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by: Elody Bogisich DDS


Elody Bogisich DDS
GPA 3.78

Steven Allen

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Steven Allen
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This 13 page Class Notes was uploaded by Elody Bogisich DDS on Thursday October 15, 2015. The Class Notes belongs to ECG 507 at North Carolina State University taught by Steven Allen in Fall. Since its upload, it has received 20 views. For similar materials see /class/223872/ecg-507-north-carolina-state-university in Economcs at North Carolina State University.




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Date Created: 10/15/15
ECG 507 Professor Allen Fall 2005 Price discrimination Motivation Examples Necessary conditions Thirddegree price discrimination Seconddegree price discrimination Firstdegree price discrimination 39nrnuop gt ll Timebased pricing A lntertemporal price discrimination B Peakload pricing Price discrimination A Motivation Firms with monopoly power do not like to leave money on the table The standard monopolist has two sources of regret First even at the monopoly price some consumers would have been willing to pay even more for the good region of demand curve to left of monopoly output region A in Figure 111 Raising the price for everyone would result in lower profits because MR gt MC in region A but what if you could raise the price for some and keep it the same for others lfthe monopolist could figure out how to charge one group a higher price and others the plain vanilla monopoly price then TR would increase and TC would be unchanged thus leading to extra profits Second there are additional consumers who are willing to pay PgtMC region of demand curve to right of monopoly output region B in Figure 111 Lowering the price will not work with these people because MRltMC But if you could keep the consumers you already have at the monopoly price and add these consumers on the side profits would grow B Price discrimination is the practice of selling different prices to different customers for similar goods Majortypes include Same good but different prices coupons cosmetics cars Price differentials much larger than cost differentials Purina vs ProPlan private floors at hotels 1St class air travel Price paid varies with consumption buy one pizza at 899 get second for 399 Price paid varies by location cement in Wake County vs cement in Sampson County 0 Necessary conditions 1 Monopoly power in each market limited number of carriers 2 Ability to identify each group Saturday stayover time of day 3 No arbitrage name on ticket matches photo ID D Third degree price discrimination Suppose there are two or more different segments of customer demand each with its own demand curve Possible examples include matinee and evening movies brand new and 6 month old novels weekday flights or weekend flights Elasticity of demand would vary between these segments Suppose also that costs of production cannot be separated by market segment For instance if you own a movie theatre and decide to show Harry Potter and the Goblet of Fire for a week this Thanksgiving you get charged a flat sum but you still have to staff the theatre and pay the power bill for each showing whether afternoon or evening If costs for each segment were totally separable then the problem would have the same structure as the standard monopoly problem and you would have MRi MCi in each segment i The question facing the firm is what price to charge each segment Let s look at how an airline such as American might price airtravel Rather than going through more fancy math let s apply some common sense principles from earlier in the course Suppose right now that American has 5 flights to Boston on weekdays and 3 flights on the weekend It estimates that the 5th weekday flight generates 50000 in revenue per day and the 3rd weekend flight generates 25000 per day Cost of each flight is the same so this is not a concern for now Also suppose American can run charters or schedule most maintenance on weekends it is not obligated to have the same number of flights on weekends and weekdays Q does this allocation of flights make sense for American NO American would be better off scrapping the 3rd weekend flight and moving around its maintenance schedule so that it could schedule 6 flights on weekdays It would lose 25000 in weekend revenue but gain close to 50000 in weekday revenue This example illustrates a simple decision rule for output and pricing by market segment the firm should adjust its production mix so that MR1 MR2 The final step is to take cost into account Profit maximization would dictate that MR MC In this situation MC of each flight is probably the same labor jet fuel gourmet meals so we would end up with MR1 MR2 MC Pricing strategy would be dictated by the elasticities of demand for the two market segments Rememberthat MR P1 1Ed meaning P111E1 P211E2 P1P2 11E211E1 This looks a bit formidable but the underlying basis is common sense customers with the fewest alternatives pay the higher price To follow the numbers just imagine that E1 3 and E2 6 In this case we would expect P1 gt P2 Plugging in the values we get P1P2 116113 08330667 