Topic 1 - Value Creation and Capture - Full

RMIT Classification: Trusted
ECON 1268
Managerial and
Business Economics
Topic 1: Value creation &

capture
1
Topics for today's lecture . . .
1. Economics in business
2. Creating value
3. Buyer-seller bargaining
4. Competition
5. The law of one price
6. Competitive equilibrium
22
—
Economics in business
3
The economics toolkit: What problems

is economics best at solving?
Evaluating business decisions: Economics provides the most
comprehensive toolkit for evaluating the opportunity cost and
benefit associated with a decision.
The importance of incentives: Economics demonstrates how the
incentives people face drive their decisions.
Price formation: Economics explains how prices form in markets,
the relationship between prices and the competitive environment,
and the way in which prices respond to various events.
Strategic analysis: Economics uses game theory to analyse
markets in which each firm’s actions have a significant impact on the
profits of their rivals.
44
Definition: Positive analysis
Using objective, testable methods to describe the way the world is.
Positive economic analysis alone, cannot guide decision-

making as it does not inherently value one outcome over
another.
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Definition: Normative analysis
Determining the relative desirability of different courses of action

based on which will best achieve a desired outcome.
The question of `what you should do', naturally depends on

what it is you are trying to achieve.
66
Two perspectives for normative

analysis
In this course we will be particularly interested in the objectives of
business and government decision-makers.
Profit maximisation: We will typically assume that managers are
seeking to maximise the profits of their business (or equivalently, the
return to its owners).
Social welfare: An idealised view of a government's objective is that
it seeks to maximise thecombined welfare of all market participants;
businesses and consumers.
These descriptions of business and government objectives are
somewhat stylised. In reality, both business and government may
have additional objectives that need to be accounted for.
77
Discussion
1. Why should business students care about the social welfare

objectives of governments?
2. What are some other objectives that a business might pursue?
3. What are some other objectives that decision-makers in

government might pursue?
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—
Creating value
9
A simple exchange
David is looking to sell a rare painting by the early 20th century

Australian tonalist artist, Clarice Beckett.
• David values his painting at $20,000.
Bryn would like to add one of Beckett's works to his collection.
• Bryn values David's painting at $50,000.
Make a prediction: Will David sell his painting to Bryn? If so, what
price would you expect for the painting?
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Creating value
Value is created when a good or service is sold by a seller to a

buyer.
The amount of value created in the transaction is the buyer's
valuation for the good or service, minus the seller's valuation.
• Value created is also referred to as the gains from trade in the
economics literature.
• Value is measured in monetary units (such as dollars).
Key insight: In order for value to be created, a buyer must value a
good or service more than its seller.
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Quiz 1
How much value is created if David

sells his painting to Bryn?
a. $20,000
b. $30,000
c. $50,000
d. $70,000
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Value capture
The division of the value created, between the buyer and seller, is
determined by the price at which the transaction occurs.
• The seller's surplus is the price the seller receives minus the
seller's valuation.
• The buyer's surplus is the buyer's valuation minus the price the
buyer pays.
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Value capture (2)
Notice that the sum of the buyer and seller surpluses is equal to the
value created,
buyer surplus + seller surplus = (buyer valuation - price) + (price -

seller valuation) = buyer valuation - seller valuation
= value created
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Exercise: Capturing value
Suppose that Bryn purchases the

painting from David at a price of
$40,000.
•How much value does David
capture from the transaction?
•How much value does Bryn
capture?
Repeat the exercise for the prices
$20,000and $55,000.
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Exercise solutions
David's surplus is the price at which he sells the painting ($40,000)

less his valuation for the painting ($20,000),
David's surplus = $40,000 - $20,000 = $20,000:
Bryn's surplus is his valuation for the painting ($50,000) less the
price he pays for the painting ($40,000),
Bryn's surplus = $50,000 - $40,000 = $10,000.
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Exercise solutions cont.
If the price of the painting is $20,000 then the two surpluses are,
David's surplus = $20,000 - $20,000 = $0,
Bryn's surplus = $50,000 - $20,000 = $30,000.
If the price of the painting is $55,000 then the two surpluses are,
David's surplus = $55,000 - $20,000 = $35,000,
Bryn's surplus = $50,000 - $55,000 =-$5,000.
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—
Buyer-seller bargaining
18
Where do prices come from?
A central theme of this course is that the price at which a transaction

