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Porter's 5 Forces (for sustainable industry profitability)
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1. Threat of substitute products and services 2. Threat of new entrants 3. Bargaining power of buyers 4. Bargaining power of suppliers 5. Level of competition in industry
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Production function
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maximum quantity of output that can produced from given amounts of various inputs (can be expressed in a graph, spreadsheet, etc)
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Inputs
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a resource or factor of production such as a raw material, labor skill or a piece of equipment that is employed in a production process
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Cobb-Douglas production function
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a particular type of mathematical model, known as multiplicative exponential function, used to represent the relationship between inputs and outputs
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Short run
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the period of time in which one or more of the resources employed in a production process is fixed or incapable of being varied
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Long run
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the period of time in which all resources employed in a production process can be varied
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Marginal product
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the incremental change in total output that can be obtained from the use of one or more unit of an input in the production process - while holding constant all other outputs
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Average product
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the ratio of total output to the amount of the variable input used in producing the output
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Network effects
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an exception to the law of diminishing returns that occurs when the installed base of a network product makes the efforts to acquire new customers increasingly more productive - more possible value for a new customer (LinkedIn or Facebook)
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Marginal Revenue Product
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the amount that an additional unit of the variable production input adds to total revenue (also known as marginal value added) -- defined as the value of the output that an additional unit of the variable input adds to the total revenue
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Marginal value added
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the amount by which potential sales revenue is increased as a result of employing an additional unit of variable input to increase output
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Marginal factor cost
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the amount the an additional unit of variable input adds to total cost
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Production isoquant
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a geometric curve or an algebraic function representing all the various combinations of the two inputs that can be used in producing a given quantity of output
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Marginal rate of technical substitution (MRTS)
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the rate at which one input may be substituted for another input in producing a given quantity of output
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Isocost Line
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the total cost of each possible input combination
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Production process
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a fixed proportions production relationship - inputs are combined in fixed proportion to obtain the output
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Allocative efficiency
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a measure of how closely production achieves the least-cost input mix or process, given the desired level of output
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Technical efficiency
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a measure of how closely production achieves maximum potential output given the input mix or process
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Overall production efficiency
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a measure of allocative and technical efficiency
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Returns to scale
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the proportionate increase in output that results from a given proportionate increase in all the inputs employed in the production process. *increasing returns to scale = output increases by more than amount of input, proportionally. long run increasing returns as production increases. Constant returns = exactly. *Output increases by a larger proportion than the increase of inputs
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Accounting costs
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concerned with identifying highly stable and predictable costs for financial reporting purposes - they define and measure cost by the known certain historical outlay of funds - price paid for a commodity or service inputs is a measure of accounting costs - interest paid to bond holders or lending institutions is used to measure accounting cost of funds to the borrower - explicit costs (labor, raw materials, supplies, rent, interest, utilities) (inventory valuation - would be acquisition cost)
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Economic costs
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concerned with measuring costs for decision making purposes - determine present and future costs of resources associated with various alternative courses of action (consideration of opportunities forgone - explicit costs AND opportunity costs (inventory valuation - would be replacement cost)
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Opportunity costs
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implicit of time and capital that has been invested into the business - value of a resource in its next-best alternative use. EX opportunity cost of owners time is measured by the most attractive salary offer that the owner could have if they worked for someone else
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Capital assets
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a durable input that depreciates with use, time and that wears out - production of s good or service that requires the use of a plant and equipment (Depreciation is a loss of asset value)
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Sunk cost
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a cost incurred regardless of the alternative action chosen in a decision making problem - Ex a lease payment that must be paid regardless of whether the company rents the unneeded wearhouse space ** Sunk costs should NOT be considered relevant costs because such costs are unavoidable, indecent of the course of action chosen
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Fixed costs
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the costs of inputs to the production process that are constant over the short run
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Cost function