gt 1 So P1gtP2 We will get the same type of result as long as the absolute value of E2 is greater than absolute value of E1 Again the common sense side of this is that customers with the least elastic demand new novels business travel pay the higher price Graphical analysis Figure 115 1 Sum MR1 business and MR2 leisure to get MRT This shows additional revenue coming from both markets from additional output 2 Set aggregate output where MRT MC at QT 3 Output in market 1 is read off MR1 price for market 1 is read off D1 4 Output in market 2 is read off MR2 price for market 2 is read off D2 No surprise less elastic market pays higher price Numerical example look at problem 5 part i p 421 The trick is to solve for Q1 and Q2 in the following equations MR1MC 152Q1 3 Q1 Then go back to the demand equations to solve for P1 P2 P19 and P214 Then calculate TR TC and profits Profits 96 1455 5 36 115 915 Comparison to perfect competition here we would have MR1 MC 3 ditto for market 2 Result would be Q1 12 and Q2 11 Pretty big difference E Seconddegree price discrimination This form of price discrimination allows the price paid by each customer to vary with the quantity purchased by that customer providing volume discountsquot to those who purchase the most One example would be a lower price per roll when you buy 8 rolls of paper towels at once than when you buy a single roll Another would be for Burger King to sell one Whopper for 189 and two Whoppers at 249 Aside cost savings is an alternative explanation of some quantity discounts Public utilities engage in a practice called block pricing where the customer is charged different amounts at different consumption levels For instance the first 500 kilowatt hours of electricity used per month might cost 10 cents apiece whereas the next 500 may cost 75 cents and the next 500 cost 5 cents This practice allows the firm to transfer more consumer surplus into revenue than it would under singleprice monopoly pricing F Firstdegree price discrimination In this situation sellers can charge everyone a different price Leading examples include professions doctors before Medicare lawyers accountants consultants car salespersons and private universities The ideal from the monopolist s perspective is displayed in Figure 112 Each customer would be charged the maximum price that heshe is willing to pay Key results 1 Output would now be same as competitive case where P MC This is because the demand curve becomes the monopolist s MR curve This would leave no consumer surplus at all The monopolist s profits would go from the standard rectangle for some reason this is not displayed to the area between the demand curve and the marginal cost curve 9 Timebased pricing lntertemporal price discrimination Most common example is markdowns of retail merchandise Latest stuff fashions high tech gizmos is sold at very high prices but then gradually markdowns occur Basic idea is to extract maximum consumer surplus from those who cannot wait folks who have every inelastic demand curves eg those who want to be 1St on the block to have a 60quot plasma TV Costs do not necessarily change but prices do as this initial demand gets tapped out and the firm wants to reach a larger market We have seen this with PCs laptops VCRs DVDs cell phones you can count on seeing it for HDTVs and Blackberries B Peakload pricing Applies to situation where capacity is fixed but subject to rising costs as usage rises Electric power is classic case when on a hot day in July that marginal kilowatt hour can be 39 39 to p quot quot 39 lf same price is charged in all periods customers have no reason to ration their demand and CPampL has no incentive to buy or produce those extra kilowatthours Solution is to charge different prices at different times You get free weekends on many calling plans today but once you have used up your bucket of minutes you pay 5 cents or more per minute on weekdays Goal of firm would be to try to set MR MC at every period The result will be that MC in a peak period will not be the same as MC in an offpeak period which makes this case a bit different from 3rd degree price discrimination Figure 118 Professor Allen ECG 507 9805 Compensation and incentives see last set of notes Cost the basics A Cost what you give up Explicit and imputed costs Comparing cash flows Sunk costs Fixed and variable costs Average costs Average variable cost Marginal cost ey economic issues Economic vs accounting costs 2 Replacement cost 3 Fixed not same as sunk 4 Overhead C Short run cost curves D Long run cost curves More on cost A Economies of scale 1 Theory 2 Estimation B Economies of scope C Learning curves 07 XNP Q PPNE Cost A Critical definitions Cost in economics is defined as what you give up to pursue a particular objective Text definition is cost associated with opportunities that are foregone when a firm s resources are not put to their highest value usequot Let s start with some examples designed to flesh out this rather abstract concept 1 ADON vvv 01 v What is cost of NC State s MBA program 0 List of major cost items 0 Impact on cash flow 0 Cost to whom Student vs IBM What is cost of launching a new product eg new drug at GSK What is cost of