Managerial Economics: Applying the Tools Topic 2: Value Creation 2

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Managerial Economics Applying the ToolsTopic
2 Value Creation (2)

• Willingness to Pay
• Willingness to Sell
• Value Creation
• Paul Kerin Sam Wylie
• MBS Term 3, 2004

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Willingness-to-Pay

• Willingness-to-Pay (WTP) is the highest price
  that a buyer will agree to pay for a good or
  service.
• In other words
• WTP is the price at which the buyer doesnt care
  if he buys or walks away
• WTP is the price at which the economic profit
  from buying is zero

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Example

• Suppose a Sothebys antiques trader sees a Ming
  vase for sale in China. There will be 8000 of
  costs associated with bringing the vase to
  Australia and selling it. He is certain that he
  can sell the vase for 200,000. He is not passing
  up any other alternatives for this vase.
• His willingness to pay is the HIGHEST price that
  he will be willing to pay for the vase.
• How do we work this out?

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Step One model the buyers decision using a
decision tree

• Suppose the price of the vase to the buyer is
  given by p

Buy vase
200,000 8,000 p
Buyer
0
Dont buy
Buy vase
200,000 8,000 100,000 92,000
EXAMPLE p100,000
Buyer
0
Dont buy
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Step 2 Calculate how economic profit depends on
the price
Here it is easy The next best alternative is to
not buy the vase so the opportunity cost is 0.
Economic Profit 200,000 - 8,000 - p
For example, if p 100,000, the buyers
economic profit is 92,000. What if p197,000?
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Step 3 Calculate the highest price that just
leads to zero economic profit. This price is the
willingness to pay.
In our example, economic profit is 200,000 -
8,000 p So this equals zero if p
192,000. So 192,000 is the buyers willingness
to pay
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Common confusion

• If you make no profit why would you buy it? Why
  dont you need to get a margin?
• Remember we are talking about economic profit
  NOT accounting profit.
• Economic profit already includes the next best
  alternative. So it includes the opportunity cost
  of any funds tied up by the transaction, any
  opportunity cost of the buyers time, and so on.
  In other words, it has a margin built in.

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Example continued

• Suppose that the Sothebys trader has only room
  for one more item in his shipment, before he
  returns to Australia. He has seen another item
  available at a fixed price, and has calculated
  that he would earn 15,000 in profit from that
  item.
• How does this alter his willingness to pay for
  the vase?

Economic Profit is now 177,000 p. So his WTP
is now 177,000.
Buy vase
200,000 8,000 p 192,000 p
Buyer
15,000
Dont buy
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Why does a buyer need to know his or her
willingness to pay?

• To know how high to bid in an auction (e.g. for a
  house)
• To know your bargaining position for negotiation
• To avoid mistakes when dealing with complex
  business and everyday decisions

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Utility

• For firms seeking to maximise profits,
  willingness to pay can easily be expressed in
  dollar terms it is a business
• For individuals (e.g. consumers) willingness to
  pay is related to the pleasure/use they derive
  from them economists call this utility
• To keep things simple, we will talk about utility
  in dollar terms (but need to be careful. For
  example, does buying your 20th cup of coffee in
  one day give you the same pleasure or utility
  as your first?)
• Willingness to pay can be objective or subjective
  but either way it is an important concept for a
  decision maker.

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Utility and WTP

• Paul is thinking about buying a Segway on
  Amazon.com, for US 4950
• Utility from being the first person in Melbourne
  to own a Segway US 10,000
• (Utility from owning a Segway if Paul lived in
  San Francisco, where they are outlawed 0)
• buy 10,000 - 4,950
• Paul
• dont 0

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Application House Auction

• If you enter a house auction, you decide on a
  stopping price the price at which youll stop
  bidding, let someone else get the house
• Suppose your stopping price is 350,000
• Your stopping price is your Willingness to Pay
  (or just below it) youre just as happy to get
  the house for 350,000 as to walk away
• If you get carried away, and bid more than your
  stopping price, youll regret it!

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Example time and willingness to pay
Dana runs a logging mill. He currently uses a
Mobile Stacker to move logs. But his Stacker
needs replacing. He can either buy another
Stacker for 250,000 or a Portal Crane for 1m
(all prices include delivery and installation).
Both a Stacker and a Crane cost 280,000 per
year to operate. But the Stacker only lasts for 4
years while a Portal Crane lasts for 20 years. He
has decided that he will buy one or the other
(shutting the mill is not an option). Further, he
expects to continue in operations for at least
the next 20 years. But which should he buy?
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ASIDE Time is money!

• Suppose the interest rate is 5.
• Is getting 10,000 today the same as getting
  10,000 in 12 months time?

