Corporate Economics EMBA 752

1. Corporate EconomicsEMBA 752 Richard D. Marcus Summer 2019

2. Executive MBA Program :Corporate Economics 752 • When the price rises, people tend to buy less • But how much less? • Economists come up with a measure of the sensitivity of price to quantity called the price elasticity. • Identical reasoning works for sensitive to income, advertising, weather, and prices of other goods. • Chapter 3 discusses Demand Elasticities • Page 65: Managerial Rule of Thumb • Answer in Two Questions for Income Elasticity • What fraction of your income do you spend on rent? • If you earned a bonus of $1,000, what part of that bonus would you spend in rent? • Suppose 20% is answer to 1. • Suppose 5% is answer to 2. • The income elasticity of renting is 5% / 20% = .25

3. Understanding Markets and Industry Changesquick review from unassigned Chapter 2 and our Success Residency A markethas a product, geographic, and time dimension. Define the market before using supply–demand analysis. Market demanddescribes buyer behavior. Market supplydescribes seller behavior in a competitive market. If price changes, quantity demanded increases or decreases (represented by a movement along the demand curve). If a factor other than price (like income) changes, we say that demand curve increases or decreases (a shift of demand curve).

4. Demand ElasticitiesChapter 3 • Procter & Gamble • Many familiar brand names, including Crest, Tide, Gain, Bounty, Pampers, Luvs, Charmin, Dawn, and Downey. • When material prices rise, they raise prices. • But generic products may not. • Even if they cut prices, some of their own products compete with their other products. • How people react to price changes depends on price elasticities.

5. Elasticities • Elasticity is measure of responsiveness or sensitivity • Beware of using Slopes Slopes change with a mere change in the units of measure price price per per bu. bu bushels tons

6. Price Elasticity • Price elasticities are often given as the absolute value of their price elasticity for historical reasons. We’ll let them be negative numbers • Elasticity of Demand = eP ≡ EQ,P≡EP ≡ (% change in Q) / (% change in P) • Ratios of percentages are not affected by units of measure. They are pure numbers. -30% / 10% = -3 • Price elasticities are also known as own-price elasticities or demand elasticities. • Some economists use the absolute value when talking of elasticities.

7. Price Elasticitya.k.a. “The Own Price Elasticity of Demand” • E P = % change in Q / % change in P • Shortcut notation:E P = Q* / P* • A percentage change from 100 to 150 is 50% • A percentage change from 150 to 100 is -33% • Arc Price Elasticity-- averages over the two points arc price elasticity D

8. Arc Price ElasticityExample • Q = 1000 at a price of $10 • Then Q= 1500 when the price was cut to $6 • Find the arc price elasticity Solution: E P = Q* / P* = +500/1250= -.40 -4 / 8 50 or -0.8 • An elasticity is a number, not a percentage. • But a 1% increase in price reduces quantity by .8 percent. • Or a 1% decrease in price increasesquantity by .8 percent.

9. Point Price ElasticityExample • Need a demand curve or demand function to find the price elasticity at a point. E P = Q* / P* = (Q/P)·(P/Q) ( slope ) • (P/Q) If Q = 370 - 10•P + 5 • I, find the point price elasticity at P = 30 and I = 10 Q = 370 - 10(30) + 5(10) = 120 E P = (Q/P)(P/Q) = - 10(30/120) = -2.5 which iselastic

10. 2 Extreme Cases of Price Elasticity Perfectly Inelastic= 0 Perfectly Elastic =  P P D IBM D Q Q e.g., insuline.g., my share of IBM stock vs. others

11. Point Price Elasticity Straight Line Example • Need a demand curve or demand function to find the price elasticity at a point. EP = Q* / P* = (Q/P)(P/Q) If Q = 500 - 5•P, find the point price elasticity at P = 30; P = 50; and P = 80. • E P = (Q/P)(P/Q) = - 5(30/350) = -0.43 • E P = (Q/P)(P/Q) = - 5(50/250) = -1.0 • E P = (Q/P)(P/Q) = - 5(80/100) = -4.0

12. Price Elasticity ( both point price and arc elasticity ) • If E P = -1, it is unit elastic • If |E P|< 1, inelastic, e.g., -.43 • If |EP| > 1, elastic, e.g., -4 PAGE 51 Table 3.1 price elastic region ( e.g. -4) unit elastic (-1) inelastic region (e.g., -.43) $80 $50 $30

13. Gasoline & Price Elasticity • Gasoline prices have risen and then fallen dramatically and are rising again. • But response of drivers is not very great. Sales are about flat. • Is gasoline elastic, inelastic, or more like perfectly inelastic? • Our response takes time to buy more efficient cars or change locations of home & work.

