The Cornell Queens Executive MBA

Managerial Economics and Industry Analysis MBUS 881/NCCB 505 Summary of Discussions Session 2 Bo Pazderka

Session 2 Slide # 6
Diagram: The variable factor on the horizontal axis is the amount of time spent studying The output on the vertical axis is the amount of knowledge generated by studying The underlying fixed factor(s): Innate ability Family background Attitude, diligence

Session 2 Slide # 7
In class discussion, the following hypotheses were offered for the Canadas productivity lag behind U.S.: Some of the less productive U.S. jobs have been outsourced to other countries, thus raising the U.S. productivity. This happened to a lesser extent in Canada The shift from manufacturing to knowledge-based economy (more productive) has been faster in the U.S. Unionization of labour in Canada is higher Information technology utilization is higher in the U.S. Cultural difference: The Americans are more driven due in part to the founding principles of for-profit mentality and individualism
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Session 2 Slide # 7 (cont.)

Intensity of competition in most markets is higher in the U.S. and creates greater incentive to innovate The calibre of immigrants into the U.S. may be higher The structure of the Canadian economy: Sectors where productivity growth is more difficult to achieve have a higher share of GDP Canadas low population density and harsher winters contribute to higher costs and lower productivity (also costs of bilingualism) Reliance on resource wealth leads to greater riskavoidance in Canada and thus less innovation Share of government sector in the Canadian economy is higher (contributes to lower productivity)
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Session 2 Slide # 7 (cont.)

The regulatory environment in Canada is more stringent The military-industrial complex is smaller in Canada Unemployment insurance, maternity/paternity leaves, length of vacations, and other social policies are more generous in Canada and create a disincentive to work In some industries (e.g. the oilsands) Canadian productivity is lower, even taking account of adverse weather. Reason: Limited ability to attract high-quality labour and other resources Canada has many subsidiaries of U.S. companies; they perform the lower-level (and less productive) tasks, while the more productive tasks are done in the U.S.
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Session 2 Slide # 10
How should advertising manager allocate advertising budget of $100,000? Some options: Allocate equal amount to each medium Repeat last years allocation Imitate competitors Apply the bang-for-the-buck rule (formula on next slide)

Session 2 Slide # 10 (cont.)

The bang-for-the-buck rule:

MPPrint MPRadio MPTV MPInternet PPrint PRadio P TV PInternet

Session 2 Slide # 10 (cont.)

Information required: 1) Cost of advertising in each medium (the denominator) 2) Measure of MP of advertising in each medium (the numerator). Some measurement techniques: Increase spending in a test market, keeping spending elsewhere constant, and observe the change () in sales, where Sales = MPAdv Statistical analysis of past data from several regions and time periods (much like the pipeline engineer measured MP of diameter and MP of horse-power see Course Notes, pp. 72-74) Other techniques (Market Research courses)
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Session 2 Slide # 16
Q. 1: Relationship between circumstances described in the article and the cost curves: The article describes a set of factors which make the short-run TVC (and TC) curves almost vertical as capacity is approached Additional factor (from class discussion): Quality assurance may be neglected, leading to product recalls and higher cost in the future Both TVC and TC curves are affected, since the TC curve has exactly the same shape as the TVC (see Fig. 3.11 in Course Notes)

Session 2 Slide # 16 (cont.)

Q 2: Dealing with the pressures: In the short run, not much can be done In the long run when the existing facilities become obsolete and time comes to replace them consideration should be given to expanding the plant capacity, i.e. building a bigger plant size, as in Fig. 3.15

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Session 2 Slide # 19
Q 1: Advantages of size (Course Notes, pp. 89-91): a) Benefits to firm alone [i.e. large firms benefit at the expense of customers or suppliers]: Large firms have lower input costs (they are able to extract discounts from suppliers) Large firms get lower interest rate from banks Dominant suppliers are able to extract higher prices from buyers b) Benefits to society as a whole [i.e. not merely a transfer of profits to large firms, but net benefits]: Economies of scale Economies of scope
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Session 2 Slide # 19 (cont.)

Q 2: Potential disadvantages of large size Loss of control as operations gets too large Possible loss of innovative potential in large firms, due to excessive centralization of R&D and the consequent stifling of creativity Social cost (lessening of competition) when previously competing firms merge (more details in Chapter 4)

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Session 2 Slide # 24
Q 1: E-commerce satisfies two key requirements as an example of perfectly competitive market: Large number of buyers and sellers (Almost) perfect information However, Obtaining information is costly (time-consuming) Consequently, consumers sample only a small subset of the large number of sellers, i.e. the number of sellers which is relevant to a typical buyer is not necessarily large

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Session 2 Slide # 24 (cont.)

