Behavioural Theories of the Firm (Behavioural Economics)

As a response to the question from Yousuf last week, here is the simplest explanation (and all you need to know) on why firms organisational decision making.

Behavioural theories of the firm consider alternatives to profit maximisation as a business objective. 

Behavioural economists believe that large businesses are complex organisations made up of many different stakeholders.

Stakeholders are groups made up of people who each have a vested interest in the activity of a business. Examples include:

• Managers employed by a business and other employees
• Shareholders are people who have a stake in a business
• Customers
• The government and its agencies

Each group of stakeholders will have different objectives or goals. 

The dominant group at any moment can focus on their own objectives. For example price and output decisions may be taken at a local level by managers, with shareholders taking only a distant view of the company's performance and strategy.

Examples of alternatives to profit maximisation

Satisficing behaviour 

This happens when businesses aim for minimum acceptable levels of achievement in terms of revenue and profit.

Read more on satisficing behaviour

Sales (output) maximisation

Selling as much as you can without making a loss. At sales maximisation there are normal profits or no supernormal profits.

Sales (revenue) maximisation

The objective of maximising sales revenue rather than profits was developed by economist William Baumol whose work focused on the behaviour of manager-controlled businesses.

• Annual salaries and perks are linked to sales revenue rather than profits
• Companies geared towards maximising revenue are likely to make frequent use of price discrimination to extract extra revenue and marginal profit from consumers
• A business might also aim to maximise sales revenue rather than profits because it wishes to deter the entry of new firms
• If a firm decides to aim to maximise sales revenue rather than profits, one of the consequences might be a reduction in the price of the firm's shares since the rate of profit is likely to be lower

Read more about sales maximisation as a business objective

Managerial Satisfaction Model

If a firm's managers are looking to maximise revenue rather than profit, this will lead to a different price and output combination.

Assuming that the firm's costs remain the same, a firm will choose a lower price and supply a higher output when sales revenue maximisation is the main objective.

Consumer surplus is higher with sales revenue maximisation because output is higher and price is lower. Producer surplus is greater when profits are maximised.

Non-Price competition & why it is important for oligopolies

Non-price competition involves advertising and marketing strategies to increase consumer demand and develop brand loyalty.

Businesses will use other policies to increase market share:

• Better quality of customer service including guaranteed delivery times for consumers and low-cost servicing agreements, good after-sales service
• Longer opening hours for retailers, 24 hour online customer support.
• Discounts on product upgrades when they become available in the market.
• Contractual relationships with suppliers - for example the system of tied houses for pubs and contractual agreements with franchises (offering exclusive distribution agreements). For example, Apple has signed exclusive distribution agreements with T-Mobile of Germany, Orange in France and O2 in the UK for the iPhone. The agreements give Apple 10 percent of sales from phone calls and data transfers made over the devices

Brands and Non Price Competition Brands provide clarity and guidance for choices made by companies, consumers, investors and other stakeholders. They embody a core promise of values and benefits consistently delivered and provide the signposts needed to make decisions

BOGOF techniques – buy one, get one free tactics

1. Loyalty cards, free delivery, online ordering, free gifts, guarantees
2. Location of stores and outlets and also the types of outlets that they operate e.g. local convenience compared to hypermarkets

Advertising spending runs in millions of pounds for many firms. Some businesses apply a profit maximising rule to their marketing strategies. A promotional campaign is profitable if the marginal revenue from extra sales exceeds the marginal cost of the campaign and supplying an increase in output. However, it is not always easy to measure accurately the incremental sales arising from a campaign.

Other businesses see advertising as a way of increasing revenue. If persuasive advertising leads to an outward shift in demand, consumers are willing to pay more for each unit consumed. This increases the consumer surplus that a business might extract.

High spending on marketing is important for new business start-ups and for firms trying to break into an existing market where there is consumer or brand loyalty to the existing products in

Brand loyalty

• A brand name is a name used to distinguish one product from its competitors

• It can apply to a single product, an entire product range, or even a company (e.g. Virgin, Ferrari, Bang and Olufsen)

• Brand loyalty is hugely important. The costs of acquiring a new customer vastly outweigh the expense of selling more to existing buyers

• When brand loyalty is strong, cross-price elasticity of demand for price changes between two substitutes weakens and fewer consumers will switch their demand when there is a change in relative prices in the market.

