Short Run Cost Analysis And Pricing Strategies: An Economic Essay.

Costs of Production line and Labor

Your firm prints the novelty baseball cards that candy makers include in their bubble gum. Since you regularly sell 100,000 cards per week, you invested in four separate production lines that can each produce 25,000 cards in a standard 40 hour work week. Now a few of the candy makers are increasing their orders so that you will need to produce 150,000 cards per week, at least temporarily. If you produce these cards by adding a swing shift from 4 pm to midnight, you will have to pay workers time and a half. What does this imply for the shape of your short-run marginal cost curve? What does it imply for your pricing?

Nora's Nicest Knick Knacks has produces a variety of products sold as souvenirs. She started out printing local sayings on tee-shirts, e.g., FDNY, and purchased plain tee-shirts from a single supplier. Since then, she has added coffee mugs, key chains, souvenirs spoons and many other items. For each of these, she has lined up one or more suppliers. How does the change in the sourcing of her inputs affect how much of the value she creates that she gets to capture?

Hank's Honkytonk is a local bar and nightspot. On weekends, it requires a $5 cover charge to defray the costs of the live musical acts Hank brings in. This has worked wonderfully, as it generates capacity crowds and a long line of people waiting to enter. However, after the cost of
the acts, he still loses money on the weekends. What is his marginal revenue and marginal cost of a patron on weekends and how should he attempt to fix his unprofitability problem?

The Six Flags Over Texas amusement park in the middle of the Dallas-Fort Worth Metroplex has a tie-in marketing campaign with Coca-Cola during the summer. In local grocery stores, some Coke cans offer $5 off admission to the park. Why does Six Flags limit these cans so that none are sold further than 20 miles from the park?

A firm and its supplier are going to negotiate a deal every quarter. Since the supplier's cost is $10 million per quarter and the value to the firm is $14 million per quarter, there is $4 million per quarter to split between the two. However, they can hire a negotiation consultant for a quarter for $500,000. If neither hires the consultant, each expects to get half of the $4 million pot. If only one hires the consultant, it expects to get three-fourths of the pot minus the consultant costs. If they both hire consultants, they cancel each other out and they expect to get half the pot minus the consulting costs. They expect to repeat this process every quarter for the foreseeable future. Can they agree to ban the consultants?

A buyer for a department store must decide on which designs the stores will carry before he knows what the demand will be in the coming season. Choosing a poorly demanded design means lots of unsold merchandise and losses that are $200,000 on average. Passing on a highly demanded design means unsold merchandise and missing out on profits that are $300,000 on average. What probability of a design's success should he be in order to choose to carry it?

At an oral auction for a lamp, half of all bidders have a value of $50 and half have a value of $70. What is the expected winning bid if there are four bidders?

The costs of Production line are fixed while the costs of labour can be changed. (It is assumed the factory produces at a the lowest minimum cost currently. ) Assuming that labour is the only variable cost here,

MC = C_l.. 

C_l.. = Cost of Labour per unit of cards produced

Total Cost of Production is

TC= C_k + 100,000 C_l..

C_K = Total Cost per Unit of the capital Used (Capital = Production line Costs)

It is generally, assumed that , in the Short run, the capital is fixed and cannot change. It is the labour costs that are variable. Hence, the total change in costs will be the Labour Costs. Given that the labour has to be paid a time and half, new Marginal cost will be:

MC = 1.5 C_l.. 

The Total Costs will be

TC = C_k  + (1.5C _l  X 150,000)

Total cost = C_k  + 225,000 C_l

The change in costs is 125,000 C_L for 50,000 units. Hence, the change in cost per unit is 2.5 C_l.

In order to maximize profits, Marginal Revenue (Price) should equal Marginal Costs. (Chauhan 2009)Hence, the price should increase by 2.5 C_L.

The Short Run Cost Curve will move upward will the marginal revenue or price will move higher too.

Nora specializes in the job of printing, Nora can achieve greater economies of scale, if her total number of units printed increases. Nora can gain cost advantages, if she sources printing materials by the bulk from the suppliers (in addition to other reasons for achieving economies of scale. Nora’s Nicest Knick Knacks must attempt to buy in bulk from the suppliers, in order to gain economies of scale for any production, if she decides to increase production.

Nora gains value from diversification of product since not only does it help increase Nora achieve more sources of revenue but also possibly insure against the increases or decreases in demand of T-shirts.

Nora loses value from diversification at it reduces the possibility of specialization to some extent. If the diversification of product, has caused Nora to reduce her demand for T-shirts, then Nora may lose the advantage of bulk buying. However, there will be a “floor price” to the T-shirt that Nora buys. If Nora’s demand for T-shirts has exceed the output that is corresponding to the floor price, then there will be no negative impact on the diversification of the portfolio. The Portfolio diversification is expected to have only a positive impact. However if, the demand for Tshirts (Q) is lower than the demand corresponding the floor price, then there will be a loss of value due to the loss of gains from bulk buying.

Maximizing Profits and Marginal Revenue

In order to reduce the unprofitability, the bar must attempt to equate the Marginal Cost to Marginal Revenue since profits are maximized at this point. Hence, the Marginal costs must be decreased by way of increasing the number of customers (assuming capped by capacity Q^*).  The Marginal Cost of the consumer on the weekend is the Total Costs to Hank’s HonkTonk (total cost of operations on the weekend + Total Cost of the Live Music) / (Total Number of Customers)

TC_o + TC_LM / Q

Let us assume that the consumer spends the “x” amount on food and drinks. Let us assume that this is the maximum willingness to pay by the consumer.  This is the Marginal Revenue when no cover charge is introduced. Therefore, without a cover charge, the Total Revenue of the bar is Qx. Therefore, TC_o + TC_LM must be equal to or greater than “x”.

