Managerial Economics

1. Choose a company that markets computer products over the Internet through a Web search. Name the company, give the Internet link, and include a copy of the logo in your essay. In what ways does this company create value? Is it likely to capture much of this value? Explain and give your own opinion on the success of this company. Do not use a company found in the textbook.

Micro Center is a brick and mortar, as well as online retailer of computer products. Its

strategy is predicated on locating its stores in large upper middleclass cities or metropolitan

areas where the customers often add enhancements to their computer, build their own

customized computers for business or gaming, and are willing to pay for repair services. They

attract casual computer users and committed technophiles.

Link – http://www.microcenter.com/

Logo –

Micro Center is able to create value for its customers by providing a wide variety of

choices for high- and low-end computer parts. It advertises to attract customers who are not

computer savvy with sales and an information desk that they can refer to immediately upon

entering their stores. It also sends emails and direct mail advertisements to the do-it-

yourselfers, who often use its web site to order parts for the computers they build. It is based

on its concept of “technical retailing,” where it provides its customers, using highly

knowledgeable staff, with as much information as they need to make computer purchases that

meet their needs and wants.

The company has been successful in capturing this value. For example, it doesn’t try to

appeal to as many people as possible, similar to the Best Buy approach. Rather, it has targeted

a specific segment of the market, located it stores in very attractive locations, and provided its

customers with information and assistance, while having a store layout that allows do-it-

yourselfers to get what they want and get out without being bothered by Micro Center staff.

For customers who are wary of spending too much on computer equipment, Micro Center also

offers refurbished computer equipment for very low prices. It is engaging price discrimination

by choosing a market segment that has above average disposable income, a tendency to shop

in very nice locations, and a willingness to pay more for computer equipment than many other

customers.

Micro Center is a part of the privately held Micro Electronics Corporation based out of

Hillard, Ohio. It has not only been successful with its technical retailing approach, but it has

been able to grow organically solely based on the financial strength of its retail stores and

ecommerce web site, even as other retailers, such as CompUSA and Circuit City have been

driven into bankruptcy by electronics retail giant, Best Buy.

2. What are team capabilities? Name four examples of firms that appear to have them and the characteristics that prove it. DO NOT use companies found in the textbook, but go online.

Team capabilities are the collection of various assets and resources, tangible and

intangible, which make the whole of a firm more valuable than the sum of the individual assets

and resources. It can probably be argued that firms for which the opposite is true – the sum of

the individual parts is worth more than the whole of a firm – become targets for takeover.

Leveraged buyout firms made billions of dollars in the 1980’s and 1990’s buying firms with a lot

of debt and selling them piece by piece for more than what was paid for them originally. Four

firms that exhibit team capabilities are Berkshire Hathaway, Lockheed Martin, PIMCO, and ARM

Holdings.

Berkshire Hathaway, led by Warren Buffet, is a holding company primarily involved in

insurance, investments, freight rail, utilities and finance. It does this through a combination of

investments in other companies, such as Coca Cola, and wholly owned subsidiaries, such as

GEICO insurance. The team capabilities for Berkshire Hathaway lie not just in the investment

philosophy of Warren Buffett, but in the discipline he and his firm has shown over the decades

in their investments.

Warren Buffett’s investment philosophy that has made him the only investor on the

world’s wealthiest list is based on value investing, where he attempts to buy companies that he

thinks are in good shape at a price lower than his estimate of their intrinsic (or “true”) value

with good growth opportunities. His philosophy also involves not investing in businesses that

he doesn’t understand well, so he avoids most technology stocks. Over the last 45 years,

Berkshire Hathaway as earned an average annual return on book value of 20.2% (Berkshire

Hathaway, 2011), about twice the rate of the S&P 500, including dividends (Fuhrmann, 2011).

Lockheed Martin produces state of the art aerospace vehicles and technology, defense

electronics and systems integration, primarily for the U.S. military. Its team capabilities are

derived from its firm history and its special internal resource, the Skunk Works. Predecessor

companies are responsible for designing and delivering the U.S. military’s first fighter jet, the

XP-80, during World War II (Lockheed Martin, 2011).

One of the intangible resources which contributes to Lockheed Martin’s team

capabilities is its Skunk Works operations, also known as its Advanced Development Program.

