Price Elasticity and Asymmetric Information in Managerial Economics

Introduction and Overview

The following analysis examines three articles through the lens of managerial economics. The first is "The Finite World," a column by Paul Krugman that appeared in the New York Times on December 26, 2010. The second is "Platform Competition under Asymmetric Information" by Hanna Halaburda and Yaron Yehezkel, published as a working paper by Harvard Business School. The third is "New York Times Paywall Goes Live Today" by Allan Chernoff of CNN. Together, these articles illustrate key concepts in managerial economics — most notably price elasticity of demand, asymmetric information, and strategic pricing decisions — and demonstrate how macro-level economic forces shape firm-level strategy.

Krugman's article discusses the recent run-up in commodity prices, which has included metals, energy, and food. It also relates commodity prices to inflation, industrial production, and the implications for monetary policy. One line in particular hints at the implications for managerial economics: rising commodity prices "will require that we gradually change the way we live, adapting our economy and our lifestyles to the reality of more expensive resources."

Commodity Prices, Elasticity, and Business Risk

At the core of Krugman's argument is that rising commodity prices reflect a long-term story, one increasingly focused on growth in emerging economies. While he warns that policymakers should not be tempted to attribute these price increases solely to domestic demand, the same caution applies to domestic corporations. Firms need to understand how global economic shifts will impact their businesses. With specific respect to managerial economics, this means firms must adjust to changes in price elasticity as consumers alter their spending patterns, and they must minimize the risk associated with volatile commodity markets.

Krugman notes that economic adjustment to a world of consistently higher commodity prices is inevitable, and that this will affect purchasing decisions. Firms will need to understand the implications for their own products as consumer purchasing behavior shifts. As prices increase, substitutes are more likely to emerge, and consumption of goods that become too expensive is likely to decline. Consider the example of food prices. Some foods are relatively price inelastic with respect to demand. A staple such as wheat will be consumed in most countries by anyone who can afford bread. Should the price of wheat increase to the point where substitutes become cheaper, however, the elasticity curve will become steeper. Within the range where substitutes are not yet viable, there will be little to no change in the price elasticity of demand for bread. When the price of bread rises to the point where a substitute such as rice becomes cheaper, people in most cultures will begin to substitute rice for bread — at this point there is greater price elasticity of demand for wheat than when its price was out of the range of substitutes.

For firms, it is essential to understand where their price elasticities lie and what substitutes may arise if the price of key inputs — and by extension, prices to consumers — increases. Attention paid to broad trends in the macroeconomic environment can help managers make decisions in both the long and short run about the risks they face. Firms can institute commodity hedging strategies if inputs are important enough to the cost structure (as is the case with airlines and jet fuel), or they can make decisions to substitute inputs before high commodity prices drive consumers away.

This article is a strong illustration of the concept of price elasticity of demand because it shows how macro-level trends can impact a business and highlights the need for managers to understand how elasticity works in their industry. This understanding enables better decisions with respect to managing risk, particularly in response to rising commodity prices. In a world where resources are finite, this issue will become increasingly important in the coming decades.

The second article, "Platform Competition under Asymmetric Information" by Hanna Halaburda and Yaron Yehezkel, discusses the impact on business strategy of asymmetric information and uncertainty regarding the market outcomes of new technology. The authors conclude that "the incumbent dominates the market by setting the welfare-maximizing quantity when the difference in the degree of asymmetric information between buyers and sellers is significant."

The authors note that technological innovation often comes from new entrants rather than established incumbent competitors. New entrants, however, do not have sufficient market power to maximize welfare. Considerable risk arises from this asymmetric information for the market incumbent, but it is the incumbent that retains the power to set output levels. This creates a balance by which the incumbent is able to compensate for its relative lack of technological capability. The incumbent, despite being at a competitive disadvantage technologically, can use its market muscle to either acquire key technology from the innovator or imitate the innovator and continue to set output at the welfare-maximizing level.

Asymmetric Information and Platform Competition

New entrants often rely on technological innovation as a means to enter a market. For incumbents, new entrants, and consumers alike, this creates a situation characterized by asymmetric information. In this scenario, the authors find that trade is less efficient than it would be under a monopoly. Consumers may be wary of the new technology, or they may find the new platform more difficult to acquire than the established one. In either case, the market does not return to full efficiency until either the new entrant becomes the incumbent, the incumbent closes the technology gap, or the incumbent leverages its size to acquire the technology from the upstart.

For firms, this article has implications for strategy, particularly with respect to technological innovation and market entry. Firms in the new entrant category must devise strategies that will maintain the asymmetry of information long enough to overtake the incumbent in size, in order to bring the market to an efficient state. A useful example is the iPhone. Smartphones effectively represented a new technology that overtook handheld computers. Palm was unable to close the technological gap with Apple, allowing Apple to gain substantial market share. BlackBerry maintained its position by rapidly closing the technological gap. That market has still not reached a state of efficiency due to continued new entrants, but Apple's displacement of Palm illustrates the dynamics created by technological innovation and information asymmetry — the incumbent firm must close the asymmetry gap in order for its existing size to remain a source of competitive advantage.

This article effectively provides a real-world example of how firms should behave in markets characterized by asymmetric information, a strong incumbent, and a technologically superior upstart. This situation has become commonplace over the past two decades, and the authors' contribution to our understanding of this particular dynamic is valuable for managers, investors, and even consumers seeking to better understand the markets for their favorite products.

The third article, "New York Times Paywall Goes Live Today" by Allan Chernoff of CNN, discusses the decision by the New York Times to charge for online access to its content. The Times implemented a metered paywall, though the system includes several loopholes that allow users to access content through indirect means. The article is significant for its discussion of the microeconomic factors behind the pricing decision.

Several factors that went into the pricing decision are discussed in the article. Among them are the prices charged by competitors, website usage statistics, and the price elasticity of demand. It is believed, for example, that heavier users are willing to pay, while casual users are not. In addition, there is the consideration of advertising revenue. The fees may decrease site traffic, which would in turn decrease advertising revenue. The Times needed to set its pricing policy based on its determination of the optimal balance between these competing revenue streams.

Conclusion

These three articles collectively illustrate how foundational microeconomic concepts — price elasticity, asymmetric information, and strategic pricing — operate in real business environments. Krugman's column underscores the importance of understanding demand elasticity in the face of rising input costs. The Harvard Business School working paper demonstrates how information asymmetry shapes competitive dynamics between incumbents and innovators. The CNN article on the Times paywall shows how pricing decisions in practice involve layered uncertainties, competing revenue considerations, and incomplete information. Taken together, they offer managers a useful framework for thinking about risk, market behavior, and strategic decision-making in a complex economic landscape.