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the relationship between cost and output - showing the minimum achievable cost of producing various quantities of output
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Variable input costs
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the costs of the variable inputs to the production process
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Marginal cost
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the incremental increase in total variable cost that results from a one-unit increase in output (U shaped for marginal and average costs - gains from specialization in the use of the variable input are inevitably followed by diminishing returns)
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Optimal Capacity Utilization (3 concepts)
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1. Optimal output for a given plant size: output rate that results in lowest average total cost for a given plant size
2. Optimal plant size for a given output rate: plant size that results in lowest average total cost for a given output
3. Optimal plant size: plant size that achieves minimum long-run average total cost
2. Optimal plant size for a given output rate: plant size that results in lowest average total cost for a given output
3. Optimal plant size: plant size that achieves minimum long-run average total cost
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Internal economies of scale
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Declining long run average fixed costs as the rate of output for a product, plant or firm is increased (the product level, the multi product plant level, or the firm level of operations)
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Learning Curve effect
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*** Leads to more output with the same amount of labor input -- Declining unit cost attributable to greater cumulative from longer production runs -- the amount of labor input required to produce another unit of output decreases as the cumulative volume of output rises
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External economies of scale / Volume discount
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1. lower average variable costs (not fixed) 2. volume discounts and learning curve depend upon cumulative output no matter how small the production throughput rate per time period -- Reduced variable cost attributable to larger purchase orders
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Diseconomies of scale (external) (internal) CON
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rising long run average total costs as the level of output is increased - 1. transportation costs 2. inflexible operations - problems often arise from delayed or faulty decisions and weakened or distorted managerial incentives -- External: higher input prices reflects an increase in higher unit costs; as industry expands in response to increase in market demand -- Internal: unit cost changes as rate of output increases
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Minimum efficient scale (MES)
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the smallest scale at which minimum costs per unit are attained
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Economies of scope
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whenever inputs can be shared in production of different products - EX: in airlines, cost of transporting both passengers and freight on a single airplane is less than the cost of using two airplanes to transport them separately - economies that exist whenever the cost of producing two or more products jointly by one plant is less than the cost of producing these products separately
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Engineering cost techniques
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an alternative way to estimate long run cost functions without using accounting cost data - using production data instead, this approach attempts to determine the least cost combination of labor, capital, equipment, etc required to produce various levels of output -- 1. easier to hold certain factors constant such as input prices, allowing one to isolate the effects on costs of changes in output 2. avoids some of the cost allocation and depreciation problems encountered when using accounting data
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Survivor technique
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classifying the firms in an industry by size and calculating the share of industry output coming from each size class over time - if the share decreases over time, then this size class is presumed to be relatively inefficient and to have higher average costs - an increasing share indicates that the size class is relatively efficient and has average lower costs *** big companies survive
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Break even analysis
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a calculation of the output level at which total contributions cover direct plus indirect fixed costs - 1. change the selling price to get TR > TC 2. substitute fixed costs for variable costs
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Contribution margin (or Marginal profit)
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the difference between price and variable cost per unit (P-VC) - revenue not used for variable costs so covers fixed costs
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Contribution analysis
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calculates whether sufficient gross operating profits result from the incremental sales attributable to the ad, new product, or promotion to offset the proposed increase in fixed cost - are the total contributions to cover fixed cost increased by an amount greater than the increase in direct fixed cost avoidable by the decision?
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Operating leverage
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the use of assets having fixed costs in an effort to increase expected returns - use of more fixed cost assets in exchanged for lower variable cost and higher margins
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Degree of operating leverage
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the percentage change in earnings before interest and taxes (EBIT) resulting from a given percentage change in sales (output) - change in sales earnings given a change in sales before taxes and interest *** a measure of how sensitive a firm's EBIT will be for a given change in sales
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Inherent business risk
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inherent variability of a firms EBIT - variability or uncertainty of sales / selling prices and variable costs - a firm with high fixed costs and stable sales will have a high DOL, stable EBIT and low business risk (i.e public utilities) - however high fixed cost but unstable sales means high business risk -
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Target markets
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what businesses one wants to enter and stay in (physical assets, Human Resources and intellectual property like patents and licenses can limit firms capabilities) > where in the value chain firm intends to create > how and when revenue will be realized > gross and net margins > value in network relationships > competitive strategy
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Industry analysis
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identifying industries in which it would be attractive to do business (assessment of strengths and weaknesses of a set of competitors)