Not only is Skunk Works responsible for designing the XP-80 fighter, it is also responsible for

developing the C-141 Starlifter, F-117 stealth fighter, SR-71 Blackbird spy plane, F-22 Raptor,

and F-35 joint strike fighter. Not only has the Skunk Works continued to innovate and its later

projects, starting with the SR-71 Blackbird, have outlasted many technology cycles, it also

operated under a different set of rules to ensure secrecy and maximize creativity and

productivity.

PIMCO (Pacific Investment Management Company), an autonomous, wholly owned

subsidiary of global German insurer, Allianz Group, manages over a trillion dollars in assets and

is the manager of the world’s largest bond mutual fund – the $241 billion PIMCO Total Return

Fund. Although PIMCO manages many types of assets, it is especially known as being a great

active manager of fixed income securities.

Its team capabilities is based on the continuity and stability of the involvement of one its

original founders from 1971, Bill Gross, who is currently PIMCO’s co-Chief Investment Officer

and the portfolio manager of the PIMCO Total Return Fund (PIMCO, 2011). Gross has built a

global investment team whose knowledge of securities and foreign currency exchange rival his

own. This has made PIMCO a trendsetter and leading indicator in forecasting the performance

of the U.S. dollar as PIMCO moves in and out of U.S. dollar denominated securities.

ARM Holdings is the global leading designer of microprocessors and other chips for

smartphones. It does not use an x86 architecture that is common to most computing

environments. Rather it uses reduced instruction set computing to run its chips, which are

optimized for low power use, a very important criteria for cell phone manufacturers, such as

Apple, which uses ARM microprocessors in its cell phones. What the company actually owns is

the intellectual property for its chip designs, which it licenses to manufacturers and also

receives a royalty for every ARM-based chip sold.

Its team capabilities come from its origins. It was originally formed as a joint venture

between Acorn Computer Group, Apple and VLSI Technology to develop a new microprocessor

standard, presumably, to compete with Intel. Acorn Computer Group developed the first RISC

processor (ARM Holdings, 2011). ARM Holdings is in a continuous and never ending process of

improving its chip designs and lowering their power consumption. It has used its first mover

advantage to sustain its team capabilities as the global leader in semiconductors for mobile

phones. Since the company does not manufacture or sell its chip, it is strictly focused on design

and intellectual property. It is also using its chips’ low power requirements to expand into

other segments, such as server chips, to directly compete with Intel, as it moves to directly

compete with ARM Holdings in the smartphone market starting in 2012.

3. Some manufacturers that contract with the U.S. Government have "most-favored" clauses in their contracts. This provision makes the firm sell to the Government at the lowest price it charges related to other customers. On the surface, this provision seems to be advantageous to the Government because it ensures them the lowest price. Others argue, however, that the clause gives manufacturers more power in bargaining with other buyers. Explain how this increased bargaining power might occur.

There are a few ways in which most favored clauses can provide suppliers with a little

more bargaining power. The first way is that suppliers would be loathe to offer prices lower

than what they agreed to with the federal government because it is likely to be their largest

customer and offering a lower price to another buyer produces a disproportionately large effect

on margins.

The second way in which a supplier can gain more bargaining power with other buyers is

to effectively raise the costs for competitors. Firms that employ most-favored clauses also

usually contracted to their suppliers for long-term contracts, up to five years. This effectively

raises the costs for rivals. The Federal Trade Commission posted a brief description of this

problem on their web site in the health care industry, where hundreds of doctors ended their

affiliation with an HMO after a Blue Cross, which had a most favored clause, which could have

cost the doctors revenue because the payment plan with the HMO included some profit-

sharing. But when the HMO did not have a profit, then the doctors effective payment was

lower than what the Blue Cross was paying (Baker, 1995).

Another way suppliers can gain more bargaining power through these contract clauses

is by raising barriers to entry and reducing competition. Firms that provide the federal

government with similar services, most likely at a different agency, may not feel the need to be

as aggressive if another agency has already accepted a given price for a product under that

clause. When there is a lot of business to be done across the country, as there is with the

federal government, the dampening of the intensity of rivalry can lead to accepting a given

price level if they can get a piece of the action.

