FINAL WIKI (weekly wiki posts can be found on the discussion tab) According to our text book, Managerial Economics and Business Strategy, a business should only shut down if their price per unit is less than the average variable cost. If the price per unit is greater than the average variable cost, then they should remain open. If a company were to continue producing items when the price is below the average variable cost, then they are losing money every time an item is produced. Please see the graph below for a visual aid. The area shaded pink represents when a company should shutdown or exit a market. In economic terms, they should shutdown when total revenue < variable cost and when price < average variable cost. The grey area represents the loss a company would experience if they were to shutdown; that is, when price > average variable cost. In the example above, the company should shutdown or exit their current market because price is below the average variable cost.
No company wants to experience this tough decision to remain open or to close the doors, but in today's economy, many companies face this daunting task. Below are a few examples of companies and industries facing that tough decision.
The first company up for discussion is Time Warner. They are just entering a new market and they are trying to figure out the best pricing scheme to 1) remain profitable 2) reach their target market share. Time Warner’s goal is to target a market share of 65% in the Kansas City Area. The company invested nearly $500 million to upgrade the infrastructure of the city so they could provide a full line of services including cable, broadband internet, and phone services. The $500 million is considered a sunk cost while variable operation costs consist of monthly, per subscriber programming of $32.50 and maintenance fees of $7.60. (Total variable monthly cost of $40.10).
Time Warner's largest competitor in the Kansas City market is Everest, a company who provides similar bundled services at a price of $84.95 per month. The key to Time Warner's success in this market is how they price their product since the two companies off almost identical product bundles. To best price their product, Time Warner first figured out what their average total cost is to determine at what price they lose profit. To figure out ATC, they first calculate the monthly average fixed costs. They came up with $10.85 per monthly subscriber. They also figured in the average variable costs which came to $40.10. Time Warner determined that they will be profitable at any price over $50.95, well below the current price of their competitor.
While profitability is non-existent at a price below $50.95, if hard times were to fall in the area, Time Warner should not exit the Kansas City market until their price falls below $40.10 per monthly subscriber. At any point between $50.95 and $40.10, the subscription costs would cover all of Time Warner's variable costs and a portion of its fixed costs. When the price falls below $40.10, the company would be losing more money than they would be making, thus causing for a detrimental business plan.
I did a bit of my own research to see how Time Warner priced their products. Currently, the bundle costs $89.99. That is slightly higher than Everest’s price in the case, but the price could be a bit dated. I was unable to find Everest’s pricing online. It appears as though Time Warner has earned a nice profit margin on the products it is offering.
The second industry that is facing the question of whether to stay in a market or leave is the mobile phone industry of Japan. One might think of Japan of having quite a bit of success in the global mobile phone market. However, in recent years, this apparent success may just be an appearance. Japan is actually losing its position in the global mobile phone market. There are few reasons for Japan's slipping numbers. The first is that the Japanese market is overly saturated. All major electronic firms make and sell mobile phones. This results in 11 different domestic phone manufacturers selling phones in a saturated market. They manufacture and sell phones as a sense of corporate pride; if they do not compete in the phone industry, they are considered weak. Most of them are losing money as a result of their company pride. Secondly, the Japanese focused on the domestic market at the expense of expanding internationally. Typically, the mobile operators design the features of the phone and the manufacturers must comply. This is easier to do in a domestic market than an international market. A few companies tried expanding, but were reluctantly pushed back. Thirdly, since the manufacturers designed products around the mobile operators needs, the special features are not always able to be used outside of the country. If the Japanese companies wanted to work with international markets, the cost would be higher and the margins would be lower, thus creating an unattractive business plan. Finally, high end customers who want sophisticated phones drive the Japanese market. However, the largest growth is found in the emerging markets, who are after cheap phones. In the hardware business, competition over price funnels down to scale: firms with high volume and produce products at a cheaper price. This causes a viscous circle for many of the Japanese companies. Because they are not selling to the emerging markets, their volume stays low which keeps prices high, which makes selling to emerging markets nearly impossible.
In recent years and months, some of the competing Japanese companies have dropped out of the mobile phone industry because the losses they were receiving were much more valuable than the corporate pride they found in selling phones. However, not all of the companies receiving losses have felt this way. To some, the corporate pride is more important than any losses they may come across.
