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Name required. Authors Nicolai J. Foss home posts Peter G. Klein home posts Richard Langlois home posts Lasse B. Lien home posts. Guests Former Guests posts. In what follows, when we use the term cost, we refer to opportunity cost. Costs depend on what you give up your next-best alternative.
Since these costs vary with the decision that you are trying to make, cost and decisions are inherently linked to one another. Management could have sold them and used the capital to expand operations. To fix the problem, the company began rewarding managers for increasing EVA—which is more closely associated with the profit that matters to the shareholders. The company-instituted change in measuring costs motivated the managers of the Bombay operation to move the capital tied up in the apartments to a higher-valued use.
Does your company charge you for the capital that you use? If not, does this lead you to make bad decisions? When making decisions, you should consider all costs and benefits that vary with the consequence of a decision and only costs and benefits that vary with the decision. These are the relevant costs and relevant benefits of a decision. You can make only two mistakes as you make decisions: You can consider irrelevant costs, or you can ignore relevant ones.
In this section and the next, we describe these two potential mistakes and how to avoid them. The fixed-cost fallacy or sunk-cost fallacy means that you consider costs and benefits that do not vary with the consequences of your decision. In other words, you make decisions using irrelevant costs and benefits.
As a simple example, consider a football game. The ticket price does not vary with the decision to stay or leave.
Managerial Economics: A Problem Solving Approach
You should make the decision without considering the ticket price, which is a sunk cost and therefore irrelevant. Because overhead is a fixed or sunk cost, it should not influence most business decisions within a company. If managers make decisions based on their overhead allocations, they commit the fixed-cost fallacy. Look back at the Table income statement. Overhead costs appear in the line item of Selling, General, and Administrative Expense. An example of such an overhead expense would be costs associated with the corporate headquarters staff or with the sales force.
These costs are considered fixed because output can be increased without the need to increase the corporate staff, like the CFO or CEO.
Managerial Economics: A Problem-Solving Approach (MBA Series)
For example, suppose that you, as head of a new products division, are considering launching a product that you will be able to distribute through your existing sales force without incurring extra expenses. However, if you launch the new product, your division will be forced to pay for a portion of the sales force. In this case, the tax deters a profitable product launch. Depreciation5 often becomes another case of the fixed-cost fallacy. For example, in , a washing machine firm considered outsourcing its plastic agitator production, rather than making them internally as had been done for several years.
Play along and make your decision on the basis of the Table The relevant comparison should neglect the costs of depreciation and overhead6 because your firm incurs these costs regardless of whether you decide to outsource. So outsourcing is cheaper. In this example, identifying the right decision was easier than making it for the manager in charge of the manufacturing division. Labor would not be considered a fixed cost unless the company would keep the workers on payroll regardless of whether the part was produced internally or externally.
The manager rationally decided not to outsource even though outsourcing would have been a profitable move for the company. This leads to an important lesson: Accounting profit does not necessarily correspond to real or economic profit.
The Obstacle Is the Way: The Timeless Art of Turning Trials into Triumph
Economic profit measures the true profitability of decisions. Rewarding employees for increasing accounting profit may lead to decisions that reduce economic profit. In the case of the washing machine agitator, the company should have rewarded its manager for increasing economic profit.
This would have better aligned his incentives with the goals of the shareholders. Companies find it difficult to avoid the sunk-cost fallacy because the person who decided to make the sunk-cost investment is often the only one who has enough information to know when the investment should be abandoned. If decision makers fear punishment for making what turns out to be a bad investment, then they may continue the investment to hide the mistake. We see this in the pharmaceutical industry, where drug development programs are very difficult to stop once they get started, and in companies that continue to develop computer software in-house, even after cheaper and better alternatives become available on the market.
In each case, the person or division who made the decision to develop the drug or software fears punishment should the decision be exposed as a mistake. For this reason, drug and software development frequently continues long after it should stop. The hidden-cost fallacy occurs when you ignore relevant costs—those costs that do vary with the consequences of your decision.
As a simple example of this, consider another football game. By going to the game, you give up the opportunity to scalp them. Unless you value going to the game as much as the rival fans, then yours is not the highest-valued use for the ticket. In other words, you are sitting on an unconsummated wealth-creating transaction. Scalp the tickets and stay home! Consider another example: Suppose that you wish to fire an employee. Should you fire the employee? Fire him. When making decisions that involve capital expenditures or savings, it is obviously important to explicitly consider what else you could do with the capital—lest you commit the hidden-cost fallacy.
