Transcript lecture 1 - Vanderbilt University

Chapter 4
Extent (How Much) Decisions
Managerial Economics: A Problem Solving Approach (2nd Edition)
Luke M. Froeb, [email protected]
Brian T. McCann, [email protected]
Website, managerialecon.com
COPYRIGHT © 2008
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
trademarks used herein under license.
Chapter 4 – 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.
Chapter 4 – Summary (cont.)
• 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).
• 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.
Introductory anecdote: 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)
• Concurrently mortgages were being packaged
into securities 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?
Background: Average cost
• Definition: Average cost is simply the total cost of
production divided by the number of units produced.
AC = TC/Q
• Average costs often decrease as quantity increases
due to presence of fixed costs
• AC = (VC + FC)/Q
• FC does not change as Q increases
• Average costs are not relevant to extent decisions
Background: Average cost
(cont.)
Background: Marginal cost
• Marginal cost is the cost to make and sell
one additional unit of output.
MC = TCQ+1 – TCQ.
• Marginal cost is often lower than average
cost (due to falling average costs) but not
always.
• Marginal costs are what matter in extent
decisions
Extent (how much?) decisions
• Definition: Marginal cost (MC) is the additional
cost required to produce and sell one more unit.
• Definition: Marginal revenue (MR) is the
additional revenue gained from producing and
selling one more unit.
• If the benefits of selling another unit (MR) are
bigger than the costs (MC), then sell another unit.
• So, produce more when MR>MC; less when
MR<MC. Profits are maximized when MR=MC.
Extent decisions (cont.)
• Examples of extent decisions
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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?
• Marginal analysis answers these questions
• 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
Extent decision example
• Discussion: How much advertising?
• A $50,000 increase in the TV ad budget brings in 1,000 new
customers
• Estimated MCTV 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.
Extent decision example (cont.)
• Even if we do not know the marginal revenue, we can still use
marginal analysis to make extent decisions
• Compare TV advertising to telephone solicitation
• Say you recently cut telephone budget by $10,000
and lost 100 customers
• Estimated MCPH = $100= ($10,000 / 100)
• So, to get one more customer costs $50 for TV and
$100 for phone
• MCPH > MCTV 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.
Another example
• 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?
• The decision seems simple, but
• 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
Effort is an extent decision
• Discussion: Royalty rates vs. fixed fee contracts
• 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?
• Discussion: Sales Commissions
• Expected sales level: 100 units @ $10,000/unit=$1M
• Option 1: 10% commission
• Option 2: 5% commission + $50,000 salary
• Discussion: give example of royalty rate or
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  $177K
• Discussion: what are the disadvantages to incentive pay?
Alternate intro anecdote
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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, company considered expanding
number of card holders
How many more should be added?
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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.
1. Introduction: What this book is about
Managerial Economics
2. The one lesson of business
Table of contents
3. Benefits, costs and decisions
4. Extent (how much) decisions
5. Investment decisions: Look ahead and reason back
6. Simple pricing
7. Economies of scale and scope
8. Understanding markets and industry changes
9. Relationships between industries: The forces moving us towards long-run equilibrium
10. Strategy, the quest to slow profit erosion
11. Using supply and demand: Trade, bubbles, market making
12. More realistic and complex pricing
13. Direct price discrimination
14. Indirect price discrimination
15. Strategic games
16. Bargaining
17. Making decisions with uncertainty
18. Auctions
19. The problem of adverse selection
20. The problem of moral hazard
21. Getting employees to work in the best interests of the firm
22. Getting divisions to work in the best interests of the firm
23. Managing vertical relationships
24. You be the consultant
EPILOG: Can those who teach, do?
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