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OHT 12.1
CHAPTER 12.
Understanding pricing strategies
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Price determination and managerial objectives.
Generic pricing strategies.
Pricing and the competitive environment.
The marketing mix and the product life cycle.
The economics of price discrimination.
Pricing in multi-plant and multi-product firms.
Peak-load pricing.
Two-part tariffs.
Pricing policy and the role of government.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.2A
Learning outcomes
This chapter will help you to:
• Understand that price serves three functions: (a) as the basis on
which firms generate revenue; (b) as a rationing device in
markets; and (c) as a signal to producers to alter supply.
• Identify how price is determined in a competitive market economy
through the interaction of demand and supply.
• Realise that pricing decisions are driven by particular managerial
objectives (such as profit maximisation, sales revenue
maximisation, etc.).
• Distinguish between different generic pricing strategies adopted
by firms, namely: marginal cost pricing, incremental pricing,
breakeven pricing and mark-up pricing.
• Appreciate the nature of various pricing strategies in markets with
differing degrees of competition.
• Recognise that pricing strategies require the integration of pricing
decisions into a wider marketing mix, taking into account nonprice as well as price factors that affect demand.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.2B
Learning outcomes
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Appreciate how pricing decisions may vary over the
life cycle of a product or service in the market.
Understand the economics of price discrimination.
Grasp the complexities introduced into pricing
decisions where multi-plant or multi-product
production occurs and the nature of transfer pricing.
Identify when peak-load pricing and two-part tariff
pricing may be appropriate.
Recognise the ways in which government affects
prices in market economies today.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.3
Price determination and managerial objectives
Prices serve three broad functions.
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Prices raise revenue for the firm.
Prices act as a rationing device.
Prices indicate changes in the wants of consumers
and induce suppliers to alter product accordingly.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.4
Figure 12.1 The market for Sony TVs
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.5
Generic pricing strategies
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Marginal cost pricing.
Incremental pricing.
Breakeven pricing.
Mark-up pricing.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.6
Marginal cost pricing
Marginal cost pricing involves setting prices, and therefore
determining the amount produced, according to the marginal
costs of production, and is normally associated with a profitmaximising objective.
Incremental pricing
Incremental pricing deals with the relationship between larger
changes in revenues and costs associated with managerial
decisions.Proper use of incremental analysis requires a wideranging examination of the total effect of any decision rather
than simply the effect at the margin.
Breakeven pricing
Breakeven pricing requires that the price of the product is set so
that total revenue earned equals the total costs of production.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.7
Figure 12.2 Pricing strategies compared
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.8
Mark-up pricing
Mark-up pricing is similar to breakeven pricing,
except that a desired rate of profit is built into the
price (hence this pricing is associated with terms
such as cost-plus pricing,full-cost pricing and targetprofit pricing).
M = (P - AC)/AC
where m is the mark-up, AC is the average total
cost, and P - AC is the profit margin.
The price, P, is then given by:
P = AC (1 + m)
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.9
Pricing and the competitive environment
The nature of the market in which the product is
sold will have a major influence on the pricing
policy adopted. As we saw earlier markets can be
conveniently divided into four broad kinds:
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Perfectly competitive markets.
Monopoly markets.
Monopolistically competitive markets.
Oligopoly markets.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.10
Pricing in perfectly competitive markets
In perfectly competitive markets the firm is a pricetaker .
Pricing in monopoly markets
In a monopoly situation, the firm is a price-maker.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.11
The marketing mix and the product life cycle
The marketing mix
In developing an effective marketing strategy,
marketing professionals draw attention to the
importance of the following ‘ four Ps’:
• Product.
• Place.
• Promotion.
• Price.
Together the four Ps determine what is called the ‘offer’
to the consumer.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.12
Figure 12.3 Product positioning and customers’ perceptions
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.13
The product life cycle
(1) ‘Promotional’ or ‘penetration pricing’ occurs
when the price is set low to enter the market
against existing competitors, attract consumers
to the new product and gain market share.