running your own business You run a construction company and have just purchased 100k worth of lumber Price of lumber then goes up 20 What is cost of using that lumber to build structures You run an auto parts manufacturing company and purchase a die press for 50k The die press will last for 3 years What is the cost of that die press in the first year In the third year Now let s turn to some more formal definitions 1 Cost explicit cost imputed cost opportunity cost Explicit cost identifiable expenditures that are associated with current inputs eg wages equipment rent interest materials taxes These are items that any accounting system will be able to flag The main trick here is to understand which ones to include see discussions of sunk costs and overhead below lmputed costs lost chances to make that are associated with current input allocation Examples salary not drawn by entrepreneur rent not collected on land or structures profits or interest that could have been earned on capital These items can be measured by a good managerial accounting system but will not be captured in any financial accounting system because of their backwardlooking nature In practice the best way to estimate cost is to compare cash flows as suggested in HBS case You need to structure the decision into two or more alternatives and then cash out each option This is what we were doing at the end of each of the examples that we talked about earlier 2 Comparing cash flows Companies make multiyear commitments when they decide to invest in new plant and equipment To the extent they get locked into contracts with suppliers or workers they would have to factor that into account as well Merck is opening a new plant north of Durham Suppose Merck execs know this will cost them 5m in 2005 5m in 2006 and 5m in 2007 Does the total cost equal 15m Companies also must make decisions about the value of future revenue streams Suppose Pfizer has a new drug coming to market that is likely to generate 10m in revenue for each of the next 10 years How much is that worth now Is it 100m The answer to both of these questions is clearly NO A dollar today is not worth the same as the same dollar a year from now for at least two reasons 0 risk we may not be here tomorrow something might happen to the dollar 0 foregone earnings opportunities 1 could become 102 by this time next year at an insured checking or savings account To estimate the value of future cash flows we calculate their present discounted value or PDV To make these calculations one must use an interest rate R that best represents the opportunity cost of the agent making the decision You will spend a good deal of time in your finance class learning about which value of R to use when As you might guess Bill Gates uses a different value of R for valuing possible new projects for Microsoft than a 75yearold widow uses to value an annuity Hint Bill would use a much higher value of R because he will expect a much greater rate of return than an elderly individual managing retirement assets Once we have a value of R we know that 1 today is worth the same as 1 1R a year from now 11R2 two years from now 11R3 three years from now and 11Rquot in n years We also know that 0 1 a year from now is worth the same as 11R today 0 1 two years from now is worth the same as 11R2 today 0 1 three years from now is worth the same as 11R3 today 0 0 1 n years from now is worth the same as 11Rquot today Examples of PDV calculations a Cost of Merck plant assuming RO5 PDV 5105 51O52 51O53 476 454 432 1362m well below 15m b Present value of future Pfizer profits assuming R08 PDV 10108 101082 101083 101084 101085 101086 101087 101088 101089 101081 PDV 926857794735680630583540500463 6708 well below 100m Whenever you are evaluating a decision that involves future revenue or costs you must use PDV to evaluate the cash flow 3 Sunk cost expenditures that have been made and cannot be recovered Example When the Eddie Murphy movie The Adventures of Pluto Nashquot got delivered to the studio 100m had been spent on the film This is a sunk cost The studio still has to decide whether it should distribute the film which will cost an additional 20m As long as the studio thinks it can generate enough revenues from theatres and video to offset these additional costs it should go ahead and distribute the film However if the studio thinks that the movie is such a big stinker that it will never see its 20m back it should not release the movie As we now know Pluto Nash was released and was one of the biggest bombs in movie history netting 44 million on opening weekend and a total of 71 million over its entire viewing cycle Another movie that came out last weekend may also be in budget trouble The Constant Gardenerquot cost 255 million to make probably cost another 20 million to distribute and netted a mere 39 million opening weekend Data source The Numbers web site The key point on sunk costs is to not include them in explicit costs in making decisions about future activity Before the film was made the 255m or 100m figure plus distribution was relevant to decision making But it is not relevant to decisions about the future marketing and distribution of the film The Forbes article