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Unformatted text preview: J MANAGERIAL ECONOMICS MANAGERIAL ECONOMICS by JOEL DEAN GRADUA'!E SCHOOL OF BUSINESS COLUMBIA UNIVERSITY and JotL DEAN ASSOCIATES PRENTICE-HALL OF INDIA PRIVATE LIMITED New Delhi, ) 968 U. A. S. BANGALORE UN'VERSITY LIBRARY. nls Indian rlnt - (Original U. S. E tjo~ =A·,,_, y Rs2 8.~: R~. 78.75) . 22010 ''''',:' I • •••• " . . ~ ...... ~ . • ., •• ).. '''~··'·I~" MANAGERIAL fJt!iOlIlj()·.Mlfl&._ _ --=."''''" by joel o.,.n PRENTICE· HALL PRENTICE·HALL PRENTICE·HALL PRENTICE·HALL PRENTICE·HALL ." '''~;JG ", .. ,...... INTERNATIONAL, INC., Engl.-wood Cliff,. OF INDIA 'PRIVATE LIMITED, N.. w Delhi. INTERNATIONAL INC., London. OF CANADA LTD., Toronto. OF JAPAN, INC., Tokyo @ 1951 by Prentice.Hall, Inc., Englewood Cliffs, N. j., U.S.A. All right. reserved. No part of this book may be reploduc ..d in any form, by mim ..ograph or any other means, without permissioll in writing from th ... publishers. This East ..rn Economy Edition is the only authoris.-d, complete and un.b,·idged photo-offset reproduction of the latest American edition lpecially published and pric..d for ·.ale only in Ceylon, India, ami Pakistan. Reprinted in India by special arrangement with Prentice.Hall, Inc .. Englewood Cliffs, N. j., U.S.A. This book has been published with the assistance of the joint Indian American Standard Works Programme. Printed by G. D. Makhija at the India Offset Pr{'lI. Delhi and by Prentice·Hall of India Private Limited, New Delhi. Publish~ To PHYLLIS, JOEL, GRETCHEN, GILLIAN, and jURRIEN Acknowledgments ·to Publishers Tm:: AUTHOR wishes to acknowledge his gratitude to the pub· lishers who graciously permitted him to use parts of the following of his articles and monographs in this book: ARTICU:S "Cost Structures of Enterprises and Break·even Charts," American Economic Review, May, 1948. "When A Motor Vehicle Should Be Replaced," Sotiely of Automotive Engineers Quarterly Transactions, October, 1948. "Determination of Pricing Policy Under Competitive Conditions," Amerilan Management Association, 1949. "Problems of Product·Line Pricing," Journal of Marketing, January, 1950. "Product Line Policy," Journal of Busin(~ss, October, 1950. "Pricing Policies for New Products," Harvard Business Review, Novem her, 1950. "How Much to Spend on Advertising," Harvard Business ReviellJ, .J alluary, 1951. "Cyclical Policy on the Advertising Appropriation," Journal of Marketi~lg, january, 1951. "Measuring Profits for· Executive Decisions," Auountin15 Review, April, 1951. "Capital Rationing and the Firm's Demand for Capital," 7.eitschrift fiir ()kotlOmelrie, 19:'1. MONOGRAPHS Statistical Determination of Cost.i, With S/)ecial Refertmce to Marginal Costs, University of Chicago Press, 1936. Statistical Cost Fundio1lS of a Hosie,) Mill, University of Chicago Press, 1941. The Relation of Cost to Oul/)ut for a Leather Belt Shop, National Bureau oC Economic Research, 1941. Long-Run Behavior of Costs in a Chain of Shoe Stores, University of Chkago Press, 1942, with R. Warren James. Pricing from the Seller's Standpoint, Columbia University, 1949. Capital Budgeting,. Columbia Universi~y Pres.", 1951. Preface THE PURPOSE of this book is to show how economic analysis can be used in formulating business policies. It is therefore a departure from the main stream of economic writings on the theory of the firm, much of which is too simple in its assumptions and too complicated in its logical development to be managerially useful. The big gap between the problems of logic that intrigue economic theorists and the problems of policy that plague practical management needs to be bridgcd in order to give executives access to the practical contributions that economic thinking can make to top-management policies. In developing an economic approach to executive decisions, this hook draws upon economic analysis for the ('oncepts of demand, cost, profit, competition, and so on, that are