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SCRIPTS FOR ONLINE LECTURES TO
COMPLEMENT FROEB&MCCANN,
MANAGERIAL ECONOMICS


CHAPTER 6: SIMPLE PRICING
Opening anecdote
Background: Consumer Surplus and Demand Curves
Marginal Analysis of Pricing
Price Elasticity and Marginal Revenue
What Makes Demand More Elastic?
Forecasting Demand Using Elasticity
Stay-Even Analysis, Pricing, and Elasticity
Summary & Homework Problems


CH 6 Script

OUTLINE

         1.   Intro
         2.   Demand curves
         3.   Price elasticity
         4.   Marginal Analysis of pricing in practice
INTRO:

This is Luke Froeb at Vanderbilt University. I am the author, along with Brian McCann, of the textbook
“Managerial Economics: A Problem Solving Approach.” This lecture is designed to supplement Chapter
6, “Simple Pricing.”

When the Soviet Union fell and embraced capitalism, Mars decided to begin selling its popular Snickers
candy bar in Russia. They priced it at the same price in rubles as it sold for in England, adjusted for the
exchange rate.
This was a huge mistake. Since it was the first western-style candy bar sold in Russia, it had no
competitors, and there was a huge demand for the product. Distributors purchased all the candy bars
for themselves, and then re-sold the candy bar at 2-3 times the recommended retail price. It took
Snickers a long time to recognize their mistake, because distributors were reporting sales at the price
that Snickers had originally set.

Obviously, Mars could have benefited from a better understanding about how to set profitable prices,
the topic of this chapter. We begin with the simple case of a firm that owns a single product and sets a
single price. Later we will talk about setting prices on multiple, commonly owned products, and about
selling a single product at different prices, called “price discrimination.” But before we get there, we
have to understand how to price in this simpler case.

When choosing price, a firm faces a tradeoff: a higher price means fewer goods sold, but higher margin
earned on each sale; while a lower price means more goods sold, but a lower margin on each sale.

<<CAN YOU ILLUSTRATE THIS WITH A FIGURE?>>

This is an extent decision, and we know from Chapter 4 that marginal analysis tells us how to choose the
optimal price.

There are two big ideas in this chapter. The first is that we use a demand curve to turn a difficult price
decision into easy quantity decision. The question “what price should I charge?” is equivalent to the
question “how much quantity should I sell?”

Fortunately, we already know how to use marginal analysis to figure this out: If the marginal revenue is
bigger than the marginal cost, then sell more. And we do that by reducing price.

<<Maybe some kind of moving figures showing that MR>MC means that you should Raise price, and
MR<MC means that you should reduce price>>

The second big idea of the chapter is that the biggest problem with marginal analysis is measurement.
You may have some idea of what your marginal cost is, but figuring out what your marginal revenue is is
much more difficult. If you get any information about marginal revenue, it is likely to come in the form
of a price elasticity. The more price elastic your demand curve is, the lower the price you should charge.

DEMAND CURVES

To construct a demand curve, imagine that we have ten consumers, each of whom wants to purchase
one unit of a good. We arrange them by their values, by what they are willing to pay for the item.
Imagine that the first consumer is willing to pay $10, the second consumer $9, the third consumer $8,
and so on. The tenth consumer is willing to pay only $1.

So if we charge a price of $10, only one consumer buys; but if we reduce the price to $9, two consumers
buy (both the consumer with the $10 value and the consumer with the $9 value). If we lower price all
the way down to $1, all ten consumers purchase. This is a demand curve. It describes the behavior of
this group of consumers, and tells you how much you will sell if you charge a particular price.

Now let’s show you how to use the demand curve to turn the pricing decision into a quantity decision.
In the Table below, we show the demand curve in the first two columns. For each price, the demand
curve tells us how much we will sell.

