Microeconomics Primer

Professor David Besanko

Kellogg School of Management

Northwestern University

November 17, 2009

© David Besanko, 2009 Please do not reproduce with permission of Professor Besanko

OBJECTIVES:

• Provide introduction to some basic microeconomic concepts that will be

useful for consulting interviews

• Illustrate how these concepts can be used, in conjunction with case facts,

to develop hypotheses about situations with ambiguous or messy fact

patterns.

• Goal is not to explore the deeper theoretical dimensions of the concepts

themselves

ROAD MAP:

• Price elasticity of demand

• Relevant costs and decision making

• Industry cost curves

2© David Besanko, 2009 Please do not reproduce with permission of Professor Besanko

• Price Elasticity of Demand

• Relevant Costs and Decision Making

• Industry Cost Curves


4

Price Elasticity of Demand: percentage change in quantity demanded per one percent change in price

Price

Quantity

Inelastic demand

Elastic demand

D2

D1


5

Price

Quantity

Inelastic demand

Elastic demand

$1.20

$1.00

1092

D2

D1

Along D1: %ΔQ = - 80% and %ΔP = +20%,

so price elasticity = - 80%/20% = - 4.0

Along D2: %ΔQ = - 10% and %ΔP = +20%,

so price elasticity = - 10%/20% = - 0.5

Price Elasticity of Demand: percentage change in quantity demanded per one percent change in price


In general, - < eQ,P < 0

If …

eQ,P is between –1 and - , we say demand is elastic.

eQ,P is between 0 and –1, we demand is inelastic.

8

8


• Market-level price elasticity of demand:

– What happens to market demand for a product when the prices of all brands in the

market go up or down at the same time?

▪ e.g., due to increases in the prices of raw materials such as aluminum, the prices of new

automobiles rises by 5%. What is the percentage change in the quantity of new automobiles

demanded?

• Brand-level price elasticity of demand:

– What happens to the demand for a particular brand when the price of that brand goes

up or down, holding the prices of other brands fixed?

▪ e.g., BMW announces that the price of its line of 325 vehicles will go up. The prices of other

makes of cars (including BMWs) remains the same. What is the percentage change in the

quantity of BMW 325s demanded?


• Price elasticity of market demand

for automobiles is on the order of

- 1 and - 1.5

• Price elasticity of demand for

ready-to-eat breakfast cereal in the

U.S. is on the order of - 0.25 to

- 0.5.

• Price elasticity of demand for BMW

325 is on the order of - 3.5 to - 4.

• Price elasticity of demand for

individual brands, such as Captain

Crunch, is on the order - 2 to - 4.


9

Demand is very

sensitive to pricee.g., high-end discretionary

consumer durables such as

boats or motorcycles

Demand is very

insensitive to pricee.g., electricity for

residential users

Substitution Opportunities

Do consumers have readily available substitutes

to which they can switch?

YES NOExpense

Relative to

Budget

Do expenditures

on the good

account for a

large fraction

of the buyer’s

budget?

YES

NO

TENDS TO MAKE DEMAND MORE PRICE SENSITIVE

TE

ND

S T

O M

AK

E D

EM

AN

D

MO

RE

PR

ICE

SE

NS

ITIV

E

Demand is moderately

sensitive to pricee.g., automobiles or

consumer appliances

Demand is moderately

sensitive to pricee.g., consumer packaged

goods that have close substitutes

such as butter or paper towels


• In 2002, some airlines (e.g., Continental, Delta) experimented with

cuts in unrestricted “walk-up” fares (generally used for business

travel)

– e.g., Delta lowered “walk-up” fares by about 21 percent in small markets over a

seven-week period

– Fare cuts were generally matched by competing airlines in these markets

– Conventional wisdom: cuts in unrestricted “walk-up” fares result in decreases in

total revenues

– Results of Delta’s experiments: double-digit increase in total revenue

What does conventional wisdom assume about the price

elasticity of demand for business air travel?

What do Delta’s pricing experiments tell us about the

price elasticity of demand for business air travel?


• Suppose your company contemplates a temporary shut-down of

one of its factories for a period of one year.

• Consider all categories of cost associated with the existence of this

factory, the production of output in this factory, and the possible

shut-down of this factory:

– Which categories are relevant to the shut-down decision?

• Relevant costs:

– What costs do you avoid if you shut down this factory? What extra costs

do you incur if you shut down this factory? These are categories that

are relevant.

