Managerial Economics

Course Overview/Topics 1 and 2

Agenda

Introduction

What is Economics and Managerial Economics?

Course Objectives

Review of Syllabus

Your Chance to Ask Questions about the Course

How to Think Like an Economist: Scarcity and Rationality

What is Economics?

Economics: the study of how society (households, businesses and governments) allocate scarce resources

Scarcity implies that choices must be made

Scope of economics is wide since scarcity is everywhere

Economics is not a subject matter, it is a way of thinking!

It is how incentives and institutions affect behavior

What is Managerial Economics?

Managerial Economics: a subspecialty of microeconomics that focuses on the use of economic reasoning in managerial decision making and problem solving within a firm(Eco analysis by bus pp to make decision)

It attempts to bridge the gap between the purely theoretical problems discussed in Principles of Econ and the more practical problems faced by business

Economics can give us clues as to why management behavior and decisions are generating bad outcomes:

Netflix raised its price for movies and lost revenues

Coke introducing “New Coke”

KMART trying to compete with Wal-Mart’s low prices in the 1990’s

Understanding important economic concepts, such as price elasticity, price discrimination, and incremental analysis are tools that managers can use to improve a firm’s performance.

More than this, economics gives us an understanding of how people behave, which is of direct relevance to management

Managerial Economics: What is it good for?

Managerial Economics gives you the tools to analyze business problems and make sound business decisions

You will learn the methods of how to think through and how to analyze business problems in a logical manner

You will learn how to make pricing decisions

You will understand why recessions are great news for some companies, and not for others

You will learn how to use incentives to change people’s behavior

This Class will be Different than All of your Other Economics Classes

Use Terminology appropriate to business (not economics)

Use Graphs only when necessary (supply and demand)

Use Math and Formulas only when necessary

The first half of the class will focus on Thinking Like an Economist

The second half of the class will focus on using these principles of analytical thinking to solve business problems

How to Price

How to respond to competitive behavior and anticipate competitor reactions to your firm’s behavior

How to change Employees’ behavior with incentives

How to deal with suppliers of inputs to the production of your firm’s goods

Course Objectives

Students should be able to:

Be able to solve business problems using correct analytical principles and economic reasoning

Assess the impact of external factors on the market for a good or service

Derive price and output combinations which are in the best interests of the firm

Describe relevant costs which should be used in business decisions

Analyze competitive behavior

Assess the behavior within and outside of the firm

Review of Syllabus

Book: Managerial Economics: A Problem Solving Approach by Froeb, McCann, Shor and Ward, 4th edition

The book is OPTIONAL.

We will be covering topics that are not covered in the book; and topics straight out of the book.

3rd edition of the book will work too.

It is expected that you will know or be familiar with the following:

Principles of Economics BAA505

The first 4 weeks of the course will be a review of some principles already discussed in BAA505

Basic high school mathematics and algebra, such as functions, graph of a line, slopes, etc.

Knowledge of Excel will help, but not necessary

Grading:

3 Problem Sets: 300 pts (100 points each)

6 Quizzes 300 pts (50 points each)

In Class Midterm: 250 pts

On Line Final Exam: 250 pts

1, 100 pts

Problem Sets, Quizzes and On Line Final will be available on Canvas and will be submitted in Canvas

Lecture Notes will be available 2-4 days before class

Other Issues

Technology Policy:

Please keep cell phones off and in your pocket/briefcase

5-10 minute Break every 1 hour

Teaching philosophy

Business Meeting

Class participation is expected and will affect final grade, positively.

My expectations from you

Come to class (on time)

Come to class prepared beforehand

Come to class and be involved

Come to class and ask questions

Come to office hours and ask questions

Questions about the Course

The Approach to Thinking Like an Economist

Involves thinking analytically and objectively

We will make Assumptions in order to make the world easier to understand

Use of Models based on these Assumptions to simplify analysis in order to improve our understanding of the world, solve problems and make better decisions

Model of Supply and Demand

Game Theory Model

Topics Covered

How Individuals Make Decisions

How Businesses Make Decisions

Applications of Business Decision Making

Pricing

Competitive Decision Making (Game Theory)

How to Compensate Employees

Make or Buy Decision

Important Assumption #1: Scarcity (income,time)

Scarcity Principle: People (and firms) face tradeoffs and must make choices in the face of scarce resources.

In most contexts, “scarce” means that something is rare or that little of it is available

In our context, we add a second part of definition: “scarce” also means that consumers want more of something than is available

Scarcity for Consumers: As a consumer, you can’t get everything you want, because your resources (for example, your income or time) are limited.

You need to make choices based upon what you need and want

Scarcity for Firms: A firm cannot produce all of the products or services it wants:

Resources, such as land, labor, capital and entrepreneurship, are needed to produce goods

Competition for these resources forces the firm to make choices regarding what to produce, how to produce and who will receive the goods

Scarcity for a Country: An economy or country has to make choices about whether to spend money on defense or education or social welfare programs, on exploring for oil or investing in alternative forms of energy

Tradeoffs, Tradeoffs, Tradeoffs…..

Can You “ever get too much of a good thing”?

Most economists would say you can get too much of one good.

Why? Because getting more of one good means that you have to give up some other good.

Should you try to achieve perfect state of good health?

Is some one who is capable of getting an A in my class with hard work and a significant time commitment, but decides to work only hard enough to get a B acting unreasonably?

No, perhaps there are other goods that he/she wants to spend his time on

Spending time and effort to get one good (an “A”) means spending less time and effort on getting other goods (like socializing with friends)

Life is full of Tradeoffs

Can There Ever be Too Little of a Bad Thing?

Is zero the “right” amount of a bad thing?

Most people would consider pollution a bad.

Should society strive to get the amount of pollution down to zero?

Most people would say that driving our cars is a better option than no pollution and not driving our cars

How Individuals Make Decisions Important Assumption #2: Rationality

Individuals ACT AS IF they pursue their own self interests

RATIONALITY ASSUMPTION: individuals do not intentionally make decisions that would leave themselves worse off( or make decision with expectation to be better off)#rationality

Individuals act with the intention to make themselves as well off as possible

Both monetary and non-monetary benefits matter

Realize that people have their own tastes and preferences

A decision that makes someone else better off may not make you better off

Do not confuse acting in your own self interests with acting selfishly

We give to charity

We hold doors open for others

Do not assume that we always make the perfect, or even good, decision

Each of us tries to make the best possible decision given the information available at the time

Limitations of time, money, information and your own intelligence

We are sometime wrong and actually worse off after the decision is made

Do not assume that pursing your own self interest is easy:

Life is complex and uncertain.

There are a myriad of things that we could do at any one time.

We may trade off being worse off today with being better off tomorrow

Objections to the Assumption of Rationality

People do things that make themselves worse off

Counter: In their expectation, the choice that was made was perceived by the person to make him/herself better off

Rationality implies Self-Centeredness

Counter: Some people get great joy (benefits) from seeing others happy, helping others, giving to charity, etc.

It seems that people are taking actions that, in my opinion, make themselves worse off

Counter: Simply because choices are not the ones that you would make, does not make the choice wrong

People often take actions which have the interests of others at stake

Counter: It is quite plausible that people get pleasure (benefits) from helping others

Individuals Make Decisions

Given limited time and income (scarcity), individuals make decisions that they believe will make themselves better off.

Every decision you make, every action you take has one sole purpose: to make yourself better off.

Who to marry?

What car to buy?

Whether to change lines on I-85?

