Faculty
Professors Joseph M. Hall, Robert G. Hansen
Objectives
This course covers some of the most important concepts from microeconomics and illustrates how they apply to business analysis and managerial decision-making.
We then move from a view of how prices are determined in competitive markets to the pricing decision within a single firm. Topics include basic (monopoly) pricing; price discrimination (segmenting); and the use of advanced pricing strategies such as bundling and versioning to capture value. We will also discuss how these issues intersect with public policy in the form of regulation of monopoly, marketing and pricing tactics.
In our final session we will cover some “nuances” that expand upon our economic models, especially in regard to information economics and behavioral economics.
Throughout, the focus of the course will be on understanding the theory and principles sufficiently to apply them to understand real world issues and to make real world decisions. You should expect to leave the course with a firm grip on how economists think about business problems, and the ability to apply tools from the course to a variety of business situations.
Requirements
Exam/Case Presentation Schedule and Grading Breakdown:
CASE PRESENTATION I
Type: Due in Class, Group
Due: Before class on Friday, Sept. 18th
Weight: 15%
MIDTERM QUIZ
Type: Individual, Timed
Due: Sunday, Sept. 20th - 5:00 PM
Weight: 20%
CASE PRESENTATION II
Type: Due in Class, Group
Due: (a) Sections 2 & 4: Before class on TUESDAY, SEPT. 29th
(b) Sections 1 & 3: Before class on WEDNESDAY, SEPT. 30th
Weight 15%
FINAL EXAM
Type: Individual, Timed
Due: Monday, Oct. 5th, NOON
Weight: 40%
CLASS CONTRIBUTION
Type: Individual
Due: N/A
Weight: 10%
Quiz/Exam Reviews
Friday, September 18, 1:00-2:30
Friday, October 2, 3:00-4:30
Weekly Review Schedule
These weekly reviews will be run by a teaching assistant.
Saturday, September 12, 1:00-2:30
Friday, September 18, 6:00-7:30
Friday, September 25, 1:00-2:30
Friday, October 2, 5:00-6:30
Review Problems
Students often want to see problems similar to what will be on the midterm quiz and the final exam. We will put some old quizzes and exams in the course folder, along with solutions.
Materials
Course Text
Pindyck and Rubinfeld, Microeconomics, 7th Edition.
This text is available at both Wheelock Books and the Dartmouth Bookstore. We have examined previous editions of this text, back to the 4th. We believe the differences to be marginal, so you are welcome to use an earlier edition but it is up to you to verify that the chapters correspond. The text is an excellent reference, but be aware that we do not teach out of the text – instead, we focus on more specific cases or problems. The text should be looked upon as background reading, sometimes essential and sometimes supplemental. It is a book that has and will stand the test of time as a classic intermediate microeconomics book, one that you will always be glad to have on your bookshelf.
Class Attendance
You are expected to be in class and prepared each day.
Class Preparation
During the course, problems, cases, and other material will be distributed and used as a basis for class meetings. You should review and work through these materials before class. Group discussion is encouraged before and after class. Be advised that material within each case or problem only should form the basis for any answers to case questions, whether written or oral (i.e., you cannot appeal to what you found on Google as a justification for your case analysis.)
Previous Materials Use
Note that materials from previous offerings of ManEc should not be used or referenced, except as distributed by the faculty.
Quiz and Exam
We will have a midterm quiz and a final exam. Both are purely individual efforts. They will be open book, open note, and you may use a computer.
Case Presenations
The two case presentations are to be prepared with your study group. If your name is on the final product, you must have put significant effort into the process that produced the final product, an effort that is not significantly different from other members of the group.
TUCK HONOR CODE
Generally, we consider honor an individual matter guided by the policies set forth in the MBA Student Handbook. If there are any questions about what is expected, please raise them. If you encounter a question when we are not available, note your concern in writing and tell us how you proceeded.
