Managerial Economics Review Questions for the Final Exam (Illustrative Answers) PRICE IS LOWER IN A MORE ELASCTIC MARKET!!!!!!!!!! 0. 1-1 Introduction:Managerial Decision-Making and Market Processes (a) How does operational effectiveness differ from organizational strategy? Operational effectiveness is achieving excellence in individual activities while organizational strategy is about combining these activities to fit and reinforce one another and create competitive advantage and obtain superior profitability. OE refers to being “on” the production frontier, while OS refers to where the firm is on the frontier (cost leadership vs. igh quality product) (b) If cost leadership and differentiation (creation of customer value) are the two main strategies available to firms in your industry, what determines your own organization’s best strategy? The requirements for a firm in using cost leadership differ from those of a firm using differentiation. In order for a firm to successfully pursue a strategy of cost leadership, it must have skills and resources such as the ability to sustain capital investments (and access to capital), process engineering skills, intense supervision of labor, products designed for ease of manufacture, and the low-cost distribution system.
It must also avoid product proliferation. In order for a firm to successfully pursue a strategy of differentiation, it must have skills and resources including core capabilities, such as marketing or innovation. It must have product, rather than process, engineering skills, and it must have strengths in basic research and brand equity in the form of a corporate reputation for quality or technological leadership. The firm must also have a long tradition in the industry for the ability to acquire skills from others.
Strong cooperation from distribution and supply channels is also very important. Ultimately, whether a firm chooses cost leadership or differentiation as a strategy depends upon the skills and resources available to the firm. (c) Explain why $1000 three years from now is not equal to $1000 today. The purchasing power of $1000 today is greater that $1000 three years from now because one can always invest money today and get some return on the investment. For example, $1000 invested at rate of return of 6% for three years will be worth: $1000(1. 06)^3 = $1191. 02 hile the $1000 that you receive three years from now would be worth, well, $1000. Conversely, the present value of your $1000 gift in three years will be: $1000(1/(1+0. 06))^3 = $839. 62 The inflation rate will also devalue the future value of the dollar. This could be modeled by subtracting the expected inflation rate from the rate of return, but generally the rate of return includes a component reflecting expected inflation. (d) What are the most powerful incentives within your own organization? To what extent are decisions determined by their impacts on profitability?
The most powerful incentives within an organization as described by the theory of the firm, is to maximize its value (PV of expected future cash flows). This may include various attempts to maximize stock price and/or perceived shareholder value. However a couple of other issues that may arise include satisficing and the principal-agent problem. Satisficing is where a firm aims at a satisfactory rate of profit rather than attempt to maximize profit. The principal-agent problem occurs when managers pursue their own interests/objectives even though decreases the profit of the owners.
To deal with these problems firms often establish contracts with their managers that give the latter incentives to achieve profit maximization. (e) How do economic profits differ from accounting profits? Economic profits take into account the opportunity costs (what labor and capital could have earned elsewhere) while accounting profits only look at actual accounting revenues and actual monetary outlays from day to day operations. Thus, accounting profits involve subtracting depreciation, operating expenses, and taxes from revenues. Depreciation reflects accounting conventions rather than economic reality. Economic Value Added” represents a better estimate of economic profits, since the opportunity cost of capital is taken into account. 0. 1-2Market Structure and Competition (a) Incomes rise, causing a change in the demand for rental apartments in Shanghai, and technological changes lower the cost of constructing rental apartments. What do you predict will happen to the equilibrium number of apartments rented in the long run? To the price of rental apartments? Explain. The number of apartments rented will increase since both the demand and supply curve have shifted to the right.
The price of the rental apartments, however, can either go up or down depending on the magnitude of the technological change. The price will go up if the technological change in construction is not enough to compensate for the additional demand; or it will go down if it overcompensates. If both the demand and supply curves move the same amount, the price will remain the same. (b) How is the profitability of a firm affected by rivalry, the availability of substitutes, the bargaining power of suppliers, the bargaining power of customers, and potential entrants?
Rivalry can affect the firm’s profitability in several ways. Price competition and advertising expenditures tend to increase, thus erode profitability, during periods of intense rivalry. Conversely, the presence of many varieties may stimulate overall demand for the product and actually increase profitability for a firm. If possible, a company should focus on differentiation or decide to implement loyalty incentives, such as creating high switching costs, to avoid losing its customers to its competitors. A firm’s profits may be negatively affected if there are substitutes for the firm’s products or services.