Sometimes we make ourselves worse off in order to be better off in the future

Going to college

Saving

Most of the time we do not have all of the information, do not have the time, and perhaps the intelligence we need to make the best decision

We cannot predict the future with certainty

We therefore make decisions that make ourselves worse off in the end, but this is still a rational decision

PP make decision and look for 1- expect / benefits of decision, 2- expect/ cost of decision( expectation to be better off)

Also they look for Monetary cost and non monetary cost

How Individuals Make Decisions Important Assumption #3: Cost-Benefits

By assuming rationality:

People make choice from a wide array of alternatives

By making a choice, people forego other options

AND

Cost-Benefit Principle: Rational people will take an action if they believe/expect that the additional benefits from that action exceed the additional costs of that action

If expected benefits > costs of an action, the action will be taken because it makes the person better off

People IMPLICITLY or explicitly weigh the costs and benefits of each and every action

Explicitly by listing the “pros” and “cons” of an activity

The benefits and costs of an action do not have to be monetary or material goods

Non-Monetary Benefits may be the enjoyment or satisfaction you get from an action

Non-Monetary costs may be the dissatisfaction you get from an action

People also include non-monetary Opportunity Costs as a “cost” when considering which action to take

Includes the value of leisure time that you give up to do something else

The costs of something is far more than the dollar and cents you hand over at the cash register

All of these benefits and costs are implicitly or explicitly taken into account when deciding to take an action

Why did the Chicken Cross the Road?

Because the additional benefits from crossing the road were greater than the additional costs of crossing the road

The chicken believes he/she would be made better off by crossing the road (or else he/she wouldn’t have crossed the road )

Opportunity Costs or “There is No Such Thing as a Free Lunch” important concept

Given limited resources, you often have to choose among several different alternatives

Opportunity Costs: the value of the next best activity that you sacrifice doing by choosing that activity

Opportunity Costs are the value of the NEXT best activity, not all alternatives

Opportunity Costs are considered a cost of choosing one activity and giving up the value of the next best alternative

Opportunity costs are included in COSTS when calculating the benefits vs. costs of an action/decision

Examples of Opportunity Costs:

A high school graduate chooses to go to college; with the opportunity cost being what he/she would earn if you chose to work instead

He/She must think that the additional benefits of going to college (higher future income) exceed the additional costs of going to college plus the income lost from not working straight out of high school

A college student decides to play a sport for one hour; with the opportunity cost being the one hour of studying for an Economics test scheduled for the next day

He/She must believe that the additional benefits from the enjoyment of playing the sport for one hour exceeds the additional costs from the potentially lower grade (and the dislike of studying) from not studying for one hour

You have $1,000 in cash and decide to put it under your mattress

The opportunity cost of putting the cash under your mattress is the interest you lose by not putting the money in a safe interest bearing account, like a savings account or money market fund

The lower the interest rate, the less the interest earned and the lower the opportunity cost.

The lower the interest rate, the more likely that people will hold cash – since the opportunity cost of holding cash will be lower

Opportunity costs do not have to be monetary in nature:

You give up leisure time or time with your family

Every action you take has a cost: the opportunity costs of what you gave up by taking that action

Opportunity Costs is not very Popular Concept!

It essentially says that nothing in life is “free”

Whenever you choose to do something, there will always be a cost (either monetary or non-monetary) of the next best alternative that you gave up (opportunity cost).

Choosing Mercer means you cannot go to Tech or Georgia State

Marrying one person means you miss out on marrying another

Is a house a great investment?

Many people include direct monetary costs, such as repairs , taxes, costs of selling, when determining the gain from a sale of a house

Most do not include the opportunity costs of the lost investment gains from potentially investing the down payment and mortgage payment

Many realtors say that remodeling your kitchen is a great idea since you get all of your money back when you sell: your new kitchen will be “FREE”

Pleasure from the new kitchen has to be greater than the lost investment opportunity from spending the money on the new kitchen and the non-monetary return from doing something else with the money

Is mowing your own lawn or cleaning your own house always a good idea?

Sure, it saves you money.

But, the opportunity cost of doing these chores yourself is the value of other things you could be doing with your time

Monetary opportunity costs: consulting or a part time job

Non-Monetary opportunity costs: time spent with family, your own leisure time, or volunteering

Three Results from Assumptions of Rationality Scarcity and Cost-Benefits

People have to make choices

By making a choice, people forgo other options (Opportunity Costs)

A person will only take an action if the benefits from that action are greater than the costs (or makes them better off)

– These costs include opportunity costs

Our choices may be limited by financial, technological and physical barriers

Impact of Rationality and Costs/Benefits Assumption

Helps you determine how people are expected to behave

Also suggests ways to motivate people to change their behavior

To change behavior, you need to change the perceived additional benefits and/or costs of a person’s actions

Incentives: change a person’s expected benefits or costs from any action that individual may take

How to Think Like an Economist #1: Incentives Matter

Since people explicitly or implicitly weigh the costs and benefits of any action: INCENTIVES MATTER ex, sometime I give waseen candy to change his decision and action

Incentive principle: A person is more likely to take an action if its benefits increases and less likely to take an action it if its costs rises.

(Some) people will respond by taking actions if you change that action’s benefits or costs.

Increasing the benefits or lowering the costs of an activity will make more people use that activity

Not all people respond the same way to incentives

Incentives come in all flavors (money, prestige, self-respect, comfort, etc.)

Incentives are a powerful tool for explaining human behavior

Examples:

Most students study the day before a test, because the benefits (in terms of a potentially higher grade) of studying a day before the test is much greater than studying a week or a month before a test

As the benefits of studying increases, students tend to study more

Electric vehicles used to receive a $5,000 credit on taxes in Georgia. By lowering the costs of owning an electric vehicle, more people will be incented to take the action to buy electric vehicles in Georgia.

As the costs of buying an electric vehicle decreases, people will buy more electric vehicles

Incentives and Consumer Behavior

When buying a good or service, the price of the good or service is a cost in the cost-benefit principle

People will purchase a good or service if they believe that the benefits of buying the good are greater than the costs

If prices/costs go up, people will buy less of the good (do less of the “action”)

If the price of gasoline goes up, (some) people buy less of it

Some people car pool, take less trips, drive slower, buy electric cars, etc.

But not everyone responds to higher gasoline prices in the same way

In the end, with higher gasoline prices, there will be less gasoline purchased

Non-Monetary Incentives

When I say that, “Incentives Matter”, most people automatically assume that I am talking about prices/money

Non-monetary incentives can be just as important as monetary incentives in affecting behavior

Time is one important non-monetary cost that affects human behavior

But reputation, fame, your conscience, patriotism, love and glory are also non-monetary benefits that affect behavior

Suppose your favorite band is offering a “free” concert for the first 250 people in line.

Is it really “free”?

Yogi Berra once said: “Nobody goes there anymore, it’s too crowded”

What he really meant is that a person with a high value of time or a more relaxed atmosphere had better alternatives

It is illegal in the US to buy and sell human organs (i.e., kidneys)

People who need a kidney transplant rely upon altruism: Strangers and loved ones willing to give up one of their kidneys

The incentive to donate kidneys is based upon the satisfaction/benefit derived from willingness to help others

But this incentive is not enough to satisfy the need for kidney transplants: many people die waiting for kidneys

We need to change the incentives to donate kidneys in order to get more donated kidneys

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Incentives Matter: Perverse Examples

Your home town should install cameras at its traffic lights in order to nab drivers who run red lights.

Our city is infested with cockroaches, so the city should put a bounty (of $1 per cockroach) to turn them in (dead or alive).