Price         Quantiity Revenue MR      MC       Profit
        $10           1     $10    $10     $3.50     $6.50
         $9           2     $18     $8     $3.50    $11.00
         $8           3     $24     $6     $3.50    $13.50
         $7           4     $28     $4     $3.50    $14.00
         $6           5     $30     $2     $3.50    $12.50
         $5           6     $30     $0     $3.50     $9.00
         $4           7     $28    ($2)    $3.50     $3.50
         $3           8     $24    ($4)    $3.50    -$4.00
         $2           9     $18    ($6)    $3.50   -$13.50
         $1          10     $10    ($8)    $3.50   -$25.00


<<IN THE TEXT THAT FOLLOWS, CAN YOU HIGHLIGHT THE CELLS IN THE TABLE THAT CORRESPOND TO
THE FIGURES AS I SAY THEM.>>

At a price of $10, we sell only one unit, for a revenue of $10. The “extra” or marginal revenue we get
from selling the first unit is $10, which is bigger than the marginal cost of $3.50, so we sell the first unit.

Then we ask, “should we sell another unit?” We do this by reducing the price to $9. The revenue is $18,
and the marginal or extra revenue from selling the second unit is $8. This is still greater than the
marginal cost, so we sell the second unit.

To sell the third unit, we have to reduce price to $8, for a revenue of $24 and a marginal revenue of $6.
This is still bigger than the marginal cost of producing the third unit, so we make the sale.

To sell the fourth unit, we have to reduce price to $7, for a revenue of $28 and a marginal revenue of $4.
This is still bigger than the marginal cost of $3.50, so we sell the fourth unit.

To sell the fifth unit, we have to reduce price to $6, for a revenue of $30 and a marginal revenue of only
$2. This is below the marginal cost of $3.50, so we do NOT sell the fifth unit.

The optimal price is $7, and in the last column, we see that profit is maximized at this price.

There are three things to take away from this analysis. First, the demand curve allowed us to turn a
difficult pricing problem into a simple quantity problem that we know how to solve using marginal
analysis.
Second, note that the marginal revenue is always LESS than the price. At the optimum output of four,
price is bigger than marginal cost. So while it might appear that you could gain $7 by selling one more
unit, and this is bigger than the marginal cost of $3.50, that would be wrong. You can sell more ONLY by
reducing price. The relevant benefits and costs of an extent decision are the marginal revenue and
marginal cost, NOT the price.

<<MOVING DOWN THE ROW HIGHLIGHTING THE FALLING MARGINAL REVENUE IN THE TABLE ABOVE.>>

Third, note that marginal revenue falls as we sell more. This is a critical feature of demand curves. It is
similar to the idea that marginal costs increase as we sell more. You pick the low hanging fruit first, and
then move on to the higher hanging fruit which is more costly to harvest. Similarly, you make the easy
sales first, to the high value customers, but to sell more you have to reduce price. This results in a falling
marginal revenue curve -- as you sell more, the extra revenue that you earn on each sale falls.

PRICE ELASTICITY OF DEMAND

After using a demand curve to show you how to price optimally, I feel a little guilty for telling you that
you will never “see” a demand curve. They are very difficult to estimate, especially with the kind of
precision that might be useful to someone facing a pricing decision. You can see only the current price
and the current quantity, but not the rest of the demand curve.

Fortunately, you don’t need to know much in order to figure out whether price is too high or too low.
All you need to know are the marginal cost and the marginal revenue at the current output level. If
MR>MC, then sell more, and you do this by reducing price. If MR<MC, then sell less, and you do this by
raising price. As in Chapter 4, marginal analysis tells you which direction to go, but not how far to go.

Still, marginal revenue is hard to measure. If you get some information about marginal revenue, it is
likely to be in the form of a price elasticity.

Price Elasticity = e = %∆Q ÷ %∆P

Price elasticity measures how sensitive consumers are to price. The more price elastic they are, the
more they react to price changes. So for example, if price goes up by 5%, and Quantity goes down by
10%, the price elasticity of demand is e=-2. In this case we say that demand is “price elastic” or simply
“elastic” because |e|>1. In other words, quantity changes more than price. For an Inelastic demand,
one where |e|<1, quantity changes less than price.

