2009 B-2 Lecture

Business Environment & Concepts 2
1. 2. 3. 4. 5. 6. 7. 8. 9.
Business cycles and reasons for business fluctuations ......................................................... 3 Economic measures and reasons for changes in the economy ............................................ 14 Market influences on business strategies......................................................................... 28 Implications of dealing in foreign currencies .................................................................... 67 Appendix I: Homework reading...................................................................................... 80 Appendix II: Homework reading .................................................................................... 84 Appendix III: Homework reading ................................................................................... 88 Terminology ............................................................................................................... 97 Class questions ........................................................................................................... 99
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BUSINESS CYCLES AND REASONS FOR BUSINESS FLUCTUATIONS I. BUSINESS CYCLES A. INTRODUCTION Business cycles refer to the rise and fall of economic activity relative to its long-term growth trend (i.e., the swings in total national output, income, and employment over time). Although the economy tends to grow over time, the growth in economic activity is not stable. Rather, economic activity is characterized by fluctuations, and these fluctuations are known as business cycles. Business cycles vary in duration and severity. Some cycles are quite mild. Others are characterized by large increases in unemployment and/or inflation. The analysis of business cycles is part of the field of macroeconomics. Macroeconomics is the study of the economy as a whole. It examines the determinants of national income, unemployment, and inflation and how monetary and fiscal policies affect economic activity. On the other hand, microeconomics studies consumers, producers, and suppliers operating in a narrowly defined market. B. MEASURING ECONOMIC ACTIVITY: GROSS DOMESTIC PRODUCT Because business cycles refer to the rise and fall of economic activity, it is important to first examine how economic activity is measured. The most common measure of the economic activity or output of an economy is Gross Domestic Product (GDP). GDP is the total market value of all final goods and services (the term "final goods and services" excludes used goods that have been resold) produced within the borders of a nation in a particular time period (i.e., the nation's output of goods and services). Note that GDP includes all final goods and services produced by resources within a country regardless of who owns the resources. Thus, U.S. GDP includes the output of foreign-owned factories in the U.S. but excludes the output of U.S.-owned factories operating abroad. C. NOMINAL VERSUS REAL GDP 1. Nominal GDP Nominal GDP (unadjusted) measures the value of all final goods and services in prices prevailing at the time of production. That is, nominal GDP measures the value of all final goods and services in current prices. 2. Real GDP a. Definition Real GDP (adjusted) measures the value of all final goods and services in constant prices. That is, real GDP is adjusted to account for changes in the price level (i.e., it removes the effects of inflation by using a price index). Real GDP is the most commonly used measure of economic activity and national output (i.e. the total output of an economy). b. Price Index (GDP Deflator) The price index used to calculate real GDP is called the GDP Deflator. It is a price index for all goods and services included in GDP. Using the GDP deflator, real GDP is calculated as the ratio of nominal GDP to the GDP deflator times 100.
Real GDP = Nominal GDP 100 GDP Deflator
2009 DeVry/Becker Educational Development Corp. All rights reserved.
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D.
REAL GDP PER CAPITA AND ECONOMIC GROWTH Real Per Capita GDP (Real GDP per Capita) is real GDP divided by population. Real GDP per capita is typically used to compare standards of living across countries or across time. Real GDP per capita is also used to measure economic growth. Economic growth is the increase in real GDP per capita over time.
E.
SUMMARY COMPOSITION OF BUSINESS CYCLES As noted above, economic activity is characterized by fluctuations, and these fluctuations are known as business cycles. Business cycles are typically comprised of: 1. Expansionary Phase An expansionary phase is characterized by rising economic activity (real GDP) and growth. During an expansionary phase, economic activity is rising above its long-term growth trend. Firm profits are likely to be rising during an expansionary phase as the demand for goods and services increases. Firms are also likely to increase the size of their workforce during an expansion, and the price of goods and services is likely to be rising. 2. Peak A peak is a high point of economic activity. It marks the end of an expansionary phase and the beginning of a contractionary phase in economic activity. At the peak of a business cycle, firm profits are likely to be at their highest level. Firms are also likely to face capacity constraints and input shortages (raw material and labor), leading to higher costs and a higher overall price level. 3. Contractionary Phase A contractionary phase is characterized by falling economic activity and growth and follows a peak. During a contractionary phase, firm profits are likely to be falling from their highest levels. 4. Trough A trough is a low point of economic activity. At this point of the business cycle, firm profits are likely to be at their lowest level. Firms are also likely to experience significant excess production capacity, leading them to reduce the size of their workforce and cut costs. 5. Recovery Phase A recovery phase follows a trough. During a recovery phase, economic activity begins to increase and return to its long-term growth trend. Further, firm profits typically begin to stabilize as the demand for goods and services begins to rise.
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II.
TERMINOLOGY USED IN DESCRIBING BUSINESS CYCLES A. RECESSION A recession occurs when the economy experiences negative real economic growth (declines in national output). Economists define a recession as two consecutive quarters of falling national output. During a recession, firm profits tend to fall and many firms incur losses. Firms are also likely to have excess capacity. As a result, during a recession, resources (including labor) are likely to be underutilized and unemployment is likely to be high. B. DEPRESSION A depression is a very severe recession. It is characterized by a relatively long period of stagnation in business activity and high unemployment rates. As a result, firms will experience significant excess capacity. Furthermore, due to the significant reduction in the demand for goods and services, it is likely that many firms will go out of business during a depression. C. ILLUSTRATION Graph A illustrates the business cycle.
Graph A Output (Real GDP) Contractionary Phase Peak
Long-term growth trend in national output
Expansionary Phase Peak
Recovery Phase Trough Trough
Time (Years)
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III.
ECONOMIC INDICATORS Although business cycles tend to be irregular and unpredictable, economists nevertheless attempt to predict business cycles and their severity and duration using economic indicators. Economic indicators (gathered by The Conference Board) are variables that have historically correlated highly with economic activity. They can be "leading indicators," "lagging indicators," or "coincident indicators." A. LEADING INDICATORS Leading indicators tend to predict economic activity. The government routinely revises the numbers as more data becomes available. Thus, leading indicators are subject to change. They include: 1. 2. 3. 4. 5. 6. 7. 8. B. Average new unemployment claims Building permits for residences Average length of the workweek Money supply Prices of selected stocks Orders for goods Price changes of materials Index of consumer expectations
LAGGING INDICATORS Lagging indicators tend to follow economic activity. They give signals after the fact and include the following: 1. 2. 3. Prime rate charged by banks Average duration of unemployment Bank loans outstanding
C.
COINCIDENT INDICATORS Coincident indicators tend to occur coincident to economic activity. They include the following: 1. 2. Industrial production Manufacturing and trade sales
IV.
REASONS FOR FLUCTUATIONS While there are a variety of theories regarding the cause of business cycles, economists generally agree that business cycles result from shifts in aggregate demand and/or aggregate supply. Aggregate demand and aggregate supply curves can be used to illustrate the relationship between a country's output (real GDP) and price level (the GDP Deflator). They are also used to examine the causes of economic fluctuations. A. AGGREGATE DEMAND (AD) CURVE The aggregate demand (AD) curve illustrates the maximum quantity of all goods and services that households, firms, and the government are willing and able to purchase at any given price level. It shows the relationship between total output (real GDP) of the economy and the price level. Note that this "aggregate" demand curve is the macroeconomic demand curve of the "total" demand in the economy as a whole. This particular "line" just happens to be drawn as a straight line; although it is often drawn as a curve. The x-axis is real GDP.
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B.
AGGREGATE SUPPLY (AS) CURVE The aggregate supply (AS) curve illustrates the maximum quantity of all goods and services producers are willing and able to produce at any given price level. Note that this "aggregate" supply curve is the macroeconomic supply curve of the "total" supply in the economy as a whole. 1. Short-Run Aggregate Supply Curve The short-run aggregate supply (SRAS) curve is upward sloping, illustrating the fact that as the price level rises, firms are willing to produce more goods and services. 2. Long-Run Aggregate Supply Curve The long-run aggregate supply (LRAS) curve is vertical, illustrating the fact that in the long-run, if all resources are fully utilized, output is determined solely by the factors of production. This curve corresponds to the potential level of output in the economy. 3. Potential Level of Output (Potential GDP) Potential GDP refers to the level of real GDP (national output) that the economy would produce if its resources (capital and labor) were fully employed. When real GDP is below the potential level of output, the economy will typically be experiencing a recession. Similarly, when real GDP rises above the potential level of output, the economy will typically be experiencing an expansion.
C.
ILLUSTRATION Graph B illustrates the aggregate demand and aggregate supply curves for an economy.
Graph B Price Level
Long-Run Aggregate Supply Short-Run Aggregate Supply
P0
Aggregate Demand Y* Real GDP
The intersection of the Short-Run Aggregate Supply (SRAS) curve and the Aggregate Demand (AD) curve determines the level of output (real GDP) and price level in the short run. The position of the long-run aggregate supply (LRAS) curve determines the level of output in the long run. The LRAS curve is vertical at the economys potential level of output. Y* = GDP at the potential (equilibrium) level of output.
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D.
AGGREGATE DEMAND, AGGREGATE SUPPLY, AND ECONOMIC FLUCTUATIONS Business cycles, or economic fluctuations, are the result of shifts in aggregate demand and short-run aggregate supply (note that shifts in the long-run aggregate supply curve are associated with long-run growth in the economy and do not affect business cycles). 1. Reduction in Demand If circumstances cause individuals, businesses, or governments to reduce their demand for goods and services, economic activity (real GDP) will decline, leading to a contraction in economic activity and possibly a recession. As a result, a reduction in demand tends to cause firm profits to decline. Firms are also likely to experience an increase in excess capacity, leading them to reduce the size of their workforce. 2. Increase in Demand In contrast, if circumstances cause individuals, businesses, and governments to increase their demand for goods and services, economic activity will rise, leading to a recovery or an expansion in economic activity. As a result, an increase in demand tends to cause firm profits to rise. Firms are also likely to experience a reduction in excess capacity, leading them to increase the size of their workforce. 3. Reduction of Supply If circumstances cause firms to reduce their supply of goods and services, economic activity will fall, leading to a contraction or possibly a recession. As firms reduce their supply, they are also likely to reduce the size of their workforce, leading to higher unemployment. 4. Increase in Supply If circumstances cause firms to increase their supply of goods and services, economic activity will rise, leading to an expansionary phase of economic activity. As firms increase their supply, they are also likely to increase the size of their workforce, leading to lower unemployment. Graphs C and D illustrate recessions caused by shifts in aggregate demand and short-run aggregate supply.
Graph C Price Level LRAS SRAS
Graph D Price Level LRAS SRAS1 SRAS
P0 P1 AD AD1 Y1 Y0 Output (Real GDP)
P1 P0
AD Y1 Y0 Output (Real GDP)
A recession caused by a shift in the aggregate demand curve: A decrease in aggregate demand causes actual GDP to fall below potential GDP. This is illustrated as the leftward shift in aggregate demand. As a result, real GDP falls from Y0 to Y1.
A recession caused by a shift in the short run aggregate supply curve: A decrease in short-run aggregate supply causes actual GDP to fall below potential GDP. This is illustrated as the leftward shift in the short run aggregate supply curve. As a result, real GDP falls from Y0 to Y1.
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E.
FACTORS THAT SHIFT AGGREGATE DEMAND The primary factors that shift aggregate demand are: 1. Changes in Wealth a. Increase in Wealth An increase in wealth causes the aggregate demand curve to shift to the right. Thus, an increase in wealth causes the economy to expand and leads to an increase in national output (real GDP). b. Decrease in Wealth A decrease in wealth causes the aggregate demand curve to shift to the left. A decrease in wealth does the opposite of an increase in wealth. For example, a large decline in stock prices would decrease consumer wealth and therefore shift the aggregate demand curve to the left. As a result, national output would fall, causing a contraction and possibly a recession. 2. Changes in Real Interest Rates a. Increase in Real Interest Rates An increase in interest rates increases the cost of capital and, therefore, tends to reduce consumer demand for durable goods such as new cars and homes and firm demand for new plants and equipment. b. Decrease in Real Interest Rates A decrease in real interest rates does the opposite of an increase in real interest rates. A decrease in real interest rates reduces the cost of capital, thereby increasing the demand for investment goods and shifting the aggregate demand curve to the right, causing national output to rise. Conversely, an increase in real interest rates causes the cost of capital to rise and shifts the aggregate demand curve to the left, causing national output to fall. 3. Changes in Expectations about the Future Economic Outlook (Consumer Confidence) a. Confident Economic Outlook If households become confident about the economic outlook (consumer confidence increases), the willingness to acquire investment and consumer goods increases and the aggregate demand curve shifts right, causing national output to rise. b. Uncertain Economic Outlook When the economic outlook appears more uncertain, consumers tend to reduce current spending, shifting aggregate demand to the left and causing national output to fall.
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4.
Changes in Exchange Rates a. Appreciated Currencies If the currency of a country appreciates in real terms relative to the currencies of its trading partners, its goods will become relatively expensive for foreigners, while foreign goods will become relatively cheap for its residents. As a result, net exports (exports minus imports) will fall, shifting the aggregate demand curve to the left and causing national output to fall. b. Depreciated Currencies If the currency of a country depreciates in real terms relative to the currencies of its trading partners, its goods will become relatively cheap for foreigners, while foreign goods will become relatively expensive for its residents. As a result, net exports (exports minus imports) will rise, shifting the aggregate demand curve to the right and causing national output to rise.
5.
Changes in Government Spending a. Increase in Government Spending An increase in government spending shifts the aggregate demand curve to the right, causing national output to rise. b. Decrease in Government Spending A decrease in government spending shifts the aggregate demand curve to the left, causing national output to fall.
6.
Changes in Consumer Taxes a. Increase in Consumer Taxes An increase in consumer taxes (e.g., the personal income tax) reduces the disposable income (gross income minus taxes) of consumers and, therefore, shifts the aggregate demand curve to the left, causing national output to fall. b. Decrease in Consumer Taxes A decrease in taxes increases the disposable income of consumers and therefore shifts the aggregate demand curve to the right causing national output to rise.
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7.
Illustration: Changes in Government Spending and/or Taxes Graph E illustrates the effect of an increase in government spending and/or a decrease in taxes (known as expansionary fiscal policy), and Graph F illustrates the effect of a decrease in government spending and/or an increase in taxes (known as contractionary fiscal policy).
Graph E Price Level LRAS SRAS
Graph F Price Level LRAS SRAS
P1 P0 AD1 AD Y0 Y1 Output (Real GDP) Y1 Y0 AD P0 P1
AD1
Output (Real GDP)
In graph E, the economy is initially in a recession, illustrated as output level Y0, which is below the potential level of output Y1. The government can stimulate the economy by increasing government spending or decreasing taxes (or both) shifting the aggregate demand curve to the right and causing national output (real GDP) to rise.
In graph F, the economy is initially in an expansionary phase, illustrated as output level Y0, which is above the potential level of output Y1. The government can contract the economy by decreasing government spending or increasing taxes (or both), shifting the aggregate demand curve to the left and causing national output (real GDP) to fall.
F.
THE MULTIPLIER EFFECT The multiplier effect refers to the fact that an increase in consumer, firm, or government spending, produces a multiplied increase in the level of economic activity. For example, a $1 increase in government spending results in a greater than $1 increase in real GDP. The multiplier effect stems from the fact that increases in spending generate income for firms, which in turn spend that income. Their spending gives other households and firms income, and so on. Therefore, the effect of a $1 increase in spending is magnified by the multiplier effect. The multiplier effect results from the marginal propensity to consume (MPC). The MPC is the change in consumption due to a $1 increase in income. Because people tend to save part of their income, the MPC is typically less than one. Using the MPC, the size of the multiplier effect can be calculated using the following formula:
Multiplier = 1 Change in Spending (1 MPC)
Note: The examiners could refer to "1 MPC" as the marginal propensity to save (MPS), so be aware of this terminology as well.
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For example, suppose the MPC is 0.8 (i.e., the change in consumption due to a $1 increase in income is 80 cents) and that spending increases by $100. Then the multiplier would be:
Multiplier = 1 $100 = $500 (1 0.8)
Thus a $100 dollar increase in spending results in a $500 increase in real GDP. G. FACTORS THAT SHIFT SHORT-RUN AGGREGATE SUPPLY Recall that shifts in long-run aggregate supply are associated with economic growth NOT business cycles. Therefore, when discussing business cycles we focus on shifts in the shortrun aggregate supply curve. The primary factors that shift short-run aggregate supply are: 1. Changes in Input (Resource) Prices a. Increase in Input Prices An increase in input prices (raw material prices, wages, etc.) causes the shortrun aggregate supply curve to shift left. Thus, an increase in input prices causes the economy to contract and leads to a decrease in national output (real GDP).
EXAMPLE
For example, a large increase in oil prices (oil is a primary input in production) would shift the short-run aggregate supply curve to the left. As a result, national output would fall, causing a contraction and possibly a recession. This is illustrated in Graph D. b. Decrease in Input Prices A decrease in input prices causes the short-run aggregate supply curve to shift to the right. A decrease in input prices causes the economy to expand and leads to an increase in national output (real GDP). 2. Supply Shocks a. Supplies are Plentiful If resource supplies become more plentiful, the short-run aggregate supply curve will shift to the right, causing national output to increase. b. Supplies are Curtailed If resource supplies are curtailed (e.g., crop failures, damage to infrastructure caused by earthquakes, etc.) the short-run supply curve will shift to the left, causing national output (real GDP) to decline.
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H.
SHIFTS IN AGGREGATE DEMAND AND SUPPLY AND THE EFFECTS ON FIRM BUSINESS OPERATIONS Shifts in either the aggregate demand or aggregate supply curve affect the business conditions of firms. 1. Example As was discussed above, when the aggregate demand curve shifts right (an increase in aggregate demand), firm profits tend to increase. In addition, firms are likely to experience a decrease in excess capacity, leading them to increase the size of their workforce. 2. Effect of Economic Events on the Firm When economic events (such as those discussed above) cause either the aggregate demand curve or short-run aggregate supply curve to shift, they also affect the business conditions of firms. a. Shifts in Aggregate Demand Economic events that cause aggregate demand to increase (e.g., an increase in wealth or a decrease in interest rates) tend to cause firm profits to rise. In contrast, economic events that cause aggregate demand to decrease (e.g., a decline in consumer confidence) tend to cause firm profits to fall. b. Shifts in Aggregate Supply Economic events that shift the aggregate supply curve also affect firm profits, employment, and other conditions. For example, a rise in input costs tends to reduce firm profits and cause firms to reduce the size of their workforce.
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ECONOMIC MEASURES AND REASONS FOR CHANGES IN THE ECONOMY
I.
OVERVIEW Economists and policy-makers rely on a host of economic measures or indicators to determine the overall state of economic activity. Some of the most commonly cited economic measures are: (1) real Gross Domestic Product (real GDP), (2) the unemployment rate, (3) the inflation rate, and (4) interest rates. It is important to remember that these economic measures tend to move together. For example, when real GDP is rising, unemployment tends to be falling. Similarly, when the unemployment rate is rising the inflation rate tends to be falling.
II.
THE NATIONAL INCOME ACCOUNTING SYSTEM The National Income and Product Accounting (NIPA) system was developed by the U.S. Department of Commerce in order to monitor the health and performance of the U.S. economy. The two approaches to measuring GDP (expenditure approach and income approach, both discussed in detail below) are calculated using NIPA. The combined economic output of the following four sectors is called Gross Domestic Product (GDP), the total dollar value of all new final goods and services produced within the economy in a given time period. Households (or Consumers) Businesses Federal, State, and Local Governments The Foreign Sector Remember that GDP was introduced on page B2-3 where nominal GDP and real GDP were discussed. A. TWO METHODS OF MEASURING GDP The two methods of measuring GDP are the expenditure approach and the income approach. 1. The Expenditure Approach Under the expenditure approach, GDP is the sum of the following four components:
G I C E
Government purchases of goods and services Gross private domestic investment (nonresidential fixed investment, residential fixed investment, and change in business inventories) Personal consumption expenditures (durable goods, non-durable goods, and services) Net exports (exports minus imports)
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2.
The Income Approach The income approach accounts for GDP as the value of resource costs and incomes generated during the measurement period. a. b. The income approach includes business profits, rent, wages, interest, depreciation, and business taxes. Calculate GDP through the income approach by using the following mnemonic:
I P I R A T E D
B.
Income of proprietors Profits of corporations Interest (net) Rental income Adjustments for net foreign income and miscellaneous items Taxes (indirect business taxes) Employee compensation (wages) Depreciation (also known as capital consumption allowance)
COMPARISON OF APPROACHES The different approaches to preparing an "income statement" for the domestic economy (the GDP) are shown in the table below. 1. 2. The aggregate expenditures approach on the left is a flow-of-product approach (at market prices). The income approach on the right is a flow of earnings and costs approach (valueadded items plus taxes).
Table 1 (Billions of Dollars)
Expenditures Approach (Flow-of-Product) Government purchases Investment Consumption Exports (net) $1,314.7 1,014.4 4,698.7 (96.4)
Income Approach (Earnings and Cost) Income of proprietors Profits of corporations Interest (net) Rental income Adjustments for net foreign income/miscellaneous Taxes (indirect business) Employee compensation Depreciation (consumption of fixed capital) Domestic Income $ 450.9 526.5 392.8 116.6 45.0 572.5 4,008.3 818.8 $6,931.4
Aggregate Expenditure
$6,931.4
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C.
OTHER MEASURES OF NATIONAL INCOME While GDP is the most common measure of national income and an economy's output and performance, there are several other noteworthy measures. These measures are calculated by making specific deductions and additions to GDP and include: Net Domestic Product (NDP), Gross National Product (GNP), Net National Product (NNP), National Income (NI), Personal Income (PI), and Disposable Income (DI). 1. Net Domestic Product Net domestic product (NDP) is GDP minus depreciation (the capital consumption allowance), the expenditure necessary to maintain production capacity (or "depreciation" to accountants). 2. Gross National Product (GNP) GNP is defined as the market value of final goods and services produced by residents of a country in a given time period. GNP differs from GDP because GNP includes goods and services that are produced overseas by U.S. firms and excludes goods and services that are produced domestically by foreign firms. For example, if BMW produces cars in the U.S., that production is counted as part of U.S. GDP, but it is not counted as part of U.S. GNP because BMW is a foreign-owned company. 3. Net National Product (NNP) Net national product (NNP) is defined as the total income of a country's residents less losses from economic depreciation (i.e., losses in the value of capital goods due to age and wear). Thus, NNP equals GNP minus economic depreciation. This depreciation is not accounting depreciation, which is allocation of costs to accounting periods. 4. National Income (NI) National income (NI) is NNP less indirect business taxes (e.g., sales tax). It measures the income received by all factors of production within a country. 5. Personal Income (PI) Personal Income (PI) is the income received by households and noncorporate businesses. Specifically,
NI Less: Undistributed corporate profits (retained earnings) Net interest Contributions for social measures (social security contributions) Corporate income taxes Government transfer payments to individuals Personal interest income Business transfer payments/dividends PI
Plus: =
6.
Disposable Income (DI) Disposable Income (DI) is personal income less personal taxes. It is the amount of income households have available either to spend or save.
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III.
THE UNEMPLOYMENT RATE The unemployment rate measures the ratio of the number of people classified as unemployed to the total labor force. The total labor force includes all non-institutionalized individuals 16 years of age or older who are either working or actively looking for work. (An unemployed person is defined as a person 16 years of age or older who is available for work and who has actively sought employment during the previous four weeks.) Note that to be counted as unemployed a person must be actively looking for work. The unemployment rate can be expressed as:
Unemployment Rate = Number of Unemployed 100 Total Labor Force
A.
TYPES OF UNEMPLOYMENT 1. Frictional Unemployment Frictional unemployment is normal unemployment resulting from workers routinely changing jobs or from workers being temporarily laid off. It is the unemployment that arises because of the time needed to match qualified job seekers with available jobs. 2. Structural Unemployment Structural unemployment occurs when: a. b. 3. Jobs available in the market do not correspond to the skills of the work force, and Unemployed workers do not live where the jobs are located.
Seasonal Unemployment Seasonal unemployment is the result of seasonal changes in the demand and supply of labor. For example, shortly before Christmas, the demand for labor increases and then decreases again after Christmas.
4.
Cyclical Unemployment Cyclical unemployment is the amount of unemployment resulting from declines in real GDP during periods of contraction or recession or in any period when the economy fails to operate at its potential. When real GDP is below the potential level of output, cyclical unemployment is positive. When real GDP is above the potential level of output, cyclical unemployment is negative. Thus, cyclical unemployment rises during a recession and falls during an expansion.
B.
NATURAL RATE OF UNEMPLOYMENT AND THE MEANING OF FULL EMPLOYMENT 1. Natural Rate of Unemployment The natural rate of unemployment is the "normal" rate of unemployment around which the unemployment rate fluctuates due to cyclical unemployment. Thus, the natural rate of unemployment is the sum of frictional, structural, and seasonal unemployment or the employment rate that exists when the economy is at its potential output level (recall that the position of the Long-Run Aggregate Supply (LRAS) curve is determined by the potential level of output). 2. Full Employment Full employment is defined as the level of unemployment when there is no cyclical unemployment. Full employment does not mean zero unemployment. When the economy is operating at full employment, there is still frictional, structural, and seasonal unemployment.
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C.
THE LINK BETWEEN UNEMPLOYMENT AND OUTPUT (REAL GDP) The unemployment rate and national output (real GDP) tend to move in opposite directions. That is, when real GDP is rising, the unemployment rate tends to be falling. Similarly, when real GDP is falling (for example, when the economy is in a recession), the unemployment rate tends to be rising. The reason for the link between the two variables is straightforward. When the demand for goods and services increases (when real GDP is rising), firms typically need to hire additional workers to produce the additional goods and services demanded and hence the unemployment rate tends to fall. Obviously the opposite is true when the demand for goods and services decreases.
IV.
THE PRICE LEVEL AND INFLATION A. DEFINITIONS 1. Inflation Inflation is defined as a sustained increase in the general prices of goods and services. It occurs when prices on average are increasing over time. 2. Deflation Deflation is defined as a sustained decrease in the general prices of goods and services. It occurs when prices on average are falling over time. Most economists believe deflation is a much bigger economic problem than inflation. During periods of deflation, firms are likely to experience significant excess production capacity. This occurs because consumers tend to hold off purchasing goods and services during a period of deflation because they realize the price of goods and services is likely to continue to fall. Consequently, firm profits are likely to be falling during periods of deflation. 3. Inflation/Deflation Rate The inflation or deflation rate is typically measured as the percentage change in the Consumer Price Index (CPI) from one period to the next. a. Consumer Price Index (CPI) The CPI is a measure of the overall cost of a fixed basket of goods and services purchased by an average household. (The Producer Price Index (PPI) measures the overall cost of a basket of goods and services typically purchased by firms.) b. Formula Using the CPI, the inflation rate is calculated as the percentage change in the CPI from one period to the next:
CPI this period CPI last period CPI last period 100
Inflation Rate =
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B.
CAUSES OF INFLATION AND DEFLATION Inflation and deflation are caused by shifts in the aggregate demand and short-run aggregate supply curves. A shift right in the aggregate demand curve will cause the price level to rise, leading to inflation. Similarly, a shift left in the short-run aggregate supply curve will also cause the price level to rise, leading to inflation. 1. Demand-Pull Inflation Demand-pull inflation is caused by increases in aggregate demand. Thus, demand-pull inflation could be caused by factors such as: a. b. c. d. 2. Increases in government spending, Decreases in taxes, Increases in wealth, and Increases in the money supply.
Cost-Push Inflation Cost-push inflation is caused by reductions in short-run aggregate supply. Thus, costpush inflation could be caused by factors such as: a. b. An increase in oil prices, or An increase in nominal wages.
3.
Illustrations Graphs G and H illustrate demand-pull and cost-push inflation using the aggregate demand and short-run aggregate supply curves.
Graph G Price Level SRAS
Graph H Price Level SRAS1 SRAS
P1 P0 AD1 AD Y0 Y1 Output (Real GDP)
P1 P0
AD
Y1 Y0 Output (Real GDP)
Demand-Pull Inflation: An increase in aggregate demand causes the short-run equilibrium price level to rise from P0 to P1.
Cost-Push Inflation: A decrease in shortrun aggregate supply causes the short-run equilibrium price level to rise from P0 to P1.
4.
Deflation Deflation is also caused by shifts in aggregate demand or short-run aggregate supply. A shift left in aggregate demand (perhaps brought about by a stock market crash or a large increase in taxes) will cause the aggregate price level to fall. Similarly, a shift right in the short-run aggregate supply curve will also cause the aggregate price level to fall.
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C.
INFLATION AND THE VALUE OF MONEY Inflation has an inverse relationship with purchasing power. As the price level rises, the value of money declines. 1. Definitions a. Monetary Assets and Liabilities Monetary assets and liabilities (e.g., cash, accounts receivable, notes payable, etc.) are fixed in dollar amounts regardless of changes in specific prices or the general price level. b. Non-Monetary Assets and Liabilities The value of non-monetary assets (e.g., a building, land, machinery, etc.) and non-monetary liabilities will fluctuate with inflation and deflation. 2. Holding Monetary Assets During a period of inflation, those with a fixed amount of money or income (e.g., retired persons) will be hurt (i.e., their purchasing power will be eroded). Similarly, firms that lend out money at fixed interest rates are likely to be hurt by inflation. 3. Holding Monetary Liabilities During a period of inflation, those with a fixed amount of debt (e.g., those with home mortgages) will be aided (i.e., the debt will be repaid with inflated dollars). Thus, inflation also tends to be benefit firms with large amounts of outstanding debt. OPEC and the Stagflation of the 1970s
Between 1973 and 1974, OPEC (Organization of Petroleum Exporting Countries) substantially curtailed its production of crude oil. As a result, the price of a barrel of crude oil rose from approximately $2.00 per barrel in late 1973 to $10.00 per barrel in late 1974.
EXAMPLE
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This increase in the price of crude oil had a substantial effect on the U.S. economy. Specifically, rising crude oil prices represented an increase in input costs for U.S. firms. As a result, firms cut back production and the short-run aggregate supply curve shifted left. This is the situation depicted in Graph D. As the short-run aggregate supply curve shifted left, national output (real GDP) began to decline, unemployment began to rise, and the aggregate price level began to rise (cost-push inflation). The combination of falling national output and a rising price level is known as stagflation. The actions of OPEC in 197374 led to a recession in the U.S. that was particularly harsh because not only was the unemployment rate rising, but the newly unemployed were facing higher prices for goods and services due to inflation!
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The Great Depression and Deflation The Great Depression began with the stock market crash of October 24, 1929. By 1932, the Dow Jones industrial average had fallen 89% from its peak in 1929. In addition, shortly before the stock market crash, the Federal Reserve (the Central Bank of the U.S.) increased interest rates in an attempt to control inflation. It then increased interest rates again in early 1931. While the stock market crash was not the only cause of the great depression, it does mark the beginning of the depression. The depression was caused by a number of factors including ill-timed interest rate hikes by the Federal Reserve, the stock market crash, and protectionist trade policies. Table 1 shows what happened to real GDP, the unemployment rate, and the price level (as measured by the CPI) between 1929 and 1933. Table 1 Year
EXAMPLE
Real GDP (Billions of 1987 Dollars) 821.8 748.9 691.3 599.7 587.1
Unemployment Rate 3.15% 8.71% 15.91% 23.65% 24.87%
Price Level (CPI) 17.1 16.7 15.2 13.7 13.0
1929 1930 1931 1932 1933
As the table illustrates, the Great Depression was characterized by falling output (falling real GDP), rising unemployment and deflation. The deflation that occurred can be seen by noting that between 1929 and 1933 the price level fell continuously. Furthermore, at the height of the Great Depression, one out of every four workers was unemployed! The data suggests that the Great Depression was caused by a shift left in aggregate demand, as in Graph C. Specifically, the stock market crash reduced household wealth, which shifted the aggregate demand curve to the left. In addition, the interest rate hikes, orchestrated by the Federal Reserve, increased the cost of capital, thereby decreasing the demand for investment goods and shifting the aggregate demand curve even further to the left. As aggregate demand fell, the price level also fell and the nation experienced a period of deflation.
V.
INVERSE RELATIONSHIP BETWEEN INFLATION AND UNEMPLOYMENT A. THE PHILLIPS CURVE Inflation and unemployment are traditionally thought to have an inverse relationship in the short run. The Phillips Curve illustrates the inverse relationship between the rate of inflation and the unemployment rate. It illustrates the tradeoff that exists in the short run between inflation and unemployment. While unemployment and inflation have historically moved in opposite directions, during the oil shocks of the 1970s the Phillips Curve broke down. Specifically, the oil shocks (negative supply shocks) of the 1970s led to a situation where both unemployment and the price level were rising.
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B.
ILLUSTRATION OF THE PHILLIPS CURVE The Phillips Curve is illustrated in Graph I.
Inflation Rate
Graph I
The Phillips Curve illustrates the tradeoff between inflation and unemployment. When unemployment is high, inflation tends to be low, and when unemployment is very low, inflation tends to be high.
Unemployment Rate
VI.
BUDGET DEFICITS AND SURPLUSES The budget is the federal government's plan for spending funds and raising revenues through taxation, fees, and other means (and for borrowing funds if necessary). The budget deficit and the budget surplus are important indicators of the current and future health of an economy. A. BUDGET DEFICITS A budget deficit occurs when a country spends more than it takes in (mostly in the form of taxes). 1. Financing Budget Deficits Budget deficits are usually financed by government borrowing, which affects interest rates. The government could also finance budget deficits by printing new money. However, financing budget deficits by printing money causes inflation. 2. Cyclical Budget Deficit A cyclical budget deficit is caused by temporarily low economic activity. For example, a cyclical budget deficit might be caused by a recession. 3. Structural Budget Deficit A structural budget deficit is one that is caused by a structural imbalance between government spending and revenue. Structural deficits are not caused by temporarily low economic activity. B. BUDGET SURPLUSES A budget surplus occurs when government revenues exceed government spending during the year.
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VII.
INTEREST RATES A. NOMINAL AND REAL INTEREST RATES 1. Nominal Interest Rate The nominal interest rate is the amount of interest paid (or earned) measured in current dollars. When the economy experiences inflation, nominal interest rates are not a good measure of how much borrowers really pay or lenders really receive when they take out or make a loan. A more accurate measure of the interest borrowers pay or lenders receive is the real interest rate. 2. Real Interest Rate The real interest rate is defined as the nominal interest rate minus the inflation rate. It is a measure of the purchasing power of interest earned or paid. Real Interest Rate = Nominal Interest Rate Inflation Rate
EXAMPLE
For example, if you take out a loan with a 10% nominal interest rate and the inflation rate is 3%, then your real interest rate is only 7%. That is, after adjusting for the fact that the dollars with which you will repay the loan in the future are worth less than current dollars due to inflation, you are really only paying 7% to borrow the money! 3. Relationship Between Nominal Interest Rates and Inflation Nominal interest rates and inflation tend to move together. When the inflation rate increases, so does the nominal interest rate. The relationship between nominal interest rates and inflation may be shown by rearranging the above equation for real interest rates as follows: Nominal Interest Rate = Real Interest Rate + Inflation Thus, if real interest rates do not change, a 1% increase in the inflation rate will lead to a 1% increase in nominal interest rates.
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Illustration: Nominal Interest Rates and Inflation (Graph J)