The more attractive the price-performance trade-off offered by substitute products, the more firmly the lid placed on the industry’s profit potential. Substitutes not only limit profits in normal times, they also reduce the bonanza the industry can reap in boom times. Substitute products that are subject to trends improving their price-performance trade-off with the industry’s product, or which are produced by industries earning high profits, have the greatest ability to reduce a firm’s profits. Powerful suppliers can squeeze profitability out of an industry and make it so that a firm is unable to recover cost increases in its own prices.
The firm’s profitability can be affected if the industry is dominated by a few Suppliers and is more concentrated than the industry it sells to, or if a Supplier’s product is unique, differentiated or if it has built up switching costs. If a Supplier is not obliged to contend with other products for sale to the industry, if the Supplier poses a credible threat of integrating forward into the industries business, or if the industry is not an important customer of the Suppliers, the firm’s profits may be reduced..
Powerful Buyers can force down prices, demand higher quality or more service, and play competitors off against each other, all at the expense of industry profits. The firm’s profitability can be affected if the Buyer is concentrated or purchases in large volumes, if the products it purchases from the firm are standard or undifferentiated, if the products it purchases from the industry form a component of its product and represent a significant fraction of its cost, or if the Buyers earns low profits, which create great incentive to lower its purchasing costs.
Also if the firm’s product is unimportant to the quality of the buyer’s products or services, or if the firm’s product does not save the buyer money, the firm’s profitability can be affected, and likewise, if the Buyer poses a credible threat of integrating backward to make the firm’s product. A firm’s profits may be favorably affected if there are sufficient barriers to entry facing potential entrants. Barriers such as economies of scale deter entry by forcing the entrants either to come in on a large scale or accept a cost disadvantage, while product differentiation forces entrants to spend heavily to overcome customer loyalty.
The need to invest large financial resources in order to compete (i. e. capital requirements) creates a barrier to entry, particularly if the capital is required for unrecoverable expenditures in upfront advertising or R&D. Cost advantages independent of size, such as proprietary technology and patents, learning curves, access to the best raw material sources, and assets purchased at pre-inflation prices can provide barriers to entry. If access to distribution channels is limited (e. g. ittle available supermarket shelves space, wholesale or retail channels are tied up) a new entrant will experience significantly higher distribution costs than the incumbent. Likewise, government policy can limit or even foreclose entry to industries through controls such as license requirements and limits on access to raw materials. The greater the barriers to entry, the more likely a firm’s profits will be favorably affected 1. Optimization (a) If the firm does not have much information about demand and costs, how can it make good price and output decisions?
Short answer is the firm cannot make good price and output decisions. Decisions based on reality are more likely to achieve their intended objectives than those based on fantasy. If the assumption is that the firm will act to set price and output to maximize profit then information on the crucial variables of demand and cost must be known. Generally, these relationships are estimated, based on historical experience—so decision-makers generally have rough approximations of the key functions. Profit (() is a function of total cost (TC) and total revenue (TR): pic] Where TR is quantity (Q) multiplied by price (P) and TC is quantity (Q) multiplied by cost (C ). A further assumption is that quantity produced (Q) is related to demand. The equation for profit will hold for any price or quantity that the firm would set, however if a firm wanted to make good price and output decisions, then the profit equation should be maximized. [pic] In order to do this mathematical analysis, a firm has to first have demand and cost equations that relate to quantity produced (i. e. have information about demand and cost).
From the differential set equal to zero, solved for quantity (Q), the firm can determine the production quantity (output) that maximizes profit. This quantity value then can be input into the price function to determine the optimal price for profit maximization. (b) To what extent do spreadsheet models capture fundamental constraints facing firms? The fundamental constraints a firm faces may include price, quantity, demand, various cost, populations, etc. These all have equations that relate one to another or that express the relationships between them and the firm.