14. Percentage Rate of Change NotationMarcus’four rules for percentages 1. A percentage change: Q/Q = Q* From Q1 = 100 to Q2 = 150 is 50% 2. The percentage rates of change of a product , (e.g., TR = P·Q) (P·Q)* = P* + Q* Q: If price rises 4%, but output drops 1%, what happens to total revenue?

15. 3. The percentage rate of change of a sum (e.g., a two product firm: TR = A + B): (A+B)* = [A/(A+B)]·A* + [B/(A+B)]·B*. Q: If product A is improved, revenues are anticipated to rise 20%, but our related product B will see erosion of about 10%. • What happens to Total Revenue if about half our revenue comes from product A and the rest from product B? TR* = ( .5 )(20%) + ( .5 )( -10%) = +5%

16. 4. The percentage rate of change of a function, (e.g., a demand function) Q = f(P, I ): Q* = E P · P* + E I·I* where EP is a price elasticity without taking absolute values and EI is the income elasticity Q: If the price elasticity is -2, price rises 4%, the income elasticity is +1.5, and income rises 4%, what will happen to Q? What happens to TR?

17. Answer Q* = E P · P* + E I·I* Q* = -2 (4%) + 1.5 (4%) = -8% + 6% = -2% TR* = P* + Q* = +4% -2% = +2% Aside: asterisks -- are log derivative operators Q* = d Log Q = dQ/Q

18. TR and Price Elasticities • If you raise price,does TR rise ? • Suppose demand is elastic, and we raise price. TR = P•Q, so, TR* = P* + Q* • If elastic, P , but Q a lot • Hence TR FALLS !!! • Suppose demand is inelastic, and we decide to raise price. What happens to TR and TC and profit? Should we Raise the Price?

19. TR & Elasticity Elastic Region Unit Elastic Inelastic Region • Figures 3.4 and 3.5 on pages 60-61. • Linear demand curve • TR on other curve • Look at arrows to see movement in TR Q Q TR

20. 1979 Deregulation of Airfares • Prices declined • Passengers increased • Total Revenue Increased • What does this imply about the price elasticity of air travel ?

21. Extended Determinantsof the Price Elasticity • More closesubstitutes, more elastic • One brand is more elastic than the whole industry • More close complements, less elastic • Seen as a part of a bundle, so not so price elastic • As price rises, more elastic • The larger the proportion of the whole budget • larger proportion, more elastic • The longer the time period permitted • more time, generally, more elastic • consider examples of a discount trip to Paris (this weekend only) • The nature of the good’s durability • Durable goods are more elastic than nondurable ones See pages 53 – 54

22. Airline Travel for Vacationers vs.Business Travelers 1. Which group has closer substitutes as modes of travel? 2. For which group is the transportation expense the greater proportion of budget? 3. Which group has a longer time period to consider for the travel? Which group is more price sensitive?

23. Income Elasticity E I = Q* / I* = (Q/I) • ( I / Q) • arc income elasticity: • Suppose that the dollar quantity of food expenditures of families earning $20,000 is $5,200; and that food expenditures rises to $6,760 for families earning $30,000. • Find the income elasticity of food Q* / I*= (1560/5980)/ (10,000/25,000) = + .652

24. Income Elasticities -- Definitions • If E I is positive, then it’s a normal good some goods are Luxuries: E I > 1 some goods are Necessities: E I < 1 • If E I is negative, then it’s aninferiorgood • consider: Expenditures on automobiles Expenditures on Fords Expenditures on 2010 Ford Taurus with 100,000 miles http://www.kbb.com/ford/taurus/2010/se-sedan-4d/?vehicleid=249047&intent=buy-used&mileage=100000&condition=good&pricetype=retail

25. Point Income Elasticity Problem • Suppose the demand function is: Q = 10 - 2•P + 3•I • find the income and price elasticities at a price of P = 2, and income I = 10 • So: Q = 10 -2(2) + 3(10) = 36 • E I = (Q/I)( I/Q) = 3( 10/ 36) = .833 • E P = (Q/P)(P/Q) = -2(2/ 36) = - .111 • Characterizethis demand curve!  means use elasticity language to describe it.

