After completing the reading assignments, compose a response to the following questions: How do a company’s goals, constraints, incentives and market rivalry affect its economic decision-making? To wh

After completing the reading assignments, compose a response to the following questions: How do a company’s goals, constraints, incentives and market rivalry affect its economic decision-making? To wh
©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages CHAPTER Introduction: What This Book is About 1 ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Summary Of Main Points ● Problem solving requires two steps: 1) figure out what’s causing the problem 2) figure out how to fix it ● For both steps, predict how people behave ● Rational -actor paradigm: assumes that people act rationally, optimally, and self -interestedly ● Simply put, people respond to incentives ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Summary Of Main Points, cont. ● Good incentives come from rewarding good performance • Ex: commission on sales ● A well -designed organization aligns employee incentives with organizational goals ● Specifically, employees have enough information to make good decisions, and the incentive to do so ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Summary Of Main Points, cont. ● Three questions to find the source of the problem: 1) Who is making the bad decision? 2) Does the decision maker have enough information to make a good decision? 3) Does the decision maker have the incentive to make a good decision? ● Answers to these questions will suggest solutions: 1) Letting someone with better information or incentives make the decision 2) Giving the decision maker more information 3) Changing the decision maker’s incentives ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Problem: Over -bidding OVI G as T ract ● A young geologist was preparing a bid recommendation for an oil tract in the Gulf of Mexico ● The geologist knew the productivity of nearby tracts also owned by the company ● Knowing this, he recommended a bid of $5 million ● Senior management bid $20 million – far over the next highest bid of $ 750,000 ● What, if anything, is wrong? ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Problem Solving ● The goal of this text is to provide tools to help identify and solve problems like this ● Two distinct steps: 1) Figure out what’s wrong • i.e., why overbidding occurred 2) Figure out how to fix it ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Model of Behavior ● Both steps require a model of behavior • Why are people making mistakes? • What can we do to make them change? ● Economists use the rational -actor paradigm to model behavior ● The rational actor paradigm states: • People act rationally, optimally, self -interestedly • Meaning, they respond to incentives – to change behavior you must change incentives ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Answer to Overbidding Problem ● Answer the three questions: 1) Senior management made the bad decision to overbid 2) They had enough information to make the right decision 3) They didn’t have the incentive to do so ● A bonus system created incentives to over -bid. • Senior managers were rewarded for acquiring reserves regardless of their profitability • They had the young geologist “do what he could” to increase the size of estimated reserves • Bonuses also created an incentive to manipulate the reserve estimate ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Solution to Overbidding Problem Now that we know what is wrong, how do we fix it? ● Let someone else decide? NO ● Change information flow? NO ● Change incentives? YES • Change performance evaluation metric • Ex: Increased profitability as measurement of success instead of increased acquired reserves • Reward scheme • Ex: Make bonuses tied to profitability, not acquired reserves ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages NAR Problem ● In 2006, a TV reporter was sent into a National Auto Repair (NAR) shop with a perfectly good car ● The reporter came out with a new muffler and transmission – and a bill for over $8,000 ● The news story badly hurt NAR’s profits ● How do you solve this problem? ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Problem -Solving Algorithm 1) Who is making the bad decision? • The mechanic recommended unnecessary repairs 2) Does the decision maker have enough information to make a good decision? • Yes, in fact, the mechanic is the only one with enough information to know whether repairs are necessary ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Problem -Solving Algorithm, cont. 3) Does the decision maker have the incentive to make a good decision? • No, the mechanic is evaluated based on the amount of repair work he does, and receives bonuses or commissions tied to the amount of repair work ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages NAR Solution ● There was an incentive issue ● NAR tried two solutions 1) reorganized into two division – led to colluding 2) adopted flat pay – led to less incentive to work hard ● Suggested resolution: add an additional performance evaluation metric to original commission scheme • Ex: Sporadically send in “secret shoppers” like the news reporter ● This shows the trade -offs you face when creating solutions ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Ethics and Economics ● The rational -actor paradigm can make students uncomfortable • It seems to disregard personal ethics that guide behavior of most people ● You have to understand why unethical behavior occurs to fix it though • Be able to anticipate opportunistic behavior to know how to avoid it ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Value System ● Debates about ethics and economics really are about different value systems ● Deontologists : actions are good or ethical if they conform to a set of principles (ex: The Golden Rule) ● Consequentialists : actions are judged based on whether they lead to a good consequence ● Economics is more consequentialist • Uses analysis to understand the consequences of different solutions ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Reference Froeb, L. M., McCann, B. T., Shor, M., & Ward, M. R. (2018 ). Managerial economics: a p roblem solving approach (5 th ed.). Boston, MA: Cengage Learning.