Once these functions are developed, they can be imbedded into a spreadsheet to allow for scenario test or simulations. What can be done mathematically through derivatives (profit maximizations and cost minimizations) can be done by creating a spreadsheet of the relationships between variables and then, varying the inputs and by inspection, the max or min can be seen. The effects of varying the inputs can be readily shown – causation and functional effects – and these relationships can be manipulated and presented from a spread sheet in a variety of outputs – tables, graphs, or raw data. . Demand and Profit Maximizing Pricing (a)The weekly demand for a text on Modern Managerial Economics was P = 100 – 4Q i) Find the marginal revenue when price is $80. P = 100 – 4Q = $80 Solve for Q: Q = 5 Total Revenue(TR) = P*Q = 100Q-4Q^2 Marginal Revenue(MR) = (TR/(Q = 100 – 8Q MR(5) = 100 – 8*5 = $60 (ii)The marginal cost is constant and equal to $10. What output should be set to maximize profits? Show your work. Profit is maximized when Marginal Revenue (MR) is equal to Marginal Cost (MC) TR = P*Q = 100Q-4Q^2 MC = $10 MR = (TR/(Q = 100 – 8Q MC = MR 100 – 8Q = 10
Q=90/8=11. 25 (b)What are the major determinants of a product’s price elasticity of demand? How does the firm’s price elasticity of demand differ from the market elasticity of demand? The major determinants are number of close substitutes, proportion of consumer’s budget, ability to adjust in the short-run and long-run. The firm’s price elasticity of demand is affected by the prices of other firms. For example, in a perfectly competitive market, a firm is a price taker and an increase in price above the market price would result in a dramatic drop (maybe to zero) in revenue.
The price elasticity of a firm is specific demand, within a market, for the products of a specific firm. The market demand is consumer demand for the industry or market. Cigarettes, in general have relatively low elasticity, but an individual brand may have very high elasticity in the market. (c)For a linear demand, over what price range is demand elastic? Inelastic? Would a firm produce in the inelastic portion of its own (perceived) demand? Would it produce in an inelastic portion of the market demand? e = ((Q/(P)(P/Q) Demand is elastic at all prices where MR is positive.
Demand is inelastic at all prices where MR is negative. For a typical “linear” demand curve the price is elastic from the price where quantity demanded is zero to the point of unitary elasticity and the price is inelastic from the price of unitary elasticity to the price of zero. A firm should not produce in the inelastic portion of its own demand, as the increases in quantity sold will result in lower total revenue. (d)The Executive VP of Berg Enterprise Company wants to reduce the price on its major product. The price elasticity of demand for this product is about -0. 5.
Will a price cut likely increase sales and profits? No – because a price elasticity of – . 5 is price inelastic. This means that a decrease in price will lead to a decrease in revenue. With the absolute value of eMR and profits would drop. (e) The demand for precision microchips is P = 3000 – Q . What is the Marginal Revenue equation? Total Revenue(TR) = PQ = 3000Q – Q^2 Marginal Revenue (MR) = MR = (TR/(Q = 3000 – 2Q (f) Over what range of prices is demand elastic. For a linear demand ,demand is unitary at, P = a-bQ and Q=a/2b. When Q 1500, price elasticity is elastic.
If the absolute value of ? > 1. 0, then demand is price elastic. ? = (? Q / ? P * P/Q) or in this case -1 * P/Q. When P = 1500 then Q = 1500 and elasticity is unitary. Therefore, if P > 1500 then Q < 1500 and the absolute value of ? will be > 1 or elastic. (g) If the firm in (e) wants to maximize total revenue, what price should be set? Maximizing Revenue in P = a-bQ equations can be found by setting Q = A / 2B. In this case, P = $1,500. MR = 3000-2Q = 0; Q=1500 corresponding price P = 3000-Q =1500. A price of 1500 should be set to maximize total revenue. h) The Arch Construction Company has concluded that its demand function is Q = 500 -2P +3Pr +2I Where Q is the quantity demanded, P is the price of its product, Pr is the price of its rival’s product, and I is the per capita disposable income. At present P = $10, Pr = 20 and I = $6,000 What is the price elasticity of demand for the firm’s product? e = ((Q/(P)(P/Q) = (-2)(10/Q); Q = 500-20+60+12000 = 12540 e =-20/12540= -. 0016 What is the income elasticity of demand for the firm’s product Income Elasticity =( (Q/(I)(I/Q) = 2(6000/12540) = 0. 957
What is the implicit assumption regarding the population in the market? That the population of the market remains constant. 3. 1 Forecasting: Application of Consumer Surplus a) If a monopoly has 1000 customers, each with a monthly demand represented by P = 11 – Q Let marginal cost be $1. What is the profit-maximizing uniform price? Price where profit is maximum (MR = MC) MR=dTR/dQ=11-2Q Since MC=1, MR=11-2Q=1 when Q=5 At Q=5; P=$6 b) What is the maximum monthly fee that can be charged to each customer, assuming that there are no substitutes for this product and no potential entrants.
