Monthly Archives: March 2012

QUESTIONS FOR CLASSROOM DISCUSSION ON BASIC MARKET STRUCTURE AND PERFECT COMPETITION

This real-world application is a bit different than our other applications because it actually doubts the economic theory we have been working with all semester. Could the supply curve actually be downward sloping in the “new economy?” Consider the following:

  • The author states that the products of the ‘new economy,’ “cost nothing at all to produce and distribute, and never get used up.” Do you agree with this statement?
  • Can you imagine a good or service with NEGATIVE marginal cost?!

Our classroom discussion will take place after exam #2!  

Posted by Prof. C-S

Basic Market Structure and Perfect Competition

Discussion on “So What’s New? Is the “New Economy” really different from the old one?” (Slate Magazine, Aug. 22, 2000)

 Summary

In ‘So What’s New?,’ Michael Kinsley challenges the classical economic model of supply and demand and proposes the idea that supply curves could be downward sloping. 

Kinsley discusses the idea of supply curves as being derived from marginal costs, because “each producer increases production until the cost of producing the net unit starts to exceed the price she can get” (Kinsley).  He says that marginal costs must be increasing (so that supply and demand curves always cross) and also that marginal costs must exceed average costs at market equilibrium price because the price of producing one more item must not exceed the selling price of the item (you have to make money on the sale or you wouldn’t bother selling!)  The problem these days, Kinsley says, is that market controversies have been rising when marginal costs fail to rise.  Rather, they “start out below average cost and stay that way” (Kinsley) effectively undermining the basic assumption in economics that marginal costs rise.

Kinsley uses the example of airline tickets, in which two tickets for the same flight with the same levels of service can cost $501 and $105; the marginal cost of filling an empty seat on a plane is less than a dollar, but you must charge some people $501 to cover your average costs across the board.

He also discusses the case of prescription drugs, in which the cost of producing one more pill is extremely cheap (a few cents perhaps), compared to developing the first pill of its kind, so some people must pay much more than that marginal cost of the pill to cover (if you will) the relatively cheap selling price of that first expensive (relative to cost of production) pill.

Basically, Kinsley’s argument boils down to the fact that even though we often assume that they do, marginal cost curves are not always upward sloping, because at some points in the lifecycle of the product, marginal cost will greatly exceed the selling price of the product (such as at the beginning phases of the market introduction of a new drug, or on the ‘early-bird specials’ that can be found on airline ticketing sites) but at later points in the product lifecycle the selling price of a product will greatly exceed the marginal cost (like when mass-produced mature drugs are cheap to roll out onto shelves and are sold at relatively exorbitant prices, or when it would cost nothing to board an extra passenger on a flight but the ticket costs $501.)

Kinsley goes further to discuss the implications of these marginal cost issues on the “new economy” in which information and knowledge cost hardly anything to reproduce and distribute, so marginal costs are virtually negligible.  Kinsley argues that in such a “new economy,” basic economic theory won’t necessarily help you predict prices, and that market competition that drives down prices could be “ruinous.”

Commentary

The market supply curve is assumed to be upward curving because we assume that a higher market price will induce a producer to sell more of a good.

Originally, the marginal cost curve is ultimately upward sloping, indicating that in the long run marginal cost increases as quantity increases.  For airplane tickets, average costs need to be met and since seats are there whether anyone is in them or not, marginal cost lowers as time before the flight decreases.  So the last seat may cost less than other seats.  In this case, the marginal cost curve would be downward sloping.  Prescription drugs would be similar.  The cost for producing the first pill is very high and lessens over time, so it would be downward sloping.  This means that new drugs could be produced and later sales help to pay the cost for the high marginal costs in the beginning.  Software is similar to prescription drugs, in the fact that it has a high cost in the beginning to develop the software, and later it is cheaper to produce copies.  The marginal cost would be downward sloping because the first products costs would be high then lower dramatically once the program is developed.

Real-World Example

A real-world example would be new technological devices, like the iPad.  It costs the most to develop the design and concept as well the technology needed to make this product real.  After that the marginal cost lowers to just the parts necessary and pricing is effected by time.  When the iPad first came out the selling price was $499 and now is lowered to $399 and it only costs $259.60 to make.  Marginal cost is ultimately a flat straight line: the cost for the first iPad had the highest cost, then lowered and did not increase.  The supply curve is similar to the new economy that Kinsley described since new technological devices are similar to new software where most of the cost is in developing the first product.

