Chapter 4Extent (How Much) Decisions

Managerial Economics: A Problem Solving Approach (2nd Edition)Luke M. Froeb, luke.froeb@owen.vanderbilt.edu

Brian T. McCann, brian.mccann@owen.vanderbilt.edu

Website, managerialecon.com

COPYRIGHT © 2008

Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Chapter 4 – Summary of main 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.

Chapter 4 – Summary (cont.)• 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 =

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 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.

Introductory anecdote: US Financial Crisis

• The financial crisis began in the subprime housing market, where government policies encouraged lenders to extend credit to low-income borrowers (by lowering lending standards)

• Concurrently mortgages were being packaged into securities and sold to investors.

• If the risk had been recognized investor demand would have been low, but rating agencies were too liberal with AAA ratings, increasing demand for loans.

• The result? A credit “bubble”• How did this lending crisis arise?

Background: Average cost• Definition: Average cost is simply the total cost of

production divided by the number of units produced. AC = TC/Q• Average costs often decrease as quantity increases

due to presence of fixed costs• AC = (VC + FC)/Q• FC does not change as Q increases

• Average costs are not relevant to extent decisions

Background: Average cost (cont.)

Background: Marginal cost

• Marginal cost is the cost to make and sell one additional unit of output. MC = TCQ+1 – TCQ.

• Marginal cost is often lower than average cost (due to falling average costs) but not always.

• Marginal costs are what matter in extent decisions

Extent (how much?) decisions• Definition: Marginal cost (MC) is the additional

cost required to produce and sell one more unit.

• Definition: Marginal revenue (MR) is the additional revenue gained from producing and selling one more unit.

• If the benefits of selling another unit (MR) are bigger than the costs (MC), then sell another unit.

• So, produce more when MR>MC; less when MR<MC. Profits are maximized when MR=MC.

Extent decisions (cont.)• Examples of extent decisions

• Should you change the level of advertising?• Should you increase the quality of service?• Is your staff big enough, or too big?• How many parking spaces should you lease?

• Marginal analysis answers these questions• This analysis tells you direction of change but not the

distance. • You can only measure MR and MC at the current

level of output – make a change and re-measure

Extent decision example

• Discussion: How much advertising?• A $50,000 increase in the TV ad budget brings in 1,000 new

customers• Estimated MCTV is $50 (the cost to get one more customer)

• $50,000 / 1,000 = $50• If the marginal revenue generated by this customer is greater

than $50, do more advertising.

Extent decision example (cont.)• Even if we do not know the marginal revenue, we can still use

marginal analysis to make extent decisions• Compare TV advertising to telephone solicitation

• Say you recently cut telephone budget by $10,000 and lost 100 customers

• Estimated MCPH = $100= ($10,000 / 100)

• So, to get one more customer costs $50 for TV and $100 for phone

• MCPH > MCTV so shift ad dollars from phone to TV

• Advice: make changes one-at-a-time to gather valuable information about marginal effectiveness of each medium.

Another example• SAH=“Standard Absorbed Hours” a measure of textile

factory output• Allows managers to compare factories making different

items, e.g. t-shirt = 1 SAH while dress=3 SAH• Suppose Factory A has costs of $30 per SAH while Factory

B has cost of $20 per SAH. How can you profitably use this information?

• The decision seems simple, but• Make sure you are not including fixed costs in the analysis• Marginal costs matter, not average costs!• If the $20 and $30 rates are good MC proxies, shift some

production from Factory A to Factory B

Effort is an extent decision• Discussion: Royalty rates vs. fixed fee contracts

• You receive two bids to harvest 100 trees on your land

• $150/tree or $15,000 for the right to harvest all the trees.

• On your tract there are pines (worth $200) and fir (worth $100)

• Which offer should you accept?

• Discussion: Sales Commissions• Expected sales level: 100 units @ $10,000/unit=$1M

• Option 1: 10% commission

• Option 2: 5% commission + $50,000 salary

• Discussion: give example of royalty rate or fixed fee contracts in your firm

Tie pay to performance• A consulting firm COO received a flat salary of $75,000

• After learning about the benefits of incentive pay in class, the CEO changed COO compensation to $50K + (1/3)* (Profits-$150K)

• Profits increased 74% to $1.2 M

• Compensation increased $75K $177K

• Discussion: what are the disadvantages to incentive pay?

Alternate intro anecdote• American Express offers a Platinum Card to affluent customers• In 2001, there were approximately 2,000 Platinum cardholders in the Japanese

market. Numbers had been limited to ensure high quality customer service• With customer service technology advances, company considered expanding

number of card holders• How many more should be added?

• As more members are acquired, average spending per card member decreases because the financial threshold for membership is lowered

• Costs of customer service rise for each additional member added, and growing beyond a certain point would require building and operating an additional call center

• After analyzing the costs and benefits, American Express realized that it should expand its offering to only 15,000 more Platinum Card members

• We call this an “extent” decision, because the company needed to decide “how many” platinum cards to provide. In this chapter, we show you how to make profitable extent decisions.

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1. Introduction: What this book is about2. The one lesson of business3. Benefits, costs and decisions4. Extent (how much) decisions5. Investment decisions: Look ahead and reason back6. Simple pricing7. Economies of scale and scope8. Understanding markets and industry changes9. Relationships between industries: The forces moving us towards long-run equilibrium10. Strategy, the quest to slow profit erosion11. Using supply and demand: Trade, bubbles, market making 12. More realistic and complex pricing13. Direct price discrimination14. Indirect price discrimination15. Strategic games16. Bargaining 17. Making decisions with uncertainty 18. Auctions19. The problem of adverse selection20. The problem of moral hazard21. Getting employees to work in the best interests of the firm22. Getting divisions to work in the best interests of the firm23. Managing vertical relationships24. You be the consultantEPILOG: Can those who teach, do?

Managerial Economics - Table of contents