University of the Cumberlands Managerial Economics Discussion

Description

Assigned Readings:
Chapter 2. The One Lessor of Business.
Chapter 3. Benefits, Costs, and Decisions.
Chapter 4. Extent (How Much) Decisions.
Initial Postings: Read and reflect on the assigned readings for the week. Then post what you thought was the most important concept(s), method(s), term(s), and/or any other thing that you felt was worthy of your understanding in each assigned textbook chapter.Your initial post should be based upon the assigned reading for the week, so the textbook should be a source listed in your reference section and cited within the body of the text. Other sources are not required but feel free to use them if they aid in your discussion.
Also, provide a graduate-level response to each of the following questions:

Describe a decision that you or your company made that involved opportunity costs that should have been considered. Why did your company make the decision? What should it have done? Compute the profit consequences of the change.

 
 

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CHAPTER
2 The One Lesson
of Business
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? Voluntary transactions create wealth by moving assets from
lower- to higher-valued uses.
? Anything that impedes the movement of assets to highervalued uses, like taxes, subsidies, or price controls, destroys
wealth.
? Economic analysis is useful to business for identifying assets
in lower-valued uses.
? The art of business consists of identifying assets in lowvalued uses and devising ways to profitably move them to
higher-valued ones.
? A company can be thought of as a series of transactions.
A well-designed organization rewards employees who
identify and consummate profitable transactions or who stop
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2
Kidney Transplants
? Two prominent hospitals recently refused patients for
kidney transplants because the organs were from
“directed donations.”
• The kidneys were meant for specific people
? Demand for organs is high – far exceeding supply –
and many never receive them.
? Despite high demand and low supply, buying and
selling organs is illegal.
? Why?
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3
Apartments
Suppose you want to move from Detroit to Nashville
? First, you would try a two-way trade
? Failing that, you’d try a three-way
connection with another city
Detroit
Detroit
Nashville
Nashville
Los Angeles
? Need to find correct trades with
correct timing = difficult!
? Like with kidney transplants, compatibility problems
lead to inefficiency
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4
Capitalism 101
To identify money-making opportunities,
you must first understand how wealth is created
(and sometimes destroyed).
? Key note: Wealth is created when assets are moved
from lower to higher-valued uses
? Definition: Value = willingness to pay
Desire + Income = You want something + you can pay for it
? Key note: Voluntary transactions, between individuals
or firms, create wealth.
• Meaning, people create wealth by pursuing self-interest.
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5
Housing Example
A house is for sale:
? The buyer values the house at $130,000
• This is the buyer’s top dollar – willingness to pay
? The seller values the house at $120,000
• This is the seller’s bottom line – won’t accept less
The buyer and seller must agree to a price that “splits”
surplus between buyer and seller. Here, $128,000.
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6
Surplus
The buyer and seller both benefit from this transaction:
? Buyer surplus = buyer’s value minus the price
$130,000 – $128,000 = $2,000 buyer surplus
? Seller surplus = the price minus the seller’s value
$128,000 – $120,000 = $8,000 seller surplus
? Total surplus = buyer + seller surplus = difference in
values
$2,000 + $8,000 = $10,000 ? $130,000 – $120,000 = $10,000
$10,000 are the gains from trade
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7
Wealth-Creating Transactions
? Which assets do these transactions move to highervalued uses?
• Factory Owners
• Real Estate Agents
• Investment Bankers
• Corporate Raiders
• Insurance Salesman
? Discussion: How does eBay create wealth?
? Discussion: Which individual has created the most
wealth during your lifetime?
? Discussion: How do you create wealth?
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8
Do Mergers Create Wealth?
? Do mergers follow the wealth-creating engine of
capitalism? Do they move assets to a higher-valued use?
• Our largest and most valuable assets are corporations.
? Ex: Dell-Alienware merger:
• In 2006, Dell purchased Alienware, a manufacturer of
high-end gaming computers.
• Dell left design, marketing, sales and support in
Alienware’s hands.
• Dell took over manufacturing though, using its expertise
to build Alienware’s computers at a much lower cost.
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9
Do Mergers Create Wealth?
? However, many mergers and acquisitions do not
create value
• If they do, value creation is rarely so clear
? To create value, the assets of the acquired firm
must be more valuable to the buyer than to the
seller
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10
Does Government Create Wealth?
? Discussion: What’s the government’s role is wealth creation?
• Enforcing property rights and contracts legal tools that
facilitate wealth creating transactions
• Ensures that buyers and sellers keep gains from trade
? Discussion: Why are some countries so poor?