takes place depends on the competitive environment in which it
occurs.
In our example, there is no competition on either side of the market
as David is the only seller and Bryn is the only buyer. Therefore,
David and Bryn must bargain over the price.
To begin our analysis of bargaining we will identify the range of
prices that are feasible given that:
1. Both the buyer and the seller must agree to a price for a
transaction to take place.
2. A buyer or seller will only agree to a price if it is in their individual
interest to do so.
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Definition: Willingness-to-sell
The minimum price a seller is willing to accept for a good or service.
When the price of a good or service is equal to a seller's

willingness-to-sell they will be indifferent between selling and
exercising their outside option.
20
20
David's willingness-to-sell
If David does not agree to a price then his outside option is to keep
his painting.
• David would continue to enjoy the benefits of owning the painting
which he values at $20,000.
Conversely, if David agrees to a price then he gains the value of the
money he receives, but loses the value he derived from the painting.
• David's surplus from the transaction would be the price he
receives minus his $20,000 valuation for the painting.
David is better off selling the painting if the price is above his
valuation, and worse off if the price is below his valuation. Therefore,
his willingness-to-sell is equal to his valuation.
21
21
Definition: Willingness-to-pay
The maximum price a buyer is willing to pay for a good or service.
When the price of a good or service is equal to a buyer's

willingness-to-pay they will be indifferent between buying and
exercising their outside option.
22
22
Exercise: Bryn's willingness-to-pay
1. Would Bryn be willing to pay $55,000 for the painting? Explain

with reference to Bryn’s outside option. (Recall that Bryn values the
painting at $50,000.)
2. What is Bryn's willingness-to-pay? Explain.
3. What range of prices are feasible in the sense that both David and
Bryn are willing to accept them?
23
23
Exercise solutions
1.If Bryn does not purchase the painting then he gains no value from
the painting, but he keeps his money. His surplus would be equal to
$0, his outside option.
If Bryn purchases the painting for the price $55,000 then his surplus
is -$5,000 (see the previous exercise).
As this is worse than his outside option, Bryn would not be willing to
pay $55,000 for the painting.
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24
Exercise solutions cont.
2.Bryn has a positive surplus if he buys at a price that is less than his
valuation for the painting, and a negative surplus if the price is higher
than his valuation. Therefore, his willingness-to-pay will be equal to his
valuation of $50,000.
3.David will accept prices that are greater than or equal to $20,000.
Bryn will accept prices that are less than or equal to $50,000. This is
the range of feasible prices.
Key insight: A transaction is only feasible if the buyer's willingness-to-
pay is greater than (or equal to) the seller's willingness-to-sell.
(Equivalently, if the transaction creates value.)
25
25
Bargaining power
Within the range of feasible prices, the interests of the buyer and
seller are in tension.
•David (the seller) always prefers a higher price, while Bryn (the
buyer) always prefers a lower price.
The outcome of buyer-seller negotiations depends on a range of
idiosyncratic characteristics which may include:
•Patience: The longer a buyer or seller is willing to wait before
reaching an agreement, the more favourable the price is likely to be.
•Persuasion: A particularly persuasive buyer or seller may be able
to convince their counter part to accept a less favourable price.
26
26
—
Competition
27
Buyer-seller bargaining with 2 buyers
Suppose that along with Bryn a

second buyer, Ingrid, is also
interested in purchasing David's
painting.
• Ingrid values the painting at
$45,000.
Make a prediction: Who will
purchase David's painting, what is
the range of feasible prices, and
what is the value created?
28
28
Competition between buyers
Suppose that Ingrid offers David

$30,000 for the painting.
Bryn's willingness-to-pay is higher
than$30,000 so he will make a
counter-offer, say $35,000.
Likewise, $35,000 is less than
Ingrid’s willingness-to-pay so she
will come back with a new offer, say
$40,000.
Competition between Bryn and
Ingrid ends when the price exceeds
Ingrid’s willingness-to-pay.
29
29
Definition: Excluded buyer
Any buyer who misses out on purchasing a good due to limited

supply and low willingness-to-pay.
Excluded buyers have no effect on the value created in a

transaction, but may influence the division of that value between
buyer and seller.
30
30
Excluded buyers
Bryn will purchase David's painting

