BUSECON (10/22/09) test 3 next Thursday 10/29 (work on assignment 3 questions)

Remuneration, Compensation and Reservation Wage

• ½ of test 3 is cost management the other ½ is production mgmt.

• Remuneration or “pay”: What you are going to get in a higher paying job. ($5000)

• Compensation: ($3,000)

• Reservation: minimum you are willing to accept. Rents – you enjoy your job, you
would be willing to work for free.

o Why would blue pay more if the jobs are equivalent??

The Human Resource Productivity Chain - Incentives have to be matched to effort.
Effort by itself is worthless. Effort has to lead to results. We don’t pay people just
because its so nice to pay people. And results have to be matched to pay. **Incentives
are rewards and penalties**

**TEST 3 Q: What is motivating is also satisfying. FALSE. 

How do we strengthen each link so that employee and employer dance to same
que…..applying 5 principles (next slide)

Key Principles of Labor Productivity

• Principle of responsibility – you should tell yoru people (workers) what they
should do. Simple.  (ex: when you have an interview and they allow you to ask
questions you ask: what is my responsibility going to be in this company?) More
responsibilities that are clear from the start…the more the chain (previous slide)
will work

• Principle of incentive – people don’t work for free. Not saying people only work
for the money, but simply incentives work. Something (besides money) that make
people tick. (if someone is saving your life, you won’t reward with a piece of candy
– incentive must match the demand)

• Principle of information – Whoever has information should make the decision,

Subject to control and incentives. If I have information, then I should make the
decision but there is a change in control that has to match the new decision rights.
(Work at best buy, know someone will buy a computer only if you give them a free
mouse – when they ask for it, you say you need to speak to yoru manager that you
don’t have the decision rights – but then you lose the sale. Best buy allows sales
people to give free things away.

• Principle of Balanced Incentive – You have to have a mix of incentives

(penalties (not receiving a promotion) and rewards) balancing incentives in the
following way  selling too many flat screen TVs instead of IPods and Best buy
 employees are played on incentive. Instead of increasing commission on IPods (in
which you could have the reverse effect) you should make incentive - “if you sell
so many flat screen TVs and so many IPods, you will get a commission”.

o Ex: provide reward in mathematics, then put less effort in History. (explains
why schools require a GPA)

• Principle of Control – When you change decision rights and incentives, you have
to consider changing control. **More information in assignment questions**

Factors in Remuneration (Pay) Decisions

Market Wage – Market salary for certain position is “xyz” (average – not variance) Ave:
80,000 Variance 60,000-120,000. So what do you have to know to neglitate better pay.

• Commitment (Human asset specificity) – Manager decides on 70,000 to offer

the new employee. Notice, you are willing to have a lower pay but more job
security  commitment. Commitment by the company makes you less demanding.
(related to human asset specifity – locked specifically to the company (to prevent
you leaving after company pays for training, they ask you to show that you are
committed to the company)

o Transaction is being balanced – RELATIONAL CONRTACTING. By the

commitment that you give the company, is matched by the commitment that
the company makes to you

• Reputation – Lecturers at Harvard Business school work for free – just so they
have the card that says what they do – to give them more opportunities.
Reputations matter. Higher the reputation, the lower the salary you can offer the
employee

o corporate - name of company matters (willing work for less money at

Microsoft than a small computer company)

o Labor – company that higher you HONORS commitments. If you are fired,
 they will tell you in advance.

• Task Structurability - A lot of what you do can be automated (structured)  why

would you hire an MBA in finance, if the cheaper alternative is doing the same
work electronically? If a job is STRUCTURABLE a CD will eventually replace you.

• Internal work conditions –

• External environment – Eventually the company can indirectly sell you

insurance when the company employs you. (Suppose income fluctuates a lot – the
EMPLOYER can bear risk more efficiently)

• Costs of Control – As we know there is type of a relationship btw decision rights

and..?

o Instead of making fixed salaries, why not have variable salaries 

will become self controllers of your profits (don’t need a supervisor, you will
control yourself based on incentives) What you EARN is based on WHO
CONTROLS AND THE COST OF CONTROL…

Case: Higher Wages and Lower Labor Costs?

• Above-Market Wages – Eventually, that is what you should put on the table. If
you pay me more there will be these benefits…

o More selectivity

o Improved labor retention

o Higher productivity
 o More exigency

o Lower costs of control

• Someone who makes more money than someone else will more carefully control
his work. If you make 5000 and the alternative is 3000…you will make sure not to
take advantage of your job. In CERTAIN cases, it may be beneficial for companies
to pay more than what the market wage is (what the worker can make in other
situations)

o Why blue box exceeds gray box – not a waste…in SOME cases these benefits
(above)are way more than the money you pay people

COST MANAGEMENT (all info is in any econ book)

Cost Typology

• Oppurtunity cost

• Total costs - FC + VC – **Test 3: FIXED COSTS MAY CHANGE IN SHORT RUN**

Short run is the time period in which we face constraints (want to have twice the
capacity – ex: add second oven to bakery – In long run you can do anything you
 want (close company, declare bankruptcy) in SHORT RUN you have constraints

o SR not defined like it is in finance (1 year or less) in this class SR is problem

dependent

o **Test 3: SR is less than one year: FALSE  depends**

• Sunk Cost – (past tense) More important  what is the consequence in the future.
Only incremental costs and benefits matter.