After reading about the two different industries above, it made me wonder if companies are more prone to the daunting decision of staying open or shutting down. Does pride truly make a difference or is there more to it than that? Could the Japanese companies keep making the mobile phones because of their grand economies of scope? Throughout the time of doing research about this topic, I stumbled upon a research paper written by INSEAD that addressed a similar topic.
A study completed by INSEAD, a university in France, examined two hypotheses in market exit strategies: 1) “The higher the synergy, the less likely firms will exit a market.” 2) “The larger the retrenchment scope, the more likely firms will exit a market.” What exactly do these hypotheses mean? I believe the first hypothesis is in regards to companies who have high economies of scope. For example, they would be a diversified company who uses similar technologies and ideologies for each of its products. The second hypothesis is actually quite the opposite of the first. Retrenchment typically deals with downsizing and reorganizing to better make do with the resources that are available. This means that a company could decrease the breadth of product and reduce the number of employees. After taking a sample size of 657 markets, the y arrived at the following conclusions. A company is has a high level of synergy (economies of scope), they were 28% less likely to exit a market than the base case, a company who has neither a high synergy nor a large retrenchment scope. On the other hand, a company who has a large retrenchment scope is 20% more likely to exit a market than the base case.
In closing, I think companies that have large economies of scope are more likely to tough a loss in a certain market because their costs, not just fixed, but variable as well, are spread out amongst different areas of business. Again, no company ever wants to face this tough decision of staying open or shutting the doors. It is important for upper management to know how to access the situation. If they ask themselves is revenue < variable cost or is price < average variable cost? If the answer is yes to either, they need to shutdown. ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- WORKS CITED:
Baye, M. Managerial Economics and Business Strategy. 7. McGraw-Hill/Irwin, 2009. Print.
"Time Warner Cable." . Time Warner, n.d. Web. 5 Dec 2011. <http://www.timewarnercable.com/kansascity/>. ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- QUIZ QUESTIONS
1) When should a firm shutdown/exit the market?
2) When should a firm stay open?
3) According to the Time Warner case, at what price should Time Warner exit the market?
4) True or False: Sunk costs should be considered when make a shutdown decision?
5) In the graph above, what does the grey area and the pink area represent?
QUIZ ANSWERS AND EXPLANATIONS
1) A firm should shutdown exit when TR < VC or when P < AVC. If your price is not covering your average variable cost, then you are losing money on each product sold.
2) A firm should stay open when P > AVC. Although a profit is not being made, the company is not losing money on each product sent out the door.
3) $40.10. This is the point where P < AVC
4) False. Sunk costs are sunk costs. They should not effect future decisions.
5) The grey area represents how much a company would lose if they chose to shut down business. The pink area represents the loss the company would incur on each product sent out the door. Five Forces Summary
The Five Forces model was a management model conceived by Dr. Michael Porter. This model is used to analyze an industry by a potential entrant into the industry and can also be used to evaluate case studies concerning competitive advantage. The Five Forces consists of the following: competitive rivalry, threat from new entrants, threat from substitutes, bargaining power over buyers, and finally bargaining power over suppliers. This wiki then goes on to break down each of the Five Forces. Competitive rivalry refers to how many firms compete in an industry and how strongly they compete. The threat from new entrants refers to how easily a firm can successfully enter the market. This can be affected by many factors such as economies of scale and barriers to entry. The threat from substitutes refers to how differentiated a product may be. The more differentiated, the less likely there will be threats from substitutes. Bargaining power over buyers is based on how limited the choices are for the buyers and whether or not they would by a product. The final force, bargaining power over suppliers, refers to the strength of the firms that provide the goods a firm uses to produce its products. Comparative Advantage and Trade Summary
This wiki explained what comparative advantage is, examples of comparative advantage, and how do determine if you have a comparative advantage. The author had several definitions on comparative advantage, but in short, it is when a company experiences the lowest opportunity cost in producing a good. An example of this is Apple. This company usually gets something right the first time it tries, rather than the three times another company might try the same thing. This lowers Apple’s opportunity cost dramatically in comparison to its competitors. The wiki goes on to explain how a company knows if it has a comparative advantage. It says that Apple has a great design and excellent marketing capabilities. Couple this with the monetary success and Apple can clearly see it has a leg up on its competitors. Monopoly Summary
