Learning MBA Master Degree

The Economics of Business Organizations

2009-12-30T08:04:00.001-08:00

TEACHER: Hello, Student. As you know we are now going to discuss The Economics of Business Organizations. I’ll appreciate that you begin this Module by mentioning a couple of matters you’d like to know about this subject.

STUDENT: Let’s see. In connection with the internal organization of firms, I’d like to discuss if some forms of organization are more efficient than others. I’d also like to know what activities are best done within a single firm, and what activities are best done within independent firms that then trade with one another.

TEACHER: Very well. We’ll also talk about a new perspective on why firms exist, which is based on the idea that firms provide an organization that is able to co-ordinate the resources of a diversity of employees, each of whom has specific limited knowledge. This new approach is known as the knowledge-based or resource-based theory of the firm.

Now, let’s begin by taking a look at firms as organizations.

When we were talking in earlier Modules about how firms made decisions on output and pricing, how did we assume these decisions were made?

STUDENT: We assumed the existence of one central decision-making unit for all the firm's output and pricing choices.

TEACHER: That's correct; we actually made that assumption. But in real life, a firm’s managers have different motivations, interests and opinions. To reach final decisions, some way to coordinate these conflicting interests must be found.

One way to reach this objective is Co-ordination by coalition.

R. M. Cyert and J. G. March conducted a very influential study in the 1960s.(A behavioral Theory of the Firm – Englewood Cliffs, NJ – Prentice Hall).

The authors consider the firm’s decision making as the outcome of a process of bargaining between a set of involved parties whose objectives differ. Can you think of a categorization of these employees?

STUDENT: You mentioned managers before, but it can be argued that firms contain many individuals with different roles and goals. Apart from managers, I can think of workers, shareholders, and customers. Obviously there is no particular coherence of interest within groups.

TEACHER: Correct. The outcome of the interaction of these different individuals is perceived to be an organizational coalition, in which every individual has to make some compromise over objectives, since not all can be simultaneously satisfied.

STUDENT: But Teacher, internal compromise does no look as the best way to identify the optimal price, product mix, rate of asset utilization, and rate of innovation, does it?

TEACHER: A sharp observation, Student. It is a fact that firms in which political processes (akin to those in a coalition government) determine outcomes will typically exhibit organizational slack in the sense that they will not be maximizing profit or the value of the firm. This type of firms can survive in spite of being slack (or sub-optimal, using a more sophisticated word) and not maximizing profits as long as the outcome is satisfactory for all parties involved.

STUDENT: This approach looks somewhat dated to me. It may have worked nicely in the 1960s, but then company riders, hostile takeovers, shareholder’s revolts, etc. etc. appeared on the scene.

TEACHER: Quite true. While the Cyert and March analysis had great plausibility in the 1960s, it is hard to reconcile with the business environment of the 1990s and the early 21st century. In short, the strong focus on value maximization has made the concept of organizational slack unacceptable at least for public corporations.

STUDENT: And it is easy to guess that the basic issue is how to achieve a structure within which internal conflict is resolved and the overall goals of the firm are pursued by all parts of the organization.

TEACHER: We can give such a structure a name: incentive compatibility.

This is a structure within which individuals have an incentive to perform not only in their own interest but also in the overall firm's interest.

STUDENT: Nice definition. How can it be implemented?

TEACHER: A modern version of the Cyert and March approach is based upon identifying the interests of various groups of stakeholders. Remember who the main stakeholders are?

STUDENT: Sure. The stakeholders in a firm are all those who have a direct economic interest in the firm's results; mainly employees, suppliers, shareholders, and customers.

TEACHER: Correct. Successful firms have to build their success on a constructive alliance of all interested parties. No firm can succeed in the long term without a high-quality and motivated management, productive employees, and satisfied customers and suppliers.

STUDENT: Are you not leaving out the all-important shareholders? A firm needs capital and the stock market is a vital source of it; and managers can get fired by shareholders.

TEACHER: You are right about the vital importance of shareholders, and I am not leaving them out; I only wanted to stress that if a firm has bad relations with any of the groups mentioned before, it will not serve the value-maximizing objectives of shareholders.

Now we’ll discuss the three basic business structures that have categorized firms in the 20th and are still valid in the 21st century.

* In a unitary form (U-form) of business there are several departments that perform different functions, but they all report to the chief executive (or the office of the CEO), who is responsible for the overall running of day-to-day operations.

* In a multi-divisional form (M-form), specific product groups are formed into separate divisions, each with its own functional departments. Every division has its own general manager who is responsible for the day-to-day running of the division. The CEO of the firm is responsible for co-ordination of the activities of the divisions and for providing strategic focus for the business.

* In a portfolio form (P-form), the main company (the Group, or Holding) is made up of a collection of several wholly, or partly, owned subsidiary companies. Each of the companies within the group has its own chief executive, who is responsible for the day to-day running of that business, and each of these subsidiary companies may itself be U-form or M-form in structure. The Group has a CEO responsible for deciding the strategy of the entire group, including deciding which businesses should remain in the Group portfolio and which others might be acquired. There is a board of directors for the group, usually referred to as the 'main board', and there is a board for each subsidiary company.

STUDENT: My guess is all companies that started small and grew organically (that is by expanding the existing business rather than taking over other businesses) started out with a U-form structure. And it is a fact that many small businesses today also have such a structure.

TEACHER: Correct. The M-form structure was first introduced into General Motors in the 1920s by Alfred P. Sloan, in order to handle the problems of running a large manufacturing concern. Other large US companies, such as Du Pont, Standard Oil, and Sears, also reorganized along these lines in the inter-war years. This structure proved to be a considerable success and was widely imitated.

But by now almost all large public companies have gone further than the M-form structure -although parts of the business may be in this form. These firms are collections of many subsidiary companies and we can consider them as having a P-form structure.

STUDENT: You are mentioning the facts. Can we look now into the economic reasons for this evolution of structure?

TEACHER: We’ll do precisely that, right now.

U-Form Structure

The unitary form of structure is the natural place to start for any small business. In a start-up manufacturing business the product might, for example, be produced in a small plant. As the product’s sales grow, additional staff will be hired. The business has to have accounts, so the services of an accountant will be hired. At first, the accountant might be part time, but if growth continues, there will be a finance department. Similarly, someone will have to take charge of sales, and eventually there may be an entire marketing department. Having taken on all these new staff, the firm will need a personnel department to handle hiring and firing and terms of employment, etc.

This chart illustrates what the organizational structure looks like in a U-form business:

Employment: The Supply and Demand for Labor

2009-12-30T07:22:00.001-08:00

TEACHER: Hi, Student. Economists frequently classify inputs into three categories: labor, capital, and land. The problem of this simple classification is that each category contains an enormous variety of specific inputs.

When we speak of labor we must keep in mind that the category includes a great deal more than the organized labor. Since trade unions get a lot of press coverage, we may forget that in the US only about 20% of the labor force belongs to trade unions. This percentage is much higher in other parts of the world, of course. Student, will you give me a few examples of "labor" other than factory workers?

STUDENT: Sure. A secretary who works at Unilever, an account executive at Merrill Lynch, my dentist, a University professor like yourself... etc., etc., etc.

TEACHER: Correct. In advanced economies, about 2/3 of the people an economist would call "labor" are not factory or farm workers; they are the so called "white collar" workers –clerks, salespeople, managers- or service workers (such as waiters, hairdressers, or lawyers).

STUDENT: And it is common knowledge that people in these different types of labor earn very different wages.

TEACHER: Exactly. Average earnings vary considerably from one industry to another. For example, recent data in the US show that if we standardize the wages of construction workers at 100 points, workers in manufacturing averaged about 88 points, and workers in retail trade averaged only 38 points.

STUDENT: I am certain that we will investigate the reasons for these differences in wages, aren’t we?

TEACHER: Not only that, we will also be concerned with the total price of labor, which includes a great many forms of remuneration other than what we usually call wages.

As said, economists include as labor the services performed by professional people (such as lawyers, doctors, and professors) and self-employed businesspeople (such as electricians, mechanics, and barbers). The money such people earn is considered a particular sort of price of labor, even though these amounts are often called fees or salaries rather than wages.

STUDENT: I have been looking at some "time series", that is, wage earnings over time, and have seen very substantial differences in the same industries and for the same type of labor over a period of say, 10 years. In general, wages show important increments.

TEACHER: Naturally it is important to distinguish between money (nominal) wages and real wages. The real wage depends on the price level for goods and services as well as on the magnitude of the money wage. In many cases, if the time series is adjusted to inflation, real wages did not rise at all, an din many cases they fell.

The Equilibrium Wage And Employment Under Perfect Competition

Let’s begin by discussing the determinants of the price of labor under perfect competition. Student, please remind me about the basic assumption we made of the prices of products and inputs of firms under perfect competition.

STUDENT: No problem for me, Teacher. We assume that firms take the prices of their products, as well as the prices of all inputs, as given, and we assume that owners of inputs take input prices as given.

TEACHER: Correct. In this case, what determines how much labor an individual firm will hire at a specified wage rate? Once we answer this rhetorical question of mine, we can derive a firm's demand curve for labor. Incidentally, what do you think a demand curve for labor would be?

STUDENT: Not very differently from the firm’s demand for other inputs, a firm’s demand curve for labor is the relationship between the price of labor and the amount of labor utilized by the firm.

TEACHER: Exactly. It shows, for each price, the amount of labor that the firm will use. And it is reasonable to assume that a firm will utilize the profit-maximizing quantity of labor. Before we continue, let me remind you of a basic concept, the marginal product of labor. Or maybe you remember it?

STUDENT: I do. The marginal product of labor is the additional output resulting from an extra unit of labor. And before you ask me, I also remember the concept of diminishing marginal returns, Teacher.

TEACHER: Excellent. Let’s assume that we know the firm's production function and that labor is the only variable input. Given the production function, we can determine the marginal product of labor when various quantities are used. Student, what would you do if as a businessperson you notice that hiring an additional worker would yield you a revenue higher than the wage you’d have to pay to that worker?

STUDENT: For purely economic reasons I’d hire that worker; and I’d continue doing so until –as a result of diminishing returns- an additional worker would cost me more than the revenue that worker would yield.

TEACHER: I was going to ask you how many workers should the firm hire if it wants to maximize profit, but you have already answered the question; it should hire more workers as long as the extra workers result in at least as great an addition to revenues as they do to costs.

STUDENT: Let me put it in other words: profits are at maximum when the value of the marginal product of labor is equal to the price of labor.

TEACHER: What you just said shows me that you understand that the value of the marginal product of labor is the physical marginal product of labor multiplied by the product’s price. And I see you also realize that to maximize profit, the value of the marginal product of labor must be set equal to the price of labor. Can you tell me why?

STUDENT: Because if the value of the marginal product is greater than labor's price, the firm can increase its profit by increasing the quantity of labor used; while if the value of the marginal product is less than labor's price, the firm can increase its profit by reducing the quantity of labor used.

TEACHER: It is now a simple matter to derive the firm's demand curve for labor. We can also easily understand that many firms, not just one, are part of the labor market, and therefore the price of labor depends on the demands of all of these firms.

The market demand curve for labor shows the relationship between the price of labor and the total amount of labor demanded in the market.

STUDENT: Obviously it shows, for each price, the amount of labor that will be demanded in the entire market.

TEACHER: The market demand curve for labor, like any other input, is quite analogous to the market demand curve for a consumer good, which we discussed previously. But can you tell me at least one important difference between the demand for labor and the demand for a consumer good?

STUDENT:: Naturally, the demand for labor and other inputs is a derived demand, since inputs are demanded to produce other things, not for their own intrinsic value.

TEACHER: Yes, and this is the reason why the price elasticity of demand is higher for some inputs than for others. It is apparent that the higher the price elasticity of demand for the product the input helps produce, the higher the price elasticity of demand for the input.

STUDENT: Now that you have showed me the market demand for labor curve, it is not difficult to guess what comes next, is it?

TEACHER: That’s right, we will now discuss the market supply curve for labor. As we have seen, a product's price depends on its market supply curve as well as its market demand curve. This is also true for labor. Obviously, the market supply curve for labor is the relationship between the price of labor and the total amount of labor supplied in the market. Now let me ask you something, Student. Suppose your salary or wage is increased constantly. If you could decide how much overtime to work, would you work more or less overtime?

STUDENT: Well, at the beginning of that process I would probably work more overtime, since it would be more worthwhile for me to do the extra effort. But after a time, as I made more money working my regular hours, I’d work less overtime in order to have more leisure time.

STUDENT: A flawless description of how the market supply for labor behaves. When individuals supply labor, they are supplying something they themselves can use; the time that they do not work can be used for leisure activities.

Due to this, the market supply curve for labor, unlike the supply curve for inputs supplied by business firms, may be backward bending, particularly for the economy as a whole. That is, beyond some point, increases in price may result in smaller amounts of labor being supplied, as shown on the graph.

As you so well illustrated with your attitude in response to a constantly increased salary, the reason for the shape of this curve is that as the price of labor increases, workers become richer. And when they become richer, they want to have more leisure time. The consequence is that they want to work less.

STUDENT: But Teacher, is there no contradiction between the assumption that the supply curve of labor or other inputs to an individual firm is horizontal under perfect competition and the fact that the market supply curve for the input may not be horizontal?

TEACHER: We have to distinguish between the view of a single firm and what happens in the market as a whole. For example, an unlimited supply of unskilled labor may be available to any firm in a particular area at a given wage rate. But the total amount of unskilled labor supplied in this area may vary with changes in the wage rate due to variations of the aggregate demand for workers.

STUDENT: I see. This is similar to the sale of products. A particular firm under perfect competition rightly believes that it can sell all it wants at the existing price. However, the aggregate amount of the product sold in the entire market can be increased only by lowering the price.

TEACHER: Exactly, and by how much, depends on the price elasticity of the product. Now let’s turn to the equilibrium price and quantity of labor. The price of labor (or wages) under perfect competition is determined by supply and demand in essentially the same way that a product's price is.
The price of labor will be at equilibrium at the level where the quantity of labor demanded equals the quantity of labor supplied. As seen on the graph, the equilibrium amount of labor utilized is given by the intersection of the market supply and demand curves

Naturally, since labor is not an homogeneous input, these curves will be different for different types of workers in different geographical locations at a given point in time. Let’s compare the market for computer programmers and that for unskilled labor.

We can see in this graph that the demand curve for the services of programmers is to the right of the demand curve for unskilled labor. Also, the supply curve for the services of programmers is far to the left of the supply curve for unskilled labor.

I’ sure you can easily explain this difference, Student, can’t you?

STUDENT: The reason is that relatively few people are trained computer programmers, while practically everyone can do unskilled labor. In other words, programmers are much more scarce than unskilled laborers.

TEACHER: Exactly. It is then easy to understand why computer programmers receive a much higher wage rate than do unskilled laborers. The previous graph illustrates that the equilibrium price of labor for programmers is much higher than that for unskilled labor. This is a rather permanent situation, Student. Can you tell me why?

STUDENT: Well, the reason is that unskilled workers lack the training and often the ability to become computer programmers.

TEACHER: That’s right. Computer programmers and unskilled labor are examples of non-competing groups. Wage differentials can be expected to persist among these groups because people cannot move from the low-paid to the high-paid jobs.

But apart from this fact, there is an element that distorts our elegant analysis; and that element are the labor (trade) unions. You know what the labor unions are, don’t you, Student?

STUDENT: Of course. The unions are organizations of workers with power to collectively negotiate wages and other non-monetary compensations with employers.

TEACHER: Correct. The perfectly competitive model does not apply to these workers. Unions arose because workers recognized that acting together gave them more bargaining power. In short, unions increase wages.

Unions have considerable power, and we must include them in our analysis if we want our models of the labor market to be accurate.

From an economic theory point of view, the union may try to shift the supply curve of labor to the left, with the result that the price of labor will increase. How can the union reach this end? Unions have frequently forced employers to hire only union members, and then restricted union membership by high initiation fees, reduction in new membership, and other devices. In addition, unions have favored legislation to reduce immigration, shorten working hours, and limit the labor supply in other ways.

STUDENT: Reminds me of the very long apprenticeship periods common in the middle ages, which were also designed to restrict the supply of craftsmen allowed to practice a trade.

TEACHER: Same idea, indeed. Medieval trade unions were very powerful. To be allowed to be a shoemaker, an aspirant had to work for maybe 10 or more years as an apprentice in a union member’s shop, practically without pay.

The union may also try to shift the demand curve for labor upward and to the right. To cause this shift in the demand for labor, the union may resort to a practice known as featherbedding; it may try to restrict output per worker in order to increase the amount of labor required to do a certain job.

STUDENT: Yes, I remember that for decades the railroads had to man diesel engines with firemen (stokers), the workers needed to keep the fire going on obsolete steam locomotives.

TEACHER: There are many examples. The linotype operators at large newspapers violently resisted the use of computers; the prestigious US newspaper Herald Tribune closed due to this situation. And airlines were forced for years to man cockpits with navigators, a job made obsolete by satellite technology.

Unions also try to shift the demand curve by helping the employers compete against other industries or by encouraging the passing of legislation that protects the employers from foreign competition by instituting high tariffs.

STUDENT: And what can you tell me about collective bargaining?

TEACHER: Collective bargaining is the process of negotiation between the union and management over wages and working conditions. Representatives of the union and management meet to work out an agreement or contract. Obviously the main pressure element the union can use in these negotiations is the strike.

STUDENT: In many parts of the world minimum wages are fixed by federal governments or state governments. What effect do these have on the demand and supply of labor?

TEACHER: Minimum wages, as well as the many types of payroll taxes that exist, interfere with the market mechanism.

Minimum wages and payroll taxes shift the supply curve of labor to the left, obviously increasing the price of labor and displacing the equilibrium point to a lower level of employment. Basically minimum wages only affect the market for unskilled labor, while payroll taxes affect a much wider range of workers.

STUDENT: Defenders of the minimum wage argue that the level of poverty is decreased by these regulations. But of course, the contrary argument is that unemployment is higher than it would be in the absence of a minimum wage.

TEACHER: Depending on each country’s capacity to enforce labor regulations, in many cases minimum wages are not observed by employers. As workers in these cases become part of the underground economy, less taxes are collected. Also, because these workers do not contribute to social security schemes, they are not protected by them. And finally, employers that respect the regulations are subject to an unfair competition.

On the other hand, a reasonable level of social security contributions is justified, since if well run these schemes provide unemployment insurance as well as health and retirement benefits, which are valuable elements in a modern society.

Let me finish by saying that the tide is now working against all types of manipulation of the free demand and supply for labor. Globalization, the constantly increasing freedom of international trade, creates a pressure towards equalization of the price of labor all over the world. The differences in wages among countries are still very large; but the tendency towards a confluence is very clear. Real wages in the US and other developed countries have not grown for a long time, while real wages in a large number of developing countries from China to Korea to Mexico have been constantly increasing.

Introduction to Economics and Business

2009-10-23T03:40:00.000-07:00

STUDENT: Hello, Teacher. Yes, I know what's coming up now! For several coming Modules you are going to lecture me about "Microeconomics"!
And I also know that "Macroeconomics is the study of how the economy functions in broad outline", because you lectured me on that one before. You have also told me before that "Microeconomics is the part of economics dealing with the activities of individual markets and firms".

TEACHER:. Good for you. I see that you remember my previous lecture on the subject of economics very well.

STUDENT: Yes, and I also remember having asked you "why should I, as a business person, be interested in macroeconomics"? Now, I will ask you this... why should I, as a business person, be interested in microeconomics?

TEACHER: Simply because economics is a very relevant subject if a business person is to understand the environment in which he or she operates. A skill that may help the business to be successful, of course.

STUDENT: You mean to say that to be a good business person I need to be a good economist?

TEACHER: Not exactly. A deep knowledge of economics is neither necessary nor sufficient for being successful in business. However, a good grounding in economics will help you to analyze business situations much better. Now let me ask you something? Do you know what kind of science economics is?

STUDENT: I remember something like "the dismal science".

TEACHER: That was ages ago, when Malthus made very negative forecasts about what would happen as population increased faster than food production. No, the answer I was hoping for was "economics is a social or behavioral science". And this is so because basically economics deals with how people behave in different circumstances. By the way, you know who Malthus was, don't you?

STUDENT: Thomas Robert Malthus (1766-1834) was an English economist, sociologist, clergyman and pioneer in modern population study. Malthus argued that poverty and distress were unavoidable because population, when left unchecked, increased faster than the means of subsistence.
And getting back to your definition of economics, what it means is that what economists do is theorize on behavior. Is that all?
TEACHER: After congratulating you for your encyclopedic knowledge, let me tell you that economics is a social science that tries to explain the behavior of the economy; more exactly, the behavior of the economic agents which are, after all, people. Naturally since economics is not an exact science, economists develop theories which are sometimes called economic models.

STUDENT: And why and when are these models useful to a business manager?

TEACHER: Economic models are simplifications of the real world. They may be useful in explaining how the world works. Of course, the ultimate test of how useful economics is to business is... does it really explain or accurately predict what is going on in the real world?

STUDENT: Fine. And so which is the subject we will discuss in this first Module of microeconomics?

TEACHER: We will outline some of the key topics that are of interest to both economists and business persons. Later you and I will discuss them in greater detail.

To begin with, let me state that all business firms operate within a market. Would you attempt to define what a market is?

STUDENT: Sure. A market is the environment in which suppliers and demanders of a given product or service interact. And let me add that this interaction determines what is produced and consumed and in what quantities.

TEACHER: A very good "economic" definition. Obviously you mean that this "determination of what is produced and consumed and in what quantities" is reached via the price mechanism, the result of the interaction of suppliers and demanders in the market.

STUDENT: Sure. And I may add that this is why any business person must have a very good understanding of the markets in which he or she operates. But I have a question. Do all activities of a firm actually take place in a market?

TEACHER: Not necessarily. A key question for managers of firms to be asking all the time is: should we be doing activity X within the firm, or should we buy it the market from another firm? In other words... should we make it or purchase it?

STUDENT: So, an activity conducted within a firm is an alternative to a transaction in the market.

TEACHER: Exactly. While firms always operate in some market, they also perform internal activities, and one of the key economic issues managers face is to decide which transactions should be internal to the firm and which ones should be left to the market.

STUDENT: I see; and it seems to me that lately there has been a strong tendency towards "farming out" functions.

TEACHER: True. From administrative tasks to manufacturing, more and more functions are contracted in the market. EDS and IBM have dramatically increased their taking over of IS activities from firms; and farming out manufacturing to "toll producers" has also increased very much.

The theory of the firm

But allow me to expand on the subject of markets, and mention "the theory of the firm". When we discuss how markets work, we are primarily interested on the determination of the price and quantity sold of specific products.

* The theory of the firm will be used to study the supply decisions of firms.
* Consumer demand theory will help us to generate predictions about how demand will change in response to changes in key economic variables, such as the price of the product and the incomes of consumers.

The Economics Of The Firm

While in a large economy decisions are made by an enormous number of participants, many of which are individuals, one of the key economic decision-making units is the business firm. Can you imagine why this is so?

STUDENT: Well, the business firm is an economic actor that hires workers, buys inputs, and produces some product that it then sells in the market. Of course, a firm may be organized in many different ways from a legal point of view; sole proprietorships, partnerships, corporations, etc.

TEACHER: True, but from the economics point of view the firm is an entity in itself that is conceptually separate from its owners and workers.

STUDENT: And what is the conceptual difference between the word 'firm', and others such as 'business', ‘enterprise’, 'company', 'corporation', etc. ?

TEACHER: Conceptually, there is no difference at all, according to the broad definition given above. When I use the word 'firm' I will be referring to this broad definition. Obviously, sometimes I will refer to specific types of firms, since in fact there are important legal (although not economical) differences between a partnership and a corporation, for instance.

Now please allow me to discuss...

The elementary theory of the firm

We call it the elementary theory of the firm because in order to simplify the "model", we discuss a single-product firm; usually the product is assumed to be a manufactured one.

STUDENT: Is this not an over-simplification?

TEACHER: No, because the principles involved can be applied to any firm. What is it that any firm typically needs in order to manufacture any product?

STUDENT: I’m sure it needs plant and equipment, and workers to operate the equipment and for ancillary tasks. It must also buy inputs, such as components, raw materials, energy, etc.

TEACHER: Right. How would you, in general, call the plant and machinery a firm employs?

STUDENT: You are obviously referring to land, buildings, machines, tools, vehicles, etc. This is often referred to as capital or capital goods. But I am a bit confused. There is no question that land, buildings, etc., are capital. But we also often speak of capital when we talk about money in the bank and other financial assets.

TEACHER: Good point. In the theory of the firm "capital" will generally be used to refer to physical capital, such as plant and equipment. Of course the word capital is also validly used to mean financial assets, such as "working capital", which is not invested in physical capital. But again, in the theory of the firm we will in general use it meaning physical capital

STUDENT: Fine, now I understand. But I have another question. Since the theory of the firm is based on a single-product firm, does this mean that economics can not deal with multi-product firms?

TEACHER: Economics can deal perfectly well with multi-product firms. As a matter of fact, these firms are an important topic in the branch of economics known as Industrial Organization. Don’t worry, we will discuss this matter in one of the following Modules of this Subject.

STUDENT: Would you please summarize what exactly the theory of the firm is about, in practical terms?

TEACHER: Sure. In the theory of the firm, we analyze how the technology used in production, combined with input prices, affects unit costs as the volume of output is changed. We also discuss how the demand for the firm's product changes at various prices.

STUDENT: Sounds great. And what is the usefulness of all this analyzing?

TEACHER: The importance of all this is that, given the cost structure at different levels of output and the market demand at different prices we can conclude what level of output will maximize the firm's profit.

STUDENT: A precise way to put it, Teacher.

TEACHER: Thanks. And since I mentioned "market demand", let me tell you that the choices available to firms in the markets they sell to are very much influenced by the competition in those markets.

STUDENT: Easy to agree with; and I’d add that, to some extent, the firms may also be constrained by the competition in the markets where they purchase their inputs.

TEACHER: True. Competition in the market a firm sell in may be more or less intense depending upon the availability of similar or superior products, potential substitutes, and the number and characteristics of competing firms. There are basically three types of markets from the point of view of the structure of the competition.

Perfect competition

Under perfect competition, there are many firms in the market producing an identical product and none of the firms is sufficiently large to influence the market price. Can you think of an example?

STUDENT: I guess they are not too many examples for manufactured products, but in general producers of commodities such as those of grains, crude oil, etc. operate under perfect competition. An let me add that you forget one conditions, which is that for a market to operate under perfect competition all buyers and sellers must be constantly informed of the prevailing price at which transactions are taking place.

TEACHER: Good observation. Not let’s describe...

Imperfect Competition

The most common structure in which firms operate is imperfect competition. In this type of market there are a finite number of competing suppliers, each selling differentiated products that can, to varying degrees, be substitutes for each other. What type of situation do you think firms face in these types of markets?

STUDENT: I guess most firms will have to make decisions about how much to produce and at what price to sell.

TEACHER: Correct. And also of course they have to worry in varying degrees about what the competition is doing. Now let me ask you ... what type of competition do you think would be in extreme contrast to perfect competition?

STUDENT: This is the M word: monopoly!

Monopoly

TEACHER: Right, monopoly. This is a situation where there is only one producer of a product; the single producer faces no competition from other local producers and the product can not be imported.

A monopolist has the power to set not just output but also the price of the product.

STUDENT: Nice situation for any business to be in!

TEACHER: Sure. No other suppliers can take market share from a monopolist. But while monopoly may be good for the firm involved, it will generally be bad for consumers, because the monopolist will tend to charge higher prices than those that would prevail under a competitive situation.

STUDENT: Naturally, I’m sure this is why most countries have regulations to prohibit monopolies, or to control them when they can not be avoided –cases like water, electricity or local telephone service.

TEACHER: The latter are examples of "natural" monopolies, where under prevailing technologies consumers would have to pay more if several firms were competing in the market, than they pay if a well regulated monopoly is allowed. The key word is "prevailing technologies"; long-distance phone service used to be a natural monopoly years ago, but this is no longer so due to modern communications technology.

The basic condition for a monopoly to operate is the existence of some barriers to entry, like those given by patent protection.

But let’s return to the commonest type of market, imperfect competition. This type of market lies between the two extremes of perfect competition and monopoly, and involves a range of different cases. In general, imperfectly competitive markets involve products that, actually or in the mind of the buyers, are similar but not identical. Can you think of another condition?

STUDENT: There are a limited number of potential producers, each of which can influence the others by its own behavior; changing output, prices, advertising, etc.

TEACHER: True. The most common cases of imperfect competition are oligopoly and monopolistic competition.

Oligopoly

Oligopoly exists where the market is dominated by a small group of competing firms. Most large firms operate in this type of markets. Just as an example, let me mention the PC (Personal Computer) industry. Here each firm is greatly affected by what its close rivals do in terms of product prices and innovations.

Monopolistic competition

In this type of markets there are many firms but in general their products or services are differentiated. The restaurant business is a good example, especially if we exclude large chains. Each individual restaurant not belonging to a chain, has a small share of the market as in perfect competition; but the difference is that the restaurant has some discretionary power on the prices it charges. Why do you think this is so?

STUDENT: Because, in contrast to perfect competition markets, here the products are not exactly alike. Restaurants are differentiated by physical location, the type of food they offer, the quality of food and service, ambience, prestige, etc. I am sure this is why they have some price fixing power, but it certainly is a limited one. At some point customers will be willing to travel farther for a meal and/or accept other types and qualities of food and service.

TEACHER: Exactly. Now let’s discuss the following theme: What determines the behavior of the business firm?

Motivation Of The Firm

What do you think is the best answer to that question?

STUDENT: I’d say, as a first approximation, that a firm attempts to maximize profits. Let me add that profits are defined as the difference between the firm's revenue (or gross income) and its costs.

TEACHER: That all firms attempt to maximize profits is not an unreasonable assumption indeed, since most businesses appear to be interested in making money. The decisions a firm should make in order to maximize its profits are determined by the current state of technology.

Technology, Inputs, And The Production Function

Technology is the total knowledge available concerning the production of certain goods or services. Firms are limited by the current state of technology. In making its decisions, the firm must take this into account.

Input is anything the firm uses in its production process; machines, energy, raw materials, labor, etc.

The Production Function

For any final product, the production function is the relationship between the quantities of various inputs used per period of time and the maximum quantity of the product that can be produced per period of time.

Now, Student, in analyzing production processes we suppose that all inputs can be classified into two categories. Can you guess what these two categories are?

STUDENT: I sure can try. Some inputs are fixed (such as the machines available at a certain point in time) and other inputs are variable; those whose quantity can be changed during the relevant period. In the latter category we may mention, with natural limitations, labor and raw materials.

TEACHER: Good. Whether an input is considered variable or fixed depends on the length of the period under consideration. The longer the period, the more inputs are variable, not fixed. In general we can define two time periods: the short run and the long run.

The short run is defined as the period of time in which at least one of the firms inputs is fixed. Since the firm's plant and equipment are among the most difficult inputs to change quickly, the short run is generally understood to mean the length of time during which the firm’s land and equipment are fixed.

The long run is that period of time in which all inputs are variable. In the long run, it is assumed that the firm can make a complete adjustment to any change in its environment.

Average Product Of An Input

In order to determine which production technique -that is, which combination of inputs- a firm should use, it is necessary to define the average product and marginal product of an input.

The average product of an input is the total output divided by the amount of input used to produce this amount of output. Example: In an eight hour shift a machine can produce 800 units of product; the average product of the machine is 100 units per hour.

The marginal product of an input is the addition to total output due to the addition of the last unit of input while other inputs used being held constant. Example: assume that a machine makes chocolate tablets which are then put into cases by hand. With the same machine and ten workers putting tablets into cases we can produce 1000 filled cases per hour, an average of 100 cases per worker. If we add one worker, we can produce 1090 cases per hour. The marginal product of a worker is 90 boxes per hour.

STUDENT: Why is it that the additional worker only adds 90 cases of product, while the average of the first ten workers was 100 cases each?

TEACHER: Ah, this is because you have the infamous law of diminishing marginal returns working against you! Which is perhaps the best-known, and certainly one of the least-understood, laws of economics

In short, the idea is that if equal increments of an input are added, the quantities of other inputs being held constant, beyond some point the resulting increments of product will decrease. That is, the marginal product of the input will diminish. The reasons for that general law to apply are different in different situations. In our example we can assume that the chocolate tablets coming out of the machine move on a conveyor belt from which the workers take them to put them into cases. As you put one more person to work on the same conveyor belt, the workers will possibly have less space to work efficiently. It is also possible that the 11th. worker is less trained and efficient than the first ten. By the same token, if you add a twelfth worker it is likely that the marginal product of this additional person will be less than 90 cases per hour, an so on.
THE OPTIMAL INPUT DECISION

Now we are in a position to answer a very important question; what is the optimal input combination to maximize profits? In other words, assuming that the firm is going to produce a particular quantity of output, what combination of inputs should it choose to maximize profits? Any comment?

STUDENT: Well, obviously to maximize its profits the firm must minimize the cost of its output.

TEACHER: Yes, this seems obvious enough. OK, the let me tell you now that "the firm will minimize cost by combining inputs in such a way that the marginal product of a dollar’s worth of any one input equals the marginal product of a dollars worth of any other input used".

STUDENT: Now is does not sound so obvious. Can you explain what this means?

TEACHER: Sure. Going back to our chocolate tablets example, let’s assume that the firm could either change the speed of the machine –consuming more or less energy per hour- and/or change the number of workers operating the packing line.

Within the practical limits of the machine and the space available for workers, the firm will combine speed of the machine and workers in such way that the additional cost of producing one more case is the same whether machine speed is increased or a worker is added.

Negotiation Basics

2009-03-04T23:28:00.000-08:00

What is "Negotiation"?

Let’s define a very simple situation. A has something B wants and is in a position to deliver it; and B has something A wants, and would also be able to deliver it. These are the necessary conditions for any type of negotiation; if either of these conditions are not met, there is no point in conducting any negotiation.

The more basic form of negotiation is barter. Let’s assume that:

* A has shirts and B wants shirts. A is in a position to deliver shirts
* B has pants, and A wants pants. B is in a position to deliver pants

A negotiation may now begin, with a lot of components.

To name just a few of them:

* Quality of the merchandise
* "Terms of the exchange": how many shirts for how many pants? Or, in a monetary environment, "price of the goods and payment terms".
* When and where will each party will deliver?
* In case of differences, who will be the arbiter?

On the other hand, if A is not interested in pants, and/or B does not care for shirts, there will be no reason for any negotiation to take place.

The same is true if, regardless of both parties having something the other party wants, one or both of them is not in a position to deliver the goods.

One of the most distinguished authors in the subject, Gavin Kennedy, defines negotiation as "the management of movement, because without movement no negotiation can succeed". A very concise and to the point definition. Incidentally, the only books on Negotiation we will mention as recommended reading, are Kennedy’s "Everything is Negotiable" , "The Perfect Negotiation" and "Pocket Negotiator". If you are specifically interested in the subject, they are highly recommendable.

What Kennedy’s definition implies is that to enable a negotiation to take place, both parties must be flexible. They very likely have an ideal target (get as much as they can for as little as possible) but they must be willing to settle for less in order to close a deal.

If one of the parties is not flexible, there is no possible negotiation. If you go to a fixed price store (Wal-Mart, for instance) to buy something, you find out Wal-Mart’s price for the item and you either purchase it or you don’t. There is no room for negotiation, because Wal-Mart is not "flexible"; their position is "this is the price, take it or leave it".

Usually in any negotiation both parties have an ideal target and a minimum point at which they are willing to deal (which of course they will carefully hide from their counterpart). For the negotiation to end with a deal, there must be some overlapping of both positions.

A simple example:

* You want to purchase a bike and are willing (secretly) to pay up to $100 for it.
* You go to a store and tell the seller you are willing to pay $80 for the bike (your "bid")
* The seller asks for $120 (his "ask")
* If the seller is willing (in secret) to finally sell it for say $90, a deal may be closed at any point of the overlapping bid and ask positions: between $90 and $100.

The final price will be closer to $90.- or to $100 depending on the negotiating skills of both parties.

Effective Negotiation

What is the meaning of "effective" in this context? Some people think that negotiating effectively means using whatever tricks, bluffs and ploys serve their purpose to obtain what they want from the other party, giving away nothing or as little as possible of their own goodies the other party may want.

This is not a realistic approach for serious professional business negotiators. Bluffs and tricks usually create a negative reaction. The "Machiavellian" approach is best left to unserious amateurs.

STUDENT: What do you mean by "Machiavellian"?

TEACHER: Machiavelli was an Italian statesman, historian, diplomat and political theorist. His famous treatise The Prince (written in 1513, published 1532), is a handbook for rulers. Though admired for its incisive brilliance, the book has long been widely condemned as cynical and amoral, and "Machiavellian" has come to mean deceitful, unscrupulous, and manipulative.

Anyway, the purpose of this course is not to teach you tricks and ploys to trap the people you negotiate with.

STUDENT: No? And why not?

TEACHER: Because as a businessperson you will usually negotiate with peers, not with gullible neophytes. These people will not be easily tricked. And many times your negotiations will be repetitive with the same party and you will not want to antagonize them by using bluffs and tricks which will jeopardize a mutually beneficial long-term relationship.

STUDENT: Then what is this course about?

TEACHER: This course is about realistic, effective techniques for getting the best possible results in serious, professional negotiations.

We will also teach you all known tricks, ploys and traps etc. But not to induce you to use them in serious negotiations. The aim is to prepare you for what the other party may throw at you, because "a ploy identified is a ploy neutralized". And we will also describe the basic types of tricky and difficult negotiators you may encounter, and help you to learn how to deal with them.

STUDENT: Are you serious about your statement that "tricky" negotiators always fail? Because there are many seminars about negotiation which endorse these strategies.

TEACHER: Seminars are good business for many people conducting them. They are mostly advertised in flight magazines, and aimed at business people coming back from frustrated negotiations. More often than not participants walk away from this type of seminar happily convinced that they have become skilled negotiators... only to fail again next time.

Naturally there are situations were being tricky pays off. When the deals are "one time" transactions –as opposed to repetitive- and one of the parties is a professional conducting several negotiations every day, and the other is an amateur negotiating once every five years or so, the chance of tricks paying off is high. Typical examples are car, real estate and time-sharing transactions.

On the other hand, over the years people selling those goods have earned a reputation of being tricky, and nowadays even inexperienced buyers enter into negotiations very suspicious of the other party. Not being skilled negotiators, this extreme self-protective attitude may lead them to reject proposals which are in fact advantageous for them. Which in turn means the seller fails; the reputation of being a tricky negotiator, even if not a fact in a particular case, may work against him or her.

Planning a negotiation

A basic condition you should meet before entering into any negotiation is doing some planning. Naturally the time and effort devoted to this planning must be proportional to the importance of the negotiation. If you are going to purchase a bike, you need less planning that if you are going to purchase a new home. But in all cases some planning is very useful.