Nominal Interest Rates and Inflation
20.00% 18.00% 16.00% 14.00% Interest Rate/Inflation Rate 12.00% 10.00% 8.00% 6.00% 4.00% Inflation Rate 2.00% 0.00% 1955
Nominal Interest Rate
1960
1965
1970
1975 Year
1980
1985
1990
1995
Note the close relationship between nominal interest rates and the inflation rate. As the inflation rate increases, the nominal interest rate also increases. Also note that around 1974/1975 the inflation rate was actually higher than the nominal interest rate implying real interest rates were negative! B. DEFINITION OF MONEY AND THE MONEY SUPPLY Money is the set of liquid assets that are generally accepted in exchange for goods and services. The money supply is defined as the stock of all liquid assets available for transactions in the economy at any given point in time. There are several definitions of money supply. M1 and M2 are the most common measures of money supply and are reported (periodically) in financial publications such as the Wall Street Journal. M1 is defined broadly as money that is used for purchases of goods and services. It typically includes coins, currency, checkable deposits (accounts that allow holders to write checks against interest-bearing funds within them), and traveler's checks. M1 does not typically include savings accounts or certificates of deposit (CDs). M2 is defined broadly as M1 plus liquid assets that cannot be used as a medium of exchange but that can be converted easily into checkable deposits or other components of M1. These include time certificates of deposit less than $100,000, money market deposit accounts at banks, mutual fund accounts, and savings accounts. M3 includes all items in M2 as well as time certificates of deposit in excess of $100,000.
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C.
MONETARY POLICY AND THE MONEY SUPPLY Monetary policy is the use of the money supply to stabilize the economy. The Federal Reserve uses monetary policy to increase or decrease the money supply in an effort to promote price stability and full employment. Understanding the effects of changes in the money supply is important because changes in the money supply lead to changes in interest rates, changes in the price level, and changes in national output (real GDP). The Fed controls the money supply through: 1. Open Market Operations (OMO) Open Market Operations (OMO) consist of the purchase and sale of government securities (Treasury Bills and bonds) in the open market. a. Increase in the Money Supply When the Fed purchases government securities, it increases the money supply (i.e., puts money into circulation to pay for the securities). b. Decrease in the Money Supply When the Fed sells government securities, it decreases the money supply (i.e., takes money out of circulation). 2. Changes in the Discount Rate The discount rate is the interest rate the Fed charges member banks for short-term (normally overnight) loans. a. b. c. 3. Member banks may borrow money from the Fed to cover liquidity needs, increase reserves, or make investments. Raising the discount rate discourages borrowing by member banks and decreases the money supply. Lowering the discount rate encourages borrowing by member banks and increases the money supply.
Changes in the Required Reserve Ratio (RRR) The Required Reserve Ratio (RRR) is the fraction of total deposits banks must hold in reserve. a. b. Raising the reserve requirement decreases the money supply. Lowering the reserve requirement increases the money supply.
D.
INTEREST RATES AND THE SUPPLY OF AND DEMAND FOR MONEY 1. Demand for Money is Inversely Related to Interest Rates Changes in the money supply have a direct effect on interest rates because interest rates are determined by the supply of and demand for money. The demand for money is the relationship between how much money individuals want to hold and the interest rate. The demand for money is inversely related to the interest rateas interest rates rise, it becomes more expensive to hold money (because holding money rather than saving or investing it means you do not earn interest), thus reducing the demand for money.
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2.
Supply of Money is Fixed at a Given Point in Time As noted above, the supply of money is determined by the Federal Reserve and is therefore fixed at any given point in time at the level set by the Federal Reserve. Graph K illustrates the demand for and supply of money. The intersection of the money demand curve and the money supply line determines the interest rate. a. b.
Graph K
An increase in the money supply will cause interest rates to fall. Conversely, a decrease in the money supply will cause interest rates to rise.
The Money Market MS MS1
Interest Rate
Equilibrium interest rate; I0 I1 Demand for Money
Quantity of Money The Money Market: The equilibrium interest rate is found where the demand for money intersects the supply of money. The money supply curve is vertical since the Federal Reserve controls the supply of money (thus it is independent of the interest rate). If the Fed increases the money supply, interest rates will fall, as illustrated by the fall in interest rates from I0 to I1.
VIII. MONETARY POLICY AND ITS EFFECTS ON INTEREST RATES, THE PRICE LEVEL, OUTPUT (REAL GDP) AND UNEMPLOYMENT When the Federal Reserve increases or decreases the money supply it has a direct effect on interest rates and an indirect effect on the price level, real GDP, and the unemployment rate. Specifically, when the Fed changes the money supply, it causes interest rates to either increase or decrease. As we saw earlier, changes in the interest rate directly affect the cost of capital and thus shift the aggregate demand curve. Finally, shifts in aggregate demand cause changes in the price level, real GDP, and the unemployment rate. A. EXPANSIONARY MONETARY POLICY (INCREASES IN THE MONEY SUPPLY) Expansionary monetary policy results when the Fed increases the money supply. Expansionary monetary policy affects the economy through the following chain of events: 1. 2. 3. 4.
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An increase in the money supply causes interest rates to fall. Falling interest rates reduce the cost of capital and hence stimulate the desired levels of firm investment and household consumption. Increases in desired investment and consumption cause an increase in aggregate demand. Aggregate demand shifts to the right, causing real GDP to rise, the unemployment rate to fall, and the price level to rise.
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B.
CONTRACTIONARY MONETARY POLICY (DECREASES IN THE MONEY SUPPLY) Contractionary monetary policy results when the Fed decreases the money supply. The effect of contractionary monetary policy is the exact opposite of expansionary monetary policy. Specifically: 1. 2. 3. 4. A decrease in the money supply causes interest rates to rise. Rising interest rates reduce the desired levels of firm investment and household consumption. Decreases in desired investment and consumption cause a decrease in aggregate demand. Aggregate demand shifts to the left, causing real GDP to fall, the unemployment rate to rise, and the price level to fall. The 2001 Recession and Monetary Policy
After growing steadily for almost a decade, the U.S. economy started to slow down at the end of 2000. The slowdown in the economy was accompanied by a large drop in stock prices that marked the end of the bull market of the late 1990's. In 2001, the U.S. economy experienced two consecutive quarters of negative real GDP growth implying the economy had slipped into a recession. As the economy began to falter, Alan Greenspan, the Chairman of the Federal Reserve, initiated expansionary monetary policy. Specifically, the Federal Reserve began lowering interest rates by increasing the money supply. Lower interest rates helped keep the economy from slipping even further into a recession. Specifically, lower interest rates led to a large increase in home purchases starting in 2001 and continuing through 2002. In addition, lower interest rates made it possible for the auto industry to offer attractive financing rates, including zero-percent financing! This helped increase consumer purchases of automobiles and overall demand for goods and services in the economy. The recession of 2001 and the actions taken by the Federal Reserve are illustrated in Graphs L and M. Graph L
Interest Rate
EXAMPLE
Graph M
Price Level MS0 MS1 LRAS SRAS
I0 P1 I1 Money Demand Mo M1 AD0 Quantity of Money Y0 Y1 Real GDP P0 AD1
Graph M illustrates the recession of 2001. During the recession, output (real GDP) is at Y0, which is below the potential level of output Y1, indicating a recession. Graph L illustrates the money market and the expansionary monetary policy of the Federal Reserve. By increasing the money supply, the Federal Reserve caused interest rates to fall from I0 to I1. Lower interest rates spurred new home investments and consumer consumption of durable goods such as automobiles. The increased consumption and investment led to a shift right in aggregate demand as depicted in graph M. As aggregate demand shifted right, real GDP began to increase and the economy began to recover from the recession.
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MARKET INFLUENCES ON BUSINESS STRATEGIES I. INTRODUCTION The strategic goals of a firm are influenced by the market in which the firm operates. The ability of a firm to achieve success is a direct result of how well the strategic plan fits the market in which the firm operates and how well the firm carries out its strategic plan. The firm must create an overall plan (a strategic plan) to assist in combating competition and helping it to develop an approach to achieve its objectives (in line with the firm's vision and mission statement). Strategic thinking encompasses a wide variety of issues with various types of benefits, such as the unification of organizational and operational decisions, goal-orientation toward the desired company achievements, directed focus on planning for flexible responses for new developments in the market, the creation of bases for evaluation, and the overall company focus on the vision, mission statement, and objectives of the firm. A. STEPS IN STRATEGIC MANAGEMENT (STRATEGIC POSITIONING) Strategic management (positioning) normally involves defining the mission, identifying the strategy, identifying the critical success factors, and analyzing those success factors by recognition of strengths, weaknesses, opportunities, and threats. 1. Define the Firm's Vision and Mission Statements Organizational mission statements usually represent one or two line descriptions of what the organization is in business to do. Ultimately, however, mission philosophies fall into one of three basic categories that impact the overall manner in which the organization carries out its business. a. Build Missions Build missions are for organizations that accommodate a volume or range of work as a means of accomplishing organizational objectives. Organizations with build missions tend to take a long-term view and are likely to invest in significant capital projects. b. Hold Missions Hold missions are for organizations that maintain their current competitive position. c. Harvest Missions Harvest missions are for organizations that reap immediate benefits from the organization. Organizations with harvest missions tend to have a short-term view, are less likely to invest in significant capital projects, and are more likely to focus on net income, cash flows, and immediate return. 2. Set the Goals of the Firm Organizations can choose any number of ways to achieve their missions. Generally, however, there are two broad and distinct paths for achieving organizational goals: cost leadership and differentiation. Each path has its own characteristics and implications for operational planning, budgeting, and corporate culture and will be discussed in detail later in this lecture.
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3.
Define the Objectives of the Firm a. Financial Objectives Financial objectives are the improvement of the overall financial outcomes of a firm's strategy. b. Non-Financial Objectives Non-financial objectives are the improvement of the overall ability of the firm to compete in the market in the long run, which is the ultimate focus for overall shareholder wealth maximization.
4.
Decide What to Measure and Take a Baseline Measurement Organizations use various measures of success to determine the achievement of strategic objectives. These measures are generally referred to as critical success factors, which may be either financial or non-financial. a. Financial Measures (Financial) Financial measures of success are generally derived from the financial reporting system of the organization or the marketplace. Examples of financial measures include sales or earnings growth, dividend growth, and growth in the market value of the organization's stock, credit ratings, cash flows, etc. b. Internal Business Processes (Non-Financial) Internal business process measures of success generally relate to non-financial measures of efficiency or production effectiveness derived from internal records. Internal business process measures of success include quality measures, cycle time computations, yields, reduction in waste, etc. c. Customer Measures (Non-Financial) Customer measures of success are non-financial measures of organizational effectiveness derived from information provided directly or indirectly by customers or from data derived from responses to customers. Customer measures of success include market share data, customer satisfaction data, brand recognition information, on-time delivery data, etc. d. Advance Learning and Innovation (Non-Financial) Learning and innovation measures of success are internal measures of effective use of human resources including morale and corporate culture, innovation in new products and methods, education and training, etc.
5.
Strategic Analysis (SWOT) Organizations use strategic or SWOT (Strengths, Weaknesses, Opportunities, and Threats) analysis to ascertain the overall strategy and critical success factors that the organization will measure. Factors internal to an organization that impact strategy are the sources of strengths and weaknesses. Outstanding skills that represent strengths in relation to competitors are referred to as core competencies. Factors external to the organization are the sources of opportunities and threats. As managers review these factors, the organization builds clarity regarding the mission, consensus as to strategy, critical success factors, and the impact of internal and external factors on the business.
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6.
Create the Strategic Plan a. Focus of the Plan In general, a strategic plan of a company must create a set of steps to achieve the objectives of the firm while staying in line with the firm's vision and mission statement. The plan must provide an environment and a model under which the goals and profitability of the firm can be achieved. The plan must focus on the ways the company will: (1) (2) (3) (4) b. Conduct business operations, Respond to competitive movements and other issues, Achieve/maintain competitive advantage, and Provide a way to address the needs and preferences of its customers.
Strategic Plans Vary Based on Segments Strategic plans may vary for each segment of an organization based on the characteristics of that segment. Characteristics that will affect strategic planning include: (1) (2) (3) (4) (5) (6) Growth potential as indicated by industry maturity and regulatory constraints Profitability Discretionary cash flow Contribution margins Levels of risk Management talent (e.g., limited career opportunities in low-growth industries and markets will reduce the pool of talent available for management)
7.
Implement the Strategic Plan In general, the overall vision, mission statement, objectives, and strategy of the firm must be embraced and executed at various levels within the organization. The plan should be able to address those areas that will be applicable at all the different levels of the firm so that the plan is executed as a team that shares a common goal. The levels (from top to bottom) include: a. b. c. d. Corporate level, Business level, Functional level, and Operating level.
8.
Evaluate and Revise the Plan as Necessary The plan must be evaluated and revised as necessary.
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B.
CONTINUAL REVISION AND EVALUATION OF THE PLAN (CONTINGENCY PLANNING) Contingency planning addresses development of alternative plans in the event that adopted plans do not work, assumed variables prove to be faulty, or objectives become impractical or irrelevant. Contingency planning will first consider the impact of changes in variables and then document and quantify management's corrective action to deal with those changes. For example, contingency plans that are part of the strategic plan focus on the ability of the firm to change products or adapt to new markets. 1. Three Questions a Firm Should Ask Itself The firm must have an on-going process of attempting to determine three things: a. b. c. 2. Do the goals of the firm continue to be aligned with the mission statement and current strategy? Has the firm been able to attain or maintain competitive advantage? Is the firm able to be profitable under the current strategy?
Flexibility of the Plan is Necessary The selected strategic plan of the firm must be flexible to adapt to changes in such things as: a. b. c. d. e. Technology, Competition, Crisis situations, Regulatory laws, and Customer preferences.
3.
Proper Reaction is Essential The firm must have a strategic plan that will allow it to be able to react to the changes in the market in such a way as to still maintain competitive advantage and attain its goals in line with its vision and mission statement. Sustaining competitive advantage is crucial to the success of a firm.
C.
CHOICE OF A BUSINESS MODEL Once a strategic plan is in place, the company will choose a business model concerned with cash flows and profits under which it believes the company will best be able to achieve its strategic plan.
II.
THE LAWS OF DEMAND AND SUPPLY Basic principles of microeconomic theory are very important on the CPA Exam, but understanding the fundamentals is also important to the business manager. Managers are more likely to be successful if they understand how their actions and various governmental policies or collusive actions (e.g., cartels) affect their market and firm. A market is simply a collection of buyers and sellers meeting or communicating in order to trade goods or services.
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A.
DEMAND 1. Definitions a. Demand Curve The demand curve illustrates the maximum quantity of a good consumers are willing and able to purchase at each and every price (at any given price), all else equal. Note that this demand curve is similar to the aggregate demand curve discussed on page B2-6 except that the x-axis here is quantity and not real GDP. It does, however, illustrate the same kind of relationship. However, this demand curve is the microeconomics demand curve for a certain good or product and not the total demand in the economy as a whole. b. Quantity Demanded Quantity demanded is defined as the quantity of a good (or service) individuals are willing and able to purchase at each and every price (at any given price), all else equal. c. Change in Quantity Demanded A change in quantity demanded is a change in the amount of a good demanded resulting solely from a change in price. Changes in quantity demanded are shown by movements along the demand curve (D). When the assumptions regarding price or quantity change, then the "demand point" will change along this demand curve. For example, if the price of a product increases, there will be a move up the demand curve. d. Change in Demand A change in demand is a change in the amount of a good demanded resulting from a change in something other than the price of the good. A change in demand cannot be due to a change in price. A change in demand causes a shift in the demand curve. 2. Fundamental Law of Demand The fundamental law of demand states that the price of a product (or service) and the quantity demanded of that product (or service) are inversely related. As the price of the product increases, the quantity demanded decreases. Quantity demanded is inversely related to price for two reasons: a. Substitution Effect The substitution effect refers to the fact that consumers tend to purchase more (less) of a good when its price falls (rises) in relation to the price of other goods. The substitution effect exists because people tend to substitute one similar good for another when the price of a good they usually purchase increases. For example, if the price of Pepsi-Cola decreases, it will be used as a substitute for Coca-Cola (a similar good). b. Income Effect The income effect means that as prices are lowered with income remaining constant (i.e., as purchasing power or real income increases), people will purchase more of all of the lower priced products. For example, a decrease in the price of a good increases a consumer's real income even when nominal income remains constant. As a result, the consumer can purchase more of all goods.
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3.
Factors that Shift Demand Curves (Factors Other than Price) Mnemonic: W R I T E N
W R
a.
Changes in Wealth For example, people whose wealth increases may increase their demand for luxury cars.
b.
Changes in the Price of Related Goods (substitutes and complements) For example, if the price of a similar good (a substitute good) increases, the demand curve will shift to the right (increase) for the original good, now perceived as a bargain. If the price of a good used in conjunction with the original good (referred to as a complementary good) decreases, then the demand for the original good will increase (e.g., if personal computer prices diminish, demand increases for peripherals such as monitors and laser printers).
I T E N
c.
Changes in Consumer Income For example, an increase in income will shift the demand curve to the right (depicted as the shift from D1 to D2).
d.
Changes in Consumer Tastes or Preferences for a Product For example, in the clothing industry, a revival of the "1960s era" will increase the demand for bell-bottom jeans (retro clothing). This is also depicted as the shift from D1 to D2.
e.
Changes in Consumer Expectations For example, if consumers anticipate that there will be a future price increase, immediate demand will increase for that product (at the current lower price).
f.
Changes in the Number of Buyers Served by the Market For example, an increase in the number of buyers will shift the demand curve to the right.
Graph A: Change in Quantity Demanded
Graph B: Change in Demand D3 D1 D2 An increase in demand Price (in $) A decrease in demand D2 D1 D3 Quantity
Price (in $) PX1 PX 2
D X1 X2 Quantity
Changes in price cause movements along the demand curve
Shift in demand curve or change in demand caused by external influences (other than the price of the good)
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4.
Market Demand Market demand is the total amount of a good all individuals are willing and able to purchase at each and every price, all else equal. The market demand curve for a good is the sum total of all the individual demand curves and is also downward sloping (demonstrating the inverse relationship between price and quantity demanded). The market demand curve is derived by summing the quantities demanded at each price over all individuals. Graph C illustrates how the market demand curve is constructed when the market contains just two individuals.
Graph C
Price Price Price
P2 P1
P2 P1
P2 P1
Quantity
Quantity
11
Quantity
Individual 1's demand curve
Individual 2's demand curve
The market demand curve
B.
SUPPLY 1. Definitions The fundamental law of supply states that price and quantity supplied are positively related (i.e., they have a positive correlation). The higher the price received for a good, the more sellers will produce (higher quantity). a. Supply Curve The supply curve illustrates the maximum quantity of a good sellers are willing and able to produce at each and every price (at any given price), all else equal. Note that this supply curve is similar to the aggregate supply curve discussed on page B2-7 except that the x-axis here is quantity and not real GDP. It does, however, illustrate the same kind of relationship. However, this supply curve is the microeconomics supply curve for a certain good or product and not the total demand in the economy as a whole. b. Quantity Supplied Quantity supplied is the amount of a good that producers are willing and able to produce at each and every price (at any given price), all else equal. c. Change in Quantity Supplied A change in quantity supplied is a change in the amount producers are willing and able to produce resulting solely from a change in price. A change in quantity supplied is represented by a movement along the supply curve. When price changes, move up or down the supply curve to find the new quantity that will be supplied. d. Change in Supply A change in supply is a change in the amount of a good supplied resulting from a change in something other than the price of the good. A change in supply cannot be due to a change in price. A change in supply causes a shift in the supply curve.
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2.
Factors that Shift Supply Curves Mnemonic: ECOST
a.
Changes in Price Expectations of the Supplying Firm For example, if prices are expected to decrease, the firm will supply more now at each price level to take advantage of the currently higher prices. This is represented by the shift in the supply curve from supply curve S1 to supply curve S2.
b.
Changes in Production Costs (Price of Inputs) For example, a decrease in wages paid to workers would cause a shift to the right in the supply curve because for the same total amount of production dollars, the firm is willing to supply more product. This is represented by the shift in the supply curve from supply curve S1 to supply curve S2.
O S T
c.
Changes in the Price or Demand for Other Goods For example, a decrease in the demand for another good supplied by a firm would cause the firm to shift its resources and increase the supply of its remaining goods.
d.
Changes in Subsidies or Taxes For example, a decrease in taxes or an increase in subsidies would increase the amount supplied at each price level.
e.
Changes in Production Technology For example, an improvement in technology would cause a shift to the right of the supply curve.
Graph D: Change in Quantity Supplied

