Business &

Economic
Forecasting

Managerial Economics
 “Part of my advantage is that my strength is economic
forecasting, but that only works in free markets, when
markets are smarter than people. That’s how I started. I
watched the stock market, how equities reacted to
change in levels of economic activity, and I could
understand how price signals worked and how to forecast
them.” –Stanley Druckenmiller (an American investor,
hedge fund manager and philanthropist)

References: Managerial Economics by Luke M. Froeb, etal; c2014

Managerial Economics and Business Strategy by Michael Baye ; c2010
Study Guide and Case Book for Managerial Economics
What is Economic Forecasting? (Investopedia)

Economic forecasting is the process of attempting to predict the future condition of the economy using a

combination of important and widely followed indicators.

Economic forecasting involves the building of statistical models with inputs of several key variables, or

indicators, typically in an attempt to come up with a future gross domestic product (GDP) growth rate.

Primary economic indicators include inflation, interest rates, industrial production, consumer

confidence, worker productivity, retail sales, and unemployment rates.

Business managers rely on economic forecasts, using them as a guide to plan future operating

activities. Private sector companies may have in-house economists to focus on forecasts most

pertinent to their specific businesses (e.g., a shipping company that wants to know how much of GDP

growth is driven by trade.) Alternatively, they might rely on Reports or academic economists, those

attached to think tanks or boutique consultants.

Although surveys are of considerable use, most major firms seem to base their forecasts in large

part on the quantitative analysis of economic time series.

The classical approach to business forecasting assumes that an economic time series can be

decomposed into four (4) components: trend, seasonal variation, cyclical variation, and irregular

movements.
If the trend in a time series is LINEAR, simple regression may be used to estimate an equation

representing the trend. If it seems to be NONLINEAR, a quadratic equation may be estimated by

multiple regression, or an exponential trend may be fitted.

The seasonal variation in a particular time series is described by a figure for each month (the

seasonal index) that shows the extent to which the month’s value typically departs from what

would be expected on the basis of trend and cyclical variation. Such seasonal indexes can be used

to deseasonalize a time series, that is, to remove seasonal element from the data.
A seasonal index is a measure of how a particular season through some

cycle compares with the average season of that cycle. By deseasonalizing

data, we're removing seasonal fluctuations, or patterns in the data, to

predict or approximate future data values.

Study the separate case illustrating this concept.

Be ready for a graded discussion/recitation on Friday, January 29, 2021.

Many businesses and economic time series go up and down with the fluctuations of the economy as a whole.

This cyclical variation, as well as trend and seasonal variation, is reflected in many time series. It is
customary to divide business fluctuations into four phases: TROUGH, EXPANSION, PEAK and RECESSION.
Variables that go down before the peak and up before the trough are called leading series. Some important

leading series are new orders for durable goods, average work week, building contracts, stock prices, certain

wholesale prices, and claims for unemployment insurance.

Economists sometimes use leading series, which are often called leading indicators to forecast whether

a turning point is about to occur. If a large number of leading indicators turn downward, this is viewed

as a sign of a coming peak. If a large number turn upward, this is thought to signal an impending

trough. Although these indicators are not very reliable, they are watched closely and are used to

supplement other, more sophisticated forecasting techniques.

The simplest kind of forecasting method is a straightforward extrapolation of a trend. To allow

for seasonal variation, such an extrapolation can be multiplied by the seasonal index (divided

by 100) for the month to which the forecast applies. This entire procedure is simply a

mechanical extrapolation of the time series into the future.

In recent years, managerial economists have tended to base their forecasts less on simple

extrapolations and more on equations (or systems of equations) showing the effects of various

independent variables on the variable (or variable) one wants to forecast. These equations (or

systems of equations) are called ECONOMETRIC MODELS.

Thank You!
ECONOMIES OF SCALE AND SCOPE

Managerial Economics
Reference: Managerial Economics by Luke M. Froeb, etal
In 1906, three entrepreneurs launched the French Battery Company in

Madison, Wisconsin. The company’s early growth was driven by the

demand for radio batteries, and its most successful product was the Ray-

O-Vac battery, leading the firm to change its name to Rayovac in 1930.

Over the next 60 years, it grew to become one of the top three battery

producers in the United States along with Duracell and Energizer.

In 1996, the company was acquired by the Thomas H. Lee

Company, a Boston-based private equity firm. After making

an initial public offering the following year, the company took

advantage of easy credit availability to expand via acquisition.

It purchased battery manufacturers such as BRISCO GmbH,

ROV Limited, VARTA AG, Direct Power Plus, and Ningbo

Baowang in order to take advantage of “efficiencies and

economies of scale.” Company managers expected that as

they produced more of the same good, average costs would

fall.
In 2003, Rayovac purchased Remington Products (electric razors); in 2005, it purchased
United Industries Corporation (lawn and garden care, household insect control, and pet
supplies) and Tetra Holding GmbH, a German supplier of fish and aquatic supplies. To
reflect its position as a provider of a broad portfolio of products, the company changed its
name to Spectrum Brands in 2005.
Managers often justified the company’s expansions into these new areas with claims of cost
savings.