Planning consists basically of:

* Making the best possible estimate of which facts you don’t know about your counterpart and the products and services you are interested in.
* Determining which of these facts you are not able to find something about.
* Getting as much information as possible about those facts you are in a position to find out about.

Establishing objectives

First question to put to yourself: Why do I want to negotiate? In other words, what is my objective in this negotiation?

Once you know exactly what you want to get from a negotiation (your goal), you must be as sure as possible of what the other party can do for you to help you reach your goal. Your counterparts in a negotiation are your adversaries because your interests are different; but at the same time they must be your collaborators, because without them you can not reach your goal.

Simple, obvious (and almost stupid!) example: if your goal is adding a garage to your home, your counterpart in negotiating the construction must be a building contractor, not a car mechanic!

And naturally the remarks made above work both ways; your potential counterparts must believe that YOU can satisfy all or at least most of their own goals. Continuing with example of the addition of a garage to your home, you may identify a very good contractor, but if this business person does not think you can satisfy his own minimum goal (as say getting $4,000 for building the garage) there will be no possible negotiation.

STUDENT: I notice you used the plural of "goal", "goals". Would you please elaborate?

TEACHER: All negotiations except the simplest ones, will contain different elements. Your main goal may be to get a nice garage added to your home; but you will also have sub-goals for cost, timing of starting and finishing the job, automatic or manual door for the garage, etc.

Once your objective is clear to you, and you have identified a suitable counterpart you think will be willing to negotiate with you, you should establish, for your main goal and for all the sub-goals, a MinAO (Minimum Acceptable Objective) and a MaxDO (Maximum Defensible Objective).

Understanding what a MinAO is easy. As for the MaxDO, it is your estimate of the maximum benefit for yourself you can realistically expect your counterpart may consider acceptable.

Your mix of MinAOs and MaxDOs will be your "opening environment"; you will enter negotiations offering your MaxDOs. Naturally your different sub-goals will have different priorities, but we will talk about this later on.

In our example the MinAO for the main goal may look easy to establish; you will not settle for anything less than a well built garage of a certain size.

But for the sub-goals, your may define a MinAO for total cost (say, no more than $5,000), having it completed for next winter, etc. To keep it simple we will stick to one single goal, cost.

STUDENT: Pretty easy. But how about establishing a MaxDO?

TEACHER: You are right, the MinAO is exclusively your own decision, but in order to establish a MaxDO, you must have some information or insight about your counterpart.

In our example, obviously if you attempt to begin negotiations with a MaxDO of paying $1000 for the garage and make this opening offer, you may be asked to leave the contractor’s office at once, maybe with some use of force involved. The MaxDO must be realistic, and as said before, you need as much information as possible to estimate a realistic level. In our example you may find out how much the contractor charged for comparable jobs, or the average going rate per surface unit (square foot or meter, depending on where you live). If you know of a case when the contractor charged say $3,000 for a comparable garage, you may realistically think that a MaxDO for cost might be this amount.

STUDENT: Let me see if I understood.

You will make an appointment with the contractor, show him a plan (blueprint) of the garage which you took from a specialized magazine, and tell him:

* That you want a garage added to your house as explained in the plan
* That you have a budget of $3,000 (your MaxDO for price) without revealing that you actually might settle for up to $5,000 (your MinAO).
* The contractor may be interested in the job and at this point negotiations may start; or else the contractor will show no interest and you will have to look for someone else to build the garage.

TEACHER: Your got it right. I love to have clever students!

STUDENT: Oh yes, and I’d love to have clever teachers, too!

TEACHER: I won’t comment on that. But since your are such a wise person, please answer the following question. If I were willing to accept no less than $10 an hour for teaching a clever person like yourself, but would start our negotiation demanding $20 an hour... which would be my MinAO and which my MaxDO?

correct answer : MinAO: $10 MaxDO: $20

STUDENT: OK, but if my MinAO is paying you no more than $5 an hour, then what?

TEACHER: There is no chance of a successful negotiation (reaching a deal). There is no "overlapping". For a negotiation to be successful, as explained before in different words, your (the buyer's) MinAO must be higher than my (the seller's) MinAO. Since the former is $5 and the latter $ 10, we would never reach an agreement unless one of us or both changed our objectives enough for them to "overlap". For example, if you decide to change your MinAO to $9 and I to change my own MinAO to $8, then our negotiation could succeed at a price of between $8 and $9.

Planning a Strategy

For some types of negotiations (say, selling time-sharing on a resort hotel) standard strategies have been developed by the sellers based on experience and are applied to every counterpart. There may be slightly different approaches for mature couples and for newlyweds, but all people in the same "category" will be faced with the same strategy.

In serious business negotiations a strategy must be "tailor made" for your counterpart. In order to develop, apply and if necessary change a successful strategy, you need to prepare yourself for this particular negotiation.

* Be as much informed as possible about the subject of the negotiation, even if your counterpart is the specialist. When you deal with your contractor he is obviously the specialist, but the more you know about construction jobs the better. It will prepare you to understand his arguments and make it easier for you to recognize fallacious arguments. Indicating, even subtly, to your counterparts that you are well informed on the subject matter of the negotiation, will also win their respect.

* Know as much as possible of you counterpart values and beliefs. This is a very large array of information and you will never know all there is to know. But try hard. Talk to people who have already negotiated with this person or group, and if possible with people inside the organization they belong to. One example: finding out about your counterpart’s situation and ambitions in his own organization, you may use as part of your strategy stressing how closing a deal with you may help them in their career. It does not sound so nice, but you may also "scare" your counterpart about the risk of dealing with your competition. But be careful and subtle, because of what is explained on the following paragraph.

* Know as much as possible of you counterpart values and beliefs. This is a very large array of information and you will never know all there is to know. But try hard. Talk to people who have already negotiated with this person or group, and if possible with people inside the organization they belong to. One example: finding out about your counterpart’s situation and ambitions in his own organization, you may use as part of your strategy stressing how closing a deal with you may help them in their career. It does not sound so nice, but you may also "scare" your counterpart about the risk of dealing with your competition. But be careful and subtle, because of what is explained on the following paragraph.

Forecast future consequences

If you enter into a one-time negotiation, you will probably not worry too much about what will happen in the future.

But if as it is frequent in business negotiations you are entering or already committed to a long-term relationship, each of your possible moves must be evaluated considering the probable effect not only on the specific negotiation you are engaged in, but also in a valuable long-term relationship with your counterpart.

A customer with the urgent need of a specific good may agree to pay your outrageous price for a time: but he will probably look for a substitute good and/or another supplier.

Let me tell a real life example. The subsidiary of the American company K&H in a certain country enjoyed a quasi-monopolistic position in the local market of a certain branded food product. They manufactured the product locally and were protected by heavy tariffs from competitive imports of similar products. Every time K&H negotiated with its customers (wholesalers and supermarkets) they behaved in a way the latter interpreted as abusive; but since the consumers wanted the product and the points of sale had to have to product available, they had to give in most of the times. H&H felt very secure in its position because for a competitor to build a plant in this country would have meant a considerable investment. They did not worry too much about possible future consequences of their negotiating behavior with its customers.
But at a certain moment the tariff barriers were almost eliminated, and imports of the same product from a neighboring country became competitive in price.

K&H paid dearly for their use of strong arm negotiating tactics in the past. It’s customers were more than happy to deal with the new competitor. No doubt that K&H would have lost market share and price in any case, but if they had built good will over the years with their traditional customers, the entrance of the new competitor into the market could have been resisted more effectively.

Defensive Planning

Certainly your counterparts are doing the same as you are supposed to do. They are trying to find out things about you to define a strategy for the negotiation process.

Defensive planning means identifying your own weak points and decide what (if anything!) you can do to avoid your counterpart finding out about them. Ask yourself questions like: How important is it for me to reach a deal in this negotiation? What actions from the counterpart may hurt me?

Sometimes the best strategy resulting from defensive planning is to clearly tell your counterparts about some of your weak points, especially if you think they already know about them or are likely to find out. This may position you in the mind of the others as a good faith negotiator, which in turn may be a strong point during the negotiation.

OK, now we may hold a session of questions and answers. But you may want to review this Module before we start with it.

Question 1
What is the basic condition for two parties to enter into a negotiation?

Each of the parties must be in a position to deliver a good or service the other party wants

Question 2
Gavin Kennedy, defines negotiation as "the management of .... what?

Gavin Kennedy, defines negotiation as "the management of movement"

Question 3
Do you agree with the statement "when a customer purchased a good in Wal-Mart, it was a successful negotiation? If not, why?

There is no negotiation for customers at a fixed price store. The store, of course, negotiates with its suppliers

Question 4
You are willing to pay up to $100 for a good and are negotiating with a seller who is ready to sell it for as low as $70. At what price can the deal be closed?

Between $70 and $100, depending on the negotiating skill of the participants

Question 5
What is the rationale of this course teaching you ploys, tricks and bluffs if their use is discouraged?

To prepare you for what the other party may throw at you., because "a ploy identified is a ploy neutralized"

Question 6
Are tricky negotiators never successful?

Sometimes they are successful, especially when the deals are "one time" transactions

Question 7
Which is the basic thing you should do before entering into a negotiation?

Before entering into any negotiation doing some planning is crucial

Question 8
What is it you are doing when you ask yourself: "Why do I want to negotiate?"

Establishing your objectives

Negotiation : Streetwise Tactical Ploys

2009-03-04T23:23:00.000-08:00

Possibly the subject of the largest number of seminars and courses being offered today is "Successful Negotiation Techniques" or some similar title. Also many books can be found on the shelves of any bookstore, written by authors of very different backgrounds, from academicians to business executives. The reason for the high demand for these seminars, courses and "how to" books is obviously the perceived need of possessing, and the perceived possibility of acquiring the very valuable skill of being a successful negotiator.

Since negotiation can be defined as an art and not a science or a technology, it is natural that the advice given at seminars and found in books differs very much.

According to the basic approach taken, the type of advice given can be grouped into three differentiated schools of thought:

* Streetwise Tactical Ploys (STP)
* Principled Negotiation, and
* Negotiation as a phased process

In this Module of the Effective Business Negotiation course we will discuss the first of the three approaches:

Streetwise Tactical Ploys (STP)

This system was probably practiced since prehistoric times, but in modern times it was first promoted by Chester Karass of the Center for Effective Negotiation in Southern California.

Since it is natural to perceive at first sight that our counterparts in a negotiation are our rivals or even our enemies, it is not surprising that the promotion of the STP method was very successful, especially during the 80´s.

Karras belonged to the academic world holding nothing less than a Ph.D. in negotiation behavior from the University of California. But he also had considerable "real world" experience acquired as an executive of Hughes Aircraft. He published a first book targeted at an academic audience (The Negotiating Game) in 1970.

But in 1974 he published a second book (Give and take: The Complete Guide to Negotiating Strategies and Tactics), targeted to a wider audience. It was very successful, because many people felt that their counterparts in past negotiations had taken advantage of them and were desperate for some way to stop being street dumb. They wanted to be able to defend themselves from the plots of their streetwise adversaries and come out on top in their negotiations.

The STP approach is still quite popular, and very expensive; and professional seminars concentrate in teaching the ploys supposed to help attendees to "defeat" their adversaries. The STP approach defines negotiations as duels where the "strong" will always defeat the "weak". And to evolve from a weakling to a strong fighter, you need to know these ploys. You can then use them yourself in your negotiations and defeat your adversaries.

STUDENT: Very nice, but what if your counterpart happens to have attended a seminar of the same kind and also knows about the ploys of the STP approach?

TEACHER: This is a good point. The value of knowing the STP ploys lays more in the fact that you will be able to recognize them and defend yourself against them, than in using them yourself against your counterpart.

STUDENT: As you wrote on the previous Module, "a ploy identified is a ploy neutralized".

TEACHER: Exactly, because practically for any ploy there is a defense or counter. This is why it is important for any negotiator to be able to recognize ploys when used by a counterpart.

On the other hand, while knowing the STP is a necessary condition to be a successful negotiator, it is not sufficient in most cases. Admittedly, you can sometimes use them yourself against some "street dumb" counterpart, but there seems to be a scarcity of this type of negotiator, and in most cases your counterpart will belong to the streetwise species.

Also, in complicated, long term and repetitive negotiations the use of ploys and counter-ploys is useless and tends to create hard feelings between the negotiators.

STUDENT: Which is the best approach, then?

TEACHER: Have a little patience, please. First let me tell you about those famous ploys you ought to know about in order to recognize them and defend yourself.

Karass did not claim to invent them, but he standardized and popularized three basic ploys: The Bogey, the Krunch and the Nibble.

The Bogey

According to Karass, this ploy is simple, effective and ethical. We can also call it "the poor boy approach", because it consists in claiming you as prospective buyer love your counterpart’s product or service (be it a piece of candy or a tractor) but that you can’t afford it (because your parents cut your allowance or because the giant corporation you represent is stingy and you have a very restricted budget).

The meaning of these statements is that the seller will make a sale if he comes down in price to the buyer’s price range. The promoters of the Bogey claim that it tests the seller’s asking price credibility. They also claim that the seller may be inclined to review his or her estimate of the buyer’s economic possibilities. And eventually, in trying to justify the asking price, the seller may come forward with information which can be useful to the buyer. To quote Karass, "before long it is discovered that some things in the original price can be trimmed away, others can be changed and still others can be adjusted by the buyer himself to meet the budget. Each party has helped the other reach its overall goals".

Actually most of the times the Bogey works it will mean a confirmation of the fact that all prices are padded in advance in order to be protected from the buyer’s possible use of the Bogey.

This writer has perceived a seller’s trick Karass did not describe. We may call it "the seller’s voluntary Bogey". This trick usually disarms the Bogey before the buyer uses it, or at least makes it more difficult to propose.

STUDENT: Give me an example, please.

TEACHER: Sure. Let’s assume I am trying to sell you a car. I would tell you: "Dear Student, the regular price of this car is $10,000. I already sold three today at this price. But I know you are a student, and I am sure you are on a tight budget. I will give you my best possible price at once; for you, only $ 9,500. And I hope my boss will not fire me for this. And of course, you have to close the deal today".

The Krunch

At this point in our negotiations you (the buyer) might resort to the Krunch, the second of the most popular proposals of Karass.

The buyer tells the seller: "You have to do better than that to close a deal with me".

In our example, the car salesperson, after a lot of protestations, will come down say to $ 9,000 for the car. You may be happy to see that the Krunch worked and accept the lowered price. But most probably the car seller has anticipated your possible use of the Krunch and has padded his price. It is very likely that he could give you a better deal.

STUDENT: You mean the Krunch never works?

TEACHER: Most of the times it is self-defeating, because the sellers anticipate it and the buyers may be tricked into believing their use of the Krunch got them the best deal when it actually did not.

STUDENT: Let me draw attention to a weak point in your reasoning. If sellers have already padded their prices in preparation for these ploys, it becomes necessary to use them in order to get a better price. It would be silly to accept the first, padded price of the seller. Even (and especially) if we think the seller has padded the price in preparation for them, we MUST use the ploys.

TEACHER: Certainly, in the type of negotiations illustrated, such as purchasing a car (especially an used car!). Not necessarily in serious, repetitive business negotiations.

The Nibble

The third ploy Karass mentions as useful is the Nibble. I assume you already know what it is.

STUDENT: Oh, come on, writer, you have to do better than that to teach me!

TEACHER: Fine, I see you just applied a variant of the Krunch to me! I will give you a good explanation, but please be aware that I had anticipated your ploy and was ready to give you a good explanation anyway!

Nibbling means "to take tiny bites at something", as in "fish nibbling at the bait".

According to Karass, the philosophy of the "nibbler" is "if I can’t get a dinner, I'll be happy with a sandwich". Karass argues that the Nibble pays; while it may not do much for the nibblers ego, it helps their pocketbooks.

Karass says "buyers nibble on sellers and sellers nibble on buyers. Sellers nibble by making over shipments, by supplying slightly inferior merchandise, by not performing promised services, by delivering late, by adding special charges".

"Buyers nibble by paying bills late, by taking discounts not earned, by requesting special delivery or warehousing services, by asking for slightly better quality than contracted for, by demanding extra reports, certifications or invoices, by getting free engineering charges and by requesting extra consulting and training help for nothing".

The Nibble may work in some special instances, but it is the source of a lot of conflict. A nibbler is soon recognized as such and this will surely damage the business relationship. As Kennedy says, "ultimately this kind of behavior is self-destructive". This is true, because the use of these type of tricks creates hard feelings and participants tend to get angry with each other. This may be acceptable in a disarmament treaty between potential enemies who already hate and are angry at each other anyway; but it is deadly in business relationships. Most business people will accept and even admire a tough negotiator, but once an agreement is reached, they will expect the other party to respect the terms of the deal.

STUDENT: I have prepared myself a little for these classes, and I browsed through a book by Kennedy. He asks the following question, which I will put forward to you: "How do we stop the cycle of ploy-counter ploy by those who are trying to do business together".

TEACHER: I can’t tell you how to stop it, but I can tell you why it should be stopped or not started at all. Because most of the time people who use these ploys and simultaneously keep on the defensive can not advance in complex negotiations. Ploys and counter ploys mean constant confrontation between negotiators and a total lack of confidence in their counterpart’s good faith and fairness. To quote Kennedy again, "Only by addressing each party’s interests, through debate and proposals on issues and positions, is it possible to secure a lasting and implementable deal". And we want to stress "implementable". Many times negotiators finish a negotiation with a deal they are very happy about because they are sure they got the upper hand, only to discover later that it can not be implemented. Many times this is only discovered after both parties have wasted a lot of time, money and energy.
STUDENT: I’ll buy this, especially because I was involved in such a deal. A well known hardware supplier I used to work for sold a powerful computer to a large wholesaler. Both parties tricked each other in some ways. Basically the buyer exaggerated his capability and commitment to adapt his manual procedures to a computer, and the seller started to nibble at the support he was willing to give to the conversion effort. Soon a period of continued confrontation began, resulting in delays. As may happen with computer hardware, this specific model became obsolete before installation and the contract had to be re-negotiated. This was used by the buyer as a pretext to cancel the contract without penalty; in the process both parties lost a lot of time, money and effort.
TEACHER: Good real-life example. In this case, obviously the parties did not address each one’s interests.
Aim High ("shock them with your opening offer")

This is Karass’ advice: aim high, do not be modest with your opening offer. This is valid for buyers and for sellers. The reasoning behind this streetwise injunction is that the party using it will make the other believe he or she has a lot of bargaining power, this not being actually true.

In other words, the maxim means "go ahead and bluff". Because if you actually had a lot of bargaining power, as, for example, being a monopoly supplier of a scarce good, you wouldn’t need Karass’ advice. You would just use your power and force your counterpart to deal with your terms.

Followers of this method are convinced that, as Karass claims his research proved, behaving as if you had power and "aiming high" will increase your chances of getting a good deal. The experiments conducted by Karass are supposed to show that negotiators aiming low are frequently "losers", making large concessions and settling for a mediocre deal; while negotiators aiming high are frequently "winners", making smaller concessions and getting better deals.

The idea is that "a high unexpected demand or offer can succeed rather than lead to a deadlock because the initial high demand is likely to structure the other negotiator’s expectations" (Kennedy, "Pocket Negotiator").

STUDENT: Let me tell you something that happened to me when I was in my early teens, and we may try to see how it relates with the subject of this Module.

Once I saw a nice stereo in the window of a store selling used goods (I now suspect some were stolen). I didn’t have any money, but I wanted to have a look at the equipment. So, I walked into the store and said I was interested in the merchandise. The owner let me listen to it and told me the price was $300. I wasn’t going to purchase it at any price, simply because I had just enough money for the fare back home. But being reluctant to confess it, I decided to make a ridiculous offer assuming that the seller would reject it and then I would walk out with my ego intact. I decided that $30, compared with the asking price of $300, was low enough. Showing regret, I told the owner that I loved the stereo, but that I had only $30 and that I would be ashamed to make such a low offer. The owner looked at me in surprise and told me: "Why, is $30 not money". There I was: the guy was ready to give me for $30 a good he had previously told me was worth $300, and I did not have the $30. I don’t remember the excuse I used to get away, but I always remember the incident as an interesting practical learning experience.

TEACHER: Interesting story. Let’s try to see what happened. To begin with, the owner seems to have used the "aim high" approach, thinking he could convey that he had power over you, a young inexperienced person fascinated by a shining stereo device. He certainly had padded his price a lot, just in case you were not as stupid as you looked (sorry!) and came out with the Bogey.

STUDENT: Yes, and then I responded with a "fake Bogey" telling him I had only the imaginary $30.

TEACHER: Sure, and we can also say your false counteroffer was also a "aim high" (in this case you being the buyer an "aim low") countermove, and an unintentional bluff. The owner may have felt that you had "power" because he actually believed your statement that you had only $30, because of you being so young. In his mind this gave you the power of refusing any higher price, even if you thought the price was fair.

But I feel that the best part of this anecdote is the conclusion we may draw that many times the limits of a negotiation are wider that the participants think at the entry point. And that even an experienced negotiator as the owner of the store surely was, after using a "aim high" ploy, may be persuaded to reduce his price considerably when confronted with a believable Bogey and/or a "aim low" countermove by the other negotiator.

STUDENT: Also, I think this episode shows how some of the "streetwise" ploys can be self-defeating. After this experience I never returned to that particular store even when I actually had money, because I concluded that a seller asking for $300 for a good he was prepared to sell for $30, was the type of person I would not want to deal with.

TEACHER: OK, now we may hold our customary session of questions and answers. But you may want to review this Module before we start with it.

Question 1
What is the name of the negotiation approach based on the theory that "negotiations are like duels where the strong will always defeat the weak"?

Streetwise Tactical Ploys (STP)

Question 2
If the opinion of experienced negotiators is that streetwise ploys are not effective in serious business negotiations... what is the use of learning them?

The value of knowing the STP ploys lays more in the fact that you will be able to recognize them and defend yourself against them.

Question 3
Define The Bogey in your own words.

Basically, claiming that the prospective buyer loves the seller’s product or service but that he or she can’t afford it. This is supposed to induce the seller to lower his or her price.

Question 4
You quote the price of a product to a prospective customer and he or she tells you: "You can’t be serious. You certainly have to lower this price a lot if you expect me to even consider buying from you". What type of streetwise ploy is the buyer using on you?

The Krunch

Question 5
How would you call a negotiator who thinks "if I can’t get a dinner, I’ll be happy with a sandwich"?

A "nibbler".

Question 6
What does it mean that a deal must be "implementable"?

That it should be capable of being successfully completed

Question 7
"Shock them with your opening offer". What is the name of the maxim recommending this behavior?

Aim High

Negotiation Practice: Principled Negotiation

2009-03-04T23:20:00.000-08:00

In Module II of this course we mentioned that the three basic competing approaches to good negotiation practice are

* Streetwise Tactical Ploys (STP)
* Principled Negotiation
* Negotiation as a phased process

In Module II we described the Streetwise Tactical Ploys (STP). We will now continue with the next approach.

Principled Negotiation

In 1982 Roger Fisher and Bill Ury of Harvard University published "Getting to Yes without Giving in", a bestseller about negotiation. The proposals made in this book can be called "Principled Negotiations". The view on negotiations proposed in the book is almost the opposite of the Streetwise Tactical Ploys method. At least it is radically different, from its basic assumptions to the practical tactics it suggests.

The theoretical basis of Principled Negotiations is that "issues and controversies are decided on their merits rather than through a haggling (dickering) process. Under Principled Negotiations you are supposed to look for mutual gains wherever possible, and where your interests conflict, you should insist that the result be based on some fair standards independently of the will of either side. The method of principled negotiation is hard on the merits and soft on the people. It employs no tricks and no posturing. Principled negotiation shows you how to obtain what you are entitled to and still be decent. It enables you to be fair while protecting you against those who would take advantage of your fairness".

STUDENT: Very nice and clean sounding. It suggests that in negotiations you can get what you deserve. While the motto of most the Streetwise Tactical Ploys Seminars is "get what you negotiate, not what you deserve". I guess they actually mean that by negotiating effectively you can get more and not less of what you deserve!

But I see a couple of problems here. How is it possible to define what each party "deserves"? And how does this approach deal with real life realities like the relative power of the parties?

TEACHER: Your points are very valid and we will discuss them later on. But to confirm your reservations, at least in relation to political negotiations, let me tell you a real story. When Mexico, after 70 years of a One Party government system evolved towards a multi-party political environment, the newly democratically elected President appointed a famous writer as Foreign Minister, obviously as a gesture to the country’s cultural world. A reporter interviewed the writer and asked him what was the basic difference between the academic world and the world of politics. The writer answered: "I was used to an environment where issues are debated and decided on the basis of who is right. In politics issues are decided according to power, alliances and pacts, not on who is right."

But we shall go on describing the Principled Negotiations approach and then discuss its merits with you. It may not be perfect, but it certainly has its merits.

Haggling has no basis in principled negotiations. They should be avoided because they tend to create antagonism between the parties.

STUDENT: I notice a strong cultural bias here. This may be true in a certain business environment or for specific people. But remember my experience (Module II) when the seller of the stereo set asked for $300 and I counter-offered $30. He could not understand why I said I was ashamed of making such a low offer. He said "Why, is $30 not money". He was not offended nor antagonized.

TEACHER: Yes, but you decided not to visit that store again; you actually made a judgment and defined the other party as disreputable. And this is another of the reasons why the proponents of principled negotiations do not like haggling: because it is disreputable. Anyway, I concede your point. Haggling, in certain circles, is the normal way to negotiate. It is not only accepted but expected. Let’s go on.
The four components of Principled negotiations are:

* People: separate the people from the problem
* Interests: focus on interests, not positions
* Options: generate a variety of possibilities before deciding what to do
* Criteria: insist that the result be based on some objective standard.

As you can see, in many aspects the contrary of the streetwise method.

People: separate the people from the problem

It is important to separate the issues themselves from the people who hold opinions on those issues. Obviously people are an important part of a negotiation. They can be a part of a negotiation problem. Or they can be the single problem.

STUDENT: Easier said than done. How do you go about this "separation"? Does it mean you accept the issues and opinions of the other person but not the person itself? And is it implied that the solution is to get that person replaced by some other more acceptable individual?

TEACHER: Obviously you rarely have the power to do the latter. What the principle of "separating the people from the problem" means is that you should separate them in you own mind.

Your counterpart in the negotiation may hold a view you disagree with.

He or she may insist that your company must deliver separately to 20 of his company’s points of sale. You are prepared to deliver to a single distribution center. This is a problem.

Now let’s assume the other person is a bigot, supports a political party you despise, and in general expresses opinions which you consider biased and wrong. But this fact is not part of the negotiation nor of the specific problem of the delivery process you and your counterpart disagree on.

You have to separate the person from the problem in your mind. The (in your personal opinion!) negative qualities of the other person should not be part of the problem. You should not let your dislike of your counterpart and of his or her views be reflected in your movements in the negotiation. Quietly but firmly you should insist on your reasons for wanting to deliver to a single central warehouse. Do not show your irritation at the other person’s views on politics, economics or any other subject. This also applies to any other characteristic of the other person, no matter how irritating they can be to you. Concentrate on the problem, not the person.

STUDENT: I do not disagree with the advice. But sometimes it is hard to apply. Once I was negotiating an important sale with a man I really did not like for several reasons, but I kept trying to separate him from the problem which was the delivery schedule. At the time there was one of those little wars somewhere, and this person said the war was good and would bring great benefits. I asked him what he thought about the victims of the conflict. And he answered: "Come on, we are talking about only two to three thousand dead, about the same number of people a large theater can contain". At this point I could not stop myself from saying; "Would you feel the same way if it was your own son or daughter instead of other people’s sons and daughters that were among those ‘few’ dead?" He took offense and quickly found an excuse to reject my whole proposal, in spite of having agreed to it previously.

TEACHER: As much as I can understand how you felt, and while I agree with your opinion, I must tell you that you did not act as a good negotiator should. You did not separate the views of your counterpart on matters not related with the problem, from the problem itself. You could have worked out your disagreement on the delivery schedule if you had separated it from the other person’s valuation of human life versus economic advantage, an issue not related to the problem under discussion.

But let’s advance to the following principle.

Focus on interests, not positions

The most effective way of solving a problem in negotiation is to avoid putting too much stress on positions as compared with interests. Fisher and Ury call people who do that "positional bargainers"; these people attach great importance to their positions in a negotiation. For them positions are all-important and they defend them vigorously. This is usually done by attacking the other party’s positions. The result is usually a stand-off. Neither side will move and both expect the other to yield.

STUDENT: Reminds me of two car drivers meeting on a very narrow road. Unless one moves to the shoulder of the road and lets the other pass, they will be locked in place, each one expecting the other to yield.

TEACHER: Exactly. In fact one assumes that the interest of both drivers is to proceed to their respective destinations. But if their position is "I won’t move, you have to let me pass", then both are "positional bargainers". They give their position so much importance that they will act against their own interests. Kennedy says that "neither side will move but both sides expect the other to move first. Not moving at all is a strange form of bargaining, so it is more correct to describe this as positional posturing rather than bargaining".

STUDENT: Let me see if I grasped the differences between interest, position and issues. My interest in my negotiations with a customer is to close one or more profitable deals. An issue under discussion might be payment terms. And positions would be if I insisted on payment within 7 days, and/or my counterpart demanded 60 days.

TEACHER: Good example. According to Fisher and Ury, interests and not positions should become the focus of negotiation. This is good advice because as in your example of the two drivers, negotiators often neglect interests and come to a stand-off because they maintain their positions with total inflexibility.

But eventually issues and positions must be negotiated; the idea is that they should be considered without forgetting the all-important interests. This will allow actual bargaining to take place; movement and flexibility on issues and positions while focusing on interests. In your example your basic interest is to close a profitable deal, and we assume that your counterpart’s interest is also to close a deal advantageous for him or her. If both parties focus on their interest, the issue of payment terms and the positions on the credit terms would be solved. At least movement and bargaining would be possible.

Options: generate a variety of possibilities before deciding what to do

The third component suggests that the negotiator should encourage his or her counterpart to work together to invent or discover options and possibilities for mutual gain.

To be able to do this it is necessary that both parties recognize that in most negotiations there is not a "zero sum" situation in every issue. "Zero sum" means that whatever one party gains the other party loses. In other words, the pie has a fixed size, and if one party takes a larger piece, the other party gets a smaller piece.

If both parties recognize that "the pie can be made larger" by inventing options for mutual gain, there is a good chance that these options can be found.

One technique often used is "brainstorming". We can describe this method in a few words: "Everyone offers ideas while everyone postpones criticism and judgment".

Basically the brainstorming procedure is based on the following sequence:

* Participants express their thoughts trying not to suppress any idea that comes into their minds.
* All ideas are written down without anyone commenting on them.
* Only when the brainstorming session is completed (usually a time limit is fixed at the start) are the options reviewed, discussed and judged.

Normally most of the ideas are rejected but many times interesting options for mutual gain can be discovered. Naturally the brainstorming process can also be performed separately by the parties within their own organizations and promising options can be later brought to the negotiating table.

Within the framework of the third component of Principled Negotiations we should also mention the good practice of helping your counterpart to find solutions to his or her problems. A creative negotiator can imagine being in the position of the other person and cooperate in finding solutions to the other person’s difficulties.

STUDENT: You are so good at telling real life stories; can you mention a case where a brainstorming session was successful?

TEACHER: No problem. Some time ago I was negotiating with a customer and we could not agree on the price. He was very firm on it; he behaved as a "positional bargainer" on this. I went back to my office and called a meeting of medium-level managers from all departments. We did a brainstorming session. Among the many suggestions a good one appeared. The option was: "Offer them to share logistics". The suggestion made sense because both firms produced goods of the same kind but not competitive, and their factories and distribution centers were not far from each other. We knew that the trucks we rented many times were not loaded to capacity when moving goods from factory to distribution center. Possibly our customer had the same problem. It was worthwhile to explore this option.
I met with my customer again and suggested that if they accepted our price, we would be ready to share transportation facilities. A quick study showed that by doing this both companies could save a lot of money in transportation costs. The customer realized that my proposal would make him more money than reducing my price. The deal was completed and led to a long term relationship of mutual benefit.

STUDENT: Was it really that easy?

TEACHER: Well, not exactly. Of course our proposal was the subject of a "sub-negotiation" on how the savings in transportation would be shared. But this is another story! Let’s move to the next component.

Insist that the results be based on objective standards

The key here is: what is actually a really objective standard? Of course, the idea is wonderful. But its practical application is very difficult. Parties have very different views on how to define "objective".

STUDENT: Well, laws and regulations are objective standards. They do not depend on the wish of the parties.

TEACHER: Sure, but there is a lot of room for disagreement on many matters not subject to laws or regulations. And in these cases the parties will have to agree first on what are the objective criteria. And even after they agree on the criteria, they must agree on a way to settle disputes on facts.

Kennedy says that the "universal application (of this component) is doubtful". But still the advice is very useful in assuring that an agreement is implementable. The fact that an agreement contains specific objective criteria and a specific arbitration system is very important. This is especially true in respect of the technical or chemical specifications of products.

STUDENT: I see a story coming!

TEACHER: If you insist. One large multinational food company I worked for made a deal with the former Soviet Union to export a large quantity of dehydrated chicken broth manufactured in South America. The agreement did not contain specific objective data like maximum acceptable bacteria count. The agreement referred to samples which would be used as basis of comparison for the inspection of shipments. Apparently this was an objective criteria. But dehydrated chicken broth contains a lot of salt. And bacteria do not like a salty environment, and so the bacteria count on the samples diminished substantially as time passed. When the bacteria content of the samples was compared with recently produced dehydrated chicken broth, the soviet inspector argued –rightly- that the bacteria content was much higher than the sample, and did not allow the product to be shipped. There was a long delay in implementing the agreement and the matter was only resolved after a lot of haggling and confrontation.

Best Alternative to a Negotiated Agreement: BATNA

According to Kennedy, " besides the four components, principled negotiation’s main contribution to negotiating practice has been that of a negotiator’s BATNA".

BATNA means that a negotiator must have a clear idea of the best that could happen if he fails to reach a deal. The best, not the worst.

Let’s go back to the dehydrated chicken broth case. After the soviets rejected the product before shipment, the producers came up with their BATNA, which was to sell the product in their home market. Since they would have to repack the cubes (in general South Americans can not read food labels written in Russian), this had a certain cost. They compared this cost with the penalty the soviets demanded for accepting the "below standard" produce. As long as their BATNA was better than the deal offered by the Soviets, they continued the negotiations, insisting that the penalty was excessive. Finally the Soviets made an offer topping the seller’s BATNA.

STUDENT: And the sellers quickly agreed, of course. Right?

TEACHER: Wrong. When you have an offer on the table better than your BATNA, this is not the end of the negotiations. To the contrary, it signals that from that point on you can keep negotiating for a better deal. As long as your counterparts' offers are below your BATNA, you do not actually "negotiate" because you can not "move"; all you can do is insisting that the position of your counterpart is unacceptable. And if eventually you do not get a better offer you will have to abandon negotiations, because your BATNA is better than the best you can get from a deal at this moment.

Take the Questions and Answers Session whenever you are ready

Question 1
Which is the missing word in this statement: "the theoretical basis of Principled Negotiations is that "issues and controversies as decided on their .......... rather than through a haggling process".

Merits

Question 2
Consider the statement that you should "get what you negotiate, not what you deserve". Does it reflect the Streetwise Tactical Ploys or the Principled Negotiations approach?

The Streetwise Tactical Ploys

Question 3
You are in the middle of an important negotiation. You and your counterpart disagree on the way your product should be packaged. And your counterpart also keeps annoying you by making negative comments on the racial group or faith you belong to. Which of the components of the principled negotiations approach should you apply in this case?

Separate the People from the Problem

Question 4
You are dealing with a prospective customer and you have already agreed on price and delivery schedule. But your counterpart is demanding a 5% discount on cash payment and tells you that unless you accept this demand, there is no deal. You know that the deal would be advantageous to your counterpart even if you did not grant the 5% discount. What is the other party doing wrong according to the Principle Negotiations approach?

The other party is focusing on a position (the "non-negotiable" 5% discount) instead of focusing on interests (your mutual interest in closing the deal). Your counterpart is acting as a "positional bargainer".

Question 5
We said that "in most negotiations there is not a ‘zero sum’ situation in every issue". What does ‘zero sum’ mean?

"Zero sum" means that whatever one party gains the other party loses.

Question 6
The writer tells us a story of a negotiator who offered his counterpart the sharing of transportation facilities.

1. Which of the components of the Principled Negotiation approach was applied in this case?
2. And which method was used to discover this proposal?

1. The generation of options and possibilities of mutual benefit.
2. Brainstorming

Question 7
You are about to enter into a negotiation. You have decided the best thing you could do if you can’t reach an agreement. What do we call this "best thing you could do" if your negotiation fails?

Best Alternative to a Negotiated Agreement: BATNA

Negotiation as a phased process

2009-03-04T23:16:00.000-08:00

In Module III of this course we mentioned that the three basic competing approaches to good negotiation practice are

* Streetwise Tactical Ploys (STP)
* Principled Negotiation
* Negotiation as a phased process

In Modules II and III we described the Streetwise Tactical Ploys (STP) and Principled Negotiation. We will now continue with the next approach.

Negotiation as a phased process

This third approach can actually be applied to the other two.

The first published work on a phased approach was Anne Douglas’ book "Industrial Peacemaking". As the title indicates, the book concentrated on labor negotiations.

Ms. Douglas proposed a three-phased approach:

1. Establishing the negotiation range
2. Getting intelligence (knowledge) about the range
3. Precipitating the decision-reaching crisis

STUDENT: Phase 1 is not too difficult to understand. If I intend to negotiate with my employer, I must decide if I am going to negotiate one or more of the following items: salary and or wages, health insurance, vacations, overtime, etc. What about phase 2?

TEACHER: It means you should find out as much as possible about the range your have decided upon. For example, if you intend to negotiate on salary, you should find out about salary levels for comparable positions in your industry and within your own company.

And before you ask me about phase 3, let me emphasize that Ms. Douglas’ work was centered on labor negotiations. We may interpret the decision-reaching crisis to be a strike or the threat of a strike or a lock-out. In your hypothetical negotiation with your employer you might indicate that you have been receiving calls from headhunters lately, or something like that. Of course, this may be a risky tactic, since a strike or a lock-out may cause serious damage to both parties. And your boss may react by telling you to go ahead and quit. Your decision whether to advance to phase 3 or not must be based upon your research in phase 2. If you are a specialist in a high-demand technical area you may go ahead and try it. If you are an easily replaced clerk you should think twice.
Gavin Kennedy observed what negotiators did and concluded that they followed 8 steps. The hypothesis is that all negotiations have a common structure, independent of the subject, the environment, the culture, or any other particular characteristic (G.Kennedy, J.Benson and J.McMillan "Managing Negotiations")

The 8 steps are:

1. Prepare
2. Argue
3. Signal
4. Propose
5. Package
6. Bargain
7. Close
8. Agree

STUDENT: This is very neat as a clinical description. But what is the practical use of having discovered that these steps are followed almost universally by negotiators?