Price (in $) S Price (in $)
Graph E: Change in Supply

S3 S1 S2 A decrease in supply
P2 P1 An increase in supply
X1
X2
Quantity Shifts in supply caused by external factors (other than price)
Quantity
Changes in price cause movements along the supply curve
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3.
Market Supply Market supply is the total amount of a good all producers are willing and able to produce at each and every price, all else equal. The market supply curve for a good is the sum total of all the individual supply curves, and is also upward sloping (demonstrating the positive relationship between price and quantity supplied). The market supply curve is derived in the same manner as the market demand curve, namely, by summing the quantities supplied at each price over all producers. Graph F illustrates how the market supply curve is constructed when the market contains just two producers.
Graph F
Price
Price
Price
P2 P1
P2 P1
P2 P1
10
Quantity
Quantity
15
Quantity
Producer 1's supply curve
Producer 2's supply curve
The market supply curve
C.
MARKET EQUILIBRIUM A market is in equilibrium when there are no forces acting to change the current price/quantity combination. 1. 2. 3. The market's equilibrium price and output (quantity) is the point where the supply and demand curves intersect. The interaction of demand and supply determines equilibrium price. Graph G illustrates equilibrium price.
Graph G P
D $12 Price (P) 10 9 S Shortage Surplus S for example, minimum wage Equilibrium price ceiling price D QD
QS
QE
a.
As illustrated above, price (P) is $10 at equilibrium and the quantity supplied (Q) is QE.
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b. c. 4.
If price is set below the equilibrium price, the quantity demanded will exceed the quantity supplied, and a shortage will result. If price is set above the equilibrium price, the quantity demanded will be less than the quantity supplied, and a surplus will result.
Changes in Equilibrium If supply and/or demand curves shift, the equilibrium price and quantity will change. a. Effects of a Change in Demand on Equilibrium A shift right (increase) in demand from curve D to curve D1, as shown in Graph H, will result in an increase in price (from P to P1) and an increase in market clearing quantity (from Q to Q1). Conversely, a shift left (decrease) in demand from curve D to curve D1, as shown in Graph I, will result in a decrease in price (from P to P1) and a decrease in market clearing quantity (from Q to Q1).
Graph H Price S Price
Graph I S
P1 P D Q Q1 Quantity D1
P P1 D1 Q1 Q Quantity D
b.
Effects of a Change in Supply on Equilibrium A shift right (increase) in supply from curve S to curve S1, as shown in Graph J, will result in a decrease in price (from P to P1) and an increase in market clearing quantity (from Q to Q1). Conversely, a shift left (decrease) in supply from curve S to curve S1, as shown in Graph K, will result in an increase in price (from P to P1) and a decrease in market clearing quantity (from Q to Q1). Market clearing quantity is the equilibrium quantity. Market clearing is the idea that the market will "eventually" be cleared of all excess supply and demand (all surpluses and shortages), assuming that prices are free to change.
Graph J Price S S1 Price
Graph K
S1 S
P P1 D
P1 P D D1 Q Q1 Quantity Q1 Q Quantity
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c.
General Effects of Changes in Demand and Supply on Equilibrium (1) An increase in demand and supply results in an increase in equilibrium quantity, but the effect on price is indeterminate. It is certain that the effect is an increase of equilibrium quantity (because both an increase in demand and an increase in supply cause quantity to increase). However, the effect on equilibrium price is indeterminate because an increase in demand and supply could cause an increase, decrease, or no change (if equal changes) in equilibrium price. (a) (b) (2) If the increase in demand is larger than the increase in supply, the equilibrium price will rise. Conversely, if the increase in supply is larger than the increase in demand, the equilibrium price will fall.
The effect of other complex cases such as (a) a decrease in demand and an increase in supply, (b) an increase in demand and a decrease in supply, and (c) a decrease in demand and a decrease in supply, can be analyzed in a similar manner. Table 1 summarizes the effect of all four cases discussed above on equilibrium price and quantity. To understand them more fully, you should draw supply and demand diagrams for each case to verify the effects listed in the table.
Change in Supply Increase Decrease Decrease Increase Effect on Equilibrium Price Indeterminate Increase Indeterminate Decrease Effect on Equilibrium Quantity Increase Indeterminate Decrease Indeterminate
Change in Demand Increase Increase Decrease Decrease
III.
ELASTICITY OF DEMAND AND SUPPLY Elasticity is a measure of how sensitive the demand for or the supply of a product is to a change in its price. A. PRICE ELASTICITY OF DEMAND The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price. 1. In a normal demand curve, the price elasticity of demand is usually negative. This negative price elasticity reflects the downward sloping demand curve; as price goes up (positive percentage change), the quantity demanded goes down (negative percentage change). A negative price elasticity coefficient results if the demand curve is normal. Generally, the absolute elasticity coefficient (positive value) is considered when elasticity problems are posed on the examination, because it is presumed that price elasticity is negative for a demand curve. Measuring the Price Elasticity of Demand The price elasticity of demand can be measured in two ways.
2.
3.
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a.
The Point Method The point elasticity of demand measures the price elasticity of demand at a particular point on the demand curve. For example, suppose that when the price of a product increases from $100 to $120, quantity demanded decreases from 1,000 units to 900 units. Using the point elasticity method, the price elasticity of demand would be:
ep = Price Elasticity of Demand = % change in quantity demanded % change in price
% Change = 900 (new demand) - 1,000 (old demand) = (-100) units = (10%) in Quantity 1,000 (old demand) 1,000 units Divided by: % Change = $120 (new price) - $100 (old price) = $20 = $1 = 20% in Price $100 (old price) $100 $5 ep = Price Elasticity of Demand = (10) , or = -.5 (Absolute Value = .5) 20
b.
The Midpoint Method The midpoint method measures the price elasticity of demand between any two points on the demand curve. For example, suppose once again that when the price of a product increases from $100 to $120, quantity demanded decreases from 1,000 units to 900 units. Using the midpoint method, the price elasticity of demand would be:
ep = (Q2 Q1 ) (Q2 + Q1 ) (P2 P1 ) (P2 + P1 )
ep =
(900 1,000) (900 + 1,000) = .58 (Absolute Value = .58) (120 100) (120 + 100)
4.
Price Inelasticity (Demand < 1.0) Demand for a good is price inelastic if the absolute price elasticity of demand is less than 1.0. The smaller the number after the minus sign, the more inelastic the demand for the good. a. If price inelasticity is zero, demand is perfectly inelastic. Note also that perfectly inelastic demand curves are vertical, depicting that the quantity demanded stays the same no matter how price changes (e.g., in the pharmaceutical industry, the demand for insulin by diabetics). The calculation above with a 0.5 value is an example of inelastic demand.
b. 5.
Price Elasticity (Demand > 1.0) Demand is price elastic if the absolute price elasticity of demand is greater than 1.0. When the value is greater than 1.0 (defined as elastic), the greater the number, the more elastic the demand.
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6.
Unit Elasticity (Demand = 1.0) Demand is unit elastic if the absolute price elasticity of demand is equal to exactly 1.0. Demand is unit elastic if the percentage change in the quantity demanded caused by a price change equals the percentage change in price.
7.
Factors Affecting Price Elasticity of Demand a. b. Product demand is more elastic with more substitutes available but is inelastic if few substitutes are available. The longer the time period, the more product demand becomes elastic because more choices are available.
8.
Price Elasticity Effects on Total Revenue If we know the price elasticity of demand for a good, we can determine how a change in price will affect a firm's total revenue. Total revenue is simply the price of a good multiplied by the quantity of the good sold. a. Effects of Price Inelasticity on Total Revenue (Positive Relationship) If demand is price inelastic, an increase in price will result in an increase in total revenue (positive relationship), and a decrease in price will result in a decrease in total revenue. When demand is price inelastic, an increase in price results in a decrease in quantity demanded that is proportionally smaller than the increase in price. As a result, total revenue (equal to price times quantity) will increase. b. Effects of Price Elasticity on Total Revenue (Negative Relationship) If demand is price elastic, an increase in price will result in a decrease in total revenue (negative relationship), and a decrease in price will result in an increase in total revenue. When demand is price elastic, an increase in price results in a decrease in quantity demanded that is proportionally larger than the increase in price. As a result, total revenue (equal to price times quantity) will decrease. c. d. Effects of Unit Elasticity on Revenue (No Effect) If demand is unit elastic, a change in price will have no effect on total revenue. Summary The table below summarizes the relationship between the price elasticity of demand and total revenue.
Price Elasticity of Demand Elastic Inelastic Unit Elastic
Implied Elasticity Greater than 1 Less than 1 Equal to 1
Impact of a Price Increase on Total Revenue Total revenue decreases Total revenue increases Total revenue is unchanged
Impact of a Price Decrease on Total Revenue Total revenue increases Total revenue decreases Total revenue is unchanged
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B.
PRICE ELASTICITY OF SUPPLY The price elasticity of supply is calculated the same way as the price elasticity of demand, except that the change in quantity supplied is now measured. 1. Formula for Price Elasticity of Supply
es = Price Elasticity of Supply =
% change in quantity supplied % change in price
% Change = 600 (new supply) - 500 (old supply) = 100 = 20% in Quantity 500 (old supply) 500 Divided by: % Change = $11 (new price) - $10 (old price) = 1 = 10% in Price $10 (old price) 10 es = Price Elasticity of Supply =
2. Price Inelasticity (Supply < 1.0) Supply is price inelastic if the absolute price elasticity of supply is less than 1.0. If supply is perfectly inelastic, the price elasticity of supply equals zero. Perfectly inelastic supply curves are vertical, which reflects that quantity supplied is insensitive to price changes. 3. 4. 5. Price Elasticity (Supply > 1.0) Supply is price elastic if the absolute price elasticity of supply is greater than 1.0. Unit Elasticity (Supply = 1.0) Supply is unit elastic if the absolute price elasticity of supply is equal to 1.0. Factors Affecting Price Elasticity of Supply a. Feasibility of customers storing the product will affect the price elasticity of supply. For example, it may result in high elasticity if the product can be stored and does not have to be bought today. The time it takes to produce and supply the good will affect the price elasticity of supply. For example, longer production time leads to lower price elasticities.
20% =2 10%
b. C.
CROSS ELASTICITY Cross elasticity of demand (or supply) is the percentage change in the quantity demanded (or supplied) of one good caused by the price change of another good.
Ce = Cross Elasticity of Demand/Supply = % change in number of units of X demanded (supplied) % change in price of Y
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1.
Substitute Goods: Positive Coefficient If the coefficient is positive (i.e., the price of Product A goes up, causing the demand for Product B to go up), the two goods are substitutes (people stop buying the higher priced goods and begin to buy the substitute).
2.
Complement Goods: Negative Coefficient If the coefficient is negative (i.e., an increase in the price of Product A results in a decrease in quantity demanded for Product B), the commodities are complements.
3. D.
If the coefficient is zero, the goods are unrelated.
INCOME ELASTICITY OF DEMAND The income elasticity of demand measures the percentage change in quantity demanded for a product for a given percentage change in income.
Ie = Income Elasticity of Demand = % change in number of units of X demanded % change in income
1.
Positive Income Elasticity If the income elasticity of demand is positive (e.g., demand increases as income increases), the good is a normal good. A normal good is a product whose demand is positively related to income. As income goes up, demand for normal goods increases (e.g., premium foods such as steak and lobster).
2.
Negative Income Elasticity If the income elasticity of demand is negative (e.g., demand decreases as income increases), the good is an inferior good. An inferior good is a product whose demand is inversely related to income (opposite of normal good). As income goes up, demand for inferior goods decreases (e.g., canned vegetables or hamburger).
IV.
GOVERNMENT INTERVENTION IN MARKET OPERATIONS Sometimes, the government will intervene in a market by mandating a price different from the "market price" (causing either a surplus or a shortage). This is most often accomplished by using price ceilings and price floors. A. PRICE CEILINGS A price ceiling is a price that is established below the equilibrium price, which causes shortages to develop. Price ceilings cause prices to be artificially low, creating a greater demand than the supply available. For example, if the government sets a ceiling price (i.e., price cannot go above this amount) for a good (e.g., $9), then QD (in Graph G from page B236, equilibrium) will be demanded, but only QS will be supplied. Hence, there will be a market shortage.
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B.
PRICE FLOORS A price floor is a minimum price set above the equilibrium price, which causes surpluses to develop. Price floors are minimum prices established by law, such as minimum wages and agricultural price supports. For example, if the government sets a price floor (i.e., prices cannot go below this amount) for a good (e.g., a minimum wage set at $12), a market surplus will result.
V.
ECONOMIC COSTS A. TYPES OF COSTS 1. Explicit Costs Explicit costs are documented out-of-pocket expenses (e.g., wages, materials, and utilities). 2. Implicit Costs (Includes Opportunity Costs) Implicit costs are opportunity costs of inputs supplied by the owners (entrepreneurship, equity, capital, etc.). A key point in economics is opportunity cost, which represents the value of the next best alternative foregone (or not chosen). Opportunity cost is usually considered to be the profits that are lost from business because one strategy is pursued instead of another. B. COST CONCEPTS The two major concepts of costs to economists are accounting costs and economic costs. 1. Accounting Costs Accounting costs measure the explicit costs of operating a business (e.g., purchases of input services). a. b. Accounting costs do not consider opportunity costs. For example, accountants treat entrepreneurial costs (e.g., the value of a sole proprietor's time) as profits (i.e., no expense to the company), but economists view these as added costs to the organization.
2.
Economic Costs Economic costs are accounting (explicit) costs plus opportunity (implicit) costs. The most common economic costs are land costs (rent), labor costs (wages), capital costs (interest), and entrepreneurial costs.
VI.
ECONOMIC PROFIT VS. PROFIT A. ECONOMIC PROFIT Economic profit equals the difference between total revenue and total economic costs, which include opportunity costs. B. ACCOUNTING PROFIT Accounting profit equals the difference between total revenue and total accounting costs. Accounting profit is generally higher than economic profit because economic profit takes into account both explicit and implicit (opportunity) costs.
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VII.
PRODUCTION COSTS IN THE SHORT RUN Economists differentiate between the short run and the long run. The short run is a period of time in which some of the inputs used for production are fixed. In the short run, some of the economic costs are fixed because the inputs are fixed. The long run is a period of time in which all of the inputs used for production are variable. In the long run, all costs have the opportunity to change, even capital costs. Thus, in the long run, all costs are variable. A. PRODUCTION FUNCTION A firm's production function refers to the relationship between the firm's input of productive resources (the mnemonic "CELL": capital, entrepreneurial talent, land, and labor) and its output of goods and services. B. PRODUCTION CONCEPTS The three main production concepts are: 1. 2. Total Product Total product (TP) equals the total amount of output (Q) produced. Marginal Product Marginal product (MP) equals the change in total product resulting from a one- unit increase in the quantity of an input employed. For example, the marginal product of labor (L) is:
MPL = TP L
3.
Average Product Average product (AP) equals the total product divided by the quantity of an input. For example, the average product of labor (L) is APL = TP / L.
C.
LAW OF DIMINISHING RETURNS One of the main economic concepts that governs production is the law of diminishing returns which states that, when more and more units of a input are combined with a fixed amount of other inputs, output increases but at a diminishing rate. For example, adding additional workers to the production process, while holding the amount of other inputs constant, causes output to increase at a decreasing rate.
D.
FIXED AND VARIABLE COSTS Because some resources are fixed and others are variable in the short run, the short-run total cost structure of a firm consists of fixed costs and variable costs: 1. Fixed costs are the cost of acquiring the fixed resources used in production (one example is depreciation). Fixed costs do not change during the production period; they are independent of the level of production. Variable costs are the costs of acquiring the variable resources (such as labor); they are dependent upon the level of production.
2.
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E.
COST FUNCTIONS The four major cost functions are: 1. Average Fixed Cost (AFC) Average fixed cost (AFC) equals total fixed costs (FC) divided by quantity (Q). AFC = FC / Q 2. Average Variable Cost (AVC) Average variable cost (AVC) equals total variable cost (VC) divided by quantity. AVC = VC / Q 3. Average Total Cost (ATC) Average total cost (ATC), or unit cost, equals total (fixed plus variable) costs (TC) divided by quantity. ATC = TC / Q 4. Marginal Cost (MC) Marginal cost (incremental cost) is the change in total cost associated with a change in output quantity over a period of time. For example, the marginal cost of the 10th unit is the total cost of producing 10 units less the total cost of producing 9 units (the difference between the total cost of each). Marginal cost (MC), or incremental cost, equals the change in total cost, resulting from a one-unit increase in quantity.
MC = TC Q
a. b. F.
Marginal cost depends solely on variable costs. Fixed costs do not influence marginal costs.
ILLUSTRATION AND ANALYSIS OF SHORT-RUN COST CURVES

