91972018 Managerial Economies PRINTED BY: hgil’530@ucumberlands.ed, Printing is for personal, private use only. No part of this book may be reproduced or ansmited without publisher's prior permission Violators will be prosecuted. ‘58 SECTION « Pobiem Sang ane Desiston Mating Ler's look more generally at the problem of post investraent hold-up by ewriting profit as a function of the difference berween price and average cost. Profit = Rev ~ Gast = Q* P~ Q* (Cast! Q) = Q* (P ~ AC} If “Cost” includes all your cost, including your opportunity cost of capital, chen you ate just breaking even (earning zero profi) when P = AC. If price falls below AC, tien you are losing money. “Toste how this affees investment decisions, imagine thar you areadvising regional commercial printer, who is negotiating wit a magazine, ike National (Geographic. For the magazine, using a regional printer reduces shipping co Barto print a high-quality magazine, the printer must buy 2 $12 milion oto- gravure printing press, For the sake of caviry, we assume thar the press has no resale value and the fim has no capital cost ie can borrow money and pay n0 lnerest). Suppose thatthe MG of printing a single copy s $2 and the printer expects to print one million copies per year over a two-year petiod. Tr the following cable, we compare the average cos of printing the maga- zine over the length of the contract. RP Quay ‘arable Cost |S2/Uni) o $12,000,000 1 1,000,000 $2,000,000, 2 1,000,000 $2,000,000, Tout 2,900,000 $12,900,000 $4,000,000 Average ss 2 Average Coxe 3 Inthe above table, we ee that $8 is the average cost of printing magazines ver the length of the conteac. This ste breakeven price forthe printer and represents her bocrom lie in negotiations withthe magazine. Before they are incurred, sunk costs are relevant ro che negotiation, QUESTION: Now suppose chat the magazine accepts your offer of S8/ tunic and immediately hands you a purchase order for $8,000,000, far the first-year production. Do you accept che purchase order? IF you said "Yes" you have just been held up. Since the $12M cose of ce printer is sunk, the magazine can device to reduce its second-year price to only 52, and you wonld have no option but to aecepe i. Instead, you should instead refs the purchase order at that price. TF the printer anccipaces hold-up, ic will be celuctant o deal with the mag- zine. When this happens, hold-up becomes 2 problem not just forthe poten- ‘ial vietim but also for the potential perpetrator. The one dessom of business hitpslcongage-vtalsource.comiiibooks/27813374680 Sic t56/4i4@0.00.0.0091972018 Managerial Economies PRINTED BY: hgill?530@ucumberlands.ed. Printing is for personal, private use only. No part of this book may be reproduced or tansmited without publisher's prior permission Violators will be prosecuted. CVAPTER 5 « IrvestnentDeslons: Look Angad ars Reason Gack $9 is to figure out how ro profitably consummars the transaction between the printer and che magazine. If possible, the printer will negotiate a contract that penalizes the maga zine should it decce to hold them up. With the assurance of a contract, the printer may fel confident enough to ineur sunk costs. But contracts are often difficue and costly ra enforce. A better solution might be to make che maga- zine purchase che printing press and thea lease it to te printex. In this ease, the magazine no longer poses hold-up chreat ra the printer because the printer has incurred no sank costs.” ‘Note that ifthe cost of che printing press fied, meaning that it ean be recovered by selling the machine, tien hold-up is Rot 2 problem. If che magazine cies co renegotiate a priceless than average cost, the printer will refuse the business, soll the press, and recover its entire investment. Hold-up ‘aan occur only if costs are suk, In general, many inverements are vulnerable to hold-up. Anytime that ‘one party makes a specific investment-—one that is sunk or lacks value out- side of 2 trading relaionship—the party can be held up by is trading part- het. If one party anticipates thac she is at risk of eing held up, she will he reluctant to make relationship-specifc investments, or demand costly safe- ‘poare, inching compensation in the form of beter terms from her trading partner. This gives both parties an inceative to adopt conteacts or organiza fHonal forms, such as investments in eeputation or merges to reduce the ris ‘of hold-up. The goal is to eusure that each party has both the incentive to make reationship-specific investments and ta trade after these investments have been