Reading assignment Chapter 4, Extent DecisionsChapter 5, Investment DecisionsChapter 6, Simple PricingMatthew 17:17-20Joshua 24:14-15Daniel 3:16-18After reviewing the slides that I attached to this po

Reading assignment Chapter 4, Extent DecisionsChapter 5, Investment DecisionsChapter 6, Simple PricingMatthew 17:17-20Joshua 24:14-15Daniel 3:16-18After reviewing the slides that I attached to this po
MBA 658 Managerial Economics Belhaven University Unit 2 Christian Worldview Application 1  Matthew 17:17 -20  Joshua 24:14 -15  Daniel 3:16 -18 2 Biblical Foundations  Matthew 17:17 -20  17 Jesus said: “You faithless and corrupt people! How long must I be with you? How long must I put up with you? Bring the boy here to me .”  18 Then Jesus rebuked the demon in the boy, and it left him. From that moment the boy was well .  19 Afterward the disciples asked Jesus privately, “ Why couldn’t we cast out that demon ?”  20 “You don’t have enough faith, “Jesus told them . “I tell you the truth, if you had faith even as small as a mustard seed, you could say to this mountain “Move from here to there”, and it would move. Nothing would be impossible. 3 Christian Worldview Touchpoint  Faith is essential to decision making. In business we have to make assumptions, set priorities, and make decisions. As Christians we should have faith that God has a plan and that nothing is impossible. 4 Christian Worldview Touchpoint, cont.  Joshua 24:14 -15  14 “ So fear the Lord and serve him wholeheartedly . Put away forever the idols your ancestors worshipped when they lived beyond the Euphrates River and in Egypt. Serve the Lord alone .  15 But if you refuse to serve the Lord, then choose today whom you will serve. Would you prefer the gods your ancestors served beyond the Euphrates ? Or will it be the gods of the Amorites in whose land you now live? But as for me and my family, we will serve the Lord” 5 Christian Worldview Touchpoint, cont.  Life is about making choices based on opportunity cost. Christians have faith in God to guide their behavior and their treatment of others …….“we will serve the Lord”. 6 Christian Worldview Touchpoint, cont.  Daniel 3:16 -18  16 Shadrach , Meshach, and Abednego replied: “O Nebuchadnezzar, we do not need to defend ourselves before you  17 If we are thrown into the blazing furnace, the God whom we serve is able to save us. He will rescue us from your power, Your Majesty.  18 But even if he doesn’t, we want to make it clear to you, Your Majesty, that we will never serve your gods or worship the gold statue you have set up.” 7 Christian Worldview Touchpoint, cont. Christian Worldview Touchpoint, cont.  The power of faith is shown in the case of Shadrach, Meshach, and Abednego as they were thrown into the fiery furnace. They followed their faith in spite of challenges – and they were not harmed by the fire.
Reading assignment Chapter 4, Extent DecisionsChapter 5, Investment DecisionsChapter 6, Simple PricingMatthew 17:17-20Joshua 24:14-15Daniel 3:16-18After reviewing the slides that I attached to this po
©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 Extent (How Much) Decisions 4 ©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 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. ● 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!). ©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. ● 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. ©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 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 ). ● These high -risk loans, or mortgages, were being packaged into securities by lenders 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? ©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 Average Cost Caution! ● Memorial Hospital’s CEO conducted performance reviews of the hospital departments. ● During this process, the chief of obstetrics proposed an increase in the number of babies being delivered in his department. ● The CEO wondered why since the cost of delivering babies was higher than the revenues brought in. ● The CEO’s mistake: He began with the costs instead of the decision. • He committed the fixed -cost fallacy by looking at average cost, which include costs that do not vary with the decision. • If he had ignored fixed costs, he would have seen that increasing the number of deliveries would increase profit. ©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: Average Cost ● Definition: Average cost (AC) is simply the total cost (TC) of production divided by the number of units produced (Q ) • AC = TC/Q ● Average costs often decrease as quantity increases due to presence of fixed costs (FC) • AC = (VC + FC)/Q • FC does not change as Q increases ● Key note: Average costs are not relevant to extent 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 Background: Average Cost, cont. FIGURE 4.1 Average Cost Curve ©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 Memorial Hospital Revisited ● Memorial made 500 deliveries originally • Fixed cost: $1,000,000 • Variable cost: $3,000/delivery • Total cost: $1,000,000 + ($3,000 x 500) • Average cost: total costs/# of deliveries ● Average costs fall as you increase output, but the variable costs remain constant ● Marginal cost is only $3,000 at Memorial Hospital ©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 Marginal Cost & Marginal Revenue ● Definition: Marginal cost is the additional cost to make and sell one additional unit of output (Q) MC = TCQ+1 – TCQ ● Marginal cost is often lower than average cost (due to fixed costs) but not always ● Marginal costs are what matter in extent decisions ● Definition: Marginal revenue (MR) is the additional revenue gained from producing and selling one more unit ©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 Extent Decisions ● 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? ● For extent decisions, we break the decision into small steps • If taking a step provides more benefit than cost, take a step forward • If not, step backward ©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 Extent (How Much?) Decisions ● 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 ● If the benefits of selling another unit (MR) are bigger than the costs (MC), then sell another unit. ● Maxim: • Produce more when MR>MC • Produce less when MRMC so the hospital was not delivering enough babies ● This explains why the CEO was 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 Advertising Extent Decision Example Answering the “How much advertising?” question ● A $50,000 increase in the TV ad budget brings in 1,000 new customers ● Estimated MC TV 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 ©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 Advertising Extent Decision Example, cont. ● You know the direction (do more), but you do not know how far to go ● You have to take a step and re -compute marginal cost and benefit to see if you should continue in the direction your analysis originally pointed you in ● Also, even if we do not know the marginal revenue, we can still use marginal analysis to make extent decisions • by comparing marginal effectiveness of different media ©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 Competing Strategies & Marginal Analysis ● Example: Compare TV advertising to telephone solicitation • The opportunity cost of spending one more $ on TV advertising is the forgone opportunity to spend $ on telephone solicitation • Say you recently cut telephone (PH) budget by $10,000 and lost 100 customers Estimated MC PH = $100= ($10,000 / 100) • So, to get one more customer costs $50 for TV and $100 for phone MC PH > MC TV 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 ©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 Textile Production Example ● A textile company with manufacturing plants in Latin America uses 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? ● Should you move production to cheaper factory? • 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 ©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 Incentive Pay ● Discussion: Royalty rates vs. fixed fee contracts ● How hard to work is an extent decision so you can design incentives to encourage hard work by using marginal analysis ● Example: 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? • Hint: consider the effects of the two bids on the incentives of the logger ©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 Tree Harvesting Answer ● The bids have the same face value, but are very different in terms of logger’s incentives • Fixed fee: the logger will ignore the $15,000 because it doesn’t vary with the decision to cut down trees • The logger will end up cutting down all trees that are profitable to cut down, MR>MC • Royalty Rate: The logger will only cut down trees that generate profit of $150, MR>MC+150 • Mix of $200 – and $100 -value trees – logger will harvest only the $200 • The landowner receives less money since the logger only harvests one type of tree • Royalties deter some wealth -creating transactions as fir trees are not harvested ©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 Sales Commission Example Motivating salespeople: ● Expected sales level: 100 units @ $10,000/unit=$1M • Option 1: 10% commission • Option 2: 5% commission + $50,000 salary • Hint: consider incentives for salespeople ● Use Option 1 because MR=$1000/sale > $500/sale, the MR under Option 2 ● The sales force responds to larger marginal benefits of selling with more effort • Lower sales effort under option 2 is called “shirking” ©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 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 g $177K ● Discussion: What are the disadvantages to incentive pay? ©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 American Express Platinum ● 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, the 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. ©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.