TEACHER: Good observation. The answer is that the steps or phases actually do not describe what negotiators should or should not do. But once these steps have been identified, negotiators can concentrate in improving their skills in each individual step. Naturally the better they become in their behavior in each of steps of the process, the more effective they will be as negotiators.

It is also helpful for negotiators to be aware of which of the steps they are working on. The steps must not necessarily be followed in the order given, and frequently the process may jump back and forth from one to another; say, between proposing and bargaining. But a negotiator must know at each moment what he and his counterpart are doing, without confusing one step with another.

But let me give you a short description of each of the points Kennedy defined.

1. Preparation. For any negotiation good preparation is crucial, and the more important the negotiation, the more important the preparation. Basically it is necessary to:

* Identify the negotiable issues
* Issues have different priorities and these priorities must be defined
* Define the entry point of the negotiation: how are you going to start?
* Define the exit point: the situation at which you will be prepared to abandon the negotiation

2. Arguing

This word has two meanings. One of them involves conflict and destructive behavior; in this sense it usually includes the word "with". As in "he argued with his boss". The other meaning is about constructive exchange of ideas, as "he and his boss argued about the best way to solve their problem". It is the latter meaning that is used in our list of steps. Arguing, in the former sense, is usually bad for both parties and not advisable. But in any negotiation parties "argue" in the sense of debating, explaining their reasons for certain positions, discussing issues, and exploring alternatives.

Debate is a constant in any negotiation. But sometimes participants get stuck in debate and do not progress. Trained negotiators are skilled in ways to "escape" deadlocks in debate, most based on telling the other party something like: "OK, we can’t agree on this right now, lets move on and come back to this issue later on". Many times the deadlock is not on the basic issue under debate but on an ancillary issue. In this case a skilled negotiator diplomatically suggests that the discussion return to the main point of debate.

If a debate is going to progress towards agreement, it is necessary for the parties to "move", that is to change their positions. This is natural because for every issue there are two initial solutions, since each party will have their own. So the problem you have as a negotiator is how to move without giving in. It is necessary to discover a third solution different from the initial ones.

STUDENT: Let me see. Assume I start by offering a 5% discount and the other party wants 10%. We are in a deadlock, and therefore I move and say: "OK, I’ll give you 7%". Is that a good strategy?

TEACHER: I don’t think so. If you move unilaterally in the hope that the other party will move too, you will probably be disappointed. The other negotiators will interpret that you are just delaying your final surrender, which in your example means giving them the 10% discount. So they will probably insist on their demand, and your unilateral movement will not have solved the deadlock.

STUDENT: I see, but not moving at all is no solution either. The deadlock will become more serious as time passes.

TEACHER: Yes. You should make a proposal of a certain kind. We will talk about that in a moment. But let’s move to Step 3.

3. Signaling

If you ever negotiated with an experienced professional, such as a real estate or car salesperson, maybe you were aware as how attentively this person observed you and whoever accompanied you at the moment. This is because professional negotiators are very alert to signaling. A signal can be verbal or not. If you are inspecting a house as a prospective buyer and tell your spouse: "We could use this room as a home office", say goodbye to any reduction in the asking price. You have signaled that you are accepting the realtor’s price. If you look at your spouse and get a smile and a nod as mute response, you are done too.

Verbal signals can be rather subtle.

Assume you are the realtor now and your prospective customers’ first reaction was saying: "it is impossible that we spend that much money on a house". You "debate" by stressing the value of the nice garden, the view, and the proximity of good schools. Now your prospective customer repeats: "it is difficult for us to spend that much money on a house". If you are alert for signals, you must have noticed one. Which was it?

STUDENT: The prospect changed the wording, from "impossible" to "difficult".

TEACHER: Very good. There are of course many variations. But you have grasped the concept. Negotiators who are not alert for signals should better learn this lesson or change their profession.

The next step is...

4. Proposing

The effective way to make a proposal without indicating your readiness to surrender is the "if-then" format. The best way to word the proposal is the interrogative form. Let’s return to your example of the 5% vs. 10% deadlock. Instead of moving unilaterally and saying "OK, I’ll give you 7%" you might say: "If I did something for you like giving you a 7% discount, would you then do something for me, like shortening credit terms from 30 days to 7 days? Or what else would you propose?

You can make many questions of this kind without committing yourself and as your counterparts answer the questions you will learn more about their positions and attitudes. And you could advance to the next step...

5. Packaging

You can put together a proposal which, by taking into consideration the answers given to the "if-then" questions, will have a good prospect of leading to a deal.

6. Bargaining

The sixth step consists in repeating the proposing and packaging steps until both parties can agree and advance to the last two steps,

7. Closing, and

8. Agreeing

Once bargaining has reached a point were both parties are ready to close the negotiation process by reaching a deal, a written agreement is necessary. This must not be necessarily a full contract, but at least a clear outline of the agreement must be put in black and white and signed by the negotiators. Otherwise, as it frequently happens, people may think they have an agreement only to discover later that they had none. "Misunderstandings" about the terms of an agreement must be avoided at all cost, they are much harder to surmount than an interruption of a negotiation.

Very well, let us have our Q&A session.

Question 1
"Issues have different priorities and these priorities must by defined". To which of Kennedy’s 8 steps do you think this applies?

Step 1, Preparation

Question 2
A negotiation is going on about the sale of a used sports car between the owner and a couple, the prospective buyers. One member of the couple tells the other: "This car is the exact size that fits into our small garage" .

1. To which of Kennedy’s 8 steps do you think this applies?
2. Is it a good negotiating practice for the prospective buyers?

1. Step 3, Signaling
2. No, because it signals to the seller that the buyers are ready to "surrender" and accept the seller’s terms.

Question 3
You and your counterpart are in a deadlock position in a debate. They want to inspect your processing plant twelve times a year without notice, you want 4 inspections a year with one week notice. You decide to move out of the deadlock and say "Well, I’ll settle for 6 times a year and 3 days notice".

1. Is this an effective movement for you? If not, why?
2. What would be an advisable action to break the deadlock?

1. No, because a unilateral movement of this kind tells the other party that they can get more out of you without giving anything in exchange, and they will probably press for more.
2. It is advisable to make a proposal in the "if-then" format. Like "Let’s think of something you could do for me if I accepted a few more inspections a year, which as you know have a cost".

Question 4
It is widely accepted that "arguing" is not a positive behavior. Pedro is negotiating with a US company about supplying canned beans made in his Mexican factory. He tells the American negotiators that his plant has state-of-the-art equipment and very good manufacturing practices, and they answer that they do not agree. Pedro has good reasons to support his claim, like an article published in a German trade magazine about his Mexican plant. But Pedro wants to avoid "arguing", so he refrains from debating this point. What do you, being a first class negotiator, think of Pedro’s attitude?

In the situation described , Pedro did not correctly interpret the advice "do not argue". Arguing in the sense of debating, explaining your reasons for certain positions and discussing issues is not only acceptable but recommendable. Pedro should politely mention the article on the trade magazine as support of his claim and offer to send someone for a copy immediately.

Question 5
You and your counterparts in a negotiation have reached a verbal deal. What should be done before leaving the negotiation table?

All parties should sign a written agreement, in order to avoid possible misunderstandings.

The People Factor in Negotiations

2009-03-04T23:13:00.000-08:00

The People Factor in Negotiations: Personality

TEACHER: I will start this module by making a confession to you. I get the feeling that teaching you about negotiations is very difficult. I feel a bit apprehensive about the best way to continue.

STUDENT: Well, I understand that. It is a rather elusive subject, but I will do my best to cooperate with your teaching effort.

TEACHER: Very well. The point of my statement was to get a reaction from you and establish if you are by nature (personality) a cooperator or a competitor. Your response indicates that your Motivational Orientation is one of being a cooperator. A competitor would have answered my comment with something on the line of "Well, this is your problem, not mine. I am a good student. Maybe you are not as good a teacher as I am a good student".

STUDENT: So it was a trap. OK, I get the point. You are telling me that all people have a basic motivational orientation either to be competitors or cooperators.

TEACHER: Yes, but this is a generalization defining both extremes. Real people have a mixture of both orientations, but in general each individual has a natural inclination towards one of these extremes.

And now we begin our discussion on the role of personality in negotiations. Allow me to express a truism: negotiators are people, and people have different personalities. Therefore, it is reasonable to conclude that personality influences negotiation behavior and, in consequence, the results of the negotiation process.

As proven by your reaction to my statement at the beginning of this session, your personality traits are a predisposition to react in a given form to given stimuli. You responded in a way that was natural to you. It is safe to assume that you would respond in a similar way each time you are in a similar situation.

STUDENT: You are telling me that I am very predictable. Is that good or bad in negotiations?

TEACHER: The point is not whether it is good or bad. The point is whether a negotiator can learn to "manage" his or her personality to respond in the most convenient way. Ideally negotiators should respond to situations according to a cool evaluation of what the best response is, not automatically according to what comes natural to them.

Personality can be defined as an array of traits. The most important work describing the different personality styles of negotiators is the book by Rubin and Brown "The Social Psychology of Bargaining and Negotiation".

We shall continue with the classification of personalities in connection with negotiation behavior.

As we have already seen,

In the aspect of Motivational Orientation (MO) we have two categories:

* Cooperators, or
* Competitors

Now let me add that regarding Interpersonal Orientation (IO) people can be classified according to their degree of social awareness and social ability. The higher a person’s IO is, the more this person will be responsive to his or her relationship with the other negotiators. We can define the extremes to be

* Accommodators (high IO), or
* Avoiders (low IO)

STUDENT: Which personality style is most successful in negotiations?

TEACHER: There is no single answer to this question. Anthropologists say that the key to the survival of the human species is our adaptability. This does not mean that every individual is adaptable. The species is adaptable because individuals have very different traits, and some will adapt to almost any change in the environment, thus ensuring the survival of the species.

STUDENT: Sorry, I thought this was a Negotiation class. I am not interested in anthropology. And I'm saying this to show you that I am not always a "cooperator" nor an "accommodator"!

TEACHER: Naturally. I was using an illustration. My point is that any of the four basic negotiation styles can be highly successful or fail miserably under different circumstances.

STUDENT: Now, if personalities can not be changed, what is the point of your telling me about the different styles?

TEACHER: Two reasons. One is that if you are able to recognize the style of your counterpart, you may be able to manage your relationship more effectively. The other reason is that it may be possible for you to manage a zone of your own personality. This would allow you to be more efficient as a negotiator by adapting at least part of your own unique personality to different circumstances.

Now let me challenge you a bit. A negotiation is going on between Mary and John. John mentions that his boss is a very tough person and that he expects him to return to the office with a good deal. Give me examples of how Mary, John’s counterpart, would react if she were an avoider, and how she would react if she were an accommodator.

STUDENT: Let’s see. Mary the avoider may simply ignore the remark, shrug or even say "sorry, this is not my problem". She may interpret John’s remark as a signal of weakness and press harder. Mary the accommodator instead would show some sympathy and suggest that she is ready to work with John to find a mutually advantageous solution which would help John to please his boss. Since she is an accommodator, not a fool, she may add that this will depend on reaching an agreement advantageous for both parties, not just to make John happy.

I can tell you that much. I wouldn’t know which attitude would be more advantageous for Mary to take as a negotiator.

TEACHER: Neither would I. This depends on the circumstances. If John’s remark is a trick and he is fishing for Mary’s sympathy to gain advantage, responding as an avoider would be the best. If John is sincerely indicating his willingness to reach a deal convenient for both parties, the accommodator reaction would possibly be the best for Mary to make.

Continuing with the personality factor in negotiations, let’s look at the contribution of Andrew Gottchalk, formerly from the London Business School and a person with long time associations with professional business negotiators. Gottchalk also defines four styles, emphasizing in his successful negotiation seminars his concept of the "habit zone" and the "managed zone" of people’s personality. He maintains that the habit zone changes very slowly or not at all, while the managed zone can change quickly to adapt to circumstances if we learn how to do it. Negotiators can also expand their managed zone by learning behaviors basically alien to their particular basic style.

STUDENT: You mean that, according to Gottchalk, Mary the avoider could learn to expand the managed zone of her personality and react more positively to remarks like the one John made, if she decided that this attitude was more advantageous for her in that particular circumstance? Instead of reacting automatically according to her true "natural" style, she could learn to manage her behavior.
TEACHER: Exactly; she could widen her repertoire of behaviors to rapidly adjust to different circumstances.

Negotiators behave with a mixture of their habits and learned behaviors. The more in control of themselves they are, the more easily they will be able to change according to circumstances and to the other negotiator’s behavior. When they lose control, they will tend to relapse to their basic personality traits. Which of course depend on each person’s genetic inheritance, upbringing, life and work experience, etc.

STUDENT: You said Gottchalk had defined four styles, but did not elaborate. Are you going to?

TEACHER: Of course, what do you think I am, an incompetent teacher? Don't be pushy, will you?

STUDENT: I can see what you are trying to show me by your intemperate response to my innocent question. You are illustrating a reversion to his basic personality traits (over-sensitivity, irritability) of a person who lost control after being able to "manage" his or her behavior for a time. And no, I do not think you are incompetent.

TEACHER: I know I am not. And I know you don’t think I am. As you so quickly discovered, I was trying to drive a point home. Anyway, here are Gottchalk's four styles. Please remember, these are not real people, these are stereotypes. In practice real people possess a varying mix of these personality styles.

* The tough style negotiator. Dominant, aggressive. Power oriented. Does not avoid conflict, and many times provokes it, and enjoys it. Competitive, takes risks, and hates losing. Assertive, does not care about other people’s feelings. This style can be effective under the right circumstances. There are also negative aspects: a tough style negotiator can easily be excessively aggressive if upset about not getting his or her way; makes threats, gets into arguments (the bad kind of arguments). Can be perceived as manipulative, inflexible and obstinate, thus creating strong resistance from the other party.

Gottchalk’s advise if you have to deal with this style of negotiator:

1. Give them recognition...
2. but not flattery; they will interpret it as weakness on your part
3. Do not engage in "small talk", stay on the issues and emphasize common goals
4. You can always say no; do not allow yourself to be bullied...
5. but do not play along entering into arguments. Slow down the process to allow the other negotiator to realize that you are not going to surrender.

* The warm style negotiator. People oriented, understanding, supportive and collaborative. Friendly, interested in other people. A good listener. Supports other people’s proposals. Tends to trust others. Patient and calm under pressure. Optimistic about the final results of the negotiation. Seeks and takes advise. Is ready to concede reasonable points of counterparts. The bad aspects: too concerned with relationships, can be soft on issues and submissive. May jeopardize his or her own interests. Is easily disillusioned. Trusting others too much can turn into gullibility. May panic under pressure.

Gottchalk’s advise:

1. Build trust but keep a courteous distance.
2. Get him or her to your side, and ask for more. Do not put on excessive pressure to avoid a retreat in panic.
3. Advance cautiously and slowly.
4. Make sure his concessions will be supported by his superiors.

My own advise: careful, it may all be a ploy to trick you!

* The number stylist. Rational, analytical. Good grasp of detail and facts. Well prepared and well organized. Difficult to upset emotionally, is concerned basically with the practicality of the deal. Can it be implemented? Good at using objective data to justify positions, proposals and negatives. Negative aspects: too focused on details, may miss the basic issues. Emotionally cold. Tends to be obsessive. Despises people using wrong or irrelevant numbers and information.

Gottchalk’s advise:

1. Do not allow the agenda to be delayed by too much detail. Keep it moving.
2. Show and actually take interest in the number stylist’s facts and numbers, they may contain valuable information,
3. Any set of numbers you present must be accurate, your party can not refrain from checking them.
4. Show respect for your party’s expertise.

* The dealer. Flexible, compromising. Great persuasion skills, never gives offense. Open and imaginative, sees opportunities and finds ways to make them work. Highly articulate and willing to make progress. Good to make and accept "if-then" proposals. The negative aspects: too ready to compromise; too little command of details which may lead to sacrificing his or her own interests. A fast talker and too ready to shift positions, may impress others as tricky and insincere.

Gottchalk advises to be positive with dealers. Let them talk to get information. Insist on frequent summarizing and note taking for the minutes of the meeting. Do not let yourself be side-tracked. Insist and repeat your position as needed.
STUDENT: Gottchalk’s classification of styles and his advice on how to react to them is convincing. But I know you are very inclined towards G.Kennedy’s opinions. What does he think about personality analysis in negotiations?

TEACHER: As I said before, a book I consider important if you are seriously interested in business negotiations is Kennedy’s Pocket Negotiator, which the author himself defines as "an aide-mémoire, not a treatise". In this book Kennedy says that these "insights into personality styles" are based on a shaky hypothesis. He concedes that they may be helpful in some circumstances. But relying too much on this approach to evaluate your opponent may be dangerous. Most people, as I said before, are in real life a mix of styles. And they are often able to switch from one style to another. So, if you define your opponent clearly as having one of these specific styles and predict a behavior based on this analysis, you might make a costly mistake. Not because your judgment was wrong to begin with, but because your opponent may be able to switch styles. He or she may start showing a very cooperative behavior and suddenly become highly competitive.

Kennedy’s proposition is to rely more on the actual behavior of the negotiators than on establishing their personality style. He argues that behavior is "much more clear cut, more visible and more reliable that the negotiator’s personality traits".

STUDENT: I see. So we are now moving on to study "behavioral styles" as distinct from "personality styles". Right?

TEACHER: Correct. Let’s move on.

The People Factor in Negotiations: Behavior

Negotiation is of course a decision making process. But is different from other types of decision making processes in business because it involves trading. The decision must be finally taken by an agreement made by two parties with different interests and at least a certain degree of decision power on the final outcome. If one of the parties has no decision power, then there cannot be any negotiation.

In negotiations both parties trade something they have and others want for something others have and they want.

STUDENT: You are repeating yourself. This is the same as the example of shirts and pants on Module I.

TEACHER: Yes, but we are at a more advanced stage now, and I had to re-formulate the definition of negotiations in a more refined and general way. But you are right, the essence is the same.

STUDENT: Fine. Your definition that negotiators are traders should mean that both parties must enter a negotiation willing to reach a deal involving an exchange of goods or services. Or money, of course.

TEACHER: Ideally yes, but let me tell you that negotiations do not necessarily begin with both parties acting as bona fide traders. Many times one of the parties intends to get something for nothing by exploiting the other party’s ignorance, or by making threats. The notion of fairness is frequently absent in the mind of one or both negotiators.

STUDENT: I hope you will now tell me how to proceed if my counterpart in a negotiation does not really want to trade but wants to take advantage of me.

TEACHER: Certainly, but a little later. Let me first define the behavioral styles you will encounter in your negotiations.

* Those who want something for nothing. Kennedy calls them Reds.
* Those who exchange (trade) something for something. Kennedy calls them Blues.

As in the case of personalities, real people show behavioral styles that are a continuum going from extreme Red to extreme Blue. Most of us are naturally in some intermediate zone. But let’s describe the two extreme styles.

* Reds:
* see every negotiation as a contest they have to win and you have to lose.
* try to win by exerting some form of force or domination on you.
* believe in the zero sum concept. All they win you lose and vice-versa.
* do not have a notion of fairness in negotiations. They will lie, bluff, use ploys and dirty tricks, and will not stop short of coercion.
* Blues:
* are willing to trade, to get something by giving you something
* are ready to cooperate with you to find a solution advantageous for both of you
* do not use manipulation, tricks and ploys, believing instead in considering each party’s interests as a way to reach a solution.
* think that most of the times zero sum is not a valid concept and solutions can be found that add value to both parties.

STUDENT: So, when a Red and a Blue negotiate, who wins more often?

TEACHER: Several outcomes occur. The Reds may succeed in intimidating the Blues and make them surrender and give up something for nothing. But Reds may also encounter Blues who are assertive and resist the Reds’ aggressive behavior. This may lead to the negotiation to be abandoned, or may force the Reds to change their behavior and recognize that they must trade if they want to reach a deal.

STUDENT: I met several Reds during the many years I drove in countries where corrupt policemen are the norm. I was stopped many times without good reason and Red Cop threatened to write me a ticket. This was his way to open a negotiation on the size of the "contribution" I would make if he changed his mind about the ticket. I usually behaved as an Assertive Blue. I did not argue, I told the officer to go ahead and write the ticket if he thought it was his duty. But that of course I would dispute it in court, since both he and I knew there was no ground to write it. Red Cop was not really interested in giving me a ticket but in collecting a bribe and as he realized that I was not going to pay, in almost every occasion I got away without the ticket.

TEACHER: Very clever. But maybe you did not even notice that you acted as a disguised, devious Red rather than as an Assertive Blue. You apparently recognized the policeman's authority, but then your firmness and your statement that you would dispute the ticket in court contained a hidden threat for Red Cop. Because you did not propose a trade. You came across as maybe being somebody important with power to somehow harm Red Cop, who knew that his behavior was illegal. So he turned into a Submissive Blue and capitulated by letting you go.

And your story opens the way for me to define four combinations of Red and Blue.

Reds may be:

* Aggressive: want something for nothing. Make threats. Impress you with their power over you.
* Devious: do not make open threats but use finesse. Hide their Red behavior. (Dear Student, do not get angry at me, but this was yourself dealing with Red Cop!)

Blues may be:

* Submissive: ready to capitulate and give something for nothing.
* Assertive: firmly insist that no deal is possible without a trade of something for something.

STUDENT: And according to your interpretation of my dealings with Aggressive Red Cops, I am a Devious Red!

TEACHER: I don’t think so. What I said was that on these particular occasions, when confronted with an aggressive Red Cop, you behaved as a Devious Red. I did not mean that you are always a Devious Red.
The idea of observing behaviors rather than personalities is based on the belief that all of us may behave in different occasions as any of the described types. Sure, people may have an inclination towards one or the other types of behavior. But most of us are capable of all attitudes.

To illustrate this, we will use today’s Q&A session. The questions will define behaviors and you will answer to which of the described styles each behavior belongs.

Questions and Answers Session

Question 1
You make an unconditional offer. To which of the described styles does this behavior belong?

Submissive Blue

Question 2
You make an unilateral demand without offering anything in return. To which of the described styles does this behavior belong?

Aggressive Red

Question 3
You take advantage of somebody’s fear or ignorance hiding your real intention. To which of the described styles does this behavior belong?

Devious Red

Question 4
You keep making offers in the "if-then" format, offering something on condition that the other party gives you something in return. And you reject outright all unilateral demands from your counterpart. To which of the described styles does this behavior belong?

Assertive Blue

Handling Difficult Negotiations... and Difficult Negotiators!

2009-03-04T23:09:00.000-08:00

TEACHER: Hello! In this Module we will witness a very difficult negotiation process. We will comment on the ploys being used, and the behavioral styles of the negotiators.

STUDENT: Did you say a difficult negotiation? Why, are they any easy ones? My counterparts have always been difficult. They rejected my most reasonable requests and did not agree with me. Any deal I have been able to close has been difficult.

TEACHER: True. Any negotiation is difficult to a certain degree. But when I say difficult, I mean a negotiation where one of the parties is what we have previously described as "Red", be it an "aggressive" or a "devious" red or both.

My purpose is to discuss with you how to handle this type of person in the best possible way.

We will observe the negotiation between Mr. Red A. Sell and Dr. Blue A. Driver. Mr. Red is a salesman for an importer of a brand of very expensive, prestigious European sports cars. Dr. Blue is a wealthy physician and an experienced driver, and he often participates in sports car rallies.

OK, let's listen to the imaginary tape of the negotiation process. And please let me tell you in advance that the statements the participants make are exaggerated on purpose, to emphasize the concepts.

Tape play

Dr. B: Nice to meet, you Mr. R. I am interested in one of the cars from the line you sell. Your model FF211 would suit me well.

Mr. R: Yeah. Top of the line. Limited production. OK, maybe I will sell one to you. You must pay the full price in advance; that will be 1 million. Cash.

Dr. B: When can you deliver?

Mr. R: Don’t know. We’ll let you know. Got a lot of orders booked. You know that the FF211 is a limited production car. Let me bring a standard contract for you to sign.

Dr. B: I wish we could discuss the matter somewhat more. Price, delivery date, warranty.

Mr. R: Price is fixed. Payment is in advance. We deliver whenever we get delivery. And as for a warranty, our policy is "no warranty". Make up your mind, mister, I haven’t got all day to spend with you. And I may decide not to sell an FF211 to you anyway if you do not sign the order within the next 5 minutes. I am a busy person.

Tape pause

TEACHER: Let’s pause the tape for a moment. Do you care to comment?

STUDENT: Well, looks like Dr. Blue is prepared to negotiate, and Mr. Red is not. He seems to be extremely difficult and has no manners. He expects Dr. Blue to pay the full asking price in advance, go home to his patients and patiently wait for the car (no pun intended!). He is not even offering a decent warranty on his product. And he is threatening the good doctor with not selling him that lovely sport car.

TEACHER: Very good analysis. The A in the seller’s name Red A. Sell stands for Aggressive. He is a typical aggressive Red.

STUDENT: But there is something I don’t understand. He is not selling bananas, he is selling automobiles. I do not think buyers come in droves to buy them. Why does he behave in such a way? It looks that most buyers would simply walk out and go to some other seller.

TEACHER: You are right; some buyers certainly would leave when treated so badly. But the point we are illustrating here is that Mr. R. confuses aggression with toughness because this behavior worked for him more than once. He has experienced that many prospective customers have submitted to him and accepted his conditions. So he convinced himself that being "tough" is effective for quickly closing a sale on his own terms, and he continues displaying this aggressive behavior.

What he does not know is that the A in Blue A. Driver stands for "Assertive". Let’s push Play and continue listening to the tape.

Tape play

Dr. B: My dear Mr. R, allow me to respectfully tell you a few things: I am not buying any car on these terms; I came to negotiate, not to be bullied into purchasing a high price item on the seller’s unilateral conditions.

I am ready to consider the merits of your propositions, and I expect to trade. You have cars, I have money. I want a car, you want money. That’s a good beginning, but we must agree on how much of a car for how much money, timing of payments and delivery, and the degree of support you give to your product. That is what I mean by trading. No trading, no purchase. There are several good sports cars comparable to the FF211 available for sale. And no hard feelings, this is not personal, it is just business.

Tape pause

TEACHER: We have just seen how Dr. Blue, being an assertive Blue as his name indicates, has reacted to Mr. Red’s aggressive tactics. He has made it clear that he will not submit to intimidation, that bullying does not impress him, and that he is not scared by empty threats. And he has done this in a firm but reasonably polite format. He was firm, not rude. Let’ see if Mr. R has got the message.
Tape play

Mr. R: You are talking bull, Driver. You probably can’t distinguish a good sports car from a jalopy. And you know what, I think you don’t have the money to purchase a FF211, you are just fooling around with me. For the last time, do you want to buy the car or not? (He looks at his watch and then looks at Dr. B). And by the way, are you a real doctor? Or are you trying to impress me with a fancy title you don’t have?

Dr. B: I can’t understand how this company allows an incompetent character like you to represent them. I bet you did not sell a single expensive car like the FF211 in your life. What are you, the dumb son of the owner? Come on, don’t be stupid and you may still make the first sale of your life. Now, let’s talk business, will you?

Tape pause

TEACHER: What Dr. B has done now is match Red’s style. He is responding by switching from an assertive blue to an aggressive red. The tactic may work, but is very dangerous. The two parties may start trading insults instead of trading in the real sense of a negotiation’s give and take. Matching styles must be carefully controlled and the party initiating it must have a clear idea of how to return to civilized negotiation. Usually offering the other party a chance to change behavior without "losing face" is an effective tactic.

Dr. B may add to his last remark something like: "I do not intend to offend you. I am a bit tense after the long trip here, and I understand your being anxious to make a sale on your terms. But a negotiation involves two parties with different interests; so, may we give it another chance and start again?". If Red is not completely bull-headed, he may take up Dr. B’s offer which allows him to abandon his aggressive conduct without losing face and without giving the impression of surrendering. But again, matching styles is dangerous. Mr. R may continue with his aggressive and insulting behavior and Dr. B may respond the same way. An escalation of aggression and insult may start and may lead to results unwanted by both parties. In our example the worst that can happen is that Dr. B walks away without purchasing a car. But in other types of negotiations, like in labor relations, the results may be very damaging, leading to a bitter strike, a lock-out or even sabotage. And more than a few bloody wars started this way.

STUDENT: So, when is resorting to matching the red style justified?

TEACHER: A controlled match of style may be useful to avoid giving the Red the impression of what is called constructive submission. This is the name given to a situation where the submissive Blue is only saving face with his responses to Red, in fact surrendering in all but name.

Let’s rewind the tape and go back to the aggressive opening remarks of Mr. R, and then illustrate a hypothetical response by Dr. B which possibly Mr. R would interpreted as constructive submission, a surrender disguised to save face.

Tape play

Mr. R: Price is fixed. Payment is in advance. We deliver whenever we are ready. And as for a warranty, you won’t need one. Anyway, our policy is "no warranty". Make up your mind, mister, I haven’t got all day to spend with you. And I may decide not to sell an FF211 to you anyway if you do not sign the order within the next 5 minutes. I am a busy person.

Dr. B: Mr. R, I like your car, but I certainly would like a better price, a fixed date of delivery, and some kind of warranty on the car. I guess you will be able to satisfy these requests.

Tape pause

STUDENT: I see. The doctor may not be willing to surrender, but his rather bland response may be interpreted by Red as a surrender all but in name. Now tell me, which is the best attitude to negotiate with the likes of Mr. Red A. Sell?

TEACHER: I will quote G.Kennedy again. His advice is:

* Speak more quietly than they do
* Speak more slowly than they do
* Give way to their interruptions, but pause for a few seconds each time they finish
* Not respond in kind if they swear
* Not argue with their attacks on you and their apportioning of blame
* Not defend yourself against ascribed motives
* Ignore all threats
* Respond positively but specifically and without rancor to any Blue moves they make even in the midst of their Red-dominated activities
* Not respond at all to their Red moves, other than to say "no"
* Affirm whenever appropriate the two principles on which you will agree to a solution (merits of the case and trading)

STUDENT: Good advice. I am sure I will be able to handle aggressive reds. Assertive blues are no problem, I intend to behave like one and negotiating with a counterpart with the same style should not be too difficult. But what other kind of dangerous wild animal can I encounter in the jungle of business negotiations?

TEACHER: A very dangerous one. A wolf covered with a lamb’s hide: a "devious Red". The name tells it all. The problem is how to recognize them, because in general they act as assertive Blues until they gain your confidence and then they strike showing their true style.

STUDENT: Scary. I have met them. And the worst part is that sometimes I created the monster myself.

TEACHER: Exactly. Because there is a "Red side" in all of us (even inside yourself, although you claim to be mostly an assertive Blue). It is human nature to grab an opportunity of getting something for nothing. This is why you "created the monster yourself" on occasions when you offered your assertive Blue counterpart a chance to turn into a Red and get something out of you for nothing. Tell me, what types of mistakes did you make to tempt the Blue to become a Red for a moment at least?

STUDENT: Well, once I confided to the other party after they quoted a price I assumed to be final and was ready to accept, that I needed their services very urgently and did not have another supplier. Blue instantly turned Red and said: "Oh, I forgot to mention that the price I quoted did not include my provision for income tax. I was talking of my net pocket income. I am in the 40% marginal tax bracket, so it’s the quoted price plus 67%."

And I was trapped, because I really needed the services urgently. And his arithmetic was correct! Say he quoted $1000 at opening. He then asked for $1670, a net income of ca. $1000 after a 40% income tax. Due to my mistake I had to pay 67% more than the opening offer from my counterpart!

TEACHER: Well, you mentioned that you knew that the other party was normally an assertive Blue. You "created the monster" yourself. But the same may happen if the other party is not a Blue tempted by a chance to gain something for nothing, but a devious Red. The results would have been the same. And the problem is that one can never be sure of what the other party’s true style is, or when an authentic Blue will act as a Red if we tempt him by showing a weakness, as you did.

STUDENT: What you are saying is that a clever negotiator should never not even when dealing with known Blue counterparts, expose himself to exploitation by revealing expectations or true interests.

TEACHER: Right. Also, our clever negotiator will never make an unconditional offer in the expectation that the other part, being also a Blue, will reciprocate automatically. You must never allow yourself to slip from the assertive Blue attitude of insisting that you are open to trading, not to making concessions.

If you keep making conditional proposals (the if-then format) you may be able to deal with all styles of negotiators.

The Reds, once they are convinced that you are serious about your proposals, will realize that they can not bully you into accepting their terms.

STUDENT: Yes, but if the other party is a submissive Blue, I may be losing the chance of getting something for nothing!

TEACHER: You are showing your Red side. I am assuming you are not trying to exploit the other side. Anyway, you avoid the always present danger of scaring a submissive Blue away from the table; and a serious conditioned offer will be quickly accepted by a submissive Blue and you can move on.

As for devious Reds, they must be very careful in handling your proposal because they may show their true style if they reject it emphatically. They must continue being devious and at least make you a counteroffer. And honest assertive Blues will easily understand your movement because it is the way he or she normally acts, and will respond in the same way.

STUDENT: Fine, I guess we have covered the subject of how to proceed with difficult negotiators quite well. I have learned about personalities and styles. But at the beginning of this course you told me that you would teach me all "manipulative ploys".

TEACHER: I will, but remember that I am not recommending their indiscriminate use. Leaving apart any ethical considerations, most of the times they do not work in serious business negotiations. Why? Because most business negotiations are repetitive, with the same counterparts. If you use tricks and ploys with a customer, you may win once. However, you will probably say goodbye to the customer, he won’t return. Also, most experienced business negotiators will immediately recognize a ploy and counter it, and possibly identify you as an aggressive Red and treat you as one.

I said I will describe these ploys and tricks for you to be able to quickly recognize them and counter them when used against you. I am not encouraging you to apply them as a way to become a successful negotiator.

But it will be useful for you to recognize ploys and tricks that might be used against you, both to counter them and to recognize that your counterpart is an aggressive Red stylist. A "red" light will be turned on inside you, and this is good.

Most tricks, bluffs and ploys are targeted to influence your perception of the relative power of your counterpart and yourself. Perception of power influences your expectations. If you perceive that they have less power relative to you, you increase your expectations. And vice-versa. People using these tricks try to manipulate your expectations according to their interests and the strategy they apply. They may feign weakness making you believe that you have a lot more power than they have, to make you jump into a dubious deal by believing you have the upper hand. Or they may feign power to get concessions out of you.

In any case, these are manipulative actions.

Manipulative ploys are usually applied in three phases. To illustrate how a typical manipulator works, let me return to our friend Dr. Blue A. Driver. He did not purchase the car from Red A. Sell, and since he felt he was street dumb he attended a seminar, learned lots of ploys and tricks, and decided to become a manipulator himself. He visited a different sports car importer. Let’s play the tape. Once again, the example is exaggerated to emphasize the concept.

Tape play

Driver: (in phase 1, establishing his dominance)

"I am interested in your car, but you must give me a 10 year free warranty" (establishing preconditions)

"I am not negotiating payment terms, I need a 5 year interest free loan to pay for the car" (defines issues as non-negotiable)

"Also, we must finish our talks within two hours, I have another meeting" (deciding the Agenda unilaterally)

"And you better give me a good deal, I am very friendly with the head of the Better Business Bureau" (hinting at threats)

"And don’t forget that your car is not the best in the market, and your company has not the best of reputations. And I understand you did not fulfill your sales quota last year" (disdainfully dismiss your product, your company, and yourself)

Driver: (in phase two, shaping the deal in his favor)

"We are almost there, just give me a free voucher for 1000 gallons of fuel"

The seller agrees, and Driver says: "Oh, and I would need you to pay half of the insurance on the car the first year". (using "salami" –cutting a slice at a time to his advantage)

Driver (in phase three, working to close the deal on his terms):

"OK, our two hours are almost up, I have to leave very soon" (a phony deadline) "If I don’t walk out of here with a deal, I’m not coming back" (claiming it is now or never)

Tape pause

STUDENT: That was really a metamorphosis of our doctor / driver. Anyway, did he succeed by using these manipulative tactics?

TEACHER: Well, he bought the car and he is convinced that he won the negotiation. I suspect the seller played along and outwitted him; the doctor was fresh out of a seminar, and the salesman had been at this work for many years. Anyway, we saw how the doctor applied a few manipulative ploys. The rest of this course will be an A to Z of negotiation concepts, including ploys and counters. And whenever you are ready, let’s move to our questions and answers session.

Take the Questions and Answers Session whenever you are ready Top
Homework Assignment Before advancing to the next Module please do the Homework Assignment of this Module click HERE. Thanks.
Questions and Answers Session
These are self-evaluating questions, not to be sent to the school for grading. They are intended for your own evaluation of the knowledge you have acquired. If you feel you need it, just review the Module again. When comparing your responses with the Model Answers, do not expect them to be exactly the same. The idea is to make sure that you have grasped the concepts, not the exact wording.

Question 1
Why is it that so many negotiators continue displaying an Aggressive Red attitude when this is often a negative behavior?

They have experienced that many prospective customers have submitted and accepted their conditions. So they have convinced themselves that being "tough" is effective for quickly closing a sale on their own terms, and continue displaying this aggressive behavior.

Question 2
When Dr. Blue firmly stands up to Mr. Red’s aggression, with what style is he behaving?

As an Assertive Blue

Question 3
When Dr. Blue is quoted as responding insults with offense, what strategy is he following?

Matching Styles

Question 4
What would be the useful purpose of a controlled style matching strategy?

Avoid giving the Red the impression that we are showing constructive submission

Question 5
What type of attitude may turn a Blue counterpart into a Red?

Revealing expectations or true interests, or making unconditional concessions

Question 6
Which is the basic purpose of bluffs, tricks and ploys?

Most tricks, bluffs and ploys are targeted to influence your perception of the relative power of them and yourself

Question 7
Manipulative ploys are usually applied in three phases. Which are they?

Establishing dominance - Shaping the deal in their favor - Closing the deal on their terms

Question 8
When Dr. Blue, in his new manipulative style, stated: "OK, our two hours are almost up, I have to leave very soon", what trick is he using?

Setting a phony deadline

The A – Z of Negotiations Part I

2009-03-04T23:08:00.001-08:00

TEACHER: Hi. Let’s begin this Module by observing my friend Jim in the process of negotiating the purchase of a car. This is a very different situation from the one described in Module VI, where the negotiation was about a limited production luxury sports car. Jim is looking for a standard car and there are many competitors in this market; several brands as well as different points of sale for the same brand. The salespersons normally can not afford to act as "aggressive reds". But they can and often do use ploys and tricks. The salesperson, named D.Seller, is standing at Jim's side as the latter looks at a car in the showroom.

JIM: What is the price of this car here?