Consumer surplus defines the net benefit to the consumer of purchasing the good. You can calculate this by looking at the area of the triangle above the price and below the demand curve. In this case, if the firm continues to charge a per unit price of $6, then the remaining consumer surplus is 1/2(base x height) = 1/2(5 x (11-6)) where 5 is the quantity demanded and if price is $11, the quantity demanded is zero. So the maximum monthly fee would be $12. 5: exactly the triangle of “consumer surplus”. However, if we set a per unit price of 1 (=MC), the quantity demanded would be 10.
Now the consumer surplus would be 1/2(10×10) =$50. Thus, the fee depends on the per unit price being charged. If it’s hard for you to see this, try illustrating it with a graph and it becomes easier to recognize. 3. 2 Forecasting: Government and Business a) What types of government intervention have the greatest impacts on Profits? Policies that put a limit on pricing such as anti-trust concerns have the greatest impact on Profits. Policies that increase cost such as environmental regulations can have a great impact on a firm’s bottom line if this additional cost cannot be passed on to the customer.
Compliance with certain environmental policies such as the Cluster Rule, force some firms to incur a lot of extra cost unrelated to production output. Government intervention on anti-trust concerns can force a firm to change its business structure or may lower prices by allowing more entrants into the market. (b) What types of government programs have substantial benefits relative to their compliance costs? Some government policies are designed to assist firms in an industry. These may include tax breaks or other incentives to promote growth in a new industry or within a specific region.
Other programs may be beneficial despite causing a firm to incur costs for compliance. For example: Transportation safety ? eg. Automobile safety (airbags, seatbelts) and Railroad safety (crossing guard arms and lights). c) Why might a government program be adopted that is very costly to society relative to the benefits obtained from the program? (Are “benefits” always easy to measure? ) If the benefits are concentrated and the costs diffused throughout the citizenry, the beneficiaries are likely to lobby strongly for the particular policy.
In addition, benefit can be a subjective term and certain policies and programs may be viewed differently by different people. A good example of this is the Boeing decision to move from Seattle to Chicago. In this case, the Chicago government offered more than $22 million in tax breaks and incentives to convince Boeing to move its corporate headquarters to that city. The move will only involve about 500 jobs, almost all of which are simply transfers from Seattle. The incentives will have to be made up by Chicago citizens who may not see much of a direct benefit from having Boeing’s headquarters in the city d) What are some key public policy trends in affecting your industry? Illustrative answers— Public goods (like national defense) might be provided as a matter of public policy. “Free” education represents a public policy. Probably the most important issues are whether salaries, incentives, and testing promote good educational output. The ability of firms to hire skilled labor depends on public policies towards education. The same applies to healthcare, where employers (due to tax savings from a deductible expense) provide healthcare benefits.
These are “private” benefits although if they reduce the incidence of some contagious diseases, they have public goods components. Copyright and patent protections are two other examples of public policies directed at promoting creative works and innovation, respectively. A: In the past several years there have been a series of mergers and acquisitions throughout the paper industry which has dramatically changed the structure of the industry. Mergers among the paper companies have increased individual company’s power on both the purchasing and selling side.
On the other hand, the paper industry has also been affected heavily by environmental policies. The Cluster Rules have forced some mills to spend millions of dollars to get in compliance with these regulations. At the same time, restrictions on land use and logging have affected the raw material supply for many paper mills, especially in the western states. B: The greatest public policy issue facing Adtran Inc. is the Telecommunications Act of 1996. This law forces Incumbent Local Exchange Carriers(ILECs), companies like Verizon and SBC Communications, to rent space and infrastructure to Competitive Local Exchange Carriers(CLECs).
The emergence of the CLEC’s has greatly expanded Adtran’s business. Adtran used to only sale to ILECs and end users. Now Adtran has a new market segment to explore. Also, since the conception of the Telecommunications Act of 1996, the ILECs have started major acquisitions. QWEST communications bought US West. South West Bell is now SBC Communications, and they have acquired BellSouth. Due to this restructuring and the emergence of CLECs, Adtran’s sales are continuing to grow in order to meet the new requirements. C: US Navy Pollution control. Into the early 1980’s ships released sanitary tanks pierside.