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Sustainable competitive advantages
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difficult to imitate features of a company processes or products vs their competitors in a relative market
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Product differentiation strategy
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usually involves competing on capabilities, brand names or product endorsements - relies on differences in products or processes affecting perceived customer value - can command a price premium because of product image and successful branding
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Cost based strategy
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strategy that relies upon low cost operations, marketing or distribution - ie like Southwest Airlines with a focused cost strategy on point to point, medium distance, non stop routes
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Information technology strategy
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strategy that relies on IT capabilities - conducive to broad target market initiatives
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Relevant market (concentrated, fragmented, consolidated)
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a group of firms that interact with each other in a buyer-seller relationship - 1. Concentrated (majority of total sales occurring in the largest four firms) 2. Fragmented (market shares are uniformly small across many businesses) 3. Consolidated (market whose firms has declined through acquisition, merger and buyout)
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Pure competition (short run) (long run)
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1. large number of buyers and sellers, each of which owns a small portion of the totally industry output that a single buyer/seller cannot have a perceptible impact on the market 2. homogenous product produced by each firm with no product differentiation 3. complete knowledge of all relevant marketing information by all firms 4. free entry and exit from the market (minimal barriers to entry and exit) -- Short run: individual firm is a price taker because all of the other firms are perfect substitutes (may break even, make transitory profit - excess of normal returns to capital, or operate at a temporary loss ** MR = P, because each additional unit of sale is equal to price -- Long run: all inputs are free to vary so no distinction exists between fixed and variable costs. average cost will equal price
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Monopoly (short run) (long run) (limit pricing)
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market structure characterized by one firm producing a highly differentiated product in a market with significant barriers to entry - 1. Only one firm producing some specific product line 2. Low cross price elasticity, no close substitute products 3. No interdependent with other competitiors because firm in a monopolist in relevant market 4. Substantial barriers to entry and exit that prevent competition from entering the industry -- Short run: maximizing short run profits by setting MR = MC may not maximize long run profits. Keeping prices high in short run and earning monopoly profits encourages potential competitors to obtain a portion of these shares. (long term profits will decline this way) VS instead of charging short run profit maximizing price, monopoly might limit pricing where it charges a lower price that discourages entry into the industry. this means firm will forgo some of the short run profits in order to maintain monopoly status in long run ** should limit pricing if present value of discounting long run is higher than short run MR = MC
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Monopolistic Competition (short run) (long run)
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a market structure like pure competition, with the major distinction being the existence of a differentiated product - 1. a few dominant firms and a large number of competitive fringe firms 2. dominant firms selling products that are differentiated (real, perceived or imagined) 3. independent decision making by individual firms 4. Ease of entry and exit from market as a whole, but substantial barriers to effective entry among leading brands -- Short run: like pure competition, may or may not make profit, will set MR = MC to be optimal. as new firms enter, supply will increase and prices will fall so if profits are earned, it will not be for long -- Long run: will produce excess capacity, but MR = MC
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Oligopoly
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a market structure in which the number of firms is so small that the actions of any one firm are likely to have noticeable impacts on the other firms in the industry (interdependence between firms)(anticipated responses by other competitors may make a price change by the focal firm)
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Lemons Markets
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asymmetric information exchange leads to the low quality products and services driving out the higher quality products and services - sellers know more than buyers (seen in used car sales EX)
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Incomplete information
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uncertain knowledge of payoffs, choices, et. - uncertainty - leads to insurance markets, decision makers are sometimes uncertain - ***uncertain for all
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Asymmetric information
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unequal, dissimilar knowledge - I know something you don't - either the buyer or seller possess information that the other party cannot verify or to which the other party does not have access (i.e mail order computer parts)
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Search goods
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products and services whose quality can be detected through market search
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Experience goods
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products and services whose quality is undetectable when purchased - cannot be observed at point of purchase
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Adverse selection
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a limited choice of lower quality alternatives attributable to asymmetric information - motivated by rational seller in experience good market - because sellers can anticipate low offers from buyers, sellers never produce high quality goods so market for experience goods will be incomplete - bad apples drive out the good ones *** solutions: reliance relationships or hostage mechanisms
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Reliance relationships
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long-term, mutual beneficial agreements, often informal - solution to adverse selection - escrow account or surety bond
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Hostage / bonding mechanism
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a procedure for establishing trust by pledging valuable property contingent on your nonperformance of an agreement - necessary to induce unregulated asymmetric information exchange - ** buyers must be convinced that fraud is more costly to the seller than the cost of delivering the promised product quality - I.E a product warranty - or brand name reputations
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Non redeployable assets (Asset specificity)
