Prof. Besanko Micro Primer 2003

Microeconomics Workshop: Microeconomics Workshop: Fall 2003 Fall 2003

Professor David Besanko

These notes have been prepared for participants in a workshop sponsored by the Kellogg Consulting Club. They may not be reproduced or circulated without permission of Professor David Besanko.

Objectives and Road Map for the TalkObjectives and Road Map for the Talk

OBJECTIVES:• Provide primer on basic microeconomic concepts that will be useful for

consulting interviews• To illustrate how micro 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:• Supply and Demand Analysis• Price Elasticity of Demand• Relevant Costs and Decision Making• Profit-Maximizing Pricing Decisions• Decision Making in Oligopoly Markets• Sample Consulting Interview Case

© 2003 David Besanko and Kellogg Consulting Club2

1.1. Supply and Demand AnalysisSupply and Demand Analysis2. Price Elasticity of Demand3. Relevant Costs and Decision Making4. Profit-Maximizing Pricing Decisions5. Decision Making in Oligopoly Markets6. Sample Consulting Interview Case


Market Equilibrium: What Will the Market Price Be?Market Equilibrium: What Will the Market Price Be?

• In equilibrium, the market clears: quantity demanded equals quantity supplied.

• Why is P = $4,000 not an equilibrium? At this price, quantity supplied exceeds quantity demanded. There is excess supply. The price will be bid down.

• Why is P = $1,000 not an equilibrium? At this price, quantity demanded exceeds quantity supplied. There is excess demand. The price will be bid up.

2,5002,0001,5001,000500

4,000

1,000

0

Price ($ per metric ton)

D

S

2,670

1,310

Excess supplywhen P = $4,000

Excess demand when P = $1,000

Quantity(metric tons per year)


Case: Chicken BroilersCase: Chicken Broilers

1900 1950 1990

U.S. per capitaconsumption

Price(adjusted forinflation)

What accounts for this patternof prices and consumption?

PRIC

E an

d C

ON

SUM

PTIO

NIN

DEX

for B

RO

ILER

S

YEAR


Price

D1950D1990

S1950

S1990

market equilibrium:1950


Quantity


Price

D1950D1990

S1950

S1990

Key Demand Drivers• changes in consumer tastes• health concerns

Key Supply Drivers• technological progress• entry of new producers



Quantity


Demand and Supply DriversDemand and Supply Drivers

Demand drivers are factors --- other than the price of the product itself ---that affect the product’s demand.

Supply drivers are factors --- other than the price of the product itself ---that affect the product’s supply.

• Common supply drivers:– prices of key inputs in the

production process – number of active firms in

industry.– prices of other goods firms

could/does produce– state of technology– temporary “shocks”

• Common demand drivers:– market demographics– prices of other good– macroeconomic factors– marketing activity– consumer tastes


1. Supply and Demand Analysis2.2. Price Elasticity of DemandPrice Elasticity of Demand3. Relevant Costs and Decision Making4. Profit-Maximizing Pricing Decisions5. Decision Making in Oligopoly Markets6. Sample Consulting Interview Case


Price Elasticity of DemandPrice Elasticity of Demand

“Own” Price Elasticity of Demand: measure of the sensitivity of quantity demandedto price:

QP

PQ

PP

QQ

PQ ∆∆

=∆

∆

=,ε = rate of percentage change in quantityas price changes by one percent

pricein change percentage

quantityin change percentage

=∆

=∆

PP

QQ Price


Quantity

Inelastic demand

Elastic demand

Price Elasticity of DemandPrice Elasticity of Demand

“Own” Price Elasticity of Demand: measure of the sensitivity of quantity demandedto price:

QP

PQ

PP

QQ

PQ ∆∆

=∆

∆

=,ε = rate of percentage change in quantityas price changes by one percent

pricein change percentage

quantityin change percentage

=∆

=∆

PP

QQ Price


Quantity

Inelastic demand

$1.20

$1.00

1092

Elastic demand

Terminology ConventionsTerminology Conventions

In general, - < εQ,P < 0 8

If …

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

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

εQ,P = -1, we say demand is unitary elastic.

8


MarketMarket--Level Versus BrandLevel Versus Brand--Level Price Elasticities Level Price Elasticities of Demandof Demand

• 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?

• 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?