(2)A ‘skimming policy ’arises when price is set
high initially to earn high profits before
competition arrives or to cover large unit costs in
the early stage of the product life.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.14
Figure 12.4 Phases of the product life cycle
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.15
Definition of price discrimination
Price discrimination represents the practice of
charging different prices for various units of a
single product when the price differences are
not justified by differences in production/supply
costs.
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First-degree price discrimination.
Second-degree price discrimination.
Third-degree price discrimination.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.16
Figure 12.5 First-degree price discrimination
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.17
Third-degree price discrimination
Most frequently found is third-degree price discrimination,
which simply involves charging different prices for the same
product in different segments of the market.
The markets may be separated in the following ways:
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By geography 紡as when an exporter charges a different price
overseas than at home.
By type of demand 紡as in the market for,say,butter where
demand by households differs from the bulk purchase demand
of large catering firms.
By time 殆with a lower price charged for off-peak periods (as
in the case of seasonal charges for hotel rooms).
By the nature of the product 紡as with private dental care with
differential pricing, where if one patient is treated he or she is
unable to resell that treatment to someone else.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.18
Figure 12.6 Third-degree price discrimination
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.19
Pricing in multi-plant and multi-product firms
The multi-plant firm
Where a firm ’s output of the same product is
produced on more than one site, the profitmaximising output rule that marginal supply costs
must equal marginal revenue, is unchanged, but in
this case this marginal cost is the sum of the
separate plants ’marginal costs and production
must be allocated between the plants so that
the marginal supply cost at each plant is identical.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.20
Figure 12.7 Pricing in a multi-plant firm
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.21
Pricing in multi-plant and multi-product firms
The multi-product firm
When producing and pricing a product, the multi-product
firm has to take into consideration not only the impact on
the demand for that product of a price change (its own
price elasticity of demand)but the impact on the demand
for the other products in the firm ’s product range (the
relevant cross-price elasticities).In other words,
pricing now involves obtaining maximum profits from the
full product range rather than from the individual products.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.22
Figure 12.8 Peak-load pricing
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Two-part tariffs
OHT 12.23
A two-part tariff is concerned with levying a charge according to the number of
volume of the units consumed, plus a fixed charge to cover fixed joint or
common costs, usually on a quarterly of annual basis.
Figure 12.9 Two-part tariffs
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.24
Pricing policy and the role of government
Taxes and subsidies
Direct price controls
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Rate-of-return regulation.
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Price-cap regulation.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.25A
Key learning points
• Equilibrium pricing is likely to be short-lived since the
conditions of demand and supply are likely to change regularly
if not continuously. In addition,producers may lack adequate
information about the market to predict the equilibrium price
precisely.
• Pricing ,in practice,is driven by managerial objectives relating
to factors such as profitability,corporate growth,sales revenue,
managerial satisfaction,etc.
• Generic pricing strategies may be based on marginal
cost,incremental cost,break-even or mark-up pricing.
• Marginal cost pricing involves setting prices,and therefore
determining the amount produced,according to the marginal
costs of production,and is normally associated with a profitmaximising objective.
• Incremental pricing deals with the relationship between larger
changes in revenues and costs associated with managerial
decisions.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 12.25B
Key learning points
• Breakeven pricing requires that the price of the product is set
so that total revenue earned equals the total costs of production.
• Mark-up pricing is similar to breakeven pricing,except that a
desired rate of profit is built into the price (therefore this pricing is
also sometimes referred to as cost-plus, full-cost or target-profit
pricing).
• In perfectly competitive markets, the supplier is a price-taker.
• In a monopoly situation,the firm is a price-maker.
• In developing an effective marketing strategy, marketing
professionals draw attention to the importance of the four Ps:
product, place, promotion and price.
• With respect to the product life cycle ,promotional or
penetration pricing sets the price low to enter the market
against existing competitors and in order to attract customers to
the new product and gain market share.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Key learning points
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•
•
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OHT 12.2C
A skimming policy arises when price is initially set high
perhaps to cover large unit costs (e.g.R&D costs)in the early
stage of the product life cycle or to make higher profits before
competitors can respond.