Reading assignment Chapter 4, Extent DecisionsChapter 5, Investment DecisionsChapter 6, Simple PricingMatthew 17:17-20Joshua 24:14-15Daniel 3:16-18After reviewing the slides that I attached to this po
©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 Investment Decisions: Look Ahead and Reason Back 5 ©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 ● Investments imply willingness to trade dollars in the present for dollars in the future. Wealth -creating transactions occur when individuals with low discount rates (rate at which they value future vs. current dollars) lend to those with high discount rates. ● Companies, like individuals, have different discount rates, determined by their cost of capital. They invest only in projects that earn a return higher than the cost of capital. ● The NPV rule states that if the present value of the net cash flow of a project is larger than zero, the project earns economic profit (i.e., the investment earns more than the cost of capital). ● Although NPV is the correct way to analyze investments, not all companies use it. Instead, they use break -even analysis because it is easier and more intuitive. ● Break -even quantity is equal to fixed cost divided by the contribution margin. If you expect to sell more than the break -even quantity, then your investment is profitable. ©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. ● Avoidable costs can be recovered by shutting down. 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. ● If you incur sunk costs, you are vulnerable to post -investment hold -up. Anticipate hold -up and choose contracts or organizational forms that minimize the costs of hold -up. ● Once relationship -specific investments are made, parties are locked into a trading relationship with each other, and can be held up by their trading partners. Anticipate hold -up and choose organizational or contractual forms to give each party both the incentive to make relationship -specific investments and to trade after these investments are made. ©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 Estate Example ● In summer 2007, Bert Matthews was contemplating purchasing a 48 -unit apartment building. • The building was 95% occupied and generated $550,000 in annual profit • Investors expected a 15% return on their capital • The bank offered to loan Mr. Matthews 80% of the purchase price at a rate of 5.5% ● Mr. Matthews computed the cost of capital as a weighted average of equity and debt. .2*(15%) + .8*(5.5%) = 7.4% • Mr. Matthews could pay no more than $550,000/7.4% = $7.4 million and still break even ● Mr. Matthews decided not to buy the building. A good decision – one year later, the cost of capital was 10.125% and Mr. Matthews could offer only $5.4 million for the building. ● This story illustrates both the effect of the bursting credit bubble on real estate valuations and, more importantly, the relevant costs and benefits of investment 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 Background: Investment Profitability ● All investments represent a trade -off between possible future gain and current sacrifice. ● Willingness to invest in projects with a low rate of return, indicates a willingness to trade current dollars for future dollars at a relatively low rate. • This is also known as having a low discount rate (r ). • Individuals with low discount rates would willingly lend to those with higher discount rates. • Discounting helps you figure out if future gains are larger than current sacrifice. ©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 Compounding ● To understand discounting, let’s first look at compounding: (future value, k periods in the future) = (present value) x (1 + r) K ● Example: If you invest $1 (present value) today at a 10% (r), then you would expect to have $1.10 in one year • In two years, $1 becomes $1.21 = $1.10 x (1+.1) ● A good compounding rule of thumb: “Rule of 72” : If you invest at a rate of return r, divide 72 by r to get the number of years it takes to double your money ©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 Discounting ● Discounting (the inverse of compounding): Present value = (future value, k periods in the future) (1 + r) k ● Example: At a 10% r, $1 is worth: • Next year: ($1)/1.1 = $0.91 • Two years: ($0.91)/1.1 =$0.83 ● Discussion: If my discount rate is 10%, would I lend to or borrow from someone with a discount rate of 15%? • What does this say about behavior? ©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: Nashville Pension Obligations ● The city of Nashville uses discounting to decide how much to save for future pension obligations. ● For a pension that pays out $100,000 in 20 years, with a discount rate of 8.25% Nashville must save: • $100,000/(1.0825) 20 =$20,485 • If the city invests the $20,485 and earns 8.25%, then the savings will compound in 20 years – unrealistic! • Somewhat of high savings rate that may not be returned; however, a high savings rate means less current spending, which is politically popular. • A more realistic (but less popular) discount rate would be 6.5%, which would lead to saving $28,380 now . ©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 Determining the Profitability of Investments ● Remember the simple rule: discount the future benefits of an investment, and compare them to the current cost ● Companies use discount rates, which are determined by cost of capital • A company’s cost of capital is a blend of debt and equity, its “weighted average cost of capital” or WACC ● Time is a critical element in investment decisions • Cash flows to be received in the future need to be discounted to present value using the cost of capital ● The NPV Rule: if the present value of the net cash flows is larger than zero, then the project earns more than the 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 The NPV Rule In Action ● Consider two projects that each require an initial investment of $100 • Project 1 returns $115 at the end of the first year • Project 2 returns $60 at the end of the first, and $60 at the end of the second • The company’s cost of capital is 14% ©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 