After completing the reading assignments, compose a response to the following questions: How do a company’s goals, constraints, incentives and market rivalry affect its economic decision-making? To wh
©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages CHAPTER The One Lesson of Business 2 ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Summary Of Main Points ● Voluntary transactions create wealth by moving assets from lower – to higher -valued uses ● Anything that impedes the movement of assets to higher – valued uses (taxes, subsidies, price controls) destroys wealth ● Economic analysis is useful to business for identifying assets in lower -valued uses ● The art of business consists of identifying assets in low -valued uses and devising ways to move them to higher -valued ones ● A company can be thought of as a series of transactions. A well -designed organization rewards employees who identify and consummate profitable transactions or who stop unprofitable ones ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Kidney Transplants ● Two prominent hospitals recently refused patients for kidney transplants because the organs were from “directed donations” • The kidneys were meant for specific people ● Demand for organs is high – far exceeding supply – and many never receive them ● Despite high demand and low supply, buying and selling organs is illegal ● Why? ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Apartments Suppose you want to move from Detroit to Nashville ● First, you would try a two -way trade ● Failing that, you’d try a three -way connection with another city ● Need to find correct trades with correct timing = difficult! ● Like with kidney transplants, compatibility problems lead to inefficiency Detroit Nashville Detroit Nashville Los Angeles ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Capitalism 101 To identify money -making opportunities, you must first understand how wealth is created (and sometimes destroyed ) ● Key note : Wealth is created when assets are moved from lower to higher -valued uses ● Definition : Value = willingness to pay Desire + Income = You want something + you can pay for it ● Key note : Voluntary transactions, between individuals or firms, create wealth • Meaning, people create wealth by pursuing self -interest ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Housing Example A house is for sale: ● The buyer values the house at $130,000 • This is the buyer’s top dollar – willingness to pay ● The seller values the house at $120,000 • This is the seller’s bottom line – won’t accept less The buyer and seller must agree to a price that “splits” surplus between buyer and seller. Here, $ 128,000 ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Surplus The buyer and seller both benefit from this transaction: ● Buyer surplus = buyer’s value minus the price $130,000 – $128,000 = $2,000 buyer surplus ● Seller surplus = the price minus the seller’s value $128,000 – $120,000 = $8,000 seller surplus ● Total surplus = buyer + seller surplus = difference in values $2,000 + $8,000 = $10,000  $130,000 – $120,000 = $10,000 $10,000 are the gains from trade ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Wealth -Creating Transactions ● Which assets do these transactions move to higher – valued uses? • Factory Owners • Corporate Raiders • Real Estate Agents • Insurance Salesman • Investment Bankers ● Discussion : How does eBay create wealth? ● Discussion : Which individual has created the most wealth during your lifetime? ● Discussion : How do you create wealth? ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Do Mergers Create Wealth? ● Do mergers follow the wealth -creating engine of capitalism? Do they move assets to a higher -valued use? • Our largest and most valuable assets are corporations ● Ex: Dell -Alienware merger: • In 2006, Dell purchased Alienware , a manufacturer of high -end gaming computers • Dell left design, marketing, sales and support in Alienware’s hands • Dell took over manufacturing though, using its expertise to build Alienware’s computers at a much lower cost ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Do Mergers Create Wealth? ● However, many mergers and acquisitions do not create value • If they do, value creation is rarely so clear ● To create value, the assets of the acquired firm must be more valuable to the buyer than to the seller ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Does Government Create Wealth? ● Discussion : What’s the government’s role is wealth creation? • Enforcing property rights and contracts legal tools that facilitate wealth creating transactions • Ensures that buyers and sellers keep gains from trade ● Discussion : Why are some countries so poor? • No property rights • No rule of law ● Discussion : Much of the justification for government intervention comes from the assertion that markets have failed. One money manager scoffed at this idea. “The markets are working fine, but they’re giving people answers that they don’t like, so people cry market failure.” ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages The One Lesson of Economics ● Definition : An economy is efficient if all assets are employed in their highest -valued assets • This is an unattainable, but useful benchmark ● The One Lesson of Economics : The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups ● Must look at the intended and unintended effects of policies to understand their efficiency ● The economist’s solution to inefficient outcomes is to argue for a change in public policy ● Business person’s solution is to try to make money on the inefficiency ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages The One Lesson of Business ● Definition : Inefficiency implies the existence of unconsummated, wealth -creating transactions ● The One Lesson of Business : The art of business consists of identifying assets in lower valued uses and devising ways to profitably moving them to higher valued uses ● In other words, make money by identifying unconsummated wealth -creating transactions and devise ways to profitably consummate them ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Destroying Wealth Anything that stops assets from moving to higher valued uses is destroying wealth • Taxes Destroy Wealth: • By deterring wealth -creating transactions – when the tax is larger than the surplus for a transaction • Subsidies Destroy Wealth: • Example: flood insurance encourages people to build in areas that they otherwise wouldn’t • Price Controls Destroy Wealth: • Example: rent control (price ceiling) in New York City deters transactions between owners and renters ● Which assets end up in lower -valued uses? ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Profiting from Inefficiency ● Taxes create a profit opportunity • Discussion : 1983 Sweden tax ● Subsidies create opportunity • Discussion : health insurance ● Price -controls create opportunity • Discussion : Regulation Q. & euro dollars • Discussion : What about ethics? ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Wealth Creation in Organizations ● Companies = a collection of transactions ● They buy raw materials (capital, labor, etc.) and create and sell higher -valued goods and services ● Can equate market -level problems (taxes, subsidies and price controls) with organization -level goal alignment problems • Ex: The overbidding from the oil company = “subsidy” paid to management for acquiring oil reserves ● Allows us to use the same analysis ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Reference Froeb , L. M., McCann, B. T., Shor, M., & Ward, M. R. (2018). Managerial economics: a problem solving approach (5 th ed.). Boston, MA: Cengage Learning.
After completing the reading assignments, compose a response to the following questions: How do a company’s goals, constraints, incentives and market rivalry affect its economic decision-making? To wh
©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages CHAPTER Benefits, Costs, and Decisions 3 ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Summary Of Main Points ● Costs are associated with decisions, not activities. ● The opportunity cost of an alternative is the profit you give up to pursue it. ● In computing costs and benefits, consider all costs and benefits that vary with the consequences of a decision and only those costs and benefits that vary with the consequences of the decision. These are the relevant costs and benefits of a decision. ● Fixed costs do not vary with the amount of output. Variable costs change as output changes. Decisions that change output will change only variable costs. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Summary Of Main Points, cont. ● Accounting profit does not necessarily correspond to real or economic profit. ● 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. ● 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. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Summary Of Main Points, cont. ● EVA ® is a measure of financial performance that makes visible 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. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Big Coal Power Company Big Coal Power Co. switched to a 8400 coal when the price fell 5% below the price of 8800 coal • 8400 coal generates 5% less power than 8800 • The manager was compensated based on the average cost of electricity, and expected this move to save money • Instead – company profit reduced ● Why? What happened? ● Discussion : Diagnose the problem ● Discussion : Come up with a proposal to fix it ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Big Coal Solution Use our three questions for analysis: 1) Who is making the bad decision? • The plant manager made the switch to the lower -priced 8400 coal. 2) Did he have enough information to make a good decision? • Yes, presumably he knew that this would reduce his output. 3) Did he have the incentive to make a good decision? • No, because he was evaluated based on the average cost of electricity produced at his plant . ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Lesson From Coal Problem ● The plant manager should have considered all the costs of switching to the lower Btu coal • Namely, the lost electricity ● Average costs can be a poor measure of plant performance ● Need to align incentives of a business unit with the goals of the parent company ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Background: Types of Costs ● Definition : Fixed costs do not vary with the amount of output. ● Definition : Variable costs change as output changes. FIGURE 3.1 Cost Curves ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Example: A Candy Factory ● The cost of the factory is fixed. ● Employee pay and cost of ingredients are variable costs. TABLE 3.1 Candy Factory Costs ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Your Turn Are these costs fixed or variable? ● Payments to your accountants to prepare your tax returns. ● Electricity to run the candy making machines. ● Fees to design the packaging of your candy bar. ● Costs of material for packaging. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Real Example: Cadbury (Bombay) ● Beginning in 1978, Cadbury offered managers free housing in company owned flats to offset the high cost of living. ● In 1991, Cadbury added low -interest housing loans to its benefits package. Managers moved out of the company housing and purchased houses. The empty company flats remained on Cadbury’s balance sheet for 6 years. ● In 1997, Cadbury adopted Economic Value Added (EVA) ® • Charges each division within a firm for the amount of capital it uses • Provides an incentive for management to reduce capital expenditures if they do not cover costs ● Senior managers then decided to sell the unused apartments after seeing the implicit cost of capital. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Accounting Costs for Cadbury TABLE 3.2 Cadbury Income Statement ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Cadbury Accounting Profit ● Accounting profit recognizes only explicit costs ● Typical income statements include explicit costs: • Costs paid to its suppliers for product inputs • General operating expenses, like salaries to factory managers and marketing expenses • Depreciation expenses related to investments in buildings and equipment • Interest payments on borrowed funds ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Cadbury Accounting Profit vs. Economic Profit ● What’s missing from Cadbury’s statements are implicit costs: • Payments to other capital suppliers (stockholders) • Stockholders expect a certain return on their money (they could have invested elsewhere) • “Profit” should recognize whether firm is generating a return beyond shareholders expected return ● Economic profit recognizes these implicit costs; accounting profit recognizes only explicit costs ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Opportunity Costs & Decisions Definition : the opportunity cost of an action is what you give up (forgone profit) to pursue it ● Costs imply decision -making rules and vice -versa ● The goal is to make decisions that increase profit ● If the profit of an action is greater than the alternative, pursue it ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Identifying Costs ● Whenever you get confused by costs, step back and ask, “What decision am I trying to make?” • If you start with costs, you will always get confused • If you start with a decision, you will never get confused ● Apply it to Cadbury: • The cost of the company of holding onto the apartments was the forgone opportunity to invest capital in the company’s organization to earn a higher return ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Cadbury’s Costs ● Holding on to the flats cost the company £600,000 each year. ● Unless the benefits to the company of holding onto the apartments were at least £600,000, the capital was not employed in its highest -valued use. ● The cost of the company of holding onto the apartments was the forgone opportunity to invest capital in the company’s organization to earn a higher return. ● By selling the flats, the company moved the capital to a higher -valued use. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Relevant Costs and Benefits ● 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 • You can consider irrelevant costs • You can ignore relevant ones ● Definition : The fixed -cost/sunk -cost fallacy means you make decisions using irrelevant costs and benefits ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Fixed -Cost/Sunk -Cost Fallacy Examples Football game: ● You pay $20 for a ticket. At halftime, you’re team is losing by 56 points. ● You say you’ll stay to get your money’s worth, but you can’t get your money’s worth! ● The ticket price does not vary whether you stay or leave – it’s a sunk cost and irrelevant. Launching a new product: ● You are in a new products division and will be able to distribute a new product through your existing sales force ● You will be forced to pay for a portion of the sales force ● If you believe this “overhead” is big enough to deter an otherwise profitable product launch, then you’ve committed the sunk -cost fallacy ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Hidden -Cost Fallacy Definition : ignoring relevant costs (costs that vary with the consequences of your decision) when making a decision Example: Football game (again) ● You buy a ticket for $20 ● Scalpers are selling tickets for $50 because your team is playing cross -state rivals ● You go to the game, saying, “These tickets cost me only $20.” WRONG ● The tickets really cost you $50 because you give up the opportunity to scalp them