There are different pricing strategies that a bar can levy (Pricing strategies do not include any strategies to reduce the marginal cost). Below is a two part pricing strategy:

Strategy A: Set a low entry charge instead of a cover charge that covers the Marginal Cost with no free drinks or food available. However, this may decrease the demand for the ticket but may increase the Total Revenues, depending on the elasticity of demand for the tickets.

Strategy B: Keep the cover charge but increase the price of the cover. Such a pricing is called two part pricing. The long line of consumers suggests that the demand for the cover ticket is high as the number of people waiting to enter is high. Customers will be willing to pay as much cover charge as is their consumer surplus and no more. This is the maximum consumer surplus. (Food and Drinks + Entertainment) The cover charge can be increased to point “x” since this the customer is already willing to pay that much.

Let the price of the ticket be “P”. Let the profit per ticket price of the Six Flags of Texas be x.. A discounted price of (P-5) would have to be offered to every customer who enters the Six Flags over Texas with a promotional can.

The profits per ticket for the sale of every can , is reduced to $(x- 5).  On the other hand, the marginal cost of the tickets is higher due to promotion as the tie-up (probably) requires additional spending.

Economies of Scale and Diversification

The consumers who choose to buy Coca Cola, who may be outside of the 20 miles radius (or outside the Dallas Fortworth Metroplex may gain negligible, zero consumer surplus due to the promotion , if the promotion offers entry to only the Dallas Forthworth location since the cost of traveling to Dallas Fortworth nullifies the utility gained from the promotion. These customers are not expected to be repeat customers. Hence, the promotion may not be expected to improve the long run total revenue of the park.

If Six Flags over Texas targets the promotion towards the residents of the Dallas- Fortworth area, then the cans must be picked up by the residents of the Dallas Fortworth area or those people who are currently in the area.

In summation, the short run costs may or may not increase due to promotion. However, negligible or no short run marginal benefits would be expected from the promotion. Hence, the promotion should be restricted to grocery stores selling the promotional cans within the 20 miles radius.

The given scenario is a case of infinite repeated games. Given below is matrix of the expected gain, with or without games: The pay off without co-operation i.e the payoff when the two firms co-operate and do not hire a consultant is $2 million for both the firm and the supplier.

If the firm hires a consultant, then it gains ¾ of the gains i.e 3 million. The net gain is $ 3,000,000 - $ 500,000 i.e the net gain is 2,500,000. However, this gain is accrued only until the supplier does not retaliate. Let us call this process as Round 1 of the game. Assuming perfect information, the supplier may also employ a consultant to gain a greater share of the market. However, the hiring of the consultant will lead to capturing ¾ of the market share I,e  $3,000,000.  The net gain is $2,500,000. This is round 2

The process of hiring a consultant by the supplier will cause the firm to hire another consultant. In such a scenario, the gains that the firm stands to gain are valued at $3 million but the net gain is $2 million since the hiring of consultants will costs the firm $ 1 million. This is Round 3.

 The supplier will experience the same process with the same net gains in Round 4. Thus, the games can be repeated infinitely and the net gains and losses will decrease and increase with every round. Thus, the firms are better off by co-operating and stabilizing the net gains at $2 million.

Net Pay off with Co-Operation         Net Payoff with Non  Co-operation

Table 1 :Net Pay Off in every Round of the Game

	Supplier             Firm	Supplier Firm
Round 1	$ 2,000,000 $ 2,000,000	$ 1,000,000 $3,000,000
Round 2	$ 2,000,000 $ 2,000,000	$ 3,000,000 $1,000,000
Round 3	$ 2,000,000 $ 2,000,000	$ 1,000,000 $ 2,000,000
Round 3	$ 2,000,000 $ 2,000,000	$ 2,000,000 $ 1,000,000

Let the possibility of choosing the wrong merchandise be “x” and the possibility of choosing the right merchandise  will be (1-x) since whenever the wrong merchandise is not selected , the right merchandise is selected

In this case, x is less than 1 since the possibility of the buyer choosing the wrong merchandise always is 1.

The total expected losses, if the wrong merchandise is selected is 200,000 x  i.e  the average loss  X  probability of selection of the wrong  merchandise.

The expected profits from selecting the right merchandise is (1-x) 300,00.

For the buyer to have made the right decision, the expected losses of the merchandise must be less than or equal to the profits expected. The probability where the expected losses are equal to the expected profits is the threshold.

Thus, the threshold is

200,000 x =  (1-x) 300,000

Therefore,

200,000 x = 300,000 – 300,000 x

Therefore x = 0.6. The probability of the design’s failure that the firm should carry is 0.6.

Therefore, the probability of the design’s success that the firm must carry is 0.4 i.e the buyer must be right 40% of the time.

There is perfect symmetry of information available in this situation since there is oral bidding. Let the consumers that bid $50 for the lamp be A and B; let the consumers that bid $70 be C and D Hence, there may be a bidding war between the two consumers that are, the person bidding the higher bid wins. This sets the minimum bid at $5. Bidders A and B will be priced out of the auction, unless they are willing to bid higher.  However, the maximum bid will go to the person that bids the highest i.e. either consumer C or D. If the utility of the lamp derived for bidder C or D is higher than $70, then they will bid higher. The consumer with the highest utility will win the bid, since their willingness to pay will be higher.  

Chauhan, SPS (2009). MICROECONOMICS: Theory and Applications, Part 1. New Delhi, PHI Learning PVT. Ltd. ISBN8120337158.

Samuelson, Paul A and Nordhaus, William R. (2004). Economics: Seventeenth Edition. 2002 ed., New Delhi, Tata- McGraw Hill Publishing Company. ISBN0-07-048645-X