SELLER: You have good taste, sir. A very nice car. List price is $ 10,000. We have to move it, so today it will be only $9,000. (A seller’s voluntary Bogey! And he is being obsequious, too, calling young Jim "sir").

JIM: (Does not give buying signal). I see.

SELLER: It has 4-way stereo, that will be $300 more.

JIM: (Does not give buying signal). Mm.

SELLER: The only car we have for delivery today has genuine leather upholstery. Beautiful, really. And only $ 400 more.

JIM: (Does not give buying signal). I see.

SELLER: OK, that will be all, except this car has a special 1.8 liter motor while the standard is only 1.5 liter. You will feel the extra power, for sure. And it’s only $500.

JIM: (Does not give buying signal). I see. Anything else special about this particular car?

SELLER: No, that’s all. Just $ 10,200 for a beautiful machine. Let’s walk to the office to do the paperwork. Are you going to pay cash or will you need us to help you get a bank loan?
----
TEACHER: The seller is using the ASSUMPTIVE CLOSE tactic. It is a classic seller’s ploy. A positive answer by the buyer is a commitment to buy.
Jim will counter it by making it clear he is not ready to answer this question.
---
JIM: No, I am not ready to walk to the office now, nor to answer your question about a bank loan. Now that you have finally told me the features this car has and the total price, we may begin negotiating. Unless you still have some more add-ons you wish to mention!
...
TEACHER: The seller has been using the ADD-ON tactic first and when he thought that Jim was interested enough, he used the assumptive close tactic. The latter consists in quoting a basic price and then keep adding features, each priced individually.

Jim countered by not giving any buying signal and waiting until he actually knew the total asking price for the basic product plus all the add-ons the seller was going to mention. Only then did he show an interest in starting to negotiate, but still did not give any buying signal, and let the seller know that he had discovered his add-on ploy. Let’s watch a little more.

JIM: (after negotiating for a while, makes a conditional offer). OK, if you pay for the insurance for the first year, I am ready to pay 9,200 dollars for the car.

SELLER: I don’t think my boss will accept such a low offer, but you just wait for me here, I am going into the office and I will try to convince him.
...
TEACHER: The seller is probably leaving Jim to admire the car a little more and then come back with a counteroffer, or reject Jim’s offer outright. By suspending the negotiation he is using the ADJOURNMENT tactic, the equivalent of a time-out. It may be effective; Jim may convince himself during the adjournment that he can not get a better deal, but it is risky tactic for the seller. Jim may change his mind and walk away. He may talk to his wife on his cell phone and she may not agree with the purchase, or advise him to visit another car dealer; many things may happen during an adjournment.

Another risk of this tactic presents itself if the party asking for the adjournment comes back and sustains the previous position, like the seller saying to Jim: "sorry, the boss said no way". This creates hostility because Jim would have developed expectations assuming that the seller would come back at least with a counteroffer. Admittedly, in this particular case the seller would probably bring back a counteroffer, but there are cases when the party asking for the adjournment comes back and maintains the previous position.

But let us assume that in our case the seller comes back with a counteroffer of $9,000 (but no insurance added!) and Jim decides to buy the car. Now the time has come to sign an AGREEMENT (a nice name for a CONTRACT). Jim must make sure that the agreement he signs contains everything the seller expressed verbally. Anything not written and signed will not be part of the final transaction; people have a tendency to forget what they promised verbally. Jim should read the fine print very carefully, and if the transaction is important for him he should ask a lawyer to review it. In the world of business practically all contracts are reviewed by lawyers before being signed.

Agreements should specify who will be the arbiter in case of dispute. The parties may agree to be subject to a given legal authority, or to name a certain person or institution as arbiter. Binding or non-binding ARBITRATION in commercial matters is common due to the high cost of litigation.

JIM: (reviewing the car’s specifications): I notice that this car does not have power steering. I had assumed it had.

SELLER: Well, you did not ask, I would have told you if you had. But this is a very light car, you don’t really need power steering.
...
Jim is a predicament now. He made ASSUMPTIONS and did not check them by making specific questions. Well, at least in this case he found out that his assumptions were not correct before signing the contract; he may still back out of the deal or try to re-open the negotiation to get a lower price. But finding out that one’s assumption were wrong after signing a contract may be deadly.

Anyway, my friend Jim finally bought the car and before picking it up called his "friendly insurance broker", S.Nake. S.Nake’s friends (he claims that all his customers are his friends) call him Ess. Jim tells him the make and cost of the car, and explains the type of insurance he wants.

S.NAKE: Jim, I'll give you a deal. A comprehensive policy for only three dollars a day. A bagatelle, really!
...
S.Nake is a sophisticated person and said "bagatelle" instead of "peanuts"; and the word he used describes exactly the ploy he is using: the BAGATELLE. The total yearly cost of the insurance is $1,095, a considerable sum.. Jim might find this amount unacceptable, too onerous. But $3 a day is nothing for someone who just bought a car for nine thousand dollars!

Jim is a pretty shrewd negotiator, and counters the bagatelle ploy by grossing up to the total cost.

JIM: Ess, I don’t have my calculator with me, but you are quoting the premium at around 1100 dollars a year. Pretty expensive, Ess. I know we are friends, but business is business. I’ll call a few more brokers and get quotations.
---

After closing the deal to purchase the car Jim went back to his office. He and a partner called Bob run a small construction company. They have to decide whether they will BID or not on a contract to repave several blocks of city road. The condition of this bidding procedure is that bidders must present their offers by a given date in a sealed envelope. All envelopes will be opened in a public session. Jim and Bob are aware that this system, if properly run, puts maximum pressure on sellers. If there is no secret agreement between bidders (collusion), prices can not be padded and costing must be precise.

JIM: OK, Bob, are we going to bid on this job or not?

BOB: I’m not sure, Jim. There will be many bidders. We must really calculate our costs very accurately or we may end up losing money if we win. We won’t be able to pad the price to cover ourselves for unforeseen errors in our cost calculation, or some unexpected increase in our inputs.

JIM: Is the City really going to run a "one-offer-only" process. Or will they give bidders a chance to negotiate after the envelopes are opened?

BOB: There will be no negotiation. Best bid wins. The city has established a maximum price and no bid can be higher. And all bidders must make a cash deposit; if they win and then withdraw the offer, they forsake the deposit.

JIM: Pretty tough. We have to decide if we BID / NO BID. Bidding costs may be high and a total loss if we do not win. And if we win and if we make a mistake we may lose money, too.

BOB: OK, let’s prepare a check list:

1. What happens if we do not bid? Of course we can't win if we don't bid and there will be no bidding costs, but... do we have spare capacity, for instance, which will remain unused if we do not win this contract?
2. What is the cost of bidding and losing?
3. What are the risks if we win the contract?
4. Can we win by emphasizing factors other than just price, such as our good reputation or the offer of road maintenance after the job is completed?

JIM: Good idea. We’ll find an answer to these questions and decide if we bid or not according to the answers. It is a fact that in this case we can not BID LAST.

BOB: No, we can’t do what we did on the "open" bidding on the private road of that country club. That was not a "closed envelope" bidding, and by bidding last we made sure we put in the best bid, since we were able to find out the prices of other competitors who had eagerly bided before us.

JIM: Bob, you run this company before we became partners. Did you ever participate in an AUCTION bidding?

BOB: Yes, a few times. In an auction bidding the firsts bids for a contract involve highly padded prices and then as competitors bid, the price comes down. In these cases you should bid only once. Do not bid at the opening. As the bid prices fall, you wait until the last offer is slightly higher than the price you set as your minimum. At this point you bid; if you don’t win, you get out. Never bid more than once.

JIM: And did you ever have to deal with a BLOCKING OFFER from your competitors?

BOB: Certainly. I was negotiating with the JGH Corporation on a contract to build a parking lot next to their office building. We were close to an agreement when out of the blue my competitor I PAVE Inc. made an unsolicited offer for the same job at about 30% off my price. Naturally JGH suspended negotiations with me and started to negotiate with I PAVE Inc. I withdrew my offer because I closed another deal and had all my equipment employed. As soon as I PAVE Inc. found out about my withdrawal, they started to ADD ON, inventing "last minute difficulties", "unexpected increases in input costs", etc., until their total price was higher that mine. JGH Inc. called me back, but by then I could not bid again because almost all my equipment was in use, and they had to settle with I PAVE Inc.

JIM: And how could the JGH Co. have acted to protect itself when receiving I PAVE’s blocking offer?

BOB: A surprisingly low offer is to be suspected. JGH could have asked I PAVE to make a deposit amounting to the difference of their offer with my company’s bid as a condition to stop negotiating with me. I PAVE would forfeit the deposit if they did not make good on their offer as stated.

And I could have countered by telling JGH to request such a deposit from I PAVE. I am sure I PAVE would have refused and I would have won the contract. But I was inexperienced then, and I let it pass.

Sometimes a blocking offer is made not with the intention of finally winning a contract, but just to damage a competitor, forcing him to reduce his price and profits on a contract.

JIM: Excuse me, Bob, I am only your junior partner. But when JGH called you back to negotiate, didn't you at least have part of the necessary equipment idle?

BOB: Yes, I had some idle capacity, but not enough to do the job.

JIM: And did you explore the chance of a COALITION (a JOINT VENTURE) with a competitor?

BOB: No, I didn't because at that time I did not have the benefit you now have: the advice of an experienced senior partner! Right, I could have tried to negotiate a joint venture with another construction company. We could have joined forces and won the contract.

As you know a joint venture is a partnership but it differs from a "normal" partnership because it is limited to either a specific objective or a specific time frame, or both. It is a very frequent type of agreement between firms with many variations. For instance, in September 2002 IBM and Intel agreed to jointly design and develop modular server solutions, commonly called blade servers (computers). Of course, entering into a joint venture or coalition involves a lot of additional negotiations. Interests of the participants in a the joint venture differ. And many times, as would have been the case in the example we are discussing, the parties in a coalition are also competitors. The risk of disclosing information that may be damaging in future competitive situations is very high.

Once the Joint Venture is formed, it has to negotiate with its customers and suppliers. This involves the risk of inside disagreements between the members of the coalition. If some members have more power than others, they can be tempted to make COMMAND DECISIONS; deciding about tactics or agreements without their partner’s agreement. Sometimes a command decision is better than no decision at all, but in general it is disruptive of the joint venture’s operation.

And don’t forget, when a Joint Venture is formed, the conditions on how and when to end it must be clearly stated.

JIM: And I guess that, maybe even more that in any other negotiation, within a Joint Venture effective COMMUNICATIONS are vital.

BOB: You bet. Messages sent are not necessarily the same that are received. There is a very interesting game kindergarten children play: they call it the "malfunctioning phone line". A group of kids sit or stand in a circle. The "originator" tells something no one else can hear to the child next to him or her. The message goes around the circle until it returns to the "originator". Almost always the return message is very different from the original one, and children have a lot of fun comparing the different versions. Serious business negotiators have left kindergarten many years ago, but they still misunderstand each other a lot.

JIM: My father used to do business in Asia and he told me stories about how people from different cultures must be very careful to get the right messages across. Different interpretations of verbal and body languages may cause serious problems.

BOB: Yes, a problem made worse because in fact one of the parties, or both of them, may not be using their own native language. I was once negotiating with a very polite businesswoman in Hong Kong, and at certain point she told me: "I can’t hear you". So I raised my voice and she repeated that she couldn't hear me. This happened several times, until I realized that what she meant to say was "I don’t understand you". She was hearing me perfectly; she simply did not understand the English expression I was using! It is very important to learn as much as possible of the culture and customs of the people one negotiates with. In the West if you are introduced to a small child it is a nice gesture to touch the child’s head; in Thailand it is an offense. There are hundred’s of examples of this type of mistake one can make. When starting negotiations with people from very different cultures I used to excuse myself in advance for any blunder I could commit due to my ignorance of local customs and communication "codes".

JIM: I heard of a type of partnership which does not share profits or costs, but the relationship has mutual benefits for each other, and the success of one is influenced by the success/failure of the other.

BOB: Yes, this arrangement is also very frequent. A good example may be a company naming another to be the prime supplier of a certain product or service. If this arrangement works well, it means more business for the supplier and additional favors and benefits for the purchaser, e.g. in the form of technical support.

JIM: Getting back to our day-to-day business, yesterday I called on our prospective customer KKL and after I quoted our price they asked for a COST BREAKDOWN. I know you don’t like to do this, but how can I counter?

BOB: Let’s be more precise. I don’t like to give it, but I love to get it from my suppliers! Because a cost breakdown easily reveals the padding of prices, or at least reveals the sellers weak points. To resist a demand for a cost breakdown, you may show a written policy from our company prohibiting it; or claim it would reveal "confidential or secret proprietary information". Or being more practical, tell the customer that he should compare our final prices with our competitors’, instead of being concerned about our internal business practices.

JIM: OK, I will do that with KKL. But I understand many large companies, as for instance car manufacturers, demand and get this from their suppliers.

BOB: "Manufacturers" of cars and other complicated products like aircraft actually manufacture a very small part of the components of the final product; most of the parts are built by suppliers bases upon the manufacturer’s specifications. Of course companies like Ford or GE have a lot of clout with suppliers and usually demand and get cost breakdowns. But there is a positive aspect of discussing cost breakdowns in this particular type of relationships. Because companies like GM or Boeing, although they may not actually manufacture certain parts, have a lot of expertise and may actually help a supplier to reduce costs for mutual benefit
JIM: One more issue I wish to discuss. At a cocktail party I met Dick Jones, the owner of DJ Constructions. As you know, we compete mainly in building internal roads for country clubs and closed communities. He suggested we divide the physical area in which we compete into two regions, one for each of us, to reduce competition.

BOB: I see. He wants us to enter into DISTRIBUTIVE BARGAINING. I am not refusing, but let us discuss the pros and cons. Obviously this is going to be a zero sum situation as to the number of our prospective customers. Each possible area of operation we agree not to compete in, he gains for himself, and vice-versa. On the other hand, it may be advantageous for both companies if reduced competition allowed us to increase our prices.

JIM: So, how should we proceed?

BOB: Naturally in this type of territorial negotiations we will both want to reserve and keep our existing customers, even if they eventually fall into the other party’s physical territory. Since we are presently negotiating with several prospective customers, I suggest we use a ploy. You know this is not our usual conduct, but this time I want to apply a DELAYING PLOY. Because the more of our prospective customers we sign up before closing a territorial agreement with DJ Constructions, the better for us.

JIM: And how do you intend to produce these delays?

BOB: I know a few tricks. We can quibble about details, take long adjournments, tell him you and I have a disagreement we must solve first, one of us may get "diplomatically ill", or we can provoke a few not too serious rows, and so on.

JIM: And what if Dick applies the same strategy of delaying an agreement and uses the same tricks (sorry, tactics) you plan to use?

BOB: He probably will do it, and this is why reaching an agreement in Distributive Bargaining is very difficult, be it between us and DJ Constructions, or between Brazil and Colombia trying to divide up the world coffee market, or between two Mafia "families" distributing their zones of operation. And after an agreement is reached, it is very difficult to implement because most of the times both parties will cheat as much as they think they can get away with.

TEACHER: I hope you have enjoyed the dialogue between Bob and Jim, and learned something at the same time. Let’s see how much you have learned!

The A – Z of Negotiations Part II

2009-03-04T22:59:00.000-08:00

TEACHER: Hello! I suggest we start this module by talking about a false and a real Dutch. Do you agree?

STUDENT: An intriguing proposition I can’t refuse, for sure. Are you going to talk about counterfeit Heineken beer and an authentic renaissance painting, or what? Go ahead, please.

TEACHER: I was referring to an auction system called "DUTCH AUCTION". And the reference to a false and a real one is due to the fact that two different auction systems are called Dutch.

Let’s start with the "false" Dutch Auction.
You are purchasing an item and ask for bids from suppliers. Once you have the bids, you call the suppliers separately and give them a chance to improve on their rival’s last bid. Assume you got a bid from A for $10 and a bid from B for $9. You call A and tell them you have a bid for $9, and ask them to re-quote a lower price. Say they now re-quote $ 8. Then you call B and tell them you have a bid for $8 and invite them to re-quote. This process continues until you do not get any of your suppliers to re-quote a lower price. At this point you accept the last bid you got, which is the lowest one. Again, calling this system a Dutch Auction is incorrect.

STUDENT: OK, this one was new to me. But I actually think I know what a real Dutch Auction is.

TEACHER: Fine, you tell me.

STUDENT: In an actual Dutch auction, the auctioneer is normally a seller. He starts by mentioning a high price to which there is no response from any of the potential buyers.
The auctioneer calls lower and lower prices, and the first buyer who calls out in response to a reduced price, wins. The longer a potential buyer holds back, the higher his or her chance to pay less, but then the chance that another buyer calls in and wins also increases as he or she holds back.

Of course, this is the reverse of a traditional public auction, where the bids of the competing buyers rise and the last one to call wins. But let me tell you something, auctions are not actually "negotiations", are they?

TEACHER: No, not exactly. But at least the "false" Dutch auction is a form of negotiation you should know about. Anyway, let’s continue.

STUDENT: Let me ask a question, then. What about EMOTION in negotiations?

TEACHER: Most negotiators will deny it, but actually emotion is part of almost every negotiation. Some people feign emotions as a ploy; they falsely pretend to be hurt, sad, offended, etc., to produce a desired effect on their counterparts. Others actually feel and often unintentionally show emotions, which in general is no good. If your counterpart produces an emotional outburst, either in attack or in defense, remain as calm as you are capable of.

And now I will ask you to "pardon my French" (seriously, no pun intended), because I will explain two common French expressions.

FAIT ACCOMPLI is a French expression used in almost any western language. It refers to an action already taken and impossible or at least difficult to reverse. It is a ploy to give more power to the party which took the action. Example: a buyer sends a check with a non-earned discount, and waits for the seller to start negotiating on the difference; but he already has taken the action of paying less than agreed. He did not attempt to negotiate a discount before sending the check; he presented the other party with a fait accompli. This is often a difficult to counter action: it is advisable to include firm rules in a contract with heavy penalties, and react firmly the first time the other party behaves in this way. If you let it pass once... you are signaling that you will accept it again and again. Do you remember the meaning of the word "appeasement"? OK, do not practice it!

The other French expression frequently used is Force Majeure, roughly equivalent to "Acts of God"; strikes, war, floods, and any unforeseeable event that can prevent an agreement being implemented. In your contracts, add as many as you can if you must deliver, allow as few as you can if you are on the receiving end of a product or service.

STUDENT: Merci, mister Le Teacher. Are we returning to English now?

TEACHER: Yes, and I don’t want anyone to connect my next subject with the previous one!

I am going to explain the HOOKER’S PRINCIPLE to you. It is very simple and very true: "services are valued more highly before they are performed than they are afterwards". I guess I do not need to explain the reason why this principle was given this name, do I?

Let me give you a more innocent example. If you have a short circuit in your home’s wiring and can not watch you favorite TV show, you will give more value to the services of an electrician before he actually fixes the problem, than you will after he did fix it and you have watched your TV show. You will probably accept the electrician’s estimate gladly and let him repair your wiring. But you will feel less happy when after he has fixed the problem and you can watch TV at your pleasure, the electrician's bill arrives.

If you are selling services, make sure your customer can not find an excuse to reduce the price after you have performed it; he will probably do it if he can. And whenever possible, do as the professionals do after whom the principle in named: demand payment in advance!

STUDENT: Good advice. But I am missing your interesting cases in which you illustrate negotiation procedures.

TEACHER: You like true stories, don’t you? OK, here is one. A negotiation involving two teams about the "turnkey" delivery of a food processing plant. The prospective supplier is FabTec and the buyer is TastyFoods Inc. As you can imagine, this is a long negotiation which in turn will involve a lot of second level deals between FabTec and its suppliers.

Since both teams are very professional, they come to the negotiation after careful PREPARATION. Preparation is "the jewel in the crown of effective negotiation". Getting it right dramatically improves your performance in negotiations. And the necessary condition for good preparation is of course knowing your business; and in many cases, as in the one we are studying, you need to know your customer’s business. How can you negotiate the construction of a turnkey plant if you don’t know your customer's industry as well as he does?
Some basics on preparation:

1. What are my interests?
2. What are the issues? Itemize them.
3. How important is each issue for me? Prioritize
4. Quantify my entry offers
5. What are my exit offers?
6. What do I NOT want? Prioritize.
7. What are the other negotiator’s interests? What will be their priorities?
8. How to handle information on both sides.

Obviously TastyFoods Inc. prepared itself by finding out as much as they could about FabTec: expertise in the specific engineering field, reputation, customer satisfaction of previous jobs done, etc. The first item negotiated was based on point 8 above. Since TastyFoods Inc. would have to supply a lot of information about their business, manufacturing practices, sales forecasts and even trade secrets, they asked for a severe CONFIDENTIALITY AGREEMENT.

FabTec was used to this type of request from customers; they debated for some time about the penalties they would have to pay if some confidential information was leaked, and on how to establish their actual guilt, but soon agreed to most of TastyFoods Inc.'s demands. TastyFoods Inc. used the STANDARD TERMS strategy: a printed contract they claimed was used in all parts of the world by all subsidiaries of TastyFoods Inc. when contracting for the construction of a plant. They claimed they had no authority to accept any change in this confidentiality agreement.

Both parties defined their interests and issues and prioritized them (points 1 to 3 above). TastyFoods Inc.’s basic interests:

1. Getting a state of the art food processing plant capable of producing a specific volume at the lowest possible cost
2. Planned additions to increment capacity in the future
3. A convenient price from the supplier. Financing?
4. Quick completion
5. And you can imagine a lot more...

A few of the interests, issues and priorities of FabTec:

1. Employing their considerable idle capacity in engineering manpower
2. Maximizing their profit
3. This job as an important reference for future works with the same multinational client and others.
4. And you can imagine a lot more...

Once the confidentiality agreement was signed and TastyFoods Inc. supplied the necessary information, FabTec established their Entry and Exit points: First offer to start negotiations, and the point at which they would abandon negotiations.

TastyFoods Inc. had no entry point, since the first move would come as a quotation from FabTec, but they did have a maximum they were willing to invest in the construction of the plant (capital expenditure budget). Of course they did not reveal this information to anyone.

STUDENT: OK, now both parties have prepared themselves, the necessary information has been exchanged, and FabTec quotes a price for supplying the turnkey plant. Right?

TEACHER: Before even considering the quotation, TastyFoods Inc. insisted on a LIFEBOAT CLAUSE. This is an unlimited escape clause, and the wording TastyFoods Inc. wanted was "...acceptance of the offer is contingent on the veracity of all statements made by the seller regarding performance, quality, and specifications, and approval of the buyer of all matters relevant to the purchase, whether presently known or not, and any other material facts that may affect the buyer’s interest". You realize that such a clause gives TastyFoods Inc. the chance to "jump into a lifeboat" and cancel the contract at any time without any PENALTY CLAUSE.

The FabTec team countered with the TIT-FOR-TAT strategy: "Yes, but ... we would agree if you accepted:"

1. Fixing specific stages of the construction process and amounts due to FabTec if TastyFoods Inc. jumps into the lifeboat at these points (no free lunch!).
2. Your decision to cancel the contract must be based on objective criteria subject to arbitration

Point ii. was obviously an OFFER THEY MUST REFUSE because it was totally contrary to the demand of a lifeboat clause made by TastyFoods Inc.

If allowing TastyFoods Inc. to escape the contract was to be based on "objective criteria", by definition it would not be a "lifeboat". FabTec's offer was designed to be refused and begin a trading process.

The parties debated and finally settled conceptually on point i. As for the fixing of the stages and the money to be paid for canceling at each stage this was left for later negotiating rounds.

The question of the lifeboat clause preliminary settled, TastyFoods Inc. challenged the price and the "package", the specifications of the plant. Not surprisingly they wanted both a price reduction and a plant with more costly features. FabTec countered with the ONE PRICE, ONE PACKAGE defensive ploy. They maintained "this package, this price; that package, that price" principle. Their team had a TOUGH GUY and a NICE GUY; while the latter listened carefully and stated his understanding (not his agreement) with TastyFoods Inc.’s demands, the former kept countering with the OVER-AND-UNDER ploy. This is the impossible response to the "impossible" demand. He said for instance "OK, we may reduce the price by 10% for a plant with 25% less capacity".

To counter the One Price, One Package strategy, the TastyFoods Inc. team applied the SALAMI strategy. The USA used to accuse the Soviet Union of applying this strategy during the Cold War. It is based on the principle that "a slice of a cut sausage will not be missed". K&G kept saying that they might accept FabTec’s price, but on condition that... and "slices" were cut in the form of added features. A bit more capacity here, a faster machine there, a few more sanitary facilities for workers, etc. They combined SALAMI with the SELL CHEAP, GET FAMOUS buyer’s ploy: "make this plant and you will have a lot of other customers lining up to deal with you".
TastyFoods Inc. was a US company but they had a joint venture with a Japanese enterprise to do business in certain Asian countries, and the plant under negotiation was for one of these countries. Mr. Suji, the representative from the Japanese company, had not spoken at all. At one point the FabTec team was totally resistant to allow one more Salami slice to be cut from their price and TastyFoods Inc. wanted more. One of the members of the FabTec team decided to use the WAKING UP THE DEAD ploy. This ploy’s objective is to exploit possible differences within the counterpart’s team, by inviting a member of the latter who has remained silent to comment.
The FabTec person said: "What do you think, Mr. Suji? Do you have any suggestion on how to break this impasse?" A risky tactic. The Americans in the TastyFoods Inc. team resented the interference and stiffened their position. Mr. Suji´s role was actually to be present only as an observer, and he made a polite evasive statement.

STUDENT: Tough position for FabTec. How did they move?

TEACHER: Actually, they had to sacrifice one more cut of salami, but one of their most senior negotiators minimized the damage by using the MAJOR SACRIFICE GAMBIT. This is a ploy to manipulate the perceptions of the other negotiators. FabTec had no option but to make a concession after the blunder they had made with their attempt to "wake up the dead". But the FabTec negotiator defined it as a significant concession and stressed the "sacrifice" they were making in order to do business with TastyFoods Inc.; he hinted that he would expect some compensation for the "heroic sacrifice" his company was making.

STUDENT: Did it work? Did the TastyFoods Inc. people believe it?

TEACHER: I do not think they believed it, but it broke the impasse while allowing both parties to "save face".

At this point the TastyFoods Inc. team decided that they could not continue with the Salami tactic and began giving some very subtle buying signals. This caused the FabTec people to "salivate" in anticipation and signaled their satisfaction about the deal being about to be closed. Taking advantage of this situation, the TastyFoods Inc. people hit with the MOTHER HUBBARD price pressure ploy.

STUDENT: Mother Hubbard? Was it the mother of one of the negotiators?

TEACHER: The name refers to a famous English nursery rime: "Old Mother Hubbard went to the cupboard to give her poor dog a bone, when she got there the cupboard was bare...". The TastyFoods Inc. team "confessed" that they had made a mistake when estimating the total investment needed, and thus their capital investment budget was not sufficient to allow for the expenditure at that price. Only a reduction in price, or else delayed payment terms at no interest to carry over the expenditure to future budget periods could allow them to continue negotiations. "Their cupboard was bare!"

FabTec countered by claiming that their price included maintenance of the machinery for 5 years; they said " if your investment budget is so bare, let’s take the maintenance out of the price. We can reduce the price of the turnkey plant and you can pay for the maintenance of the machinery out of your maintenance budget". What they suggested was "creative accounting" (in TastyFoods Inc.’s accounts, not in theirs). This solution would "solve" the capital investment budget limitation, but the total price paid by TastyFoods Inc. would be the same. Wisely, the TastyFoods Inc. negotiators rejected this proposal on the basis that their senior management would immediately discover the trick.

FabTec then suggested to SPLIT THE DIFFERENCE between their last offer and the price TastyFoods Inc. was prepared to pay. This a settlement ploy which may work and be equitable, but all depends on whether both parties can afford to split the difference. Can FabTec still make a decent profit if the difference is split? Can TastyFoods Inc. get an acceptable return on their investment in the new plant?

At this point an agreement seemed to be reachable, since TastyFoods Inc. accepted to split the difference in price and all plant specifications and other details had been settled. Yes but.... TastyFoods Inc. demanded a RESTRICTIVE COVENANT, a contract prohibiting FabTec from using any original technology they developed for TastyFoods Inc. if they built plants for other companies in the future, with stiff penalties. FabTec in turn demanded ROYALTY payment if TastyFoods Inc. used this technology in future plants built for TastyFoods Inc. by other construction firms. Lawyers were called in and finally a clause was added to the agreement which partially contemplated TastyFoods Inc.’s request. Of course this particular issue involved a lot of GIVE AND TAKE; FabTec was allowed to use the new technology in new plants which did not manufacture products competitive with TastyFoods Inc.’s, while TastyFoods Inc. was permitted to use any new technology in its future new plants without royalty payments to FabTec.

STUDENT: It looks that they had an agreement. Or was it a GAZUMP situation?

TEACHER: I see you have done some reading on negotiations. As you know, Gazump is a situation where one of the parties thinks it has a contract and the other one considers it a STATEMENT OF INTENTION of which it can get out easily if a better opportunity comes up. In this case detailed MINUTES were taken on the partial agreements of every session, and the final contract was reviewed by lawyers on both sides. The made sure that it was a contract, not a gazump.

STUDENT: This was an interesting case of a complicated negotiation ending successfully in an agreement advantageous for both parties. Was the plant actually built, delivered and did it perform well? In other words, was the agreement IMPLEMENTABLE?

TEACHER: Yes it was. And I will finish this module by telling you about some of the good negotiating practices used by both these experienced teams.

They were very careful about PROTECTING INFORMATION. They worked separately in secure premises when preparing for the negotiation. Circulation of documents was controlled and restricted. Senior personnel was briefed in person. Superseded documents were shredded, carbons and printer ribbons destroyed (this was some time ago when these kind of things were still in use!), computer files and disks were erased. Only people who really NEEDED TO KNOW received specific information. Taking documents home or on trips was strictly prohibited.

And, this being the last Module of this course... goodbye, and happy negotiations to you!

Macroeconomic issues and measurement

2009-03-03T08:32:00.000-08:00

TEACHER: Hi, Student! Welcome to my "Economics for Business and Management - Macroeconomics" class. Of course, we shall begin by a general definition of Economics. I hope you will enjoy this class and find it useful.

STUDENT: I hope so too. But tell me something, please. Why should I, as a business person, be interested in economics, or in macroeconomics?

TEACHER: Well, maybe you shouldn’t. You might not be interested in issues such as inflation, unemployment, recession, competitiveness. As a business person you might not care about how inflation, recession and foreign competition related with exchange rates may affect your profits. Not being the government, you might not care as governments do (or should) to prevent or counteract recessions, control inflation, increase competitiveness and employment. Unless you are working, you might not be anxious at all about unemployment, and not being a pensioner you might not care about the effect of inflation on your savings and pensions.

STUDENT: OK, sorry. I admit that I shouldn’t have questioned the usefulness of learning economics, but your answer was somewhat too sardonic, wasn’t it? And of course, I do care about all the issues you mentioned.

TEACHER: OK. I apologize. And having settled the matter of your interest in the subject, let’s begin.

What Is Economics?

There are many definitions, and this is the one I consider most comprehensive:

* Economics is the study of how people and society choose to use scarce production facilities to make different goods and how to distribute them among persons and groups for consumption.

Economics used to be called Political Economy, and this was a good name, because many of the choices mentioned above are influenced by political conditions.

STUDENT: But is it a real science?

TEACHER: Perhaps not an exact science the way physics and mathematics are. Economics, being very dependent on choices made by people, is a behavioral science, overlapping with psychology, sociology and anthropology. But it certainly includes the use of "exact" tools such as statistics and probability analysis.
But now allow me to explain...

A Principle And A Concept: Opportunity Cost and the Fallacy of Composition

Due to the almost universal scarcity of raw materials, labor and capital goods, choosing to produce something means giving up producing something else. This is the foundation of a basic economic principle: the opportunity cost. If it is decided to produce good A instead of good B, the opportunity cost of making A is the benefit we forgo by not producing B.

A caveat: this is true when practically all people and production facilities are employed. If a substantial portion of labor and capital goods are idle, we could make more goods without forgoing production of others.

A very important concept in Economics is the fallacy of composition: what is a good solution for a person or a group, is not necessarily a good solution for society. If there is a recession, it may be wise for a person who has a job to spend less and save money to build a reserve for the eventuality of becoming unemployed. But if everyone does the same, the fall in demand would worsen the recession, more people would lose their jobs, and everyone would be worse off.

STUDENT: I understand. But economies can be organized in different ways, can't they?

TEACHER: True. So, lets take a quick look at...

Economic Organization

A society, even one composed by only two people who interact economically, must be organized. Somehow it must be decided what to produce; who will do what, and how produce should be distributed among members. The basic forms of economic organization are:

* A fully planned economy (the defunct Soviet Union or communist China years ago). All economic decisions are made by the government.
* A pure free enterprise economy, where the government does not make any economic decision.
* A mixed economy. The government makes some decisions and the rest are left to the people.

Almost all economies today are mixed, with varying degrees of government intervention. The tendency, from China to Germany, is for government to leave more economic decisions to the market forces.

The question is, in those areas of the economy where the government does not interfere, who makes the decisions of what, how and for whom produce? The answer is no one, unless we accept Adam Smith's concept of the invisible hand. In a competitive system of free markets and prices, decisions are made by millions of people acting as consumers and /or producers.

STUDENT: I understand. And now, I guess you will begin with the specific subject of this Module, Macroeconomics.

What is Macroeconomics?

TEACHER: Right. "Macroeconomics" is the study of how the economy functions in broad outline. Much of the detail macro does not describe is very interesting indeed, but macro (as we will familiarly call Macroeconomics from now on) is concerned basically with what are called "aggregates", meaning roughly "the total sum of". Macro is concerned with total national product, total investment, total exports and imports, total consumer spending, etc.

STUDENT: Do you mean that macro is only concerned with aggregates?

TEACHER: Not exactly. Macro is also interested in averages, such as average prices, salaries, etc. Aggregates and averages result from the activities of many different markets, private firms, government agencies, and individual persons acting as consumers or investors.

STUDENT: Since macro means "big" and "micro" small, I guess that microeconomics is the part of economics dealing with the activities of individual markets and firms.

TEACHER. Right. In macro the value of all goods and services produced is added together, be it gasoline, soft drinks, bread, wine, haircuts, restaurant meals, or whatever. The value of all these goods and services is the aggregate national product, the main concern of macro.

STUDENT: And what about averages?

TEACHER: The best known average used in macro is the general price level: an average, or index, of the prices of all goods and services produced. This index can be calculated with prices at the consumer level or at intermediate levels such as wholesalers. The index at the consumer level is known as CPI (Consumer Price Index) in the US and RPI (Retail Price Index) in the UK.

STUDENT: Is there any disadvantage in putting everything together ("aggregate" it) and deal only with these broad figures?

TEACHER: Of course we miss important information about the composition of the economy, but dealing with aggregates shows the big picture. An increase in the price level immediately shows that there are inflationary pressures in the economy. In fact, probably some individual prices did not increase and could even have decreased; but for most economic agents (firms and persons) prices are increasing and the purchasing power of money is falling.

STUDENT: I see. For instance, if the interest rate index rises, it means that I probably have to pay more interest for a loan, and possibly get a better return on my bank savings account. And if unemployment rises, my chances of getting fired increase, and my chances of getting a job decrease.

Should a businessperson be concerned about macroeconomics?

TEACHER: Yes indeed. As a businessperson, you need to understand macro because if affects your own "micro". You may be an expert in your micro environment: the market segment your firm operates in, your competition, the workings of your own enterprise. Certainly you need this information for your day to day operation and for making plans. But since the macro will affect your business, you can not ignore it. You can make a nice business plan based on your micro only to watch it being upset by a recession, rapid inflation, and variations in the exchange and interest rates.

And now let me name the

Main Macroeconomic issues:

1. The Business Cycle (recession, depression)
2. General Living standards
3. Inflation and deflation (movements of the price level)
4. Unemployment
5. Fiscal Policy (Government deficits and surpluses)
6. Monetary Policy (management of average interest rates in the economy)

Having said that, let me ask you a question, dear Student. Can you detect a difference between these six items?

STUDENT: I think so. The first four involve ends, or targets, to be reached: avoid depressions and recessions, rise the living standard, prevent inflation and deflation, and keep unemployment as low as possible.

TEACHER: Very well. And what about numbers five and six?

STUDENT: Obviously they are means, instruments to reach the desirable ends I mentioned. Government actions like budget deficits or surpluses, or affecting the interest rate, are the basic tools to reach those desirable ends.

TEACHER: I am impressed. Now let’s describe the six main macroeconomic issues.

1 -The Business Cycle

The level of overall activity in an economy moves in "waves", with ups and downs. The downs are called recessions, the ups recoveries. The point of inflexion from the former to the latter is called the bottom, and the point of inflexion from the latter to the former is called the peak.

Let me show you a graphic illustrating a typical business cycle.

A prolonged deep level bottom is a depression. The world economy experienced a deep depression in the 1930’s. For 25 years after 1945 there was sustained economic growth. Then rather serious worldwide recessions came (1974/75, 1980/82 and 1990/92), but they were mild compared with the Great Depression of the 1930´s. Sometimes the business cycle is not coincident in different economic areas, which is good since the growing areas can help the depressed to recover. Japan has been in a depression for a long time while the US, other regions of Asia and the EC (European Community) were growing; if all others had been n recession at the same time, Japan would have had an even more serious problem. Economists think that the US has suffered a rather mild depression starting in 2000, while Japan remained in depression and the EC economy, while showing some more resilience, did not perform too well either. This created doubts about a quick recover of the 2000 depression.

Eventually, thanks to the actions of the Federal Reserve -reducing interest rate substantially- the US economy recovered. So did the EC, and the fast growth of India and China added considerable impulse to the recovering of the world economy.. The financial crisis of the low-quality mortgages of 2007 again signaled a possible reduction of the growth rates worldwide.

Macroeconomics was invented to help in the developing of actions or tools that could flatten economic fluctuations.

STUDENT: I can imagine it, but why don’t you tell me yourself how these cycles affect businesses and people?

TEACHER: Glad to oblige. At the bottom of the cycle there is high unemployment, a low level of aggregate demand, a total production lower than the economy has capacity to produce. Business profits are low or negative, and many firms fail. There is low confidence among consumers and entrepreneurs, and therefore firms delay new investments.

During a recovery, also called an expansion, employment, income and consumer spending begin to rise. For a time not much new investment is needed because idle labor and equipment can be put to work, but at a certain point firms start investing in new plant and equipment and hiring workers. Sales and profits rise, of course.

At the peak of the cycle, most existing capacity is in use. Shortages develop and costs and prices tend to rise. Business in general remain profitable.

A recession, or contraction, is a downturn in the total output of the economy. Demand falls and in consequence employment and production fall too. Personal income and business profits drop. New investment falls to very low levels.