No. If you have the money today you can do
something with it today and not have to wait. For
example, you could invest the money and have
10,500 in 12 months time ? 10,000 today
10,500 in 12 months. The 5 interest rate on
bank accounts is like an exchange rate between
money you spend this year, and money you get (or
spend next year) 1.00 this year
1.05 next year
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ASIDE discount rates
Suppose that your firm has 2 possible sources for
an input the US market (where you have to pay in
US dollars), and the Australian market. The
exchange rate is currently 0.80 US dollars to 1
Australian dollar. then US 0.80 AUS
1.00 The inputs are available for US 450,000
plus AUS 50,000 transportation costs or for AUS
650,000 here with no transportation costs. Where
should you get your inputs? How do you make the
comparison? Have to convert everything to the
same currency, to compare
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ASIDE discount rates
Decision tree where everything is in Australian
dollars Divide the amount in US by 0.80, to
get Australian dollars. AUS
612,500 Source in US Firm
Source in Australia AUS 650,000 With
this exchange rate, its cheaper to get the goods
in the US but if the exchange rate improves in
the USs favour, the calculation may change
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ASIDE discount rates
Suppose MBS needs to make repairs to the
building it will cost 100,000 this year, or
104,000 if it waits until next year. If MBS
waits, the money can stay in the bank earning 5
interest. Whats left next year, in each
scenario? Repair today 0
MBS Repair next year
105,000 - 104,000 With this interest rate,
its cheaper to wait until next year if the
interest rate were lower, it would be cheaper to
go ahead
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Time is money!

• So 1 in one year is only worth 1/(1 r) in
  terms of present value today.
• Similarly, if you invest 1 today, in 2 years you
  would have 1(1 r)2.
• So 1 in two years is only worth 1/(1 r)2 in
  present value terms today.
• More generally, 1 in n years time is only worth
  1/(1 r)n in present value terms.
• This calculation (called discounting future
  payments into todays dollars) is the basis of
  net present value (NPV) calculation

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Example time and willingness to pay
Dana runs a logging mill. He currently uses a
Mobile Stacker to move logs. But his Stacker
needs replacing. He can either buy another
Stacker for 250,000 or a Portal Crane for 1m
(all prices include delivery and installation).
Both a Stacker and a Crane cost 280,000 per
year to operate. But the Stacker only lasts for 4
years while a Portal Crane lasts for 20 years. He
has decided that he will buy one or the other
(shutting the mill is not an option). Further, he
expects to continue in operations for at least
the next 20 years. But which should he buy?
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Buy Stacker
Dana
Buy Portal Crane
Note as the running costs are the same, these
will cancel out when comparing alternatives
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Buy Stacker
Dana
Buy Portal Crane
So, the relative cost depends on the interest
rate.
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r 5
Buy Stacker
250,000 205,676 169,210 139,209
114,528 878,623
Dana
1,000,000
Buy Portal Crane
So the Mobile Stackers are cheaper in present
value terms. (What assumptions are built into
the above?)
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WTP for a Portal Crane

• Suppose the manufacturer of Portal Cranes offers
  Dana a discount. What is his willingness-to-pay
  for a Portal Crane?
• What would happen to Danas willingness to pay
  for a Portal Crane if
• Interest rates fell from 5 to 3?
• If he was unsure whether or not his business
  would last for the next 20 years (and the resale
  value of both a Portal Crane and a Mobile Stacker
  is low)?

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Willingness-to-Sell

• Willingness-to-Sell (WTS) is the lowest price
  that a seller will agree to accept in return for
  a good or service.
• In other words
• WTS is the price at which the seller doesnt care
  if she sells or walks away
• WTS is the price at which the economic profit
  from selling is zero

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Discussion Point Tough bikkies ...

• Caroline baked excellent chocolate-chip biscuits
  in the Midwestern US
• She wanted to market them to supermarkets.
• However, she ran into the practice of slotting.
  Caroline was charged a high fee just to place
  products on the shelves. These prices ranged from
  3,000 to 25,000. She also had to buy back items
  unsold
• Caroline complained on 60 Minutes about
  discrimination against smaller firms

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response

• Supermarket manager
• I run a good store. Each yard of shelf space in
  my store generates about 10,000 in sales every
  week! If I put a new product on a yards worth of
  shelf space, and if it fails to sell well, I lose
  those 10,000 in sales. That is the real cost to
  me, just as if I had taken money out of the safe
  or written a check. It is a cost even if I get
  the new product for nothing or sell it on
  consignment. It is a cost, because sales are
  foregone or lost

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Going forward use the tools!

