The Ten-Day MBA 4th Ed.

by Steven A. Silbiger

  From that information you can see that the only marginal cost of running the automated cookie production line is the extra batter. The machine operator would be there anyway, and the large oven would be on anyhow. The factory would continue to require the usual maintenance.

  The factory manager should welcome the order because he can make a marginal profit. The only reason to reject the order would be if word were to get out to regular customers that you sold the $2.00 cookies for $1.00. The rub is that if everyone paid the $1.00 special price per dozen, there would be no profits to pay for the fixed costs, such as the operator’s salary and the cost of running the factory.

  As shown in the example of steers and cookies, “marginal” costs and revenues are critical in making “marginal” pricing and production decisions. However, to evaluate profitability of an entire business, rather than one transaction, total revenue must exceed total costs to make a bottom-line company profit.

  MARGINAL UTILITY

  Utility is a term used to describe the value of a product to a consumer. Marginal utility (MU) means the usefulness or utility of having an additional unit of a product. At some point a buyer is fully satisfied, and an additional unit is of no value. Going back to the beer example, suppose you are looking to forget whatever troubles you have and you order one beer at Porth Tavern. A second beer would be welcome and would in fact be of great marginal utility. Five hours later you’ve had twelve beers, played pool, danced, and forgotten your troubles. At this point, an extra beer would be of little value. The marginal utility of the thirteenth beer is negligible.

  PRICE ELASTICITY OF DEMAND

  In the first illustration of supply and demand, Heineken drinkers were willing to buy Duff beer at a price. When the price was lowered, demand increased. Conversely, if the price had been higher, demand would have fallen. Buyers’ responsiveness or sensitivity to changes in price is called elasticity.

  Elasticity of demand is one of the few economic theories that my MBA alumni friends have reportedly used. Brand managers at Procter & Gamble, for example, want to know how a price change will affect demand for their brand of soap. Production foremen at Ford Motor Company want to know how price changes will affect their production requirements.

  If consumers are sensitive to price changes, their demand is termed elastic. Consider the fast-food junkies’ buying habits at Taco Bell. In 1988, Taco Bell lowered its prices by introducing “value meals.” Consumers responded strongly by increasing their purchases. With tacos priced at fifty-nine cents, only fifty-nine cents stood in the way of having a third or fourth helping. Competitors followed. Package deals at McDonald’s gave permission to fence-sitters to order the large fries, large Coke, and apple pie with their Big Macs at savings of twenty to fifty cents over ordering each item separately.

  When consumers are not sensitive to prices, economists call their demand inelastic. Their purchasing behavior does not change with price changes. Necessities such as medical services or cigarettes fall into the inelastic category. When patients are in pain because of an appendicitis attack, they pay whatever the surgeon wants. Hard-core nicotine addicts accept cigarette price increases in the same way.

  As you can see by now, the price elasticity of consumer demand for product is important to consider when pricing a product. To quantify elasticity, a descriptive elasticity coefficient is used:

  The higher the elasticity coefficient, the higher the price elasticity. A coefficient equal to or greater than 1 is considered elastic. For example, researchers have calculated elasticities for restaurant meals at 2 and medical services at .31. Usually a great deal of research is necessary to determine elasticity, but of course the process may be simplified at the expense of accuracy. Managers must analyze historical data and also try to sort out the nonprice influences that may have caused a demand change, such as weather and competition.

  Another important aspect of elasticity is that it is not constant at all price levels. At different price levels elasticity may vary. This phenomenon is illustrated in a hypothetical table showing how people responded to price changes of hamburger meat sold by a particular butcher.

  ELASTICITY OF DEMAND FOR HAMBURGER

  (HYPOTHETICAL)

  If you were a butcher, this information would confirm what you might expect. At lower price levels, affordable to most families, changes in prices do not prompt the cook of the house to switch to other meats. However, when prices are higher, in the $2 to $5 range per pound, hamburger loses its broad appeal. Shoppers demonstrate elastic demand by selecting hot dogs or even pasta instead of beef. Those with unlimited cash tend to be more price inelastic and buy regardless of the price. That is why the elasticity of “quantity demanded” differs from the elasticity of “total revenue.” The die-hard beef eaters who are willing to buy at higher prices make up for the lost revenue of higher sales volumes.

  The same concept of elasticity of demand can be applied to the supply side of the economy, but in the opposite direction. Higher prices encourage more production while simultaneously discouraging more consumption. Lower prices discourage production but encourage more consumption. At the point that the quantity supplied and the quantity demanded meet at a market price, the market reaches equilibrium.

  COMPETITIVE MARKET STRUCTURES

  In addition to elasticity of demand, the competitive environment drives supply, demand, and prices. The greater the competition in a given market, the more sensitive the market price is to changes in supply and demand. In the gold market, there are many suppliers worldwide and the price fluctuates daily on commodity exchanges. The same holds true in the beef market in which Bud Montana operates. Now that you understand the principle involved, let’s look at the four basic market structures.

