PowerPoint Slides © Michael R. Ward, UTA 2014

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.

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“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.

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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

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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

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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

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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

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Problem 4.2fEcon 5313

0 40,000 80,000 120,000 160,000 200,000 240,000$0.00

$1.00

$2.00

$3.00

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$5.00

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MCAC

Output

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it

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?• $0.7629

• 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.

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Extent Decisions• If MR exceeds MC, should you sell another unit?• Always?• If MC exceeds MR, how should you respond?• Always?

• 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.

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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

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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?

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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?

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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.

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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.

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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.

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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?

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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.

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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

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

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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

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