Reference no: EM131853014

MANAGERIAL ECONOMICS ASSIGNMENT

Case study 1: Is Coca-Cola the ‘Perfect' Business?

What does a perfect business look like? For Warren Buffet and his partner Charlie Munger, vice chairman of Berkshire Hathaway, Inc., it looks a lot like Coca-Cola. To see why, imagine going back in time to 1885, to Atlanta, Georgina, and trying to invent from scratch a nonalcoholic beverage that would make you, your family, and all your friends rich.

Your beverage would be nonalcoholic to ensure widespread appeal among both young and old alike. It would be cold rather than hot so as to provide relief from climatic effects. It must be ordered by name - a trademarked name. nobody gets rich selling easy-to-imitate generic products. It must generate a lot of repeat business through what psychologist call conditioned reflexes. To get the desired positive condition reflex, you will want to make it sweet, rather than bitter, with no after-taste. Without any after-taste, consumers will able to drink as much of your product as they like. By adding sugar to make your beverage sweet, gains food value in addition to a positive stimulant. To get extra powerful combinational effects, you want to add caffeine as an additional stimulant. Both sugar and caffeine work; by combining them, you get more than a double effect, you get what Munger calls a "lollapalooza" effect. Additional combinatorial effects could be realized if you designed a product to appear exotic. Coffee is another popular product, so making your beverage dark in color seems like a safe bet. By adding carbonation, a little fizz can be added to your beverage's appearance and its appeal.

To keep the lollapalooza effects coming, you will want to advertise. If people associate your beverage with happy times, they will tend to reach for it whenever they are happy, or want to be happy. (Isn't that always, as in "always Coca-Cola"?) Make it available at sporting events, concerts, the beach, and at the theme parks- wherever and whenever people have fun. Enclose your product in bright, upbeat colors that customers tend to associate with festive occasions (another combinatorial effect). Red and white packaging would be a good choice. Also make sure that customers associate with festive occasions. Well-timed advertising and price promotions can help in this regard - annual price promotions tied to the fourth of July holiday, for example, would be a good idea.

To ensure enormous profits, profit margins and the rate of return on invested capital must be both high. To ensure a high rate of return on sales, the price charged must be substantially above unit cost. Because consumers tend to be least price sensitive for moderate priced items, you would like to have a modest "price point", say roughly $1 to $2 per serving. This is a big problem for most beverage because water is a key ingredient, and water is very expensive to ship long distances. To get around this cost-of-delivery difficulty, you will not want to sell the beverage itself, but a key ingredient, like syrup, to local bottlers. By selling syrup to independent bottlers, your company can also better safeguard it's "secret ingredients." This also avoids the problem of having to invest a substantial amount in bottling plants, machinery. Delivery trucks. And so on. This minimizes capital requirements and boost the rate of return on invested capital. Moreover, if you correctly price the key syrup ingredient, you can ensure that enormous profits generated by carefully development lollapalooza effects accrue to your company, and not to the bottlers. Of course, you want to offer independent bottlers the potential for highly satisfactory profits in order to provide the necessary incentive for them to push your product. You not only want to "leave something on the table" for the bottlers in terms of the bottlers' profit potential, but they in turn must also be encouraged to "leave something on the table" for restaurant and the customers. This means that you must demand that bottlers deliver a consistently high-quality product at carefully specified prices if they are to maintain their valuable franchise to sell your beverage in the local are.

If you had indeed gone back to 1885, to Atlanta, Georgina, and followed all of these suggestions, you would have created what you and I know as the Coca-Cola Company. To be sure, there would have been surprises as the primary driver in cold carbonated beverage sales. They did not foretell that widespread refrigeration would make grocery store and in-home consumption popular. Still, much of the Coca-Cola's success has been achieved because its management had, and still has, a good grasp of both economics and the psychology of the beverage business. By getting into rapidly growing foreign markets with a winning formula, they hope to create local brand-name recognition, scale economies in distribution, achieve other "first mover" advantages like the ones they have nurtured in the United states for more than 100 years.

