Economic Concept: Demand Analysis

Case 1: Walmart Hoping for Another Big Holiday Showing

In October of every year, Walmart’s national sales director knows the calls are coming for
his holiday forecasts. This year, the firm’s holiday performance is especially important,
after disappointing sales to date.
While the director has no problem expressing his hope for strong holiday sales, investors
and reporters as well as local managers are seeking a prediction that has evidence to
back it. Consequently, he turns to his analytics department, which has been collecting
wide swaths of data for Walmart over many years across the 381 metropolitan statistical
areas (MSAs) in the United States. Some variables of particular interest include holiday
sales, average prices, and consumer confidence. Using these data, the analysts arrive at
the following equation, designed to predict HolidaySales(measured as revenues):
In(Holiday Sales) = 25.8 - 0.8(Price) + 0.9(Consumer Confidence)
The director notes that most MSAs saw a decrease in consumer confidence of
approximately 4 percent. Based on this information, does the evidence support optimism
for holiday sales if prices remain unchanged? Could a change in price help to bolster
revenues?
Answer:

1. Consider the impact of the change in price and change in consumer confidence in
profit not only on sales revenue
2. The coefficient on price shows that a decrease in price will result to an increase in
revenue which means that the demand is elastic.
Economic Concept: Theory of Individual Behaviour
Case 2: Packaging Firm Uses Overtime Pay to Overcome Labor Shortage
Boxes Ltd. produces corrugated paper containers at a small plant in Sunrise Beach,
Texas. Sunrise Beach is a retirement community with an aging population, and over the
past decade the size of its working population has shrunk. In 2016, this labor shortage
hampered Boxes Ltd.’s ability to hire enough workers to meet its growing demand and
production targets. This is despite the fact that it pays $16 per hour—almost 30 percent
more than the local average—to its workers.
Last year, Boxes Ltd. hired a new manager who instituted an overtime wage plan at the
firm. Under her plan, workers earn $16 per hour for the first eight hours worked each day,
and $24 per hour for each hour worked in a day in excess of eight hours. This plan
eliminated the firm’s problems, as the firm’s production levels and profits are up by 20
percent this year.
Why did the new manager institute the overtime plan instead of simply raising the wage
rate in an attempt to attract more workers to the firm?

Answer:
1. Overtime pay increases the amount of work hours and this will eliminate labor
shortage in terms of hours
2. Labor cost will also be lower compared to increasing the regular hourly labor rate
3. Workers should view leisure as a normal goods so they will choose to work longer
hours
4. If workers will be paid an hourly labor rate of $24 instead of $16 there will be a higher
indifference curve.
5. If there is a given combination of work and leisure(indifference schedules) that gives
same level of satisfaction compute for the MRS(marginal Rate of Substitution)
Economic Concept: Production and Cost Function
Case 3: Boeing Loses the Battle but Wins the War
After nearly eight weeks, Boeing and its International Association of Machinists and
Aerospace Workers Union (IAM) reached an agreement that ended a strike involving
27,000 workers. The strike followed several days of “last minute,” around-the-clock talks
that began when management and union negotiators failed to reach an agreement over
compensation and job protection issues.
As a result of the agreement, IAM workers won benefits in areas that include health care,
pensions, wages, and job security for 2,900 workers in inventory management and
delivery categories. Boeing also agreed to retrain workers who are laid off or displaced.
Despite these concessions, a spokesman for Boeing was quoted as saying that the
agreement “gives us the flexibility we need to run the company.” The four- year
agreement allows Boeing to retain critical subcontracting provisions it won in past
struggles with the union.
Commenting on all this, one analysis concluded that “the union probably won the battle
and Boeing probably wins the war.” Can you explain what this analyst means?

Answer:

1. The phrase “wins the battle” refers to the short-run implications of the agreement
between Boeing and the IAM, while “wins the war” refers to the agreement’s long-run
implications.
2. The analyst recognizes that the agreement benefited union workers in the short run,
but the agreement also increased Boeing’s long-term value by giving it the flexibility to
substitute away from more costly unionized inputs.
3. Boeing’s new union contract provided a number of “short-term” provisions (health and
pension benefits, higher wages, and job security for some of the union’s more senior
workers) that were costly to Boeing but beneficial to the union.
4. In the long run, however, the higher labor costs associated with the agreement provide
Boeing with an incentive to substitute away from more expensive union labor, and the
agreement provides Boeing the flexibility to do so.

