MANAGERIAL ECONOMICS Let’s go back to OVI’s story.

After his
SECTION 1: PROBLEM SOLVING AND DECISION company won the auction, our geologist increased the
MAKING company’s oil reserves by the amount of oil estimated
CHAPTER 1: Introduction: What This Book Is About to be in the tract. But then the company drilled a well
that was essentially dry. Furthermore, the company
In 1992, a young geologist was preparing a could access what little oil there was in the new tract
bid recommendation for an oil tract on the outer through existing wells, so the acquisition did nothing to
continental shelf in the Gulf of Mexico. He suspected increase the size of the company’s oil reserves. Our
that this new tract of land contained a large geologist reevaluated the reservoir map and then
accumulation of oil because the adjacent tract reduced the reserve estimate by two-thirds. Senior
contained several productive wells—wells management, however, rejected the revised estimate
that his company, Oil Ventures International (OVI), and directed the geologist to do what he could to
already owned. The geologist estimated both the increase the size of the estimated reserves. So, he
amount of oil the tract was likely to contain and what revised the reservoir map again and added “additional”
competitors were likely to bid; then, given these reserves to the company’s asset base. Several months
estimates, he recommended a bid of $5 million. No later, OVI’s senior managers resigned, collecting
competitors had neighboring tracts, so none suspected a bonuses tied to the increase in oil reserves that had
large accumulation of oil. accumulated during their tenure.
Surprisingly, OVI’s senior management The bonus plan is the key piece of evidence
ignored the recommendation and submitted a bid of that ties all the evidence together. You can see that both
$20 million, and the company won the tract—over the the overbidding and the effort to inflate the reserve
next-highest bid of $750,000. estimate were rational, self-interested responses to
If the board of directors hired you as a incentives. Even if you didn’t know about the
management consultant to review the bidding geologist’s bid recommendation, you’d still suspect
procedures at OVI, how would you proceed? What that the senior managers overbid because they had the
questions would you ask? Where would you begin your incentive to do so. Senior managers’ ability to
investigation? manipulate the reserve estimate made it difficult for
You’d find it difficult to gather information shareholders and their representatives on the board of
from those closest to the bidding. Senior management directors to spot the mistake.
would be suspicious, if not openly hostile. No one likes To fix this problem, you have to find a better
to be singled out for bidding $19 million more than way to align the managers’ incentives with company
necessary to win. Likewise, our junior geologist would goals. You want to find a way to reward management
be reluctant to criticize his superiors. You might be for increasing profitability, not for acquiring reserves.
able to rely on your experience—provided that you had This is not as easy as it sounds because it is difficult to
ever run into a similar problem. But when you have no measure a manager’s contribution to company
experience or when you face novel problems, you’d be profitability. You can do this measurement
lost. subjectively, with annual performance reviews, or
Our goal in this book is to give you the tools objectively, using company earnings or stock price
you need to complete an assignment like this one. appreciation as performance metrics. Each performance
measure has problems, as we’ll see in later chapters.
PROBLEM SOLVING In general, rational, self-interested actors
make mistakes for one of two reasons. Either they do
To solve a problem like OVI’s, you have to
not have enough information to make good decisions,
figure out what’s wrong, and then you have to figure
or they lack incentives to do so. Accordingly, when
out how to fix it. Here, you’d begin by determining
you’re using the rational-actor paradigm to find the
whether the $20 million bid was too high at the time it
cause of a problem, you need to ask only three
was made, not just in retrospect. Next, if the bid was
questions:
too high at the time it was made, you’d have to figure
out why the senior managers overbid and find ways to  Who is making the bad decision?
make sure they don’t do it again  Does the decision maker have enough
Both steps require that you predict how information to make a good decision?
people are likely to behave in different circumstances  Does the decision maker have the incentives
—this is where the economic content of the book to make a good decision?
comes in. The one thing that unites economists is their Answers to these three questions will immediately
use of the rational-actor paradigm to predict behavior. suggest ways to fix the problem by
Simply put, this paradigm says that people act  letting someone else make the decision,
rationally, optimally, and self-interestedly. The  giving more information to the decision
paradigm not only helps you figure out why people maker, or
behave the way they do but also suggests how to  changing the decision makers’ incentives.
motivate them to change. To change behavior, you In OVI’s case, we see that (1) senior management
have to change people’s self-interests; you can do that
made the bad decision to overbid; (2) they had enough
by changing incentives. information to make a good decision, but (3) they
didn’t have the incentive to do so. These answers against the University of Michigan, the South Bend
suggest changing incentives as one potential way to fix Marriott charged $649 per night—$500 more than its
the problem. normal weekend rate of $149.
When reading about various business mistakes in On a campus founded by Jesuits, where many
this book, you should ask yourself these three questions students dedicate their year after graduation to working
to see if you can diagnose and fix the problems before with the underprivileged, these high prices caused
reading the answers. By the time you finish the book, alarm. The Wall Street Journal quotes Professor Joe
this kind of analysis should become second nature. Holt, a former Jesuit priest who teaches ethics in the
school’s executive MBA program: “It is an ‘act of
ETHICS AND ECONOMICS moral abdication’ for businesses to pretend they have
no choice but to charge as much as they can based on
Using the rational-actor paradigm in this way supply and demand.” The article further reports Mr.
—to change behavior by changing incentives— makes Holt’s intention to use the example of rising hotel rates
some students uncomfortable because it seems to deny on football weekends for a case study in his class on
the altruism, affection, and personal ethics that most the integration of business and values.
people use to guide their behavior. These students resist
learning the paradigm because they think it implicitly Ethicists like Professor Holt would object to
endorses self-interested behavior, as if the primary the practice of raising prices in times of shortage based
purpose of economics were to teach students to behave on principle. We might label one such principle, the
rationally, optimally, and selfishly. Spider Man principle: With great power comes great
responsibility. The laws of capitalist systems allow
These students would probably agree with a corporations to amass significant power; in turn,
Washington Post editorial, “When It Comes to Ethics, society should demand a high level of responsibility
B-Schools Get an F,” which blames business schools in from corporations. In particular, property rights might
general, and economists in particular, for the ethical give a hotel the option of increasing prices, but
lapses at Enron and other companies. possession of these rights does not relieve the hotel of
A subtle but damaging factor in this is the its obligations to be concerned about the consequences
dominance of economists at business schools. of its choices. A simple beneficence argument might
Although there is no evidence that suggest that keeping prices low would be better for
economists are personally less ethical than consumers.
members of other disciplines, approaching Economics, on the other hand, gives us an
the world through the dollar sign does make ethical defense of high prices by comparing them to the
people more cynical. implied alternative. In the case of the South Bend
What these students and the author, a former hotels, we would compare the world with high prices to
Harvard ethics professor, do not understand is that to the alternative of not raising prices. Economists would
control unethical behavior, you first have to understand show, using supply–demand analysis, that if prices did
why it occurs. When we analyze problems like the one not rise, the consequence would be excess demand for
at OVI, we’re not encouraging students to behave hotel rooms. Would-be guests would find their rooms
opportunistically. Rather, we’re teaching them to rationed, perhaps on a first-come/ first-served basis.
anticipate opportunistic behavior and to design More likely, arbitrageurs would set up a black market,
organizations that are less susceptible to it. Remember, by making early reservations, then “selling” their
the rational-actor paradigm is only a tool for analyzing reservations to customers willing to pay the market-
behavior, not advice on how to live your life. clearing price. Also, without the ability to earn
Often, these kinds of debates are really additional profit during times of scarcity, hotels would
debates about value systems, between deontology and have smaller incentives to build additional rooms,
consequentialism. Deontologists judge actions as good which would make the problem even worse!
or ethical by whether they conform to a set of Versions of this debate—between those who
principles, like the Ten Commandments or the Golden take a principled approach to business and those who
Rule. Consequentialists, on the other hand, judge are simply trying to make money—have been going on
actions by their consequences. If the consequences of in this country since its founding. Although a full
an action are good, then the action is deemed to be treatment of the ethical dimensions of business is
good or moral. To illustrate these contrasting views, beyond the scope of this book, many disagreements are
consider this story about price gouging during periods really about whether morality should be defined by
of high demand. deontology or consequentialism. Once you realize that
When Notre Dame entered the 2006 season a debate is really a debate between value systems, it
as one of the top-ranked football teams in the country, becomes much easier to understand opposing points of
demand for local hotels during home games rose view, and to reach compromise with your adversaries.
dramatically. In response, local hotels raised room For example, if the government were considering price-
rates. According to the Wall Street Journal, the gouging laws that made it illegal to raise prices on
Hampton Inn charged $400 a night on football football weekends, you might offer to donate some of
weekends for a room that cost travelers only $129 a the profits earned on football weekends to a local
night on non-football dates. Rates climbed even higher charity. This might assuage the political concerns of
for games against top-ranked foes. For the game those who ascribe to the Spider Man principle.
 As a footnote to our story of prices in South  Problem solving requires two steps: First,
Bend, when someone offered our Jesuit priest $1,500 figure out why mistakes are being made; and
for his apartment on home-game weekends, he took the then figure out how to make them stop.
offer and now spends his weekends in Chicago.  The rational-actor paradigm assumes that
Apparently, his principles became too costly for him. people act rationally, optimally, and self-
interestedly. To change behavior, you have to
ECONOMICS IN JOB INTERVIEWS change incentives.
If this well-reasoned introduction doesn’t  Good incentives are created by rewarding
motivate you to learn economics, read the following good performance.
interview questions—all from real interviews of my  A well-designed organization is one in which
students. These questions should awaken interest in the employee incentives are aligned with
material for those of you who think economics is organizational goals. By this we mean that
merely an obstacle between you and a six-figure salary. employees have enough information to make
good decisions, and the incentive to do so.
 You can analyze any problem by asking three
questions: (1) Who is making the bad
decision?; (2) Does the decision maker have
enough information to make a good
decision?; and (3) the incentive to do so?
 Answers to these questions will suggest
solutions centered on (1) letting someone else
make the decision, someone with better
information or incentives; (2) giving the
decision maker more information; or (3)
changing the decision maker’s incentives.

CHAPTER 2: The One Lesson of Business

Recently, both Beth Israel Deaconess
Medical Center (affiliated with Harvard Medical
School) and New York University Hospital refused to
perform kidney transplants for two seriously ill
patients. The reason? The kidneys were “directed
donations” from strangers rather than anonymous donor
organs or kidneys from close relatives. A number of
hospitals refuse to support such directed donation
programs. They hold this position despite the fact that
more than 66,000 Americans are on the waiting list for
kidney donations, and some 40,000 of those have been
waiting for more than a year to receive a kidney.
Unfortunately, “the most common way to get off the
list is to die.” The problem afflicts rich and poor alike
because it’s illegal to buy or sell human kidneys in the
United States, although a black market flourishes.
Let’s start this chapter by asking the
following question: Why is buying or selling human
kidneys in the United States illegal? Here are some
common, and conflicting, views on the question.
Choose the answer that best reflects your views.
A. Trafficking in body parts is morally abhorrent
and should be condemned as such. Only
libertarians and investment bankers would
trust markets to make such life and-death
decisions.
B. Do-gooders and religious leaders don’t
understand that outlawing kidney sales
reduces the quantity of kidneys available for
transplant. I hold them responsible for the
SUMMARY AND HOMEWORK PROBLEMS thousands of patients who die each year
SUMMARY OF MAIN POINTS waiting for donated kidneys.
C. Who cares why it’s illegal? If I can borrow
$100 million at 20% interest, I can buy a
 hospital ship, anchor it in international  Internet auctions, like those on eBay, have
waters, and begin selling kidneys. I can set replaced traditional selling mechanisms (like
up a database to match donors to recipients, garage sales and newspaper classified ads)
broker sales, and fly in experienced because Internet auctions are much better at
transplant teams. If I charge $200,000 and matching buyers and sellers. An enthusiastic
earn 10% on each transaction, the break-even collector in Boise can now buy an item that a
quantity is just 1,000 transplants each year. Shreveport resident might have otherwise
This represents about 1% of the potential relegated to the trash heap for lack of local
demand in the United States alone. interest.
If you’re like most people, you answered A. If you  Corporate raiders buy up companies and sell
paid attention during your economics class, you have off their component pieces. They earn money
the analytical tools to know that B is correct. But rather only if the value of the sum of the pieces is
than wading into the ethical debate between A and B, higher than the value of the company as a
we want to show you how to solve the problem whole.
profitably (answer C). Those of you starting at B have a  When consumers purchase insurance, they
slight edge but getting to C requires as much creativity pay an insurance company to assume risk for
and imagination as analytic ability. them. In this context, you can think of risk as
Students who’ve had some economics a “bad,” the opposite of a “good,” moving
training will find the material in this chapter especially from consumers willing to pay to get rid of it
useful because it shows how managerial economics to insurance companies willing to assume it
differs from its public policy cousin, microeconomics, for a fee.
or equivalently, how business differs from economics.  Factory owners purchase labor from workers,
borrow capital from investors, and sell
manufactured products to consumers. In
CAPITALISM AND WEALTH
essence, factory owners are intermediaries
To identify money-making opportunities, like who move labor and capital from lower-
those in the kidney market, we first have to understand valued to higher-valued uses, determined by
how wealth is created and destroyed. consumers’ willingness to pay for the labor
Wealth is created when assets move from and capital embodied in manufactured
lower- to higher-valued uses. products.
An individual’s value for a good or service is  AIDS patients will often sell their life
the amount of money he or she is willing to pay for it. insurance policies to investors at a discount
This willingness requires both desire for the good and of 50% or more. The transaction allows
the ability to pay for it. If we adopt the linguistic patients to collect money from investors, who
convention that buyers are male and the sellers are must wait until the patient dies to collect
female, we say that a buyer’s value for an item is how from the insurance company. This transaction
much he will pay for it, his “top dollar.” Likewise, a moves money across time, from investors
seller won’t accept less than her value, “cost,” or who are willing and able to wait to those who
“bottom line.” don’t want to wait.
Our biggest and most valuable assets are
The biggest advantage of capitalism is that it corporations, so it is not surprising that a lot of firms
creates wealth by letting a person follow his or her self- try to find higher-valued uses for entire companies. In
interest. A buyer willingly buys if the price is below his 2004, a private equity consortium purchased Mervyn’s,
value, and a seller sells for the same selfish reason— a department store located in the western United States.
because the price is above her value. Both buyer and They sold off the real estate on which the stores were
seller gain; otherwise, they would not transact. located, and the new owners set store rents at market