  Pure Monopoly. If there is only one seller with a unique product, then the seller is said to have a pure monopoly. The National Basketball Association controls professional basketball. Electric utilities are another monopoly. They are “price makers” because they can set the price of stadium tickets and of your utilities. And when a pharmaceutical company holds an exclusive patent, as GlaxoSmithKline does for its AIDS drug AZT, it can charge thousands of dollars for treatments that cost little to produce. Government regulation is usually the only restraint on greed. For a monopoly to exist there shouldn’t be any close substitutes to which consumers can switch.

  Oligopoly. When there are only a few suppliers for a product for which there are few substitutes, then what prevails is an oligopoly. With only a few competitors, prices can be maintained at high levels if the producers choose not to compete on price. If not, the market players can engage in price wars that can push prices down. Airlines are a good example of both of these conditions. Occasionally on busy routes price wars break out, but once it becomes clear that nobody can win, oligopolists return prices to higher levels.

  Monopolistic Competition. In a market where there are many producers with products that can be differentiated, monopolistic competition can occur. Copy stores are known for this. The copies may be the same, but the service varies. FedEx Kinko’s copy centers, for example, sell copies for eleven cents each, while some economy shops charge only five cents a copy. FedEx Kinko’s justifies the higher price by being open twenty-four hours, and offering competent and friendly service in clean stores. The lower-priced shops provide bare-bones service. But the existence of discounters places a lid on copy prices for the whole market. FedEx Kinko’s would most likely experience a downturn if its prices were two or three times those of economy shops.

  Pure Competition. In pure competition there are many competitors selling a similar, substitutable product. Marketing does not affect the price producers can get. Gold, silver, wheat, and corn are products that fit into this category. Many suppliers and buyers compete on commodity exchanges, and the prices are determined by the market forces of supply and demand. The producers are “price takers” from the market that arrives at prices by competitive bidding.

  In summary, when y
ou are thinking about the specific market conditions of an industry, a company, or the buying behavior of individuals, microeconomic theory governs. Industries produce the quantity that meets demand at an equilibrium price based on the competitive market structure. Companies produce the quantity at which the marginal revenue of the last unit produced equals the marginal cost. Individuals purchase based on their elasticity of demand.

  MACROECONOMICS

  MBAs study macroeconomics to understand the forces that shape the larger economy in which their companies operate. Is a recession coming? Are interest rates heading up? Is inflation a threat? Those are legitimate questions that business owners need to ask and consider. Even though theories may not offer you the answers, knowing the fundamental principles of macroeconomics may provide the framework within which to make intelligent guesses about the future.

  THE BATTLE OVER HOW THE ECONOMY WORKS: KEYNES VERSUS FRIEDMAN

  Economists rarely agree on what drives the economy. Just as there are Democrats and Republicans in politics, there are Keynesians and monetarists in economics. Keynesians hold that government intervention can significantly improve the operation of the economy. On the other hand, monetarists believe that markets work best if left alone with minimal government interference.

  The fathers of these opposing economic camps were profoundly influenced by the times in which they lived. John Maynard Keynes of Cambridge wrote The General Theory of Employment, Interest and Money (1936), the cornerstone of modern Keynesian macroeconomics, in the midst of the chaos of the worldwide Great Depression of the 1930s. Keynes saw the hands-off policies of world leaders as a failure and felt that judicious and timely government intervention could have a stabilizing and beneficial effect on the economy.

  In the boom years following World War II, Milton Friedman of the University of Chicago became a forceful advocate of the monetarist view of economics. He is the same person who asserts that a business’s sole function is to make profits (see the ethics chapter). Having witnessed the prosperity of the Eisenhower and Kennedy years, he believed in the power of the market to heal itself. Friedman was convinced that government ought to keep its hands off the economy. In areas as varied as income tax policy, agricultural subsidies, public housing, and others, he thought governmental regulation had done more harm than good.

  The macroeconomic debate of good-versus-evil government occupies an inordinate amount of time at MBA schools. The mostly conservative Republican MBA majority frequently clashes with a small but vocal Democratic minority. Using the following chart as a guide, I feel confident you can argue both sides if you wish to, in true MBA form!

  KEYNESIAN THOUGHT: Free enterprise without government intervention does not cause full employment.

  MONETARIST THOUGHT: Free market economics are best in the long run even at the cost of unemployment.

  KEYNESIAN THOUGHT: Unemployment is the big problem that needs a solution.

  MONETARIST THOUGHT: Inflation is the big evil; it is a tax on everyone.

  KEYNESIAN THOUGHT: With government spending and monetary policy, government should smooth out the business cycles.

  MONETARIST THOUGHT: Government tinkering makes the economy worse off in the long run.

  KEYNESIAN THOUGHT: Adequate information is available to take government action.

  MONETARIST THOUGHT: Available economic data are usually inaccurate and too late for useful government intervention.

  KEYNESIAN THOUGHT: Government spending can help spur efficient economic growth.

  MONETARIST THOUGHT: Government spending crowds out efficient private activity.

