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Managerial Economics Problem Solving and Decision Making Part 2

1) Marginal cost is the additional cost of producing one more unit, while marginal revenue is the additional revenue from selling one more unit. Firms should produce up to the point where marginal revenue equals marginal cost. 2) Break-even analysis determines the quantity a firm must sell to cover total costs. The break-even quantity is where total revenue equals total cost. 3) Net present value analysis compares the present value of cash inflows to the present value of cash outflows to determine if a project is profitable after accounting for the time value of money. A positive NPV means the project earns more than the cost of capital.

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199 views

Managerial Economics Problem Solving and Decision Making Part 2

1) Marginal cost is the additional cost of producing one more unit, while marginal revenue is the additional revenue from selling one more unit. Firms should produce up to the point where marginal revenue equals marginal cost. 2) Break-even analysis determines the quantity a firm must sell to cover total costs. The break-even quantity is where total revenue equals total cost. 3) Net present value analysis compares the present value of cash inflows to the present value of cash outflows to determine if a project is profitable after accounting for the time value of money. A positive NPV means the project earns more than the cost of capital.

Uploaded by

ABMAYALADANO ,Ervin
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Knowing how costs vary with output allows you to compute the costs associated

with the consequence of a decision


• Variable Cost
• Fixed Cost
Accounting Profit vs. Economic Profit

Economic Profit Accounting Profit


Earnings after deducting explicit
Earnings after deducting explicit
and implicit costs from total
costs of running a business
revenue
Derived from assumptions and Measurable and calculated as
estimates per GAAP

Reported on corporate income


Not reported
statements and to the IRS

1. Explicit costs include wages, leases, utilities, and the


cost of raw materials

2. Implicit costs include any opportunity costs, such as


the loss of interest on an investment.
Sunk Cost and Hidden Cost Fallacy

In making a decision, the general rule is to consider all costs and benefits that vary with the
consequence of a decision.

• If you miss some, that is the hidden-cost fallacy


• If you take into account irrelevant costs or benefits, that is the sunk- or fixed-cost fallacy

Sunk Cost Hidden Cost

The company is thinking of outsourcing the creation You buy a ticket for Php1000, but at the concert
of certain parts of the product that cost them Php100 time, scalpers are selling tickets for Php3000
with the following detailed cost: Material Php50,
Labor Php30, Overhead Cost Php 10, Depreciation
Php 10

The Supplier Bid at Php70, would they go with


outsourcing?
Marginal Revenue and Marginal Cost

• 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.

• If the benefit of selling another unit


(MR) is bigger than the MC, then sell
another unit.

• Sell more if MR > MC;


• sell less if MR < MC. What’s the optimal level of advertising?
MC and MR: Test Yourself
Incentive Pay

Marginal analysis can be used to design incentives to encourage hard work

Scenario 2
Scenario 1:
Suppose you are considering two different
Suppose you are a landowner compensation schemes.
evaluating two different bids for
harvesting a tract of timber containing One is based on a 10% commission rate.
100 trees.
The other pays a 5% commission rate plus a
Php50,000 per year flat salary.
One bid is for Php7500 per tree, and the
other bid is for Php750,000 for the right Each year, you expect salespeople to sell about
to harvest all the trees. 100 units at a price of Php10,000 per unit.

Which bid should you accept? Which compensation scheme should you use?
Incentive Pay

Is Incentive Pay Unfair?

• Incentive pay generates inequality simply because more productive workers or those who work harder get paid
more

• Incentive Pay typically exposes workers to risk beyond their control

• Incentive Pay helps company achieve higher productivity (procedural fairness) but also greater inequality.
Item 1 Item 2
You run a game day shuttle service for parking A copier company wants to expand production.
services for the local ball club. Your costs for
different customer loads are: It currently has 20 workers who share eight copiers.
1: Php30,
2: Php32, Two months ago, the firm added two copiers, and output
3: Php35, increased by 100,000 pages per day.
4: Php38,
5: Php42, One month ago, it added five workers, and productivity also
6: Php48, increased by 50,000 pages per day.
7: Php57, and
8: Php68. Copiers cost about twice as much as workers.

1. What are your MCs for each customer load level? Would you recommend it hire another employee or buy
2. What is the AC? If you are compensated another copier?
3. Php10 per ride, what customer load would you want?
Scenario 1 Scenario 2:

Bryan is contemplating the purchase Bryan did not push through with the purchase as
of a 48-unit apartment building he was worried about the deteriorating housing
market and the rising number of mortgage
The building was 95% occupied and defaults.
generated $500,000 in annual profit.
A year later, the building’s occupancy rate fell to
His investors were expecting 90%, which reduced annual profit to $450,000.
a 15% return and the bank had
offered to loan him 80% of the In addition, the bank was willing to lend only 65%
purchase price at a rate of 5.5% of the purchase price, and at the higher rate of
interest. 7.5%.

• What is the WACC? • What is the WACC?


• How much should he pay for the • Does Bryan make the good decision?
property
If the net present value of the sum of all discounted cash flows is larger than zero, then the project earns more
than the cost of capital.

*Cost of Capital is 14%


Net Present Value

IRR is the discount rate that sets NPV equal to zero. To find the IRR, we increase the discount rate, until the
NPV falls to zero.

*Cost of Capital is 7.93% . If our cost of capital is less


*Cost of Capital is 5% than this, for example, 5%, we would invest in the project.
Break-Even Analysis
• Break-even analysis asks an easier question,
• “Can I sell enough to break even?”

• The break-even quantity is the quantity that will lead to zero profit

The break-even quantity is Q = F/(P - MC),


where F is annual fixed cost, P is price, and MC is marginal cost.
Choosing the Right Manufacturing Technology

If Top Management expects to sell more than five units, it should choose the low-marginal-cost technology;
and for less than five units, they should choose the low-fixed-cost technology.
Shut-down Decisions and Break-Even Prices

• If you shut down, you lose your revenue, but you get back your avoidable cost.
• The break-even price is the average avoidable cost per unit

Illustration:

Fixed cost is $100/year, MC is $5/year, and you’re producing 100 units per year.
• How low can price go before it is profitable to shut down?
Sunk Cost and Post Investment Hold Up

Sunk costs are unavoidable, even in the long run, so after you incur them, you become vulnerable to post-investment
hold-up.

Illustration:

Suppose that the magazine accepts your offer of $8/ unit and immediately hands you a purchase order for
$8,000,000, for the first-year production.
Option to secure profit: Thru Contracts or Property Rental
• Do you accept the purchase order?

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