Professional Documents
Culture Documents
Chapter 1 Overview
Chapter 1 Overview
Overview of
Business Economics
◎ Accounting Profits
○ Total revenue (sales) minus dollar cost of producing
goods or services.
○ Reported on the firm’s income statement
◎ Economic Profits
○ Total revenue minus total opportunity cost
OPPORTUNITY COST
◎ Accounting Costs: The explicit costs of the resources needed to
produce goods or services and reported on the firm’s income
Statement
◎ Opportunity Cost: The cost of the explicit and implicit resources
that are foregone when a decision is made.
○ Implicit costs are very hard to measure →managers often overlook them
○ Ex: what does it cost you to read a book?
○ Suppose you own a building in New York that you use to run a small pizzeria.
Food supplies are your only accounting costs. At the end of the year, your
accountant informs you that these costs were $20,000 and that your revenues
were $100,000. Thus, your accounting profits are $80,000. Economic profits?
◎ Economic Profits: Total revenue minus total opportunity cost.
“
“It is not out of the benevolence of the
butcher, the brewer, or the
baker, that we expect our dinner, but from
their regard to their own interest.”
Source: Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, 1776.
PROFITS AS A SIGNAL
◎ Problem 1-1:
The manager of Automated Products is contemplating the purchase of a
new machine that will cost $300,000 and has a useful life of five years.
The machine will yield (year-end) cost reductions to Automated
Products of $50,000 in year 1, $60,000 in year 2, $75,000 in year 3, and
$90,000 in years 4 and 5. What is the present value of the cost savings of
the machine if the interest rate is 8 percent? Should the manager
purchase the machine?
PRESENT VALUE OF INDEFINITELY LIVED ASSETS
◎ Some decisions generate cash flows that continue indefinitely.
6-39
RELATIVELY ELASTIC
As price changes, there is a
LARGE change in quantity
demanded for a good or service
RELATIVELY INELASTIC
As price changes, there is a
SMALL change in quantity
demanded for a good or service
UNIT ELASTICITY
As price changes, quantity
demand for a good or service
will change by the same amount
Price Elasticity of Demand (E)
6-44
Calculating Price Elasticity of Demand
◎ Price elasticity can be calculated by multiplying the
slope of demand (Q/P) times the ratio of price to
quantity (P/Q)
Q
100
%Q Q Q P
E
%P P P Q
100
P
◎ Given Q = a + bP where b = Q/P
P P
E b or E
Q PA
Where P and Q are values of price and quantity demanded
at the point of measure along demand, and A ( a'/ b )
is the price-intercept of demand 6-45
Group discussion
6-46
Price Elasticity & Total Revenue
6-47
Price Elasticity & Total Revenue
The manager at Borderline Video Emporium faces the demand curve
for Blu-ray DVD discs shown in Figure 6.1. Predict and calculate the
change in total revenue in below instances:
1. At the current price of $18 per DVD Borderline can sell 600 DVDs
each week. The manager can lower price to $16 per DVD and increase
sales to 800 DVDs per week. Over the interval a to b on demand curve
D the price elasticity is equal to -2.43.
2. Now suppose the manager at Borderline is charging just $9 per
compact disc and sells 1,500 DVDs per week (see Panel B). The
manager can lower price to $7 per disc and increase sales to 1,700
DVDs per week. Over the interval c to d on demand curve D, the
elasticity of demand equals -0.50.
○ From those results, what do you infer?
6-48
Price Elasticity & Total Revenue
6-49
Marginal Revenue
◎ Marginal revenue (MR) is the change in total revenue
per unit change in output
◎ Since MR measures the rate of change in total revenue
as quantity changes, MR is the slope of the total
revenue (TR) curve
TR
MR
Q
6-50
Marginal Revenue & Price Elasticity
1
MR P 1
E
6-51
MR, TR, & Price Elasticity
Unit Unit
elastic (E=
elastic
MR = 0 TR is maximized
1) (E= 1)
TR decreases as Inelastic (E< 1)
Inelastic
MR < 0 Q increases (E< 1)
(P decreases) 6-52
2.