rates. As a consequence, lease payments doubled.
Voluntary transactions create wealth.
Soon, the 59-year-old retailer went out of business,
Suppose that a buyer values a house at throwing 30,000 employees out of work.
$130,000 and a seller at $120,000. If they can agree on
So why is this a wealth-creating transaction?
a price—say, $128,000—the seller receives $8,000
Because the real estate eventually found its way to a
more than the price at which she’s willing to sell it for.
higher-valued use. Charging market rates to the retailer
The difference between the agreed-on price and the
uncovered the real source of Mervyn’s profit, its real
seller’s value is called seller surplus. Likewise, the
estate. It also exposed the retail operation as a money-
buyer receives an item worth $2,000 more than he is
losing entity. So, the private equity group made money
willing to pay; his buyer surplus is equal to his value
by moving real estate to a higher-valued use and by
minus the price. The total surplus or gains from trade
shutting down a money-losing operation.
created by the transaction is the sum of buyer and seller
surplus ($10,000), the difference between the buyer’s How do you create wealth? Which assets do you
and the seller’s values. move to higher-valued uses?
The following are examples of wealth- We close this section with a warning against
creating, voluntary transactions: critics of capitalism who think that if one person makes
money, someone else must be losing it. They do not Conversely, the absence of property rights
understand that the voluntary nature of trade ensures contributes to poverty. People living in countries with
that both parties gain. This is such a common mistake little economic freedom had an average per-capita
that it even has a name, the “zero sum fallacy.” Policy income of just $2,560 and an average negative
makers invoke this fallacy to justify limits on pay, economic growth rate of 0.9%. In countries that enjoy a
profitability, or prices. They do not seem to understand higher level of economic freedom, income and growth
that their policies often hurt the very people they are are much higher, averaging $23,450 and 2.6%,
designed to help. respectively.12 The reasons are simple: Without private
property and contract enforcement, wealth-creating
DO MERGERS MOVE ASSETS TO HIGHER- transactions are less likely to occur and this stunts
VALUE USES? development. Ironically, many poor countries survive
largely on the wealth created in the so-called
In 2006, Dell purchased Alienware, a underground, or black market, economy, where
manufacturer of liquid-cooled, high-end gaming transactions are hidden from the government.
computers. Dell planned to leave the design, sales,
marketing, and support of Alienware computers under Interestingly, secure property rights are also
the control of a separate division, run by the acquired associated with measures of environmental quality and
firm’s management team; however, Dell planned to human well-being. In nations where property rights are
take control of their manufacture. By plugging well protected, more people have access to safe
Alienware into the Dell supply chain, Dell hoped to be drinking water and sewage treatment and people live
able to manufacture Alienware computers much faster about 20 years longer (to 70 instead of 50). In other
and at lower cost than Alienware. For this reason, the words, if you give people ownership to their property,
acquired company was worth more to Dell than it was they take care of it, invest in it, and keep it clean.
to Alienware’s shareholders. In other words, the Peruvian economist Hernando de Soto is
acquisition moved the assets of Alienware to a higher- trying hard to convince Third World governments to try
valued use. this approach to fighting poverty.
For most mergers, however, the value “Imagine a country,” de Soto says, “where
creation is not nearly so obvious. Following nobody can identify who owns what,
announcement of a merger, the stock price of the addresses cannot be verified and the rules
acquired firm typically increases, but the stock price of that govern property vary from
the acquiring firm simultaneously decreases. And more neighborhood to neighborhood, or even from
often than not, the fall in value of the acquiring firm is street to street.” This is what life is like, he
bigger than the increase in value of the acquired firm, says, for 80% of the people in the developing
so that the merger appears to be destroying value, or world and the former communist countries.
moving assets to lower-valued uses. Without title to the property, not only do
This observation corresponds to the people find it difficult to get credit, but they have to
experience of regulators who enforce the antitrust laws spend an enormous amount of time protecting their
that prevent anticompetitive mergers. The internal property—often from the government itself. All of this
documents of the merging firms rarely articulate the makes it much more difficult to rise out of poverty.
value-creating purpose of the merger. Instead, the Professor de Soto has encouraged
internal merger memos say only that the acquired firm governments to fight poverty with legal systems that
is unusually profitable or has a large market share. protect private property and encourage transactions.
But profit or share is worth just as much to Fortunately, his ideas are gaining credence in the world
the acquired company’s shareholders as it is to the community, if only because most other approaches to
acquiring firm, so this motivation is not a good reason fighting poverty have failed.
to transact. Unless there is some synergy—like that
between Dell and Alienware—which makes the ECONOMICS VERSUS BUSINESS
acquired firm more valuable to the buyer than it is to
the seller, the assets are not necessarily moving to a Economics is useful to business because it
higher-valued use. shows us how to spot money-making opportunities
(assets in lower-valued uses). However, economics is
not easy to learn because it is taught on a very abstract
DOES THE GOVERNMENT CREATE WEALTH? level, often using complex models. Fortunately, the
Governments play a critical role in the most useful ideas in economics are not that difficult. In
wealth-creating process by enforcing property rights this section we teach the ideas of economics that are
and contracts—legal mechanisms that facilitate most useful to business.
voluntary transactions. Wealth-creating transactions are We begin with efficiency, the Holy Grail of
more likely to occur when sellers and buyers can keep economics.
the gains from trade. The U.S. legal system, with its An economy is efficient if all assets are
protections for private property, is designed to secure employed in their highest-valued uses.
the gains from trade and is responsible for our nation’s
enormous wealth-creating ability. Economists obsess about efficiency. They
search for assets in lower-valued uses and then suggest
public policies to move them to higher-valued ones. A According to recent research, there is a thriving illegal
good policy facilitates the movement of assets to or “black” market for kidneys in the United States. For
higher-valued uses; and a bad policy prevents assets about $150,000, organ brokers will connect wealthy
from moving to higher-valued uses buyers with poor foreign donors, who receive a few
or, worse, moves assets to lower-valued uses. thousand dollars and the chance to visit an American
Determining whether an economic policy is city. Once there, transplants are performed at “broker-
good or bad requires analyzing all of its effects—the friendly” hospitals with surgeons who are either
unintended as well as the intended effects. Henry complicit in the scheme or willing to turn a blind eye.
Hazlitt, former editorial page editor of the Wall Street Kidney brokers often hire clergy to accompany their
Journal, reduced all of economics into a single lesson: clients into the hospital to ensure that the process goes
smoothly.
The art of economics consists in looking not
merely at the immediate but at the longer In the following examples, we want you to
effects of any act or policy; it consists of first apply the “one lesson of economics” to each
tracing the consequences of that policy not government policy to identify which assets end up in
merely for one group but for all groups. lower-valued uses. Next, think about applying the “one
lesson of business” to devise a way to profitably move
For example, recent proposals to prevent the assets to a higher-valued use.
lenders from foreclosing on houses will benefit the
delinquent homeowners, but the policy will also raise
the costs of lending to new homeowners. And as Taxes
Steven Landsburg has noted, “one man’s foreclosure is The government collects taxes out of the total
another man’s joy.” The houses don’t disappear; they surplus created by a transaction. If the tax is larger than
simply change hands. Determining whether the policy the surplus, the transaction will not take place. In our
improves efficiency requires that we look not only the housing example, if a sales tax is 10%, the tax has to be
sad faces of the family moving out, but also the happy at least $12,000 because the price has to be above the
faces of the family moving in. seller’s value ($120,000). Since the tax is more than the
In our analysis of the prohibition on selling $10,000 surplus created by the transaction, the buyer
kidneys, well-intentioned legislators were probably and seller
trying to stop what they considered immoral trade in cannot find a mutually agreeable price that lets them
human flesh. The one lesson of economics tells them to pay the tax.
consider that their policy also reduced the incentive to First, apply the “one lesson of economics” to
donate kidneys. This means fewer kidneys available to determine all of the consequences of the tax, both the
save people and, consequently, more deaths. We call intended and unintended ones. The intended effect of a
the policy inefficient because some current kidney tax is to raise revenue for the government, but the
owners would willingly sell their organs to recipients unintended consequence of a tax is that it stops some
who would gladly pay. wealth-creating transactions. If too many transactions
Having identified inefficiency—an asset in a are deterred, then raising tax rates can actually reduce
lower-valued use—economists will argue for changes tax revenue. As John F. Kennedy said, “An economy
in public policy to eliminate the inefficiency. It is here hampered by restrictive tax rates will never produce
that business parts ways with economics. Although enough revenues to balance our budget—just as it will
economists see inefficiency as a threat, and something never produce enough jobs or profits.” To illustrate the
to be eliminated, businesspeople see inefficiency as an transaction-deterring effect of taxes, we need only look
opportunity, and something to be exploited. They at California, which has the highest combined income
realize that inefficiencies (including those created by (10%) and sales (8%) tax rates in the country. These
public policy) give them an opportunity to make taxes reduce the incentive to work and to move assets
money. to higher-valued uses. In addition, the wealthiest and
Making money is simple in principle—find most productive people are leaving the state. Both of
an asset employed in lower-valued use, buy it, and then these factors have contributed to a sharp drop in tax
sell it to someone who puts a higher value on it. revenue. As this book goes to press, the state is on the
The one lesson of business: The art of verge of
business consists of identifying assets in low-valued bankruptcy.
uses and devising ways to profitably move them to All of these unconsummated transactions
higher-valued ones. represent money-making opportunities to a
In other words, each underemployed asset businessperson. To make money, figure out how they
represents a potential wealth-creating transaction. The can be profitably consummated. Here’s an example. In
art of business is to identify these transactions and find 1983, Sweden imposed a 1% “turnover” (sales) tax on
ways to profitably consummate them. stock sales on the Swedish Stock Exchange. Before the
For example, once the government banned tax, large institutional investors paid commissions that
kidney sales, it simultaneously created an incentive to averaged 25 basis points (0.25%). The turnover tax, by
try to circumvent the ban. Buying a hospital ship and itself, was four times the size of the old trading costs,
sailing to international waters is just one solution. and it fell most heavily on these big institutional
investors.
 After the tax was imposed, institutional selling kidneys is a form of price ceiling. Americans
traders began trading shares on the London and New are allowed to buy and sell kidneys—but only at a price
York Stock Exchanges, and the number of transactions of zero or less.
on the Swedish Stock Exchange fell by 40%. Smart Price floors above the buyer’s top dollar and
brokers recognized this opportunity and profited by price ceilings below a seller’s bottom line deter wealth-
moving their trades to London and New York. The creating transactions. In our kidney example, potential
Swedish government finally removed the turnover tax kidney sellers are deterred from selling because they
in 1990, but the Swedish Stock Exchange has never can do so only at a price of zero.
regained its former vitality. Rent control in New York City is another
example of a price ceiling. Potential tenants who are
Subsidies willing to pay more than the price ceiling and potential
The opposite of a tax is a subsidy. By landlords who are willing to rent at prices above the
encouraging low-value consumers to buy or high-value ceiling are deterred from transacting. The price control
sellers to sell, subsidies destroy wealth by moving destroys wealth by preventing the movement of
assets from higher- to lower-valued uses— apartments to higher-valued uses.
in exactly the wrong direction. Price controls also create money-making
For example, government policies designed opportunities. For example, the Federal Reserve’s
to extend credit to low-income Americans increased Regulation Q (enforced until the mid-1970s) placed a
homeownership from 64% to 69% of the population. 5.25% price ceiling on interest rates that U. S. banks
Many of these recipients, like Victor Ramirez, were paid to depositors. This price control deterred wealth-
able to afford houses only due to the subsidies. Once creating transactions between consumers willing to
the housing bubble burst, they could not afford to stay lend at a rate higher than 5.25% and borrowers willing
in them. “This was our first home. I had nothing to to borrow at a higher rate. As intermediaries between
compare it to,” Mr. Ramirez says. “I was a student lenders and borrowers, banks had a big incentive to try
making $17,000 a year, my wife was between jobs. In to circumvent the regulation. U.S. banks began to offer
retrospect, how in hell did we qualify?” nonprice incentives, like toasters, to attract additional
deposits. And foreign banks, not subject to U.S.
He qualified mainly due to government regulation, offered dollar-denominated savings
subsidies. We know that these subsidies destroy wealth accounts to U.S. depositors at higher interest rates. The
because without them, the money would have been success of these dollar-denominated savings accounts,
spent on different and higher-valued uses. To see this, called eurodollars, in attracting U.S. deposits
offer each potential homeowner a payment equal to the eventually
amount of the subsidy. If they would rather spend the
money on something besides a home loan, then there is forced the Federal Reserve to abandon Regulation Q.
a higher-valued use for the money. Many states have price-gouging laws that
The same logic can be used to identify ways prevent stores from raising prices following a natural
to profit from inefficiency. To see this, let’s turn to a disaster. This inevitably leads to shortages, like those
simple example: health insurance that fully subsidizes following Hurricane Katrina in Mississippi. John
visits to the doctor. If you get a cold, you go to the Shepperson, a Kentucky resident, recognized a money-
doctor, who charges the insurance company $200 for making opportunity. He bought 19 electrical generators
your care. Is this a wealth-creating transaction? (Hint: and drove 600 miles to Mississippi in a rented U-Haul,
Would you rather self-medicate and keep the $200 or and began selling the generators for twice what he paid
visit the doctor?) If employees would rather suffer at for them. He made money and his customers were
home and keep the $200, then this subsidy destroys thrilled to have power.
wealth. Unfortunately, Shepperson was arrested for
Employers could profit by offering insurance price gouging, and thrown in jail. The Mississippi
that requires a deductible or copayment. These fees Attorney General confiscated the generators, and they
would stop low-value doctor visits and dramatically remained in police custody until long after the
reduce the cost of insurance. Employers could keep the emergency had passed.
money or simply raise workers’ wages (by the amount
they save on insurance) to attract better workers. WEALTH CREATION IN ORGANIZATIONS
Companies can be thought of as collections
Price Controls of transactions, from buying raw materials like capital
A price control is a regulation that allows and labor to selling finished goods and services. In a
trade only at certain prices. successful company, these transactions move assets to
higher-valued uses and thus make money for the
Two types of price controls exist: price company.
ceilings, which outlaw trade at prices above the ceiling,
and price floors, which outlaw trade at prices below the As we saw from the story of the oil company
floor. The prohibition on buying and in the introductory chapter, a firm’s organizational
design influences decision making within the firm.
Some designs encourage profitable decision making;
others do not. A poorly designed company will
consummate unprofitable transactions or fail to
consummate profitable ones.
The inability of organizations to move assets
to higher-valued uses is analogous to the wealth-
destroying effects of government policies.
Organizations impose “taxes,” “subsidies,” and “price
controls” that lead to unprofitable decisions. For
example, overbidding at the oil company was caused
by a “subsidy” paid to management for acquiring oil
reserves. Senior management responded to the subsidy
by acquiring reserves, regardless of the price. Our
solution to the problem was to eliminate the subsidy.

