Chapter 4 Extent (How Much) Decisions Managerial Economics: A Problem Solving Approach (2nd Edition) Luke M. Froeb, luke.froeb@owen.vanderbilt.edu Brian T. McCann, brian.mccann@owen.vanderbilt.edu Website, managerialecon.com Ordering Information: Betty Jung Marketing Specialist, Finance/Economics/Decision Sciences South-Western | Cengage Learning 5191 Natorp Boulevard, Mason, OH 45040 The ISBN for your 2e book alone is:  1439077983   The Bundle ISBN for your 2e book + the printed access card for MBA Primer is: 0538771240 COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Chapter 4 – Summary of main points Do not confuse average and marginal costs. Average cost (AC) is total cost (fixed and variable) divided by total units produced. Average cost is irrelevant to an extent decision. Marginal cost (MC) is the additional cost incurred by producing and selling one more unit.

Chapter 4 – Summary (cont.) Marginal revenue (MR) is the additional revenue gained from selling one more unit. Sell more if MR > MC; sell less if MR < MC. If MR = MC, you are selling the right amount (maximizing profit). The relevant costs and benefits of an extent decision are marginal costs and marginal revenue. If the marginal revenue of an activity is larger than the marginal cost, then do more of it. An incentive compensation scheme that increases marginal revenue or reduces marginal cost will increase effort. Fixed fees have no effects on effort. A good incentive compensation scheme links pay to performance measures that reflect effort.

Introductory anecdote: US Financial Crisis The financial crisis began in the subprime housing market, where government policies encouraged lenders to extend credit to low-income borrowers (by lowering lending standards) Concurrently mortgages were being packaged into securities and sold to investors. If the risk had been recognized investor demand would have been low, but rating agencies were too liberal with AAA ratings, increasing demand for loans. The result? A credit “bubble” How did this lending crisis arise?

Background: Average cost Definition: Average cost is simply the total cost of production divided by the number of units produced. AC = TC/Q Average costs often decrease as quantity increases due to presence of fixed costs AC = (VC + FC)/Q FC does not change as Q increases Average costs are not relevant to extent decisions Hospital Example Say fixed costs = $1 million; variable costs of $3,000 to deliver 500 babies. Total costs would be $2.5 million ($1,000,000 + $3,000*500) Average per delivery cost would be $5,000. If no additional fixed costs needed to deliver more babies up to a limit of 600 deliveries Average cost at 600 customers = $4,666.67; ($1,000,000 + $3,000*600) / 600 Marginal cost of customer 501 = $3,000 Compare to average cost at 501 customers = $4,960.78; ($1,000,000 + $3,000*501) / 501

Background: Average cost (cont.)

Background: Marginal cost Marginal cost is the cost to make and sell one additional unit of output. MC = TCQ+1 – TCQ. Marginal cost is often lower than average cost (due to falling average costs) but not always. Marginal costs are what matter in extent decisions

Extent (how much?) decisions Definition: Marginal cost (MC) is the additional cost required to produce and sell one more unit. Definition: Marginal revenue (MR) is the additional revenue gained from producing and selling one more unit. If the benefits of selling another unit (MR) are bigger than the costs (MC), then sell another unit. So, produce more when MR>MC; less when MR<MC. Profits are maximized when MR=MC.

Extent decisions (cont.) Examples of extent decisions Should you change the level of advertising? Should you increase the quality of service? Is your staff big enough, or too big? How many parking spaces should you lease? Marginal analysis answers these questions This analysis tells you direction of change but not the distance. You can only measure MR and MC at the current level of output – make a change and re-measure

Extent decision example Discussion: How much advertising? A $50,000 increase in the TV ad budget brings in 1,000 new customers Estimated MCTV is $50 (the cost to get one more customer) $50,000 / 1,000 = $50 If the marginal revenue generated by this customer is greater than $50, do more advertising. Note sometimes you have to “average” marginal costs since quantities are added are often added in lumps

