Microeconomics Primer

Professor David Besanko Kellogg School of Management Northwestern University
November 17, 2009
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
OBJECTIVES: Provide introduction to some basic microeconomic concepts that will be useful for consulting interviews Illustrate how these concepts can be used, in conjunction with case facts, to develop hypotheses about situations with ambiguous or messy fact patterns. Goal is not to explore the deeper theoretical dimensions of the concepts themselves ROAD MAP: Price elasticity of demand Relevant costs and decision making Industry cost curves
Price Elasticity of Demand Relevant Costs and Decision Making Industry Cost Curves
Price Elasticity of Demand: percentage change in quantity demanded per one percent change in price
Price Inelastic demand
Elastic demand
D1
D2
Quantity
Price Elasticity of Demand: percentage change in quantity demanded per one percent change in price
Price Inelastic demand

$1.20 $1.00
Elastic demand
D1
D2 2 9 10
Quantity
Along D1: %Q = - 80% and %P = +20%, so price elasticity = - 80%/20% = - 4.0 Along D2: %Q = - 10% and %P = +20%, so price elasticity = - 10%/20% = - 0.5
In general, If
< eQ,P < 0
eQ,P is between 1 and -
eQ,P is between 0 and 1, we demand is inelastic.
, we say demand is elastic.
Market-level price elasticity of demand:
What happens to market demand for a product when the prices of all brands in the market go up or down at the same time?
e.g., due to increases in the prices of raw materials such as aluminum, the prices of new automobiles rises by 5%. What is the percentage change in the quantity of new automobiles demanded?
Brand-level price elasticity of demand:
What happens to the demand for a particular brand when the price of that brand goes up or down, holding the prices of other brands fixed?
e.g., BMW announces that the price of its line of 325 vehicles will go up. The prices of other makes of cars (including BMWs) remains the same. What is the percentage change in the quantity of BMW 325s demanded?
Price elasticity of market demand for automobiles is on the order of - 1 and - 1.5
Price elasticity of demand for BMW 325 is on the order of - 3.5 to - 4.

Price elasticity of demand for individual brands, such as Captain Crunch, is on the order - 2 to - 4.
Price elasticity of demand for ready-to-eat breakfast cereal in the U.S. is on the order of - 0.25 to - 0.5.
Substitution Opportunities
Do consumers have readily available substitutes to which they can switch?

Expense Relative to Budget
TENDS TO MAKE DEMAND MORE PRICE SENSITIVE
YES
Demand is very sensitive to price
e.g., high-end discretionary consumer durables such as boats or motorcycles
NO Demand is moderately sensitive to price

e.g., automobiles or consumer appliances
Do expenditures on the good account for a large fraction of the buyers budget?
YES
TENDS TO MAKE DEMAND MORE PRICE SENSITIVE
NO
Demand is moderately sensitive to price

e.g., consumer packaged goods that have close substitutes such as butter or paper towels
Demand is very insensitive to price

e.g., electricity for residential users
In 2002, some airlines (e.g., Continental, Delta) experimented with cuts in unrestricted walk-up fares (generally used for business travel)
e.g., Delta lowered walk-up fares by about 21 percent in small markets over a seven-week period Fare cuts were generally matched by competing airlines in these markets Conventional wisdom: cuts in unrestricted walk-up fares result in decreases in total revenues Results of Deltas experiments: double-digit increase in total revenue
What does conventional wisdom assume about the price elasticity of demand for business air travel? What do Deltas pricing experiments tell us about the price elasticity of demand for business air travel?
10
Suppose your company contemplates a temporary shut-down of one of its factories for a period of one year.
Consider all categories of cost associated with the existence of this factory, the production of output in this factory, and the possible shut-down of this factory: Which categories are relevant to the shut-down decision?
Relevant costs:
What costs do you avoid if you shut down this factory? What extra costs
do you incur if you shut down this factory? These are categories that are relevant. Costs whose level is not affected by the shut-down decision are irrelevant to the shut-down decision
12
At current output level, total revenue = $100,000/month total cost = $120,000/month Costs consists of labor, materials, and leasing expenses
Keep factory open and produce at current volume Your choice
Labor and Leasing Total Revenue Materials expense cost (000) (000) Costs (000) (000)
$100
Cash flow (000) -$20
$50
$70
$120
Shut the factory down over the next year
$0
$0
This bucket of costs goes away if we shut down: it is non-sunk
$70
$70
-$70
This bucket of costs does not go away if we shut down: it is sunk 13
Client: business unit of a large diversified company. Produces different types of valves used in industrial process control systems
Product Line Profitability Analysis for Clients Product Lines, FY 2009 Per unit revenue Direct materials costs (per unit) Manufacturing overhead and selling expenses (per unit) * Corporate overhead charge (per unit)** Total cost (per unit)
Digital Pressure Vacuum control reducing regulating valves valves valves $10.00 $9.00 $3.00 $3.50 $6.00 $4.00
Business unit is profitable:

Total revenue: $163,000,000 Total cost: $156,500,000 Total profit: $6,500,000
$0.20
$0.40
$1.00
Question: should it drop one of its product lines? Average profit per unit of vacuum regulating valves was negative last year. Seems like a no-brainer, right?
$5.00
$8.20 $1.80
$5.00
$8.90 $0.10
$5.00
$10.00 ($4.00)
Profit (per unit)
Annual unit sales (thousands)
10,000 5,000
3,000
* Directly traceable to each product line ** $90,000,000 of corporate level overhead is allocated to the business unit. Per unit charge is $90,000,000. total number of units sold by business unit
14

$0.20
$0.40
$1.00
Profit (per unit)
$6.00 $5.00 $9.20 $8.20 $0.80 $1.80
$6.00 $5.00 $5.00 $9.90 $8.90 $10.00 $(0.90) $0.10 ($4.00) 3,000
10,000 5,000
15

$0.20
$0.40
$1.00
Profit (per unit)
$9.00 $5.00 $5.00 $12.20 $8.20 $8.90 ($2.20) $1.80 $0.10 10,000 5,000
$5.00
$10.00 ($4.00)
3,000
16
Keep vacuum reg. valves
Valve type Digital Pressure-red. Vacuum reg. TOTAL (thousands)
Total Revenue $100,000 $ 45,000 $ 18,000
Total Direct Costs $30,000 $17,500
Total Mfg. OH & Selling Cost $ 2,000 $ 2,000
Total Corp. OH
Total Profit
$12,000 $ 3,000
$163,000
$59,500 $ 7,000 $90,000 $ 6,500
Drop vacuum reg. valves
Valve type Digital Pressure-red. Vacuum reg. TOTAL (thousands)
Total Revenue
Total Direct Costs
Total Mfg. OH Total & Selling Corp. OH Cost $ 2,000 $ 2,000 $ 4,000
unavoidable!
Total Profit
$100,000 $30,000 $ 45,000 $17,500 $145,000 $47,500
$90,000 $3,500
17
Total cost (TC): sum total of all of the firms operating costs
Marginal cost (MC): the rate at which total cost changes as the volume of production changes i.e., MC = DTC/DQ cost per unit of the last unit produced Average total cost (ATC): total cost per unit, i.e., ATC = TC/Q Operating cost per unit, averaged over all units produced
Example: It costs me 100 minutes to make 20 slides in a PowerPoint deck. It will cost me 115 minutes to make 21 slides
TC of 20 slides = 100 minutes, TC of 21 slides = 115 minutes ATC of 20 slides = 100/20 = 5 minutes per slide; ATC of 21 slides = 115/21 = 5.48 minutes per slide MC of the 21st slide = 15
18
Full-reinvestment total cost (FRTC): sum total of all of the firms operating costs plus
the cash flow needed to achieve a cost-of-capital return on long-run sunk investments needed to enter the business and grow it. This is called the capital charge Thus: FRTC = TC + capital charge
Full-reinvestment average total cost (FRATC): total cost per unit, i.e., FRATC = FRTC/Q Full-reinvestment cost per unit, averaged over all units produced
19
Textbook concept
MC, marginal cost
Consultant lingo
Marginal cost or incremental cost
Usually relevant for

Incremental changes in production volume Pricing decisions
ATC, average total cost
Cash cost
Capacity idling or withdrawal decisions Dropping product lines Capacity expansion decisions New market entry decisions R&D investment decisions
FRATC, full-reinvestment average total costs
Full reinvestment cost
20
Cash Costs By Nickel Mine in Global Nickel Industry, 2004