Graph L Costs (dollars) MC ATC AVC Short-Run Cost Curves
AFC Output (quantity)
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1. 2. 3.
The average fixed cost curve (AFC) decreases continually over the range of quantity produced (as output increases). ATC is the sum of AFC and AVC. Thus, the vertical distance between the AVC curve and the ATC curve is equal to AFC. The average total cost (ATC) curve is U-shaped. At low levels of output, average total costs are high because average fixed costs are high. As output increases, average fixed costs fall and thus average total costs fall. However, as output continues to increase, marginal costs and average costs start to increase causing average total costs to rise. The marginal cost curve (MC) intersects the AVC and ATC curves at their minimum points. The short run supply curve is the marginal cost (MC) curve above the minimum point of its average variable cost curve (AVC).
4. 5.
VIII. PRODUCTION COSTS IN THE LONG RUN A. B. C. D. In the long run, all resource inputs are variable. To be in position to produce at the lowest possible cost means adjusting the scale of production by adjusting plant size or numbers of plants. Generally the long-run average total cost (LRATC) curve is U-shaped. Therefore, the optimal size or number of plants is at the minimum point of the LRAC curve. LONG-RUN COST GRAPH Graph M illustrates the long-run average total cost (LRATC) curve and the long-run marginal cost (LRMC) curves.
Graph M Long-Run Costs Economies of Scale Diseconomies of Scale LRMC LRATC
Quantity of Output
E.
ECONOMIES OF SCALE Companies that are able to reduce per unit costs by using large plants to produce large amounts of output are said to have economies of scale. Economies of scale are reductions in unit costs resulting from increased size of operations. In the long run, economies of scale will cause the long-run average total cost curve (LRATC) to decline within the range of production. Economies of scale will eventually be lost, and diseconomies of scale will result (see Graph M). Factors enabling economies of scale (increases in the productivity of inputs) include:
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1. 2. 3. F.
Opportunity for specialization Utilization of advanced technology Mass production is normally more efficient
DISECONOMIES OF SCALE Diseconomies of scale may occur when these large firms become inefficient and are no longer cost productive. Diseconomies of scale are increases in average costs of operations resulting from problems in managing large-scale enterprises. For example, diseconomies of scale can also cause workers to feel disassociated from the firm with a resulting lack of motivation. Factors causing diseconomies of scale include: 1. 2. Bottlenecks and costs of transporting materials Difficulty of supervising and managing a large bureaucracy (reasons for diseconomies of scale for the firm result almost entirely from the inefficient performance of the management function)
IX.
MARKET STRUCTURES AND PRICING Operating environments influence the strategic plan. Following is a brief discussion of the overall market structures in which firms may operate. A. PERFECT (PURE) COMPETITION 1. Introduction Under perfect competition, strategic plans may include maintaining the market share and responsiveness of the sales price to market conditions. In a perfectly competitive market, no individual firm can influence the market price of its product, nor shift the market supply sufficiently to make a good more scarce or abundant. Attributes of perfect competition include: a. b. c. A large number of suppliers and customers acting independently. Very little product differentiation (homogeneous products). No barriers to entry because firms exert no influence over the market or price (thus, goods and services are produced at the lowest cost to the consumer in the long run).
2.
Maximizing Short-Run Profits (MR = MC = P) It is assumed that the objective of any business is to maximize its profits. To do this, a firm must find that price-quantity combination that will produce the largest spread between its revenues and its costs. Average Revenue (AR) is Total Revenue (TR) divided by Total Output. Marginal Revenue (MR) is the additional revenue brought in by producing one additional unit of output. Marginal Cost (MC) is the cost of producing one additional unit. A profitmaximizing firm will continue adding units to production until the cost of producing one more unit is greater than the revenue that unit will generate. In other words, the firm will continue adding units to production until it becomes unprofitable to do so (MR MC = 0). Therefore, the condition for maximizing profit is: MR=MC. To maximize short-run profits, competitive firms must produce at the output rate where Price = Marginal Revenue = Marginal Cost (or P = MR = MC). This is illustrated in Graphs N and O below.
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The Profit Maximizing Price and Output for a Firm Operating in a Perfectly Competitive Market Environment Graph N The Whole Industry $/Unit S $/Unit P=MC=MR Graph O One Firm MC ATC P=MR Total Profit
P ATC D Q Quantity of Output Q1
Quantity of Output
P is the price at which all firms in the industry sell their product in the short run and Q is industry output. Q1 is the profit-maximizing level of output of an individual firm. As illustrated in Graph O, the firms total profit in the short-run is given by the shaded area.
3.
Operating at a Loss (P > AVC) In the short run, firms may operate at a loss. If price is less than ATC at the profit maximizing level of output (i.e., where MR = MC), economic profits will be negative (i.e., the firm incurs economic losses). However, the firm should continue to operate in the short run as long as price is greater than average variable costs (i.e., P > AVC) because it will still cover all of its variable costs and some of its fixed costs.
4.
Firms are Price Takers Note that although the industry (market) demand curve slopes down, under conditions of perfect competition, each firm has a horizontal demand curve at the equilibrium price for the industry; thus, the firm is a "price taker" (i.e., cannot change the price itself). Because the price of an individual firm's output is the same regardless of how much it produces, price equals marginal revenue, which equals average revenue (P = MR = AR). (In a monopolistic market, the monopoly firm sets prices and is a "price setter," discussed below.)
5.
Long-Run Profits with Perfect Competition The long-run equilibrium position for a competitive firm is where price equals marginal cost equals minimum average total cost (i.e., P = MC = Minimum ATC). In the long run, economic profits are zero because firms produce where price equals minimum average total cost. The entry and exit of new firms ensures that economic profits are zero in the long run and, thus, that firms earn a normal rate of return.
6.
Advantages Derived from Perfect Competition a. The market maintains a lower price and larger quantity than in any other market structure. If abnormal profits exist, new competitors enter and drive the price down. Each buyer that is willing to pay the market price will get as many units as the buyer desires; thus, utility is maximized.
b.
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B.
MONOPOLY Under a monopoly, strategic plans will likely ignore market share and focus on profitability from production levels that maximize profits. Monopoly (e.g., the classic utility company, which was a "regulated" monopoly) represents concentration of supply in the hands of a single firm. 1. Assumptions and Market Characteristics of Monopoly a. b. c. d. 2. A single firm with a unique product Significant barriers to market entry The ability of the firm to set output and prices (e.g., through patents or regulatory restrictions against competition) No substitute products (the firm's demand curve is the same as the industry's demand curve)
Firm is a Price Setter Monopolies are "price setters," as opposed to firms in perfect competition (which are "price takers"). Higher prices are charged for supplying less of the product. In a monopoly, the firm will maximize profits where marginal revenue equals marginal cost; however, the monopolist's price will be higher than marginal revenue.
P
Graph P Profit Maximizing Price and Output of a Monopolist

MC Monopoly Profit
P1
ATC
ATC Firm Demand = Industry Demand
MR=MC
Q1
MR
MR = MC and P > MR (and MC) In pure monopoly, the firm's demand curve coincides with the industry demand curve for the product (because the firm and the industry are the same). Since the firm produces where MR = MC, it produces at a lower output and higher price than the competitive firms and earns above-normal profits.
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3.
Operating at a Loss In the short run, firms may operate at an economic loss. If price is less than ATC at the profit maximizing level of output (i.e., where MR = MC), economic profits will be negative (i.e., the firm incurs economic losses). If the situation does not change in the long run, a monopolist that operates at an economic loss will shut down.
4.
Natural Monopoly A natural monopoly exists when economic and technical conditions permit only one efficient supplier.
5.
Inefficiency of Monopoly Monopolists produce at a point where price is greater than marginal cost. As a result, the quantity produced by a monopolist is below the socially efficient level. Thus, the economic consequence of monopoly is that less output is produced than is socially optimal. In that sense, monopolies are inefficient because they produce a deadweight loss to society.
C.
MONOPOLISTIC COMPETITION Under monopolistic competition, strategic plans may include maintaining the market share (as with pure competition) but will also likely include a plan for enhanced product differentiation and extensive allocation of resources to advertising, marketing, product research, etc. Monopolistic competition exists when many sellers compete to sell a differentiated product in a market into which the entry of new sellers is possible (e.g., brand name cosmetic products). 1. Assumptions and Market Conditions a. b. c. d. 2. Numerous firms with differentiated products Few barriers to entry The ability of firms to exert some influence over the price and market Significant non-price competition in the market (e.g., competition to increase brand awareness and loyalty)
Brand Loyalty Instead of reducing prices, the firms spend money to create brand loyalty (e.g., aspirin, soft drinks, etc.).
3.
Little Market Control by the Firm Because many firms compete in this scenario, no one firm will be able to affect the prices charged by the other firms, and therefore, there is little market control by each firm.
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4.
Maximize Profits Where MR = MC The following graph illustrates the profit maximizing output level and price of a monopolistically competitive firm. Because the firm sells a differentiated product, it faces a downward sloping demand curve (similar to a monopolist). The firm maximizes profits by producing the level of output that equates marginal revenue and marginal cost (i.e., produce where MR = MC). In Graph Q, the firm earns an economic profit illustrated as the shaded area.
Graph Q Profit Maximization Price MC
ATC P ATC AVC
MR Q1
Demand Quantity of Output
5.
Zero Economic Profit in the Long Run Economic profit equals the difference between total revenue and total economic costs, which include opportunity costs. Because there are few barriers to entry under monopolistic competition, in the long run, monopolistically competitive firms will earn zero economic profits. If profits are positive in the short run, more firms will enter and drive profits down to zero. If firm profits are negative in the short run, firms will exit and drive profits up to zero. The long run equilibrium position for a monopolistically competitive firm is, therefore, to produce where MR = MC and P = ATC.
D.
OLIGOPOLY Under oligopoly, strategic plans focus on market share and call for the proper amount of advertising (to ensure appropriate product differentiation) and ways to properly adapt to price changes or required changes in production volume. An oligopoly is a market structure in which a few sellers (e.g., the "Big Three" automotive manufacturers) dominate the sales of a product and entry of new sellers is difficult or impossible. 1. Assumptions and Market Conditions a. b. c. Relatively few firms with differentiated products Fairly significant barriers to entry (e.g., high capital cost of designing a safety tested car and building an auto plant) Strongly interdependent firms (prices tend to be fixed)
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2.
Illustration of Kinked Demand Curve a. Oligopolists face a kinked demand curve because firms match price cuts of competitors but ignore price increases. This causes the demand curves to have different slopes above and below the prevailing price. Graph R illustrates the effects of price adjustment by an oligopolist.
b.
Graph R An Oligopolist's Kinked Demand Curve

If price is raised above the prevailing level, rival firms will ignore the increase, and the firm will lose a large portion of its sales. A kink in the demand-AR curve appears at the prevailing price.
P3 P1 P2
If price is cut, rival firms will match the reduction, thereby limiting the potential gain in sales.
D Q4 Q5 Q1 Q3 Q2 Quantity of output per period of time

The matching of price cuts and the ignoring of price increases by rival firms has the effect of making an oligopolist's demand curve highly elastic above the ruling (prevailing) price. This causes the demand curve to be kinked, illustrating that there is not a direct relationship between price and quantity at all points on the demand curve. Firms would be foolish to engage in price cutting because rivals merely match the price reduction (e.g., the airline industry).
E.
MARKET ASSUMPTIONS AND CONDITIONS 1. 2. 3. Regardless of the model that represents the industry, the firm will operate best when marginal revenue equals marginal cost (MR = MC). Microeconomic theory holds that firms make decisions based upon marginal cost and marginal revenue (essentially ignoring fixed or sunk costs). The following table summarizes the market assumptions and conditions underlying perfect competition, monopoly, monopolistic competition, and oligopoly.
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Market Structure Characteristic Number of firms in the industry Size of firms relative to industry Perfect Competition Many (Highly competitive) Small None (Easy to enter industry) None (All firms sell the same commodity product) Perfectly elastic (Firm sells as much, or as little, as it wants at the given market price) Firm has control over quantity produced only; price is set by the market, firm must accept the market price Accepts market price; can only adjust production so that P = MR = MC Zero economic profit Monopolistic Competition Many (Highly competitive) Small Oligopoly Few (Moderately competitive) Large High (Difficult to enter industry because of Economies of Scale) Various (Firms usually sell differentiated products) Inelastic (Firms face a kinked downward-sloping demand curve) Monopoly One (No competition) 100% of industry Insurmountable (No entry is possible) None (One firm sells only one product) Inelastic (Firm faces the entire demand curve for the product, which slopes downward)
Barriers to entry
Low (Easy to enter industry) Some (Firms sell slightly different products that are close substitutes) Highly elastic but downward sloping (Firm can adjust quantity of products sold without affecting the price very much) Firm has control mostly over quantity produced; price is mostly set by the market Searches for best price to maximize profits P > MR = MC in the short run Zero economic profit
Differentiation of product
Elasticity of demand
Firm's control over price and quantity
Firm has control over both the quantity produced and the price charged
Firm has control over both price and quantity Searches for optimum price P > MR = MC in the short and the long run Positive economic profit
Pricing strategy
Does not like to engage in price competition P > MR = MC Positive economic profit
Long-run profitability
F.
EFFECTS OF BOYCOTTS AND CARTELS ON PRICING AND OUTPUT 1. Cartels Cartels are groups of firms acting together to coordinate output decisions and control prices as if they were a single monopoly (i.e., OPEC and the Central Selling Organization of De Beers). The likely effect of a cartel is to increase price and reduce output below the socially efficient level.
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2.
Boycotts Boycotts are organized group refusals to conduct market transactions with a target group (using only social pressure, not legal obligation). The effectiveness of a boycott is measured as the achieved change in the target's disputed policies (normally price). Results indicate that a boycott will be most effective when economic and image pressure on the target are high and the target's policy commitment (how firm the company is on not changing its mind) is low.
X.
THE ECONOMY AS A SYSTEM OF MARKETS A. PRODUCTION AND DEMAND FOR ECONOMIC RESOURCES 1. Factors of Production (Resources) Businesses use resources to make final products. The primary resources from which final products are made consist of land (natural resources), labor (human capital), and capital (non-human physical capital accumulated through past investment). These resources are known as factors of production. Factors of production are bought and sold in markets just like final goods and services are bought and sold in markets. a. b. 2. To maximize profits, firms need to decide on the optimal levels of inputs to employ. The price firms must pay for the factors of production is determined by the interaction of supply and demand in the input market. Complementary Inputs Inputs are complementary inputs if an increase in the usage of one input results in an increase in the usage of the other input. b. Substitute Inputs Inputs are substitute inputs if an increase in the usage of one input results in a decrease in the usage of the other input. 3. Derived Demand Derived demand is the demand for factors of production. A firm's demand for inputs is derived from its decision to produce a good or service. Therefore, the demand for inputs is directly related to the demand for the goods and services those inputs produce. a. Demand for Inputs Depends on Demand for Outputs The demand for any input depends on the demand for the product the input produces (i.e., the firms output) and the marginal product of the input itself. (Recall that marginal product (MP) is the change in total product resulting from a one-unit change in an input). (1) (2) If the demand for a firm's output increases, the demand for the inputs used to produce that output will also increase. Similarly, if the marginal product of an input increases, the demand for that input will also increase.
Types of Inputs a.
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b.
Examples (1) (2) The demand for labor is directly related to the demand for the goods and services that labor produces. If the demand for medical services increases, the derived demand for doctors, nurses, and medical equipment will also increase.
B.
THE LABOR MARKET In modern economies, workers sell their services to employers in labor markets, where workers independently offer skills of a given quality to employers who compete for the workers' services. Just like in any other market, the supply of labor and demand for labor determines the price, or wage, of workers. Thus, in the labor market, wages are the price paid for labor. The laws of demand and supply prevail in labor markets as they do in product markets. The lower the wage, the greater the quantity of labor service demanded by employers. 1. Illustration Graph S illustrates equilibrium in the labor market. The equilibrium wage depends on the supply of and demand for labor. The equilibrium wage is found where the demand curve for labor intersects the supply curve for labor. Graph S The Labor Market Wage Supply of Labor
w1
Demand for Labor L1 Hours per Year
2.
Labor Demand and Supply Under Monopsony A monopsony occurs when there is only one employer in a market. For example, if a town contains a single firm, that firm is known as a monopsonist. Much like a monopolist has market power in the product market, a monopsonist has market power in the input (labor) market. Relative to purely competitive labor market, monopsony results in lower wages and lower levels of employment.
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3.
Unions and Wages a. Effect on Unionized Workers By forming a union and acting collectively, workers gain market power much in the same way that a monopoly or cartel has market power. The union may use its market power to bargain collectively for higher wages or restrict the supply of labor. As a result, wages of unionized workers increase. b. Effect on Non-Unionized Workers Unions may also affect the wages of non-unionized workers. Suppose there are two sectors in an economy, one unionized and the other not. Because employment falls in the unionized sector, displaced workers may seek employment in the nonunion sector. As a result, wages in the nonunion sector may fall as the supply of labor in that sector increases. Thus, while wages rise in the unionized sector, they may fall in the sector that is not unionized.
4.
Minimum Wage Laws The use of minimum wage laws to increase the wages of low skilled labor is controversial. If the minimum wage is set above the equilibrium wage, an excess supply of labor will result. In other words, if the minimum wage is above the equilibrium wage, the result is unemployment. As a result, the imposition of a minimum wage increases the income of those workers who have a job, but it decreases the income of workers who find themselves unemployed as a result of the imposition of the minimum wage. The effect of a minimum wage is illustrated in Graph T.
Graph T Minimum Wages Wage Supply of Labor
wmin w1 Minimum Wage
Demand for Labor LD L1

min
LS
Hours per Year
When the minimum wage is set at w , the quantity of labor demanded decreases from L1 to LD and the quantity of labor supplied increases from L1 to LS. As a result, the minimum wage causes unemployment, or an excess supply of labor, of (Ls LD).
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XI.
VALUE CHAIN ANALYSIS Companies strive to attain competitive advantage in a variety of means, and this does not only include doing all they can to match or beat what their competitors do. It also means that they need to take a good, long look at what drives the consumers in the marketplace. Firms desiring to achieve competitive advantage must focus on the needs and preferences of the buyers and then either meet or exceed their expectations. A. STRATEGIC TOOL Value chain analysis is a strategic tool that assists a firm in determining how important its perceived value (perceived by the buyers) is with respect to the market the firm operates in. The firm will go through exercises to assess how its activities create value in the marketplace. Managers must determine the flow of activities undertaken by the organization to produce a service or product and critique the value added to the customer by each link in the value chain. Once the firm is aware of how its product is perceived, value chain analysis is invaluable in assessing the ability of the firm to attain competitive advantage. B. LINK VALUE CHAIN ANALYSIS TO STRATEGY Value chain analysis must be used in conjunction with the organizational objectives and goals as well as the strategic plan that the firm employs so that competitive advantage can be assessed. Once costs have been analyzed relative to each activity, incremental analysis of relevant costs associated with changing the manner in which the identified activity in the value chain is accomplished can be performed. Reduced cost or improved innovation can result. Relationship between strategic planning activities:
Strategic Positioning
Value Chain Analysis
Balanced Scorecard*
* Balanced Scorecard is discussed in Chapter B5.

