BUS7500 Managerial Economics Week 3 Dr. Jenne Meyer

Background: consumer surplus and demand curves First Law of Demand - consumers demand (purchase) more as price falls, assuming other factors are held constant. Consumers make consumption decisions using marginal analysis, consume more if marginal value > price But, the marginal value of consuming each subsequent unit diminishes the more you consume. Consumer surplus = value to consumer - price paid Definition: Demand curves are functions that relate the price of a product to the quantity demanded by consumers

Background: consumer surplus and demand curves (cont.) Hot dog consumer Values first dog at $5, next at $4 . . . fifth at $1 Note that if hot dogs price is $3, consumer will purchase 3 hot dogs NEED TO REPLACE CHART WITH NEW GRAPHICS.

Background: aggregate demand Aggregate Demand: the buying behavior of a group of consumers; a total of all the individual demand curves. To construct demand, sort by value. Discussion: Why do aggregate demand curves slope downward? Role of heterogeneity? How to estimate?

Pricing trade-off Pricing is an extent decision Profit= Revenue - Cost Demand curves turn pricing decisions into quantity decisions: “what price should I charge?” is equivalent to “how much should I sell?” Fundamental tradeoff: Lower price sell more, but earn less on each unit sold Higher price sell less, but earn more on each unit sold Tradeoff created by downward sloping demand

Marginal analysis of pricing Marginal analysis finds the profit increasing solution to the pricing tradeoff. It tells you only whether to raise or lower price, not . Definition: marginal revenue (MR) is change in total revenue from selling extra unit. If MR>0, then total revenue will increase if you sell one more. If MR>MC, then total profits will increase if you sell one more. Proposition: Profits are maximized when MR = MC

Example: finding the optimal price Start from the top If MR > MC, reduce price (sell one more unit) REPLACE WITH BETTER GAPHIC

Find the optimum price Additional expenses: Web - $140/year 5760 10800 15840 25200 Total Quantity 5,760 10,800 15,840 25,200 Quantity per version 1,920 ea. Of 3 3,600 ea. Of 3 5,280 ea. Of 3 8,400 ea. Of 3 Total Cost $ 5,161.17 $ 6,675.30 $ 8,230.69 $ 11,204.36 Makeready* $ 1,546.89 Printing Costs $ 3,614.28 $ 5,128.41 $ 6,683.80 $ 9,657.47   Packaging/Inserting On tab #3 sticker cost per $ 0.63 $ 0.47 $ 0.42 $ 0.38 packaging cost $ 2,077.08 $ 3,469.90 $ 4,848.15 $ 7,377.77 sticker + packaging $ 5,691.36 $ 8,598.31 $ 11,531.95 $ 17,035.25 cost per sheet $ 0.99 $ 0.80 $ 0.73 $ 0.68 Additional expenses: Web - $140/year Printed envelopes - $0.08/each for 10K Other expenses?

Estimating elasticities Definition: Arc (price) elasticity= [(q1-q2)/(q1+q2)]  [(p1-p2)/(p1+p2)]. Discussion: Why, when price changes from $10 to $8, does quantity changes from 1 to 2? Example: On a promotion week for Vlasic, the price of Vlasic pickles dropped by 25% and quantity increased by 300%. Is the price elasticity of demand -12? HINT: could something other than price be changing? Note that in many examples, the arc price formula is not used for simplicity Answer: In the Vlasic example, price of Heinz is coming off promotion and the Vlasic price is being advertised in the newspaper, in store coupons, and end of aisle displays.

Estimating elasticities (cont.) 3-Liter Coke Promotion (Instituted to meet Wal-Mart promotion) Extra credit: aggregate elasticity of demand for 2 and 3 liter coke. (compute change in price index and change in liters consumed. REPLACE WITH BETTER GRAPHIC

Intuition: MR and price elasticity Revenue and price elasticity are related. %Rev ≈ %P + %Q Elasticity tells you the size of |%P| relative to |%Q| If demand is elastic If P↑ then Rev↓ If P↓ then Rev↑ If demand is inelastic If P↑ then Rev↑ If P↓ then Rev↓ Discussion: In 1980, Marion Barry, mayor of the District of Columbia, raised the sales tax on gasoline sold in the District by 6%. What happened to gas sales and availability of gas? Why? ANSWER to question: tax revenue declined by 40% because demand for gasoline in the District of Columbia is very price elastic.

