1Managerial EconomicsTutorial Solutions – Week 2Hirschey 15th Edition: Chapter 1: Questions 1.4 and 1.8Q1.4: In the wake of corporate scandals at Enron, Tyco, and WorldCom, some argue that managers oflarge, publicly owned firms sometimes make decisions to maximize their own welfare asopposed to that of stockholders. Does such behaviour create problems in using valuemaximization as a basis for examining managerial decision making?Q1.4: SolutionYes, like virtually all theory, the value maximization model involves some simplification and abstractionfrom reality. The important question is whether or not the model is realistic enough to provide usefulinsight into the managerial decision-making process. While managers undoubtedly do take their ownwelfare into account when making decisions, evidence strongly indicates that market pressures providea strong incentive for managers to act in accord with the dictates of economic efficiency. Furthermore,managers who pursue policies detrimental to stockholder interests run the risk of being replacedfollowing stockholder “revolts” or unfriendly takeovers.Q1.8: Why is the concept of enlightened self-interest important in economics?Q1.8: SolutionThe concept of self-interest is important because it provides the underlying rationale for economicdecisions. Consumers and producers make economic decisions in such a manner as to further their ownmaterial well-being. Consumers make purchase decisions when goods and services represent a relativebargain in terms of the benefits they provide. Firms and other producers make the decision to supplyoutput when doing so is profitable. In both cases, furthering the self-interest of each decision makerprovides the underlying rationale for economic decisions. Interestingly, the desire to further eachdecision maker’s own self-interest results in voluntary economic exchange that is mutually beneficial. Abusiness or consumer transaction takes place if and only if both parties benefit.2Hirschey 15th Edition: Chapter 1: Case StudyIs Coca-Cola the “Perfect” Business?What does a perfect business look like? For Warren Buffett and his partner Charlie Munger, vicechairman of Berkshire Hathaway, Inc., it looks a lot like Coca-Cola. To see why, imagine going back intime to 1885, to Atlanta, Georgia, and trying to invent from scratch a non-alcoholic beverage that wouldmake you, your family, and all of your friends rich.Your beverage would be non-alcoholic to ensure widespread appeal among both young and old alike. Itwould be cold rather than hot so as to provide relief from climatic effects. It must be ordered by name–a trademarked name. Nobody gets rich selling easy-to- imitate generic products. It must generate a lotof repeat business through what psychologists call conditioned reflexes. To get the desired positiveconditioned reflex, you will want to make it sweet, rather than bitter, with no after-taste. Without anyafter-taste, consumers will be able to drink as much of your product as they like. By adding sugar tomake your beverage sweet, it gains food value in addition to a positive stimulant. To get extra-powerfulcombinatorial effects, you may want to add caffeine as an additional stimulant. Both sugar and caffeinework; by combining them, you get more than a double effect; you get what Munger calls a “lollapalooza”effect. Additional combinatorial effects could be realized if you design the product to appear exotic.Coffee is another popular product, so making your beverage dark in colour seems like a safe bet. Byadding carbonation, a little fizz can be added to your beverage’s appearance and its appeal.To keep the lollapalooza effects coming, you will want to advertise. If people associate your beveragewith happy times, they will tend to reach for it whenever they are happy, or want to be happy. (Isn’t thatalways, as in “Always Coca-Cola”?) Make it available at sporting events, concerts, the beach, and attheme parks–wherever and whenever people have fun. Enclose your product in bright, upbeat coloursthat customers tend to associate with festive occasions (another combinatorial effect). Red and whitepackaging would be a good choice. Also make sure that customers associate your beverage with festiveoccasions. Well- timed advertising and price promotions can help in this regard–annual price promotionstied to the Fourth of July holiday, for example, would be a good idea.To ensure enormous profits, profit margins and the rate of return on invested capital must both be high.To ensure a high rate of return on sales, the price charged must be substantially above unit costs.Because consumers tend to be least price sensitive for moderately priced items, you would like to havea modest “price point”, say roughly $1-$2 per serving. This is a big problem for most beverages becausewater is a key ingredient, and water is very expensive to ship long distances. To get around this cost-ofdelivery difficulty, you will not want to sell the beverage itself, but a key ingredient, like syrup, to localbottlers. By selling syrup to independent bottlers, your company