NPV and Economic Profit ● Projects with a positive NPV create economic profit. ● Only positive NPV projects earn a return higher than the company’s cost of capital. ● Projects with negative NPV may create accounting profits, but not economic profit. ● In making investment decisions, choose only projects with a positive NPV. ©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 Another Method: Break -Even Quantities ● The break -even quantity is the amount you need to sell to just cover your costs • At this sales level, profit is zero ● The break -even quantity is: Q=FC/(P -MC) FC: fixed costs P: price MC : marginal cost • (P -MC) is the “contribution margin” – what’s left after marginal cost to “contribute” to covering fixed 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 Break -Even Example: Nissan Truck ● Nissan’s popular truck model, the Titan, had only two years remaining on its production cycle. Redesigning the “Titan” would cost $400M. • Cost of capital was 12%, implying annual fixed cost of $48M • (because $400 million times 0.12 = $48 million) • Contribution margin on each truck is $1,500 • Break -even quantity is 32,000 trucks • The decision to redesign or not came down to a break -even analysis ● Nissan had a 3% share of the market, implying only 12,000 Titan sales per year – not enough to break even. ● Instead they decided to license the Dodge Ram Truck, which would reduce the fixed cost of redesign, and a lower break -even point. ● After the Government took over Chrysler, Nissan reconsidered. ©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 Deciding Between Two Technologies ● In 1983, John Deere was in the midst of building a Henry -Ford -style production line factory for large 4WD tractors • Unexpectedly, wheat prices fell dramatically reducing demand for large tractors ● Deere decided to abandon the new factory and instead purchased Versatile, a company that assembled tractors in a garage using off -the -shelf components ● Deere chose one manufacturing technology over another • A discrete investment decision – the factory had big FC and small MC, Versatile had small FC but bigger MC ©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 John Deere: Right Decision? ● Was purchasing Versatile the right choice? ● It depends … on how much John Deere expected to sell. • Suppose the capital -intensive technology would involve $100 FC and $10 MC • Suppose Versatile’s technology had $50 FC and $20 MC • To determine break -even quantity (point of indifference), solve for the quantity that equates the costs: $150 for 5 units • If you expect to sell less than 5 units, choose the low -MC technology • If you expect to sell more than 5 units, choose the low -FC technology ©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 John Deere Lesson ● John Deere made the right decision by acquiring Versatile; however, the Antitrust Division of he U.S. Department of Justice challenged the acquisition as anticompetitive. ● John Deere and Versatile were only two of 4 firms selling 4WD tractors in North America. ©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 Break -Even Advice ● Remember this advice: Do not invoke break -even analysis to justify higher prices or greater output. ● Managers sometimes believe they must raise prices to cover fixed costs or they must sell as much as possible to make average costs lower. ● These are extent decisions though! • They require marginal analysis, not break -even ©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 Decision to Shut -Down ● Shut -down decisions are made using break -even prices rather than quantities. • The break -even price is the average avoidable cost per unit • Profit = (Rev -Cost)= (P -AC)(Q) ● If you shut down, you lose your revenue, but you get back your avoidable cost. • If average avoidable cost is less than price, shut down ● Determining avoidable costs can be difficult. • To identify avoidable costs firms use Cost Taxonomy ©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 Cost Taxonomy ● Example: FC=$100, MC=$5, and you produce 100 units/year ● How low of a price before you shut down? IT DEPENDS ● It depends on which costs are avoidable • Long -run : fixed costs become avoidable so they are included in the shutdown price • Short run : fixed costs are unavoidable and should not be included in the shutdown price Fixed Costs (avoidable in long run) Variable Costs (avoidable in short run) Avoidable Costs Unavoidable or “Sunk” Costs 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 Sunk Costs and Post -Investment Hold Up ● Always remember the business maxim “look ahead and reason back.” This can help you avoid potential hold up. ● Before making a sunk cost investment, ask what you will do if you are held up. ● What would you do to address hold up? ©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 Sunk Costs and Post -Investment Hold Up Example ● National Geographic can reduce shipping costs by printing with regional printers. • To print a high quality magazine, the printer must buy a $12 million printing press. • Each magazine has a MC of $1 and the printer would print 12 million copies over two years. • The break -even cost/average cost is $7 = ($12M / 2M copies) + $1/copy • BUT once the press is purchased, the cost is sunk and the break -even price changes. • Because of this the magazine can hold up the printer by renegotiating the terms of the deal – because the price of the press is unavoidable, and sunk, the break -even price falls to $1, the marginal 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 Vertical Integration ● One possible solution to post -investment hold -up is vertical integration ● Example: Bauxite mine and alumina refinery • Refineries are tailored to specific qualities of ore • The transaction options are: • Spot -market transactions • Long -term contracts • Vertical integration – 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 • Discussion : How is vertical integration a solution to hold up? ● Contractual view of marriage • Long -term contracts induce higher levels of relationship – specific investment ©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.
