he buys all of the models at the end of the year, so no one else can possibly match his price.

What from this is relevant for other businesses? Not much due to his unique situation.

What is equilibrium? No incentive to change any policy variable.

Should you advertise a lot? Depends

(p 29, top) Why do firms consistently look at average cost when they “should” be looking at marginal cost?

Profit should be greater than zero. This is equivalent to “Total revenue should exceed total cost.” If they estimate Q* and divide both sides by this Q*, then they have the condition that, in order to have positive profits, price should be greater than average cost. This is consistent with positive profits as a goal.

Quantity discounts and price discrimination

Need secrecy when it comes to deals – otherwise, everyone will expect to get the same deal, which will affect my other sales and hence my average revenues.

Why do we assume only marginal cost matters? We assume everything sells itself.

Price discrimination and large numbers. What is the cost of going elsewhere? Search costs.

Standard model assumes no search costs.

Want to pick a good strategy that is hard to imitate.

Gives a sustainable advantage.

Prices, for example, are too easy to imitate.

Levitz – might choose to give away free furniture with purchase instead of a discount, since they have an advantage in that they purchase in large quantities.

(p 29) Why do people imitate patterns of action observable in past successes? 6 items are listed on the page:

Uncertainty about the future – variability of environment

Many policy variables.

Each variable is interdependent.

Uncertainty about results of certain policies and others’ policies.

Relative superiority is important.

No trial-and-error process which converges to optimum

Imitation reduces choice making costs and liability from wrong choices

These choice costs are not in our models.

MBA programs do case studies to teach judgment

Read every footnote in Klein, Crawford, Alchian

(p 33) Footnote 15:

Models start with given knowledge. What if you are venturing into an area with no knowledge?

Economic approach to information: Acquire information as long as benefits outweigh costs

How do you know the benefits or costs in a world of uncertainty?

Alchian – search costs (Chapter 2)

Standard model assumes these away

Is it legitimate to use misleading models?

Model airplane to test flight ability – don’t need seats

Model airplane to train stewardesses – don’t need the wings

What if we use the wrong model in the wrong place?

If we assume away things that are not important, it is okay.

If we assume away important things, it is not okay.

(p 55-56) Economists force everything into a model

Why do economists fit everything into monopoly models?

Since some power is exercised over some variables.

What if search costs are really the problem?

Idle resources

Natural rate of unemployment in macro models.

No unemployment in micro models.

(p 37 bottom) Are there shortages, surpluses, unemployment, queues, non-price rationing, price stabilization in competitive models? No. Maybe these are important factors with respect to search costs.

(p 38) Unemployed resources – not necessarily inefficient.

Economizing on search costs

(p 38 and following) How to achieve equilibrium price in competitive models? Our models are institution free. How do institutions affect the results?

(p 39 middle) Core theoretical issue – marketing

What if you are not selling on an organized exchange?

Marketing – search for buyers and sellers

Communication about characteristics of items (intensive search)

Contract information – terms of the deal

Contract enforcement

Why do repossessors exist?

Buffer inventories, etc.

Why might we want to stabilize prices? Saves search costs

Inventories ensure that one can make good on promises of prices.

How many things disappear when we assume an organized exchange?

Eliminates barriers to entry

There are always informational barriers to entry

College degrees eliminate barriers to entry

Reputational effects

Eliminates price policies

Assumes only quantity policies

Eliminates price discrimination

Assumes zero search costs, which would imply no price discrimination

Large numbers are not a reason to assume away price discrimination

Quantity discounts and corn example

Eliminates geography

With geography, one can charge more since there are travel costs

Eliminates inability to sell

Eliminates the need to keep inventories

Suppose demand is either D or D’. Pick Q. Then there is only uncertainty about what price to sell at, not what Q to produce.

What if we pick P instead? Then there is uncertainty about what Q to produce. Therefore, inventories may become necessary.

**Diagram**

**Diagram**

Excess capacity? Ability to create more. Plays the role of inventories

Trade-off between excess capacity and inventories

Eliminates the need for excess capacity.

No uncertainty about what Q to produce

Take restaurants for example

No free entry. Thus, we cannot get to monopolistic competition equilibrium

Peak-load concerns. Should I have a bigger restaurant if some parts of the day are really busy even when other times of the day are not?

Can’t expand/contract capacity quickly.

Might it be cheaper to have excess capacity than to deal with the alternative?

Consider the tractor at night example.

Eliminates search cost reduction techniques – marketing

Marketing issues and policy. We don’t know what is the most effective

No need to advertise in Russia with no brand names, etc.

What if I can tell how good a commodity is before I buy it and use it? Won’t I use a different strategy here?

Eliminates reputation and reliability issues

Everyone is the same.

Eliminates differences among transactors

Anonymity

The seller sells to the organized exchange and the buyer buys from the organized exchange.

Eliminating the middleman gets rid of anonymity

Reputation effects

Do I know you will pay? Do I know you will deliver?

All competition on organized exchanges involve common knowledge prices.

Competition between middlemen

This is why markets clear – incentives to maximize transactions fees. Thus, they would maximize transactions.

Implication that markets clear is lost when these middlemen are eliminated

New products and innovation

Eliminated by organized exchange.

Why are there so few organized exchanges?

You need a large number of transactions

Disqualifies a lot of things

You need a standardize-able product

You need a place where buyers and sellers are in close proximity to each other. Dominant direction of trade flows

Alchian – “Why money?” – zero search cost good

Monetary policy and counterfeiting increases search costs with respect to money.

Disequilibrium behavior

Auctions – competition to transact

Only the middlemen are out of equilibrium in standard model.

But they are not shown in the model

Does history matter? Do yesterday’s prices matter?

Yes. If you are the first to raise your price, then you get the blame of raising prices.

Does it matter which way you change prices?

Can’t force others to raise prices.

Can force others to lower prices.

Why might you worry about lowering prices?

Competitors might follow and then you might not be able to raise them back up.

No secret price cuts on an organized exchange.

You sell people stuff sequentially in the real world, not at the same time.

This allows for possibility of secrecy

Alert policy equilibrium – not necessary to be alert in an organized exchange.

These assumptions eliminate every single thing that managers deal with

Why is maximizing short run profits the same as maximizing present value profits on an organized exchange?

No future consequences due to anonymity.

Eliminating the exchange allows for reputation effects.

Maximizing short run profits is no longer the same as maximizing present value of profits.

Is it easier to build or trash a reputation?

Even in a monopoly model, you only pick Q, which assumes an organized exchange. (Always assumed when Q is the only choice variable)

**Diagram**

The longer you search, the higher the “best offer” will probably be.

Why do middlemen arise? They have lower search costs.

Why might you accept voluntary unemployment as specialization in search?

**Diagram**

(p 44) Price stability, etc.

Price changing can increase search costs. Consider the “taking someone out to dinner” example.

You value knowing exactly how much something costs

Stabilizing prices reduces risk of making mistakes that are costly

How can I ensure that I can back up my stabilized prices?

Excess capacity and inventory. (Heat lamps are an example of inventory in the fast food industry)

What is the lowest cost way of stabilizing prices?

Might be lines

Might be inventory

Might be excess capacity

Who has cheaper travel times – you or a doctor? Why, then did doctors used to do house calls? They used to have low incomes.

Who travels now? Doctors have high incomes and are more productive in hospitals now.

Newsboy and newspapers

Inventories and price stability ensure customers keep coming

Coase next week

Read Chapter 3 Alchian

Read Chapter 9 Alchian (pages 241-243)