made. Contracts shotld enconnage both investment and trade. For example, marriages ae wulaerabl ro the same rype of posefavestment ‘opportunism that plagues commercial relationships. Partce inves i, energy, ‘and money ina maesiage, the kinds ofinvescmenss thar differentiate marriages from more casual relationships, which can be thought of as spot-markertrans- actions. These javestments ate valuable 0 the marrage partes but are largely in that they have a much lower value outside the selationship, The iage contract penalizes post investment hold-up (ue. divorce) aad this ‘makes couples wiling ro invest more i the marrage." ‘We close the chaprer with the story of an economist and his fiancée who were receiving premarital counseling from 2 priest before he would marry them. The priests fest question tothe couple was “Why do you want ta get ‘married?” Tae economist's fiancée answered, “Because I love him and want to spend che res of my lfe with him.” As you might imagine, the economist hhad a dtferent answer, “Because longe-teom contracts induce higher levels of relatioaship-specitic investment.” A year lates trying hard co find che right words to express how he felt about his wife, he wrote an anniversary e-miail—using @ cursive fom— declaring that his “relationship-specific investment was earning an above- average race of recur.” hitpslcongage-vtalsource.comiiibooks/27813374680 Sic t56/4i4@0.00.0.0091972018 Managerial Economies PRINTED BY: hgil’530@ucumberlands.ed. Printing is for personal, private use only. No part of this book may be reproduced or tansmited without publisher's prior permission, Violators will be prosecuted. 160 SECTION « Pobiem Sang ane Desiton Mating ‘SUMMARY & HOMEWORK PROBLEMS Summary of Main Ponts + Allinvestment decisions involve a wade-off berween eure sarifce and future pain. Before investing you need ro know whether the fate bens ae bigee than the cur rent cons, Discounting allows you 0 figure this out + Companies, ike individuals, have diferear discount rates determined by ther cost of capital Thy invest ony in projec that am a return higher than the cost of capa + TheNPY rae tae hat the ne pres et value ofthe et eash lows from an investment repose, the projec cars conomic profit the investment ears more than the cot of capil + Although NPV isthe correct way to iyzeinvesenenes, nr all companies se Tastad hey use a variety of shortcuts like ay back period they are oe easier 0 fo and more inte + Breal-oen quant bogul to xed cost divided bythe contabution mange you fxpect to vell more than the breakeven gua tiysthen your investment willbe rofiabl + Avoidable coms can be recovered by shut ting dows. If the benefits of shutting down {you get back your avoidable costs) are Jangr than the cost (you give up your revese hen shut dor. The break-even Price is average avoidable cost ‘+ TEyoutincar son coms, you are vainers- ‘eto postiavestment hold-up. Anvciate folds and choos eantracts or organzs- tional forms that gieeach parry bth the Incenive wo make sunkccos vestments an to wade after these invesunens are made. ah ‘Muttiple-Choice Questions 1. Which of the following will increase the break-even quanticy? a. A decrease in overall fixed costs by A decrease in the marginal costs hitpslcongage-vtalsource.comiiibooks/27813374680 Sic t56/4i4@0.00.0.00 A dectense inthe price level d. An increase in price level 2. ‘The higher the discount rates, a. the more value individuals place on facure dollars b, the more value individuals place on current dollars. «the more investments will ake place, 4d. does not affect the investmant strategy |. Assume a fir has the following cost and revenue characteristics a its current level of output price = $10.00, average variable ose = $4.00, and average fied cost = $4.00. This frm is 2. inearring a loss of $2.00 per unit and should shut down. realizing only a normal profi. realizing an economic profit of $2.00 per unit. 4. incurring a loss per unit of $2.00 bur should continue t operate in the short Sarah's Machinery Company is deciding ‘0 dump its current technology A fora ‘new technology B with smaller fixed coms but bigger MCs. The current technology has fixed cost of 8500 and MCs of $50, whereas the new technology has fixed costs ‘of $250 and MCs of $100. At what quan- try is Sarah's Machinery Company indif- ferenc beeween two technologies? ‘Whar isthe not present value ofa project ‘thac requires a $100 investment roday and zetums $50 atthe end of the fist year and $40 at the end of the second year? Assume a discount rate of 10%, a $10.52 b su: © Sisis d. $30.00 35