Reading assignment Chapter 4, Extent DecisionsChapter 5, Investment DecisionsChapter 6, Simple PricingMatthew 17:17-20Joshua 24:14-15Daniel 3:16-18After reviewing the slides that I attached to this po
©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 Simple Pricing 6 ©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 ● Aggregate demand or market demand is the total number of units that will be purchased by a group of consumers at a given price. ● Pricing is an extent decision. Reduce price (increase quantity) if MR > MC. Increase price (reduce quantity) if MR < MC. The optimal price is where MR = MC. ● Price elasticity of demand : e = (% change in quantity demanded) ÷ (% change in price) • Estimated price elasticity is used to estimate demand from a price and quantity change. [(Q 1 - Q 2)/(Q 1 + Q 2)] ÷ [(P 1 - P 2)/(P 1 + P 2)] • If |e| > 1, demand is elastic; if |e| < 1, demand is inelastic. ©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. ● % ΔRevenue ≈ % ΔPrice + % ΔQuantity • Elastic Demand (|e| > 1): Quantity changes more than price • Inelastic Demand (|e| < 1): Quantity changes less than price ● MR > MC implies that (P – MC)/P > 1/|e|; in words, if the actual margin is bigger than the desired margin, reduce price • Equivalently, sell more ● Four factors make demand more elastic: 1) Products with close substitutes (or distant complements) have more elastic demand 2) Demand for brands is more elastic than industry demand 3) In the long run, demand becomes more elastic 4) As price increases, demand becomes more elastic ©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. ● Income elasticity, cross -price elasticity, and advertising elasticity are measures of how changes in these other factors affect demand. ● It is possible to use elasticity to forecast changes in demand: • % ΔQuantity ≈ (factor elasticity)*(% ΔFactor ) ● Stay -even analysis can be used to determine the volume required to offset a change in costs or prices, which is how businesses often implement marginal 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 Hot Wheels ● Mattel introduced Hot Wheels in 1968 ● They kept price below $1.00 for 40 years, even as production costs rose ● Finally tested a price increase, experienced profit increase of 20% • Why? Profit=(P -C)xQ • Businesses tend to focus on C and Q, neglect P ● In many instances, companies can make money by simply raising price ©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 Simple Pricing In this chapter, we consider “simple pricing”: ● A single firm selling a single product at a single price ● Most firms sell: in competition with rivals; multiple products, and at different prices, so this is rare ● Important to understand simple pricing first though ● Simple pricing has become part of business vernacular • When your boss says that “demand is elastic,” she often means that price is too high ©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: Consumer Surplus and Demand Curves ● First Law of Demand – consumers demand more (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 ©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 Consumer Surplus and Demand Curves Example Pizza consumer ● Values first slice at $5, next at $4 . . . fifth at $1 ● Note that if pizza slice price is $3, consumer will purchase 3 slices Pizza Demand Schedule ©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 Pizza Example, cont. ● For the first slice, the total and marginal value are the same at $5 ● For the second, the marginal value is $4, while the total value is $9 = $5 + $4 Pizza Value Table ©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: 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 Pizza Consumer Surplus ©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 Aggregate Demand, cont. ● Demand curves describe buyer behavior and tell you how much they will buy at a given price ● If something other than price causes an increase in demand, we say that “demand shifts” to the right or “demand increases” such that consumers purchase more at the same prices ©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 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 g sell more, but earn less on each unit sold • Higher price g sell less, but earn more on each unit sold ● Tradeoff created by downward sloping demand ©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 Marginal analysis of pricing ● Marginal analysis finds the profit increasing solution to the pricing tradeoff • It tells you which direction to go (to raise or lower price), but not how far to go ● Definition : marginal revenue (MR) is change in total revenue from selling another unit ● If MR>0 , then total revenue will increase if you sell one more ● If MR>MC , then total profit will increase if you sell one more ● Proposition : Profit is maximized when MR = MC ©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: Find the Optimal Price ● Once you reach the 4th unit, total profit decreases by %0.50 because the MR from the 4th unit is only $1, which is less than $1.50 MC ● Therefore, the profit maximizing quantity is 3 and we see that the price is $5.00 for 3 units to be sold Optimal Price ©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 How Do We Estimate MR? ● Price elasticity allows us to calculate MR ● Definition: price elasticity of demand (e) (%change in quantity demanded) (%change in price) • If |e| is less than one, demand is said to be inelastic • If |e| is greater than one, demand is said to be elastic ©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 Mistake in 3rd Edition ● The Correct Answer • Elastic Demand implies |e|>1 • Inelastic Demand implies |e|<1 ● The following figures are mis -labled (The inequality in parentheses should be reversed) Elastic Demand [| e| < 1] Inelastic Demand [| e| > 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 Price Elasticity Example ● Mayor Marion Barry increased taxes on gasoline sales in DC by 6%. ● Before the tax, gas station predicted that the increase in a sales tax would reduce quantity demanded by 40%. ● The gas station owners were indirectly arguing that gasoline revenue, and the taxes collected out of revenues, would decline because gasoline sales in DC has a very elastic demand. ©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 Estimating elasticities ● Definition : Arc (price) elasticity = [(q 1-q 2)/(q 1+q 2)] [(p 1-p 2)/(p 1+p 2)] • Discussion : Compute elasticity, when price changes from $10 to $8, and quantity changes from 1 to 2? ● Example : On a promotion week for Vlasic, the price of Vlasic pickles drops by 25% and quantity increases by 300 % • Is the price elasticity of demand -12? • HINT : could something other than price be changing? ©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 Intuition: MR and Price Elasticity ● Revenue and price elasticity are related by the following approximation: % 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  ©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 Formula: Elasticity and MR ● Proposition : MR = P(1 -1/|e|) • If |e|>1, MR>0. • If |e|<1, MR<0. ● Discussion : If demand for Nike sneakers is inelastic , should Nike raise or lower price? ● Discussion : If demand for Nike sneakers is elastic , should Nike raise or lower price? ©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 Elasticity and Pricing ● MR>MC is equivalent to • P(1 -1/|e|)>MC • P>MC/(1 -1/|e|) • (P -MC)/P>1/|e| ● MR > MC means that (P -MC)/P > 1/|e| ● The left side of the expression is the current margin = (P -MC)/P ● The right side is the desired margin, or the inverse elasticity = 1/|e| ● If the current margin is greater than the desired margin, reduce the price because MR>MC and vice versa ● Intuition: the more elastic demand becomes (1/|e| becomes smaller), the less you can raise price over MC because you lose too many customers ©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 What Makes Demand More Elastic? 5 factors that affect demand elasticity and optimal pricing: 1) Products with close substitutes have elastic demand. 2) Demand for an individual brand is more elastic than industry aggregate demand. 3) Products with many complements have less elastic demand. 4) In the long run, demand curves become more elastic. 5) As price increases, demand becomes more elastic. ©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 Factor 1 1. Products with close substitutes have elastic demand. ● Consumers respond to a price increase by switching to their next -best alternative. ● If their next -best alternative is a very close substitute, then it doesn’t take much change in price for them to switch. ● When Mayor Barry raised the price of gasoline, DC commuters began buying gasoline in nearby Virginia and Maryland. ©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 Factor 2 2. Demand for an individual brand is more elastic than industry aggregate demand. ● Rough rule of thumb: brand price elasticity is approximately equal to industry price elasticity divided by brand share ● Example: • elasticity of demand for all running shoes = -0.4 • Market share of Nike running shoes is 20% • Price elasticity of