Price discrimination represents the practice of charging
different prices for various units of a single product when the
price differences are not justified by differences in
production/supply costs.Successful price discrimination
requires an absence of arbitrage opportunities and differing
elasticities of demand in the various markets.
First-degree price discrimination arises in the case of a
producer selling each unit of output separately,charging a
different price for each unit according to the consumer 痴
demand function.This results in the transfer of all consumer
surplus to the producer.
Second-degree price discrimination involves charging a
uniform price per unit for a specific quantity or block of output
sold to each consumer.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Key learning points
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OHT 12.25D
Third-degree price discrimination involves charging different
prices for the same product in different segments of the
market.The market may be segmented by geography,by type of
demand,by time,or by the nature of the product itself.
In the case of a product produced by a multi-plant firm, the
profit-maximising output rule (MR =MC)is unchanged,but in this
case the marginal cost is the sum of the separate plants 知
marginal costs and production should be allocated between the
plants so that the marginal supply cost at each plant is identical.
The multi-product firm has to take into consideration not only
the impact of a price change on the demand for the product,but
also the impact on the demand for the other products in the
firm’s product range.Pricing policy, therefore, involves obtaining
the desired rate of return from the full product range rather than
from individual products.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Key learning points
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OHT 12.25E
Decentralisation of large firms brings with it problems of internal
resource allocation, one aspect of which is the pricing of
products which are transferred between the firm’s divisions.This
gives rise to the need for an appropriate transfer pricing policy
and the problem of determining the transfer price so as to
maximise overall company profits.
Peak-load pricing involves differentiated pricing which reflects
differences in supply costs,given variations in demand for the
product over time.
A two-part tariff is concerned with levying a charge per unit
according to units consumed plus a charge to reflect fixed joint
or common costs.
The inverse price elasticity rule ,sometimes referred to as
Ramsey pricing,suggests that consumers with the more price
inelastic demands should bear a higher proportion of fixed
charges than consumers with a higher price elasticity of
demand.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Key learning points
OHT 12.25F
•
On the basis of a public interest or economic welfare
maximation rule, state enterprises should set prices in
order to reflect the marginal social benefits from the
additional output and the marginal social costs or
producing that output.
•
Taxes and subsidies should be set so as to minimise
the damage to resource allocation in the economy. In
practice, state policies are determined by a mixture of
political, social and economic criteria so economic
welfare maximisation is far from guaranteed.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 13.1
CHAPTER 13.
Understanding the market for
labour
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The demand for labour and the concept of the
marginal revenue product .
The supply of labour and the concept of the elasticity
of labour supply .
The determination of wages in the labour market.
The impact of collective bargaining and trade unions
on wages and employment.
Discrimination in labour markets.
Minimum wage legislation.
Taxation and the incentive to work.
The importance of education and training.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 13.2A
Learning outcomes
This chapter will help you to:
• Understand how wages and employment levels are
determined in competitive labour markets.
• Grasp what is meant by the marginal product of labour
and the important role that it plays in explaining the
demand for labour in market economies.
• Identify those factors which influence the supply of
labour and the effect of the willingness to work on
wages and employment levels.
• Appreciate the effects of labour market imperfections
on wages and employment levels.
• Recognise the ways in which trade unions affect
labour markets in terms of their impact on the demand
for and supply of labour.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Learning outcomes
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•
OHT 13.2B
Realise the significance of both negative and positive
discrimination in modern labour markets and the
resultant economic consequences.
Understand the likely impact of minimum wage
legislation on wages and employment.
Recognise the role of taxation in explaining the
incentive to work and the implications for the labour
market.
