Principles of Economics Case Study Essay
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Principles of Economics Case Study Essay
Module 1 – Background
Principles of Economics
This module focuses on microeconomics, rather than macroeconomics. Microeconomics is the study of individual and company economic decisions. In this module, we analyze:
- supply, demand, and equilibrium (covered on the home page)
- how actors in a market behave to minimize opportunity costs and maximize profits and utility
- changes in consumer behavior in response to price changes (elasticity)
We will also look at how the structure of the competitive environment influences business decisions.
Opportunity costs
As was mentioned in the discussion on supply and demand, economics assumes that humans have an insatiable appetite for goods and services. Decisions must be made in how to allocate a finite supply at an acceptable price, and this is often done by determining how much or how little of the good to supply – or to consume. Often, these decisions involve some kind of sacrifice. In economics, these sacrifices are called opportunity costs.
In short, when we choose option A, we forgo the benefit we could gain from option B. In manufacturing, if a firm makes a given product, the opportunity cost would be the potential profit they could make from using their facilities to manufacture another product. Thus, opportunity costs are the cost of the choices we make: when production, time, or money are limited.
Here is an example: When you decided to enroll in a master’s program, your choice involved some sacrifices. You may have found that you had to limit overtime work opportunities, give up a moonlighting job, or even pass up a promotion in order to have time to study. Lost wages are the opportunity cost you incur in order to increase your earning potential in the future. Perhaps your opportunity costs were not financial, but personal. Perhaps you had to give up singing in the church choir, coaching your son’s little league team, or taking vacations. The point is, whatever you had to give up for a while to pursue your degree is an opportunity cost.
The concept of opportunity costs has applications in financial, manufacturing, and marketing decisions. It also has relevance to HR decisions regarding such topics as benefits packages, outsourcing decisions, and calculating turnover costs. The following article examines many of the costs associated with turnover. Although he identifies lost business as an opportunity cost, how many other costs described in the article could you reasonably call opportunity costs?
Reh, F. J. (2018) The high cost of employee turnover. Retrieved from http://management.about.com/od/money/a/The-High-Cost-Of-High-Employee-Turnover.htm
Fixed and Variable Costs
Business firms exist to earn a profit. Profits are increased when revenues (income) are maximized and costs are minimized. Executives and top leadership teams spend a lot of time thinking about how to control costs. They will frequently talk about fixed and variable costs when planning how to make operations more efficient and cost effective.
Here is a short video explaining the difference between fixed and variable costs:
McCarthy, J. (2012). Difference Between Fixed and Variable Costs – Quick Draw with Jim McCarthy, Goldstar CEO. Retrieved from https://www.youtube.com/watch?v=wBBfA9q8FSQ
The following article in the Trident Online Library explains how companies use variable pay incentives to lower the fixed costs of labor:
Coombs, J. (2014). Slow going ahead. HRMagazine, 59(12), 34-38.
Marginal Revenue and Cost
Two important concepts business managers and analysts use often are marginal revenue and marginal cost. (Marginal means “additional”.) These terms describe the total additional revenue earned from selling one additional unit over the cost of producing it.
The following article from the online version of the Houston Chronicle describes marginal revenues and marginal costs and explains their relationship to opportunity costs.
Metcalf, Thomas. (n.d.). What Are the Benefits of Marginal Costs Equal to Marginal Revenue? Small Business – Chron.com. Retrieved from http://smallbusiness.chron.com/benefits-marginal-costs-equal-marginal-revenue-59579.html
This easy-to-follow video explains cost and revenue equilibrium.
Lobsey, S. (2013) Marginal cost and marginal revenue. Retrieved from https://www.youtube.com/watch?v=iViIC3A3rr8
Marginal costs and marginal revenues are essential factors to consider when firms make pricing and production decisions for a given product or product line. However, a firm might operate at a marginal loss for a particular product, but still maintain a profitable company if total revenue exceeds total costs.
Marginal Utility
One way to increase profit is to control cost. The other way is to increase revenue by increasing demand. Utility is a term often used in economics, and it is used to describe the satisfaction an individual consumer derives from consuming a product or service. The higher the utility of the product, the more the consumer values it, and the higher the demand.
Marginal utility is the additional satisfaction the consumer derives from having an additional unit of the product. If a product has high marginal utility, the consumer will want to buy more because a greater quantity increases total satisfaction (think of your friend with a ridiculously large collection of shoes!). On the other hand, there is the law of diminishing utility.