• Production costs

• Organization – hire people, control what they do

• Transaction – Cost of communicating the value of these to potential customers

o Can divide costs in all three types

**TEST 3**

Opportunity Cost and Incremental Economic Gain

You are right now making blue (5000) you have two options (C and B)

• If you are in BLUE your opportunity cost (forgoing) is what you could make in
the BEST feasible (real) opportunity --- If you do BLUE your opportunity cost is
RED. B is your opportunity cost, the difference between A and B is economic
Gain. 2,000 is your GAIN.

• If you do RED you forgo BLUE (5000) and your LOSS is (2000) DON’T CONFUSE
opportunity cost with LOST and LOSS. Suppose you were Red, then best feasible
opportunity is BLUE and your opportunity cost is 5000 and the economic LOSS
is 2000.
Total Cost, Average Cost and Marginal Cost (1)

*When you produce more (Q) your TOTAL COST will rise and rise and continue rising but
in a distinct way. This happens for all companies. *Average Cost FALLS (typical)* but
then increases. If you calculate MC notice than it also falls and falls and continues falling
and then rising, rising, and that is no conincidence. We can plot these babies (AC/MC)
and NO COINCIDENCE that you get U SHAPED CURVES.

• MC cuts AC at its Minimum

Total Cost, Average Cost and Marginal Cost (2)

• (plotting table in previous slide)

• TOP RIGHT: special case. TC is a straight line (in some companies it is possible –
but in general it is curved like the left side)

Two Constanst MC Cases (Linear TC)

**3-4 points in TEST THREE STUDY TABLES**

• Left:

• Right: NO FIXED COST

 o TEST THREE** If MC is constant, AC is constant : FALSE** if MC is constant,
then AC is NOT Constant.

AC and MC in LR

In SR, “Panera” cannot make itself larger, what is constraining Panera the time period it
takes to expand capacity.

Graph shows different sizes of Panera  The size of the company. What is in BLUE can
be labeled the LRAC curve. Which is basically the difference between all the SR sizes.
Each of these sizes have their own AC and MC  what you see LR and SR is simply an
issue of size/magnitude.

• **Economies of Scale - (0-MES “best sized lowest cost plan) explain the huge size
of walmart - **T3 considerably EOS go with industries with relatively few firms:
TRUE**  why there are not too many walmarts but thousands of bakery (not EOS
in bakeries making fresh bread) Bakery industry fragmented, RETAIL is
consolidated.

• **T3: Case on the bottom. Example  you merge two small banks and when they
merge there are no cost efficiencies (20 tellers in one bank, 20 in the other, now
you have 40. NO ECONOMIES OF SCALE) or “constant economies of scale” The
 banks merge and the costs fall – but NOW you only need 30 tellers (ECONOMIES OF
SCALE – advantage of size)

EOS, Economies of Scope, and Revenue Synergy

• EOS – larger plant = lower costs

• Economies of Scope – Two goodies (not one). When a University has many
programs and a 2nd program of the same size of the 1st your costs do not double.
EO-scope does NOT only happen if X and Y are complements, X and Y can be
unrelated.

o A train can support cargo and passengers (because TRACKS can do both)

• Revenue Synergy – When a restaurant serves beer and “salty peanuts” by

putting them together, they create synergy. (drinks compensate for losses)

Case: Production Costs, Organization Costs, and Transaction costs as

Determinants of Optimum Firm size

• As time passes, ability to build more plant  May be tempted to buy companies
that produce what you need in production. So company grows in PRODUCTION,
PLANTS that produce INPUT, and stores that sell my OUTPUT.
 • But overextended myself eventually

o This case shows how decision to make company larger or smaller depends
on PRODUCTION costs ORGANIZATION costs and TRANSACTION costs. (by
buying production of input – not have to negotiate with other companies)

• But the more you grow (as an owner) you must check to see what your “loyal”
employees are doing. Through trial and error Find right size for your company.
Explains demise of bigger companies

Case: EOS and Firm Size in the Automobile Industry

• GM  What led companies to do this, is the idea that EOS is what managers
should WORSHIP. EOS in production is only ONE part of the puzzle. The larger you
get, the more you may induce control over distribution, control of customers ect…
Profit Maximization: A Numerical Example

• Where Marginal Revenue = Marginal Cost

o Already covered in our exam with example, ALSO ON TEST 3

(108) Profit Maximization

• On the left (company has pricing power), on the right you have no pricing power
and perfect competition accept what the price used to be. (bottom right) common
when you have competition