STUDENT: Naturally even during a recovery or a peak there must be short-time mild variations. Suppose that at a certain point during a peak there is a fall of GDP. When does it become a depression?

TEACHER. Naturally this is a conventional or common usage definition: in general it is accepted that the economy is in a depression when the GDP falls for two consecutive quarters.

STUDENT: And as your graphic shows, the terms boom and slump are used to indicate expansions and contractions.

TEACHER: Correct. Now let’s move to the next macro issue.

2- Living standards

The most common measure of overall living standard is the real wage: the quantity of goods and services that can be purchased with the average hourly wage.

Total output of goods and services has risen for decades in most industrialized regions. So has the per capita output.

STUDENT: Per capita?

TEACHER: "By head" in English. If you divide any aggregate amount of a region by the number of inhabitants, you have the per capita figure, be it income per capita, Gross Domestic Product (GDP) per capita, or whatever.

The fact is that the real wage also grew, but not all the time. In the US, the real hourly wage was roughly the same in 1995 as in 1973.

STUDENT: Real hourly wage? Is there an imaginary one?

TEACHER: Gook joke. Real here means adjusted for inflation. We all know that the nominal hourly wage was much higher in 1995 than in 1973; but prices were also higher in practically the same proportion.

Let me stress that long-term growth is the necessary factor in determining higher living standards for the population as a whole. Of course it is possible to distribute the product of an economy in a more egalitarian way, but there is a limit to this. In the long run, if the pie does not grow and it must be distributed among more people, living standards fall.

The challenge to macroeconomics is finding procedures that would allow sustained worldwide economic growth with a minimum of fluctuations. Utopia? Possibly, but it is the objective to be pursued.

3- Inflation

Inflation is a rise in the price level. We should however distinguish between different scenarios. It is possible to experience a one-time increase in the price level due to a particular situation (i.e., a rise in the price of fuel) followed by price stabilization. But the most dangerous type of inflation is the spiraling inflation; in this case prices rise continuously. This is usually the result of a sustained high demand (the demand-pull factor) combined with the increase in production costs (the cost-push factor). The latter is the result of shortages in the factors of production: inputs (labor and raw materials) and capital (equipment and working capital financing costs). An excessive supply of money is usually present as a result of government deficit spending.

Governments try to keep inflation as low as possible, in most advanced economies a task given to an autonomous Central Bank. This is theoretically quite easy: a Central Bank (the Fed in the US) can manipulate the interest rate and by increasing it reduce demand. The problem is that this instrument must be carefully used, because adjusting too much may cause a depression. On the other hand the Central Bank can stimulate economic activity by lowering the interest rate; but the risk of overshooting and causing inflation always exists. We shall elaborate on this question a little later.

4- Unemployment

Unemployment is a central concern of macroeconomics. There is no consensus about the minimum sustainable unemployment level. If it is too low, many firms do not find workers and wages rise, creating inflation. If the level is too high, it creates a fall in demand and a tendency towards a depression and falling prices. During the later years of the twentieth century it was widely believed that the "new paradigm of the economy" would allow sustainable growth without inflation at very low levels of unemployment. The rationale behind it was that the increase in productivity would be continuous due to the use of computerized procedures. The behavior of the economy during the first years of the twenty-first century considerably discredited this theory.

5- Fiscal Policy

After the Great Depression it became popular to believe that government deficit spending was a panacea for fighting depressions. If the government spends more than it collects in taxes, obviously it is stimulating demand. On the other hand if the governments "saves" by spending less than it collects and runs a budget surplus, it is reducing demand and so this practice can be used to bring inflation under control. These two elements constitute what is called "Fiscal Policy".

STUDENT: Where does the difference in tax collections and spending come when there is deficit spending?

TEACHER: The "difference" can come from "printing money" (expanding the money supply). This may work as long as a substantial part of production capacity remains idle, but this practice has to be stopped in a timely manner in order to avoid inflationary pressure.

The government can cover the gap by borrowing. If it borrows locally it competes with firms in need of credit and interest rates tend to go up, which works against the objective of deficit spending. If the government borrows from a foreign financial market this influences the exchange rate, the tendency being to increase the value of the local currency. This is also a negative factor if the objective is to stimulate the economy. In either case the "national debt" increases, interest has to be paid, meaning more deficit spending or higher taxes.

STUDENT: No simple solution, right?

TEACHER: Unfortunately not. In an economy, everything is related to everything else, and any action taken may cause undesired results. But let’s advance to the second of the two "tools":

6- Interest and exchange rates

In addition to fiscal policy, governments or the Central Bank can use "monetary policy" to influence economic activity, Monetary policy is basically the manipulation of interest rates. It is not difficult to understand why lower interest rates stimulate demand and vice-versa; the lower interest rates are, the more eager people and firms will be to borrow and spend and invest. And the reverse is also true, of course.

To a certain degree governments may also manipulate the exchange rate, lowering or increasing the value of their currencies relative to others. These actions change the relative prices of foreign and local goods. A fall in the exchange rate of the local currency stimulates exports and tends to reduce imports, thus stimulating the local economy.

STUDENT: So this is a fool-proof solution, isn't it?

TEACHER: Not quite. After a devaluation of the local currency, firms get better prices by exporting; naturally they will increase the prices of the exportable goods in the local market too. Dearer imports, be it industrial inputs or consumer products increase costs and thus prices. The result is that local prices tend to rise to the same point of real relative prices before devaluation; inflation has chased devaluation and nullified its effect. Now a new devaluation becomes necessary, and so on and on.

GDP and the concept of Added Value

GDP stands for Gross Domestic Product and is the aggregate money value of all goods and services produced in an economy during a period.
Let me add that we are only talking about added value.
Some firms produce outputs that are used as inputs for other firms, and so on. This means that to calculate the GDP by adding the output of all economic factors in a country would not be realistic. If I sell you paper for $500 and you use it to make photocopies you sell for $ 800, you have not added $800 to the aggregate GDP. What you have contributed is the "added value", the difference between the cost of your inputs ($500 in paper plus other costs). Assuming your total cost was $600, you have added $200 to the GDP.

GDP is calculated by adding up the value added of all economic factors in a region.

The circular flow of income and expenditure

Over a period of time, every product and service (GDP) is sold to someone. The "money" from these sales must go to someone, either as salaries or profits. Thus, the Total Value of the Output (GDP) equals Total Income (TI).

This income in turn is either spent, saved or paid in taxes ("Expenditure"). So, GDP=TI=Total Expenditure (purchases + taxes + savings).

We may refine the equation a little more by discriminating the different types of incomes and expenditures: Thus

* GDP = Total Income = Total Expenditure
* GDP = Personal Consumption + Business Investment + Government Spending + (Exports minus Imports)

GDP is normally calculated at "market prices". When comparing GDP figures over time, changes in the general level of prices must be considered. One way is to apply a "deflator index" to neutralize the effect of price inflation.

GDP, GNP, NDP and National Income

National Income accounting is the name given to the calculation of GDP and other indicators such as GNP, Gross National Product.

STUDENT: Like many other people, I get confused by the way the media use GDP (Gross Domestic Product) and GNP (Gross National Product). Are they the same?

TEACHER: Not exactly. Total output produced in the economy measured by GDP should be equal to total net income received. This would be true in a completely closed economy but is not a fact in real life open economies. This is because residents in a country receive income from assets they hold abroad and pay out money to foreign residents for assets own locally by the latter.

To arrive at the GNP starting from GDP it is necessary to add income received by domestic residents and subtract income paid to non-residents.

STUDENT: And what about NDP, Net Domestic Product?

TEACHER: The word gross in GDP conveys the meaning that depreciation, or capital consumption, is not taken into account. To arrive at NDP, it is necessary to subtract from the GDP figure the value of the depreciation, the amount to be spent just to replenish the consumed capital, usually plant and equipment.

STUDENT: A couple more questions. What is Personal Income, and what makes it different from Personal Disposable Income?

TEACHER: Personal Income is the gross amount paid to individuals for any reason. Disposable Income is what remains from Personal Income after taxes and other compulsory payments individuals must make. In short, DI is the amount left to individuals for either spending or saving.

Interpreting national income figures

There is no doubt about the usefulness of national income accounting. However, as is the case of most statistical information, it may be misleading unless carefully interpreted. It is also necessary to choose among the different measures to use the one more appropriate for a specific need.

Real and nominal figures

We have already explained above that nominal figures almost always are misleading for comparing different periods. Nominal figures reflect the effect of inflation, since they are computed at market values. We mentioned the deflator index before. The adjustments can be done by different procedures, but the main objective is the same, to allow realistic comparisons over time.

International comparisons

Since national income figures are calculated in the local currency in each country, comparisons between countries are affected by exchange rates. And exchange rates often fluctuate significantly over time, or remain fixed while local prices fluctuate. Suppose country A has a per capita GDP of LC (local currency) 20,000 in Year 1. The exchange rate in year 1 is LC 10=1 US$, and so we have a per capita GDP of US$ 2,000. The following year country A reports a per capita GDP of LC 30,000, a 50% increase. Somehow (possibly by government management of the exchange rate), 1 US$ is still worth LC 10. Thus, the per capita GDP in year 2 could be reported as being US$ 3,000. Obviously, this is a misleading figure, because the real GNP per capita could not possible have grown 50% in a year.

To solve this problem, instead of using the actual market exchange rate, an index called "equilibrium exchange rate" is used. This is a theoretical figure, expressing what the exchange ought to be at a given time. How to arrive at this figure is not easy. The most common system is the PPP, the purchasing power parity. This is the exchange rate that equates the prices of a group of representative products in different countries.

You will also see national income figures expressed in "constant dollars"; i.e., "1995 dollars". This means that the GDP is calculated for different years adjusting local currency figures and the exchange rate to the values of the chosen year.

Unreported output

STUDENT: I still have the feeling that an important part of an economy’s output is not measured by national income accounting.

TEACHER: Naturally illegal activities are not reported and thus not included in official national income accounts. We do not wish to make any moral or ethical judgment here: what is illegal in one country is often legal in another, as for example, gambling, prostitution and alcoholic beverages. Anyway a part of the output of illegal activities is actually computed indirectly because business people involved in illegal activities report some of their income as coming from legal activities (the famous "money laundering" process).

Many perfectly legal activities are not included in the accounts simply because they are not reported to avoid paying taxes. This so called "black" economy is very important even in advanced industrial countries such as Canada (estimated at 15% of GDP). In some less developed countries it is much higher, especially because the agencies in charge of collecting taxes and enforcing tax laws are inefficient and/or corrupt.

STUDENT: I often hear housewives complain about not getting a salary for their very important work. I assume that this activity, as many other "non-marketed" activities, is not included either. But are all these omissions important?

TEACHER: If one is interested basically in changes of the GDP over time in the same country, and the omitted percentage does not change rapidly, then the omissions are not important. If one is interested in calculating the actual aggregate flow of products and services, the omissions become important. It is of course possible to estimate the amounts omitted, but they will still be only estimates. As for comparisons between countries or regions, the omitted proportion of the GDP can be very different. In rural areas there is a lot more "non-marketed" activity than in urban settings, and this makes comparisons between these two types of economic regions more difficult.

Which is the best measure?

STUDENT: Is there a "best" measure of national income?

TEACHER: Not really, each one has advantages for a specific purpose. Employment will be in general related with changes in the GDP and business profits, while Disposable Income may be more helpful in predicting consumer spending behavior.

Well, this will be all for this Module. See you in next one!

Determination of GDP

2009-03-03T08:29:00.001-08:00

WRITER: In Module I we discussed the most important macroeconomic variables. We will now develop a conceptual model of the economy.

STUDENT: What for, Writer?

WRITER: Macroeconomics is based on a theory. To develop, confirm and apply a theory you need a model. At least at the beginning, this model must necessarily be simple. With this model we will begin to study how the economic variables described in Module I are interrelated, and why they behave in a certain way. We will define the forces that shape the GDP and the general price level.

STUDENT: If your intention is to scare me, you are almost succeeding!

WRITER: No reason to be scared. We will start with a very simply structured model, and add more elements as we progress.

To develop a model it is necessary to make certain assumptions. As the model becomes more sophisticated, some of these assumptions are changed or abandoned, and new ones are added.

The way we will work will be to rather closely follow the way the macro branch of economics developed from its inception in the mid 1930’s. This means that we will move in the following Modules from the simple models formulated by the founders of the discipline, to contemporary macro’s sophisticated models.

STUDENT: What you mean to say is that I can not just read Module II and go ahead and formulate macro policies.

WRITER: Right. Let’s go on and describe the basic foundations of macro, and build a very simple model of national income determination. For this we will have to make a few special assumptions; you may feel they are too simplistic, but we need them for a start. Later on, as I said before, we will turn more realistic.

Potential and actual GDP

This is a simple concept. At a given time, an economy has a potential GDP; the level the GDP could reach if all means of production were fully employed with the current systems of production. The last phrase is important: we are not considering potential as including possible innovations, increases in productivity, or improved production methods. We define the potential GDP as the amount attainable with the normal utilization of land, capital goods and labor. Potential GDP is also called full (or high) employment income. For short, we will call it level P GDP.

At any given time, we have an actual GDP level; the aggregate value of what the economy is in fact producing. Let’s call it level A GDP.

Now let me ask you a simple question, Student. How would you calculate the gap between the potential and the actual GDP?

STUDENT: An easy question indeed. The value of P minus A is the gap; the difference between the potential aggregate production of the economy and what is actually produced. G (gap) = P-A. But I am not sure if P minus A can be a negative or positive figure,

WRITER: If P is larger than A, calculating P-A will result in a positive figure (+). The figure can also be negative (-) when A is larger that P, because we define level P as the potential GDP at normal utilization of the means of production. But it is possible, and actually happens, that during a boom those means are over-utilized; i.e., workers do a lot of overtime, normal maintenance of equipment is delayed, etc.

STUDENT: I see. Do these two types of gaps have special names?

WRITER: Yes. When G is a positive figure (P larger than A), means of production are under-employed, and prices tend to fall. This situation is called a deflationary or recessionary gap.

On the other hand, if G is a negative figure (P smaller than A), prices tend to rise and we call this situation an inflationary gap.

Variations in the Potential GNP

While potential GDP is fixed at a given moment, it changes over time. Capital investment, innovation, a larger and more productive labor force among other factors cause a growth in P over time. Unfortunately it is also possible that disinvestment, excessive emigration, wars or natural disasters may cause a fall of P over time. But let’s look at the bright side: the value of P during the years 1950 to 2000 in the developed economies grew constantly. As for developing areas, we find very different situations; in some P grew much faster and in others at a much slower rate than in developed areas.

I will show you a picture illustrating the tendency of P and how A moved around P over time in the world at large, oscillating from inflationary to deflationary gaps and vice-versa. The graphic is not based on actual figures, it is intended to illustrate the general growth tendency of P and the fluctuation of A around P.

The goods and services not produced during the deflationary gaps are lost forever. The value of this negative G is sometimes called the deadweight loss of unemployment.

Macroeconomics concentrates in explaining and finding ways to minimize the GDP gap, while the branch of economics which aims to explain the long-term trend in potential GDP is called growth theory.

Basic Assumptions for building a Macroeconomic Model

As we said before, we need to build a simple model. To that end, we need some simplified assumptions.

1. In macro, we assume that there is a single productive sector. The output of this single sector is homogeneous; it produces the same good. We imagine that there are many competitive firms all producing the same good. All these firms are aggregated and form a single productive sector. When national output expands or contracts, this single sector represents all sectors which expand and contract together.

We used the word "goods" above in a general sense of physical products and services. However as a matter of convenience in general the single producing sector is analyzed as if it were a manufacturing industry.
2. Rather obviously, if we assume that only a single good is produced and sold, we also assume that all aggregate expenditure is spent on this single product.

STUDENT: Is the government part of the productive sector?

WRITER: In macro we ignore whatever production the government itself does, and we assume that...

3. Government is treated as a purchaser of the output of private industry

STUDENT: I see the need of such a simple model, but is it not too simplified?

WRITER: Well, it is not meant as a description of reality, it is a theoretical abstraction. In this way we can simplify our study maintaining the basic nature of the situation we are analyzing.

STUDENT: Returning to the assumption that all expenditure is made on a single product, is that also realistic?

WRITER: Let me make an important point. The assumption is that all expenditure has the same effect on the GDP. We are not assuming that the motivation of all consumption is the same. In fact macro is very much concerned with the different motives for the various expenditure flows.

Introducing some "short run" confusion

The concept of the "short run" is different in micro than in macro economics. In micro short run is used to describe the period when a firm has a fixed amount of capital and can only change its inputs of labor and materials.

In macro short run is the period during which there is a GDP gap. This of course means that the "short" run can in fact last several years.

In macro, the short run is the period it takes the economy to return to its potential GDP once it has deviated from it.

STUDENT: Quite confusing indeed, Writer.

WRITER: True. To create some more confusion, let’s define the long run in micro and in macro. In the case of micro it is not too hard: since we said that "in micro short run is used to describe the period when a firm has a fixed amount of capital and can only change its inputs of labor and materials", it is natural to call long run the period during which the firm can change its capital.

In macro the long run is the period during which the economy is producing at its potential level (GDP gap equal to zero). This situation can be static (potential output does not change) or dynamic (potential output changes).

A few more assumptions... but these are only temporary!

1. The price level is fixed. This is so for prices of end products as well as for all inputs.
2. The economy is assumed to have excess (unused) capacity. It could be perfectly possible to produce more goods and services with the existing stock of capital and labor. Under these conditions, the only factor affecting the aggregate output is demand, since there are no restrictions on the productive side.

STUDENT: Any special reasons for assumption # 2?

WRITER: Yes. The first is historical; macro was invented to help solve the big problems recessions caused to society. The second reason is that in general macro analysis is needed more in a situation of recession. Full employment (GAP zero) situations are not considered an urgent problem, and during booms people are in general rather happy.

STUDENT: True, but a zero G may not necessarily be good; it may be an equilibrium situation where most people have a job but are poor nonetheless. And as for booms, people may be happy while they last, but policy makers should be aware that a recession will eventually occur and act accordingly.

WRITER:. Very good thinking. But remember we are only starting. Your former concern is addressed by growth theory. And assumption #2 is also valid if we are studying a boom situation, since demand is also an important determinant of production during this "short run in the macro sense" situation of positive G.

3. For a very short time, we will assume that the economy is closed. Under conditions of zero imports, exports and international payments, domestic expenditure and domestic output are exactly the same.
4. Also for a short time, we will have no government purchases or taxes.

STUDENT: So what is left on this model?

WRITER: A single productive sector producing an homogeneous output. Prices are fixed. There is no government acting in the market, and the economy is closed. A totally fixed structure.

STUDENT: Let me rephrase my question. What is left that can be dynamic in this model?

WRITER: Something very important: the effect of aggregate final expenditure (demand) on GDP. Since from the first days of macro it was assumed that recessions and depressions were caused by a lack of demand, the focus was concentrated on this factor as the single variable.

Examining Aggregate Expenditure

We already know that GDP is equal to the four components of expenditure: consumption, investment, government and net international trade.

Le me introduce the concept of desired expenditure, also called planned or intended expenditure. It is important to stress that these concept does not refer to what people would desire or plan to spend if they had an imaginary income; it refers to what people desire (plan, intend) to spend with the purchasing power they actually can command.

Naturally, actual expenditure does not necessarily coincide with planned expenditure. There may be deviations in the total as well as in the components; reality often causes intended expenditure to change from one component to another. A firm may produce a quantity of consumer goods expecting a certain demand and if the actual demand is lower the result will be an increase in unintended and undesired investment in inventory.

National income accounts measure actual expenditures in each of the four components (consumption, investment, government and net international trade).

The theory of GDP determination studies the desired expenditures in those four categories.

As said before, while in our model the effect of the expenditures is the same since all go to purchase the same single output, the motivations for the spending are different, and the agents doing the spending are different.

Desired consumption expenditure

WRITER: Now please tell me something, Student. What can you do with the money you receive as disposable income?

STUDENT: Well, it is not a lot, but I can pay rent, buy food and clothing, go to the cinema, and so on. I spend my income the same way most people do.

WRITER: Fine. Apart from spending it, you could also save part of your income, of course. But what else could you do with your income, apart from spending or saving?

STUDENT: I can’t think of any other alternative.

WRITER: Naturally, because there isn’t any other alternative. Disposable income can only be spent or saved. Once you decide how much to spend, you have actually decided how much to save, and vice-versa.

We said that in the economy decisions to spend and to invest are made by different people for different reasons.

Now the subject of our study is to determine why people decide how much to spend and how much to save. The different factors influencing people may be classified in two categories,

1. The consumption function, and
2. The saving function

The consumption function

Consumption and disposable income

In our simple model, since there are no taxes, disposable income is equal to national income. We will talk about the effect of taxes later on.

Rather obviously, consumer expenditure is in direct relationship with disposable income. But although this is true in general for most individuals, the way in which this relationship works is quite different.

We can simplify the study by describing two prototypical individuals.

The first individual spends all his or her disposable income, and as this income varies, so does the amount spent.

The second type of individual plans for the future and his or her spending is related to long-range expectations of income. Part of the income can go to savings, but also sometimes this person will borrow to maintain a living standard, paying back the debt later as income increases. By the same token a temporary fall in income will be supplemented by the utilization of savings, again to maintain the usual standard of living.

In short, the first individual’s spending will be very closely related to his or her disposable income, while the second individual’s spending will not vary substantially in the short run with fluctuations of disposable income.

And now, allow me to mention the ideas of John Maynard Keynes.

STUDENT: I was wondering when you would do it. A course in economics, much less in macro, without mentioning JMK would be unthinkable, wouldn’t it?

WRITER: Possibly, because Keynes developed the basic theory of macroeconomics and gave his name to a school of thought called Keynesian economics. Nowadays there are several so-called non-Keynesian schools of thought in economics. But in the opinion of this writer, this is not exactly true. All those schools of thought are basically Keynesian, the only difference being that some are "more Keynesian than others".

The Keynesian consumption function is based on the assumption that all individuals belong to the "spend all my income" category. This is natural given that Keynes wrote during the Great Depression and actually at that time the immense majority of people did exactly that. And since the basic reasoning was that the Depression was caused by a failure of demand, and there was no chance of motivating people to spend more because they were already spending all their income, Keynes recommended government deficit spending as the only remedy. Much later Franco Modigliani and Milton Friedman won a Nobel prize for describing the "prudent individual" consumption function (life-cycle theory or permanent-income theory).

STUDENT: If you allow me to introduce a thought, Writer, I feel that in reality most people behave in both ways, over time. There is no such clear-cut division.

WRITER: True, especially when income is higher that the minimum to cover basic needs. Up to that point, in general people have no other choice that to spend all their income.

In our simplified model we will use the Keynesian consumption function; more sophisticated functions will be used later. In general, we will see that in most countries and most of the time the personal disposable income and the consumer’s expenditure series are closely related.

STUDENT: For my benefit, would you summarize what the "consumption function" is?

WRITER: Of course. It is the relationship between consumption and the variables that influence it. In our simple model, consumption is determined almost exclusively by disposable income.

St. Thanks. But what about people who have zero income? They have to consume something, at least some food.

WRITER: Of course. They may borrow or use savings or get some type of help. We call this type of consumption autonomous because it exists even if the person has no income. The "normal" consumption which is related to income we call induced because it is a function of income.

The propensity to consume

* Average propensity to consume

The definition is very simple: TC/TDI=APV. In other words, APV (Average Propensity to Consume) equal total consumption TC over (divided by) total disposable income TDI. If TDI=1000 and TC=900, the average propensity to consume is 0.9. Which simply means that at this level of TDI people spend 90% of their disposable income.

* Marginal propensity to consume

MPC is the change in TC produced by a change in TDI . If TDI increases from 1000 to 1100, and TC changes from 900 to 950, the marginal propensity to consume at this point is 50/100=0.5; it means that at this point, people will spend half of the change (increase in this case) of their TDI.

Please, student, what is your common sense perception of the behavior of consumption and savings as disposable income rises?

STUDENT: Assuming that I am an average person, I would both spend more and save more as my disposable income rises. At my present "level of poverty" I would spend more and continue saving nothing for a time. Then, as my income continues to rise, I would save more in total and as percentage of my income.

WRITER: Excellent. In academic terms, as disposable income rises, both total consumption and savings rise. Marginal propensity to save (the opposite of marginal propensity to consume) also rises at each point of the TDI curve.

STUDENT: Right. Let me see if I understood. Let’s assume that at a given time I am earning $10,000 and saving 10% of my income. If I land a better job with a 50% salary increase to $15,000 I will be inclined to save 15% of my income instead of just 10% as before.

WRITER: Correct, understanding that your figures are just to illustrate the situation, not realistic figures. And we are of course assuming the your increase in salary was in real terms, meaning that the general level of prices did not change.

The Saving Function

Since we know that a person has only two possible things to do with disposable income, spending it or saving it, we can deduce that the Saving Function relationship with total disposable income is exactly the same as the relationship of the Consumption Function.

The average propensity to save and the marginal propensity to save are exactly parallel to their "cousins" in the Consumption function.

Wealth and the Consumption function

Simply put: if you are or feel richer, you will spend a higher proportion of your disposable current income, since you feel safe due to your wealth. This "wealth effect" on consumption was believed to be the main driver of the consumption boom of the 1990’s, as the stock markets created a lot of paper wealth. Strangely enough, the crash of 2000 did not substantially reduce consumption in the US. Can this be interpreted as that the wealth effect does not exist? Not really. Value of stock portfolios sank, but prices of homes increased. Interest rates fell, and people refinanced the mortgages on their homes at lower rates, which put more cash into their pockets, an increase in disposable income.

Investment expenditure

This is the most volatile component of the GDP. As firms detect a possible decrease in demand and therefore in sales and profits, they modify their "desired investment expenditure". Using the 2000 recession in the US as example again, it was basically caused by a fall in investment, not in consumption. Consumers for several years "saved" the economy from falling into a severe depression by maintaining their spending pattern.

Influence of the real interest rate in investment

Here again a common sense conclusion is that investment tends to be in inverse proportion to the real interest rate. The higher the interest rate, the less inclined firms will be to invest, and vice-versa.

Equilibrium GDP

If at a given point firms are producing the same aggregate value of goods that are effectively demanded, the GDP is at equilibrium at that point. The word effectively means that consumers and firms desire and are able to make this level of aggregate consumption and investment expenditure.

The equilibrium level of GDP means that the aggregate desired expenditure equals total output. If the former is higher than the latter, the GDP will tend to rise, and vice-versa.

STUDENT: Why?

WRITER: Because as demand increases firms will see their sales and profit margins grow and will start investing to expand production facilities, and will hire more workers. And vice-versa, of course.

STUDENT: I can draw two conclusions from your explanation. First that Economics is not purely an exact or mathematical science, because while numbers are important, the basic reason things happen in an economy are due to people’s behavior in different circumstances: decisions to spend, to invest, etc.

WRITER: Right. Economics (if a science at all) is a behavioral science. And the second conclusion?

STUDENT: That I see Keynes’ point very clearly. An increase in aggregate desired consumption expenditure will push the equilibrium level of the GDP up. During a depression desired investment expenditure will not respond immediately but eventually it will also increase. We shall then have an increased total aggregate expenditure tending to rise the equilibrium point of the GDP.

WRITER: Very well. The question now is how much should a government stimulate the economy to help it get out or recession or to grow at a sustainable rate without excessive inflation?

No one has an exact answer to that, and one of the reasons why is something called the multiplier.

The Multiplier

A simple example. The government loans firm A $10,000 to expand a plant. This will initially add $10,000 to the GDP. But as the firm spends the money, it will go to more wages and profits for suppliers, which will increase demand and in turn motivate other firms to invest. Calculating the exact number of the multiplier is difficult because it depends on several factors as the marginal propensity to consume at this point of GDP. In more sophisticated models we would see that some industries, such as auto manufacturing and construction, have a higher multiplier than others basically because they demand a lot of components from other industries. For now, it will be sufficient to:

1. Grasp the concept of the multiplier; the final result of an increase in spending has an effect in total spending and GDP higher that the value of the initial increase.
2. Understand that the multiplier M is inversely proportional to the Marginal Propensity to Save: M=1/MPS. This formula is called the Simple Keynesian Multiplier.

And now let us go relax, if you are tired.

GDP in an open economy with government

2009-03-03T08:17:00.000-08:00

TEACHER: In this module we will start to relax some of the assumptions we made before when we designed a simple model of GDP.

You surely recall that the Simplified Model of GDP (also called the Simple Keynesian Model) assumed an economy with no government, no foreign trade, a fixed price level, and excess capacity.

You will also remember that in the Simplified Model we explained that:

GDP = aggregate domestic product = aggregate domestic income.

We now will make the model more realistic, and for that purpose in this Module we will relax the assumption that there are neither government nor foreign trade.

STUDENT: What will this expanded model allow us to do?

TEACHER: The following:

1. Adding the government sector allows us to study fiscal policy.
2. Adding the foreign trade sector allows us to study the effect of imports and exports on the GDP equilibrium level.

STUDENT: Let me guess: in the following module you will relax the other two assumptions, a fixed price level and excess capacity.

TEACHER: Right. But some key elements will remain unchanged. Let me tell you which:

Unchanged Key Elements

The following key elements of the theory remain unchanged:

1. Aggregate desired expenditure can be divided into autonomous and induced, The latter depends on (is a function of) the level of national income.
2. The equilibrium level of GDP is the level at which the aggregate desired expenditure is equal to output.
3. The Simple Multiplier is the measure of the changes in the equilibrium GDP caused by a unit change in autonomous domestic expenditure. It is called "simple" because it is assumed that the price level does not change.

Government expenditure and gross domestic product

In the simple Keynesian model we built in Module 2, we assumed that government spending was not going to affect the consumption function or the level of intended investment. That is, in our very simple model government spending did not change the intended (desired) propensity to consume or invest at each level of income.

STUDENT: Which of course was not realistic.

TEACHER: True, but as I said before, a theory must be developed in steps, and explaining it in this way helps in understanding it.

Now suppose that the government purchases say $100 billion worth of goods and services, independently of the level of the GDP (an autonomous expenditure, independent of the level of national income). We must distinguish here between purchases and "transfer payments", the latter being payments made by the government without receiving a good or service in return, like unemployment insurance, welfare payments, pensions, etc. There is no doubt that adding those $100 billion to the private expenditures on consumption and investment results in a higher level of desired spending.

Remember: No foreign sector here yet, so at this point we can say:

1. Total Intended Spending (IS) = Consumption IS + Investment IS + Government IS. Remember also: The equilibrium level of GDP is the level at which total intended (desired) spending equals GDP.
2. The formula in point 1 shows that as we add Government Intended Spending, the equilibrium value of the GDP increases.

Let me show you a figure:
In Figure B203_1, on the horizontal axis we have the value of the GDP. On the vertical axis we have the value of Aggregate Desired Spending (ADS).

The 45° line is the value of Equilibrium GDP.

STUDENT: Why is it that when the value of equilibrium GDP is plotted on a graphic, it always results a 45° line?

TEACHER: Because we defined the equilibrium level as the point where GDP equals aggregate desired demand. This means that each point of the line is a point where GDP = ADS

In line C we have plotted the Consumption Function: Intended Consumption at each level of GDP.

When Intended Investment is added to Consumption we can plot line C + I., and as we add Government Intended Expenditure, the line is C+ I + G.

Summing up: The C + I + G line is Aggregate Desired Spending (ADS); the Equilibrium Level of GDP is where ADS = GDP. This means that the equilibrium level in the graphic is where line C + I + G intersects the 45° line.

Effect of Increased Government Spending

STUDENT: OK, I see that government spending increases the equilibrium level of GDP. What happens if government expenditure fluctuates?

TEACHER: We will establish what happens to the equilibrium level of GDP if government expenditure changes. To illustrate this situation graphically, let me show you.... well, a graph, what else!
In Figure B203_2 we see the C + I + G line representing the Aggregate Desired Spending (ADS) at a given moment.

If government expenditure increases, the line "shifts to the left" as represented by line C + I + G1; it now intersects with the 45° line at a higher level of GDP, the new higher equilibrium level of GDP.

Obvious conclusion: more government spending increases the equilibrium level of GDP.

The contrary is naturally true also: less government spending diminishes the equilibrium level of GDP.

This we can see represented by line C + I + G2 which is the original line "shifted to the right" that now intersects with the 45° equilibrium line at a lower level of GDP.

Multiplier effect of Government Spending

The multiplier effect of Government Expenditure is the same as the effect of consumption or investment expenditure.

Effect of taxes on GDP

We will speak of taxes as being net of transfer payments, since the latter are not expenditures by the government but a transfer of purchasing power from tax payers to people who receive the payments. Thus transfer payments will be reflected in the disposable income and affect desired consumption indirectly.

Let’s assume for simplicity that all tax revenues come from personal taxes, and that the average tax rate is 20% (remember, net of transfer payments). The effect of such a tax is a reduction of 20% in aggregate disposable income DI.

Without taxes, DI was equal to GDP; with the 20% tax, DI now equals 80% of GDP.

The reduction of DI affects the Consumption Function because people must spend less at each level of equilibrium GDP than before.

Here is a graphic representation:
We can see in Picture B203_3 that the tax rate has changed the slope of the consumption function; it has pivoted and the slope is less steep. It now intersects the 45° equilibrium line at a lower level of GDP. The effect of a tax is then a reduction of the equilibrium level of GDP.

We can also easily conclude that the higher the increase in the tax rate the larger the decrease in the equilibrium level of GDP will be. We can also see in the picture that the decrease will not be proportional: there was not a parallel shift to the right of the line, but a non-parallel change of slope.

This is because the higher the income tax rate, the smaller the simple multiplier (and vice-versa, of course).

The Budget Balance

The budget balance is the difference between total government revenue and total government expenditure. When revenues exceed expenditure, the government is running a budget surplus. When expenditures exceed revenues, the government is running a budget deficit. When expenditures are equal to revenues, the government has a balanced budget.

Government spending is part of the "autonomous" aggregate expenditure. This is so because government spending does not depend on the level of personal income.

Fiscal Policy

A very large part of government expenditure has no relationship with fiscal policy. The amount of money spent on bureaucracy, health services, road maintenance, etc. is to a high degree fixed.

But the government can marginally increase or diminish expenditure, and make changes in the tax rate, pursuing a macroeconomic goal: avoiding undesirable booms and recessions.

We have already seen that if the government increases expenditure, the aggregate desired expenditure curve shifts to the left intersecting the 45° line at a higher level of GDP. On the other hand, higher taxes tend to lower the equilibrium level of GDP.

Knowing this, it is easy to deduce in what direction government spending and tax rates should move to counter a negative tendency towards an unsustainable boom or a depression. This procedure is called a stabilization policy.

If the economy is moving towards a boom, less government spending and more taxation are advisable. If the economy is heading to a depression, more spending and less taxation are the remedy.

STUDENT: Sounds very simple. Why is it then that we still have booms and depressions?

TEACHER: It is easy to determine the direction of the correction. But the problem is to define the right timing, the size of the changes in the variables, and the mix of spending and taxation changes that will do the job. You will often hear or read on the news that government corrective measures were "too little too late", "or too much too early".

And let me stress that when we discuss changes in government spending we mean that this is done without changing aggregate tax revenue. We have seen that taxes have a negative effect on the GDP. If government were to "increase spending" and finance the increase by rising more taxes, or reduce expenditure while diminishing tax revenue by the same amount, the effect of the changes in expenditure would be very small.

The Keynesian Revolution

Until Keynes presented his proposition that governments can avoid or get out of a recession by stimulation aggregate demand, economists and policy makers believed that in a recession the government should "save" and spend less. This procedure of course worsened recessions by diminishing aggregate desired expenditure still more.

STUDENT: But saving sounds like a reasonable thing to do in crisis times.

TEACHER: Remember what we said in Module I about the fallacy of composition. In a recession, when salaries fall and unemployment is a menace, it is wise for a family to reduce expenditure and save "for a rainy day". But what is good for individuals is often not good for the aggregate of individuals. When feeling threatened by a depression people save for their own good, but in acting so they worsen the recession and eventually harm themselves too. Now, if the government also reduces its expenditure, the situation is a deflationary spiral: as the recession gets worse, people and government save more, the recession gets worse, and in response economic actors save more, and so on. A real vicious circle.

Keynes’ ideas created a revolution in economic thought. The concept that "GDP can get stuck at a level below its maximum potential (large unemployment) and that the remedy could be to use fiscal policy to direct the economy towards its potential level is still called "the Keynesian revolution".

We will examine fiscal policy in more detail in a following Module.

Including the Balance of Trade (BT) in the Simple Keynesian Model

It is time to relax the assumption that our economy is closed, with no foreign trade.

We will add the effect of the BT to the formation of GDP. BT is the difference between Imports (I) and Exports of goods and services (X). In a formula it is expressed as BT = (X – I)

With the addition of the foreign sector, we now say that GDP is equal to consumption plus investment plus government spending plus balance of trade. Expressed by means of a formula,

GNP = C + I + G + (X - I).

Some textbooks use the expression "Net Exports" for the Balance of Trade concept.

Macro is interested in how the value of the BT or Net Exports responds to changes in the exchange rate, the price level and national income.

Exports are autonomous or exogenous expenditures because they depend on the decisions of foreigners of how much to import.

We can then safely assume that gross exports are not related to changes in GDP in the exporting country

On the other hand, imports depend on the decisions of local residents; they are the ones who decide how much to spend. We also know that normally many locally produced goods include imported materials.

In conclusion, we can say that...

1. Since consumption rises with income, as income increases the resulting higher consumption will include more foreign components (a higher value of imports).
2. Higher imports will negatively affect BT (the balance of trade), also called "net exports".

We can then say that the net export function is the negative relationship between net exports and national income; that is to say, as income increases net exports diminish.

Changes in the Net Export Function

We can easily identify the major factors that affect the level of net exports:

1. Foreign income. With the usual proviso that "other things are equal", a change in income in other countries will tend to affect local exports. Higher foreign income will increase demand for local exports, and vice-versa.
2. Relative international prices.

1. If local prices fall relative to foreign prices, foreigners will be more inclined to import, and local exports will increase as a result. This tendency to a higher level of net exports will be re-enforced by the fact that local residents will tend to replace foreign products and purchase more local substitutes.
2. If local prices rise relative to foreign prices, by the same reasoning the level of net exports will fall.

STUDENT: What causes these changes in relative international prices?

TEACHER: Basically, in the short run, inflation and exchange rates. In the long run other factors may appear, such as changes in productivity due to investment, innovations and training of labor.

Now we will show the effects of Net Exports on the GDP equilibrium level in graphical form.
In Figure B203_4 we see line C+I+G representing aggregate desired spending without considering the balance of trade ("net exports", i.e. eXports less Imports)

When net exports (NE) are added, we notice that:

1. If NE is a positive number (exports higher than imports), the line shifts to the left and intersects the 45° line at a higher level of GDP.
2. If NE is a negative number, the line shifts to the right and intersects the 45° line at a lower level of GDP.