Demand Estimation
and Forcasting
By using regression and statistical
knowlede
Empirical Demand Functions
◎ Demand equations derived from actual market data
◎ Useful in making pricing & production decisions
◎ In linear form, an empirical demand function can be
specified as
Q a bP cM dPR
where Q is quantity demanded, P is the price of the good
or service, M is consumer income, & PR is the price of some
related good R
7-54
Example: Estimating the Demand for a Pizza Firm
6-55
Example: Estimating the Demand for a Pizza Firm
6-56
Example: Estimating the Demand for a Pizza Firm
6-57
Time-Series Forecasts
Qt a bt
7-58
Linear Trend Forecasting
Use regression analysis to estimate
values of a and b
Qˆ t aˆ bt
ˆ
○ If b > 0, sales are increasing over time
○ If b < 0, sales are decreasing over time
○ If b = 0, sales are constant over time
7-60
Direct Methods of Demand Estimation
◎ Consumer interviews
○ Range from stopping shoppers to speak with them to
administering detailed questionnaires
○ Potential problems
◉ Selection of a representative sample, which is a sample (usually
random) having characteristics that accurately reflect the population
as a whole
◉ Response bias, which is the difference between responses given by an
individual to a hypothetical question and the action the individual
takes when the situation actually occurs
◉ Inability of the respondent to answer accurately
7-61
Direct Methods of Demand Estimation
7-62
Chapter 3
Production and cost analysis;
The organization of a firm
8-65
Basic Concepts of Production Theory
◎ Short run
○ At least one input is fixed
○ All changes in output achieved by changing usage
of variable inputs
◎ Long run
○ All inputs are variable
○ Output changed by varying usage of all inputs
8-66
Short Run Production
◎ In the short run, capital is fixed
○ Only changes in the variable labor input can
change the level of output
◎ Short run production function
Q f ( L,K ) f ( L )
8-67
1.
Production and Cost in
the Short Run
Average & Marginal Products
8-69
Total, Average & Marginal Product
Curves
o Increasing marginal returns:
Range of input usage over
which marginal product
increases
o Decreasing (diminishing)
marginal returns: Range of
input usage over which
marginal product declines.
o Negative marginal returns:
Range of input usage over
which marginal product is
negative.
8-70
Phases of
Marginal Returns
As the usage of an input increases, marginal product
initially increases (increasing marginal returns), then
begins to decline (decreasing marginal returns), and
eventually becomes negative (negative marginal
returns).
The Role of the Manager in the
Production Process
1. To ensure that the firm
operates on the production
function
2. To ensure that the firm uses
the correct level of inputs.
○ value marginal product: The
value of the output produced
by the last unit of an input.
8-72
Profit-Maximizing Input
Usage
To maximize profits, a manager should use inputs at levels at
which the marginal benefit equals the marginal cost. More
specifically, when the cost of each additional unit of labor is w,
the manager should continue to employ labor up to the point
where VMPL = w in the range of diminishing marginal product
Short Run Production Costs
8-75
Total Cost Curves
8-76
Average Costs
• Average variable cost ( AVC )
TVC
AVC
Q
• Average fixed cost ( AFC )
TFC
AFC
Q
• Average total cost ( ATC )
TC
ATC AVC AFC
Q
8-77
Short Run Marginal Cost
8-78
Average & Marginal Cost Schedules
0 -- -- -- --
100 $60 $40 $100 $40
200 30 30 60 20
20 30 50 30
300
15 35 50 50
400
12 44 56 80
500 10 56.7 66.7 120
600
8-79
Average & Marginal Cost Curves
8-80
Short Run Average & Marginal Cost
Curves
8-81
Short Run Cost Curve Relations
8-82
Short Run Cost Curve Relations
◎ SMC is U-shaped
○ Intersects AVC & ATC at their minimum points
○ Lies below AVC & ATC when AVC & ATC are
falling
○ Lies above AVC & ATC when AVC & ATC are
rising
8-83
Relations Between Short-Run Costs & Production
8-84
Relations Between Short-Run Costs & Production
w w
AVC and SMC
MP
A MP
8-85
Short-Run Production & Cost Relations
8-86
Relations Between Short-Run Costs &
Production
◎ When marginal product (average product) is increasing,
marginal cost (average cost) is decreasing
◎ When marginal product (average product) is decreasing,
marginal cost (average variable cost) is increasing
◎ When marginal product = average product at maximum AP,
marginal cost = average variable cost at minimum AVC
8-87
Summary of Short-Run Empirical
Production Functions
Short-run cubic
production equations
8-91
Exercise 1
◎
8-92
Exercise 1
8-93
Exercise 2
◎
8-94
Exercise 2
8-95
Typical Isoquants
9-96
2.