• Robust brand loyalty makes it easier to charge premium prices and earn supernormal profits because loyalty is a barrier to entry.

• When we become strongly attached to a brand, our purchasing decisions are more likely to stay in default mode and we may no longer even consider rival products.

Competitiveness – a key to success in an oligopoly

Traditionally, the main measures of competitiveness are in financial or marketing terms. For example, a competitive business might be expected to achieve one or more of the following:

• A higher growth rate (sales, revenues) than competitors and the market as a whole
• Higher-than average net profit margin (compared with others in the same industry)
• Better than average returns on investment – again, compared with competitors
• A high (perhaps leading) market share – measured in either value or volume terms. The leading firms in a market usually enjoy a significant proportion of the available revenues or customer demand, unless the market is highly fragmented.
• The strongest brand reputation in the market – e.g. brand awareness
• A clearly defined unique selling point ("USP") that enables the business to differentiate its product or service in the eyes of customers
• Significant access to, or control of, distribution channels in the market (e.g. products or brands that are widely stocked or demanded by intermediaries who provide distribution to the final consumers)
• Better product quality – e.g. reliability, product features, performance
• Better customer service – e.g. after-sales support, customer information, handling of problems & complaints
• Better than average efficiency – e.g. being able to produce at a lower unit cost than most other competitors, either though better productivity or economies of scale

IF SUCCESSFUL, HOW WILL NON-PRICE STRATEGIES AFFECT THE IMPERFECTLY COMPETITIVE MARKET DIAGRAM??

Regulations (Government Intervention)

Regulations are a form of government intervention in markets - there are many examples we can use:

Examples include:

• Laws on minimum age for buying cigarettes and alcohol
• The Competition Act which penalizes businesses found guilty of price fixing cartels
• Statutory national minimum wage
• A new law in Scotland banning under-18s from using sun-beds
• Equal Pay Act and acts preventing other forms of discrimination
• Changes in the law on cannabis
• Maximum CO2 emissions for new vehicles, laws which restrict flight times at night
• Government appointed utility regulators who may impose price controls on privatized monopolists e.g. telecommunications, the water industry

The economy operates with a huge and growing amount of regulation. The government appointed regulators who can impose price controls in most of the main utilities such as telecommunications, electricity, gas and rail transport.

Free market economists criticize the scale of regulation in the economy arguing that it creates an unnecessary burden of costs for businesses – with a huge amount of "red tape" damaging the competitiveness of businesses.

Regulation may be used to introduce fresh competition into a market – for example breaking up the existing monopoly power of a service provider. A good example of this is the attempt to introduce more competition for British Telecom. This is known as market liberalization.

Problems that regulators of markets / industries can face

1. Hard to find evidence of anti-competitive behaviour:
   • Lack of spoken or written evidence
   • Conflicting or asymmetric information
   • Complex information
   • Conflicting evidence – e.g. it might be markets forces or collusion in an oligopoly
2. Fear of fines or other control mean that there is strong incentive to conceal collusion
3. Lack of regulator power and lack of regulator resources

Revision Video: Evaluating Government Intervention in Markets

Carbon Emissions - Evaluating Potential Policies

This is a revision video looking at carbon trading and carbon taxes as policies to cut emissions. Most economists favour carbon taxes but public support for new environmental taxes in many countries is relatively low.

Evaluating Carbon Policies from tutor2u

Carbon Trading and Carbon Taxes (Evaluation Skills Video)

In this short revision video we analyse and evaluate three key points relating to this question: "To what extent are tradable permits less effective than taxation in reducing CO2 emissions?"

Core Notes:

A rising price of carbon permits – in theory – gives firms an incentive to invest in new technologies that lower carbon emissions.

Eval: But if the carbon price is too low or volatile from year to year, the risks from investment will be hard to justify to shareholders and fewer firms will commit to this.