Do seat belt laws really decrease the number of accidents?

Would forcing children under 2 years old to sit in their own (infant) seats on airplanes increase safety?

Incentives Matter: Effort of Employees

How much effort employees exert will depend upon the benefits of exerting additional effort vs. the costs of exerting additional effort

If there is no extra pay for exerting additional effort – such as a flat salary – employees have little incentive to exert additional effort.

If an employees salary is tied to his performance, such as a salesman’s salary is tied to amount of sales (i.e., commissions), the salesman has additional benefits from exerting additional effort – higher pay!

Major problem in developing incentive pay plans is MEASURING performance.

How to Think Like an Economist #2: Marginal Analysis or “There is a Right Amount of Everything”

Every action you take, every decision you make gives you some benefits and incurs some costs (including opportunity costs)

A rational person will take an action as long as the additional benefits from that action are greater than the additional costs of that action (or makes them better off)

Total vs Marginal (Additional) Benefits

Suppose you are studying for a test.

The TOTAL benefits from studying for the test equal the sum of the benefits from studying for a total of 5 hours = “all” of the benefits

The MARGINAL benefits of studying for the test are the additional benefits of studying one additional unit of time, say one additional minute

Same distinction applies to Total vs. Marginal Costs

Suppose you are studying for a test

The TOTAL Costs of studying for the test for 5 hours might be the lost $250 that you could have earned by working

The MARGINAL costs of studying for one minute more would equal $1.67

How Much to Do Anything: There is a Right Amount of Everything

The optimum amount of ANY action – the optimum amount of hours that you study, the optimum amount of cups of coffee you drink, the optimum amount of TV that you watch,…. etc. is determined by the Marginal Principles:

Increase the level of an activity if its marginal benefit is greater than its marginal cost

Decrease the level of an activity if its marginal benefit is less than its marginal cost

If possible, pick the level of an activity at which marginal benefits equal marginal costs

You’ve been watching College Football games for the past 6 hours. In the game you are currently watching, the score is 42 -0 with 6 minutes left in the game. Is the game worth watching for 1 additional minute?

The answer is “Yes” for you if your marginal benefits of watching the game are greater than the marginal costs.

You will continue to watch the game for an additional minute as long as you perceive that the marginal benefits are greater than the marginal costs

You will be indifferent about watching the game when the two are equal.

You will never watch the game if you perceive that the marginal costs are greater than the marginal benefits

Why Don’t You Hit Yourself in the Head with the Hammer One Time?

Your Answer: It hurts!

My Answer: the marginal costs of that action (getting hurt) are greater than the marginal benefits of that action

What is the optimum amount of hitting yourself in the head with a hammer?

Why there are no $10 bills on the sidewalk?

People do not ignore opportunities to make themselves better off

People will take advantage of opportunities when the marginal benefits of an action ( getting $10) are relatively high; and the marginal costs of an action (leaning over and picking up a $10 bill) are low.

Marginal Analysis: Example 1

John is about to buy a $20 headphones at the store next to his apartment. A friend tells him that the same headphones are available at Wal-Mart 2 miles away for $10. (Assume that if the headphone malfunctions under warranty, you must send it to the manufacturer for repairs).

Should he buy at the store near his apartment or at Wal-Mart?

Marginal Analysis: Example 2

John is about to buy a laptop for $999 at the store next to his apartment. You can get the very same laptop at Wal-Mart 2 miles away for $989. (Same guarantees; no matter where you buy it, you have to send it to the manufacturer for repairs).

Where should John buy the laptop?

Marginal Analysis: Example #3

You have two business trips coming up and a discount coupon you can use on only one of them.

You can save either $90 on your $200 trip to Chicago OR

You can save $100 on your $1000 trip to Tokyo

For which trip should you use the coupon?

Thinking at the Margin: Example #4

You have $300 in a piggy bank which you are walking through the woods to bring to the bank. You trip and fall, break the piggy bank, and your money is scattered thoughout the woods.

In the first hour, you find all of the $20 and $10 bills for $200

$200 in one hour is very good

In the second hour, you find the smaller bills and bigger denomination coins for a total of $99

$99 in one hour is pretty good

You have $1 in 100 pennies to find. It will take you an hour to gather them

Is it worth an hour of your time to get $1? Probably not.

This is marginal analysis: is it worth one more hour of your time to get $1 in additional benefits?

Marginal Benefits = $1 and marginal costs = 1 hour of your time

Wrong ways to analyze:

I just earned $300 in 3 hours for an average of $100 an hour.

After 2 hours I earned $149.50 per hour. That’s a lot per hour. I should work another hour.

Marginal Analysis: Problem

In the following examples, how would you use marginal analysis to make a decision:

Deciding how many days to wait to do your laundry

Deciding how much library research to do before writing a paper for this class

Deciding how many bags of potato chips to eat

Deciding how many lectures of a class to skip

Answers to Marginal Analysis Problem

Each day you wait to do your laundry imposes an additional cost: you have less clean clothes. Each day you wait also provides an additional benefit: you get to do what you want and you do not have to do laundry. You will wait another day as long as the additional (marginal) benefit you get from waiting another day is greater than the additional (marginal) cost of waiting another day. Once you have no clean clothes, the marginal cost of waiting another day becomes very high, the marginal benefits of waiting are not greater than these higher marginal costs and you do laundry.

The more research you do, the better the paper will be and presumably the higher your grade. But spending an additional hour on research imposes an additional cost: you cannot do other things you probably would enjoy better. So, you will work another hour on the research paper if the marginal benefits in terms of an improved grade from that additional hour are greater than the additional costs of not doing something you would prefer to do.

Each bag of chips confers you a benefit: it satisfies your hunger. But it also has an additional cost: the cost of the bag of chips plus potential weight and health concerns. You will have another bag of chips as long as the marginal benefit of the additional bag of chips (solving hunger issues) is greater than the marginal costs of the bag of chips (its costs plus the increase in negative effects on weight and health)

Every lecture you skip implies a cost: you may fall further behind in the material and you will have to learn the material yourself. The benefit of skipping the lecture is that you can spend that time doing other things. If your marginal benefit from doing other things is greater than the marginal cost of skipping the lecture (having to learn the material yourself and potentially a poorer grade), you will skip the lecture

Thinking at the Margin

Thinking at the Margin: you are thinking about what the next or additional action does for you. Let the past go and think forward to the next hour, day, year or $ spent.

If an extra hour of weeding in your garden gets you 12 extra tomatoes, the marginal benefit of the 1 hour of your time is 12 tomatoes

The additional cost is the 1 hour of leisure time that you could be doing something else (such as watching TV)

If one additional Facebook friend costs you an additional 10 minutes of your time paying attention to him/her, then the marginal cost is 10 minutes of your time for each new Facebook friend

You drive around the block to find the perfect parking space on the streets of a crowded city, and keep on driving and keep on driving or you can stop searching and spend $10 in a parking lot. What matters is what you do in the future – not what happens in the past. Your past driving around searching should not affect your decision to spend $10 in a parking lot.

Thinking at the margin means weighing future options, not dwelling on the past.

You should look at the additional benefits and costs starting afresh of the next few minutes of your time

At the margin, you could get a parking spot for $10 or you could find the perfect spot at a 20% probability

The amount of searching for a parking spot in the past should have no bearing on this decision

Sunk Cost Fallacy: Marginal Analysis and Sunk Cost

Costs that have already been spent and cannot be recovered are irrelevant to any decision using marginal analysis

Sunk Costs: costs that have already been incurred and cannot be recovered

Whether you decide or not to go ahead with the decision, your sunk costs will still be the same

You have no control over sunk costs so they are not part of any decision making process

Ex, when you buy some product then after some time you decide to sell it. what the sunk cost= is the depression of the price** mine

Sunk Costs: Example #1

You have spent $100 to go to a concert on February 2nd. You find out later that your best friend is having a party on the same night. You know for certain that you will have a better time at the party. Assuming that the ticket cannot be resold, should you go to the party?

