Prelim week 4: An incentive compensation scheme

that increases MC or reduces MC

Decision on Extent of will increase effort. Fixed fees
Costs have no effects on effort.

Average Cost
- the total cost of
production divided by the number
of units produced. AC=TC/Q
- not relevant to extent
decision
- this often decreases as
quantity increases due to presence
of fixed costs AC=(VC+FC)/Q, FC
does not change as Q increases.
Marginal Cost
- the cost to make and sell
one additional unit of output. MC=
TC↓Q+1 - TC↓Q-
- additional cost required
to produce and sell one more unit.
Marginal Revenue (MR)
- additional revenue gained
from producing and selling one
more unit.
- if benefits of selling
another unit (MR) are bigger than
the costs (MC), then sell another
unit. Produce more when MR>MC,
less when MR<MC. Profits are
maximized when MR=MC.
 Midterm week 7:
Investment Decisions
Investment Profitability
All investments represent a trade-
off between possible future gain
and current sacrifice.
Determining Investment
profitability
The current/future trade-off can be
calculated by,
Compounding
Future value, one period in the
future = Present value x (1 + r)
where r is the rate of return
Future value, n period in the future
= Present value x (1 + r)^n
Discounting (the opposite of
compounding)
Present value, one period in the
future = Future value/ (1+r) where
r is the rate of return
Present value, n period in the
future = Future value / (1+r)^n
Present value and investment
decisions
The NPV rule: if the present value
of the net cash flows > 0, the
project is profitable.
Break-even quantity
- is the amount you need to
sell to just cover your costs. Profit
is 0.
- Q=FC/(P-MC), p= price
-if you expect to sell more
than the break-even quantity, then
your investment id profitable.
Shutdown decision
- made using break-even
prices rather than quantities. The
break-even price is the average
avoidable cost per unit.
- Profit= Rev-st=(P-AC)
(Q)
- if you shutdown you will
lose revenue but you get back your
avoidable cost. If average AC <
Price, shutdown.
To identify Avoidable Cost use
Cost Taxonomy.
Costs
Avoidable Unavoidable
Costs or "Sunk" cost
FC (Avoidable VC (AVoidable
in long term) in short term)
Example problem:
Fixed Cost(FC)= $100/year
Marginal Costs(MC)=$5/unit
Quantity(Q)=100/year
In short run Mc is the only AC, so
the shutdown price is $5.
In the long run, FC become
avoidable, and it become relevant
to the shutdown decision. The
shutdown price includes average
FC and so rises to $6.
*Avoidable costs can be recovered
by shutting down.
*If you are incur to sunk costs, you
are vulnerable to post-investment
hold-up. Anticipate hold-up and
choose contracts or organizational
forms that give each party both
incentives to make sunk-cost
investments and to trade after these
investments are made.
 Midterm week 8:
Pricing Decisions
Pricing is a powerful but often
neglected tool. Profit = (P-AC) x
Q.
Simple pricing
- involves charging what
competitions charge for similar
products and services. This is often
used by retailers and wholesalers.
Complex pricing
- based on the originality
of a product or service and what
customers are willing to pay for it.
Demand curves
- functions that release the
price of a product to the quantity
demanded by consumers.
- gives the idea on how
much goods and services a
consumer purchases at a given
price
Individual demand
- refers to how many units
an individual would purchase at a
given price.
Aggregate demand or market
demand
- the total number of units
that will be purchased by a group
of Consumers at a given price.
Consumer values and demand
curve
Ceteris paribus
- a latin term meaning, all
other things being equal,
unchanged or constant
Mutatis Mutandis
- states changing some
factors, the opposite of Ceteris
paribus.
Example: If the price of milk
increases, ceteris paribus, people
will purchase less milk.
Pricing Tradeoff
Lower price – sell more, but earn
less on each unit sold.
Higher price- sell less, but earn
more on each unit sold.
Proposition: Profits are maximized
when MR-MC
Example:

Price Elasticity is related to
Marginal Revenue (MR)
Price Elasticity = (%Change in
quantity demanded) +
(%Change in price)
*If |e| is < 1, demand is said to be
inelastic
*If |e| is > 1, demand is said to be
elastic
MR and Price Elasticity
%DRev ≈ %DP + %DQ
Elasticity tells you the size of |
%DP| relative to |%DQ|
If demand is elastic
*If P↑ then Rev↓
* If P↓ then Rev↑
If demand is inelastic
*If P↑ then Rev↑
*If P↓ then Rev↓
Formula: Elasticity and MR
Proposition: MR=P(1-1/|e|)
*If |e|>1, MR>0.
*If |e|<1, MR<0.
Elasticity and Pricing
MR>MC is equivalent to
*P(1-1/|e|)>MC
*P>MC/(1-1/|e|)
*(P-MC)/P>1/|e|
What Makes Demand More
Elastic?
Products with close substitutes
have elastic demand.
Demand for an individual brand is
more elastic than industry
aggregate demand.
Products with many complements
have less elastic demand.
Describing Demand with Price
Elasticity
First law of demand: e<0 (price
goes up, quantity goes down).
Second law of demand: in the long
run, |e| increases.
Third law of demand: as price
increases, demand curves become
more price elastic, |e| increases.
Other elasticities
Income Elasticity =
(%change in quantity demanded) +
(%change in income)
- Inferior if Negative,
normal if positive
Cross-price elasticity of good one
with respect to the price of good
two = (%change in quantity of
good one) ¸ (%change in price of
good two)
- Substitute (positive)
complement (negative).
Advertising elasticity=(%change
in quantity) ¸ (%change in
advertising) .
Stay-even analysis can be used to
determine the volume required to
offset a change in costs or prices.