Prof. Besanko Micro Primer 2003

Microeconomics Workshop: Fall 2003
Professor David Besanko
These notes have been prepared for participants in a workshop sponsored by the Kellogg Consulting Club. They may not be reproduced or circulated without permission of Professor David Besanko.
Objectives and Road Map for the Talk

OBJECTIVES: Provide primer on basic microeconomic concepts that will be useful for consulting interviews To illustrate how micro concepts can be used, in conjunction with case facts, to develop hypotheses about situations with ambiguous or messy fact patterns. Goal is not to explore the deeper theoretical dimensions of the concepts themselves ROAD MAP: Supply and Demand Analysis Price Elasticity of Demand Relevant Costs and Decision Making Profit-Maximizing Pricing Decisions Decision Making in Oligopoly Markets Sample Consulting Interview Case
2003 David Besanko and Kellogg Consulting Club
1. 2. 3. 4. 5. 6.
Supply and Demand Analysis Price Elasticity of Demand Relevant Costs and Decision Making Profit-Maximizing Pricing Decisions Decision Making in Oligopoly Markets Sample Consulting Interview Case
Market Equilibrium: What Will the Market Price Be?
Price ($ per metric ton)
S
Excess supply when P = $4,000
4,000
In equilibrium, the market clears: quantity demanded equals quantity supplied. Why is P = $4,000 not an equilibrium? At this price, quantity supplied exceeds quantity demanded. There is excess supply. The price will be bid down. Why is P = $1,000 not an equilibrium? At this price, quantity demanded exceeds quantity supplied. There is excess demand. The price will be bid up.
2,670
1,000
Excess demand when P = $1,000
D
0 500 1,000 1,500 1,310 2,000 2,500
Quantity (metric tons per year)

Case: Chicken Broilers

PRICE and CONSUMPTION INDEX for BROILERS U.S. per capita consumption
What accounts for this pattern of prices and consumption?
Price (adjusted for inflation) 1900 1950 YEAR

1990
Price
S1950
market equilibrium: 1950
S1990 D1950
D1990 Quantity
Price
Key Demand Drivers changes in consumer tastes health concerns Key Supply Drivers technological progress entry of new producers
S1950
S1990 D1950
D1990 Quantity
Demand and Supply Drivers

Demand drivers are factors --- other than the price of the product itself --that affect the products demand. Supply drivers are factors --- other than the price of the product itself --that affect the products supply.
Common demand drivers:

market demographics prices of other good macroeconomic factors marketing activity consumer tastes
Common supply drivers:

prices of key inputs in the production process number of active firms in industry. prices of other goods firms could/does produce state of technology temporary shocks
8
1. 2. 3. 4. 5. 6.
Price Elasticity of Demand

Own Price Elasticity of Demand: measure of the sensitivity of quantity demanded to price:
Q,P
Q Q P Q = = P P Q P
= rate of percentage change in quantity as price changes by one percent
Q = percentage change in quantity Q P = percentage change in price P
Price Inelastic demand
Elastic demand
Quantity
10
Price Elasticity of Demand

Own Price Elasticity of Demand: measure of the sensitivity of quantity demanded to price:
Q,P
Q Q P Q = = P P Q P
= rate of percentage change in quantity as price changes by one percent
Q Price = percentage change in quantity Q P = percentage change in price $1.20 P
Inelastic demand
$1.00
Elastic demand
2
9 10
Quantity
11
Terminology Conventions In general, If Q,P is between 1 and - , we say demand is elastic. Q,P is between 0 and 1, we demand is inelastic. Q,P = -1, we say demand is unitary elastic. 8 < Q,P < 0 8
12
Market-Level Versus Brand-Level Price Elasticities of Demand
Market-level price elasticity of demand

What happens to market demand for a product when the prices of all brands in the market go up or down at the same time?
Brand-level price elasticity of demand

What happens to the demand for a particular brand when the price of that brand goes up or down, holding the prices of other brands fixed?
13
Market-Level Versus Firm-Level Price Elasticities of Demand
Price elasticity of market demand for automobiles is between -1 and -1.5 Price elasticity of demand for ready-to-eat breakfast cereal in the U.S. is on the order of 0.25 to -0.5.
Price elasticity of demand for BMW 325 is on the order of -3.5 to -4. Price elasticity of demand for individual brands, such as Captain Crunch, is on the order 2 to -4.
14
Key Drivers of Price Elasticity

Substitution opportunities: Do consumers have readily available close substitutes to which they can switch if necessary? Carbonated Beverages
Diet Pepsi ELASTIC
Diet Colas
Colas
Beverages INELASTIC
More price inelastic (Q,P less negative)
Expense relative to budget: Do expenditures for the good account for a large fraction of a consumers budget? Household Items (e.g., Salt, Napkins) More price inelastic (Q,P less negative) INELASTIC
15
Big Ticket Consumer Durables ELASTIC

Case: Airline Pricing Experiments, Fall 2002
Last year at this time, some airlines (e.g., Continental, Delta) experimented with cuts in unrestricted walk-up fares (generally used for business travel)
e.g., Delta lowered walk-up fares by about 21 percent in small markets over a seven-week period Fare cuts were generally matched by competing airlines in these markets Conventional wisdom: cuts in unrestricted walk-up fares result in decreases in total revenues Results of Deltas experiments: double-digit increase in total revenue
What does conventional wisdom assume about the price elasticity of demand for business air travel? What do Deltas pricing experiments tell us about the price elasticity of demand for business air travel?
16
Price Elasticity of Demand and the Effect of Changes in Price on Total Revenue
First, some words Decrease in price has a dual affect on total revenue:
Revenue on each ticket sold goes down but the number of tickets sold goes up! Which effect dominates? If rate at which tickets are sold goes up faster than rate at which price falls, then wed expect total revenue would go up Not quite precise enough, though: what do we mean by rate at which tickets are sold goes up, rate at which price falls?
Now, some math
TR ( P Q) (Q P ) + (P Q ) = = P P P Q =Q+P P Q P = Q 1 + P Q = Q (1 + Q , P )
recall:
Q,P
Q Q P Q = = P P Q P
If demand is elastic, i.e., Q,P between -1 and -, then P and a decrease in price yields an increase in total revenue
TR
<0
17
1. 2. 3. 4. 5. 6.
18
The Relevant Cost Principle: The Costs That Are Relevant to a Particular Decision Are Those Whose Level is Affected By the Decision
Suppose your company contemplates a temporary shut-down of one of its factories for a period of one year. Consider all categories of cost associated with the existence of this factory, the production of output in this factory, and the possible shut-down of this factory: Which categories are relevant to the shut-down decision? Relevant costs:
What costs do you avoid if you shut down this factory? What extra costs do you incur if you shut down this factory? These are categories that are relevant. Costs whose level is not affected by the shut-down decision are irrelevant to the shut-down decision
19
Relevant Costs and Decision Making

Company incurs $50,000 per year in labor and materials costs at the current rate of volume It has signed a five-year lease on the facility that entails an annual payment of $70,000: the company cannot get out of this lease. A useful way to picture which costs are relevant to the decision is to draw a decision tree: Keep factory open and produce at current volume Your choice Shut the factory down Labor and Leasing Materials expense Costs (000) (000) $50 $70 Total cost (000) $120
Revenue (000) $100
$0
$0
These costs vary across the alternatives: they are relevant to this decision
$70
$70
This cost does not vary across the alternatives: it is not relevant to this decision
20
Case: Relevant Costs for a Pricing Decision*

Client is market-leading producer of a variety of different types of synthetic fabrics used in a wide range of applications Client has asked for advice on how to price M-50, a particular fiber based on a blend of rayon, nylon, and other synthetic fibers. Current price is $4 per yard; client is considering setting a price of $3. Current quarterly volume is about 95,000 yards; expected volume if price is cut to $3 is 155,000. There is only one other supplier of M-50, and it is currently charging a price of $3 per yard. Our best available information suggests that the competitor will not cut its price if client cuts to $3 per yard. Some other information: M-50 is produced in a multi-purpose plant that is also used to produce other synthetic fabrics Company sales people are paid straight salaries
* Based on Beauregard Textile Company, HBS Case 9-191-058
21
Case: Relevant Costs for a Pricing Decision
Estimated Cost per Yard of M-50 at Various Volumes of Production

35,000 Direct Labor $ 0.860 Material $ 0.400 Materials spoilage $ 0.042 M-50 department expenses Direct* $ 0.198 Indirect** $ 1.714 General overhead*** $ 0.258 Unit factory cost $ 3.472 SG&A expenses**** $ Unit cost $ M-50 Quarterly Production Volume in Yards of Material 65,000 95,000 125,000 155,000 185,000 215,000 245,000 $ 0.830 $ 0.800 $ 0.780 $ 0.760 $ 0.740 $ 0.760 $ 0.800 $ 0.400 $ 0.400 $ 0.400 $ 0.400 $ 0.400 $ 0.400 $ 0.400 $ 0.040 $ 0.040 $ 0.040 $ 0.038 $ 0.038 $ 0.038 $ 0.040 $ $ $ $ 0.140 0.923 0.249 2.582 $ $ $ $ 0.120 0.632 0.240 2.232 $ $ $ $ 0.112 0.480 0.234 2.046 $ $ $ $ 0.100 0.387 0.228 1.913 $ $ $ $ 0.100 0.324 0.222 1.824 $ $ $ $ 0.100 0.279 0.228 1.805 $ $ $ $ 0.100 0.245 0.240 1.825 1.186 3.011
2.257 $ 5.729 $
1.678 $ 4.260 $
1.451 $ 3.682 $
1.330 $ 3.376 $
1.244 $ 3.157 $
1.186 $ 3.010 $
1.173 $ 2.978 $
* Power, supplies, repairs ** Depreciation and supervisory personnel *** Insurance, security, plant accounting, plant managers salary: allocated to M50 at rate equal to 30 percent of M-50 direct labor expenses **** Company selling, general, administrative expenses: allocated to M50 at a rate equal to 65 percent of M50 unit factory cost
22
Price = $4 per yard Clients choice Price = $3 per yard
Quantity Sold Revenue 95,000 $380,000
Direct Labor
Material Material Spoilage
Direct Indirect Dept. Dept. Gen'l Expense Expense OH SG&A Y
$ 76,000 $ 38,000 $ 3,800 $ 11,400 $ 60,000 X
155,000 $465,000
$117,800 $ 62,000 $ 5,890 $ 15,500 $ 60,000 X
relevant
not relevant
23
Price = $4 per yard Clients choice Price = $3 per yard
Quantity Sold Revenue 95,000 $380,000
Direct Direct Material Dept. Labor Material Spoilage Expense $ 76,000 $ 38,000 $ 3,800 $ 11,400
Contribution to company profit

$250,800
155,000 $465,000
$117,800 $ 62,000 $ 5,890 $ 15,500
$263,8100*
relevant
*$263,810 = $465,000 - $117,800 - $62,000 - $5,890 - $15,500

24
Key Cost Concepts Total cost (TC): sum total of the firms variable and fixed costs
Average total cost (ATC): total cost per unit
TC ATC = Q
Marginal cost (MC): rate at which total cost changes as output changes TC MC = Q
25
Illustration Total cost:

TC = 100 + 5Q
Average total cost:
TC 100 + 5Q ATC = = Q Q 100 = +5 Q

MC = TC [100 + 5(Q + Q)] [100 + 5Q ] = Q Q 5Q = Q =5
Marginal cost:
26
1. 2. 3. 4. 5. 6.
27
What Price-Quantity Combination on this Demand Curve Should the Firm Choose?
P ($ per unit)
100 90 80 70 60 50 40 30 20 10 0 0 1 2 3 4 5 6 7 8 9 10 11 12
MC
Q (units per year)

28
To Evaluate the Profitability of a Change in Quantity and Price, We Compare Marginal Revenue and Marginal Cost
P ($ per unit)
100 90
Marginal Cost A
80 70 60
= TC/Q = E Q = $30 per unit
B
50 40 30 20 10 0 0 1 2 3 4 5
Marginal Revenue = TR/Q = (B + E - A) Q = ($80 - $10)/1 unit = $70 per unit
MC
E
D
6 7 8 9 10 11 12
Q (units per year)

29
Marginal Revenue Changes as We Slide Down the Demand Curve P ($ per unit)
100 90
A
80 70 60
Marginal Revenue at P = 90, Q = 1 = (B + E - A) Q = ($80- $10)/1 unit = $70 per unit
B
50 40 30 20 10 0 0 1 2 3 4 5 6 7 8 9 10 11 12
MC
E
Q (units per year)

30
100 90
Marginal Revenue A at P = 90, Q = 1 = (B + E - A) Q = ($80- $10)/1 unit = $70 per unit
80 70 60
B F
50 40 30 20 10 0 0 1 2 3 4 5
Marginal Revenue at P = 60, Q = 4 = (G + H - F) Q = ($50 - $40)/1 unit = $10 per unit G
MC
E H
D
6 7 8 9 10 11 12
Q (units per year)

31
100 90 80 70 60 50 40 30 20 10 0 0 1 2 3 4 5 6 7 8 9 10 11 12
MC
D MR
Q (units per year)
32
Profit-Maximizing Pricing: Marginal Analysis
TR TC = Q Q Q = MR MC Q
Profits will go up if you ... - Expand output when MR > MC - Reduce output when MR < MC
Profits are maximized when the firm produces at a volume of output at which MR is just equal to MC
33
What Price-Quantity Combination Should the Firm Choose? P ($ per unit)

100 90 80 70 60 50 40 30 20 10 0 0 1 2 3 4 5 6 7 8 9 10 11 12
MR > MC: we can increase profit by increasing Q
MR > MC
MC
MR < MC
MR < MC: we can increase profit by decreasing Q
MR
Q (units per year)
34
P ($ per unit)
100 90 80 70
Profit is Maximized at the Price-Quantity Combination at Which MR = MC
65
60 50 40 30 20 10 0 0 1 2 3 4 5 6 7 8
MR = MC (the sweet spot)
MC
D
9 10 11 12
3.5
MR
Q (units per year)
35
Profit-Maximizing Output With a Consultants Cost Curve.

$/ton
$2.50
Height of each block is the MC of producing in each plant.
$2.00
MC
$1.50 $1.00
PLANT 3
capacity plant 1
What is the profitmaximizing price and volume?
PLANT 1
PLANT 2
0
100
150 175
Q (tons per year)

36
MR
Marginal Revenue Depends on Price Elasticity

Initial price is $10, and initial quantity is 100 units
P ($ per unit)
initial price
We want to increase Q by 50 units our new P must be $7/unit MRB = (B A) 50 = (350 300)/50 = $1.00 per unit, or 14.3% of new price
10
A
7
B
DA
0 100 150
37
Q (units per year)
Marginal Revenue Depends on Price Elasticity

Initial price is $10, and initial quantity is 100 units
P ($ per unit)
We want to increase Q by 50 units our new P is $9 MRB = (B A) 50 = (450 - 100)/50 = $7.00 per unit, or 77.7% of new price
initial price
10 9
A
DB
When demand is more elastic, MR is a bigger fraction of price Along which demand curve is the temptation to increase volume greater?
B
DA
0 100 150
Q (units per year)

38
Marginal Revenue and Elasticity Return to our formula for marginal revenue:
P MR = P + Q Q
If we rearrange terms in this formula, we get this:
P Q MR = P1 + Q P
continued
39
Marginal Revenue and Elasticity

But now recall the definition of the price elasticity of demand, which we denote by E:
% change in quantity Q Q P = = Q,P = P % change in price P Q P 1 P Q = Q , P Q P

Plugging in to the formula on the previous slide gives us a formula for MR in terms of the price elasticity of demand:
1 MR = P1 + Q,P
40
Inverse Elasticity Pricing Rule (IEPR)
1 = MC MR = MC P1 + Q,P P MC 1 = Inverse Elasticity Pricing Rule P Q,P

Percentage Contribution Margin (PCM)
IEPR in words: At the optimal monopoly output the markup of price over marginal cost --- the percentage contribution margin --is inversely proportional to the price elasticity of demand.
41
Case: Pricing a Proprietary Chemical Compound

Client:
Specialty chemical producer selling a version of TiO2, called TiO2+, produced via a proprietary process. Higher purity and superior refractive index Two major end-user segments: paint industry and high-pressure laminate (HPL) industry.
Paint industry:
Volume of TiO2+ sold to paint industry customers fell by 17.5 percent between 2002 and 2003.
HPL industry:
Volume of TiO2+ sold to HPL industry declined by 10 percent between 02 and 03
Pricing strategy:
Client sets price to cover costs and provide return on investment. All customers charged a common price. Client increased price by 5 percent last year to cover increases in cost.
Distribution strategy:
All TiO2+ distributed to customers from a terminal situated on a major rail line. Client does not see HPL customers because product is sold to intermediary who packages TiO2+ in special way to facilitate the usage of TiO2+ in production of laminates.
How can client unlock additional profitability through its pricing strategy?
42
Quick and Dirty Estimates of Price Elasticity of Demand Paint industry seems to have more elastic demand for TiO2+ than HPL industry HPL: %P = 5%, %Q = -10%, implying Q,P = -2. Paint: %P = 5%, %Q = -17.5%, implying Q,P = -3.5. So What?
43
Customize Price According to Price Elasticity

We can compute MR:
MRPaint = P(1 + 1/Paint) = 10(1 + 1/(-3.5)) = $7.14 MRHPL = P(1 + 1/HPL) = 10(1 + 1/(-2)) = $5.00
We dont know marginal cost, but we can still identify a change that will increase profit at zero cost. Can you see it?
44
Customize Price According to Price Elasticity

We can compute MR:
MRPaint = P(1 + 1/Paint) = 10(1 + 1/(-3.5)) = $7.14 MRHPL = P(1 + 1/HPL) = 10(1 + 1/(-2)) = $5.00
We dont know marginal cost, but we can still identify a change that will increase profit at zero cost. Can you see it? Zero cost way to increase profits
Increase price to the HPL segment. Demand will fall by -Q. Decrease price to the Paint segment so that demand goes up by Q, just enough to compensate for the decline in the HPL segment. Costs dont change Revenue goes up by $7.15 Q - $5.00Q This is called price discrimination, price customization, or revenue management.
But how do you prevent arbitrage?

45
Price Customization Challenges
Segmentation:
Are there market segments that differ according to their price elasticity of demand?
Identification:
Can we identify which segment any particular customer belongs to?
Implementation:
Can we develop mechanisms (marketing, distribution, packaging, etc.) to prevent arbitrage?
46
An Implementation Problem*
DuPont and Rohm and Haas charged 85 cents per pound to general industrial users of methy methacrylate, a plastic molding powder, but charged $22 per pound for a special mixture sold to manufacturers of dentures Attracted arbitageurs who purchased at 85 cents a pound, incurred modest conversion costs, and undercut DuPont and R&Hs denture price R&H considered a strategy of spiking the powder: adding arsenic to industrial powder. Other strategies?
*This example comes from Scherer, F.M. and D. Ross, Industrial Market Structure and Economic Performance, 3rd edition (Boston: Houghton Mifflin), 1991.
47
1. 2. 3. 4. 5. 6.
48
Types of Industry Structures

Product differentiation? Competitors produce differentiated products Number of competitors in the market? Many Few Monopolistic competition Differentiated product oligopoly
One
Competitors produce identical or nearly identical products
Examples: Examples: Local physicians Cola Automobiles markets Mutual funds Beer Credit card issuers Perfect Homogeneous competition product oligopoly Examples: Fresh-cut roses Copper mining Chicken broilers Examples: Salt Steel Ethylene
Monopoly
Examples: PC Operating systems Internet domain name registry (until 2000)
49
Price Levels and Market Structure in an Oligopoly

Generally speaking, the more sellers a market includes, the more difficult it is to maintain prices above marginal costs. Why? More competitors bigger (in absolute value) brand-level price elasticities (due to greater substitution opportunities for consumers) Thus: price cuts becomes a more tempting competitive weapon, resulting in lower PCMs (remember the IEPR). Fewer competitors easier for firms to independently and tacitly to work their way toward the price a monopolist would charge and avoid the paranoia that leads to unilateral price cutting. Why? More fertile setting for price and/or capacity leadership to emerge Market more transparent Less likely that mavericks or rogues will disrupt industry discipline Lower likelihood of disagreement about most advantageous price
50
Case: Global Nickel Industry in 1999

Cash Costs By Nickel Mine in Global Nickel Industry, 1999
Capacity (tonnes) 4.4 27.0 50.0 35.9 42.0 21.0 103.0 12.0 40.0 28.8 46.0 32.0 7.7 Cash Cost (cents per lb) 58.5 81.4 100.3 131.3 138.7 139.5 142.3 154.1 165.9 171.9 180.6 183.7 218.2
Cawse Murrin Murrin Soroako Leinster Mt Keith Raglan Ontario Division Kambalda Sudbury Cerro Matoso Manitoba Division Falcondo Forrestania
Company Centaur Mining Anaconda Nickel Inco WMC WMC Falconbridge Inco WMC Falconbridge Billiton Inco Falconbridge Outokumpu
Country Australia Australia Indonesia Australia Australia Canada Canada Australia Canada Colombia Canada Dominican Republic Australia
source: Minecost.com World Mine Cost Data Exchange
51
Industry Supply Curve: Global Nickel Industry, 1999

300
OutoKumpo Falconbridge
Each bar represents an individual nickel mine What will the market price be?
Centaur Mining
Cash cost per unit (cents per pound)
250
200
150
Falconbridge
Falconbridge
Anaconda Nickel
WMC
WMC
50
0 0 50 100 150 200 250 300 350 400 450 500
INC0
Cumulative Capacity (kilotons per year)

INCO
INC0
100
Billiton
WMC
52
Industry Supply Curve: Global Nickel Industry, 1999: What Do We Learn?

300
OutoKumpo
Price is set by the marginal producer: firm whose capacity is just outside the market
Centaur Mining
250
D, industry demand curve
200
150 142.3
Falconbridge Falconbridge Falconbridge Billiton
WMC
Anaconda Nickel
WMC
WMC
50
0 0 50 100 150 200 250 300 350 400 450 500
INC0

INCO
INC0
100
53
Industry Supply Curve: Global Nickel Industry, 1999 Strategic Analysis

300
250
Centaur Mining
INCO is the client: What strategies would you recommend for INCO to increase profitability in the nickel industry? D
200
150 142.3
Falconbridge Falconbridge Falconbridge Billiton
WMC
Anaconda Nickel
WMC
WMC
50
0 0 50 100 150 200 250 300 350 400 450 500
INC0

INCO
INC0
100
OutoKumpo
54
Cash Costs By Nickel Mine in Global Nickel Industry: 1999

300
One possibility: Capacity withdrawal
250
Centaur Mining
200
171.9 142.3 Falconbridge Falconbridge Falconbridge OutoKumpo Billiton
WMC
Anaconda Nickel
50
0 0 50 100 150 200 250 300 350 400 450 500
INC0
WMC

WMC
INC0
100
55
1. 2. 3. 4. 5. 6.
56
Situation: Broadly Described Client is a wholesale distributor of a variety of food products. Client has a steady stream of business, but is looking to unlock additional profitability from its existing line of business. Your question: What major areas would you want to look at to assess how client could increase profitability?
57
Situation: Some Additional Background

Market economics
Industry demand growing at the rate of GDP No new competitors have entered the market in the last several years
Companys position and characteristics

Client is industry market share leader Products sold to a range of customers, primarily hotels and restaurants, ranging from high-end to low-end Gross margins: generally above average, but dependent on customer and product
Competitive dynamics may depend on the region
58
Some Additional Background
1997
Share of sales by region
59
Asia
Client Client
Competitor Competitor #1 #1
Competitor Others Competitor #2 Others #2
5%
Europe
40%
North America
55%
0%
25%
50%
75%
100%
Share of relevant market
More Background: Industry Evolution Over Time

1997 2000
Europe
40%
35%
North America
55%
50%
0%
25%
50%
75%
100%
0%
25%
50%
75%
100%
How Would You Characterize the Industry in the U.S. and Asia in 2000? What are the Implications for Price-Cost Margins?
60
Asia
Client
Competitor #1
Competitor #2
Others
5%
Client Competitor #1
Competitor #2
Others
15%
How Would You Characterize the Industry in the U.S. and Asia in 2000? What are the Implications for Price-Cost Margins?
The U.S. market can be characterized as a duopoly in which client is the dominant firm. In Asia, by contrast, the market is less concentrated. Price competition should be relatively softer in the U.S. market than in Asia:
Fewer competitors in U.S. More fertile ground for communication and coordination strategies, such as price leadership. U.S. market probably more transparent (e.g., better knowledge of competitor costs, easier to track competitor moves), engendering less paranoia. Firms probably face more price-elastic demand in Asia than in U.S. Client is not the dominant firm in Asia, and has weaker incentive to preserve industry discipline in Asia than in U.S.
Price-cost margins should be higher in the U.S. than in Asia, and prices in Asia may tend toward marginal cost.
61
Generic Strategies for Unlocking Additional Profitability