5. The subcontracting provisions Boeing won in the agreement may, in the long run,
permit the company to substitute away from its costly and heavily unionized Pacific
Northwest inputs toward assembly facilities in less costly areas.

6. The long- run flexibility imbedded in the agreement translates into cost-reducing
substitution possibilities for Boeing that generate long-run benefits that probably more
than offset the short-run costs.
Economic Concept: Obtaining Input through Vertical Integration
Case 4: Google Buys Motorola Mobility to Vertically Integrate
In a bold move, Google purchased Motorola Mobility—the recently spun-off cellular arm
of Motorola—for $12.5 billion. This move marks an attempt by Google to vertically
integrate into the smartphone hardware market. Industry experts note that the purchase
will allow Google to build prototypes and advanced hardware devices that will help to
point its software business partners in the direction Google wants to go. Google is
banking on the increased coordination between its software and Motorola’s hardware and
the reduction in risks associated with vertical integration outweighing the costs.
If you were a decision maker at Google, would you have recommended vertical
integration?
Answer:
1. Smartphone software and hardware require a great deal of interoperability to work well
together. This means that both the software producers and hardware manufacturers
often must make substantial specialized investments.
2. Google’s purchase of Motorola Mobility gives it direct control of the specialized
hardware investments made by Motorola Mobility, ensuring they will be tailored for
Google’s software products and avoiding any risk of hold-up.
3. The high-tech nature of the smartphone market also makes for significant uncertainty
about future products and market conditions, resulting in a complex contracting
environment. Consequently, there is sound economic rationale for vertical integration, but
before making such a recommendation you should verify that the expected benefits of
avoided hold-up problems and quality improvements justify the costs of vertical
integration.

Economic Concept: Nature of Industry:Merger

Case 5: AT&T Puts Halt to T-Mobile Merger
A few years ago, the U.S. Justice Department filed suit to block the merger between
AT&T and T-Mobile USA. Estimated reports placed AT&T’s share of the wireless
subscription market at 32 percent, while T-Mobile’s share was 10 percent. This market
had two other major competitors: Verizon, with a 34 percent share, and Sprint, with a 17
percent share. After spending millions on merger plans, AT&T decided to call off the deal.
The impact on AT&T’s bottom line was so significant that its CEO saw his pay cut by $2
million as a result.
Do you think AT&T should have spent millions on merger plans in the first place?
Explain.

Answer:
1. Given that AT&T was unwilling to fight the battle in court, the safe strategy would have
been not to spend the millions on the merger plans in the first place.
2. Given the high concentration of the market, AT&T should have realized that the
merger might be heavily scrutinized by antitrust authorities and that strong justifications
might be needed to overcome the presumption that the merger would harm consumers.

3. The FTC and DOJ Horizontal Merger Guidelines suggest that U.S. antitrust authorities
are more likely to challenge a merger when the relevant Herfindahl-Hirschman index is
greater than 2,500 and the resulting increase in the index as a result of the merger is
more than 200. Based on the reported market shares of the four largest firms in this
industry, the Herfindahl-Hirschman index for the wireless subscription market was at
least 2,569 before the proposed merger and would have increased to at least 3,209 after
the merger. AT&T should have realized that the Justice Department might attempt to
block the merger. Spending millions attempting to justify the merger on technological or
efficiency grounds was a gamble that did not pay off for AT&T.

Economic Concept: Monopolistic Competition

Case 6: McDonald’s New Buzz: Specialty Coffee
Not long ago, McDonald’s unveiled plans to roll out McCafé in the United States, a
premium line of coffee that includes cappuccino, latte, and iced mocha. The recession
during the late 2000s in the United States left some analysts questioning whether it was
the right time for McDonald’s to roll out its line of new specialty drinks. However,
McDonald’s quickly saw a tripling of its share of U.S. coffee sales.
Why do you think McDonald’s embarked on the program, and related, what do you think
was the source of its success? Do you think this new product line will sustain its impact
on the company’s bottom line? Explain.
Answer:

1. The fast-food restaurant business has many features of monopolistic competition.

Indeed, the owner of a typical McDonald’s franchise competes not only against Burger
King and Wendy’s but against a host of other establishments. While each of these
restaurants offers quick meals at reasonable prices, the products offered are clearly
differentiated. Product differentiation gives these businesses some market power.

2. The McCafé program was designed to further differentiate McDonald’s from the
competition. In so doing, McDonald’s hoped to increase its own demand by attracting
customers away from traditional coffee shops and other fast- food restaurants. In fact,
this is exactly what happened, as McDonald’s saw a large increase in its coffee sales
over a short period of time.

