Respond to the following discussion question. To earn full credit, post a response of 150 words that includes at least 1 APA citation and the associated reference. How is the company’s optimal capital
ECO 518
Unit 5 Lecture
This lecture will function as a guide to assist you in studying. It contains questions that you
should be able to answer after you read the chapters. As you read the text book think about the
questions posed below. The answers comprise the main topics and concepts that you should
know and understand after you have finished your readings. There are no quiz or test activities
associated with this lecture content.
Unit Learning Outcomes
Unit 5
ULO 1. Define game theory, and explain how it helps better to understand mutually
interdependent management decisions to predict and manage risk.
ULO 2. Identify types of capital budgeting decisions explaining the meaning of the capital
budgeting model.
Chapter 11
Continue to use the resources provided by the author and publisher at:
http://wps.prenhall.com/bp_keat_managerial_7/236/60596/15512752.cw/index.html
An inherent uncertainty exi sts when dealing with oligopolistic markets that does not exist with
perfect competition, monopoly, or monopolistic competition. This uncertainty is based on the
interdependence of firms within oligopoly markets. Each firm’s actions are predicated on how
that firm expects other firms to react. Put another way, each firm’s actions are based on
assumptions regarding rival behavior. Common behavioral assumptions include the following:
rival firms will match price changes, rival firms will maintain their curren t prices, rival firms will
maintain their current output, rival firms will match price decreases but not price increases, and
rival firms will always choose the option that produces the worst outcome for their rivals. Each of
these (and many other) behavio ral assumptions lead to a different deterministic models of
oligopoly interaction. Each implies different market outcomes because each is based on
different presumed behavior patterns: Different behavior leads to different outcomes.
Oligopolistic interacti on can be modeled using game theory. Games are most easily examined if
we restrict our analysis to two players. Each player has a set of possible strategies they can
follow. The outcome, or payout, to each player depends not only on which strategy she or h e
decides to pursue but also which strategy her or his rival decides to pursue. A payoff matrix
describes the set of strategies and payouts available in the game.
Sometimes one strategy provides the highest payout regardless of what rivals do. This is call ed
a dominant strategy. If both firms have a dominant strategy, then the result is a dominant
strategy equilibrium. Even when there is not a dominant strategy equilibrium, there may be a
“best” outcome for the game. A Nash equilibrium is such a best outcom e. A Nash equilibrium
occurs if every player’s strategy is optimal given its competitors’ strategies. The problem with
Nash as an equilibrium notion is that some games have no Nash equilibrium and some games
have more than one.
Many oligopolistic interacti ons have the structure of a prisoners’ dilemma. The prisoners’
dilemma is a game in which the option of “confessing” dominates “not confessing” for both
players, but confessing leads to a worse outcome for both than if both could decide not to
confess. In the context of oligopolistic price and quantity setting, for example, the cartel solution
has a higher price and lower output than the individual profit -maximizing solution; therefore,
there is an incentive for each party to cheat on the cartel solution.
The prisoners’ dilemma is a bigger problem for an oligopolistic rivalry that is “played” once than
for those rivalries played over the long term. When oligopolists confront the prisoners’ dilemma
on a continual basis, it is possible to learn from their mist akes and to learn from their rivals.
They can engage in bargaining with their rivals.
Bargaining is negotiating over the terms of an agreement. Bargaining can be explicit and
enforceable, or it can be tacit and formally unenforceable. Many games played by oligopolists
are, by necessity, tacit in nature. When such bargaining occurs, the outcome depends critically on the prominence or conspicuousness of that outcome. Focal points are critical to achieving
oligopolistic agreement, and the important skill for t acit bargaining is in being able to set the
agenda so that the obvious outcome is the one most favorable to your firm.
This chapter has also scratched the surface of an important topic: the economics of information.
Information is itself costly to obtain and, as a result, individuals are not perfectly informed
despite assumptions to the contrary. When we explicitly consider how markets respond to
information imperfections, some of the cornerstone conclusions of the market model are turned
upside down. This is especially true when we consider situations when there is an informational
asymmetry between buyers and sellers in a market. Three economists jointly shared the Nobel
Prize in 2001 for their work in the area of asymmetric information. An informational asymmetry
exists when one side knows more than the other in a transaction. One might expect that sellers
are more informed than buyers involved in a market transaction, but this is not necessarily the
case.
The lemons model developed by George Akerlof invo lves sellers with more information than
buyers. In this setting, an adverse selection problem occurs as the market for used cars
becomes skewed toward low -quality cars (lemons) because buyers are not able to distinguish a
good used car from a lemon. As a r esult, used cars sell for a discount purely based on the
informational asymmetry that exists in this market.
The lemons problem can lead to markets in which only low -quality cars will be sold, or it may
simply lead to a market in which the proportion of lo w-quality cars is higher than would be sold if
buyers and sellers had the same information. A secondary implication of the lemons model is
that demand may be backward bending because buyers will recognize that average quality
declines as price declines. If used car prices decline, consumers will demand more due to the
law of downward sloping demand. But this decline in used car price increases the odds of
obtaining a lemon.