SUMMARY & HOMEWORK PROBLEMS

SUMMARY OF MAIN POINTS: Group Problems
 Voluntary transactions create wealth by
moving assets from lower- to higher-valued
uses.
 Anything that impedes the movement of
assets to higher-valued uses, like taxes,
subsidies, or price controls, destroys wealth.
This inefficiency implies a money-making
opportunity.
 The art of business consists of identifying
assets in low-valued uses and devising ways
to profitably move them to higher-valued
ones. CHAPTER 3: Benefits, Costs, and Decisions
 A company can be thought of as a series of Armadillo Appliances manufactures a diverse
transactions. A well-designed organization line of appliances for home use (ovens, washers,
rewards employees who identify and dryers, etc.). As part of a recent effort to reduce costs,
consummate profitable transactions or who their corporate Purchasing Department switched steel
stop unprofitable ones. suppliers because a new manufacturer offered a price
Multiple-Choice Questions that was a penny/pound less than the old purchase
price. Multiplied by the nine million pounds of steel
they use each year, Armadillo anticipated savings of
$90,000. Instead, however, acquisition costs increased
by $75,000.
It turns out that the Purchasing Department
managers failed to account for the “hidden costs” of
freight in making their decision to switch
manufacturers. Because the new manufacturer was
located farther away, increased shipping costs more
than offset the lower purchase price.
You might wonder how the managers in the
Purchasing Department could make such an obvious
mistake. It turns out that these managers were
evaluated based on the raw material cost of steel, not
the total acquisition cost. Shipping costs were
considered to be part of operations, and so were
charged to the Manufacturing Division. Consequently,
the Purchasing Department managers had no incentive
to consider this freight cost when making their
decision. After senior managers recognized the
Individual Problems problem, they changed the evaluation metrics for the
Purchasing Department to include freight costs.
The result was a closer alignment of the
incentives of the Purchasing Department with the
profitability goals of the company. After the change,
Purchasing considered all of the costs that varied with
the consequence of their decisions, including freight. variable costs, consider which of the following costs
The goal of this chapter is to show you how to identify are variable:
the benefits and costs of the decisions you make.  Payments to your accountants to prepare your
tax returns
BACKGROUND: VARIABLE, FIXED, AND TOTAL  Electricity to run the candy-making machines
COSTS  Fees to design the packaging of your candy
For decisions that affect output, knowing bar
how costs vary with output will help you compute  Costs of material for packaging
some of the costs associated with these decisions. To
illustrate, suppose that you are the manager of a new BACKGROUND: ECONOMICS VERSUS PROFIT
candy factory. To produce candy, you have to build a
We now leave our fictitious candy
factory, purchase ingredients, and hire employees to
manufacturer to talk about a real one. In 1990, Cadbury
run it and to sell your product. Suppose your factory
India offered its managers free housing in company-
cost is $1 million, employees cost $50,000 total each,
owned flats to offset the high cost of living in Bombay.
and ingredients cost $0.50/candy bar. If you decided to
In 1991, when Cadbury added low-interest housing
produce 1,000 candy bars, you need to hire ten
loans to its benefits package, managers took advantage
employees, but if you decide to produce 2,000 bars,
of this incentive and purchased their own homes,
you need 20 employees. For 2,000 bars, your
leaving the company flats empty. The empty flats
production costs would be $1,500,500— $1 million for
remained on the company’s balance sheet for the next
the factory, $500,000 in employee costs, and $500 in
six years.
ingredient costs. If you decide to produce 2,000 bars,
your costs would be $2,001,000—$1 million for the In 1997, Cadbury adopted Economic Value
factory, $1 million in employee costs, and $1,000 in Added (EVA®), a financial performance measure
ingredients. trademarked by Stern Stewart & Co. EVA® charges
each division within a firm for the amount of capital it
Notice that some, but not all, of the costs
uses and rewards management for increasing its
change as you increase output. Total costs increase as
division’s Economic Value Added, or EVA®. EVA®
you produce more candy bars, but your factory costs $1
dictated that Cadbury India take on a capital charge of
million regardless of the amount you produce. The
15%, representing the return that Cadbury could have
factory is a fixed cost, as opposed to the labor or
made had it invested the capital elsewhere.
ingredients, whose costs vary with input. We call costs
that change with output level variable costs. The After EVA® adoption, Bombay’s division
distinction is a key lesson for this chapter: saw a charge on its annual income statement equal to
$600,000 (15% times $4,000,000—the value of the
Fixed costs do not vary with the amount of
apartments). To increase their division’s EVA®, senior
output. Variable costs change as output changes.
managers decided to sell the unused apartments. By
Table 3-1 shows total, fixed, and variable charging each division for the amount of capital it uses,
costs for your new candy factory at various production the company gives managers incentives to abandon
levels. Notice that the fixed costs remain the same investments earning less than 15% and to undertake
whether your factory produces nothing or 5,000 candy only those investments earning more than 15%.
bars. Variable costs, on the other hand, rise and fall as
output changes. Total costs show a similar pattern with
the important exception that total costs are also greater
than zero regardless of output.
To reinforce the relationships among these
costs, we can also represent them graphically. Figure 3-
1 shows the general relationship between output and
total, fixed, and variable costs. For output levels of
zero, both fixed and total costs are greater than zero.
Total and variable costs both increase with output, and
variable costs appear as the difference between the total
cost
curve and the fixed cost line. To test your
understanding of the distinction between fixed and The Bombay Cadbury managers likely had a
very good sense of their factories’ variable, fixed, and
total costs. So why were they making bad decisions
concerning the company-owned flats? To understand
this problem, we must recognize another very
important distinction: the difference between
accounting and economic costs. Table 3-2 presents a
recent annual income statement for Cadbury. The firm
sold over £6 billion in goods for the year; and after
subtracting various expenses, it ended up with a profit The opportunity cost of an alternative is what
of £431 million, or approximately 6.4%. you give up to pursue it.
Expense categories include items like the In what follows, when we use the term cost,
following: we refer to opportunity cost. Costs depend on what you
 Costs paid to its suppliers for product give up and this depends on the decision that you are
ingredients trying to make. The most important lesson of this
 General operating expenses, like salaries to chapter is that costs and decisions are inherently linked
factory managers and marketing expenses to one another. To illustrate the link, consider the
 Depreciation expenses related to investments Cadbury managers’ decision to hold onto the
in buildings and equipment companyowned flats. Management could have sold
them and used the capital to expand operations. In other
 Interest payments on borrowed funds
words, the cost to the company of holding onto the
These types of expenses are the accounting costs apartments was the forgone opportunity to invest
of the business. capital in the company’s operations and earn a 15%
Economists, however, are also interested in return. Holding onto the flats cost the company
implicit costs, costs that likely do not show up in the $600,000 each year. Unless the benefits to the company
accounting statements. What’s an example of an of holding onto the apartments were at least $600,000,
implicit cost? Look at the income statement again, and the capital was not employed in its highest-valued use.
notice that it lists payments to one class of capital Managers ignored the empty flats on the
providers of the company (debt holders). Interest is the company’s balance sheet because they had no incentive
cost that creditors charge for use of their capital. But to do otherwise. To fix the problem, the company
creditors are not the only providers of capital. began rewarding managers for increasing EVA®—
Stockholders provide equity, just as bond holders which is more closely associated with the profit that
provide debt. Yet the income statement reflects no matters to the shareholders. The company-instituted
charge for equity. Suppose that Cadbury had received change in measuring costs motivated the managers of
£4 billion in equity financing. If these equity holders the Bombay operation to move the capital tied up in the
expect an annual return of 10% on their money (or apartments to a higher-valued use.
£400 million), we would subtract this amount from the
Does your company charge you for the
£431 million in net earnings to get a better idea of the
capital that you use? If not, does this lead you to make
economic profit of the business. Similarly, if equity
bad decisions?
investors expected a 12% annual return (or £480
million), Cadbury would have an economic loss of £49
million (£431 million in net earnings less the £480 FIXED- OR SUNK-COST FALLACY
million expected return). The economic profit tells Opportunity costs are conceptually simple;
investors whether they should keep investing in the the hard part is identifying the profit consequences of
firm. Negative economic profit means that the firm is the associated decisions.
earning less than equity holders expect to make from When making decisions, you should consider
their investment in the firm. all costs and benefits that vary with the
What does this mean in practical terms? It consequence of a decision and only costs and
means that a firm may show an accounting profit while benefits that vary with the decision. These
experiencing an economic loss. The two amounts are are the relevant costs and relevant benefits of
not equal because economic profit recognizes both the a decision.
explicit and implicit costs of capital. A failure to You can make only two mistakes as you
consider these implicit costs is why the Cadbury India make decisions: You can consider irrelevant costs, or
managers continued to maintain their flats. By adopting you can ignore relevant ones. In this section and the
EVA®, the firm made visible the hidden cost of equity, next, we describe these two potential mistakes and how
and the mangers sold the abandoned flats. To be able to to avoid them.
calculate these types of implicit costs, it is critical to
The fixed-cost fallacy or sunk-cost fallacy
understand the concept of opportunity costs.
means that you consider costs and benefits
that do not vary with the consequences of
COSTS ARE WHAT YOU GIVE UP your decision. In other words, you make
So how do we calculate implicit costs? The decisions using irrelevant costs and benefits.
trick is recognizing how implicit or economic costs As a simple example, consider a football
relate to the decisions that you are trying to make. game. You pay $20 for a ticket, but by halftime your
When deciding between two alternatives, always team is losing 56–0. You stay because you say to
choose the one that returns the highest profit. We yourself, “I want to get my money’s worth.” Of course,
define the costs of one as the forgone opportunity to you cannot get your money’s worth, even if you stay.
earn profit from the other. With this definition, costs The ticket price does not vary with the decision to stay
imply decision-making rules, and vice versa. If the or leave. You should make the decision without
benefits of the first alternative are larger than its costs considering the ticket price, which is a sunk cost and
—the profit of the second alternative—then choose the therefore not relevant to the decision.
first. Otherwise, choose the second.
 One of the most frequent causes of the fixed- rationally decided not to outsource even though
cost fallacy in business is the “overhead” allocated to outsourcing would have been a profitable move for the
various activities within a company. Because overhead company.
is a fixed or sunk cost, it should not influence most
business decisions within a company. If managers
make decisions based on their overhead allocations,
they commit the fixed-cost fallacy. Look back at the
Table 3-2 income statement. Overhead costs appear in
the line item of Selling, General, and Administrative
Expense. An example of such an overhead expense
would be costs associated with the corporate The company’s incentive compensation
headquarters staff or with the sales force. These costs scheme that rewarded managers for increasing
are considered fixed because output can be increased accounting profit rather than economic profit gave him
without the need to increase the corporate staff, like the an incentive to commit the sunk-cost
CFO or CEO. Because these costs will not vary with fallacy. This leads to an important lesson:
decisions about changing output, they should be Accounting profit does not necessarily
ignored in the decision-making process. correspond to real or economic profit.
For example, suppose that you are in charge Economic profit measures the true
of a new products division, and are considering profitability of decisions. Rewarding employees for
launching a product that you will be able to distribute increasing accounting profit may lead to decisions that
through your existing sales force, without incurring reduce economic profit. In the case of the
extra expenses. However, if you launch the new washing machine agitator, the company should have
product, your division will be forced to pay for a rewarded its manager for increasing economic profit.
portion of the sales force. If this “overhead” charge is This would have better aligned his incentives with the
big enough to deter an otherwise profitable product goals of the shareholders.
launch, then you will commit the fixed-cost fallacy. Companies find it difficult to avoid the sunk-
Overhead expenses are analogous to a “tax” on cost fallacy because the person who decided to make
launching a new product. In this case, the tax deters a the sunk-cost investment is often the only one who has
profitable enough information to know when the investment
product launch. should be abandoned. If decision makers fear
Depreciation often becomes another case of punishment for making what turns out to be a bad
the fixed-cost fallacy. For example, in 1996, a washing investment, then they may continue the investment just
machine firm considered outsourcing its plastic agitator to hide the original mistake. We see this in the
production, rather than making them internally as had pharmaceutical industry, where drug development
been done for several years. The firm received a bid of programs are very difficult to stop once they get
$0.70 per unit from a trusted supplier and compared started, and in companies that continue to develop
this bid with its internal production costs. Play along computer software in-house, even after cheaper and
and make your decision on the basis of Table 3-3. better alternatives become available on the market. In
The relevant comparison should neglect the each case, the person or division continues drug and
costs of depreciation and overhead because your firm software development long after it should stop to avoid
incurs these costs regardless of whether you decide to punishment.
outsource. The relevant cost of production is $0.80, and
the relevant cost of outsourcing is $0.70. So HIDDEN – COST FALLACY
outsourcing is cheaper. The second mistake you can make is to
In this example, however, identifying the ignore hidden costs.
right decision was easier than making it for the The hidden-cost fallacy occurs when you
manager in charge of the washing machine plant. Six ignore relevant costs—those costs that do vary with the
years earlier, they had incurred $1 million worth of consequences of your decision.
tooling costs to make molds for the agitators.
Following Generally Accepted Accounting Principles, As a simple example of this, consider another
they were charging themselves $100,000/year, over ten football game. You buy a ticket for $20, but at game
years, for the tooling cost. This is called “straight-line time scalpers are selling tickets for $50 because your
depreciation.” But this also meant that there was still team is playing its cross-state rivals who have legions
$400,000 worth of un-depreciated capital still on the of fans willing to pay over $50 to go to the game. Even
company’s balance sheet. Accountants at his firm told though you do not value the tickets at $50, you go
the manager that if he decided to outsource the agitator, anyway because, you say, “These tickets cost me only
these “assets” would “become worthless,” and the $20.”
manager would be forced to take a charge7 against his But wait, the tickets really cost you $50. By
division’s profitability. The $400,000 charge would going to the game, you give up the opportunity to scalp
prevent him from reaching his performance goal, and them. Unless you value going to the game as much as
he would have to forgo his bonus. The manager the rival fans, then yours is not the highest-valued use
for the ticket. In other words, you are sitting on an
unconsummated wealthcreating transaction. Instead, By adopting compensation schemes tied to
scalp the tickets and stay home! EVA®, firms are less likely to commit the hiddencost
Consider another example: Suppose that you fallacy. As the promotional material of Stern Stewart &
wish to fire an employee. You estimate that the Co. puts it:
employee contributes $2,500 per month to the company The capital charge is the most distinctive and
and that his compensation package costs the company important aspect of EVA®.
$1,900 per month. Should you fire the employee? How Under conventional accounting, most
does your answer change if you can sublet his office companies appear profitable but many in fact
for $800 per month? are not. As Peter Drucker put the matter in a
If you can rent the employee’s office space Harvard Business Review article, “Until a
for $800 per month, the hidden cost of the employee is business returns a profit that is greater than
$800. The total cost of the employee is $2,700 per its cost of capital, it operates at a loss. Never
month, which is higher than the benefit he contributes mind that it pays taxes as if it had a genuine
to the company. Fire him. profit. The enterprise still returns less to the
The subprime mortgage crisis of 2008 can be economy than it devours in resources . . .:
traced to a failure to recognize the higher costs of loans Until then it does not create wealth; it
made by dubious lenders, like Long Beach Financial, destroys it.”
wholly owned by Washington Mutual (now bankrupt). EVA corrects this error by explicitly
Long Beach Financial was moving money recognizing that when managers employ
out the door as fast as it could, few questions capital they must pay for it, just as if it were
asked, in loans built to self-destruct. It a wage.
specialized in asking homeowners with bad By taking all capital costs into account,
credit and no proof of income to put no including the cost of equity, EVA® shows the
money down and defer interest payments for dollar amount of wealth a business has
as long as possible. In Bakersfield, created or destroyed in each reporting
California, a Mexican strawberry picker with period. In other words, EVA® is profit the
an income of $14,000 and no English was way shareholders define it. If the
lent every penny he needed to buy a house shareholders expect, say, a 10% return on
for $720,000. their investment, they “make money” only to
The credit-rating agencies should have the extent that their share of after-tax
recognized the high cost of the subprime mortgages operating profit exceeds 10% of equity
(high probability of default) but their ratings did not capital. Everything before that is just
reflect the hidden cost of these very risky loans. As a building up to the minimum acceptable
consequence of this failure, Long Beach financial was compensation for investing in a risky
able to package and sell the risky loans to Wall Street enterprise.
investors, like Lehman Brothers, who went bankrupt This is not to say that adopting EVA® can
when the loans eventually solve all your incentive alignment problems.
defaulted. Implementing EVA® still requires managers to exert a
considerable amount of judgment and analysis. Even
though EVA® is designed to make visible the hidden
ECONOMIC VALUE ADDED cost of capital, unless you can identify all hidden costs,
When making decisions that involve capital you can still commit the hidden-cost fallacy. For
expenditures or savings, it is obviously important to example, if it is difficult to value the uncertain future
explicitly consider what else you could do with the benefits of an investment, you can commit the fallacy if
capital—lest you commit the hidden-cost fallacy. As you ignore the investment’s future benefits while
discussed in the Cadbury India story above, EVA® is a considering current costs. The answer to every difficult
performance measure that makes visible the hidden economic question is almost always “it depends”—in
cost of capital by charging each division within a firm this case, on being able to identify all the relevant costs
for the amount of capital it uses. This gives managers and benefits of the investment decision. Stern Stewart
an incentive to increase their division’s EVA® by & Co. can be credited for designing a system that
either liquidating investments earning less than the cost makes visible the hidden cost of capital, but it is only a
of capital, or by undertaking new investments earning performance metric, not a substitute for careful
more than the cost of capital. Typically, the cost of analysis.
capital is computed as the risk-adjusted cost of equity,
the cost of debt, or a weighted average of the two,
sometimes called the weighted average cost of capital, DOES EVA® WORK?
or WACC. By adopting EVA®, or a similar economic
Specifically EVA® is the net operating profit profit plan (EPP), and linking pay to performance,
after taxes minus the cost of capital times the amount of firms reward managers for making good decisions—
capital utilized. In equation form: those that increase economic profit. If managers begin
making better decisions, firms that adopt such plans
should experience improved operating performance.
Stern Stewart & Co. claims that “more than 300 client they’re not. Typically, those with mugs value them
companies worldwide now use EVA®, and evidence twice as much as those without. Retailers are very
shows that most of them significantly outperform other aware of this bias – why do you think you so often see
companies in their industries.” programs like “Buy now, pay later” or “Try it before
As expected, Professors Craig Lewis and you buy it?” The retailers want to get the product in
Chris Hogan find that operating performance of your hands to increase its perceived value to you. This
companies adopting EPPs significantly improves same bias makes it very difficult for managers to pull
following adoption. For the companies that they the plug on businesses or investments that they
examined, the median return on assets (ROA) increases originally initiated. In making decisions, you should
from 3.5% in the year prior to adoption to 4.7% four carefully think about how ownership might be affecting
years later. Median operating income-to-total assets your valuation.
rises to 16.7% from 15.8% in four years. It appears that Loss aversion can also explain the reluctance
firms adopting EPPs realize dramatic long-run of mangers to abandon projects. Loss aversion means
improvements in operating performance. that managers would pay more to avoid losses than to
But before we can conclude that adopting an realize gains. In other words,
EPP is a good idea, we have to figure out what the firm losses have more emotional impact than gains of the
would have done had it not adopted an EPP. We have same size. This bias also causes stickiness in house
to compare EPP adoption with the next-best alternative: prices. Two homeowners, with identical houses, will
That is, what else can firms do to increase profitability? list the houses at different prices, depending on what
This is the opportunity cost of EPP adoption. To they paid for it. This can prevent markets from
answer this question, Lewis and Hogan set up “natural clearing. During the big bust in the Boston
experiments” matching each adopting company with a condominium market in the 1990’s, for example,
comparable firm (same industry, similar operating sellers listed properties at a price 35% above the
performance, same size) that did not adopt an EPP. expected sales price, and most properties just sat there,
Surprisingly, they found that operating performance of unsold. The market “froze up” because sellers held out
nonadopting firms was statistically indistinguishable for prices that no one would reasonably pay. And if the
from that of adopting firms. real estate market does not clear, then no one knows
Although bonus payments increase 39.1% in how much the mortgage-backed securities are worth
the adoption year for EPP firms, they also increase because their value depends on the real estate market.
37.4% for the nonadopters. Thus, well-managed firms This uncertainty has made investors wary and
respond to poor recent performance by strengthening contributed to the run on banks who invested in these
the link between pay and performance, but the choice mortgage-backed securities.
of performance evaluation metric, whether economic Confirmation bias is a tendency to gather
profit (including the hidden cost of capital) or earnings information that confirms your prior beliefs, and to
(accounting profit), does not seem to matter. ignore information that contradicts them. To see how
The bottom line is that new trends, fads, or this affects decision making, suppose you are a senior
analytical tools should be viewed skeptically. If a manager listening to a project team pitching a new
radical change is necessary to kick managers into project. The team has talked to project engineers about
action, the conclusion could well be that adoption of an feasibility, and they’ve run some test marketing to see
economic performance plan is the necessary boot. how consumers might react to the product. Their
However, Lewis and Hogan’s research points out that financial models indicate a very profitable product.
change can also be accommodated within the structure Should you invest? Before you do, try to determine
of existing compensation schemes. whether the team has subconsciously filtered the
information being presented. If they were particularly
enthusiastic about the project from the start, it’s likely
PSYCHOLOGICAL BIASES AND DECISION that they have gathered mostly favorable information.
MAKING Push the analysis to look for disconfirming information
After reading this chapter, you should be able they may have missed or ignored.
to recognize the relevant benefits and costs of Anchoring bias relates to the effects of how
decisions. But the frequency and magnitude of the information is presented or framed. The classic
mistakes made by businesses cannot be explained by illustration of this effect involves asking people to
ignorance alone. For that we have to turn to estimate when Genghis Khan died after first asking
psychology, and the common biases that get in the way them to think about the last three digits of their phone
of rational decision making. number. Those with lower values of the last three digits
The endowment effect explains how the mere tend to give lower estimates because they have been
fact of taking ownership of an item increases the value anchored to this lower
that a person puts on the item. This effect is commonly number. If you pay attention, you will often see
shown in classroom settings by giving one-half of the retailers trying to anchor you to high numbers: “What
class coffee mugs and then comparing the bottom-line would you expect to pay for this beautiful item, $200,
values of mug owners to the top-dollar values of non- $150? Well, it’s available for a short time for only
mug owners. If the mugs are randomly distributed, the $39.99.” Having been anchored to the values of $200
average of each group should be about the same. But
and $150, all of the sudden $39.99 sounds like a great consider how your own decisions might be
deal. Anchoring your opponent is often an effective affected.
negotiation tool— it gets them thinking about a high Multiple-Choice Questions
number initially and you can negotiate down from
there.
Overconfidence bias is the tendency to place
too much confidence in the accuracy of your analysis.
For example, suppose you are projecting the annual
revenues for a new product launch. You’ll probably
base your estimate on some test marketing or historical
comparisons to similar launches. Study after study has
shown that you will likely be overconfident in your
analysis. Not only are you likely to have overestimated
the sales level, but also your belief in its accuracy will
likely be too high. Be aware of this bias as you make
decisions. Consider a wider range of scenarios.
Analyze what might happen if sales are significantly
lower than you anticipate. Think about a more flexible
solution that would allow you to adjust your decision as
uncertainty about performance is resolved. Dealing
with uncertainty is an important topic in decision
making and one we will return to in a later chapter.