Appreciate the importance of education and training,
and therefore investment in human capital, in
determining real wages and employment in all
economies.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 13.3
The demand for labour
MVP =MPP x P
where
MVP is the marginal value product;
MPP is the marginal physical product,i.e.the
volume of output added by employing one more
person;and
P is the price at which the output sells in the
market place.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 13.4
Table 13.1 Calculation of marginal value product (firm in
perfect competition) ($)
Quantity
produced
(units)
550
600
660
710
750
780
800
810
Number of
workers
employed
11
12
13
14
15
16
17
18
Marginal
physical
product (MPP)
x
Price
(per unit)
=
Marginal
value
product (MVP)
50
60
50
40
30
20
10
X
X
X
X
X
X
X
X
30
30
30
30
30
30
30
=
=
=
=
=
=
=
=
1,500
1,800
1,500
1,200
900
600
300
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 13.5
Figure 13.1 The marginal value product (MVP) curve
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Marginal Revenue Product (MRP) = Marginal Physical
Product (MPP) x Marginal Revenue (MR)
OHT 13.6
= MPP x MR
Table 13.2 Calculation of marginal revenue product
Quantity
produced
(units)
Number of
workers
employed
Marginal
physical
product (MPP)
x
Price
(per unit)
($)
=
550
600
660
710
750
780
800
810
11
12
13
14
15
16
17
18
50
60
50
40
30
20
10
x
x
x
x
x
x
x
x
30
29
28
27
26
25
24
=
=
=
=
=
=
=
=
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Marginal
revenue
product (MRP) ($)
1,500
1,740
1,400
1,080
780
500
240
OHT 13.7
Figure 13.2 The marginal revenue product (MRP) curve
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 13.8
Figure 13.3 Raising labour’s marginal revenue product
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 13.9
The supply of labour
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Demographic factors.
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The wage rate and other employment
inducements
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Barriers to entry into different occupations
•
Labour mobility
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 13.10
Figure 13.4 The effect of restricting the supply of labour
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Wage determination in the labour market
OHT 13.11
Figure 13.5 Wage determination in a highly competitive labour market
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Wage determination in the labour market
Figure 13.6 Wage determination in a less competitive labour market
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 13.12
Collective bargaining
OHT 13.13
Unions will tend to be at their strongest in wage bargaining if:
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The firm currently makes more than a normal profit so higher wages can
be paid out of the higher profits.
•
The employer is a monopsonist and currently the average wage paid is
less than the MRP (as in Figure 13.6).
•
The employer has limited scope to introduce further labour savings.
•
Labour costs are only a small part of total costs so that a wage rise can
be more easily absorbed.
•
Firms can more easily pass on some or all of a wage increase to
consumers through higher prices.This will occur when either the demand
for the product is rising (e.g.because incomes are rising)or where
consumer choice is restricted and the price elasticity of demand of the
product is,therefore,low (e.g.in a monopolistic industry such as water
supply).
•
In state enterprises where wage increases for state employees are
funded from compulsory tax payments 勃unless there is strong public
opposition to taxation.
•
The employer,although not a monopsonist,is currently paying a wage
which is less than the MRP of labour (for example,as illustrated in Figure
13.6).
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 13.14
Figure 13.7 Illustrating the possible impact of trade unions on wages and
employment
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 13.15
Further issues in the labour market
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Discrimination.
Minimum wage legislation.
Taxation and the incentive to work.
The importance of education and training.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 13.16
Figure 13.8 Illustrating the effects of discrimination on the labour market
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 13.17
Figure 13.9 Impact of minimum wage legislation
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 13.18
Figure 13.10 The impact of taxation
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 13.19
Figure 13.11 Investment in human capital
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Key learning points
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•
•
•
OHT 13.20A
The demand for labour is a derived demand,i.e.people are
employed for the output they produce.
The marginal value product of labour (MVP)under conditions
of perfect competition is the value added to production by
employing one more person and is calculated as follows:
MVP =MPP x P
where MPP is the marginal physical product (i.e.the volume of
output added by employing one more person)and P is the
constant price at which the output sells.
Under conditions of imperfect competition the marginal revenue
product of labour (MRP)is affected by MPP and changes in
price (i.e.MR),so that
MRP =MPP ﾗMR
Managers seeking to maximise profits should employ more
labour only if the marginal revenue product exceeds or is equal
to the marginal cost of employment.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 13.20C
Key learning points
• The elasticity of supply of labour is a measure of the
responsiveness of the supply of labour to a change in the wage
paid, calculated as:
Percentage change in supply of labour
Percentage change in the wage rate
• Collective bargaining refers to arrangements between employers
and trade unions regarding the setting of wages and conditions of
work.