• No property rights
• No rule of law
? Discussion: Much of the justification for government
intervention comes from the assertion that markets have
failed. One money manager scoffed at this idea. “The markets
are working fine, but they’re giving people answers that they
don’t like, so people cry market failure.”
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11
The One Lesson of Economics
? Definition: An economy is efficient if all assets are employed in
their highest-valued assets.
• This is an unattainable, but useful benchmark
? The One Lesson of Economics: The art of economics consists in
looking not merely at the immediate but at the longer effects of any
act or policy; it consists in tracing the consequences of that policy
not merely for one group but for all groups.
? Must look at the intended and unintended effects of policies to
understand their efficiency
? The economist’s solution to inefficient outcomes is to argue for a
change in public policy.
? Business person’s solution is to try to make money on the
inefficiency
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12
The One Lesson of Business
? Definition: Inefficiency implies the existence of
unconsummated, wealth-creating transactions
? The One Lesson of Business: The art of business
consists of identifying assets in lower valued uses
and devising ways to profitably moving them to
higher valued uses.
? In other words, make money by identifying
unconsummated wealth-creating transactions and
devise ways to profitably consummate them.
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13
Destroying Wealth
Anything that stops assets from moving to higher
valued uses is destroying wealth.
• Taxes Destroy Wealth:
• By deterring wealth-creating transactions – when the tax is
larger than the surplus for a transaction.
• Subsidies Destroy Wealth:
• Example: flood insurance encourages people to build in areas
that they otherwise wouldn’t
• Price Controls Destroy Wealth:
• Example: rent control (price ceiling) in New York City
deters transactions between owners and renters
? Which assets end up in lower-valued uses?
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14
Profiting from Inefficiency
? Taxes create a profit opportunity
• Discussion: 1983 Sweden tax
? Subsidies create opportunity
• Discussion: health insurance
? Price-controls create opportunity
• Discussion: Regulation Q. & euro dollars
• Discussion: What about ethics?
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15
Wealth Creation in Organizations
? Companies = a collection of transactions
? They buy raw materials (capital, labor, etc.) and create
and sell higher-valued goods and services
? Can equate market-level problems (taxes, subsidies
and price controls) with organization-level goal
alignment problems
• Ex: The overbidding from the oil company = “subsidy”
paid to management for acquiring oil reserves
? Allows us to use the same analysis
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16
CHAPTER
3
Benefits, Costs,
and Decisions
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? Costs are associated with decisions, not activities.
? The opportunity cost of an alternative is the profit
you give up to pursue it.
? In computing costs and benefits, consider all costs
and benefits that vary with the consequences of a
decision and only those costs and benefits that vary
with the consequences of the decision. These are the
relevant costs and benefits of a decision.
? Fixed costs do not vary with the amount of output.
Variable costs change as output changes. Decisions
that change output will change only variable costs.
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2
• continued
? Accounting profit does not necessarily correspond to
real or economic profit.
? The fixed-cost fallacy or sunk-cost fallacy means
that you consider irrelevant costs. A common fixedcost fallacy is to let overhead or depreciation costs
influence short-run decisions.
? The hidden-cost fallacy occurs when you ignore
relevant costs. A common hidden-cost fallacy is to
ignore the opportunity cost of capital when making
investment or shutdown decisions.
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3
• continued
? EVA® is a measure of financial performance that
makes visible the hidden cost of capital.
? Rewarding managers for increasing economic profit
increases profitability, but evidence suggests that
economic performance plans work no better than
traditional incentive compensation schemes based on
accounting measures.
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4
Big Coal Power Company
Big Coal Power Co. switched to a 8400 coal when the
price fell 5% below the price of 8800 coal
• 8400 coal generates 5% less power than 8800
• The manager was compensated based on the average
cost of electricity, and expected this move to save money
• Instead – company profit reduced
? Why? What happened?
? Discussion: Diagnose the problem.
? Discussion: Come up with a proposal to fix it.
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5
Big Coal Solution
Use our three questions for analysis
1) Who is making the bad decision?
• The plant manager made the switch to the lower-priced
8400 coal.
2) Did he have enough information to make a good
decision?
• Yes, presumably he knew that this would reduce his output.
3) Did he have the incentive to make a good decision?
• No, because he was evaluated based on the average cost of
electricity produced at his plant.