It is also important to notice how changes in the value of net exports affect the equilibrium GDP level.

Let’s look at this picture:
In Figure B203_5 we can very clearly see the effect of changes in the value of net exports: as net exports rise, so does the equilibrium level of GDP.

Well, it’s time for a break. See you in next module!

The Changing Price Level. Aggregate Demand and Aggregate Supply

2009-03-03T08:11:00.000-08:00

TEACHER: Hello, Student. In this Module we will refine our model of national income (GDP), making it more realistic and sophisticated.

STUDENT: Let me guess. We are going to abandon the assumption that the price level is constant, right?

TEACHER: Right. Because practically every situation affecting the economy will affect both the real GDP and the price level.

STUDENT: Do you mean to say that there will be changes in the GDP measured at constant prices (the real GDP) as well as changes in the nominal GDP (the GDP at current prices)?

TEACHER: Exactly. And to do that we need to abandon our assumption that national output depends exclusively on demand. This will permit analyzing situations where the economy is working close to full employment (potential GDP). And to this end we need more tools. Since we will have to study how aggregate demand and supply react to price changes, we will need the help of the aggregate demand and the aggregate supply curves.
Now, do you have one of your intelligent questions at this point?

STUDENT: Sure. What happens to equilibrium GDP when there is a change in the price level?

TEACHER: Good question. We will assume that the changes in the price level are exogenous, that they are caused by factors external to our economy, like the rise in price of imported products.

Changes in Consumption

Changes in the price level will necessarily affect desired consumption. If the price level increases, people will tend to consume less, and vice-versa.

STUDENT: Sounds like an obvious situation. As products and services become more expensive and if disposable income remains fixed, people will have less purchasing power and spend less.

TEACHER: Not exactly. They could still spend the same money for less products. The desired expenditure curve is not a function of prices, but a function of national income and of the propensity to spend.

The main reason why an increase in prices drives the desired expenditure curve downwards is the wealth effect. People save for long-term goals like retirement. A rise in the price level reduces the real value of their assets and savings. In order to recover these losses, people will tend to save more. The propensity to save will increase and obviously the propensity to spend will diminish. Thus, the desired consumption function will move to the right, causing the same movement in the aggregate expenditure curve.

STUDENT: Will you show me one of your nice pictures with a graphic representation of what happens to the Aggregate Expenditure when there is a change in the price level?

TEACHER: Sure, here it is:
In Figure B204_1 we see the line representing Aggregate Expenditure at initial price level. We also see that at an increased price level, the line shifts to the right and intersects with the 45° line at a lower level of GDP.
Now, can you tell me what happens if the price level diminishes?

STUDENT: Easily. The AE line shifts to the left and intersects the 45° line at a higher level of equilibrium GDP.

TEACHER: Very well. Now we will discuss what happens to net exports when the domestic price level changes.

Changes in Net Exports

When goods produced locally in country A become more expensive, consumers will demand more imported substitutes. By the same token, foreigners will be less inclined to purchase goods imported from country A since they will have increased in price.

Can you tell me what will happen to net exports when the domestic price level rises, and how this will influence the aggregate expenditure curve?

STUDENT: Yes, I guess I can. Exports will fall, imports will rise; in consequence, net exports will fall. This will cause the aggregate expenditure to shift downwards (to the right).

TEACHER: Very well. We can conclude that an increase in domestic prices will negatively affect the desired consumption curve and net exports. The sum of both individual effects will be reflected in the Aggregate Expenditure curve, which will intersect with the 45° line at a lower equilibrium level of GDP. A decrease in domestic prices will cause the opposite to happen.

STUDENT: May I add the usual proviso, "if all other exogenous variables are constant"?

TEACHER: You are already speaking like a macroeconomist. You are right, in economics we usually analyze each variable while assuming the rest to be constant.

Now let us begin to discuss the Aggregate Demand curve.

STUDENT: Just a second, please. What is the difference between the aggregate expenditure and the aggregate demand curve?

TEACHER: The desired expenditure curve is related to national income (GDP) at a given price level. The aggregate demand curve relates each combination of equilibrium GDP with different price levels.

Please take a look at this picture:
In Figure B204_2i we see how equilibrium GDP is determined by the Aggregate Expenditure AE curve at price levels 1, 2 and 3. The resulting equilibrium GDP values are GD1, GD2 and GD3.

In Figure B204_2ii we have plotted the same three GDP levels and the corresponding price levels 1, 2 and 3. The points of intersection define the Aggregate Demand AD curve.

STUDENT: By looking at both parts of Figure B204_2 I notice that a change in the price level causes:

1. a shift of the AE curve and,
2. a movement along the AD curve.

Am I right?

TEACHER: That is correct. The AD curve shows, for each price level, the associated equilibrium GDP. For instance, in our Figure B204_2, at price level 2 the equilibrium level of GDP would be GDP 2.

STUDENT: And the AD curve slopes downward and to the right for the same reason that the demand curve of any good has this shape: higher price, less demand. Right?

TEACHER: Wrong. That would be a fallacy of composition. The case of particular goods can not be applied to the aggregate prices and output of the economy.

STUDENT: I see, but the AD curve slopes downward and to the right anyway.

TEACHER: Yes, but for different reasons. The basic one is that increases in the price level will push interest rates up while the quantity of money in the economy is fixed. And increases in the interest rate tend to reduce output as people and businesses restrict borrowing for investments or purchases.

Changes in the AD Curve

You mentioned yourself, rightly, that changes in the price level produce movements along the AD curve.

But if something alters the equilibrium GDP at a given price level, the result will be a shift of the AD curve.

In general, we can say that a change in the amount of autonomous desired consumption, investment, government or net export expenditure at a given price level, will cause a shift of the AD curve.

STUDENT: And it will shift to the right if the changes are increases, and to the left if the changes are decreases. True?

TEACHER: True. These shifts are called aggregate demand shocks. For instance a large lowering of tax rates while government spending is maintained will cause an expansionary demand shock and create a boom (inflationary gap) in the economy.

The Aggregate Supply Curve

The aggregate supply (AS) curve indicates the level of GDP that will be supplied at price level. We have two types of AS curves: the short-run and the long-run curve. In the short run prices of all inputs (labor and materials) are fixed, while in the long run they will adjust to the new general level of prices.

Let me show you another picture:
Now, would you mind describing what you see in Figure B204_3?

STUDENT: I’ll try. First of all I observe that the curve slopes upward and to the right (other things being equal, of course!). And this time I will avoid the fallacy of composition, and will not tell you that this is so for the same reason that an individual good’s AS curve has this shape. So, you tell me why, Teacher.

TEACHER: The curve has this shape because since we assume that in the short run prices of inputs are unchanged, firms will make a higher profit by supplying a higher output if the price level of their produce goes up. But what else do you notice about the AS curve in the figure?

STUDENT: Well, I see that the short-run AS curve gets steeper as output rises. It is close to the horizontal on relatively low levels of output and gets steeper and steeper as output increases. Why, I do not know.

TEACHER: Your observation is correct. And the reason is that at lower levels of output it is likely that idle capacity is called into production. As output increases more and more, firms finally have employed most idle capacity and it becomes more and more expensive to increase production, no matter how much prices rise. Eventually the curve will get close to vertical.

STUDENT: Just a second! Didn’t you say before that prices of all inputs where stable in the short run?

TEACHER: Right. But this does not mean that unit prices remain unchanged. The average price level does not change, but as output increases less efficient machinery and workers are utilized, and this increases marginal unit costs.

Anyway, let me tell you that the shape of the AS curve is a somewhat controversial subject. Some economist, as the ones belonging to the "New classical economists" school founded by Lucas, Sargent and Wallace, maintains that the short-run AS curve is always vertical.

STUDENT: There is always a bunch of economists hoping to win a Nobel prize by inventing something obvious. To me, there is no difference: it depends on the point of the curve you start with. If the level of prices starts to rise when there is idle capacity, the curve will have the shape shown in Figure B204_3. If prices start to rise close to full capacity, then the slope will be vertical. It’s that simple.

TEACHER: I’ll nominate you, dear Student, to the Nobel Prize. You are probably right Now, let us continue.

National Output and the Price level

We will now combine the AS and the AD curves in the same graphic:
What can you deduce from Figure B204_4?

STUDENT: Well, what I can see is that the equilibrium level of prices and GDP are at the intersection of the AS and the AD curves.

TEACHER: Good observation. Now that we understand the use off aggregate supply and demand curves, we can take a look at specific examples and analyze them.

First let’s discuss the "Great Crash" of 1929. The US and the developed world economies prospered in 1928 and part of 1929. There was low unemployment and an investment boom, especially for equipment to manufacture in quantity new products such as autos, trucks, radios, electricity generating equipment, etc. In October 1929 the stock market collapsed and the economy in the US fell into a deep depression, with unemployment rate reaching a staggering 25%. The depression was mainly the result of a fall in gross domestic investment.

STUDENT: Well, I read that there was also a fall in consumer demand. This is a natural consequence of unemployment, people consume less if they lose their jobs, or are afraid of losing them.

TEACHER: Correct. There also was a widespread failure of banks, and many people lost their savings. Plus people who had invested in stocks saw their paper wealth disappear. Understanding the concept of aggregate demand and supply you can see why the economy fell into a deep depression, since the AD curve shifted violently to the left and the new equilibrium level of the GDP was much lower.

As we have already mentioned, the government of the US did not act wisely (Keynes had not published his theory yet). Nor did the government of other countries; the US and all developed countries implemented tariff barriers for imports. Each country tried to protect local producers. The aggregate result of these ultra-protectionist measures was a collapse of international trade and as a result all economies suffered still more. When F.D.Roosevelt became President he succeeded in implementing some Keynesian policies, against a strong resistance from traditional politicians and businessmen. But although there was some improvement, the US did not completely emerge from depression until after the beginning of World War II.

In preparation and during the war, the government spent huge amounts of money and the economy was over-stimulated. Can you tell me using AD and AS curves what happened?

STUDENT: The AD curve shifted to the right, and this must have created a strong upward pressure on the price level.

TEACHER: Very well. To resist the inflationary pressure the government implemented price controls. This policy may work in the short run to keep prices from rising, but the underlying "repressed" inflation eventually takes its course. Between 1945 and 1948 the consumer price index rose 34%.

STUDENT: Can we discuss unemployment now? Because after all, one of the main objectives of policymakers is keeping unemployment as low as possible.

TEACHER: Certainly, but first let me tell you that we can identify three types of unemployment:

* Frictional unemployment is the result of some people working only part of the year, young people looking for their first job, or workers who quit or are fired and are looking for a new position.
* Structural unemployment is the result of:

1. A part of the potential labor force not being skilled enough to do the jobs for which there is demand, and
2. The economy being stuck for long periods at an equilibrium GDP level below potential.

* Cyclical unemployment, due to short or medium term business cycle fluctuations.

Unemployment imposes high costs to an economy. We can speak of economic costs, like the goods and services lost forever during the "deflationary gap" periods when equilibrium GDP is below potential. And of course, there are important non-economic human costs. Unemployed people and their families are under strong emotional pressure in the industrialized world where holding a job is not only an economic question but also a measure of social prestige and self-image, and of course material hardship is also a very probable occurrence.

Very well, let’s stop here.

GDP, the Price Level and Fiscal Policy

2009-03-03T08:06:00.000-08:00

TEACHER: Hello, Student! Let me ask you a personal question, please. Did you ever ask an employer for a salary rise?

STUDENT: Yes, a few times. Why?

TEACHER: Did you notice any difference in reactions to your requests according to how the economy was performing at the time?

STUDENT: I see your point. Obviously, it was much easier to get a rise during a boom than during a recession.

TEACHER: Good observation. The prices of all inputs (labor and materials) tend to increase at boom times and to fall during depressions.

STUDENT: Can we say then that "prices of inputs change with the prevalent conditions in the economy"? And I guess this is an important factor to be taken into account in any economic analysis.

TEACHER: The answer to both is yes. As you will recall, when observing the effects of changes in aggregate demand and aggregate demand shocks , for the sake of simplicity we had assumed that input prices did not change.

In a longer term observation we have to study the changes in prices induced by changes in the GDP.

STUDENT: Sounds like a useful approach... but why is it useful?

TEACHER: Because with this more elaborate model we can find out the causes and consequences of the business cycle, and discuss the right fiscal policy measures to stabilize the economy.

Student, you have a good memory. Can you recall how we defined "potential GDP"?

STUDENT: Surely. Potential GDP is the total output possible when all available means of production are employed. And let me add "at their normal rates of utilization".

TEACHER: Very well. You will surely also recall that when the actual output does not coincide with the potential one, we have a GDP (output) gap.

Now let me make a statement on changes in potential output over time.

Over a period of several years, changes in potential GDP may be very important. But over a shorter period (say, 1 year) normally the change is relatively small.

STUDENT: So we will continue to ignore the changes in potential GDP caused by changes in productivity over a one year period.

TEACHER: Right. And since you are so alert today... can you tell me what is the sole element causing variations in the GDP gap if we assume there are no changes in potential GDP?

STUDENT: Yes, I can. The GDP gap will change according to the movements of the actual GDP line around the fixed potential GDP. Nicely pictured in figure B202_1, in Module 2 of this course.

TEACHER: Correct. We will now discuss the effects of changes in input prices

Input Prices and the Output gap

Please take a look at Figure B205_1 below.
Figure B205_1 has two parts, i and ii. In both parts we can see the potential GDP level represented by a vertical line and the SRAS (Short-run aggregate supply) curve. Both are the same in either part of the figure.

In part i the AD (Aggregate demand) curve intersects the SRAS curve at a point below potential GDP. The difference is the "output gap" illustrated by the two-point arrow, in this case a deflationary gap (prices are pushed downwards)

This creates a downward pressure on the price level of inputs; the price level is lower that it would be if the AD curve intersected the SRAS at the equilibrium level (potential GDP).

In part ii the AD (Aggregate demand) curve intersects the SRAS curve at a point above potential GDP. The difference again is the "output gap" illustrated by the two-point arrow, but in this case it is an inflationary gap.

This creates an upward pressure on the price level of inputs; the price level is higher that it would be if the AD curve intersected the SRAS at the equilibrium level (potential GDP).

STUDENT: OK, let me see. The output gap is a good indication of the pressure of demand on input prices.

If GDP is higher than potential output, demand for input will be high, and vice-versa. In other words, when we see an inflationary gap actual output exceeds potential and there will be an upward pressure on input prices. And vice-versa, of course.

But I have a question, does this affect all inputs?

TEACHER: The relationship is true for all inputs. But the degree of pressure may change according to the availability of each input. Labor for instance is usually an input whose total availability can not change rapidly, and once it is fully employed it is hard to get additional supply.

Let’s discuss the effect of the GDP gaps on wages (labor costs).

The effect on wages depends very much on the legal environment and the relative forces of labor unions. In the US there is little legal restraint on firing people or reducing wages; as for unions, there are great differences between industries. In many European countries on the other hand there are important legal restraints on firing and wage reduction.

There is no truly "right" answer to the question of which of these situations is better. Obviously the US economy is much more flexible in responding to changes in the output gap and thus the return to the equilibrium level is quicker than in most European countries. After a time most people are better of as the GDP returns to the equilibrium level. But it is also true that in the European system there is less human suffering in the short run.

STUDENT: And what about firm’s profits?

TEACHER: Naturally profits tend to diminish during a deflationary gap and to increase during an inflationary gap, a "boom".

But returning to wages, it is a fact that in industrial economies labor costs tend to grow more rapidly during a boom than they fall during a recession. Again this is due mostly to legal or union enforced impediments to reduce wages.

STUDENT: This is true, because people resist reductions in nominal wages. If a worker earns $5 and hour he will strongly resist getting paid $4, and the government and the unions will usually support him. But I have noticed that there is a lot less resistance to reductions in real wages. Our worker may not resist as much or get the same support from government and unions if he gets the same $5 an hour but due to the inflationary pressure on prices his purchasing power is reduced by 20%.

TEACHER: Very true, and reducing real wages via inflation and eventual devaluation of the currency is common, because it is politically easier to attain that reducing nominal wages and avoiding inflation.

The long-run effects of aggregate demand shocks

Expansionary shocks

Let’s imagine that we are on an almost ideal situation; the economy is operating at a stable price level at full employment, as we can see represented in Figure B205_2 part i, when the Aggregate Demand curve is AD1.
Now something happens to disturb this idyllic picture; we can imagine that there is a sudden and sizable increase in autonomous demand due to say a boom in investment spending.

In the same part i of the figure we see the first effect of this change.

The Aggregate Demand curve is now AD2 . Starting from full employment, the AD curve shifts upwards along a given SRAS curve. There is an increase in GDP, and as output expands beyond its normal capacity, there is pressure on the input price level and prices go up.

In part ii of the figure we see the next effect, delayed in respect to the previous one: as prices of inputs go up, the SRAS curve shifts upwards. Prices are higher at every level of output.

Notice that the shift of the SRAS curve causes GDP to fall along the AD curve. This process does not stop until actual output falls back to its potential level, but now at a higher price level.

STUDENT: Your explanation shows that a one time expansionary shock, starting from full employment, causes an inflationary shock. And eventually actual GDP is equal to potential again, at a higher price level. I also interpret that trying to get more output and income from a full employment economy via an increase in expenditure is possible only for a short time, and with the consequence of creating inflation.

TEACHER: Almost completely correct. And I say "almost" because we must distinguish between the one-time increase in prices created by a one-time increase in expenditure, and spiraling inflation.

In the case we are discussing, you can see in part ii of the figure that once the economy has returned to its potential output, the inflationary gap disappears. There is no more inflation. There is an "automatic" adjustment mechanism that over time eliminates the inflationary pressure, and prices stabilize... but at a higher level than before.

STUDENT: I guess we can summarize by saying that increasing expenditure when actual GDP is below potential may produce a sustainable increase in output at stable prices. The same increase in expenditure under full employment only produces a temporary increase in output that soon returns to equilibrium level at a higher price level.

TEACHER: True. The only way to increase output permanently over and above the full employment level is to increase productivity.

STUDENT: Sure. If we start from full employment and for some reason we begin to obtain more output out of the same labor force, this gain in productivity will mean that potential GDP increases. But this is normally a slow process, right?

TEACHER: Relatively slow, yes. Historically we can observe periods of almost no gain in productivity in industrial economies, contrasting with improvements of the order of 3 to 4% a year in other periods.

Deflationary shocks

Starting again from the ideal position of full employment at equilibrium GDP we will now discuss the results of a sudden fall in autonomous expenditure, such as a reduction in investment or exports.

For this analysis we will have to distinguish between a flexible and inflexible wage environment. Let’s begin with a flexible wage situation first.
Figure B205_3 has two parts. Part i is similar to Figure B205_2, because we start from the same equilibrium situation. As the AD curve shifts downwards from AD1 to AD2 , price level falls as well as actual GDP, and a recessionary gap opens. Slowly the SRDS curve, responding to the fall in input prices and wages, shifts rightwards, as shown in part ii of the figure. Eventually the recessionary gap closes, and the actual GDP is again at equilibrium but at a lower price level that when the fall in AD started.
STUDENT: This seems to be again an automatic stabilization process at work. But of course it means lower wages and a lower standard of living for workers. And what happens if due to government and/or labor union pressures wages do not fall?

TEACHER: In this case the economy will stay in the position shown in part i of the figure for an indefinite time. There will be unemployment but the workers who keep their jobs will earn the same as before. From a social point of view, societies have to make a difficult decision. Which is better, return to full employment at lower wages, or maintain the level of wages for some workers while others have no jobs?

Anyway, wages are "sticky" not only due to government and/or labor union pressures. Employers are also reluctant to reduce wages because they are afraid of de-motivating efficient employees, and of other consequences such as getting a reputation of ruthlessness.

In any case, the rightwards shifting of the SRAS is normally slow and not sufficient to close the deflationary gap. Normally, if the economy is to return to a situation of equilibrium (actual equal to potential output), it becomes necessary to shift the AD upwards.

STUDENT: Nice. No one would suffer. We go back to full employment at the previous level of wages. But easier said than done, I presume.

TEACHER: Let’s discuss this question in the following paragraph.

Fiscal Policy and the Business Cycle

As you know, macro was developed not just to explain the business cycle but mainly to find solutions to avoid or at least minimize fluctuations and the consequent human suffering during depressions. Keynes and his followers argued that fiscal policy was the tool to use to achieve counter-cyclical effects. Later on macro included monetary policy as an effective counter-cyclical element. But we will discuss monetary policy later on. Presently we will concentrate on fiscal policy.

Discretionary Fiscal Policy

This is the name given to fiscal policy when changes in tax rates and government expenditure are made deliberately with the purpose of stabilizing the economy as close as possible to full employment at equilibrium GDP level.

We have already mentioned that determining the direction of changes in fiscal expenditure and taxes is not difficult. Do you remember, Student?

STUDENT: Of course. In a recession government must increase spending and or reduce taxes, and vice-versa. These measures cause a shift of the AD curve in the desired direction.

TEACHER: Correct. The problem consists in determining when and how much to change tax rates and expenditure; that is, in determining the right moment and the right amount of the changes to be made in the mentioned variables. It is easy to err on either side: to soon, too late, too much, or too little fiscal policy actions.

But anyway it is better to have a counter-cyclical tool, no matter how imperfect, than not having any tool as was the case before Keynes.

Let me finish this Module by mentioning the paradox of thrift. We have already discussed the fallacy of composition, of which the paradox of thrift is a special case. But may be you can take over from here, Student.

STUDENT: Sure. A classical example of the fallacy of composition is the case of a short person sitting in a theater. If this person stands up, he or she will see much better. But if everyone else in the theater stands up, the short person is worst off than before.

Applied to saving vs. spending decisions, saving may be good for individuals or firms as long as few of them do it. But if a sizable proportion of firms and individuals increase savings, our "famous" AD curve will shift downwards and to the left, opening a deflationary gap... and everyone will be worst off than before.

TEACHER: Very well. And this is the end of Module V. See you later!

Money and monetary policy

2009-03-03T08:02:00.000-08:00

TEACHER: This module starts with a subject that fascinates most people: Money!

We will discuss the nature of money and the workings of the banking system.

STUDENT: I agree that money is a fascinating commodity, but... the banking system? Banks and bankers are rather boring, aren’t they?

TEACHER: Not really once you understand the important functions of the banking system, one of which is the creation of money. Most people don’t know this, but if you allow me to continue, I will elaborate on this rather intriguing effect of the banking system.

What is Money?

Student, do you want to try and define money?

STUDENT: Well, these printed paper bills I have in my pocket are certainly money.

TEACHER: And how can you be so sure of that?

STUDENT: Because in my experience any person or institution in this country will accept them in payment of purchases or cancellation of debts.

TEACHER: You have given me the best possible definition of money. "Money is whatever commodity people accept as such". Roman soldiers were paid their wages with salt (this is the origin of the word salary). Historically many different things have been used as money.

Naturally in modern economies money is a more subtle commodity. Paper bills and coins are money, of course, but there are other forms such as bank deposits.

We will define money by describing its uses rather than its many different physical forms.

Medium of Exchange

The best known use of money is its acting as medium of exchange. Firms and persons exchange their goods and services for something called money, and they do this because they have faith that this money will in turn be accepted by other firms and persons in exchange for goods and services. Can you thing of an alternative to the use of money in commerce?

STUDENT: The only alternative would be barter, the direct exchange of goods and services for other goods and services. Definitely not a very practical alternative.

TEACHER: True. Only very primitive economies could subsist without some type of money.

Standard of Value and Store of Value

We say that money acts as a standard of value because all prices are expressed in a given quantity of money. Assuming our money is the US dollar, we can find out the price of any good or service in US dollars. Money prices indicate the relative value of goods and services. If a suit costs $200 and a pair of shoes $100, we immediately notice that the value of a suit is twice the value of a pair of shoes.

Money also acts as a store of value. People hold money because they intend to buy goods and services in the future.

STUDENT: You mentioned the US dollar as an example of money. I can think of many other "currencies", such as the Euro, the Yen, etc. These types of money are accepted by millions of people. But do they have a "real", objective value?

TEACHER: No. Money is a social invention. Only because they were scarce, metals such as gold and silver were used as money for many centuries. Paper money was first invented only as a convenience: instead of having to carry metallic coins, people used a paper "receipt" that could be exchanged for a given quantity of metal. In other words, paper currency was backed by metal, normally gold or silver.

But nowadays practically no money has any specific backing other that the faith people have on the issuer of the money, normally the government of a country through a national "central bank". It is "fiat" money.

STUDENT: I thought Fiat was a car manufacturer.

TEACHER:. Very funny. I am sure you know that "fiat" means "faith" in Latin. And if you didn’t... now you know!

The Supply of Money

It is rather difficult to define exactly what is and what is not money. But we can easily state a "narrow definition" of money, because all people and firms accept that coins, paper money, checking accounts and other demand deposits are money.

STUDENT: Demand deposits? Please clarify the concept.

TEACHER: A bank deposit from which any part of the balance can be withdrawn immediately just by demanding it, without any delay or condition.

Now let me say that the aggregate amount of coins, bills, demand deposits and checking accounts is the supply of money, "narrowly defined".

Let me give you a rough estimate of the relative weight of each of these types of money in a typical industrial economy:

1. Demand deposits: 36%
2. Bills and coins 25% (not held by commercial banks or the Central Bank)
3. Checking accounts 38%
4. Other (traveler’s checks, etc.) 1%

Naturally these proportions change over time and from one economy to the other. In the US the quantity of money has increased very year, at rates varying form 5 to 10% a year.

STUDENT: Since you have explained the narrowly defined money supply, I am sure there is also a "broadly defined" money supply. Right?

TEACHER: That is correct. Let me tell you that the former is called M1 and the latter M2. M2 includes M1 plus Certificates of Deposit (CDs), money market bank balances and money market fund balances. You can see that we have added to M1 (money instantly usable) other types of money which can not be used instantly. CDs and money market funds can only be used at a certain future date, or after a specific waiting time after requesting it.

STUDENT: I would say the M2 minus M1 is "almost money". It can not be used to make purchases at will, but it is still money because it can be used as such in the future.

TEACHER: Yes. You probably also noticed that the definitions of M1 and M2 are arbitrary. We could include other types of assets in M2; but in most countries M1 and M2 are defined as described above. We will in the future refer to M1 as the "money supply" in an economy.

The Banking System

As promised, I will now discuss how banks operate. There are different types of banks. But we will look at the ones most influential in the workings of the monetary system:

Commercial Banks

These banks have two basic functions. They:

1. Hold demand deposits and allow checks to be written against these deposits.
2. Lend money to persons and firms

There are also other types of institutions with different names whose functions overlap with those of commercial banks to a significant degree: savings and loan associations, building societies, consumer finance companies, insurance companies, etc. All of them basically act as intermediaries between economic actors who "save" (defer the spending of the money) and others who demand money for immediate consumption or investing.

STUDENT: I am looking forward to your explanation of how banks can create money!

TEACHER: To be more precise, it is the banking system rather than individual banks that creates money. The key to this mechanism is "fractional-reserve banking". Imagine that you deposit $1,000 in a commercial bank. The bank will keep a fraction of your deposit (say $200) as reserve, and lend the remaining $80. The minimum percentage of deposits commercial banks must keep as reserves is usually fixed by the Central Bank: the legal reserve requirement.

STUDENT: I guess the basic reason for a legal reserve requirement is to make sure the bank does not fail.

TEACHER: Only partially. A badly run bank may fail even with a 25% reserve while a well run bank may operate safely with just a 2% reserve. One important reason for legal reserve requirements is to control the supply of money.

STUDENT: Fine, but I still do not see how banks... sorry, the banking system, can create money.

TEACHER: OK, here we go.

How the Banking System creates Money

The process by which the banking system creates money is called the multiple expansion of deposits.

Many individual bankers deny that banks can create money. After all, they truly claim that they can lend only a fraction of the money they receive in deposits.

But let’s see what happens if Mr. Jones has just received $1000 in cash as interest on a government bond. Mr. Jones goes to bank A and deposits this amount.

Assuming the legal reserve is 20% of deposits, Bank A can now lend $800 to Mr. Smith. Bank A has already increased the money supply by $800: now Mr. Jones still has access to his $1000, and Mr. Smith can spend his $800 loan.

STUDENT: This means that an individual bank can create money after all!

TEACHER: Yes. But the process goes on. No one takes a loan to leave the money in the bank. Most likely Mr. Smith will spend his $800 and the recipients will in turn deposit them in some bank. For simplicity, let’s assume the full amount is deposited in Bank B. This bank can now expand its lending by the 80% of 800, or $640. If it lends $640 to Miss Petersen, the money supply has increased by

* $800 to Mr. Smith
* $640 to Mr. Petersen

that is, by a total of $ 1440.

STUDENT: But there must be a limit to this, otherwise the money supply would expand indefinitely.

TEACHER: Right. Let’s look at:

The Multiple Expansion Of Bank Deposits And Its Limits

In an economy where most money is kept in banks rather than in cash, the described process will continue to a certain point. In our example where the legal reserve requirement is 20%of deposits, each of the intervening banks can increase the money supply by 20% less than the previous one. If we make the calculation, we will find out that the initial deposit of $1000 in new money can expand the money supply by a maximum total of $5000.

It’s not a miracle, nor a mysterious process. It is the result of fractional reserve banking and the intensive use of banking by the public.

And now, let’s move on to discuss monetary policy.

The Central Bank (Federal Reserve or Fed in the US) and Monetary Policy

Monetary Policy is the sum of actions the Central Bank takes to control the supply of money and interest rates.

Changing the Money Supply

The money supply has influence on the GDP and the general level of prices. Can you guess what the effect of these changes is?

STUDENT: I think so. Increases in the money supply should tend to rise both the real GDP and the price level, while a reduction on the money supply should have the reverse effect. But my concern is... to what extent will an increase in the money supply push the real GDP up, and to what extent will it only push up prices?

TEACHER: In the short run the result depends on the slope of the aggregate supply curve: the steeper it is, the greater the effect on prices and the smaller on real GDP. In the long run the effects of changes in the money supply only affect the price level, not the real GDP.

When a recession seems imminent and business is soft, the central bank usually increases the money supply and pushes down interest rates. That is, it "eases credit" or "eases money," as the common expression is. On the other hand, when the economy is in danger of overheating and inflation threatens, the central bank often pushes up interest rates. That is, in common language, it "tightens credit or "tightens money."

In designing monetary policy, the government’s objectives generally are to attain or maintain reasonably full employment at moderate inflation.

Nor all economists agree that the discretionary policies described above are the best to achieve these objectives. But we shall postpone a discussion of this controversy.

STUDENT: I know there is not total agreement on how to best use monetary policy. But in any case it is useful for me to know how the central bank can make changes in the money supply.

TEACHER: Right. The monetary authorities can influence the money supply by managing the reserves of the banking system. Imagine this: the monetary authorities want to increase the money supply more rapid1y than they would normally. How can they attain this objective?

STUDENT: Let me guess. By providing the banks with plenty of excess reserves, true?

TEACHER: Correct. Excess reserves enable the banks to increase the money supply, as we have seen when discussing how banks create money.

How the monetary authorities can increase the reserves of the banking system will be discussed later on.

Now suppose that the Federal Reserve decides to reduce, or slow the rate of growth, of the money supply. It can do so by slowing down the rate of increase of bank reserves.

Functions of a Central Bank

As we have seen, in the US the functions of a Central Bank are performed by the Federal Reserve. Every major country or economic area has a Central Bank; the bank of England, the Bank of Japan, the European Central Bank.

The basic responsibilities of a Central Bank are:

* Holding the reserves of commercial banks.
* Performing the collection of checks between banks ("clearing").
* Issuing money in the form of coins, bills, or bank deposits.
* Supervising commercial banks.

OPEN MARKET OPERATIONS

Government securities constitute a large proportion of the assets held by the Federal Reserve Banks in the US. Similar situation exists in other major central banks. The market for government securities is huge and well developed. The Federal Reserve is part of this market and whether it is buying or selling-and how much- can have a heavy impact on the quantity of bank reserves. Actually the most important means the Central Bank has to control the quantity of bank reserves (and thus the quantity of excess reserves) are the open market operations, which is the name given to the purchase and sale by the Federal Reserve of U.S. government securities in the open market.

STUDENT: I read that the Bank of England also buys and sells "gilt edged" securities. What are they?

TEACHER:. As you know, the Bank of England is the central bank of Great Britain (at least while the UK does not become part of the Euro region). The Bank buys and sells not only government securities but also securities issued by top private companies; these are called "gilt edged" securities.

Now let me elaborate on the effect of the central bank’s open market operations.

BUYING AND SELLING SECURITIES

Suppose that the Federal Reserve buys $10 million worth of government securities in the open market and that the seller is IBM.

In this transaction, the Fed receives $10 million in government securities and gives IBM a check for $10 million. When IBM deposits this check to a Bank, the bank's demand deposits and reserves increase by $10 million. Obviously the consequence is an increase in the money supply.

The contrary effect is achieved by selling securities in the market. When the central bank sells securities, it delivers say bonds and receives money in payment. This money is withdrawn from the banking system and the "creation of money" effect works in reverse; the money supply falls.

USA: THE FEDERAL OPEN MARKET COMMITTEE

We said that open market operations are the Fed's most important method for controlling the money supply. The Fed adds to bank reserves when it buys government securities and reduces bank reserves when it sells them. Obviously, the extent to which the Federal Reserve increases or reduces bank reserves depends in an important way on the amount of government securities it buys or sells. The greater the amount, the greater the increase or decrease in bank reserves.

In the US the power to decide on the amount of government securities the Fed should buy or sell at any given moment rests with the Federal Open Market Committee. This group wields an extremely powerful influence over bank reserves and the nation's money supply. Every three or four weeks, the Federal Open Market Committee meets to discuss the current situation and trends and gives instructions to the manager of the Open Market Account at the Federal Reserve Bank of New York, who actually buys and sells the government securities.

CHANGES IN LEGAL RESERVE REQUIREMENTS

Open market operations are not the only means the Federal Reserve has to influence the money supply. Another way is to change the legal reserve requirements. In other words, the Federal Reserve Board can change the amount of reserves banks must hold for every dollar of demand deposits.

The effect of an increase in the legally required ratio of reserves to deposits is that banks must hold larger reserves to support the existing amount of demand deposits. This in turn means that banks will have to sell securities, refuse to renew loans, and reduce their demand deposits to meet the new reserve requirements.

CHANGES IN THE DISCOUNT RATE

Another way that the Federal Reserve can influence the money supply is through changes in the discount rate. Commercial banks can borrow from the Federal Reserve when their reserves are low (if the Fed allows it).

This is one of the functions of the Federal Reserve. The interest rate the Fed charges the banks for loans is called the discount rate, and the Fed can increase or decrease the discount rate whenever it chooses. Increases in the discount rate discourage borrowing from the Fed, while decreases in the discount rate encourage it.

The discount rate can change substantially and fairly often.

When the Fed increases the discount rate (relative to other interest

rates), it makes ¡t more expensive for banks to augment their reserves by borrowing from the Fed; hence it tightens up a bit on the money supply.

On the other hand, when the Fed decreases the discount rate, it is cheaper for banks to augment their reserves in this way; hence the money supply eases up a bit.

The Fed is largely passive in these relations with the banks. It cannot

force the banks to borrow. It can only set the discount rate and see how many banks show up at the "discount window" to borrow. Also, the Fed will not allow banks to borrow on a permanent or long-term basis. They are expected to use this privilege only to tide themselves over for short periods, not in order to re-lend at a profit. To discourage banks from excessive use of the borrowing privilege, the discount rate is kept relatively close to short term market interest rates.

Monetary Policy and the Aggregate Demand Curve

Monetary policy has an important effect on the aggregate demand curve, as we mentioned before.

Please take a look at this picture:

When aggregate demand is AD1 at price level P0 we have an inflationary gap and price level will soon push upwards till it reaches P1. At this point the central bank reduces the supply of money and the aggregate supply curve shifts to the left to AD2. In this was the inflationary gap is reduced and the new equilibrium price will be P2, closer to the current price level P0.

Here as usual the problem is how much to tighten the money supply to stay as close as possible to full employment and avoiding inflation without overshooting and causing a recession.

We have covered the subject matter of this Module. Go to the Q&A part when you are ready.

Exchange Rates and the Balance of Payments

2009-03-03T08:00:00.000-08:00

TEACHER: The relative value of different currencies is highly variable. In 1985, a dollar was worth about 3 German marks; in 1994, it was worth only about 1.5 German marks. Why was this change of importance to tourists or to exporters or importers? This is one of the subjects of this Module. The Euro fluctuated from ca. 0.80 to 1.49 US dollar per EUR in the first five years of its existence (The euro was launched on 1 January 1999 as an electronic currency and became legal tender on 1 January 2002)

We must consider several other questions:

1. What are exchange rates, and how are they determined?

2. How are international business transactions carried out?

3. Should there be fixed or flexible exchange rates?

4. What problems have afflicted the international monetary system in recent years?

International Transactions And Exchange Rates

Suppose you want to buy a book from an European publisher, and the book costs 20 euros. To buy the book, you must somehow get euros to pay the publisher, since this is the currency in which the publisher deals. Or, if the publisher agrees, you might pay in dollars, but the publisher would then have to exchange the dollars for euros, because its bills must be paid in euros. Whatever happens, either you or the publisher must somehow exchange dollars for euros, since international business transactions, unlike transactions within a country, involve two different currencies.

If you decide to exchange dollars for euros to pay the European publisher, how can you make the exchange?

STUDENT: The answer is simple. I can buy European euros at a bank.

TEACHER: Correct. And the European euros have a price (expressed in dollars). The bank may tell you that each euro you buy will cost you $0.98. This makes the exchange rate between dollars and euros .98 to 1, since it takes .98 dollars to purchase 1 euro.

In general, the exchange rate is simply the number of units of one currency that exchanges for a unit of another currency.

STUDENT: What determines the exchange rate? Why is the exchange rate between European euros and U.S. dollars what it is?

TEACHER: Good questions. Let me answer them:

Exchange rates under the gold standard

We’ll discuss a bit of the history of exchange rates.

Let's see how exchange rates were determined under the gold standard, which prevailed before the 1930s. If a country was on the gold standard, a unit of its currency was convertible into a certain amount of gold. Before World War 1 the dollar was convertible into one-twentieth of an ounce of gold, and the British pound was convertible into one-quarter of an ounce of gold. Thus, since the pound exchanged for 5 times as much gold as the dollar, the pound exchanged for $5. The currency of any other country on the gold standard was convertible into a certain amount of gold in the same way; to see how much its currency was worth in dollars, you divided the amount of gold a unit of its currency was worth by the amount of gold (one-twentieth of an ounce) a dollar was worth.

The Foreign Exchange Market

The gold standard is long gone. After many decades of fixed exchange rates (discussed later), the major trading nations of the world began to experiment with flexible exchange rates in early 1973.