appropriate for the dc<:ision, and it draws upon modern methods of cconometrics and markct r{'search for getting estimates of the relevant concept. For certain prob. lems it was necessary to develop some extensions and reformulations of economic theory, in the light of what a businessman knows or can reasonably expect to guess. Although the book is preoccupied with concepts rather than detailed techniques of estimation, it concentrates on those concepts that can be measured and applied to management problems. The book does not attempt to cover all aspects of either management or economics: it deals only with those phases of enterprise economics that strike me as particularly useful to the management of a large industrial corporation. Most of the analysis is an outgrowth of my consulting work, and I have learned much from my clients and from my consulting associates. My greatest debt is to Stephen Taylor of Joel Dean Associates. He has been of major assistance at every stage of this undertaking: hammering out the ideas, criticizing, editing, and re.writing my drafts, revising galleys, and preparing exhibits. Philip Brooks, another assocj· ate, developed many of the ideas in the course of our work for clients. He also suggested important improvements in the chapters on "Profits," "Costs," "Advertising," and "Capital Budgeting." Melvin de Chazcau, of Cornell U!liversity, read the entire manuscript with discernment and made many helpful suggestions. James Bonbright and Carl Shoup of Columbia Urtiversity have heartened and helped me throughout this undertaking; David Blank and Samuel Richmond bave also been vii viii PREFACE kind enougn to read much of the manuscript and make useful suggestions. Ralph Cordiner of General Electric Company, Frederick Donner of General Motors Corporation, John Kusik of the Chesapeake and Ohio Railway Company, and Albert Nickerson of SoconyVacuum Oil Company also read parts of the manuscript and heiped me with their comments. Miss Mary Hudson typed the whole manuscript, cheerfully, competently, and in many versions. It is a pleasure to express my gratitude for all this assistance. Yonkers January. 1951. J.D. < Table of Contents v(!) 1 Profits I Introduction II Nature of Profits . III Profit Measurement • IV Policies on Profit Maximization V Profits for Control lJ S 12 28 59 2 Competition. I Introduction II Kinds of Competitive Situations III Destructive Competition ......l-V The Nature of Monopoly and Oligopoly ,y Market Structure and Competitive Behavior VI The Monopoly Problem VII Measuring the Concentration of Economic Power 3 Multiple Products. . I Introduction II Opportunities for Multiple Products III Policy on Adding New Products IV Policy on Dropping Old Products V Summary. [email protected] ~ Demand Analysis I Introduction II Demand Theory ....-111 Methods for Forecasting Demand --IV Price Relations -v Income Relations . -vI Multiple Relations . . VII Demand for Automobiles VIn Demand for Steel Cost. I Introduction ....·..U Cost Concepts ....III ~st and Rate of Output vfV Cost and Size of Plant . V Costs of Multiple Productt • .....Yf Cost and Profit Forecuting ix 45 47 48 57 65 71 80 97 III 113 Il4 120 .' 133 137 139 141 145 164 177 191 210 220 229 247 249 257 272 296 515 524 TABLE OF CONT£NTS x 6 Advertising I Introduction II Contribution of Economic Theory ~I Methods for Determining Total Advertising Budget. • • IV Cyclical Fluctuations of Advertising V Measuring the Economic Effects of Advertising • (j) 8 Basic l)rice I Introduction II Pricing Products of Lasting Distinctiveness III Pricing Products of Perishable Distinctiveness IV Pricing Standard Products When 9>mpetitors Are Few. V Cost-Plus Pricing VI Cyclical Pricing Product-Line Pricing . I Introduction JI General Considerations In Product-Line Pricing. ill Specific Problems of Product·Line Pricing -..9- Price Differentials . I Introduction II Distributor Discounts III Quantity Discounts IV Cash Discounts V Geographical Price DiflRrentials ,. .J6 Capital I II v III IV V Budgeting. Introduction Demand for Capital Supply of Capital . Capital Rationing. Classification of Capital Expenditures S49 351 355 363 375 385 395 397 403 410 427 444 457 469 471 472 485 501 503 517 529 540 541 549 .,51 558 570 586 600 Charts Number I-I 1-2 2-1 2-2 4-1 4-2 4-3 ,1-4 4-5 4-6 4-7 Title Reported Income Compared to Real Income: Three Electrical Manufacturers-1935-1947 .............. Net Profits as a Per Cent of Net Worth for Leading Manufacturing Corporations-I 925-1 948 ................ Concentration of Productiv.c }o'acilities-19·17 .......... Distribution of Value of Products by Concentration Ratio Classes .......................................... Planned and Actual Purchascs of Hoincs and Duraule Goods, 1946-1949 ................................ Alternative Forms of Demand Functioll .............. P4ge 25 37 103 107 168 I8H Department Store Prices and Sales. Original Data .... Department Store Demand Function ................ Varieties of Income-Sales Function ................. , 189 Sales Distribution by Income Brackets-I!l35-19:16 .... Relation Between Disposab!e..lncome and Consumption Expenditures for Furniture, 1909-1941, Extended to 1950 and 1960 .......... , ... , . . . . .. . . . . . . . . . . . . .. 197 IH9 192 19B 4-8 Consumption Expenditures. 1929-1940, Grouped by Income Sensitivity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 201 4-9 Relation Between State and National Income Payments 209 4-10· Personal Consumption ExpendiLUres tor Furniture: Actual and Calcul,ted .............................. 212 4-11 Manufacturers' Domestic Sales of Electric Refrigerators 214 4-12 New Passenger Car Registrations .................... 216 4-U Insurance Sales and Seven Regional Factors ......... _.' 219 4-14 Relation of Passenger Car Sales to Disposable Income.. 222 4-15 'Relation of Passenger Car Sales to Supernumerary Income 222 4-16 Dem~d for Steel and Influencing Farton ........... 246 5-1 Three TyJ,lCS of Short-Run Cost Behavior .... _....... 276 5-2. Relation of Changes in Combined Cost to Changes in ,?utput: Hosiery Mill ............................ xi 291 x.ii Number CHARTS Title PAge ~ Partial Regressions of Total. Average, and Marginal Combined Cost on Output: Leather Belt Shop .. . . .. 5-4 Total, Average, and Marginal Combined Cost Derived From Partial Regression on Output: Hosiery Mill . . . . 5-5 Relation of Direct Labor Cost to Five Independent Factors: Furniture Factory ........................... 5-6 Theoretical Long-Run Cost Curve . . . . . . . . . . . . . . . . . . .. 5-7 Size-Cost Relation for Steam-Electric Generating Plants 5-8 Total-Cost Function for Shoe Store Chain. . . . . . . . . . .. 5-9 Average-Cost Function for Shoe Store Chain. .. . ...... 5-10 Break-Even Chart ................................. 5-11 Break-Even Point as a Function of Wage Rates-U. S. Steel Corp. ...................................... 5-12 Relation of Prices to Production Necessary to Yield a Given Profit, and Double that Profit: Automobiles .. 5-13 Profit Margin as a Function of Operating Rate. . . . . . .. 6-1 Short-Run Determination of Advertising Outlay by Marginal Analysis ................................... 6-2 Advertising Index and Federal Reserve Index of Industrial Production-192!1-1939 ...................... 6-3 Selling Costs in a Department Store: Coat Department. Total, Average, and Marginal Combined Cost Derived from Partial Regression on-Transactions . . . . . . . . . . .. 6-4 Relation of Advertising to Sales for a Proprietory Drug. Observed and Generalized. . . . . . . . . . . . . . . . . . . . . . . .. 7-1 Theory of Monopoly Price .............. . . . . . . . . . . .. 7-2 Prices of Six New Drugs from the Time They Were Introduced to 1949 ....... . . . . . . . . . . . . . . . . . . . . . . . . . . 9-1 Quantity Discount Structures . . . . . . . . . . . . . . . . . . . . . . .. 