Marginal revenue is related to price with the simple formula, MR=P(1-1/|e|). Note that this relationship
holds only for an elastic demand.

We can plug this formula into our marginal calculus to derive the following equivalent relationships:

MR>MC

P(1-1/|e|)>MC
(P-MC)/P > 1/|e|

I call the left side of this equation the “actual mark-up” and the right side of the equation the “desired
markup.” MR>MC if and only if the actual markup is greater than the desired markup. And we know
from above that if MR>MC, we should sell more, and we do this by reducing price.

A numerical example, can easily illustrate this idea. If Price is $10, MC is $8, and elasticity is -2, then the
actual markup is 80%, but the desired markup is only 50%. In this case, MR>MC, so reduce price.

Note that this equation tells us that the price if we could somehow make our demand less elastic, we
could raise price. This makes intuitive sense. If our consumers are less sensitive to price, then we can
profitably raise price.

In chapter 10, we will show you that this is the logic behind what is called a “product differentiation
strategy.” If a firm can do something unique, creative, innovative or different to reduce the elasticity of
demand, then they can command a higher price. One example is Whole Foods. They sell food in the
“Premium, Natural, and Organic” segment, and give 5% of their profit to socially responsible causes.
This gives them a less elastic demand curve, the consequence of which is that they can command the
highest markup in the grocery industry.



MARGINAL ANALYSIS OF PRICING IN PRACTICE:

Even information on price elasticity is difficult to come by so you are probably going to have to do
something else. Here is an example of how you might use marginal analysis in practice. Imagine that
you are working for John Mackey, CEO of Whole Foods, and he asks you whether he ought to raise price
by 5% on all the products sold at Whole Foods. It is obvious that Whole Foods sells an entire range of
products, and that the elasticity for the demand curve facing the entire store would be very difficult to
estimate.

But let’s imagine that everyone who comes to Whole foods buys a similar “basket” of goods, and let’s
try to figure out if a 5% price increase on the basket would be profitable. To do this we can use a
version of “break even” analysis. We could ask “how much quantity could we afford to lose and still
break even?”

This is sometimes called the ‘stay even” quantity or “critical loss.” It can be computed as

Critical Loss= %∆Q = %∆P/(%∆P+Markup) where the Markup=(P-MC)/P.

If we lose less than the critical loss, then the price increase is profitable, but if we lose more, then it is
not. For example, if the markup at Whole Foods is 40%, then the

Critical Loss= 5%/(5%+40%)=11.1%.

So how do we determine whether Whole Foods would lose more than the critical loss?
An economist working on behalf of Whole Foods read marketing studies and found that most people
who shop at Whole Foods also shop at another grocery store, like Kroger or Safeway. Since these stories
carry many of the same items that Whole Foods does, the economist concluded that the shoppers could
easily many of their purchases if Whole Foods raised price.

He concluded that the price increase would not be profitable because demand for Whole Foods is very
elastic. This is equivalent to the marginal analysis of pricing mentioned above, but it is done with two
simple steps. First you calculate the break even quantity, and second, you study demand to determine
whether you would lose more than the break even quantity.
CHAPTER 7: ECONOMIES OF SCALE AND SCOPE
Opening anecdote
Increasing Marginal Cost
Economies of Scale
Learning Curves
Economies of Scope
Diseconomies of Scope
Summary & Homework Problems

OUTLINE:

   1. ANECDOTE ABOUT BRUCE HENDERSON AND LOCKHEED TRI STAR

   2. BIG IDEA IS THAT THE SIMPLE COST FUNCTION WITH A FIXED COST TO ENTER AND A CONSTANT
      MARGINAL COST OF PRODUCTION IS SUFFICIENT FOR MOST DECISIONS BUT NOT ALWAYS.
      SOMETIMES, YOU NEED MORE.

