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Economics for Business and Management
K. Alec Chrystal and Richard G. Lipsey

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Oxford University Press, Great Clarendon Street, Oxford OX2 6DP
Oxford New York
Athens Auckland Bangkok Bogotá Buenos Aires Calcutta Cape Town Chennai Dar es Salaam Delhi Florence
Hong Kong Istanbul Karachi Kuala Lumpur Madrid Melbourne Mexico City Mumbai Nairobi Paris São Paulo
Singapore Taipei Tokyo Toronto Warsaw and associated companies in Berlin Ibadan
Oxford is a registered trade mark of Oxford University Press
Published in the United States by
Oxford University Press Inc., New York
© K. Alec Chrystal and Richard G. Lipsey 1997
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted,
in any form or by any means, without the prior permission in writing of Oxford University Press. Within the
UK, exceptions are allowed in respect of any fair dealing for the purpose of research or private study, or
criticism or review, as permitted under the Copyright, Designs and Patents Act, 1988, or in the case of
reprographic reproduction in accordance with the terms of the licences issued by the Copyright Licensing
Agency. Enquiries concerning reproduction outside these terms and in other countries should be sent to the
Rights Department, Oxford University Press, at the address above
This book is sold subject to the condition that it shall not, by way of trade or otherwise, be lent, re-sold, hired
out or otherwise circulated without the publisher's prior consent in any form of binding or cover other than
that in which it is published and without a similar condition including this condition being imposed on the
subsequent purchaser
British Library Cataloguing in Publication Data
Data available
Library of Congress Cataloging in Publication Data
Data available
ISBN 0-19-877539-3
ISBN 0-19-877538-5 (pbk)
5 7 9 10 8 6 4
Printed in Great Britain
on acid-free paper by
Butler & Tanner Ltd., Frome and London

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To Alison

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CONTENTS
Preface

xi

Part I. Firms and Markets

1

1. Introduction to Economics and Business

3
4

Economics and the Analysis of Business Issues
17
The Problem of Resource Allocation
29
Performance of the UK Economy
Section 1. Markets and Prices

43

2. Demand, Supply, and Price

45
46

Demand
60
Supply
65
The Determination of Market Price
72
Demand and Supply in Action
3. Elasticity of Demand and Supply

84
86

Demand Elasticity
101
Elasticity of Supply
104
Measurement of Demand and Supply
Section 2. Optimization of the Firm

117

4. The Firm, Production, and Profit

119
120

The Firm in Practice


127
The Firm in Economic Theory
130
Production, Costs, and Profit
5. Costs and Output

142
143

The Relationship between Output and Inputs
146
The Short Run
158
The Long Run
173
The Very Long Run: Endogenous Technical Change

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6. Profit Maximization

180
181

Market Structure and Firm Behaviour
184
Profit Maximization
189
The Firm in Perfectly Competitive Markets
193
Short-Run Optimization for the Firm
198
Long-Run Optimization for the Firm
204
The Very Long Run
Section 3. Firms and Competition

211

7. Firms in Imperfect Markets I: Monopoly and Monopolistic Competition

213
214

A Pure Monopolist
227
Market Segmentation: A Multi-Price Monopolist
234
Monopolistic Competition
8. Firms in Imperfect Markets II: Oligopoly and Business Strategy

242
243

Key Features of Imperfectly Competitive Markets
247
Oligopoly: Imperfect Competition among the Few
267
Oligopoly in Action: Two Case Studies
9. Government and the Market

278
279

Economic Efficiency
288


The Case for Government Involvement in Markets
296
Public Policy towards Monopoly and Competition
Section 4. Economics of Business

311

10. The Economics of Employment

313
314

The Demand for a Homogeneous Input
324
Contracts and Performance Monitoring
335
Internal Labour Markets
11. The Economics of Investment

345
346

Capital and the Firm
352
Investment Appraisal
12. The Economics of Business Organizations

377
378

Firms as Organizations
388
Business Integration
399
The Market for Corporate Control
404
Firms and Markets

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Part II. The Economy as a Whole

