Managerial Economics

Reflection and Discussion

Chapter 5: Investment Decisions: Look Ahead and Reason Back

Chapter 6: Simple Pricing

Chapter 7: Economies of Scale

Reflect on the assigned readings for the week. Identify what you thought was the most important concept(s), method(s), term(s), and/or any other thing that you felt was worthy of your understanding.

Also, provide a graduate-level response to each of the following questions:

Describe an investment decision you or your company has made. Compute the opportunity costs and benefits of the decision. Did your company make the right decision? If not, what would you do differently? Compute the NPV of the investment.

Assignment

Problem Set #2

1. Describe two activities inside your organization, or one inside and one outside your organization, that exhibit economies (or diseconomies) of scope. Describe the source of the scope economies. How could your organization exploit the scope economy or diseconomy? Compute the profit consequences of the advice.

2. Describe a pricing decision your company has made. Was it optimal? If not, why not? How would you adjust price? Compute the profit consequences of the change.

The assignment is to answer the question provided above in essay form. This is to be in narrative form. Bullet points should not to be used. The paper should be at least 1.5 – 2 pages in length, Times New Roman 12-pt font, double-spaced, 1 inch margins and utilizing at least one outside scholarly or professional source related to organizational behavior. This does not mean blogs or websites. This source should be a published article in a scholarly journal. This source should provide substance and not just be mentioned briefly to fulfill this criteria. The textbook should also be utilized. Do not use quotes. Do not insert excess line spacing. APA formatting and citation should be used.

Investment Decisions: Look Ahead and Reason Back

©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images

CHAPTER

Investments imply willingness to trade dollars in the present for dollars in the future. Wealth-creating transactions occur when individuals with low discount rates (rate at which they value future vs. current dollars) lend to those with high discount rates.

Companies, like individuals, have different discount rates, determined by their cost of capital. They invest only in projects that earn a return higher than the cost of capital.

The NPV rule states that if the present value of the net cash ﬂow of a project is larger than zero, the project earns economic proﬁt (i.e., the investment earns more than the cost of capital).

Although NPV is the correct way to analyze investments, not all companies use it. Instead, they use break-even analysis because it is easier and more intuitive.

Break-even quantity is equal to ﬁxed cost divided by the contribution margin. If you expect to sell more than the break-even quantity, then your investment is proﬁtable.

Avoidable costs can be recovered by shutting down. If the beneﬁts of shutting down (you recover your avoidable costs) are larger than the costs (you forgo revenue), then shut down. The break-even price is average avoidable cost.

If you incur sunk costs, you are vulnerable to post-investment hold-up. Anticipate hold-up and choose contracts or organizational forms that minimize the costs of hold-up.

Once relationship-speciﬁc investments are made, parties are locked into a trading relationship with each other, and can be held up by their trading partners. Anticipate hold-up and choose organizational or contractual forms to give each party both the incentive to make relationship-speciﬁc investments and to trade after these investments are made.

continued

Title?

In summer 2007, Bert Matthews was contemplating purchasing a 48-unit apartment building.

The building was 95% occupied and generated $550,000 in annual profit.

Investors expected a 15% return on their capital

The bank offered to loan Mr. Matthews 80% of the purchase price at a rate of 5.5%

Mr. Matthews computed the cost of capital as a weighted average of equity and debt.

.2*(15%) + .8*(5.5%) = 7.4%

Mr. Matthews could pay no more than $550,000/7.4% = $7.4 million and still break even.

Mr. Matthews decided not to buy the building. A good decision – one year later, the cost of capital was 10.125% and Mr. Matthews could offer only $5.4 million for the building.

This story illustrates both the effect of the bursting credit bubble on real estate valuations and, more importantly, the relevant costs and benefits of investment decisions.

Background: Investment Profitability

All investments represent a trade-off between possible future gain and current sacrifice.

Willingness to invest in projects with a low rate of return, indicates a willingness to trade current dollars for future dollars at a relatively low rate.

This is also known as having a low discount rate (r).

Individuals with low discount rates would willingly lend to those with higher discount rates.

Discounting helps you figure out if future gains are larger than current sacrifice.

Compounding

To understand discounting, let’s first look at compounding:

(future value, k periods in the future) = (present value) x (1 + r)K

Example: If you invest $1 (present value) today at a 10% (r), then you would expect to have $1.10 in one year.

In two years, $1 becomes $1.21 = $1.10 x (1+.1)

A good compounding rule of thumb: “Rule of 72”: If you invest at a rate of return r, divide 72 by r to get the number of years it takes to double your money

Discounting

Discounting (the inverse of compounding):

Present value = (future value, k periods in the future)

(1 + r)k

Example: At a 10% r, $1 is worth:

Next year: ($1)/1.1 = $0.91

Two years: ($0.91)/1.1 =$0.83

Discussion: If my discount rate is 10%, would I lend to or borrow from someone with a discount rate of 15%?

What does this say about behavior?

Example: Nashville Pension Obligations

The city of Nashville uses discounting to decide how much to save for future pension obligations.

For a pension that pays out $100,000 in 20 years, with a discount rate of 8.25% Nashville must save:

$100,000/(1.0825)20 =$20,485

If the city invests the $20,485 and earns 8.25%, then the savings will compound in 20 years – unrealistic!

Somewhat of high savings rate that may not be returned; however, a high savings rate means less current spending, which is politically popular

A more realistic (but less popular) discount rate would be 6.5%, which would lead to saving $28,380 now.

Determining the Profitability of Investments

Remember the simple rule: discount the future benefits of an investment, and compare them to the current cost.

Companies use discount rates, which are determined by cost of capital.

A company’s cost of capital is a blend of debt and equity, its “weighted average cost of capital” or WACC

Time is a critical element in investment decisions

Cash flows to be received in the future need to be discounted to present value using the cost of capital

The NPV Rule: if the present value of the net cash flows is larger than zero, then the project earns more than the cost of capital.

The NPV Rule In Action

Consider two projects that each require an initial investment of $100

Project 1 returns $115 at the end of the first year

Project 2 returns $60 at the end of the first, and $60 at the end of the second

The company’s cost of capital is 14%

Project 1 earns more than the cost of capital. Project 2 does not.

NPV and Economic Profit

Projects with a positive NPV create economic profit.

Only positive NPV projects earn a return higher than the company’s cost of capital.

Projects with negative NPV may create accounting profits, but not economic profit.

In making investment decisions, choose only projects with a positive NPV.

Another Method: Break-Even Quantities

The break-even quantity is the amount you need to sell to just cover your costs

At this sales level, profit is zero.

The break-even quantity is:

Q=FC/(P-MC)

FC: fixed costs P: price MC:marginal cost

(P-MC) is the “contribution margin” – what’s left after marginal cost to “contribute” to covering fixed costs

Break-Even Example: Nissan Truck

Nissan’s popular truck model, the Titan, had only two years remaining on its production cycle. Redesigning the “Titan” would cost $400M.

Cost of capital was 12%, implying annual fixed cost of $48M

Contribution margin on each truck is $1,500

Break-even quantity is 32,000 trucks

The decision to redesign or not came down to a break-even analysis

Nissan had a 3% share of the market, implying only 12,000 Titan sales per year – not enough to break even.

Instead they decided to license the Dodge Ram Truck, which would reduce the fixed cost of redesign, and a lower break-even point.

After the Government took over Chrysler, Nissan reconsidered.

Deciding Between Two Technologies

In 1983, John Deere was in the midst of building a Henry-Ford-style production line factory for large 4WD tractors

Unexpectedly, wheat prices fell dramatically reducing demand for large tractors

Deere decided to abandon the new factory and instead purchased Versatile, a company that assembled tractors in a garage using off-the-shelf components

Deere chose one manufacturing technology over another

A discrete investment decision – the factory had big FC and small MC, Versatile had small FC but bigger MC

John Deere: Right Decision?

Was purchasing Versatile the right choice?

It depends… on how much John Deere expected to sell.

Suppose the capital-intensive technology would involve $100 FC and $10 MC

Suppose Versatile’s technology had $50 FC and $20 MC

To determine break-even quantity (point of indifference), solve for the quantity that equates the costs: $150 for 5 units

If you expect to sell less than 5 units, choose the low-MC technology

If you expect to sell more than 5 units, choose the low-FC technology

John Deere Lesson

John Deere made the right decision by acquiring Versatile; however, the Antitrust Division of he U.S. Department of Justice challenged the acquisition as anticompetitive.

John Deere and Versatile were only two of 4 firms selling 4WD tractors in North America.

Break-Even Advice

Remember this advice: Do not invoke break-even analysis to justify higher prices or greater output.

Managers sometimes believe they must raise prices to cover fixed costs or they must sell as much as possible to make average costs lower

These are extent decisions though!

They require marginal analysis, not break-even

The Decision to Shut-Down

Shut-down decisions are made using break-even prices rather than quantities.

The break-even price is the average avoidable cost per unit

Profit = (Rev-Cost)= (P-AC)(Q)

If you shut down, you lose your revenue, but you get back your avoidable cost.

If average avoidable cost is less than price, shut down.

Determining avoidable costs can be difficult.

To identify avoidable costs firms use Cost Taxonomy

Cost Taxonomy

Example: FC=$100, MC=$5, and you produce 100 units/year

How low of a price before you shut down? IT DEPENDS

It depends on which costs are avoidable

Long-run: fixed costs become avoidable so they are included in the shutdown price

Short run: they are unavoidable and should not be included in the shutdown price

Fixed Costs

(avoidable in long run)

Variable Costs

(avoidable in short run)

Avoidable Costs

Unavoidable or “Sunk” Costs

Costs

Sunk Costs and Post-Investment Hold Up

Always remember the business maxim “look ahead and reason back.” This can help you avoid potential hold up.

Before making a sunk cost investment, ask what you will do if you are held up.

What would you do to address hold up?

Sunk Costs and Post-Investment Hold Up Example

National Geographic can reduce shipping costs by printing with regional printers.

To print a high quality magazine, the printer must buy a $12 million printing press.

Each magazine has a MC of $1 and the printer would print 12 million copies over two years.

The break-even cost/average cost is $7 = ($12M / 2M copies) + $1/copy

BUT once the press is purchased, the cost is sunk and the break-even price changes.

Because of this the magazine can hold up the printer by renegotiating the terms of the deal – because the price of the press is unavoidable, and sunk, the break-even price falls to $1, the marginal cost.

Vertical Integration

One possible solution to post-investment hold-up is vertical integration.

Example: Bauxite mine and alumina refinery

Refineries are tailored to specific qualities of ore

The transaction options are:

Spot-market transactions

Long-term contracts

Vertical integration

Vertical integration refers to the common ownership of two firms in separate stages of the vertical supply chain that connects raw materials to finished goods

Discussion: How is vertical integration a solution to hold up?

Contractual view of marriage

Long-term contracts induce higher levels of relationship-specific investment

Economies of Scale and Scope

CHAPTER

The law of diminishing marginal returns states that as you expand output, your marginal productivity (the extra output associated with extra inputs) eventually declines.

Increasing marginal costs eventually cause increasing average costs and make it more difficult to compute break-even prices. When negotiating contracts, it is important to know what your costs curves look like; otherwise, you could end up accepting contracts with unprofitable prices.

If average cost falls with output, then you have increasing returns to scale. In this case you want to focus strategy on securing sales that enable you to realize lower costs. Alternatively, if you offer suppliers big orders that allow them to realize economies of scale, try to share in their profit by demanding lower prices.

If your average costs are constant with respect to output, then you have constant returns to scale. If average costs rise with output, you have decreasing returns to scale or diseconomies of scale.

Learning curves mean that current production lowers future costs. It’s important to look over the life cycle of a product when working with products characterized by learning curves.

If the cost of producing two outputs jointly is less than the cost of producing them separately — that is

Cost(Q1,Q2) < Cost(Q1) + Cost(Q20)

— then there are economies of scope between the two products. This can be an important source of competitive advantage and shape acquisition strategy.

continued

Rayovac Company

Founded in 1906, three entrepreneurs started a battery production company that grew to rival Energizer and Duracell.

In 1996, The Thomas H. Lee Company acquired Rayovac – taking advantage of easy credit availability the company then bought many other battery production companies as well. A move the company said they made to take advantage of efficiencies and economies of scale.

They expected that as they produced more of the same good, average costs would fall.

The company also bought many unrelated companies at the same time as the battery binge – the reasoning being that because of synergies, if they centralized the production of many different goods the costs of production would be lower.

By February 2009 the new conglomerate was bankrupt

Moral of the story? In business investments if you hear the words “efficiency” or “synergy,” hold on to your money.

Increasing Marginal Costs

Definition: The law of diminishing marginal returns: as you try to expand output marginal productivity (the extra output associated with extra inputs) eventually declines.

Diminishing marginal returns g marginal productivity declines

Diminishing marginal productivity g increasing marginal costs

Increasing marginal costs eventually lead to increasing average costs

Some causes of diminishing marginal returns

Difficulty of monitoring and motivating a large work force

Increasing complexity of a large system

The “fixity” of some factor, like testing capacity

Graph 1: Marginal Cost

Graph 2: Marginal vs. Average Cost

When marginal cost rises above average, the average rises.

Increasing Marginal Cost (cont.)

Example: Akio Morita and the Sony Transistor radio

In 1955, Akio Morita found a retailer that would sell his $29.95 transistor radio under his “Sony” brand name

The problem: the retailer wanted to buy 100,000 for its 150 stores, 10 times more than Mr. Morita’s capacity.

Mr. Morita had to turn down the offer

He knew that he would lose money producing 100,000 units because increasing output would require hiring/training more workers and an expansion of facilities

This would raise his average costs.

The retailer agreed to settle for 10,000 units, the rest is history

Lesson: know what your costs look like!

Economies of Scale

Definition: short run “fixity” vs. long run “flexibility”

i.e. factors that are fixed costs in the SR but become variable in the long run

If long-run average costs are constant with respect to output, then you have constant returns to scale.

If long run average costs rise with output, you have decreasing returns to scale or diseconomies of scale.

If average costs fall with output, you have increasing returns to scale or economies of scale.

Example: Poultry Industry

In 1967 in the US, a total of 2.6 billion chicken and turkeys were processed

By 1992, that number was almost 7 billion BUT the number of processing facilities dropped from 215 to 174

The share of shipment plants with over 400 employees grew immensely

The shift in the structure of the industry was due largely to changes in technology, which reduced cost of processing poultry in larger plants

Learning Curves

Learning curve: when you produce more, you learn from the experience so that you produce at a lower cost in the future

Use the maxim “Look ahead and reason back”

Example: Every time an airplane manufacturer doubles production, marginal cost decreases by 20%

Airplane Learning Curve

American Airline negotiates with Boeing to purchase planes

Boeing sees a big order from the world’s largest airline as a chance to “walk down its learning curve”

Airplane Manufacturing Costs

Airplane Learning Curve (cont’d)

American knows its order will allow Boeing to reduce costs for future sales, they want to capture some of Boeing’s profit

If American could know how many planes Boeing would make over the lifetime of the plane, they could offer Boeing’s average cost

Airplane Learning Curve (cont’d)

What actually happened with American and Boeing:

American offered to purchase planes exclusively from Boeing over the next 30 years

This provided Boeing with a big chunk of demand that would lower costs

In exchange, Boeing offered a discounted price

Guitar Fingerboards

Firm X produces guitar fingerboards

Rosewood is used for budget guitars

Ebony is used for high-end guitars

However, there is a decreasing supply streak-free of ebony

Brown streaks in ebony are seen as a blemish for high-end guitars, but a step up from rosewood.

The streaked ebony can be used on budget guitars

Better than rosewoodg cost and quality advantage

Therefore, there are economies of scope between production of high-end and low-end guitars.

Economies of Scope

If the cost of producing two products jointly is less than the cost of producing those two products separately then there are economies of scope between the two products

Cost(Q1, Q2) < Cost(Q1) + Cost(Q2)

You want to exploit economies of scale by producing both Q1 and Q2

Major cause of mergers

Example: Kraft, Sara Lee and ConAgra sell a variety of meat products, hot dogs, sausage, and lunchmeats because they can derive economies of scope by distributing these products together

Diseconomies of Scope

Production can also exhibit diseconomies of scope when the cost of producing two products together is higher than the cost of separate production.

Pet Food Production

AnimalSnax, a pet food company has 2,500 products (SKU’s) with 200 different formulas

They receive a lot of pressure from large customers like Wal-Mart to reduce prices

These requests worry the firm because of the so-called 80/20 rule (80% of a firm’s profit comes from 20% of its customers)

To respond to Wal-Mart, the company shrinks it product offerings

AnimalSnax reduced its product offerings to 70 SKUs using only 13 different formulas AND it began offering price discounts for larger orders.

The company could consolidate small orders into large ones to reduce setup costs.

Pet Food Production Graph

Typical savings for one extruder line are illustrated below

Under the new approach, the same amount of pet food could be produced faster

This led to a 25% savings for the company because of reduced production costs (see graph)

Sample Question

Learning curves: every time you double production, your costs decrease by 50%. The first unit costs you $64 to produce. On a project for 4 units, what is your break-even price?

You can win another project for 2 more units.

What is your break-even price for those units?

Answer

The break-even price for 4 units is $33.

The extra costs for the fifth and sixth units is only $24, so break-even is $12/unit for those two.

If the project were for six units total, break-even would be $26/unit for those six.

Q MC TC AC 1 $64 $64 $64 2 $32 $96 $48 3 $21 $117 $39 4 $16 $133 $33 5 $13 $146 $29 6 $11 $157 $26

QMCTCAC

1$64$64$64

2$32$96$48

3$21$117$39

4$16$133$33

5$13$146$29

6$11$157$26

Sheet1

Q	MC	TC	AC
1	$64	$64	$64
2	$32	$96	$48
3	$21	$117	$39
4	$16	$133	$33
5	$13	$146	$29
6	$11	$157	$26

Managerial Economics

Sheet1

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