Production and Cost in
the Long Run
Marginal Rate of Technical Substitution
K
MRTS
L
The minus sign is added to make MRTS a positive
number since K L , the slope of the isoquant, is
negative
9-98
Marginal Rate of Technical Substitution
K MPL
MRTS
L MPK
9-99
Isocost Curves
9-
Optimal Input Combination to Minimize Cost
for Given Output
9-
Optimal Combination of Inputs
Terry’s Lawn Service rents five small push mowers and two
large riding mowers to cut the lawns of neighborhood
households. The marginal product of a small push mower is 3
lawns per day, and the marginal product of a large riding
mower is 6 lawns per day. The rental price of a small push
mower is $10 per day, whereas the rental price of a large riding
mower is $25 per day. Is Terry’s Lawn Service utilizing small
push mowers and large riding mowers in a cost-minimizing
manner?
8-
Long-Run Costs
9-
Long-Run Costs
◎ Long-run average cost (LAC) measures the cost per unit
of output when production can be adjusted so that the
optimal amount of each input is employed
○ LAC is U-shaped
○ Falling LAC indicates economies of scale
○ Rising LAC indicates diseconomies of scale
LTC
LAC
Q
9-
Long-Run Costs
◎ Long-run marginal cost (LMC) measures the rate of
change in long-run total cost as output changes along
expansion path
○ LMC is U-shaped
○ LMC lies below LAC when LAC is falling
○ LMC lies above LAC when LAC is rising
○ LMC = LAC at the minimum value of LAC
LTC
LMC
Q
9-
Long-Run Average & Marginal Cost
9-
INSIDE BUSINESS
In industries with economies of scale, firms that produce greater levels of output produce at lower
average costs and thus gain a potential competitive advantage over rivals. Recently, two
international businesses pursued such strategies to enhance their bottom line.
Japan’s Matsushita Plasma Display Panel Company, Ltd., invested $835 million to build the world’s
largest plant for producing plasma display panels. The factory—a joint venture between Panasonic
and Toray Industries—had the capacity to produce 250,000 panels per month by the late 2000s. This
strategy was implemented in response to rising global demand for plasma display panels, and a
desire on the part of the company to gain a competitive advantage over rivals in this increasingly
competitive industry.
An automaker in India—Maruti Udyog Ltd.—produced tangible evidence that economies of scale
are important in business decisions. It enjoyed a 271 percent increase in net profits in the mid-
2000s, thanks to its ability to exploit these economies. The increase was spawned by a 30 percent
increase in sales volume that permitted the firm to spread its sizable fixed costs over greater
output. Importantly, the company’s reduction in average costs due to economies of scale was more
than enough to offset the higher costs stemming from increases in the price of steel.
SOURCES: “Matsushita Plans Big Expansion of PDP Manufacturing,” IDG News Service, May 19, 2004; “MUL Gains from Cost-Saving Measures,” Sify India, May 18,
2004.
“
Part 2.
The organization of a firm
OVERVIEW
I. Methods of Procuring Inputs
○ Spot Exchange
○ Contracts
○ Vertical Integration
II. Optimal Procurement Input
III. Principal-Agent Problem
○ Owners-Managers
○ Managers-Workers
Learning objectives
1. Discuss the economic trade-offs associated with obtaining inputs
through spot exchange, contract, or vertical integration.
