Chapter 1
Question #4

What is the difference between economic profit and accounting profit? Why should managers focus mainly on economic profits? Why do you suppose managers often focus on accounting profits?

The biggest difference between accounting and economic profit is that accounting profit is based on verifiable historical data and does not take opportunity costs (time and capital) into account when determining the profit.

For example, Kobe Bryant might consider leaving his basketball career to start a lawn mowing business. Is this a smart choice? In accounting profit calculation, which omits opportunity costs, the lawn mowing business would look lucrative if he’s making big profit. Perhaps people might pay $100 an hour to have a celebrity athlete cut their lawn. However, in economic profit calculation, he must subtract the opportunity cost of about the $50M he would be making as a Laker (2012 annual earnings according to Forbes) to realize the profit of his lawn-mowing venture?

Management should focus mainly on economic profits because by factoring in the opportunity costs, it allows them to make the best decision to better allocate their resources of all other competitive alternatives. If they don’t, they could be choosing options that could prevent the firm from making more profit.

Managers often focus on accounting profit method because they are easy to obtain and are more commonly used to present the company performance to the investors.

Question #4

Is the prisoners’ dilemma always a Nash equilibrium? Is Nash equilibrium always a prisoners’ dilemma? Explain.

The Nash equilibrium states that NO participant can gain by a change of strategy as long as all the other participants remain unchanged. So the prisoner’s dilemma is always a Nash equilibrium.

On the other hand, Nash equilibrium is not always a prisoner’s dilemma because the Nash equilibrium looks at “collective interest” involving all parties.

Chapter 12
Question #2

Comment on the following: All of wisdom contained in the five-forces framework is reflected in the economic identity:
Profit = (Price – Average Cost) x Quantity

In one way or another, everything on the right side of the equation affects profit.

Buyer Power can affect Quantity and Price. If the buyer demand is high and there aren’t any subsidies, the price and quantity can be high which results in more profit. If the buyer demand is low or there are many sellers, the price has to be lowered and the business owner may lose customers to its competitors resulting in smaller profit.

Entry can affect the Price as well. If the entry barrier is low, there will be many competitors in the same market and the quantity of your sales will decrease resulting in smaller profit. The costs can be kept high in order to keep the entry barriers high.

Substitutes and Complements can affect the Price and Quantity. If there are many substitutes, the buyers don’t necessarily have to buy your products. Therefore, the quantity decreases and profits suffer. If the price of the complements goes up, the price of your product needs to be lowered and again the profits suffer.

Supplier Power can affect the Cost of a product. If the supplier power is high, you end up paying the supplier higher costs which can lower your profit.

Internal Rivalry can affect the Price and Quantity. Too much rivalry can affect your market share and price. If you have to lower your price and/or lose market share, your profit gets smaller.

A firm must carefully take all these things into account when developing their strategies or their position in the market to maximize their profitability.

Additional Problem

Mr. Romley is in direct competition with Mr. Obana, including price-cutting to gain market share. This is especially troublesome since the market demand is known to be price inelastic. Mr. Obana has decided to see if it is possible to enter into a cooperative agreement with Mr. Romley. He has asked you to analyze the prospects for such an agreement. You have calculated the payoffs if Mr. Romley and Mr. Obana cooperate in terms of pricing rather than if they get into a price war. You determine the following payoffs: If both Romley and Obana cooperate and maintain a high price, Romley will earn $25 million in profits and Obana will earn $20 million. If Romley lowers his price while Obana does not, Romley will earn $45 million in profits while Obana loses $10 million (that is to say, profits are negative $10 million). If Romley maintains his high price while Obana lowers his price, Romley will lose $10 million and Obana will earn $40 million. If both lower their prices, Romley will earn $5 million and Obana will earn $5 million.

a. Develop a payoff matrix for this situation.

| | Mr. Obana | | | Maintain Price | Lower Price | Mr. Romley | Maintain Price | 25 20 | -10 40 | | Lower Price | 45 -10 | 5 5 |

b. In the absence of a collusive agreement, do the players have dominant strategies? If so, what is the dominant strategy and what will be the results?

Yes, both the players have dominant strategies. A dominant strategy is a choice that is clearly better than the other choices. In this scenario, both Mr. Obana and Mr. Romley’s dominant strategy would be to lower their price.

c. Is there a prisoner’s dilemma? Explain why or why not.

Yes, there is a prisoner’s dilemma. They can both choose to maintain their price and earn $25M (Mr. Romley) and $20 (Mr. Obana) each. Even though they know what the globally optimal choice is, the dominant strategy forces them to lower their prices.