Carbon trading helps to cut emissions in the lowest cost way because each permit is worth more to the most carbon-efficient businesses.

Eval: Carbon trading raises less revenue than a carbon tax; this revenue could be used to fund investment in renewables or help finance improvements in human capital.

The UK government has introduced a carbon price floor to make the EU trading scheme more effective in cutting CO2 emissions.

Eval: Carbon price floors make domestic businesses less price competitive overseas. A carbon tax provides just as much certainty for firms.

Price discrimination in action - Sainsbury's and valentines day cards!

This is a brilliant story, though it may do Sainsbury's reputation no favours. 

Two cards, looking pretty much identical, one 'For my husband' and one 'For my wife'.

All very cute - but why would the 'For my husband' one cost 25% more than the other?

It's a great question for students to discuss - 

What might cause a difference in the PED of the different market segments?

Why are Sainsbury's doing this?

How can they do this?

Should they be regulated due to customer exploitation?

Does the consumer benefit at all from this pricing strategy?

Draw the diagram showing this example of 3rd degree price discrimination....Oh, OK, I'll do it for you!

Can you see how the price in the combined market is lower than the inelastic market, but higher than in the elastic market.

Oligopoly - 5 Key points

A useful starter when looking at the most important market structure in economics!

An oligopoly is a market dominated by a few producers. An oligopoly is an industry where there is a high level of market concentration. Examples of markets that can be described as oligopolies include the markets for petrol in the UK, soft drinks producers and the major high street banks. Another example is the global market for sports footwear – 60% of which is held by Nike and Adidas. However, oligopoly is best defined by the conduct (or behaviour) of firms within a market.

The concentration ratio measures the extent to which a market or industry is dominated by a few leading firms. A rule of thumb is that an oligopoly exists when the top five firms in the market account for more than 60% of total market sales.

Characteristics of an oligopoly

There is no single theory of price and output under conditions of oligopoly. If a price war breaks out, oligopolists may choose produce and price much as a highly competitive industry would; whereas at other times they act like a pure monopoly.

An oligopoly usually exhibits the following features:

1. Product branding: Each firm in the market is selling a branded product.

2. Entry barriers: Entry barriers maintain supernormal profits for the dominant firms. It is possible for many smaller firms to operate on the periphery of an oligopolistic market, but none of them is large enough to have any significant effect on prices and output

3. Inter-dependent decision-making: Inter-dependence means that firms must take into account the likely reactions of their rivals to any change in price, output or forms of non-price competition.

4. Non-price competition: Non-price competition is a consistent feature of the competitive strategies of oligopolistic firms.

Duopoly

Duopoly is a form of oligopoly. In its purest form two firms control all of the market, but in reality the term duopoly is used to describe any market where two firms dominate with a significant market share. There are many examples of duopoly; including Coca-Cola and Pepsi (soft drinks), Unilever and Proctor & Gamble (detergents), Bloomberg and Reuters (Financial information services), Sotheby’s and Christie’s (auctioneers of antiques/paintings), Standard and Poor’s and Moody’s (credit rating agencies), BSkyB and ESPN (live Premiership football), and Airbus and Boeing (aircraft manufacturers). 
In these markets entry barriers are high although there are usually smaller players in the market surviving successfully.

The high entry barriers in duopolies are usually based on one or more of the following: brand loyalty, product differentiation and huge research economies of scale.

The importance of non-price competition under oligopoly

Non-price competition assumes increased importance in oligopolistic markets. This involves advertising and marketing strategies to increase demand and develop brand loyalty among consumers. Businesses will use other policies to increase market share:

o Better quality of service including guaranteed delivery times for consumers and low-cost servicing agreements.

o Longer opening hours for retailers, 24 hour online customer support.

o Discounts on product upgrades when they become available in the market.

o Contractual relationships with suppliers - for example the system of tied houses for pubs and contractual agreements with franchises (offering exclusive distribution agreements). For example, Apple has signed exclusive distribution agreements with T-Mobile of Germany, Orange in France and O2 in the UK for the iPhone. The agreements give Apple 10 percent of sales from phone calls and data transfers made over the devices.