Grading
Case Presentation I - 15%
Midterm Quiz - 20%
Case Presentation II - 15%
Final Exam - 40%
Class Contribution - 10%
Schedule
Session 1
Tues. 9/8 -Sections 2&4
OR
Wed. 9/9 -Sections 1&3
TOPICS: Costs, Opportunity Costs, Fixed Costs, Marginal Costs, Pricing, Bidding
Read before class: Pindyck and Rubinfeld: Chapter 1 (skim), Chapter 7 (only section 7.1)
Prepare: Littleton Bottleworks, Tuck Case
In this session we will briefly introduce the course and then move on to our first case discussion. Consider the following questions for class discussion (nothing is to be handed-in):
1. Build a cost model that will portray the current situation as well as help you analyze the impact of different bids for the new business. A template is available in the course folder to assist in your analyses.
2. The corporate finance manager has heard about the prospective deal with N-Y and said it is not worth consideration as it could never meet the 25% EBITDA target. What do you think about this position?
3. What do you calculate as the cost of producing the bottles for the new opportunity? In doing this, you can assume that the UBR line will not be shut down for the next two years even if this opportunity is lost. If Littleton won the business at a price equal to your estimated cost, what would Littleton’s overall financial situation look like? Should that be acceptable?
4. What do you think Littleton should bid in order to win the two-year contract of 45 million bottles annually? What will Littleton’s financial situation be if your bid is accepted? To help determine your bid, what further information would you like, and how would you use that information?
5. The corporate finance manager has recommended that the UBR line be shut down if no new business can be secured in the near future. How would you respond to this proposal? What essential information do you need, and how would you use it to make the decision?
Session 2
Thurs. 9/10-Sections 2&4
OR
Fri. 9/11 -Sections 1&3
TOPICS: Theory of Competitive Markets, Supply and Demand, Equilibrium and Efficiency
Read before class: Pindyck and Rubinfeld: Chapter 2 (through section 2.5), Ch. 7 (introductory section and section on costs in short run); Chapter 8; Chapter 9 (first two sections, focusing on consumer and producer surplus, and efficiency). NOTE: These chapters are core readings for the next several sessions. Look them over once now, and return to them at least once again!
In this session we begin our analysis of how markets allocate resources and the economic forces at work in markets. We will work to develop the fundamental economic understanding of how a competitive industry works. This day will be as close to “lecture” as we will get. There are many chapters from the text listed for reading, but they are background reading for the entire first module of the course and indeed the entire course. You should try to do as much of it as possible before this session, so you're somewhat familiar with the general ideas.
Session 3
Sat. 9/12
TOPICS: Competitive Industry Equilibrium, in the Immediate-, Short- and Long-Run
Read before class: Same as for Session 2.
Prepare: Competitive Industry Equilibrium, Tuck Note
In this session, we will finish our discussion of modeling a competitive industry. We will also cover the numerical problem titled Competitive Industry Equilibrium found in your course pack. Please prepare your solution to this problem before class, but note that it is not to be handed in. (Be aware that similar problems have appeared on past ManEc quizzes and exams.)
Read/investigate after class: Catherine Rampell, “Economix: Can OPEC Force Oil Prices Up?,” New York Times, Oct. 24, 2008; and Carola Hoyos and Javier Blas, “Dark Art of Assessing Oil Production Cuts,” FT.com, November 28, 2008.
Session 4
Mon. 9/14-Sections 2&4
OR
Tues. 9/15-Sections 1&3
TOPICS: Applying the competitive industry model: the oil tanker industry
Read before class: Excerpts from Teekay, Inc. 1999 Annual Report
Prepare: The Oil Tanker Shipping Industry (HBS 9-384-034)
The purpose of this case is to apply the principles of competitive markets theory to a real industry. We will see how fundamental economic forces determine not only the performance of the industry overall, but also the performance and valuation of an individual firm. Consider the following questions for class discussion (nothing is to be handed-in):
1. Be prepared to discuss the short-run economic forces of supply and demand for the industry. Using case facts, information from Teekay, and logic, determine the shape (elasticity) of the short-run demand and supply curves. What do the elasticities imply about the performance of important industry variables? Are there core facts that confirm your analysis?
2. Using the excerpts from the 1999 Annual Report, determine Teekay’s cost structure: What are the costs, fixed and variable, for owning and operating a typical Teekay ship for one day? You may assume a new tanker costs Teekay $38,000,000 and lasts 25 years with zero salvage value at the end. You may also assume a 10% discount rate.