   3. INCREASING MC: STORY ABOUT SONY

   4. ECONOMIES OF SCALE: STORY ABOUT OFFICE SUPERSTORES AND MERGER OF TWO SUPPLIERS
      OF COMB BINDING EQUIPMENT

   5. RETURN TO BRUCE HENDERSON

   6. STORY OF PET FOOD


CHAPTER 8: UNDERSTANDING MARKETS AND INDUSTRY CHANGES
Opening anecdote
Which Industry or Market?
Shifts in Demand
Shifts in Supply
Market Equilibrium
Predicting Industry Changes Using Supply and Demand
Explaining Industry Changes Using Supply and Demand
Prices Convey Valuable Information
Market Making
Summary & Homework Problems


OUTLINE FOR SCRIPT

   1. Opening Anecdote: Cash for clunkers: Looks like a good deal but don’t realize that price of new
      cars will increase, and price of old cars will increase, so the changes doesn’t look near as good.
2. In this chapter we show you how to analyze changes that occur at the industry or “market”
   level.

        a. Different from MR=MC pricing as that concerned a single monopolist and a demand
           curve; whereas this is applicable only for a group of sellers competing to sell and a group
           of buyers competing to buy. So do NOT use this to say something about the supply and
           demand for iPads, as this analysis does not apply to single products. You can use this to
           say something about the demand and supply of mobile reading tablets.

        b. Before you start, define the market: product and geographic dimensions

        c. This analysis is particularly useful for firms whose fortunes are tied closely to the
           fortunes of the industry in which they operate.

3. Supply curves are constructed similarly to demand curves. But instead of lining up buyers by
   their top dollar values, we line up sellers by their bottom line costs. In contrast to demand
   curves, where high prices mean that fewer buyers are willing to buy, high prices mean that more
   sellers are willing to sell.

        a. Market equilibrium occurs when the number of sellers equals the number of buyers.

        b. No such thing as a shortage—unless prices cannot adjust.

4. We use demand and supply curves to answer two types of questions: how can I predict changes
   in this industry: and how do I explain past movements of price and quantity at the industry level.

5. We begin with the prediction problem associated with the cash for clunkers program. It was a
   subsidy paid by the government tied to the purchase of a new low-mileage car and the
   destruction of an old high-mileage car.

        a. Lets begin by examining the monthly market for new low-mileage cars in the united
           states. <<DRAW DEMAND CURVE SHIFTING RIGHT, DRAW AN ARROW SHOWING PRICE
           AND QUANTITY INCREASING>> We can see in the graph below that the demand curve
           shifted to the right, or increased, which increased the price and quantity of new cars.

        b. But then what happened after the program ended? It is likely that some of the demand
           increase for August was demand that would have been ordinarily occurred in
           September, so when September finally gets here, demand goes down below it would
           have ordinarily been. As a result, <<DRAW DEMAND CURVE SHIFTING BACK DOWN
           BELOW WHERE IT WAS ORIGINALY. SHOW THE PRICE AND QUANTITY GOING BACK
           DOWN BELOW WHERE IT WAS ORIGINALLY>> In fact, if we look at the monthly sales
           data for US cars, this is exactly what we see. <<SHOW TIME SERIES GRAPH OF
           MONTHLY CAR SALES SHOWING>> The demand increase in July and August was mainly
           “stolen” from September. In other words, the program served mainly to accelerate
               sales that would have occurred in September by a couple of months, and there was no
               long run, or permanent effect of the stimulus.




Now we turn our attention to the monthly used high mileage car market. What happened here?
Predictably, when you destroy 5 million used cars, supply of used cars for
sale decreases, and this pushed prices of used cars higher.
<<DRAW GRAPH SHOWING A SUPPLY DECREASE WITH THE PRICE GOING UP AND
THE QUANTITY GOING DOWN>>


The used car models jumping the most in price include mid-size SUVs and mini-
vans designed to carry around families. Used Cadillac Escalades are almost 36%
more; Chevy Suburbans and Dodge Grand Caravans jumped 34% in price; a.
BMW X5 is 33% higher; and an Acura MDX will run you 29% more.