by going ● Unless you value them at $50, you are sitting on an unconsummated wealth -creating transaction ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Example: Should You Fire an Employee? ● The revenue he provides to the company is $2,500 per month ● His wages are $1,900 per month ● His office could be rented out $800 per month ● YES, you are only making $600 a month from this employee but could make $800 a month from renting his office ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Subprime Mortgages ● The subprime mortgage crisis of 2008 is a good example of the hidden -cost fallacy. ● Credit -rating agencies failed to recognize the higher costs of loans made by dubious lenders. • Example: Long Beach Financial • Gave loans out to homeowners with bad credit, asked for no proof of income, deferred interest payments as long as possible. ● Credit ratings didn’t reflect the hidden costs of risky loans. ● As a result, many Wall Street investors purchased packaged risky loans and eventually went bankrupt when the debtors defaulted. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Hidden cost of capital ● Recall that accounting profit does not necessarily correspond to economic profit. ● Discussion : Economic Value Added • EVA ® = net operating profit after taxes minus the cost of capital times the amount of capital utilized. • Makes visible the hidden cost of capital. ● The major benefit of EVA is identifying costs. If you cannot measure something, you cannot control it. • Those who control costs should be responsible for them. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Incentives and EVA ® ● Goal alignment : “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. … EVA is profit the way shareholders define it.” ● Discussion : can you make mistakes using EVA? • Does it help avoid the hidden cost fallacy? • Does it help avoid the fixed cost fallacy? ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Does EVA ® work? ● Adopting companies of EPP’s (+ four years) • ROA from 3.5 to 4.7% • operating income/assets from 15.8 to 16.7% ● Indistinguishable from non -adopters • Bonuses increase 39.1% for EVA ® firms • But 37.4% for control group ● Interpretations • Selection bias? • NO, cheaper to use existing plans • Goal alignment, YES. ● EVA ® is no better or worse • Rival EPP’s • Bonus plans • Discussion: WHY? ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Psychological Biases ● Not enough information or bad incentives are not the only causes for business mistakes. Often psychological biases get in the way of rational decision making. ● Definition : the endowment effect means that taking ownership of item causes owner to increase value she places on the item. ● Definition : loss aversion – individuals would pay more to avoid loss than to realize gains. ● Definition : confirmation bias – a tendency to gather information that confirms your prior beliefs, and to ignore information that contradicts them. ● Definition : anchoring bias – relates the effects of how information is presented or “framed ”. ● Definition : overconfidence bias – the tendency to place too much confidence in the accuracy of your analysis. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages In Class P roblem (1) You won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performing on the same night and is your next -best alternative activity. Tickets to see Dylan cost $40. On any given day, you would be willing to pay up to $50 to see Dylan. Assume there are no other costs of seeing either performer. Based on this information, what is the opportunity cost of seeing Eric Clapton? A. $0 B. $10 C. $40 D. $50 ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages In Class P roblem (2) You won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performing on the same night and is your next -best alternative activity. Tickets to see Dylan cost $40. On any given day, you would be willing to pay up to $50 to see Dylan. Assume there are no other costs of seeing either performer. Based on this information, what is the minimum amount (in dollars) you would have to value seeing Eric Clapton for you to choose his concert? A. $0 B. $10 C. $40 D. $50 ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Alternate Intro A necdote ● Coca -Cola in the 1980s had very little debt, preferring to raise equity capital from its stockholders. ● The company had a diversified product line, including products like aquaculture and wine. These other businesses generated positive profits, earning a ten percent return on capital invested. ● The company, however, decided to sell off these “under – performing businesses ”. ● Why? • At the time, soft drink division was earning 16 percent return on capital • The “opportunity cost” of investing in aquaculture and wine is the foregone profit that could have been earned by investing in soft drinks • A dollar invested in aquaculture and wine is a dollar that was not invested in soft drinks • Divisions sold off and proceeds invested in core soft drink business ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Reference Froeb, L. M., McCann, B. T., Shor, M., & Ward, M. R. (2018). Managerial economics: a problem solving approach (5 th ed.). Boston, MA: Cengage Learning.