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6
Lesson From Coal Problem
? The plant manager should have considered all the
costs of switching to the lower Btu coal
• Namely, the lost electricity
? Average costs can be a poor measure of plant
performance
? Need to align incentives of a business unit with the
goals of the parent company
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7
Background: Types of Costs
? Definition: Fixed costs do not vary with the amount
of output.
? Definition: Variable costs change as output changes.
FIGURE 3.1 Cost Curves
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8
Example: A Candy Factory
? The cost of the factory is fixed.
? Employee pay and cost of ingredients are variable costs.
TABLE 3.1 Candy Factory Costs
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9
Your Turn
Are these costs fixed or variable?
? Payments to your accountants to prepare your
tax returns.
? Electricity to run the candy making machines.
? Fees to design the packaging of your candy bar.
? Costs of material for packaging.
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10
Real Example: Cadbury (Bombay)
? Beginning in 1978, Cadbury offered managers free housing in
company owned flats to offset the high cost of living.
? In 1991, Cadbury added low-interest housing loans to its
benefits package. Managers moved out of the company
housing and purchased houses. The empty company flats
remained on Cadbury’s balance sheet for 6 years.
? In 1997, Cadbury adopted Economic Value Added (EVA)®
• Charges each division within a firm for the amount of capital it uses
• Provides an incentive for management to reduce capital expenditures if
they do not cover costs
? Senior managers then decided to sell the unused apartments
after seeing the implicit cost of capital.
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11
Accounting Costs for Cadbury
TABLE 3.2 Cadbury Income Statement
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12
Cadbury Accounting Profit
? Accounting profit recognizes only explicit costs
? Typical income statements include explicit costs:
• Costs paid to its suppliers for product inputs
• General operating expenses, like salaries to factory
managers and marketing expenses
• Depreciation expenses related to investments in
buildings and equipment
• Interest payments on borrowed funds
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13
Cadbury Accounting Profit vs. Economic Profit
? What’s missing from Cadbury’s statements are
implicit costs:
• Payments to other capital suppliers (stockholders)
• Stockholders expect a certain return on their money
(they could have invested elsewhere)
• “Profit” should recognize whether firm is generating a
return beyond shareholders expected return
? Economic profit recognizes these implicit costs;
accounting profit recognizes only explicit costs
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14
Opportunity Costs & Decisions
Definition: the opportunity cost of an action is what
you give up (forgone profit) to pursue it.
? Costs imply decision-making rules and vice-versa
? The goal is to make decisions that increase profit
? If the profit of an action is greater than the
alternative, pursue it.
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15
Identifying Costs
? Whenever you get confused by costs, step back and
ask, “What decision am I trying to make?”
• If you start with costs, you will always get confused
• If you start with a decision, you will never get
confused
? Apply it to Cadbury:
• The cost of the company of holding onto the
apartments was the forgone opportunity to invest
capital in the company’s organization to earn a higher
return.
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16
Cadbury’s Costs
? Holding on to the flats cost the company £600,000
each year.
? Unless the benefits to the company of holding onto
the apartments were at least £600,000, the capital
was not employed in its highest-valued use.
? The cost of the company of holding onto the
apartments was the forgone opportunity to invest
capital in the company’s organization to earn a
higher return.
? By selling the flats, the company moved the capital
to a higher-valued use.
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17
Relevant Costs and Benefits
? When making decisions, you should consider all costs
and benefits that vary with the consequence of a decision
and only costs and benefits that vary with the decision.
? These are the relevant costs and relevant benefits of a
decision.
? You can make only two mistakes
• You can consider irrelevant costs
• You can ignore relevant ones
? Definition: The fixed-cost/sunk-cost fallacy means you
make decisions using irrelevant costs and benefits
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18
Fixed-Cost/Sunk-Cost Fallacy Examples
Football game:
? You pay $20 for a ticket. At halftime, you’re team is losing by 56 points.
? You say you’ll stay to get your money’s worth, but you can’t get your
money’s worth!
? The ticket price does not vary whether you stay or leave – it’s a sunk
cost and irrelevant.
Launching a new product:
? You are in a new products division and will be able to distribute a new
product through your existing sales force
? You will be forced to pay for a portion of the sales force
? If you believe this “overhead” is big enough to deter an otherwise
profitable product launch, then you’ve committed the sunk-cost fallacy
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19
Hidden-Cost Fallacy
Definition: ignoring relevant costs (costs that vary with the
consequences of your decision) when making a decision
Example: Football game (again)
? You buy a ticket for $20
? Scalpers are selling tickets for $50 because your team is playing
cross-state rivals
? You go to the game, saying, “These tickets cost me only $20.”