Those of you who are thinking ahead, might realize that demand for the used car
market would go down because the cash for clunkers subsidy has made it more
attractive to buy new cars. But this effect must have been small because we see
that the price has fallen. And this highlights another feature of this kind of
modeling: you use this to isolate the big effects that cause price and quantity to
change. Your model is useful only in so far as it


Now put yourself in the place of the owner of one of these cars, contemplating
trading it in to qualify for the Cash for Clunkers program. You do the profit
calculus, and figure out that the trade in will be a good deal, because the program
pays you more for your used car ($3000) than you can get by selling it or trading it
in to the dealer. HOWEVER, unless you explicitly took account the higher
opportunity cost of your used car caused by the decrease in supply the higher price
of the new cars caused by the increase in demand, you might have made an
unprofitable decision.



   6. The second thing we want you to do is to be able to explain past price and
      quantity movements. For example, suppose I tell you that in the past two
      years, quantity of smart phones has increased while price has fallen. What
      explains this? <<INSERT GRAPH OF SUPPLY INCREASE, AND AN ARROW
      BETWEEN INITIAL PRICE AND QUANTITY AND FINAL PRICE AND
      QUANTITY>> The only explanation is that supply has increased because the
      costs of producing smart phones has gone down.
   7. Similarly, if I tell you htat price has increased, and quantity has increased,
      the only explanation is an increase in demand. <<INSERT graph showing
      chae>>
          a. Demand and supply analysis is part of the business vernacular, and
             you have to learn it and be able to articulate it quickly and clearly.
             More than any other analytical skill, this is likely to come up in
             interviews, as the interviewer brings up a current “fact” in the news,
             and asks you to explain it. For example, an interviewer might ask you
             why long term interest rates are going down. If you think of the
             demand and supply of loans, and the interest rate as the “price” of a
             loan, then an increase in the supply of loans (as when the federal
             reserve prints money and makes loans by buying bonds) would explain
             this.
CHAPTER 9: RELATIONSHIPS BETWEEN INDUSTRIES: THE FORCES MOVING
US TOWARDS LONG-RUN EQUILIBRIUM
Opening anecdote
Competitive Industries
The Indifference Principle
Monopoly
Summary & Homework Problems
CHAPTER 10: STRATEGY, THE QUEST TO SLOW PROFIT EROSION (NOTE THIS
IS A NEW CHAPTER BASED ON SPLITTING OLD CHAPTER 9 AND EXPANDING)
Opening anecdote
Strategy—The Quest to Slow Profit Erosion
Strategy is Simple
Sources of Economic Profit
The Three Basic Strategies
Summary & Homework Problems


CHAPTER 11: USING SUPPLY AND DEMAND: TRADE, BUBBLES, MARKET
MAKING (NOTE THIS IS A NEW CHAPTER BASED ON SPLITTING OLD CHAPTER
8 AND EXPANDING)
Opening anecdote
The Market for Foreign Exchange
Purchasing Power Parity
The Effects of Currency Appreciation and Devaluations
Bubbles
Summary & Homework Problems
III PRICING FOR GREATER PROFIT
CHAPTER 12: MORE REALISTIC AND COMPLEX PRICING 135
New anecdote:
Pricing Commonly Owned Products 135
Revenue Management 137
Advertising and Promotional Pricing 140
Psychological Pricing
Summary & Homework Problems 141


CHAPTER 13: DIRECT PRICE DISCRIMINATION 145
New anecdote:
Introduction 145
Why (Price) Discriminate? 147
Direct Price Discrimination 149
Robinson–Patman Act 150
Implementing Price Discrimination Schemes
Only Schmucks Pay Retail 152
Summary & Homework Problems 153


CHAPTER 14: INDIRECT PRICE DISCRIMINATION 155
New anecdote:
Indirect Price Discrimination 156
Volume Discounts as Discrimination 159
Bundled Pricing 160
Summary & Homework Problems 161


IV. STRATEGIC DECISION MAKING

CHAPTER 15: STRATEGIC GAMES 167
New anecdote:
Sequential-Move Games 168
Simultaneous-Move Games 170
What Can I Learn from Studying Games Like the Prisoners’ Dilemma? 177
Other Games 180
Summary & Homework Problems 184


Thursday, October 25, 2007
How movie studios play "chicken"
Another gem from Mike Shor's collection, from the NY Times:
The first principle of scheduling any film's release date is to avoid going directly against a similar movie.