For example, as part of its acquisition of United Industries, Spectrum’s managers anticipated
“that there would be synergies*, better performance, and all that.”

As is often the case, it is much easier to describe synergies than it is to capture them, and
although it’s not clear whether this was the case for Spectrum, the company declared
bankruptcy in 2009.

*Synergy is the concept that the value and performance of two companies combined will be greater than
the sum of the separate individual parts. If two companies can merge to create greater efficiency or scale,
the result is what is sometimes referred to as a synergy merge. (Source: Investopedia)
Since emerging from bankruptcy, Spectrum has

delivered impressive performance, and it has

continued to pursue synergies via acquisitions of

businesses like the Hardware & Home Improvement

Group of Stanley Black & Decker in 2012 and

Armored AutoGroup in 2015.

 L E T U S E X A M I N E T H E T WO T Y P E S O F
S Y N E R G I E S D E S C R I B E D I N T H E C A S E / S TO RY:
ECONOMIES OF SCALE AND SCOPE

This is especially important if your company is

following a cost leadership strategy, but managers

should always be looking for ways to cut costs,

regardless of whether it is the company’s primary

strategy.
A reduction in average cost translates to an immediate increase in profit. If marginal cost

(MC) goes down as well, you get an “extra” increase in profit from the increase in output;

remember that if MC falls below marginal revenue (MR), it becomes profitable to increase

output.

Many business decisions, like break-even analysis, can be made using very simple

characterizations of cost (like a fixed cost plus a constant per-unit cost). With economies

of scale or scope, however, decision making may require more complex (and realistic) cost

functions.
INCREASING MARGINAL COST

Most firms will eventually face increasing average costs as they try to increase output.

The firm finds that each extra unit of output requires more inputs to produce than

previous units, an outcome described as the law of diminishing marginal returns.

The law of diminishing marginal returns states that as you try to expand output, your

marginal productivity (the extra output associated with extra inputs) eventually declines.
 INCREASING
MARGINAL
COST

THE LAW OF
DIMINISHING RETURNS
Diminishing marginal returns occur for a variety of reasons, among them are the difficulty of

monitoring and motivating larger workforces, the increasing complexity of larger systems, or the

fixed nature of some factors.

In popular jargon, these are known as “bottlenecks.”

Bottlenecks often arise when more workers, or any variable input, must share a fixed amount of

a complementary input. When productivity falls from bottlenecks, costs increase.

 DIMINISHING MARGINAL PRODUCTIVITY
IMPLIES INCREASING MARGINAL COST.

If more inputs are needed to produce each extra

unit of output, then the cost of producing these
extra units—the marginal cost—must increase. And
once the marginal cost rises above the average
cost, the average will rise as well.

Say, for example, the average cost to produce the

first 100 units of a product is $50 per unit. If the
marginal cost of the 101st unit is more than $50,
overall average cost will increase.
 INCREASING MARGINAL COSTS
EVENTUALLY LEAD TO
INCREASING AVERAGE COSTS

Just as a baseball player’s season batting average

will rise if his game batting average is above his
season batting average, so too does average cost
rise if marginal cost is above the average.

In Figure 7.1, the rising average cost of production

implies that marginal cost is above average cost. In
the presence of fixed costs, increasing marginal cost
gives you a U-shaped average cost curve. The curve
initially falls due to the presence of fixed costs, but
then it rises due to increasing marginal costs.
Knowing what your average costs look like will help you make better decisions.

Here’s a famous example: In 1955, Akio Morita brought his newly invented $29.95 transistor
radio to New York. He shopped it around, and after turning down an original equipment
manufacturer (OEM) deal from Bulova, he eventually found a retailer that would sell it under
his “Sony” brand name. The problem was that the retailer had a chain of around 150 stores
and wanted to buy 100,000 radios, 10 times more than Mr. Morita’s capacity. Mr. Morita
turned the offer down. He knew that he would lose money producing 100,000 units because
increasing output would require hiring and training more workers and an expansion of
facilities, raising his average cost or break-even price.
After being turned down, the retailer agreed to
settle for 10,000 units at the lowest unit price,
and the rest is history. The Sony brand radios
became very popular, and the company evolved
into the giant electronics firm it is today. The
moral of the story is to know what your costs look
like—otherwise, you could end up making
unprofitable deals. In this case, using a more
realistic cost function, Morita was able to compute
his break-even prices, allowing him to bargain
effectively with the retail chain.
 ECONOMIES OF SCALE

The law of diminishing marginal returns is primarily a

short-run phenomenon arising from the fixity of at least

one factor of production, like capital or plant size. In

the long run, however, you can increase the size of the

plant, hire more workers, buy more machines, and

remove production bottlenecks. In other words, your

“fixed” costs become “variable” in the long run.