MarketMarket--Level Versus FirmLevel Versus Firm--Level Price Elasticities of Level Price Elasticities of DemandDemand

• 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.

• Price elasticity of market demand for automobiles is between -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.


Key Drivers of Price ElasticityKey Drivers of Price Elasticity

• Substitution opportunities: Do consumers have readily available close substitutes to which they can switch if necessary?


CarbonatedBeveragesDiet Colas ColasDiet Pepsi Beverages

ELASTIC INELASTICMore price inelastic(εQ,P less negative)

• Expense relative to budget: Do expenditures for the good account for a large fraction of a consumer’s budget?

Household Items(e.g., Salt, Napkins)

“Big Ticket” Consumer Durables

More price inelastic(εQ,P less negative)

ELASTIC INELASTIC

Case: Airline Pricing Experiments, Fall 2002Case: Airline Pricing Experiments, Fall 2002

• Last year at this time, 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?


Price Elasticity of Demand and the Effect of Price Elasticity of Demand and the Effect of Changes in Price on Total RevenueChanges in Price on Total Revenue

QP

PQ

PP

QQ

PQ ∆∆

=∆

∆

=,ε

( ) ( )

( )PQQQP

PQQ

PQPQ

PQPPQ

PQP

PTR

,1

1

)(

ε+=

⎟⎟⎠

⎞⎜⎜⎝

⎛∆∆

+=

∆∆

+=

∆∆×+∆×

=∆×∆

=∆∆

recall:

• Decrease in price has a dual affect on total revenue:– Revenue on each ticket sold goes down … but the number of tickets sold goes up! Which

effect dominates?– If rate at which tickets are sold goes up faster than rate at which price falls, then we’d

expect total revenue would go up– Not quite precise enough, though: what do we mean by “rate at which tickets are sold goes

up”, “rate at which price falls”?

First, some words …

Now, somemath…


If demand is elastic, i.e., εQ,P between -1 and -∞, thenand a decrease in price yields an increase in total revenue

0<∆∆

PTR

1. Supply and Demand Analysis2. Price Elasticity of Demand3.3. Relevant Costs and Decision MakingRelevant Costs and Decision Making4. Profit-Maximizing Pricing Decisions5. Decision Making in Oligopoly Markets6. Sample Consulting Interview Case


The Relevant Cost Principle: The Relevant Cost Principle: The Costs That Are Relevant to a Particular The Costs That Are Relevant to a Particular

Decision Are Those Whose Level is Affected By the Decision Are Those Whose Level is Affected By the DecisionDecision

• 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


Relevant Costs and Decision MakingRelevant Costs and Decision Making

• Company incurs $50,000 per year in labor and materials costs at the current rate of volume

• It has signed a five-year lease on the facility that entails an annual payment of $70,000: the company cannot get out of this lease.

• A useful way to picture which costs are relevant to the decision is to draw a decision tree:

Labor and Materials Costs (000)

Leasingexpense (000)


Keep factory open andproduce at currentvolume

Revenue (000)

Totalcost(000)

$100 $50

$0 $0

$70

$70

$120

Shut the factory down

Your choice

$70

These costs varyacross the alternatives:they are relevant tothis decision

This cost does notvary across the alternatives:it is not relevant tothis decision

Case: Relevant Costs for a Pricing Decision*Case: Relevant Costs for a Pricing Decision*

• Client is market-leading producer of a variety of different types of synthetic fabrics used in a wide range of applications

• Client has asked for advice on how to price M-50, a particular fiber based on a blend of rayon, nylon, and other synthetic fibers.

• Current price is $4 per yard; client is considering setting a price of $3.

• Current quarterly volume is about 95,000 yards; expected volume if price is cut to $3 is 155,000.

• There is only one other supplier of M-50, and it is currently charging a price of $3 per yard. Our best available information suggests that the competitor will not cutits price if client cuts to $3 per yard.