Studios realize that a standoff between films aimed at the same demographic -- kids, women, ''urban''

teenagers -- splits the vote, in effect, and hurts both films. ''No one is interested in going head to head in

this business,'' Harper says. ''Someone is almost always going to give. It's just a question of who.''



Given the stakes involved, film companies generally disclose their future release dates well in advance,

giving everyone time to minimize the chance of collision. But at the end of the year, with so many films

vying for coveted berths, some jostling is inevitable. As Jeff Blake, vice chairman of Sony Pictures

Entertainment, notes, ''There are only four weekends in December, so you're always going to be bumping

into other movies.''

Posted by Luke Froeb at 9:23 PM 0 comments

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Labels: 15. Strategic games
CHAPTER 16: BARGAINING 189
New anecdote:
Strategic View of Bargaining
Non-strategic View of Bargaining
Summary & Homework Problems 196


V. UNCERTAINTY
CHAPTER 17: MAKING DECISIONS WITH UNCERTAINTY 203
Opening anecdote:
Random Variables & Sensitivity analysis
Uncertainty in Pricing 207
Maximize Expected Profit or Minimize Expected Error Costs
Run Natural Experiments to reduce uncertainty:
Summary & Homework Problems 217


CHAPTER 18: AUCTIONS 189 (NOTE THIS IS A NEW CHAPTER BASED ON
SPLITTING OLD UNCERTAINTY CHAPTER AND EXPANDING)
New anecdote:
Oral Auctions
Sealed-Bid Auctions 212
Bid Rigging 213
Common-Value Auctions 215
Summary & Homework Problems 196


CHAPTER 19: THE PROBLEM OF ADVERSE SELECTION 221
New anecdote:
Insurance and Risk 222
Anticipating Adverse Selection 223
Screening
Signaling 227
Adverse Selection in Sales
Adverse Selection in IPO’s 228
Summary & Homework Problems 229


CHAPTER 20: THE PROBLEM OF MORAL HAZARD 233
New anecdote:
Insurance 233
Moral Hazard versus Adverse Selection 235
Shirking as Moral Hazard
Moral Hazard in Lending 238
Summary & Homework Problems 240


VI. ORGANIZATIONAL DESIGN
CHAPTER 21: GETTING EMPLOYEES TO WORK IN THE FIRM’S BEST INTERESTS
Opening anecdote:
Incentive Conflict 248
Controlling Incentive Conflict 249
Marketing versus Sales 251
Franchising 252
A Framework for Diagnosing and Solving Problems 254
Summary & Homework Problems 256


CHAPTER 22: GETTING DIVISIONS TO WORK IN THE FIRM’S BEST INTERESTS
Opening anecdote:
Incentive Conflict between Divisions 262
Transfer Pricing 264
Functional Silos versus Process Teams 267
Budget Games: Paying People to Lie 269
Summary & Homework Problems 272


CHAPTER 23: MANAGING VERTICAL RELATIONSHIPS 277
New anecdote:
Do Not Buy a Customer or Supplier Simply Because They Are Profitable 278
Evading Regulation 279
Eliminate the Double Markup 280
Aligning Retailer Incentives with the Goals of Manufacturers 282
Price Discrimination 284
Fighting a standards war
Outsourcing 285
Summary & Homework Problems 286


VII. WRAPPING UP
CHAPTER 24: YOU BE THE CONSULTANT 291
New anecdote:
Excess Inventory of Prosthetic Heart Valves 291
High Transportation Costs at a Coal-Burning Utility 293
Overpaying for Acquired Hospitals 294
Large E&O Claims at an Insurance Company 296
What You Should Have Learned 298


EPILOG: CAN THOSE WHO TEACH, DO?

				
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