2. Identify four types of specialized investments, and explain how each can
lead to costly bargaining, underinvestment, and/or a “hold-up problem.”
3. Explain the optimal manner of procuring different types of inputs.
4. Describe the principal–agent problem as it relates to owners and
managers.
5. Discuss three forces that owners can use to discipline managers.
6. Describe the principal–agent problem as it relates to managers and
workers.
7. Discuss four tools the manager can use to mitigate incentive problems in
8. the workplace.
1.
METHODS OF
PROCURING INPUTS
1. Spot exchange
2. Contract
3. Vertical integration
METHODS OF PROCURING INPUTS
1. Site specificity
2. Physical asset specificity
3. Human asset
4. Dedication
FORMS OF SPECIALIZED INVESTMENTS (SIs)
(3) opportunism:
→ The “hold-up problem”: Once a firm makes a
specialized investment, the other party may attempt to
“rob” it of its investment by taking advantage of the
investment’s sunk nature.
→ This behavior make firms reluctant to engage in
relationship-specific investments in the first place
unless they can structure contracts to mitigate the hold-
up problem.
1.
OPTIMAL INPUT
PROCUREMENT
When to use each form of input
procurement?
OPTIMAL INPUT PROCUREMENT
Spot exchange
Jiffyburger, a fast-food outlet, sells approximately 8,000 quarter-pound
hamburgers in a given week. To meet that demand, Jiffyburger needs
2,000 pounds of ground beef delivered to its premises every Monday
morning by 8:00 AM sharp.
1. As the manager of a Jiffyburger franchise, what problems would
you anticipate if you acquired ground beef using spot exchange?
2. As the manager of a firm that sells ground beef, what problems
would you anticipate if you were to supply meat to Jiffyburger
through spot exchange?
SPOT EXCHANGE
◎ Spot Exchange
○ When the buyer and seller of an input meet,
exchange, and then go their separate ways.
◎ Contracts
○ A legal document that creates an extended
relationship between a buyer and a seller
◎ Vertical Integration
○ When a firm shuns other suppliers and chooses to
produce an input internally
KEY FEATURES
◎ Spot Exchange
○ Specialization, avoids contracting costs, avoids costs of vertical
integration.
○ Possible “hold-up problem.”
◎ Contracts
○ Specialization, reduces opportunism, avoids skimping on
specialized investments
○ Costly in complex environments
◎ Vertical Integration
○ Reduces opportunism, avoids contracting costs
○ Lost specialization and may increase organizational costs
THE PRINCIPAL-AGENT PROBLEM
◎ Occurs when the principal cannot observe the effort of the agent.
○ Example: Shareholders (principal) cannot observe the effort of the
manager (agent).
◎ The Problem: Principal cannot determine whether a bad outcome
was the result of the agent’s low effort or due to bad luck
◎ Manager’s must recognize the existence of the principal-agent
problem and devise plans to align the interests of workers with that
of the firm
◎ Shareholders must create plans to align the interest of the manager
with those of the shareholders.
Manager receive 10 percent of profits
SOLVING THE PROBLEM BETWEEN OWNERS AND
MANAGERS
◎ Internal incentives
○ Incentive contracts
○ Stock options, year-end bonuses
◎ External incentives
○ Personal reputation.
○ Potential for takeover.
SOLVING THE PROBLEM BETWEEN WORKERS AND
MANAGERS
◎ Profit sharing: Mechanism used to enhance workers’ efforts that
involves tying compensation to the underlying profitability of the
firm.
◎ Revenue sharing: Mechanism used to enhance workers’ efforts that
involves linking compensation to the underlying revenues of the
firm.
◎ Piece rates: depend on the output produced
◎ Time clocks and spot checks
CONCLUSION
◎ Vertical Integration.
○ Where various stages in the production of a single product
are carried out by one firm.
◎ Horizontal Integration.