Advertising spending runs in millions of pounds for many firms. Some simply apply a profit maximising rule to their marketing strategies. A promotional campaign is profitable if the marginal revenue from any extra sales exceeds the cost of the advertising campaign and marginal costs of producing an increase in output. However, it is not always easy to measure accurately the incremental sales arising from a specific advertising campaign. Other businesses see advertising simply as a way of increasing sales revenue. If persuasive advertising leads to an outward shift in demand, consumers are willing to pay more for each unit consumed. This increases the potential consumer surplus that a business might extract.

High spending on marketing is important for new business start-ups and for firms trying to break into an existing market where there is consumer or brand loyalty to the existing products

Behavioural economics in action - Black Friday, now singles day!!!

Internet giant Alibaba has set new sales records on Sunday for its biggest shopping day, the annual Singles Day. The Chinese company hit a record $1bn (£774m; €883m) in sales in 85 seconds, and then just shy of $10bn in the first hour of the 24-hour spree.   

Click here to access the article.

What areas of behavioural economics could this identify with?

Monopsony power in action! Tanzania Cashew crisis

Click here to access an article discussing the crisis over cashew farming in Tanzania. About 20 houses have been burnt down in riots by cashew nut farmers and other protesters in southern Tanzania, the local MP has told the BBC.

Faith Mitambo said two buildings at her home in Liwale town had been set alight and that other houses targeted belonged to members of the ruling CCM party.

The trouble began after payouts being made to farmers for their crop were less than the price agreed last year.

Topics of relevance are monopsony power, supply & demand, government intervention. Excellent real world economics. 

Behavioiural Economics - Useful revision/starter material

Some useful revision material for behavioural economics. This area of economics can be used in many types of essay, ranging from market failure/government failure in micro economics to economic policy in macro essays. Excellent when evaluation the effectiveness of government intervention into markets.

Behavioural economics from mattbentley34

Behavioural economics extra resources from mattbentley34

Behavioural economics key terms from mattbentley34

Essay on market failure & government intervention - Model answer

Market Failure & Beef Consumption

Thanks to Mr Wakerley for finding this latest study on beef.

New research out today from Oxford University indicate that red meat should rise in price by 20% to cover the health costs, and processed meat by 100%! At current prices the social cost of consumption is way higher than the social benefit. Are you for a tax on red meat to internalize the externality and bring red meat production and consumption to a socially economic quantity?

Click here for the article.

Questions to discuss:

Could you draw the market failure diagram?
How effective would this policy be?
Are there any potential unintended consequences?

UAE Tax - Law of unintended consequences

Thanks to Mr Wakerley for finding this article on illegal cigarettes in the UAE. Click here fore the link.

Regulation, Government Failure - Price Capping & ineffective regulation

This is a big topic these days. Governments try to intervene in markets in many ways, sometimes with success, others causing bigger issues. Below is a few presentations, videos, notes on the topic.

We will be going through in class.

Regulation and externalities:

Examples include:

• Laws on minimum age for buying cigarettes and alcohol
• The Competition Act which penalizes businesses found guilty of price fixing cartels
• Statutory national minimum wage
• A new law in Scotland banning under-18s from using sun-beds
• Equal Pay Act and acts preventing other forms of discrimination
• Changes in the law on cannabis
• Maximum CO2 emissions for new vehicles, laws which restrict flight times at night
• Government appointed utility regulators who may impose price controls on privatized monopolists e.g. telecommunications, the water industry (see later)

Regulation and Monopoly

The main aims of competition policy are to promote competition; make markets work better and contribute towards improved efficiency in individual markets and enhanced competitiveness of UK businesses within the European Union (EU) single market.