can also better safeguard its “secretingredients.” This also avoids the problem of having to invest a substantial amount in bottling plants,machinery, delivery trucks, and so on. This minimizes capital requirements and boosts the rate of returnon invested capital. Moreover, if you correctly price the key syrup ingredient, you can ensure that theenormous profits generated by carefully developed lollapalooza effects accrue to your company, and notto the bottlers. Of course, you want to offer independent bottlers the potential for highly satisfactoryprofits in order to provide the necessary incentive for them to push your product. You not only want to“leave something on the table” for the bottlers in terms of the bottlers’ profit potential, but they in turnmust also be encouraged to “leave something on the table” for restaurant and other customers. Thismeans that you must demand that bottlers deliver a consistently high-quality product at carefullyspecified prices if they are to maintain their valuable franchise to sell your beverage in the local area.If you had indeed gone back to 1885, to Atlanta, Georgia, and followed all of these suggestions, youwould have created what you and I know as The Coca-Cola Company. To be sure, there would have beensurprises along the way. Take widespread refrigeration, for example. Early on, Coca-Cola management3saw the fountain business as the primary driver in cold carbonated beverage sales. They did not foretellthat widespread refrigeration would make grocery store sales and in-home consumption popular. Still,much of Coca-Cola’s success has been achieved because its management had, and still has, a goodgrasp of both the economics and the psychology of the beverage business. By getting into rapidlygrowing foreign markets with a winning formula, they hope to create local brand-name recognition,scale economies in distribution, and achieve other “first mover” advantages like the ones they havenurtured in the United States for more than 100 years.As shown in Figure 1.4, in a world where the typical company earns 10 percent rates of return oninvested capital, Coca-Cola earns three and four times as much. Typical profit rates, let alone operatinglosses, are unheard of at Coca-Cola. It enjoys large and growing profits, and requires practically notangible capital investment. Almost its entire value is derived from brand equity derived fromgenerations of advertising and carefully nurtured positive lollapalooza effects. On an overall basis, it iseasy to see why Buffett and Munger regard Coca-Cola as a “perfect” business.A. One of the most important skills to learn in managerial economics is the ability to identify agood business. Discuss at least four characteristics of a good business.Part A Case Study: SolutionInteresting perspective on the characteristics of wonderful businesses has been given by legendary WallStreet investors T. Rowe Price and Warren E. Buffett. The late T. Rowe Price was founder of Baltimorebased T. Rowe Price and Associates, Inc., one of the largest no-load mutual fund organizations in theUnited States, and the father of the “growth stock” theory of investing. According to Price, attractivegrowth stocks have low labour costs, superior research to develop products and new markets, a highrate of return on stockholder’s equity (ROE), elevated profit margins, rapid earnings per share (EPS)growth, lack cutthroat competition, and are comparatively immune from regulation. Omaha’s WarrenE. Buffett, the billionaire head of Berkshire Hathaway, Inc., also looks for companies that have strongfranchises and enjoy pricing flexibility, high ROE, high cash flow, owner-oriented management, andpredictable earnings that are not natural targets of regulation. Like Price, Buffett has profitedenormously through his investments.To apply Price’s and Buffett’s investment criteria successfully, business managers and investors mustbe sensitive to fundamental economic and demographic trends. Perhaps the most obvious of these isthe aging of the population. Health-care demands will continue to soar. In recognition of this fact,investors have bid up the shares of companies offering prescription drugs, health care, and health-carecost containment (e.g., home health agencies). Perhaps less obvious is that an aging and increasinglywealthy population will save growing amounts for their children’s education and retirement. Thisbodes well for mutual fund operators, insurance companies, and other firms that offer distinctivefinancial services.As the overall population continues to enjoy growing income, spending on leisure activities is apt togrow; companies that offer distinctive goods and services in this area will do well. Helping well-heeledcustomers have fun has always been a good business. Productivity enhancement to combat economicstagnation is also likely to be a major thrust during the coming decade. In this area, it is perhaps easierto pick likely beneficiaries of emerging technologies than it is to chart the future course of technicaladvance. For example, catalogue retailers, long-distance