10-1 Private Business Investment in the United States-19291949 ............................................ 10-2 Demand for Capital. .. .. ...... .... ............ .. ... 10-3 Theory of Capital Rationing: Fluctuating Effective Rate 295 294 295 297 300 !Ill 313 328 340 340 314 356 377 389 391 405 421 530 552 561 590 Tables Number 2-1 2-2 2-3 4-1 4-2 4-3 4-4 Title PaM Profits in Cotton Textiles and AIl Manufacturing, Per62 centage to Capitalization . . . . . . . . . . . . . . . . . . . . . . . . . . Concentration of Productive Facilities-1947 .......... ]04 Distribution of Value of Products by Concentration Ratio Classes, 1937 .................................... 106 Classification of Industries by Number of Sellers and Degree of Product Differentiation. . . . . . . . . . . . . . . . . . 152 Price Elasticity of Demar.d for Agricultural Products. 1915-1929 ...... ,. . .. .. . . .. . .. . .. . .. .. . . .. . . . . ... ]86 Personal Consumption Expenditure Items Classified According to Sensitivity to Changes in Disposable Personal Income ............. ,...................... 202 Personal Consumption Expenditures in 1948 Classified by Income Sensitivity ............................ 205 4-5 Sensitivity of Income Payments of Each of the States to United States Income Payments-Based on Period 1929-1940 ...................................... 4-6 Retail Passenger Car Sales. Disposable Income, Minimum Cost of Living and Supernumerary Income, 1919-1938 4-7 Elasticity of Demand for Automobiles with Respect to Price, 1919-1938 ................................ 4-8 Elasticity of Demand for Automobiles with Respect to Income. 1919-1938- . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 4-9 Variation in Steel Sales Related to Variation in Demand Factors ......................................... 4-10 Elasticity of Demand for Steel. . . . . . . . . . . . . . . . . . . . . . .. 4-11 Basic Series Used in Statistical Analysis. . . . . . . . . . . . . . .. 5-1 Classification of CoSt Distinction .................... 5-2 Relation of Volume of Output to Cost of Manufacturing a Pound of Butter in 78 Creameries-Prairie Provinces. 1933 ............................................ 5-3 Estimated Costs and Size of Refinery . . . . . . . . . . . . . . . . .. 5-4 Bases Used in Application of Overhead. ............... ,!iii 208 221 227 227 249 244 245 271 301 302 317 xiv Number 5--5 5-7 7-1 7-2 8-1 8-2 8-3 9-1 9-2 9-3 9--4 9-5 9-6 10-1 TABLES Tille Relation of Production Indexes in Manufacturing to Total FRB Index ............................... . Profit Margins in Manufacturing Related to Rate of Operation ............... : ...................... . Relation of Industry Profits to FRB Ind.ex ........... . Degree of Adherence to Full Cost Principle ........... . Reasons for Adhering to Full Cost Principle ......... . Product-Line Cost Structure ....................... . Alternate Product-Line Price Structures ............... Unwcighted Aver::ges of Gross and Net Margins for Different Price Lines of Washing Machines .......... . Varieties of Non-Discriminatory Prices ............... . Trade Channel Discounts in Various Industries ..... . Net Prices Resulting from Spark-Plug Manufacturer's Schedule of Distributor Discounts ................. . Minimum Quantity Discounts and Quantity Required to Obtain Them-Selected Products ............... . Quantity Discount Structure for Grinding Wheels ... . Relative Prices of Grinding Wheels to One Class of Distributors, Combining Quantity and Material Discounts .. '...... " ............. " ... , ........... ,. Demand Schedule for CapitaL ...................... . Page 343 345 346 446 446 474 474 488 511 520 521 530 535 536 560 MANAGERIAL ECONOMICS Chapter 1 PR.OFITS I. INTRODUCTION II. NATURE OF PROFITS WHAT To EXCLUDE TyPES OF PROFIT THEORY Reward for Risk-taking Frictions and Imperfections Innovations SUMMARY III. PROFIT MEASUREMENT CONCEPTUAL CONFUCT SPECIFIC ISSUES Depreciation Treatment of Capital Gains and Losses Current vs. Historical Costs