  This rather simplistic table covers the major theoretical macroeconomic arguments.

  GROSS NATIONAL PRODUCT, INFLATION, AND THE KEYNESIAN VIEW

  The centerpiece of macroeconomics is understanding a nation’s gross national product (GNP). GNP is the total market value of all final goods and services produced by an economy in a year. Changes in GNP are used as a measure of the health of an economy. The qualifier “final” is important. There is no double counting. An automobile, for example, is the sum of many components. Steel is counted in production only once, when the car is finished.

  Because prices change from year to year, economists must adjust GNP for year-to-year comparisons. The cost of a pound of steel usually increases from year to year. If price levels rise, it is called inflation. GNP adjusted for inflation is called real GNP. If left unadjusted, the so-called nominal GNP could show dollar growth, even if the economy produced the same amount of goods and services.

  To convert the unadjusted nominal GNP to real GNP, economists use a GNP deflator index. Using 2005 as a base year, the GNP deflator index then equaled 100. In 1950 it equaled 17. To translate, in 1950 the price of goods and services was 17 percent of what it was in 2005. During recessions and depressions real GNP falls, and during booms, it grows.

  For example, imagine that in 2011 you produced in your kitchen one pound of saltwater taffy worth $1. Then the following year, you made an identical pound of candy, now worth $1.04 due to inflation. “Nominally,” in “current” dollar terms in 2012, you produced 4 percent more value. But did you really? No. Your output was the same. Therefore, economists adjust nominal GNP numbers with a deflator to yield real GNP. With “real” figures analysts can measure and compare “real” growth in the economy.

  In addition to a GNP deflator, economists use two more measures of inflation to gauge inflation’s impact on the economy. The consumer price index (CPI) measures the price changes of a specifically defined basket of consumer goods and services that people buy most often. This shopping basket or collection of goods is kept constant from year to year. The producer price index (PPI) measures price changes of a collection of raw materials used most often by producers. The CPI index uses 1982–84 as its base years (1982–84 = 100). The PPI uses 1982 (1982 = 100). In 2010 the CPI was 224 and the PPI 184. That means that consumer prices in 2010 were 224 percent greater than they were in 1984 for identical goods.

  There are also two additional variations of GNP measures called net national product (NNP) and gross domestic product (GDP). NNP considers the cost of using up machinery, factories, and equipment in production. In accounting, as I know you remember, they call that wasting of assets depreciation. NNP is GNP less the depreciation on the fixed assets used in the economy.

  Gross domestic product is the part of GNP that is produced within a country’s borders. It is an important statistic for economies heavily involved in trade. For example, Japan’s GNP includes profits from Honda’s assembly plants in the United States, but these profits would be excluded from its GDP. GDP is widely used.

  The GNP Equation. The gross national product, in the Keynesian view, is composed of four types of spending that result in income for others. Each component can and should be influenced by the government’s desire to maintain steady economic growth and low unemployment. When MBAs refer to the components of GNP, they call them the drivers of GNP.

  GNP = C + I + G + X where:

  C is Personal Consumption

  I is Private Investment

  G is Government Purchases

  X is Net of Exports over Imports

  As illustrated by the equation, any increase in consumption, investment, or government spending will result in growth for the economy. Countries such as China, Japan, and Taiwan use exports as their engines for growth. The United States, by contrast, drags its economy with a yearly trade deficit.

  As mentioned previously, the Keynesians’ main goal is full employment. A lowering in GNP is distressing since it means fewer jobs. If the economy is operating at a level below full employment, then there is what is called a GNP gap. If the government intervenes in the equation by increasing spending, the economy will be buoyed up and there will be a rise in employment to close the gap.

  Playing the devil’s advocate, a monetarist would argue that the measures of the economy provided by government statistics are not accurate. Absent from GNP are
the underground and unrecognized economies of crime, unreported earnings, and the output of mothers working at home. GNP also neglects to subtract the cost of environmental damage and add the value of leisure time produced.

  The Multiplier Effect and Fiscal Policy. Keynesian theorists favor government spending to spur the economy because they believe in its positive impact. Spending by one person or by a government provides income to another individual or company. The way that such spending ripples through the economy in a repetitive cycle of spending and income is called the multiplier effect. How the Congress and the president decide to spend money is called the government’s fiscal policy.

  The Keynesians believe that a government’s fiscal policy can “prime the pump” of a slow economy. In 2009 members of Congress raced to start public works projects to boost the economy during the deep recession. Road construction involves the purchase of rock, cement, steel, equipment, and labor, and the people involved in this work spend their wages and profits on food, housing, and clothes. This multiplies throughout the community the effect of the original government spending.

  Let’s see the multiplier at work for $1,000,000 of those construction salaries. The workers’ impact on the economy is dependent on their marginal propensity to consume (MPC) or spend the money they earn. If construction workers spent 80 percent of what they earned and saved 20 percent, they are said to have an MPC of .8. The higher the MPC, the greater the impact of their earnings on the economy. The effect on the economy would be calculated as follows: