ECO 6301 III

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Course Learning Outcomes for Unit II At the end of this unit, you should be able to:

2. Apply the different types of elasticity concepts to business scenarios. 2.1 Predict demand using elasticity.

7. Explain the implications of uncertainty in managerial decision-making.

7.1 Describe how marginal analysis can lead to better decision-making. Required Unit Resources Chapter 5: Investment Decisions: Look Ahead and Reason Back (ULO 2.1) Chapter 6: Simple Pricing (ULO 7.1) Chapter 7: Economies of Scale and Scope (ULO 7.1) Unit Lesson Lesson: Production Decisions, Costs, and Prices (ULOs 2.1 and 7.1) This lesson will introduce you to the ways that business use tools for decision-making. This unit’s material focuses on business decision-making and explores some tools that can help businesses make good decisions. Costs are the first type of information firms need to know for decision-making. If firms do not know their own costs, it is really difficult to make decisions. Of course, information is seldom known 100%, but the closer firms can get to 100%, the better their decision-making will be. There are some obvious costs businesses need to know, such as their rent, cost of material, and cost of labor. With these costs, firms need to know how the costs will change with their decisions. For example, if a business wants to double production, will its cost double to do so? Some probably will, but not all of them. Rent and CEO salary are examples of fixed costs. Fixed costs are costs that do not change with changes in output. Variables costs are expenses such as labor or materials that change with production. If McDonald’s wants to produce another Quarter Pounder, they need more hamburger patties. So when making production decisions, fixed costs should not be considered. They do not change, so they do not matter to production decisions.

The Shutdown This leads to one of the first important decisions a business should make called the shutdown decision. Shutting down does not mean closing-up shop for good. In fact, it can often be reasonable for a business to operate even if it is earning at a loss. Consider that fixed costs should not be involved in this decision since they cannot be avoided. Fixed costs are important, however, for determining profit. So, if a business shuts down, it still has to pay the fixed costs. If a business is able to sell their product for more than it costs to produce the product (meaning just looking at variable costs), then a firm can offset some of the loss of the fixed costs by continuing to operate. If this is the case, the business would want to continue operating so long as the fixed costs remain (a time period economists refer to as the short-run). Once their fixed costs are no longer fixed and the business has decision-making control over them (the long-run), then the business owners can consider exiting the market entirely. So just to reiterate, it can make perfectly good sense for a business

UNIT II STUDY GUIDE Production Decisions, Costs, and Prices

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to operate at a loss; simply earning a loss does not mean the business should shutdown. As long as price exceeds average variable cost (variable cost per unit), the firm should continue to operate. The shutdown decision applies to more than just firms operating at a loss, however. The same approach is used by just about every business, just about every day. It is not based on the income statement the business might produce for a month or a quarter or a year, but on a daily decision—on something as simple as which hours to be open. Breakfast restaurants typically close shortly after lunch time as there is not a lot of demand for omelets at dinner time. Fancy steak houses are often open only at dinner time as there is not a demand for $50 steaks at breakfast or even lunch.

More Tools Other decisions by firms involve comparisons to other alternatives. To make these decisions, firms need to have information about their alternatives to help make good choices. What is the value of doing different alternatives? Economists call this opportunity cost. If a frozen yogurt shop opts to replace their chocolate yogurt with mint yogurt, what is the cost of doing that? It is not just the cost of the mint yogurt, it is also the revenue they would have earned from selling chocolate yogurt. If chocolate yogurt would have sold more, then the frozen yogurt shop is essentially losing money by selling mint instead. This is known as economic profit (or loss). Firms should not just be concerned with how much money their accountant tells them they are making; they should be concerned about how much money they could make by choosing different alternatives.

Oftentimes, looking at different alternatives can be cumbersome. It can be difficult to compare the alternatives; however, there are financial tools businesses can use to make comparing the options easier. Discounting, for example, uses a rate of return to compare cash flows across different time periods. Is a dollar tomorrow worth the same as a dollar today? No, the dollar today is more valuable. Discounting allows decision-makers to make a better apples-to-apples comparison of the financial projections for different potential projects. Financial analysis can also help businesses determine what they need to do to break even on a project. Determining the break-even quantity is fairly straight forward. It is simply the fixed costs divided by the difference between price and marginal cost (the cost of producing an additional unit). The more challenging part is determining what costs to include. As discussed above, opportunity costs are an important cost to consider in decision-making.