This wiki defines a monopoly, explains how to prevent monopolies, and shows examples of monopolies. The definition is a market structure in which on single firm serves the entire market, where there are no close substitutes. Four sources can create a monopoly power: economies of scale, economies of scope, cost complementary, and patents and other legal barriers. In 1890, the Sherman Antitrust Act was passed to help curb monopolies. This act was in response to price fixing and it helped to prevent firms from becoming a monopoly. The US DOJ Antitrust division helps to promote competition and aid in blocking monopolies. An example of a monopoly lies with Furukawa Electric Company. They were accused of and pleaded to guilty to price fixing and bid rigging involving the sale of parts to manufacturers. They were forcing these manufacturers to pay noncompetitive and high prices for the car parts. Risk Summary
This wiki broke down definitions for the following words: mean, variance, standard deviation, risk aversion, risk neutral, risk lover, and optimal search. The wiki says that risk is measured by mean, variance, and standard deviation. Mean is the average of a group of numbers. Variance measures how far a set of numbers are spread out from each other. Standard deviation shows how much variation there is from the average. Next the author examines types of risk. Risk aversion refers to people who shy away from risky situations. Risk Neutral is somewhere in the middle of a risk averse person and a risk lover. A risk lover loves the thrill of risk; they will choose an option with risk rather than something guaranteed because the higher the risk, the higher the pay out. Finally, there is optimal search. This helps find the optimal path and produces the best product by searching for it. Government Policies Summary
This wiki heavily focused on prohibition in the 1920s. Prohibition began because another source of tax began bringing in more money to the country than the liquor tax did. The government gave into the Puritans and made alcohol illegal. When prohibition was enacted, people were willing to pay more money for alcohol than before, so illegal suppliers entered the market. After the Great Depression hit, the income tax which was brining in 2/3 of the government’s money, began decreasing because not many had money. This is when Prohibition ended because the government needed a way to generate more money.
According to our text book, Managerial Economics and Business Strategy, a business should only shut down if their price per unit is less than the average variable cost. If the price per unit is greater than the average variable cost, then they should remain open. If a company were to continue producing items when the price is below the average variable cost, then they are losing money every time an item is produced. Please see the graph below for a visual aid.
The area shaded pink represents when a company should shutdown or exit a market. In economic terms, they should shutdown when total revenue < variable cost and when price < average variable cost. The grey area represents the loss a company would experience if they were to shutdown; that is, when price > average variable cost. In the example above, the company should shutdown or exit their current market because price is below the average variable cost.
No company wants to experience this tough decision to remain open or to close the doors, but in today's economy, many companies face this daunting task. Below are a few examples of companies and industries facing that tough decision.
The first company up for discussion is Time Warner. They are just entering a new market and they are trying to figure out the best pricing scheme to 1) remain profitable 2) reach their target market share. Time Warner’s goal is to target a market share of 65% in the Kansas City Area. The company invested nearly $500 million to upgrade the infrastructure of the city so they could provide a full line of services including cable, broadband internet, and phone services. The $500 million is considered a sunk cost while variable operation costs consist of monthly, per subscriber programming of $32.50 and maintenance fees of $7.60. (Total variable monthly cost of $40.10).
Time Warner's largest competitor in the Kansas City market is Everest, a company who provides similar bundled services at a price of $84.95 per month. The key to Time Warner's success in this market is how they price their product since the two companies off almost identical product bundles. To best price their product, Time Warner first figured out what their average total cost is to determine at what price they lose profit. To figure out ATC, they first calculate the monthly average fixed costs. They came up with $10.85 per monthly subscriber. They also figured in the average variable costs which came to $40.10. Time Warner determined that they will be profitable at any price over $50.95, well below the current price of their competitor.
While profitability is non-existent at a price below $50.95, if hard times were to fall in the area, Time Warner should not exit the Kansas City market until their price falls below $40.10 per monthly subscriber. At any point between $50.95 and $40.10, the subscription costs would cover all of Time Warner's variable costs and a portion of its fixed costs. When the price falls below $40.10, the company would be losing more money than they would be making, thus causing for a detrimental business plan.
I did a bit of my own research to see how Time Warner priced their products. Currently, the bundle costs $89.99. That is slightly higher than Everest’s price in the case, but the price could be a bit dated. I was unable to find Everest’s pricing online. It appears as though Time Warner has earned a nice profit margin on the products it is offering.