Typically, the cost of capital is computed as the risk-adjusted cost of equity, the cost of debt, or a weighted average of the two, sometimes called the weighted average cost of capital, or WACC. EVA is the net operating profit after taxes minus the cost of capital times the amount of capital utilized. By adopting compensation schemes tied to EVA, firms are less likely to commit the hidden-cost fallacy.
Under conventional accounting, most companies appear profitable but many in fact are not. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources. By taking all capital costs into account, including the cost of equity, EVA shows the dollar amount of wealth a business has created or destroyed in each reporting period. In other words, EVA is profit the way shareholders define it.
Everything before that is just building up to the minimum acceptable compensation for investing in a risky enterprise. Implementing EVA to avoid the hidden-cost fallacy still requires managers to exert a considerable amount of judgment and analysis. Even though EVA is designed to make visible the hidden cost of capital, unless you can identify all hidden costs, you can still commit the hidden-cost fallacy.
By adopting EVA, or a similar economic profit plan9 EPP , and linking pay to performance, firms reward managers for making good decisions—those that increase economic profit. If managers begin making better decisions, firms that adopt such plans should experience improved operating performance. Median operating income-to-total assets rises to It appears that firms adopting EPPs realize dramatic long-run improvements in operating performance. Other EPPs include earnings-based bonuses and stock ownership including employee stock ownership plans, restricted stock, phantom stock, and stock options.
We have to compare EPP adoption with the next-best alternative: That is, what else can firms do to increase profitability? This is the opportunity cost of EPP adoption. Surprisingly, they found that operating performance of nonadopting firms was statistically indistinguishable from that of adopting firms. Thus, well-managed firms respond to poor recent performance by strengthening the link between pay and performance, but the choice of performance evaluation metric, whether economic profit including the hidden cost of capital or earnings accounting profit , does not seem to matter. The bottom line is that new trends, fads, or analytical tools should be viewed skeptically.
If a radical change is necessary to kick managers into action, the conclusion could well be that adoption of an economic performance plan is the necessary boot. The opportunity cost of an alternative is the profit you give up to pursue it. These are the relevant costs and benefits of a decision. Decisions that change output will change only variable costs.
Web site. Why do we choose the one we report in the paper? Because academics have shown that it has the best statistical properties. The fixed-cost fallacy or sunk-cost fallacy means that you consider irrelevant costs. A common fixed-cost fallacy is to let overhead or depreciation costs influence short-run decisions.
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The hidden-cost fallacy occurs when you ignore relevant costs. A common hidden-cost fallacy is to ignore the opportunity cost of capital when making investment or shutdown decisions. EVA is a measure of financial performance that makes explicit the hidden cost of capital. Rewarding managers for increasing economic profit increases profitability, but evidence suggests that economic performance plans work no better than traditional incentive compensation schemes based on accounting measures. A manufacturing company is considering purchasing a new machine that doubles capacity from to 1, units per week.
The machine will occupy approximately square feet of vacant unused space on the factory floor. Which of the following costs are irrelevant in the decision to purchase this machine? The additional cost of utilities necessary to run the machine b. Monthly rental expense associated with the 10,square-foot factory c. Additional machinists who will need to be hired to run the machine d. Maintenance costs for regular repair and cleaning of the machine 2.
A company manufactures both pens and pencils in the same facility. Due to a federal ruling requiring all elementary school students to use only pencils, the overall demand for pencils has shifted outward leading to an increase in pencil prices. Surprisingly, this has had no effect on pen demand. The firm will find in the short term that a.
Which of the following costs always must be considered relevant in decision making? Variable costs b. Avoidable costs c. Fixed costs d. Corporate overhead rent, general and administrative expense, etc. After reviewing the statement, company managers are concerned about the loss on Version Z and are considering ceasing production of that version. Should they do so? Why or why not?
Neglect other concerns, like closing costs, capital gains, and tax consequences of owning, and determine whether it is better to rent or own. Opportunity Cost of Steel Your firm usually uses about to tons of steel per year. Which of the following are correct? Hold onto your tons, and wait until it is needed for production. Nor can you take it out of the country. Because the gift shop was closed, you decided to spend the remaining money on refreshments—for complete strangers!
What is the cost of the refreshments? Calculate accounting profit. What are the opportunity costs for the manager of being in this business relative to returning to his old job? What is the economic profit of the business? Fixed-Cost Fallacy Describe a decision made by your company that involved costs that should have been ignored. Why did your company make the decision? What should they have done? Compute the profit consequences of the decision. Hidden-Cost Fallacy Describe a decision that you or your company made that involved opportunity costs that should have been considered.
