Review of elasticity concepts
• The popular image of Wal-Mart Stores has in part been defined
by its vast consumer discounting on one side, and alleged
stinginess like scant employee health benefits on the other.
Yesterday, those stories intersected when the retailing
behemoth said it was cutting the cost of some generic drugs to
just $4 for a 30-day supply. Starting yesterday with 65 stores
around Tampa Bay, Fla., and with a plan to expand elsewhere in
the state later this year, Wal-Mart will apply its purchasing and
distribution prowess to lowering the prices of about 150 different
existing drugs to about 20% lower than existing prices, The Wall
Street Journal says. And the savings on some drugs will be
considerable. The $4 for 850 milligrams of diabetes treatment
metformin compares with $17.72 at other Florida stores and
$28.19 at Walgreen, the Journal says.
For simplicity, assume that consumers take brand name
drugs and their generic equivalents to treat existing
medical conditions in all the questions that follow.
1. Wal-Mart’s decision to lower the price of
generic drugs to $4 is best represented as a
A) Downward movement along the supply curve for
generic drugs
B) Shift of the supply curve to the left for generic
drugs
C) Shift of the supply curve to the right for generic
drugs
D) Shift of the demand curve to the right for generic
drugs
E) None of the above
2. Consumers’ demand for the generic drugs
whose prices Wal-Mart is reducing is most
likely
A)
B)
C)
D)
E)
perfectly elastic
Elastic
Unit-elastic
Inelastic
Perfectly inelastic
•
Building on you answer to Q2, in the wake
of Wal-Mart’s decision to lower generic drug
prices, the quantity of generic drugs
demanded is most likely to
A)
B)
C)
D)
E)
Increase dramatically
Increase slightly
Not change
Decrease slightly
Decrease dramatically
•
Once the market for generic drugs
adjusts, Wal-Mart’s revenue from
generic drug sales is most likely to
A)
B)
C)
D)
E)
Increase dramatically
Increase slightly
Not change
Decrease decrease slightly
Decrease dramatically
•
We our answers to the previous questions
could be more precise in if we knew the
A)
B)
C)
D)
Price elasticity of supply for generic drugs
Income elasticity of generic drugs
Price elasticity of demand for generic drugs
Cross-price elasticity of demand for generic and
brand name drugs
E) Prices of the brand name drug equivalents
•
As a result of Wal-Mart’s decision to reduce
the price of generic drugs, the demand for
brand-name substitutes is most likely to
A)
B)
C)
D)
E)
Increase
Decrease
Stay the same
Become more elastic
None of the above
Making Decisions
Chapter 7
September 26
Assignment for Next Lecture
• Submit Homework 7 on ‘Homework
Assignment’ by Wednesday at 11:55 PM
• Read Chapter 8
• Topics Next Time
– The Firm’s Cost Structure
In This Lecture
• Making Decisions on the Margin
• Nature of Costs
• Present Value
The Context of
Decision-making
• My decision of what to do doesn’t affect the decisions
of others -- perfect competition (Ch. 7)
• Strategic decisions and Manipulation (Ch. 14-16)
• Decisions under Risk and Uncertainty (Ch. 18)
Benefits and Costs
from different perspectives
• Benefits
– Consumers: the value or enjoyment of the
consumption derived from the ownership of the
good
– Producers: revenues from the sale of a good
• Costs (opportunity costs)
– Consumers: what you have to pay for the good
– Producers: what you had to paid to acquire or
produce the good
Cost Considerations
What is Appropriate?
• Explicit and Implicit Costs
• Accounting and Economic Profits
• Sunk Costs
Explicit and Implicit Costs
• Explicit Costs: ‘out of pocket’ expenditures
on the activity -- cost of a concert ticket or the
wages you pay to your employees
• Implicit Costs: not a monetary outlay but the
value of a forgone activity -- forgone wages
when attending college or forgone rental
income from the ownership of a capital asset
Accounting Profits versus
Economic Profits
• Accounting Profits: the firm’s revenue
minus its explicit costs and depreciated cost
of capital
• Economic Profits: the firm’s revenue minus
its opportunity costs (includes its explicit costs
plus the implicit cost of capital and the
owner’s time)
Example -- Self Owned Business
Economic Profits
Accounting Profits
Total Sales
$100,000
Profits
$100,000
$53,000
Total Costs
Wages to Employees
$40,000
Rent for Building
$10,000
Rental Value of Computers $5,000
Opportunity Cost Your Time $50,000
Total
$105,000
$47,000
Profits
Total Costs
Wages to Employees
$40,000
Rent for Building
$10,000
Depreciation on Computers $3,000
Total
Total Sales
-$5,000
Clicker time
•
You decide to quit your $60,000 per year
job as an information-technology specialist
and illustrate children’s books. At the end of
the first year of illustrating, you have earned
$20,000. You also spent $5,000 for paint
and paper. Your economic profit is:
A)
B)
C)
D)
$15,000
$20,000
-$40,000
-$45,000
Sunk Costs
• A cost that has been incurred and can’t be recovered
• Example: I bought a ticket for a ND football game for
$47.14 and on the night of the game there is a rain
storm. Should the cost of the ticket enter my decision
whether to go to the concert?
• Example: The government has completed one half of
a dam and finds that the cost of completing the dam
is three times what was originally estimated. Should
the cost of the already completed portion of the dam
influence its decision whether to complete the dam?
The Role of Marginal Analysis:
When to use it
• Either Or Decisions?
– Should I go to college or not?
– Should I start a business or go to work for someone else?
– Should I buy CDs or go to a concert?
• How Much?
– Which college should I enroll at?
– What kind of business should I start?
– How many CDs should I purchase?
• Use marginal analysis for the “How Much”
decisions
Living on the Margin:
The Principle of Marginal
Analysis
The Principle of Marginal Analysis:
The optimal a level of activity is the quantity at
which the marginal benefit is equal to the
marginal cost.
Marginal Benefit = Marginal Cost
Discrete Example:
buying a good at a constant $3 price
Q
0
TB
0
MB
Q
0
TC
0
10=10-0
1
10
1
14
3=6-3
2
17.5
3=9-6
3
20
3=12-9
4
22
23.5
8
12
3=15-12
5
7
15
1.5=23.5-22
6
8.5
9
2=22-20
5
8
6
2.5=20-17.5
4
7
3
3.5=17.5-14
3
NB
0
3=3-0
4=14-10
2
MC
3=18-15
6
18
5.5
Graphical Illustration of a
Continuous Example
$
Would the individual decide upon QM
number of donuts?
Total Benefits
Total Costs
At QM, total benefits are maximized and
the cost don’t exceed the benefits.
Is the principle of marginal analysis
satisfied at QM ?
Net
Benefits
(Surplus)
At QM the individuals net benefit (total
benefits - total costs = surplus) would
be zero. Couldn’t the individual gain
more surplus by reducing the number of
donuts chosen?
QM
Donuts
Net Benefits (Surplus)
At Q1 the slope of the net benefit
function is positive implying that
an increase in Q will increase net
benefits
$
$
At Q*, the slope is zero and NB is maximized
Total Benefits
At Q2 the slope of the net
benefit function is negative
implying that an increase in Q
will reduce net benefits, so it
is best to reduce Q
Total Costs
Net
Benefits
(Surplus)
Net Benefits
QM
Donuts
Q1
Q*
Q2
QM
Donuts
Maximizing Net Benefits
Net benefits are maximized when the slope of the net benefit function is
zero. This happens when the marginal benefit = the marginal cost.


 TB TC TB TC
NB
0


 MB  MC
Q
Q
Q
Q
Where NB = Net Benefits

TB = Total Benefits depends upon Q
TC = Total Costs depends upon Q
MB = Marginal Benefit (change in TB for a change in Q)
MC = Marginal Cost (Change in TC for a change in Q)
Marginal Benefit = Marginal Cost
At QM MC > MB implies if the
individual reduces Q the reduction in
cost will greater than the loss in
benefits -- net benefits rise!
$
Total Benefits
$
Note Slope of TB is
falling
Total Costs
At Q1 MB > MC implying that if the
individual increases Q then
additional benefits will exceed the
additional costs -- net benefits rise
MC
Note Slope of
TC is rising
QM
MB
Donuts
Q1
Q*
QM
At Q*, the net benefits are maximized.
This is the optimal quantity!
Donuts
Present Value at Work
Structured Settlement
Suppose as part of the settlement of a legal suit, I promise to pay you $100
next year. But you want the money today -- you have expenses now. How
much can you borrow against the promise of $100 a year from now?
For every dollar you borrow (B) you will have to pay back that dollar and
the interest you have to pay on the loan. Assuming you can borrow at r
percent your total payment would be equal to
B + r B = B(1+r)
which must be equal to promise of $100. Consequently you can borrow
B = $100/(1+r) = present value of the $100
Present Value
Assuming a constant rate of interest r, if It is the amount of income
in the time period t, then the present value is
T
It
t 0
(1 r )t
PV  

 Io 
I1
I
I
 2 2  ... T T
(1 r ) (1 r )
(1 r )
Example 1:
Cashing out a future settlement
I0 = 0
I1 = 150
I2 = 175
r = 0% (.00)
PV  0 
150
175

 0 150 175  325
2
1 .00 (1 .00)
r = 5% (.05)

PV  0 
150
175

 0 148.9 158.7  301.6
1 .05 (1 .05)2
r = 10% (.10)

PV  0 
150
175

 0 136.4 144.6  281
1 .10 (1 .10)2
Example 2:
Current Investment with Future
Benefits (NB = Benefit - Cost)
NB0 = -100
NB1 = 40
NB2 = 75
r = 0% (.00)
PVNB  100  40  75  15
r = 5% (.05) 
PVNB  100 
r = 10% (.10)

PVNB  100 
40
75

 100  38.1 68.0  6.1
1 .05 (1 .05)2
40
75

 100  36.4  62.0  1.6
2
1 .10 (1 .10)