shows that the theory that sunk costs should be ignored is not always followed up in practice The key lesson keep your ego in check when making decisions Other examples of sunk costs class 2 TC Total cost fixed cost variable cost FC VC Fixed cost costs that do not vary with output they are usually called overhead They include buildings equipment and staff workers plus any materials or labor that are under contract Variable cost costs that vary with output mainly materials and labor 3 Average cost ATC TCQ 4 Average variable cost AVC VCQ These are the cost concepts that are most often used by managers because data on output and total cost are readily available But the cost concept that is of greatest importance for decision making is 5 Marginal cost MC dTCdQ MC is the change in total cost resulting from the decision to produce an extra unit or batch of goods In deciding production levels or doing costbenefit analysis this is the cost measure you want to be using B Key economic issues 1 Difference between economic and accounting costs Balance sheets and income statements are historical documents designed to inform stockholders potential investors and top management about the firm s overall financial health They are important sources of information for estimating economic costs but cannot be used without some adjustment to reflect such considerations as foregone opportunities to make money and sunk costs Keep in mind that accountants must answer to regulatory bodies such as the FASB and IRS which require them to follow standard procedures Economists are not subject to such pressures and so can think more freely Managerial accounting systems used to make decisions within organizations are much more flexible and thus more closely aligned with the economic definition of cost Note that the accounting distinction between direct and indirect overhead costs is very similar to the economics distinction between variable and fixed costs Replacement cost Must be careful about what you paid for items currently in stock and what you will pay to replace them This concept comes into play in talking about 0 Depreciation Value of equipment and structures declines over time to reflect wear and tear plus possible obsolescence If you purchase a server at the beginning of the year at 10000 that one year later is worth 8000 then the economic cost of that equipment is its decline in value of 2000 NOT the original 10000 Inventory valuation Suppose price of new servers goes down from 10000 to 5000 in first year Then the economic cost must include notjust wear and tear but also loss of resale value If used servers market for 4k then the economic cost is 6k This process can work the other way if price of servers went up by enough then this could offset the effect of depreciation on value OK servers are not a great example of a capital good that could increase in value But what about oil drilling equipment if price of oil goes up 3 Fixed costs are not the same as sunk costs Some fixed costs are sunk especially inputs that are highly specialized to one particular organization eg proprietary l software or specialized equipment But some fixed costs are not sunk For instance most types of equipment and all types of structures can be sold and used by another organization Example suppose IBM spends 10m on developing a particular piece of software that is not worth more than 4m to any other organization Then 6m is sunk and 4m is recoverable Allocating overhead expenses to product lines or divisions is messy This is well illustrated in the Harvard case Relevant Costs and Revenuesquot All 3 product lines in that example have to cover overhead together but many commonly used rules for overhead allocation make one or more of the product lines look like losers on paper As more companies shift to performancebased pay decisions about overhead allocation have become increasingly similar to discussions about the IRS A Source Lecture notes developed by Steve Margolis for earlier vintages of ECG 507 were used to develop much of the above discussion Exercises in class see sample problems on the last two pages C Cost curve mechanics short run NOTE Please read this section before class I would prefer to answer questions about this material rather than lecture This is covered in the text pp 220223 This refers to the situation when some inputs are fixed Consider a simple technology where all K is fixed and all L is variable The key factors behind TC are as follows 1 Productivity same output from fewer inputs lowers TC ATC AVC and MC 2 Price of inputs higher wages mean higher TC ATC AVC and MC 3 Fixed cost greater overhead translates into higher TC and ATC Note the close resemblance between the production function in Figure 61 and the TC function in Figure 71 Suppose you did the following simple transformation 0 Start with the production function that relates Q vertical to L horizontal 0 Multiply the scale of the horizontal axis by the wage rate so that you get a function relating Q vertical to VC horizontal 0 Move the scale of the horizontal axis to the right by F units where Ffixed costs Now we have a relationship between Q vertical and TC horizontal 0 Now flip the axes to make TC