due to his higher valuation.
Ingrid is an excluded buyer.
The value created remains $30,000.
The range of feasible prices
becomes $45,000 to $50,000.
David is guaranteed $25,000 of the
value created, and bargains with
Bryn over the remaining $5,000.
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31
The value of excluded buyers to

sellers
Sellers benefit when there is competition between buyers for their
products.
• The price must be greater than the willingness-to-pay of each
excluded buyer.
• If the highest valuation of an excluded buyer is higher than the
seller's valuation then the seller is guaranteed to capture a part of
the value created.
• The seller is less reliant on bargaining power to capture value.
Example: Realestate agents try to have lots of bidders at an auction
even though they are only selling one property.
Example: Artists produce limited edition prints of their works to
ensure that buyers must compete for a copy.
32
32
Exercise: Competition between identical

buyers
Suppose that Ingrid valued David's
painting at $50,000 (the same as
Bryn’s valuation).
Who will purchase the painting?
What is the range of feasible
prices?
What is David's share of the
surplus?
33
33
Exercise solutions
Given that Bryn and Ingrid have the

same valuation, one will buy the
painting and the other will be
excluded.
The price cannot be greater than
the willingness-to-pay of the buyer,
and cannot be less than the
willingness-to-pay of the excluded
buyer.
Therefore, the price will be $50,000
and David will capture all of the
value created.
34
34
Buyer-seller bargaining with 2 sellers
Suppose that Andrea also has a

Painting by Clarice Beckett to sell.
• Andrea values her painting at
$35,000.
• Bryn values both paintings at
$50,000, but only want to
purchase one painting.
Make a prediction: Who will Bryn
purchase from, what is the range of
feasible prices, and what is the
value created?
35
35
Competition between sellers
David will sell his painting as he is

willing to accept a lower price.
• Andrea will be excluded.
The value created remains
$30,000.
Competition between sellers
ensures that the price will not be
greater than $35,000. (Why?)
Bryn is guaranteed $15,000 of
surplus, and bargains with David
over the remaining $15,000.
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36
The value of excluded sellers to

buyers
Buyers benefit when there is competition between sellers for their
purchases.
• The price must be less than the willingness-to-sell of each

excluded seller.
• If the lowest valuation of an excluded seller is lower than the

buyer's valuation then the buyer is guaranteed to capture a part of
the value created.
• The buyer is less reliant on bargaining power to capture value.
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37
The value of excluded sellers to

buyers (2)
Example: Many business have internal procurement policies
requiring them to obtain multiple quotes before purchasing from a
supplier.
Example: Major government contracts are put out to tender, eliciting

competing bids from multiple vendors.
38
38
—
The law of one price
39
Buyer-seller bargaining with 2 buyers and 2

sellers
Suppose that we have two people,
David and Andrea, with paintings to
sell.
And two buyers, Bryn and Ingrid,
interested in purchasing a painting.
Make a prediction: Which buyer
will trade with each seller, what is
the range of feasible prices for each
transaction, and what is the value
created?
40
40
Value created by 2 buyers and 2 sellers
Bryn has the highest buyer

valuation, and David has the lowest
seller valuation.
• If they trade they create $30,000
of value.
Ingrid's valuation is higher than
Andrea's.
• If they trade they create an
additional $10,000 of value.
The same total value is created if
Bryn buys from Andrea, and Ingrid
from David. (You should check this.)
41
41
Price interdependence
Even though Bryn and David are participating in a different

transaction to Ingrid and Andrea, the prices of the two transactions
are interdependent.
To see this, suppose that David and Bryn agree to the price $35,000,
and that Ingrid and Andrea agree to the price $40,000.
At first glance these prices appear to be feasible; the prices lie
between that willingness-to-pay and willingness-to-sell in each
transaction.
However, there is a counter-offer that could be made here, that will
increase the surpluses of the buyer and seller involved. Can you
spot it?
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42
Arbitrage in bargaining
Under the proposed prices, Ingrid

pays $40,000 and David receives
$35,000.
• David's surplus is $15,000.
• Ingrid's surplus is $5,000.
If, instead, Ingrid offers David a
price of $37,500, David's surplus
increases to $17,500, and Ingrid's
to $7,500.
Key insight: All transactions must
take place at the same price.
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43
Summary: Feasible prices
• All transactions must take place at the same price.