○ The merging of the production of similar products into a
single firm
◎ Conglomerate Mergers
○ The integration of different product lines into a single firm
PROS & CONS OF HORIZONTAL INTEGRATION
PROS CONS
◎ Lower costs → economics ◎ Destroyed value.
of scale / scope. ◎ Legal repercussions.
◎ Increased differentiation ◎ Reduced flexibility.
◎ Increased market power.
◎ Reduced competition.
◎ Access to new markets.
DOJ/FTC HORIZONTAL MERGER GUIDELINES
◎ Based on ; Where:
◎ Merger may be challenged if:
○ HHI exceeds 2500, or would be after merger, and
○ Merger increases the HHI by more than 200
◎ But....
○ Recognizes efficiencies: “The primary benefit of mergers to the
economy is their efficiency potential...which can result in lower
prices to consumers...In the majority of cases the Guidelines will
allow firms to achieve efficiencies through mergers without
interference...”
EXAMPLE
TYPE OF MARKET STRUCTURE
Disadvantages
◎ Exploitation of consumer – higher prices
◎ Potential for supply to be limited – less choice
◎ Potential for inefficiency – X-inefficiency – complacency over
controls on costs
MONOPOLY
Advantages
◎ May be appropriate if natural monopoly
◎ Encourages R&D
◎ Encourages innovation
◎ Development of some products not likely without some
guarantee of monopoly in production
◎ Economies of scale can be gained – consumer may benefit
OLIGOPOLY
Internet service provider 750 SBC, Comcast, AOL, Verizon, Road Runner,…
Sources: Canadian Government; Diamond Facts 2006; www.w3counter.com; Planet retail; Autodata; Reuters; ISP Planet; Swivel. Data cover 2006-2007
MONOPOLISTIC COMPETITION
Monopolistic competition is a market structure in which:
◎ There are many competing producers in an industry
◎ Each producer sells a differentiated product
◎ There is free entry into and exit from the industry in
the long run
SUMMARY
Perfect
Monopolistic
Competition Oligopoly Monopoly
Competition
Price (dollars)
P0
P0 D = MR
0 Q0 0 Quantity
Quantity Panel B – Demand curve facing
Panel A – Market a price-taker
PERFECT COMPETITION
TotalProfit
revenue =$36 x 600
= $21,600 - $11,400
= $21,600
= $10,200
Profitcost
Total = $3,150
= $17 -x$5,100
300
= -$1,950
= $5,100
14-
BASIC PRICING
◎ Perfect competition: P = MC
◎ Monopoly and Monopolistic: MR = MC
14-
THIRD-DEGREE PRICE DISCRIMINATION
14-
THIRD-DEGREE PRICE DISCRIMINATION
◎ Equal-marginal-revenue principle
○ Allocating output (sales) so MR1 = MR2 which will
maximize total revenue for the firm (TR1 + TR2)
○ More elastic market gets lower price
○ Less elastic market gets higher price
;
14-
AN EXAMPLE
◎ Suppose the elasticity of demand for Kodak film in the
US is = -1.5, and the elasticity of demand in Japan is = -
2.5.
◎ Marginal cost of manufacturing film is $3.
◎ Determine the profit-maximizing prices?
14-
THIRD-DEGREE PRICE DISCRIMINATION
14-
ALLOCATING SALES BETWEEN MARKETS
14-
CONSTRUCTING THE MARGINAL REVENUE CURVE
14-
PROFIT-MAXIMIZATION UNDER THIRD-DEGREE
PRICE DISCRIMINATION
14-
TWO-PART PRICING
◎ Two-part pricing: Pricing strategy in which consumers
are charged a fixed fee for the right to purchase a product,
plus a per-unit charge for each unit purchased.
○ Example: Athletic club memberships.
14-
“
Two-Part Pricing:
A firm can enhance profits by engaging in two-
part pricing: charge a per-unit price that equals
marginal cost, plus a fixed fee equal to the
consumer surplus each consumer receives at
this per-unit price.
