Escolar Documentos
Profissional Documentos
Cultura Documentos
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
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
Price Elasticity of Demand Relevant Costs and Decision Making Industry Cost Curves
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
Price Elasticity of Demand: percentage change in quantity demanded per one percent change in price
Elastic demand
D1
D2
Quantity
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
Price Elasticity of Demand: percentage change in quantity demanded per one percent change in price
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
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
In general, If
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
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?
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?
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
Price elasticity of market demand for automobiles is on the order of - 1 and - 1.5
Price elasticity of demand for ready-to-eat breakfast cereal in the U.S. is on the order of - 0.25 to - 0.5.
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
Substitution Opportunities
YES
Demand is very sensitive to price
e.g., high-end discretionary consumer durables such as boats or motorcycles
Do expenditures on the good account for a large fraction of the buyers budget?
YES
TENDS TO MAKE DEMAND MORE PRICE SENSITIVE
NO
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
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?
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
10
Price Elasticity of Demand Relevant Costs and Decision Making Industry Cost Curves
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
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
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
12
At current output level, total revenue = $100,000/month total cost = $120,000/month Costs consists of labor, materials, and leasing expenses
Labor and Leasing Total Revenue Materials expense cost (000) (000) Costs (000) (000)
$100
$50
$70
$120
$0
$0
This bucket of costs goes away if we shut down: it is non-sunk
$70
$70
-$70
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
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
$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)
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
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
14
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
$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?
$6.00 $5.00 $5.00 $9.90 $8.90 $10.00 $(0.90) $0.10 ($4.00) 3,000
10,000 5,000
* 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
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
15
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
$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?
$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
* 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
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
16
Total Corp. OH
Total Profit
$12,000 $ 3,000
$163,000
Total Revenue
Total Mfg. OH Total & Selling Corp. OH Cost $ 2,000 $ 2,000 $ 4,000
unavoidable!
Total Profit
$90,000 $3,500
17
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
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
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
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
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
19
Textbook concept
MC, marginal cost
Consultant lingo
Marginal cost or incremental cost
Cash cost
Capacity idling or withdrawal decisions Dropping product lines Capacity expansion decisions New market entry decisions R&D investment decisions
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
20
Price Elasticity of Demand Relevant Costs and Decision Making Industry Cost Curves
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
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.
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
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.
200
150
Anaconda Nickel
WMC
WMC
50
INC0
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
Anaconda Nickel
WMC
WMC
50
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
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
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko
25
300
250
D1
D2
150
Falconbridge
OutoKumpo
Falconbridge
Anaconda Nickel
WMC
WMC
50
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
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
D1
150
Falconbridge
OutoKumpo
Falconbridge
INC0 (Indonesia)
WMC
WMC
50
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
D1
150
Falconbridge
OutoKumpo
Falconbridge
Anaconda Nickel
WMC
WMC
50
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
INC0
INCO
WMC
100
Falconbridge
Billiton
WMC
300
D1
150
Falconbridge
OutoKumpo
Falconbridge
Anaconda Nickel
WMC
WMC
50
INC0
INCO
WMC
100
Falconbridge
Billiton
WMC
300
D1
150
Falconbridge
OutoKumpo
Falconbridge
Anaconda Nickel
WMC
WMC
50
INC0
INCO
WMC
100
Falconbridge
Billiton
WMC
300
D1
150
Falconbridge 300
OutoKumpo
Falconbridge
Anaconda Nickel
50
INC0
WMC
WMC
WMC
100
Falconbridge
Billiton
WMC
300
Inco gives up
and increases the market-clearing price Is this good for Inco?
D1
but gains
200
Falconbridge
Falconbridge
Anaconda Nickel
50
INC0
WMC
WMC
WMC
100
Falconbridge
OutoKumpo
Billiton
WMC
David Besanko, 2009 Please do not reproduce with permission of Professor Besanko