vertical and Q horizontal you would now have the TC curve in Figure 71 Key facts about cost curve shape 1 MC is rising after some output level because of law of diminishing returns 2 ATC is Ushaped downward sloping at low outputs as FCQ declines but ultimately starts rising because of MC reaches minimum where ATCMC then upward sloping because MCgtATC 3 AVC also Ushaped downward sloping at first because MC is downward sloping at low levels of output convex region of production function where there are large gains from specialization stays downward sloping for awhile when MC starts rising because MCltAVC reaches minimum where AVCMC then upward sloping because MCgtAVC D Long run cost curves Changes in fixed input result in new levels of fixed costs and potential changes in the shape of the TC curve at different ranges of output In a simple world where K is fixed and L is variable there is a unique set of short run cost curves defined by each level of K Shape of this function depends on returns to scale Longrun ATC LAC declines with Q when there are increasing returns is constant when there are constant returns and is increasing when there are decreasing returns to scale This is shown in Figure 79 in text E Real world cost curves Great example on pp 223225 of text dealing with aluminum smelting Iquot More on cost A Economies of scale 1 Theory The firm may decide to change KL at different output levels so instead of talking about how Q changes with a given KL ratio we will find it more useful to talk about how TC changes with Q which we define as economies of scale EC where E AC AQ When there are economies of scale costs increase by less than 1 percent for each 1 percent increase in output which means EC lt 1 When there are diseconomies of scale costs increase by more than 1 percent for each 1 percent increase in output which means EC gt 1 Sources Economies of scale arise from o Spreading overhead over larger base Examples half a boxcar costs same to ship as full boxcar 0 Physical properties of production Classic example is cubesquare rule volume increases with the cube of its linear dimension pipelines while surface area increases with the square Don t believe me Compare volume and surface area of 1x1x2 box to that of 2x2x4 box Production capacity increases with volume but cost increases with surface area Since volume increases at greater rate than surface area we get economies of scale Examples pipelines warehouses brewing 0 Marketing economies National advertising is cheaper on a per viewer basis than local so McDonald s and Bud have an edge on CharGrill and Carolina Brewing 0 Purchasing economies Cheaper to sell HP computers to WalMart and Radio Shack under national contract than to deal with local stores in each area so WalMart and Radio Shack can negotiate better terms Diseconomies arise from 0 Labor costs Larger firms pay more although this is partially offset by lower turnover of workers and thus economizing on hiringtraining costs 0 Bureaucracy Harder to link individual or small group performance to firm performance in large firm so incentives for good performance may not be as great But how can they afford high wages then 0 Spread specialized resources too thin Great chef can run one restaurant but can get into trouble if he expands too much Estimation Empirically we must examine scatterplots or regression analysis of costs to determine if economies of scale are present Key issue is whether ATC declines or increases with production level 2 Economies of scope Take two or more separate product lines that have complementarities in production or distribution Examples Kellogg can produce corn flakes or sugar frosted flakes using same production line WalMart can sell clothing hardware garden supplies toys in the same store space 3M took its knowledge of adhesives from selling Scotch Tape to develop PostIts American Airlines gets more passengers by flying RDUDFW and DFWLAX than by flying just one of the routes When is it economical for these goods to be produced by the same firm in the same facility The answer depends on whether the costs ofjoint production are lower than the sum of the costs of producing each in separate facilities Economies of scope result when costs to a single firm of producing two or more goods is less than the costs of having separate firms produce each good Economies of scale can be accompanied by economies of scope eg WalMart but the two do not necessarily go together Economies of scope are believed to be very important in RampD A firm with a large well diversified portfolio of research projects is in better position to leverage any breakthroughs than a firm with a smaller set of projects Ideas from one project increase the odds of success on other projects One study in pharmaceuticals found that for the average firm with 19 research programs the addition of 2 more programs increased the productivity patents per dollar spent on RampD of the other 19 by almost 5 percent Aside economies of scope concept is used widely in businessstrategy Often called leveraging core competenciesquot which can be in production research or marketing 3 Learning curves Concept originated in analysis of aircraft production by TP Wright