407

Section 5. National Product and National Income

409

13. Macroeconomic Issues and Measurement

411
412

What Is Macroeconomics?
413
Why Macroeconomics?
419
Value Added as Output
421
GDP, GNP, and National Income
435
Interpreting National Income and Output Measures
14. A Basic Model of the Determination of GDP

446
447

Potential GDP and the GDP Gap
450
Key Assumptions
454
What Determines Aggregate Expenditure?
468
Equilibrium GDP
473
Changes in GDP
15. GDP in an Open Economy with Government

484
485

Government Spending and Taxes
488
Net Exports
492
Equilibrium GDP
499


Changes in Aggregate Expenditure
16. Aggregate Demand and Aggregate Supply

509
510

Aggregate Demand
520
Aggregate Supply
527
Changes in GDP and the Price Level
Section 6. Macroeconomic Policy

541

17. GDP, the Price Level, and Fiscal Policy

543
544

Induced Changes in Input Prices
549
The Long-Run Consequences of Aggregate Demand Shocks
557
Real GDP in the Short and Long Runs
562
Fiscal Policy and the Business Cycle
18. Money and Monetary Policy

575
579

Supply of Money and the Demand for Money
588
Monetary Forces and GDP
602
Aggregate Demand, the Price Level, and GDP

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613

Appendix. Schools of thought in Macroeconomics
19. The Balance of Payments and Exchange Rates

619
620

The Balance of Payments
627
The Market for Foreign Exchange
632
The Determination of Exchange Rates
648
The Exchange Rate Regime and Macroeconomic Policy
20. Government Policy and the Business Cycle

659
660

Characteristics of Business Cycles
664
Theories of the Cycle
670
Controversies about the Cause of Cycles and the Role of Government
681
Macroeconomics: The Unfulfilled Promise
Glossary

686

Index

706

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PREFACE
Economics for Business and Management is designed to meet the needs of students who have to study some
economics as part of their business course. It is a book about economics that focuses on those principles and
analytic tools developed by economists that are important for an understanding of the business world.
Until recently most business studies students have had to use the same introductory texts as students who
wished to go on to be professional economists. These books were written with the latter in mind and so
contained much material that was inappropriate or too abstract. This book is an introduction to the key parts of
economics that business people need to understand, and wherever possible it uses business examples to
illustrate the ideas.
While this is a new book, some of the material in it has been tried and tested as part of our book An
Introduction to Positive Economics (Oxford University Press, 1995). We believe that this will prove to be a
strength of the book, since we have had considerable feedback from teachers and students in the past that has
helped us to continue improving the exposition. New material and new emphases have been added to virtually
all chapters, but only Chapters 1012 are entirely new.
Another advantage of this book is that it is shorter than most of the other major introductory economics texts.
Our intention is to make it suitable for single-term or single-semester courses. Although such courses will not
use the whole book, they may use just the micro (Chapters 212) or just the macro (Chapters 1320) sections.
Only a two-term course would be likely to cover all the chapters. We offer some suggested course structures
below.
So What's the Big Idea?
We now set out some of the most important ideas that can be understood by studying economics and that are
relevant to those heading for a career in business. Some people may think that, once they have read this list,
there is no need to read the rest of the book. This is not so. It is easy to state the messages of economics in
simple sentences, but understanding the full implications of economic analysis takes considerably more work. It
is a good idea to return to this list at the end of the course to make sure that the lessons have been learned.
There are many other important things to learn in this book that are not in this list. Here we emphasize some
general ideas from economics that have virtually universal application in business.

