PowerPoint Slides © Michael R. Ward, UTA 2014 Econ 5313 Donut Holes • Making Decisions on the Margin • A friend does an experiment in class • Hands one student a box of donut holes. “Eat as many as you want.” • Hands another student a watch. “Mark the time between donut holes.” • Expect the time between donut holes to increase as more are eaten • Graphs 1/time versus quantity – cool! • Except when he mistakenly gave the box to a football player. Why was this a problem? • No variation in 1/time. Econ 5313 • • • • “Nobody can eat fifty eggs” Cool Hand Luke movie clip Declining marginal value http://www.youtube.com/watch?v=xDWczgxsSaM The marginal value of the 50th egg eaten within an hour is much less than the 1st. Econ 5313 Fixed and Variable Costs • A factory producing jump drives has rent of $120,000 per month. Material inputs are $100 for plastic for 1000 units, connectors at $20 for 100 units, and mini-circuit boards at $1.30 apiece. Twenty-five workers produce 500 units in an hour at total compensation of $12/hour. Taxes amount to $0.70 unit. Management, accounting, and other overhead come to $80,000 per month. • Which costs items are variable costs and which are fixed costs? • Variable: plastic, connectors, circuits, labor & taxes • Fixed: rent and overhead Econ 5313 Fixed and Variable Costs • What are the marginal costs per unit for each of the variable cost items? • • • • Plastic $100/1000 units = $0.10/unit Connectors $20/100 units = $0.20/unit Circuit boards $1.30 Labor input 25/500 = 0.05 worker hours per unit. At $12/hour this is $0.60/unit • Taxes $0.70/unit • What are the marginal costs per unit? • Total MC = $0.10 + $0.20 + $1.30 + $0.60 + $0.70 = $2.90/unit Econ 5313 Fixed and Variable Costs • The plant produces 80,000 units per month on average. • What are average fixed costs? • Rent: $120,000/80,000 = $1.50/unit • Overhead: $80,000/80,000 = $1.00/unit • Total: ($120,000+$80,000)/80,000 = $2.50/unit • What are the average costs per unit? • AC = MC + AFC = $2.90/unit + 2.50/unit = $5.40 • Suppose the plant had excess capacity and management doubled output per month. What are MC, AFC and AC? • MC unchanged at $2.90/unit • AFC: ($120,000+$80,000)/160,000 = $1.25/unit • AC = MC + AFC = $2.90/unit + 1.25/unit = $4.15 Econ 5313 Fixed and Variable Costs • What does a plot of the MC and AC with output look like? • MC is constant at $2.90 • AC falls with Q getting closer to MC Econ 5313 Problem 4.2f $9.00 $8.00 $7.00 $/unit $6.00 $5.00 $4.00 MC $3.00 AC $2.00 $1.00 $0.00 0 40 80 120 Output 160 200 240 Thousands Econ 5313 Marginal Revenue • You are a typical farmer producing cotton for export. The world price of a pound of cotton for December delivery is currently $0.7629. What is your marginal revenue per pound if you sell contracts for 100,000 pounds? • $0.7629 • What is your marginal revenue per pound if you sell contracts for 200,000 pounds? • $0.7629 • In this case, we have that the marginal revenue per pound is constant. Why would this situation likely have a constant marginal revenue? • One typical farmer’s output is not likely to affect price. Econ 5313 • • • • Extent Decisions If MR exceeds MC, should you sell another unit? Always? If MC exceeds MR, how should you respond? Always? • Depends on whether MR and/or MC are rising or falling • If AC exceeds MR , how should you respond? • We do not know. MC is relevant not AC. Econ 5313 Thinking on the Margin • UT Arlington is experimenting with changing prices tuition to customers students from a fixed amount per course to a fixed amount for full-time status regardless of the number of courses • How does this affect student behavior? • Expect your counter-party to think on the margin Econ 5313 MR and Compensation • What does the marginal revenue from effort look like for an hourly sales clerk in the housewares department of Macy’s? • What does the marginal revenue from effort look like for a commission sales clerk in the shoe department of Macy’s? Econ 5313 Incentive Pay • Would incentive pay work better for employees selling tickets at a Cowboy’s stadium box office or employee lining up group purchases for upcoming events? • Whose effort is more easily monitored? Econ 5313 Comparing Across Alternatives • A mobile telephone company is always looking for new customers. Their marketing department determines that a $50,000 increase in the TV ad budget brings in 1,000 new customers. • What is the MC for “customer acquisition” from advertising on TV? • $50,000 / 1,000 = $50 • Should they increase TV advertising? • If the marginal revenue generated by this customer is greater than $50, yes. • Need to know: expected profits per month, how long they can expect to keep customer, etc. Econ 5313 Comparing Across Alternatives • The mobile telephone company recently cut its telephone solicitation operations by $10,000 per month and discovered that their total telephone solicitation yield per month fell by 100 new customers. • What is the MC for “customer acquisition” from telephone solicitations? • $10,000 / 100 = $100 • Should they increase telephone solicitation operations? • Need to know if marginal effectiveness from increase is same as for decrease. (layoff poor workers?) • If so, increase if the marginal revenue generated by this customer is greater than $100. Econ 5313 Comparing Across Alternatives • Suppose you are responsible for customer acquisition at the mobile telephone company but you do not know the marginal revenue generated by a new customer. Your boss gives you the directive to acquire more customers. • Do you have enough information to know how you will spend your budget? • Yes. MCTV = $50 and MCTel = $100 • TV is cheaper • Even if you do not know the MR, you can compare MC across options if you must choose one. Econ 5313 Where to Downsize? • Your insurance firm processes claims through its newer, larger high-tech facility and its older, smaller low-tech facility. • Each month, the high-tech facility handles 10,000 claims, incurs $100,000 in fixed costs and $100,000 in variable costs. • Each month, the low-tech facility handles 2,000 claims, incurs $16,000 in fixed costs and $24,000 in variable costs. • If you anticipate a decrease in the number of claims, where will you lay off workers? Econ 5313 Diamond Wholesaling • Diamond wholesalers sell finished diamonds to various merchants every day. A diamond merchant can buy and sell packets of 200 diamonds of variable quality for $100,000 for an average wholesale value of $500 each. • Why don't sellers offer diamonds individually for $500 each? • Look ahead to the MR and MC to the counter-party and reason back. • Some diamonds are worth more than $500 and some less. If sold individually, the merchant will ‘cherry-pick’ only those with MR > $500. Econ 5313 • • • • • The Marginal Voter Marginal Value of a Voter Kelsey Grammer pandering for votes in Swing Vote http://www.youtube.com/watch?v=XvLrRC567zQ “Flexible” with positions in order to get 50% + 1 The marginal voter is the most powerful voter • Ex Ohio versus Texas in 2012 election Econ 5313 • • • • • From the Blog Chapter 4 Margins in the ACA “High Powered Incentives” Sicker Patients Third-Party Incentives to Cut Medical Costs Econ 5313 • • • • • Main Points AC = TC/Q MC is additional cost for another unit MR is additional revenue for another unit Extent decisions compare MR to MC Expect your counter-party to alter behaviors based on fixed fees versus fee per unit • Prime example is incentive compensation