• Where trade unions are powerful they are able to raise wages
above the levels that would otherwise exist but this may occur at
the expense of the number employed resulting in unemployment.
• Trade unions can impact on the labour market by both reducing
the supply of labour and raising the demand for labour.
• Negative discrimination can occur in labour markets,for example
on grounds of race,sex,creed,physical disabilities,etc.,leading to a
lower demand for labour from these groups.
• Positive discrimination can also occur leading to increased
demand for labour from particular groups in society.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 13.20B
Key learning points
• The elasticity of demand for labour measures the
responsiveness of employment to a change in wages, calculated
as:
Percentage change in number employed
Percentage change in the wage rate
•
•
•
The supply of labour is determined by demographic factors,the
wage rate and other employment inducements,barriers to entry
into different occupations and labour mobility.
In a highly competitive labour market, the supply curve for
labour is horizontal at the industry wage rate W ; the average and
marginal costs of employing labour are therefore constant at that
wage,so that the optimal level of employment will correspond to
the point where MC =MRP.
In a less competitive labour market ,the marginal cost of labour
rises more quickly than the average cost of employment. While
the profit-maximising condition MC =MRP still holds,the average
wage rate will be less than the value of the marginal revenue
product.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Key learning points
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•
•
•
OHT 13.20D
A number of countries have introduced minimum wage
legislation ,preventing employers from ‘exploiting蜘workers
by offering wages at levels which society may consider to be
unacceptable 釦The result may, however, be higher
unemployment.
Taxation can reduce the incentive (willingness)to work and,in
effect,shift the supply curve of labour leftwards,resulting in
lower employment levels.
Higher levels of education and training are an investment
that lead to improved human capital with a consequent
increase in the marginal revenue product of labour and
therefore higher real wages and more employment.
Educational qualifications also act as a screening device in
the labour market, thereby reducing the cost imposed on
employers in searching for suitably skilled labour to fill job
vacancies.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 14.1
CHAPTER 14.
Understanding the market for
capital
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•
•
•
•
•
Capital as a resource of the firm.
Capital and profit maximisation.
The investment decision-making process.
Estimating and ranking capital investment
projects.
Calculating the cost of capital.
Understanding cost benefit analysis.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 14.2A
Learning outcomes
This chapter will help you to:
• Understand the basis upon which capital investment decisions are
made by firms.
• Identify the level of capital investment which will be undertaken by
a profit maximising firm.
• Distinguish between the stock of capital and the flow of new capital
(i.e.investment in the capital stock).
• Identify the various stages involved in the capital investment
decision-making process.
• Grasp the importance of estimating the cash flows from a planned
capital investment project.
• Distinguish between three different methods for evaluating and
ranking capital investment projects, namely the payback method,
the discounted cash flow method and the internal rate of return
method.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Learning outcomes
•
•
OHT 14.2B
Appreciate the role of the cost of capital in capital
investment decisions and why a weighted average cost of
capital is calculated when a range of sources of finance is
used.
Understand the principles and stages involved in
undertaking a cost benefit analysis – CBA takes into
account the usual financial returns on an investment and
the cost of capital but also the impact of the investment
decision on the wider economy (the external or social
costs and benefits of the investment).
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 14.3
Capital as a resource of the firm
•
•
The stock of capital is the quantity or value of the
total capital invested within the firm, i.e. the total
value of buildings, machines, equipment,etc. that are
available within the firm.
The flow of capital is the increase or reduction in the
stock of capital over a given time period, i.e.the net
addition to the capital stock arising from purchasing
new machines.Investment is the term used for
additional capital expenditure that creates new
assets.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 14.4
Capital and profit maximisation
Employment of capital to maximise profits requires
that:
MCK =MRPK
This applies irrespective of whether the firm buys or
hires its capital inputs.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 14.5
Figure 14.1 Employment of capital - under conditions of a perfectly competitive
factor market
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 14.6
Figure 14.2 Employment of capital - a monopsony factory market
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 14.7
The investment decision-making process
•
•
•
•
•
Step 1:Generation of capital investment
proposals.
Step 2:Determination of the capital investment
budget.
Step 3:Evaluation and selection of capital
investment projects.
Step 4:Monitoring of capital investment
performance.
Step 5:Post-audit project review.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 14.8
Figure 14.3 The investment decision process
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 14.9
Estimating capital investment cash flows
The following three points should be borne in mind
when estimating cash flows:
•
Incremental analysis
•
The role of tax
•
Spillover effects
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 14.10
Figure 14.4 Estimating cash flows
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 14.11
Evaluating and ranking capital investment
projects
•
Payback method.
•
Net present value method.
•
Internal rate of return method.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 14.12
Net present value (NPV)
n
s
NPV  
2
t 1 1  r 
where
s is the future sum or, more correctly, the
incremental after-tax net cash flow in each year;
t represents each year in the life of the investment
from the present (t =1)up to a certain number of n
years in the future;
r is the discount rate;and
S denotes summation over the time period
concerned.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 14.13
Net present value method
n
st
NPV  
I
t
t 1 1  r 
where s ,t and r are as defined in the earlier
net present value formula,and I is the initial
investment outlay for the project.Where the
investment outlay occurs over more than
the current year the value of I would also
need discounting.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 14.14
Internal rate of return method
n
st
NPV  
I 0
t
t 1 1  IRR 
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 14.15
Calculating the cost of capital
In essence the cost of capital is related to the
source of the funds used for the investment. A
firm may raise funds in a number of ways,
including the following:
•
•
•
Loan capital,e.g.bank loans and debenture
(fixed interest) stock.
Retained earnings.
New equity issues (issuing shares or stock on
which dividends are paid out of profits
earned).
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 14.16
Figure 14.5 The weighted average cost of capital (WACC)
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 14.17
Undertaking a cost-benefit analysis
Cost –benefit analysis is a method for
assessing capital projects where it is important
to take into account all of the impacts of the
investment decision,including the effects on
other people,other firms, regions and so on.This
involves accounting for the total social costs
and benefits of a capital investment project.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 14.18
Figure 14.6 Stages of a cost-benefit analysis
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 14.19A
Key learning points
• Capital is a factor of production which includes all
physical, manufactured goods that are used in the
production of other goods and services 貿for example,
plant, machinery,buildings and business fixtures and
fittings.
• The stock of capital is the quantity or value of the total
capital invested with the firm.
• The flow of capital is the increase in the stock of capital
over a given time period resulting from new capital
investment.
• Employment of capital to maximise profits requires that
the marginal cost of capital(MCK) equals the marginal
revenue product of capital (MRPK), i.e.
MCK =MRPK
• The marginal cost of capital reflects the cost of financing
investment and will vary depending upon the degree of
competition for funds in the capital market.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
•
•
•
•
OHT 14.19B
Key learning points
There are five steps in the investment decision-making process:
generation of capital investment proposals,determination of the capital
investment budget, evaluation and selection of capital investment
projects,monitoring of capital investment performance, and post-audit
project review.
The payback method for evaluation of an investment project is based
on an assessment of how quickly the investment can generate
sufficient net cash returns to cover the initial investment outlay.
The net present value and internal rate of return methods for
evaluating and ranking investment projects are based on the concept
of discounting expected cash flows back to the present day so as to
obtain their net present value (PV).
Net present value (NPV)is given by the formula:
n
st
NPV  
t


1

r
t 1
•
where s is the incremental after-tax cash flow in each year t of the life
of the project and is the discount rate.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 14.19C
Key learning points
•
If all of the capital outlays for a project occur in the current year, the net
present value (NPV)of the stream of future cash flows arising from the
n
project is given by:
st
NPV  
t 1
•
1  r 
t
 I
where I is the initial investment outlay for the project .In general terms, if
the NPV is positive the investment has a positive net return in present
value terms and should be accepted;if NPV is negative it should be
rejected.