WRONG
? The tickets really cost you $50 because you give up the
opportunity to scalp them by going
? Unless you value them at $50, you are sitting on an
unconsummated wealth-creating transaction
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20
Example: Should You Fire an Employee?
? The revenue he provides to the company is $2,500
per month
? His wages are $1,900 per month
? His office could be rented out $800 per month
? YES, you are only making $600 a month from this
employee but could make $800 a month from renting
his office
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21
Subprime Mortgages
? The subprime mortgage crisis of 2008 is a good example
of the hidden-cost fallacy.
? Credit-rating agencies failed to recognize the higher costs
of loans made by dubious lenders.
• Example: Long Beach Financial
• Gave loans out to homeowners with bad credit, asked for no
proof of income, deferred interest payments as long as possible.
? Credit ratings didnt reflect the hidden costs of risky loans
? As a result, many Wall Street investors purchased packaged
risky loans and eventually went bankrupt when the debtors
defaulted.
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22
Hidden cost of capital
? Recall that accounting profit does not necessarily
correspond to economic profit.
? Discussion: Economic Value Added
• EVA®= net operating profit after taxes minus the cost of
capital times the amount of capital utilized
• Makes visible the hidden cost of capital
? The major benefit of EVA is identifying costs.
If you cannot measure something, you cannot control
it.
• Those who control costs should be responsible for them.
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23
Incentives and EVA®
? Goal alignment: “By taking all capital costs into
account, including the cost of equity, EVA shows the
dollar amount of wealth a business has created or
destroyed in each reporting period.
… EVA is profit the way shareholders define it.”
? Discussion: can you make mistakes using EVA?
• Does it help avoid the hidden cost fallacy?
• Does it help avoid the fixed cost fallacy?
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24
Does EVA® work?
? Adopting companies of EPP’s (+ four years)
• ROA from 3.5 to 4.7%
• operating income/assets from 15.8 to 16.7%
? Indistinguishable from non-adopters
• Bonuses increase 39.1% for EVA® firms
• But 37.4% for control group
? Interpretations
• Selection bias?
• NO, cheaper to use existing plans
• Goal alignment, YES.
? EVA® is no better or worse
• Rival EPP’s
• Bonus plans
• Discussion: WHY?
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25
Psychological Biases
? Not enough information or bad incentives are not the only
causes for business mistakes. Often psychological biases get in
the way of rational decision making.
? Definition: the endowment effect means that taking ownership
of item causes owner to increase value she places on the item.
? Definition: loss aversion – individuals would pay more to
avoid loss than to realize gains.
? Definition: confirmation bias – a tendency to gather
information that confirms your prior beliefs, and to ignore
information that contradicts them.
? Definition: anchoring bias – relates the effects of how
information is presented or “framed”
? Definition: overconfidence bias – the tendency to place too
much confidence in the accuracy of your analysis
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26
In class problem (1)
You won a free ticket to see an Eric Clapton concert
(which has no resale value). Bob Dylan is performing
on the same night and is your next-best alternative
activity. Tickets to see Dylan cost $40. On any given
day, you would be willing to pay up to $50 to see
Dylan. Assume there are no other costs of seeing either
performer. Based on this information, what is the
opportunity cost of seeing Eric Clapton?
A. $0
B. $10
C. $40
D. $50
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27
In class problem (2)
You won a free ticket to see an Eric Clapton concert
(which has no resale value). Bob Dylan is performing
on the same night and is your next-best alternative
activity. Tickets to see Dylan cost $40. On any given
day, you would be willing to pay up to $50 to see
Dylan. Assume there are no other costs of seeing either
performer. Based on this information, what is the
minimum amount (in dollars) you would have to
value seeing Eric Clapton for you to choose his
concert?
A. $0
B. $10
C. $40
D. $50
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28
Alternate intro anecdote
? Coca-Cola in the 1980s had very little debt, preferring to raise
equity capital from its stockholders
? The company had a diversified product line, including products
like aquaculture and wine. These other businesses generated
positive profits, earning a ten percent return on capital invested.
? The company, however, decided to sell off these “underperforming businesses”
? Why?
•
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At the time, soft drink division was earning 16 percent return on capital
The “opportunity cost” of investing in aquaculture and wine is the
foregone profit that could have been earned by investing in soft drinks
A dollar invested in aquaculture and wine is a dollar that was not invested
in soft drinks
Divisions sold off and proceeds invested in core soft drink business
©2018