Now, when pierside, ships must pump sanitary tanks to either a holding tank afloat or to a land sanitary system through piping on the pier. More expensive, but has really helped to clean up the water at Navy bases. D: The key public policy affecting software industry is enforcement of software piracy laws. It is extremely easy to steal software and hence we need strong piracy laws to be enforced if govt. wants the US software firms to keep developing innovating software (e) Which is more profitable, a uniform price or a multi-part price? Explain.
Depends on whether the market is segmented. E. g. Industrial buyers who buy in mass quantity comprise a different segment of the market than individual buyers. If the market is clearly segmented for the given product, then there are distinctively different Demand Curves and price discrimination generally addresses these differences and captures higher revenues. In situations where it is possible, multi-part pricing can be more profitable for a firm than uniform price. Multi-part pricing can help a firm capture some consumer surplus without affecting the quantity demanded or marginal costs f) If there is a distribution of customers (say, into ten different groupings with different demand curves), how does this affect the choice of having a high fee and low marginal price and having a low fee and a high marginal price? The choice of which pricing strategy to use will depend on each customers demand pattern and consumer surplus at a given price level. The “Optional Pricing Schedule” allow customers the freedom to pick the pricing schedule that best suites them and basically creates Multipart Pricing Options that are available to all customers.
Users that will need large quantity service or product will probably pick the high fee and low marginal price choice and small quantity users will select the low fee and high marginal price choice. E. g. cellular phone service where users that make lots of calls will be most interested in the former. With a large relative number of market segments, 10 here, the situation allows you to offer many different Multipart Pricing Options – different mixes of fees and marginal prices. (g) If there are two types of customers, large and small, but you cannot price discriminate, how might optional multi-part prices enhance revenues?
Use 2 part tariffs or Optional Pricing. This can serve the same purpose as price discrimination. By allowing the customer to choose her own multi-part pricing structure, a firm can capture consumer surplus and increase demand at the same time. A large customer with high usage demand might benefit from accepting a high fixed fee and low unit costs while the smaller customer may choose to have a lower fee and be willing to pay more for the smaller amount of units demanded 4. Principles of Production a) What is the difference between a production isoquant and the isocost curve?
How could an analyst derive the long run total cost relationship from information about the underlying production technology and input prices? The production isoquant graph shows all input quantities that can make a certain quantity of output. The isocost curve shows the given input quantities that can be used at a given cost. An analyst could create isoquants and isocost curves using empirical data for the current production technology. The minimum cost given a certain output level is the point of tangency of the isocost curve to the specific quantity? s isoquant.
However, long-run results could change with changes in technology or input prices. (b) Can there be increasing returns to scale and diminishing returns at the same time? Carefully define terms and Explain. You can have increasing returns to scale but decreasing returns to a particular input (holding scale constant). So the issue is one of long run (where scale varies) versus short run (where scale is fixed and diminishing returns implies falling marginal product of the variable input and thus rising SMC). Furthermore, there can be increasing and then decreasing returns to scale-depending on the output level (i. . the LAC falls then rises). (c) Gainesville Shoe Repair competes with a number of other shops. The CEO wants you to predict (in qualitative terms) what will happen to the number of employees needed if she invests in additional repair equipment (making current workers more productive) and the price of shoe repair drops 25% due to entry of new firms into the industry. What is your prediction? Why? The additional capacity shifts the marginal product of workers up. The drop in the price of shoes, shifts the marginal revenue product down (here, MP x P, since the question states that this is a competitive market)) n.
The net impact on the demand for workers depends on the degree the two impacts. If MP increased by MORE than 25%, then employment in Gainesville Shoe Repair could increase—at least in the SR. In the LR, if firms are not making profits, exit occurs, and the price of repairs will rise. 5. Innovation Honda is considering the time-cost trade-off for introducing a new automotive product. Honda has estimated the present value of R&D costs incurred over the development process (C ) and of Net Operating Revenues (R ) as functions of the months (t) to introduction: C = 2000 – 100 t + 2 t2 R = 4000 – 4 t a) Explain why the formulas have these functional forms and indicate difficulties in estimating each function. The functions have these forms to represent what will occur to both revenue and cost of innovation over time. The cost function shows as time progresses the cost to innovate becomes cheaper. However, this decrease in cost will stop at 25 months. At 25 months the cost of the innovation will begin to increase until the end of time. The revenue function demonstrates that it is decreasing with respect to time (ie. As more time progresses, less revenue is earned from the product in NPV terms
One of the difficulties in estimating these functions is the fact that these functions may have been used in calculating the innovation for a small car line and this particular innovation that is being estimated is for a line of trucks. In other words, past experience may only be an reasonable approximation for the new function. (b) Find the optimal number of months before the product should be introduced. dC/t = dR/dt -100 + 4t = -4 t = 24 months (c) How does a firm’s research and development program (R&D) affect its ability to deal with the five forces identified by Porter as affecting a firm’s competitive position?
