EXAM ONE

What is the marginal cost of the 5th unit? a.$100 b.$105 c.$110 $115

110

Which assets end up in lower-valued uses? 16 Wealth Creation in Organizations ● Companies = a collection of transactions

They buy raw materials (capital, labor, etc.) and create and sell higher-valued goods and services

A well-designed organization is one in which employee incentives are aligned with organizational goals, meaning

employees have enough information to make good decisions, and the incentive to do so.

_____ costs do not vary with the amount of output. _______ costs change as output changes. Decisions that change output change only variable costs.

fixed and variable costs

The _________ aka 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.

fixed-cost fallacy

Willingness to invest in projects with a low rate of return, indicates a willingness to trade current dollars for future dollars at a relatively low rate. • This is also known as

having a low discount rate (r). • Individuals with low discount rates would willingly lend to those with higher discount rates. Discounting helps you figure out if future gains are larger than current sacrifice.

Break-even quantity

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

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.

Average cost (AC)

is total cost (fixed and variable) divided by total units produced.Average cost is irrelevant to an extent decision. Why? Because AC contains fixed costs. t's fixed costs that are not relevant to an extent decision.

Correct incentives are created by

rewarding good performance or punishing bad performance.

NPV (net present value)

states that if the net present value of the net cash flows from an investment are positive, the project earns economic profit (the investment earns more than t

Problem solving requires two steps:

First, figure out why mistakes are being made,then figure out how to make them stop. This seems trivial. But what is being stressed is order. First things first. Don't skip steps.

Why are some countries so poor?

No property rights • No rule of law

Discounting (the inverse of compounding):

Present value = (future value, k periods in the future) (1 + r) Example: At a 10% r, $1 is worth: • Next year: ($1)/1.1 = $0.91 • Two years: ($0.91)/1.1 =$0.83

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

Unexpectedly, wheat prices fell dramatically reducing demand for large tractors

Wealth is created when

assets are moved from lower to higher-valued uses

The rational-actor paradigm (or model) assumes that people act rationally, optimally, and self-interestedly. Rational-actor means people have "goal-directed behavior." There was a reason a 'bad' decision was made. People do not act randomly. They respond to incentives To change behavior, you have to change incentives.

assumes that people act rationally, optimally, and self-interestedly. Rational-actor means people have "goal-directed behavior." There was a reason a 'bad' decision was made. People do not act randomly. They respond to incentives - To change behavior, you have to change incentives This point is worth stating again. As economists, our assumption is that people are "rational." But only means they had "goal-directed behavior." There is a reason the decision was made.

Two prominent hospitals recently refused patients for kidney transplants because the organs were from

"directed donations." • The kidneys were meant for specific peopl

Seller surplus = the price minus the seller's value

$128,000 - $120,000 = $8,000 seller surplus

Buyer surplus = buyer's value minus the price

$130,000 - $128,000 = $2,000 buyer surplus

Total surplus = buyer + seller surplus = difference in values

$2,000 + $8,000 = $10,000 $130,000 - $120,000 = $10,000 $10,000 are the gains from trade

•Jim's burgers produces 600 burgers per week. Each burger sells for $3. Betty's Boutique orders 500 burgers for their pre-season party. Jim's charged $1,250 the order. What is Jim's marginal revenue per burger for this order? a.$3 b.$2.50 c.$0.50 d.It cannot be determined with the information given.

$2.50

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

(future value, k periods in the future) = (present value) x (1 + r) Example: If you invest $1 (present value) today at a 10% (r), then you would expect to have $1.10 in one year. • In two years, $1 becomes $1.21 = $1.10 x (1+.1)

# Units Produced Total Revenue Total Costs 0 0 200 1 600 660 2 780 720 3 840 780 4 890 870 5 910 980 What is the marginal cost of producing the third unit? a.60 b.70 c.90 110

60

Accounting profit does not necessarily correspond to economic profit.

