CLASS 12 OUTLINE The Economics of Business Harvard Extension School Instructor: Bob Wayland Teaching...

CLASS 12 OUTLINE

The Economics of Business

Harvard Extension SchoolInstructor: Bob WaylandTeaching Assistant: Natasha Wambebe

incomplete w/o oral accompaniment

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In Previous Episodes of E1600

How did Frank Knight distinguish risk and uncertainty?Is profit the reward for bearing risk?If people have to make decisions under uncertainty, how does

Simon suggest they proceed (i.e. what are the essential simplifications)?

How does Nelson and Winter’s notion of the competency puzzle relate to Simon’s bounded rationality

If you are familiar with Bayesian statistical analysis, how would you connect it with the sort of judgment defined by Knight and the acquisition of expertise described by Simon?

Thorstein Veblen said, “The addiction to sports, therefore, in a peculiar degree marks an arrested development in man’s moral nature.” Is this consistent with neoclassical utility theory? Why would anyone listen to this man?


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Veblen on Advertising…

Veblen also said, “Advertising is competitive; the greater part of it aims to divert purchases,

etc., from one channel to another channel of the same general class. And to the extent to which the efforts of advertising in all its branches are spent on this competitive disturbance of trade, they are, on the whole, of slight if any immediate service to the community.

Such advertising, however, is indispensable to most branches of modern industry; but the necessity of most of the advertising is not due to its serving the needs of the community nor to any aggregate advantage accruing to the concerts which advertise, but to the fact that a business concern which falls short in advertising fails to get its share of trade.

Each [business] concern must advertise, chiefly because the others do.”

How might Lancaster respond? How might Stigler respond?


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Information Costs

Recall Coase’s argument for transactions costs, in particular identifying sellers and prices, as a cost of using the market

Alchian and Demsetz, emphasized the metering costs of using resources in cooperative production

Simon emphasized the difficulty of finding and using information relevant to decisions

Stigler noted that buyers and sellers are searching for one another and that contrary to the classical model of one, uniform, market clearing price there is usually a distribution (dispersion) of prices


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George Stigler and The Economics of Information

Information “occupies a slum dwelling in the town of economics”

Price dispersion is a manifestation and measure “of ignorance in the market”

Some dispersion is the result of heterogeneity (recall Lancaster multi-attribute goods) but some is ignorance

Transactions costs e.g. re-labeling all goods, comparing all rivals, seeking all prices inhibit price uniformity

At any time, a distribution (probably skewed right) prevails for prices


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Sampling and Searching

Stigler’s marketplace is similar to a jar with equal numbers of black ($3) and white ($2) marbles.

The probability of drawing a white or a black ball is .5. therefore the expected first draw value is:

E(P) = .5($3) + .5($2) =$2.50

First draw is for maximum or minimum value; continue the experiment, our expected minimum price observation converges on the real minimum of $2.00.

Chances of drawing a $3 or a $2 ball on the second try is still .5 but, the chances of drawing the same value ball as from the first draw is only .5 * .5 or .25

Chance of drawing a white ($2) ball after three draws is same as one minus chance of drawing 3 black balls:

1- (.5*.5*.5) = 1 - .12.5 = .875

Now the expected minimum price is .875*($2) + .125*($3) = $2.125


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Sampling and Searching continued


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Expected Incremental Minimum Price


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Introduce the Search Costs to Find Optimal

As always we equate the marginal or incremental return to the marginal cost.

Assume a $.10 constant search cost:


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Search and Recurrent Purchase

Stigler ignores the second term which he believes is usually minorThat may not be the case, especially for recurrent purchases or contracts.The demand curve below shows increase in one consumer’s purchaseprogram as she discovers the lower prices available. (q = 30 – 2p).


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Uniform Distribution of Prices

In a uniform distribution (sometimes called a rectangular distribution) the frequency or probability of every value is the same. Flipping a coin, tossing a die…

Normalized by dividing all values by the maximum value, resulting in distribution from 0 to 1.

Normalized form of the uniform distribution properties: The distribution of minimum prices with n searches is:

The average minimum price is:

Finally, the variance of the average minimum price is:


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Search and Sampling

As you increase number of searches, your chances of

finding a representative from the lower end increase:


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Expected Savings for Incremental Searches

Ceteris paribus: expected net savings of an incremental search will be influenced by: Greater the higher the expenditure on the commodity. You will

search longer and harder for a car than for a popsicle. The larger the fraction of the buyer’s expenditures represented by

the commodity, the greater the potential savings and hence the greater the amount of search.