C. REQUIRED READING AT APPENDIX I As a supplement to the material above, please read the expanded discussion of Value Chain Analysis at Appendix I. XII. FACTORS THAT INFLUENCE STRATEGY When determining the effects of the market on business strategy, a look at the overall macroenvironment in which the firm operates is essential because it can significantly assist the company in developing and choosing the best strategy to meet its goals. A. TWO GENERAL TYPES OF FACTORS THAT INFLUENCE STRATEGY Firms use SWOT (Strengths, Weaknesses, Opportunities, and Threats) analysis to assist in developing their appropriate strategic plans. Any strategy must consider these factors in its development.
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1.
Internal Factors (Strengths and Weaknesses) Factors internal to the organization that impact strategy are sources of strengths and weaknesses and include: a. b. c. d. e. f. g. h. i. j. Innovation of product lines Competence of management Core competencies (outstanding skills that are better than those of the competitors) Influence of high-level managers Capital improvements Leadership in research and development Cohesiveness of the values of the organization Marketing effectiveness Effectiveness of communication Clarity of the strategic mission
2.
External Factors (Opportunities and Threats) Factors external to the organization are sources of opportunities in the market and threats to the firm's ability to continue with its strategic plan. a. Factors that Affect the Overall Industry and Competitive Environment of the Industry (1) (2) (3) (4) (5) (6) b. The economy Regulations and laws Demographics of the population Technological advances and existing technology Social values Political issues
Factors that Affect the Competitive Environment of the Firm A detailed discussion of the following five factors that affect the competitive environment of the firm is provided in item B, below. (1) (2) (3) (4) (5) Barriers to market entry Market competitiveness Existence of substitute products Bargaining power of the customers Bargaining power of the suppliers
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B.
FIVE FORCES THAT AFFECT THE COMPETITIVE ENVIRONMENT (AND PROFITABILITY) OF THE FIRM (MICHAEL PORTER, 1980 AND 1985) One of the goals of a firm is to create a strategy that attempts to keep the operations of the firm away from the unnecessary and oftentimes hazardous influences of the following five forces as much as possible. A strategic plan must be put in place so that a move in any of the forces that can have a significant impact on the operations of the firm cannot seriously jeopardize the ability of the firm to operate. A good strategic plan will position the firm so that it is always "on the look out" for changes in the forces so that it can preempt and predict the strategic moves of rival firms, respond appropriately and timely, and maintain its competitive advantage. The amount of overall competition the firm is faced with can only be determined after analysis of how significant of an impact the following five forces have with respect to the competitive environment of the firm. 1. Barriers to Entry The firm faces the threat of new firms entering the market in which it operates. Barriers to entry are the various "hoops" and other obstacles that firms must combat, along with facing the retaliation of those firms already competing in the market and the competitive cost advantages that existing firms enjoy. a. Types of Barriers to Entry Often, rival firms face barriers to entry in the form of government regulation, supplier access, high up-front capital requirements, pre-existing customer preferences and loyalties, economies of scale, learning curve issues, and other up-front competitive cost disadvantages, including patents, trade barriers, and other restrictions. b. When New Companies Will Attempt to Enter New companies will attempt to enter the competition when barriers to entry are low, potential high profits exist in the market, and the risk of retaliation by other firms is low. If the industry as a whole is earning a profit, other firms will desire to enter the market. Unless barriers to entry exist, firms will enter until profits fall to a competitive level. It is also possible that the simple threat of new entrants will scare firms into keeping their prices at competitive levels. 2. Market Competitiveness (Intensity of Competition) The existence of competition from rival firms is often the most significant of the five forces of competition. Firms need to be cognizant of their rivals' competitive moves and evaluate their current actions in an attempt to determine the future moves of the competition in the market. a. Ability of Rival Firms to Respond to Change If a firm is in competition with other firms who are all able to respond to changes in various components affecting business (e.g., regulation, input costs, labor issues, technology changes, consumer desires for improved quality and service, etc.), the firm faces a strong competitive force. b. Advertising of Rival Firms If rival firms are apt to spend large amounts of money on advertising aimed at changing customer preferences and creating loyalty, the impact of this competitive factor is increased.
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c.
Research and Development of Rival Firms When rival firms expend large amounts of money on research and development to improve their products or create new innovations in technology, the impact of this competitive factor is increased.
d.
Alliances of Rival Firms and Suppliers Often, rival firms focus on developing strong alliances with suppliers, and this could impact the firm's ability to obtain its inputs to the production process at advantageous prices and, thus, reduce its competitive advantage. When alliances are created, the impact of this competitive factor is increased.
e.
Increase in Competition Competition becomes an even stronger force impacting the firm when the market is not growing fast (in contrast, in fast growing markets, competitors are usually able to sustain profitability without having to take market share from their rivals), several equal-sized firms exist in the market, customers do not have strong brand preferences, the costs of exiting the market exceed the cost of continuing to operate, some firms profit from making certain moves to increase market share, and the various firms employ different types of strategic plans.
3.
Existence of Substitute Products If a firm operates in a market in which substitute products are available, it faces issues that need to be addressed in its strategic plan. If the firm faces heavy competition from substitute products, this force will have a stronger influence on the firm's competitive environment because the ability of a firm to sustain profits is significantly impacted by the maximum amount that buyers are willing to pay for a product. This is especially true if the substitutes are readily available to consumers, have equal performance, and are priced at or below the price of the firm's product. The effect is further intensified when the costs of the buyer switching to the substitute product are low. If few substitutes exist, buyers have little choice of products and may be willing to pay a higher price for the products that are available. If close substitutes exist, buyers may have a limit on the maximum price that they are willing to pay, and this has a direct impact on the profits of the firm.
4.
Bargaining Power of the Customers If buyers are in the position to bargain with suppliers on the conditions of service, price, and quality, they are a strong force in the competitive market in which the firm operates and will have a large impact on the competitive environment of the firm. Buyers may be quite price sensitive and change products solely based on price or they may have such brand loyalty and strong preferences that they will stay with a product regardless of price (oftentimes depending on the elasticity of demand). Marketing strategies are focused on the consumer of goods, and large amounts of funds are expended by firms each year in this area. The strength of the relationship between the value chains of buyers and firms impacts the bargaining power that buyers have. a. Large Volume of a Firm's Business (High Buyer Concentration) If one group of customers makes up a large volume of the firm's business, the bargaining power (negotiating power) of the customer will significantly impact the competitive environment of the firm, and the strategy of firms should focus on pleasing this group of customers.
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b.
Availability of Information The more information that is available to the buyer, the more the buyer will be able to compare and contrast features of a product and choose one over the other.
c.
Buyer's Low Cost of Switching Products If the costs of switching from one product to another are low, the impact of the effect on the competitive environment from buyers is increased. This result is intensified if the firm cannot easily change production without incurring high costs to begin producing another product.
d.
High Number of Alternate Suppliers When a large number of suppliers exist to serve the customers, the bargaining power of the buyer is increased.
5.
Bargaining Power of the Suppliers When the bargaining power of the suppliers of inputs to the production process is high, the firm must take a good look at its strategic plan with respect to the suppliers. Suppliers can take profits away from a firm simply by increasing the cost of the inputs to the firm's production process. The strength of the relationship between the value chains of sellers and firms impacts the bargaining power that suppliers have. a. Firm is Unable to Change Suppliers If the firm is unable to use different suppliers or cannot change its inputs (i.e., no substitutes are available), changes in the operations of the supplier, and thus the price of the input, will affect the profitability of firms, especially when those input costs are a significant part of the overall product cost. b. Reputation of Supplier and Demand for its Goods If the reputation of the supplier (e.g., the quality of its product) is excellent and crucial to the success of the firm's product and the demand for its goods from other firms is high, the firm could be placed in a difficult situation, especially if the firm is not a large client of the supplier or if strategic alliances have been formed between the supplier and a competitor.
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XIII. TYPES OF COMPETITIVE STRATEGIES Building a successful competitive strategy requires being able to attain some sort of competitive advantage while still holding customer loyalty and having value to the customer. Value chain analysis (a strategic management tool that requires managers to determine the flow of activities undertaken by the organization to produce a service or product) was discussed earlier in this chapter. In any of the following strategic alternatives, the related value chain would be altered to take into account the chosen strategy. A. COMPETITIVE ADVANTAGE IN GENERAL The overall competitive advantage of a firm is determined by the value the firm offers to its customers minus the cost of creating that value. When firms desire to achieve competitive advantage with respect to products, there are two basic forms of advantage that they will choose from. 1. Cost Leadership Advantage The cost leadership advantage stems from the fact that the buyers of the product are better off because the firm has been able to produce and sell its product for less than its rivals. If the total costs of the firm are less than those of rival firms, the firm has a competitive market advantage. This advantage may be used by the firm in one of two ways: a. Build Market Share If the firm lowers the price of its product below the price of its competitors, it may be able to secure a larger part of the market as its customer base and gain market share while still maintaining the profits that are required. b. Match the Price of Rivals If a firm enjoys a low-cost competitive advantage, it will be able to match the price of its rivals and, because it has overall lower total costs, beat the profitability of its rivals. 2. Differentiation Advantage (Offering Advantage) The differentiation (product differentiation) advantage stems from the fact that buyers are better off because the customer perceives the firm's product to be superior in some way to those of its rivals. Therefore, they are willing to pay a higher price for its uniqueness. All parts of the buying decision are affected by the perceived value of the product (e.g., higher quality, timeliness of delivery, superior service, wide range of goods, less risks, performance measures, etc.). After the product has been differentiated, the firm must always be sure to remain profitable and recoup the cost of the "premium" they have included with their product. This advantage may be used by the firm in one of two ways: a. Build Market Share The firm may attempt to build market share by pricing its product below what it would charge to recoup the premium with a standard number of buyers and try to recover its costs because it captures more than an average share of the market. b. Increase Price The firm may increase the price of its product to the point where it exactly offsets the value the customer perceives from the product.
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B.
FIVE BASIC TYPES OF COMPETITIVE STRATEGIES 1. 2. 3. 4. 5. Cost Leadership Focused on a Broad Range of Buyers Cost Leadership Focused on a Narrow Range (Niche) of Buyers Differentiation Focused on a Broad Range of Buyers Differentiation Focused on a Narrow Range (Niche) of Buyers Best Cost Provider
C.
COST LEADERSHIP STRATEGIES Organizations may choose to achieve their organizational missions by selling their product or service for less than any other participant in the marketplace. Cost leaders undermine the profitability of their competitors as a means of achieving overwhelming market share. 1. Lowest Overall Costs In order to be a low cost provider, the overall cost of a firm must be lower than other firms in the market. Careful analysis of all the costs in the process must be made and costs must be eliminated, if necessary. Also, evaluation of budgets and benchmarks are crucial. In this way, the firm will gain competitive advantage by either having higher overall profit margins or being able to undercut the prices of the other firms. Firms may choose to evaluate the value chain for areas to cut costs while still maintaining the perception of maintaining the value to the consumer. 2. When Cost Leadership Strategies Work Well Cost leadership strategies work well in markets where the buyers have large amounts of bargaining power and are able to switch between competitive products without incurring significant cost. They are also successful in markets where there is heavy price competition and where firms (especially new entry firms) can influence buyers to switch to their product and then increase their base of customers simply by cutting the price of the product for a period of time. 3. When Cost Leadership Strategies Fail If firms focus too much on cutting costs of the current process, they may end up overlooking technological advances that may also assist in lowering costs (especially those that the rivals have latched onto) or overlooking the fact that consumers may desire improvements to the product or may not care much anymore about the existence of a lower price in the desired product. If new features exist in other products, and customers desire those features, and the firm has ignored this fact, the firm has lost its cost leadership competitive advantage. Further, the strategy of cost leadership is not "rocket science." Any firm could easily use the same strategy (thus, reducing the firm's competitive advantage) if it sees that this strategy has worked in the marketplace.
D.
DIFFERENTIATION STRATEGIES (PRODUCT DIFFERENTIATION) Organizations may choose to achieve their organizational missions by creating the perception that their product is better or has a unique quality that differentiates it from competing products in the marketplace. Firms that successfully differentiate their products are able to command higher prices. 1. Create/Promote a Unique Feature in the Product When firms employ a differentiation strategy, they desire to create a competitive advantage by focusing customer preference on their products and away from the products of competitors. They are able to do this by setting their product "aside" from the others through a unique feature (e.g., quality, superior customer service, special taste, image, value, prestige, etc.).
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2.
Build Customer Brand Loyalty If the firm can achieve differentiation and still make a profit (i.e., the firm cannot succeed if it loses profit because of the higher costs of the feature in the differentiation strategy), it will succeed in achieving competitive advantage because it will build customer brand loyalty and increase sales.
3.
Perception is Often Greater than Reality Firms with differentiation strategies will evaluate their value chains and perhaps put more money into research and development and innovation and focus on heavy marketing of their "superior products" to customers, highlighting the areas the ultimate consumer cares about (e.g., quality, superior customer service, prestige, etc.). Remember, "perception is often greater than reality," and this is especially important to firms whose products are not purchased frequently or are directed towards first-time or one-time buyers who are not that sophisticated in that market. It is possible for the firm to create a perception of value that is often as significant as the real value that exists in the product.
4.
When Differentiation Strategies Work Well Differentiation strategies work well when customers are able to see value in a product, when the product appeals to different people for different reasons, and when the firms who are competing in the market choose different features with which to differentiate their products.
5.
When Differentiation Strategies Fail When a firm chooses to differentiate in an area without properly assessing the requirements of the consumer for desired features and preferences or without creating value for the consumer, a differentiation strategy can fail. Further, firms that focus too much on one area (or the wrong area) may "overdo it" and end up creating a product whose value does not exceed the higher price that must be charged for the feature. If a firm is in a market where customers do not care about differentiation, will not pay extra for unique features, and are happy with paying a lower price for a more generic product, the differentiation strategies can fail.
E.
BEST COST STRATEGIES The best cost strategy combines the cost leadership strategy with the differentiation strategy to give customers higher value for their purchase price (i.e., a quality product at a reasonable price). If the firm is able to create a strategy that will allow it to evaluate and change its value chain so that it can achieve the lowest cost among its closest competitors while matching them on the features desired by consumers, it will succeed. 1. Overall Lowest Cost in Industry is Not an Option Of course, a firm employing a best cost strategy cannot have the overall lowest cost in the entire industry or it could not compete profit-wise because of the special, unique features that are part of the differentiation strategy. Therefore, the firm strives to be the low cost leader among firms in the marketplace that have comparable quality products that have been differentiated in some way. 2. When Best Cost Strategies Work Well Best cost strategies work well when generic products are not acceptable to the varied needs and preferences of the buyers but the buyers are still sensitive to the value that they are receiving for the money they are spending and the overall price they are paying.
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3.
When Best Cost Strategies Fail Because the best cost strategist plays the "middle," it faces risks of losing customers to other firms that are using cost leadership strategies or those that are specifically focused on differentiation. It often becomes difficult to attain the proper "middle" ground in the marketplace, and some firms may end up leaning to one side or the other and then finding themselves attempting to compete in a market where their chosen strategy does not work.
F.
FOCUS/NICHE STRATEGIES Firms with cost leadership or differentiation strategies may choose to focus their chosen strategy on a select small group of consumers, or a niche. Rather than having to address the needs and preferences of a broad range of consumers, these firms are able to focus on market niches where consumers have specialized needs and preferences. 1. When Focus/Niche Strategies Work Well The focus/niche strategy works well provided the niche has a large enough demand to create a profit for the firm, and provided the firm has the proper resources to adequately serve the needs of the niche group, and that provided that few firms are focusing in an area where others cannot compete in price or are not currently addressing with a particular feature. 2. When Focus/Niche Strategies Fail When other firms see that the niche has been successful for those serving it, they will attempt to enter the market as competitors and take away some of the sales of the firm, likely reducing the firm's profits and its competitive advantage. The firm also faces a risk that those consumers in the current niche may find that they actually prefer the features of products that the overall market desires (i.e., preferences change or the standard products have significantly improved), thus causing consumers to buy the standard products on the market and stop buying the niche product that the firm offers. If the firm is not easily responsive to change (flexible) for whatever reason, the focus/niche strategies can fail.
G.
OTHER TYPES OF STRATEGIES 1. Merger and Acquisition Firms may choose to combine with or acquire other firms in a formal process of merger or acquisition in order to obtain opportunities for cost reductions that they could not otherwise obtain, to obtain technological knowledge of others that they do not currently have, to combine research and development activities for efficiency and effectiveness, expand, or to cover areas of market demand that they are not currently serving. While all of this can be beneficial for firms, unless the combined management is able to work together well and unless the combined operations can be run effectively together, this strategy may not work well.
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2.
Cooperative/Strategic Alliances When companies desire to achieve such things as economies of scale (in marketing or production), to share the cost of obtaining information on innovations in technology, or to obtain information as a group that they could not obtain individually (or that may be too costly to obtain individually), they may choose to form strategic alliances in a cooperative strategy. While this strategy is not as formal as a merger or acquisition, the participating firms are usually able to obtain competitive advantage by acquiring information and skills they could not obtain on their own (or were prohibited from obtaining because it was too costly, etc.). However, this strategy requires that the individual partners are able to work as a team toward a common goal and that the partners do not take the information they receive and begin to compete heavily with each other.
3.
Vertical Integration A firm may desire to improve its competitive advantage through vertical integration, a strategy in which the firm seeks to control the value chain on the supply end (backward integration to the suppliers) and on the demand end (forward integration to consumers via distribution channels) within the same industry via integration of these processes to the firm's operations. When more of the competitive factors are controlled, a firm may be able to be successful in achieving the desired competitive advantage. However, this may end up reducing the firm's flexibility with respect to suppliers and distribution channels and force the firm to be too focused on one industry or too committed to one supplier or distribution channel.
XIV. SUPPLY CHAIN MANAGEMENT/INTEGRATED SUPPLY CHAIN MANAGEMENT (ISCM) A. COLLABORATIVE EFFORT OF BUYERS AND SELLERS If a firm and the entire supply chain (producers, distributors, retailers, customers, and service providers) are able to reasonably predict the expected demand of consumers for a product and then plan accordingly for supplying that demand, it would be employing the concept of integrated supply chain management (ISCM). Integrated supply chain management is a collaborative effort between buyers and sellers, and the relationship between them must be evaluated and managed as goods flows through the value chain. B. GOAL IS TO UNDERSTAND NEEDS AND PREFERENCES OF CUSTOMERS In order to attain and sustain competitive advantage, profits must be made and consumers must have perceived value. To increase value to the consumer, supply chain operations should generally be improved. The goal of ISCM is to better understand the needs and preferences of customers and cultivate the relationship with them. If the actual demand of the customer is met and excess supply does not sit on the market, the firm will be able to minimize costs all along the supply chain (e.g., raw materials, production, packaging, shipping, etc.). C. REQUIRED READING AT APPENDIX II As a supplement to the material above, please read the expanded discussion of Supply Chain Management at Appendix II.
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IMPLICATIONS OF DEALING IN FOREIGN CURRENCIES
The introduction of foreign currency transactions to business operations adds unique concepts essential to understanding an entity's business and industry. Dealing with foreign economies offers the opportunity for entities to capitalize on comparative advantages in trade or production but also exposes the entity to exchange rate fluctuations that result in potential risks frequently classified as transaction, economic or translation risk. The character of those risks and their implications to both financial position and operations along with the steps an entity can take to mitigate those risks (including hedge transactions) are areas specifically identified by the content specification outline for the CPA Examination.
I.
INTERNATIONAL BUSINESS OVERVIEW Reduced barriers to trade have created business opportunities to conduct operations in multiple countries or conduct import/export operations within the context of a traditional domestic operation. Entities that conduct business outside the country in which they are organized are frequently referred to as multinational corporations (MNC). A. MOTIVATIONS FOR INTERNATIONAL BUSINESS OPERATIONS Entities are encouraged to look beyond the political borders in which they were organized to maximize shareholder value. Several economic theories support international trade as a means of achieving improved shareholder value. 1. Comparative Advantage Specialization in the production and trade of specific products produces a comparative advantage in relation to trading partners. Companies and countries use their comparative advantage as a means of maximizing the value of their efforts and the value of their resources. The island nation of Bermuda produces no gasoline or vehicles, yet its roadways are teaming with vehicles of all types. The country predominantly specializes in tourism and uses the money it earns from its visitors to buy (import) vehicles and petroleum products. The country maximizes the number of resources it can import by specializing in tourism and buying transportation resources elsewhere. 2. Imperfect Markets Resource markets are often deemed to be imperfect. The ability to trade freely between markets is often limited by the physical immobility of the resource or regulatory barriers. In order to retrieve more resources, companies must trade outside their borders. Auto manufacturers in Detroit may seek a vacation from time to time on a sandy beach with a balmy breeze. Lake Michigan is breezy but, in January, is not balmy and won't compare with Bermuda! In order to capitalize on resources available from that vacation destination, the auto manufacturer must go to Bermuda and spend dollars there. Clearly there is not opportunity to simply import the resource.
EXAMPLE
EXAMPLE
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3.
Product Cycle Product manufacture or delivery is subject to a definable cycle that will start with the initial development of the product to meet needs in domestic markets. Product cycle theory anticipates that domestic success will result in domestic competition that will encourage the export of products or services to meet foreign demand and maintain efficient use of capacity. Foreign success will promote foreign competition. The entity is then motivated to actually establish a business outside its boundaries to more effectively differentiate itself and compete with foreign competitors.
B.
METHODS OF CONDUCTING INTERNATIONAL BUSINESS OPERATIONS Multinational operations are structured in any number of ways. The following terms help define different methods of organization. 1. International Trade Import/export operations characterize the use of purely international trade as a means of conducting international business. 2. Licensing Entities that provide the right to use processes or technologies in exchange for a fee are engaged in licensing activities.
EXAMPLE
Wireless, Inc., a U.S. corporation, obligates itself to establishing and maintaining cellular telephone systems in Mexico in exchange for a licensing fee to use its technology. 3. Franchising Entities whose marketing service or delivery strategy provides training and related service delivery resources in exchange for a fee are franchisors.
EXAMPLE
Flip-a-burger, Inc., a U.S. corporation, obligates itself to providing training and the use of unique company logos to businesses that operate in Peru. 4. Joint Ventures Joint ventures (defined on page B1-4) take advantage of comparative advantage of one ore both of the venturers in marketing or delivering a product.
EXAMPLE
Engulf & Devour Food products, a U.S. corporation, teams with Chez Brule, a French concern, to distribute US confections throughout France using Chez Brule's distribution network. 5. Direct Foreign Investment (DFI) a. Acquisitions of Existing Operations The outright purchase of foreign companies as subsidiaries serves as a means of establishing international operations. b. Establishing New Foreign Subsidiaries The startup of a subsidiary operation within the borders of a foreign country serves as a means of establishing international operations.
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C.
INHERENT RISKS OF INTERNATIONAL BUSINESS OPERATIONS The issues associated with conducting international business operations are generally categorized in the following manner. 1. Exchange Rate Fluctuation Exchange rate risks are generally divided into the following three categories: a. b. c. 2. Transaction risk Economic risk Translation risk
Foreign Economies Operation within foreign economies carries with it the risk of functioning within the general health or weakness of a particular economy. Domestic economies may be booming while international economies are suffering and acting as a drag on overall performance.
3.
Political Risk The potential of unstable political environments that are potentially disruptive, corrupt, or destructive amplifies the risk of doing business outside domestic borders. Ultimately, political climates or actions can disrupt cash flows.
II.
EXCHANGE RATE RISK: FACTORS AND EXPOSURE CATEGORIES Business transactions are typically denominated and valued in terms of money. Currency or money is the medium of exchange. Within domestic environments, a single currency defines the value of assets, liabilities, and operating transactions. In international settings, the values of assets, liabilities, and operating transactions are established not only in terms of the single currency but also in relation to other currencies. The relationship between currencies is not always stable and, therefore, creates exchange rate risk. A. FACTORS INFLUENCING EXCHANGE RATES Circumstances that give rise to changes in exchange rates are generally divided between trade-related factors (including differences in inflation, income, and government regulation) and financial factors (including differences in interest rates and restrictions on capital movements between companies). 1. Trade Factor: Relative Inflation Rates When domestic inflation exceeds foreign inflation, holders of domestic currency are motivated to purchase foreign currency to maintain the purchasing power of their money. The increase in demand for foreign currency will force the value of the foreign currency to rise in relation to the domestic currency, thereby changing the rate of exchange from domestic to foreign currency. Assume the United States dollar is relatively stable while the Mexican peso is suffering from sudden inflationary pressures. As the Mexican peso buys less in the domestic Mexican economy, Mexicans and their banking institutions seek the safe haven of the United States dollar to maintain the purchasing power of their liquid resources. The demand for United States dollars created by Mexicans buying them with Mexican pesos makes the United States dollar more valuable in terms of the peso and drives up the exchange rate. The United States dollar commands more pesos in an exchange of currency.
EXAMPLE
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2.
Trade Factor: Relative Income Levels As income increases in one country relative to another, exchange rates change as a result of increased demand for the currency in the country where income in increasing.
The income level in the United States increases significantly in the second quarter. Americans flock to Mexico City on vacation to buy piatas. The increased supply of American dollars seeking to buy pesos to purchase Mexican goods causes the value of the American dollar to fall in relation to a stated number of pesos. The exchange rate is thus impacted by relative income levels and the associated demand for foreign currency created by new domestic income. 3. Trade Factor: Government Controls Various trade and exchange barriers that artificially suppress the natural forces of supply and demand will impact exchange rates.
EXAMPLE
EXAMPLE
A tariff on imported piatas would have the impact of discouraging the purchase of imports, thereby reducing demand for the peso and maintaining the exchange rate. 4. Financial Factors: Relative Interest Rates and Capital Flows Interest rates create demands for currency by motivating either domestic or foreign investments. The forces of supply and demand create changes in the exchange rate as investors seek fixed returns. The impact of interest rates is directly impacted by the volume of capital that is allowed to flow between countries. Assume that guaranteed returns on institutional investments in Mexico skyrocket in the third quarter while interest rates in the United States remain low. American investors find the opportunity to earn high returns in Mexican banks irresistible. The demand for pesos increases as American investment increases. The exchange rate changes as the peso commands more United States dollars.
Summary Chart: Circumstances That Impact Exchange Rates Trade Related Factors Relative Inflation Rates Relative Income Levels Government Controls (Trade Restrictions) Financial Factors Relative Interest Rates Capital Flow Demand/ Supply of Currency Exchange Rate Demand for Securities Demand/ Supply of Currency
EXAMPLE
Demand for Goods
B.
THEORIES EXPLAINING EXCHANGE RATE RISK Several theories are used to explain the dynamic relationship between inflation rates and interest rates in the determination of currency exchange rates. These theories include the purchasing power parity theory, the International Fischer effect, and the interest rate parity theory. 1. Purchasing Power Parity Theory The purchasing power parity theory generally suggests that the price of identical goods sold in separate economies are identical when measured in a common currency. Exchange rates will constantly adjust to ensure purchasing power parity (equality).
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a.
Absolute Form The absolute form of the purchasing power parity theory is referred to as the "law of one price." The absolute form asserts that identical goods sold in separate economies will command equal prices when denominated in a common currency. Differences are self-adjusting.
b.
Relative Form The relative form holds to the basic theory of the absolute form but accounts for transportation and government regulation (such as tariffs and quotas) as determining factors and acknowledges that the price of identical items in different countries will not necessarily be absolutely equal even when measured in a common currency. The rate of incremental change in the exchange rate should be approximately equal assuming no change in the market imperfections associated with government regulation and transportation costs.
2.
International Fischer Effect The International Fischer effect explains the fluctuation in exchange rates through analysis of interest rates. Interest rates are viewed as a compound measurement of both financing costs and expected inflation that more accurately explains exchange rate changes. a. Interest Rate Components Interest rates are deemed to include a real risk-free rate of return and an additional component that accounts for inflation. b. Inflation Rates Changes in inflation derived from the International Fischer effect pinpoint the anticipated fluctuation in exchange rates.
3.
Interest Rate Parity Theory The interest rate parity theory holds that foreign and domestic interest rates will reach equilibrium once covered interest arbitrage is no longer possible. a. Covered Interest Arbitrage Covered interest arbitrage is a currency swap in which the counterparties exchange currencies at both the spot and forward rates simultaneously (see Glossary for definitions of spot and forward rate). In other words, the party engaging in covered interest arbitrage for an investment exchanges its domestic currency for a foreign currency to make the investment and also at the same time enters into a forward contract to sell an equal amount of the foreign currency to coincide with the maturity of the investment (and the attendant proceeds of the investment). The swap restores currency exposures to the original position without a currency gain or loss, making this a way to adjust exposure to a narrowing or widening of interest rate differentials. Covered interest arbitrage also ensures interest rate parity because this relationship prevents speculators from profiting by borrowing in a low interest rate country and simultaneously lending in a high interest country and hedging the currency risk. b. Interest Rate Parity Theory The difference between forward contract prices represents the difference in interest rates in effect in each country and thereby accounts for exchange rate differences.
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C.
TRANSACTION EXPOSURE: DEFINITION AND MEASUREMENT Exchange rate risk is defined, in part, by transaction exposure. Transaction exposure is defined as the potential that an organization could suffer economic loss or experience economic gain upon settlement of individual transactions as a result of changes in the exchange rates. Transaction exposure is generally measured in relation to currency variability or currency correlation. 1. General Measurement of transaction exposure is generally done in two steps: a. b. Project foreign currency inflows and foreign currency outflows. Estimate the variability (risk) associated with the foreign currency.
EXAMPLE
Seattle Import/Export, a U.S. import/export company imports commodities from Canada that it pays for in Canadian dollars and exports commodities to Canada for which it receives Canadian dollars. If Seattle Import/Export anticipated that it would export C$10,000,000 to Canada over the next year while importing C$8,000,000 over the same period, the net exposure in Canadian dollars is a C$2,000,000 inflow. If the exchange rate is $.75 to each Canadian dollar, then the net exposure in United States dollars is $1,500,000 (C$2,000,000 .75). If the rate is anticipated to fluctuate five cents, between $.70 and $.80, the total fluctuation exposure would be expected to be between $1,400,000 and $1,600,000. 2. Currency Variability (Single Foreign Currency) While the projected net inflow or outflow of a foreign currency may be determined from a budget or business plan, the expected variability in exchange rates is more difficult. a. Standard Deviation Currency variability may be estimated by computing the standard deviation of monthly exchange rates to the average exchange rate over a single period. b. Standard Deviation Over Time Currency variability may be estimated by computing the standard deviation of monthly exchange rates to the average exchange rate over multiple periods and selecting, judgmentally, the most likely exchange rate. 3. Currency Correlation (Multiple Foreign Currencies) Currency correlation scenarios anticipate the settlement of future transactions in multiple foreign currencies. The degree of transaction exposure is determined statistically by the degree to which the movement of exchange rates of multiple foreign currencies correlate. a. The higher the degree of correlation, the greater the possibility that changes in exchange rates (either favorable or unfavorable) will compound and increase the risk of exchange rate fluctuation.
4.
Value-at-Risk The value-at-risk method computes the maximum one day loss based on exchange rate fluctuations using both variability and correlation measurements.
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D.
ECONOMIC EXPOSURE: DEFINITION AND MEASUREMENT In addition to transaction exposure, exchange rate risk is defined, in part, by economic exposure. Economic exposure is defined as the potential that the present value of an organization's cash flows could increase or decrease as a result of changes in the exchange rates. Economic exposure is generally defined through local currency appreciation or depreciation and is measured in relation to organization earnings and cash flows. 1. Currency Appreciation and Depreciation Currency appreciation and depreciation refer to the strengthening (appreciation) or weakening (depreciation) of a currency in relation to other currencies. a. Impact of Currency Appreciation As a domestic currency appreciates in value or becomes stronger, it becomes more expensive in terms of a foreign currency. As currency appreciates, the volume of outflows tends to decline as domestic exports become more expensive. However, the volume of inflows tends to increase as foreign imports become less expensive. b. Impact of Currency Depreciation As a domestic currency depreciates in value or becomes weaker, it becomes less expensive in terms of a foreign currency. As a currency depreciates, the volume of outflows tends to rise as domestic exports become less expensive. However, the volume of inflows tends to decline as foreign imports become more expensive. The economic exposure created by domestic currency appreciation or depreciation with respect to a foreign currency depends upon the net inflow or outflow of foreign currency and is summarized as follows: Domestic Currency
Appreciation Depreciation
Foreign Currency
Net inflows Loss Gain Net outflows Gain Loss
2.
Measuring Economic Exposure through Earnings Economic exposure can be measured using the sensitivity of earnings to changes in exchange rates. The approach to sensitivity analysis involves three different steps: a. b. c. Prepare an income statement computing earnings expressed in terms of the foreign currency. Apply a range of likely exchange rates to each line item of the income statement and compute earnings under each scenario. Compare the earnings amounts in relation to fluctuations in expected exchange rates to determine the sensitivity of earnings to changes in exchange rates.
