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Business firms

Businesses are entities in which resources are combined to produce an output.

There are three types of businesses:

• Proprietorship is an unincorporated business owned by an individual.
  
  
• Partnership is an unincorporated business owned by two or more people.
  
  
• Corporation is a business with limited liability owned by its shareholders.
  
  

Teaching Strategy: Many students do not understand the concept of liability and limited liability. Consider using the massive Enron bankruptcy to discuss corporate versus personal liability.


1. Price Strategies for Independent Firms

1. Price discrimination occurs when different customers are charged different prices for the same product, but the difference is not due to cost differentials. The firm tries to extract more consumer surplus.
   
   Necessary conditions for price discrimination: The firm must be able to separate customers according to price elasticity, the buyers must have different elasticities of demand, and the firm must be able to prevent resale of the products or services from one customer to another.
   
   Teaching Strategy: Show that students are charged different tuition rates at public universities depending on whether they live in or out of state. Show that airlines charge less for weekend flights than for weekday flights.
   
   When an identical good is sold to foreign buyers for a lower price than the price charged to domestic buyers, it is called dumping. Predatory dumping is intended to drive rival firms out of business.
   
   Teaching Strategy: Cite the famous Sony Corporation example of TV set dumping.
   
   
2. Peak load pricing is a special form of price discrimination; a higher (lower) price is charged during periods when demand is higher (lower).
   
   Teaching Strategy: Ask the students to cite three personal experiences they have had with peak load pricing.
   
   
3. Discount coupons allow firms to discriminate among consumers on the basis of price elasticity of demand.
   
   
4. Bundling is the practice of combining products and selling the bundle for a single price.
   
   Teaching Strategy: Cite the example of cable TV producers who make extensive use of bundling in their pricing. A more recent example is Microsofts bundled software. The marginal costs of installing different software such as spreadsheets, Internet access, and other programs are very small.
   
   
5. Rebates and other price strategies
   
   

2. Interdependence
Firms act interdependently; that is, firms change product quantity and price after considering what other firms are likely to do in response.

Teaching Strategy: Discuss how interdependence operates in the automobile industry as firms change models, styles, accessories, and prices each model year.

1. The Kinked demand curve occurs when firms follow or copy market price decreases but not price increases.
   
   Teaching Strategy: Construct the kinked demand curve of Figure 1. This is quite complex, so construct it slowly.
   
   Teaching Strategy: Explain why new-car sticker prices are held constant for the model year.
   
   
2. Price wars are an example of a dominant strategy, a strategy that produces the best results for a firm no matter what strategy the opposing player follows.
   
   Teaching Strategy: Carefully explain the payoff matrix analysis for the example in Figure 2.
   
   The result is often what is called a prisoners dilemma, where a firm acting in what they think is their best action relative to the actions of their rivals ends up in a poorer situation than if they had acted differently.
   
   
3. Cooperation
   
   

• Price leadership is when firms follow the pricing behavior of one firm, thus eliminating the kink in the demand curve.
  
  

Teaching Strategy: Cite U.S. Steel as the price leader in the steel industry.

• Collusion, cartels, and other cooperative mechanisms: Cartels occur when firms divide the market and each acts as a monopolist. Their purpose is to control and limit production and maintain or increase prices and profits. A secretive, cooperative agreement to form a cartel is known as collusion and is illegal in the United States.
  
  

Teaching Strategy: Discuss the example of OPEC from a historical and operational aspect. Explain why oil prices fell to $12 a barrel in 1988 and rose to more than $35 a barrel in 1990.

• Facilitating practices occur when firms have no formal agreement but still cooperate and effectively colludefor example, cost-plus pricing or most-favored customer policies. These policies discourage price competition.
  
  

Teaching Strategy: Discuss the behavior of firms that produced antiknock gasoline in the 1970s.

1. Summary: Business behavior
   
   Teaching Strategy: Stress that firms develop strategies to earn and keep economic profits. Strategic behavior is the result of having only a few large firms in the market competing with each other.
   
   

3. Government and Firms
The two approaches government uses to intervene in the activities of business are antitrust policy and regulation.

1. Antitrust laws: Government antitrust policies and programs are designed to control the growth of monopolies and prevent firms from engaging in undesirable practices.
   
   Teaching Strategy: Cite key cases during each of these three phases, for example, the AT&T breakup in 1984, the Coca-Cola Company case in 1986, and the Microsoft cases in the 1980s and in the late 1990s. Have students find and summarize the recent Microsoft settlement.
   
   The Justice Department and the Federal Trade Commission enforce antitrust laws. Alleged antitrust violations may be investigated by the U.S. Justice Department, the Federal Trade Commission, or private plaintiffs.
   
   Teaching Strategy: Stress that, since 1974, more than 90 percent of all cases have been private cases.
   
   More recently, the World Trade Organization, the international agency involved in supporting international trade, has played an active role in responding to the filed claims of an industry in one country accusing competitors in another country. Such complaints have largely involved dumping.
   
   Teaching Strategy: Ask your students to provide you with a list of cases currently investigated by WTO.
   
   
2. Economic regulation includes the regulation of price and output of a monopoly. It is common in the case of natural monopolies, situations where economies of scale exist with production by one firm. Economic regulation also includes antitrust policy, the objective of which is to enhance the competitive environment by controlling and limiting the abuse of market power.
   
   Teaching Strategy: Discuss regulation of utilities and changes in regulation of telecommunications firms.
   
   
3. Social regulation is concerned with the conditions under which goods and services are produced and the impact of these goods on the public welfare.
   
   Teaching Strategy: Discuss the goals and operations of the EPA as a prime example of social regulation of pollution.
   
   
4. Government interferes with business activities to sustain competition and to provide benefits to special interest groups. Rent seeking is using resources to gain benefits from government.
   
   Teaching Strategy: Microsoft was sued for bundling programs. Who was their major competitor in Internet browsers? What is that firms current market share? (Netscape went from 50 to 5 percent market share.)