Let's consider a situation where exchange rates are allowed to fluctuate freely, like the price of any commodity in a competitive market. In a case of this sort, exchange rates, like any price, are determined by supply and demand. There is a market for various types of currencies - American dollars, European euros, British pounds, Japanese yen, and so on - just as there are markets for any other commodity.

The Demand And Supply Sides Of The Market

Let's look in more detail at the demand and supply sides of the market using the dollar vs. the euro as example. On the demand side are people who want to import European goods into the United States, people who want to travel in Europe (where they'll need European money), people who want to make investments in Europe, and others with dollars who want European currency for different reasons.

The people on the supply side are those who want to import U.S. goods into Europe, Europeans who want to travel in the United States (where they'11 need U.S. money), people with euros who want to invest in the United States, and others with euros who want U.S. currency for other reasons.

When Americans demand more European goods, the price (in dollars) of the European euro will tend to increase. Thus the result will be an increase in the equilibrium price (in dollars) of an euro. Conversely, when the Europeans demand more U.S. goods, the price (in dollars) of the European euro will tend to decrease.

Appreciation And Depreciation Of A Currency

Two terms frequently encountered in discussions of the foreign exchange market are appreciation and depreciation. When Country A's currency becomes more valuable relative to Country B's currency, Country A's currency is said to appreciate relative to that of Country B, and Country B's currency is said to depreciate relative to that of Country A. This use of terms makes sense. Since the number of dollars commanded by an euro increased, the euro became more valuable relative to the dollar and the dollar became less valuable relative to the euro.

Note that such a change in exchange rates would not have been possible under the gold standard. Unless a country changed the amount of gold that could be exchanged for a unit of its currency, exchange rates were fixed under the gold standard. Sometimes governments did change the amount of gold that could be exchanged for their currencies. For example, in 1933 the United States increased the price of gold from $21 an ounce to $35 an ounce. When a country increased the price of gold, this was called a devaluation of currency.

Determinants Of Exchange Rates

STUDENT: We saw that flexible exchange rates are determined by supply and demand. But what are some of the major factors determining the position of these supply and demand curves?

TEACHER: Let me describe the most important ones:

Relative price levels

In the long run, the exchange rate between any two currencies may be expected to reflect differences in the price levels in the two countries. To see why, suppose that Europe and the United States are the only exporters or importers of automobiles and that automobiles are the only product they export or import.

If an automobile costs $10,000 in the United States and 10,000 euros in Europe, what must be the exchange rate between the dollar and the euro? Clearly, an euro must be worth one dollar, because otherwise the two countries' automobiles would not be competitive in the world market. If an euro were set equal to 1.50 dollar, this would mean that a European automobile would cost $15,000 (that is, 10,000 times $ 1.50), which is far more than what a U.S. automobile would cost. Thus foreign buyers would obtain their automobiles in the United States.

Based on this theory, one would expect that if the rate of inflation in Country A is higher than in Country B, Country A's currency is likely to depreciate relative to Country B's.

Relative rates of growth

Although relative price levels may play an important role in the long run, other factors tend to exert more influence on exchange rates in the short run. In particular, if one country's rate of economic growth is higher than the rest of the world’s, its currency is likely to depreciate. If a country's economy is booming, this tends to increase its imports. If a country's imports tend to grow faster than its exports, its demand for foreign currency will tend to grow more rapid1y than the amount of foreign currency that is supplied to it. Consequently, its currency is likely to depreciate.

Relative interest rate levels

If the rate of interest in Europe is higher than in the United States banks, multinational corporations, and other investors in the United States will sell dollars and buy euros in order to invest in the high-yielding European securities. Also, European investors (and others) will be less likely to find U.S. securities attractive. Thus the euro will tend to appreciate relative to the dollar, since the demand curve for euros will shift to the right and the supply curve for euros will shift to the left. In general, an increase in a country’s interest rates leads to an appreciation of its currency, and a decrease in its interest rates leads to a depreciation of its currency. In the short run, interest rate differentials can have a major impact on exchange rates, since there is a huge amount of funds that is moved from country to country in response to differentials in interest rates.

STUDENT: I assume inflation is also a factor, except in the very short run. Otherwise the speculators would be falling into a trap, confusing nominal with real interest rates.

TEACHER: You are certainly right. This is an important consideration.

STUDENT: And under flexible exchange rates, what ensures a balance in the exports and imports between countries?

TEACHER: Let's take a look at:

The Adjustment Mechanism Under Flexible Exchange Rates

Under flexible exchange rates, the balance is achieved through changes in exchange rates. Suppose that for some reason Britain is importing far more from the US than the US is from Britain. This will mean that the British, needing dollars to buy American goods, will be willing to supply pounds more cheaply. Or, from Britain's point of view, the price (in pounds) of a dollar will have been bid up by the swollen demand for imports from the United States.

Because of the increase in the price (in pounds) of a dollar, American goods will become more expensive in Britain. Thus the British will tend to reduce their imports of US goods. At the same time, since the price (in dollars) of a pound has decreased, British goods will become cheaper in the United States, and this will stimulate Americans to import more from Britain. Consequently, as the US currency appreciates in terms of the pound -or, to put it another way, as the pound depreciates in terms of the dollar- the British are induced to import less and export more. Thus there is an automatic mechanism (just as there was under the gold standard) to bring trade between countries into balance.

Fixed Exchange Rates

Although many economists believed that exchange rates should be allowed to fluctuate, very few exchange rates really did so in the period from the end of World War II up to 1973. Instead, most exchange rates were fixed by government action and international agreement. Although they may have varied slightly about the fixed level, the extent to which they were allowed to vary was small. Every now and then, governments changed the exchange rates, for reasons discussed below, but for long periods of time, they remained fixed.

If exchange rates remain fixed, the amount demanded of a foreign currency may not equal the amount supplied, forcing government intervention to keep the exchange rate fixed.

Types Of Government Intervention

To maintain exchange rates at their fixed levels, governments can intervene in a variety of ways. For example, they may reduce the demand for foreign currencies by reducing defense expenditures abroad, by limiting the amount that their citizens can travel abroad, and by curbing imports from other countries.

When exchange rates are fixed, mismatches of this sort cannot be eliminated entirely and permanently. To deal with such temporary mismatches, governments enter the market and buy and sell their currencies in order to maintain fixed exchange rates. Take the case of post-World War II Britain. At times the amount of British pounds supplied exceeded the amount demanded. Then the British government bought up the excess at the fixed exchange rate.

At other times, when the quantity demanded exceeded the amount supplied, the British government supplied the pounds desired at the fixed exchange rate. As long as the equilibrium exchange rate was close to (sometimes above and sometimes below) the fixed exchange rate, the amount of its currency the government sold at one time equaled, more or less, the amount it bought at another time.

But in some cases governments have tried to maintain a fixed exchange rate far from the equilibrium exchange rate, but such a situation can not go on indefinitely.

Balance-of-Payments Deficits And Surpluses

Under a system of fixed exchange rates, economists and financial analysts look at whether a country has a balance-of-payments deficit or surplus to see whether its currency is above or below its equilibrium value.

STUDENT: What is a balance-of-payments deficit? What is a balance-of-payments surplus?

TEACHER: I will explain, since it is important that both these terms be clearly understood.

The Balance-Of-Payments Deficit

If a country's currency is overvalued (that is, if its fixed price exceeds the equilibrium price), the quantity supplied of its currency will exceed the quantity demanded.

In a situation of this sort, there may be a run on the overvalued currency. Suppose that speculators become convinced that the country with the balance-of-payments deficit cannot maintain the artificially high price of its currency much longer because its reserves are running low. Because they will suffer losses if they hold on to a currency that is devalued, the speculators are likely to sell the overvalued currency in very large amounts, and thus cause an even bigger balance-of-payments deficit for the country with the overvalued currency. Faced with the exhaustion of its foreign exchange reserves, the country is likely to be forced to allow the price of its currency to fall.

The Balance-of-Payments Surplus

If a country's currency is undervalued (that is, if its price is less than the equilibrium price), the quantity demanded of its currency will exceed the quantity supplied..

While a country with an overvalued currency is likely to be forced by the reduction in its reserves to reduce the price of its currency, a country with an undervalued currency is unlikely to be forced by the increase in its reserves to increase the price of its currency. And a country with an undervalued currency often is reluctant to increase the price of its currency, because of political pressures by its exporters (and their workers), who point out that such a revaluation would make the country's goods more expensive in foreign markets and thus would reduce its exports. Consequently, when exchange rates were fixed, countries with undervalued currencies were less likely to adjust their exchange rates than countries with overvalued currencies.

TEACHER: How do you think we could measure deficits and surpluses?

STUDENT: Well, if we are given the demand and supply curves for a country's currency, it is a simple matter to determine the deficit or surplus in its balance of payments. All we have to do is subtract the quantity demanded of the currency from the quantity supplied.

TEACHER: True, in theory. However, since we do not observe these demand and supply curves in the real world, this method of determining the deficit or surplus, while fine in principle, is not practical. The available data show only the total amount of the country's currency bought and the total amount of the country’s currency sold. Since each unit of the country's currency that is bought must also be sold, it is evident that the total amount bought must equal the total amount sold.

STUDENT: Given that this is the case, how can one identify and measure a balance-of-payments deficit or surplus?

TEACHER: The answer lies in the transactions of the country’s central bank. If the central bank’s purchases or sales of currency make up for the difference between the quantity demanded and the quantity supplied, it will purchase currency if there is a balance-of-payments deficit and sell currency if there is a balance-of-payments surplus. The amount it purchases or sells measures the size of the deficit or surplus. In other words, the official transactions of this country's government with other governments are used to measure the deficit or surplus. Rough1y speaking, this is how a balance-of-payments deficit or surplus was traditionally measured.

However, beginning in May 1976, the U.S. and other countries stopped publishing figures on the deficit or surplus in its balance of payments. Under the current regime of flexible exchange rates, changes in demand and supply for foreign exchange generally show up as changes in exchange rates, rather than in the transactions of the central bank.
Exchange Rates: Pre-World War II Experience

Now that we are familiar with a balance-of-payments deficit and surplus, we can begin to see how various types of exchange rates have worked out.

During the latter part of the nineteenth century, the gold standard seemed to work very well, but serious trouble developed after World War I. During the war, practically all the warring nations went off the gold standard to keep people from hoarding gold or from sending ¡t to neutral countries. After the war, some countries tried to reestablish the old rates of exchange. Because the wartime and postwar rates of inflation were greater in some countries than in others, under the old exchange rates the goods of some countries were underpriced and those of other countries were overpriced. According to the doctrines of David Hume, this imbalance should have been remedied by increases in the general price level in countries where goods were underpriced and by reductions in the general price level in countries where goods were overpriced.

But wages and prices proved to be inflexible, and, as one would expect, it proved especially difficult to adjust them downward. When the adjustment mechanism failed to work quickly enough, the gold standard was abandoned.

During the 1930s, governments tried various schemes. This was the time of the Great Depression, and governments were trying frantically to reduce unemployment. Sometimes a government allowed the exchange rate to be flexible for a while, and, when it found what seemed to be an equilibrium level, fixed the exchange rate there. Sometimes a government depreciated the value of its own currency relative to those of other countries in an attempt to increase employment by making its goods cheap to other countries. When one country adopted such policies, others retaliated; this caused a reduction in international trade and lending, but little or no benefit for the country that started the fracas.

The Gold-Exchange Standard

In 1944, the Allied governments (in World War II) sent representatives to the American city of Bretton Woods, New Hampshire, to work out a more effective system for the postwar era. It was generally agreed that competitive devaluations, such as occurred in the 1930s, should be avoided. Out of the Bretton Woods conference came the International Monetary Fund (IMF), which was set up to maintain a stable system of fixed exchange rates and to ensure that when exchange rates had to be changed because of significant trade imbalances, disruption was minimized.

The system developed during the postwar period was generally labeled the gold-exchange standard, as opposed to the gold standard. Under this system, the dollar -which had by this time taken the place of the British pound as the world's key currency- was convertible (for official monetary purposes only) into gold at a fixed price. And since other currencies could be converted into dollars at fixed exchange rates, other currencies were convertible indirect1y into gold at a fixed price.

During the early postwar period, the gold-exchange standard worked reasonably well. However, it was not too long before problems began to develop.

When exchange rates are fixed, a U.S. balance-of-payments deficit is evidence of pressure on the dollar in foreign exchange markets. During the period from 1950 to 1972 (the last on March 1973). representatives of the major trading nations met in Paris to establish a system of fluctuating exchange rates, and thus abandoned the Bretton Woods system of fixed exchange rates. This was a major break with the past, and one that was greeted with considerable apprehension as well as hope. However, the major trading nations did not go so far as to establish completely flexible exchange rates. Instead, the float was to be managed. Central banks would step in to buy and sell their currency. Thus the United States agreed that "when necessary and desirable" it would support the value of the dollar. Also, some European countries decided to maintain fixed exchange rates among their own currencies, but to float jointly against other currencies.
Fixed Versus Flexible Exchange Rates

STUDENT: Why, until 1973, did most countries fix their exchange rates rather than allow them to fluctuate?

TEACHER: One important reason was the feeling that flexible exchange rates might vary so erratically that it might be difficult to carry out normal trade. Thus U.S. exporters of machine tools to Britain might not know what British pounds would be worth six months from now, when they would collect a debt in pounds. According to the proponents of fixed exchange rates, fluctuating rates would increase uncertainties for people and firms engaged in international trade and thus reduce the volume of such trade. Moreover, they argued, the harmful effects of speculation over exchange rates would increase if exchange rates were flexible, because speculators could push a currency's exchange rate up or down and destabilize the exchange market. They argued further that flexible exchange rates might promote more rapid inflation, because countries would be less affected by balance-of-payments discipline.

Many economists disagreed, feeling that flexible exchange rates would work better. They asked why flexible prices are used and trusted in other areas of the economy, but not in connection with foreign exchange. They pointed out that a country would have more autonomy in formulating its fiscal and monetary policy if exchange rates were flexible, and they claimed that speculation regarding exchange rates would not be destabilizing. But until 1973, the advocates of flexible exchange rates persuaded few of the world's central bankers and policymakers.
STUDENT: How well have floating exchange rates worked?

TEACHER: Since 1973, exchange rates have been flexible, not fixed. However, there has been some intervention by central banks to keep the movement of exchange rates within broad bounds, but this intervention generally has not been very great. The result has been considerable volatility in exchange rates. The exchange rate between the dollar and the European euro has sometimes varied by 2 percent or more from one day to the next and by 15 percent or more over a period of several months. The value of the dollar (in terms of other major currencies) has gyrated substantially during the past 20 years.

Unquestionably, the variations in exchange rates, some of which are erratic and without fundamental economic significance, have made international transactions more difficult. Thus Renault, the French auto manufacturer, is reported to have hesitated to launch an export drive into the U.S. market because of the erratic behavior of the dollar-franc exchange rate.

Government and the Business Cycle

2009-03-03T07:59:00.000-08:00

TEACHER: Hi, Student. The macroeconomic model that we built in the previous Modules is useful to explain the causes of the price level and deviations of actual GDP from potential.

Now we will take a look at the cyclical nature of fluctuations in activity and the role of government in these cycles.

Student, you will recall that on our first Module you asked me why you should be interested in macroeconomics. Here is a comprehensive answer:

"Understanding the cyc1e in the economy is of vital importance for business because sustainable businesses have to ride out recessions as well as take advantage of booms".

STUDENT: I see why the cycle in the economy is now known as the 'business cycle'.

TEACHER: Good observation. Business cycles have been with us for almost as long as recorded history. The cyclical nature of economic activity has been equally apparent in recent times, and scholars have long tried to establish regularities in the data.

Some have tried to make a case for the existence of a long-wave cycle, with a duration of about fifty years from peak to trough.

However, when we refer to the business cycle today, we are talking about the shorter-term cycles in GDP, which usually have something in the range of five to ten years from peak to peak.

The macro model we built up in previous Modules was a static model. In that model, a single shock leads to a period of adjustment; the economy eventually returns to the potential level of real GDP.

Keynesian economists adopted the static analysis because they wanted to explain why the economy recessed while there was excess capacity and unemployment.

It is possible, however, to approach the problem with dynamic models that can generate cycles as ongoing phenomena. In such models, a single shock may generate cycles for some time, or cycles may be an intrinsic characteristic of the models even without external shocks.

In this Module we will:

* Observe some of the empirical regularities in business cycles.
* Review some of the economic analysis underlying many explanations of business cycles.
* Outline the approaches of different schools of thought in economics to the analysis of business cycles.

Characteristics of business cycles

No two business cycles are exactly the same, but there are a surprising number of similarities in most recent cycles.

Inflation And Unemployment

We have extensively discussed in previous Modules the determination of GDP and the price level. This discussion is very similar to the determination of slightly different measures of the same phenomena; unemployment and inflation.

Tell me please, Student, with what do you associate high unemployment?

STUDENT: High unemployment is associated with recessions, so when GDP falls below its potential level unemployment rises. Conversely, when output is above potential GDP, firms are running above normal capacity and unemployment tends to be low.

TEACHER: Correct. Inflation is the rate of change of the price level, so the same forces that cause the price level to adjust upwards will also tend to raise inflation.

The exact relationship between inflation and unemployment depends upon both structural factors in the economy and the nature of the shocks. An increase in aggregate demand, for example, is likely to increase inflation and reduce unemployment.

However, a supply shock that shifts the SRAS curve upwards to the left is likely to raise inflation and unemployment at the same time, as we have seen before.

If we look at unemployment and inflation in the major trading nations since 1963, we will observe that:

1. The dominant pattern in the 1980s (and probably also in the 1960s) was of a clear inverse relationship between inflation and unemployment, suggesting that shocks to aggregate demand were the key drivers of the cycle.
2. In the 1970s there were two clear shocks to aggregate supply, associated with major oil-price rises in 1973 and 1979; as predicted by the theory, these supply shocks led to rising unemployment at times of simultaneous high inflation -sometimes known as stagflation. Such dramatic shocks to aggregate supply as occurred in the 1970s are, fortunately, quite rare, so it is more likely that the dominant pattern over the business cycle will be the one shown in the 1980s and early 1990s of an inverse relationship between inflation and unemployment.

Industry Cycles

Business cycles are important for most firms because almost all sectors of the economy are normally affected at the same time. Most sectors (or industries) tend to have an increase in output during a boom and a fall in output during a recession.

Industrial sectors have very different volatility. Student, can you make an educated guess?

STUDENT: I would say that for instance, manufacturing is much more volatile than food, because people always have to eat.

TEACHER: Correct, but even the food sector has clear cycles. Those cycles are closely related to the cycle in the rest of the economy. Investment goods industries are generally among the most volatile.

One of the reasons that some sectors are more volatile than others relates to the nature of the products involved. As we have seen from the food sector, people have to eat even when times are hard; however, they do not have to eat out, so the restaurant business is high1y cyclical, while food manufacturing and retailing is relatively stable.

Another source of volatility relates to durability. Some products are bought infrequently and consume their services over an extended period of time. Such products include the capital equipment purchased by firms (investment goods) and the durable goods purchased by consumers. Durable expenditure is high1y volatile relative to non-durable expenditure. The reason for this is that purchases of durable goods (like cars, TVs, and hi-fi equipment) can be postponed when times are hard (as can the purchase of investment goods by firms.

STUDENT: I guess there is a kind of "repressed demand" for this type of goods, which will free itself when the situation improves.

TEACHER: True. But when times look good, a high proportion of extra spending will go on these luxury items. Necessities, like food and shelter, will be purchased basically under any circumstances. Thus, industrial sectors producing consumer durable goods will see much greater fluctuations in demand across the business cycle than sectors providing non-durable consumption goods.

Profits And Wages

We should also comment that profits tend to be highly variable and pro-cyclical. This is because during booms the demand for the output of firms is rising and firms are able to increase their sales volume, while also (possibly) increasing their profit margins (price minus unit cost). It is also generally true that money-wage rates tend to rise during booms as firms increase their demand for labor and the labor market tightens.

STUDENT: Booms are good for wage earners too, you mean.

TEACHER: Yes, but the share of wages in national income tends to fall during booms as the share of profit rises. Conversely, the share of profits falls sharply in recessions and the share of wages rises.

We now turn to theoretical explanations of business cycles.

Theories of the cyc1e

Systematic Or Random Shocks

In economies dominated by agriculture, cycles could be caused by weather patterns, over-planting followed by under-planting , or perhaps even cycles in the incidence of crop diseases. In industrial economies, cycles could result from patterns of innovation (product cycles) or waves of productivity improvements. There are certainly, also, cycles in demand for exports from open economies resulting from cycles in the rest of the world

Many empirical macro models have quite long lags in the timing between an occurrence and the expected consequences.. For example, if a fall in the rate of interest makes a new investment program profitable, it may take six months to plan it, three months to draw up contracts, six more months before spending builds up to its top rate, and another two years to complete the project. In the meantime, many other factors can appear and affect the cycle.

Cyclical Adjustment Mechanisms

There may be many ways of formulating a dynamic model of the economy so that it generates cycles. Here we outline one simple mechanism that can generate cycles in response to discrete changes in exogenous variables. It is called the multiplier-accelerator mechanism. No one believes any longer that it provides the explanation of cycles, though it probably captures one major element of cyclical fluctuations. To understand it, we need to return to a discussion of the causes of variations in investment.

The accelerator theory of investment

We have mentioned that investment changes in response to changes in interest rates. The accelerator theory of investment relies on another determinant of investment, real GDP.

The demand for machinery and factories is obviously derived from the demand for the goods that the capital equipment is designed to produce. If there is a demand that is expected to persist, and that cannot be met by increasing production with existing industrial capacity, then new plant and equipment will be needed.

Investment expenditure occurs while the new capital equipment is being built and installed. If the desired stock of capital goods increases, there will be an investment boom while the new capital is being produced. But if nothing else changes, and even though business conditions continue to look rosy enough to justify the increased stock of capital, investment in new plant and equipment will cease once the larger capital stock is achieved.

This makes investment depend on changes in sales, and hence on changes in GDP.

Taken literally, the accelerator proposes a mechanical and rigid response of investment to changes in sales (and thus to changes in GDP). It does so by assuming a proportional relationship between changes in GDP and changes in the desired capital stock, and by assuming a fixed capital-output ratio. Each assumption is to some degree questionable.

Yet accelerator-like influences do exist, and they play a role in the cyclical variability of investment. Modern investment theories often include a flexible version of the accelerator, in which the coefficient is a function of other variables such as interest rates.

Multiplier-accelerator interaction

The theory linking systematic fluctuations in GDP to systematic fluctuations in investment expenditure unites the accelerator theory just discussed with the version of Keynesian multiplier theory that sees the multiplier as a process working over time as successive rounds of induced expenditure build up in response to some initiating shock.

This multiplier-accelerator theory of the cycle is divided into three steps.

* First, a theory of cumulative upswings and downswings explains why, once started, movements tend to carry on in the same direction.
* Second, a theory of floors and ceilings explains why upward and downward movements are eventually brought to a halt.
* And third, a theory of instability explains how, once a process of upward or downward movement is brought to a halt, it tends to reverse itself.

Why does a period of expansion or contraction, once begun, tend to develop its own momentum? First, the multiplier process tends to cause cumulative movements. As soon as a revival begins, some unemployed people find work again. These people, with their newly acquired income, can afford to make much-needed consumption expenditures. This new demand causes an increase in production and creates new jobs for others. As incomes rise, demand rises; as demand rises, incomes rise.

STUDENT: And just the reverse happens in a downswing, I suppose.

TEACHER: Right. Unemployment in one sector causes a fall in demand for the products of other sectors, which leads to a further fall in employment and a further fall in demand.

A second major factor is the accelerator theory. New investment is needed to expand existing productive capacity and to introduce new methods of production. When consumer demand is low and there is excess capacity, investment is likely to fall to a very low level; once demand starts to rise and entrepreneurs come to expect further rises, investment expenditure may rise very rapid1y. Furthermore, when full employment of existing capacity is reached, new investment becomes one of the few ways available for firms to increase their output.
A third major explanation for cumulative movements is expectations. All production plans take time to fulfill. Current decisions to produce consumer goods and investment goods are very strongly influenced by business expectations. Such expectations can sometimes be volatile, and sometimes self-fulfilling. If enough people think, for example, that bond prices are going to rise, they will all buy bonds in anticipation of the price rise, and these purchases will themselves cause prices to rise. If, on the other hand, enough people think bond prices are going to fall, they will sell quickly at what they regard as a high price and thereby actually cause prices to fall.
This is the phenomenon of self-realizing expectations. It applies to many parts of the economy. If enough managers think the future looks rosy and begin to invest in increasing capacity, this will create new employment and income in the capital-goods industries, and the resulting increase in demand will he1p to create the rosy conditions whose vision started the whole process.

One cannot lay down simple rules about so complicated a psychological phenomenon as the formation of expectations, but there is a bandwagon effect. Once things begin to improve, people expect further improvements, and their actions, based on this expectation, he1p to cause further improvements. On the other hand, once things begin to worsen, people often expect further worsening, and their actions, based on this expectation, he1p to make things worse.

Controversies about the cause of cycles and the role of government

Many of the different schools of thought in economics have had their own approach to explaining business cycles. We concentrate here on the views of the major macro schools of thought. It is of importance to note the contrasting views of the role of government in the business cycle. For Keynesians the instability that triggered cycles was in the private sector and it was for government to step in and stabilize the cycle. Other schools, however, see government as part of the problem; and extreme views see it as the major cause of instability.

The Monetarist Approach

Monetarists believe that the economy is inherently stable because private-sector expenditure functions are relatively stable and price adjustment will bring the economy back to potential GDP. In addition, they believe that shifts in the aggregate demand curve arise mainly from policy-induced changes in the money supply.

According to monetarists, fluctuations in the money supply cause fluctuations in GDP. This leads the monetarists to advocate a policy of stabilizing the growth of the money supply. In their view this would avoid policy-induced instability of the aggregate demand curve.

The Keynesian Approach

The traditional Keynesian explanation of cyclical fluctuations in the economy has two parts. First, it emphasizes variations in investment as a cause of business cycles and stresses the non-monetary causes of such variations, such as expectations, or as Keynes put it, ‘animal spirits'.

Keynesians reject what they regard as the extreme monetarist view that only money matters in explaining cyclical fluctuations. Many Keynesians believe that both monetary and non-monetary forces are important in explaining cycles. Although they accept serious monetary mismanagement as one potential source of economic fluctuations, they do not believe that it is the only, or even the major, source of such fluctuations. They believe that most fluctuations in the aggregate demand curve are due to variations in the desire to spend on the part of the private sector and are not induced by government policy.

Keynesians also believe that the economy lacks strong natural corrective mechanisms that will always force it easily and quickly back to full employment (potential GDP). They believe that, while the price level rises fairly quickly to eliminate inflationary gaps, prices and wages fall only slow1y in response to recessionary gaps. As a result, Keynesians believe that recessionary gaps can persist for long periods of time unless they are eliminated by an active stabilization policy.
The second part of the Keynesian view on cyclical fluctuations concerns the alleged correlation between changes in the money supply and changes in the level of economic activity. In so far as this correlation exists, the Keynesian explanation reverses the causality suggested by the monetarists. Keynesians argue that changes in the level of economic activity often cause changes in the money supply.

According to Keynesians, fluctuations in GDP are often caused by fluctuations in autonomous expenditures. Further, they believe that fluctuations in GDP usually cause fluctuations in the money supply.

A shift of emphasis within the Keynesian school has come about in recent years, associated with what is now called the New Keynesian school. Early Keynesians focused mainly on the use of aggregate demand (especially fiscal) policies to stabilize the cycle. New Keynesians would be happy to see GDP kept close to its potential level by whatever means possible, including monetary and fiscal policies

Macroeconomics: the unfulfilled promise

In the 1950s and 1960s, it was widely believed that the business cycle had been abolished. Many economists thought that the newly invented tools of macroeconomic stabilization policy meant that recessions could be avoided. Indeed, the 1950s and 1960s were a period of relative stability. Unemployment and inflation were both low, and, although there were cycles in activity, these cycles did not involve any major fall in output, only variations in positive growth rates.

In contrast, since the early 1970s there have been four recessions during which output fell (1974-5, 1980-1, 1991-2 and 2000- 2002).

When most major countries experience a similar cycle the explanation probably lies not in any single country but in worldwide economic forces. Globalization of the world economy has tied most economies closer together and there is little that any one government can do in the face of a shift of world aggregate demand. Realistically, therefore, the business cycle is here to stay and business people are going to have to learn to live with it.

Macroeconomics was invented in order to give governments the tools to control business cycles. However, most now believe that monetary and fiscal polices have only a modest role in the stabilization of the business cycle. The business cycle is a global phenomenon that most governments cannot influence.

The Strategic Management Process

2009-03-03T07:58:00.001-08:00

TEACHER: Hello, Student. I am glad to begin teaching the Strategic Management course today, and to have you as my student.

This course is about developing, implementing, and executing company strategies; a job that belongs to managers, of course.

STUDENT: Teacher, everyone talks about "strategy", but my feeling is that many people do not know exactly what it is. Can you give me a clear definition?

TEACHER: Yes, but let me confine the definition to business strategy: "Business Strategy is the array of competitive moves and business approaches management uses to produce the best possible results".

Strategy is management's "game plan" for strengthening the organization's position, pleasing customers, and achieving performance targets.

Obviously in business as in life there are many possible paths to follow and choices must be made. The strategy managers decide on indicates that they have chosen an objective, a route, and a manner to conduct business.

STUDENT: I assume that a comprehensive strategy should cover every major function and department of a company. Am I correct?

TEACHER: Yes, of course. Each major function has a role in the company strategy. The challenge is to coordinate business decisions and competitive actions taken across the company so that they are consistent with the overall strategy. Again, developing and executing strategy are basic management functions.

STUDENT: What you are saying is that management must successfully define the company's long-term objectives, develop and implement effective strategic actions and business plans, and execute the strategy so that it produces the expected results.

TEACHER: Right. Indeed, good strategy definition and good strategy execution are the key competencies of good management.

STUDENT: I see that you are stressing both "defining" and "executing" as vital management competencies.

TEACHER: No doubt about it. Some managers design good strategies but fail to implement them well. Others design poor strategies but execute them competently.

Managers must combine good strategy-making with good strategy execution in order to lead a company successfully.

STUDENT: I am inclined to believe that all we need to make a company successful is hiring a management team able to develop and implement a good strategy, right?

TEACHER: Student, you are too clever a person to believe this. I know that you are perfectly aware that good strategy combined with good strategy execution doesn't guarantee that a company will avoid periods of weak performance.

It may take time to show good results. And any business can be confronted with adverse and unforeseen conditions.

But it is management's job to adjust to unexpected1y tough conditions by devising strategic defenses and novel business approaches adjusted to adverse conditions.

STUDENT: I am glad that you think I’m clever. I do, too. To prove it, let me summarize what you have said: "The essence of good strategy-making and executing is to build a competitive position strong enough and an organization capable enough to succeed despite unforeseeable events, strong competition, and internal problems".
TEACHER: Correct. Now let’s go on to describe...
THE FIVE TASKS OF STRATEGIC MANAGEMENT

The strategy-making, strategy-implementing process consists of five interrelated managerial tasks:

1. Deciding what business the company will be in and forming a strategic vision of where the organization needs to be headed -giving the organization a sense of purpose, providing long-term direction, and establishing a clear mission to be accomplished.
2. Converting the strategic vision and mission into measurable objectives and performance targets.
3. Developing a strategy to achieve the desired results.
4. Implementing and executing the chosen strategy efficiently and effectively.
5. Evaluating performance, making corrective adjustments in execution, and adjusting long-term strategy according to experience, changing conditions, new ideas, and new opportunities.

DEVELOPING A STRATEGIC VISION AND BUSINESS MISSION

The basic questions senior managers need to ask and find answers to are:

* What is our vision for the company?
* What are we trying to do and to become?

Finding intelligent answers to these questions forces managers to think about what the company's business character is and should be and to develop a clear picture of where the company needs to be headed over the next 5 to 10 years.

Management's answer to "who we are, what we do, and where we're headed" shows the way for the organization to take and establishes the foundations of a strong organizational identity.

What a company intends to do and to become is commonly called the company's mission.

A mission statement defines a company's business and provides a clear view of what the company is trying to do for its customers.

But managers also have to think strategically about where they are trying to take the company. They must have a concept of the company's future organization and long-term direction.

Management's view of the kind of company it is trying to create and its objective in terms of a specific business positions represent a strategic vision for the company.

By developing and communicating a business mission and strategic vision, management provides its employees with a sense of purpose and an understanding of the company's future direction.

STUDENT: I guess you have a few real life examples of company mission and vision statements to show me, do you?

TEACHER: Of course. Here they are:

* Avis Rent-a-Car: "Our business is renting cars. Our mission is total customer satisfaction".
* Eastman Kodak: "To be the world’s best in chemical and electronic imaging".
* Compaq Computer: "To be the leading supplier of PCs and PC servers in all customer segments".
* The Saturn Division of General Motors: "To market vehicles developed and manufactured in the United States that are world leaders in quality, cost, and customer satisfaction through the integration of people, technology and business systems and to transfer knowledge, technology and experience throughout General Motors".
* Otis Elevator: "Our mission is to provide any customer a means of moving people and things up, down and sideways over short distances with higher reliability than any similar enterprise in the world".

STUDENT: I must say that these statements convey a clear meaning in a very condensed way.

TEACHER: Yes, and this is a must for these type of statements to be effective.

SETTING OBJECTIVES

The purpose of setting objectives is to evolve statements of business mission and company direction into specific performance targets.

Objective-setting implies challenge; the performance targets must require considerable effort.

The challenge of achieving the desired performance forces an organization to be more inventive, to experiment a sense of urgency in improving both its financial performance and its business position.

STUDENT: This is true, but I have also experienced the demoralizing effects of objectives that are perceived by employees as impossible to achieve.

TEACHER: Right. It is very difficult to judge in advance whether objectives are challenging but achievable or are impossible to achieve. It is important that management, after having set challenging but realistic objectives, convinces employees that these objectives are achievable.

The objectives managers establish should ideally include both short-range and long-range performance targets. Short-range objectives describe the immediate improvements and results management expects.

Long-range objectives motivate employees to consider what to do now to position the company to perform well over the longer term.

STUDENT: In real life, short-term and long-term objectives sometimes are in collusion. I think that ideally when tradeoffs have to be made between achieving long-run objectives and achieving short-run objectives, long-run objectives should take precedence.

TEACHER: True. Rarely does a company prosper from repeated management actions that sacrifice better long-run performance for better short-tern performance. However, due to the way top managers are compensated and judged, often the short-run takes precedence.

Every unit in a company needs concrete, measurable performance targets. When company-wide objectives are broken down into specific targets for each organizational unit and lower-level managers are held accountable for achieving them, a results-oriented climate builds throughout the enterprise.

From a company-wide perspective there must be financial objectives and strategic objectives. Financial objectives are important for obvious reasons. Strategic objectives are needed to bring about efforts to strengthen a company's overall business and competitive position.

Financial objectives typically relate to such measures as earnings growth, return on investment, borrowing power, cash flow, and shareholder returns.

Strategic objectives are about the company’s competitiveness and long-term business position in its markets: growing faster than the industry average, constantly improving product quality, customer service and market share, being the lower cost producer, etc.

STUDENT: A few examples of well-known companies are called for, aren’t they?

TEACHER: Glad to oblige. Here the are:

* Exxon: "To provide shareholders a secure investment with a superior return".
* General Electric: "To become the most competitive enterprise in the world by being number one or number two in market share in every business the company is in".
* Apple Computer: "To offer the best possible personal computing technology and to put that technology in the hands of as many people as possible".
* Ford Motor Company: To satisfy our customers by providing quality cars and trucks, developing new products, reducing the time it takes to bring new vehicles to market, improving the efficiency of all our plants and processes, and building on our teamwork with employees, unions, dealers, and suppliers".

DEVISING A STRATEGY

Objectives are the "ends," and strategy is the "means" of achieving them. Strategy is the array of actions managers employ to achieve strategic and financial performance targets.

The task of crafting a strategy starts with a solid diagnosis of the company's internal and external situation. A misdiagnosis of the situation involves the risk of pursuing ill-conceived strategic actions.

A company's strategy is normally a mix of:

1. Deliberate and purposeful actions, and
2. Reactions to unanticipated developments and fresh competitive pressures.

Strategy is more than what managers have carefully plotted out in advance. New situations always emerge, such as important technological developments, rivals' actions, etc.

Company strategies in practice end up being a mix of planned actions and unplanned strategy responses.

Strategy and the outside world

The challenge is for company managers to keep their strategies closely matched to such outside drivers as changing buyer preferences, the latest actions of rivals, market opportunities and threats, and newly appearing business conditions.

The faster a company's business environment is changing, the more critical it becomes for its managers to be good entrepreneurs in diagnosing shifting conditions and instituting strategic adjustments.

STUDENT: What you mean, in short, is that managers must be good entrepreneurs.

TEACHER: Exactly. Managers with poor entrepreneurial skills are usually risk-averse and do not develop a new strategic course while the current strategy produces acceptable results. They tend to dismiss new outside developments as unimportant or else waste valuable time before taking actions.

Why Company Strategies Evolve

Making frequent adjustments of a company's strategy in different departments and functional areas is quite normal.

Sometimes fundamental changes in strategy are needed for, i.e. when a competitor makes an important move, or when technological breakthroughs occur.

For the reasons stated an organization's strategy forms over a period of time.

Current strategy is typically a mix of historical approaches and new actions. Except for crisis situations (where many strategic moves are usually made quickly to produce a substantially new strategy almost overnight) and new company start-ups (where strategy exists most1y in the form of plans and intended actions), it is common for key elements of a company's strategy to emerge in bits and pieces as the business develops.

STUDENT: What you said about crisis situations reminds me of 1993 when Lou Gerstner took over as top boss of money loosing IBM; he had to quickly develop a radically different strategy to turn around the company.

TEACHER: Good example. It also shows how strategy is usually devised by the top people in a company. When Palmistrano took over as IBM CEO from Gerstner in 2002, the first thing he did was implementing a new strategy exemplified by the acquisition of the consulting arm of PricewaterhouseCoopers (PwC) for $3.5 billion in cash and shares. Gerstner did never make a large acquisition during his tenure. Plamistrano stated that IBM would make a ca. $3 billion acquisition every year.

Rarely is a company's strategy so perfect and durable that it can remain unchanged for a very long time. Even the best business plans must be adapted to changing market conditions, new customer needs and preferences, the actions of rival firms, etc.

STUDENT: It is apparent that strategy-making is a dynamic process. Management must reevaluate strategy regularly, refining and modifying it as needed.

TEACHER: Good observation. However, when strategy changes so often and so deeply that the game plan is revised every few months, managers are almost certainly guilty of poor strategic analysis. Important changes in strategy are needed occasionally, especially in crisis situations, but they cannot be made too often without creating undue organizational confusion and disrupting performance.