Extent decision example (cont.) Even if we do not know the marginal revenue, we can still use marginal analysis to make extent decisions Compare TV advertising to telephone solicitation Say you recently cut telephone budget by $10,000 and lost 100 customers Estimated MCPH = $100= ($10,000 / 100) So, to get one more customer costs $50 for TV and $100 for phone MCPH > MCTV so shift ad dollars from phone to TV Advice: make changes one-at-a-time to gather valuable information about marginal effectiveness of each medium. Note: TV vs. phone comparison assumes TV and phone customers generate same amount of marginal revenue

Another example SAH=“Standard Absorbed Hours” a measure of textile factory output Allows managers to compare factories making different items, e.g. t-shirt = 1 SAH while dress=3 SAH Suppose Factory A has costs of $30 per SAH while Factory B has cost of $20 per SAH. How can you profitably use this information? The decision seems simple, but Make sure you are not including fixed costs in the analysis Marginal costs matter, not average costs! If the $20 and $30 rates are good MC proxies, shift some production from Factory A to Factory B To check whether A and B are good MC proxies: make sure that when you reduce output in the Dominican Republic, you really are avoiding close to $30/SAH for each SAH of output reduction in the Dominican Republic facility, and make sure that you are incurring only about $20/SAH for each SAH of output increase in the Yucatán. If this is not correct, then cost per SAH is a poor proxy for marginal cost.

Effort is an extent decision Discussion: Royalty rates vs. fixed fee contracts You receive two bids to harvest 100 trees on your land $150/tree or $15,000 for the right to harvest all the trees. On your tract there are pines (worth $200) and fir (worth $100) Which offer should you accept? Discussion: Sales Commissions Expected sales level: 100 units @ $10,000/unit=$1M Option 1: 10% commission Option 2: 5% commission + $50,000 salary Discussion: give example of royalty rate or fixed fee contracts in your firm

Tie pay to performance A consulting firm COO received a flat salary of $75,000 After learning about the benefits of incentive pay in class, the CEO changed COO compensation to $50K + (1/3)* (Profits- $150K) Profits increased 74% to $1.2 M Compensation increased $75K  $177K Discussion: what are the disadvantages to incentive pay? Disadvantages: risk; may not have a good measure of effort

Alternate intro anecdote American Express offers a Platinum Card to affluent customers In 2001, there were approximately 2,000 Platinum cardholders in the Japanese market. Numbers had been limited to ensure high quality customer service With customer service technology advances, company considered expanding number of card holders How many more should be added? As more members are acquired, average spending per card member decreases because the financial threshold for membership is lowered Costs of customer service rise for each additional member added, and growing beyond a certain point would require building and operating an additional call center After analyzing the costs and benefits, American Express realized that it should expand its offering to only 15,000 more Platinum Card members We call this an “extent” decision, because the company needed to decide “how many” platinum cards to provide. In this chapter, we show you how to make profitable extent decisions.

Managerial Economics - Table of contents 1. Introduction: What this book is about 2. The one lesson of business 3. Benefits, costs and decisions 4. Extent (how much) decisions 5. Investment decisions: Look ahead and reason back 6. Simple pricing 7. Economies of scale and scope 8. Understanding markets and industry changes 9. Relationships between industries: The forces moving us towards long-run equilibrium 10. Strategy, the quest to slow profit erosion 11. Using supply and demand: Trade, bubbles, market making 12. More realistic and complex pricing 13. Direct price discrimination 14. Indirect price discrimination 15. Strategic games 16. Bargaining 17. Making decisions with uncertainty 18. Auctions 19. The problem of adverse selection 20. The problem of moral hazard 21. Getting employees to work in the best interests of the firm 22. Getting divisions to work in the best interests of the firm 23. Managing vertical relationships 24. You be the consultant EPILOG: Can those who teach, do? Managerial Economics - Table of contents