Competition policy aims to ensure

• Technological innovation which promotes dynamic efficiency in different markets
• Effective price competition between suppliers
• Safeguard and promote the interests of consumers through increased choice and lower price levels

There are four key pillars of competition policy in the UK and in the European Union

1. Antitrust & cartels: This involves the elimination of agreements that restrict competition including price-fixing and other abuses by firms who hold a dominant market position (defined as having a market share in excess of forty per cent)
2. Market liberalisation: Liberalisation involves introducing competition in previously monopolistic sectors such as energy supply, retail banking, postal services, mobile telecommunications and air transport
3. State aid control: Competition policy analyses state aid measures such as airline subsidies to ensure that such measures do not distort the level of competition in the Single Market
4. Merger control: This involves the investigation of mergers and take-overs between firms (e.g. a merger between two large groups which would result in their dominating the market)

Main Roles of the Regulators

• Regulators are the rule-enforcers and they are appointed by the government to oversee how a market works and the outcomes that result for producers and consumers

• The main competition regulator in the UK is the Competition and Markets Authority (CMA)

• The European Union Competition Commission is also an important body for the UK (although not for much longer)

Examples of competition policy in action

• De-regulation - laws to reduce monopoly power
  • Preventing mergers/acquisitions that create a monopoly
  • Laws to introduce competition into the postal services industry
  • Forced sales of assets e.g. BAA and airports in the UK
• Privatisation - transferring ownership
  • Stock market floatation of the Royal Mail
  • Part-privatisation of Network Rail similar to the sell-off of HS1 - the high-speed link that connects London's St Pancras to the Channel tunnel, on a long-term concession
• Tough laws on anti-competitive behaviour
  • Strong laws and penalties against proven cases of price fixing or collusion that involves market sharing
  • Companies breaching EU and UK competition rules risk hefty fines of up to 10 per cent of global turnover - senior executives can be jailed
• Reductions in import controls
  • A reduction in import tariffs encourages cheaper products from overseas
  • Increasing or eliminating import quotas can also have the same effect
  • Allowing new countries into the European Union single market increases contestability

• Price controls: The government appointed regulators can also impose price capping formula in most of the main utilities such as telecommunications, electricity, gas and rail transport. (this is due to natural monopoly element of these industries)

Regulation may be used to introduce fresh competition into a market – for example breaking up the existing monopoly power of a service provider. A good example of this is the attempt to introduce more competition for British Telecom. This is known as market liberalization.

Free market economists criticize the scale of regulation in the economy arguing that it creates an unnecessary burden of costs for businesses – with a huge amount of "red tape" damaging the competitiveness of businesses.

Problems that regulators of markets / industries can face

1. Hard to find evidence of anti-competitive behaviour:
   • Lack of spoken or written evidence
   • Conflicting or asymmetric information
   • Complex information
   • Conflicting evidence – e.g. it might be markets forces or collusion in an oligopoly
2. Fear of fines or other control mean that there is strong incentive to conceal collusion
3. Lack of regulator power and lack of regulator resources

Fiscal Policy - Budgets that went wrong!

Click here to access a piece on how some recent budgets had unintended consequences. This is why macro economic policy is such a subjective topic. Even the best economists make mistakes.

Government regulation in oligopolistic market

Click here to access a relevant piece on the UK supermarket industry. Regulators will widen their investigation into Sainsbury's planned merger with Asda to take account of the rapid rise of Aldi and Lidl.

The Competition and Markets Authority will also assess the rise of online firms in its probe of a deal that would create the UK's largest grocer.

Practice question on Supply & Demand + real world case study

Click on this link to read an interesting article on VAT in the UAE. Questions for discussion:

How would thus effect prices in the UAE. (Hint, draw a diagram to show this).

Now answer the following MCQ question:

The table below shows the demand & supply schedule for shortbread biscuits. You may use the last column to show your workings.

Price per packet	Quantity of packets demanded per month (000’s)	Quantity of packets supplied per month (000’s)	New quantity supplied per month (000’s)
$2.00	200	160
$2.10	180	180
$2.20	160	200
$2.30	140	220

A a result of the increase in baking costs for packaging shortbread biscuits (due to BREXIT and the falling pound increasing import costs), supply has fallen by 40,000 units at all price levels. As a result, the new equilibrium price is:

A) $2.00
B) $2.10
C) $2.20
D) 2.30

Answer:

Explanation: