Download Course Summary - Columbia Business School

Summary of the Plot
Demand curve – shows how D depends on P.
Also depends on income.
Price
Demand curve shifts out as income
Rises.
Quantity demanded or
supplied
The Market Mechanism
Price
($ per unit)
S
The curves intersect at
equilibrium, or marketclearing, price. At P0 the
quantity supplied is equal
to the quantity demanded
at Q0 .
P0
D
Q0
Quantity
The Market Mechanism
Price
($ per unit)
S
Surplus
P1
Assume the price is P1 , then:
1) Qs : Q1 > Qd : Q2
2) Excess supply is Q1:Q2.
3) Producers lower price.
4) Quantity supplied decreases
and quantity demanded
increases.
5) Equilibrium at P2Q3
P2
D
Q1
Q3
Q2 Quantity
Consumption & Price of Copper
1880-1998
Price elasticity of demand:
Measures responsiveness of demand to price.
Defined as E = (dQ/Q)/(dP/P) = (dQ/dP)*(P/Q)
Why is it defined in proportional terms?
- Unit free.
- Scale sensitive.
A negative number.
Short-run vs. long-run elasticities
Critical in understanding oil market, energy
markets, metal markets
Responding to a price movement takes time possibly many years
Long-run elasticity measures total response
Short-run elasticity measures immediate
response
Summary on demand:
• How demand depends on prices and
income.
• How the time period (s-r vs l-r) affects
response to prices and incomes.
• How D and S interact to determine prices.
• How revenue varies with output.
Cost Categories
Fixed Costs
Variable Costs
Average Costs
Yes
Yes
Marginal Costs
No
Yes
The Learning Curve
Hours of labor
per machine lot
• The horizontal axis
measures the
cumulative number of
hours of machine tools
the firm has produced
• The vertical axis
measures the number of
hours of labor needed
to produce each lot.
10
8
6
4
2
0
10
20
30
40
50
Breakeven:
• Occurs at the output level at which total cost
equals total revenue.
• Let P(N) be the price at which N units can
be sold. Then breakeven means:
P(N) . N = FC + VC(N)
Leverage
• Study the elasticity of profits  with
respect to output Q.
• Let output change from Q to Q + Q,
and profits from  to  + 
•Intuition - must be greater, the greater
are fixed costs.
Table 4
Reconfigured Income Statement for Product A Using a Variable Budget Format (1000s)
Sales (40 million lbs. @ 50 cents/lb)
less:
Variable Costs:
Materials
Direct labour
Manufacturing overhead
Sales Commissions
Total Variable Costs
Variable Margin (Profit Contribution)
less:
Fixed Costs:
Advertising
Promotion
Field Sales
Product Management
Marketing Management
Product Development
Marketing Research
Manufacturing Overhead
General and Administrative
Total Fixed Costs
Net Profit Before Taxes
$20,000
8,000
2,000
1,000
1.000
12,000
8,000
800
200
2,200
50
300
300
150
1,200
1,400
6,600
1,400
Summary on Costs:
• Identify which cost are relevant to a decision.
• Distinguish fixed and variable costs and use this to
determine impact of output change on profits.
• Understand allocation of overhead costs.
• Determine when to shut down in short and long
runs.
• Analyze breakeven.
Example of Profit Maximization
• Observations
–
–
–
–
–
Slope of rr’ = slope cc’
and they are parallel at 10
units
Profits are maximized at 10
units
P = $30, Q = 10,
TR = P x Q = $300
AC = $15, Q = 10,
TC = AC x Q = 150
Profit = TR - TC
• $150 = $300 - $150
C
$
t'
400
R
300
c
200
t
150
Profits
100
50
c
0
5
10
15
20
Quantity
Example of Profit Maximization
• Observations
–
–
–
AC = $15, Q = 10,
TC = AC x Q = 150
Profit = TR = TC = $300 $150 = $150 or
Profit = (P - AC) x Q =
($30 - $15)(10) = $150
$/Q
40
MC
30
AC
Profit
20
AR
15
MR
10
0
5
10
15
20
Quantity
$/Q
Elasticity of Demand and Price Markup
$/Q
The more elastic is
demand, the less the
markup.
P*
MC
MC
P*
AR
P*-MC
MR
AR
MR
Q*
Quantity
Q*
Quantity
For maximum profits, MR = MC so
P
1
Ep
+ P = MC
Or
P - MC =
P
-
1
Ep
Consumer Surplus
• With a downward sloping demand curve,
and uniform price for all buyers, some
buyers will be paying less than they are
willing to pay for the good (for example, the
buyers at the top left hand end of the
demand curve)
Buyer #:
1
2
3
4
5
6
7
8
9
10
Total
Will Pay: Revenue: Price:
10
10
10
9
18
9
8
24
8
7
28
7
6
30
6
5
30
5
4
28
4
3
24
3
2
18
2
1
10
1
55
Revenue:
35
Revenue
30
25
20
15
Revenue:
10
5
0
1
2
3
4
5
6
Price
7
8
9
10
Examples of Price Discrimination
• By country – Cars, pharmaceuticals,
Reuters. (Becoming more difficult.)
• By income level – catalogs (zip code), The
Gap, Mexican retail, supermarkets chains
by location, Switzerland in food brands,
• On line – double click (possible bypass via
anonymizer etc.).
• No price list – individualized prices.
The Two-Part Tariff
• The purchase of some products and services
can be separated into two decisions, and
therefore, two prices
• Decision to enter market and decision about
how much to buy
The Two-Part Tariff
• Examples
1) Amusement Park
• Pay to enter
• Pay for rides and food within the park
2) Tennis Club
• Pay to join
• Pay to play
The Two-Part Tariff
• Pricing decision is setting the entry fee (T)
and the usage fee (P)
• Choosing the trade-off between free-entry
and high user charges or high-entry and
zero user charges
Two-Part Tariff with a Single Type of
Consumer
$/Q
T*
P*
User price P* is set at
MC. Entry price T*
is equal to the entire
consumer surplus.
MC
D
Quantity
Bundling
• Selling several goods in one bundle
– Hardware and software
– Software suites
– Auto accessories
A & B are individuals
described by the amounts they
are willing to pay for each
good.
A will pay $9.25 for the bundle and B, $11.50. To sell 1 and 2 separately and get
both customers to buy both, cannot charge more than $3.25 for either good. Gives
revenue of 4x$3.25 = $13. Bundling gets $2x$9.25 = $18.50. Selling only to
customer willing to pay most gets $6 + $8.25 = $14.25. Selling 1 for $8.25 and 2
for $3.25 gets $8.25 + $6.50 = $14.75.
= MC
r2 C Versus
Mixed
Pure Bundling
C = 20
1
100
A
1
With positive marginal
costs, mixed bundling
may be more profitable
than pure bundling.
1
90
80
70
60
50
B
C
Consumer A, for example, has
a reservation price for good 1
that is below marginal cost c1.
With mixed bundling, consumer A
is induced to buy only good 2, while
consumer D is induced to buy only good 1,
reducing the firm’s cost.
40
30
20
D
C2 = MC2
C2 = 30
10
10 20 30 40 50 60 70 80 90 100
r1
Pricing Cell-Phones
• A mix of discrimination, bundling and twopart pricing
• Buy the phone (connection/membership
charge) & pay for service - like Polaroid,
Gilette. Phones at different price points.
• Then you have a choice between several
two-part tariffs
Different two-part tariffs
• Typically $40 per month with 400 minutes
free and 40c/min additionally
• or $60 per month with 600 minutes free and
30c/min additionally, etc.
• Choice of two-part tariffs - intended to price
discriminate. Heavy users - willing to pay a
lot - will opt for high fixed charge to get the
lower per unit price, and vice versa.
Pricing policy
• For each market segment try to estimate
– Maximum consumption if marginal
consumption cost is zero.
– Consumer surplus at this consumption level.
• Use this surplus as a fixed monthly charge
and then have a steep fee for going over the
allotted number of minutes.
Key aspects
• So selling 400 minutes for $40 is NOT the
same as selling each minute at the average
price, 40/400 = $0.10.
• Selling the 400 minutes together is twice as
profitable as selling each minute at $0.10.
WHY?
• Bundling earlier and later minutes together.
e-con.com
• How do the principles of managerial
economics apply in the internet world?
Look at
• Cost structures
• Selling information
• Pricing strategies & auctions
• Industry Standards.
Information Products
• Much of what the Internet excels at is
providing information
• Information is expensive to Produce but
• Cheap to Reproduce
• So average cost is high but marginal cost is
low.
• Competition may lead prices down to MC
Encyclopedia Britanica
• 1991: EB sold @ $1,600
• 1992: Microsoft introduced Encarta (bought
rights to Funk & Wagnalls), sold @ $49.95
• 1995: EB’s sales have halved
• 1995: EB offers on-line subscription for
$120 p.a. or CD for $200
Encyclopedia Britanica
• 1996: EB lowers cost of sub to $85
• 1999: EB offers FREE on-line service
(www.britanica.com)
• Key point: costs of producing EB are fixed
and sunk. Cost of reproducing - MC- is low,
zero on-line.
• Similar story with Yellow Pages.
• Long distance?
Selling Information
• Reuters, financial analysts are bundling
information with something else that makes
it possible to charge
• Few examples of successful businesses that
sell information only – usually sell it
bundled with something else
Intellectual Property Rights
• Digital distribution of “information” (which
includes music, videos, software and book)
poses serious challenges to property rights
of the owners – MC is zero
• Hence legal & economic activity on IPR
front. Napster, BMG, peer-to-peer file
sharing etc. (Another issue – unbundling
disk tracks)
Information Products
• Bottom line • Few good business models for making
money from selling information over the
internet. Business models still needed for
Yahoo et al. (eBay is an exception)
• Napster shows clearly the likely impact of
internet distribution on pricing of digital
information.
Auctions
• Auctions facilitate price discrimination
• Auction Formats
– Traditional English (oral, ascending prices, first or
second price)
– Dutch auction (descending prices)
– Sealed-bid (as in T Bills, oil exploration)
• First price
• Second price
Auctions
Common Value Auction
• Winner’s Curse
– The winner is worse off than those who did not
win
– Winner is bidder who estimates value of object
to be greatest, and so is likely to be
overestimating.
Network Effects of Standards
• Economies of Adoption:
• Examples - software for Windows vs. Mac,
Palm operating system and third party
support for these.
• Large user base means more third party
products.
• Also third party services such as training.
Network Effects
• Main issue in these cases - fax, e-mail etc
are more useful, the more people use
them
• So once they take off there is positive
feedback. Demand creates demand.
Economies of adoption.
EBAY
• Most successful pure Internet company
• No bricks & mortar – low fixed costs, no
variable costs
• Central function – providing info about
buyers to sellers & about sellers to buyers
• Providing info is key function of a market –
well suited to Internet
EBAY
• Note Yahoo & Amazon both ran FREE
auctions to enter this market yet still have
small shares
• EBAY has a good business model as it is
clear how they can charge for the info they
provide – as broker – unlike Yahoo
AOL
• AOL – provides info and Yahoo-like
services but charges as ISP, also a clear
business model
• Also gets advertising revenues
Summary
• Demand for any one PC makers’ product is
elastic whereas
• Demand for Windows, Office and
microprocessors is highly inelastic.
• Barriers to entering and competing translate
into inelastic demand and higher profits.
AMAX case
Cost Analysis
Fixed & variable
Average & Marginal
Breakeven
Entry/Exit Choice
Operating leverage
TV Listing Guide
Use of income
statements
NYNEX
Airlines
Cell phones
Demand & supply
Price & Income elasticities
PED & MR
Forecasting
Pricing:
MR = MC
Markup over MC depends on PED
Consumer surplus
Discrimination
Two-part pricing
Bundling
e-con.com
•Variable costs low relative to fixed.
• scale economies &
• intense competition for position, high leverage.
• Pricing policies
• Discrimination via versions
• Auctions
• Valuing information difficult.
• Hard to value one of internet’s main services
• Standards.
• Key aspect of IT products
• Products are more useful, the more they are used.
Microsoft & Intel vs. PC makers
• PED low for MSFT & INTC
• Implies high margins
• Low because of
• Economies of scale - high fixed costs
• Windows standard in desktop market.
• PED high for Dell, CPQ, as few barriers to entry
• fixed costs low 7
• no proprietary standards.
• NB Apple as a PC maker who tried to set a standard.