The sunk costs are the $100. You will spend that whether you attend the concert or not.

Spend $100, go to the concert and have a relatively bad time?

Spend $100, go to the party, and have a relatively good time. YES!

The $100 should not be considered in deciding to go the party or not. You will spend $100 whether you go to the party or not.

You will be better off going to the party: you will still be out $100 but you will have a better time at the party

Sunk Cost Examples

“I came all of this way, so I might as well buy something”

“I need to get my value worth at an all you can eat buffet”

“I fixed up my 10 year old car for $500. A week later I discovered another problem that will cost $1,000 to fix. Since I decided last week that I wanted to keep my car, I’m going to pay for the repair.”

“I hate the treadmill we have at home, but I’m not gonna pay for a gym membership.”

Heard at a garage sale: “Are you trying to rob me? I paid good money for this lawn furniture when I bought it!”

Any price or thing I paid for products in the past is irrelevant, the important thing what the value today ***sami,

Sunk Costs: Example #2

Suppose your very wealthy friend gives you a Van Gogh painting as a wedding present

During a party, a drunken guest plunges a knife through the painting.

Would you say that since you paid nothing for the painting, you are even?

Historical Costs are not Relevant to Your Decision Making/Actions

Replacement Costs ARE Relevant

Sunk Costs: Comment

To Think Like an Economist and avoid sunk costs fallacy: “The rest of my life begins now. What happened in the past is irrelevant”.

This way of thinking is not easy to do:

“Faulty Framing”: we tie the decision to take an action based on costs that have already been incurred

“Waste not, want not” applies to resources that have not been used yet

You can’t waste a resource that has already been used

“Cognitive Dissonance”: the knowledge that you paid a lot for that baseball ticket clashes with the realization that it isn’t really that valuable to you

What do many people do when faced with these types of decisions:

We find added attractions that make the object or action more valuable

How should you think when faced with decisions involving sunk costs?

Try to figure out if you really want to do the activity, or if it’s just the fact that you’re upset that you paid too much for something that is now not that valuable to you

HISTORY IS IRRELEVANT IN TERMS OF COSTS ……………..

SUNK COSTS SHOULD HAVE NO IMPACT ON ANY OF YOUR DECISIONS

How Businesses Make Decisions: Important Assumption #4: Firms Attempt to Maximize Profits

Profits: Revenues less Costs

Revenues are the money earned from selling goods and services

Price(P) of the good or service multiplied by Quantity of good/service sold

Revenues = P x Q

Costs: payments to labor, materials, landlords, etc. needed to make the good (including opportunity costs)

Caveats:

“Firms” do not make decisions to maximize profits; managers of the firm do

Firms may sacrifice profits today for more profits tomorrow

Investments involving costs (and lower profits) today are expected to yield higher profits in the future

Managers have to make decisions within a Firm

Firm: organization that combines and organizes resources for the purposes of producing goods and services for sale

Purchases resources or inputs of labor, capital and raw materials

Internalizes transactions which saves on transaction costs

Firms take inputs (such as labor, materials, equipment) and combine them in a way that adds value

A chef takes $30 worth of ingredients and makes an $80 meal

A firm pays $100 to its inputs to make a good/service and produces a good/service that sells for $150

Just like a chef uses his/her talents to create a meal that costs far more than its inputs, a firm takes its inputs to produce a good/service to do the same thing

Firm’s Decisions

What Goods/Services to Produce?

How to Produce the Good/Service?

Where to Produce the Good/Service?

How much to Produce?

What Price to charge?

All of these decisions are done with one purpose in mind: maximize value/profits of the firm

Fixed, Variable and Average Costs

Costs: payments to inputs, such as labor, rent, materials, needed to produce a product

Total Costs = Fixed Costs + Variable Costs

Fixed Costs: Costs that do not vary with the amount of the product

Example: rent, some management salaries

Fixed costs are often called “overhead” or “indirect” costs in business

Variable Costs: Costs that vary with how much of the product is produced

Example: materials

Variable costs are often called “direct” costs in business

Average Costs: Total costs divided by the quantity of the product

How much, on average, it costs to produce any quantity of the product

Varies with the amount of the product that is sold

Average costs are also called “unit “ or “per unit” costs

Fixed, Variable and Average Costs: An Example

An entrepreneur is considering whether to charter a bus to take people from his hometown to an event in a larger city. He/she planned to provide transportation, tickets to the event, and refreshments on the bus. He gathered the data and predicted the following expenses:

Bus rental: $80

Gas expense: $75

Bus Driver: $50

Event ticket: $12.50 per person

Refreshments: $7.50 per person

What are the fixed and variable costs of each ticket for the bus trip?

Fixed, Variable and Average Costs: An Example continued

How should the entrepreneur decide whether to charter the bus: If he makes a profit

Suppose the entrepreneur expects 40 people to buy at $30 per ticket

Revenues = P x Q = $30 x 40 = $1,200

Costs: Fixed Costs + Variable Costs

= $205 + $20 x 40

= $1,005

Profits = Revenues – Costs

$1,200 – $1,005 = $195 in profits

Average Costs = Total Costs divided by Number of Tickets

= $1,005/40

= $25.1 per ticket

Opportunity Costs Are Relevant to Business Decision Making

Let’s go back to our Entrepreneur and his/her decision to charter a bus.

If he/she sells 40 tickets, he/she expects to make $195 in profits.

Suppose he/she is certain that 40 tickets will be sold. Should the bus be rented?

What are Opportunity Costs for Business?

What an owner/operator could earn from working for someone else in a similar capacity (or the cost of his/her time)

What the owner of a capital asset could have earned by not investing in the capital asset

Cost of capital

Replacement cost of an asset/materials, not the original acquisition cost

Opportunity cost of using an asset/material is the value today of that asset/material (its replacement cost) – because the replacement value is what you are giving up by using it

Examples of Opportunity Costs for Business

Barbara is a manager in a Hobby store earning $40,000 per year. She decides to open up her own Hobby store and act as the manager. Her opportunity costs of opening up her own Hobby store is the income she gave up: $40,000 per year which is the next best income producing job. Her profit from her own store should at least be $40,000 per year, or else she would be better off returning as a manager

You take $1,000 out of your savings bank where it was earning 3% a year to invest in your friend’s business. Your opportunity cost of your investment is $30, or 3% of $1000. This is the costs that you gave up by investing in your friend’s business. If your friend’s business does not return at least $30 per year, you are better off keeping the money in the savings account.

Accounting vs. Economic Profits

We have described profits as: Total Revenues less Total Costs

Accounting Profit: Include only explicit costs or out-of-pocket expenditures

Explicit Costs: explicit monetary payments used to hire, rent or lease inputs provided by other firms

Easy to Compute

Easy to Compare Across Firms

Accounting Profit = Total Revenues – Total Explicit Costs

Economic Profit: include both implicit costs and explicit costs

Implicit Costs: opportunity costs of owner or firm supplied resources

Economic Profits = Total Revenues – Total Explicit Costs – Total Implicit Costs

Hidden Cost Fallacy: failure to include opportunity or implicit costs in decision making analysis

Accounting vs. Economic Profit Problem #1

Suppose you own a building where you run a restaurant. You act as the manager of the restaurant

Monthly Revenues: $100K

Monthly Labor Costs: $40K

Monthly Food Costs: $33K

Monthly Utilities and Other Costs: $7K

Accounting Monthly Profit: $100 – $40 – $33 -$7 = $20K

Economic Profit takes into account opportunity costs:

What you could earn as a restaurant manager somewhere else: $5K a month

What you could earn if you rented your building out: $25K a month

You could earn $30K ($25K + $5K) if you decided not to run the restaurant and lease the building

Your economic profit: $20K – $5K – $25K = -$10K

You would be better off exiting the restaurant business, renting your building out and becoming a restaurant manager

Note that negative ECONOMIC profit incents firms to exit the industry.

Economic profits are a signal to put resources (your time and the building) to better more profitable/valuable uses

Accounting vs. Economic Profit Problem #2

Kevin is a lawyer working for a large law firm and earning $60,000 a year. He is contemplating setting up his own law practice.

He estimates the following costs of setting up his own office:

Rent: $10,000 a year

Legal Secretary: $20,000 a year

Rent for Office Equipment: $15,000 a year

Utilities and Supplies: $5,000 a year

He estimates that total revenues for the year would be $100,000

Assuming he is indifferent between keeping his present occupation with the large law firm and opening his own law office:

What are the accounting/explicit costs of running his own law office?

What are the opportunity/implicit costs of running his own law office?

Should the lawyer go ahead and start his own law office?

Accounting vs. Economic Profit Problem #2

Explicit Costs are: $10,000 + $20,000 + $15,000 + $5,000 = $50,000

Opportunity/Implicit Costs: $60,000 – the earning that would be foregone from his present occupation

Total Revenues: $100,000

Less:

Explicit Costs: $50,000

Implicit Costs: $60,000

Economic Profit: -$10,000

Since Economic Profit from opening his own law practice is less than zero, he should not do so.

The other way of looking at this:

Profits from staying in Large Law Firm: $60,000

Profits from opening up own office: $50.000 = $100,000 – $50,000

Since the profits from opening up his own law office are -$10,000 less than the profits from staying in Large Law Firm, he should not open up his own practice

Most Important Opportunity Cost for Firms

The most important opportunity cost is the opportunity cost of capital: incremental return on investment that a business foregoes when it elects to use funds for an internal project, rather than investing cash in a marketable security

Suppose a business invests $1M for new machinery/robotics with an expected incremental return of 7%.

Its accounting profit is thus $70,000

Suppose the firm could invest the $1M in the “stock market” and get an incremental return of 10%.

The opportunity cost of investing $1M in machinery is the incremental return that was foregone: $1M x 10% or $100,000

Its economic profit is $70,000 – $100,000 = -$30,000

The economic profit from the $1M investment is negative – indicating that the firm would be better off (make higher profits) investing its $1M in the “stock market”

If the firm invests in the machine, it will earn less than what it could earn in the “stock market”

If economic profit < $0, firm is earning less than “average” or “normal” returns on its investment

If economic profit = $0, firm is earning “average” or “normal” returns

If economic profit > $0, firm is earning above “average” or “normal” returns

The Role of Economic Profits

Economic Profits Guide Decision Making

Firms will direct resources where economic profits are highest

There’s a reason why Tom Cruise is a movie star, and does not sell insurance (even if he would be the best insurance salesman in the country)

Profit opportunities attract firms like sharks to blood

Industries with economic profits will attract more firms to enter that industry (assuming free entry)

Firms with negative economic profits will exit the industry

Marginal Analysis Applied to a Firm: Incremental Analysis

Marginal Analysis applied to a Consumer: A rational person will take an action as long as the additional benefits from that action are greater than the additional costs of that action

Marginal Analysis applied to a Firm is called Incremental Analysis:

A firm that maximizes profits will take an action as long as the additional/incremental revenues from that action are greater than the additional/incremental costs of that action

If incremental revenues > incremental costs, profits increase

Incremental Analysis

Businesses/Firms do not usually make decisions on the margin, such as whether to add 1 more unit of output

Many business decisions are between two or more alternatives:

Should the firm manufacture in house or outsource?

Should the firm build a plant with a capacity of 500 units or 1000 units?

Should the firm accept a special order with lower than “normal” prices?

Should the firm introduce a new product?

You could accumulate all of the expected total revenues and total costs incurred under each decision outcome (i.e., the income statement)

In many instances, most of the costs are the same regardless of the decision

It makes sense, in terms of time and convenience, to only concentrate on the relevant amounts

It makes sense to examine only the information that differs between the 2 decisions

Incremental Analysis: Relevant Amounts

Relevant Amounts: the amounts that differ between the 2 decisions

No matter what decision you make, the irrelevant amounts do not differ between the 2 alternatives (and therefore do not affect impact on profitability)

Revenues and costs that do not differ under alternatives are not relevant and should be ignored in incremental analysis

Revenues and costs that differ are relevant and should be considered in the analysis.

Incremental Analysis: Relevant Amounts (cont.)

Opportunity Costs are always relevant

Sunk costs are never relevant

They have already been incurred

They cannot be changed no matter what decision is chosen

Depreciation is one example of a sunk cost.

Fixed Costs may or may not be relevant, depending upon the type of decision

In deciding to whether to increase output at an existing factory, fixed costs such as rent of the factory, would not be relevant

In deciding to whether to build a new factory versus staying in an existing factory, the increase or decrease in rent would be relevant.

Allocated Fixed Costs are never relevant.

How to Perform Incremental Analysis #1

An owner of a small ice cream parlor has been in business for 1 year.

Should she stay in business?

Would opening for longer hours help her business?

MONTHLY REVENUES:

Average purchase price: $3.00

Average # of customers per day: 240

Number of days open per month: 26 (8 hours per day)

Monthly Revenues = 240 customers per day x $3.00 per customer x 26 days

= $18,720

How to Perform Incremental Analysis #1 (cont.)

MONTHLY FIXED COSTS:

Rent: $2,500

Electricity: $400

Interest on Loan: $1,000

Maintenance: $350

Other Utilities: $150

$4,400

VARIABLE COSTS:

2 employees paid $10 hour: $20 per hour

Cost of ice cream: $5 per gallon (serves 12 customers) or $5 /12 = $0.417 per customer

Monthly Variable costs:

Monthly Cost of Labor: $20 per hour x 8 hours per day x 26 days = $4,160 labor costs each month

Monthly Cost of Ice Cream: 240 customers per day divided by 12 customers per gallon = 20 gallons per days

: 20 gallons per day x 26 days = 520 gallons per month

: 520 gallons per month x $5 per gallon = $2,600 per month in costs of ice cream

Or $0.417 per customer x 240 customers per day x 26 days = $2,6000 per month

TOTAL MONTHLY COSTS = MONTHLY FIXED COSTS + MONTHLY VARIABLE COSTS

= $4,400 + $4,160 (labor) + $2,600 (ice cream)

= $11,160

How to Perform Incremental Analysis #1 (cont.)

MONTHLY PROFITS = REVENUES – COSTS

= $18,720 – $11,160

=$7,560

This is accounting profit……does not take into account opportunity costs of the owner’s time in running/managing the ice cream store and opportunity costs of any investment of money/capital in the ice cream store

How to Perform Incremental Analysis #1 (cont.)

Should she open store longer?

Normal operations are noon until 8pm

Should she open store until 11pm?

Owner decided to open store until 11pm on an experimental basis for 1 month. The following table shows the number of additional customers for each of the added hours.

