WEEK 12

REVIEW & REVISION GUIDANCE

THEORY OF THE FIRM
PART A

WEEKS 8-11 REVIEW

(FOR WEEKS 1-6 REVIEW SEE
WEEK 7 REVIEW LECTURE)
 3

LECTURE 8 – ADVERTISING & BRANDING

Firms decide:
• Product Mix (range of products), will produce range because
of:
• Cost complementarities - mainly economies of scope
• Demand interdependencies - e.g. goods sold together or
after-sale items
• Product attributes (characteristics of products), product
differentiation is:
• Horizontal – different attributes of similar value e.g. product
in different colours
• Vertical – implies quality ranking, i.e. creating basic and
luxury versions
• Firms may establish a brand to help certify quality, consistency,
and uniqueness and also support “conspicuous consumption” (if
a luxury product).
• Powerful brand can be a source of competitive advantage
 4
ADVERTISING
The purpose of advertising is to increase sales revenue by:
1. Increasing demand (by shifting Demand Curve out so more
demanded at each price)
2. Increase Price at current output – by decreasing price
elasticity
It does this in 2 ways:
P • Informs – objective
P2 information about the product
attributes (market expansion
effect; beneficial for
consumers)
• Persuades – manipulating
P1 consumers perceptions of the
product attributes, i.e.
D2 reduces cross-price elasticity,
(merely re-distributive,
D1
harmful for consumers if
reinforcing market power)
Q1 Q3
O Q
ADVERTISING BY TYPE OF GOOD 5

• Earl & Wakeley say consumers have an information problem

(Price, quality, fit-for-purpose determine achievable surplus)
• Nelson distinguished between types of goods:
• Search goods (characteristics can be evaluated before purchase)
– advertising tends to be informational.
• Experience goods (can only effectively assess after experience of
consuming – advertising tends to be persuasive.
• He argues advertising will be higher for experience goods (only
source of information and volume signals quality)
• Also for frequently purchased, lower-priced and non-durable goods
• Credence goods evaluation is difficult even after purchase and
may be affected by beliefs (e.g. medical services, vitamins etc.)
• Search-Experience dichotomy less important for producer
goods, less advertising because fewer, more informed buyers.
• Stigler argues that customer turnover is important – more
advertising is needed if consumers frequently enter & leave the
market (e.g. market for nappies).
 6
ADVERTISING BY TYPE OF GOOD
• Doyle argues that goods that are relatively cheap goods don’t lead to
much search activity, advertising will be persuasive kind.
• A similar argument can be made for goods which are difficult to
appraise against alternatives, e.g. consumer durables.
• Davis et al (1991) – develops Nelson’s analysis further with 4
categories of consumer goods (with increasing advertising):
• Search goods - least intensively advertised as consumer searches
• Goods where experience is of little value – e.g. new cars, consumer
durables bought rarely
• Short-term experience goods – e.g. foods consumer decides quickly if
they like them and will buy again
• Long-term experience goods - e.g. shampoo, cat food, require repeat
purchase to evaluation, so will have the highest intensities as must
persuade the consumer.
• At the extremes - Goods purchased VERY frequently have low
advertising intensities because of low customer turnover & familiarity;
But also, goods purchased only once (or very seldom) tend to have
low advertising intensity
• Markets which have a high degree of innovation have high
advertising intensity so as to keep the customer well informed
SELLER CONCENTRATION EFFECTS 7

ON ADVERTISING INTENSITY
Variables:
  A – is the advertising expenditure
PQ – is the revenue (i.e. Price * Quantity)
εA – is the price elasticity of advertising
εP – is the price elasticity of demand
 8
ADVERTISING BUDGETS:
PRACTICAL METHODS
1. Percentage of Sales approach:
• The budget at pre-determined percentage of past or
anticipated sales.
2. All-you-can afford approach:
• The firm spends up to the limit of its cash resources.
3. Competitive Parity approach:
• Spend the same percentage of sales, or percentage of
assets (or some such variable).
4. Objective and task approach:
• In other methods, budget is determined before other
aspects (such as geographic area, the medium of
advertising etc.) This method reverses the trend.
Each method has advantages and disadvantages, can you
describe these?
 9

LECTURE 9 – LIMITATIONS OF NEOCLASSICAL THEORY

Standard theory of the firm is for a Single Period Profit

Maximising Firm. Modern theory extends this to long run.
 is both an holistic and an optimising model.