• Some other information:– M-50 is produced in a multi-purpose plant that is also used to produce other

synthetic fabrics– Company sales people are paid straight salaries

© 2003 David Besanko and Kellogg Consulting Club21* Based on Beauregard Textile Company, HBS Case 9-191-058

Case: Relevant Costs for a Pricing DecisionCase: Relevant Costs for a Pricing Decision

Estimated Cost per Yard of M-50 at Various Volumes of ProductionM-50 Quarterly Production Volume in Yards of Material

35,000 65,000 95,000 125,000 155,000 185,000 215,000 245,000Direct Labor 0.860$ 0.830$ 0.800$ 0.780$ 0.760$ 0.740$ 0.760$ 0.800$ Material 0.400$ 0.400$ 0.400$ 0.400$ 0.400$ 0.400$ 0.400$ 0.400$ Materials spoilage 0.042$ 0.040$ 0.040$ 0.040$ 0.038$ 0.038$ 0.038$ 0.040$ M-50 department expenses

Direct* 0.198$ 0.140$ 0.120$ 0.112$ 0.100$ 0.100$ 0.100$ 0.100$ Indirect** 1.714$ 0.923$ 0.632$ 0.480$ 0.387$ 0.324$ 0.279$ 0.245$

General overhead*** 0.258$ 0.249$ 0.240$ 0.234$ 0.228$ 0.222$ 0.228$ 0.240$ Unit factory cost 3.472$ 2.582$ 2.232$ 2.046$ 1.913$ 1.824$ 1.805$ 1.825$

SG&A expenses**** 2.257$ 1.678$ 1.451$ 1.330$ 1.244$ 1.186$ 1.173$ 1.186$ Unit cost 5.729$ 4.260$ 3.682$ 3.376$ 3.157$ 3.010$ 2.978$ 3.011$

* Power, supplies, repairs** Depreciation and supervisory personnel*** Insurance, security, plant accounting, plant manager’s salary: allocated to M50 at rate equal to 30 percent of M-50

direct labor expenses**** Company selling, general, administrative expenses: allocated to M50 at a rate equal to 65 percent of M50 unit factory

cost



Price = $4 per yard

Price = $3 per yard

Client’schoice

Quantity Sold Revenue

Direct Labor Material

Material Spoilage

Direct Dept. Expense

Indirect Dept. Expense

Gen'lOH SG&A

95,000 $380,000 76,000$ 38,000$ 3,800$ 11,400$ 60,000$ X Y

155,000 $465,000 117,800$ 62,000$ 5,890$ 15,500$ 60,000$ X Y

relevant not relevant



Contributionto companyprofit$250,800

Price = $4 per yard

Price = $3 per yardPrice = $3 per yard

Client’schoice

Quantity Sold Revenue

Direct Labor Material

Material Spoilage

Direct Dept. Expense

95,000 380,000$ 76,000$ 38,000$ 3,800$ 11,400$

155,000 465,000$ 117,800$ 62,000$ 5,890$ 15,500$ $263,8100*$263,8100*

relevant

*$263,810 = $465,000 - $117,800 - $62,000 - $5,890 - $15,500


Key Cost ConceptsKey Cost Concepts

• Total cost (TC): sum total of the firm’s variable and fixed costs

• Average total cost (ATC): total cost per unit

• Marginal cost (MC): rate at which total cost changes as output changes

QTCATC =

QTCMC∆∆

=


IllustrationIllustration

• Total cost:

• Average total cost:

• Marginal cost:

QTC 5100+=

5100

5100

+=

+==

Q

QQ

QTCATC


[ ] [ ]

5

5

5100)(5100

=∆∆

=

∆+−∆++

=∆∆

=

QQ

QQQQ

QTCMC

1. Supply and Demand Analysis2. Price Elasticity of Demand3. Relevant Costs and Decision Making4.4. ProfitProfit--Maximizing Pricing DecisionsMaximizing Pricing Decisions5. Decision Making in Oligopoly Markets6. Sample Consulting Interview Case


What PriceWhat Price--Quantity Combination on this Demand Curve Quantity Combination on this Demand Curve Should the Firm Choose?Should the Firm Choose?