SUMMARY & HOMEWORK PROBLEMS

SUMMARY OF MAIN POINTS:
 Costs are associated with decisions.
 The opportunity cost of an alternative is the
profit you give up to pursue it. Individual Problems
 Consider all costs and benefits that vary with
the consequences of a decision and only costs
and benefits that vary with the consequences
of a decision. These are the relevant costs and
benefits of a decision.
 Fixed costs do not vary with the amount of
output. Variable costs change as output
changes. Decisions that change output change
only variable costs.
 Accounting profit does not necessarily
correspond to real or economic profit.
 The fixed-cost fallacy or sunk-cost fallacy
means that you consider irrelevant costs. A
common fixed-cost fallacy is to let overhead
or depreciation costs influence short-run
decisions.
 The hidden-cost fallacy occurs when you
ignore relevant costs. A common hidden-cos
fallacy is to ignore the opportunity cost of
capital when making investment or shutdown
decisions.
 EVA® is a measure of financial performance
that makes explicit the hidden cost of capital.
 Rewarding managers for increasing
economic profit increases profitability, but
evidence suggests that economic performance
plans work no better than traditional
incentive compensation schemes based on
accounting measures.
 Decision makers are subject to a number of
psychological biases in evaluating costs and
benefits. Be aware of these biases; take
advantage of them when you can and
Group Problems BACKGROUND: AVERAGE AND MARGINAL
COSTS
In 2005, Memorial Hospital’s chief executive
officer (CEO) conducted performance reviews of the
hospital’s departments. As part of this review process,
the chief of obstetrics proposed increasing the number
of babies being delivered by his department. The CEO
examined the department’s financial statements and
noted that the cost of 540 deliveries was $3,132,000,
but revenues were only $2,754,000. The CEO asked
why anyone would want to increase a service that was
losing $700 every time the hospital delivered another
baby.
CHAPTER 4: Extent (How Much) Decisions As most of you will now recognize, the CEO
The financial crisis began in the subprime is committing the fixed-cost fallacy. As we learned in
housing market. Government policies encouraged the last chapter, the relevant costs and benefits of this
lenders to extend credit to low-income borrowers who decision are those that vary with the consequences of
previously would not have qualified for loans. This the decision. Instead of starting with the question—
occurred at the same time when mortgages were being should we be delivering more babies?—he began with
packaged into securities that were sold to investors, the costs. And since fixed costs do not vary with the
thereby shifting the credit risk. If this risk had been decision to increase the number of deliveries, they are
recognized, investor demand for these mortgage- irrelevant to the profit calculus. Had the CEO ignored
backed securities would have been low. Instead, the the fixed costs, he would have realized that increasing
rating agencies—who were paid by the very parties the number of deliveries would increase hospital profit.
who issued the securities—gave these securities AAA Average cost (AC) is irrelevant to an extent
ratings. This increased demand for the securities, which decision.
encouraged lenders to make even more subprime loans. Because average costs “hide” fixed costs by
The resulting credit “bubble” made a lumping them together with variable costs, this mistake
millionaire out of Sharman Lane, a high school dropout is easy to make. Suppose that for 5,000 deliveries,
who had previously worked as a manicurist before Memorial Hospital had fixed costs of $1 million and
joining subprime lender New Century Mortgage.1 Ms. variable costs of $3,000/delivery; total costs would
Lane bought loan applications from mortgage brokers equal $2.5 million ($1,000,000 + [$3,000 x 500]).
on behalf of her lender. As the housing market heated Divided by the number of deliveries (Q), the average
up, competition for loans became so fierce that lenders cost would be $5,000. We plot this average cost curve
were literally throwing themselves at brokers to get in Figure 4-1. Average total cost falls throughout the
loans. Lane’s unwillingness to do this cost her her range of output, but variable cost remains constant at
business. “Women who had sex for loans were known $3,000/patient.
very quickly,” says Lane, who left New Century before Marginal cost is the extra cost required to
it failed in 2007. “I didn't want to be a mortgage slut.” make and sell one additional unit of output. Formally,
Implicitly, mortgage brokers like Lane were Marginal Cost=Total Cost Q +1−Total Cost Q
deciding “how many” loans to make. If we want to . At Memorial Hospital, increasing output from 500 to
understand how the mortgage crisis began, we need to 501 units raises total cost from $2,500,000 to
examine the decision to extend credit to people like the $2,503,000, so the marginal cost is $3,000. Fixed costs
Mexican strawberry picker in Bakersfield, California, do not change as output increases, so they do not factor
who borrowed every dollar needed to buy a $720,000 into the profit calculus.
house despite speaking no English and earning an
Note that marginal costs can be below or
annual income of only $14,000.2
above average cost. It depends on whether the marginal
He qualified because lenders like New cost is above or below the average. For example,
Century had no incentive to deny him. They were consider a factory near capacity that wants to increase
rewarded for each loan they made, regardless of the output. If workers run out of space, leading to lower
risk. As a result, they made too many loans. So, part of productivity, the marginal will be above the average, so
the mortgage crisis can be blamed on lenders like New the average will increase.
Century, whose incentives were not aligned with the
profitability goals of the investors who eventually
bought mortgage-backed securities. We could also
point to the role of the credit-rating agencies in creating
these perverse incentives.
In this chapter, we show you how to make
profitable “extent” decisions by identifying the relevant
benefits and costs of these decisions.
 bigger change, so we do the best that we can. We
estimate the marginal effect of another dollar of
advertising by dividing the $50,000 by 1,000 customers
to get $50 per customer, sometimes called the customer
acquisition cost. This means that the marginal cost of
acquiring another customer is $50.4 If the marginal
benefit of another customer is bigger than $50, then
increase advertising. Otherwise, do not.
Note that marginal analysis points you in the
right direction, but it cannot tell you how far to go.
After taking a step, you have to re-compute marginal
costs and benefits to see whether further steps are
warranted.
MARGINAL ANALYSIS We can also use marginal analysis to
To analyze extent decisions, we break down compare the relative effectiveness of two different
the decision into small steps and then compute the costs extent decisions. For example, suppose that you are
and benefits of taking another one of these steps. If the trying to decide how to adjust your promotional budget,
benefits of taking another step are greater than the currently allocated between TV advertising and
costs, then take another step. Otherwise, step telephone solicitation. How much should you spend on
backwards. advertising for each medium?
We call this approach marginal analysis. To In this case, the opportunity cost of spending
illustrate, we analyze the common extent decision of one more dollar on TV advertising is the forgone
how much to sell, where marginal analysis applies to opportunity to spend that dollar on telephone
both costs and revenues. solicitation. To increase profit, increase spending on
Marginal cost (MC) is the additional cost whichever medium has a higher marginal effect, and
incurred by producing and selling one more pay for the increase by reducing spending on the other
unit. medium.
Marginal revenue (MR) is the additional If you recently decreased your telephone
revenue gained from selling one more unit. solicitation budget and this saved $10,000, but you lost
If the benefits of selling another unit (MR) 100 customers, the marginal effectiveness of phone
are bigger than the costs (MC), then sell another unit. solicitation is one customer for $100 (alternatively, the
marginal customer acquisition cost is $100). Note that
Sell more if MR > MC; sell less if MR < MC. we are implicitly assuming that you could get the
If MR ¼ MC, you are selling the right customers back by restoring your telephone solicitation
amount (maximizing profit). budget.
Marginal analysis works for any extent Since it is cheaper to gain another customer
decision, like whether to change the level of using TV advertising, increase TV advertising and
advertising, the quality of service, the size of your staff, spend less on telephone solicitation. Note that marginal
or the number of parking spaces to lease. The same analysis doesn’t even require you to measure the
principle applies to each decision—do more if MR > marginal benefit of acquiring a customer. All it requires
MC, and do less if MR < MC. is that you measure the marginal effectiveness of each
Returning to the example of Memorial activity. If one activity has higher marginal
Hospital, after a more detailed analysis, managers effectiveness than the other, then increase that activity
computed the marginal cost of a delivery at and reduce expenditures on the other. Then re-measure
approximately $1,800, whereas marginal revenue and decide whether to make further changes.
was around $5,000. The hospital was not delivering When you adjust your advertising
enough babies; that is, at the current output, MR > MC. expenditures, make the changes one at a time. Do not
Contrary to the CEO’s initial view, Memorial could increase telephone solicitation at the same time you
increase profit by delivering more babies, not by decrease TV advertising because you lose
reducing the number of deliveries. valuable information about the marginal impact of each
The main difficulty in applying marginal change when you change both at the
analysis is measuring the costs and benefits of same time. Only by changing them separately can you
additional steps. To illustrate, suppose you are working measure the marginal effectiveness of each
for a mobile phone company trying to decide whether
to adjust the amount you spend for TV advertising. to see whether further changes are profitable.
Suppose you recently increased your TV advertising It is common to confuse marginal cost with
budget by $50,000, and the ads yielded 1,000 new average cost. Average cost is total cost divided by the
customers. number of units produced. In our current example, the
In this example, we have data on a big jump average per-customer cost for TV would be computed
($50,000) but not on the little steps ($1) that make up by dividing the total spent on TV advertising by the
the jump. The only available data correspond to the total number of customers gained. But remember that
average costs are not what you need to make extent Dominican Republic to the Yucatán. Finally, remember
decisions. In some instances, they might lead to poor that marginal analysis tells you what direction to go
decisions. To compute marginal cost, look only at the (shift production), but it doesn’t tell you how far to go.
additional cost of producing one more unit. The two Decide how far to go by taking a step and then re-
cost figures may be very different. For example, some measuring marginal costs to determine whether to take
psychological models of advertising say that any fewer another step.
than four exposures to an advertisement has no effect In this example, the Fortune 50 company
on purchase decisions. The marginal effectiveness of shifted some production, but not as much as the
that fourth exposure is thus very large, but the average managers wanted because they had to maintain good
effectiveness of the entire advertising budget would be working relationships with politicians in the Dominican
much lower. Republic who would have been upset if too many local
Now that you understand the differences workers lost jobs.
between marginal and average analysis, let’s try to use
it to help reduce costs at a Fortune 50 company that INCENTIVE PAY
produces textile products at various manufacturing
plants in Latin America. The plants operate as cost How hard to work is an extent decision, so
centers, meaning that plant managers are rewarded for marginal analysis can be used to design incentives to
reducing costs of production. To evaluate the cost encourage hard work. To illustrate, suppose you are a
centers, the firm measures production using standard landowner evaluating two different bids for harvesting
absorbed hours (SAH). For each garment produced, the a tract of timber containing 100 trees. One bid is for
firm computes the time required to complete each step $150 per tree, and the other bid is for $15,000 for the
in the manufacturing process. Complex garments like right to harvest all the trees. Which bid should you
overalls require more time and thus are assigned a accept?
higher SAH (15 minutes) than simple garments like T- Although both bids have the same face value,
shirts (two minutes). The output of a factory is thus they have dramatically different effects on the logger’s
measured in SAH, and each factory is evaluated based incentives. If you charge a fixed fee of $15,000 for the
on how much it costs to get one hour’s worth of right to harvest all the trees, the logger treats the price
production in terms of cost per SAH. paid to the landowner as a fixed or sunk cost. He
Obviously, measuring output in this way should, by our reasoning in Chapter 3, ignore that cost.
allows managers to identify lower cost factories. This gives him an incentive to cut down trees as long as
Suppose that a factory in the Yucatán operates at the value of each tree is greater than the cost of
$20/SAH, and a factory in the Dominican Republic harvesting it. Under this contract, he will end up cutting
operates at $30/SAH. As a manager, do you think you down all the trees.
could save $10/SAH by shifting production from the On the other hand, if you charge the logger a
Dominican Republic to the Yucatán? Remember, this is royalty rate of $150 per tree, the logger will cut down
an extent decision about how much to produce at each only those trees with a value greater than $150. If the
factory, so you want to measure the marginal costs at forest is a mix of pine worth $200 per tree and fir worth
each plant. The extent decision here is similar to our $100 per tree, the logger will harvest only the pine and
hospital’s decision of how many babies leave the fir. Consequently, the landowner will receive
to deliver. less money under a royalty contract because the logger
Before you start, it is always helpful to will harvest only the pine trees. The royalty rate is
remind yourself of the mistakes that you can make. If analogous to a sales tax because it deters some wealth-
the cost used to compute cost per SAH include creating transactions (i.e., the fir trees are not
overhead that cannot be avoided, then you won’t save harvested).
on overhead as you shift production—they are The same idea can be applied to the problem
irrelevant for this extent decision. So, first you must of motivating salespeople. For example, suppose you
adjust the cost per SAH to remove the influence of any want to evaluate the incentive effects of two different
fixed costs, lest you commit the fixed-cost fallacy. incentive compensation schemes. One is based on a
Second, make sure that cost per SAH is a 10% commission rate, where the salesperson is paid
good proxy for marginal costs. To check whether this is 10% of all sales. The other compensation plan pays a
so, make sure that when you reduce output in the 5% commission rate plus a $50,000 per year flat salary.
Dominican Republic, you really are avoiding close to Each year, you expect salespeople to sell 100 units at a
$30/SAH for each SAH of output reduction in the price of $10,000 per unit. Which incentive
Dominican Republic facility, and make sure that you compensation scheme should you use?
are incurring only about $20/SAH for each SAH of As in our earlier example, the contracts have
output increase in the Yucatán. If this is not correct, the same face value but different effects on the
then cost per SAH is a poor proxy for marginal cost. behavior of the salesperson. If you pay a 10%
If you are convinced that $10 cost per SAH is commission, then the marginal benefit to the
a reasonable proxy for difference in marginal costs salesperson of making a sale is $1,000. If you pay a 5%
between the two factories, then you can lower costs by commission, the marginal benefit is only $500. If some
moving production from the sales are relatively easy to make (i.e., the salesperson
gives up less than $500 worth of time and effort to
make them), and some sales are relatively difficult to Along with changing the COO’s
make (i.e., they require at least $800 worth of effort), compensation scheme, the CEO also moved to a system
then only the easy sales will be made under the 5% of incentive pay for the account representatives. This
commission had equally dramatic effects on the account
rate. representatives—except for one employee who was
In essence, the sales force responds to the going through a divorce. The incentive pay scheme did
smaller marginal benefit of selling with less effort, little to increase his marginal incentives because half of
which we call shirking. This kind of shirking is everything he earned went to his estranged wife.
analogous to the decision of the logger to harvest only
the high-value, low-cost trees when he pays a royalty IF INCENTIVE PAY IS SO GOOD, WHY DON’T
rate for each tree harvested. The logger responds MORE COMPANIES USE IT?
negatively to the high marginal costs of logging just as Although the benefits of incentive pay seem
the salesperson responds negatively to the low marginal clear, it is not a panacea—especially in cases where it
benefit of selling. To induce higher effort, use is difficult to measure performance. Later on, as we
incentives that reduce marginal costs or increase develop more tools to analyze incentives, we will see
marginal benefits. Fixed costs or benefits do not change that there are situations where incentive pay can be
effort. counterproductive. Its successful application “depends”
on a number of factors.
TIE PAY TO PERFORMANCE MEASURES THAT Also, trying to implement incentive pay in an
REFLECT EFFORT organization can be more difficult than turning a
How to reward good performance is a critical Communist country toward capitalism. Consider this
part of the design of any organization, as the following 1998 reaction from a “faculty” member in the
story illustrates. In 1997, a 50-year-old chief operating “corporate learning center” of a Fortune 50 company to
officer (COO) with a bachelor’s degree in journalism a suggestion that the company adopt an incentive
and a law degree managed a consulting firm with 10 compensation plan:
account executives. The COO was in charge of keeping Forfeiting our most recently espoused values
clients happy and ensuring that the account executives of equal ownership in Firm X’s success is not
were working in the best interests of the company. The the answer. I fear that we will be attempting
COO earned a flat salary of $75,000. to compete for employees interested in a
After taking classes in human resources, classoriented system of compensation. From
economics, and accounting, the CEO of the company where I sit, this is the last thing a
became convinced of the merits of incentive pay. He corporation needing vast, systemic, team-
sat down with his COO, and together they set profit oriented change should be trying to do to
goals for the year. All revenues counted toward the compete in the global marketplace. Many
COO’s profit goal. But only the expenses that the COO folks know I am a staunch opponent of
controlled directly—like compensation and office incentive plans, and I often quote Alfie Kohn
expenses—were “charged” against his profit. All (1993), whose research shows that rewards
overhead items, like rent, were placed under another punish. Saying “If you do this, you’ll get
budget because the COO could not control them; that that” differs little from saying “Do this or
is, they were “fixed” with respect to his effort. this will happen to you.” Incentives are
By creating this new budget, the CEO controlling.
implicitly recognized that the usual accounting However, another aspect of the punishment
statements were inadequate for evaluating the COO’s is much more evident in this change of
performance. The CEO and the COO both agreed that policy: “Not receiving a reward one expects
without much effort, the COO could earn8 $150,000 to receive is also indistinguishable from
each quarter. But earning an amount over $150,000 being punished.” Just ask all those who don’t
would take more effort. To reward the COO for receive the bonuses they were previously
exerting extra effort, they agreed on an incentive entitled to how they feel about it. The
compensation scheme that paid the COO one-third of incentive pay policy is overt in its support of
each dollar that the company earned above $150,000. class separation over collective team
After making the change, the COO’s participation. It ignores the premises of
compensation jumped to $177,000—an increase of modern systems thinking and reverts to the
136%—whereas the firm’s revenues jumped from mechanistic theories of Descartes and
$720,000 to $1,251,000—an increase of 74%. A good Newton for justification. A typical business
economy certainly contributed to the increase in school text from the 1950s would have
revenues, but the compensation plan also helped. suggested instituting such an aristocratic
Revenue increased because the COO pushed hard to policy.
make and exceed earnings goals, and, for the first time, If you want to short the stock of this
he worried about expenses. For example, he attempted company, call me and I will tell you which one it is.
to contain costs by asking why phone bills were so
high. SUMMARY & HOMEWORK PROBLEMS
SUMMARY OF IMPORTANT POINTS:
 Do not confuse average and marginal costs.
 Average cost (AC) is total cost (fixed and
variable) divided by total units produced.
 Average cost is irrelevant to an extent
decision.
 Marginal cost (MC) is the additional cost
incurred by producing and selling one more
unit.
 Marginal revenue (MR) is the additional
revenue gained from selling one more unit.
 Sell more if MR > MC; sell less if MR < MC.
If MR ¼ MC, you are selling the right
amount (maximizing profit).
 The relevant costs and benefits of an extent
decision are marginal costs and marginal
revenue. If the marginal revenue of an
activity is larger than the marginal cost, then
do more of it.
 An incentive compensation scheme that
increases marginal revenue or reduces Group Problems
marginal cost will increase effort. Fixed fees
have no effects on effort.
 A good incentive compensation scheme links
pay to performance measures that reflect
effort.
Multiple – Choice Questions

CHAPTER 5: Investment Decisions: Look Ahead and

Reason Back
In the summer of 2007, Bert Mathews was
contemplating the purchase a 48-unit apartment
building in downtown Nashville. The building was
95% occupied and generated $550,000 in annual profit.
His investors were expecting a 15% return on their
capital, and the bank had offered to loan him 80% of
the purchase price of the building at a rate of 5.5%. He
computed his cost of capital as a weighted average of
equity and debt as 0.2 x (15%) + 0.8 x (5.5%) = 7.4%.
Based on his cost of capital, Mr. Mathews decided that
he could pay no more than $550,000/ 7.4% = $7.4
million and still break even. Note that profit divided by
the purchase price is the expected return, which has to
cover his cost of capital.
Even though the owner was willing to sell,
Mr. Mathews ultimately decided not to purchase
because of the uncertain outlook. The business press
was full of stories about the deteriorating housing
market and the rising number of mortgage defaults, so
Mr. Mathews decided to wait.
It turned out to be a good decision. A year
later, the building’s occupancy rate fell to 90%, which
reduced the annual profit to only $500,000. And the
Individual Problems bank was willing to loan him only 65% of the purchase
price at a rate of 7.5%. His new weighted average cost
of capital was 0.35 x (15%) + 0.65 x (7.5%) =
10.125%. This meant that he could offer only $5.4
million for the building. However, the owners rejected
the offer as too low, hoping that the market would
recover and allow them to sell at a higher price.
 This story illustrates both the effect of the to pay for the apartment building.
bursting credit bubble on real estate valuations, but As you might imagine, time is a critical
more importantly from our point of view, the relevant variable in investment decisions. Intuitively, this makes
costs and benefits of investment decisions, the topic of sense. Projects that return dollars sooner have higher
this chapter. rates of return, all else equal. For example, consider the
returns on two different projects. The first returns
HOW TO DETERMINE WHETHER INVESTMENTS $1,200,000 at the end of year 1 and the second returns
ARE PROFITABLE $1,200,000 at the end of year 2. The company would
All investment decisions involve a trade-off between obviously prefer to get its profit more quickly and so
current sacrifice and future gain. If you’re willing to would prefer the first project to the second.
invest in projects with relatively low rates of return, say This intuition can be formalized into a
5%, then you’re willing to trade current dollars for general decision rule that allows a company to decide
future ones at a relatively even rate. Equivalently, we whether an investment is profitable. The use of net
say that you have a low discount rate (r), or that the present value (NPV) leads to the rule’s name—the
future is worth almost as much to you as the present. NPV rule.
Formally, we can quantify the trade-off by
compounding, (present value) x (1 + r) = (future value),
or by discounting, (present value) = (future value)/(1 +
r). For example, if you have a 5% discount rate, then
$1.05 next year is worth $1.00 to you today.
Discounting payoffs that occur k periods in the future
can be computed by recursively discounting the If the net present value of discounted cash flow is
payoffs, one period at a time, (present value) = (future larger than zero, then the project earns more than the
cost of capital.
value)/(1+r )k
Consider the two projects shown in Table 5-
Individuals with low discount rates invest in 1, both of which require an initial investment of $100.
more projects because more investments meet their Project 1 pays off $115 at the end of the first year,
return criteria. These individuals are more likely to go whereas Project 2 pays off $60 at the end of the first
to college and graduate school, own stocks, and year and $60 at the end of the second. The company’s
exercise. The common thread in these activities is that cost of capital is 14%. To determine whether the
they have current costs and future payoffs, just like investments are profitable, we discount all future
investments. inflows and outflows to the present so we can compare
Individuals who require bigger returns, say them to the initial investment.
20%, place a lower value on future dollars. They invest Inflow 1 is divided by 1.14; Inflow 2 is
only in projects with much higher rates of return, or, if divided by 1.14 2. From the bottom two lines of Table
none is available, they borrow money. These
individuals are more likely to smoke, shun exercise, 5-1, it’s clear that Project 1 earns profit while Project 2
abuse drugs, and commit crime. The common thread in does not.
all of these activities is that they have current payoffs The NPV rule illustrates the link between
and future costs. economic profit in Chapter 3 and investment decisions.
One reason for identifying individuals with Projects with positive NPV create economic profit.
different discount rates (other than to keep those with Stated another way, only positive NPV projects earn a
high discount rates out of your study group) is to return higher than the company’s cost of capital. By
recognize the possibility of trade between them. In the calculating the returns of Projects 1 and 2, we find that
current example, there is an unconsummated wealth- Project 1’s return is higher than 14%, and Project 2’s is
creating transaction—at any interest rate above 5% and lower than 14%. Projects with negative NPV may
below 20%, the high-discount-rate individual would create accounting profit but not economic profit. In
willingly borrow from the low-discount-rate individual. making investment decisions, choose only projects with
a positive NPV.
Companies, like individuals, possess discount
rates of their own, determined by their costs of capital. In your finance classes, you will learn that
As we saw in the chapter opening, a company’s cost of NPV analysis is the “correct” way to evaluate
capital is a blend of debt and equity, its “weighted investment decisions. But real-world managers rely on
average cost of capital” or WACC. Companies with a a number of other techniques, as well. In a recent study,
high cost of capital invest only in high-return projects, over one-half of chief financial officers (CFOs) used
whereas companies with a lower cost of capital invest payback periods as their decision tool. To evaluate the
in a wider range of projects. Before the credit bubble profitability of investments, CFOs calculate how many
burst, Mr. Mathews had a relatively low cost of capital, months it would take for an investment to break even.
and so was willing to pay more for the apartment If it is longer than their break-even period, then they do
building. After the credit bubble burst, his cost of not make the investment.
capital increased from 7% to 10% which reduced the
amount he was willing BREAK-EVEN ANALYSIS
 In general, break-even analysis can be used in break-even quantity (9,600) would still be below
a variety of situations. Although these techniques may expected sales.
not be as “correct” as NPV analysis, break-even Outsourcing the Titan to Chrysler would have
analysis is easier to do and it generates simple, intuitive made economic sense, but in early 2009, the companies
answers. To illustrate, let’s examine an entry decision. issued a joint statement indefinitely postponing the
Instead of asking whether entry is profitable, we are project due to “declining economic conditions.” If the
going to ask an easier question, “Can I sell enough to recession forces Chrysler into liquidation, look for
break even?” If you can sell more than the break-even Nissan to purchase Chrysler’s truck plant in Mexico.
quantity, then entry is profitable; otherwise, entry is You can also think of stock market valuations
unprofitable. in break-even terms. Price/Earnings or P/E ratios can
To compute the break-even quantity, we have be interpreted as a payback period for evaluating stock
to distinguish between marginal costs (MC), which investments. The P/E ratio of the S&P 500 index in
vary with quantity, and fixed costs (F), which don’t. December 2008 was 15, which implies that it takes 15
You’ll be able to analyze the vast majority of your years of earnings to break even on the purchase price.
investment decisions with this very simple cost This P/E ratio is near its historical average of about 16,
structure: You incur a fixed cost to enter an industry which is one way that analysts determine whether the
and a constant per-unit marginal cost when you begin stock market is under- or overvalued.
production.