Greater the dispersion of the prices. If prices are all over the place, you will sense that looking further may well pay off.

The greater the geographical extent of the market the larger will be the cost of search and therefore less will be undertaken.

Smaller the higher the cost per search. If sellers are widely separated or it is difficult to compare quality or other factors, you will settle sooner. Conversely, if search is facilitated by the Internet, Consumer Reports, or other agents, you can search more extensively.


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Expected Savings Per Incremental Search, continued

The higher the positive correlation of prices over successive searches, the less investment in search in subsequent periods. If buyer finds that repeated searches reveal the same results, he is likely to reduce or eliminate searches for that product Gives rise to reputational advantages, or a form of brand equity, Stigler suggests that goodwill can be defined as the propensity to purchase without

significant re-searching Tendency to “lock-in” perceptions formed by multiple searches explains why Wal-Mart

seeks to be identified as the low cost supplier and maintain an everyday low price policy (“sales” are a form of search-provoking tactic).

Explains why bad reputations are so hard to shed – people have to go back to searching and must have a strong incentive to do so. Hyundai, for example, had to introduce exceptional warranties to offset the bad taste left by their earlier low quality.

Explains why tourists, without accumulated knowledge of prices, pay more than locals The need for search never goes completely away; there will always be

some price dispersion: Information becomes obsolete with shifting supply and demand patterns. Retailers change strategies, some are slower to re-price than others, Local conditions may diverge from regional or national norms.


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Advertising

Stigler, like Lancaster, takes a kinder view of advertising than did (do) many economists,

Advertising provides information for buyersAdvertising for buyers reduces the search

cost of buyersIn its absence (especially price advertising),

buyers would have to spend more to find the best price and therefore would succeed less often with the result that less would be purchased.


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Advertising, continued

Consider advertising a way to inform N customers where c=g(a) is the proportion reached, a is the volume of advertising.

Generally assume diminishing returns at some point

What about viral advertising?


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Let N be total of potential customers Let b equal the number of new customers

who are born or die each period then the Path of informed customers will be cN in the first period In the second period cN(1-b) customers will still be

informed and cbN new potential customers will be reached while c[(1-b)N – cN(1-b)] of the old potential customers not reached the first time will now be informed.

Total is now: cN[1+ (1-b)(1-c)]


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Advertising

You can generalize this sequence into an infinite series over k periods and then find the limit as k gets large as:

cN/1-(1-c)(1-b) =N The proportion of buyers informed, , thus depends on c and b. As c and/or b are

large relative to 1 (as proportions both must be less than or equal to 1) then will become larger

If there are r sellers advertising, then is the probability of any one of them reaching any particular customer and the number of sellers therefore known to an average buyer is between 0 and r with a mean of r and variance r(1-).

The more advertising and by more sellers, the larger the number of sellers known to each buyer and the lower the variance in knowledge among buyers.

Sellers will invest in marketing so long as the incremental revenue from more

contacts, which requires an estimate of propensity to buy for each new contact, is greater than or equal to the cost of reaching an incremental prospect.


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Brokers as Information Appliances

Advertising is less effective when there are relatively few buyers as a percentage of the medium’s circulation or viewership. Specialized dealers (brokers) arise in this situation.

My friend Larry Rayman, president of GTI Power, is a specialist in quickly finding and delivering aircraft components which he can do by knowing a vast multitude of operators and suppliers.

Operators, distributors, and manufacturers contact him about needs and availability of parts.

Larry is essentially an information appliance. Efforts to computerize the market haven’t worked so far. Why do you think Larry has not been digitally displaced?


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Advertising mediums have to attract potential buyers in order to offer value to sellers.

The creation of newspaper or television program can be viewed as a device to assemble potential buyers for the advertisers.

Hence concern about ratings and demographics. In conclusion, Stigler notes that ignorance is like sub-zero

weather (recall that he taught at the University of Chicago). We can spend to reduce its effects and even achieve a degree of comfort but it is uneconomic to eliminate all of its effects. So too we can neither eliminate nor ignore the cold winds of ignorance.


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Thoughts for Discussion

Stigler, like Simon, does not assume hyper-rationality (e.g. omniscience on market prices) on the parts of buyers and sellers. Is his model of search a form of bounded rationality?

Stigler describes search costs and investment in them as part of the product transaction. Does this anticipate Williamson’s notion of transactions costs as an element to be considered in choosing among governance or contracting relationships?

Does Stigler’s treatment of search costs comport with Coase’s notion of costs to use the market?

CLASS 12 OUTLINE The Economics of Business Harvard Extension School Instructor: Bob Wayland Teaching...

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