in 1925 Wright noticed that average cost per plane assembled declined with cumulative number of planes produced Rate of decline was about 20 percent every time output doubled In other words cost per plane would fall 20 percent as output went from 1 to 2 another 20 percent as output went from 2 to 4 etc Aside this is exactly the pattern in Table 73 as you go from 10 to 20 40 80 In technologies where the learning curve is known this allows managers to make sensible cost projections which in turn can be fed into business and marketing plans Learning curve phenomenon helps explain why new technologies start off very expensive in the market place but price gradually falls over time Examples VCRs PCs cell phones highdef TVs we hope Also seems to apply to some service industries eg surgery Sources of learning improved training and worker efficiency from learningbydoing better organization and coordination product redesign and standardization new processes There also can be organizational forgetting resulting from poor labor relations turnover Strategic implications firms should recognize growth potential in technologies subject to learning curve Firm should endeavorto grab dominant market share quickly so it will be in position to exploit learning curve Can be used for planning Lockheed should have used a learning curve in 1971 At that time it wanted to launch a widebody jet the L1011 Tristar but could not get further support from commercial lenders after spending 1b Ultimately it got a quarterbillion loan from Congress The first plane would cost 100 million to produce It was expected to follow a 77 percent learning curve ie AC after second plane 77m AC after fourth plane 59m AC after eighth plane 45m etc Market price of these jets was expected to be about 15m How many jets would Lockheed have to sell before it starts making money A over 128 an unrealistically large share of world market at that time Sample problems 1 Leith Honda has six Civics on the lot for which it paid 14500 New models are coming in and with special promotions will cost Leith 13900 A customer offers Leith 14250 for a Civic in stock Should Leith accept or reject l Shania Twain has a contract that calls for her to make one album per year for which she gets paid 5 million She decides to change musical directions and sing famous arias from wellknown operas It has cost 500000 to produce and market each of her earlier albums Whatjudgments do you have to make before deciding whether to release Shania s new material 9 Pete Zah is thinking about opening a submarine sandwich in Morrisville He knows that over the year he can sell 50000 subs at 4 each His accountant tells him that the costs of producing so many sandwiches include Materials bread cheese meat etc 60000 Labor 120000 Rent 20000 Zah wonders whetherto open the shop Assuming that Zah continues in his current job and does not work in the shop what is your advice 4 Here is what it would cost you to fulfill your lifelong ambition to operate a small ski resort Land acquisition 200000 Build ski lift 100000 Build an open shelter 20000 Operation 50hour You plan to be open 50 hours per week for 20 weeks per year so operating costs should be 50000 per year You will be able to borrow 320000 under a 20year loan with annual payments principal and interest of 43000 per year 039 v O V What is the minimum amount of annual revenue from the sale of lift tickets that you will expect in order to take the plunge and invest 320000 Suppose your actual revenue in the first year of operation turns out to be 60000 Keeping in mind that your resort is already built would you have been better off in retrospect by not opening that year Once in a while you can earn 600 by opening your resort for 8 hours on weekdays when it would otherwise be closed for the benefit of special charter groups The revenue will cover your operating costs of 400 per day but since your operating costs are 54 percent of your total costs you would need about 750 in revenue to make it worth your while to be open Or would you If you spend 10000 on advertising in your second year and as a result total revenue increases to 75000 was the decision to advertise a good one From Steve Margolis A tent making company is considering an offer from a restaurant chain The restaurant chain would contract to purchase 115 awnings in the coming year and none afterthat The tentmaker currently turns out 1500 tents per year which it wholesales for 140 each The costs of tent production are Fixed overhead rent equipment insurance utilities etc 12000 Other overhead manager 30000 Direct materials 40000 Direct labor 60000 The tentmaker cannot accommodate any additional workers but it estimates that it could produce the awnings with the current staff and manager as long as it cuts tent production in half They also would have to have some special forms made at a cost of 10000 These forms are proprietary to the restaurant chain so they could not be used for any other purpose Direct materials per awning are 135 The contract would pay 800 per awning Should they contract to produce the awnings How much better or worse off are they if they accept the offer


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