Deck 18: Strategy Myths

Question 1

Suppose economic profit was used to evaluate each division in a company. Describe how it would serve to foster the correct incentives inside the firm.

Answer 1

Accounting profit and economic profit:
Accounting profit is the total earnings of a firm calculated according to the generally accepted accounting principles. All the explicit cost will be considered for the calculation of accounting profit. Accounting profit represents the monetary expenses and revenues of a firm.
Economic profit is not calculated according to the generally accepted accounting principles. Economic profit considers implicit costs along with the explicit costs. Normally, economic profit will be used to evaluate the total value of a company.
Determine the way in which a firm can foster the correct incentive inside a business firm:
Economic profit shows the ultimate real profit of a firm by considering both explicit and implicit cost. Accounting profit does not consider the implicit cost of a firm. Implicit costs also should be considered, because these costs also will add value to the product.
Hence, economic profit can show the real position of the firm. By analyzing the economic profit, stakeholders can understand the real growth of the entity. Based on the economic profit the firm can implement incentive plans in a better way. All the firms will try to improve its economic profit; there by the firm will be able to ensure better performance.
Conclusion:
The economic profit can foster the correct incentive inside a business firm. This is because; the economic profit indicates the real profit of a firm. Economic profit considers both explicit and the implicit costs.

Question 2

The following demand and marginal cost equations represent the demand for some service inside the firm. At what price should the service be sold? Would it matter whether there was an external market for this service?
The demand function
P = 30 - 2Q
The marginal cost function: MC = 20.

Answer 2

Internal markets:
Internal market is the system in which a company can sell the services and goods to the customers inside the organization. Internal market also denotes the system, which supports the free trade between the countries belonging to the E Union.
Determine the marginal revenue equation:
At the equilibrium level, the marginal cost and marginal revenue will be equal. Given marginal cost are 20. Marginal revenue is the revenue realized from the sale of one additional unit. Hence, the marginal revenue equation will be as follows:
Where,
P= Price
Q=Quantity demanded
Calculate the equilibrium quantity:
Optimum quantity can be computed by using the marginal revenue equation. It is given that the marginal cost is 20, hence at the optimum level the marginal revenue will be 20.
Hence, the optimum quantity will be
.
Determine the price of the service:
The price of the service can be determined by applying the calculated equilibrium quantity in demand function.
Hence, price of the service will be
.
Determine the change in price if there is external market for the service:
Most probably, the price external price will be higher than the internal price. It is because; at the internal price, the firm is only attaining the optimum price. This price does not create profits. Hence, the management will decide to earn some profit from the external market.

Question 3

A firm has estimated the following demand function for its product:
Q = 8 −2 P + 0.10 I + E
where Q is quantity demanded per month in thousands, P is product price, I is an index of consumer income, and E is expectations of economic conditions in the future. Assume that P = $10, I = 100, and E = 20 when conditions are expected to be good and ?10 when conditions are expected to be bad. Explain and/or demonstrate what it means to say that price takes into account all information available.

Answer 3

Internal markets:
Internal market is the system in which a company can sell the services and goods to the customers inside the organization. Internal market also denotes the system, which supports the free trade between the countries belonging to the E Union.
Demand function:
Demand function states that, quantity demanded is a function of different factors. These factors include price, future expectations in the market, and income of the consumer. The demand function can be mathematically expressed as follows:
Where,
Q = Quantity demanded
P = Price of the product
I = Index of consumer income
E = Expectation of economic condition
Determine the quantity demanded when the conditions are expected to be good or bad:
The quantity demanded will be half of the price of the product. There is an inverse relationship between the product rice and demand. The relationship between income and demand is direct. On unit of demand will be increased by a 0.10 increase in income. The expectation of the economic condition is having direct impact on the demand. If there is a positive improvement in the economic condition, then the quantity demanded also will increase.
Situation is demonstrating two different situations; first, it is showing a good condition in the market. According to the increase in the economic condition, the quantity demanded will increase. Second condition is the decline in the economic condition, according to the bad condition in the economy, the quantity demanded will decline.
Conclusion:
Law of demand will be applied to indicate the relationship between quantity demanded and price. That is when the price increases, then the quantity demanded will decline and vice versa. Income and expectation regarding the economy will have positive impact on the quantity demanded.