A firm’s R&D program affects its ability to deal with Porter’s five forces in the following ways: It can help with direct competitors by providing a competitive advantage through better processes or better products. It can deal with entrants through the creation of economies of scale by the development of complex experiences and learning curves. It can control buyers by keeping the market a seller’s market – in other words create products or processes that cannot be easily replicated by competitors, making a virtual monopoly.
Suppliers can be dealt with through the development of processes that would eliminate suppliers – producing inputs more efficiently then the former suppliers or vertical integration. Finally, developing a superior product or becoming the cost leader through more efficient production can deal with substitutions. 6. 1 Cost a) In estimating a cost function, what is the difference between a “long run” cost function and a “short run” cost function. Which is relevant for current pricing? Why? A “long run” cost function cannot assume any fixed costs since no inputs are fixed.
A “short run” cost function does assume a fixed cost because the firm has an investment in a particular amount of capital (and will not have the time to alter its capacity). Therefore, the short run marginal cost is more relevant for current pricing, although the strategies implied by the long run function and the learning curve certainly influence pricing strategies that have implications for long run demand. (b) A team of consultants has estimated your firm’s weekly cost function to be: TC = 70 + 3Q + 5Q2 What is assumed about the firm’s capacity?
We assume a fixed definition of the firm’s product, a given level of technology, and specific scale of plant, hence we assume capacity to be constant. The form of the equation also assumes that marginal cost increases with output. Find MC when Q = 3. MC = 3 + 10Q, so that MC= $33 Does this differ from the incremental cost of producing the third unit of output each week? Yes, because marginal cost is defined as the change of TC associated with a small increase of output. It is the “slope” of the total cost function at a specific output level.
The incremental cost of producing the third unit is the change in total cost in moving from producing two units to producing three units per period. Thus, it is calculated from discrete output changes, and can differ from the MC. (c) Demand changes, and now marginal revenue is 50. What should the firm do if it is currently producing 3 units per week? Given that the firm maximizes profit by setting MR = MC, Then 50 = 3 + 10Q 47 = 10Q 4. 7 units per week should be the output the firm aims for to maximize its profit, so it should try to produce another 1. 7 units per week 6. 2 Breakeven Analysis: Revenues and Costs a) Find the breakeven point for the following firm TC = 100 + 4Q P = 8 We set TC = TR, so that the breakeven is PQ = TFC + AVC * Q Or (100/(8-4)) or 25 units. (b) How would you use this framework for a firm producing a mix of products? For a mix of products we would need the cost and revenue data for each to use this framework. However, there are models wherein products that are not profitable when produced alone, become profitable when produced with other items due to various economies of scope. (c) How does the Blockbuster case illustrate a change in the breakeven point?
Blockbuster significantly lowered its breakeven point by lowering its total costs in obtaining its primary revenue-producing input (namely, videos) and sacrificing some revenue. It also raised the number of its highest revenue-producing inputs (the most widely sought after videos) via its arrangement with the major studios. A new balance of risk-sharing was achieved. 7. Quality: Pricing and Advertising a. How is an improvement in quality like an outlay on advertising? An improvement in quality is like an outlay on advertising because they both increase demand (and therefore total revenues at a given price), entry barriers, and total costs.
Because of diminishing returns, both will also have an optimal point where they provide maximum profit enhancement. b. Contrast an increase in product durability with a quality increase that expands the market. (Think in terms of changes in demand). An increase in product durability may reduce product demand in the short run because customers will retain their purchased goods for a longer period of time. In equilibrium, willingness to pay should increase, so the demand rotates upward, with the quantity associated with a zero price remaining the same.
However, a quality increase that expands the market obviously increases demand perhaps because more people find a use for the item. The quantity intercept will shift out, but the price intercept need not. c. How does the price elasticity of demand relate to the “productivity” of advertising? The productivity of advertising is essentially the increased revenue that you receive from advertising. Thus, the productivity of advertising is advertising marginal revenue (P x dQ/dA). Profits are maximized when advertising marginal revenue (AMR) equals a product’s price elasticity.