P ($ per unit)

1211109876543210

100

90

80

70

60

50

40

30

20

10

0

MC

D


Q (units per year)

To Evaluate the Profitability of a Change in Quantity and Price,To Evaluate the Profitability of a Change in Quantity and Price,We Compare Marginal Revenue and Marginal CostWe Compare Marginal Revenue and Marginal Cost


Marginal Revenue = ∆TR/∆Q= (B + E - A) ÷ ∆Q= ($80 - $10)/1 unit= $70 per unit

Marginal Cost = ∆TC/∆Q= E ÷ ∆Q= $30 per unit

1211109876543210

100

90

80

70

60

50

40

30

20

10

0

P ($ per unit)

A

B

MC

E

D

Q (units per year)

Marginal Revenue Changes as We Slide Down the Marginal Revenue Changes as We Slide Down the Demand CurveDemand Curve

Marginal Revenue at P = 90, Q = 1 = (B + E - A) ÷ ∆Q

= ($80- $10)/1 unit= $70 per unit

1211109876543210

100

90

80

70

60

50

40

30

20

10

0

MC

D

P ($ per unit)

B

E

A


Q (units per year)


1211109876543210

100

90

80

70

60

50

40

30

20

10

0

MC

D

P ($ per unit)

Marginal Revenue at P = 60, Q = 4 = (G + H - F) ÷ ∆Q

= ($50 - $40)/1 unit= $10 per unit

Marginal Revenue at P = 90, Q = 1 = (B + E - A) ÷ ∆Q

= ($80- $10)/1 unit= $70 per unit

F

G

H

B

E

A


Q (units per year)


1211109876543210

100

90

80

70

60

50

40

30

20

10

0

MC

D

P ($ per unit)

MR

© 2003 David Besanko and Kellogg Consulting Club32Q (units per year)

ProfitProfit--Maximizing Pricing: Marginal AnalysisMaximizing Pricing: Marginal Analysis

MCMRQ

QTC

QTR

Q

−=∆∆

∆∆

−∆∆

=∆∆

π

π

• Profits will go up if you ...- Expand output when MR > MC- Reduce output when MR < MC

Profits are maximized when the firm produces at a volume of output at which MR is just equal to MC


What PriceWhat Price--Quantity Combination Should the Firm Quantity Combination Should the Firm Choose?Choose?

1211109876543210

100

90

80

70

60

50

40

30

20

10

0

MC

D

P ($ per unit)

MR

MR > MC

MR > MC:we can increaseprofit by increasingQ

MR < MC MR < MC:we can increaseprofit by decreasing Q

© 2003 David Besanko and Kellogg Consulting Club34Q (units per year)


Profit is Maximized at the PriceProfit is Maximized at the Price--Quantity Quantity Combination at Which Combination at Which MRMR = = MCMC

Q (units per year)

1211109876543210

100

90

80

70

60

50

40

30

20

10

0

P ($ per unit)

MR3.5

MC

D

MR = MC(the “sweet

spot”)65


ProfitProfit--Maximizing Output With a “Consultant’s” Cost Maximizing Output With a “Consultant’s” Cost Curve.”Curve.”

$/ton

$1.00

$1.50

0 100 150 175

MC$2.00

PLANT 1 PLANT 2 PLA

NT

3

Q (tons per year)

$2.50 • Height of each blockis the MC of producing in each plant.

• What is the profit-maximizingprice and volume?

capacity plant 1

MR

D

Marginal Revenue Depends on Price ElasticityMarginal Revenue Depends on Price Elasticity

Q (units per year)

P ($ per unit)

100

10

0

DA

150

7

A

B

initialprice

• Initial price is $10, and initial quantity is 100 units

• We want to increase Q by 50 units ⇒ our new P must be $7/unit

• MRB = (B – A) ÷ 50= (350 – 300)/50= $1.00 per unit, or 14.3% of new price


Marginal Revenue Depends on Price ElasticityMarginal Revenue Depends on Price Elasticity

P ($ per unit)

Q (units per year)


100

10

9

0

DA

DB

150

A

B

When demand is more elastic, MR is a bigger fraction of price

Along which demand curve is thetemptation to increase volumegreater?