• Many of the decision-making tools discussed last
  week are important for calculating WTP and WTS
• dont consider sunk costs
• dont worry about costs that you pay under either
  decision, or revenues that you earn under either
  decision Focus on what makes your payoff
  different if you buy (or sell) versus if you
  dont.
• consider the time frame (fixed costs, variable
  costs)
• carefully consider what your best alternative to
  buying (or selling) is.
• (?consider all the alternatives)

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Value Creation

• Surplus
• the additional value created by reaching
  an agreement

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1 Buyer, 1 Seller When is trade possible?
pWTP
Buyer will accept a Price anywhere along red
interval
Seller will accept a Price anywhere along blue
interval
pWTS

• If WTP ? WTS, then trade is possible
• But if WTP lt WTS, no trade is possible there
  is no price that both will accept!

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Economic Profit of the buyer

• In most cases, the economic profit of the buyer
  is equal to (WTP P)
• Example of the Sothebys trader Hell sell the
  vase for 200,000, and he has 8,000 of costs.
• buy 200,000 - 8,000 - P
• Buyer
• dont 0
• Economic Profit (or consumer surplus)
• 192,000 P
• WTP - P

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Economic Profit of the seller

• In most cases, the economic profit of the buyer
  is equal to (P - WTS)
• Suppose the seller of the Ming vase can sell it
  to a museum for 120,000.
• sell P
• Seller
• dont 120,000
• Sellers Economic Profit (producer surplus)
• P - 120,000 P WTS

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Surplus created by trade

• What is the surplus created by trade? After the
  trade, the buyer is better off and the seller is
  also better off
• (we know theyre better off because they agreed
  to trade)
• Value created by trade
• economic profit of buyer economic profit
  of seller
• (WTP - P) (P
  - WTS)
• WTP P -
  P - WTS
• WTP - WTS
• Interesting! The value of trade has nothing to do
  with P, the price.

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Value division between buyer seller
Buyers Willingness-to-Pay
Price will be somewhere along red interval
Total Value Created
Suppliers Willingness-to-Sell

• There is no value without both the customer and
  the supplier
• ? partners in creating the pie (
  Co-opetition)
• The price is the way that value is shared
  between the customer and supplier ( how the pie
  is split).

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The Division of Value between Buyer and Seller
Value captured by...
Willingness -to- Pay
Buyer
Value Created
Price
Seller
Willingness-to-Sell
Bargaining/pricing determines where the price is
on the interval
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More generally, whats going on when firms reach
agreements with each other?

• Firms do 2 separate things
• Take actions that affect the size of the surplus
• Bargain over the division of the surplus
• Payments firms make to each other only
  affect the division of the surplus, not the size
  of the surplus.
• If watertight contracts can be written, firms
  will generally agree to make the surplus as big
  as possible.
• (Later well discuss the circumstances in which
  contracts are imperfect, and surplus isnt
  maximised.)

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The first step How do we maximise surplus?

• Think of the bargaining players as a big team or
  a family, doing whats best for the group.
• Look at payoffs to the whole group
• Example Two banks can either have their own
  network of ATMs for 1m each, or share a network
  that costs 1.2m.
• share
• (Bank A Bank B)
• dont

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How do we maximise the surplus?( making the
pie as big as possible)

• Surplus created by Sharing 0.8m
• (Separately these banks will decide how to split
  the cost of the network. In this simple case,
  theyll probably contribute 0.6m each to the
  cost of the network.)
• Some other sources of surplus
• Production and Trade
• Joint ventures
• Sharing facilities
• Bringing in complements to your product

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Value of trade on Survivor

• Two players want 1 fish each and 1 coconut each.
  They can either both build a fishing rod and
  climb the coconut tree, or they can trade.
• 1 hour to build a fishing rod, 1 hour per fish
• 3 hours for an inexperienced person to climb up
  down a coconut tree and pick coconuts.
• trade (payoffs in hours)
• Survivors 1 and 2
• dont
• Economic Profit of Trading utility from ___
  hours of scheming / talking to the camera

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Caveat on the value of trade!

• The idea of comparative advantage (that some
  people/firms/countries are relatively better at
  some tasks) reinforces the benefits of trade
• BUT You cant think of trade in these simple
  terms
• when there are long-term implications one spouse
  may not be willing to stay home with the kids, if
  his/her skills are deteriorating
• When youre trying to compensate someone in money
  for lost utility remember that utility is not
  really a money concept

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Complementor Technical definition

• Why might introducing a complement to a market
  create more surplus?
• Two firms are complementors if, to a customer
• WTP (A B) gt WTP (A) WTP (B)
• There will be more surplus, if a complement is
  present and without a complement, there may be
  no surplus!
• Examples
• Hardware and software
• Cars and car loans
• Desktop color printers and digital cameras
• Intel and Windows

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Complementor Technical definition

• For suppliers,
• WTS(AB) lt WTS(A) WTS(B)
• Economies of scale and scope
• Peak and off peak
• cricket and football
• network usage