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Key Messages from Economics to Business
We list these topics in roughly the order in which they are discussed in the book, rather than in any rank order
of importance.
Resource Constraints and Trade-Offs
Resources are limited and choices have to be made that involve giving up some of one thing in order to have
more of another. This is true in different ways for individuals, for firms, and for whole economies. Individuals
have a limited income and have to decide to have, for example, either a new car or a holiday. Firms have
limited capital and employees and have to decide whether, say, to invest in new computerized equipment or to
refurbish their existing hand-controlled machinery, whether to hire more drivers or more accountants, or
whether to concentrate on producing more black-and-white or more colour printers. Nations have similar
choices, such as whether they should devote more resources to health services or to defence.
Comparative Advantage
Scarce resources are most effectively employed when they are allocated to uses in which they are
comparatively (relatively) most productive. Accordingly, individuals, firms, and nations are best off
concentrating on the production of goods or service in which they have a comparative advantage and then
trading with others who have different comparative advantages. This is one of the most important ideas in
economics, and although it is simple it is widely misunderstood. One example from business is that it would be
a mistake for a manufacturer to try to make all the components of a complex product when some of them could
be bought more cheaply from other firms. Rather, the most profitable strategy is to concentrate on doing the
parts of the process the firm does relatively more effectively for itself and to buy in those components or
services that can be made or done relatively more efficiently by others.
Demand and Supply
Most markets can be understood with the use of the same analytic apparatus of demand and supply. It is pretty
obvious that businesses need to understand both their input and output markets. Demand and supply tools are
essential in this task. However, the need to understand markets goes much further. Most people in business get
to be very good at understanding the market for their own product, but they are less good at under-

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standing other important markets that will affect them from time to time. The capital markets are important for
firms that want to raise funds. The money markets affect what interest rate will be charged by the bank, and the
foreign exchange markets determine how competitive a product is in foreign markets as well as how expensive
the goods of foreign producers are. Economic analysis of demand and supply is a helpful tool for understanding
these markets.
Incremental Decisions
Firms face myriad decisions about whether to produce more or less, to hire more or fewer workers, or to buy
new machines or not. The economic analysis of firms provides a simple decision rule that managers and
entrepreneurs will find useful. This is that any action that adds more to revenue than it adds to cost should be
undertaken, while actions that add more to costs than to revenues should not. In the economic theory of the firm
this rule is heavily disguised by the assumption that all firms are profit maximizing and thus will be at a point
where marginal (incremental) cost is equal to marginal (incremental) revenue. In practice most firms are
seeking to take profit-increasing actions, and in this context the incremental decision rule applies.
Market Structure Matters
The range of decisions that firms make and the degree of discretion over those decisions varies considerably
with the nature of the product involved and the structure of the market in which firms sell. Understanding this
market environment is one of the key tasks faced by senior management. In some cases it is technological
innovations that give market advantage, in others it may be competitive pricing or brand identity. Economics is
not the only tool needed to understand these issues, but economics gives important insights into them.
Asymmetric Information
In some markets there is uncertainty about the quality of the product or the future behaviour of one of the
contracting parties. In labour markets, that fact that potential employees know more about themselves than
employers do leads to many subtle issues. Devices to signal quality are often used, and employers have to
worry about monitoring and enforcement of contractual obligations. The general problem involved is said to be
one of asymmetric information, and recent studies of this problem by economists have led to substantial
advances in our understanding of how best to deal with such problems.

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Present Value
One problem that frequently occurs in business involves choosing between different time paths of cash flow.
Should we invest for the long term, or should we distribute as much of today's profit as possible to the
shareholders? No one can tell the owner of a business what he or she must do. But economic analysis is helpful
in showing how to make these intertemporal allocation decisions given simple goals, such as the goal of
maximizing the value of the firm. The appraisal of investment decisions can be made manageable by converting
cash flows at different times into present value. Where the various choices open to the firm are mutually
exclusive, owners or managers can choose the option that maximizes the present value of the firm (otherwise
maximizing the value of the firm involves undertaking any option that increases the firm's present value). Again
the key idea here is very simple, but applying it in practice requires much greater understanding and experience.
Sunk Costs
A common mistake is to be influenced by past investment decisions that didn't work: 'We must spend more on
our Newtown factory because we have already spent so much on it, and it has to made to work!' Economics
makes it clear that such reasoning is always wrong. Bygones are bygones. Future expenditures should be
directed to their most productive uses, not to trying to salvage past errorsunless, of course, this offers the
highest return available at the margin. Costs that have been incurred in the past but are irreversible are known
as sunk costs. The simple rule is that, after they have been incurred, sunk costs should not influence future
decisions. However, before such costs have been incurred a value should be assigned to them. This is
equivalent to valuing an option. This option to invest should only be exercised (that is, the investment made
and the costs sunk) if the value to the firm from proceeding exceeds the value of a wait-and-see strategy.
Organizations Matter
The traditional economic theory of the firm ignored internal organization. However, much work has been done
by economists over the last few decades, especially in US business schools, that has increased our
understanding of the importance of internal organization for efficiency. This work also throws light on the issue
of why firms exist at all. Some of the theorizing in this area may appear abstract at first sight. However, it is a
short step from asking questions such as 'Why do firms exist?' to asking questions such as 'What makes a
successful as opposed to an unsuccessful firm?' and 'How can we reorganize this firm to make it perform
better?'