Comparing apples to oranges is not exactly an equal comparison. (Gregory, n.d.)

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While deciding what costs to include in decision-making is important, equally important is knowing what costs should not be included in decision-making. When making a decision, only costs that are controllable should be considered. Costs that have already been incurred (or committed to), known as sunk costs, should not be considered in the decision. This again reflects the shutdown decision when fixed costs should not be considered. If something will not change based on your decision, then do not bother including it in your decision-making process.

Pricing and Elasticity On the other side of the decision-making ledger from costs is prices. Costs need to be managed, but real strategy comes with setting prices. Set the price too high and customers will not buy the product. Some businesses will set price based on costs (firms that use a standard mark-up over costs are an example of basing price on costs), but this completely ignores demand. Businesses might be over-charging or under-charging. Set the price too low and businesses will not bring in as much revenue as they could have. This is where elasticity comes into play. Elasticity is the responsiveness of one variable to a change in another. The most commonly used elasticity is the elasticity of demand, which is the responsiveness of quantity demanded to a change in price. If quantity demanded changes a lot when price changes a little, the product or good has an elastic demand. If quantity demanded does not change very much when price changes considerably, the good has an inelastic demand. The most obvious application of elasticity is the effect price changes have on total revenue. If a good has an elastic demand, then a price decrease will result in an increase in total revenue. Since total revenue is equal to price times quantity, then if price is decreasing a little but quantity increases a lot, then total revenue will increase. If a good has an inelastic demand, then a price increase will result in an increase in total revenue. Looking back at total revenue, if price can increase a lot without much loss in quantity, then total revenue will increase. Firms can estimate elasticity using regression analysis (note: to do this, take the natural log of price and the natural log of quantity—just putting price and quantity into a regression will not yield elasticities). This requires sufficient data to estimate a demand function. Businesses can get most of what they need for making decisions by understanding what determines elasticity. There are three main determinants of elasticity, but really, they can be boiled down to one: what other available options consumers have. The more options you have, the more sensitive you will be to a price change of a good. Options can arise in a variety of ways. The first option is the amount of time a consumer has to make the purchase decision. Imagine you are at a baseball game and you are getting hungry. You can certainly go get a hotdog. You will pay more money for it

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at a concession within the venue, but the other option is to wait until the game is over. But that might be longer than you would like to wait to eat. Elasticity can also change based on how broadly the good is defined. Gas is an inelastic good. People need it to get to work, the grocery store, go on trips, take their kids to school, etc. But that does not mean a gas station can simply charge as high of a price for gas as they want because there is likely to be a gas station across the street or at most just down the road. If a particular gas station increases price much more than competitor gas stations, then consumers will simply go to the competitor. If a business understands the nature of their product and understands the alternatives consumers have to their product, the business will be able to make sound decisions on whether they should raise or cut prices. The business may not know exactly what will happen to the demand for their product, but they will have a pretty good idea. In business, often being able to make an educated, informed decision in a world of uncertainty is the best that can be asked.

References Gregory, R. (n.d.). Comparing apples to oranges. Concept, isolated (ID 597747) [Photograph]. Dreamstime.

https://www.dreamstime.com/royalty-free-stock-photography-comparing-apples-to-oranges- image597747

Siddique, K., Ali, G., Ullah, I., Shah, A. U., & Fayaz, M. (2019). An estimation of expenditure, own and cross

price elasticities of meat in Pakistan. Sarhad Journal of Agriculture, 35(2), 623–629. https://libraryresources.columbiasouthern.edu/login?url=http://search.ebscohost.com/login.aspx?direc t=true&db=asn&AN=136655162&site=ehost-live&scope=site

Suggested Unit Resources Elasticities of Meat in Pakistan (Optional) This article gives an example of estimating elasticities, both own-price and cross-price elasticities. The article also demonstrates how understanding elasticities can be used to make inferences about buying habits of consumers being studied (in this case, consumers in rural and urban areas of Pakistan).