Q 2: Can frictions in cyberspace be eliminated? Information technology and new software in ecommerce reduce search time for consumers But, proliferation of sellers (web sites) increases search time Increased product differentiation makes comparison shopping increasingly difficult Buyers do not necessarily trust every website

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Session 2 Slide # 28
Optimal quantity of output is that for which P = MC. To find it, equate 10 = 2 Q to obtain Q = 5 units (2) Profit: TR TC = P x Q (100 + Q2) = 10x5 (100+52) = 50 125 = - $75 [i.e. the firm is making a loss] (3) Since the firm is making a loss, the question whether it should operate in the short run or shut down depends on whether P > AVC. In this case, P = 10 and AVC = TVC/Q = Q2/Q [since from the cost function TFC = 100 and TVC =Q2]. Thus, for the optimal output Q = 5 units, AVC = 52/5 = $5. Since P > AVC, the firm should operate in the short run. In the long run, if the market does not improve, the firm should exit the market
(1)

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Session 2 Slide # 32
Q 1: Economic profit and perfect competition: Firms in perfect competition can earn economic profit (i.e. profit over and above the normal profit) only in the short run, i.e. temporarily. For example, this could be a result of a shift to the right in the market D curve, which raises the going market price to a level above the minimum of the ATC curve (such as price level P* in Fig. 4.4 or P*0 in Fig. 4.7) In the long run, since entry in perfectly competitive industries is free, other firms will enter the industry, and the market S curve shifts to the right. As shown in Fig. 4.7, the equilibrium price drops to P*1 and the economic profit is eliminated
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Session 2 Slide # 32 (cont.)

Q 2: Investing in business where economic profit is zero: Note that economic profit is zero, while normal profit is positive (included in the ATC) when P = min. of ATC Therefore it is perfectly rational to operate in such an industry (recall that normal profit is that profit which can be made in other industries with comparable level of risk)

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Session 2 Slide # 32 (cont.)

Q 3: Determination of normal profit The Coca-Cola Company determined that its shareholders required 16% - this was their opportunity cost of capital (Course Notes, p. 108) For other companies, this rate may be higher or lower the main reason for differences is risk In Finance, cost of capital is determined by reference to some riskless rate of return plus risk premium

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Session 2 Slide # 32 (cont.)

Q 4: Impact of the Coca-Cola practice on managerial decision making: Managers become more conscious of the value of buildings, equipment, and inventories they control, since the 16% levy reduces their profits and their bonuses Thus, managers make a conscious effort to reduce (eliminate) excess capacity, excess inventories, etc.; in the process, they reduce costs for the company as a whole

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Session 2 Elaboration of Slide No. 33

Graphical and numerical illustration of the relationship between the Demand curve and the Marginal Revenue curve is in Chapter 2, pp. 27-30. Three tables showing the derivation of Total Revenue and Marginal Revenue from Demand Curve Q = 30 P were shown in Discussion Points from Session 1, and are reproduced on next three slides. A diagram showing that when Q = 6, P = 24 and MR = 19 (i.e. P > MR) is shown below, immediately after the three tables.

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Session 2 Slide # 33 (cont.)

Plotting a curve from the equation Q = 30 - P: Pick (arbitrarily) a few numbers for P, plug in the equation to calculate the Q, as in the table below (when the equation is linear, only two points are needed)
P ($ per unit) 0 5 10 30 Q (units per period) 30 25 20 0

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Session 2 Slide # 33 (cont.)

Substitute P1 = 25, P2 = 24, P3 = 3, and P4 = 2 into the equation to evaluate the impact of a price cut on sales revenue (or total revenue, TR):
P 25 24 3 Q 5 6 27 TR = P.Q 125 144 81

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56

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Session 2 Slide # 33 (cont.)

Note that the marginal revenue (MR) for the price cut from $25/unit to $24/unit is positive, while the MR for the price cut from $3/unit to $2/unit is negative:
P 25 24 3 2 Q 5 6 27 28 TR = P.Q 125 144 81 56 56-81 = -25 144-125 = 19 MR = TR

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Session 2 Slide No. 33 (cont.)

$24/unit
$19/unit

6 units

MR

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Session 2 Slide # 35

The objective of the publishing firm is to maximize profit (the difference between TR and TC); this is achieved for the level of output where MR = MC In contrast, the authors objective is to maximize sales revenue (TR); this is achieved a higher level of output where MR = 0 (see Fig. 2.4) The publishing firm therefore aims for a lower output and higher price than the author (see Fig. 4.9, where the profit-maximizing quantity is smaller than the quantity for which MR = 0)

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