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Business Cycles
All businesses are affected in some way by the general cycles in the economy. Such cycles have been well
documented since biblical times, and they are unlikely to disappear any time soon. Understanding the patterns
and causes of business cycles is of vital importance to all those who wish to work in industry, commerce, or
finance. Hence, an essential input into the training for any business career is an understanding of the economic
forces that lead to booms and recessions. It is true that forecasts made by professional economists can be read in
the press or bought for a modest sum. However, these forecasts have little informational content beyond about
six months ahead, and most businesses need to take a much longer-term view than this. So it would be very
dangerous to neglect study of the economy at large. The key message from macro-economics is that most
industrial economies display some positive growth of output and incomes over time (in real terms) but that
there is considerable volatility about the long-term trend. Governments have limited power to influence these
variations, and there can be little optimism that cycles can ever be eliminated by any single government acting
alone, or even in concert with others. Business people need to learn to survive recurrent downturns and to profit
from booms.
Course Structures
There are several different course structures that could profitably utilize this book. We suggest some of the
possibilities below.
A traditional one-year introduction to economics covering micro and macro:
Chapters 19 and 1320
A one-term or one-semester introduction to business economics (micro):
Chapters 112
A one-term or one-semester introduction to the basics of both micro and macro:
Chapters 18 and 1317
A one-term MBA course covering micro and macro:
Chapters 120, with emphasis on Chapters 912 and 20
A one-term course in macroeconomics:
Chapters 1320
Please let us know what you think about the book, if you come across errors, have suggestions for
improvement, or find some passages unclear. We take such feedback very seriously. This book is our product,
and we want to know as much about what you the customers want as possible. We hope for many successful
future editions, and your responses are vital in helping us develop this book to fit the needs of as many students
and teachers as possible.

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ACKNOWLEDGEMENTS
This book owes a great deal to all those who have contributed over the years to the development of Positive
Economics. They are too numerous to mention, but both authors remain grateful to all their former colleagues
and students who have influenced their evolution as teachers and writers. The current book evolved from
discussions between the authors and Tracy Mawson of Oxford University Press. Tracy left OUP just as the
final stages of production were under way. Without her, the project would probably never have started.
Brendan Lambon also played an important part in bringing the book to fruition, and Andrew Schuller had a
central role to play in bringing the 'Lipsey' label to OUP in the first place.
The 1995/6 and 1996/7 MBA classes at City University Business School have acted as guinea-pigs for some of
the new material in this book, especially Chapters 1012. Students on the City University Masters in Health
Management have worked through some of the exercises as well as Chapter 11. Several colleagues have
commented on earlier drafts of chapters. Two who have had a measurable impact on the content of the book are
Charles Baden-Fuller, who alerted us to a new line of literature on the reasons for the existence of firms, and
Simon Price, who clarified for us the role of option pricing in the evaluation of irreversible investments.
Finally, Debra Durston provided valuable secretarial assistance.
All errors and omissions remain the joint responsibility of the authors.
KAC AND RGL
LONDON AND VANCOUVER
APRIL 1997

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Page 1

PART I
FIRMS AND MARKETS

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Chapter 1
Introduction to Economics and Business
4
Economics and the Analysis of Business Issues
5
Key Issues for Business
5
Markets and Prices
9
The Economics of the Firm
10
Concentration and Market Power
10
Perfect Competition
11
Monopoly
11
Imperfect Competition
12
The Economics of Organizations
12
Economics of Employment
13
Economics of Investment
13
The Structure of Organizations
14
The Market for Corporate Control
15
Business Cycles
17
The Problem of Resource Allocation


17
Resources and Scarcity
17
Kinds of Resources
20
Kinds of Production
20
Scarcity
21
Choice and Opportunity Cost
22
Specialization and the Principle of Comparative Advantage
25
The Production-Possibility Boundary
28
Economics: A Working Definition
29
Performance of the UK Economy
29
Living Standards
29
Jobs
31
Labour Productivity
34
Changing Technology
34
Job Structure
34
Services in Manufacturing
36
Services for Final Consumption
36
New Products
36

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Globalization
39
Conclusion
39
Summary
40
Topics for Review
41
Questions for Discussion
7
Box 1.1. The Failure of Central Planning
18
Box 1.2. Company Failures and the Business Cycle
23
Box 1.3. The Principle of Comparative Advantage
What has economics got to do with business? Why do students heading for a business career need to study
economics? The answer is that economics addresses many questions that help us to understand the environment
in which all businesses operate. Economics contains a body of knowledge about how the economy works, and
economists are perpetually testing and extending that knowledge. Business leaders are continually asking
themselves questions like 'Will the economy pick up next year?', 'What will happen if a new producer enters
my market?', 'Will the

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Deutschmark appreciate against the dollar?', 'Is the Federal Reserve going to raise interest rates soon, and will
European central banks follow suit?', 'How will the North American Free Trade Association affect my exports
to Canada and Mexico?', and 'How will the introduction of a European single currency affect the economies of
member countries, and of those who stay outside?' These are all questions that an understanding of economics
helps to answer. After all, the world of business is the most important part of the economy.
Economics is not the only the subject that is needed in business. Many other subjectssuch as accounting,
statistics, law, psychology, computer science, languages, not to mention management scienceare important.
However, economics has to be one of the core subjects relevant to business because economics studies key
aspects of the behaviour of business itself, as well as of the environment in which businesses operate.
Being good at economics is neither necessary nor sufficient for being successful in business, but then no course
of training provides guarantees of success in later life. However, a good grounding in economics will provide a
capacity to analyse business situations with a depth of understanding that is hard to achieve in other ways.
Many of the leading thinkers and writers in the business studies field have had a training in economics.
In this chapter, we first review many of the areas in which business studies and economics overlap and outline
the approach of economics to these issues. Then we give a broader perspective on what economics is all about
before summarizing some important characteristics of the UK economy.
Economics and the Analysis of Business Issues
In this section we outline some of the key topics that are of interest to both economists and those in business.
These will be covered in greater depth later in the book. Indeed, the topic areas outlined are essentially a plan
of the topics to be discussed in successive chapters. However, before we proceed it is important to note that
economics and business studies as academic subjects have fundamentally different goals and, to some extent,
different methods.
Economics is a social science that tries to explain the behaviour of the economy by building hypotheses or
theories. Specific versions of these theories are sometimes referred to as economic models. These models are
simplifications of the real world that are potentially useful in illustrating some key feature of how the world
works. Theories are tested by their internal consistency, by their conformity with established principles, and
against available data. The latter is the ultimate test of how useful economics is to non-economistsdoes it help
explain or predict things that are going on in the real world?
Business studies as a subject has the goal of identifying the knowledge that will help people to make a success
of a career in business, either by offering skills that businesses