Mine Cawse Murrin Murrin Soroako Leinster Mt Keith Raglan Ontario Division Kambalda Sudbury Cerro Matoso Manitoba Division Falcondo Forrestania Capacity (kt) 4.4 27.0 50.0 35.9 42.0 21.0 103.0 12.0 40.0 28.8 46.0 32.0 7.7 Cash Cost (cents per lb) 58.5 81.4 100.3 131.3 138.7 139.5 142.3 154.1 165.9 171.9 205.0 205.0 218.2
Company Centaur Mining Anaconda Nickel Inco WMC WMC Falconbridge Inco WMC Falconbridge Billiton WMC Falconbridge Outokumpu
Country Australia Australia Indonesia Australia Australia Canada Canada Australia Canada Colombia Canada Dominican Republic Australia
Based on data from: Minecost.com, World Mine Cost Data Exchange Data altered for illustrative purposes.
22
300
250
Represent each plant by a bar whose width is plant capacity and height is cash cost. Rank each plant in merit order --- lowest cash cost to highest cash cost.
Cash cost (cents per pound)
200
Full-reinvestment cost of hypothetical new capacity
150
Centaur Mining Falconbridge Falconbridge

OutoKumpo
Anaconda Nickel
WMC
WMC
50
0 0 50 100 150 200 250 300 350 400 450 500 23
INC0
Cumulative Capacity (kilotons per year)

INCO
WMC
100
Falconbridge
Billiton
WMC
300
250
200
This tells us how much would be supplied in the long run at various possible market price scenarios! If average price is expected to be 125 over the foreseeable future, the three shaded plants would stay open Other plants are better off being idled or shut down Total supply at price of 125 is 81.
150 125
Centaur Mining Falconbridge Falconbridge OutoKumpo 450
Anaconda Nickel
WMC
WMC
50
0 0 50 81 100 150 200 250 300 350 400 500 24
INC0

INCO
WMC
100
Falconbridge
Billiton
WMC
It depends on the question! If the question is: How do changes in prices on a week-to-week or monthto-month basis affect market supply? Use marginal cost
Short run industry cost curves
If the question is: How do changes in prices over a longer period of time (say 1 year out and beyond) affect market supply? Use cash cost for existing plants and full reinvestment cost for potential plants that havent been built
Long-run industry cost curves
25
300
250
Centaur Mining 200
D1
D2
150
Falconbridge
OutoKumpo
Falconbridge
Anaconda Nickel
WMC
WMC
50
0 0 50 100 150 200 250 300 350 400 450 500 26
INC0

INCO
WMC
100
Falconbridge
Billiton
WMC
300
250
200
At this price, quantity supplied = quantity Centaur Mining demanded (market clearing price)
D1
D2
150
Falconbridge
OutoKumpo
Falconbridge
Anaconda Nickel
WMC
WMC
50
0 0 50 100 150 200 250 300 350 400 450 500 27
INC0

INCO
WMC
100
Falconbridge
Billiton
WMC
300
Suppose price of electricity in Indonesia goes up, increasing the cash cost of INCOs Indonesian mine to 120, but not affecting the cash costs of other mines. What happens to the market-clearing price?
250
Centaur Mining 200
D1
150
Falconbridge
OutoKumpo
Falconbridge
INC0 (Indonesia)
WMC
WMC
50
0 0 50 100 150 200 250 300 350 400 450 500 28
Anaconda Nickel

INCO (Canada)
WMC
100
Falconbridge
Billiton
WMC
300
Market-clearing price is not affected! Market-clearing price equals the cash cost of the highest-cost producer needed to satisfy demand
250
Centaur Mining 200
D1
150
Falconbridge
OutoKumpo
Falconbridge
Anaconda Nickel
WMC
WMC
50
0 0 50 100 150 200 250 300 350 400 450 500 29
INC0

INCO
WMC
100
Falconbridge
Billiton
WMC
300
250
INCO is the client. If demand curve is expected to be D1 for the foreseeable future, what strategies would you recommend for INCO to increase its profitability in the nickel business?
Centaur Mining
D1
200
150
Falconbridge
OutoKumpo
Falconbridge
Anaconda Nickel
WMC
WMC
50
0 0 50 100 150 200 250 300 350 400 450 500 30
INC0

INCO
WMC
100
Falconbridge
Billiton
WMC
300
One possibility: capacity withdrawal

250
Centaur Mining 200
D1
150
Falconbridge
OutoKumpo
Falconbridge
Anaconda Nickel
WMC
WMC
50
0 0 50 100 150 200 250 300 350 400 450 500 31
INC0

