PowerPoint Slides © Michael R. Ward, UTA 2014

Donut Holes Making Decisions on the Margin Econ 5313 Donut Holes Making Decisions on the Margin A friend does an experiment in class Hands one student a box of donut holes. “Eat as many as you want.” Hands another student a watch. “Mark the time between donut holes.” Expect the time between donut holes to increase as more are eaten Graphs 1/time versus quantity – cool! Except when he mistakenly gave the box to a football player. Why was this a problem? No variation in 1/time.

“Nobody can eat fifty eggs” Econ 5313 “Nobody can eat fifty eggs” Cool Hand Luke movie clip Declining marginal value http://www.youtube.com/watch?v=xDWczgxsSaM The marginal value of the 50th egg eaten within an hour is much less than the 1st.

Fixed and Variable Costs Econ 5313 Fixed and Variable Costs A factory producing jump drives has rent of $120,000 per month. Material inputs are $100 for plastic for 1000 units, connectors at $20 for 100 units, and mini-circuit boards at $1.30 apiece. Twenty-five workers produce 500 units in an hour at total compensation of $12/hour. Taxes amount to $0.70 unit. Management, accounting, and other overhead come to $80,000 per month. Which costs items are variable costs and which are fixed costs? Variable: plastic, connectors, circuits, labor & taxes Fixed: rent and overhead

Fixed and Variable Costs Econ 5313 Fixed and Variable Costs What are the marginal costs per unit for each of the variable cost items? Plastic $100/1000 units = $0.10/unit Connectors $20/100 units = $0.20/unit Circuit boards $1.30 Labor input 25/500 = 0.05 worker hours per unit. At $12/hour this is $0.60/unit Taxes $0.70/unit What are the marginal costs per unit? Total MC = $0.10 + $0.20 + $1.30 + $0.60 + $0.70 = $2.90/unit

Fixed and Variable Costs Econ 5313 Fixed and Variable Costs The plant produces 80,000 units per month on average. What are average fixed costs? Rent: $120,000/80,000 = $1.50/unit Overhead: $80,000/80,000 = $1.00/unit Total: ($120,000+$80,000)/80,000 = $2.50/unit What are the average costs per unit? AC = MC + AFC = $2.90/unit + 2.50/unit = $5.40 Suppose the plant had excess capacity and management doubled output per month. What are MC, AFC and AC? MC unchanged at $2.90/unit AFC: ($120,000+$80,000)/160,000 = $1.25/unit AC = MC + AFC = $2.90/unit + 1.25/unit = $4.15

Fixed and Variable Costs Econ 5313 Fixed and Variable Costs What does a plot of the MC and AC with output look like? MC is constant at $2.90 AC falls with Q getting closer to MC 5

Econ 5313 Problem 4.2f

Econ 5313 Marginal Revenue You are a typical farmer producing cotton for export. The world price of a pound of cotton for December delivery is currently $0.7629. What is your marginal revenue per pound if you sell contracts for 100,000 pounds? $0.7629 What is your marginal revenue per pound if you sell contracts for 200,000 pounds? In this case, we have that the marginal revenue per pound is constant. Why would this situation likely have a constant marginal revenue? One typical farmer’s output is not likely to affect price. 5

Extent Decisions If MR exceeds MC, should you sell another unit? Econ 5313 Extent Decisions If MR exceeds MC, should you sell another unit? Always? If MC exceeds MR, how should you respond? Depends on whether MR and/or MC are rising or falling If AC exceeds MR , how should you respond? We do not know. MC is relevant not AC. 5

Econ 5313 Thinking on the Margin UT Arlington is experimenting with changing prices tuition to customers students from a fixed amount per course to a fixed amount for full-time status regardless of the number of courses How does this affect student behavior? Expect your counter-party to think on the margin 5

Econ 5313 MR and Compensation What does the marginal revenue from effort look like for an hourly sales clerk in the housewares department of Macy’s? What does the marginal revenue from effort look like for a commission sales clerk in the shoe department of Macy’s? 5

Econ 5313 Incentive Pay Would incentive pay work better for employees selling tickets at a Cowboy’s stadium box office or employee lining up group purchases for upcoming events? Whose effort is more easily monitored? 5

Comparing Across Alternatives Econ 5313 Comparing Across Alternatives A mobile telephone company is always looking for new customers. Their marketing department determines that a $50,000 increase in the TV ad budget brings in 1,000 new customers. What is the MC for “customer acquisition” from advertising on TV? $50,000 / 1,000 = $50 Should they increase TV advertising? If the marginal revenue generated by this customer is greater than $50, yes. Need to know: expected profits per month, how long they can expect to keep customer, etc. 5

Comparing Across Alternatives Econ 5313 Comparing Across Alternatives The mobile telephone company recently cut its telephone solicitation operations by $10,000 per month and discovered that their total telephone solicitation yield per month fell by 100 new customers. What is the MC for “customer acquisition” from telephone solicitations? $10,000 / 100 = $100 Should they increase telephone solicitation operations? Need to know if marginal effectiveness from increase is same as for decrease. (layoff poor workers?) If so, increase if the marginal revenue generated by this customer is greater than $100. 5

Comparing Across Alternatives Econ 5313 Comparing Across Alternatives Suppose you are responsible for customer acquisition at the mobile telephone company but you do not know the marginal revenue generated by a new customer. Your boss gives you the directive to acquire more customers. Do you have enough information to know how you will spend your budget? Yes. MCTV = $50 and MCTel = $100 TV is cheaper Even if you do not know the MR, you can compare MC across options if you must choose one. 5

Econ 5313 Where to Downsize? Your insurance firm processes claims through its newer, larger high-tech facility and its older, smaller low-tech facility. Each month, the high-tech facility handles 10,000 claims, incurs $100,000 in fixed costs and $100,000 in variable costs. Each month, the low-tech facility handles 2,000 claims, incurs $16,000 in fixed costs and $24,000 in variable costs. If you anticipate a decrease in the number of claims, where will you lay off workers? 5

Econ 5313 Diamond Wholesaling Diamond wholesalers sell finished diamonds to various merchants every day. A diamond merchant can buy and sell packets of 200 diamonds of variable quality for $100,000 for an average wholesale value of $500 each. Why don't sellers offer diamonds individually for $500 each? Look ahead to the MR and MC to the counter-party and reason back. Some diamonds are worth more than $500 and some less. If sold individually, the merchant will ‘cherry-pick’ only those with MR > $500. 5

The Marginal Voter Marginal Value of a Voter Econ 5313 The Marginal Voter Marginal Value of a Voter Kelsey Grammer pandering for votes in Swing Vote http://www.youtube.com/watch?v=XvLrRC567zQ “Flexible” with positions in order to get 50% + 1 The marginal voter is the most powerful voter Ex Ohio versus Texas in 2012 election 5

From the Blog Chapter 4 Margins in the ACA “High Powered Incentives” Econ 5313 From the Blog Chapter 4 Margins in the ACA “High Powered Incentives” Sicker Patients Third-Party Incentives to Cut Medical Costs

Main Points AC = TC/Q MC is additional cost for another unit Econ 5313 Main Points AC = TC/Q MC is additional cost for another unit MR is additional revenue for another unit Extent decisions compare MR to MC Expect your counter-party to alter behaviors based on fixed fees versus fee per unit Prime example is incentive compensation 5