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| A well-designed organization |
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| is one in which employee incentives are aligned with organizational goals. Employee access to accurate information is critical |
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| create wealth by moving assets from lower-valued to higher-valued uses. |
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| Anything that impedes the movement of assets to higher-valued uses, like taxes, subsidies, price ceilings, and/or price floors, |
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| Stopping unprofitable transactions is |
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| is nearly as important as completing profitable transactions. |
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| This principle may be even more important in government: |
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| stopping bad bills/laws may be more important than passing good ones! |
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| example: What are you giving up to study (next best thing...and NOT everything)? |
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| Consider ALL costs and benefits that vary with a decision...and ONLY the costs and benefits that vary with the consequences of a decision. |
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| These are know as the relevant costs and relevant benefits of a decision. |
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| fixed cost example: rent on the business space; variable cost example: raw materials |
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| Explicit vs. implicit costs |
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| explicit costs are accounting costs; implicit costs are opportunity costs |
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| Total revenue - minus total explicit costs; also known as net income |
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| does not necessarily correspond to economic profit |
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| should be ignored in decision-making (to the extent that they are irreversible). |
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| irrelevant costs. Example: allowing overhead or depreciation costs to influence short-run decisions |
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| Hidden-cost fallacy occurs |
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| when you ignore relevant costs |
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| Example of Hidden-cost fallacy |
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| ignoring the opportunity cost of capital when making investment or shutdown decisions. |
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| Hidden-cost fallacy Question that should be asked...... |
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| could the money used to acquire this capital be used more effectively elsewhere? |
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| Hidden-cost fallacy - Solid decision-making advice: |
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| begin your analysis with the decision that you are considering (and not by looking at costs, which are only a means to that end). |
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| the additional cost of producing and selling an additional unit of output; decisions are made at the margin |
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| Total Cost/Quantity produced...where Total Cost = Fixed Cost (FC) + Variable Cost (VC) |
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| It is important not to confuse Marginal Cost and Average Cost. Average Cost is |
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| irrelevant to extent decisions. |
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| is the additional revenue gained from selling one more unit. |
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| Selling decisions - Sell more if |
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| Selling decisions - Sell less if |
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| you are selling the right amount if |
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| MR = MC (you are also maximizing profit!) |
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| An incentive compensation program that increases marginal revenue or reduces marginal cost |
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| Good incentive compensation programs |
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| link pay-for-performance measures with effort (aka behavior). |
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| You are faced with an investment decision. Are the future benefits greater than the current costs? |
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| Discounting helps one see the future benefits in current dollars |
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| Invest only in projects where |
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| the return is greater than the cost of capital |
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| that if the present value of the net cash flows of a project is larger than zero, the project earns economic profit |
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| Invest only in projects where the return is greater than the cost of capital. The NPV rule states that if the present value of the net cash flows of a project is larger than zero, the project earns economic profit. These concepts are also covered in |
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| a Principles of Finance course |
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| sometimes (incorrectly) used to analyze investments |
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| , if you expect to sell more than the break-even quantity, |
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| then your investment will be profitable |
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| equal to fixed cost divided by contribution margin |
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| can be recovered by shutting down |
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| If the benefits of shutting down (getting back your avoidable costs) are greater than the costs (giving up your revenue), |
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| Sunk costs make one vulnerable to |
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| To prevent post-investment hold-up |
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| one must be careful in contract negotiations and organizational management. |
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| buyer and seller should negotiate |
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| appropriate incentives to do business and incur necessary sunk (often capital) costs. |
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| As price increases, all else equal, quantity demanded decreases (common sense) |
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| Reduce price (increase quantity) if |
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| Increase price (reduce quantity) if |
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| Price elasticity of demand (e) |
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| (% change in quantity demanded) / (% change in price) |
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| - is due to more substitute goods, more time to shop, and/or the good/service being a big purchase relative to one's budget |
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| - is due to less substitute goods, less time to shop, and/or the good/service being a small purchase relative to one's budget |
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| When demand is more elastic, |
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| optimal price tends to be lower |
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| more elastic than industry demand |
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| . Elasticity may be used to |
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| forecast changes in demand. However, recognize that forecasting is an inexact science. |
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– substitute goods (subjective): burgers and chicken sandwiches;
complementary goods example (subjective): hot dog and mustard |
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Does TR increase or decrease due to a price increase?
What happens when the price is reduced? |
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| Income elasticity, cross-price elasticity, and advertising elasticity are measures of |
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| how changes in these factors affect demand. |
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| Stay-even analysis can be used to |
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| determine the quantity change required to offset a price change |
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| A proposed price increase is |
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| is profitable if the predicted quantity loss is less than the stay-even quantity |
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| Law of diminishing marginal returns |
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| As output increases, marginal productivity (the extra output associated with extra inputs) eventually declines |
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| Example of Law of diminishing marginal returns |
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| hiring more workers when lack of capital is the problem |
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| Economies of scale (increasing returns to scale) |
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| As output increases, average cost decreases. |
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| fixed cost + variable cost |
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| Economies of scale usually happen when |
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| most of total cost is fixed cost |
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| Example of Economies of scale |
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| banking – this is why so much consolidation has happened |
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| What does MPV Rule stand for? |
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| Diseconomies of scale (decreasing returns to scale) |
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| - As output increases, average cost increases |
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| Examples of Diseconomies of scale |
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| a “bureaucracy” effect ---> for instance, governments and large corporations sometimes experience this |
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| when current production lowers future costs. Make sure to consider the product’s life cycle here! |
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when the cost of producing outputs jointly is less than the cost of producing them separately;
can be an important source of competitive advantage and can influence acquisitions |
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| has product, geographic, and time dimensions. It is important to properly define one’s market. |
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| describes seller behavior in a competitive market. |
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As price increases, all else equal, quantity demanded decreases (common sense)
changes in quantity demanded are represented by a movement along the demand curve |
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| Determinants of Demand (consumer perspective) |
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price, income, prices of other goods, tastes and preferences (wants, needs, quality), expectations of future conditions (particularly prices and income)
any changes in these factors are represented by a shift in the demand curve, and are referred to as changes in demand |
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| As price increases, all else equal, quantity supplied increases (common sense) |
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| Determinants of Supply (producer perspective) |
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| price, costs (such as wages, raw materials), technology (ways and methods), number of producers, expectations, taxes/subsidies |
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surplus is excess supply (incentive for price reduction)
shortage is excess demand (incentive for price increase) |
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free market works toward this, exactly the amount offered for sale is sold
the resulting market price conveys valuable information |
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| is costly, and competition between market makers forces the bid-ask spread down to the costs of making a market |
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The example, lawnmowing businesses.
Doing the analysis:
1. There are many firms
2. Product is pretty standardized (I guess it's possible to do a bad job with a lawn - then again, it's possible to do shoddy/variable work in any field)…therefore, demand is very elastic
3. Firms can freely enter and leave the market (the only capital requirement is a ~ $200 lawnmower)
4. Market price is a given (I know, I know - there's some variation here. But not too much.)...a different way of saying this is that market participants are price takers |
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| mean reversion, where the mean is zero economic profit. |
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| asset is mobile, it will make the same profit no matter where it goes |
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| Unattractive jobs will pay |
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| compensating wage differentials |
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| risky investments will pay |
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| compensating risk differentials (or a risk premium). |
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| The difference between stock returns and bond yields |
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| a compensating risk premium |
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| when risk premiums become too small, some investors view this as a time to get out of risky assets because |
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| the market may be ignoring risk in pursuit of higher returns |
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a one-firm situation
there are no close product substitutes
the firm is a price maker |
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| many monopolies are subject to |
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pricing regulation, which gives little incentive to minimize costs
example: electric utilities and “fair-return” pricing |
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‘winning’ the competition and/or gaining control of a scarce resource;
most examples are actually “near-monopolies”; |
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| while monopolies can earn positive profits longer than competitive firms, entry and imitation eventually |
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| erode their profit as well |
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| Read what Warren Buffett means by moats… |
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| , figure out a way to increase price or reduce cost (and make sure you know the difference between price and cost!). |
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| matching the resources and capabilities of a firm (or of yourself?) to the opportunities and risks in the external environment. |
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| Porter’s Five Forces model |
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| model is a framework for analyzing the attractiveness of an industry |
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| Attractive industries have |
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have low supplier power,
low buyer power,
low threat of entry,
low threat of substitutes,
low rivalry. |
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| To be the source of sustainable competitive advantage, |
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| resources should be valuable, rare, and difficult to imitate/substitute. |
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| any advice you read that claims to identify critical resources or capabilities that successful companies must develop in order to gain competitive advantage |
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| To stay ahead of the competition, a firm |
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| can adopt one of three basic strategies: cost reduction, product differentiation, or reduction in competitive intensity (i.e. the Warren Buffett moats concept). |
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| In the market for foreign exchange between England and Iceland, the supply of British Pounds includes |
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| everyone in Britain who wants to sell British Pounds to buy Icelandic Krona…in order to buy Icelandic goods or invest in Iceland. |
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| In the market for foreign exchange between England and Iceland, the demand for British Pounds includes |
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| everyone in Iceland who wants to sell Icelandic Krona to buy British Pounds…in order to buy British goods or invest in Britain |
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| A decline in U.S. interest rates will induce |
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| foreign investors to borrow in dollars |
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| These foreign investors may sell the dollars to buy foreign currency, and then invest in the foreign country |
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| The result of carry trade is |
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| devaluations increase domestic demand by making exports cheaper and imports more expensive. |
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| Expectations about the future play a role in |
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| If buyers expect a future price increase |
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| they will accelerate their purchases to avoid it. |
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| If a sellers expects a future price increase |
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| they will delay selling to take advantage of this |
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| One may be able to identify bubbles by |
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| applying the indifference principle (see Chapter 9). |
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| Are market prices moving away from their long-run equilibriums? |
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| The rational-actor paradigm assumes what? |
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| People act rationally, optimally, and self-interestedly |
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| A well-designed organization is one in which employee Incentives are aligned with what? |
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| What power does the government have to control economic stability? |
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| the ability to control the economy by bills/laws that prevent inhibiting economic growth |
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| increase marginal revenue and decreased marginal costs provide room for what? |
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| NPV stands for what Rule? |
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| Break Even Quantity=annual fixed cost/(Profit-Marginal Cost) |
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