INCO
WMC
100
Falconbridge
Billiton
WMC
300
One possibility: capacity withdrawal

250
Centaur Mining 200
D1
150
Falconbridge
OutoKumpo
Falconbridge
Anaconda Nickel
WMC
WMC
50
0 0 50 100 150 200 250 300 350 400 450 500 32
INC0

INCO
WMC
100
Falconbridge
Billiton
WMC
300
One possibility: capacity withdrawal which shifts the cost curve

250
Centaur Mining 200
D1
150
Falconbridge 300
OutoKumpo
Falconbridge
Anaconda Nickel
50
0 0 50 100 150 200 250 350 400 450 500 33
INC0
WMC

WMC
WMC
100
Falconbridge
Billiton
WMC
300
Inco gives up
and increases the market-clearing price Is this good for Inco?
250 Centaur Mining
D1
but gains
200
Falconbridge
Falconbridge
Anaconda Nickel
50
0 0 50 100 150 200 250 300 350 400 450 500 34
INC0
WMC

WMC
WMC
100
Falconbridge
OutoKumpo
Billiton
WMC

Microeconomics Primer

Cargado por

Información del documento

Derechos de autor

Formatos disponibles

Compartir este documento

Compartir o incrustar documentos

Opciones para compartir

¿Le pareció útil este documento?

¿Este contenido es inapropiado?

Copyright:

Formatos disponibles

Microeconomics Primer

Cargado por

Copyright:

Formatos disponibles

Professor David Besanko Kellogg School of Management Northwestern University

November 17, 2009

Price Inelastic demand

Price Inelastic demand

< eQ,P < 0

eQ,P is between 1 and -

eQ,P is between 0 and 1, we demand is inelastic.

, we say demand is elastic.

Market-level price elasticity of demand:

Brand-level price elasticity of demand:

Price elasticity of demand for BMW 325 is on the order of - 3.5 to - 4.

Do consumers have readily available substitutes to which they can switch?

NO Demand is moderately sensitive to price

Demand is moderately sensitive to price

Demand is very insensitive to price

Keep factory open and produce at current volume Your choice

Cash flow (000) -$20

Shut the factory down over the next year

This bucket of costs does not go away if we shut down: it is sunk 13

Business unit is profitable:

Profit (per unit)

Annual unit sales (thousands)

Business unit is profitable:

Profit (per unit)

$6.00 $5.00 $9.20 $8.20 $0.80 $1.80

Annual unit sales (thousands)

Business unit is profitable:

Profit (per unit)

Annual unit sales (thousands)

Keep vacuum reg. valves

Valve type Digital Pressure-red. Vacuum reg. TOTAL (thousands)

Total Revenue $100,000 $ 45,000 $ 18,000

Total Direct Costs $30,000 $17,500

Total Mfg. OH & Selling Cost $ 2,000 $ 2,000

$59,500 $ 7,000 $90,000 $ 6,500

Drop vacuum reg. valves

Valve type Digital Pressure-red. Vacuum reg. TOTAL (thousands)

Total Direct Costs

$100,000 $30,000 $ 45,000 $17,500 $145,000 $47,500

Usually relevant for

ATC, average total cost

FRATC, full-reinvestment average total costs

Full reinvestment cost

Cash Costs By Nickel Mine in Global Nickel Industry, 2004

Cash cost (cents per pound)

Full-reinvestment cost of hypothetical new capacity

Centaur Mining Falconbridge Falconbridge

0 0 50 100 150 200 250 300 350 400 450 500 23

Cumulative Capacity (kilotons per year)

Cash cost (cents per pound)

Centaur Mining Falconbridge Falconbridge OutoKumpo 450

0 0 50 81 100 150 200 250 300 350 400 500 24

Cumulative Capacity (kilotons per year)

Short run industry cost curves

Long-run industry cost curves

Cash cost (cents per pound)

Centaur Mining 200

0 0 50 100 150 200 250 300 350 400 450 500 26

Cumulative Capacity (kilotons per year)

Cash cost (cents per pound)

0 0 50 100 150 200 250 300 350 400 450 500 27

Cumulative Capacity (kilotons per year)

Cash cost (cents per pound)

Centaur Mining 200