• Initial price is $10, and initial quantity is 100 units

• We want to increase Q by 50 units ⇒ our new P is $9

• MRB = (B – A) ÷ 50= (450 - 100)/50= $7.00 per unit, or 77.7% of new price

initialprice

Marginal Revenue and ElasticityMarginal Revenue and Elasticity

• Return to our formula for marginal revenue:

QQPPMR

∆∆

+=

• If we rearrange terms in this formula, we get this:

⎟⎟⎠

⎞⎜⎜⎝

⎛∆∆

+=PQ

QPPMR 1

continued …


Marginal Revenue and ElasticityMarginal Revenue and Elasticity

• But now recall the definition of the price elasticity of demand, whichwe denote by E:

QP

PQ

PP

QQ

PQ ∆∆

=∆

∆

==pricein change %

quantityin change %,ε

PQ

QP

PQ ∆∆

=,

1ε

⇒

• Plugging in to the formula on the previous slide gives us a formula for MR in terms of the price elasticity of demand:


⎟⎟⎠

⎞⎜⎜⎝

⎛+=

PQ

PMR,

11ε

Inverse Elasticity Pricing Rule (IEPR)Inverse Elasticity Pricing Rule (IEPR)

PQ

PQ

PMCP

MCPMCMR

,

,

1

11

ε

ε

−=−

⇒

=⎟⎟⎠

⎞⎜⎜⎝

⎛+⇒=

Inverse Elasticity Pricing Rule

Percentage Contribution Margin (PCM)

• IEPR in words: At the optimal monopoly output the markup of price over marginal cost --- the percentage contribution margin ---is inversely proportional to the price elasticity of demand.


Case: Pricing a Proprietary Chemical CompoundCase: Pricing a Proprietary Chemical Compound• Client:

– Specialty chemical producer selling a version of TiO2, called TiO2+, produced via a proprietary process.

– Higher purity and superior refractive index– Two major end-user segments: paint industry

and high-pressure laminate (HPL) industry.

• Pricing strategy:– Client sets price to “cover costs” and provide

return on investment. All customers charged a common price.

– Client increased price by 5 percent last year to cover increases in cost.

• Distribution strategy:– All TiO2+ distributed to customers from a

terminal situated on a major rail line. – Client does not “see” HPL customers because

product is sold to intermediary who packages TiO2+ in special way to facilitate the usage of TiO2+ in production of laminates.

• Paint industry:– Volume of TiO2+ sold to paint industry

customers fell by 17.5 percent between 2002 and 2003.

• HPL industry:– Volume of TiO2+ sold to HPL industry declined

by 10 percent between ’02 and ‘03

How can client unlock additional profitability through its pricing strategy?


Quick and Dirty Estimates of Price Elasticity of Quick and Dirty Estimates of Price Elasticity of DemandDemand

• Paint industry seems to have more elastic demand for TiO2+ than HPL industry

• HPL: %∆P = 5%, %∆Q = -10%, implying εQ,P = -2.

• Paint: %∆P = 5%, %∆Q = -17.5%, implying εQ,P = -3.5.

• So What?


Customize Price According to Price ElasticityCustomize Price According to Price Elasticity

• We can compute MR:– MRPaint = P(1 + 1/εPaint) = 10(1 + 1/(-3.5)) = $7.14– MRHPL = P(1 + 1/εHPL) = 10(1 + 1/(-2)) = $5.00

• We don’t know marginal cost, but we can still identify a change that will increase profit at zero cost. Can you see it?


Customize Price According to Price ElasticityCustomize Price According to Price Elasticity

• We can compute MR:– MRPaint = P(1 + 1/εPaint) = 10(1 + 1/(-3.5)) = $7.14– MRHPL = P(1 + 1/εHPL) = 10(1 + 1/(-2)) = $5.00

• We don’t know marginal cost, but we can still identify a change that will increase profit at zero cost. Can you see it?

• Zero cost way to increase profits– Increase price to the HPL segment. Demand will fall by -∆Q.– Decrease price to the Paint segment so that demand goes up by ∆Q, just

enough to compensate for the decline in the HPL segment.– Costs don’t change– Revenue goes up by $7.15 ∆Q - $5.00∆Q– This is called price discrimination, price customization, or revenue

management.

• But how do you prevent arbitrage?


Price Customization ChallengesPrice Customization Challenges

• Segmentation: – Are there market segments that differ according to their price

elasticity of demand?

• Identification: – Can we identify which segment any particular customer belongs

to?

• Implementation: – Can we develop mechanisms (marketing, distribution,

packaging, etc.) to prevent arbitrage?


An Implementation Problem*An Implementation Problem*

• DuPont and Rohm and Haas charged 85 cents per pound to general industrial users of methy methacrylate, a plastic molding powder, but charged $22 per pound for a special mixture sold to manufacturers of dentures

• Attracted arbitageurs who purchased at 85 cents a pound, incurred modest conversion costs, and undercut DuPont and R&H’s denture price

• R&H considered a strategy of spiking the powder: adding arsenic to industrial powder.