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assets whose value in second best use is near zero (firm specific input like Ethan Allen show room or Cadillac) -- highly specific assets make the best hostages to convince customers that asymmetric information transactions will be non fraudulent -- Asset specificity: difference in value between first best and second best use)
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Value proposition
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all effective business plans begin with this - a statement of the specific source of perceived value, the value drivers, for customers in a target market (functionality, exceeds customer expectations, can warrant a price premium)
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Gross profit margin
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Revenue minus the sum variable cost plus direct fixed cost, also known as direct costs of goods sold in manufacturing
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Regulated monopolies
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Public utilities (electric power, natural gas, communications, etc) are regulated by government as these regulations set prices, control entry into the business, influence total profits that may be earned by firms
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Natural Monopoly
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an industry in which maximum economic efficiency is obtained when the firm produces, distributes and transmits all of the commodity or service produced in that industry. Increasing returns to scale throughout the relevant range of output. *** a single supplier tends to emerge because of a production process characterized by massive economies of scale
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The threat of substitutes (Porters 5 Forces)
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- depends upon the number and closeness of substitutes as determined by brand naming, product development, strategies of pre existing competitors, etc. - Complements in consumption can be a source of network effects which raises sustainable profitability - when threat of substitutes is high, industry profitability suffers, substitute products put a ceiling on prices ***Threat of substitutes is high if: it offers an attractive price-performance trade-off to the industry's product, buyers cost of switching is low
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The threat of entry (Porters 5 Forces)
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- depends upon height of barriers to potential entrants including capital requirements, economies of scale, absolute cost advantages, switching costs, access to distribution, etc and other difficult to imitate forms of product differentiation - New entrants bring new capacity that puts pressure on prices and cost that's necessary to compete - puts a cap on the profit potential of an industry, if entryy barriers are low than new comers can expect little retaliation from the entrenched competitors **Barriers to entry: 1. Supply side economies of scale (larger firms can spread fixed costs across more units) 2. Demand side benefits of scale (network effects, willingness to pay for a company product rises with the number of people buying it) 3. Customer switching costs (fixed costs that customers face when they change suppliers) 4. Capital requirements (need to invest larger financial resources in order to compete) 5. Incumbency advantage independent of size (cost or quality advantages not available to potential rivals) 6. Unequal access to distribution channels 7. Restrictive government policy (can hinder or aid new entry directly, can amplify or nullify the entry barriers)
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The bargaining power of Buyers (Porters 5 Forces)
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- depends on number, size distribution, relationship between industry capacity and industry demand, uniqueness of inputs, *ability of buyers to influence the setting of industry standard, and the extent of which each party has to outside alternatives *Powerful buyers can force down prices, demand better quality, play industry participants against one another - particularly powerful if they have negotiating leverage if: there are few buyers, industry products are undifferentiated and buyers believe they can find equivalent elsewhere, buyers face few switching costs, can product industry product themselves, if a large portion of their cost structure they will shop around and bargain hard, if they are strapped for cash, if quality of buyers product is little affected by suppliers product, if does not pay for itself than the buyer will fight on cost rather than quality
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The bargaining power of Suppliers (Porters 5 Forces)
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- capture more of the value for themselves by charging higher prices, limiting quality or shifting costs to industry participants - can squeeze profitability out of an industry that cannot pass cost onto their own customers ** Suppliers are powerful when: more concentrated than the industry it sells to, does depend heavily on the industry it sells to for its revenue, industry participants face switching costs in switching suppliers, offer products that are differentiated, no substitutes, will induce new suppliers to enter markets so industry participants don't make too much money
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The intensity of rivalry (Porters 5 Forces)
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depends upon number and size of sellers in relevant market, the frequency of price vs non price competition, switching costs, proportion of fixed to total costs, barriers to exit, growth rate of industry demand and incumbent's speed of adjustment - high rivalry limited the profitability of an industry, depends on the intensity and basis in which they compete** Intensity of rivalry is greatest if: competitors are numerous and roughly equal in size or power, exit barriers are high, rivals are highly committed to the business and have leadership aspirations, firms cannot read each others signals well *Rivalry is especially destructive to profitability if it gravitates solely to price - sustained price competition trains customers to pay less attention to product features and services
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Price competition (threat of rivals) (Porters 5 Forces)
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most liable to occur if: 1. products of rivals are identical and there are few switching costs 2. Fixed costs are high and marginal costs are low (encourages customers to cut prices below average costs to steal customers) 3. capacity must be expanded in large increments to be efficient 4. product is perishable
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Market Performance
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Producers of goods and services that: 1. allocate resources efficiently 2. develop and quickly adopt new technologies that will result in lower costs, improved quality or greater product diversity 3. operate in a manner that encourages full employment
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Market Conduct
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Influences Market performance: 1. Pricing behavior 2. Product decisions 3. Sales promotions and advertising policies 4. Research, development and innovation strategies
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Market Structure
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1. The degree of buyer and seller concentration 2. The degree of objective or perceived differentiation 3. The conditions surrounding entry
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Contestable market