Good strategies normally have a life of several years, requiring only minor adjustments to keep them in tune with changes in the environment.

The components of a Company’s Strategy

The basic concerns of a company’s strategy are:

* How to grow the business
* How to satisfy customers
* How to effectively compete with rivals
* How to adapt to changing market conditions
* How to manage the different functional areas of the business
* How to achieve strategic and financial objectives.

In the business world, companies have a large degree of freedom on what strategy they decide to adopt.

They can diversify in different degree, into related or unrelated industries, via acquisition, joint venture, strategic alliances, or internal start-up.

Even when a company elects to concentrate on a single business, there is usually enough strategy-making latitude to differentiate a firm from its close competitors. Companies in the same business can pursue low-cost leadership and position themselves as the lowest cost but high quality suppliers; others stress various combinations of product/service attributes that justify a premium price as perceived by customers, and still others elect to concentrate on the special needs and preferences of narrow buyer segments

Many elements of a firm’s strategy are visible to outside observers, and therefore most of a company's strategy can be deduced from its actions and public pronouncements. Yet, there's an unrevealed portion of strategy outsiders can only speculate about -the actions and moves company managers are considering. Managers often, for good reason, choose not to reveal certain elements of their strategy until the time is right.

STUDENT: Will you give me an example of a real world company’s strategy?

TEACHER: Yes. No company is more "real world" that McDonald’s.

These are the following core elements of this company’s strategy as stated in the mid 90’s and implemented since then:

Growth Strategy

* Add 700 to 900 restaurants annually, some company-owned and some franchised, with about two-thirds outside the USA.
* Promote more frequent customer visits via de addition of breakfast and dinner menu items, low-price specials and Extra Value Meals.

Franchising Strategy

* Be highly selective in granting franchising, extend them only to highly motivated entrepreneurs willing to be active on-premise owners.

Store Location and Construction Strategy

* Locate restaurants only on sites that offer convenience to customers and afford long-term sales growth potential.
* Reduce site costs and building costs by using standardized, cost-efficient store designs and consolidating purchases of equipment and materials via a global sourcing system.
* Utilize store and site designs that are attractive and pleasing and where feasible provide drive-thru service and play areas for children.

Product Line Strategy

* Offer a limited menu.
* Expand product offering into new categories of fast food (chicken, Mexican, pizza and so on) and include more items for health-conscious customers.
* Do extensive testing to ensure consistent high quality before implementing new menu items system-wide.

Store Operations

* Establish stringent product standards, strictly enforce restaurant operating procedures (especially as concerns food preparation, store cleanliness and friendly, courteous counter service) and build close working relationships with suppliers to assure that food is safe and of the highest quality.
* Develop new equipment and production systems that improve the ability to serve hotter, better-tasting food, faster and with greater accuracy.

Sales Promotion, Marketing and Merchandising

* Enhance the McDonald’s image of quality, service, cleanliness, and value globally via heavy media advertising and in-store merchandise promotions funded with fees tied to a percent of sales revenues at each restaurant.
* Continue to use value pricing and Extra Value Meals to build customer traffic.
* Use Ronald McDonald to create greater brand awareness among children and Mc prefix to reinforce the connection of menu items and McDonald’s.

Social Responsibility

* Operate in a socially responsible manner by supporting education programs for student employees and by providing nutritional information on McDonald’s products to customers.

STUDENT: There is little doubt that the "McStrategy" worked!

TEACHER: Yes. A sound, well implemented strategy. Let’s examine the different aspects of the "total strategy process".

Strategy and Strategic Plans

Developing a strategic vision and mission, establishing objectives, and deciding on a strategy are basic direction-setting tasks. They map out where the organization is headed, its short-range and long-range performance targets, and the competitive moves and internal action approaches to be used in achieving the targeted results. Together, they constitute a strategic plan.

STRATEGY IMPLEMENTATION AND EXECUTION

The strategy-implementing function consists of defining what it will take to make the strategy work and to reach the targeted performance on schedule

STUDENT: I guess the required skill here is being good at figuring out what must be done to put the strategy in place, execute it proficiently, and produce good results.

TEACHER: Right. The job of implementing strategy is primarily a hands-on administrative task that includes the following principal aspects:

Building an organization capable of carrying out the strategy successfully.

• Developing budgets that steer resources into those internal activities critical to strategic success.

• Establishing strategy-supportive policies.

• Motivating people in ways that induce them to pursue the target objectives energetically and, if need be, modifying their duties and job behavior to better fit the requirements of successful strategy execution.

• Tying the reward structure to the achievement of targeted results.

• Creating a company culture and work climate conductive to successful strategy implementation.

• Installing internal support systems that enable company personnel to carry out their strategic roles effectively day in and day out.

• Instituting best practices and programs for continuous improvement.

• Exerting the internal leadership needed to drive implementation forward and to keep improving on how the strategy is being executed.

EVALUATING PERFORMANCE, REVIEWING NEW DEVELOPMENTS, AND INITIATING CORRECTIVE ADJUSTMENTS

None of the previous tasks are one-time exercises. New circumstances call for corrective adjustments. Long-term direction may need to be altered, the business redefined, and management's vision of the organization's future course narrowed or broadened. Performance targets may need raising or lowering in light of past experience and future prospects. Strategy may need to be modified because of shifts in long-term direction, because new objectives have been set, or because of changing conditions in the environment.

The search for ever better strategy execution is also continuous. Sometimes an aspect of implementation does not go as well as intended and changes have to be made. Progress is typically uneven -faster in some areas and slower in others. Some tasks get done easily; others prove to be difficult. Implementation has to be thought of as a process, not an event. It occurs through the pooling effect of many managerial decisions and many incremental actions on the part of work groups and individuals across the organization. Budget revisions, policy changes, reorganization, personnel changes, reengineered activities and work processes, culture-changing actions, and revised compensation practices are typical actions managers take to make a strategy work better.

WHY STRATEGIC MANAGEMENT IS AN ONGOING PROCESS

Because each one of the tasks of strategic management requires constant evaluation and a decision whether to continue or change, a manager cannot afford distractions. Nothing about the strategic management process is final; all prior actions are subject to modification as conditions in the surrounding environment change and ideas for improvement emerge. Strategic management is a process filled with motion

CHARACTERISTICS OF THE PROCESS

Although developing a mission, setting objectives, forming a strategy, implementing and executing the strategic plan, and evaluating performance portray what strategic management involves, actually performing these five tasks is not so cleanly divided into separate, neatly sequenced compartments. There is much interplay among the five tasks.

THE ROLE AND TASKS OF STRATEGIC PLANNERS

If senior and middle managers have the lead roles in strategy-making and strategy implementing in their areas of responsibility, what should strategic planers do? Is there a legitimate place in big companies for a strategic planning department staffed with specialists in planning and strategic analysis?

The answer is yes. But the planning departments role and tasks should consist chiefly of helping to gather and organize information that strategy-makers need, establishing and administering an annual strategy review cycle whereby managers reconsider and refine their strategic plans, and coordinating the process of reviewing and approving the strategic plans developed for all the various parts of the company.

THE STRATEGIC ROLE OF THE BOARD OF DIRECTORS

Since lead responsibility for crafting and implementing strategy falls to key managers, the chief strategic role of an organization's board of directors is to see that the overall task of managing strategy is adequately done. Boards of directors normally review important strategic moves and officially approve the strategic plans submitted by senior management-a procedure that makes the board ultimately responsible for the strategic actions taken. But directors rarely can or should play a direct role in formulating Strategy. The immediate task of directors is to ensure that all proposals have been adequately analyzed and considered and that the proposed strategic actions are superior to available alternatives

The three strategy-making task one: developing a strategic vision

2009-03-03T07:57:00.001-08:00

TEACHER: Hello, Student. In this Module, I will give you a more in-depth look at the first of the three strategy-making tasks: developing a strategic vision and business mission.

STUDENT: Hi, Teacher. May I know the names of the other two tasks now?

TEACHER: Yes, they are:

* Setting performance objectives, and
* Developing a strategy to produce the desired results.

We will describe these two tasks in the following two Modules.

We will also examine the kinds of strategic decisions made at each management level, the major determinants of a company's strategy, and four frequently used managerial approaches to forming a strategic plan.

DEVELOPING A STRATEGIC VISION AND MISSION
The First Strategy-Making Task

A strategic vision provides a big picture perspective of "who we are, what we do, and where we are headed."

Management's views about what activities the organization intends to pursue and the long-term direction it signals for the future constitute a strategic vision.

A well-conceived strategic vision is a prerequisite to effective strategic leadership. A manager cannot be a good leader or strategy-maker without a sound concept of the business.

STUDENT: I guess we are talking specifically about top managers here, right?

TEACHER: Certainly. The top manager and/or the top management team must have a clear vision of what the company will do, what it will not do, and what kind of long-term competitive position to develop.

STUDENT: Sorry to interrupt again, but I become confused when I read the terms "strategic vision" and "business mission or mission statement". Are they exactly the same?

TEACHER: Many textbooks and companies use these terms interchangeably.

If we look closer a the meaning of the words, we may conclude that "Missions" tend to be more concerned with the present ("what is our business') while a "Vision" refers to the bigger issue of long-term direction (where are we headed, what new objectives will we have, what will our business be in 5 to 10 years, what kind of company are we trying to become, and what type of market position do we expect to hold?)

A basic condition of an effective strategic vision and company mission statement it that it must be high1y personalized. Statements applicable to any company or to any industry have no real value. A good strategic vision/mission statement sets an organization apart from others in its industry and gives it its own special identity, approach to the business, and path for development.

STUDENT: It must be a difficult task to develop personalized visions for companies that are exactly in the same business.

TEACHER: In many cases being in the same industry does not mean two companies are very similar. We can think of "banking" as an industry, but within this industry there are many different categories: small local banks, large global banks, banks specializing in catering to large commercial customers, others geared towards a mass market of individuals or small companies, commercial banks, investment banks, savings and loan associations, etc. STUDENT: I see your point. Hewlett Packard and Dell are both in the computer business, but Hip's business range is much wider than Dell’s.
TEACHER: Exactly. To expand the list of examples, General Electric is not on the same long-term strategic course as Whirlpool Corp., even though both are leaders in the major home appliance business; while Whirlpool's business is concentrated in appliances, GE has major business positions in aircraft engines, defense electronics, engineering plastics, electric power generation equipment, factory automation, locomotives, lighting, medical diagnostics imaging, and TV broadcasting (it owns NBC). STUDENT: But one thing I an sure all companies have in common is that they are interested in being profitable.
TEACHER: Sometimes companies define their mission in terms of making a profit. This is a mistake. Profit is actually an objective and a result of what the company does. Stating that a company is set to make a profit is a truism; making a profit is the basic and common objective of all commercial enterprises.

The desire to make a profit says nothing about the business environment in which profits are to be pursued. Missions based on making a profit are incapable of distinguishing one type of enterprise from another. The business and long-term direction of McDonald’s are plainly different from the business and long-term direction of Ford; but there is no doubt that both want to be profitable.

STUDENT: I see. In other words, for a mission statement to be informative it has to spell out how the company will make a profit.

TEACHER: Exactly. We must know management's answer to "make a profit doing what and for whom?".

There are three different concepts involved in forming a well-conceived strategic vision and expressing it in a company mission statement:

* Understanding what business a company is really in.
* Communicating the vision and mission clearly, and

Deciding when to modify the company's strategic course and change its business mission.

UNDERSTANDING AND DEFINING THE BUSINESS

It may appear a an easy task at first sight, but actually deciding what business an organization is in, is neither obvious nor easy. Is IBM in the computer business (a product-oriented definition) or the information and data processing business (a customer service or customer needs type of definition) or the advanced electronics business (a technology-based definition? Is Coca-Cola in the soft-drink business (in which case its strategic vision can be trained narrow1y on the actions of Pepsi, 7UP, Dr Pepper, Canada Dry, and Schweppes? Or is it in the beverage industry (in which case management must think strategically about positioning Coca-Cola products in a market that includes fruit juices, alcoholic drinks, milk, bottled water, coffee, and tea?

STUDENT: This reminds me of the famous anecdote about the railroads in the USA. It is said that many railroad companies failed because they insisted in defining themselves as being in the railroad business instead of as being in the transportation business. They became victims of the expansion of road and air transportation; if they had defined themselves as being in the transportation business rather that exclusively in the railroad business they could have diversified into these types of transportation.

TEACHER: Good example. Going back to Coca-Cola, defining the type of business they are in is not a trivial question. Many young adults get their morning caffeine dose by drinking cola instead of coffee. With a beverage industry perspective as opposed to a soft-drink industry perspective, Coca-Cola’s management is more likely to perceive a long-term growth opportunity in winning youthful coffee drinkers over to its colas.

Arriving at a good business definition usually requires taking three factors into account:

1. Customer needs, or what need or desire is being satisfied.

2. Customer groups, or who’s needs or desires are being satisfied.

3. The technologies used and functions performed -how customers' needs or desires are satisfied.

Defining a business in terms of what to satisfy, who to satisfy, and how the organization will go about producing the satisfaction makes a complete definition.

STUDENT: I can see that it takes all three. Certainly, just knowing what products or services a firm provides is not enough, because products or services are not important to customers if they do not need or want them.

TEACHER: Exactly. The capacity to deliver a product or service becomes a business when it satisfies a need or want. Without the need or want there is no business.

Customer groups are relevant because they indicate the market to be served, the geographic domain to be covered and the types of buyers the firm is targeting.

Technology and functions performed are important because they indicate how the company will satisfy the customers' needs.

STUDENT: I feel there is something missing here. What about the specific part of a possible array of related products or services the company will be active in?

TEACHER: Good observation. A firm's business can be specialized, concentrated in just one stage of an industry's total production-distribution chain, or partially or fully integrated, spanning all parts of the industry chain. Wal-Mart, Home Depot, and Toys-R-Us, are essentially one-stage firms. Their operations focus on the retail end of the consumer goods business; they don't manufacture the items they sell. Most airlines are one-stage enterprises; they made the decision to limit its business mission to moving travelers from one location to another via commercial jet aircraft.

On the other hand, we can mention a major global oil company such as Exxon as examples of full "vertical" integration. They drill wells, pump oil, transport crude oil in their own ships and pipelines to their own refineries, and sell gasoline and other refined products through their own networks of branded distributors and service station outlets.

STUDENT: Your said "vertical" integration. Is there a "horizontal" integration?

TEACHER: Yes, and GE is a good example here. Horizontally integrated firms are active in completely different business; let me just remind you that GE manufactures aircraft engines and owns NBC, a TV broadcasting network. Certainly these two types of businesses are not related.

STUDENT: It is apparent that the business of a retailer like Sears or Wal-Mart is much narrower and quite different than that of a fully integrated enterprise like Exxon.

TEACHER: It is certainly so because of the disparity in functions performed and technology employed. Between these two extremes, firms can be partially integrated, participating only in selected stages of the industry. Goodyear, for instance, both manufactures tires and operates a chain of company-owned retail tire stores, but it has not integrated backward into rubber plantations and other tire-making components. General Motors, the world's most integrated manufacturer of cars and trucks, makes between 60 and 70 percent of the parts and components used in assembling GM vehicles. But GM is moving to outsource a greater fraction of its parts and systems components, and it relies totally on a network of independent, franchised dealers to handle sales and service functions.

STUDENT: Thanks to your explanation I now realize that one way of distinguishing between firms in the same industry, is by looking at which functions they perform and how far their scope of operation extend across all the business activities involved in getting products to end-users. In other words, determine the extension of the vertical integration of each firm.

TEACHER: Exactly. And before you ask me for it, I will mention a few examples.

One good example of a business definition that incorporates all three components -needs served, target market, and functions performed- is Polaroid's business definition during the early 1970s: "perfecting and marketing instant photography to satisfy the needs of more affluent U.S. and West European families for affection, friendship, fond memories, and humor."

McDonald's mission is focused on "serving a limited menu of hot, tasty food quickly in a clean, friendly restaurant for a good value" to a broad base of fast-food customers worldwide (McDonald's serves approximately 25 million customers daily at some,13,000 restaurants in over 65 countries). The concepts that McDonald's uses to define its business are a limited menu, good-tasting fast-food products of consistent quality, value pricing, exceptional customer care, convenient locations, and global market coverage.

Trying to identify needs served, target market, and functions performed in a single sentence is a strong challenge, and many firms' mission statements fail to communicate all three concepts clearly.

COMMUNICATING THE STRATEGIC VISION

How to describe the strategic vision, state it in the form of a mission statement, and communicate it down the line to lower-level managers and employees is almost as important as the strategic soundness of the organization's business concept and long-term direction.

A vision and mission in words that inspire and challenge he1p build committed effort from employees and serve as powerful motivational tools. Having an exciting mission or cause brings the workforce together, galvanizes people to act, stimulates extra effort, and causes people to feel part of the business instead of just coming to work.

WHEN TO CHANGE THE MISSION

A very simple explanation of why missions have to change sometimes is this one: "Times change, conditions change." Managers must continually reassess their company's position and prospects, and be alert to the moment when it's time to steer a new course and adjust the mission. The key strategic question here is "What new directions should we be moving in now to get ready for the changes we see coming in our business?"

Repositioning or even reinventing an enterprise in light of emerging developments and changes on the horizon lessens the chances of getting trapped in a stagnant or declining core business or letting attractive new growth opportunities slip away because of inaction. Good entrepreneurs have a sharp eye for shifting customer wants and needs, emerging technological capabilities, changing international trade conditions, and other important signs of growing or shrinking business opportunity.

STUDENT: I can think of one example myself: cable TV companies and telephone companies are in a strategic race to install fiber optics technology and position themselves to market a whole new array of services such as pay-per-view TV, home shopping, and internet access.

TEACHER: We can conclude that a company's mission has a finite life, one subject to change whenever top management feels that the present mission is no longer adequate. But we should add that sometimes a strategy must be altered quickly (maybe only temporarily) to adapt to unforeseen circumstances. Just let me show you a change announced by McDonald’s in November 2002: "Fast-food giant McDonald's Corp. said it would close about 175 restaurants worldwide and slash up to 600 jobs, forecasting a shortfall in 2002 earnings as it struggles to turn around its U.S. performance and trim worldwide costs. McDonald's, besieged by lackluster U.S. sales and poor service in its U.S. stores, has returned to price discounting in its largest market, sparking increased competition amid large fast-food rivals Burger King Corp. and Wendy's International Inc."

STUDENT: It appears that they did not effectively implement the "clean, friendly restaurants" strategy in the US, and had to resort to "price discounting" instead of offering "good value" –which implies a premium price justified by the quality of the food and the service.

TEACHER: I totally agree. Well, see you in next Module.

The three strategy-making task two: setting objectives

2009-03-03T07:56:00.001-08:00

TEACHER: Hello, Student. In the previous Module we discussed the definition of a strategic vision. Now we will start our discussion on "setting objectives".

Setting objectives converts the strategic vision and directional course into concrete expected results and performance targets.

Now please tell me: how would you describe what business "objectives" are?

STUDENT: I'd say that objectives represent a commitment to producing specified results in a specified time frame.

TEACHER: Good. Objectives specify how much of what kind of performance is to be reached by when. They are a specific commitment by management, and direct attention and energy to what needs to be accomplished.

The Managerial Value Of Setting Objectives

Unless an organization's long-term direction and business mission are translated into measurable performance targets and managers are pressured to show progress in reaching these targets, statements about direction and mission will end up being no more than wishful thinking.

STUDENT: I know of many managers who think that objectives are always little more than wishful thinking. They say that all managers can and should do is have good intentions, try hard, and hope for success. Sure, they go along with what is expected from them and write down vision statements and set objectives. But they do not actually believe in them. They feel that they will always find good excuses to justify eventual shortcomings.

TEACHER: I am sure that there are good reasons to dispute such thinking. The experiences of many firms show us that companies whose managers set objectives for each key result area and then aggressively pursue actions calculated to achieve their performance targets typically outperform companies whose managers have good intentions, try hard, and hope for success (or for finding good excuses!)

STUDENT: I agree, but the fact that many managers do not sincerely believe in the usefulness of setting objectives explains why in many cases they state generalities like "maximize profits," "reduce costs," "become more efficient," or "increase sales," and specify neither how much or when.

TEACHER: You made a very good point. For performance objectives to have value as a management tool, they must be stated in measurable terms and they must contain a deadline for achievement. Objective-setting is a call for action -what to achieve, when to achieve it, and who is responsible.

STUDENT: I read that Bill Hewlett, co-founder of Hewlett-Packard, once observed, "You cannot manage what you cannot measure . . . And what gets measured gets done."

TEACHER: Mr. Hewlett was right. Spelling out organization objectives in measurable terms and then holding managers accountable for reaching their assigned targets within a specified time frame is the one and only correct way to do it.

In this way the company is actually defining purposeful strategic decision-making.

STUDENT: And you are implying that firms that don't do this correctly are promoting aimless actions and confusion over what to accomplish.

TEACHER: Correct.

What Kinds Of Objectives To Set

Objectives are needed for each key result managers deem important to success. Two types of key result areas stand out:

1. those relating to financial performance and

2. those relating to strategic performance.

* Achieving acceptable financial performance is a must; otherwise the organization's survival is at risk.

* Achieving acceptable strategic performance is essential to sustaining and improving the company's long-term market position and competitiveness.

STUDENT: Examples, please?

Specific kinds of financial objectives are, among many other possible ones:

* Faster revenue growth
* Faster earning growth
* Larger profit margins
* Increased cash flow

As for strategic performance objectives, we can mention:

* A bigger market share
* Higher product quality
* Lower costs
* Superior customer service
* A broader product line

STUDENT: So we have Strategic Objectives and Financial Objectives. Which take precedence?

TEACHER: Both financial and strategic objectives are equally important. However, sometimes companies under pressure to improve near-term financial performance elect to kill or postpone strategic moves that hold promise for strengthening the enterprise's business and competitive position for the long haul.

STUDENT: I understand that this type of problem is more frequent in the USA due to the legal requirement to publish very comprehensive quarterly financial reports. A single quarter with less than stellar results may cause a substantial fall in the price of the firm's stock.

TEACHER: Right, European and Asian companies are not required to publish the same detailed information as the US companies are.

The pressures on managers to opt for better near-term financial performance and to sacrifice at least some strategic moves aimed at building a stronger competitive position are especially pronounced when

(1) an enterprise is struggling financially,

(2) the resource commitments for strategically beneficial moves will materially detract from the bottom line for several years, and

(3) the proposed strategic moves are risky and have an uncertain market and competitive payoff.

STUDENT: Aren't you forgetting the very important fact that managers are often compensated based on the current price of shares? Obviously they will try to get the best results in the short-run and worry about the long-run... well, later, if they are still working for the same company?

TEACHER: Good point. Whatever the reason, there are dangers in management's succumbing time and again to the temptation of immediate gains in margins and return on investment when it means delaying strategic moves that would build a stronger business position.

A company that consistently passes up opportunities to strengthen its long-term competitive position in order to realize better near-term financial gains risks diluting its competitiveness, losing momentum in its markets, and impairing its ability to stave off market challenges from ambitious rivals.

STUDENT: Paraphrasing a very well known saying, it appears to me that "The road to bankruptcy is paved with ex-market leaders who put more emphasis on boosting next quarter's profit than strengthening long-term market position".

TEACHER: Yes indeed. The danger of trading off long-term gains in market position for near-term gains in bottom-line performance is greatest when a profit-conscious market leader has competitors who invest relentlessly in gaining market share in preparation for the time when they will be big and strong enough to out-compete the leader in a head-to-head market battle.

STUDENT: As you say this I am reminded of the Japanese companies' patient and persistent strategic efforts to gain market ground on their more profit-centered American and European rivals.

TEACHER: You are correct. The surest path to protecting and sustaining a company's profitability quarter after quarter and year after year is to pursue strategic actions that strengthen its competitiveness and business position

The Concept of Strategic Intent

A company's strategic objectives are important for another reason -they indicate strategic intent to stake out a particular business position.

* The strategic intent of a large company may be industry leadership on a national or global scale.
* The strategic intent of a small company may be to dominate a market niche.
* The strategic intent of an up-and-coming enterprise may be to overtake the market leaders.
* The strategic intent of a technologically innovative company may be to pioneer a promising discovery and open a whole new vista of products and market opportunities -as did Xerox, Apple Computer, Microsoft, Merck, and Sony.

STUDENT: I guess that the time horizon of a company's strategic intent is long-term, right?

TEACHER: Yes. Companies that rise to prominence in their markets almost invariably begin with strategic intents that are out of proportion to their immediate capabilities and market positions. But they set ambitious long-term strategic objectives and then pursue them relentlessly, sometimes even obsessively, over a 10 - to 20-year period.

In the 1960s, Komatsu, Japan's leading earth-moving equipment company, was less than one-third the size of Caterpillar, had little market presence outside Japan, and depended on its small bulldozers for most of its revenue.

Kornatsu's strategic intent was to "encircle Caterpillar" with a broader product line and then compete globally against Caterpillar. By the late 1980s, Komatsu was the industry's second-ranking company, with a strong sales presence in North America, Europe, and Asia plus a product line that included industrial robots and semiconductors as well as a broad array of earth-moving equipment

Often, a company's strategic intent takes on a heroic character, serving as a rallying cry for managers and employees alike to go all out and do their very best. Canon's strategic intent in copying equipment was to "Beat Xerox." Komatsu's motivating battle cry was "Beat Caterpillar."

The strategic intent of the U.S. government's Apollo space program was to put a person on the moon ahead of the Soviet Union. Throughout the 1980s, Wal-Mart's strategic intent was to "overtake Sears" as the largest U.S. retailer (a feat accomplished in 1991).

In such instances, strategic intent signals a deep-seated commitment to winning -unseating the industry leader, remaining the industry leader (and becoming more dominant in the process), or otherwise beating long odds to gain a significantly stronger business position. A capably managed enterprise whose strategic objectives exceed its present reach and resources can be a more formidable competitor than a company with modest strategic intent.

Long-Range versus Short-Range Objectives

An organization needs both long-range and short-range objectives. Long-range objectives serve two purposes.

* First, setting performance targets five or more years ahead pushes managers to take actions now in order to achieve the targeted long-range performance later.

* Second, having explicit long-range objectives prompts managers to weigh the impact of today's decisions on longer-range performance.

Without the pressure to make progress in meeting long-range performance targets, it is human nature to base decisions on what is most expedient and worry about the, future later. The problem with short-sighted decisions, of course, is that they put a company's long-term business position at greater risk.

Short-range objectives spell out the immediate and near-term results to be achieved. They indicate the speed at which management wants the organization to progress as well as the level of performance being aimed for over the next two or three periods.

STUDENT: Can short-range objectives be identical to long-range objectives?

TEACHER: Yes. Anytime an organization is already performing at the targeted long-term level. For instance, if a company has an ongoing objective of 15 percent profit growth every year and is currently achieving this objective, then the company's long-range and short-range profit objectives coincide.

The "Challenging But Achievable" Test

Objectives should not represent whatever levels of achievement management decides would be "nice." Wishful thinking has no place in objective-setting. For objectives to serve as a tool for stretching an organization to reach its full potential, they must be challenging but achievable. Satisfying this criterion means setting objectives in light of several important "inside-outside" considerations:

* What performance levels will industry and competitive conditions realistically allow?

* What results will it take for the organization to be a successful performer?

* What performance is the organization capable of when pushed?

To set challenging but achievable objectives, managers must judge what performance is possible in light of external conditions as well as what performance the organization is capable of achieving.

The tasks of objective-setting and strategy-making often become intertwined at this point. Strategic choices, for example, cannot be made in a financial vacuum; the money has to be there to execute them. Consequently, decisions about strategy are contingent on setting the organization's financial performance objectives high enough to

(1) execute the chosen strategy,

(2) fund other needed actions, and

(3) please investors and the financial community.

Objectives and strategy also intertwine when it comes to matching the means (strategy) with the ends (objectives). If a company can't achieve established objectives (because the objectives are set unrealistically high or the present strategy can't deliver the desired performance), the objectives or the strategy need adjustment to produce a better fit.

The Need For Objectives At All Management Levels

For strategic thinking and strategy-driven decision-making to permeate organization behavior, performance targets must be established not only for the organization as a whole but also for each of the organization's separate businesses, product lines, functional areas, and departments.

Only when every manager, from the CEO to the lowest-level manager, is held accountable for achieving specific results and when each unit's objectives support achievement of company objectives is the objective-setting process complete enough to ensure that the whole organization is headed down the chosen path and that each part of the organization knows what it needs to accomplish.

The three strategy-making task three: crafting a strategy

2009-03-03T07:55:00.001-08:00

Hello, Student. I am sure you agree that business organizations need strategies, don't you?

STUDENT: I sure do, Teacher.

TEACHER: Good. Now, would you mind telling me what for?

STUDENT: That's a difficult question, and this is only the beginning of this Module! But let me try: "organizations need strategies to make it clear how to achieve objectives and how to pursue the organization's mission." How about that, Teacher?

TEACHER: Not bad at all. Strategy-making is all about "how":

* how to reach performance targets,

* how to fight competition,

* how to achieve long-term competitive advantage,

* how to sustain the firm's long-term business position,

* how to make management's strategic vision for the company a reality.

We have already established that a strategy is needed for the company as a whole. Do you want to remind me for what else a strategy is needed?

STUDENT: Sure. A strategy is needed for each business the company is in, and for each functional area of each business.

TEACHER: Would you please give me examples of what you call "functional areas"?

STUDENT: Research and development, purchasing, production, sales and marketing, finance, human resources, etc.

TEACHER: Very well. In forming a strategy out of the many feasible options, a manager acts as a forger of responses to market change, a seeker of new opportunities, and a synthesizer of the different moves and approaches taken at various times in various parts of the organization.

The strategy-making spotlight, however, needs to be kept trained on the important facets of management's game plan for running the enterprise -those actions that determine what market position the company is trying to stake out and that underpin whether the company will succeed.

STUDENT: What you are telling me is the only high-priority issues are part of a basic strategy.

TEACHER: Exactly. Low-priority issues (whether to increase the advertising budget, raise the dividend, locate a new plant in country X or country Y) and routine managerial housekeeping (whether to own or lease company vehicles, how to reduce sales force turnover) are not basic to the strategy, even though they must be dealt with.

STUDENT: But I think that strategy is related to taking specific actions, too.

TEACHER: Sure. Strategy is inherently action-oriented; it concern what to do, when to do it, and who should be involved. Unless there is action, unless something happens, unless somebody does something, strategic thinking and planning simply go to waste and, in the end, amount to nothing.

STUDENT: What is supposed to happen to a company's strategy as time passes?

TEACHER: An organization's strategy evolves over time. It's seldom possible to plan all the bits and pieces of a company's strategy in advance and then go for long periods without change. Reacting and responding to happenings either inside the company or in the surrounding environment is a normal part of the strategy-making process. I am making myself clear?

STUDENT: Yes. You are saying that reality is dynamic and partly unpredictable. If you'd ask me for examples, I'd mention changes in competition, unplanned increases or decreases in costs, mergers and acquisitions among major industry players, new regulations, the raising or lowering of trade barriers, etc.

TEACHER: Good examples, and of course the list is never ending and constantly changing. There is always something new to react to and some new strategic window opening up. This is why the task of crafting strategy is never ending. And it is why a company's actual strategy turns out to be a blend of its intended or planned strategy and its unplanned reactions to fresh developments.

The Strategy-Making Pyramid

Let me say it again: strategy-making is not just a task for senior executives. In large enterprises, decisions about what approaches to take and what new moves to initiate involve senior executives in the corporate office, heads of business units and product divisions, the heads of major functional areas within a business or division (manufacturing, marketing and sales, finance, human resources, and the like), plant managers, product managers, district and regional sales managers, and lower level supervisors.

In diversified enterprises, strategies are initiated at four distinct organization levels.

1. There's a strategy for the company and all of its businesses as a whole (corporate strategy).

2. There's a strategy for each separate business the company has diversified into (business strategy).

3. Then there is a strategy for each specific functional unit within a business (functional strategy) -each business usually has a production strategy, a marketing strategy, a finance strategy, and so on.

4. And, finally, there are still narrower strategies for basic operating units-plants, sales districts and regions, and departments within functional areas (operating strategy).

Student, can you guess which of these strategy-making levels we find in single-business firms?

STUDENT: Sure. In single-business enterprises, there are only three levels of strategy-making: business strategy, functional strategy, and operating strategy.

TEACHER: Correct. Now let's discuss...

Corporate Strategy

Corporate strategy is the overall managerial game plan for a diversified company.

It consists of the moves made to establish business positions in different industries and the approaches used to manage the company's group of businesses.

Crafting corporate strategy for a diversified company involves four kinds of initiatives:

1. Making the moves to accomplish diversification.

The first concern in diversification is what the company's portfolio of businesses should consist of; specifically,

* what industries to diversify into, and
* whether to enter the industries by starting a new business or acquiring another company.

2. Initiating actions to boost the combined performance of the businesses the firm has diversified into.

Decisions must be reached about how to strengthen the long-term competitive positions and profitabilities of the businesses the firm has invested in. Corporate parents can he1p their business subsidiaries be more successful by financing additional capacity and efficiency improvements, by supplying missing skills and managerial know-how, by acquiring another company in the same industry and merging the two operations into a stronger business, and/or by acquiring new businesses that strongly complement existing businesses.

3. Finding ways to capture the synergy among related business units and turn it into competitive advantage.

When a company diversifies into businesses with related technologies, similar operating characteristics, the same distribution channels, common customers, or some other synergistic relationship, it gains competitive advantage potential not open to a company that diversifies into totally unrelated businesses.

4. Establishing investment priorities and steering corporate resources into the most attractive business units.

A diversified company's different businesses are usually not equally attractive from the standpoint of investing additional funds. This facet of corporate strategy-making involves deciding on the priorities, such as investing more capital in some of the businesses and channeling resources into areas where earnings potentials are higher and away from areas where they are lower. Corporate strategy may include divesting business units that are chronically poor performers or those in an increasingly unattractive industry. Divestiture frees up unproductive investments for redeployment to promising business units or for financing attractive new acquisitions.

STUDENT: Who is normally in charge of defining corporate strategy?

TEACHER: Corporate strategy is crafted at the highest levels of management. Senior corporate executives normally have lead responsibility for devising corporate strategy and for choosing among whatever recommended actions come up from lower-level managers. Key business-unit heads may also be influential, especially in strategic decisions affecting the businesses they head. Major strategic decisions are usually reviewed and approved by the company's board of directors.

Business Strategy

The term business strategy (or business-level strategy) refers to the managerial game plan for a single business. It specified the approaches and moves devised by management to produce successful performance in one specific line of business.

STUDENT: From what you said I conclude that for a stand-alone single-business company, corporate strategy and business strategy are one and the same, right?

TEACHER: Yes, because there is only one business to form a strategy for. The distinction between corporate strategy and business strategy is relevant only for diversified firms.

OK, let's have a closer look at "business strategy".

The central objective of business strategy is how to build and strengthen the Company's long-term competitive position in the marketplace. Toward this end, business strategy is concerned principally with:

1. creating responses to changes under way in the industry, the economy at large, the regulatory and political arena, and other relevant areas,

2. devising competitive moves and market approaches that can lead to sustainable competitive advantage,

3. coordinating the strategic initiatives of functional departments, and addressing specific strategic issues facing the company's business.

STUDENT: What distinguishes an effective business strategy from a weak one?

TEACHER: Basically, it is the strategist's ability to attain a sustainable competitive advantage for the company. With a competitive advantage, a company has good prospects for above-average profitability and success.

Developing a business strategy that yields sustainable competitive advantage has three facets:

1. deciding where a firm has the best chance to win a competitive edge,

2. developing product/service attributes that have strong buyer appeal and set the company apart from rivals, and

3. neutralizing the competitive moves of rival companies.

STUDENT: Teacher, can you give me some examples of competitive strategies?

TEACHER: Three of the most frequently used competitive approaches are

1. aiming at becoming the industry's low-cost producer to get a cost-based competitive advantage over rivals,

2. pursuing differentiation based on such advantages as quality, performance, service, styling, technological superiority, or unusually good value, and

3. focusing on a narrow market niche and winning a competitive edge by doing a better job than rivals of serving the special needs and tastes of its buyers

Functional Strategy

The third functional strategy refers to the managerial game plan for a particular department or key functional activity within a business. A company's marketing strategy, for example, represents the plan for running the marketing part of the business.

A company needs a functional strategy for every major departmental unit and piece of the business.

Functional strategies, while narrower in scope than business strategy, add relevant detail to the overall business game plan.

STUDENT: Specifically, what is the basic objective of a functional strategy?

TEACHER: The primary role of a functional strategy is to support the company's overall business strategy and competitive approach.

Also, a related role is to create a managerial road map for achieving the functional area's objectives and mission.

STUDENT: Do you mean that, for example, the functional strategy in the production/manufacturing area represents the game plan for how manufacturing activities will be managed to support business strategy and achieve the manufacturing department's objectives and mission?

TEACHER: Correct. To add one more example, functional strategy in the finance area consists of how financial activities will be managed in supporting business strategy and achieving the finance department's objectives and mission.

STUDENT: And who is mainly in charge of developing a strategy for a functional area?

TEACHER: Lead responsibility for strategy-making in the functional areas of a business is normally delegated to the respective functional department heads. But often the business-unit head decides to exert a strong influence, too.

Operating Strategy

Operating strategies concern the even narrower strategic initiatives and approaches for managing key operating units (plants, sales districts, distribution centers) and for handling daily operating tasks with strategic significance (advertising campaigns, materials purchasing, inventory control, maintenance, shipping).

STUDENT: We are now talking about the lowest level strategies, right?

TEACHER: Yes, but operating strategies, while of lesser scope, add further detail and completeness to functional strategies and to the overall business plan.

Even though operating strategy is at the bottom of the strategy-making pyramid, its importance should not be downplayed. For example, a major plant that fai1s in its strategy to achieve production volume, unit cost, and quality targets can undercut the achievement of company sales and profit objectives and wreak havoc with the whole company's strategic efforts to build a quality image with customers.

STUDENT: From what you have said until now, I notice that a company's strategic plan is a collection of strategies devised by different managers at different levels in the organizational hierarchy. How can all this be harmonized?

TEACHER: To address this problem, we will now talk about...

Coordinating The Strategy-Making Effort

Management's direction-setting effort is not complete until the separate layers of strategy are unified into a coherent, supportive pattern.

Unified objectives and strategies don't emerge from an undirected process where managers at each level set objectives and craft strategies independently.

Harmonizing objectives and strategies piece by piece and level by level can be tedious and frustrating, requiring numerous consultations and meetings, annual strategy review and approval processes, the experience of trial and error, and months (sometimes years) of consensus building. The polities of gaining strategic consensus and the battle of trying to keep all managers and departments focused on what's best for the total enterprise (as opposed to what's best for their departments or careers) are often big obstacles in unifying the layers of objectives and strategies.