– Costs whose level is not affected by the shut-down decision are

irrelevant to the shut-down decision


13

Keep factory open and

produce at current

volume

Shut the factory down over the

next year

Revenue

(000)

Labor and

Materials

Costs (000)

$100 $50

$0 $0

Your

choice

Leasing

expense

(000)

$70

$70

Total

cost

(000)

$120

$70

This “bucket” of

costs goes away

if we shut down:

it is non-sunk

This “bucket” of

costs does not

go away if we shut down:

it is sunk

Cash

flow

(000)

-$20

-$70

• At current output level,

– total revenue = $100,000/month

– total cost = $120,000/month

• Costs consists of labor, materials, and leasing expenses


Product Line Profitability Analysis for

Client’s Product Lines, FY 2009

Pressure

reducing

valves

Vacuum

-regulating

valves

Per unit revenue $10.00 $9.00 $6.00

Direct materials

costs (per unit) $3.00 $3.50 $4.00

10,000 5,000 3,000

Manufacturing

overhead and

selling expenses

(per unit) * $0.20 $0.40 $1.00

Corporate overhead

charge (per unit)** $5.00 $5.00 $5.00

Total cost (per unit) $8.20 $8.90 $10.00

Profit (per unit) $1.80 $0.10 ($4.00)

.

Digital

control

valves

14

* Directly traceable to each product line

** $90,000,000 of corporate level overhead is allocated to the business unit.

Per unit charge is $90,000,000 total number of units sold by business unit

Annual unit sales

(thousands)

• Client: business unit of a large

diversified company. Produces

different types of valves used in

industrial process control

systems

• Business unit is profitable:

– Total revenue: $163,000,000

– Total cost: $156,500,000

– Total profit: $6,500,000

• Question: should it drop one of

its product lines?

• Average profit per unit of

vacuum regulating valves was

negative last year. Seems like a

“no-brainer,” right?




Pressure

reducing

valves

Vacuum

-regulating

valves


Direct materials

costs (per unit) $3.00 $3.50 $4.00

Annual unit sales

(thousands) 10,000 5,000 3,000

Manufacturing

overhead and

selling expenses

(per unit) * $0.20 $0.40 $1.00

Corporate overhead

charge (per unit)** $5.00 $5.00 $5.00


Profit (per unit) $1.80 $0.10 ($4.00)

.

Digital

control

valves

15

$6.00 $6.00

$0.80 $(0.90)

$9.20 $9.90





systems



– Total cost: $156,500,000



its product lines?











Pressure

reducing

valves

Vacuum

-regulating

valves


Direct materials

costs (per unit) $3.00 $3.50 $4.00

Annual unit sales

(thousands) 10,000 5,000 3,000

Manufacturing

overhead and

selling expenses

(per unit) * $0.20 $0.40 $1.00

Corporate overhead

charge (per unit)** $5.00 $5.00 $5.00


Profit (per unit) $1.80 $0.10 ($4.00)

.

Digital

control

valves

16

$9.00

($2.20)

$12.20





systems



– Total cost: $156,500,000



its product lines?









Total

Revenue

Total

Direct

Costs

Total

Mfg. OH

& Selling

Cost

Total

Corp.

OHTotal

ProfitValve type

Digital

Pressure-red.

Vacuum reg.

TOTAL

(thousands)

$100,000

$ 45,000

$ 18,000

$163,000

$30,000

$17,500

$12,000

$59,500

$ 2,000

$ 2,000

$ 3,000

$ 7,000 $90,000 $ 6,500

Total

Revenue

Total

Direct

Costs

Total

Corp.

OH

Total

ProfitValve type

Digital

Pressure-red.

Vacuum reg.

TOTAL

(thousands)

$100,000

$ 45,000

$145,000

$30,000

$17,500

$47,500

$ 2,000

$ 2,000

$ 4,000 $90,000 $3,500

Keep

vacuum

reg.

valves

Drop

vacuum

reg.

valves

unavoidable!

17

Total

Mfg. OH

& Selling

Cost


• Total cost (TC): sum total of all of the firm’s operating costs

• Marginal cost (MC): the rate at which total cost changes as the volume of

production changes i.e., MC = DTC/DQ

– cost per unit of the last unit produced

• Average total cost (ATC): total cost per unit, i.e., ATC = TC/Q

– Operating cost per unit, averaged over all units produced

• Example: It “costs” me 100 minutes to make 20 slides in a PowerPoint

deck. It will cost me 115 minutes to make 21 slides

– TC of 20 slides = 100 minutes, TC of 21 slides = 115 minutes

– ATC of 20 slides = 100/20 = 5 minutes per slide; ATC of 21 slides = 115/21 =

5.48 minutes per slide

– MC of the 21st slide = 15


• Full-reinvestment total cost (FRTC): sum total of all of the firm’s operating

costs plus …

• … the cash flow needed to achieve a cost-of-capital return on long-run

sunk investments needed to enter the business and grow it. This is called

the capital charge

• Thus: FRTC = TC + capital charge

• Full-reinvestment average total cost (FRATC): total cost per unit, i.e.,

FRATC = FRTC/Q

– Full-reinvestment cost per unit, averaged over all units produced


20

Textbook concept Consultant lingo Usually relevant for …

MC, marginal cost Marginal cost or

incremental cost

• Incremental changes in

production volume

• Pricing decisions

ATC, average total cost Cash cost • Capacity idling or

withdrawal decisions

• Dropping product lines

FRATC, full-reinvestment

average total costs

Full reinvestment cost • Capacity expansion

decisions

• New market entry

decisions

• R&D investment

decisions


Capacity

(kt)