ECONOMIES OF SCALE

✓ If long-run average costs are constant with respect to output, then you have

constant returns to scale.

✓ If long-run average costs rise with output, you have decreasing returns to scale or

diseconomies of scale.

✓ If long-run average costs fall with output, you have increasing returns to scale or

economies of scale.
ECONOMIES
OF SCALE
Economies of scale can result from a variety of areas.

Larger firms can benefit more from capital equipment like

machinery: average costs decrease as volume increases

and fixed costs are unchanged. Larger firms may also

benefit from purchasing economies if they receive

discounts for buying in larger quantities. Average costs

associated with shared administrative services can also

fall as output increases.

 ECONOMIES OF SCOPE
Gibson Guitar traditionally used rosewood for
fingerboards on its less expensive Epiphone guitars
and reserved ebony for its high-end Gibson brand.
Both rosewood and ebony are excellent tone woods,
but ebony is preferred for its distinct sound and pure
black appearance. A significant number of ebony
fingerboard blanks are rejected for use on the Gibson
brand guitars because carving of the fingerboard
reveals brown streaks in the otherwise pure black
wood. The percentage of fingerboards rejected has
increased steadily over the past 10 years as the
world supply of streak-free ebony has shrunk.
 ECONOMIES OF SCOPE
Gibson Guitar began installing these streaked
blanks on its lower-end instruments. The buyers
perceive the streaked ebony fingerboard as an
upgrade over rosewood. Its ability to use discarded
ebony in its Epiphone guitars gives Gibson both a
cost and quality advantage over rivals that produce
only high-end or only low-end instruments. In this
case, we say there are economies of scope
between production of high-end and low-end
guitars.
 ECONOMIES OF SCOPE

If the cost of producing two products jointly is

less than the cost of producing those two
products separately—that is:

Cost (Q1, Q2) < Cost (Q1) 1 + Cost (Q2)

—then there are economies of scope between the

two products.
ECONOMIES OF SCOPE

Obviously, you want to exploit economies of scope by producing both Q1 and Q2. This
is a major cause of mergers.

For example, about eight years ago, we saw a consolidation in the food distribution
business. Companies like Kraft, Sara Lee, and ConAgra sell a variety of meat products,
hotdogs, sausage, and lunchmeats because they can derive economies of scope by
distributing these products together. Once you set up a distribution network, you can
easily pump more products through the network without incurring additional costs.
ECONOMIES OF SCOPE

These low costs put pressure on their competitors, in particular, a regional breakfast
sausage manufacturer in 1997. This manufacturer used 18 trucks and a single
distribution center that served retail customers located in 21 southern and Midwestern
states. Unfortunately, the demand for breakfast sausage is seasonal, with a peak in
November and December. During the heavy winter months, the manufacturer had to pay
outside carriers a premium to handle excess product, but for the other eight months, half
of its trucking fleet sat idle.
 ECONOMIES OF SCOPE

Because the firm sold only a single product—breakfast sausage—it could not exploit the

scope economies associated with distributing a full product line. The manufacturer had several

choices. It could have acquired other companies to have a full product line to distribute. It

could have sold out to one of the larger, full-line companies, like ConAgra. Such a company

could exploit the scope economies associated with distribution, thus placing a higher value on

the firm. Or it could have outsourced its distribution function. Several regional and nationwide

distribution companies distribute a variety of food products, and these companies could take

advantage of scope economies by distributing a full portfolio of meat products.

 ECONOMIES
OF SCOPE

Our sausage maker eventually

decided to outsource its
distribution. However, after it
sold its trucking fleet, it was
held up by the distributor.
Outsourcing was a good idea,
but poorly executed.
ECONOMIES
OF SCOPE
STRATEGY: THE QUEST TO KEEP PROFIT FROM ERODING

MANAGERIAL ECONOMICS
LECTURE #6
Reference: Managerial Economics by Luke M. Froeb, etal
In 1971, three partners opened a coffee shop in Seattle’s Pike
Place Market. Two of the partners wanted to name the store after
the ship Pequod from the Moby Dick, but the third disagreed.

Eventually they agreed to name the store after the Pequod’s first
mate. The company enjoyed mild growth until 1988 when the
partners agreed to sell the company to their former director of
retail operations and marketing.

Over the following 20-plus years, that director has overseen the
expansion of the company to over 17,000 worldwide stores as yet
- Starbuck was the first mate on the Pequod and that former
director of retail operations is Howard Schultz, the current CEO
of the world’s largest coffee retailer, Starbuck’s.