• The price must not be greater than the willingness-to-pay of all
included buyers.
• The price must not be greater than the willingness-to-sell of all
excluded sellers.
• The price must not be less than the willingness-to-sell of all
included sellers.
• The price must not be less than the willingness-to-pay of all
excluded buyers.
44
44
—
Competitive equilibrium
45
Constructing a demand curve
A demand curve shows the

relationship between the price of a
good and the quantity demanded
by buyers.
We can construct the demand
curve byordering buyer willingness-
to-pay from highest to lowest.
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46
Constructing a supply curve
A supply curve shows the

relationship between the price of a
good and the quantity supplied by
sellers.
We can construct the supply curve
by ordering seller willingness-to-sell
from lowest to highest.
Explain why three units will be
traded in this market?
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47
Quiz 2
What is the highest feasible price in

this market?
a. $25,000
b. $30,000
c. $35,000
d. $40,000
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48
Quiz 3
What is the lowest feasible price in

this market?
a. $25,000
b. $30,000
c. $35,000
d. $40,000
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49
Buyer and seller surpluses
The total value created in this

market is the area between the
demand curve and supply curve.
The market price divides this value
between buyers and sellers.
The area between the demand
curve and the price is the buyer
surplus (also known as consumer
surplus).
The area between the supply curve
and the price is the seller surplus
(also known as producer surplus).
50
50
Competitive markets
A competitive market is a market

with a large number of small buyers
and sellers, all trading similar goods
or services.
The market is in equilibrium when
the quantity supplied is equal to the
quantity demanded.
• This is called the equilibrium
quantity (Q*).
Key insight: The equilibrium
price (P*) is the unique feasible
price.
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51
Questions?
52
52
Quiz solutions
1. b
2. c
3. b
53
53

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Topic 1: Value creation &

Topics for today's lecture . . .

5. The law of one price

The economics toolkit: What problems

Definition: Positive analysis

Positive economic analysis alone, cannot guide decision-

Definition: Normative analysis

Determining the relative desirability of different courses of action

The question of `what you should do', naturally depends on

Two perspectives for normative

1. Why should business students care about the social welfare

2. What are some other objectives that a business might pursue?

3. What are some other objectives that decision-makers in

David is looking to sell a rare painting by the early 20th century

• David values his painting at $20,000.

Bryn would like to add one of Beckett's works to his collection.

• Bryn values David's painting at $50,000.

Value is created when a good or service is sold by a seller to a

How much value is created if David

Value capture (2)

buyer surplus + seller surplus = (buyer valuation - price) + (price -

Exercise: Capturing value

Suppose that Bryn purchases the

David's surplus is the price at which he sells the painting ($40,000)

David's surplus = $40,000 - $20,000 = $20,000:

Bryn's surplus = $50,000 - $40,000 = $10,000.

Exercise solutions cont.

David's surplus = $20,000 - $20,000 = $0,

Bryn's surplus = $50,000 - $20,000 = $30,000.

David's surplus = $55,000 - $20,000 = $35,000,

Bryn's surplus = $50,000 - $55,000 =-$5,000.

Where do prices come from?

A central theme of this course is that the price at which a transaction

The minimum price a seller is willing to accept for a good or service.

When the price of a good or service is equal to a seller's

The maximum price a buyer is willing to pay for a good or service.

When the price of a good or service is equal to a buyer's

Exercise: Bryn's willingness-to-pay

1. Would Bryn be willing to pay $55,000 for the painting? Explain

2. What is Bryn's willingness-to-pay? Explain.

Exercise solutions cont.

Buyer-seller bargaining with 2 buyers

Suppose that along with Bryn a

Competition between buyers

Suppose that Ingrid offers David

Definition: Excluded buyer

Any buyer who misses out on purchasing a good due to limited

Excluded buyers have no effect on the value created in a

Bryn will purchase David's painting

The value of excluded buyers to

Exercise: Competition between identical

Given that Bryn and Ingrid have the

Buyer-seller bargaining with 2 sellers

Suppose that Andrea also has a

Competition between sellers

David will sell his painting as he is

The value of excluded sellers to

• The price must be less than the willingness-to-sell of each

• If the lowest valuation of an excluded seller is lower than the

• The buyer is less reliant on bargaining power to capture value.

The value of excluded sellers to

Example: Major government contracts are put out to tender, eliciting