Transcript power point slides for lecture #5 (ppt file)

Lecture 5: Review
Investment decisions and
break even analysis
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Summary
• 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.
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Shutdown decisions
 Shutdown decisions are difficult psychologically, but
economically, the rule of thumb is straightforward
 Avoidable costs are costs that can be recovered from
shutting down.
 Shutdown if the marginal benefits associated with
recouping avoidable costs exceeds marginal costs, in this
case, the foregone revenue from shutting down.
 If you incur sunk costs specific to a trade relationship, you
are subject to the hold-up problem.
 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.
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Should we 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
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Costs “Taxonomy”
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KEY POINT #3
 Difficult decisions to shutdown often
involve psychological costs. A firm
should shut down when average
avoidable cost is less than the price.
 Example:
Consider a firm that produces 500,000 units per year.
The firm’s fixed costs are $100,000, marginal costs are $250 and the
price per unit is $400. In the short-run, how low can price go before
it is profitable to shut down?
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Uh Oh! It’s a hold up!
• 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
renogiating 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.
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?
• One possible solution to post-investment hold-up is
vertical integration. Another, is the so called
“exchange of hostages.”
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Solutions and a final example
• Example: Bauxite mine and alumina refinery
• Refineries are tailored to specific qualities of ore
• Building refineries near mines reduces costs for the refiner,
but, the building of the refinery becomes a sunk cost
• The transaction options are:
• 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
• We can make it expensive to hold up. Incentives should be
introduced that cause both parties to adhere to original
agreements.
• Contractual view of marriage
• What is the hold-up problem?
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Lecture 5
TOPIC #1: Simple
Pricing and demand
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)
• If |e| > 1, demand is elastic; if |e| < 1, demand is inelastic.
• %ΔRevenue ≈ %ΔPrice + %ΔQuantity
• Elastic Demand (|e| > 1): Quantity changes more than price.
• Inelastic Demand (|e| < 1): Quantity changes less than price.
Summary (cont.)
• MR > MC implies that (P - MC)/P > 1/|e|; in words, if the actual
markup is bigger than the desired markup, reduce price
•
•
Equivalently, sell more
Four factors make demand more elastic:
•
•
•
•
Products with close substitutes (or distant complements) have more
elastic demand.
Demand for brands is more elastic than industry demand.
In the long run, demand becomes more elastic.
As price increases, demand becomes more elastic.
• 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.
Introductory anecdote: Mattel
• Mattel: introduced Hot Wheels in 1968, kept price
below $1.00 for 40 years, even as production
costs rose
• Finally tested a price increase, experienced
profits increase of 20%
• Why? Profit=(P-TC)xQ
• Businesses tend to focus on TC and Q, neglect P
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Roger Brinner, Parthenon Group
 “In many instances, companies can make money by
simply raising prices. Pricing is the grossly neglected
orphan of profit management. Most companies leave list
prices unchanged year after year or simply modestly
increase list prices in an unchallenged annual ritual.
Other companies perform strategic analyses, producing
the facts and generating the confidence to change
prices aggressively and to raise profits dramatically.”
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
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KEY POINT #1
 INDIVIDUAL DEMAND CURVES SLOPE
DOWN…. THE LAW OF DEMAND!
 As we raise price, consumers will
respond by purchasing less.
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
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.
Price
$7.00
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
Quantity
1
2
3
4
5
6
7
Revenue
$7.00
$12.00
$15.00
$16.00
$15.00
$12.00
$7.00
Marginal
Revenue
$7.00
$5.00
$3.00
$1.00
-$1.00
-$3.00
-$5.00
$8.00
• Discussion: Why do aggregate demand curves slope downward?
Price
$6.00
$4.00
$2.00
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Pricing trade-off
• Pricing is an extent decision
• Profit= Total Revenue – Total 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
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Pricing
• Marginal analysis finds the profit increasing solution to
the pricing tradeoff.
• It tells you only whether to raise or lower price, not by
how much.
• 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. Highest level of MR doesn’t mean profits are
maximized as we saw on our quiz.
• If MR>MC, then total profits will increase if you sell one
more.
• We already know: Profits are maximized when MR = MC
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KEY POINT #2
 MARGINAL ANALYSIS TELLS US THAT
WHEN MR>MC…. PRODUCE AND SELL
MORE!!! HOW???? DECREASE PRICE
 WHEN MR<MC…. WE ARE PRODUCING
AND SELLING TOO MUCH…. SELL
LESS!!! HOW??? INCREASE PRICE
Start from the top… FILL IT IN:
FIXED COST =$5
PRICE
Q Demand
$7
1
$1.50
$6
2
$1.50
$5
3
$1.50
$4
4
$1.50
$3
5
$1.50
$2
6
$1.50
$1
7
$1.50
Revnue
MR
MC
Profit
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Let’s tell the truth
 Having worked as an economic consultant, I can tell
you, you will never see a complete demand curve.
 Even still, the analysis we have just seen can give
invaluable intuition into understanding pricing
decisions.
 In particular, what we have just seen is that MR and MC
are what we need to know.
 We can use this information and market information
about elasticities to form the proper decisions.
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Elasticity of demand
• Price elasticity is a factor in calculating MR.
• Definition: price elasticity of demand (e)
• (%D in Qd)  (%D 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.
Price change between month 1
and month 2
• Definition: Elasticity=
[(q2-q1)/(q1+q2)]  [(p2-p1)/(p1+p2)].
• Note, by the law of demand, elasticity of price
change should be negative.
• 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?
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KEY POINT #3
 WHEN DEMAND IS ELASTIC, RAISING
THE PRICE WILL REDUCE REVENUE.
 WHEN DEMAND IS INELASTIC, RAISING
THE PRICE WILL RAISE REVENUE!!
 Note: Remember revenue is only one
side of the coin. We would need to
know something about costs to
determine if profit are maximized.
Example: Grocery Store
(MidSouth in 1999).
 3-Liter Coke Promotion (Instituted to meet WalMart promotion)
• Compute price elasticity of 3 liter coke; cross price
elasticity of 2 liter coke with respect to 3 liter price;
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Revenue:
 Demand for 3-liters was very elastic. Please calculate
the revenue that resulted from the price decrease.
 Did revenue increase or decrease?
 Should increase as we already discussed.
 We can show the %change in revenue is equal to the
%change in price + % change in quantity.
 Since prices and quantities move in opposite directions,
total revenue changes will determined by which changes by
more (in absolute value).
If you want, I’ll show you the
math
• Proposition: MR = Avg(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?
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Example
 MR>MC




=> avg(P)[1-1/|e|]>MC
=>avg(P)-avg(P)/|e|>MC
=>avg(P)-MC>avg(P)/|e|
=>[avg(P)-MC]/avg(P)>1/|e|
 The firm’s actual mark-up exceeds the desired markup!
 It should lower price!
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Example
 Suppose you have the following data:
 Elasticity=–2
 Average Price =$10
 Marginal Cost= $8
 Should we raise the price? How do you know?