A NUMERICAL EXAMPLE
Assume that an individual’s inverse demand curve is given
by: P = 20 – 2Q, and the cost function is C(Q) = 2Q. The firm
seeks to find the optimal, profit-maximizing two-part pricing.
Find the optimal price and initiation fee for this product.
14-
BLOCK PRICING
◎ Block pricing: Pricing
strategy in which
identical products are
packaged together in
order to enhance
profits by forcing
customers to make an
all-or-none decision to
purchase.
E.g. Paper, Six-packs of soda,
Different sized of cans of green
beans.
14-
AN ALGEBRAIC EXAMPLE
◎ Typical consumer’s ◎ Optimal Quantity To
demand is P = 10 - 2Q Package: 4 Units
◎ C(Q) = 2Q
◎ Optimal number of
units in a package?
◎ Optimal package price?
14-
AN ALGEBRAIC EXAMPLE
◎ Optimal Price for the ◎ Costs and Profits with
Package: $24 Block Pricing
14-
“
Block Pricing: By packaging units of a
product and selling them as one package, the
firm earns more than by posting a simple per-
unit price. The profit-maximizing price on a
package is the total value the consumer
receives for the package.
COMMODITY BUNDLING
◎ Commodity Bundling: The practice of bundling several
different products together and selling them at a single
“bundle price.”
○ E.g. Vacation packages, Computers and software, Film and
developing.
14-
DEMONSTRATION PROBLEM
14-
PRICING STRATEGIES FOR SPECIAL COST
AND DEMAND STRUCTURES
1. Peak-Load Pricing
2. Cross-subsidization
PEAK-LOAD PRICING
◎ Peak-load Pricing:
Pricing strategy in
which higher prices
are charged during
peak hours than
during off-peak hours.
14-
“
Peak-Load Pricing: When demand is higher
at some times of the day than at other times,
a firm may enhance profits by peak-load
pricing: charging a higher price during peak
times than is charged during off-peak times.
“
CROSS-SUBSIDIES PRICING
◎ Principle: Whenever the demands for two products
produced by a firm are interrelated through costs or
demand, the firm may enhance profits by cross-
subsidization: selling one product at or below cost and
the other product above cost.
○ E.g.: Browser and server software, Drinks and meals at restaurants.
14-
EXAMPLE
◎ The demand for electricity is Q =5-P in peak periods and Q =4-2P
in off-peak periods. Both periods take up half of each day.
Variable cost is 0.25 per unit of output per period and capital cost
capacity are 0.75 per unit of capacity per day. Capacity costs are
sunk and cannot be adjusted between periods
◎ Find the optimal capacity, peak price and off-peak price
14-
CONCLUSION
◎ First degree price discrimination, block pricing,
and two part pricing permit a firm to extract all
consumer surplus.
◎ Commodity bundling, second-degree and third
degree price discrimination permit a firm to
extract some (but not all) consumer surplus.
◎ Simple markup rules are the easiest to implement,
but leave consumers with the most surplus and
may result in double-marginalization.
◎ Different strategies require different information.
14-
ANSWERING THE headLINE
Why does Disney World charge a cover fee for entering the
park and then let everyone who enters ride for free? The
answer lies in the ability to extract consumer surplus by
engaging in two-part pricing. In particular, the marginal
cost of an individual ride at an amusement park is close to
zero, as in Figure. If the average consumer has a demand
curve like the one in Figure, setting the monopoly price
would result in a price of $10.50 per ride. Since each
customer would go on five rides, the amusement park
would earn $52.50 per customer. (This ignores fixed costs,
which must be paid regardless of the pricing strategy.) But
this would leave the average consumer with $26.25 in
consumer surplus. By charging an entry fee of $105 but
pricing each ride at $0, each consumer rides an average of
10 rides and the park extracts all consumer surplus and
earns higher profits
14-
2.
Advertising policies in
business
1. Advertisement and its roles
2. Economic analysis of advertising in business
ADVERTISEMENT
◎ Definition: expenditure undertaken by a firm to
promote the sales of its products or services.