The second industry that is facing the question of whether to stay in a market or leave is the mobile phone industry of Japan. One might think of Japan of having quite a bit of success in the global mobile phone market. However, in recent years, this apparent success may just be an appearance. Japan is actually losing its position in the global mobile phone market. There are few reasons for Japan's slipping numbers. The first is that the Japanese market is overly saturated. All major electronic firms make and sell mobile phones. This results in 11 different domestic phone manufacturers selling phones in a saturated market. They manufacture and sell phones as a sense of corporate pride; if they do not compete in the phone industry, they are considered weak. Most of them are losing money as a result of their company pride. Secondly, the Japanese focused on the domestic market at the expense of expanding internationally. Typically, the mobile operators design the features of the phone and the manufacturers must comply. This is easier to do in a domestic market than an international market. A few companies tried expanding, but were reluctantly pushed back. Thirdly, since the manufacturers designed products around the mobile operators needs, the special features are not always able to be used outside of the country. If the Japanese companies wanted to work with international markets, the cost would be higher and the margins would be lower, thus creating an unattractive business plan. Finally, high end customers who want sophisticated phones drive the Japanese market. However, the largest growth is found in the emerging markets, who are after cheap phones. In the hardware business, competition over price funnels down to scale: firms with high volume and produce products at a cheaper price. This causes a viscous circle for many of the Japanese companies. Because they are not selling to the emerging markets, their volume stays low which keeps prices high, which makes selling to emerging markets nearly impossible.
In recent years and months, some of the competing Japanese companies have dropped out of the mobile phone industry because the losses they were receiving were much more valuable than the corporate pride they found in selling phones. However, not all of the companies receiving losses have felt this way. To some, the corporate pride is more important than any losses they may come across.
After reading about the two different industries above, it made me wonder if companies are more prone to the daunting decision of staying open or shutting down. Does pride truly make a difference or is there more to it than that? Could the Japanese companies keep making the mobile phones because of their grand economies of scope? Throughout the time of doing research about this topic, I stumbled upon a research paper written by INSEAD that addressed a similar topic.
A study completed by INSEAD, a university in France, examined two hypotheses in market exit strategies: 1) “The higher the synergy, the less likely firms will exit a market.” 2) “The larger the retrenchment scope, the more likely firms will exit a market.” What exactly do these hypotheses mean? I believe the first hypothesis is in regards to companies who have high economies of scope. For example, they would be a diversified company who uses similar technologies and ideologies for each of its products. The second hypothesis is actually quite the opposite of the first. Retrenchment typically deals with downsizing and reorganizing to better make do with the resources that are available. This means that a company could decrease the breadth of product and reduce the number of employees. After taking a sample size of 657 markets, the y arrived at the following conclusions. A company is has a high level of synergy (economies of scope), they were 28% less likely to exit a market than the base case, a company who has neither a high synergy nor a large retrenchment scope. On the other hand, a company who has a large retrenchment scope is 20% more likely to exit a market than the base case.
In closing, I think companies that have large economies of scope are more likely to tough a loss in a certain market because their costs, not just fixed, but variable as well, are spread out amongst different areas of business. Again, no company ever wants to face this tough decision of staying open or shutting the doors. It is important for upper management to know how to access the situation. If they ask themselves is revenue < variable cost or is price < average variable cost? If the answer is yes to either, they need to shutdown.
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
WORKS CITED:
Baye, M. Managerial Economics and Business Strategy. 7. McGraw-Hill/Irwin, 2009. Print.
Baye, M. The Shut Down Case Graph. 2009. Graphic. McGraw HillWeb. 5 Dec 2011. <
http://highered.mcgraw-hill.com/sites/0073375969/student_view0/index.html
"Dropped Call: Why Japan Lost the Mobile-Phone Wars." Economist. 07 05 2008: n. page. Print. http://www.economist.com/node/10830025.
Lee, Gwendolyn. "Relatedness and Market Exit." (2010): n. page. Web. 5 Dec. 2011. http://www.insead.edu/facultyresearch/research/doc.cfm?did=44320.
"Time Warner Cable." . Time Warner, n.d. Web. 5 Dec 2011. <http://www.timewarnercable.com/kansascity/>.