3.
Evaluation As the exchange rate increases, the foreign currency becomes more expensive in terms of the domestic currency. Profitability tends to decline because fixed costs, expressed in the foreign currency, become more expensive.
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E.
TRANSLATION EXPOSURE: DEFINITION AND MEASUREMENT In addition to the transaction and economic exposures, exchange rate risk is defined, in part, by translation exposure. Translation exposure is defined as the potential that assets, liabilities, equity, or income of a consolidated organization that includes foreign subsidiaries will change as a result of changes in the exchange rates and defines the effect of exchange rate fluctuations on financial position and operations. Translation exposure is generally defined by the degree of foreign involvement, the location of foreign subsidiaries, and the accounting methods used and measured in relation to the impact on the organization's earnings or comprehensive income. 1. Degree of Foreign Involvement The translation exposure to exchange rate risk increases as the proportion of foreign involvement by subsidiaries increases.
Domestic International, Inc. has no foreign subsidiaries but is deeply involved in exporting to neighboring countries. Global International, Inc. has twelve foreign subsidiaries that, combined, comprise sixty-five percent of consolidated revenues. Domestic International has less translation exposure than Global International because it has no foreign subsidiaries. Domestic's international business does expose the company to exchange rate risks, however, in terms of both transaction and economic exposure. 2. Locations of Foreign Investments Measurements of financial results of foreign investments frequently occur in the foreign currency in which the investee company operates. The exposure of the parent company to translation risk is impacted by the stability of the foreign currency in comparison to the parent's domestic currency. The more stable the exchange rate, the lower the translation risk. The less stable the exchange rate, the higher the translation risk. 3. Accounting Methods The translation of financial statements reported in foreign currencies is specifically defined by the Financial Accounting Standards Board, and one of two methods is used. Each method requires that the parent company assess the functional currency of the foreign subsidiary and then apply accounting and reporting principles based on that assessment. Each method accounts for a subsidiary's financial results and represents a translation exposure to exchange rate risk. a. Temporal Method (Remeasurement Method) The temporal method assumes that the functional currency is the currency of the parent. Translation gains or losses flow through the income statement. (1) (2) The functional currency is defined as the currency in which the primary economic activities of the subsidiary are transacted. When the transactions are denominated in the foreign currency and measured in the foreign currency, but the foreign subsidiary is dependent upon the parent's domestic currency for cash flows, then the parent's domestic currency is the functional currency. Financial results of the foreign subsidiary must be remeasured into the functional currency used for reporting. Steps in remeasurement include restatement of the balance sheet using various exchange rates and restatement of the income statement using various exchange rates. Any difference between the balance sheet and the income statement is accounted for as a remeasurement gain or loss through income.
EXAMPLE
(3) (4)
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(5)
The parent company's translation exposure to exchange rate gain or loss is composed of both the increase or decrease in net income as a result of exchange rates applied to income statement line items as well as the adjusting entry to determine the income necessary to balance the balance sheet through the income statement as a remeasurement gain or loss.
b.
Current Method (Translation Method) The current method assumes that the functional currency is the currency used by the foreign subsidiary. Translation gains and losses flow through other comprehensive income. (1) When the transactions are denominated and measured in the foreign currency and the foreign subsidiary is not dependent upon the parent's domestic currency for cash flows, the subsidiary's currency (the foreign currency) is the functional currency. Financial results of the foreign subsidiary must be translated into the currency used for reporting. Steps in translation include restatement of the balance sheet using various exchange rates and restatement of the income statement using various exchange rates. Any difference between the balance sheet and the income statement is accounted for through other comprehensive income and accumulated other comprehensive income, which is a component of stockholders' equity on the balance sheet. The parent company's translation exposure to exchange rate gain or loss is composed of the increase or decrease in net income as a result of exchange rates applied to income statement line items. However, the "plug" goes to other accumulated comprehensive income on the balance sheet.
(2) (3)
(4)
III.
EXCHANGE RATE RISK: MANAGING TRANSACTION EXPOSURE Businesses have various methods of managing the transaction exposure associated with exchange rate risks. Generally the use of financial instruments and hedge transactions attempts to mitigate the impact of exchange rate fluctuations on individual transactions. The following discussion analyzes hedging as it relates to foreign currency transactions. A. MEASURING SPECIFIC NET TRANSACTION EXPOSURE Net transaction exposure is the amount of gain or loss that might result from either a favorable or an unfavorable settlement of a transaction. 1. Selective Hedging Hedging is a financial risk management technique in which an organization, seeking to mitigate the risk of fluctuations in value, acquires a financial security whose financial behavior is opposite that of the hedged item. Worldwide Sweet Peaches buys crates for its product for shipping from Mexico. The company incurs liabilities denominated in pesos that it satisfies in pesos bought with U.S. dollars at the time of settlement. The company incurs a significant liability in pesos at a spot rate of $.10. The company is fearful that the peso will strengthen to $.20 by the time the bill is due and thereby double its cost. Because the anticipated exchange rate (the rate at which two currencies will be exchanged at equal value) in the future of the peso is greater than the current spot rate (the exchange rate at the current date), the company will hedge its position by locking into an exchange rate that is less than the feared appreciation of the peso.
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a.
Hedges can be effective or ineffective, depending upon the actual exchange rate at the time of settlement in comparison to the hedge price and other factors. You will not be asked on the CPA exam to determine hedge effectiveness or ineffectiveness. Hedges are likely to be effective just as often as they are likely to be ineffective if done consistently and, therefore, theoretically have no impact on income. Management may elect to hedge inconsistently or selectively in order to ensure that hedge transactions are carried out with maximum effectiveness.
b. c. 2.
Identifying Net Transaction Exposure Consolidated entities consider their net transaction exposure prior to considering hedge strategies. Net transaction exposure considers the impact of transaction exposure on the entity taken as a whole rather than individual subsidiaries. While exchange rate issues might adversely affect one subsidiary, they might favorably affect another. The net transaction exposure is the aggregate exposure associated with a particular foreign currency for a particular time and is computed as follows: a. b. c. Accumulate the inflows and outflows of foreign currencies by subsidiary. Consolidate the impact on the subsidiary by currency type. Compute the net impact in total.
3.
Adjusting Invoice Policies International companies may hedge transactions without complex instruments by timing the payment for imports with the collection from exports.
B.
TECHNIQUES FOR TRANSACTION EXPOSURE MITIGATION The following hedge transactions are used to mitigate exchange rate risk presented by foreign currency transaction exposure. 1. Futures Hedge A futures hedge entitles its holder to either purchase or sell a particular number of currency units of an identified currency for a negotiated price on a stated date. Futures hedges are denominated in standard amounts and tend to be used for smaller transactions. a. Accounts Payable Application (1) Accounts payable denominated in a foreign currency represent a potential transaction exposure to exchange rate risk in the event that the domestic currency weakens in relation to the foreign currency. Should the domestic currency weaken, more domestic currency will be required to purchase the foreign currency and pay the payable. An exchange loss will result. A futures hedge contract to buy the foreign currency at a specific price at the time the account payable is due will mitigate the risk of a weakening domestic currency. Accounts receivable denominated in a foreign currency represent a potential transaction exposure to exchange rate risk in the event that the domestic currency strengthens in relation to the foreign currency. Should the domestic currency strengthen, less domestic currency than originally anticipated from the sale that created the receivable can be purchased with the foreign currency received. An exchange loss will result.
(2)
b.
Accounts Receivable Application (1)
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(2)
A futures hedge contract to sell the foreign currency received in satisfaction of the receivable at a specific price at the time the accounts receivable is due will mitigate the risk of a strengthening domestic currency.
2.
Forward Hedge A forward hedge is similar to a futures hedge in that it entitles its holder to either purchase or sell currency units of an identified currency for a negotiated price at a future point in time. While futures hedges tend to be used for smaller transactions, forward hedges are contracts between businesses and commercial banks and normally are larger transactions. While a futures hedge might hedge a particular transaction, a forward hedge would anticipate a company's needs to either buy or sell a foreign currency at a particular point in time. a. Accounts Payable Application (1) Accounts payable denominated in a foreign currency represent a potential transaction exposure to exchange rate risk in the event that the foreign currency strengthens. A forward hedge contract to buy the foreign currency at a specific price at the time accounts payable are due for an entire subsidiary will mitigate the risk of a weakening domestic currency. Accounts receivable denominated in a foreign currency represent a potential transaction exposure to exchange rate risk in the event that the domestic currency strengthens. A forward hedge contract to sell the foreign currency received in satisfaction of the receivables at a specific price at the time the accounts receivable are due or on the monthly cycle of a particular subsidiary will mitigate the risk of a strengthening domestic currency.
(2)
b.
Accounts Receivable Application (1)
(2)
3.
Money Market Hedge A money market hedge uses international money markets to plan to meet future currency requirements. A money market hedge uses domestic currency to purchase a foreign currency at current spot rates and invest them in securities timed to mature at the same time as related payables. a. Money Market Hedge: Payables (Excess Cash) Firms with excess cash use money market hedges to lock in the exchange rate associated the foreign currency needed to satisfy payables when they come due. Money market hedges for payables satisfaction are easy to understand. (1) (2) (3) (4) Determine the amount of the payable. Determine the amount of interest that can be earned prior to settling the payable. Discount the amount of the payable to the net investment required. Purchase the amount of foreign currency equal to the net investment required and deposit the proceeds in the appropriate money market vehicle.
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EXAMPLE
Duffy's Discount Piatas has a payable due to its Mexican suppliers in the amount of 1,000,000 pesos in 90 days. The current exchange rate is $.08 per peso and Mexican interest rates are 16%. Duffy has $100,000 in excess cash and elects to use a money market hedge to mitigate transaction exposure to exchange rate risk. Duffy performs the following steps: 1. 2. 3. Determine the required investment in pesos at Mexican interest rates: 1,000,000/1.04 = 961,538. Purchase 961,538 pesos with $76,923 (961,538 pesos .08). Invest pesos at Mexican interest rates and satisfy payables upon maturity of the investment.
Duffy has secured the satisfaction of its current $80,000 payable for $76,923. b. Money Market Hedge: Payables (Borrowed Funds) Firms that do not have excess cash would follow the same basic procedure for a money market hedge on payables except that they would first borrow funds domestically and invest them internationally to satisfy the payable denominated in a foreign currency. Duffy's Discount Piatas has a payable due to its Mexican suppliers in the amount of 1,000,000 pesos in 90 days. The current exchange rate is $.08 per peso, Mexican interest rates are 16%, and U.S. interest rates are 6%. Duffy computes that it must borrow $76,923 to use a money market hedge to mitigate transaction exposure to exchange rate risk consistent with the first money market hedge example but has no excess cash. Duffy borrows the needed amount for 90 days in the United States. Duffy has secured the satisfaction of its current $80,000 payable for $78,077 (76,923 1.015, 6 percent for 90 days). c. Money Market Hedge: Receivables A money market hedge used for receivables denominated in foreign currencies effectively involves factoring receivables with foreign bank loans. Foreign currency amounts are borrowed in discounted amounts that are repaid in the ultimate maturity value of the receivable denominated in the foreign currency. Borrowed foreign currency amounts are converted into the domestic currency. Duffy's Discount Piatas has a receivable from a Mexican customer in the amount of 1,000,000 pesos due in 90 days. The current exchange rate is $.08 per peso and Mexican interest rates are 16%. Duffy, as usual, is broke and cannot wait to receive $80,000 in 90 days. Duffy needs the money now, so it elects to use a money market hedge technique to expedite collection and mitigate any transaction exposure to exchange rate risk. Duffy computes that it can borrow 961,538 pesos and convert them to $76,923 consistent with the first money market hedge example. Duffy borrows the pesos from Mexican financial institutions. Duffy will be able to meet whatever its current cash requirements are in the United States with the $76,923, and when the 90-day discounted note for 961,538 pesos matures for 1,000,000 pesos, Duffy will satisfy it with the collections from the foreign accounts receivable.
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IV.
TRANSFER PRICING International businesses will likely transact businesses between the subsidiaries that cross political boundaries or between the domestic parent and foreign subsidiary. Valuation of these transactions involve transfer pricing. Transfer pricing decisions serve the purpose of minimization of local taxation while remaining within the guidelines of foreign or other host governments. A. INTERCOMPANY TRANSACTIONS: RELATIVE TAX RATES Transfer prices (selling prices) in countries with higher tax rates will be reduced to optimum levels. 1. Transfer selling prices in countries with higher taxes increase the tax burden but also increase the tax protection afforded to foreign subsidiaries operating in other countries, even if those subsidiaries have lower rates. Transfer prices should be set up to maximize consolidated benefit, reduce income in countries with higher taxes, and maximize the tax shield in countries with lower taxes.
2. B.
INTERCOMPANY CASH TRANSFERS Intercompany cash transfers are often managed through use of leading and lagging. 1. Strong Cash Position Subsidiaries with strong cash positions tend to follow a "leading" transfer policy and pay other subsidiaries in advance. 2. Weak Cash Position Subsidiaries with weak cash position tend to follow a "lagging" transfer policy where they would pay richer subsidiaries long after obligations were incurred as a means of preserving cash.
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APPENDIX I Homework Reading Topic: Market Influences on Business Strategies Expanded Discussion of Value Chain Analysis I. VALUE ACTIVITIES A. MICHAEL PORTER'S WORK IN 1985 In 1985, Michael Porter first suggested the idea of value chain analysis so that the firm could assess how the perceived value of the customer grows along the "chain" of activities that the firm goes through to bring its product to the marketplace. According to Porter, two major categories of business value activities exist: 1. Primary Activities Primary activities are those that are involved with the direct manufacture of products, the delivery of the products through distribution channels, and the support of the product that exists after the sale is made (e.g., handling the raw materials, the manufacturing process, taking orders for the product, advertising the product, and servicing the product after it is sold). 2. Support Activities Support activities are those activities that are performed by the support staff of an organization (e.g., purchasing of the materials and supplies, development of the technology used, management of employees, accounting, finance, strategic planning, etc.). B. SHANK'S AND GOVINDARAJAN'S WORK IN 1993 John Shank and V. Govindarajan took a look at the value chain in an even broader sense than Michael Porter. They indicated that the firm itself is a part of the overall value chain of the industry. In this view, the value starts with the suppliers who provide the raw materials for the production process, continues with the firm and its strategic plan, continues further with the value created by the customers, and then ends with the disposal and recycling of the materials. II. APPROACH OF VALUE CHAIN ANALYSIS Value chain analysis is part of an overall strategic plan, and it is an ongoing process used with strategic thinking. When firms must assess every part of the value chain to allow them to provide their customers with maximum value, they must determine the parts of the value chain that will provide them with the largest amount of competitive advantage. Three major forms of analysis are performed. A. INTERNAL COSTS ANALYSIS In order to determine the internal value-creating ability of a firm, the sources of profit and costs of the internal activities within the firm must be analyzed. B. INTERNAL DIFFERENTIATION ANALYSIS The firm may analyze its ability to create value through differentiation (e.g., what are the sources of differentiation and what are the related costs?) when the customer perceives that the firm's product is superior to those of its rivals.
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C.
VERTICAL LINKAGE ANALYSIS Analyzing the vertical linkage of the firm means understanding the activities of the suppliers and buyers of the product (i.e., all links from the sources of the raw materials through the recycling and disposal of the product after use) and determining where value can be created external to the firm's operations. Often the greatest value and competitive advantage stems from the information obtained from this analysis because the activities that create the most and least amount of value can be determined. Remember, the ultimate consumer actually ends up paying for the profit margins that exist all along the value chain.
III.
STEPS IN VALUE CHAIN ANALYSIS Considering all of the above introductory material regarding value chain analysis, three general "steps" emerge. A. IDENTIFY VALUE CHAIN ACTIVITIES Organizations must identify value activities performed as part of their business. Value activities are generally those processes that are involved with designing, preparing, manufacturing, and delivering a good or service. B. IDENTIFY COST DRIVERS ASSOCIATED WITH EACH ACTIVITY Cost drivers represent factors that increase total cost. Identification of cost drivers assists the organization in determining those areas in which it has a competitive advantage. Organizations might also identify those areas in which outsourcing is valuable. C. DEVELOP A COMPETITIVE ADVANTAGE BY REDUCING COST OR ADDING VALUE The final step in value chain analysis is to study the cost drivers associated with each activity in the value chain from a specific perspective. 1. Identify Competitive Advantage Firms with cost leadership strategies will look at cost saving opportunities, while firms with differentiation strategies will look at opportunities for innovation. 2. Identify Opportunities for Added Value Identification of activities that add value to the customer follows from our review of competitive advantage. Opportunities to add value depend on our overall strategy. Product innovation for those organizations depending on differentiation and reduced prices for those organizations focused on cost leadership will be the work product of this phase of value chain analysis. 3. Identify Opportunities for Reduced Cost Analysis of the cost drivers should show where the organization is not competitive. Elimination or outsourcing of those items for which the organization is not cost competitive is generally proposed from this step in value chain analysis. 4. Exploit Linkages Among Activities in the Value Chain Analysis of the value chain might also show synergies or connections that can be used to create greater efficiencies or greater value. Each step of the value chain should produce some value. In some cases, that value not only benefits the specific activity in the chain but also benefits other activities. For example, in-house customer service departments handle customer complaints in an efficient and courteous manner that establishes organizational responsiveness to the customer and creates loyalty. Inhouse customer service can also be alert for patterns of complaints and can influence product design.
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IV.
STRATEGIC FRAMEWORKS IN VALUE CHAIN ANALYSIS Although value chain analysis is hardly a science, three types of strategic frameworks have proven to be useful for value chain analysis. A. INDUSTRY STRUCTURE ANALYSIS Michael Porter's work in 1980 and 1985 identified five forces that influence profitability (either of an industry or a market) of the firm and, thus, impact the competitive environment of a firm. These five forces assist the firm in determining what makes a firm more profitable compared to another firm. They also play a significant role with respect to the market influence on business strategy. They will each be discussed in detail later in this chapter, so they are listed here for introductory purposes only. 1. 2. 3. 4. 5. B. Barriers to market entry Market competitiveness Existence of substitute products Bargaining power of the customers Bargaining power of the suppliers
CORE COMPETENCIES ANALYSIS While industry structure analysis assists in determining what it is that makes one firm more profitable than another, it does not focus on why one firm is able to create, attain, and sustain new types of competitive advantage and profits while another firm always seems to follow or why some firms are always able to come up with the best innovations while others attempt to copy them. Analysis of the core competencies of a firm answers these questions and attempts to reveal what it is within the firm that enables it to create advantage. 1. How Core Competencies are Created Core competencies are the glue that allows a firm to work as a team and to transfer good ideas from one product or segment of a business to another. When a firm has a solid foundation in excellent employees, quality physical resources, and superior technology and is also able to integrate them appropriately, the ability of the firm to adapt to change, learn new things (e.g., best practices), work as a team, and reduce inherent risks is increased, thus increasing the firm's competitive advantage. 2. Identifying Core Competencies A competency is deemed a core competency if it has the ability to: a. b. c. Reduce the threat that competitors may copy the product, Increase perceived customer value, and Provide leverage (i.e., Can a large amount of markets be accessed?).
C.
SEGMENTATION ANALYSIS Sometimes, a firm is vertically integrated, which means that it is involved in almost every aspect of the firm's value chain, from supplying the raw materials to distribution to the ultimate consumer. (Vertical integration is also discussed later in this chapter as a possible strategy for firms to follow.) When vertical integration exists within a firm and when analysis of the industry structure and the core competencies varies among the activities in the value chain, segmentation analysis, which takes a look at the competitive advantages that exist in the various segments, is often helpful.
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V.
GLOBAL COMPETITIVE ADVANTAGE AND VALUE CHAIN ANALYSIS Along with his "five forces" that impact the profits and competitive environment of an industry (1980 and 1985), in his work in 1990, Michael Porter focused on the competitive forces that exist globally in an effort to study the ability of a nation to attain and sustain worldwide competitive advantage. When the various parts of the value chain (and thus the value-creating processes) exist in different parts of the world, this often poses problems of costs of transportation and lack of control and communication, which can negatively impact the overall customer value. Porter indicated four major factors that impact global competitive advantage (to be considered along with the risks of the political environment of the nation, inflation rates, currency fluctuations, tax regulations, social values, etc.): A. CONDITIONS OF THE FACTORS OF PRODUCTION If the nation has a strong set of factors of production (e.g., a skilled labor force) that are required in a given industry, it will fare better with regard to global competitive advantage. B. CONDITIONS OF DOMESTIC DEMAND If the nation's domestic demand for the product is high, the nation will fare better with regard to global competitive advantage. C. RELATED AND SUPPORTING INDUSTRIES If suppliers of material inputs exist within the nation, it may help the nation fare better with regard to global competitive advantage (unless the costs are prohibitively high). If other rival firms who are competitive in the international environment exist, the nation's competitive advantage is increased. D. FIRM STRATEGY, STRUCTURE, AND RIVALRY The practices of a nation with respect to how companies are managed and organized, along with the laws of the nation that regulate the formation of companies and how intense the rivalry is with respect to competing firms within the nation, all influence the ability of the nation to attain and sustain competitive advantage.
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APPENDIX II Homework Reading Topic: Market Influences on Business Strategies Expanded Discussion of Supply Chain Management I. SUPPLY CHAIN OPERATIONS REFERENCE (SCOR) MODEL The SCOR Model was developed by the Supply Chain Council, which attempted to create a generic model for any organization to use in order to look at the activities of the organization from the "supplier of the supplier" (the ultimate supplier) to the "customer of the customer" (the ultimate customer), which is essentially the entire supply chain. The SCOR Model assists a firm in mapping out its true supply chain and then configuring it to best fit the needs of the firm and consists of four key management processes (i.e., core activities of SCOR). A. PLAN The process of planning consists of developing a way to properly balance aggregate demand and aggregate supply within the goals and objectives of the firm and plan for the necessary infrastructure. According to the Supply Chain Council, examples of activities associated with "plan" are: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. B. Determining the demand requirements Assessing the ability of the suppliers to supply resources Planning the inventory levels Planning the distribution of inventory Planning for the purchase of raw materials Assessing capacity concerns and capabilities Identifying viable distribution channels Configuring the supply chain Managing the product's life cycle Making make/buy decisions
SOURCE Once demand has been planned, it is necessary to procure the resources required to meet it and to manage the infrastructure that exists for the sources. According to the Supply Chain Council, this process deals with the following types of activities: 1. 2. 3. 4. 5. 6. 7. Selecting vendors Obtaining vendor feedback and certification Overseeing and obtaining proper vendor contracts Collecting and processing vendor payments Ordering, inspecting, and storing inputs to the production process Overseeing the quality assurance process Assessing vendor performance
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C.
MAKE The "make" process encompasses all the activities that turn the raw materials into finished products that are produced to meet a planned demand. According to the Supply Chain Council, the process includes the following types of activities: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. Managing the production process Implementing changes in engineering Requesting products for use in the production process Manufacturing the product Testing the product Packaging the product Releasing inventory for shipment Maintaining the production equipment and the facilities Performing quality assurance measures Scheduling production runs Analyzing capacity availability
D.
DELIVER The "deliver" process encompasses all the activities of getting the finished product into the hands of the ultimate consumers to meet their planned demand. According to the Supply Chain Council, this process includes the following types of activities: 1. 2. 3. 4. 5. 6. 7. 8. 9. Managing of orders (e.g., provide quotes, grant credit, enter orders, etc.) Forecasting Pricing Managing transportation (e.g., freight, import/export issues, truck coordination, etc.) Managing accounts receivable and collections Shipping of products Labeling of products Scheduling installation of products Delivering the inventory according to channel distribution rules
II.
STAGES OF SUPPLY CHAIN MANAGEMENT Not every firm implements supply chain management in the same way. Most are somewhere between implementing only the fundamentals of the process and having integration of the business enterprise. However, some firms have developed extended supply chains or elaborate supply chain communities. The following stages of supply chain management range from the least sophisticated to the most sophisticated. A. THE FUNDAMENTALS In this stage, the firm is focused on its day-to-day operations and internal practices (such as standardization of operating procedures) it can employ to best manage its finished goods, transportation issues, and warehousing. The firm may use spreadsheets to assist in delivering finished goods at costs that are predictable and reasonable because the main business issue it is concerned with is the cost of quality.
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B.
CROSS-FUNCTIONAL TEAMS In this stage, management will turn its attention to consolidation of the various departments that make up operations in order to solve the firm's problems. The main business issue the firm is concerned with at this stage is unreliable order fulfillment, and it is very concerned about customer service. The firm will seek to achieve communication at the cross-functional level for on-time and complete delivery of its product.
C.
INTEGRATED ENTERPRISE In this stage, management will move away from simple consolidation of its operations to an internally-integrated supply chain, which all work together with cross-functional purposes (rather than simply cross-functional communication) towards the main business issue of the cost of customer service. For this stage to be successful, it is essential that the people involved are able to work well as a team and eliminate bias so that they are all aligned with the goals of the firm (i.e., goal congruence is essential). The firm will focus on the total cost of delivery, being profitable, and responding to customer needs.
D.
EXTENDED SUPPLY CHAIN If integration of the supply chain moves external to the firm, firms may see potential for increased profits by unifying the supply chain and forming mutual objectives. The need for those involved to be able to work as a unified team without bias is even more essential, as this process strives to integrate the supply chains of many operations, not just those internally. The main business issue of this stage is slow, profitable growth, and the extended supply chain may plan with point-of-sale tools and implement with customer management systems.
E.
SUPPLY CHAIN COMMUNITIES When the extended supply chain actually forms a single competitive entity, a synchronized supply chain community is formed. However, this is significantly more difficult to implement than the previous four stages. While the other stages focus on the operational side of the supply chain, this stage directs its attention toward creating market leadership through working with partners to form strategic initiatives to assist in bringing new forms of value to the customer. Networks play a large role in this stage, and the main business issue facing the firm is creating networks of preferred suppliers. The community may be able to attain significant economies of scale, increase and leverage core competencies, and create new types of vertical integration, but all of this hinges on whether the members of the community can cooperate within the workforce and among management and maintain a solid commitment to the established objectives of the community.
III.
BENEFITS OF IMPLEMENTING SUPPLY CHAIN MANAGEMENT Typically, management requires a quantified benefit before it will embark on any new type of plan, and integrated supply chain management is no exception. While it is generally accepted that the coordination and integration of goods being brought to market is a valid business endeavor, the quantification of the benefits derived from such actions is not easily obtained. By themselves, improvements in various aspects and activities along the supply chain can provide areas of cost savings for the firm, but when considered together, the firm could enjoy a significant positive impact on its profitability and competitive advantage. Examples of benefits derived from implementing supply chain management include: A. B. C. D. Reduced costs in inventory management Reduced costs in warehousing Optimization of the distribution network and facility locations Enhanced revenues
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E. F. G. H. I. J. K. L. IV.
Improved service times Strategic shipment consolidation Reduced cost in packaging Improved delivery times Cross-docking (the minimization of handling and storage costs while receiving and process of goods in the shortest time possible) Identification of inefficiencies in supply chain activities Integration of suppliers Management of suppliers
GENERAL STEPS IN IMPLEMENTING INTEGRATED SUPPLY CHAIN MANAGEMENT Although there is no set method for which to implement integrated supply chain management because there are so many variables in operational and strategic plans, the general steps a firm would follow are: A. B. C. D. E. F. Assess the opportunities in the supply chain. Develop a vision for ISCM. Develop a strategy for ISCM. Create an optimum organizational structure for ISCM. Establish an information and communication network for ISCM. Translate the ISCM strategy into actions.
V.
ALIGNING THE SUPPLY CHAIN AND BUSINESS STRATEGY A firm must be able to manage its supply chain in a way that is aligned with its business strategy, which is directed at serving the needs of the consumers of the firm's product. A. EFFICIENCY AND RESPONSIVENESS The supply chain of a firm must be both responsive to the changing needs of customers and allow the firm to do so in an efficient manner. This is essential to the ability of the firm to increase its market share and protect profits. B. FIVE SUPPLY CHAIN DRIVERS 1. 2. 3. 4. 5. C. 1. 2. 3. Production Inventory Location Transportation Information Understand the markets the firm operates in and the customers it services. Identify the core competencies of the firm and how the firm will use these to best serve its customers. After the company has chosen how it will best serve its customers, create value along the supply chain to achieve the planned goals.
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APPENDIX III Homework Reading Implications of Dealing in Foreign Currency
Mitigating risks associated with foreign currency transactions can be highly complex. While the basic principles associated with hedge transactions are the same, the decisions made by management are influenced by the character of the transaction to be hedged and the instrument used. The following outline deals with the option contracts, longer term transactions, non-transactional risks, and assessment techniques for evaluating the effectiveness of hedge strategies.
I.
ADVANCED TECHNIQUES FOR MITIGATING TRANSACTION RISK AND EVALUATING STRATEGY A. CURRENCY OPTION HEDGES Currency option hedges use the same principles as forward hedge contracts and money market hedge transactions. However, instead of requiring a commitment to a transaction, the currency option hedge gives the business the option of executing the option contract or purely settling its originally negotiated transaction without the benefit of the hedge, depending on which result is most favorable. 1. Currency Option Hedges: Payables A call option (an option to buy) is the currency option hedge used to mitigate the transaction exposure associated with exchange rate risk for payables. a. Similar to a futures contract or forward contract, the business plans to buy a foreign currency at a low rate in anticipation of the foreign currency strengthening in comparison to the domestic currency in order to ensure that it can settle its liability at predicted value. The business has the option (not the obligation) to purchase the security at the option (strike) price. The business evaluates the relationship between the option price and the exchange rate at the settlement date. Generally, if the option price is less than the exchange rate at the time of settlement, the business will exercise its option. If the option price is more than the exchange rate at the time of settlement, the business will allow the option to expire. While premiums are used to compute any net savings associated with option transactions, they are a sunk cost and are irrelevant to the decision to exercise the options.
b.
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Gearty International owes its Mexican supplier 1,000,000 pesos due in 30 days. Although the peso is currently exchanged for the US dollar at $.08, the company is fearful that the Mexican peso will strengthen in comparison to the dollar before the settlement to as much as $.10. Gearty International pays a $.005 premium to secure a call option to buy 1,000,000 pesos in 30 days for $.08. If Gearty is correct in its assessment of international exchange rates and the exchange rate at the time of the settlement (the spot rate) increases as predicted, Gearty will exercise its option to achieve a $15,000 net savings, computed as follows:
EXAMPLE
Spot Rate At Settlement $.10 Net savings
Option Price $.08
Premium $.005
Total Option $.085
Settlement Cost for 1,000,000 pesos $ 100,000 (85,000) $ 15,000
Gearty's consideration for the option, the $.005 premium, is $5,000 and is paid regardless of whether the option is exercised. The gross savings of $20,000 [(.10 .08) * 1,000,000 pesos] is reduced by the $5,000 premium to reflect a $15,000 net savings. Remember, however, that the premium is not included in the decision to exercise the option. If Gearty is incorrect in its assessment of international exchange rates and the exchange rates stay constant at $.08, then the company will allow its option to expire because exercising the option would actually be equal to simply settling the transaction at the spot rate, computed as follows:
Spot Rate At Settlement $.08 Loss
Option Price $.08
Premium $.005
Total Option $.085
Settlement Cost for 1,000,000 pesos $ 80,000 85,000 ($ 5,000)
Gearty will likely buy pesos at the spot rate regardless of the loss associated with the premium. 2. Currency Option Hedges: Receivables A put option (an option to sell) is the currency option hedge used to mitigate the transaction exposure associated with exchange rate risk for receivables. a. Similar to a futures contract or forward contract, the business plans to sell a foreign currency at a high rate in anticipation of the foreign currency weakening in comparison to the domestic currency in order to ensure that it can capitalize on receivable collections at a stable or predicted value. The business has the option (not the obligation) to sell the collected amount of the foreign currency from the receivable at the option (strike) price. The business evaluates the relationship between the option price and the exchange rate at the settlement date. Generally, if the option price is more than the exchange rate at the time of settlement, the business will exercise its option. If the option price is less than the exchange rate at the time of settlement, the business will allow the option to expire. While premiums are used to compute any net preserved values associated with option transactions, they are a sunk cost and are irrelevant to the decision to exercise the options.
b.
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Gearty International is owed 1,000,000 pesos due in 30 days from its Mexican customer. Although the peso is currently exchanged for the US dollar at $.08, the company is fearful that the Mexican peso will weaken in comparison to the dollar before the settlement to as little as $.06. Gearty International pays a $.005 premium to secure a put option to sell 1,000,000 pesos in 30 days for $.08. If Gearty is correct in its assessment of international exchange rates and the exchange rate at the time of the settlement (the spot rate) decreases as predicted, the company will exercise its option to achieve a net preservation of $15,000 in asset value, computed as follows:
Spot Rate At Option Settlement Price $.06 $.08 Net preserved value
EXAMPLE
Premium $.005
Total Option $.075
Settlement Cost for 1,000,000 pesos $ 60,000 75,000 $ 15,000
Gearty's consideration for the option, the $.005 premium, is $5,000 and paid regardless of whether the option is exercised. The gross value "preserved" of $20,000 [(.08 .06) * 1,000,000 pesos] is reduced by the $5,000 premium paid to reflect a net $15,000 preserved receivable value. Remember, however, that the premium is not included in the decision to exercise the option. If Gearty is incorrect in its assessment of international exchange rates and the exchange rates stay constant at $.08, then it will allow their option to expire since to exercise the option would actually be equal to simply settling the transaction at the spot rate, computed as follows:
Spot Rate At Settlement $.08 Loss Option Price $.08 Premium $.005 Total Option $.075 Settlement Cost for 1,000,000 pesos $ 80,000 75,000 ($ 5,000)
Gearty will likely sell pesos at the spot rate regardless of the loss associated with the premium.
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Using Foreign Currency Options to Mitigate Exchange Rate Risk

