Microeconomics Workshop: Microeconomics Workshop: Fall 2003 Fall 2003 Professor David Besanko These notes have been prepared for participants in a workshop sponsored by the Kellogg Consulting Club. They may not be reproduced or circulated without permission of Professor David Besanko.
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Microeconomics Workshop: Microeconomics Workshop: Fall 2003 Fall 2003
Professor David Besanko
These notes have been prepared for participants in a workshop sponsored by the Kellogg Consulting Club. They may not be reproduced or circulated without permission of Professor David Besanko.
Objectives and Road Map for the TalkObjectives and Road Map for the Talk
OBJECTIVES:• Provide primer on basic microeconomic concepts that will be useful for
consulting interviews• To illustrate how micro concepts can be used, in conjunction with case
facts, to develop hypotheses about situations with ambiguous or messy fact patterns.
• Goal is not to explore the deeper theoretical dimensions of the concepts themselves
ROAD MAP:• Supply and Demand Analysis• Price Elasticity of Demand• Relevant Costs and Decision Making• Profit-Maximizing Pricing Decisions• Decision Making in Oligopoly Markets• Sample Consulting Interview Case
1.1. Supply and Demand AnalysisSupply and Demand Analysis2. Price Elasticity of Demand3. Relevant Costs and Decision Making4. Profit-Maximizing Pricing Decisions5. Decision Making in Oligopoly Markets6. Sample Consulting Interview Case
Market Equilibrium: What Will the Market Price Be?Market Equilibrium: What Will the Market Price Be?
• In equilibrium, the market clears: quantity demanded equals quantity supplied.
• Why is P = $4,000 not an equilibrium? At this price, quantity supplied exceeds quantity demanded. There is excess supply. The price will be bid down.
• Why is P = $1,000 not an equilibrium? At this price, quantity demanded exceeds quantity supplied. There is excess demand. The price will be bid up.
1. Supply and Demand Analysis2.2. Price Elasticity of DemandPrice Elasticity of Demand3. Relevant Costs and Decision Making4. Profit-Maximizing Pricing Decisions5. Decision Making in Oligopoly Markets6. Sample Consulting Interview Case
ELASTIC INELASTICMore price inelastic(εQ,P less negative)
• Expense relative to budget: Do expenditures for the good account for a large fraction of a consumer’s budget?
Household Items(e.g., Salt, Napkins)
“Big Ticket” Consumer Durables
More price inelastic(εQ,P less negative)
ELASTIC INELASTIC
Case: Airline Pricing Experiments, Fall 2002Case: Airline Pricing Experiments, Fall 2002
• Last year at this time, some airlines (e.g., Continental, Delta)experimented with cuts in unrestricted “walk-up” fares (generally used for business travel)
– e.g., Delta lowered “walk-up” fares by about 21 percent in small markets over a seven-week period
– Fare cuts were generally matched by competing airlines in these markets– Conventional wisdom: cuts in unrestricted “walk-up” fares result in decreases
in total revenues– Results of Delta’s experiments: double-digit increase in total revenue
What does conventional wisdom assume about the price elasticity of demand for business air travel?
What do Delta’s pricing experiments tell us about the price elasticity of demand for business air travel?
Price Elasticity of Demand and the Effect of Price Elasticity of Demand and the Effect of Changes in Price on Total RevenueChanges in Price on Total Revenue
QP
PQ
PP
QQ
PQ ∆∆
=∆
∆
=,ε
( ) ( )
( )PQQQP
PQQ
PQPQ
PQPPQ
PQP
PTR
,1
1
)(
ε+=
⎟⎟⎠
⎞⎜⎜⎝
⎛∆∆
+=
∆∆
+=
∆∆×+∆×
=∆×∆
=∆∆
recall:
• Decrease in price has a dual affect on total revenue:– Revenue on each ticket sold goes down … but the number of tickets sold goes up! Which
effect dominates?– If rate at which tickets are sold goes up faster than rate at which price falls, then we’d
expect total revenue would go up– Not quite precise enough, though: what do we mean by “rate at which tickets are sold goes
If demand is elastic, i.e., εQ,P between -1 and -∞, thenand a decrease in price yields an increase in total revenue
0<∆∆
PTR
1. Supply and Demand Analysis2. Price Elasticity of Demand3.3. Relevant Costs and Decision MakingRelevant Costs and Decision Making4. Profit-Maximizing Pricing Decisions5. Decision Making in Oligopoly Markets6. Sample Consulting Interview Case
The Relevant Cost Principle: The Relevant Cost Principle: The Costs That Are Relevant to a Particular The Costs That Are Relevant to a Particular
Decision Are Those Whose Level is Affected By the Decision Are Those Whose Level is Affected By the DecisionDecision
• Suppose your company contemplates a temporary shut-down of one of its factories for a period of one year.
• Consider all categories of cost associated with the existence of this factory, the production of output in this factory, and the possible shut-down of this factory: – Which categories are relevant to the shut-down decision?
• Relevant costs:– What costs do you avoid if you shut down this factory? What extra
costs do you incur if you shut down this factory? These are categories that are relevant.
– Costs whose level is not affected by the shut-down decision are irrelevant to the shut-down decision
These costs varyacross the alternatives:they are relevant tothis decision
This cost does notvary across the alternatives:it is not relevant tothis decision
Case: Relevant Costs for a Pricing Decision*Case: Relevant Costs for a Pricing Decision*
• Client is market-leading producer of a variety of different types of synthetic fabrics used in a wide range of applications
• Client has asked for advice on how to price M-50, a particular fiber based on a blend of rayon, nylon, and other synthetic fibers.
