Module 4 – Extent Decisions

Learning Objectives
1. Discuss extent decisions and its concepts;
2. Explain the concepts of the average and marginal cost;
3. Illustrate and discuss marginal analysis table;
4. Explain the marginal analysis;
5. Explain the effects of incentive pays;

OUTLINE
INTRODUCTION
AVERAGE AND MARGINAL COSTS
MARGINAL ANALYSIS
INCENTIVE PAY
IS INCENTIVE PAY UNFAIR?
SUMMARY
REVIEW QUESTIONS
REFERENCES
2 Managerial Economics

INTRODUCTION Back to top

The financial crisis began in the subprime housing market. Government policies encouraged
lenders to extend credit to low-income borrowers who previously would not have qualified for
loans. Lenders then packaged the mortgages into tradable securities and sold them to investors.
The ratings agencies – who were selected by the lenders – had an incentive to rate the securities as
low risk because favorable risk ratings increased the prices that lenders received when they sold
the loans to investors. These high prices encouraged lenders to make even more subprime loans.

Sharmen Lane, a high school dropout who had previously worked as a manicurist before joining
subprime lender New Century Mortgage bought loan applications from mortgage brokers on
behalf of her lender. As the housing market heated up, competitions for these applications became
so fierce that some of Ms. Lane’s competitors were literally throwing themselves at brokers to get
loans. Lane’s unwillingness to do this cost her dearly, who left New Century before it failed in
2007.

Unfortunately, there were many others who did. They made loans just like a strawberry picker who
borrowed money to buy a $720,000 house despite an income of only $14,000. When the price of
housing fell, these borrowers had very little to pay back the loans, and the lenders went bankrupt.

At this level, the financial crisis can be thought of as of a sequence of bad decisions by borrowers,
brokers, lenders, credit rating agencies, and investors who all ignored, for various reasons, the cost
of making loans. They collectively committed the hidden-cost fallacy because they ignored or
underestimated the riskiness of the loans.

As a result of this fallacy, too many loans were made. In this topic, we will show you how to make
profitable “extent” decisions (how many or how much) by identifying the relevant benefits and
costs of these decisions.

AVERAGE AND MARGINAL COSTS Back to top

In 2005, Memorial Hospital’s CEO conducted performance reviews of the hospital departments.
As part of this review process, the chief of obstetrics proposed increasing the number of babies
being delivered by his department. The CEO examined the department’s financial statements and
noted that the cost of 540 deliveries was $3,132,000, but revenues were only $2,754,000. The CEO
asked why anyone would want to do more of something that was losing $700 every time the
hospital delivered another baby.

As most of you should recognize, the CEO is committing the fixed-cost fallacy. As we learned in
the last chapter, the relevant costs and benefits of this decision (‘how many babies should the
hospital deliver”) are those that vary with the consequences of the decision. Instead of starting
with the question – should we be delivering more babies? – the hospital CEO began with the costs.
And since average costs include fixed cost that do not vary with the consequences of the decision,
he made a mistake. He the CEO ignored the fixed costs, he would have realized that increasing the
number of deliveries would increase hospital profit. This leads to the following piece of advice:
3 Module 4 Extent Decisions

Average cost (AC) is irrelevant to an extent decision.

Because average costs “hide” fixed costs by lumping then together with variable costs, this mistake
is easy to make. For the 500 deliveries made, Memorial Hospital had fixed costs of $1M and
variable costs of $3,000/ delivery; total costs equaled $2.5M ($1M + [$3,000 x 500]). Average
costs are total costs divided by the number of deliveries.

In the hospital example, the marginal cost is below so the average is falling, but this is not always
the case. If the marginal is above the average, then the average will rise with output. This could
occur, for example, in a factory that is already operating near capacity and wants to increase output.
If workers run out of space, productivity falls which means that more inputs are required to make
additional output, or that the marginal cost is above the average. In other words, if further output
is more expensive than past output, the marginal is above the average, the average rises with
output.

MARGINAL ANALYSIS Back to top

To analyze extent decisions, we break down the decision into small steps and then compute the
costs and benefits of taking another step. If the benefits of taking another step are greater than the
costs, then take another step. Otherwise, step backwards.

We call this approach marginal analysis. To illustrate, we analyze the decision of how much to
sell, where marginal analysis applies to both costs and revenues.

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

Sell more if MR > MC; sell less if MR < MC. If MR = MC, you are selling the right amount
(maximizing profit)

Marginal analysis works for any extent decision, like whether to change the level of advertising,
the quality of service, the size of your staff, or the number of parking spaces to lease. The same
principle applies to each decision – do more if MR > MC, and do less if MR < MC.