Sellers can undertake various actions to persuade buyers that their car is not a lem on. These
actions provide signals that the product in question is high rather than low quality. For example,
if a used car dealer offers a warranty on one vehicle and sells another “as is,” then the warranty
acts as a signal that the seller stands behind t he product. Manufacturers offer the same
assurance via warranties and by backing up products with their brand name.
Michael Spence examined the issue of signaling more closely. He argued that a signal is
effective only if it is differentially costly to obt ain. The used car warranty is a good signal
because the buyer realizes that the warranty will be costly to the seller to provide if the car for
sale is a lemon but not if it is a good used car.
Spence initially examined signaling in the labor market. High -productivity workers are difficult to
distinguish from low -productivity workers prior to hiring (and in many instances, for some time
after hiring as well). Spence argued that education acts as a separating device because
education is differentially costly to obtain. High -quality workers are likely to be able to obtain a
certain degree of education at lower cost than low -quality workers. In this event, prospective
workers can be offered a choice of jobs: a low -paying job with no education or a higher -paying one with a certain level of education. If these contingent job offers are chosen appropriately,
low -quality workers will self -select into low -paying jobs and high -quality workers will self -select
into the high -paying jobs just by obtaining the educational signal.
Joseph Stiglitz examined the reverse asymmetry. In insurance markets, the buyer knows more
than the seller because the buyer of insurance has a better idea about his or her behavior than
the seller does. Once again, this leads to adverse selection because only those individuals who
most need the insurance are likely to purchase the insurance. This will skew the distribution of
risk in the market relative to what would occur in the absence of the asymmetric information.
If an insurance company offer s multiple options for insurance, then these options can act to
screen individuals into risk categories. Low -risk individuals will tend to choose insurance that is
less expensive but has a deductible or involves a co -payment. High -risk individuals will ten d to
choose more expensive and more inclusive coverage.
If individuals alter their behavior as a result of being insured, a moral hazard problem arises.
Individuals who are fully covered in the event that their car is stolen may leave the car unlocked
when they go into the grocery store, for example. Leaving the car unlocked increases the risk of
theft, and the theft may be due to the altered behavior of the insured individual.
The moral hazard problem is a specific example of the principal -agent problem. T he principal -
agent problem occurs because the principal (the person who has hired an agent to do a task)
cannot (fully) monitor the actions of the agent. This allows the agent to pursue objectives that
may be at odds with those of the principal. The classi c example of the agency issue is the
problem faced by shareholders in monitoring the actions of managers of a firm. The separation
of ownership (principal) from control (manager) leads to the ability of managers to pursue their
own objectives. Managers do not have complete latitude in this regard — if they stray too far from
the owner’s wishes, they may find themselves without a job either because they are fired or
because their firm is acquired by corporate raiders.
The principal -agent problem can be reduced by the appropriate choice of a managerial
compensation package. If the goals of the owner are instilled in the manager via the incentive
structure built into the compensation package, then the manager’s interests will coincide more
closely with the owner’ s. Profit -sharing plans and stock options are two common mechanisms
for achieving this goal.
Chapter 12
In this chapter, we expand the economic concept of profit maximization to multi -period projects.
Capital budgeting involves the evaluation of projects i n which initial expenditures provide
streams of cash inflows over a significant period of time. The process of evaluating capital
proposals includes the following:
1. Estimating all incremental cash flows resulting from the project
2. Discounting all flo ws to the present 3. Determining whether a proposal should be accepted
Two methods are recommended for evaluating capital budgeting proposals — NPV and IRR. The
validity of these two criteria are compared. We find that, from a theoretical viewpoint, NPV is the
more valid. However, there is much to recommend the use of IRR, and business, in fact, favors
this technique. In most cases, both methods lead to the same answer.
The concept of the cost of capital was then developed, and methods of arriving at a weigh ted
cost of capital are discussed. Capital rationing was also discussed.
We then turn to the second subject of this chapter, risk analysis as applied to capital budgeting.
The most common measures of risk are discussed: standard deviation, coefficient of v ariation,
and the z -statistic. We use the concepts of expected value and standard deviation to describe
the attributes of capital budgeting for risky projects.
Two alternative calculations incorporating risk in capital budgeting are presented: risk adjuste d
discount rate and certainty equivalents. Although both methods can be employed, the former is
simpler to use and is much more popular in business.
Additional techniques are discussed. Two similar methods are sensitivity analysis and scenario
analysis. Th e latter is used in “The Situation” and “The Solution” vignettes. We further present a
brief discussion of simulation analysis and decision trees. Simulation analysis is capable of
obtaining expected value and standard deviation, whereas decision trees len d themselves to
sequential decision making.
Although many techniques of accounting for risk were discussed in this chapter, none of these
methods is completely satisfactory. However, the important lesson of this chapter is that risk is
always present in bu siness, and anyone engaging in business planning must be aware of the
dangers of risky outcomes and be able to cope with the uncertainty of future events. Thus, the
awareness of a risky situation may be more important than familiarity with any of the speci fic
methods illustrated in this chapter.