Hidden Cost of Capital Does your company charge your division for the capital that it uses? If not, does this lead to bad decision making? Its facilities cover over two million square feet and span an area of nearly 38 acres. The hospital offers a full line of services, including cardiac care, neurosurgery, orthopedics, oncology, and obstetrics. The obstetrics area has provided delivery services to area patients for over 80 years and recently underwent a multimillion-dollar renovation.
As part of this review process, the chief of obstetrics proposed increasing the number of babies being delivered by the department. As we learned in the last chapter, the relevant costs and benefits of a decision are only those that vary with the consequences of that decision. Increasing the number of deliveries would lead to an increase in hospital profit. In this chapter, we show you what the relevant costs and benefits of extent decisions are and how to make these decisions profitably. Average cost is simply the total cost of production divided by the number of units produced.
Suppose that Memorial would incur no additional fixed costs to serve more patients, up to a limit of patients. We would end up with the average cost curve depicted in Figure Notice that the curve slopes downward due to fixed costs. Similarly, average total cost is the sum of average fixed cost and average variable cost. Using average costs in extent decision making can lead to unprofitable decisions of how much of a product to make or to sell. The lessons in this chapter will help you avoid this common error. Managers make profitable extent decisions when they consider marginal costs rather than average costs.
Average cost AC is irrelevant to an extent decision.
At some point, average costs will begin to increase either through the need to add additional fixed costs or from rising per unit variable costs. We will examine the U-shaped average cost curve in a later chapter. Fixed costs do not change as output increases, so they do not factor into marginal cost calculations. Marginal costs are not always lower than average costs; it depends on the range of output we are considering.
It is possible that increasing output will add expenses or decrease productivity for the firm. For example, consider a factory near capacity that tries to increase production. Workers may run out of space, leading to lower productivity and higher costs. The marginal cost of these additional units could rise above average cost. You should take another step e. Stop when the costs of taking another step are greater than the benefits of doing so. We call this approach marginal analysis. To illustrate, we analyze the common extent decision of how much to sell, where marginal analysis applies to both costs and revenues.
Marginal cost MC is the additional cost incurred by producing and selling one more unit. Marginal revenue MR is the additional revenue gained from selling one more unit. If the benefits of selling another unit MR are bigger than the costs MC , then sell another unit. The main difficulty in applying marginal analysis is measuring the costs and benefits of additional steps. To illustrate, suppose you are working for a longdistance phone company trying to decide whether to adjust the amount you spend for TV advertising.
The only available data correspond to the bigger change, so we do the best that we can. Otherwise, do not. Note that marginal analysis points you in the right direction, but it cannot tell you how far to go. After taking a step, recompute marginal costs and benefits to see whether further steps are warranted. When the marginal benefit equals the marginal cost, stop then because you are maximizing profit i. We can also use marginal analysis to compare the relative effectiveness of two different advertising media. For example, suppose that you are trying to decide how to adjust your promotional budget, currently allocated between TV advertising and telephone solicitation.
How much should you spend on advertising for each medium? In this case, the opportunity cost of spending one more dollar on TV advertising is the forgone opportunity to spend that dollar on telephone solicitation. Increase spending on whichever medium has a higher marginal effect, and pay for the increase by reducing spending on the other medium. Note that we are implicitly assuming that you could get the customers back by restoring your telephone solicitation budget.
All it requires is that you measure the marginal effectiveness of each activity. If one activity has higher marginal effectiveness than the other, then increase that activity and reduce expenditures on the other. Then remeasure and decide whether to make further changes. When you adjust your advertising expenditures, make the changes one at a time.
Do not increase telephone solicitation at the same time you decrease TV advertising because you lose valuable information about the marginal impact of each change when you change both at the same time. Only by changing them separately can you measure the marginal effectiveness of each expenditure to see whether further changes are profitable. It is essential that you not confuse marginal cost with average cost. Recall that to calculate the average cost, divide total cost by the number of units produced. In our current example, the average per-customer cost for TV would be computed by dividing the total spent on TV advertising by the total number of customers gained.
Remember that average costs do not provide the information you need to make extent decisions. In some instances, they might lead to poor decisions. To compute marginal cost, look only at the additional cost of producing one more unit. The two cost figures may be very different. For example, some psychological models of advertising say that any fewer than four exposures to an advertisement has no effect on purchase decisions.
The marginal effectiveness of that fourth exposure is thus very large, but the average effectiveness of the entire advertising budget would be much lower. The manufacturing facilities operate as cost centers, meaning that plant managers are rewarded for reducing costs. To evaluate the cost centers, the firm measures production using standard absorbed hours SAH.