and cellular phone companies, and credit cardproviders are all major beneficiaries of the rapid pace of advance in computer and informationtechnology. Similarly, major broadcasters, cable TV companies, movie makers, and software providersare all prone to benefit from increasingly user-friendly technology for leisure-time activities.4B. Identify and talk about at least four companies that you regard as having the characteristicslisted here.Part B Case Study: SolutionThe American Express Company, Coca-Cola, Procter & Gamble, and Wells Fargo are well-knownexamples of major common stock holdings of Warren Buffett’s Berkshire Hathaway, Inc. Each ofBerkshire’s major holdings are large capital-intensive companies with long operating histories of aboveaverage rates of return. Like any really good business, they display a wise use of assets as indicated byan average ROE that is well above typical norms. Enhancing the attractiveness of these companies is thefact that they also display above-average annual rates of growth in stockholders’ equity. Thus, they canall be described as beneficiaries of high-margin growth. As is often the case, attractive financial andoperating statistics reflect essentially attractive economic characteristics of each company.The American Express Company is a premier travel and financial services firm that is strategicallypositioned to benefit from aging baby boomers. The Coca- Cola Company, one of Berkshire’s biggestand most successful holdings, typifies the concept of a wonderful business. Coca-Cola enjoys perhapsthe world’s strongest franchise, owner-oriented management, and both predictable and growingreturns. Also, the company is not subject to price or profit regulation. From the standpoint of being awonderful business, Coca-Cola is clearly the “real thing.” Newspapers, banks, and cable TV companies,such as The Washington Post Company and Wells Fargo & Company, translate immense economies ofscale in production into dominating competitive advantages. They also fit Buffett’s criteria forwonderful businesses. In the case of Gillette, above-normal returns stem from unique products thatare designed and executed by extraordinarily capable management.The late T. Rowe Price was prone to invest in high-tech companies that produced distinctiveproducts. On the other hand, Buffett is fond of saying that he doesn’t “understand” high-tech anddoesn’t want to be blown out of business by a few guys “working in a garage somewhere.” Ofcourse, Buffett’s thinly-veiled reference to Hewlett-Packard and the Silicon Valley revolution that wasstarted by “two guys in a simple garage” means that Buffett clearly does understand the problems ofinvesting in hard-to-project high-tech companies. Thus, while Buffett avoids high-tech stocks, T. RowePrice, if he were alive today, might find compelling the advantages of high-tech companies such asMicrosoft, Intel, and Cisco Systems, among others.C. Suppose you bought common stock in each of the four companies identified here. Three yearsfrom now, how would you know if your analysis was correct? What would convince you thatyour analysis was wrong?Part C Case Study: SolutionAbove-normal returns from investing in wonderful businesses are only possible to the extent that suchadvantages are not fully recognized by other investors. In the case of T. Rowe Price, early investmentsin Avon Products, Xerox, and IBM generated fantastic returns because Price saw their awesomepotential far in advance of other investors. On the other hand, Buffett has profited by taking majorpositions in wonderful companies that suffer from some significant, but curable, malady. In 1991, forexample, Buffett made a large investment in American Express when the company suffered unexpectedcredit card and real estate loan losses. When the company absorbed these losses without any lastingdamage to its intrinsic profit- making ability, its stock price soared and Buffett cleaned up. Companiesthat are conservatively financed enjoy a similar ability to profit when an unexpected business downturncauses financially distressed rivals to sell valuable assets at bargain-basement prices.5Therefore, while above-average stock-market returns provide the clearest evidence of having pickedgood businesses for investment, short-term results can be disappointingly average or below-average ifthe virtues of these good businesses are clearly recognized in the marketplace. More frustrating still isthe problem of finding and investing in good businesses at attractive prices and then having to wait whileconventional wisdom comes around to recognizing them as such. The overall stock market is extremelyefficient at ferreting out bargains and adjusting prices so that subsequent investors earn only a riskadjusted normal rate of return. For individual investors seeking above-average returns, finding goodbusinesses is a necessary first step, but they must also be incorrectly priced (too cheap). Buffettsucceeds because he is unusually adept at finding high-quality bargains.
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