Micro - Econ 102

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The CornellQueensExecutive MBA

Managerial Economicsand Industry Analysis

MBUS 881/NCCB 505

Summary of Discussions

Session 2

Bo Pazderka

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Session 2 Slide # 6

Diagram:

The variable factor on the horizontal axis is theamount of time spent studying

The output on the vertical axis is the amount ofknowledge generated by studying

The underlying fixed factor(s):

Innate ability

Family background Attitude, diligence

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Session 2 Slide # 7

In class discussion, the following hypotheses wereoffered for the Canadas productivity lag behind U.S.:

Some of the less productive U.S. jobs have beenoutsourced to other countries, thus raising the U.S.productivity. This happened to a lesser extent in

Canada

The shift from manufacturing to knowledge-basedeconomy (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-profitmentality and individualism

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Session 2 Slide # 7 (cont.)

Intensity of competition in most markets is higher inthe 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 whereproductivity growth is more difficult to achieve have ahigher share of GDP

Canadas low population density and harsher winters

contribute to higher costs and lower productivity (alsocosts of bilingualism)

Reliance on resource wealth leads to greater risk-avoidance in Canada and thus less innovation

Share of government sector in the Canadian economyis higher (contributes to lower productivity)

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The regulatory environment in Canada is morestringent

The military-industrial complex is smaller in Canada

Unemployment insurance, maternity/paternity leaves,length of vacations, and other social policies are moregenerous in Canada and create a disincentive to work

In some industries (e.g. the oilsands) Canadianproductivity is lower, even taking account of adverseweather. Reason: Limited ability to attract high-quality

labour and other resources

Canada has many subsidiaries of U.S. companies; theyperform 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 advertisingbudget 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 nextslide)

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The bang-for-the-buck rule:

Internet

Internet

TV

TV

Radio

Radio

P

MP

P

MP

P

MP

P

MP

intPr

intPr

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Information required:

1) Cost of advertising in each medium (the denominator)

2) Measure of MP of advertising in each medium (thenumerator). Some measurement techniques:

Increase spending in a test market, keepingspending elsewhere constant, and observe thechange () in sales, where Sales = MPAdv

Statistical analysis of past data from several regionsand time periods (much like the pipeline engineermeasured MP of diameter and MP of horse-powersee Course Notes, pp. 72-74)

Other techniques (Market Research courses)

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Q. 1: Relationship between circumstances described inthe article and the cost curves:

The article describes a set of factors which make theshort-run TVC (and TC) curves almost vertical ascapacity is approached

Additional factor (from class discussion): Qualityassurance may be neglected, leading to product recallsand 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)

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Q 2: Dealing with the pressures:

In the short run, not much can be done

In the long run when the existing facilities becomeobsolete and time comes to replace them -consideration should be given to expanding the plantcapacity, i.e. building a bigger plant size, as in Fig. 3.15

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Q 1: Advantages of size (Course Notes, pp. 89-91):

a) Benefits to firm alone [i.e. large firms benefit at theexpense of customers or suppliers]:

Large firms have lower input costs (they are able toextract discounts from suppliers)

Large firms get lower interest rate from banks

Dominant suppliers are able to extract higher pricesfrom buyers

b) Benefits to society as a whole [i.e. not merely atransfer of profits to large firms, but net benefits]:

Economies of scale

Economies of scope

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Q 2: Potential disadvantages of large size

Loss of control as operations gets too large

Possible loss of innovative potential in large firms, dueto excessive centralization of R&D and the consequentstifling of creativity

Social cost (lessening of competition) when previouslycompeting firms merge (more details in Chapter 4)

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Q 1: E-commerce satisfies two key requirements as anexample 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 smallsubset of the large number of sellers, i.e. the number

of sellers which is relevant to a typical buyer is notnecessarily large

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Q 2: Can frictions in cyberspace be eliminated?

Information technology and new software in e-commerce reduce search time for consumers

But, proliferation of sellers (web sites) increasessearch time

Increased product differentiation makes comparisonshopping increasingly difficult

Buyers do not necessarily trust every website

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(1) 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 whetherit should operate in the short run or shut downdepends on whether P > AVC. In this case, P = 10 andAVC = TVC/Q = Q2/Q [since from the cost functionTFC = 100 and TVC =Q2]. Thus, for the optimal output

Q = 5 units, AVC = 52/5 = $5. Since P > AVC, the firmshould operate in the short run. In the long run, if themarket does not improve, the firm should exit themarket

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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 couldbe a result of a shift to the right in the market D curve,

which raises the going market price to a level abovethe 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 inFig. 4.7, the equilibrium price drops to P*1 and theeconomic profit is eliminated

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Q 2: Investing in business where economic profit is zero:

Note that economic profit is zero, while normal profit ispositive (included in the ATC) when P = min. of ATC

Therefore it is perfectly rational to operate in such anindustry (recall that normal profit is that profit which

can be made in other industries with comparable levelof risk)

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Q 3: Determination of normal profit

The Coca-Cola Company determined that itsshareholders required 16% - this was their opportunitycost 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 referenceto some riskless rate of return plus risk premium

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Q 4: Impact of the Coca-Cola practice on managerial

decision making:

Managers become more conscious of the value ofbuildings, 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.; inthe 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 Revenuecurve is in Chapter 2, pp. 27-30.

Three tables showing the derivation of Total Revenueand Marginal Revenue from Demand Curve Q = 30 P

were shown in Discussion Points from Session 1, andare 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 thethree tables.

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Plotting a curve from the equation Q = 30 - P:

Pick (arbitrarily) a few numbers for P, plug in the equationto calculate the Q, as in the table below (when theequation is linear, only two points are needed)

P ($ per unit) Q (units per period)

0 30

5 25

10 20

30 0

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Substitute P1 = 25, P2 = 24, P3 = 3, and P4 = 2 into the

equation to evaluate the impact of a price cut on salesrevenue (or total revenue, TR):

P Q TR = P.Q

25 5 125

24 6 144

3 27 81

2 28 56

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Note that the marginal revenue (MR) for the price cut from

$25/unit to $24/unit is positive, while the MR for the pricecut from $3/unit to $2/unit is negative:

P Q TR = P.Q MR = TR

25 5 125

24 6 144 144-125 = 19

3 27 81

2 28 56 56-81 = -25

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Session 2Slide No. 33 (cont.)

P

$24/unit

$19/unit

6 unitsMR

D

Q

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The objective of the publishing firm is to maximize

profit (the difference between TR and TC); this isachieved for the level of output where MR = MC

In contrast, the authors objective is to maximize salesrevenue (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, wherethe profit-maximizing quantity is smaller than thequantity for which MR = 0)

Micro - Econ 102

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