Increase gross margin reduce COGS per unit increase average revenue per unit or both. Reduce SG&A expense ratio Increase market share Stimulate market/category sales Improve efficiency in utilizing fixed assets and working capital, (translates into need to use less capital to generate a given margin or amount of sales revenue.
62
Generic Strategies for Unlocking Additional Profitability

Increase gross margin reduce COGS per unit increase average revenue per unit or both. Reduce SG&A expense ratio Increase market share Stimulate market/category sales Improve efficiency in utilizing fixed assets and working capital, (translates into need to use less capital to generate a given margin or amount of sales revenue.
63
Not a panacea, but often times this is a place in which high-impact changes can be made at low cost: improved pricing price customization dropping unprofitable products from product line
Depicting Data
Suppose we want to characterize the opportunities for improving the profitability of the individual products in clients portfolio If we have a graph with gross margin on the y-axis, what might we want to put on the x-axis?
High
Gross Margin
Low Low
High
64
High
Depicting Data
Gross Margin
Low 0 Low High
Price Elasticity of Demand What observations would you have if you found that the clients products are graphed as below? Which quadrants are areas of improvement for pricing? What should the graph look like?
65
High
Depicting Data
Gross Margin
Low 0 Low High
Price Elasticity of Demand Inverse elasticity pricing rule suggests that ther should be inverse relationship between gross margin and price elasticity of demand? Additional profitability can be unlocked by rationalizing the clients pricing
66

Prof. Besanko Micro Primer 2003

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Prof. Besanko Micro Primer 2003

Uploaded by

Copyright:

Available Formats

Microeconomics Workshop: Fall 2003

Professor David Besanko

Objectives and Road Map for the Talk

2003 David Besanko and Kellogg Consulting Club

Market Equilibrium: What Will the Market Price Be?

Price ($ per metric ton)

Excess demand when P = $1,000

Quantity (metric tons per year)

Case: Chicken Broilers

What accounts for this pattern of prices and consumption?

Price (adjusted for inflation) 1900 1950 YEAR

market equilibrium: 1950

market equilibrium: 1990

2003 David Besanko and Kellogg Consulting Club

market equilibrium: 1950

market equilibrium: 1990

2003 David Besanko and Kellogg Consulting Club

Demand and Supply Drivers

Common demand drivers:

Common supply drivers:

2003 David Besanko and Kellogg Consulting Club

2003 David Besanko and Kellogg Consulting Club

Price Elasticity of Demand

= rate of percentage change in quantity as price changes by one percent

Q = percentage change in quantity Q P = percentage change in price P

Price Inelastic demand

Price Elasticity of Demand

= rate of percentage change in quantity as price changes by one percent

Q Price = percentage change in quantity Q P = percentage change in price $1.20 P

2003 David Besanko and Kellogg Consulting Club

Market-Level Versus Brand-Level Price Elasticities of Demand

Market-level price elasticity of demand

Brand-level price elasticity of demand

2003 David Besanko and Kellogg Consulting Club

Market-Level Versus Firm-Level Price Elasticities of Demand

2003 David Besanko and Kellogg Consulting Club

Key Drivers of Price Elasticity

Diet Pepsi ELASTIC

More price inelastic (Q,P less negative)

Big Ticket Consumer Durables ELASTIC

Case: Airline Pricing Experiments, Fall 2002

Now, some math

2003 David Besanko and Kellogg Consulting Club

Relevant Costs and Decision Making

Revenue (000) $100

2003 David Besanko and Kellogg Consulting Club

Case: Relevant Costs for a Pricing Decision*

2003 David Besanko and Kellogg Consulting Club

Case: Relevant Costs for a Pricing Decision

Estimated Cost per Yard of M-50 at Various Volumes of Production

2003 David Besanko and Kellogg Consulting Club

Case: Relevant Costs for a Pricing Decision

Price = $4 per yard Clients choice Price = $3 per yard

Quantity Sold Revenue 95,000 $380,000

Material Material Spoilage

Direct Indirect Dept. Dept. Gen'l Expense Expense OH SG&A Y

$ 76,000 $ 38,000 $ 3,800 $ 11,400 $ 60,000 X

$117,800 $ 62,000 $ 5,890 $ 15,500 $ 60,000 X

2003 David Besanko and Kellogg Consulting Club

Case: Relevant Costs for a Pricing Decision

Price = $4 per yard Clients choice Price = $3 per yard

Quantity Sold Revenue 95,000 $380,000

Contribution to company profit