Balance Sheet Date Assets Liabilities Exchange Rate Increases Spot Rate at Balance Sheet Date Spot Rate at Balance Sheet Date
Purchase call option to buy foreign currency at balance sheet spot rate to limit cash outflows at settlement
Mitigate Cash Flow Risks
Preserve Fair Value of Asset

Purchase put option to sell foreign currency at balance sheet spot rate to guarantee value of settlement.
Exchange Rate Decreases
The foregoing chart illustrates the relationship between exchange rate risk and monetary assets and liabilities and hedge strategies used to mitigate risk. If the company owns accounts receivable in a foreign currency, a monetary asset, it is at risk for declines in the exchange rate or strengthening of the domestic currency in relation to the foreign currency. To ensure that the company is able to settle (collect) its accounts receivable in an amount equal to the balance sheet value (expressed in its domestic currency), the company would purchase a put option to sell the amounts collected at the spot rate. If the exchange rate declines, there is no exposure to the risk because collection of the value booked as a receivable is assured by the option to purchase dollars at a prenegotiated rate with the foreign currency collected. If the company owes accounts payable in a foreign currency, a monetary liability, it is at risk for increases in the exchange rate or weakening of the domestic currency in relation to the foreign currency. To ensure that the company is only required to settle (pay) its accounts payable in an amount equal to the balance sheet obligation (expressed in its domestic currency), the company would purchase a call option to buy the amounts needed at the spot rate. If the exchange rate increases, there is no exposure to the risk because payment of the value booked as a liability is assured by the option to purchase the foreign currency in which the liability is denominated at the rate prenegotiated in the option contract.
B.
ASSESSING HEDGING STRATEGY EFFECTIVENESS The business decision to hedge or not to hedge using forward contracts may be evaluated using the formula for the real cost of hedging payables and the real cost of hedging receivables. The formulas take the difference between the nominal cost of hedging and the cost of not hedging to derive the additional cost of a hedge in comparison to the charges already incurred before the hedge. 1. Costs of Hedging or Not Hedging a. The nominal cost of hedging a foreign currency is the known exchange rate for the currency times the underlying.
EXAMPLE
Assume the cost of the Canadian dollar is $.75. The nominal cost of hedging C$1,000,000 is known to be $750,000.
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b.
The nominal cost of not hedging a foreign currency represents the expected value of a transaction settlement given a range of exchange rates and associated probabilities.
Assume the cost of the Canadian dollar is $.75, and we anticipate that the exchange rate has a .10 probability of falling to $.65, a .50 probability of falling to .70, and a .40 probability of rising to .8. We would compute the nominal cost of not hedging a planned C$1,000,000 as follows:
Possible Rates .65 .70 .80
Probability .10 .50 .40
Domestic Value C$1,000,000 C$1,000,000 C$1,000,000
Nominal Cost of Not Hedging $ 65,000 $350,000 $320,000 $735,000
EXAMPLE
Nominal Cost of Not Hedging