For each garment produced, the firm computes the time required to complete each step in the manufacturing process. Complex garments like overalls require more time and thus are assigned a higher SAH 15 minutes than simple garments like T-shirts two minutes. Obviously, measuring output in this way allows managers to identify lower cost factories. Remember, this is an extent decision about how much to produce at each factory, so you want to measure the marginal production costs at each plant.
The first thing to remember is the fixed-cost fallacy. So, first you must adjust the cost per SAH to remove the influence of any fixed costs. Second, make sure that cost per SAH is a good proxy for marginal costs. If this is not correct, then cost per SAH is a poor proxy for marginal cost. Decide how far to go by taking a step and then remeasuring marginal costs to determine whether to take another step. In this example, the Fortune 50 company shifted some production, but not as much as the managers wanted because they had to maintain good working relationships with politicians in the Dominican Republic who would have been upset if too many local workers lost jobs.
To illustrate, suppose you are a landowner evaluating two different bids for harvesting a tract of timber containing trees. Which bid should you accept? The royalty rate is analogous to a sales tax because it deters some wealth-creating transactions i. For example, suppose you want to evaluate the incentive effects of two different incentive compensation schemes. Which incentive compensation scheme should you use? As in our earlier example, the contracts have the same face value but different effects on the behavior of the salesperson.
If some sales are relatively easy to make i. In essence, the sales force responds to the smaller marginal benefit of selling with less effort, which we call shirking. This kind of shirking is analogous to the decision of the logger to harvest only the high-value, low-cost trees when he pays a royalty rate for each tree harvested. The logger responds negatively to the high marginal costs of logging just as the salesperson responds negatively to the low marginal benefit of selling. To induce higher effort, use incentives that reduce marginal costs or increase marginal benefits.
Fixed costs or benefits do not change effort. Recall that we noted in Chapter 2 that when a sales tax is larger than the surplus of a transaction, it deters that transaction. Similarly, when the royalty rate is larger than the surplus here, it deters the wealth-creating transaction the harvesting of the fir tree. The COO was in charge of keeping clients happy and ensuring that the account executives were working in the best interests of the company. After taking classes in human resources, economics, and accounting, the CEO of the company became convinced of the merits of incentive pay.
He sat down with his COO, and together they set profit goals for the year. A good economy certainly contributed to the increase in revenues, but the compensation plan also helped. Revenue increased because the COO pushed hard to make and exceed earnings goals, and, for the first time, he worried about expenses. For example, he attempted to contain costs by asking why phone bills were so high. This had equally dramatic effects on the account representatives—except for one employee who was going through a divorce.
The incentive pay scheme did little to increase his marginal incentives because half of everything he earned went to his estranged wife. Although the benefits of incentive pay seem clear, it is not a panacea—especially in cases where it is difficult to measure performance. Later on, as we develop more tools to analyze incentives, we will see that there are situations where 6 Earnings refers to company profit. Also, trying to implement incentive pay in an organization can be more difficult than turning a Communist country toward capitalism. I fear that we will be attempting to compete for employees interested in a class-oriented system of compensation.
From where I sit, this is the last thing a corporation needing vast, systemic, team-oriented change should be trying to do to compete in the global marketplace. Many folks know I am a staunch opponent of incentive plans, and I often quote Alfie Kohn , whose research shows that rewards punish. The incentive pay policy is overt in its support of class separation over collective team participation.
It ignores the premises of modern systems thinking and reverts to the mechanistic theories of Descartes and Newton for justification. A typical business school text from the s would have suggested instituting such an aristocratic policy. If you want to short the stock of this company, call me and I will tell you which one it is. A company is producing 1, units.
What can we conclude from this information? The company is producing too much. The company should produce more. The company is maximizing profit at this output. Not possible to determine. The staff cannot produce more than pizzas per week. What is the difference between the average cost per sofa for 12 sofas and the marginal cost of the 12th sofa? What is the marginal cost of the 11th worker? Which of the following choices represents an extent decision? A firm is considering whether to enter a business. A firm is considering whether to leave a business.
A firm is considering whether to sell a division.
The human resources director is deciding how many employees to lay off. How do we know? Should the shoe company sell any shoes to the Chinese retailer? Ignore any potential issues of bundling the two types of shoes together as part of the sale and any competitive effects that international sales might have on current domestic sales. In-Sourcing Sales Force Five years ago, to respond to cost-cutting pressure during a weak economy, your company decided to close five sales offices employing five people each.
Currently your company employs independent sales agents who earn a 2. What concerns might you have about such an approach? Copier Company A copy company wants to expand production. It currently has 20 workers who share eight copiers. Two months ago, the firm added two copiers, and output increased by , pages per day. Copiers cost about twice as much as workers. Would you recommend they hire another employee or buy another copier?