Returning to the example of Memorial Hospital, managers computed the marginal cost of a
delivery at approximately $3,000, whereas marginal revenue was around $5,000. Because MR >
MC, we know that the hospital was not delivering enough babies. Contrary to the CEO’s initial
view, Memorial could increase profit by delivering more babies, not by reducing the number of
deliveries.

The main difficulty in applying marginal analysis is measuring the marginal cost and marginal
benefit of an additional step. To illustrate, suppose you are working for a mobile phone company
4 Managerial Economics

trying to decide whether to adjust the amount you spend for TV advertising. Suppose you recently
increased your TV advertising budget by $50,000, and the ads yielded 1,000 new customers.

In this example, we have only data on a big discrete change (1,000 new customers), so we estimate
the marginal effect of another dollar of advertising by dividing the cost of the change ($50,000)
by 1,000 customers to get $50 per customer, sometimes called customer acquisition cost. This
means that our best estimate of the marginal cost of acquiring another customer is $50. If the
marginal benefit of another customer is bigger than $50, then increase advertising, otherwise do
not.

Note that marginal analysis points you in the right direction, but it cannot tell you how far to go.
The reason for this is that marginal costs typically rises, and marginal revenue falls, with additional
steps. So after taking a step, you have to recompute marginal cost and benefit to see whether further
steps are warranted.

INCENTIVE PAYS Back to top

How hard to work is an extent decision, so marginal analysis can be used to design incentives to
encourage hard work. To illustrate this idea, suppose you are a landowner evaluating two different
bids for harvesting a tract of timber containing 100 trees. One bid is for $150 per tree, and the other
bid is for $15,000 for the right to harvest all the trees. Which should you accept?

When deciding on problems like this, you should consider the effects of the two bids on the
incentives of the logger. Although both bids have the same face value, they have dramatically
different effects on the logger’s incentives. If you charge a fixed fee of $15,000 for the right to
harvest all the trees, the logger treats the price paid to the landowner as a fixed or sunk cost. He
should, by our reasoning in module 3, ignore the cost when deciding how may trees to cut down.
In other words, under the fixed fee contract, the MC of cutting down trees is zero. This gives the
logger an incentive to cut down trees as long as the value of each tree is greater than the cost of
harvesting it. Under this contract, the logger will end up cutting down all the trees that are
profitable to cut down.

On the other hand, if you charge the logger a royalty rate of $150 per tree, the logger will cut down
only those trees with a value greater than $150. If the forest is a mix of pine worth $200 per tree
and fir worth $100 per tree, the logger will harvest only the pine and leave the fir. Consequently,
the landowner will receive less money under a royalty contract because the logger will harvest
only the pine trees. The incentive effect of a royalty rate is analogous to that of a sales tax because
it deters some wealth-creating transactions.

IS INCENTIVE PAY UNFAIR? Back to top

Some employees and managers will resist even well-designed incentive pay schemes because they
consider them “unfair”. Incentive pay almost certainly leads to differences among workers: If you
reward productivity, more productive workers, or those who work harder than others, will get paid
more. Moreover, incentive pay schemes typically expose workers to risk beyond their control. For
5 Module 4 Extent Decisions

example, sales people compensated on sales commission will earn less if the macro economy does
poorly, though no fault of their own.

However, these criticisms of incentive pay make the mistake of confusing procedural fairness
(everyone has the same opportunity) with outcome equality (everyone has the same outcome). If
you adopt incentive pay, you get higher productivity but at the expense of some inequality.

SUMMARY Back to top

• Do not confuse average and marginal costs.

• Average cost (AC) is total cost (fixed and variable) divided by the 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.
• Marginal revenue (MR) is the additional revenue gained from selling one more unit.
• The relevant costs and benefits of an extent decision are marginal cost and marginal
revenue. If the marginal revenue of an activity is larger than the marginal cost, then do
more of it.
Sell more if MR > MC; sell less if MR < MC. If MR = MC, you are selling the right amount
(maximizing profit).
• 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.

REVIEW QUESTIONS Back to top

1. Why is average cost irrelevant to an extent decision?
2. Why do we need to use marginal analysis in extent decisions?
3. Is incentive pay unfair? Explain your answer.
4. Fill the table below.
If Price = 10
Qty TFC TVC TC AFC AVC ATC MC MR TR TP
0 20 0 20 0 0 0 0 0 0 -20
1 20 6
2 20 10
3 20 15
4 20 19
5 20 24
6 Managerial Economics

References
Luke M. Froeb, Brian T. McCann, Michael R. Ward, Mikael Shor. (2014). Managerial Economics Third
Edition. Cengage Learning Asia Pte Ltd.

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