BUS7500 Managerial Economics

1. BUS7500Managerial Economics Week 3 Dr. Jenne Meyer

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

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

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

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

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

7. Example: finding the optimal price • Start from the top • If MR > MC, reduce price (sell one more unit)

8. Find the optimum price • Additional expenses: • Web - $140/year • Printed envelopes - $0.08/each for 10K • Other expenses?

9. Estimating elasticities • Definition: Arc (price) elasticity= • [(q1-q2)/(q1+q2)]  [(p1-p2)/(p1+p2)]. • Discussion: Why, when price changes from $10 to $8, does quantity changes from 1 to 2? • Example: On a promotion week for Vlasic, the price of Vlasic pickles dropped by 25% and quantity increased by 300%. • Is the price elasticity of demand -12? • HINT: could something other than price be changing?

10. 3-Liter Coke Promotion (Instituted to meet Wal-Mart promotion) Estimating elasticities (cont.)

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

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

13. Describing demand with price elasticity • First law of demand: e < 0 ( as price goes up, quantity goes down). • Discussion: Do all demand curves slope downward? • Second law of demand: in the long run, |e| increases. • Discussion: Give an example of the second law of demand.

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

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

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

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

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

19. Chapter 7

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

21. Increasing marginal costs • Definition: The law of diminishing marginal returns: as you try to expand output marginal productivity eventually declines. • Diminishing marginal returns  marginal productivity declines • Diminishing marginal productivity  increasing marginal costs • Increasing marginal costs eventually lead to increasing average costs • Some causes of diminishing marginal returns • Difficulty of monitoring and motivating a large work force • Increasing complexity of a large system • The “fixity” of some factor, like testing capacity

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

23. Economies of scale • Definition: short run “fixity” vs. long run “flexibility” • i.e. factors that are fixed costs in the SR but become variable in the long run • If long-run average costs are constant with respect to output, then you have constant returns to scale. • If long run average costs rise with output, you have decreasing returns to scale or diseconomies of scale. • If average costs fall with output, you have increasing returns to scale or economies of scale. • Discussion: Category Killer stores & economies of scale

24. Learning curves • Discussion: Every time an airplane manufacturer doubles production, marginal costs decrease by 20%.

25. Learning curves graph

26. Economies of scope • If the cost of producing two products jointly is less than the cost of producing those two products separately then there are economies of scope between the two products. • Cost(Q1, Q2) < Cost(Q1) + Cost(Q2) • Discussion: Company X is a small family-owned company that makes, sells, and distributes a popular breakfast sausage. • Can this firm realize economies of scope? • Discussion: Scope economies in your company. • Implication?

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

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

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

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

31. Chapter 8

32. Anecdote: Y2K and generator sales • From 1990-98, sales of portable generators grew 2% yearly. • In 1999, public anticipation of Y2K power outages increased demand for generators. • Walters, Rosenberg and Matthews invested to increase capacity in anticipation of this demand growth – they vertically integrated their company to increase capacity and reduce variable costs. • Demand grew as expected - Industry shipments increased by 87%. Prices also increased by an average of 21%. • Discussion: What will happen next? Why?

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

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

35. Demand increase • At a given price, more quantity demanded

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

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

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

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

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

41. Generator demand shifts graph

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

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

44. Prices convey information (cont.) • Discussion: Gas pipeline burst between Tucson and Phoenix • What happened to gas prices in Phoenix, in Tucson and in Los Angeles?

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

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

47. Extra: using demand and supply • Discussion: Is there a shortage of affordable housing? • Discussion: Is there a shortage of kidneys?

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

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

50. Discussion • Key learnings? • Next weeks assignments.