• Other strategies?


*This example comes from Scherer, F.M. and D. Ross, Industrial Market Structure and Economic Performance, 3rd edition (Boston: Houghton Mifflin), 1991.

1. Supply and Demand Analysis2. Price Elasticity of Demand3. Relevant Costs and Decision Making4. Profit-Maximizing Pricing Decisions5.5. Decision Making in Oligopoly MarketsDecision Making in Oligopoly Markets6. Sample Consulting Interview Case


Types of Industry StructuresTypes of Industry Structures

Number of competitors in the market?Product differentiation?

Many Few One

Competitors produce differentiated products

Monopolistic competition

Examples: Local physicians marketsMutual fundsCredit card issuers

Differentiated product oligopoly

Examples:ColaAutomobilesBeer

Competitors produce identical or nearly identical products

Perfect competition

Examples: Fresh-cut rosesCopper miningChicken broilers

Homogeneous product oligopoly

Examples:Salt SteelEthylene

Monopoly

Examples:PC Operating systemsInternet domain name registry (until 2000)


Price Levels and Market Structure in an OligopolyPrice Levels and Market Structure in an Oligopoly

• Generally speaking, the more sellers a market includes, the more difficult it is to maintain prices above marginal costs. Why?

• More competitors ⇒ bigger (in absolute value) brand-level price elasticities (due to greater substitution opportunities for consumers)– Thus: price cuts becomes a more tempting competitive “weapon,”

resulting in lower PCMs (remember the IEPR).

• Fewer competitors ⇒ easier for firms to independently and tacitly to work their way toward the price a monopolist would charge …and avoid the paranoia that leads to unilateral price cutting. Why? – More fertile setting for price and/or capacity leadership to emerge– Market more transparent– Less likely that mavericks or rogues will disrupt industry discipline– Lower likelihood of disagreement about most advantageous price


Case: Global Nickel Industry in 1999Case: Global Nickel Industry in 1999

Cash Costs By Nickel Mine in Global Nickel Industry, 1999

Cash Cost (cents per lb)

58.581.4

100.3131.3138.7139.5142.3154.1165.9171.9180.6183.7218.2

Capacity (tonnes)

4.427.050.035.942.021.0

103.012.040.028.846.032.0

7.7

CompanyCentaur MiningAnaconda NickelIncoWMCWMCFalconbridgeIncoWMCFalconbridgeBillitonIncoFalconbridgeOutokumpu

CountryCawse AustraliaMurrin Murrin AustraliaSoroako IndonesiaLeinster AustraliaMt Keith AustraliaRaglan CanadaOntario Division CanadaKambalda AustraliaSudbury CanadaCerro Matoso ColombiaManitoba Division CanadaFalcondo Dominican RepublicForrestania Australia

© 2003 David Besanko and Kellogg Consulting Club51source: Minecost.com

World Mine Cost Data Exchange

Industry Supply Curve: Global Nickel Industry, 1999Industry Supply Curve: Global Nickel Industry, 1999


Cumulative Capacity (kilotons per year)

Cas

h co

st p

er u

nit (

cent

s per

pou

nd)

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Centaur Mining

Each bar represents an individual nickel mineWhat will the market price be?

WM

C

Industry Supply Curve: Global Nickel Industry, Industry Supply Curve: Global Nickel Industry, 1999: What Do We Learn?1999: What Do We Learn?

0

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Centaur Mining

Price is set by the “marginal” producer: firm whose capacity is just “outside” the market

Cas

h co

st p

er u

nit (

cent

s per

pou

nd)

D, industry demand curve

142.3



Industry Supply Curve: Global Nickel Industry, 1999 Industry Supply Curve: Global Nickel Industry, 1999 Strategic AnalysisStrategic Analysis

0

50

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INCO is the client: What strategies would you recommend for INCO to increase profitability in the nickel industry?

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1. Supply and Demand Analysis2. Price Elasticity of Demand3. Relevant Costs and Decision Making4. Profit-Maximizing Pricing Decisions5. Decision Making in Oligopoly Markets6.6. Sample Consulting Interview CaseSample Consulting Interview Case


Situation: Broadly DescribedSituation: Broadly Described

• Client is a wholesale distributor of a variety of food products. Client has a steady stream of business, but is looking to unlock additional profitability from its existing line of business.