3. Prices in this industry are quoted as “TCE”, which stands for “time charter equivalent”. TCE is essentially a daily price for the service of a tanker in transporting oil. Discuss, as quantitatively as possible, the impact on Teekay’s operating profits / earnings of changes in TCE.
4. Discuss the long run equilibrating forces in this industry. What are the important aspects of the long run forces?
5. Given the information you have, if you were asked for an estimate of the long-run price for this industry in 1999, what would you say?
6.On the basis of your analysis, what would you say about the advisability of companies involved in oil production, refining and marketing having their own in-house fleet of tankers? That is, should oil companies be vertically integrated into transportation?
Read/investigate after class: “Shipbuilding: Sink or Swim,” The Economist, March 28, 2009; and “Sea of Troubles: Shipping in the Downturn,” The Economist, August 1, 2009.
Session 5
Wed. 9/16-Sections 2&4
OR
Thurs. 9/17-Sections 1&3
TOPICS: Externalities, Pollution Taxes, Cap and Trade Systems
Read before class: Pindyck and Rubinfeld: Chapter 18 (especially sections 18.1-18.4); CBO Study, Feb. 2008, “Policy Options for Reducing CO2 Emissions” (PDF in Course Folder)
In this session we will return to our model of a competitive industry and supplement it with a pollution externality. We will use carbon emissions as the case in point. The CBO study, available as a PDF in course folder, can be skimmed quickly. A key question to consider for class: how do carbon taxes differ from a "cap and trade" system?
Read/investigate after class: N. Gregory Mankiw, “One Answer to Global Warming: A New Tax,” New York Times, Sept. 16, 2007; “Cap and Trade, With Handouts and Loopholes,” The Economist, May 23, 2009; and Peter Fairley, “Carbon Trading On The Cheap,” MIT Technology Review, July/August, 2009.
Session 6
Fri. 9/18
TOPICS: Applying the competitive industry model: the aluminum industry
Read before class: The Aluminum Industry in 1994 (HBS 9-799-129)
Prepare: Alusaf Hillside Project (HBS 9-704-458)
The purpose of this case analysis is to get you to apply some economic principles and general analytical thinking to a real-world industry and to an investment decision. The overarching goal is for you to come up with a solid framework for thinking about how Alusaf should make its decision on the smelter investment, and more precisely the cash flows that the Alusaf investment would yield. Of great import in those cash flows is the price of the smelter’s output. Thus, we are very interested in your analysis of what has and what will continue to determine price in this industry, and how that price will impact Alusaf’s investment decision.
The following questions and issues should serve as a guide for you.
1. How would you qualitatively assess the nature of competition and prospects for profitability in the aluminum industry? What are the most important features of the market from this standpoint?
2. In the course folder is a large spreadsheet giving cost information on all the world’s primary aluminum smelters (output is given in thousands of tons per year). Use this information to construct an industry short run supply curve: a curve that would show how much aluminum would be put onto the market at any given price. If Alusaf were to enter this industry, how would its cost position compare to that of existing firms?
3. What is the situation of the industry at the time of the Alusaf decision? Can you depict the situation graphically?
4. A key issue in Alusaf’s investment decision must be its assessment of prices in the medium and long run. How do you assess what prices are likely to be in the future, with the future being both the “near term” and the “long term”? Be as precise as you can.
5. Given your assessment of future prices, Alusaf’s variable costs, and the initial outlays associated with the new plant, can you provide an assessment of Alusaf’s expected ROI on the Hillside project? You can assume the plant lasts forever if it makes the analysis easier.
While this analysis is necessarily quantitative, we are less interested in a complicated cash flow analysis than in a good analysis of the fundamental economics, particularly in regard to price. Careful thinking and clear statements of your assumptions and sensitivity analysis are important.
This is a group assignment and we expect groups to come to class with 5-10 slides, prepared to present for 10 minutes or so, detailing and supporting your analysis and decision. Here are the key issues we expect to see in your presentations:
1. Overview of situation
2. Analysis of supply and demand in the short-run
3. Forecast of industry evolution over next five years
4. Forecast of long-term price of aluminum
5. Discussion of investment decision
Please bring a hard copy of your PowerPoint presentation to class to hand-in (one per group). We will likely rely on a combination of volunteers and “involunteers” to present their analysis in class.