Finally, a potential indirect way in which a supplier could gain more bargaining power

with other buyers would be through standard trade policies. Specifically, many manufacturers

have trade policies for buyers and can easily manipulate those policies to charge the federal

government a higher price. For example, a firm can charge an outside buyer the same price as

the federal government and offer it the same trade terms, such as 2/10 net or 2/15 net. A

trade discount of 2/15 net says that any customer who pays the invoice within 15 days will

receive a 2% discount on the invoice. A supplier could attempt to take advantage of the

bureaucracy for processing invoices to keep a higher actual price for the federal government,

while pretending to charge all of its other customers the same base price.

4. Give examples of incentive conflicts in the following two groups: a. between shareholders and managers.

Conflict between shareholders and managers is known as agency costs. Because their

utility interests are often not perfectly aligned, conflict occurs between manager and owners.

There are three very large sources of agency conflict: utility horizon, management self-

preservation and nepotism. Management and shareholders usually operate on different time

horizons with managers being concerned with maximizing their income while at a company,

while shareholders are concerned with maximizing the net present value of income over

decades, which is the basis for the intrinsic value of the firm. Too often, actions which

maximize management income can retard the maximization of shareholder income. This can

include actions that increase company growth at an unsustainable rate to persuade the capital

markets to pay more for the stock, thereby increasing the value of managements’ direct

holdings or the value of their stock rights or options.

Management self-preservation is a form of incentive conflict. This usually takes the

form of bad governance practices such as staggered elections for board of directors candidates,

poison pills and golden parachute clauses that guarantee executives minimum compensation,

even when they are replaced for performance reasons. This is observed when hostile takeovers

occur. Sometimes companies become takeover targets due to performance or because an

outside investor believes that a company can be run better with new or different management

and therefore, are willing to pay a premium above the current stock price to acquire them.

Unfortunately, the management of some takeover targets will rebuff acquisition offers, even

when it is in the interest of shareholders because they can reasonably assess that they will be

let go if the transaction proceeds to fruition. Subsequently, they will decline favorable offers

for company stock and sometimes try to identify a “white knight” or potential acquirer that is

more favorable towards existing management.

Finally, nepotism is a problem in many organizations, especially publicly traded

companies. Typically, executives will develop friendships when they join companies and, over

time, as they progress, they try to help one another progress, even if that isn’t in shareholders’

benefit due to subpar performance of these friends. And, as some rise to VP or executive rank,

they try to bring their friends with them. However, this practice also includes shielding their

friends from inappropriate behavior or poor performance because they form a support network

for their career and their decisions. This incentive conflict can extend to the board of directors,

where no director who is or has been an executive for another company wants to limit

executive compensation or tie more closely to the long-term performance of the company, in

addition to signing off on golden parachutes in contracts that are effectively anti-capitalistic

because they eliminate the incentive to do as well as they could because they still benefit, even

in failure.

b. between coworkers on teams.

The biggest incentive conflict between coworkers on teams is the free-rider problem,

which is one of the reasons that I dislike academic group assignments. Ideally, in the

workplace, most teams have project managers who can mitigate free rider issues by demanding

a minimum contribution from each team member and identify differences in performance

through the annual performance review process. However, in most companies, bonuses, if any,

for line workers are usually a small percentage of total compensation and, therefore, does not

really counteract free rider incentives. Some team members can accept the utility of 4% less

pay in return for doing 25% less work than some of their peers. Additionally, it usually takes

more than one poor performance review before a worker contributing to free rider problems is

removed, so it is a significant impact on team and potentially firm productivity.

Some industries have high requirements of all of their employees as a means to mitigate

the free rider problem, such as investment banking. But, many industries are not structured

where they can afford to pay bonuses that can be as large as 40% of salary and where they are

quick to dismiss employees they think are underperforming because of the cost and hassle of

finding new employees. That process also imposes a cost on the company, which will affect

shareholders.

5. You are in Management for IBX Steel Components. J.D. Brotsky is a top labor leader and just announced that her union will go on strike against management unless you grant the workers a significant pay raise. Economically, you realize that a strike might cost the company more money than the pay raise, but this might also just be the beginning of a pattern. Should management concede to the wage increase of 25%? Why or why not.