26. Cross Price Elasticities E xy = Qx* / Py* =(Qx/Py)(Py / Qx) • Substitutes have positive cross price elasticities • example: Butter & Margarine • Complementshave negative cross price elasticities • Ex: Cards Against Humanity Game & Expansion packs of cards • Cards Against Humanity was created by Highland Park HS alumni for a New Year’s Eve celebration, and financed by Kickstarter in 2011 http://en.wikipedia.org/wiki/Cards_Against_Humanity • When the cross price elasticity is zero or insignificant, the products are not related

27. Supply Elasticities:Extreme Cases Fixed Supply Perfectly Elastic Supply P P S S Q Q e.g., often in short rune.g., in the longer runother firms may enter

28. Supply and the Length of Time Supply in the SR P1 P0 D’ D Q

29. A Dynamic Model of Price Change Over Time Supply in the SR Supply in the LR P1 P2 P0 D’ D Q

30. PROBLEM: Find the point price elasticity, the point income elasticity, and the point cross-price elasticity at P=10, I=20, and Ps=9, if the demand function were estimated to be: Qd = 90 - 8·P + 2·I + 2·Ps Characterizethe demand for this product: Elastic?, Luxury?, Necessity? Does this product have a close substitute or complement?

31. Qd = 90 - 8 (10) + 2 (20) + 2 (9) = 68 EP = (-8)(10/68) = -1.18 EI = (2)•(20/68) = 0.59 EPs = 2•(9/68) = 0.26 • How do we “characterize the demand for this product”? • Elastic or Inelastic? • Normal or Inferior Good? • If normal,Luxury or Necessity? • Complement or Substitute?

32. Thinking Economically • Incentives matter– they often solve the most perplexing questions. • Measuring and knowing what to measure matters– measuring take away some of the emotion in hot-button social issues like crime and abortion. • Conventional wisdom is often wrong – accepting the common is herd behavior. It is sloppy thinking. Just repeating what others think – don’t do it. • Correlation is not causality – e.g., married people measure higher in happiness, so does marriage CAUSE happiness? More likely, happier people get married.

33. Discussion Time – Yeah! • Ask, “what I don’t get is…” or • Using economics, please explain why we do what we do.

34. A Economic Model of Consumer Choice & Individual Behavior Appendix 3A • We could determine what Saquanna or Gopi would do over a set of choices, if we only knew how they valued each choice? • We measure light in candles • We measure powerin horsepower • We measure a unit of pleasureor pain , called the util. • We need a utilometer. • Jeremy Bentham, teacher of John Stuart Mill, argued for the basis of ethics using utilitarianism: • Thou shalt not kill, based on highest social welfare using this rule. • What we need is a way to measure Pleasure and Pain.

35. U2 U1 X Consumer Choice- assume consumers can rank preferences (completeness), that more is better than less (nonsatiation), that preferences are transitive (transitivity), and that individuals have diminishing marginal rates of substitution. Then indifference curvesslope down, never intersect, and are convex to the origin. Uo 9 7 6 convex 5 6 7 Y give up 2X for a Y

36. Utility Maximizing Rule RULE:Consume until MU per dollar in each use is equal. • Suppose MU of a candy bar is 30, and price is $1 • Suppose MU of a soda is 10 and price is $.50 • What should you do? • A rational consumermaximizes satisfaction by reorganizing consumption until the marginal utility in each good per dollar is equal where: MUA/PA = MUB/PB = MUC/PC = ... • If MU per dollar in A and B differ, the consumer can improve utility by purchasing more of the one with higher MU per dollar.

37. The Disruptors’ FeastChapter 1The Great Acceleration • Who is Frits van Paasschen? • What is “Starwood Hotels?” • What is a “Disruption?” Claim: Humans have a tendency to “Change-blind” and to put too much faith in their plans and projections. When have you been change-blind? Three Themes • Trend lines – in cost, speed, shopping… • Digital Networks – in transport, information… • Systems Behavior – in cities & ecosystems…

38. When did this Great Acceleration start? • Well, we’ve been doubling information for quite a while. • Around the fall of the Soviet Union, early 1990’s, is the claim • Multiple nodes of influence in the new world order. Three Next Themes • Overcome Cognitive Bias – behavioral economics matters • Become Agile – doing nothing is seldom optimal • Live at the Crossroads – geography & functions & perspectives

39. The Disruptors’ FeastChapter 10Volatility in a Connected World • Its not going to happen the way you are planning – Ike • How to look at a “connected world,” at BCG = Boston Consulting Group Seven Lessons • Expect the Unexpected – not engineering problems with one solution, but 3 body problems. • Systems Thinking Leads to Creative Solutions – think of a shower temperature regulator, lighting vs. police, or adding incentives for booking.com? • Real World Systems are Complex – Yellowstone story of wolves & eagles