3. While a monopolistically competitive business like McDonald’s might benefit in the

short run by introducing new products more quickly than its rivals, in the long run its
competitors will attempt to mimic the strategies that are profitable.

4. A similar chain of events occurred in 1978 when McDonald’s successfully launched its
Egg McMuffin. Other fast-food restaurants eventually responded by launching their own
breakfast items, which ultimately reduced McDonald’s share of the breakfast market and
its economic profits. For these reasons, it is unlikely that McDonald’s McCafé program
will have a sustainable impact on its bottom line.
Economic Concept: Inside Oligopoly(Game Theory)
Case 7: Bring Back Complimentary Drinks!
Shortly before its merger with American Airlines, US Airways began charging domestic
coach class passengers $2 for soft drinks. One year later, the company abandoned the
strategy. Sources in the industry attribute the company’s decision to return to the
“industry standard of complimentary drinks” to a variety of factors, including the
depressed economy and the fact that US Airways was the only large network carrier to
charge passengers for soft drinks.
Why do you think US Airways abandoned its $2 drink strategy explain based on the
payoff matrix below:

Answer:
1. While a number of factors might have contributed to US Airways’ decision to stop
charging $2 for soft drinks, the strategy failed primarily because the airline was the only
major carrier to charge passengers for soft drinks. This damaged US Airways’ image and
led some of its customers to switch to more friendly carriers.
2. These negative effects of the company’s unilateral strategy to charge passengers $2
for drinks swamped any revenues (or cost savings) it gained by collecting cash from
passengers. US Airways learned the hard way that offering complimentary drinks is the
dominant strategy in the brutal game it plays with other carriers.
Analysis of the payoff matrix
The payoff matrix in the table above contains some hypothetical numbers that illustrate
these points. Notice that if US Airways and its rivals all offer complimentary drinks, each
of the airlines earns a zero payoff.
If US Airways and its rivals all charge $2 for drinks, US Airways and its rivals earn an
extra $4 million.
But when US Airways charges $2 for drinks and the other carriers offer complimentary
drinks, US Airways gives up $5 million and its rivals gain $5 million.
Looking at the payoff matrix it is clear that US Airways’ dominant strategy is to offer
complimentary drinks. While US Airways probably hoped that other carriers would follow
if it started charging $2 for drinks, it was not in its rivals’ interests to do so. If pricing
managers at US Airways had put themselves in their rivals’ shoes, perhaps they would
have realized that the dominant strategy of the other carriers in this game is to offer
complimentary drinks and never have traveled along this unprofitable path in the first
place.
Economic Concept: First Mover Advantage(Pricing Strategy)
Case 8: Local Restaurateur Faces Looming Challenge from Morton’s
Tom Jackson has been running a successful steakhouse that specializes in serving
upscale steak dinners. His current marketing campaign targets residential households.
Recently, it was announced that a new conference hotel was to open near his
steakhouse, bringing in many potential business customers. Speculation followed that
Morton’s steakhouse—an upscale steakhouse chain currently marketing to business
customers nationally—was considering opening one of its restaurants near the new hotel
and would therefore compete with Tom’s restaurant.

In light of the potential threat from Morton’s, Tom began considering the possibility of
making a significant investment to change his marketing campaign and target businesses
rather than households. In doing so, he estimated the following profit outcomes (in
thousands of dollars) resulting from the strategies that he and Morton’s might implement:

When analyzing this situation, Tom quickly noticed that his dominant strategy was to
continue marketing to households, and was disappointed in the resulting profits. Then, an
idea hit him, and he realized that much higher profits were possible. What did Tom
decide to do?
Answer:
1. Tom’s plan is to attempt to change the game from a simultaneous-move game (in
which Tom and Morton’s simultaneously announce their plans) to a sequential-move
game in which Tom moves first.

2. This will give Tom a first- mover advantage. By announcing as early as possible his
plans to target business customers (and credibly commit to this strategy), Tom will get
the jump on Morton’s. Once Morton’s observes this commitment, it will be too late: its
best response will be to stay out of the market since battling another upscale steakhouse
for the same customers will be unprofitable.

3. This plan critically depends on Tom’s ability to move very quickly (to make sure he
preempts any entry commitment by Morton’s) as well as his ability to credibly commit to
and signal such a strategy. If Tom can do this, he will likely earn profits of $90,000—a
marked improvement on the $50,000 he would expect to earn if he did not make this
move.