But we make assumptions that may not in reality exist:

1. Perfect market assumptions:
• Firms are price-takers (have no market power)
• Homogeneous products
2. Perfect information (knowledge about prices etc.)
3. Firm knows its MC & MR curves (optimum MC=MR)
4. “black box” production (inputs predict outputs)
5. Firm wishes to maximize profits (what about managers!?)
 10
MANAGERIAL THEORIES
5 Main theories:
• Fundamental model - The PRINCIPAL-AGENT model – separation of
ownership and control means agents may persue own goals at the
expense of the principal’s.
• Baumol’s SALES REVENUE MAXIMISATION model – when targets,
salary, status are attached to sales revenue, managers will maximise
this instead of profit, ie produce where MR=0 instead of where MR=MC
• Marris’ GROWTH MAXIMISATION theory – because salaries, status
etc. Depend on firm size, managers will pursue growth beyond optimal
for profit.
• Williamson’s MANAGERIAL UTILITY MAXIMISATION theory -
Manager’s maximise THEIR utility, via expenditure on Staff; Perks and
discretionary investments (e.g. advertising).
• Cyert & March’s BEHAVIOURAL THEORIES – managers must
manage a coalition of different interest groups, easier if there is some
‘slack’ to offset between them.
Can you discuss and explain each and consider their limitations?
Can you identify and calculate Agency cost?
 11
MANAGERIAL CONSTRAINTS
There are both internal and external constraints on
managerial behaviour:

5 Sources of external constraints:

1. External holders of shares
2. People acquiring shares
3. Bidders in take-overs
4. Debtors/Investors
5. Regulators/Auditors
 12
INTERNAL
CONSTRAINTS
1. HIERARCHICAL MONITORING
• Non-executive directors
• Shareholders
• Stakeholders
2. MANAGERIAL REMUNERATION
3. MANAGERIAL REPUTATION
• MARKET CURTAILMENT OF AGENCY COSTS
• DEBT-BONDING

Can you discuss and explain each?

 13
LECTURE 10 – GROWTH
ANSOFF MATRIX
Ansoff Matrix shows alternative directions for development

(a) Related developments (b) Related (c) Unrelated

diversification diversification
PRODUCT
Present New Backward
Financial
Market Product
New Present

Penetration Development
MARKET

Skills
[1] [2]
Horizontal
Market Diversification Risk
Development (see b and c)
[3] [4] etc.
Forward

Can you discuss each of these? Can you identify types of

development in a given case study?
 14
GROWTH
The ability to grow will be affected by a number of factors,
the more important of which are:
1. Availability of funds (Retained profits (most important
source); Shares sales; debt finance)
2. The availability of suitable opportunities
3. The availability/quality of management

Two methods by which firms grow:

• 1. Internal growth
• Horizontal expansion
• Vertical integration
• Conglomeration
• 2. External Growth
• Mergers & Acquisitions
Can you describe each
of these types of growth
and the differences
(advantages/
disadvantages) of each
 15
ECONOMIC THEORIES
OF MERGER ACTIVITY
The basic premise is that for some reason the assets
must be worth more to the buyer than the seller for the
merger to take place.

THEORIES ON MERGERS:
1. VALUATION DISCREPANCY HYPOTHESIS
2. VALUATION RATIO
3. MARKET POWER
4. ECONOMIES OF SCALE
5. MANAGERIAL THEORIES

Can you describe and compare each of these?

 16
LECTURE 11 – We have literally
just done this – so
MULTINATIONALS I’m not going to
go through it now!

MNCs can be:

• Horizontally integrated
• Vertically integrated
• Conglomerate
Entry can be Equity (new subsidiary – wholly owned or
joint venture, Aquisition) or non-equity (licensing,
franchising)
2 methods of Measurement & Ranking:
1. Foreign assets amount under MNE’s control OR
2. Transnationality Index (average of foreign assets/total
assets, foreign sales/total sales and foreign
employment/total employment)
 17
WHY BECOME A MNC?
Why become a MNC?
 Higher/more secure profits in Long Run

a. Cost-orientated MNC - reduce costs of production by

integrating vertically to benefit from cheap labour and inputs.
b. Market orientated MNC – promise of new markets (horizontal)
c. Extend product Life Cycle
d. Hymers theorem – ‘dual purpose’ oligoply behaviour

Problems faced by MNCs:

• Language/Cultural barriers/differences
• Selling/Marketing strategies
• Attitudes of Host Government
• Communications/Co-ordination
 18
THEORIES OF MNE
Dunning’s Eclectic (or OLI) Theory
• Theory is based on the advantages gained by O-L-I:
O - Ownership Advantages
L - Location Advantages
I - Internalisation Advantages

 Predictions of the Eclectic Paradigm of mode of entry:

Can you identify and discuss advantages under each of

these headings?
 19
ADVANTAGES & DISADVANTAGES
TO HOST COUNTRY
Advantages to Host Nation:
• Employment increase (possibly)
• Balance of Payments boon (possibly)
• Technology Transfer
• Taxation revenue