Extent Decision Describe an extent decision made by your company. Compute the marginal cost and marginal benefit of the decision. Was the right decision reached? If not, what would you do differently? Contracts Does your firm use royalty rate contracts or fixed-fee contracts? Describe the incentive effects of the contracts.
Should you change the contract from one to the other? Compute the profit consequences of changing the contract. With twice as many field engineers as its next-largest competitor, Mobil was able to offer custom-designed lubrication programs to complement sales of their lubricants. Early in , Mobil conducted a three-month engineering audit of CBA. This audit included employee training, equipment inspections, and, for each piece of CBA equipment, repair, service, and lubricant recommendations. CBA made the recommended repairs, but then it gave the lubricant recommendation list to a Mobil competitor that offered lubricants at lower prices.
When Mobil failed to match the lower prices, they lost the contract and their three-month investment. Mobil and its managers forgot a basic business maxim: Look ahead and reason back. By failing to anticipate self-interested behavior, they were victimized by it. Why distinguish between fixed and marginal costs? The answer is simple: Fixed costs do not vary with production, so you should ignore them when setting price or production levels—otherwise, you commit the fixed-cost fallacy.
One gallon barrel of oil yields just two quarts of lubricant. In later chapters we will analyze situations in which marginal costs are not constant. You need to consider fixed costs before you incur them. To compute the break-even quantity where profit equals zero , assume that you can sell as much as you want at a given price and that marginal costs are constant.
So you have to sell at least the breakeven quantity to earn enough to cover fixed costs. To see this, multiply the breakeven quantity by the contribution margin to see that it equals the amount of the fixed costs. If you sell more than the break-even quantity, you have earned more than enough to cover your fixed costs, or to earn a profit.
These are the fixed costs. In , John Deere was building a capital-intensive factory to produce large, four-wheel-drive farm tractors. John Deere stopped construction of its own factory and attempted to purchase Versatile, a Canadian company that assembled tractors in a garage using off-the-shelf components. Did John Deere make the right decision? To determine the quantity at which John Deere is indifferent between the two technologies—the break-even quantity—solve for the quantity that equates the two costs. John Deere would have been better off if it had abandoned the construction project and acquired Versatile because projected demand for tractors was low.
However, the Antitrust Division of the U. Department of Justice challenged the acquisition as anticompetitive. We end this section with a warning to avoid a very common business mistake: Do not invoke break-even analysis to justify higher prices or greater output. Managers often reason, for example, that they must raise prices so that price can cover fixed costs. This is wrong if fixed costs do not vary with the pricing decision. Similarly, managers sometimes reason that since average fixed costs decline with quantity, they must sell as much as they can to reduce average cost.
Remember, the relevant costs depend on which question you are asking. In the next section, we show that they can also be relevant when you decide to shut down operations. If you shut down, you lose your revenue, but you get back your avoidable costs. If revenue is less than avoidable cost, or equivalently, if price is less than average avoidable cost,5 then shut down. The break-even price is the average avoidable cost per unit. The only hard part in applying break-even analysis is deciding which costs are avoidable. For that, we use the Cost Taxonomy shown in Figure How low can price go before it is profitable to shut down?
In the long run, fixed costs become avoidable, so they become relevant. When the lease comes up for renewal, it is relevant to the shutdown decision because it is avoidable. However, until the lease comes up for renewal—during the period that economists call the short run—it is unavoidable, so you should ignore it when deciding whether to shut down.
We have already seen the utility of using this perspective to look ahead and reason back to worst-case scenarios. Nowhere is this more important than in analyzing sunk-cost investments. Sunk costs are unavoidable, even in the long run, so if you make sunk-cost investments, you are vulnerable to postinvestment hold-up.
Consider the case of a magazine, like National Geographic, trying to negotiate with a regional commercial printer to print its magazine. For the magazine, using a regional printer saves on shipping costs. Before they are incurred, sunk costs are relevant to the negotiation. However, once the printer purchases the printing press, the profit calculus changes. Once sunk costs have been incurred, the magazine can renegotiate terms of the deal; that is, the printer is subject to hold-up. If the managers of the commercial printer foresee that they are vulnerable to hold-up, they will be reluctant to deal with the magazine.
With the assurance of a contract, the printer may feel confident enough to incur sunk costs. But contracts are often difficult and costly to enforce. A better solution is to make the magazine purchase the press and then lease it to the printer. The magazine no longer poses a hold-up threat to the printer because the printer has incurred no sunk costs.
If the magazine tries to renegotiate a price less than average cost, the printer will rationally refuse the business, sell the press, and recover his entire investment. Unless each party is confident that it will not be held up, it is unlikely that either will make relationship-specific investments. In this case, it might be advantageous to write strong long-term contracts— those that impose heavy penalties for hold-up. Or it might be even better to remove the transaction from the marketplace and put it under the organizational umbrella of a single firm.