If your AMR is less than the price elasticity, this means that your incremental profits are less than your incremental advertising expenditures and you should reduce your advertising. The opposite holds true for the case where AMR exceeds price elasticity 8. Rivalry (a) How does the presence of scale economies affect the price that an incumbent firm can charge? Since the incumbent firm will realize economies of scale, it will have a cost advantage over new entrants and will be able to charge a lower price and be more profitable than new entrants who enter at a cost disadvantage.
The incumbent firm? s marginal cost is low and can produce more output at lower prices. The incumbent is able to leverage buying power with suppliers to lower costs. The prospective entrant will earn market share slowly, this means that, early, the marginal costs will be high and revenues low. b) List examples of entry barriers. 1) Economies of Scale deter entry by forcing the entrant to come in at a large scale and risk strong reaction from existing firms or come in at a small scale and accept a cost disadvantage. ) Economies of Scope are a barrier as the manufacturer is able to leverage current technology from similar products to lower marginal costs for the goods produced. 3) Product Differentiation: Established firms have brand identification and customer loyalties due to past advertising, customer service and product differences. Entrants have to spend heavily to overcome existing customer loyalties. This results in start up losses. 4) Capital Requirements: The need to invest large financial resources in order to compete creates a barrier to entry, particularly if the capital is required for risky or unrecoverable up-front advertising or R&D. ) Switching Costs: If switching costs are high, the new entrants must offer a major improvement in cost or performance in order for the buyer to switch from an incumbent. 6) Access to Distribution Channels: A barrier to entry can be created by the new entrant? s need to secure distribution for its product. The new firm will need to persuade the channels to accept its product through price breaks, cooperative advertising allowances, etc. which reduce profits. 7) Government Policy: Government can limit entry into industries with controls such as licensing requirements and limits on access to raw materials. ) Technology can act as a barrier, if the technology is protected for the good or the process to manufacture the good, then entry costs can be very high. 9) Skilled labor can act as a barrier if it is in short supply or expensive to hire. c) Why is it necessary to consider the reactions of rivals when making price, advertising and capacity decisions? It is necessary to consider the reactions of rivals because if you undercut large rivals, they may counterattack and the result could be that instead of recognizing increased profits, heavy losses are incurred.
In choosing which moves to make, rivals’ reaction and reaction times should be considered. Any move taken should be made only after incorporating your rivals’ timing and degree of reaction into the analysis. d) How can “game theory” improve our understanding of strategic decision-making? In an oligopoly the firm often faces a dilemma. It can pursue the interests of the industry as a whole and thereby not incite competitive reaction, or it can behave in its own self-interest at the risk of setting off retaliation and escalating industry competition to a battle.
The dilemma arises because choosing strategies or responses that avoid the risk of warfare and make the industry as a whole better off may mean that the firm gives up potential profits and market share. If firms are cooperative they all can make a reasonable profit. However, if one firm makes a self-interested strategic move to which others do not retaliate effectively, the deviating firm can earn even higher profits. If its competitors retaliate vigorously against the move, though, everybody can be worse off than if they were all cooperative.
This is analogous to a game in which one’s own moves and strategies affect the reaction of its competitor. Understanding game theory can therefore improve our understanding of strategic decision-making. 9. 1 Pricing Techniques–Price Discrimination Fashion Accessories of Shanghai produces gem-encrusted formal wear for sale in Hong Kong and Beijing subject to total cost TC = 100 + 5(QHK + QB). Demand for this high fashionf gem-wear in the two cities is given by QHK = 70 – 2PHK and QB = 55 – PB. (a) If FAS (Fashion Accessories of Shanghai) price discriminates between the wo cities, how much gem-wear will it sell in Beijing? TC = 100+5(Qhk+Qb), Phk = 35-Qhk/2, Pb = 55-Qb Want calculate the profit maximization point that will set the point where overall MC=MR and MRhk = MRb. From here can establish P and Q for each city based on their demand curves. (Look at Pharmaceutical example on P497 of text). Profit(b+hk) = TR-TC = (Phk)(Qhk) + (Pb)(Qb) – 100 – 5Qhk – 5Qb Obtain D(Profit)/D(Qhk) and D(Profit)/D(Qb) and set each equal to zero to get optimal Qhk and Qb. D(Profit)/D(Qhk) = 30 – Qhk = 0, Qhk = 30
D(Profit)/D(Qb) = 50 – 2Qb = 0, Qb = 25 Using given demand functions, Phk = 35-30/2 = 20, Pb = 55-25 = 30. As one can see from the above, the amount of gem wear it will sell in Beijing is given by Qb = 25. (b) If demand conditions changed such that at current prices (from (a)) that MRB was greater than MRHK, what would you recommend? A higher price and output will result for Beijing from the shift to the right in its demand curve, and a lower price and output for Hong Kong will result in order to maintain MRb = MRhk.