8 – 9 pm 40 customers

9 -10 pm 20 customers

10 – 11 pm 5 customers

Assume that each customer spends an average of $3

How to Perform Incremental Analysis #1 (cont.)

1. Identify incremental revenues from staying open longer

2. Identify and compare the costs from staying open longer–both fixed and variable costs

Costs that do not differ between the alternatives are irrelevant. OMIT them.

How to Perform Incremental Analysis #1 (cont.)

3. Determine the impact on profits (Revenues Less costs)

Take the action if profits increase; do not if profits decrease.

She should open the store from 8 – 10pm, but not from 10 -11pm

Continue to monitor number of customers in the new 8-10pm hours

Incremental Analysis: Question #1

What were the relevant revenues and costs that Amazon should consider relative to its decision to offer the Prime free-shipping subscription?

Incremental Analysis: Answer #1

Incremental Revenues: increase in revenues from offering free shipping plus the $99 fee

Incremental Costs: increase in shipping costs

JamCo currently sells 100,000 units of its product. The company has revenue and costs as shown below:

Incremental Analysis #2: Special Order Decisions

Note that “Operating Income” is an accounting term which represents “profits (before taxes)”

Sales = Revenues

JamCo is approached by an overseas company that offers to purchase 10,000 units at $8.50 per unit.

If JamCo accepts the offer, total factory overhead will increase by $5,000; total selling expenses will increase by $2,000; and total administrative expenses will increase by $1,000.

Should JamCo accept the offer?

Special Order Decisions

First let’s look at incorrect reasoning that leads to an incorrect decision.

Our cost is $9.00 per unit. I can’t sell for $8.50 per unit.

Special Order Decisions

AVERAGE OR PER UNIT COSTS ARE IRRELEVANT

This analysis leads to the correct decision.

Special Order Decisions: Incremental Revenues and Cost

$3.50 x 10,000

$8.50 x 10,000

$2.20 x 10,000

Even though the $8.50 selling price is less than the

normal $10 selling price, JamCo should accept the offer because profit will increase by $20,000.

Special Order Decisions

Exitel makes computer chips used in one of its products. Per Unit or Average costs, based on production of 20,000 chips per year, are:

Incremental Analysis #3: Make or Buy Decisions

An outside supplier has offered to provide the 20,000 chips at a cost of $25 per chip. Fixed overhead costs will not be avoided if the chips are purchased. Exitel has no alternative use for the facilities.

Should Exitel accept the offer?

Make or Buy Decisions

Make or Buy Decisions

Incremental costs of making one chip in house:

It costs $15 to make 1 additional chip in house

Exitel should not pay $25 per chip to an outside supplier, when it costs $15 to make 1 chip

Fixed Cost, such as overhead, are irrelevant to the decision because Exitel wll incur these fixed costs

whether it makes or buys the chips

If Exitel buys the chips from the outside supplier, the idle facilities could be leased to another company for $250,000 per year.

Should Exitel buy the chips and lease the facilities?

Make or Buy Decisions

Make or Buy Decisions

The opportunity cost of facilities changes the decision.

Since Exitel gets incremental $250,000 in lease revenue if it buys the chip, buying chips now increases

profits .

Sunk Costs in Incremental Analysis: Example #1

Bob is a house builder and must pay $10,000 for homebuilder’s license on January 1, 2018. The fee is non-refundable.

It is December 1, 2017 and Bob is deciding whether he should continue as a housebuilder in 2018. Should Bob consider the $10,000 fee in his decision?

It is July 1, 2018, and Bob is deciding whether he should continue homebuilding for the rest of the year. Should Bob consider the $10,000 fee in his decision?

No, the $10,000 is a sunk cost and cannot be recovered.

Whether he stays in business or not, he will still be out $10,000 since the license fee is not refundable

If instead the local government decided that $2,000 of the license was refundable, what are his sunk costs?

His sunk costs are now $8,000. If he decided not to continue as a house builder, he would NOT be able to recover $10,000 – $2,000= $8,000, since $2,000 is refundable.

Sunk Costs in Incremental Analysis: Example #2

Suppose we spend a $1M on June 1st for a large machine which will enhance productivity.

On June 2nd, a sales representative offers to sell us a competitive machine for $500,000; this machine has twice the productivity of the one purchased on June 1st.

In this classic case of “buyer’s remorse,” it is tempting to we now have a $1.5 million decision.

However, the million spent on machine #1 is a sunk cost.

If the second machine really will have the stated impact on productivity, it would be foolish not to spend the money (assuming it is available)

However, no matter what we do, the $1M is gone and is irrelevant to the decision about whether to buy machine #2.

Common Mistakes in Incremental Analysis

Allocating fixed costs/overhead

Allocating sales costs to the introduction of new products

Not including “cannibalization” in the introduction of new products

Not including opportunity costs

Incremental Analysis: Qualitative Factors

Quantitative Factor: analysis of incremental revenues and incremental costs

Qualitative Factors: are numerous and many times outweigh the numerical answer

Employee morale

Customer satisfaction

Safety

Goodwill as a corporate citizen

Other Practical Aspects of Incremental Analysis

Uncertainty: incremental analysis usually relies on forecasts/guesses

Data integrity: incremental analysis relies on gathering data which usually is not “perfect”

Impact of Time on Incremental Analysis

In all of the analysis and examples so far, we assumed that the additional revenues and additional costs happened in the current time period or year

And the rule was to take the action if the incremental revenues in the current time period were greater than the incremental costs in the same time period (on increased current time period’s profits)

How does incremental analysis change if the additional revenues and/or additional costs are predicted to occur over several years?

All investment decisions involve a tradeoff between incurring a cost today with the expectation of future gains.

You buy an apartment building for $1M today with the expectation that the revenues from charging rents in the future will offset the costs

The investment of $20M for the development of a new product today is expected to be offset by revenues from the new product for a number of years in the future

How do you know if the future benefits are greater than the current investment/costs?

Time Preferences

People generally prefer to have something today rather than later

If I have $100 today, I can invest it, earn interest or some kind of return on the $100

So, I would prefer to have $100 today rather than $100 later

When doing incremental analysis, the costs and benefits might occur in the future. But we need to make a decision today.

We want the $ in future benefits and costs to be comparable to $ today

DISCOUNTING: process of adjusting future value $ into current $ values

Time Value of Money:

To make decisions based on future additional costs and revenues , you compare current and future costs and revenues using a rate of return

This rate of return represents the time value of money:

Rate of Return: % return from what the firm could earn by investing its money elsewhere.