CHOOSING THE RIGHT MANUFACTURING

TECHNOLOGY
The break-even quantity is the quantity that will lead to
zero profit.4 The logic behind the calculation is simple. We can use a variant of break-even analysis
Each unit sold earns the contribution margin (P - MC), to choose between different manufacturing
so named because this is the amount that one sale technologies. In 1986, John Deere was building a
contributes toward covering fixed costs, and you have capital-intensive factory to produce large, four-wheel
to sell at least the break-even quantity to cover fixed drive farm tractors. Then the price of wheat dropped
costs. If you sell more than the breakeven quantity, you dramatically, reducing demand for these tractors
have earned more than enough to cover your fixed because they’re used exclusively for harvesting wheat.
costs, or to earn a profit. John Deere stopped construction of its own factory and
attempted to purchase Versatile, a Canadian company
For example, consider Nissan’s 2008
that assembled tractors in a garage using off-the-shelf
redesign of its Titan pickup truck. The Titan had only
components.
two years left on its eight-year product life cycle and
Nissan had to decide whether to redesign it. We can characterize John Deere’s decision as
Complicating the decision was a weakening demand a choice of one manufacturing technology over another.
for U.S. trucks, with sales predicted to fall from 1.3 They abandoned their capital-intensive factory,
million in 2008 to only 400,000 trucks per year by characterized by big fixed costs but
2011. small marginal costs, in favor of Versatile’s
Nissan managers used a rough break-even technology, characterized by small fixed costs but big
calculation to evaluate their investment alternatives. It marginal costs. Did John Deere make the right
would cost $400 million to design and build a new decision?
truck from the bottom up. At a 12% cost of capital, the As you should now begin to realize, the right
investment would cost Nissan about $48 million per answer is always “It depends.” In this case, it depends
year. Since they earned only $1,500 per truck, they on how much John Deere expected to sell. Suppose that
would have to sell at least 32,000 trucks each year to the capital-intensive technology had fixed costs of $100
break even. With only a 3% share of the U.S. market, and marginal costs of $10, whereas Versatile’s
however, Nissan predicted they would sell only 12,000 technology had fixed costs of $50 but marginal costs of
Titan trucks each year, not enough to break even. $20. (Note: We’re deliberately choosing easy-to-work-
The other option was to ask Chrysler to build with numbers so that we can illustrate the general
the new Titan for them. Chrysler had just made a big point.)
investment in updating its Dodge Ram pickup. It had To determine the quantity at which John
enough spare capacity on its Mexican assembly line Deere is indifferent between the two technologies— the
and would likely have a lot more capacity by 2011. If break-even quantity—solve for the quantity that
Nissan used the Dodge Ram as the base platform for equates the two costs. At a quantity of five units, total
the new Titan, the required investment to build the new costs are $150 for both technologies. If you expect to
model would fall from $400 million to only $80 sell more than five units, choose the low-marginal-cost
million. This would reduce the annual capital cost to technology; otherwise, choose the low-fixed-cost
only $9.6 million, and reduce the break-even quantity technology.
to only 6,400 trucks. Even if Chrysler were to charge a John Deere made the right decision by
Nissan a higher fee for building the Titan trucks so that abandoning its construction project and acquiring
the contribution margin fell to $1,000 per truck, the Versatile because projected demand for tractors was
low. However, the Antitrust Division of the U.S. To make this concrete, think of the fixed
Department of Justice challenged the acquisition as costs as a one-year renewable lease. When the lease
anticompetitive because John Deere and Versatile were comes up for renewal, it is relevant to the shutdown
two of just four firms that sold large four-wheel-drive decision because it is avoidable. However, until the
tractors in North America. lease comes up for renewal—during the period that
We end this section with a warning to avoid a economists call the short run—it is unavoidable, so you
very common business mistake: should ignore it when deciding whether to shut down.
Do not invoke break-even analysis to justify
higher prices or greater output. SUNK COSTS AND POST-INVESTMENT HOLD-
Managers often reason that they must raise UP
price to cover fixed costs. This is wrong if fixed costs By 2000, Mobil Oil (now ExxonMobil) was
do not vary with the pricing decision. Similarly, the leading supplier of industrial lubricants10 in the
managers sometimes reason that since average fixed United States. It achieved that position—a 13% market
costs decline with quantity, they must sell as much as share—by bundling engineering services with its high-
they can to reduce average cost. Both lines of reasoning quality lubricants. With twice as many field engineers
are flawed because, as you know, pricing and as its next-largest competitor, Mobil was able to offer
production are extent decisions that require marginal custom-designed lubrication programs to complement
analysis, not break-even analysis. sales of their lubricants.
Remember, the relevant costs depend on One of its largest customers was TVA, a
which question you are asking. We’ve just seen that regional producer of electric power whose annual
fixed costs are relevant before you incur them. In the consumption of lubricants exceeded one million
next section, we will show that they can also be gallons. Early in 2000, Mobil conducted a three-month
relevant when you decide to shut down or exit the engineering audit of TVA. This audit included
industry. employee training, equipment inspections, and, for
each piece of TVA equipment, repair, service, and
SHUTDOWN DECISIONS AND BREAK-EVEN lubricant recommendations.
PRICES TVA made the recommended repairs, but
To study shutdown decisions, we work with then it gave the lubricant recommendation list to a
break-even prices rather than quantities. If you shut Mobil competitor that offered lubricants at lower
down, you lose your revenue, but you get back your prices. When Mobil failed to match the lower prices,
avoidable cost. If revenue is less than avoidable cost, or they lost the contract and their three-month investment.
equivalently, if price is less than average avoidable Mobil and its managers forgot a basic business maxim:
cost, then shut down. Look ahead and reason back. By failing to anticipate
self-interested behavior, they were victimized by it.
The break-even price is the average
avoidable cost per unit. Economics is often called the “dismal
science,” partly because of its dark view of human
The only hard part in applying break-even nature. We have already seen the utility of using this
analysis is deciding which costs are avoidable. For that, perspective to look ahead and reason back to worst-
we use the Cost Taxonomy, shown in Figure 5-1. case scenarios. Nowhere is this more important than in
analyzing sunk-cost investments. Sunk costs are
unavoidable, even in the long run, so if you make sunk-
cost investments, you are vulnerable to post-investment
hold-up. Let’s look at the problem of post-investment
hold-up by working again with break-even prices.
Consider the case of a magazine, like
National Geographic, trying to negotiate with a
regional commercial printer to print its magazine. For
the magazine, using a regional printer saves on
To understand how to use the taxonomy, shipping costs. But to print a high-quality magazine,
consider the following problem. Fixed costs are $100, the printer must buy a $12 million rotogravure printing
marginal costs are $5, and you’re producing 100 units press. If the marginal cost of printing a single copy is
per year. How low can price go before it is profitable to $1 and the printer expects to print one million copies
shut down? per year over a two-year period, the average cost of
Again, the answer is “It depends.” In this printing the magazine over two years is $7, computed
case it depends on which costs are avoidable. In the as the average fixed cost of the investment ($12
short run, only marginal cost is avoidable, so the million/2 million copies) plus the marginal cost
shutdown price is $5. In the long run, fixed costs ($1/copy). This is the break-even price for the printer
become avoidable, so they become relevant to the and represents her bottom line in negotiations with the
shutdown decision. In the long run, the shutdown price magazine. Before they are incurred, sunk costs are
includes average fixed cost and so rises to $6. relevant to the negotiation.
 However, once the printer purchases the In this industry, the enormous investment
printing press, the profit calculus changes. If the printer required to build a refinery is vulnerable to post-
cannot recover any of the press’s value by reselling it, investment hold-up—the bauxite mine could raise the
then the cost of the press is sunk. Once sunk costs have price of ore once the refinery is built. So, we rarely see
been incurred, the magazine can hold up the printer by refineries built without vertical integration or strong
renegotiating terms of the deal. Since the cost of the long-term requirements contracts between the mine and
press is unavoidable, the printer’s break-even price falls refinery. These types of organizational forms “solve”
to the marginal cost of printing the magazine ($1). the hold-up problem by reassuring the refiner that it
If the managers of the commercial printer will not be held up once its relationship-specific
anticipate hold-up, they will be reluctant to deal with investment is made.
the magazine. Then it becomes not just a problem for Marriages are vulnerable to the same type of
the potential victim of hold-up, but also for the post-investment opportunism that plagues commercial
potential perpetrator of hold-up. The one lesson of relationships. Parties invest time, energy, and money in
business is to figure out how to profitably consummate a marriage, the kinds of investments that differentiate
the transaction between the printer and the magazine. marriages from more casual relationships, which can be
If possible, the printer’s negotiators will thought of as spot market transactions. These
insist on a contract that penalizes the magazine should investments are valuable to the marriage parties but are
it decide to hold them up. With the assurance of a largely specific, in that they have a much lower value
contract, the printer may feel confident enough to incur outside the relationship. The marriage contract
sunk costs. But contracts are often difficult and costly penalizes post-investment hold-up (i.e., divorce) and
to enforce. A better solution might be to make the this makes couples willing to invest more in the
magazine purchase the press and then lease it to the marriage.
printer. In this case, the magazine no longer poses a We close the chapter with the story of an
hold-up threat to the printer because the printer has economist and his fiancée who were receiving
incurred no sunk costs. premarital counseling from a priest before he would
Note that if the cost of the printing press is marry them. The priest’s first question to the couple
fixed, meaning that it can be recovered by selling the was “Why do you want to get married?” The
machine, then hold-up is not a problem. If the economist’s fiancée answered, “Because I love him and
magazine tries to renegotiate a price less than average want to spend the rest of my life with him.” As you
cost, the printer will rationally refuse the business, sell might imagine, the economist had a different answer:
the press, and recover his entire investment. Hold-up “Because long-term contracts induce higher levels of
can occur only if costs are sunk, like those of Mobil’s relationship-specific investment.” A year later, trying
engineering services. hard to find the right words to express how he felt
about his wife, he wrote an anniversary e-mail—using
a cursive font—declaring that his “relationship-specific
SOLUTIONS TO HOLD-UP PROBLEM investment was covering his cost of capital.”
In general, there are many investments that
are vulnerable to hold-up. Anytime that one person
makes a specific investment—one that is sunk or lacks SUMMARY & HOMEWORK PROBLEMS
value outside a trading relationship—it can be held up SUMMARY OF MAIN POINTS:
by its trading partner. If one party anticipates that she is  Investments imply willingness to trade
at risk of being held up, she will be reluctant to make dollars in the present for dollars in the future.
relationship-specific investments, or demand costly Wealth-creating transactions occur when
safeguards, including compensation in the form of individuals with low discount rates lend to
better terms from her trading partner. This gives both those with high discount rates.
parties an incentive to adopt contracts or organizational  Companies, like individuals, have different
forms, such as investments in reputation, merger, or the discount rates, determined by their cost of
exchange of “hostages” to reduce the risk of hold-up. capital. They invest only in projects that earn
The goal is to ensure that each party has both the a return higher than the cost of capital.
incentive to make relationship-specific investments and  The NPV rule states that if the present value
to trade after these investments are made. of the net cash flows of a project is larger
For example, consider the problem faced by than zero, the project earns economic profit
manufacturers of aluminum. Bauxite (aluminum ore) (i.e., the investment earns more than the cost
comes from mines in South America. The refining of capital).
process used to produce alumina from bauxite is  Although NPV is the correct way to analyze
tailored to the specific qualities of the ore. In addition, investments, not all companies use it. Instead,
transporting bauxite is costly, so it’s advantageous to they use break-even analysis because it is
locate the alumina refinery near the mine. Both the easier and more intuitive.
technological requirements of the refining process and  Break-even quantity is equal to fixed cost
the high transport costs make the investment in a divided by the contribution margin. If you
refinery specific to the relationship between the mine expect to sell more than the break-even
and the refinery.
 quantity, then your investment will be
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 Group Problems
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.
Multiple – Choice Problems
SECTION 2: PRICING, COSTS, AND PROFITS
CHAPTER 6: Simple Pricing
From early 2007 to the middle of 2008, the
average price of a gallon of gas in the United States
rose from less than $2.00 to over $4.00. Although this
was especially bad news for SUV drivers and airplane
passengers, it was really good news for two
McMinnville, Tennessee, workers named Dolly and
Molly. Dolly and Molly had been unemployed, but the
increase in gas prices put them back to work. What
made these two workers unique? They’re mules, and
when the price of gas rose dramatically, the cost of
running a tractor increased, leading to their re-
employment.
Farmers in Rajasthan, India, reacted to higher
gas prices in a similar manner. Rather than turning to
mules, however, they increased their use of camels on
farms. As oil prices rose, demand for camels increased,
leading to a tripling of prices for camels over a two-
year period.
The camel breeders could have given a lesson
to NNS, a U.S. company producing potash fertilizer. As
the cost of inputs rose, including petrochemicals, their
price of “generic” potash fertilizer doubled.
Historically, NNS had priced its branded fertilizer at a
Individual Problems
35% premium above the generic price. However, the
rapid increase in costs during the first two quarters of
2008, combined with the NNS policy of revising price
quarterly, led to stockouts and a price that was 25%
below the generic price. If the premium had been
maintained, NNS would have sold the same volume at
a higher price and would have earned an additional $13
million.
Pricing is a powerful but oft-neglected tool.
We all know that Profit = P x Q - C x Q, but many
businesses seem to focus on either Q or C and forget
about P. Think about companies you’ve worked for—I
bet they spent more time thinking about how to sell
more or how to reduce costs and not a whole lot of time
about how to raise price. Roger Brinner, Partner and
Chief Economist at The Parthenon Group, argues that We can link our two tables to get a measure
most companies can make money by raising price. of how much our consumer gains from eating hot dogs.
Theory suggests that he is correct. For a company with If the consumer pays less than the total value of the hot
a pre-tax profit margin of 8.6% (the average for the dogs, he or she has consumer surplus. Table 6-3 shows
S&P 500), revenues would have to increase by 12% to the amount of consumer surplus for different numbers
get the same payoff as a 1% increase in price. of hot dogs
consumed.
BACKGROUND: CONSUMER SURPLUS AND To describe how consumers will respond to
DEMAND CURVES price, economists use demand curves, which tell you
Let’s consider a simplified relationship how much a single consumer or a group of consumers
between price and quantity purchased by a single will consume as a function of price. Recall from the
consumer, using hot dogs. Table 6-1 shows the number First Law of Demand that we should expect demand
of hot dogs the consumer will purchase at various curves to slope downward because consumers purchase
prices. more as prices fall.
It’s easy to see from the table that, as price Demand curves describe buyer behavior and
falls, the consumer purchases more hot dogs, reflecting tell you how much consumers will buy at a given price.
the First Law of Demand: Consumers demand To describe the buying behavior of a group of
(purchase) more as price falls, assuming the value you, consumers, we add up all the individual demand curves
a hungry consumer, receive from the first hot dog you to get an aggregate demand curve. The simplest way to
purchase and consume—it’s likely to be substantial. show this is when each consumer wants only a single
The additional value you get from consuming the item (i.e., the marginal value of a second unit is zero).
second hot dog is a bit less, and by the time you’re For example, to construct a demand curve that
chowing down on your fifth hot dog, the additional describes the behavior of seven buyers, simply arrange
value is fairly small. The marginal, or additional, value the buyers by what they are willing to pay (e.g., $7, $6,
of consuming each subsequent hot dog diminishes the $5, $4, $3, $2, and $1). At a price of $7, one buyer will
more you consume. purchase; at a price of $6, two buyers will purchase; at
Suppose the consumer values that first hot $5, three buyers; and so on. At a price of $1, all seven
dog at $5, the second at $4, the third at $3, and so on. buyers will purchase the good. An aggregate or market
Knowing the value our consumer places on each demand curve is the relationship between the price and
subsequent hot dog allows us to construct Table 6-2, the number of purchases made by this group of
which shows total and marginal value for the various consumers. In Figure 6-1, we plot this demand curve.
quantities, where total value is simply the sum of the
preceding marginal values.
As always, thinking in marginal terms is
critical. Say you just looked at the fact that five hot
dogs have a total value of $15. You might be tempted
to conclude that if hot dogs were priced at $3, the
consumer would purchase five hot dogs since 5 x $3 =
$15. Thinking in marginal terms, however, shows us
that the marginal value of the fourth hot dog is only $2,
so at a price of $3, the consumer will purchase just
three. If consumers behave optimally, they will try to
maximize the surplus they get from consuming hot
dogs, the difference between their value and the price
they pay. Purchasing three hot dogs at $3 each leads to
consumer surplus of $3 (total value of $12 less
expenditure of $9). Purchasing five hot dogs at $5 each
would lead to consumer surplus of zero.
Note that price—the independent variable—
is on the wrong axis. There are good reasons for this
that will become apparent, but for now, just accept that
economists like to do things
a little differently. Note also that economists have
special jargon describing the response of demand to
price. We say that as price decreases, “quantity
demanded” increases. If something other than price
changes stimulate demand, we instead say that the
demand curve “shifts” to the right, or “increases,” such
that consumers purchase greater quantities at the same
prices. We’ll discuss factors that shift demand in a later
chapter.
 To determine the quantity demanded at each
price using the demand curve, look for the quantity on
the horizontal axis corresponding to a price on the
vertical axis. At a price of $6, buyers demand two
units; at a price of $5, three units; and so on. As price
falls, quantity demanded increases.
Your boss has confused average revenue or
MARGINAL ANALYSIS OF PRICING price with marginal revenue. They’re easy to confuse.
Demand curves present sellers with a Here’s why. As long as price is greater than average
dilemma. Sellers can raise price and sell fewer units, cost, it appears that an increase in quantity would
but earn more on each unit sold. Or they can reduce increase profit. However, this reasoning is incorrect
price and sell more, but earn less on each unit sold. because it doesn’t recognize the dependence of Q on P
This fundamental trade-off is at the heart of pricing —you cannot sell more without decreasing price. Put
decisions. We resolve it by using marginal analysis. If another way, you can say that to sell more, you have to
marginal revenue (MR) is greater than marginal cost reduce price for all customers, not just the additional
(MC),5 you can increase profit by selling another unit. customers who would be attracted by the reduced price.
Reduce price (sell more) if MR > MC. Tell your boss that you are already making all
Increase price (sell less) if MR < MC. profitable sales—those for which marginal revenue
Recall that consumers and sellers are both exceeds marginal cost. Marginal analysis, not average
using marginal analysis. But consumers are using analysis, tells you where to price or, equivalently, how
marginal analysis to maximize consumer surplus (make many to sell.
all purchases so that marginal value exceeds price),
while sellers use it to maximize profit. PRICE ELASTICITY AND MARGINAL REVENUE
To see how to use marginal analysis to Unfortunately, you’re never going to see a
maximize profit, examine Table 6-4. The columns list demand curve like the one in Figure 6-1. In general, it
the Price, Quantity, Revenue, MR, MC, and total Profit is very difficult to get information about demand at
for our demand curve. Suppose that the product costs prices above or below the current price. In fact, if
$1.50 to make. At a price of $7, one consumer would anyone—particularly an economic consultant—ever
purchase, so revenue would be $7. Cost would be tries to show you a complete
$1.50, so profit on the first sale would be $5.50.
demand curve, don’t trust it; the consultant has only a
If we reduce price to $6, two consumers very rough guess as to what demand looks like away
purchase, so revenue goes up to $12, an increase of $5. from current prices.
We say that the MR of the second unit is $5. If we
At this point (unless it’s past the drop/add
reduce price further to $5, revenue increases to $15, so
period), some students quit the class, shaking their
that the MR of the third unit is $3.
heads and wondering why they have to learn about
So far, all of these changes have been things they’ll never see. The point of Figure 6- 1 and
profitable because the increase in revenue (MR) has the associated analysis is that you don’t need the entire
been greater than the increase in cost (MC). We earned demand curve to know how to price—all you need is
$5.50 on the first unit, $3.50 on the second unit, and information on MR and MC. If MR > MC, reduce
$1.50 on the third unit. These marginal profits sum to a price; if MR < MC, increase price. As we saw earlier,
total profit of $10.50, as indicated in the last column of marginal analysis points you in the right direction, but
Table 6-4. it doesn’t tell you how far to go. You get to the best
However, if we sell a fourth unit, total profit price by taking steps and then by re-computing MR and
would go down because the marginal revenue from MC to see whether you should take another step.
selling the fourth unit is $1, which is less than the $1.50 So how do we estimate marginal revenue?
marginal cost. So, we don’t sell the The answer involves measuring quantity responses to
fourth unit. The optimal quantity is three; and to sell past price changes, “experimenting” with price
this amount, we look at the demand curve to tell us changes, or running market surveys to see how quantity
how much to charge to sell three units: $5. would change in response to a price change. If you do
After going through your analysis to compute get any useful information about demand away from
the optimal price, suppose your boss looks at you and the current price, it’s likely to come in the form of
says, “This is the stupidest thing I’ve ever seen! Since information about price elasticity of demand, which we
the price is $5, and the cost of producing another good denote by e.
is only $1.50, we’re leaving money on the table.” What
do you tell her?
Price elasticity measures the sensitivity of
quantity demanded to price changes. A demand curve
for which quantity changes more than price is said to be
elastic, or sensitive to price; and a demand curve for
which quantity changes less than price is said to be
inelastic, or insensitive to price.
 law, gas station owners in the District argued against it,
predicting that it would reduce quantity by 40%. Since
Since price and quantity move in opposite
the increase in price (6%) was smaller than the
directions—as price goes up, quantity goes down, and
projected decrease in quantity (40%), the gas station
vice versa—price elasticity is negative; that is, e < 0.
owners predicted that gasoline revenue, and the taxes
However, people often refer to elasticity without the
collected out of revenue, would decline.
minus sign, resulting in confusion. To keep things
clear, whenever we use price elasticity, as we do here, Since D.C. has many commuters who could
we will refer to its absolute value, represented by |e|. buy gasoline in Maryland and Virginia instead of D.C.,
a reasonable guess would be that demand for gasoline
To show how you might be able to estimate
sold in D.C. was very elastic. In fact, the actual
elasticity, consider this 1999 “natural experiment” at
reduction in quantity was 38%, very close to what the
MidSouth, a medium-sized retail grocery store. The
gas station owners had predicted, indicating that
store’s managers decreased the price
demand for gasoline sold in the District of Columbia
of three-liter Coke (diet, caffeine-free, and classic) was indeed very elastic. This scenario predicted by the
from $1.79 to $1.50 because they wanted to match a gas station owners is illustrated in the top row of Table
price offered at a nearby Walmart. In response to the 6-5.
price drop, the quantity sold doubled, from 210 to 420
When demand is inelastic, this relationship is
units per week.
reversed; that is, price increases raise revenue because
To compute elasticity, simply take the the price increase is bigger than the corresponding
percentage quantity increase and divide by the quantity decrease. Conversely, price decreases reduce
percentage price decrease. Some confusion inevitably revenue because the price reduction is bigger than the
occurs because we can compute percentage changes in quantity increase (see Table 6-6).
several different ways, depending on whether we divide
Let’s test our understanding of the
the price or quantity change by initial or final prices
relationship between price changes, elasticity, and
and quantities. The most accurate estimate comes from
revenue by deriving the relationships in Tables 6-5 and
dividing by the midpoint of price ( P ¿ ¿ 1+ P2)/2 ¿ 6-6 using the approximation
and the midpoint of quantity (Q 1 +Q 2) /2 :