Nichelle, E. (2012) Diminishing Marginal Utility. Retrieved from https://www.youtube.com/watch?v=d0AouX33WMk
Law of Diminishing Returns
Related to Marginal Utility is the Law of Diminishing Returns, which describes the point at which additional resources do not result in additional profit or benefit to the firm. It is particularly germane to HR professionals because it demonstrates that “as the number of new employees increases, the marginal product of an additional employee will at some point be less than the marginal product of the previous employee” (Investopedia, 2015).
For a detailed demonstration of how the law of diminishing returns works, view the following video:
Welker, J. (2012). The Law of Diminishing Marginal Returns in a Toy Truck Factory. Retrieved from https://www.youtube.com/watch?v=CfioxJ4E_h4
If you prefer a text explanation, read:
The Law of Diminishing Marginal Returns. (2015). EconomicsHelp. Retrieved from http://www.economicshelp.org/microessays/costs/diminishing-returns/
Price Elasticity of Demand
Elasticity of demand explains buyer behavior in response to price changes. This is a concern that you will run into often in business. Brand managers want to know how much less consumers will buy if they hike the price of a product by 5%. Production managers want to know how price changes will affect their labor and materials requirements on the assembly line. Marketers want to know how effective a price reduction will be at attracting new buyers. All of these concerns can be addressed by analyzing the sensitivity of demand for a product in the face of a price change.
Here’s another video from John Clifford, which will help explain this concept in easy-to-understand terms.
Clifford, J. (2014) Elasticity and the Total Revenue Test. Retrieved from https://www.youtube.com/watch?v=HHcblIxiAAk
If you prefer to slow down a bit and see the same concepts explained in more detail in text:
Price Elasticity of Demand (2010) NetMBA. Retrieved from http://www.netmba.com/econ/micro/demand/elasticity/price/
Knowing how consumers are likely to respond to price changes can reduce risk and uncertainty – a key concern of business operations. It can help in forecasting sales volume and sales revenue (and thus total revenue projections for the firm). For example, if elasticity is equal to (minus) 2, and a business decides to decrease prices by 10%, this will lead to a 20% increase in sales. Thus, if the cost of the product is $10 and reduced to $9.00, sales will increase from 100K units to 120K units. Projecting to increases in total revenue, the firm will see a rise from $1,000K to $1,080k.
Knowing the price elasticity of demand also helps in making decisions about pricing policy – a topic we shall visit in greater detail in Module 4. It should be clear that if demand is elastic, revenue will increase by reducing the price, but if demand is inelastic, revenue will be gained by raising price. Firms attempt to reduce the consumer’s perception of elasticity through advertising and other promotional activities.
It is helpful to know the factors that can affect price elasticity for a given product:
- Substitutes. If there are substitutes for the product, a consumer may just switch products in response to a price change. The more the available substitutes, the greater the elasticity. When thinking about substitutes, it is good to think broadly. For example, if the price of steak goes up, consumers may not only switch to hamburger, but they may switch away from beef altogether and eat more chicken – or macaroni and cheese. Advertising is often geared toward creating an image of “uniqueness” of a product and reducing the number of perceived substitutes.
- Luxury. If a good or service is seen as a “splurge” item, it tends to be more elastic. Again, the goal of advertising is to create a feeling that the consumer “must have” the product. Note, however, that this can depend on the income level of the consumer. For the very wealthy, luxury items may be viewed as necessities. Since they have the income to pay higher prices, these luxury items can be relatively inelastic.
- Habit. Habitually demanded products are less elastic. Think of how cigarette smokers continue to smoke in spite of rising prices.
- Proportion of income. The less expensive the item, the lower the elasticity. A $.25 rise in the cost of a fast food hamburger is likely to have much less of an effect on consumption than a $2,500 rise in the price of a car.
- Brand loyalty. To some degree, high loyalty to a specific brand reduces elasticity. Frequent flyer and other loyalty programs are designed to increase brand loyalty and reduce switching brands due to price.
- Life cycle. When a product is new to a market, there may be few substitutes and elasticity is low. As the product “ages” and competitors bring similar products to the market, there is greater choice and it is common to see sales, discounts, and rebates to stimulate consumption.