2. Real Cost of Hedging Payables
The real cost of hedging payables is expressed in the following formula: a. b. RCHp = NCHp NCp Terms are defined as follows: RCHp real cost of hedging payables NCHp nominal cost of hedging payables NCp nominal cost of payables without hedging c. Negative results indicate that the business should enter into a hedge transaction, while positive results indicate that the business should not hedge the transaction.
Assuming the results of the previous two concept examples, the real cost of hedging payables with the stated exchange rate is as follows:
EXAMPLE
RCHp = NCHp NCp RCHp = $750,000 $735,000 RCHp = $15,000 The business should not hedge. The real cost of hedging payables indicates that the company will pay $15,000 less if it does not hedge. 3. Real Cost of Hedging Receivables The real cost of hedging receivables is expressed in the following formula: a. b. RCHr = NRr NRHr Terms are defined as follows: RCHr real cost of hedging receivables NRr nominal domestic revenues received without hedging NRHr nominal domestic revenues received from hedging
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c.
Negative results indicate that the business should enter into a hedge transaction, while positive results indicate that the business should not hedge the transaction.
Assuming the results of the previous concept examples, the real cost of hedging receivables with the stated exchange rate is as follows: RCHr = NRr NRHr
EXAMPLE
RCHr = $735,000 $750,000 RCHr = $15,000 The business should hedge. The real cost of hedging receivables indicates that the business will likely receive $15,000 less if it does not hedge. Logically, the same fact pattern applied to a liability and an asset produce equal and opposite results. C. LIMITATIONS ON HEDGING 1. Uncertainty The amount of hedged transactions (e.g., payables or receivables) may not be known precisely prior to the execution of the futures, forward, or money market hedge. If the business hedges too much, the company is said to be overhedged. To avoid the potential of overhedging, the company should only hedge the minimum amount known to be due or payable. 2. Continual Short-Term Hedging Consistent short-term hedging can be ineffective over time because it mirrors the current trends of the market. Longer-term hedges expand the gap between the exchange rate for the hedged item and the hedge itself thereby maximizing the savings or value of the hedged item. D. OTHER TECHNIQUES FOR TRANSACTION EXPOSURE MITIGATION: LONG-TERM TRANSACTIONS The following hedge transactions are used to mitigate exchange rate risk presented by transaction exposure. 1. Long-Term Forward Contracts Mechanically, long-term forward contracts deal with the same issues as any other forward contracts. Long-term forward contracts are set up to stabilize transaction exposure over long periods. Long-term purchase contracts may be hedged with longterm forward contracts. 2. Currency Swaps Transaction exposure associated with exchange rate risk for longer-term transactions can be mitigated with currency swaps. a. Two Firms Two firms with coincidental needs for international currencies may agree to swap currencies collected in a future period at a specified exchange rate. The two entities essentially swap their currencies in an exchange negotiation completed years in advance of their receipt of the currencies. b. Financial Intermediaries Typically financial intermediaries are contacted to broker or match firms with currency needs.
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3.
Parallel Loan Two firms may mitigate their transaction exposure to long-term exchange rate loss by exchanging or swapping their domestic currencies for a foreign currency and simultaneously agreeing to re-exchange or repurchase their domestic currency at a later date.
E.
OTHER TECHNIQUES FOR TRANSACTION EXPOSURE MITIGATION: ALTERNATIVE HEDGING TECHNIQUES The following hedge transactions are used to mitigate exchange rate risk presented by transaction exposure. 1. Leading and Lagging Leading and lagging represent transactions between subsidiaries or a subsidiary and a parent. The entity that is owed may bill in advance if the exchange rate warrants (leading) or possibly wait until the exchange rate is favorable before settling (lagging). 2. Cross-Hedging The technique known as cross-hedging involves those transactions that cannot be hedged. Hedging one instrument's risk with a different instrument by taking a position is a related derivatives contract. This is often done when there is no derivatives contract for the instrument being hedged or when a suitable derivatives contract exists but the market is highly illiquid. 3. Currency Diversification The simplest hedge for long-term transactions is to diversify foreign currency holdings over time. A substantial decline in the value of one currency would not impact the overall dollar value of the firm if the currency represented only one of many foreign currencies.
II.
EXCHANGE RATE RISK: MANAGING ECONOMIC AND TRANSLATION EXPOSURE Businesses have various methods of managing the economic and translation exposure associated with exchange rate risks. Generally, the use of organization-wide solutions related to the entity itself and related reporting requirements are included in the approach. A. ASSESSING ECONOMIC EXPOSURE Economic exposure is defined by the degree to which cash flows of the business can be impacted by fluctuations in exchange rates. The extent to which revenues and expenses are denominated in different currencies could seriously impact the profitability of an organization and represents economic exposure. Pete's Primo Piatas manufactures piatas in Mexico. The company's expenses paid to local suppliers are denominated in the peso. The company exports nearly 80 percent of its product to the United States and receives revenues denominated in United States dollars from upscale Mexican theme party planners. If the peso were to strengthen in relation to the dollar, then imported revenues could be significantly less than domestic expenses. Pete's Primo Piatas would suffer economic losses as a result of their economic exposure to exchange rate risk.
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B.
TECHNIQUES FOR ECONOMIC EXPOSURE MITIGATION Economic exposures typically relate to organization-wide issues and can usually only be mitigated with organization-wide approaches that involve restructuring and adjustments to the business plan. 1. Restructuring Economic exposure to currency fluctuations can be mitigated by restructuring the sources of income and expense to the consolidated entity. a. Decreases in Sales A company fearful of a depreciating foreign currency used by a foreign subsidiary may elect to reduce foreign sales to preserve cash flows. b. Increases in Expenses A company anticipating a depreciating foreign currency may elect to increase reliance on those suppliers to take advantage of paying for raw materials or supplies with cheaper currency. 2. Characteristics of Restructuring and Economic Exposure Restructuring tends to be more difficult than ordinary hedges. Economic exposures to exchange rate fluctuations are viewed as more difficult to manage than transaction exposures.
III.
FOREIGN ECONOMIES AND POLITICAL RISK International business is subject to the generalized risk of operating within a foreign economy and to changes in the political climate. Although very little can be done to fully mitigate this risk exposure, international companies can perform a country risk analysis to fully assess the degree of their exposure. Unsatisfactory evaluation of country risk could either result in divestiture of foreign operations or avoidance of development of foreign operations in a particular country. A. COUNTRY RISK ANALYSIS: FOREIGN ECONOMY CONSIDERATIONS The state of the foreign economy in which the multinational company operates is highly significant to risk evaluation. 1. Foreign Demand A multinational corporation exporting to a foreign country is vitally concerned with demand within that country. Demand is directly affected by the health of the economy of the county in which it operates. a. b. Weakening demand may cause the foreign government to implement tariffs or other regulatory measures that reduce foreign penetration. Measures to reduce foreign penetration may either require curtailment of foreign operations or export of goods produced by the multinational inside the foreign country instead of selling within the foreign country. Higher interest rates in the foreign country are indicators of slower economic growth and reduced demand. Lower interest rates in the foreign country may be indicative of increased growth and demand.
2.
Interest Rates a. b.
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3.
Inflation Higher local inflation and reduced purchasing power makes imported goods more expensive and reduces local demand for them.
4.
Exchange Rate a. b. Weak local currency reduces demand for imported goods. Strong local currency increases demand for imported goods.
B.
COUNTRY RISK ANALYSIS: POLITICAL RISK CONSIDERATIONS Political risks represent non-economic events or environmental conditions that are potentially disruptive to financial operations. Although expropriation of productive resources represents the most extreme political risk, other features of political risk must also be considered including: 1. 2. 3. 4. 5. 6. Bureaucracies and related inefficiencies or barriers to trade Corruption Host government attitude toward foreign firms Attitude of consumers toward foreign firms Inconvertibility of foreign currency War
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BUSINESS ENVIRONMENT & CONCEPTS 2 Terminology
Definitions of the following terms that relate to topics presented in this lecture are provided in the comprehensive glossary located at the end of this textbook.
Accounting Costs Accounting Profit Aggregate Demand (AD) Aggregate Supply (AS) Average Fixed Cost (AFC) Average Product (AP) Average Revenue (AR) Average Fixed Cost (AFC) Average Total Cost (ATC) Average Variable Cost (AVC) Balanced Budget Best Cost Strategy Boycott Budget Deficit Budget Surplus Business Cycle Cartel Comparative Advantage Competitive Strategies Complements Consumer Price Index (CPI) Constant Returns to Scale Contractionary Monetary Policy Core Competency Cost Leadership Strategy Cost Push Inflation Country Risk Covered Interest Arbitrage Cross Elasticity of Demand Cross Elasticity of Supply Cross Hedging Currency Appreciation Currency Depreciation Currency Variability Current Method Cyclical Unemployment Deflation Demand Curve Demand Pull Inflation
Depression Derived Demand Differentiation Strategy Discount Rate Diseconomies of Scale Disposable Income Economic Costs Economic Exposure Economic Profit Economies of Scale Expenditure Approach Explicit Costs Exchange Rate Exchange Rate Risk Expansionary Monetary Policy External Factors Factors of Production Federal Reserve (Fed) Final Products Fiscal Policy Fischer Effect Frictional Unemployment Forward Exchange Rate Forward Hedge Full Employment Functional Currency Futures Hedge GDP Deflator Gross Domestic Income (GDI) Gross Domestic Product (GDP) Gross National Product (GNP) Hedge Transaction Implicit Costs Income Approach Income Elasticity of Demand Industry Structure Analysis Inferior Good Inflation Interest Arbitrage
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Interest Rate Parity Internal Factors International Fischer Effect Kinked Demand Curve Lagging Indicator Law of Demand Law of Diminishing Returns Law of Supply Leading Indicator Long Run Long-Run Aggregate Supply (LRAS) M1 M2 M3 Marginal Cost (MC) Marginal Product (MP) Marginal Propensity to Consume (MPC) Marginal Revenue (MR) Marginal Revenue Product (MRP) Market Demand Market Equilibrium Market Supply Monetary Assets and Liabilities Monetary Policy Money Market Hedge Money Supply Monopoly Monopolistic Competition Monopsony Multiplier Effect National Income National Income Accounting Natural Rate of Unemployment Natural Monopoly Natural Rate of Unemployment Net Domestic Product Net National Product Niche Strategy Nominal GDP Nominal Interest Rate Non-Monetary Assets and Liabilities Normal Good Oligopoly Open Market Operations Opportunity Cost Options Hedge
Parallel Loan Perfect Competition Personal Income Phillips Curve Price Ceiling Price Floor Price Elastic Demand Price Elasticity of Demand Price Elasticity of Supply Price Inelastic Demand Price Inelastic Supply Price Searcher Price Setter Price Taker Production Function Production Possibilities Curve Profit Purchasing Power Parity Quantity Demanded Quantity Supplied Real GDP Real Interest Rate Recession Reporting Currency Required Reserves Ratio (RRR) Seasonal Unemployment Short Run Spot Rate Structural Unemployment Substitutes Supply Curve Supply Shock Temporal Method Total Cost (TC) Total Fixed Cost (TFC) Total Output (Q) Total Variable Cost (TVC) Total Product Total Revenue (TR) Transaction Exposure Translation Exposure Unemployment Rate Unit Elastic Demand Value at Risk Value Chain Analysis Vertical Integration
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BUSINESS ENVIRONMENT & CONCEPTS 2 Class Questions Answer Worksheet
MC Question Number
First Choice Answer
Correct Answer
NOTES
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18.
Grade: Multiple-choice Questions Correct / 18 = __________% Correct Detailed explanations to the class questions are located in the back of this textbook.
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CLASS QUESTIONS 1. CPA-03291 Which of the following is not likely to cause a rightward shift in the aggregate demand curve? a. b. c. d. An increase in wealth. An increase in the level of real interest rates. An increase in government spending. An increase in the general level of confidence about the economic outlook.
2. CPA-03307 Suppose real GDP is rising while the overall price level is falling. The most plausible explanation for this is: a. b. c. d. A shift left in the aggregate supply curve. A shift right in the aggregate supply curve. A shift left in the aggregate demand curve. A shift right in the aggregate demand curve.
3. CPA-03396 Assume the following data for the U.S. economy in a recent year: Personal consumption expenditures Exports Government purchases of goods/services M1 Imports Gross private domestic investment Open market purchases by Federal Reserve a. b. c. d. $6,953 billion. $6,958 billion. $6,691 billion. $7,215 billion. $ 5,015 billion $ 106 billion $ 1,040 billion $ 262 billion $ 183 billion $ 975 billion $ 5 billion
Based on this information, which of the following was the U.S. GDP for the year in question?
4. CPA-03404 What type of unemployment is shown when individuals do not have the qualifications or skills necessary to fill available jobs? a. b. c. d. Frictional. Natural. Cyclical. Structural.
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5. CPA-03411 Deflation is best defined as: a. b. c. d. When the price of a particular good falls. A continuous rise in the overall price level. A continuous decline in real GDP. A continuous decline in the overall price level.
6. CPA-03395 An increase in the discount rate would cause: a. b. c. d. The money supply to increase and interest rates to fall. The money supply to decrease and interest rates to rise. The money supply to increase and interest rates to rise. The money supply to decrease and interest rates to fall.
7. CPA-03412 If the nominal interest rate is 10% and the rate of inflation is 5%, the real interest rate is: a. b. c. d. 15% 2% 50% 5%
8. CPA-03471 Which of the following is not true regarding strategic plans? a. b. c. d. Various levels of the organization will implement strategic plans differently. Continual re-evaluation and revision of strategic plans is necessary. The process of strategic planning begins with the creation of the plan. Strategic plans will vary by segment based on the characteristics of the segments.
9. CPA-03667 Which one of the following changes will cause the demand curve for gasoline to shift to the left? a. b. c. d. The price of gasoline increases. The supply of gasoline decreases. The price of cars increases. The price of cars decreases.
10. CPA-03670 The competitive model of supply and demand predicts that a surplus can only arise if there is a: a. b. c. d. Maximum price above the equilibrium price. Minimum price below the equilibrium price. Maximum price below the equilibrium price. Minimum price above the equilibrium price.
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11. CPA-03497 Elasticity of demand or supply is: a. b. c. d. A measure of how flexible the firm is with respect to responding to the needs of the consumers. A measure of how flexible the demand or supply of a product is when preferences change. A measure of how sensitive the demand for or supply of a product is to a change in its price. A measure of how well a firm's strategic plan is able to adapt to changes in demand or supply.
12. CPA-03708 As the price for a particular product changes, the quantity of the product demanded changes according to the following schedule: Total Quantity Demanded 100 150 200 225 230 232 Price per Unit $50 45 40 35 30 25
The price elasticity of demand for this product when the price decreases from $50 to $45 is: a. b. c. d. 0.20 10.00 0.10 5.00
13. CPA-03479 Under pure competition, strategic plans focus on: a. b. c. d. Profitability from production levels that maximize profits. Maintaining the market share and being responsive to market conditions related to sales price. Maintaining the market share and planning for enhanced product differentiation. Maintaining the market share, ensuring product differentiation, and adapting to price changes or required changes in production volume.
14. CPA-03493 Under oligopoly, strategic plans focus on: a. b. c. d. Profitability from production levels that maximize profits. Maintaining the market share and being responsive to market conditions related to sales price. Maintaining the market share and planning for enhanced product differentiation. Maintaining the market share, ensuring product differentiation, and adapting to price changes or required changes in production volume.
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Becker CPA Review
15. CPA-03583 A firm is in heavy competition with a rival firm, and its rivals are consistently able to effectively respond to changes in consumer preferences by making strategic moves in an effort to win over the buyers and gain competitive advantage. Which of the five forces that affect the competitive environment and profitability of a firm does this best demonstrate? a. b. c. d. Barriers to entry. Market competitiveness. Existence of substitute products. Bargaining power of customers.
16. CPA-03602 Which of the following statements regarding competitive advantage is not correct? a. The two major forms of competitive advantage are differentiation and cost leadership. b. If the total costs of a firm are less than those of close rivals, then the firm has a competitive market advantage. c. Cost leadership advantage may best be obtained by a firm when a firm builds market share or matches the price of its rivals. d. Differentiation advantage may best be obtained by a firm when a firm builds market share or decreases its price. 17. CPA-03609 When do differentiation strategies fail? a. The firm's product appeals to different people for different reasons. b. The value of the firm's premium does not exceed its cost. c. Customers are able to see (or perceive) a value in the firm's product compared to products of other firms. d. The various rival firms have chosen different features on which to differentiate their products. 18. CPA-03620 Vertical integration is: a. A formal process in which two or more firms combine to provide for cost reductions they could not otherwise obtain on their own. b. An alliance with another firm that allows for economies of scale and sharing of costs in a less than formal manner. c. A strategy in which the firm attempts to gain competitive advantage by seeking to control the entire value chain (or a portion of it) within the same industry. d. A process in which the firm focuses on predicting the expected demand of consumers and then plans accordingly for it.
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Business Environment & Concepts 2

Business Environment & Concepts 2

Becker CPA Review

Business Environment & Concepts 2

2009 DeVry/Becker Educational Development Corp. All rights reserved.

Business Environment & Concepts 2

Becker CPA Review

2009 DeVry/Becker Educational Development Corp. All rights reserved.

Becker CPA Review

Business Environment & Concepts 2

Expansionary Phase Peak

Recovery Phase Trough Trough

2009 DeVry/Becker Educational Development Corp. All rights reserved.

Business Environment & Concepts 2

Becker CPA Review

2009 DeVry/Becker Educational Development Corp. All rights reserved.

Becker CPA Review

Business Environment & Concepts 2

Long-Run Aggregate Supply Short-Run Aggregate Supply

Aggregate Demand Y* Real GDP

2009 DeVry/Becker Educational Development Corp. All rights reserved.

Business Environment & Concepts 2

Becker CPA Review

Graph C Price Level LRAS SRAS

Graph D Price Level LRAS SRAS1 SRAS

P0 P1 AD AD1 Y1 Y0 Output (Real GDP)

AD Y1 Y0 Output (Real GDP)

Becker CPA Review

Business Environment & Concepts 2

2009 DeVry/Becker Educational Development Corp. All rights reserved.

Business Environment & Concepts 2

Becker CPA Review

2009 DeVry/Becker Educational Development Corp. All rights reserved.

Becker CPA Review

Business Environment & Concepts 2

Graph E Price Level LRAS SRAS

Graph F Price Level LRAS SRAS

P1 P0 AD1 AD Y0 Y1 Output (Real GDP) Y1 Y0 AD P0 P1

Output (Real GDP)

2009 DeVry/Becker Educational Development Corp. All rights reserved.

Business Environment & Concepts 2

Becker CPA Review

2009 DeVry/Becker Educational Development Corp. All rights reserved.

Becker CPA Review

Business Environment & Concepts 2

2009 DeVry/Becker Educational Development Corp. All rights reserved.

Business Environment & Concepts 2

Becker CPA Review

ECONOMIC MEASURES AND REASONS FOR CHANGES IN THE ECONOMY

2009 DeVry/Becker Educational Development Corp. All rights reserved.

Becker CPA Review

Business Environment & Concepts 2

2009 DeVry/Becker Educational Development Corp. All rights reserved.

Business Environment & Concepts 2

Becker CPA Review

2009 DeVry/Becker Educational Development Corp. All rights reserved.

Becker CPA Review

Business Environment & Concepts 2

2009 DeVry/Becker Educational Development Corp. All rights reserved.

Business Environment & Concepts 2

Becker CPA Review

2009 DeVry/Becker Educational Development Corp. All rights reserved.

Becker CPA Review