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easily accessible to potential entrants and easy to exit because capital investments are fully deployable to alternative uses (i.e trucks, information, etc)
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The Sherman Act (1890)
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Makes monopolizing a market illegal
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The Clayton Act (1914)
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Anticompetitive business practices 1. Price discrimination (illegal at wholesale) 2. exclusive dealing and tying contracts 3. Antimerger (cannot acquire two or more competing firms) 4. Interlocking directorates (same person cannot be on board of two or more firms)
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The Robinson-Patman Act (1936)
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Prohibits any form of price discrimination that has the effect of reducing competition among wholesalers or retailers - cannot provide secret rebates to one customer and not another
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The Hart Scott Rodino Antitrust Improvement act (1976)
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requires companies with assets over $100 million to provide notification and information concerning any merger to the DOJ and Federal Trade Commission - within 30 days the agencies can challenger the merger in court or let it be
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Collusion and Price Fixing
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Activities in which multiple companies agree to charge a set price for a good that is above market value - also market sharing agreements are per se illegal *** meaning they are illegal whether they cause harm or not
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Market Concentration Ratio
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percentage of total industry share / output produced by the 4, 8, 20 or 50 largest firms
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Herfindahl - Hirschmann Index
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a measure of market concentration equal to the sum of the market shares of the firms in a given industry (HHI greater than 2,500 = gov is likely to challenge the merger that increases the index by 100 to 200 points more( (HHI between 1,500 - 2,500 = merger challenge unlikely unless index increases by 200 points or more) (HHI index below 2,500 = merger challenge unlikely)
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Capital Expenditure
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a cash outlay designed to generate a flow of future cash benefits over a period of time extending beyond one year
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Capital Budgeting (Process)
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the process of planning for and evaluating capital expenditures - assets replacement, expansion decisions, R and r, investments in employee education, leave vs buy etc - 1. generate alternative capital investment project proposals 2. estimate cash flows for the project proposal 3. evaluate and choose investment projects to implement 4. review the investment projects after they have been implemented to assure assumptions were accurate ***cash flows should be measured on an incremental basis, after tax, indirect effects should be included, sunk costs should not be, should be measured by opportunity costs
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Internal Rate of Return
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the discount rate that equates the present value of the stream of net cash flows from a project with the project's net investment - **a project should be accepted if the IRR is greater than or equal to the firm's required rate of return (cost of capital), if not the project should be rejected (estimates profitability of projects)
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Net Present Value
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the present value of the stream of net cash flows resulting from a project, discounted at the required rate of return (cost of capital), minus the project's net investment (difference between inflows and outflows) ** project should be accepted if NPV is greater than or equal to 0, rejected if less than 0 (positive NPV translates directly into stock prices and shareholder wealth)
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Cost of Capital
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the cost of funds that are supplied to a firm. the cost of capital is the minimum rate of return that must be earned on new investments undertaken by a firm (debt, common stock, etc) ** what the firm has to pay for the capital it uses to finance new investments - required rate of return by investors in the firm's securities
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Cost-benefit analysis (social discount rate) (constraints)
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**should be used in public and not for profit sector - resource allocation model that can be used by public and not for profit sector organizations to evaluate programs or investments on the basis of the magnitude of the discounted benefits and costs (comparison of benefits vs cost) -- Social discount rate: discount rate to be used when evaluating benefits and costs from public sector investments -- Constraints: 1. physical 2. legal 3. administrative 4. distributional 5. political 6. financial 7. religious
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Benefit-cost ratio
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ratio of the present value of the benefits from a project or program (discounted at the social discount rate_ to the present value of the costs (similarly discounted) ** accept if equal to present value of the benefits divided by present value of costs greater than or equal to 1
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Cost-effectiveness analysis
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a toll used to assist public decision makers in their resource allocation decisions when benefits cannot be easily measured in terms of dollars but costs can be monetarily quantified (least cost studies and objective level studies - estimate the costs of achieving several alternative performance levels of the same objective)
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Cartel (factors for successful collusion)
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a formal or informal agreement among firms in an oligopolistic industry that influences such issues as prices, total industry output, market shares and division of profits -- 1. Number and size distribution of sellers 2. product heterogeneity (differentiation) 3. cost structures 4. size and frequency of orders 5. threat of retaliation 6. percentage of external output
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Price Leadership (Barometric) (Dominant Firm Price Leadership)
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a pricing strategy followed in many oligopolistic industries. one firm announces all new price changes by either an explicit or implicit agreement and other firms in the industry regularly follow the pricing moves of the leader -- Barometric: one firm announces a change in price they hope the others will follow, not necessarily the leader, but needs to be right in interpretation of demand change **they initiate a reaction to changing market conditions -- Dominant: is leader because of larger size, customer loyalty or lower cost structure, can act as a monopolist in its segment of the market
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