Disadvantages to Host Nation:

• Uncertainty – potentially MNE may go elsewhere
• Control – large company ‘bargaining power’.
• Environmental & welfare concerns – large firms may
purposely exploit less stringent laws.
• Exploitative Transfer Pricing – NME can exploit profit
from low tax countries.
 20
GLOBAL FDI TRENDS
Capital Arbitrage Theory suggests:
• FDI flows from countries where profitability is low to high.
• Some inherent weaknesses – doesn’t fit evidence

FDI grown rapidly in post war period assisted by what

Griffiths and Wall call enabling technologies:
1. Improved communications
2. globalisation of consumer markets
3. new types of organisational design
In addition there have been other broad influences:
4. Sustained increase in competitive pressures associated with
international competition, in part fostered by the opening up
of markets to trade and competition worldwide.
5. The rapid economic development of some developing
countries
6. The creation of the Single European Market.
 21

QUESTIONS?
Either:

Or:

Question / Discussion Board

PART B

ANSWERING SECTION B
WRITTEN QUESTIONS IN THE
FINAL EXAM
ABOUT THE FINAL
EXAM IN JANUARY!
The final exam is 50% MCQ + 50% Written answer
• There are 20 MCQs spread from across the 10 topics.
• You may choose 2 from 4 options for the written
answer, these are also spread from across the 10
topics – roughly 2 questions from first part of course
and 2 from the second (remember there are
overlaps!)

This means revision is a game of 2 halves!...

TIPS FOR REVISION
Focus on the following materials
• Week 7 and 12 revision lectures
• Summarize the topics
• Other lectures
• Textbooks
• Seminar materials
• The problems and solutions were specifically designed to help you with revising
• Mock exams
• Structure, solutions
• Practice and homework assignments
• Book chapter end review questions
Revise the whole syllabus
• Different topics build strongly on each other, good answers for the exam questions
require an understanding of the different topics and the links between them
• For lecture weeks 8-11 materials are sourced from MORE THAN ONE TEXTBOOK
• The Sloman text is great for explanation of economic ‘models’ & diagrams
HOWEVER, as stated in the Module Handbook, doesn’t cover the whole
syllabus. For example growth – it considers the neoclassical reasons for
growth i.e. reaching M.E.S. but not others!

24
04/13/2023
ECON 354
TIPS FOR REVISION -
EXAM
16 January, 2 hour exam time, on campus
• It is a closed-book 2-hour exam, so when revising focus on understanding key
notions, ideas, big picture and links, and remember any formulae.
• Try and answer seminar questions without looking at the books/notes, and in 25-30
mins max.
• Be able to draw/ explain all diagrams
• Don’t limit answers to the materials covered in one topic week
• 2-3 mins per MCQ (Pick any graded assignment and try to complete it in 30 mins)
• For the structure, see mock exams in Exam resources
• 70% of final score
• No word limit, but
• Write briefly (may use bullet points etc if low on time)
• Very welcome to include figures, any ways you like (extra points)
• Academic dishonesty is not acceptable

25
04/13/2023
ECON 354
TIPS FOR REVISION -
EXAM
Tips
• Make sure to explicitly refer to the concepts and theories we
learned about
• But apply them to the problem at hand specifically, rather than
describe them abstractly
• Use perspectives from different weeks, if possible
• Make your arguments and assumptions clear
• Don’t have to reference external resources
• This probably goes without saying, but don’t try and learn
slides full of statistics – they are there to paint a picture of
markets.
TIPS FOR REVISION -
EXAM
• Example: The firm has not decided yet about what pricing
and marketing strategy to apply when it introduces
generation 7 (fold-up) X. Please discuss these options and
the factors that should be taken into account.
• You need to consider the pricing strategies we covered
• So ”price discrimination” and rather than ”low pricing for
innovative products”
• Pleas use the correct terms “2nd degree price
discrimination” rather than “type-2 price differentiation"
• It is not enough to list all the pricing strategies available
• You need to chose the relevant ones: for example
“predatory pricing” is not relevant
MCQS (50%)