The exact numerical relationship between

In the three-liter Coke example, the
marginal revenue (change in revenue) and elasticity is
calculation works like this:
MR = P(1 - 1/|e|). We can use this formula to express
the marginal analysis rule—reduce price if MR > MC,
In this case, the estimated price elasticity is and raise price otherwise—using price elasticity in
-3.8, indicating that a 1% decrease in price of threeliter place of marginal revenue:
Coke leads to a 3.8% increase in quantity. The change MR > MC means that (P - MC)/P > 1/|e|.
in revenue associated with the change is This expression has an intuitive
interpretation. The left side of the expression is the
current markup of price over marginal cost, (P -
The relationship between revenue and MC)/P, whereas the right side is the desired markup,
elasticity can be derived from the following formula: which is the inverse elasticity, 1/|e|. If the current
markup is greater than the desired markup, reduce price
The symbol %Δ means “percentage change because MR > MC, and vice versa. Intuitively, as
in.” All this says is that whichever change is bigger demand becomes more elastic, the less you can mark-
(price vs. quantity) determines whether revenue goes up price over marginal cost because you lose too many
up or down. And elasticity tells you this. customers.
For example, after MidSouth Grocery
reduced the price of three-liter Coke to $1.50, its actual
markup over marginal cost was 2.7%, which is much
For example, if demand is elastic, then a less than the desired markup of 1/|3.78| = 26%, so the
price decrease will be smaller than the corresponding price was much too low. Ordinarily, a profit-
quantity increase, so revenue will rise following a price maximizing store manager would raise the price in such
decrease. Likewise, a price increase will be smaller a situation. In this case, however, the managers were
than the corresponding quantity decrease, so revenue using three-liter Coke as a loss leader, deliberately
will fall following a price increase. This relationship is pricing it too low as a way to attract customers to the
illustrated in the bottom row of Table 6-5. store. Why? Because they hoped that customers would
On the other hand, if you try to increase price spend money on other items once they got there. We’ll
when demand is elastic, then revenue goes down (top discuss this and other more complex pricing strategies
row of Table 6-5). To see this, let’s look at the story of in later chapters.
Marion Barry’s 6% tax rate increase on gasoline sales
in the District of Columbia. Before the tax was put into WHAT MAKES DEMAND MORE ELASTIC?
 Given the importance of elasticity (price more widely known, so more consumers react to the
elasticity of demand) to pricing—the more elastic change.
demand is, the lower the profit-maximizing price is— As an example, consider automatic teller
it’s worthwhile to sharpen our intuitive feel for what machine (ATM) fees. In 1997, a bank in Evanston,
would make demand more or less elastic. In this Indiana, ran an experiment to determine elasticity of
section, we list four factors that affect demand demand for ATMs with respect to ATM fees. At a
elasticity and optimal pricing. selected number of ATMs, the bank raised user fees
Products with close substitutes have elastic from $1.50 to $2.00. When informed of the fee
demand. increase, users typically completed the current
Consumers respond to a price increase by transaction but avoided the higher-priced ATMs in the
switching to their next-best alternative. If their next- future. If we define the short run as the current
best alternative is a very close substitute, then it doesn’t transaction and the long run as future transactions, then
take much of a price increase to induce them to switch. the maxim holds.
For example, when District of Columbia Mayor Barry Our final maxim relates elasticity to the price
raised the price of gasoline by 6%, many consumers level. As price increases, consumers find more
began purchasing gasoline in nearby Virginia and alternatives to the good whose price has gone up. And
Maryland. with more substitutes, demand becomes more elastic.
In a similar vein, we see that individual As price increases, demand becomes more
brands have closer substitutes (other brands) than do elastic: |e| increases.
aggregate product categories that include the brands. For example, high-fructose corn syrup
This leads to our next maxim. (HFCS) is a caloric sweetener used in soft drinks. For
Demand for an individual brand is more this application, sugar is a perfect substitute for HFCS.
elastic than industry aggregate demand. However, import quotas and sugar price supports have
As a rough rule of thumb, we can say that raised the U.S. domestic price of sugar to about twice
brand price elasticity is approximately equal to industry that of HFCS. All soft drink bottlers now use HFCS
price elasticity divided by the brand share. For instead of sugar. And because bottlers have no close
example, if the elasticity of demand for all running substitutes for low-priced HFCS, its demand is
shoes is -0.4, and the market share of Nike running relatively inelastic. But if the price of HFCS were to
shoes is 20%, price elasticity of demand for Nike rise to that of sugar, sugar would become a good
running shoes is (-0.4/.20) = -2. Using our optimal substitute for HFCS. In other words, demand for high-
pricing formula, we can see that Nike has a desired priced HFCS would become very elastic.
markup of about 50%.
If you search the Internet, you’ll easily find FORECASTING DEMAND USING ELASTICITY
industry price elasticity estimates that you can combine We can also use elasticity as a forecasting
with market share estimates to get an estimate of brand tool. With an elasticity and a percentage change in
elasticity. And you can use this estimate to gain a price, you can predict the corresponding change in
general idea of whether your brand price is too high or quantity:
low.
Products with many complements have less
For example, if the price elasticity of demand
elastic demand.
is -2, and price goes up by 10%, then quantity is
Products that are consumed as part of a larger expected to go down by 20%.
bundle of complementary goods—say, shoelaces and
Remember that price is only one of many
shoes—have less elastic demand. If the price of
factors that affect demand. Income, prices of substitutes
shoelaces increases, you’re not likely to stop buying
and complements, advertising, and tastes all affect
shoelaces; if you don’t have shoelaces, you don’t have
demand. To measure the effects of these other variables
your favorite shoes. Conversely, products that are not
on demand, we define a factor elasticity of demand:
part of a bundle of complementary goods have more
elastic demand. As their price changes, consumers find
it easier to stop consuming the good. For example, demand for bottled water, iced
Another factor affecting elasticity is time. tea, and carbonated soft drinks is strongly influenced
Given more time, consumers are more responsive to by temperature. If the temperature elasticity of demand
price changes. They have more time to find more for beverages is 0.25, then a 1% increase in
substitutes when price goes up and more time to find temperature will lead to a 0.25% increase in quantity
novel uses for a good when price goes down. This leads demanded.
to our third maxim: Income elasticity of demand measures the
In the long run, demand curves become more change in demand arising from changes in income.
elastic: |e| increases. Positive income elasticity means that the good is
This phenomenon could also be explained by normal; that is, as income increases, demand increases.
the speed at which price information is disseminated. Negative income elasticity means that the good is
As time passes, information about a new price becomes inferior; that is, as income increases, demand declines.
The decreasing incomes associated with the financial STAY-EVEN ANALYSIS, PRICING, AND
crisis of 2008 ELASTICITY
provided a number of examples of inferior goods. Stay-even analysis is a simple but powerful
Although most retailers saw dramatic sales declines in tool that allows you to do marginal analysis of pricing.
2008, Walmart’s sales increased. Sales of Spam® also In particular, it is used to determine the volume
shot up in 2008, leading Hormel to add a second shift required to offset a change in price. For example, you
at its Minnesota factory. know from the First Law of Demand that raising price
Cross-price elasticity of demand for Good A will result in selling fewer units. Stay-even analysis
with respect to the price of Good B measures the tells you how many unit sales you can lose before a
change in demand of A owing to a change in the price price increase becomes unprofitable. When combined
of B. Positive cross-price elasticity means that Good B with information about elasticity of demand, the
is a substitute for Good A: As the price of a substitute analysis will give you a quick answer to the question of
increases, demand increases. Mules and camels, for whether changing price makes sense. If the predicted
example, are substitutes for gas-powered tractors. quantity decrease is bigger than the stay-even quantity
As the cost of operating a tractor increases with rising decrease, then the price increase is not profitable, and
gas prices, demand for mules and camels vice versa.
increases. The home safe market saw a similar effect in The stay-even quantity is a simple function of
2008. As interest rates declined, the the size of the price increase and the contribution
margin, %ΔQ + %ΔP/(%ΔP + margin), where margin +
opportunity cost of keeping cash at home declined, (P - MC)/P. If you are considering a price increase, and
leading to an increase in demand for home the predicted quantity decrease is bigger than the stay-
safes. even quantity decrease, the price increase is
Negative cross-price elasticity means that unprofitable.
Good B is a complement to Good A: As the price of a This type of analysis persuaded a judge to
complement increases, demand decreases. Computers, allow the Whole Foods-Wild Oats merger in 2008.
for example, are complements to operating systems that With retail margins of 40%, a 5% price increase would
run on them. We can trace part of Microsoft’s success require a quantity loss of no more than 11.1% to be
to its strategy of licensing its operating system to profitable. Citing marketing studies showing that
competing computer manufacturers. That strategy customers shopped at Whole Foods as well as other
helped keep the price of computers low but stimulated grocery stores, former FTC Chief Economist and
demand for Microsoft’s operating system. colleague David Scheffman argued that the actual
We can estimate factor elasticities by using a quantity lost would be greater than 11.1%, presumably
formula analogous to the estimated price elasticity to stores outside the category. This persuaded the judge
formula, and we can use factor elasticities to forecast or that the merged firm would not find it profitable to
predict changes over time or even changes from one raise price.
geographic area to another. Suppose you’re trying to
compare the year-to-year performance of one of your SUMMARY & HOMEWORK PROBLEMS
regional salespeople over a period in which income
grew by 3%. If demand for your products has an SUMMARY OF MAIN POINTS:
income elasticity of 2, you would expect quantity to
increase by 6%. You don’t want to reward the
salesperson for increases in quantity that are largely
unrelated to her effort. A performance measure more
closely related to effort would subtract 6% from the
actual growth because that is the growth related to
income.
Alternatively, suppose the New York Times is
trying to decide whether to begin home delivery of its
newspaper in Nashville. To compute the break-even
quantity, you need to know whether enough
Nashvillians will choose home delivery to justify the
investment in this service. If the New York Times
recently began home delivery in Charlotte, and the
income in Nashville is 5% higher than in Charlotte, you
would expect a 10% higher per-capita consumption of
the newspaper in Nashville than in Charlotte if the
income elasticity of demand for the paper is 2. If the
forecast quantity would allow you to break even, then
begin home delivery in Nashville.
 Group Problems

Multiple – Choice Questions CHAPTER 7: Economies of Scale and Scope

In 1906, three entrepreneurs launched the
French Battery Company in Madison, Wisconsin. Its
early growth was driven by the demand for radio
batteries, and its most successful product was the Ray-
O-Vac battery, leading the company to change its name
to Rayovac Company in 1930. Over the next 60 years,
it grew to become one of the top three battery
producers in the United States along with Duracell and
Energizer.
In 1996, the company was acquired by the
Thomas H. Lee Company, a Boston-based private
equity firm. After making an initial public offering the
following year, the company took advantage of easy
credit availability to go on a buying binge. It purchased
battery manufacturers BRISCO G.M.B.H., ROV
Limited, VARTA AG, Direct Power Plus, and Ningbo
Baowang. Part of the motivation for acquiring the other
battery manufacturers was to increase the company’s
size to take advantage of “efficiencies and economies
of scale” according to Rayovac’s CEO. Company
managers expected that as they produced more of the
same good, average costs would fall.
However, the company also went on a buying
Individual Problems binge of unrelated companies. In 2003, Rayovac
purchased Remington Products (electric razors); in
2005, it bought United Industries Corporation (lawn
and garden care, household insect control, and pet
supplies); in 2005, it purchased Tetra Holding
G.M.B.H., a German supplier of fish and aquatic
supplies. As part of its acquisition of United Industries,
company executives announced that they anticipated
“synergies” of around $75 million. By synergies, they
meant that the cost of producing the different products
offered by the separate companies would be less
expensive than when produced by one company.
According to the former CEO of United who became
head of North American operations after the
acquisition, “we believed that there would be synergies, Increasing marginal costs eventually lead to
better performance, and all that.” increasing average costs.
If you ever hear the words synergy or Just as a baseball player’s season batting
efficiency used to describe a business strategy, you are average will rise if his game batting average is above
probably already on the wrong end of a bad investment. his season batting average, so too does average cost rise
This newly renamed conglomerate was no exception, if marginal cost is above the average.
and by February 2009, Spectrum Brands was bankrupt.
It is not that synergies don’t exist; it is rather
that they are difficult to realize and too often used to
justify acquisitions that enrich management at the
expense of shareholders. In this chapter, we examine a
potential source of synergies, economies of scope and
scale, and show you how to exploit them. This is
especially important if your company is following a
cost leadership strategy, but managers should always be
looking for ways to cut costs, regardless of whether it is
their explicit strategy. A reduction in average cost
translates to an immediate increase in profit (recall that In Figure 7-1, the rising average cost of
Profit = (Price - Average Cost)* Quantity), and if MC production implies that marginal cost is above average
goes down as well, you get an “extra” increase in profit cost.
from the increase in output; recall that if MC falls In the presence of fixed costs, increasing
below MR, it becomes profitable to increase output. marginal cost gives you a U-shaped average cost curve
Many business decisions, like break-even (shown in Figure 7-2). The curve initially falls due to
analysis, can be made using very simple the presence of fixed costs, but then it rises due to
characterizations of cost (like a fixed cost plus a rising marginal costs.
constant per-unit cost). With economies of scale or
scope, however, decision making may require more
complex (and realistic) cost functions. In this section,
we will examine decision making in the presence of
economies of scale and scope.

INCREASING MARGINAL COST

As they try to increase output, most firms
eventually face increasing average costs. The firm
eventually finds that each extra unit of input requires Knowing what your average costs look like
more inputs to produce than previous units. This will help you make better decisions. In 1955, Akio
phenomenon arises from a variety of factors Morita brought his newly invented $29.95 transistor
collectively called the law of diminishing marginal radio to New York. He shopped it around, and after
returns. turning down an original equipment manufacturer
The law of diminishing marginal returns (OEM) deal from Bulova, he eventually found a retailer
states that as you try to expand output, your marginal that would sell it under his “Sony” brand name. The
productivity (the extra output associated with extra problem was that the retailer had a chain of around 150
inputs) eventually declines. stores and wanted to buy 100,000 radios, ten times
more than Mr. Morita’s capacity. Mr. Morita turned the
We can identify several causes for
offer down because he knew that increasing output
diminishing marginal returns, among them the
would require hiring and training more workers and an
difficulty of monitoring and motivating larger
expansion of facilities, raising his average cost or
workforces, the increasing complexity of larger
break-even price.
systems, or
The retailer decided to buy 10,000 units at
the “fixity” of some factor. In popular jargon, these are
the lowest unit price, and the rest is history. The Sony
known as “bottlenecks.” More generally, bottlenecks
brand radios became very popular, and the company
arise when more workers, or any variable input, must
evolved into the giant electronics firm it is today. The
share a fixed amount of a complementary input. And
moral of the story is to know what your costs look like
when productivity falls, costs increase.
—otherwise, you could end up making unprofitable
Diminishing marginal productivity implies deals. In this case, using a more realistic cost function,
increasing marginal cost. Morita was able to compute the break-even price
If more inputs are needed to produce each schedule, allowing him to bargain effectively with the
extra unit of output, then the cost of producing these retail chain.
extra units—the marginal cost—must increase. And
once the marginal cost rises above the average cost, the
ECONOMIES OF SCALE
average will rise as well.
 The law of diminishing marginal returns is produce at a lower cost. Learning curves mean that
primarily a short-run phenomenon arising from the current production lowers future costs, which has
fixity of at least one factor of production, like capital or important strategic consequences. Here the maxim
plant size. In the long run, however, you can increase “Look ahead and reason back” is particularly
the size of the plant, hire more workers, buy more important.
machines, and remove production bottlenecks. In other For example, every time an airplane
words, your “fixed” costs become “variable” in the manufacturer doubles production, marginal cost
long run. decreases by 20%. If the first plane costs $100 million,
However, the same factors (i.e., the fixity of then the second will cost $80 million, the fourth will
some input) that cause diminishing marginal returns in cost $64 million, the eighth will cost $51.2 million, and
the short run can also cause decreasing returns to scale so on. In Table 7-1, we illustrate such a learning curve.
in the long run. Often the managerial structure of the
company does not scale well. Management is an
important input into the production processes; and as
the company grows, so do the problems of
coordination, control, and monitoring. Managers often
behave as if they have a fixed amount of decision-
making capability, so giving them more decisions often
leads to managerial bottlenecks that raise price.
If long-run average costs are constant with To see how learning curves affect decision
respect to output, then you have constant returns to making, put yourself in American Airlines’ place, when
scale. they were negotiating with Boeing to purchase
If long run average costs rise with output, airplanes. From Boeing’s point of view, a big order
you have decreasing returns to scale or diseconomies from the world’s largest airline would allow it to “walk
of scale. down its learning curve,” as shown in Figure 7-3, and
If average costs fall with output, you have reduce the costs of future production. However,
increasing returns to scale or economies of scale. American knows that its order will allow Boeing to
Knowing whether your long-run costs exhibit reduce costs for future sales and wants to capture some
constant, decreasing, or increasing returns to scale can of the implied profit.
help you make better long-run decisions. If your long-
run costs exhibit increasing returns to scale, securing
big orders allows you to reduce average costs.
One of the reasons the “big-box” retail stores,
like Staples and Office Depot, are successful is that
they sell so many units that their suppliers enjoy scale
economies. Competition among the suppliers for the
right to supply these office superstores allows the
superstores to capture most of profit emanating from
these scale economies in the form of lower input prices.
Big-box retailers are able to offer the supplier all of its
demand (e.g., in an exclusive arrangement), which in If American knew exactly how many planes
turn allows the supplier to realize economies of scale. Boeing would make over the lifetime of the airplane,
Economies of scale have had a dramatic they could offer a price at Boeing’s average cost. For
effect on the structure of the poultry industry in the example, if Boeing expected to produce eight units,
United States. In 1967, a total of 2.6 billion chickens American could offer $66.8 million per plane, and
and turkeys were processed in the United States. By Boeing would break even on the order over the lifetime
1992, that number had increased to nearly seven of the model. But if the lifetime production is not
billion. Despite this large increase, the number of known, then American must pursue other strategies.
processing facilities dropped from 215 to 174. The For example, American could ask for “kickbacks” on
share of shipments of plants with over 400 employees sales of future Boeing planes; however, this request
grew from 29% to 88% for chicken production and may violate European or U.S. antitrust laws.
from 16% to 83% for turkey production over the same Alternatively, since stock prices reflect future earnings,
period. The shift in the structure of the industry was American could ask for a percentage of the increase in
due largely to changes in technology, which reduced Boeing’s stock market value following announcement
costs of processing poultry in larger plants. of the deal; such a request would be equivalent to
buying call options to purchase Boeing stock before
LEARNING CURVES beginning negotiations. When Boeing’s stock value
increased because of the order, the value of the call
Learning curves are characteristic of many options would also increase. These strategies may
processes. That is, when you produce more, you learn violate securities laws on insider trading, so be sure to
from the experience; then, in the future, you are able to get legal advice before trying something like this.
 Instead, American offered to purchase planes These low costs were putting pressure on
exclusively from Boeing over the next 30 years in their competitors, in particular, a regional breakfast
exchange for a very favorable price. Note the similarity sausage manufacturer in 1997. The firm used 18 trucks
of this solution to those of the big-box retailers. By and a single distribution center serving retail customers
offering exclusivity, American guaranteed Boeing a big located in 21 southern and midwestern states.
chunk of demand that would lower costs. Boeing was Unfortunately, the demand for breakfast sausage is
willing to give American a very good deal in exchange seasonal, with a peak in November and December.
for such a guarantee. During the heavy winter months, the firm must pay
As a strange footnote to this story, in 1998, outside carriers a premium to handle excess product,
Boeing tried to acquire rival McDonnell-Douglas. The but for the other eight months, it must idle half of its
European Commission antitrust authority objected trucking fleet.
because Boeing’s large European competitor, Airbus, Because the firm sells only a single product
objected to the long-term exclusive contracts as —breakfast sausage—it cannot exploit the scope
anticompetitive. Airbus claimed Boeing’s exclusive economies associated with distributing a full product
contracts prevented it from competing for American’s line. The firm has two choices. It could sell
business. To complete its purchase of McDonnell- out to one of the larger, full-line companies, like
Douglas, Boeing agreed not to enforce its exclusive ConAgra. Such a company could exploit the scope
contracts with American, leaving American free to economies associated with distribution, thus placing a
purchase from Airbus if it so chose. higher value on the firm. Or it could outsource its
distribution function. Several regional and nationwide
ECONOMIES OF SCOPE distribution companies distribute a variety of food
Traditionally, Gibson Guitar used rosewood products, and these companies could realize scope
to construct fingerboards on its less-expensive economies by distributing a full portfolio of meat
Epiphone guitars and reserved ebony for its high-end products.
Gibson brand. Both rosewood and ebony are excellent Our sausage maker eventually decided to
tone woods, but ebony is preferred for its distinct sound outsource its distribution, but after it sold its trucking
and pure black appearance. A significant number of fleet, it was held up by the distributor. It was a good
ebony fingerboard blanks are rejected for use on the idea, but poorly executed.
Gibson brand guitars because carving of the
fingerboard reveals brown streaks in the otherwise pure DISECONOMIES OF SCOPE
black wood. The percentage of fingerboards rejected Production can also exhibit diseconomies of
has increased steadily over the past 10 years as the scope if the cost of producing two products together is
world supply of streak-free ebony has shrunk. higher than the cost of producing them separately. In
Gibson Guitar began installing these streaked this case, you reduce costs by paring
blanks on its lower-end instruments. The buyers down the product line. AnimalSnax, Inc., makes pet
perceive the streaked ebony fingerboard as an upgrade food on extruder lines in 23 plants. This manufacturer
over rosewood. Their ability to use discarded ebony in has a variety of customers, from large retailers like
its Epiphone guitars gives Gibson both a cost and Wal-Mart to small momand-pop pet stores. Currently,
quality advantage over rivals that produce only high- the firm produces 2,500 different products, or stock-
end or only low-end instruments. In this case, we say keeping units (SKUs), using 200 different formulas. All
there are economies of scope between production of customers pay about the same price per ton. Recently,
high-end and low-end guitars. however, some of the large customers have demanded
If the cost of producing two products jointly price concessions.
is less than the cost of producing those two products These requests worry the firm because of the
separately—that is, so-called 80-20 rule: According to this rule of thumb,
80% of a firm’s profit come from 20% of its customers.
—then there are economies of scope between Because big customers (the 20%) order in bulk, the
the two products. manufacturer can set up its extruders for long
production runs. These big orders are much more
Obviously, you want to exploit economies of
profitable than smaller orders because all orders require
scope by producing both Q1 and Q2. This is a major
the same setup time
cause of mergers. For example, about eight years ago,
we saw a consolidation in the food distribution regardless of the amount produced and packaged.
business. Companies like Kraft, Sara Lee, and To reduce the costs associated with smaller
ConAgra sell a variety of meat products, hot dogs, orders, AnimalSnax reduced the variety of its product
sausage, and lunchmeats because they can derive offerings to 70 SKUs, using only 13 different formulas.
economies of scope by distributing these products The firm also began offering price discounts for larger
together. Once you set up a distribution network, you orders. Although some smaller customers were upset
can easily pump more products through the network about being forced to use new formulas, most were
without incurring additional costs. willing to switch. This allowed the company to
consolidate small orders into large ones to reduce setup
costs.