Read/investigate after class: Robert Guy Matthews, “Alcoa Swings to a Loss as Aluminum Prices Decline,” The Wall Street Journal, April 7, 2009.
Mid-term Quiz
Distributed:
3:00 PM, Friday, 9/18
Due:
5:00 PM, Sunday, 9/20
Session 7
Mon. 9/21-Sections 2&4
OR
Tues. 9/22-Sections 1&3
TOPICS: Marginal Revenue, Marginal Cost, Monopoly Pricing
Read before class: Pindyck and Rubinfeld: Chapter 4 (sections 4.3, 4.4); Chapter 10 (emphasis on sections 10.1-10.4)
This session begins the second module of the course: pricing by firms with market power. Read over the textbook chapters and then skim the Note on Marginal Revenue. Note that nothing is to be handed-in.
Read/investigate after class: Josh Quittner, “What Makes a Best-Selling iPhone App?,” Time, December 4, 2008; and Micheline Maynard, “At Least the Airsickness Bags Are Free,” The New York Times, August 17, 2008.
Session 8
Wed. 9/23-Sections 2&4
OR
Thurs. 9/24-Sections 1&3
TOPIC: Price Discrimination
Read before class: Pindyck and Rubinfeld: Chapter 11
Prepare: Segmenting the Market, Tuck Note
We will continue our initial discussion of pricing by examining a numerical problem, described in the note Segmenting the Market. We will go over the problem in class. The more of it you can work beforehand, the more you will get out of our discussion. Note that parts (6) and (7) are rather challenging. Nothing is to be handed-in.
Read/investigate after class: Cabolis et. al., “A Textbook Example of International Price Discrimination,” Economic Letters, 95 (2007), pp. 91-95. (PDF in Course Folder)
Session 9
Fri. 9/25
TOPICS: Two-Part Pricing, Self-Selection
Read before class: Pindyck and Rubinfeld: Chapter 11
Prepare: Fun Fair, Tuck Note
We will move on to additional pricing techniques with the Fun Fair case. We will work through this case during class. Again, the more you can prepare before class the more you will get out of the session. Nothing needs to be handed-in.
Session 10
Mon. 9/28
TOPICS: Bundling, Tying, Pricing, Antitrust
Read before class: Pindyck and Rubinfeld: Chapter 11
Prepare: Profits from Scholarship: The Case of Academic Journal Pricing, Tuck Case
Questions to think about for class discussion:
1. From the point of view of CEO Haank, what is the ideal pricing structure for journals? Why?
2. What about from the point of view of an academic librarian – what do they think the ideal pricing structure would be? Why?
3. From an overall “society” point of view, what would the ideal pricing structure be?
4. What do you think about bundling? Is it profitable for the publishers? Why or why not? Why don't the libraries like it?
5. Is there a different form of bundling that might be both more profitable and satisfy the libraries’ demands?
6. What do you think about price discrimination in this setting – charging different libraries different prices?
There are a host of other issues that we can attempt to address: effects of mergers, the buying consortia, nature of demand and costs, entry conditions, etc. Come prepared to share your views and analysis.
Read/investigate after class: Two related postings by Prof. Hansen on bundling and iTunes/iPod/iPhone economics:
http://robertghansen.blogspot.com/2006/08/pricing-of-itunes-and-ipods-vive-la.html
and
http://robertghansen.blogspot.com/2008/07/some-economics-of-iphone-pricing.html
See Weblinks Below:
and
Also, a related piece involving an antitrust suit against Apple’s policies over iTunes and iPods: Tucker v. Apple Computer, US District Court Northern District of California, Case 5:06-cv-04457-JW. (PDF in Course Folder)
Session 11
Tues. 9/29-Sections 2&4
OR
Wed. 9/30-Sections 1&3
TOPICS: Versioning, Bundling
Read before class: Pindyck and Rubinfeld: Chapter 11
Prepare: Cambridge Software Corporation (HBS 9-191-072)
Prepare the Cambridge Software Corporation case as a group presentation. You will turn-in a hard-copy of your PowerPoint slides and we will be asking some teams to present, just as with the Alusaf case.