• Your question: What major areas would you want to look at to assess how client could increase profitability?


Situation: Some Additional BackgroundSituation: Some Additional Background

• Market economics– Industry demand growing at the rate of GDP– No new competitors have entered the market in the last several years

• Company’s position and characteristics– Client is industry market share leader– Products sold to a range of customers, primarily hotels and restaurants,

ranging from high-end to low-end– Gross margins: generally above average, but dependent on customer and

product

• Competitive dynamics may depend on the region


Some Additional BackgroundSome Additional Background

1997


5%

40%

55%

Client Competitor #1 Competitor #2 Others

Shar

e of

sale

s by

regi

on

0% 25% 50% 75% 100%

Asia

Europe

North America

ClientCompetitor

#1Competitor

#2 Others

Share of relevant market

20002000

15%

35%

50%

5%

40%

55%

19971997

More Background: More Background: Industry Evolution Over TimeIndustry Evolution Over Time

Client Competitor#1

Competitor#2

Others

Shar

e of

sale

s by

regi

on

Client Competitor#1

Competitor#2

OthersAsia

Europe

NorthAmerica

Shar

e of

sale

s by

regi

on

0% 25% 50% 75% 100% 0% 25% 50% 75% 100%

Share of relevant market Share of relevant market

How Would You Characterize the Industry in the U.S. and Asia in 2000? What are the Implications for Price-Cost Margins?


How Would You Characterize the How Would You Characterize the Industry in the U.S. and Asia in 2000? Industry in the U.S. and Asia in 2000?

What are the Implications for PriceWhat are the Implications for Price--Cost Margins?Cost Margins?

• The U.S. market can be characterized as a duopoly in which client is the dominant firm. In Asia, by contrast, the market is less concentrated.

• Price competition should be relatively softer in the U.S. market than in Asia:

– Fewer competitors in U.S. More fertile ground for communication and coordination strategies, such as price leadership.

– U.S. market probably more transparent (e.g., better knowledge of competitor costs, easier to track competitor moves), engendering less paranoia.

– Firms probably face more price-elastic demand in Asia than in U.S.– Client is not the dominant firm in Asia, and has weaker incentive to preserve

industry discipline in Asia than in U.S.

• Price-cost margins should be higher in the U.S. than in Asia, and prices in Asia may tend toward marginal cost.


““Generic” Strategies for Unlocking Additional Generic” Strategies for Unlocking Additional ProfitabilityProfitability

• Increase gross margin– reduce COGS per unit– increase average revenue per unit– or both.

• Reduce SG&A expense ratio

• Increase market share

• Stimulate market/category sales

• Improve efficiency in utilizing fixed assets and working capital, (translates into need to use less capital to generate a given margin or amount of sales revenue.


““Generic” Strategies for Unlocking Additional Generic” Strategies for Unlocking Additional ProfitabilityProfitability

• Increase gross margin– reduce COGS per unit– increase average revenue per unit– or both.

• Reduce SG&A expense ratio

• Increase market share

• Stimulate market/category sales

• Improve efficiency in utilizing fixed assets and working capital, (translates into need to use less capital to generate a given margin or amount of sales revenue.

Not a panacea, butoften times thisis a place in whichhigh-impact changescan be made at low cost: • improved pricing• price customization• dropping unprofitable products from product line


Depicting DataDepicting Data

• Suppose we want to characterize the opportunities for improving the profitability of the individual products in client’s portfolio

• If we have a graph with gross margin on the y-axis, what might we want to put on the x-axis?

High

Gross Margin

Low


Low High

Depicting DataDepicting DataHigh

Gross Margin

Low 0HighLow

Price Elasticity of Demand


• What observations would you have if you found that the clients products are graphed as below?

• Which quadrants are areas of improvement for pricing?

• What should the graph look like?

Depicting DataDepicting DataHigh

Gross Margin

Low 0HighLow

Price Elasticity of Demand

• Inverse elasticity pricing rule suggests that ther should be inverse relationship between gross margin and price elasticity of demand?

• Additional profitability can be unlocked by rationalizing the client’s pricing


Documents

Prof. Besanko Micro Primer 2003