(109) Profit Max Using Excel

(110) LOSS MINIMIZATION – very important

• **TEST 3*** - Suppose you produce cars and you have revenues below cost
(losing money)

o Cases (1) should we close or should we continue with given evidence? YES
CONTINUE – No matter what decision we choose fixed costs DON’T matter,
the only thing that matter is incremental costs (VC) and incremental benefit

 Incremental Benefit – 55 – Allows you to recover, even if partially, the

fixed costs

 If we stop, then we LOSE 60 – If we continue then we LOSE 5!

o Case (2) – Continue. If stop LOSE 60 if you continue LOSE 20

o Case (3) – STOP. Incremental cost (15) which exceeds extra revenue (10)

o Case (4) – STOP.

o Rule – (Not Recoverable) – THIS CASE will be stressed in test 3. The case on
the right (NOT on test 3) assumes some of the fixed costs can be recovered.
What you do is irrelevant, if all the fixed costs are unrecoverable, then they
aren’t relevant.
(111) Loss Minimization (Graphical Analysis) – optional – same as above

• What graph on bottom shows that in simplest case, if the price falls between the
two horizontal dotted lines, then you MINIMIZE LOSSES between the break
evenand Shut down price.  You shut down or close the plant when the revenues
equal or exceed Variable costs (below that then you close)

• T/F – You continue production if you are between break even and shut down? TRUE

o Revenue is still able to cover/exceed the VC.

Case: Outsourcing or Internal Production

• ** TEST 3 **

• X - (shoes) Y - (leather) Z - (Shoelaces)

• We are thinking about outsourcing leather or laces

• **If outside suppliers can sell leather for $4 and laces for $4, DO YOU OUTSOURCE
in the short run?

o (Y) – NO, DON’T OUTSOURCE - 3 to 4 should not be outsourced

o (Z) – YES, OUTSOURCE (4 is less than 5)

• You have the FC no matter what you do in the short run (in house or outsource)
Only INCREMENTAL costs or benefits matter
Critical Volume and Opening Leverage

• What do we mean by CRITICAL VOLUME – The quantity that makes you break
even (When cost = Revenue)  in the red box.

o P-AVC Contribution Margin (b/c in contributes to eventually cover the fixed

costs)

• OPERATING LEVERAGE – (important concept) How much effort you have to

apply to lift weight. Higher OL means that with higher revenue you can generate
more profit (when the VC is relatively low). If a lot of revenue goes into profit then
the variable costs is relatively low.

o Company on the top has MORE leverage

o Change in profit (9)

o Change in revenue (22)

(114) Break-Even (or contribution) Analysis (Linear Case)

• Critical Volume – The MINIMUM you have to sell to break even.

o Ex: How many cups of coffee do you have to sell to break even?
 o At Starbucks – Choose between two technologies (one is capital intensive
and one is Labor intensive) Which is more labor intensive, which requires
more machines – SECOND GRAPH – easier to change labor then it is to get rid
of/sell machines and

o Which technology should I purchase for Starbucks? – DEPENDS on the

quantity they produce. The decision has nothing to do with the critical
volumes. In order to decide what technology to use the point (doesn’t have a
name) connecting TC1 and TC2.

(115) Cost Structure and Production Modes – How companies produce thing

• When you have an assembly line type of production, then you have a higher FC.

• Alternative 1 – (Panera) Common work stations (A,B,C) Outstations (the other

shapes)

• Alternative 2 – (McDonalds) more assembly line type of structure.

(116) CASE: ASPARAGUS - An investor decides to build asparagus processing plant.
The plant will process the asparagus grown from nearby land. Some of the investments
made by the investor to the producers are SUNK. (Some company asks for a specific type
of asparagus) All the education that the Asparagus PRODUCER must require to decide
whether or not they can produce it ($100), is a SUNK COST.

• Sunk costs lead to vulnerability – How much money can they supplier of
asparagus get from the investor **$149** If investor doesn’t agree then he loses
the incremental cost which is 150 (cost of the asparagus) if he pays the “ransom”
149 then he nets $1

• More importantly then the numbers, is to know that if the money you are
spending is SUNK or NOT SUNK. If you invest $$ that will be sunk, then it is
unrecoverable.

• ** TEST 3** IF YOU DON’T KNOW THE SUNK COST YOU DON’T KNOW WHAT
HAS MORE VULNERABILITY – If you DO know sunk costs, when making
decisions, the cheaper investment with more SUNK COSTS
Case: Furniture Maker – Furniture producer rented plant and paid rent.

• One day the landlord says he is going to raise the rent by 8% (Increase in FC).
(Legally, the landlord is allowed to do this).

• Decide to Increase in Prices

• Decrease in sales

• Increase in AFC so decide to raise prices again.

SOLUTION – WHY IS IT WRONG TO RAISE PRICES IN THE SHORT RUN – The Change in
fixed costs does NOT change Marginal COST which means there is no change in prices
(which would make situation worse). In the LONG RUN then you move to a cheaper
location b/c you don’t face the constraints.