If the same parent company owns both parties, it is less likely that either will hold the other up. Vertical integration refers to the common ownership of two firms in separate stages of the vertical supply chain that connects raw materials to finished goods. Consider bauxite aluminum ore from mines in South America.
The refining process used to produce alumina from bauxite is tailored to the specific qualities of the ore. Both the specificity of the refining process and the high transport costs make the investment in a refinery specific to the relationship between the mine and the refinery.
Managerial economics a problem solving approach
In this case, the enormous investment required to build a refinery is very vulnerable to postinvestment hold-up—the bauxite mine could raise the price of ore once the refinery is built. So, we rarely see refineries built without vertical 9 However, now the magazine can be held up by the printer and may be reluctant to buy the machine unless the printer can reassure the magazine that it will not be held up. Marriages are vulnerable to the same type of postinvestment opportunism that plagues commercial relationships. Parties invest time, energy, and money in a marriage, the kinds of investments that differentiate marriages from more casual relationships, just as in spot market transactions.
These investments are valuable to the marriage parties but are largely sunk, in that they have a much lower value outside the relationship. The marriage contract penalizes postinvestment hold-up i. The two were receiving premarital counseling from a priest. Equivalently, we say that you have a low discount rate or that the future is worth almost as much to you as the present. Individuals with low discount rates invest in more projects because more investments meet their return criteria. The weakening of the marriage contract in the United States, dramatically reducing penalties for postinvestment hold-up, allows a test of this contractual view of marriage.
Following the change, we would expect less relationship-specific investment, like the investment in children. Corresponding to the weakening of the contract, we have seen a decline in fertility rates. Couples are having fewer children and having them later in life, when it is easier to drop in and out of the labor market. The common thread in these activities is that they have current costs and future payoffs, just like investments.
They invest only in projects with much higher rates of return, or, if none is available, they borrow money. These individuals are more likely to smoke, shun exercise, abuse drugs, and commit crime. The common thread in all of these activities is that they have current payoffs and future costs. One reason for identifying individuals with different discount rates other than to keep those with high discount rates out of your study group is to recognize the possibility of trade between them.
Companies, like individuals, possess discount rates of their own, determined by their costs of capital. And, as with individuals, there is the possibility of trade. Companies with high discount rates willingly borrow from those with low discount rates. As you might imagine, time is a critical variable in investment decisions, whether companies have high or low costs of capital. Intuitively, this makes sense. The company would obviously prefer to get its profit more quickly and so would prefer the first project to the second.
All net project cash flows are projected outflows like project costs are subtracted from inflows like project revenues and discounted back to their present value. If the present value of the net cash flows is larger than zero, the project is profitable. Proper methods are the subject of much debate in the field of finance. Many companies satisfy themselves with rough estimates. Inflow 1 is divided by 1. The NPV rule has a clear link to our discussion of the concept of economic profit in Chapter 3. Projects with positive NPV create economic profit.
Projects with negative NPV may create accounting profit but not economic profit. In making investment decisions, choose only projects with a positive NPV. If you expect to sell more than the break-even quantity, then incur the fixed costs to enter the industry. If the benefits of shutting down you recover your avoidable costs are larger than the costs you forgo revenue , then shut down. The break-even price is average avoidable cost. Once relationship-specific investments are made, parties are locked into a bargaining relationship with each other.
If transactions are frequent and transaction costs are high, then organizational forms like vertical integration or long-term contracts reduce transactions costs and encourage relationship-specific investments. Investments imply willingness to trade dollars in the present for dollars in the future. Wealth-creating transactions occur when individuals with low discount rates lend to those with high discount rates. Companies, like individuals, have different discount rates.
The NPV rule states that if the present value of the net cash flows of a project is larger than zero, the project is profitable. As manager of a company that is trying to maximize long-run profit, which of the following is a rational profit-maximizing business decision? In the long run, shut down the business if price falls below long-run average costs.
In the long run, shut down the business if price falls below short-run average variable costs. In the short run, shut down the business if price falls below average costs. In the short run, shut down the business if price is not high enough to cover fixed costs. You are considering opening a new business to sell golf clubs. You are the manager of a small production facility. In the short run, what is the minimum acceptable price level before it makes economic sense to shut down? If production of a certain type of product requires a large specific investment, which of the following production setups would you least expect to see?