*Pequod is a fictional 19th-century Nantucket whaling ship that appears in

the 1851 novel Moby-Dick by American author Herman Melville.
*Pequod is a fictional 19th-century Nantucket whaling ship that appears in
the 1851 novel Moby-Dick by American author Herman Melville.
What has been the key to the company’s success?

According to Schultz: “Starbucks is the quintessential

experience brand and the experience comes to life by our
people. The only competitive advantage we have is the
relationship we have with our people and the relationship
they have built with our customers.”

The ability to create a unique experience draws om distinctive

capabilities the company has developed in both producing high-
quality coffee and establishing a relationship-oriented culture
among its employees and customers.
In a 2012 study of US consumer sentiments expressed through
social media outlets, Starbucks ranked as the most loved
restaurant-related brand, and the company generated over $1.5
billion in 2011 operating income despite operating in a very
competitive industry.

Succeeding in the face of competition requires that you find

a way to create an advantage and then figure out how to
protect that advantage.
 How important is creating and sustaining
advantage?

Warren Buffett* was once asked what is the most

important thing he looks for when evaluating a

company. Without hesitation, he replied,

“Sustainable competitive advantage.”

*Warren Edward Buffett is an American business magnate, investor, and

philanthropist. He is currently the chairman and CEO of Berkshire
Hathaway.
Powerful competitive advantages (obvious examples are Coke’s

brand and Microsoft’s control of the personal computer operating

system) create a moat around the business such that it can keep

competitors at bay and reap extraordinary growth and profits.

When a company is able to achieve competitive advantage, its

shareholders can be well rewarded for decades.

Examples are the big pharmaceutical companies.

It is extremely difficult for a company to be able to sustain, much

less expand, its moat over time. Moats are rarely enduring for

many reasons: High profit(s) can lead to complacency and are

almost certain to attract competitors, and new technologies,

customer preferences, and ways of doing business emerge.

What is competitive advantage?

It is an attribute that enables a company to outperform its competitors. It allows

company to achieve superior margin compared to its competition and generates value for

the company and its shareholders.

To keep one step ahead of the forces that erode profit, firms develop

strategies to gain sustainable competitive advantage.

Firms have a competitive advantage when they can:

1. Deliver the same product or service benefits as their competitors

but at a lower cost, or

2. Deliver superior product or service benefits at a similar cost.

Remember: Firms with competitive advantage are able to earn

positive economic profits.

Illustration:
SOURCES OF What are the keys to competitive advantage and generating
ECONOMIC PROFIT sustainable economic profit?

There are two schools of thought that offer differing points of view:

1. The industrial organization (IO) economics perspective – locates

the source of advantage at the industry level.

2. The resource-based view (RBV) – which locates it at the

individual firm level.

SOURCES OF The Industry (External) View
ECONOMIC PROFIT
The IO perspective, the focus is on the industry.

According to Michael Porter, “The essence of this paradigm is that a

firm’s performance in the marketplace depends critically on the

characteristics of the industry environment in which it competes.”

SOURCES OF
ECONOMIC PROFIT
The Industry (External) View

Certain industries, due to their structural characteristics, are more

attractive than other industries, and companies in those industries

possess market power, which allows them to keep prices above the

competitive level and to earn economic profit (above the opportunity

cost of capital).
SOURCES OF Here’s the logic:

ECONOMIC PROFIT
Industry structure determines firm conduct, and that conduct, in

turn, determines the firm’s performance. Industry structure includes

factors such as barriers to entry, product differentiation among

the firms, and the number and size distribution of firms.

Example: Industries with high barriers to entry are more attractive

because competitors find it more difficult to enter the industry and

thus cannot drive profit down to competitive levels.

SOURCES OF
Firms in industries with differentiated products have less elastic demand
ECONOMIC PROFIT and therefore higher profits; and industries with a small number of firms
of different sized are less likely to compete vigorously.

If industry structure is the most important determinant of long-run

profitability, then the key to generating economic profit is to enter the
right industry. According to Michael Porter’s Five Forces model, the
best industries are characterized by:
1. High barriers to entry
2. Low buyer power
3. Low supplier power
4. Low threat from substitutes
5. Low levels of rivalry between existing firms
SOURCES OF The Resource (Internal) View

ECONOMIC PROFIT
If industry structure told the whole story about the strategy, we wouldn’t
expect to find performance differences across firms within industries.
SOURCES OF The Resource (Internal) View

ECONOMIC PROFIT
These differences do exist, however, and the resource-based view
(RBV) gained favor in the 1990s as an explanation for the inter-firm
differences.

The RBV explains that individual firms may exhibit sustained

performance advantage due to their superior resources, where

resources are defined as “the tangible and intangible assets firms

use to conceive of and implement their strategies.”

SOURCES OF The Resource (Internal) View

ECONOMIC PROFIT
Two primary assumptions underlie the RBV:

1. Resource heterogeneity
2. Resource mobility