In a world where the typical company earns 10 percent rates of return on invested capital, Coca-Cola earns three and four times as much. Typical profit rates, let along operating losses, are unheard of at Coca-Cola. It enjoys large and growing profits, and requires practically no tangible capital investment. Almost its entire value is derived from brand equity derived from generations of advertising and carefully nurtured positive lollapalooza effects. On an overall basis, it is easy to see why Buffett and Munger regard Coca-Cola as a "perfect" business.

Questions:

A. One of the most important skills to learn in managerial economics is ability to identify a good business. Discuss at least four characteristics of a good business.

B. Identify and talk about at least four companies that re you regard as having the characteristic listed here.

C. Suppose you bought common stock in each of the four companies identified here. Three years from now, how would you know if your analysis was correct? What would convince you that your analysis was wrong?

CASE STUDY 2

Optimal level of advertising

The concept of multivariate is important in managerial economics because many demand, and supply relations involve more than two variables. In demand analysis, it is typical to consider the quantity sold as a function of the price of the product itself, the price of other goods, advertising, income, and other factors. In cost analysis, cost is determined by output, input prices, the nature of technology and so on.

To explore the concept of multivariate optimization and the optimal level of advertising, consider a hypothetical multivariate product demand function for CSI, Inc., where the demand for the product Q is determined by the price changed, P, and the level of advertising A:

Q = 5,000 - 10P + 40A + PA - 0.8A^2 - 0.5P^2

When analyzing multivariate relations such as these, one is interested in the marginal effect of each independent variable on the quantity sold, the dependent variable. Optimization requires an analysis of how a change in each independent variable affects the dependent variables. The partial derivative concept is used in this type of marginal analysis.

In light of the fact that the CSI demand function includes two independent variables, the price of the product and advertising, it is possible to examine two partial derivatives: the partial of Q with respect to the price, or ∂Q/∂P, and the partial Q with respect to advertising expenditures, or ∂Q/∂A.

In determining partial derivatives, all variables except the one with respect to which the derivative is being taken remain unchanged. In this instance, A is treated as a constant when the partial derivative of Q with respect to P is analyzed; P is treated as a constant when the partial derivative of Q with respect to A is evaluated. Therefore, the partial derivative of Q with respect to P is

∂Q/∂P = 0 - 10 + 0 + A - 0 - P
= - 10 + A - P

The partial with respect to A is

∂Q/∂P = 0 - 0 + 40 + P - 1.6A - 0
= 40 + P - 1.6A

Solving these two equations simultaneously yield the optimal price / output - advertising combination. Because - 10 + A - P = 0, P = A - 10. Substituting this value for P into 40 + P - 1.6A = 0, gives 40 + (A - 10 ) - 1.6A = 0, which implies that 0.6A = 30 and A = 50(00) or $5,000. Given this value, P = A - 10 = 50 - 10 = $40. Inserting these numbers for P and A into the CSI demand function results in a value for Q of 5,800. Therefore, the maximum value for Q is 5,800 reflects an optimal price of $40 and optimal advertising of $5000.

One attractive use of computer spreadsheets is to create a simple numerical example that can be used to conclusively show the change in sales, profits, and other variables that occur as one approaches and moves beyond the profit maximizing activity level.

Questions:

A. Set up a table or spreadsheet for CSI, that illustrates the relationships among, quantity (Q), price (P), the optimal level of advertising, (A), the advertising-sales ratio (A/S), and sales revenue (S). In this spreadsheet, use the formula functions to set

Q = 5,000 - 10P + 40A + PA - 0.8A^2 - 0.5P^2
A = $25 + $0.625P
A/S = (100 x A)/S
S = P x Q

Establish a range from P to 0 to $125 in increments of $5 (i.e., $0, $5, $10, ...., $125). To test the sensitivity of all other variables to extreme bounds for the price variable, also set price equal to $1,000, $2,500, and $10,000.

B. Based on the CSI table or spreadsheet, determine the price-adverting combination that will maximize the number of units sold.

C. Give an analytical explanation of the negative quantity and sales revenue levels observed at very high price-advertising combinations. Do these negative values have an economic interpretation as well?