Your task is to recommend which versions of Modeler that Cambridge Software should produce and at what prices they should be sold. The focus of your presentation should be both what you think they should do and why. Here are a few tips:
1. Do not miss the 40% commission for sales of units through the bookstore channel.
2. Take the size of the market segment to be how many units would be sold in that segment, if you priced properly.
3. To get you started, consider what you would do if you were to sell only one version at one price: which version would you produce, and at what price would you sell it? All teams should address this question.
4. Any assumptions you make should be noted and justified.
Read/investigate after class: Shapiro and Varian, “Versioning: The Smart Way to Sell Information,” Harvard Business Review, Vol. 76(6), 1998. (HBR 4789).
There has been much written recently about consumer choice and limitations of rationality. An interesting summary of this work is provided by Richard Thaler and Cass Sunstein in their book Nudge (Penguin Books, 2008).
Session 12
Thurs. 10/1-Sections 2&4
OR
Fri. 10/2-Sections 1&3
TOPICS: Adverse Selection, Moral Hazard and Behavioral Economics
Read before class:
Pindyck and Rubinfeld: Chapter 17, Chapter 5 (section 5.5 only);
Geraldine Fabrikant, “Prepayment Penalties Add to Subprime Borrowers’ Troubles,” The New York Times, Sept. 13, 2007.
Prepare:
1. To get you thinking about these issues, consider the following numerical example: You are a bank and are considering offering a loan to an entrepreneur to enable her to undertake an investment project. The project requires $100,000 investment up front. To keep things simple as possible we will assume that you (as the bank) are considering lending that entire amount (that is, there is initially no equity). The interest rate will be 10%, and the loan is “no recourse,” i.e., if the entrepreneur cannot pay the loan and interest with the return from the project, you cannot go after her other assets.
The project will yield a return after one year, and that return is uncertain to both you and the entrepreneur. Suppose the return will be either $120,000 or $110,000, with each outcome being equally likely.
a. At the 10% interest rate, and from an “overall” viewpoint (abstracting away from the two individual parties) does this project make sense? What is its net present value? If it is undertaken according to the above terms, what is the distribution of profit/loss between the bank and the entrepreneur?
Now suppose the project becomes “riskier” in a very specific way: the two possible outcomes are $130,000 and $100,000.
b. What does this do to the project’s net present value?
c. What happens to the distribution of the project’s value across the two parties? Explain why this happens.
2. The use of prepayment penalties in subprime mortgages has been very controversial, as you can see from the New York Times article. There are two views, one that prepayment penalties are efficient, especially in that they solve an adverse selection problem. The other view is that prepayment penalties are predatory, in that they take advantage of consumers’ ignorance and behavioral biases. (The article by Stango and Zinman below discusses the latter view.)
a. What possible “adverse selection” problems might be present with subprime borrowers? Think to the above example: is there a chance that subprime borrowers are of different risks? If so, what kind will find a mortgage to be most attractive? If this is the role of the penalty, what should we expect to observe? What about the predatory story? If this is what is going on, what should we expect to observe?
b. Which theory do you find most credible? Are you prepared to argue for or against the abolition of prepayment penalties?
Read/investigate after class: Adverse selection and behavioral economics underlie many of the causes and consequences of the subprime and credit crisis of 2007-2009. The paper below by Ashcroft and Schuermann is one of the best summaries of the subprime crisis out there, and it relies a lot on adverse selection stories. The Stango and Zinman article is one piece in a large literature suggesting that consumers do not always make wise decisions, especially when it comes to credit. If you don't have time to look at any of these now, maybe at a later point you will.
1. Ashcraft and Schuermann, “Understanding the Securitization of Subprime Mortgage Credit” (PDF in Course Folder).
2. Stango and Zinman, “What do Consumers Really Pay on Their Checking and Credit Card Accounts? Explicit, Implicit and Avoidable Costs,” forthcoming in American Economic Review (PDF in Course Folder).
3. Hansen, “An Experiment in Adverse Selection”
http://robertghansen.blogspot.com/2007/09/experiment-in-adverse-selection.html See Weblink Below:
Monday - 10/5
FINAL EXAM
9:00 AM to NOON
** THE FINAL EXAM IS CUMULATIVE **