Or

Rate of Return: the cost of acquiring the funds to make an investment

This rate of return is often called the “Cost of Capital” or “Discount Rate”

The cost of capital or discount rate is a “hurdle” rate:

If my return on an investment in the project is less than the cost of capital, we should invest the money elsewhere (and earn the cost of capital)

Compounding and Discounting

Suppose the firm has a cost of capital of 10%

If it had $100 today, it could have $110 in 1 year by investing elsewhere

Future value of $100 today is $110 = $100 x (1 + .10) a year from now

Future value of $100 today is $121 = $100 x (1 +.10)2 two years from now

Future value of $100 today is $133 = $100 x (1 +.10)3 three years from now

FV = PV x (1 + r)k where r = rate of return

k = number of periods into the future

This is Compounding where “r” is the compound interest rate

Inverse of Compounding is called Discounting

How much is $110 a year from now worth today if the rate of return is 10%: $100

PV = FV / (1 + r)k

Decision Making over Time

Suppose a firm is trying to decide whether to make an Initial Investment of $1M in order to introduce a new product

The firm expects to recoup its costs of $1M via returns (in cash) over the next five years (the life of the product)

Returns are the Cash Receipts Less Cash Expenditures

Or

Revenues Less Cash Expenses = Net Cash Flows

It should only make the investment if its incremental (discounted) returns over the next 5 years is greater than its initial investment of $1M

Projecting the Future Returns from an Investment

One of the most important and difficult aspects of analyzing investments over time is the estimation of future Net Cash Flows

Net Cash Flows: Cash Revenues less Cash Expenses

Forecast of Net Cash Flows entails a great amount of uncertainty

Guidelines for Forecasting Net Cash Flows:

Cash Flows should be measured on an incremental basis

Revenues (Costs) should be measured by the difference in revenues (costs) with and without the investment

Incremental costs can include incremental fixed and variable costs and taxes (but not sunk costs)

Cash Flows should be measured on an after-tax basis, using the firm’s marginal tax rate

Non-Cash expenses, such as depreciation and amortization, should only be included through their effect on taxes

Include salvage value of the equipment at the end of its economic life

NPV (Net Present Value) Methodology

NPV Methodology to Decide whether to Invest

Forecast the future additional revenues/benefits from the action

Forecast the future additional (cash) costs from the action

Calculate Net Cash Flows: Difference between Revenues and Costs

Discount the Net Cash Flows

Calculate the Net Present Value (NPV) = sum of the discounted net cash flows less the initial investment

NPV = Sum of discounted Cash Flows – Initial Investment

6. If the Net Present Value (NPV) is greater than zero, then the action earns more than the firm’s cost of capital (what the firm could earn elsewhere) and should be undertaken

Or

The Present Value of the returns from the project is greater than the current cost of the investment

Other Criteria for Evaluating Investments

Internal Rate of Return(IRR): rate of return that equates the present value of the net cash flows to the initial cost of the project

The firm should undertake the project as long as the IRR is greater than its cost of capital

If NPV>0 then IRR will be greater than the cost of capital (most of the time)

If NPV<0 then IRR will be less than the cost of capital

If NPV=0, then IRR will equal the cost of capital

The IRR measures the return from your initial investment

Payback Period: how many years it takes for NPV to equal zero.

Both of these are generally considered inferior to the NPV method

Note: Some Venture Capitalists require a calculation of IRR, which can be done in Excel.

Strategies for Maximizing NPV

Postpone costs as much as possible

Take in revenues as early as possible

The higher the discount rate, the lower the NPV

The more aggressively the above 2 strategies should be pursued

Present Value Problem #1

Suppose a firm estimates that it needs to make an initial investment of $1M in order to introduce a new product.

The Marketing division estimates that the product’s expected life is 5 years.

The Marketing division estimates that initial sales will be $1M and increase by 10% each year

The Production department estimates that variable costs will be 50% of incremental revenues and that fixed costs will increase by $150,000 each year.

The Finance Department estimates a marginal tax rate of 40%

The Finance Department uses straight line depreciation so that annual depreciation expense will be $200,000 each

The Finance Department estimates the salvage value of the original $1M investment of $250,000

Present Value Problem #1 continued

The following incremental revenues and costs are estimated:

Present Value Problem #1 continued

Should the firm undertake the $1M investment and introduce the new product?

Need to calculate NET CASH flows and calculate NPV

Present Value Problem #1 continued

Assuming the firm’s cost of capital is 12%., calculate NPV:

PV of the net cash flows:

PV = $290,000 + $320,000 + $353,000 + $389,300 + $679,230

(1 + 0.12)1 (1 + 0.12)2 (1 + 0.12)3 (1 + 0.12)4 (1 + 0.12)5

= $1,398,110

NPV = sum of the discounted cash flows less initial investment

= $1,398,110 – $1,000,000

= $398,110

The project would add to the long-term profits of the firm and should be undertaken

Do you have to know this formula?

This type of calculation can also be done in Excel using the “NPV” formula

Present Value Problem #2

You are contemplating the purchase of a new machine that will cost $300,000 and has a useful life of 5 years.

The machine will yield cost reductions of :

$50,000 in Year 1

$60,000 in Year 2

$75,000 in Year 3

$90,000 in Year 4

$90,000 in Year 5

With a cost of capital of 8%, should you purchase the machine?

Present Value Problem #2 continued

By spending $300,000 today, costs will be reduced by $365,000 over 5 years.

PV of the cost savings:

PV = $50,000 + $60,000 + $75,000 + $90,000 + $90,000

1.08 1.082 1.083 1.084 1.085

= $284, 679

Net Present Value = PV of the discounted cash flows less initial investment

= $284,679 – $300,000

= -$15,321

Since NPV is negative, you should not purchase the machine.

You could earn more by investing the $300,000 at 8% than by spending the money on the cost-saving technology

Present Value Problem #3

Suppose Delta Airlines offered a 4 year membership into its Sky Club for $450. Alternatively, one could purchase a 1 year membership for $120.

Suppose you wish to join for 4 years and you do not expect that Delta will change its prices in the future

On the surface, you save $30 by buying a 4 year membership ($120x 4 = $480) but this ignores the time value of money

Suppose interest rates were 10%

PV of the cost of a 4 year membership = $450 since all of the money is paid today

PV of the cost of four 1 year memberships:

PV = $120 + $120/1.10 + 120/(1.10)2 + 120/(1.10)3

= $120 + $109 + $99 + $90

=$418

In present value terms, given that you could earn 10% interest on your cash, it would only “cost” you $418 to buy 4 one year memberships vs. $450 for a 4 year memberships.

You would need $109 today, earn 10% interest for one year, and have $120 1 year from now to pay for the 1 year membership

You would need $99 today, earn 10% interests for 2 years, and have $120 2 years from now to pay for the 1 year membership

You only need $418 cash today, expected to earn 10% annually, to pay for your $120 membership fee each year for 4 years

Rules for Business Decision Making/Problem Solving

To make good business decisions, ONLY consider the additional revenues and additional costs from the consequences of making that decision.

Only consider the revenues and costs that vary with the decision

If the additional revenues are greater than the additional costs from the action, consider taking that action.

For decisions over time, take the action if NPV > 0

Use RELEVANT revenues:

Consider ALL revenues impacted by the decision

Introduction of a new product may affect the revenues of other products of the firm

Use RELEVANT cost:

Look to the future and consider all costs that are impacted by the action

Average Costs are not relevant to any decision

Sunk/Fixed Costs Fallacy: Including costs that are not relevant to any decision

Usually involve overhead costs and depreciation

Hidden Cost Fallacy: ignoring Opportunity Costs such as the

Cost of your time as owner/manager

Cost of your capital or investment

Cost to replace capital goods (not the acquisition cost)

Do NOT rely on accounting costs!