• Current price is $4 per yard; client is considering setting a price of $3.
• Current quarterly volume is about 95,000 yards; expected volume if price is cut to $3 is 155,000.
• There is only one other supplier of M-50, and it is currently charging a price of $3 per yard. Our best available information suggests that the competitor will not cutits price if client cuts to $3 per yard.
• Some other information:– M-50 is produced in a multi-purpose plant that is also used to produce other
synthetic fabrics– Company sales people are paid straight salaries
1. Supply and Demand Analysis2. Price Elasticity of Demand3. Relevant Costs and Decision Making4.4. ProfitProfit--Maximizing Pricing DecisionsMaximizing Pricing Decisions5. Decision Making in Oligopoly Markets6. Sample Consulting Interview Case
What PriceWhat Price--Quantity Combination on this Demand Curve Quantity Combination on this Demand Curve Should the Firm Choose?Should the Firm Choose?
To Evaluate the Profitability of a Change in Quantity and Price,To Evaluate the Profitability of a Change in Quantity and Price,We Compare Marginal Revenue and Marginal CostWe Compare Marginal Revenue and Marginal Cost
• IEPR in words: At the optimal monopoly output the markup of price over marginal cost --- the percentage contribution margin ---is inversely proportional to the price elasticity of demand.
• We don’t know marginal cost, but we can still identify a change that will increase profit at zero cost. Can you see it?
• Zero cost way to increase profits– Increase price to the HPL segment. Demand will fall by -∆Q.– Decrease price to the Paint segment so that demand goes up by ∆Q, just
enough to compensate for the decline in the HPL segment.– Costs don’t change– Revenue goes up by $7.15 ∆Q - $5.00∆Q– This is called price discrimination, price customization, or revenue
An Implementation Problem*An Implementation Problem*
• DuPont and Rohm and Haas charged 85 cents per pound to general industrial users of methy methacrylate, a plastic molding powder, but charged $22 per pound for a special mixture sold to manufacturers of dentures
• Attracted arbitageurs who purchased at 85 cents a pound, incurred modest conversion costs, and undercut DuPont and R&H’s denture price
• R&H considered a strategy of spiking the powder: adding arsenic to industrial powder.
*This example comes from Scherer, F.M. and D. Ross, Industrial Market Structure and Economic Performance, 3rd edition (Boston: Houghton Mifflin), 1991.
1. Supply and Demand Analysis2. Price Elasticity of Demand3. Relevant Costs and Decision Making4. Profit-Maximizing Pricing Decisions5.5. Decision Making in Oligopoly MarketsDecision Making in Oligopoly Markets6. Sample Consulting Interview Case
Price Levels and Market Structure in an OligopolyPrice Levels and Market Structure in an Oligopoly
• Generally speaking, the more sellers a market includes, the more difficult it is to maintain prices above marginal costs. Why?
• More competitors ⇒ bigger (in absolute value) brand-level price elasticities (due to greater substitution opportunities for consumers)– Thus: price cuts becomes a more tempting competitive “weapon,”
resulting in lower PCMs (remember the IEPR).
• Fewer competitors ⇒ easier for firms to independently and tacitly to work their way toward the price a monopolist would charge …and avoid the paranoia that leads to unilateral price cutting. Why? – More fertile setting for price and/or capacity leadership to emerge– Market more transparent– Less likely that mavericks or rogues will disrupt industry discipline– Lower likelihood of disagreement about most advantageous price
1. Supply and Demand Analysis2. Price Elasticity of Demand3. Relevant Costs and Decision Making4. Profit-Maximizing Pricing Decisions5. Decision Making in Oligopoly Markets6.6. Sample Consulting Interview CaseSample Consulting Interview Case
Situation: Broadly DescribedSituation: Broadly Described
• Client is a wholesale distributor of a variety of food products. Client has a steady stream of business, but is looking to unlock additional profitability from its existing line of business.
• Your question: What major areas would you want to look at to assess how client could increase profitability?
Situation: Some Additional BackgroundSituation: Some Additional Background
• Market economics– Industry demand growing at the rate of GDP– No new competitors have entered the market in the last several years
• Company’s position and characteristics– Client is industry market share leader– Products sold to a range of customers, primarily hotels and restaurants,
ranging from high-end to low-end– Gross margins: generally above average, but dependent on customer and
““Generic” Strategies for Unlocking Additional Generic” Strategies for Unlocking Additional ProfitabilityProfitability
• Increase gross margin– reduce COGS per unit– increase average revenue per unit– or both.
• Reduce SG&A expense ratio
• Increase market share
• Stimulate market/category sales
• Improve efficiency in utilizing fixed assets and working capital, (translates into need to use less capital to generate a given margin or amount of sales revenue.
““Generic” Strategies for Unlocking Additional Generic” Strategies for Unlocking Additional ProfitabilityProfitability
• Increase gross margin– reduce COGS per unit– increase average revenue per unit– or both.
• Reduce SG&A expense ratio
• Increase market share
• Stimulate market/category sales
• Improve efficiency in utilizing fixed assets and working capital, (translates into need to use less capital to generate a given margin or amount of sales revenue.
Not a panacea, butoften times thisis a place in whichhigh-impact changescan be made at low cost: • improved pricing• price customization• dropping unprofitable products from product line