-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
QUIZ QUESTIONS
1) When should a firm shutdown/exit the market?
2) When should a firm stay open?
3) According to the Time Warner case, at what price should Time Warner exit the market?
4) True or False: Sunk costs should be considered when make a shutdown decision?
5) In the graph above, what does the grey area and the pink area represent?
QUIZ ANSWERS AND EXPLANATIONS
1) A firm should shutdown exit when TR < VC or when P < AVC. If your price is not covering your average variable cost, then you are losing money on each product sold.
2) A firm should stay open when P > AVC. Although a profit is not being made, the company is not losing money on each product sent out the door.
3) $40.10. This is the point where P < AVC
4) False. Sunk costs are sunk costs. They should not effect future decisions.
5) The grey area represents how much a company would lose if they chose to shut down business. The pink area represents the loss the company would incur on each product sent out the door.
Five Forces Summary
The Five Forces model was a management model conceived by Dr. Michael Porter. This model is used to analyze an industry by a potential entrant into the industry and can also be used to evaluate case studies concerning competitive advantage. The Five Forces consists of the following: competitive rivalry, threat from new entrants, threat from substitutes, bargaining power over buyers, and finally bargaining power over suppliers. This wiki then goes on to break down each of the Five Forces. Competitive rivalry refers to how many firms compete in an industry and how strongly they compete. The threat from new entrants refers to how easily a firm can successfully enter the market. This can be affected by many factors such as economies of scale and barriers to entry. The threat from substitutes refers to how differentiated a product may be. The more differentiated, the less likely there will be threats from substitutes. Bargaining power over buyers is based on how limited the choices are for the buyers and whether or not they would by a product. The final force, bargaining power over suppliers, refers to the strength of the firms that provide the goods a firm uses to produce its products.
Comparative Advantage and Trade Summary
This wiki explained what comparative advantage is, examples of comparative advantage, and how do determine if you have a comparative advantage. The author had several definitions on comparative advantage, but in short, it is when a company experiences the lowest opportunity cost in producing a good. An example of this is Apple. This company usually gets something right the first time it tries, rather than the three times another company might try the same thing. This lowers Apple’s opportunity cost dramatically in comparison to its competitors. The wiki goes on to explain how a company knows if it has a comparative advantage. It says that Apple has a great design and excellent marketing capabilities. Couple this with the monetary success and Apple can clearly see it has a leg up on its competitors.
Monopoly Summary
This wiki defines a monopoly, explains how to prevent monopolies, and shows examples of monopolies. The definition is a market structure in which on single firm serves the entire market, where there are no close substitutes. Four sources can create a monopoly power: economies of scale, economies of scope, cost complementary, and patents and other legal barriers. In 1890, the Sherman Antitrust Act was passed to help curb monopolies. This act was in response to price fixing and it helped to prevent firms from becoming a monopoly. The US DOJ Antitrust division helps to promote competition and aid in blocking monopolies. An example of a monopoly lies with Furukawa Electric Company. They were accused of and pleaded to guilty to price fixing and bid rigging involving the sale of parts to manufacturers. They were forcing these manufacturers to pay noncompetitive and high prices for the car parts.
Risk Summary
This wiki broke down definitions for the following words: mean, variance, standard deviation, risk aversion, risk neutral, risk lover, and optimal search. The wiki says that risk is measured by mean, variance, and standard deviation. Mean is the average of a group of numbers. Variance measures how far a set of numbers are spread out from each other. Standard deviation shows how much variation there is from the average. Next the author examines types of risk. Risk aversion refers to people who shy away from risky situations. Risk Neutral is somewhere in the middle of a risk averse person and a risk lover. A risk lover loves the thrill of risk; they will choose an option with risk rather than something guaranteed because the higher the risk, the higher the pay out. Finally, there is optimal search. This helps find the optimal path and produces the best product by searching for it.
Government Policies Summary
This wiki heavily focused on prohibition in the 1920s. Prohibition began because another source of tax began bringing in more money to the country than the liquor tax did. The government gave into the Puritans and made alcohol illegal. When prohibition was enacted, people were willing to pay more money for alcohol than before, so illegal suppliers entered the market. After the Great Depression hit, the income tax which was brining in 2/3 of the government’s money, began decreasing because not many had money. This is when Prohibition ended because the government needed a way to generate more money.