The point of intersection of the overall MC curve with the overall MR curve will be up and to the right from the previous equilibrium point, which will cause the effects, indicated previously. (c) What limits the firm’s ability to price discriminate? The firm must be able to identify separate markets, determine that they have different demand elasticities, and be able to prevent resale. Thus, the possibility of transporting goods from one city to the other affects the firm’s ability to price discriminate. 9. 2 Price Structure Issues ) In what ways do airlines and hotels practice “yield management”? Is this just another term for price discrimination? Airlines and hotels practice yield management by using data on customer purchase and usage patterns in order to target demand segments with advantageous offerings. Yield management is a mixture of price discrimination and cost based price differentials based on priority and quality of scheduling of the service. Airlines and hotels utilize yield management as a form of price discrimination. Yield management is based on a sophisticated analysis of customer demand patterns.
These patterns then facilitate the separation of customers with differing values and price elasticities into “segments”, which allows the airlines and hotels to practice price discrimination in order to maximize revenues. b) What is the economic rationale for time-of-use pricing? The economic rationale for time-of-use pricing is based on the idea that the cost of providing a service may differ over time and that advantages can be obtained by rationing the production capacity in order to increase net cash flow. The economic rationale for time-of-use pricing is two-fold.
The first is that the cost of providing services and goods may differ over time, thus variations in price are warranted to maintain or enhance profitability. The second is that such pricing practices can generate additional revenues during off-peak periods when the firm would otherwise have idle capacity c) What are problems with allocating R&D costs to a product, and trying to recover them over a three year period? The price of the product will necessarily by affected by this policy and under certain circumstances a high price may place the product out of market competition.
If the price of the product is in the elastic range of the demand curve, it may be necessary to consider only the variable costs for pricing in order to remain in the market. It does not seem to be a wise strategy to set a fixed time for recovery of the R&D costs. It is probably more effective to recover these costs as soon as possible depending on competitive conditions and variations of market demand. R & D costs are not marginal costs, and therefore should not be considered in profit maximization and pricing analysis.
Attempting to recover them over a three-year period could result in a non-competitive price when the customer is not willing to pay the premium for value added by the R & D effort. Regardless, R & D costs must be evaluated throughout the project life cycle by monitoring them against the potential revenues and benefits of the endeavor. Based on the projected incremental benefits and incremental project costs, decisions can be made to continue or halt the project 10: Global Issues–Trade and Investment a) Why should firms pay attention to exchange rates?
Exchange rates affect the cost of imports and the profitability of exports. They also influence decisions to buy production capacity abroad. b) Explain the theory of comparative advantage to a fifteen year old. Then explain it to a U. S. Senator. (Which was easier? ) If you are the best physician in town AND the fastest typist, you may have an “absolute advantage” in both activities, but you have a “comparative advantage” in being a doctor. That is, it will be more economical to hire a typist and spend your time being a physician. Senators start worrying about jobs in their districts (where those affected y international competition are concentrated) rather than the interests of diffuse (and voiceless) consumers who benefit from imports. c) How do trade barriers affect suppliers and demanders? For firms facing import competition, trade barriers help suppliers and harm demanders. One can use supply and demand to show the price impact of a specific tariff, as well as the impact on domestic producers, consumers, and taxpayers. (d) What is the infant industry argument for protection? If firms in an industry do not have to face efficient competitors, they will have the time and gain the experience to become efficient themselves. Unfortunately, such infants may never grow up and consumers end up supporting industries where a nation has no comparative advantage or where firms are mismanaged. ) (e)What are the benefits and costs of direct foreign investment? Sending capital overseas can increase investor returns (or reduce risks). Technologies and managerial skills can be transferred to affiliated companies. One cost is that the human capital (managers) may jump ship and create rival firms in those countries. One benefit is that those with knowledge of local laws, demand patterns, and input market conditions can add to the net cash flows of the enterprise.