Typical savings for one extruder line are

illustrated in Figure 7-4. Under the new regime, the
same amount of pet food that had been produced in one
8-hour shift could now be produced in just six hours. Individual Problems
This dramatic increase in productivity (25%) also
allowed the company to close several of its 23 plants.

SUMMARY & HOMEWORK PROBLEMS

SUMMARY OF MAIN POINTS:

Multiple – Choice Questions

Group Problems

CHAPTER 8: Understanding Markets and Industry

Changes
In 1997, the portable electric generator
industry was mildly profitable, if unexciting. For over a
decade, consumption of portable electric generators had
been very stable, exhibiting an average annual growth
rate of 2%. But all this was about to change. Many
consumers, including my 80-year-old dad, feared that
the power grid would collapse because the computer
programs that controlled it would not be able to adapt
to the change from 1999 to 2000. Anticipating a big
increase in demand for portable generators, managers at As we’ve seen, changes in price induce
Walters, Rosenberg, and Matthews (WRM) changes in consumer behavior that lead to quantity
implemented a Y2K (year 2000) strategy designed to changes. For example, the demand curve that we saw in
double their production capacity. They vertically Chapter 6 shows that when we increase price from $6
integrated1 into alternator head production which not to $7, one fewer consumer decides to purchase, so
only increased production capacity, but also reduced quantity demanded decreases from two units to one
variable costs. Other firms in the industry made similar unit. This change is called a movement along the
investments. demand curve.
In 1999, demand boomed as predicted; But price is only one factor that affects
industry shipments increased by 87% and prices demand—we can identify many others. In general, it
increased by 21%. But following the boom year of helps to catalog these factors into controllable and
1999, the year 2000 turned out to be a bust. Demand uncontrollable factors.
fell back to 1998 levels, and prices tumbled to below- A controllable factor is something that
1998 levels. Industry profit declined dramatically, affects demand that a company can control.
along with capacity utilization rates. WRM’s Y2K Price, advertising, warranties, product
strategy to increase production capacity turned out to quality, distribution speed, service quality, and prices
be its undoing. Along with half the firms in the of substitute or complementary products also owned by
industry, they declared bankruptcy in 2000. the company—all of these are controllable factors.
WRM’s managers would have benefited from It is easiest to illustrate this distinction with
a better understanding of the changes affecting its an example of demand for an individual firm’s product,
industry. In particular, everything that happened to like Microsoft’s operating system. In the late 1970s,
WRM was perfectly predictable, not just in hindsight, Microsoft developed the DOS operating system to
but at the time they made their investments. Being able control IBM personal computers. Demand for the DOS
to forecast and interpret industry-level changes requires operating system depended on its own price but also on
an understanding of both aggregate consumer behavior the price and availability of the computers that ran it, as
(demand) and aggregate seller behavior (supply). well as on the applications that ran under it, like
Forecasting and interpreting these changes is the topic spreadsheets and word processors.
of this chapter.
To increase demand for its DOS operating
system, Microsoft manipulated the following
WHICH INDUSTRY OR MARKET? controllable factors:
Each industry or market has a product,  Microsoft licensed its operating system to
geographic, and time dimension. So, before you begin other computer manufacturers. The resulting
analyzing an industry, you must carefully consider competition between IBM and these new
what you want to learn from the analysis. Perhaps you licensees lowered the price of computers—a
want to forecast future changes or to understand past complementary product.
ones. In our example, you might want to know “Why  Microsoft developed its own versions of
did the price for portable generators in the United word processing and spreadsheet software—
States increase in 1999 and decrease in 2000?” Usually, Word and Excel—two important
the question will suggest a particular market focus. The complementary products in almost any office.
current question suggests that you should examine the  Microsoft kept the price for its DOS product
annual market for portable generators in the United relatively low. As more consumers purchased
States. Notice that this market has a time (annual), DOS computers, more companies made
product (portable generators), and geographic (the applications that ran on DOS computers,
United States) dimension. Different questions will increasing future demand for DOS software.
suggest different markets to study.
An uncontrollable factor is something that affects
Although this point may seem self-evident, demand that a company cannot control.
people often overlook it. In many cases, you can
sharpen your analysis and avoid confusion by first Uncontrollable factors include, among other
defining your market or industry. This is especially things, income, weather, interest rates, and prices of
important if your firm’s success or profitability is substitute and complementary products owned by other
closely linked to profitability of the industry in which it companies. And as is illustrated by the story in the
competes. Demand and supply analysis will help you introduction, expectations of future changes also affect
recognize business opportunities. For example, many current demand. The expectation of a massive power
towns are changing zoning laws to make it more outage in 2000 was an uncontrollable factor that
difficult to build apartment buildings. This has led affected 1999 demand for portable electric generators.
some entrepreneurs to anticipate a reduction in future Even though you may not be able to control a
supply that will drive up the price of apartments. To variable, you need to understand how it affects the
position themselves to take advantage of these changes, industry in which you compete because it can affect
they are building and renovating existing apartments. your own profitability. Understanding how both
controllable and uncontrollable factors affect your own
SHIFTS IN DEMAND
profit requires that you learn how to manipulate
demand and supply curves, our next topic.
Because we only have two variables on our
demand graph—price and quantity—the only way to
represent a change in a third variable is with a shift of
the demand curve. For example, if the price of a
substitute product increases, then industry demand for a
product will increase. We represent this as a rightward
shift in the demand curve, as in Figure 8-1.
In this case, at every price, demand shifts
rightward, or increases, by four units. In contrast, a
decrease in a substitute’s price would decrease demand.
As with demand curves, we plot supply
curves with price on the vertical axis and quantity on
the horizontal axis. In math, we are taught to plot the
dependent variable (quantity) on the vertical axis, and
the independent variable (price) on the horizontal axis.
So the economics convention of plotting quantity on
the horizontal axis may confuse those of you who are
familiar with graphical analysis. Get used to it. There is
a good reason for this, but it is also a longestablished
convention.
Also, like demand curves, supply curves shift
when a variable other than price changes. Changes in
costs, technological change, and entry or exit of new
capacity or firms will shift supply. Consider the effect
of increased costs. How would that shift the supply
curve? Think about an individual seller first—if that
SHIFTS IN SUPPLY producer now has to pay more to produce the same
Supply curves describe the behavior of a quantity, he or she will require a higher price to cover
group of sellers and tell you how much will be sold at a those increased costs. If other sellers are similarly
given price. situated, the aggregate supply curve will decrease, or
The construction of supply curves is similar shift upward (to the left)—higher prices are necessary
to that of demand curves; we arrange sellers by the to induce sellers to supply the same quantities.
prices at which they are willing to sell. Every person Alternatively, you could say that a smaller quantity will
willing to sell at or below the given price “supplies” be made available at the previous price.
product to the market. For example, suppose we have
nine sellers, with values of {$4, $5, $6, $7, $8, $9, $10, MARKET EQUILIBRIUM
$11, $12}; at a price of $4, one seller would be willing Market equilibrium is the price at which
to sell; at a price of $5, two sellers; and so on, until, at a quantity supplied equals quantity demanded.
price of $12, all nine sellers would be willing to sell.
This supply curve describes the aggregate behavior of In other words, at the equilibrium price, the
these nine sellers. numbers of buyers and sellers are equal, so there’s no
pressure for prices to change. That’s why we call it an
Note that a supply curve requires competition “equilibrium.” You can see an illustration of market
among sellers. As we have seen in Chapter 5, a single equilibrium in Figure 8-3, where, at a price of $8, five
firm will produce where MR = MC. In contrast, units are demanded and five units supplied.
multiple firms facing competition will behave as if they
produce where P = MC. In this case, price will To understand why this is an equilibrium, see
determine how much is supplied to the market: high what happens at prices higher or lower than $8. For
prices lead to big supply; low prices to smaller supply. example, at a price of $11, the quantity demanded (2) is
less than the quantity supplied (8), meaning that 8
Supply curves differ from demand curves in sellers are chasing only 2 buyers. Economists call this
one very important way. excess supply, and this type of imbalance exerts
Supply curves slope upward; that is, the downward pressure on price.
higher the price, the higher the quantity supplied. At a price of $6, the quantity demanded (7) is
In other words, at higher prices, more greater than the quantity supplied (3)—7 buyers are
suppliers are willing to sell. We plot our aggregate chasing just 3 sellers. Economists call this excess
supply curve in Figure 8-2. demand. This type of imbalance leads to upward
pressure on price. Only at a price of $8 are the numbers
of buyers and sellers equal, exerting no pressure on
price to change. This is why we call $8 an equilibrium
price.
 At the equilibrium price, only buyers with
values above $8 buy, and only sellers with values
below $8 sell. No one else wants to buy or sell.
In market equilibrium, there are no
unconsummated wealth-creating transactions.
Another way of thinking about this is that the
market has identified the high-value buyers and the
low-value sellers, brought them together, and set a
price at which they can exchange goods. The market
moves goods from lower- to higher-valued uses and
thus create wealth. Economists often personify market
forces by saying that the market works with an
“invisible hand.”

Again, the mechanism driving price to the

new equilibrium is competition among buyers to buy
and competition among sellers to sell. At the old price
of $8, there is excess demand—more buyers than
sellers. This imbalance puts upward pressure on price
until it settles at the new equilibrium price of $10.
RIDDLE: How many economists does it take to change Notice that, as the price increased from $8 to $10,
a light bulb? quantity also increased from 5 to 7 units.
ANSWER: None. The market will do it To illustrate the usefulness of demand and
supply, let’s return to the changes in the electric
generator industry that occurred around 1999. Using
demand–supply analysis, we can explain exactly what
happened. We can see this analysis in Figure 8-5.
PREDICTING INDUSTRY CHANGES USING In the graph, we see the change from 1998 to
SUPPLY AND DEMAND 1999 as the change from A to B (denoted A!B) when
We can use supply and demand curves to both demand and supply increased. Supply shifted
describe changes that occur at the industry level. In outward as firms invested in cost reductions and
Table 8-1 and Figure 8-4, we begin with a simple capacity increases, while demand increased due to
example of how an increase in demand changes price anticipation of power outages. Because price increased
and quantity. This increase in demand could arise from by 21%, we know that the increase in demand must
an increase in income, a decrease in the price of a have exceeded the increase in supply. Both shifts
complement, or an increase in price of a substitute. contributed to the quantity increase of 87%.
We see the initial equilibrium of $8, where In 2000, when demand returned to its 1998
quantity demanded equals quantity supplied (5 units) in level (denoted B!C), prices dropped below the 1998
the first three columns of Table 8-1, as indicated by the level, but quantity stayed above the 1998 level owing to
shaded numbers in the fifth row. After the demand the supply increase. Although it is relatively easy to
shift, the new equilibrium is $10, where quantity predict these kinds of qualitative changes, predicting
demanded equals quantity supplied (7 units). The exact quantitative changes is a different matter
shaded numbers in columns 1, 3, and 4 of the third row altogether. For accurate quantitative predictions, you’d
show this second equilibrium. need information about the exact magnitudes of the
supply and demand shifts, and information about the
slopes of the supply and demand curves, information
that is very difficult to obtain. In fact, you should be
very suspicious of consultants who claim they can
provide accurate quantitative forecasts because it is
difficult to precisely estimate the parameters necessary
to construct a forecast.
Nevertheless, we can learn much from simple
qualitative analysis. WRM’s managers should have
been able to predict the movement in price and quantity
A->B->C, as shown in Figure 8-5; and they could have
taken steps to prepare for the changes. For example,
because the demand shift was temporary, they could
have hired temporary workers, or even outsourced the
extra production, instead of investing in their own
capacity expansion. Alternatively, like John Deere’s
managers in Chapter 5, they could have chosen a low-
fixed-cost technology, thereby better positioning
themselves to make money once price dropped below
its 1998 levels.
We close this section by asking you to
explain a very significant increase in price and decline
in quantity of commercial paper that occurred during
September 2008. Commercial paper is a short term,
(e.g., 30-day loans supplied by companies with cash on
hand to companies who have short-run borrowing
demands). Think of them as IOUs. These loans are
used by virtually every major business to balance the
inflows of revenue with the outflows of costs and are
behind most major transactions. They have been called
the lifeblood of the economy.
There are two equivalent ways to define this
EXPLAINING INDUSTRY CHANGES WITH product: 30-day commercial paper or 30-day
SUPPLY AND DEMAND commercial loans. The difference is that the “supply”
The preceding analysis has asked you to of commercial paper is equal to the “demand” for
predict what happens to price and quantity following loans; and the “demand” for commercial paper is the
increases or decreases in supply and demand, or both. “supply” of loans. To explain the changes shown in
This kind of analysis is relatively simple, as there are Figures 8-7 and 8-8, we adopt the second convention,
only four changes that can occur: an increase or and define the “price” of a loan to be the interest rate
decrease in supply; and an increase or decrease in that clears the market.
demand. A slightly more difficult, but still very useful,
analysis involves using supply and demand to explain
industry changes. You look at a change in price and
quantity, and then describe what must have happened
to either supply and demand or both.
For example, the price of soybeans increased
by 50% from mid-2007 to early 2008. From what
we’ve learned so far, you should know that an increase
in price could have been driven by an increase in
demand, a decrease in supply, or both. In this case,
both factors appear to have been influencing price.
Demand has increased thanks to rising world
population and incomes. Supply has contracted because
many farmers decided to switch production to
substitute products, like corn, that can be turned into
biofuels. Both an increase in demand and a decrease in
supply caused the dramatic price increases.
Let’s test our understanding of the analysis
thus far. Try to explain the increase in the quantity of
personal computers and the decline in price over the
past decade using shifts in the demand or supply
curves.
To answer this question, you have to explain In the second week of September 2008, the
two points in time. On a graph, the initial point has a price (interest rate) on these loans shot up from 3% to
high price and small quantity. The final point has low 5% and the quantity of loans declined dramatically.
price and large quantity. You can These changes spooked Treasury Secretary Paulson and
Federal Reserve Chairman Ben Bernanke, and they
explain these data with a simple increase (rightward
were characterized as a “freeze” in the market for
shift) in the supply curve. In Figure 8-6, as supply
short-term lending, the essential “grease” that
increases, the equilibrium price falls from P0 to P1 facilitates the movement of assets to higher-valued
and the equilibrium quantity increases from Q 0 to Q 1. uses. What could have accounted for these changes?
The changes could be explained by a simple
decrease in the supply of loans. In fact, following the
bankruptcy of Lehman Brothers, Fannie Mae and per gallon. What is less obvious is why the Tucson
Freddie Mac, and the first bailout of AIG, commercial price also increased. Given the location of the pipeline
lenders became increasingly worried that borrowers break, it would seem that Tucson should now have an
would not be able to repay these loans. This resulting excess supply, which would reduce Tucson prices.
decrease in supply caused both an increase in the price Instead, Tucson prices increased from about $1.60 to
of borrowing (the interest rate) and a decline in the $1.80 per gallon.
amount of lending. As a footnote to this story, the
Federal Reserve has since guaranteed these short-run
financial transactions to remove the fear of default, and
the interest rates have come back down as shown in What happened? The tank wagon owners
Figure 8-9. who normally deliver gas from terminals in Tucson to
Tucson gas stations discovered that delivering gas to
Phoenix was more profitable than delivering it to
Tucson. Tucson and Phoenix tank wagons waited for as
much as six hours at the terminal in Tucson to buy
gasoline to deliver to Phoenix. The high prices in
Phoenix conveyed information to sellers in Tucson that
it was more profitable to sell in Phoenix. So, the supply
actually decreased in Tucson—hence the price increase
in that city. Similarly, supply decreased in Los Angeles
as sellers found it more profitable to divert gasoline to
Phoenix, leading to a price increase in that city as well.
So next time you hear a politician complaining about
Many of my students tell me that demand and the “high price of gas,” tell her that without those high
supply analysis is especially useful in job interviews as prices, consumers would consume too much, and
it gives them a way to show off their analytical suppliers would supply too little. If politicians set
expertise by explaining industry changes. prices instead of markets, prices would not convey the
information that provides incentives for buyers to
conserve and for sellers to increase supply. Without
PRICES CONVER VALUABLE INFORMATION higher prices, shortages would occur and gasoline
Markets play a significant role in collecting would not move from lower- to higher-valued uses.
and transmitting information between buyers and Part of the blame for flight delays traveling
sellers. In a sense, prices are the primary mechanism across the United States can be traced to a failure to
that market participants use to communicate with one allow prices to help allocate resources. The Federal
another. Buyers signal their willingness to pay, and Aviation Administration prices airport landing slots and
sellers signal their willingness to sell, with prices. access to the air traffic control system on a per-
To illustrate how this communication occurs, passenger basis, regardless of time of day, season, or
let’s examine the changes that occurred when a pipeline overall stress on the system. These prices have no
carrying gasoline to Phoenix broke. The break could relation to the marginal cost of providing service.
have been disastrous because Arizona has no refineries When you remove this communication mechanism
of its own; it obtains gasoline primarily through two from the market, you end up with problems like
pipelines, as shown in Figure 8-10. One pipeline starts shortages, delays, congestion, and misallocation.
in Los Angeles and supplies gasoline from West Coast The information conveyed by prices is
refineries to the Phoenix gasoline terminals. The other especially important in financial markets, where each
pipeline starts in El Paso and supplies gasoline from market participant possesses a little piece of
refineries in Texas and New Mexico. Upon entering information about the prospects for a traded security.
Arizona, that pipeline travels first to terminals in By trading, they reveal their information to the market.
Tucson and then to terminals in Phoenix. For example, the price of a stock is a good predictor of
On July 30, 2003, the Tucson-to-Phoenix the discounted flow of profit that will accrue to the
section of the pipeline from El Paso ruptured, closing stockholder. Likewise, prices of S&P futures are good
that section of the line from August 8 until August 23, predictors of the future level of the S&P 500 Stock
when partial service resumed. Market Index, and foreign exchange futures are good
Using supply–demand analysis, you should predictors of future exchange rates. The information
now be able to analyze what happened in the daily contained in these prices has obvious uses to companies
market for gasoline in Phoenix. Following a decrease in and individuals trying to make decisions based on an
supply to Phoenix, the price should go up and quantity uncertain future.
should go down. Indeed, the Phoenix price went from In fact, market prices are so good at
less forecasting the future that companies like Hewlett
than Packard, Eli Lilly, and Microsoft are setting up internal
$1.60 to markets to help forecast demand for their products.
over They set up an automated trading platform and let
$2.10 employees buy and sell contracts that pay off according
to how much the company will earn or sell in the  Buy at $8 and sell at $8 (five transactions).
future. The prices of the contracts tend to be much  Buy at $7 and sell at $9 (four transactions)
more accurate predictors than traditional forecasting  Buy at $6 and sell at $10 (three transactions).
methods and are being used to plan production. The  Buy at $5 and sell at $11 (two transactions).
accuracy of these prices in forecasting future sales can  Buy at $4 and sell at $12 (one transaction).
also help firms design compensation schemes for
salespeople; for example, salespeople could be
rewarded for increasing sales relative to the forecast
quantity.

