1 / 50

BUS7500 Managerial Economics

BUS7500 Managerial Economics. Week 3 Dr. Jenne Meyer. Background: consumer surplus and demand curves. First Law of Demand - consumers demand (purchase) more as price falls, assuming other factors are held constant.

kassia
Download Presentation

BUS7500 Managerial Economics

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript


  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.

More Related