○ E.g.: paid-for space in print, radio or television media;
promotional activity
◎ Advertising is intended to influence consumer
choice in favor of the advertiser’s product or
service.
14-
Graphical Analysis of Advertising
14-
OPTIMAL ADVERTISING DECISIONS
◎ To maximize these profits, managers should advertise
up to the point where the incremental revenue from
advertising equals the incremental cost
○ Incremental cost of advertising: the dollar cost of the
resources needed to increase the level of advertising (e.g.:
fees paid for additional advertising space)
○ Incremental revenue: the extra revenue the firm gets as a
result of the advertising campaign.
14-
OPTIMAL ADVERTISING DECISIONS
Formula: The Profit-Maximizing Advertising-to-Sales
Ratio.
Or:
◎ Where:
◎ The more elastic the demand for a firm’s product, the lower the
optimal advertising-to-sales ratio.
◎ The greater the advertising elasticity, the greater the optimal
advertising-to-sales ratio
14-
DEMONSTRATION PROBLEM
14-
3.
Investment policy in
business
Investment appraisal in business
1. Investment with risk and uncertainty
BASIC STEPS IN INVESTMENT APPRAISAL
1. Defining the objectives: decide the type of investment
projects.
○ Replacement investment: old equipment has to be replaced
○ Expansionary investment: firm expands its capacity to meet
growing demand
○ Other investments: health and safety or environmental
reasons.
2. Identifying options: consider the various ways in which
the objective might be met.
3. Identifying the costs, benefits, timing and uncertainties
of each option.
14-
BASIC STEPS IN INVESTMENT APPRAISAL
4. Choosing the method of appraisal: discounted
cash flow techniques, internal rate of return,
payback or the accounting rate of return
5. Choosing the cost of capital: to choose a value to
represent the opportunity cost of the resources
6. Test of viability: whether projects are individually
worth while and ranked in order of merit.
7. Presenting the results: The present value of each
of the projects should be presented to the
decision makers
14-
AN INVESTMENT EXAMPLE
◎ Step 1: An electricity supplier has decided to build
a new power station
◎ Step 2: The alternative technologies available
should be considered
◎ Step 3: Costs of undertaking each alternative
plan, variable costs of producing electricity,
expected revenues, anticipated life of the
project (25 years for a power station), costs in
closing the power station
○ Estimating the cash flows of a project: capital costs,
○ operating costs, revenues and decommissioning costs
14-
AN INVESTMENT EXAMPLE
◎ Step 4: Choosing the method of appraisal:
14-
“
Rules to choose project
Discounted cash flow techniques (NPV):
1. Projects have positive NPV should all be undertaken
2. Projects having a negative NPV should be rejected
3. Projects have higher NPV should be preferred
14-
14-
INTERNAL RATE OF RETURN (IRR)
14-
DEMONSTRATION PROBLEM
◎ According to the IRR method, which project if preferred?
14-
PAYBACK METHOD
14-
THE ACCOUNTING RATE OF RETURN
◎ Formula:
14-
SUMMARY
14-
PROJECTS RANKING AND CAPITAL RATIONING
14-
DEMONSTRATION PROBLEM
14-
SUMMARY
1. Pricing strategies:
a) Basic pricing strategies
◉ Monopoly & Monopolistic Competition
◉ Cournot Oligopoly
b) Strategic pricing for greater profits
◉ Price Discrimination o Two-part pricing
◉ Block Pricing o Commodity Bundling
c) Pricing strategies for special structure of cost and
demand structures
◉ Peak-Load Pricing o Transfer Pricing
◉ Cross Subsidies
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SUMMARY
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SUMMARY
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PRACTICE
Using the following data for project A and B:
◎ Calculate the net present value for each project, assuming a cost of capital
of 15%.
◎ Calculate the internal rate of return for each project.
◎ Which project should the firm choose based on using net present value and the
internal rate of return?
◎ If the cost of capital were to increase to 20%, would project A or B be preferred?
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