Cash Cost

(cents

per lb) Company Country

Cawse 4.4 58.5 Centaur Mining Australia

Murrin Murrin 27.0 81.4 Anaconda Nickel Australia

Soroako 50.0 100.3 Inco Indonesia

Leinster 35.9 131.3 WMC Australia

Mt Keith 42.0 138.7 WMC Australia

Raglan 21.0 139.5 Falconbridge Canada

Ontario Division 103.0 142.3 Inco Canada

Kambalda 12.0 154.1 WMC Australia

Sudbury 40.0 165.9 Falconbridge Canada

Cerro Matoso 28.8 171.9 Billiton Colombia

Manitoba Division 46.0 205.0 WMC Canada

Falcondo 32.0 205.0 Falconbridge Dominican Republic

Forrestania 7.7 218.2 Outokumpu Australia

Based on data from: Minecost.com, World Mine Cost Data Exchange

Data altered for illustrative purposes.

Cash Costs By Nickel Mine in Global Nickel Industry, 2004

Mine


Cumulative Capacity (kilotons per year)

Ca

sh

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(ce

nts

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)

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INC

0

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a N

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INC

O

• Represent each plant by a bar whose width is plant capacity and height is cash cost.

• Rank each plant in “merit order” --- lowest cash cost to highest cash cost.

Centaur Mining

WM

C

Full-reinvestment

cost of

hypothetical

new capacity



Ca

sh

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(ce

nts

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)

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0 50 100 150 200 250 300 350 400 450 500

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lco

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INC

O

• This tells us how much would be supplied in the long run at various possible market

price scenarios!

• If average price is expected to be 125 over the foreseeable future,

the three shaded plants would stay open

• Other plants are better off being idled or shut down

• Total supply at price of 125 is 81.

WM

C

125

81

Ou

toK

um

po

WM

C

24

INC

0

An

aco

nd

a N

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el

Centaur Mining


• It depends on the question!

• If the question is: “How do changes in prices on a week-to-week or month-

to-month basis affect market supply?” Use marginal cost

– Short run industry cost curves

• If the question is: “How do changes in prices over a longer period of time

(say 1 year out and beyond) affect market supply?” Use cash cost for

existing plants and full reinvestment cost for potential plants that haven’t

been built

– Long-run industry cost curves



0

50

100

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300

0 50 100 150 200 250 300 350 400 450 500

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lco

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An

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a N

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INC

O

Centaur MiningD1

Ca

sh

co

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(ce

nts

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r p

ou

nd

)

INC

0

D2

Ou

toK

um

po

WM

C



0

50

100

150

200

250

300

0 50 100 150 200 250 300 350 400 450 500

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lco

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C

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C

WM

C

An

aco

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a N

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INC

O

Centaur MiningD1

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sh

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(ce

nts

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r p

ou

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)

INC

0

D2

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toK

um

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27

At this price,

quantity supplied = quantity

demanded (“market clearing

price”)



0

50

100

150

200

250

300

0 50 100 150 200 250 300 350 400 450 500

Fa

lco

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ge

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WM

C

WM

C

An

aco

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a N

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INC

O

(Ca

na

da

)

Centaur MiningD1

Ca

sh

co

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(ce

nts

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r p

ou

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)

INC

0

(In

do

ne

sia

) Ou

toK

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28

• Suppose price of electricity in Indonesia goes up, increasing the cash cost of

INCO’s Indonesian mine to 120, but not affecting the cash costs of other mines.

• What happens to the market-clearing price?



0

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100

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200

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300

0 50 100 150 200 250 300 350 400 450 500

Fa

lco

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WM

C

WM

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An

aco

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a N

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INC

O

Centaur MiningD1

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(ce

nts

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)

INC

0

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29

• Market-clearing price is not affected!

• Market-clearing price equals the cash cost of the highest-cost

producer needed to satisfy demand



0

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100

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0 50 100 150 200 250 300 350 400 450 500

Fa

lco

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WM

C

WM

C

An

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a N

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INC

O

Centaur MiningD1

Ca

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(ce

nts

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)

INC

0

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30

• INCO is the client.

• If demand curve is expected to be D1 for the foreseeable future,

what strategies would you recommend for INCO to increase its profitability

in the nickel business?



0

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300

0 50 100 150 200 250 300 350 400 450 500

Fa

lco

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C

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C

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a N

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Centaur MiningD1

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(ce

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INC

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31

• One possibility: capacity withdrawal



0

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Centaur MiningD1

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(ce

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)

INC

0

Ou

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32




0

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0 50 100 150 200 250 300 350 400 450 500

Fa

lco

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Centaur MiningD1

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(ce

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33


• … which shifts the cost curve …



Ca

sh

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(ce

nts

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0 50 100 150 200 250 300 350 400 450 500

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Centaur Mining

• … and increases the market-clearing price

• Is this good for Inco?

WM

C

D1

Ou

toK

um

po

WM

C

Inco gives up

… but gains


Microeconomics Primer

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