Another measure of the expected profitability of an investment is based
on the internal rate of return (IRR)method where the IRR is defined as
the rate of interest that equates the present value of a project’s net cash
flow to the initial investment outlay.To calculate its value we set the NPV
for the project equal to zero and solve the equation below for the value of
IRR which produces a zero NPV:
n
st
NPV  
I 0
t
t 1 1  1RR 
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Key learning points
•
•
•
•
•
OHT 14.19D
The weighted average cost of capital (WACC)is given by
the weighted average of the cost of raising the funds for the
capital investment project.
If only retained earnings are used,the cost of capital is equal
to the return that could have been earned if the internal funds
were invested elsewhere (their opportunity cost).
lf only equity finance is used,the return to equity will be the
same as the cost of capital.
If a project is financed entirely by a loan ,the cost of capital is
the rate of interest paid on the loan.
In practice,projects are often financed by a mixture of debt
and equity capital .In this case,the calculation of the cost of
capital raises issues concerning the impact of leverage or the
gearing ratio (the proportion of debt to equity finance)on the
overall WACC.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 15.1
CHAPTER 15.
Understanding the market for
natural resources
•
The market for natural resources.
•
Economic rent verses quasi-economic rent.
•
Environmental issues.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 15.2
Learning outcomes
This chapter will help you to:
• Understand the role of land and other natural resources in the
production of goods and services.
• Appreciate how the prices of land and other natural resources
are determined by the interaction of demand and supply.
• Identify how a resource in finite supply (e.g. land) may earn
economic rent or a payment above its transfer earnings.
• Distinguish between economic rent and quasi-economic rent.
• Grasp the importance of environmental issues in the
production process.
• Appreciate the implications for social welfare of environmental
costs arising from the production of goods and services and
how these may be best tackled.
• Understand the meaning and importance of property rights in
a discussion of environmental issues.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
The market for natural resources
OHT 15.3
Economic rent represents the earnings to a factor of production over and above its
opportunity cost or the minimum payment needed to keep it in its present use, known as
the transfer earnings.
Figure 15.1 The market for land - perfectly inelastic supply
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 15.4
Figure 15.2 The market for land in a particular use
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 15.5
Economic rent versus quasi-economic rent
Quasi-economic rents occur when a factor of
production earns economic rents that are
competed away in the long run as the supply of
the factor of production is increased.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Environmental issues
OHT 15.6
Environmental issues may be discussed under the
two broad headings of :
•
•
Social welfare.
Property rights.
Social welfare relates to the well-being of society and reflects
both private (internal) and public (external) costs and benefits
stemming from the production of goods and services.
Property rights in the context of environmental issues are
concerned with assets that are over-used because their
ownership is not clearly defined or protected in law.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 15.7
The Environmental Kuznets curve
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Social welfare
•
•
•
OHT 15.8
If MSB is less than MSC, output should be reduced.
If MSB equals MSC, output is at the appropriate level to maximise
social welfare.
If MSB exceeds MSC, increased output should be encouraged.
Figure 15.3 Marginal social costs and benefits
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 15.9A
Key learning points
• Natural resources including the supply of land are an
important input into the production process, alongside labour
and capital.
• Natural resources ultimately tend to be finite in supply,
although there may be many competing alternative uses to
which they can be put.
• Economic rent represents the earnings to a factor of
production over and above its opportunity cost or the minimum
payment needed to keep the factor of production in its present
use, known as its transfer earnings .
• Economic rent tends to arise when a factor of production is
inelastic in supply such as land, and the demand for the
factor of production increases.
• Quasi-economic rents occur when the supply of the factor of
production can be increased in the long run and the economic
rents are therefore competed away.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Key learning points
OHT 15.9B
•
From the viewpoint of social welfare, natural resources
should be used in productive activities up to the point where
the marginal social benefit from their use is equal to the
marginal social cost arising from their use; i.e. MSB = MSC
represents the condition for a socially efficient level of
production.
•
Governments may become involved in the market process to
limit production and consumption where there are appreciable
external costs, such as pollution, through taxation,
prohibition, regulation and pollution permits.
•
Where there is no clear ownership or property rights over
natural resources (e.g. fish in the sea) then over-production
and over-consumption are likely to arise.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.