demand for Nike running shoes is -0.4/.20 = -2 • Using our optimal pricing formula, this would give Nike a desired margin of 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 Factor 3 3. Products with many complements have less elastic demand. ● Products that are consumed as a larger bundle of complementary goods have less elastic demand. ● Example: iPhones have less elastic demand because of the number of apps run on them • If the price of an iPhone increases, you are less likely to substitute to another product due to the complementary apps ©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 Factor 4 4. In the long run, demand curves become more elastic. ● This can also be explain by the speed at which price information is spread; or the ability of consumers to find more substitutes in the long run. ● Example: ATM fees • At a selected number of ATMs, a bank raised user fees from $1.50 to $2.00. • When informed of the fee increase, users typically completed the current transaction but avoided the higher – priced ATMs in the future. ©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 Factor 5 5. As price increases, demand becomes more elastic. ● Example: high -fructose corn syrup (HFCS) • Primary use is a caloric sweetener in soft drinks • Sugar is the perfect substitute for HCFS • Import quotas and sugar price supports have raised the US domestic price of sugar about twice that of HFCS. • Bottlers have shifted to HFCS. • Bottlers have no close substitute for low -priced HFCS, although as the price of HFCS approaches that of sugar, demand for HFCS becomes very elastic. ©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 Other Elasticities ● Definition : income elasticity measures the change in demand arising from a change in income (%change in quantity demanded) (%change in income) • Inferior goods (negative) : as income increases, demand declines • normal goods (positive): as income increases, demand increases ● 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 (positive): as the price of a substitute increases, demand increases • Complement (negative): as the price of a complement increase, demand decreases ©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 Stay -Even Analysis ● Stay -even analysis tells you how many sales you need when changing price to maintain the same profit level • How to implement marginal analysis of pricing using stay -even quantity: %ΔQ = (%ΔP) (%ΔP + margin) ● Margin=40%, %ΔP=5%, then %ΔQ = 11.1% ● In other words, a 5% price increase would be profitable if quantity went down by less than 11.1%. ● Use elasticity estimates or marketing surveys to determine whether quantity would go down by 11.1%. ©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 Cost -Based Pricing ● Our expression for optimal pricing, MR=MC or (P – MC)/P= 1/|e|, takes into account the firm’s cost structure and its consumer demand ● Often, the consumer side is ignored in pricing decisions, leading to cost -based pricing. Why? ● Often, firms do not have the demand picture ● They need to invest in a market research division to take profitability seriously ©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 Extra: Quick and Dirty estimators ● Linear Demand Curve Formula: e= p / (p max -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? ©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 Extra: Market Share Formula ● Proposition : The individual brand demand elasticity is approximately equal to the industry elasticity divided by the brand share. • Discussion : Suppose that the elasticity of demand for running shoes is – 0.4 and the market share of a Saucony brand running shoe is 20%. What is the price elasticity of demand for Saucony running shoes? ● Proposition : Demand for aggregate categories is less -elastic than demand for the individual brands in aggregate. ©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 Devaluation of Currency ● In 1994, the peso devalued by 40% in Mexico • Interest rates and unemployment shot up • Overall economy slowed dramatically and consumer income fell ● Concurrently, demand for Sara Lee hot dogs declined • This surprised managers because they thought demand would hold steady, or even increase, since hot dogs were more of a consumer staple than a luxury item. • Surveys revealed the decline was mostly confined to premium hot dogs • And, consumers were using creative substitutes • Lower priced brands did take off but were priced too low. ● Failure to understand demand and to price accordingly was costly. ©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.