Contemporary-dollar profits Constant-dollar profits IMPACT ON BUSINESS D£ClSlONS SUMMARY IV. POUCIES ON PROFIT MAXIMIZATION REAsONS FOR LIMITING PROFITS Competitive Considerations Public Relations Labor Relations Customer Relations Maintaining Control Nonfinancial Amenilies STANDARDS OF REASONAISLE horm FONn of Standard Setting the Standard Capital-attracting rate of return The "plow-back" rate Normal earnings Poptl1ar conceptioru of reasonable eamin" Choosing a Standard SUMMARY V. PROFITS FOR CONTROL Chapter 1 Profits 1. INTRODUCTION A BUSINESS FIRM is an organization designed to make prof its, and profits are the primary measure of its success. Social criteria of business performance usually relate to quality of prodocts, rate of progress, and behavior of prices. But these are tests of the desirability of the whole profit system. Within that system, profits are the acid test of the individual firm's performance. The first purpose of this chapter is to bring out what is meant by the economic concept of profit. The word "profit" has different meanings to businessmen, accountants, tax collectors, workers, and economists, and it is often used in a loose, polemical sense that buries its real significance and destroys the basis for discussion. In appraising a company, we must first understand how profits arise, before we can decide what is and is not a profit. and before we can improve the company's profit position. . The second purpose of this chapter is to consider a few managerial aspects of profits. We shall discuss three kinds of problems: (I) profit measurement. i.e .• economic analysis of accounting data for poliCY-Inaking; (2) policy decisions on profit standards and profit goals; and (3) the use of profits for control purposes in a complex business organization. 1 11. NATURE OF PROFITS In the theory of income distribution. economists classify all income of the economy into types. according to the nature of its 1 There is a fourth kind of profit problem. which we will not take up In this chapter. namely, what to do with profits after they are made. This ill a financial problem that involves a strategic choice between paying out profits in dividends as oppclIed to reinvesting them. Thill choice enters into capital budgeting and promotional outlays to increase aalea and ill discuIIed in Chapters 10 and 6. It alIo enters into dcdsioDI 00 cash budgeting, liquidity preferencea. and lbort-cerm atemal iavestmalll-lDatterl outside the .:ope of this book. S PR.OFITS source. Wages are income from direct labor; interest is the income from letting other people use one's money; rent is the excess of the value produced by a productive factor over ,the payment needed to induce it to work; and profit is the excess of income over cost of production. Wages. interest. and rent have had a firm standing in theory for well over a century. but profit has always been a center of controversy. Wh<;n does it appear? Who produces it? Who gets it? 2 In a stationary economy, in which everything turns out as expected and people know exactly what their incomes will be. costs can be accurately imputed and the whole of the economic system can be distributed as wages. interest. and rent; so there remains no residual for profits. A firm can make agreements beforehand to pay as costs these incomes to the factors of production. But in the real world, incomes do not turn out as expected. Someone gets a bonus and someone else finds himself short. The resulting unexpec·ed residuals could be shared equally by all facton of production through a profit-sharing plan. but they usually are not. Most people would rather be able to count on a limited income than depend on the uncertain chance of striking a bonanza. In practice. almost everyone gets a commitment from his employer to pay a definite income. and one or a few people (those who own the equity) agree to take what i~ left as profit. Since p...
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