40. Unexpected Outcomes • “When wolves were reintroduced to [Yellowstone] park after a 70-year hiatus, the deer population declined, as expected. The remaining deer stayed on the move, avoiding valleys where they might be trapped. As a result, in just a few years, trees grew taller along the rivers and other vegetation returned. More berries attracted more birds and bears. Wolves also ate coyotes; fewer coyotes meant more rodents and rabbits, which increased the eagle population. Beavers built more dams, slowing the river and creating pools for ducks and muskrats. Over time, the course of the river changed, and there was less erosion on riverbanks. In other word, the reappearance of a single species in this system had all kinds on unexpected effects, such as redirecting waterways and transforming forests." • This isn't just a case of "the Butterfly Effect," that one butterfly in Africa impacts rain in the Amazon. It shows that economic changes to taxes, or health care, or entitlements have wider ranging impacts for good and ill than are typically modeled. https://www.linkedin.com/pulse/wolves-impact-eagles-rivers-unexpected-outcomes-dick-marcus

41. More Lessons • Everything is connected – bad things and good things aren’t always uncorrelated • Calm precedes turbulence – sand dunes and political revolts take time to build up, then they move fast. • Systems settle into cycles – think of need for hotels and how that can then lead to oversupply • Trend lines lead to unpredictable outcomes – whether greenhouse gasses or any trend, the result can be unexpected

42. What are Black Swans? • A black swan event was pioneered by Nassim Nicholas Taleb after the results of the 2008 Financial Crisis. • Taleb argued that black swan events are impossible to predict yet have catastrophic ramifications. • Example: Starwood ringing the bell on NYSE on the day Lehman Brothers filed for bankruptcy. Getting off message.

43. What is Contagion? • A medical model has something to do with business. • Many business cycles have “contagion” effects. • A slow down in one industry lowers income. • Lowered income for those workers leads to less sales in other industries • And so the waves of impacts continue. • Information and cyberspace may actually speed up contagion. • We know of problems elsewhere almost immediately.

44. Break time

45. Executive MBA Program :Corporate Economics 752 • List of Bias and Blunders– Chapter 1 review of Nudge by Thaler & Sunstein • Automatic System is instinctive, fast, effortless. • Reflective System is deductive, slow, rule-following. • Most of our errors are of the automatic kind. Rules of Thumb– play a role in making decisions or guesses. • Anchoring and Adjustment– a fact or statement becomes the basis of the decision or choice, as when a charity suggest a $100 donation to you. • Availability - or accessibility or salience – can you recall sharknado attacks or a zombie apocalypse. then they seem more likely than death by an asthma attack.

46. 3. Representativeness • How similar is this to other things? • Often seen as stereotyping – Which is more likely a basketball player? • A 6 foot 8 inch black man, 22 years old  • A 5 foot 6 inch Jewish man, 39 years old • In 1990, two business faculty, then in Bolton Hall, came down with brain tumors. “Clusters” of incidence led many to think Bolton Hall was a death trap. One died, one survived. • Asbestoswas removed from Bolton Hall in 2014.

47. 4. Optimism and Overconfidence • Prudential Insurance yellow & blue magnet commercial: http://www.ispot.tv/ad/7Jim/prudential-the-prudential-magnets-experiment • Overestimate our abilities, our class rank, our chance of becoming ill. • Why would a life insurance firm point our overconfidence in the future?

48. 5. Loss Aversion • You know there is a coupon at home, but you want to buy an item at Macy’s. Should you wait to go home? You’d feel like an oaf if you bought it without that coupon. • Loss aversionis our tendency to prefer avoiding losses to acquiring gains. Most studies suggest that losses are twice as powerful, psychologically, as gains. • Most large ticket items offer a discount or special financing. Why not say higher price if take the financing deal?

49. 6. Endowment Trap • Also discussed on page 20 and on page 33 of Thaler. • That which we have, we value highly. Give EMBA students mugs, they won’t sell. • Give student money, and offer to buy a cool EMBA mug, you won’t buy one. • Why? UWM EMBA

50. 7. Status Quo Bias • Where do you park at work or the mall? • Where do you sit in church or in school? • Why do you only buy mutual funds from one family of funds? • Change has a chance of backfiring, and loss aversion. • Default decisions makes looking for a car, or a spot to sit less costly.