107

DateTopicsEvaluationsChapters

Aug 20

1. How to Think Like and

Economist: Scarcity,

Tradeoffs and Rational

Actors

Problem Set #1 available (Covering

Topics 1-2)

1-3

Aug 22, Aug 27

2. How to Think Like an

Economist: Benefits, Costs

and Incremental Analysis

Problem Set #2 Available on Aug 27th

(Covering Topics 3-4)

3, 4,5

Aug 29 – 31Quiz #1 (covering Topics 1-2)

Aug 29

3. How to Think Like an

Economist: Supply and

Demand, Elasticity

6, 8,9

Sep 3NO CLASS – HOLIDAY

Sep 5

3. How to Think Like an

Economist: Supply and

Demand, Elasticity

Problem Set #1 Due at 10AM6, 8,9

Sep 6 -9Quiz #2 (covering Topic 3)

Sep 10, Sep 12

3. How to Think Like an

Economist: Supply and

Demand, Elasticity

4. How to Think Like an

Economist: Markets

9, 10

Sep 13-16Quiz #3 (covering Topic 4)

Sep 17Preparation for MidtermProblem Set #2 Due at 10AM

Sep 19

In class MidtermMidterm (covering Topics 1-4)

Sep 24, Sep 265. Pricing

Problem Set #3 Available (Covering

Topics 5-7)

12,13, 14

Sep 27-30Quiz #4 (covering Topic 5)

Oct 1, 36. Games, Bargaining15,16

Oct 4-7Quiz #5 (covering Topic 6)

Oct 8

7. Employee Incentives and

Vertical Integration

21, 23

Oct 10Preparation for FinalProblem Set #3 Due at 10AM

Oct 9 -12Quiz #6 (covering Topic 7)

Oct 13- Oct 15

On Line FinalFinal (covering Topics 5-7)

Oct 15

No Class

IncrementalIncremental

HoursCustomersRevenueCosts

8 – 9 pm4040 customers x $3.00 = $120.00Labor: 2 x $10 per hour =$20.00

Ice Cream: 0.417 per customer x 40 customers$16.67

$36.67

9 – 10 pm2020 customers x $3.00 = $60.00Labor: 2 x $10 per hour =$20.00

Ice Cream: 0.417 per customer x 20 customers$8.34

$28.34

10 – 11 pm55 customers x $3.00 = $15.00Labor: 2 x $10 per hour =$20.00

Ice Cream: 0.417 per customer x 5 customers$2.09

$22.09

IncrementalIncremental

HoursCustomersRevenueCostsProfits

8 – 9 pm40$120.00$36.67$83.33

9 – 10 pm20$60.00$28.34$31.66

10 – 11 pm5$15.00$22.09($7.09)

Per Unit Total

Sales10.00$ 1,000,000$

Direct materials3.50 350,000

Direct labor2.20 220,000

Factory overhead1.10 110,000

Selling expenses1.40 140,000

Administrative expenses0.80 80,000

Total expenses9.00$ 900,000$

Operating income1.00$ 100,000$

Sheet1

Per Unit Total
Sales $ 10.00 $ 1,000,000 100,000
Direct materials 3.50 350,000
Direct labor 2.20 220,000
Factory overhead 1.10 110,000
Selling expenses 1.40 140,000
Administrative expenses 0.80 80,000
Total expenses $ 9.00 $ 900,000
Operating income $ 1.00 $ 100,000
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Sheet15

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Sheet16

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Current

Business

Additional

Business

Combined

Sales

1,000,000

$

85,000

$

1,085,000

$

Direct materials

350,000

$

35,000

$

385,000

$

Direct labor

220,000

22,000

242,000

Factory overhead

110,000

5,000

115,000

Selling expenses

140,000

2,000

142,000

Admin. expenses

80,000

1,000

81,000

Total expenses

900,000

$

65,000

$

965,000

$

Operating income

100,000

$

20,000

$

120,000

$

Sheet: Sheet1

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Sheet: Sheet10

Sheet: Sheet11

Sheet: Sheet12

Sheet: Sheet13

Sheet: Sheet14

Sheet: Sheet15

Sheet: Sheet16

Current Business

Additional Business

Combined

Sales

1000000.0

85000.0

1085000.0

Direct materials

350000.0

35000.0

385000.0

Direct labor

220000.0

22000.0

242000.0

Factory overhead

110000.0

5000.0

115000.0

Selling expenses

140000.0

2000.0

142000.0

Admin. expenses

80000.0

1000.0

81000.0

Total expenses

900000.0

65000.0

965000.0

Operating income

100000.0

20000.0

120000.0

Sheet: Sheet1

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Sheet: Sheet6

Sheet: Sheet7

Sheet: Sheet8

Sheet: Sheet9

Sheet: Sheet10

Sheet: Sheet11

Sheet: Sheet12

Sheet: Sheet13

Sheet: Sheet14

Sheet: Sheet15

Sheet: Sheet16

Current Business

Additional Business

Combined

Sales

1000000.0

85000.0

1085000.0

Direct materials

350000.0

35000.0

385000.0

Direct labor

220000.0

22000.0

242000.0

Factory overhead

110000.0

5000.0

115000.0

Selling expenses

140000.0

2000.0

142000.0

Admin. expenses

80000.0

1000.0

81000.0

Total expenses

900000.0

65000.0

965000.0

Operating income

100000.0

20000.0

120000.0

Unit Costs

Direct Material

9.00

$

Direct Labor

5.00

Variable Overhead

1.00

Fixed Overhead

13.00

Total

28.00

$

Sheet: Sheet1

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Sheet: Sheet6

Sheet: Sheet7

Sheet: Sheet8

Sheet: Sheet9

Sheet: Sheet10

Sheet: Sheet11

Sheet: Sheet12

Sheet: Sheet13

Sheet: Sheet14

Sheet: Sheet15

Sheet: Sheet16

Unit Costs

Direct Material

9.0

Direct Labor

5.0

Variable Overhead

1.0

Fixed Overhead

13.0

Total

28.0

Unit Cost

Direct Material

9.00

$

Direct Labor

5.00

Variable Overhead

1.00

Total

15.00

$

Sheet: Sheet1

Sheet: Sheet2

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Sheet: Sheet7

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Sheet: Sheet13

Sheet: Sheet14

Sheet: Sheet15

Sheet: Sheet16

Unit Cost

Direct Material

9.0

Direct Labor

5.0

Variable Overhead

1.0

Total

15.0

Disadvantage of buying

20,000 units × ($25 – $15)

200,000

$

Opportunity cost of facilities:

The lease revenue

250,000

Advantage of buying part

and leasing facilities

50,000

$

Sheet: Sheet1

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Sheet: Sheet3

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Sheet: Sheet7

Sheet: Sheet8

Sheet: Sheet9

Sheet: Sheet10

Sheet: Sheet11

Sheet: Sheet12

Sheet: Sheet13

Sheet: Sheet14

Sheet: Sheet15

Sheet: Sheet16

Disadvantage of buying

20,000 units × ($25 – $15)

200000.0

Opportunity cost of facilities:

The lease revenue

250000.0

Advantage of buying part

and leasing facilities

50000.0

Year

12345

Sales$1,000,000$1,100,000$1,210,000$1,331,000$1,464,100

Less

Variable Costs500,000550,000605,000665,500732,050

Fixed Costs150,000150,000150,000150,000150,000

Depreciation200,000200,000200,000200,000200,000

Profit Before Taxes$150,000$200,000$255,000$315,500$382,050

Less

Income Tax60,00080,000102,000126,200152,820

Profit After Tax$90,000$120,000$153,000$189,300$229,230

Year

12345

Sales$1,000,000$1,100,000$1,210,000$1,331,000$1,464,100

Less

Variable Costs500,000550,000605,000665,500732,050

Fixed Costs150,000150,000150,000150,000150,000

Depreciation200,000200,000200,000200,000200,000

Profit Before Taxes$150,000$200,000$255,000$315,500$382,050

Less

Income Tax60,00080,000102,000126,200152,820

Profit After Tax$90,000$120,000$153,000$189,300$229,230

Plus

Depreciation200,000200,000200,000200,000200,000

Salvage Value250,000

Net Cash Flow$290,000$320,000$353,000$389,300$679,230