What makes demand more elastic? Products with close substitutes have elastic demand. Demand for an individual brand is more elastic than industry aggregate demand. Products with many complements have less elastic demand.

Describing demand with price elasticity First law of demand: e < 0 ( as price goes up, quantity goes down). Discussion: Do all demand curves slope downward? Second law of demand: in the long run, |e| increases. Discussion: Give an example of the second law of demand. Second law of demand – ATM fees (checking fees), fees that go away, as time goes,

Describing demand (cont.) Third law of demand: as price increases, demand curves become more price elastic, |e| increases. P76 HFCS and sugar

Other elasticities Definition: income elasticity measures the change in demand arising from a change in income (%change in quantity demanded)  (%change in income) Inferior (neg.) vs. normal (pos). Definition: cross-price elasticity of good one with respect to the price of good two (%change in quantity of good one)  (%change in price of good two) Substitute (pos.) vs. complement (neg.). Definition: advertising elasticity; a change in demand arising form a change in advertising (%change in quantity)  (%change in advertising) . Discussion: The income elasticity of demand for WSJ is 0.50. Real income grew by 3.5% in the United States. Estimate WSJ demand

Stay-even analysis Stay-even analysis tells you how many sales you need when changing price to maintain the same profit level Q1 = Q0*(P0-VC0)/(P1-VC0) When combined with information about the elasticity of demand, the analysis gives a quick answer to the question of whether or not changing price makes sense. To see the effect of a variety of potential price changes, we can draw a stay- even curve that shows the required quantities at a variety of price levels. Derivation of formula Profit0 = P0*Q0 – VC0*Q0 – FC0 Profit1 = P1*Q1 – VC0*Q1 – FC0 Set equal and solve for Q1

Extra: quick and dirty estimators Linear Demand Curve Formula, e= p / (pmax-p) Discussion: How high would the price of the brand have to go before you would switch to another brand of running shoes? Discussion: How high would the price of all running shoes have to go before you should switch to a different type of shoe?

Elasticity Class exercises http://hspm.sph.sc.edu/COURSES/ECON/Elast/Elast.html

Chapter 7

Anecdote: Rayovac Company Founded in 1906, three entrepreneurs started a battery production company that grew to rival Energizer and Duracell. In 1996, The Thomas H. Lee Company acquired Rayovac – taking advantage of easy credit availability the company then bought many other battery production companies as well. A move the company said they made to take advantage or efficiencies and economies of scale. They expected that as they produced more of the same good, average costs would fall. The company also bought many unrelated companies at the same time as the battery binge – the reasoning being that because of synergies, if they centralized the production of many different goods the costs of production would be lower. By February 2009 the new conglomerate was bankrupt Moral of the story? In business investments if you hear the words efficiency or synergy, keep your money.

Increasing marginal costs Definition: The law of diminishing marginal returns: as you try to expand output marginal productivity eventually declines. Diminishing marginal returns  marginal productivity declines Diminishing marginal productivity  increasing marginal costs Increasing marginal costs eventually lead to increasing average costs Some causes of diminishing marginal returns Difficulty of monitoring and motivating a large work force Increasing complexity of a large system The “fixity” of some factor, like testing capacity The law of diminishing marginal returns states that as you try to expand output, your marginal productivity (the extra output associated with extra inputs) eventually declines.   Increasing marginal costs eventually cause increasing average costs and make it more difficult to compute break-even prices. When negotiating contracts, it is important to know what your costs curves look like; otherwise, you could end up accepting contracts with unprofitable prices.

Graph 2: marginal vs. average cost Increasing marginal costs eventually lead to increasing average costs.

