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) perfectly elastic

B) Elastic

C) Unit-elastic

D) Inelastic

E) 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) Increase dramatically

B) Increase slightly

C) Not change

D) Decrease slightly

E) Decrease dramatically

• Once the market for generic drugs adjusts, Wal-Mart’s revenue from generic drug sales is most likely to

A) Increase dramaticallyB) Increase slightlyC) Not changeD) Decrease decrease slightlyE) Decrease dramatically

• We our answers to the previous questions could be more precise in if we knew the

A) Price elasticity of supply for generic drugs

B) Income elasticity of generic drugs

C) Price elasticity of demand for generic drugs

D) 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) Increase

B) Decrease

C) Stay the same

D) Become more elastic

E) None of the above

Making DecisionsChapter 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 Costsfrom 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 ConsiderationsWhat 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

Accounting Profits

Total Sales $100,000

Total CostsWages to Employees $40,000Rent for Building $10,000Depreciation on Computers $3,000

Total $53,000

Profits $47,000

Economic Profits

Total Sales $100,000

Total CostsWages to Employees $40,000Rent for Building $10,000Rental Value of Computers $5,000Opportunity Cost Your Time $50,000Total $105,000

Profits -$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) $15,000B) $20,000C) -$40,000D) -$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 TB MB0 0

10=10-01 10

4=14-102 14

3.5=17.5-143 17.5

2.5=20-17.54 20

2=22-205 22

1.5=23.5-226 23.5

Q TC MC0 0

3=3-01 3

3=6-32 6

3=9-63 9

3=12-94 12

3=15-125 15

3=18-156 18

NB

0

7

8

8.5

8

7

5.5

Graphical Illustration of a Continuous Example

Donuts

$

Total Costs

Total Benefits

QM

Would the individual decide upon QM

number of donuts?

At QM, total benefits are maximized and the cost don’t exceed the benefits.

Is the principle of marginal analysis satisfied at QM ?

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?

Net Benefits (Surplus)

Net Benefits (Surplus)

Donuts

$

Total Costs

Total Benefits

QM

Net Benefits (Surplus)

Donuts

$

QMQ*Q1

At Q1 the slope of the net benefit function is positive implying that an increase in Q will increase net benefits

Q2

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

Net Benefits

At Q*, the slope is zero and NB is maximized

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.

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)

€

ΔNBΔQ

=0 =Δ TB−TC( )

ΔQ=ΔTB

ΔQ−ΔTC

ΔQ=MB−MC

Marginal Benefit = Marginal Cost

Donuts

$

Total Costs

Total Benefits

QM Donuts

$

QMQ*

MB

MC

At QM MC > MB implies if the individual reduces Q the reduction in cost will greater than the loss in benefits -- net benefits rise!

Q1

At Q1 MB > MC implying that if the individual increases Q then additional benefits will exceed the additional costs -- net benefits rise

At Q*, the net benefits are maximized. This is the optimal quantity!

Note Slope of TB is falling

Note Slope of TC is rising

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

€

PV = It(1+ r)tt=0

T∑ =Io +

I1(1+ r)

+ I2(1+ r)2

+... + IT(1+ r)T

Example 1: Cashing out a future settlement

I0 = 0 I1 = 150 I2 = 175

r = 0% (.00)

r = 5% (.05)

r = 10% (.10)

€

PV =0 + 1501+.00

+ 175(1+.00)2

=0 +150 +175 =325

€

PV =0 + 1501+.05

+ 175(1+.05)2

=0 +148 .9 +158 .7 =301 .6

€

PV =0 + 1501+.10

+ 175(1+.10)2

=0 +136 .4 +144 .6 =281

Example 2:Current Investment with Future Benefits (NB = Benefit - Cost)

NB0 = -100 NB1 = 40 NB2 = 75

r = 0% (.00)

r = 5% (.05)

r = 10% (.10)

€

PVNB =−100 +40 +75 =+15

€

PVNB =−100 + 401+.05

+ 75(1+.05)2

=−100 +38.1+68.0 =+6.1

€

PVNB =−100 + 401+.10

+ 75(1+.10)2

=−100 +36.4 +62.0 =−1.6