• The MCQ section tests for general knowledge of

the course
• It generally tests for definitions, diagrams,
equilibrium conditions and whether you have fully
understood them.
• You have practiced them in the practice and
graded homework assignments.
Tips for good section B answers:
1. Make sure you can draw/ explain the main diagrams.
2. Be sure you can give good definitions and find or explain
equilibrium conditions.
3. You should be able to answer any of the tutorial questions if they
came up in an exam or something like them. If you skimped on
preparation for the tutorials – you will have to catch up – as
nothing was ‘wasted’ in our tutorial sessions. They were focused
on analytical skills and examples
4. PLEASE DO NOT ASK ME WHICH TOPICS TO REVISE. I’ll only
say “revise the whole syllabus”.
REVISION TIPS
A 4-step process:
1. Refer to the lecture notes to fill out any gaps in your
knowledge prompted by the outline ‘leapfrog’ slides
• This probably goes without saying, but don’t try and
learn slides full of statistics – they are there to paint a
picture of markets.
2. For lecture weeks 8-11 materials are sourced from
MORE THAN ONE TEXTBOOK!
• The Sloman text is great for explanation of economic
‘models’ & diagrams HOWEVER, as stated in the
Module Handbook, doesn’t cover the whole syllabus.
For example growth – it considers the neoclassical
reasons for growth i.e. reaching M.E.S. but not others!
3. Use the tutorial questions as practice for planning out
detailed answers within different topics.
• Be able to draw/ explain all diagrams
• Don’t limit answers to the materials covered in one
topic week
4. Put yourself in an examiner’s shoes – go through topics
and ask yourself questions…
• For example Lecture 1 mainly covers ‘the
economic problem’ and ‘the nature of the firm’.
• What questions could you be asked here?
You will note, it’s all the same things you would bring up
even though you could be asked ‘different’ questions!
EXAMPLES OF PART B
EXAM QUESTIONS
Lecture 1
• The scope of firms – whether they are big/ small or
have large scope (undertake lots of activities) or small
(focus on one output), is according to Coase based on
how well markets work or don’t - mainly due to
transaction costs.
• Why businesses structure themselves the way they do
– the main alternatives being U-Form and M-Form and
the pros and cons of each of these.
Lecture 2
• You could be asked an analysis question for a
demand curve, calculate total demand, total revenue
and the elasticities for any elements. (See tutorial 1)
• You could be asked to explain the usefulness of
demand forecasting using regression analysis and its
limitations.
• You could be asked to explain the concept of different
types of elasticities (explaining diagrammatically and
with equations)
• You could be asked to explain the characteristics
approach to demand (and it’s usefulness) or apply it
in an example. (see tutorial 1)
Lecture 3
• Be able to analyse a given cost and profit situation,
this can be diagrammatically or via equations. You
should be able to sketch curves (as in tutorial 2).
• Explain/discuss where firms obtain cost advantages.
Lecture 4
• Explain industry dynamics with diagrams (demand
and supply equilibriums) and/or equations. (see
tutorial)
• Explain the features of the 4 defined market
structures, focusing on any of them e.g. Perfect
competition versus imperfect competition (or
oligopoly – linked to lecture 5 this could consider the
structure-conduct-performance paradigm). You should
be able to sketch diagrams.
Lecture 5
• Explain the oligopolists problem – including price
competition, non-price competition (avoiding
advertising wars) – and Porter’s generic strategies.
• Explain Porter’s 5 forces analysis (with examples –
see lectures) as well as apply it to a case study. (see
tutorial)
• (As mentioned in lecture 4 – consider the Structure-
conduct-performance paradigm and why it’s useful.)
Lecture 6
• Discuss different types of pricing in practice with
examples.
• Consideration of the product life cycle (linked to other
lectures – e.g. advertising).

Lecture 7
REMEMBER LECTURE 7 WAS A REVIEW SO NO
ADDITIONAL TOPIC!
Lecture 8
• Consider the consumer problem of information –
and define ‘search’, ‘experience’ and ‘credence’ goods
and services and explore their competitive implications.
• Consider the impact of advertising (i.e. Purpose) and
Define and calculate advertising elasticity and aply the
Dorfman Steiner condition for ‘optimal’ advertising.
(see tutorial)
• Consider optimal advertising over the product life
cycle (see tutorial)
• Consider practical methods for advertising budgets.
Lecture 9
• Explain and explore the implications of the separation
of ownership from control (the principal-agent
problem).
• Explain alternative models to neoclassical economic
theories of the firm – i.e. managerial & behavioural
theories to illuminate managers’ potentially risky and
self-serving behaviour.
• Examine alternative constraints and approaches for
containing managers (behaviour) from furthering their
own interests at the expense of shareholders.
Lecture 10
• Explain the reasons firms pursue growth and the
different types of growth and diversification strategy
• Which factors determine different types of growth
strategies
• Explain different means of effecting growth (Ansoff’s
matrix)
• Critically assess merger activity as a means of
achieving growth.
Lecture 11
• Define MNE and the different forms and explain why
firms become an MNE (advantages and
disadvantages)
• Apply Dunning’s Eclectic (OLI) model to describe the
optimal form of entry into a market.
GOOD LUCK AND BEST WISHES

MAYURI

Happy
holidays!