Economies of scale Definition: short run “fixity” vs. long run “flexibility” i.e. factors that are fixed costs in the SR but become variable in the long run If long-run average costs are constant with respect to output, then you have constant returns to scale. If long run average costs rise with output, you have decreasing returns to scale or diseconomies of scale. If average costs fall with output, you have increasing returns to scale or economies of scale. Discussion: Category Killer stores & economies of scale Note that with economies of scale, average costs are falling as output increases If average cost falls with output, then you have increasing returns to scale. In this case you want to focus strategy on securing sales that enable you to realize lower costs. Alternatively, if you offer suppliers big orders that allow them to realize economies of scale, try to share in their profit by demanding lower prices.   If your average costs are constant with respect to output, then you have constant returns to scale. If average costs rise with output, you have decreasing returns to scale or diseconomies of scale.

Learning curves Discussion: Every time an airplane manufacturer doubles production, marginal costs decrease by 20%. Learning curves mean that current production lowers future costs. It’s important to look over the life cycle of a product when working with products characterized by learning curves. Table Formula: Log[MC]=a+b*Log[Q] where a=Log[100] and b=-Log[.80]/Log[2] While it is clear that costs decrease as output increases, it is not clear which transaction party will capture these gains

Learning curves graph

Economies of scope If the cost of producing two products jointly is less than the cost of producing those two products separately then there are economies of scope between the two products. Cost(Q1, Q2) < Cost(Q1) + Cost(Q2) Discussion: Company X is a small family-owned company that makes, sells, and distributes a popular breakfast sausage. Can this firm realize economies of scope? Discussion: Scope economies in your company. Implication? Discussion 1 Answer: Because the firm sells only a single product—breakfast sausage—it cannot exploit the scope economies associated with distributing a full product line. The firm has two choices. It could sell out to one of the larger, full-line companies, like ConAgra. Such a company could exploit the scope economies associated with distribution, thus placing a higher value on the firm. Or it could outsource its distribution function. Several regional and nationwide distribution companies distribute a variety of food products, and these companies could realize scope economies by distributing a full portfolio of meat products. If the cost of producing two outputs jointly is less than the cost of producing them separately—that is, Cost(Q1,Q2) < Cost(Q1) + Cost(Q2) — then there are economies of scope between the two products. This can be an important source of competitive advantage and shape acquisition strategy.

Anecdote: pet food production A pet food company has 2,500 products (SKU’s) with 200 different formulas They receive a lot of pressure from large customers like Wal-Mart to reduce prices. To respond to Wal-Mart, the company shrinks it product offerings 70 SKUs w/13 formulas This led to a 25% savings for the company because of reduced production costs (see graph)

Diseconomies of scope Production can also exhibit diseconomies of scope when the cost of producing two products together is higher than the cost of separate production. This was true for the pet food company – producing so many different products in one factory was more expensive than producing each food in a different factory would have been because of the cost of set-up, clean-up and transition times associated with producing each different pet food

In class questions Learning curves: every time you double production, your costs decrease by 50%. The first unit costs you $64 to produce. On a project for 4 units, what is your break-even price? You can win another project for 2 more units. What is your break-even price for those units?

Answer The break-even price for 4 units is $33. The extra costs for the fifth and sixth units is only $24, so break-even is $12/unit for those two. If the project were for six units total, break-even would be $26/unit for those six.

Chapter 8

Anecdote: Y2K and generator sales From 1990-98, sales of portable generators grew 2% yearly. In 1999, public anticipation of Y2K power outages increased demand for generators. Walters, Rosenberg and Matthews invested to increase capacity in anticipation of this demand growth – they vertically integrated their company to increase capacity and reduce variable costs. Demand grew as expected - Industry shipments increased by 87%. Prices also increased by an average of 21%. Discussion: What will happen next? Why? Discussion Answer: But following the boom year of 1999, the year 2000 turned out to be a bust. Demand fell back to 1998 levels, and prices tumbled to below-1998 levels. Industry profit declined dramatically, along with capacity utilization rates. WRM’s Y2K strategy to increase production capacity turned out to be its undoing. Along with half the firms in the industry, they declared bankruptcy in 2000.