MARKET MAKING
Note that the market maker faces a familiar
In the supply–demand analyses in this trade-off. She can consummate fewer transactions but
chapter, we’ve been ignoring the costs of making a earn more on each transaction; or she can consummate
market. Buyers and sellers don’t simply appear in a more transactions but earn less on each transaction. In
trading pit and begin transacting with one another. Table 8-2, we calculate the optimal bid–ask spread for
Instead, someone has to incur costs to identify high- the market maker: Either buy at $6 and sell at $10 or
value buyers and low-value sellers, bring them buy at $5 and sell at $11. Both earn profit of $12.
together, and devise ways of profitably facilitating
Now suppose that competition among several
transactions among them. The
market makers forces the bid–ask spread— the price of
economies of Chicago, New York, London, and Tokyo a transaction—down to the costs of market making,
depend largely on the profit earned from making which we suppose to be $2 per transaction. Now what
markets. These profits are the “costs” of making a is the competitive bid and ask?
market that, when significant, can prevent prices from
In this case, each market maker would buy at
moving to equalize demand and supply.
$7 and sell at $9. Those offering worse prices wouldn’t
In this section, we show exactly how a make any sales, and those offering better prices
“market maker” makes a market—by buying cheap and wouldn’t cover costs. In this case, competition forces
selling dear. Consider a market maker facing the price down to cost, thereby raising the number of
demand and supply curves shown in Figure 8-11: nine transactions from three to four.
buyers have values {$12, $11, $10, $9, $8, $7, $6, $5,
Normally, we expect that prices will be
$4}, and nine sellers are willing to sell at the same
forced down to cost in highly competitive markets. But
prices. If there were but a single (monopoly) market
this is not always the case. On May 26, 1994, the Wall
maker, how much would she offer the sellers (the bid),
Street Journal and the Los Angeles Times reported on
and how much would she charge the buyers (the ask)?
academic research by Professor Bill Christie showing
How many transactions would occur?
that Amgen, Apple, Microsoft, Cisco, and Intel stocks
rarely traded at odd-eighths (fractions ending in 1/8 or
$0.125) and thus had bid–ask spreads of at least 1/4
($0.25). Christie and coauthor Paul Schultz concluded
that the behavior was the result of a price-fixing
conspiracy by the market makers that kept bid–ask
spreads abnormally high.
The following day, market makers in these
stocks stopped avoiding odd-eighth bid and ask quotes.
As a consequence, average spreads narrowed
dramatically to just over $0.125. We can see this
change illustrated in Figure 8-12—a graph showing the
average bid–ask spread of Microsoft stock.
If the market maker does not want to be left
in either a long (holding inventory) or short (owing By ruling out cost-based explanations for the
inventory) position, then she has to pick prices (the bid collapse, Christie and his coauthors concluded that
and the ask) that equalize quantity supplied and publicizing the conspiracy led to its collapse. We’ll
quantity demanded. Note that if the market maker return to this theme later on when we examine the
bought and sold at the competitive price ($8), she forces of competition and how firms attempt to control
would earn zero profit. To earn profit, the market them.
maker must buy low (at the bid) and sell high (at the
ask). For example, if the market maker were going to
engage in, say, three transactions, she would offer
sellers $6 (from the supply curve, we see that three
sellers will sell if the price is at least $6) and charge
buyers $10 (from the demand curve, we see that three
buyers are willing to pay at least $10). Consequently,
there are five obvious bid–ask price combinations:
SUMMARY & HOMEWORK PROBLEMS
SUMMARY OF MAIN POINTS:

Multiple – Choice Questions

Individual Problems
 So where did Mr. Collins’ analysis go
wrong?
He made two fatal errors. The first is called
the “fundamental error of attribution,” which you may
have heard described in your statistics class as
“confusing correlation with causality.” Just because
you observe successful firms behaving in a particular
way does not mean that the behavior caused the
success. We will return to this theme in Chapter 17
when we examine decision making under uncertainty.
Until we do, beware of consultants peddling such “best
practices.”
Mr. Collins’ second error was to ignore the
long-run forces that tend to erode profit. High profit is
like blood in the water to a shiver of sharks. Customers,
suppliers, competitors, substitutes, and new entrants
tend to behave in ways that erode above-average profit.
How and why this occurs is the topic of this chapter.
In contrast to Chapter 8, where we analyzed
short-run industry-level changes within a single market
or industry, in this chapter, we analyze how changes in
one industry affect other industries. In particular, the
ability of capital and labor to move between two
industries implies that the prices and profits of one
Group Problems industry are related to prices and profits in another.

COMPETITIVE INDUSTRIES
To understand the forces of competition, we
first consider the extreme case of a competitive
industry where:
 Firms produce a product or service with very
close substitutes so they have very elastic
demand.
CHAPTER 9: Relationships Between Industries: The  Firms have many rivals and no cost
Forces Moving Us Towards Long – Run Equilibrium advantage over them.
One of the most successful business advice  The industry has no barriers to entry or exit.
books of all time is Jim Collins’ Good to Great. Since it A competitive firm cannot affect price, so
was published in 2001, the book has sold over three there is little a competitive firm can do except react to
million copies. It has been translated into 35 languages industry price. If price is above MC, it sells more; and
and has appeared on the best-seller lists of the New if price is below MC, less. In sum, a competitive firm’s
York Times, Wall Street Journal, and Business Week. fortunes are closely tied to those of the industry in
Collins and his research team examined over 1,000 which it competes.
established companies and found 11 that made the Several industries come close to being
jump from average or below-average performance to “perfectly” competitive, like formal stock exchanges or
great results. These companies earned returns agricultural commodities. But no industry is perfectly
substantially above average market returns over a 15- competitive because it is a theoretical benchmark. We
year period. From the experiences of these 11 good-to- use the benchmark because it helps us see the long-run
great companies, Collins distilled a list of general forces that determine long-run industry performance.
management principles that he argued would help other
For example, suppose industry demand
companies make similar leaps.
suddenly increases for a product in a competitive
Anyone familiar with the 2008 mortgage industry. Following the increase in demand, price goes
crisis should easily recognize one of the good-to-great up and firms in the industry enjoy
companies, Fannie Mae. Shares of Fannie Mae were
above-average profit—but only for a while. This “for a
valued at around $70 per share in mid-2001, the year
while” is the period that economists call the “short
Collins’ book was published. By 2009, government
run.” But soon, the above-average profit attracts capital
regulators had seized the companies, and its shares
to the industry; existing firms expand capacity or new
were trading below $1. Another one of the companies,
entrants come into the industry. New entry increases
Circuit City, declared bankruptcy in 2008, and was
industry supply, which leads to a decrease in price.
liquidated. Overall, the 11 companies failed to
Entry continues and price keeps falling until firms in
outperform the market over the years following the
the industry are no longer earning above-average profit.
book’s publication.
At this point, capital flow into the industry stops, and will shift supply out until profits fall back to the
we say that the industry is in long-run equilibrium. The average. Do not confuse the short run with the long run.
length of the short run depends on how quickly assets For example, do not say things like “demand creates its
can move into or out of the industry. It could be as own supply.” Instead, analyze the changes more
short as a few seconds in highly liquid financial precisely by separating them into short- and long-run
markets or as long as several years in industries where changes.
it takes greater time and effort to move assets.
In the long run, no competitive industry can THE INDIFFERENCE PRINCIPLE
earn more than an average rate of return. If it does, We have begun to see the role of entry and
firms will enter the industry or expand, increasing exit, or asset mobility, as the major competitive force
supply until the profit rate returns to average. To a driving profit to zero. (Remember that economic profit
business student trying to make money, this seems like includes a cost of capital, so economic profit is
terrible news. But this cloud has a silver lining: In the normally zero.) Positive profit attracts entry, and
long run, no competitive industry can earn less than an negative profit leads to exit. The ability of assets to
average rate of return. If it does, firms will exit the move from lower- to higher-valued uses is the force
industry or shrink, decreasing supply until the profit that moves an industry toward long-run equilibrium.
rate returns to average. Such asset mobility leads to what Steven Landsburg
A competitive firm can earn positive or calls the indifference principle:
negative profit in the short run but only until entry or If an asset is mobile, then in long-run
exit occurs. In the long run, competitive firms are equilibrium, the asset will be indifferent about where it
condemned to earn only an average rate of return. is used; that is, it will make the same profit no matter
When firms are in long-run equilibrium, where it goes.
economic profit is zero (including the opportunity cost Labor and capital are highly mobile assets.
of capital), firms break even, and price equals average They flow into an industry when profits are high and
cost. Recall that profit is equal to (P - AC)*Q; so if out of an industry when profits are negative. Once this
Price equals Average Cost, and cost includes a capital long-run equilibrium is reached, capital is indifferent
charge for the opportunity cost of capital, there’s no about being deployed in that industry relative to other
reason for capital to move because it cannot earn a industries.
higher rate of return elsewhere.
To show you how the forces of asset mobility
In a competitive industry buffeted by demand link markets together, let’s apply long-run equilibrium
and supply shocks, prices increase and decrease, but analysis to the problem of deciding where to live.
economic profit tends to revert to zero. We say that Suppose that San Diego, California, is more attractive
profit exhibits mean reversion. According to reported than Nashville, Tennessee. What do you think will
estimates, the speed at which profit moves back toward happen?
an average rate of return is 38% per year. That is, if
profit is 20% above the mean one year, it will be only If labor is mobile, people will move from
12.4% above the mean in the following year. A Nashville to San Diego. This migration will increase
separate analysis of more than 700 business units found the demand for housing in San Diego, driving up San
that 90% of both above-average and below-average Diego house prices while simultaneously reducing
profitability differentials disappeared over a 10-year Nashville house prices. The process will continue until
period. Return on investment, as shown in Figure 9-1, the higher price of housing makes San Diego just as
revealed a strong tendency to revert to the mean level unattractive as Nashville. At that point, migration will
of approximately 20% for both over- and stop; and we say that the two cities are in long-run
underperformers. equilibrium. Both places are now equally attractive,
meaning consumers are indifferent between them. The
lower housing costs in Nashville compensate
Nashvillians for enduring Nashville’s hot and humid
summers.
Similarly, wages adjust to restore
equilibrium. The indifference principle tells us that in
long-run equilibrium, all professions should be equally
attractive, provided labor is mobile. If one profession is
more attractive than another, labor will move to the
more attractive profession, increasing supply and
reducing the wage. Wages will keep falling until all
professions are equally attractive. Now it may take a
Students have a tendency to confuse short- long time for entry to compete wages down to an
and long-run analysis. If we are analyzing an increase equilibrium level, especially in professions that require
in demand in an industry, in the short run, price and a lot of training. In these industries, the long run might
quantity will increase, and firms will earn above- be very long.
average profit. In the long run, these above-average Once equilibrium is reached, differences in
profits will attract new assets into the industry, which wages, called compensating wage differentials, reflect
differences in the inherent attractiveness of various the risky stock and buy the less risky stock. This
professions. Why do embalmers make 26% more than increases the price of the first stock, reducing its
rehabilitation counselors? Assuming the two industries expected return; it also decreases the price of the
are in long-run equilibrium, the higher wages second stock, increasing its expected return.
compensate embalmers for working in a relatively The higher return on a risky stock is called a
unattractive profession. Just as lower-cost housing risk premium and is analogous to a compensating wage
compensates Nashvillians for living in Nashville, so differential. Just as higher wages compensate
too do embalmers’ higher wages compensate them for embalmers for preserving cadavers, so too do higher
working with dead bodies. expected rates of return compensate investors in risky
As demand and supply shocks change price assets.
in one industry, region, or profession, assets move in In equilibrium, differences in the rate of
and out of industries, regions, and professions, until a return reflect differences in the riskiness of an
new equilibrium is reached. In this way, the forces of investment.
competition allocate resources to where they are most We can see this relationship in Figure 9-2,
highly valued and allow our economy to adapt rapidly which plots the CBOE Volatility Index (VIX) against
to shocks. For example, when Jose Peralta came to the the price of the S&P 500 stock index (GSPC). The VIX
United States in 2001, he worked as a field measures the implied riskiness of the index, as
handpicking strawberries. In 2003, he found a better computed from options prices. Since the fall of 2008,
job in construction, building condos in Newport Beach as the stock market has declined by about 50%, the
for $11/hour. Following the decline in demand for volatility index has increased by about 100%. Whatever
construction in the summer of 2007, when wages fell to is making stocks more volatile is also reducing the
$9/hour and work became sporadic, Mr. Peralta went stock prices, thereby increasing expected returns in
back to picking strawberries. order to compensate investors for bearing more risk.
One of the concerns following the housing
meltdown is its potential impact on labor mobility. In
previous recessions, there was a relatively rapid
migration from locations where the jobs were
disappearing (e.g., the Rust Belt) to areas where they
were being created (e.g., the Sun Belt). But this time,
the decline in housing values is making it difficult for
people to move (unless they walk away from their
mortgages) because they are reluctant to sell houses at
a loss. This has reduced the flexibility of the U.S.
economy and slowed down the adjustment to a new
long-run equilibrium. This is worrisome because this Since government bonds are thought to be
flexibility has limited the duration and size of previous risk-free, investors often benchmark expected stock
downturns. returns against the returns from holding government
We can apply the same long-run analysis to bonds. Over the last 80 years, bonds have returned
gain insight into some fundamental relationships in 1.7% whereas stocks have returned 6.9%. The
finance. We start with the proposition that investors difference is a risk premium that compensates investors
prefer higher returns and lower risk. If one investment for holding risky stocks. The equity risk premium (of
earns the same return as another but is less risky, stocks over bonds) has varied over time, from 9% to
investors will move capital from the more risky 0%, as shown in Figure 9-3.
investment to the less risky investment and bid up the
price of the less risky investment. The higher price
decreases its expected rate of return —its expected
price change—until the higher-risk investment is just as
attractive as the less risky investment. In equilibrium,
the risky investment will earn a higher rate of return
than the less risky investment to compensate investors
for bearing risk.
We can illustrate this relationship with a very
simple example. Suppose that two stocks are trading at
the same $100 price. Research analysts tell us that in a
year, the first stock will increase in value to $120 with In late 2006, most risk premia became very
probability ½ and stay where it is with probability ½. small. Not only was the difference between expected
The expected price is $110, so the expected return is returns on stocks versus bonds small, so were the
10%. The second stock will increase in value to $130 differences between expected returns on low- versus
with probability ½ and decrease in value to $90 with high-quality stocks and between emerging market debt
probability ½. Although the second stock has the same versus U.S. debt. Small spreads between risky and less
expected return (10%), it is more risky because it has a risky assets meant either that the world had become
higher variance. We can expect that investors will sell less risky or that investors were simply ignoring risk in
search of higher returns. In hindsight, it looks as if it Of course, Apple isn’t standing still. Its
was the latter. If you had been smart enough to managers keep improving the product, keeping it
recognize this, you would have moved out of risky innovative and different from substitute products—in a
assets and into less risky assets, like bonds. When risk word, unique. The fact that Apple is still making Macs
returned in late 2007, the stock market began a 50% is testament to the company’s ability to innovate.
decline, and you would have saved yourself a lot of
money. SUMMARY & HOMEWORK PROBLEMS
SUMMARY OF MAIN POINTS:
MONOPOLY
If competitive firms live in the worst of all
possible worlds, monopoly firms live in the best.
Monopolies have some attribute(s) that protect them
from the forces of competition.
 Monopolies produce a product or service
with no close substitutes,
 Monopolies have no rivals, and
 Barriers to entry prevent other firms from
entering the industry. Multiple – Choice Questions
An example of a monopoly firm might be a
pharmaceutical company that develops and patents a
new drug without any substitutes. Without rivals and
with patent protection preventing others from entering,
the firm will enjoy a period of protection from the
forces of competition.
Unlike a competitive firm, a monopoly firm
can earn positive profit—an above-average rate of
return—for a long time. We can interpret this profit as
a reward for doing something unique, innovative, or
creative—something that gives the firm less elastic
demand.
However, monopolies are not permanently
insulated from the forces of entry and imitation. No
barrier to entry lasts forever. Eventually other firms
develop substitutes or invent new products that erode
monopoly profit. The main difference between a
competitive firm and a monopoly is the length of time
that a firm can earn above-average profit.
In the long run, even monopoly profit is Individual Problems
driven to zero.
To see why this is so, recall from Chapter 6
that a firm will price at the point where (P - MC)/ P =
1/|elasticity|. In the very long run, the forces of entry
and imitation (the development of close
substitutes) make the monopolist’s demand more
elastic. The elastic demand will push price down
toward marginal cost and will eventually drive profit to
zero.
For example, in 1983, the Macintosh
computer’s innovative graphical user interface gave
Apple Computer a unique, user-friendly product. The
elasticity of demand for the Mac was very low and the
markups for the product very high. Several years later,
Microsoft came up with Windows 3.1, with its own Group Problems
graphical interface. The development of this substitute
made demand for Macs more elastic. Later, Windows
innovations (95, 98, 2000, and XP) became even better
substitutes, making demand for Macs even more
elastic. The higher elasticity reduced the Mac’s markup
over marginal cost, and Apple’s profit eroded.