Competition and Market Structures
In previous sections of this module, we have seen how laws of supply and demand and elasticity affect prices. However, prices can also be affected by the competitive environment. As a rule, the greater the degree of competition between firms, the more sensitive price is to changes in supply and demand. Read about the different types of market structures at the following site. Be sure to click on the name of each type of structure for greater depth.
Market Structures (2017) Policonomics. Retrieved from http://www.policonomics.com/lp-market-structures/
How knowledge of market share helps us
When we know the characteristics of the market structure, we can understand and interpret a lot about why the firms we are working with make the decisions they make. We know the influences of market share on the firm, the range of its competitors, and the depth/breadth of the product line needed to be competitive.
Furthermore, knowledge of market structure gives us a means to envision the future: Will there be increasing or decreasing competition? Who will be the likely market leaders? Who would be best positioned to meet demand? What competitor’s goods or services are likely to become obsolete?
Finally, it lets us understand the existing barriers to entry in our industry and how the laws of supply and demand are influenced.
Videos
Clifford, J. (2014). EconMovies 4: Indiana Jones (Demand, supply, equilibrium, shifts). Retrieved from https://www.youtube.com/watch?v=RP0j3Lnlazs. Standard YouTube License.
Clifford, J. (2014). Elasticity and the Total Revenue Test. Retrieved from https://www.youtube.com/watch?v=HHcblIxiAAk. Standard YouTube License.
Lobsey, S. (2013). Marginal cost and marginal revenue. Retrieved from https://www.youtube.com/watch?v=iViIC3A3rr8. Standard YouTube License.
McCarthy, J. (2012). Difference between fixed and variable costs – Quick Draw with Jim McCarthy, Goldstar CEO. Retrieved from https://www.youtube.com/watch?v=wBBfA9q8FSQ. Standard YouTube License.
Nichelle, E. (2012) Diminishing marginal utility. Retrieved from https://www.youtube.com/watch?v=d0AouX33WMk. Standard YouTube License.
The Law. (2019, July 21). The law (or principle) of diminishing marginal returns (or productivity) explained in one minute. One Minute Economics. Retrieved from https://youtu.be/lt6LpwBNSlM. Standard YouTube License.
Welker, J. (2012). The law of diminishing marginal returns in a toy truck factory. Retrieved from https://www.youtube.com/watch?v=CfioxJ4E_h4. Standard YouTube License.
Required Reading
Journal articles can be located in the Trident Online Library. Access the library from the TLC Portal page.
Jawad, M., Lee, J. T., Glantz, S., & Millett, C. (2018). Price elasticity of demand of non-cigarette tobacco products: A systematic review and meta-analysis. Tobacco Control, 27(6), 689. doi: http://dx.doi.org.ezproxy.trident.edu:2048/10.1136/tobaccocontrol-2017-054056. Available in the Trident Online Library.
Lee, T. W., Hom, P., Eberly, M., & Li, J. (. (2018). Managing employee retention and turnover with 21st century ideas. Organizational Dynamics, 47(2), 88-98. doi:10.1016/j.orgdyn.2017.08.004. Available in the Trident Online Library.
Marginal revenue and marginal cost of production (2019). New York, NY: Newstex. Available in the Trident Online Library.
Price Elasticity of Demand. (2010). NetMBA. Retrieved from http://www.netmba.com/econ/micro/demand/elasticity/price/
Optional Reading
Allen, K. & Economy, P. (2008) Chapter 21: Econ 101 – The Basics of Economics in Complete MBA for Dummies (2nd Ed.). Hoboken, NJ: John Wiley & Sons. Available in the Skillsoft database in the Trident University Library.
Coombs, J. (2014). Slow going ahead. HRMagazine, 59(12), 34-38. Available in the Trident Online Library.
Law of Diminishing Marginal Returns. (2018). Investopedia. Retrieved from http://www.investopedia.com/terms/l/lawofdiminishingmarginalreturn.asp
Market Structures. (2017). Policonomics. Retrieved from http://www.policonomics.com/lp-market-structures/
Metcalf, T. (2018). What are the benefits of marginal costs equal to marginal revenue? Small Business – Chron.com. Retrieved from http://smallbusiness.chron.com/benefits-marginal-costs-equal-marginal-revenue-59579.html. Copyright © 2018, Hearst Newspapers, LLC.
Pettinger, T. (2015, July 21). The Law of Diminishing Marginal Returns. EconomicsHelp. Retrieved from http://www.economicshelp.org/microessays/costs/diminishing-returns/
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