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will value or (equivalently) by managing a business successfully. The ultimate test is whether the skills
acquired lead to a successful role in running specific businesses. The value of economics to a business person is
in providing tools for analysing what may happen in real-world situations and in giving clear indications of
what factors need to be considered when developing a scenario of how some business environment may evolve.
Economics is a social science that builds theories of how the economy works and tests these theories
against data. Economics is useful to students of business studies because it incorporates accumulated
knowledge of how the economy works, and this is helpful when trying to analyse what is likely to
happen in any future business situation.
Key Issues for Business
Economics as a subject can be divided broadly into two general topic areasmicroeconomics and
macroeconomics.Microeconomics focuses on explaining the behaviour of individual firms, consumers, or
product markets. It is concerned with looking at a small part of the economy. It is, for example, a
microeconomic question to ask 'Why did the price of coffee go up after there was a frost in Brazil?' or 'Why did
the demand for large cars go down after the price of oil went up in the 1970s?'
Macroeconomics, in contrast, looks at the output of the economy as a whole and is concerned with aggregate
questions relating to inflation, unemployment, the balance of payments, and business cycles. 'Why did the UK
economy (and many other economies in the world) go into recession in 19902?' is a macroeconomic question,
as is the question 'Should the government increase its spending in order to reduce unemployment?'
Microeconomics is covered in Part I of this book, and macroeconomics is the subject of Part II. We now look at
some of the topics to be covered in these two areas in more detail.
Markets and Prices
Products are bought and sold in markets. All markets have two sides to them. Suppliers start off with (or make)
the product and offer it for sale in the market. Demanders want to acquire the product and potentially offer to
buy it through the market. Hence, each market has a supply side and a demand side. The market is simply the
area over which suppliers and demanders interact in order to determine the prices and quantities of the product
exchanges that take place.
Some markets have a specific location where buyers and sellers face each other on a

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trading floor; in other markets traders are connected by telephone around the world; yet others work via
showrooms and retail stores, so that producer and consumer are connected only indirectly. There are many
different types of market, but they all involve suppliers and demanders ultimately exchanging a product for
money. The product does not have to be a physical product, such as a bicycle or a television. It could be a
service, such as a haircut or dentistry.
In markets for manufactured consumer goods, firms are the producers of these goods, and so they are the
suppliers. Individuals and families (households) are the potential buyers, and so they are the demanders.
However, in the job (labour or employment) market, firms are the demanders and individuals are the suppliers.
In some markets, such as for machine tools, firms are both the suppliers and demanders.
All firms operate in markets, hence they need to know as much as possible about both their input and their
output markets: Could we buy our inputs cheaper by buying from X, and how much more output could we sell
if we lowered our price by 10 per cent? In many respects, business studies goes much further in studying
markets than does economics. Business strategy involves deciding what product markets a firm should be in
and whether to develop new products, but elementary economics tends to assume a given product structure and
asks how to do best with what you have got.
Economics has traditionally looked at an economy made up of many interacting markets, the market economy,
as only one possible way of organizing the process that takes the economy's natural resources and turns them
into the products that people want to consume. One alternative is a centrally planned economy, in which the
government directs what gets produced, where and when. Such a centrally planned economy is called a
command economy because it works by someone at the centre ordering what shall be produced and by whom
and is associated with political ideologies, such as communism and socialism. Until recently there were many
command economies, such as those of the Soviet Union and Eastern Europe. Some of the reasons why that
economic system failed are discussed in Box 1.1.
Even in market economies it is still necessary to ask whether it is desirable to leave uncontrolled market forces
to determine how much gets produced and at what price. There are many reasons why markets will not always
achieve a socially optimal outcome, and these reasons are used to justify government intervention of various
kinds. Students who study economics further will look at these cases of market failure in some depth. In this
book, we discuss several aspects of government intervention in the market economy in Chapter 9. However, our
primary concern is with understanding markets from the perspective of businesses that have to operate in
specific markets.
Although a market economy is an alternative to a command economy at the aggregate level, it is important to
be aware that a firm is a command economy in so far as its internal organization is concerned. The senior
management of firms decide what to produce and whom to hire and fire. They are, in effect, the central
planners of the firm. They have power over what goes on within the firm, but they are not as powerful as, say,
the Politburo in the old Soviet Union. Managers can be voted out by shareholders, and they can be fired if the
firm is taken over. They may also lose their jobs if the firm goes

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