Which industry or market? Every industry or market has a time, product, and geographic dimension. For example: The yearly market for portable generators in the U.S. Time: annual Product: portable generators Geography: US When analyzing a problem, or investment opportunity, it helps to first define the time, product and geographic dimensions of the market in question.

Shifts in the demand curve Movement along the demand curve indicates the “quantity demanded” increased. Shifts in demand curve can occur for multiple reasons Uncontrollable factor – affects demand and is out of a company’s control. Income, weather, interest rates, and prices of substitute and complementary products owned by other companies. Controllable factor – affects demand but can be controlled by a company Price, advertising, warranties, product quality, distribution speed, service quality, and prices of substitute or complementary products also owned by the company

Demand increase At a given price, more quantity demanded

Supply curves Definition: Supply curves are functions that relate the price of a product to the quantity supplied by sellers. Discussion: Why do supply curves slope upwards?

Market equilibrium Definition: Market equilibrium is the price at which quantity supplied equals quantity demanded. At the equilibrium price, there is no pressure for the price to change given the equality of quantity demanded and supplied.

Market equilibrium (cont.) Proposition: In a competitive equilibrium there are no unconsummated wealth-creating transactions.

Using supply and demand Supply and demand curves can be used to describe changes that occur at the industry level

Portable generator market 1997-1998 1997- Stable industry sales with intense competition (2% avg. sales growth) 1997- Industry anticipates record demand will occur in 1999 1998 – Massive capital expenses throughout industry on vertical integration projects Portable generator market 1999 + Demand shift due to fear of power grid failure caused by Y2K Supply shift caused by manufacturer’s eagerness to capitalize on record demand for product Manufacturers fail to anticipate reduced demand in 2000 Sales from 2000 pulled forward into 1999

Generator demand shifts graph

Using supply and demand (cont.) Discussion: “over the past decade, the price of computers has fallen, while quantity has risen.” How? Why?

Prices convey information Prices are a primary way that market participants communicate with one another Buyers signal their willingness to pay, and sellers signal their willingness to sell with prices Price information especially important in financial markets

Prices convey information (cont.) Discussion: Gas pipeline burst between Tucson and Phoenix What happened to gas prices in Phoenix, in Tucson and in Los Angeles? ANSWER: all three prices increased. In Phoenix the supply decreased. In Tucson, local supply decreased when Truckers began driving down from Phoenix to fill up a the Tucson “rack.” Supply to Los Angeles decreased as more supply was sent to Phoenix.

Alternate intro anecdote Video enhancement products are state-of-the-art graphics systems that capture, analyze, enhance, and edit all major video formats without altering underlying footage. In 1998, this market consisted of a small number of companies, and demand was relatively light due to the extremely high price of the technology (prices ranged between $45,000 and $80,000) In 2000, Intergraph entered the market at a price of $25,000, attempting to quickly capture a major share of the market. Intergraph produced a product at a substantially lower cost than the competition.

Alternate into anecdote (cont.) What happened?? Entry caused an increase in supply and a strong downward pressure on price (average pricing fell to around $40,000). A number of firms exited and prices rose back to around $45,000. Later, the events of 9/11/01 caused demand to spike. In the short run, average prices shot up. Higher prices eventually attracted more entrants, increasing supply. Pricing fell back down to an average level of around $30,000.

Extra: using demand and supply Discussion: Is there a shortage of affordable housing? Discussion: Is there a shortage of kidneys? 5. Is there a shortage of affordable housing in San Francisco? Answer: There is no such thing as a shortage in a competitive market. The price of housing is set where demand equals supply. 6. Is there a shortage of kidneys in the U.S.? Answer: Yes. The U.S. government sets the price of kidneys to zero. At this price there is excess demand for kidneys, or a “shortage.”

Naked Economics Chapter 1: The Power of Markets Chapter 2: Incentives Matter Key learnings/take-aways? What did you write about?

Class Exercise Time permitting http://hspm.sph.sc.edu/COURSES/ECON/SD/SD.html

Discussion Key learnings? Next weeks assignments.