Accounting does not consider implicit and/or OC. Economic profit is always less than accounting profit as economic costs are always greater than accounting costs due to inclusion of implicit costs Economic costs include all costs both explicit and implicit.

It follows that you can analyze problems by asking three questions:(1) Who is making the bad decision?;(2) Does the decision maker have enough information to make a good decision?;(3) And, do they have the correct 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.

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

At this sales level, profit is zero.

Time is a critical element in investment decisions

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

Value = willingness to pay

Desire + Income = You want something + you can pay for it

Subsidies Destroy Wealth: •

Example: flood insurance encourages people to build in areas that they otherwise wouldn't

Price Controls Destroy Wealth: •

Example: rent control (price ceiling) in New York City deters transactions between owners and renters

How low of a price before you shut down? not be included in the shutdown price

IT DEPENDS ● It depends on which costs are avoidable • Long-run: fixed costs become avoidable so they are included in the shutdown price • Short run: they are unavoidable and should

Discussion:

If my discount rate is 10%, would I lend to or borrow from someone with a discount rate of 15%? • What does this say about behavior?

However, many mergers and acquisitions do not create value •

If they do, value creation is rarely so clear

The One Lesson of Business: The art of business consists of identifying assets in lower valued uses and devising ways to profitably moving them to higher valued uses. •

In other words, make money by identifying unconsummated wealth-creating transactions and devise ways to profitably consummate them

Voluntary transactions, between individuals or firms, create wealth. •

Meaning, people create wealth by pursuing self-interest.

The One Lesson of Economics: The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.

Must look at the intended and unintended effects of policies to understand their efficiency • The economist's solution to inefficient outcomes is to argue for a change in public policy. • Business person's solution is to try to make money on the inefficiency

National Geographic can reduce shipping costs by printing with regional printers. • To print a high quality magazine, the printer must buy a $12 million printing press. • Each magazine has a MC of $1 and the printer would print 12 million copies over two years. • The break-even cost/average cost is $7 = ($12M / 2M copies) + $1/copy • BUT once the press is purchased, the cost is sunk and the break-even price changes. • Because of this the magazine can hold up the printer by renegotiating the terms of the deal - because the price of the press is unavoidable, and sunk, the break-even price falls to $1, the marginal cost

One possible solution to post-investment hold-up is vertical integration. ● Example: Bauxite mine and alumina refinery • Refineries are tailored to specific qualities of ore • The transaction options are: • Spot-market transactions • Long-term contracts • Vertical integration - Vertical integration refers to the common ownership of two firms in separate stages of the vertical supply chain that connects raw materials to finished goods • Discussion: How is vertical integration a solution to hold up?

The break-even quantity is:

Q=FC/(P-MC) FC: fixed costs P: price MC:marginal cost

Always remember the business maxim "look ahead and reason back." This can help you avoid potential hold up. ● Before making a sunk cost investment, ask what you will do if you are held up.

Sunk Costs and Post-Investment Hold Up

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

TRUE

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 csts and relevant benefits of a decision.

The opportunity cost of an alternative is the profit you give up to pursue it. Opportunity cost (OC) is the cost of not selecting the next bet alternative. One of the most, if not the most, important ideas for managers to learn and retain. OC fixes value.

The true cost of something is what you give up to get it.Costs can be explicit or implicit.Implicit costs are real. Your employees and customers know this.

Companies =

a collection of transactions

•The hidden-cost fallacy occurs when: a.A firm considers irrelevant costs. b.A firm ignores relevant costs. c.A firm considers overhead or depreciation cost to make a short-run decision. d.Both a and c.

a.A firm ignores relevant costs.

•Technological advancement creates unemployment in firms that shut down or lay off workers. Wealth, in this case, is: a.Destroyed, since firms are shutting down and production of certain goods and services are decreasing b.Created, since the dislocated labor and resources are absorbed by new firms, created by the technological change, moving them to higher value use. c.Destroyed, since technological progress is leading to higher unemployment d.None of the above

a.Created, since the dislocated labor and resources are absorbed by new firms, created by the technological change, moving them to higher value use.