Management should not grant a 25% wage increase, unless it can be shown that IBX

employees are paid less than their national counterparts and that IBX can still competitive in

the global market. As a specialty steel manufacturer, IBX still has to be competitive, locally and

globally. It should be no surprise that 14 of the world’s largest 25 steelmakers are based in Asia

because that is where the bulk demand is located.

As suppliers of labor, the union believes that they have significant bargaining power

because of the cost of a strike. However, strikes also pose a significant hardship for employees

because they don’t get paid while on strike and strike funds can never provide enough

compensation to cover the basic necessities. Therefore, as buyers of labor, management does

have some leverage. Additionally, the specialized nature of steelmaking makes it difficult for

the employees to transition over to other jobs. Steelmaking is very different from welding and

construction.

Most importantly, agreeing to the 25% wage increase would decrease the price

competitiveness of IBX because the price of steel can be volatile, as it is a cyclical industry.

During the good times, those wage increases are sustainable, but during the hard times, they

are not. Given that this is one of the few pension industries left, it is in management’s interest

to keep wages as low as possible. This has been demonstrated in the airline industry

(Benmelech, Bergman & Enriquez, 2010).

Realistically, one of the primary reasons that there is a lot of labor-management conflict

at some companies is that there is general lack of respect for what each does. Many managers

and executives believe that they are the “real” reasons that companies are successful and

contemptuously believe that labor are commoditized cogs that can be readily replaced.

Therefore, labor is not deserving of high wages. Labor, on the other hand, can make requests

that show a complete disregard for fiscal reality and request rules or policies that are inefficient

or defy common sense. This antagonism breeds a tense, volatile environment.

Fortunately, IBX management realizes that it takes everyone’s effort to make the

company work. Employee productivity has a tremendous impact on costs and IBX management

should make the following counteroffer to the union rep – given the cyclical nature of the

business, IBX management should offer profit sharing as bonuses to labor employees, based on

their salaries. The bonus pool will comprise 10% of earnings before taxes. However, to

mitigate the free-rider problem, it will still be allocated based on performance reviews and

salary levels and will not be taken into account for benefits or pension purposes.

This takes into account the fiscal realities of the cyclical nature of the industry and the

cut throat pricing that can occur when there is significant capacity utilization. It also allows

labor to benefit when the company does well, but keep base costs lower to be responsive to

the market. Plus, after employees receive the first bonus checks, it may spur them to be more

cooperative with management because they can directly benefit from improved

communication and cooperation and makes them a financial stakeholder with a broadened

perception of their needs and the cost of their wants. Management’s main goal is to keep

wages and pension contributions as low as possible, while maintaining the cohesiveness of the

company to maximize profitability when the opportunities present themselves.

References

ARM Holdings plc (2011). ARM company milestones. Retrieved from http://www.arm.com/about/company-profile/milestones.php

Baker, J. (1995). Vertical restraints with horizontal consequences: competitive effects of “most-favored-customer” clauses. Antitrust Law Journal, 64, 517-534. Retrieved from http://www.ftc.gov/speeches/other/bakersp.shtm

Benmelech, E., Bergman, N. & Enriquez, R. (2010). Negotiating with labor under financial distress. American Finance Association 2011 Denver Meetings Paper. Retrieved from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1558096

Berkshire Hathaway (2011). 2010 Annual Report. Retrieved from http://www.berkshirehathaway.com/2010ar/2010ar.pdf

Brickley, J., Smith, C. & Zimmerman, J. (2009). Managerial economics and organizational architecture. New York, NY: McGraw-Hill/Irwin.

Fuhrmann, R. (2011, May 6). Is Warren Buffett really a value investor? San Francisco Chronicle. Retrieved from http://www.sfgate.com/cgi-bin/article.cgi?f=/g/a/2011/05/06/investopedia52156.DTL

Lockheed Martin (2011). Lockheed Martin history. Retrieved from http://www.lockheedmartin.com/aboutus/history/index.html

Micro Center (2011). Micro Center history. Retrieved from http://www.microcenter.com/at_the_stores/history.html

PIMCO (2011). PIMCO timeline. Retrieved from http://www.pimco.com/EN/OurFirm/Pages/PIMCOTimeline.aspx