Short-term outsourcing. Vertical integration. Long-term relationship with external supplier. All production met through internal sources. Printer Hold-Up Suppose that in our National Geographic example, half of the original cost of the rotogravure printing press is fixed and half is sunk. How low can the offered price go before the printer will rationally refuse to print magazines?
What is your bottom line in negotiations with the telecom? Suppose you agree on a price slightly above your bottom line. Immediately after quoting this price to the telecom company, you receive a faxed purchase order for one million units. What should you do? Bagel Company Break-Even Analysis You are considering opening a bagel restaurant aimed primarily at the breakfast trade. What is the break-even quantity of bagels? Marketing research indicates that the store will sell bags.
Shutdown Decision Describe a shutdown decision your company has made. Compute the opportunity costs and benefits of the decision using break-even analysis if appropriate. Did your company make the right decision? Investment Decision Describe an investment decision your company has made. Compute the opportunity costs and benefits of the decision. Compute the NPV of the investment. Postinvestment Hold-Up Describe an investment or potential investment your company or one of your suppliers or customers has made that is subject to postinvestment hold-up.
What could your company do to solve the hold-up problem and ensure the investment gets made? Compute the profit consequences of the solution. Coincidentally, interest rates rose sharply, slowing business activity and increasing unemployment dramatically. Sara Lee did a survey and found that many customers had turned to a cheaper source of protein—cat food mixed with eggs, rolled up in a tortilla. As many consumer products firms do, Sara Lee produced several brands of hot dogs, differentiated by ingredients, brand names, and, perhaps most important, price.
Unfortunately, Sara Lee had priced the lower-end brands too low and lost money. Sara Lee would have profited from a better understanding of demand for its products and how to set prices, the topic of this chapter. Table shows the number of hot dogs the consumer will purchase at various prices. This makes intuitive sense. Knowing the value our consumer places on each subsequent hot dog allows us to construct Table showing total and marginal value for the various quantities, where total value is simply the sum of the preceding marginal values.
As always, thinking in marginal terms is critical. This insight leads to another important idea: consumer surplus. Consumer surplus is the difference between the price a buyer is willing to pay and what the buyer has to pay the actual price. Consumers attempt to maximize their surplus—they use marginal analysis and purchase only three hot dogs rather than five. We can link our two tables to get a measure of how much our consumer is gaining from eating hot dogs. If the consumer pays less than the total value of the hot dogs, he or she has consumer surplus. Table shows the amount of consumer surplus for different hot dog purchase levels.
To describe how consumers respond to price, economists use demand curves, which are simply plots of the information contained in demand schedules. Recall from the Law of Demand that we should expect demand curves to slope downward, as consumers purchase more as prices fall. Demand curves describe buyer behavior and tell you how much consumers will buy at a given price. To describe the buying behavior of a group of consumers, we add up all the individual demand curves to get an aggregate demand curve. Assume, for instance, that each consumer wants a single item i.
Now suppose that seven buyers each want to buy a single unit of a good. This is a result of using whole numbers to describe prices and values. For convenience, imagine that the value is a fraction above the price, so that the buyer will purchase. In Figure , we illustrate this demand curve. To determine the quantity demanded at each price, look for the quantity on the horizontal axis corresponding to a price on the vertical axis. As price falls, quantity demanded increases.
Note that we do not say that as price falls, demand increases. An increase in demand occurs when the whole curve shifts to the right such that consumers purchase greater quantities at the same prices. Sellers can raise price and sell fewer units, but earn more on each unit sold.
Or they can reduce price and sell more, but earn less on each unit sold. This fundamental trade-off is at the heart of pricing decisions, a trade-off we can resolve by using marginal analysis. If marginal revenue MR is greater than marginal cost MC ,2 you can increase profit by selling another unit. But consumers are using marginal analysis to maximize consumer surplus make all purchases so that marginal value exceeds price , while sellers use it to maximize profit. To see how to use marginal analysis to maximize profit, examine Table So far, all of these changes have been profitable because the increase in revenue MR has been greater than the increase in cost MC.
Your boss has confused average revenue or price with marginal revenue. Put another way, you can say that to sell more, you have to reduce price for all customers, not just the additional customers who would be attracted by the reduced price. Tell your boss that you are already making all profitable sales—those for which marginal revenue exceeds marginal cost. Marginal analysis, not average analysis, tells you where to price or, equivalently, how many to sell. If the managers of Sara Lee had known what the Mexican demand curve for their hot dogs looked like, they could have easily computed the optimal price, just as we did in Table In general, it is very difficult to get information about demand at prices above or below the current price.
Since 2 divides both denominator and numerator, the formula simplifies, as here. The approximation does not work well for large changes. And elasticity tells you this. For example, if demand is elastic, then a price decrease will be smaller than the corresponding quantity increase, so revenue will rise following a price decrease. Likewise, a price increase will be smaller than the corresponding quantity decrease, so revenue will fall following a price increase.