•A manager invests $400,000 in a new technology that should reduce the firm's overall costs of production. The firm did manage to reduce their cost per unit from $2.00 to $1.85. All else equal, if the firm continues its production in the same economic environment, the firm's economic profits should: a.Increase if output is low enough b.Decrease c.Stay the same d.Increase if output is high enough

a.Increase if output is high enough

•If a firm sells more than the break-even quantity: a.It will make a profit b.It will only cover variable costs c.It will make a loss A firm is unable to sell above the break-even quantity. Remember Break-even quantity (can I sell enough to BE?) is Q=FC/((P-MC) )

a.It will make a profit

•Jim's Catering's cost of producing an extra meal is $25. Each of their meals is standard and sells for $20. At this rate, the company should: a.Produce more meals and increase their profit b.Produce fewer meals and increase their profit c.Not change production d.None of the above

a.Produce fewer meals and increase their profit

Avoidable costs

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

A company's cost of capital is a blend of

debt and equity, its "weighted average cost of capital" or WACC

The "goal" is to align the incentives of employees with the goals of the organization. The message is there are only tradeoffs and no universal solutions, i.e., the answer

to every question is "it depends." The point of the class is to teach you to recognize and evaluate the tradeoffs.

true or false: Market prices don't always reflect all the opportunity costs we face as a society.

true

Inefficiency implies the existence of

unconsummated, wealth-creating transactions

Marginal analysis is simple—

you break up the extent decision into tiny steps and take another step if the benefits of taking another step are bigger than the costs of taking another step. Keep in mind that marginal analysis can tell you ONLY which direction to step; it cannot tell you how far to step.

The hidden-cost fallacy occurs when

you ignore relevant costs. A common hidden-cost fallacy is to ignore the opportunity cost of capital when making investment or shutdown decisions.

Taxes Destroy Wealth:

• By deterring wealth-creating transactions - when the tax is larger than the surplus for a transaction.

What's the government's role is wealth creation?

• Enforcing property rights and contracts legal tools that facilitate wealth creating transactions • Ensures that buyers and sellers keep gains from trade

Contractual view of marriage

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

The one lesson of economics:

• Once all the consequences of any act or policy are taken into account, the opportunity costs of government action to change economic outcomes always exceeds the benefits. • Also, market prices reflect and determine opportunity costs faced by consumers and producers

•Jim is starting his own line of designer athletic shoes. He opened his own shop and paid $2,500 in fixed licensing fee. He used $3,000 in raw materials and sold $3,500 worth of shoes. Jim's brother-in-law looked at his financial statements and told Jim he was losing money and should shut down. Jim is devastated. As an expert in managerial economics, what advise can you give Jim?

•Expert advise •Jim's BIL is considering the $2,500 in fixed costs as part of her calculation, which is why he advises Jim to shut down. Clearly, however, fixed costs should not be part of the decision in this case because they are sunk and no longer avoidable. Even if Jim shuts down, he cannot get any of the $2,500 back. •Jim is covering variable costs (and a portion of his fixed) •Jim is actually making an operating profit of $500 ($3,500-$3,000) and therefore should not shut down.

Was purchasing Versatile the right choice?

● It depends... on how much John Deere expected to sell. • Suppose the capital-intensive technology would involve $100 FC and $10 MC • Suppose Versatile's technology had $50 FC and $20 MC • To determine break-even quantity (point of indifference), solve for the quantity that equates the costs: $150 for 5 units • If you expect to sell less than 5 units, choose the low-MC technology • If you expect to sell more than 5 units, choose the low-FC technology

NPV and Economic Profit

● Projects with a positive NPV create economic profit. ● Only positive NPV projects earn a return higher than the company's cost of capital. ● Projects with negative NPV may create accounting profits, but not economic profit. ● In making investment decisions, choose only projects with a positive NPV