Question 4

Explain why firms exist. Explain why there is not just one huge firm.

Question 5

Using markets to gather information is quite different than market-based management. Explain how they are different.

Question 6

Terrorist Markets
It is vitally important for the United States to anticipate and possibly offset future terrorist attacks. Similarly, it is necessary to know whether certain government leaders might be overthrown or what developments in other parts of the world might occur such as Russia invading Georgia or Poland. How can such information be obtained? Could markets be used? A few people thought the best method would be to create a market whereby people could speculate on certain events and could profit from correct predictions. The Defense Advanced Research Projects Agency (DARPA), a research think tank within the Department of Defense, decided to create a market through which traders could buy and sell contracts that specified various events. For example, contracts could be based on questions such as "How fast will the non oil output of Egypt grow next year?" or "Will the U.S. military withdraw from country A in two years or less?" The concept was to discover whether trading in such contracts could help to predict future events and how connections between events were perceived.
Critics tore into DARPA for creating a way to bet on terrorism. It was argued that a terrorist could bet on some act of terrorism and then carry it out, thereby profiting on tragedy. Once people started to hear about the DARPA project, funding was cut and all research related to it was terminated.
What information can markets provide that spies, informants and others might not?

Question 7

What steps are necessary to create an internal market?

Question 8

You have been hired as a consultant to create a market-based economy in a nation that has never before experienced markets. Explain how you would do that.

Question 9

BP relies on internal markets to collect information and help make decisions. Would the use of a predictive market related to oil well blowouts have predicted the 2010 Gulf of Mexico disaster? Explain your answer.

Question 10

Terrorist Markets
It is vitally important for the United States to anticipate and possibly offset future terrorist attacks. Similarly, it is necessary to know whether certain government leaders might be overthrown or what developments in other parts of the world might occur such as Russia invading Georgia or Poland. How can such information be obtained? Could markets be used? A few people thought the best method would be to create a market whereby people could speculate on certain events and could profit from correct predictions. The Defense Advanced Research Projects Agency (DARPA), a research think tank within the Department of Defense, decided to create a market through which traders could buy and sell contracts that specified various events. For example, contracts could be based on questions such as "How fast will the non oil output of Egypt grow next year?" or "Will the U.S. military withdraw from country A in two years or less?" The concept was to discover whether trading in such contracts could help to predict future events and how connections between events were perceived.
Critics tore into DARPA for creating a way to bet on terrorism. It was argued that a terrorist could bet on some act of terrorism and then carry it out, thereby profiting on tragedy. Once people started to hear about the DARPA project, funding was cut and all research related to it was terminated.
How could a market provide information about terrorism?

Question 11

What is the role of headquarters and the CEO in a factory-type firm? What is their role in a market- based firm?

Question 12

A large firm has two divisions: an upstream division that is a monopoly supplier of a resource, whose only market is the downstream division that produces the final output. Would the firm's profit be maximized by paying upstream and downstream divisional managers a percentage of its divisional profits? Explain.

Question 13

A recent book was titled The End of Management. Suppose the technology evolves in such a way that a high percentage of employees do not work in the company office. They telecommute or work offline. What then is the role of management? Is there one, or is the book title correct?

Question 14

A large firm has two divisions: an upstream division that produces an output that is used by the downstream division. The downstream division could obtain that output from external firms as well as the upstream division. Should the firm allow the downstream division to purchase the product externally, or should it require that the firm use only the upstream division's product? Explain

Question 15

Define the term principal-agent problem. What principal-agent problems exist in a market? What principal-agent problems exist in a firm? What are possible solutions to principal-agent issues within the firm?

Question 16

What is moral hazard? How does the firm deal with moral hazard in its relationships with suppliers or customers? How does the firm deal with moral hazard internally?

Question 17

Capital markets enable us to spend large sums of money that don't belong to us. Would it be necessary to create an internal capital market if a firm was to be led by market-based management? Explain.

Question 18

What would be the CEO's role in a company led by market-based management?

Question 19

If market-based management is more efficient than the command and control of a hierarchy, why have firms not employed the strategy?

Question 20

How would internal markets adjust for or take the cost of capital into account?