This relationship is illustrated in the bottom row of Table On the other hand, if you try to increase price when demand is elastic, then revenue goes down top row of Table Ultimately, the elasticity of demand for gasoline in the district of Columbia would determine whether quantity would decrease by more than price would increase. Since D.
This scenario predicted by the gas station owners is illustrated in the top row of Table When demand is inelastic, this relationship is reversed; that is, price increases raise revenue because the price increase is bigger than the corresponding quantity decrease. Conversely, price decreases reduce revenue because the price reduction is bigger than the quantity increase see Table This expression has an intuitive interpretation. Intuitively, as demand becomes more elastic, the less you can mark up price over marginal cost because you lose too many customers. Ordinarily, a profit-maximizing store manager would raise the price in such a situation.
In this case, however, the managers were using three-liter Coke as a loss leader, deliberately pricing it too low as a way to attract customers to the store. Because they hoped that customers would spend money on other items once they got there. In this section, we list four factors that affect demand elasticity and optimal pricing.
Products with close substitutes have elastic demand. Consumers respond to a price increase by switching to their next-best alternative. In a similar vein, we see that individual brands have closer substitutes other brands than do aggregate product categories that include the brands. This leads to our next maxim. Demand for an individual brand is more elastic than industry aggregate demand. As a rough rule of thumb, we can say that brand price elasticity is approximately equal to industry price elasticity divided by the brand share.
And you can use this estimate to gain a general idea of whether your brand price is too high or low. Products with many complements have less elastic demand. Products that are consumed as part of a larger bundle of complementary goods—say, shoelaces and shoes—have less elastic demand. Conversely, products that are not part of a bundle of complementary goods have more elastic demand.
As their price changes, consumers find it easier to stop consuming the good. Another factor affecting elasticity is time. Given more time, consumers are more responsive to price changes.
They have more time to find more substitutes when price goes up and more time to find novel uses for a good when price goes down. This leads to our third maxim: In the long run, demand curves become more elastic: jej increases. As time passes, information about a new price becomes more widely known, so more consumers react to the change. As an example, consider automatic teller machine ATM fees. When informed of the fee increase, users typically completed the current transaction but avoided the higher-priced ATMs in the future.
If we define the short run as the current transaction and the long run as future transactions, then the maxim holds. Our final maxim relates elasticity to the price level. As price increases, consumers find more alternatives to the good whose price has gone up. And with more substitutes, demand becomes more elastic. As price increases, demand becomes more elastic: jej increases. For example, high-fructose corn syrup HFCS is a caloric sweetener used in soft drinks. For this application, sugar is a perfect substitute for HFCS.
However, import quotas and sugar price supports have raised the U. All soft drink bottlers now use HFCS instead of sugar. And because bottlers have no close substitutes for low-priced HFCS, its demand is relatively inelastic. In other words, demand for high-priced HFCS would become very elastic. Remember that price is only one of many factors that affect demand. Income, prices of substitutes and complements, advertising, and tastes all affect demand. If the temperature elasticity of demand for beverages is 0. Income elasticity of demand measures the change in demand arising from changes in income.
Positive income elasticity means that the good is normal; that is, as income increases, demand increases. Negative income elasticity means that the good is inferior; that is, as income increases, demand declines. Sara Lee thought that demand for its hot dogs was inferior; but in Mexico, consumers regarded premium hot dogs as something of a luxury, so demand went down when income went down. Cross-price elasticity of demand for Good A with respect to the price of Good B measures the change in demand of A owing to a change in the price of B.
Positive cross-price elasticity means that Good B is a substitute for Good A: As the price of a substitute increases, demand increases. Negative cross-price elasticity means that Good B is a complement to Good A: As the price of a complement increases, demand decreases. Computers, for example, are complements to operating systems that run on them. We can estimate factor elasticities by using a formula analogous to the estimated price elasticity formula, and we can use factor elasticities to forecast or predict changes over time or even changes from one geographic area to another.
To compute the break-even quantity, you need to know whether enough Nashvillians will choose home delivery to justify the investment in this service. If the forecast quantity would allow you to break even, then begin home delivery in Nashville. For example, you know from the Law of Demand that raising price will result in selling fewer units.
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Stay-even analysis tells you how many unit sales you can lose before the price increase becomes unprofitable. When combined with information about elasticity of demand, the analysis will give you a quick answer to the question of whether changing price makes sense. To see the effect of a variety of potential price changes, we can draw a stayeven curve that shows the required quantities at each new price level.