Posted by Erin and Devlin (Section 4)

Resources:

http://www.fastcompany.com/article/apples-tablet-introduced?page=0%2C0

http://mashable.com/2010/04/07/isuppli-ipad-cost/

Basic Market Structure and Perfect Competition

Discussion on “So What’s New? Is the “New Economy” really different from the old one?”  (Slate Magazine, Aug. 22, 2000)

Michael Kinsley starts out by comparing market forces to that of the cross. Following this comparison he provides definitions of both the demand curve as well as the equilibrium point but leaves out the definition for the supply curve.  He then goes into the main focus of the article by calling into question the common notion that the supply curve is always upward sloping. He argues that the problem lies within the concept of marginal cost because “marginal costs determine the supply curve” (Kinsley 1). Kinsley takes this argument further by pointing out the difficulty inherent within the two major assumptions that comprise marginal cost. He cites airplane seats, prescription drugs and software as products that have high initial costs with low marginal costs, which violate the assumptions of upward sloping supply curves. He ends his article by pointing out that this potential problem, due to marginal costs could result in a new economy.

This article is relevant to our classroom theory because it provides examples of instances where supply and demand curves may not behave in the manner we have discussed in class. This is important because if the issues Kinsley discusses are true then we are in a new economy that is driven by marginal costs that have high initial costs but cheap marginal cost.

Doctrine states that in a free market, competition will make price equal to marginal costs, because as production increases the marginal cost of producing another product increases. Thereby resulting in an upward sloping supply curve. In the instance of airline seats, prescription drugs, and software, the high initial costs cause the marginal cost function not to be upward sloping. This is because it is more expensive for the initial consumers because they have to absorb the high initial costs compared to later consumers who have low marginal cost. For example in the airplane situation some customers have to pay a higher price to cover the costs of the flight. However the marginal cost of an airplane that is flying regardless of capacity is practically nothing because the marginal cost of adding another passenger is just the cost of printing another ticket. In the prescription drug example marginal cost is downward sloping because the initial drugs are more expensive due to research and development costs but the cost of producing the pills later is very low. Likewise, in the software example there are high development cost but low disc production costs, which results in marginal cost not being upward sloping.

A real world application of this concept of downward sloping supply curves is clearly present in the film industry. In the film industry the initial costs to produce a film tend to be very expensive. However the actual marginal cost of distributing the film to more consumers in different theaters around the world is fairly cheap, given the advent of digital media. Therefore the film company will attempt to play their film in as many locations as possible because they will receive additional revenue in the form of tickets sales and the cost of reproducing the film in an additional theater is inexpensive.

Posted by Joe, John and Jim (Section 3)

Resources:

Kinsley, Michael. “So What’s New? Is the “New Economy” Really Different from the Old One?” Slate. 22 Aug. 2000. Web. 19 Mar. 2012. <http://www.slate.com/formatdynamics/CleanPrintProxy.aspx?1295416032412&gt;.

Collett-Schmitt, Kristen. FIN 30210: Managerial Economics. University of Notre Dame, 2011. Print.

Basic Market Structure and Perfect Competition

Discussion on “So What’s New? Is the “New Economy” really different from the old one?”  (Slate Magazine, Aug. 22, 2000)

 Summary

In Michael Kinsley’s article “So What’s New? Is the “New Economy” really different from the old one?”, the author discusses the traditional assumptions that underlie the supply and demand model of the economy. According to basic economic theory, market equilibrium occurs at the intersection of the demand and supply curves, or where the price of a unit is equal to the marginal cost of producing one more unit. A firm will not produce more than this amount due to these marginal costs, which increase as more units are produced. Traditional economists have assumed that the supply curve is upward-sloping due to the presence of these increasing marginal costs. Kinsley argues against this belief and states that marginal costs, in fact, do not increase over time due to a variety of factors. He uses a variety of real-world examples to illustrate his argument. He first looks at the pharmaceutical industry to show that while high start-up costs mean that the marginal cost of producing the first few units is very high, these marginal costs diminish to almost zero as the number of pills produced increases. He also lists the example of airplane seats to illustrate that the marginal cost of filling the seat of a plane that will depart regardless of how many seats are filled is zero. Finally, he uses the software industry to show that marginal costs may even be negative due to the network effect – software becomes even more desirable to consumers as the number of users grows, while it costs nothing to produce and distribute more software.

This article is clearly relevant to managerial economics, a class which relies upon the supply and demand model as the basic foundation of managerial pursuits such as price-setting and demand modeling. In a firm without an upward-sloping supply curve, our assumptions are skewed and prices set by a firm may not be optimal.

 Commentary

Kinsley’s article questions the traditional assumption that the market supply curve is upward sloping.  To understand his critique, we must first understand why we make this assumption.  In general, it is intuitive that if a higher price is offered for the products in inventory (or those that could be produced for inventory), the seller will be willing to sell more, because of the increased benefits received.  Producers have more incentive to produce and sell their products as the difference between marginal benefit and marginal cost grows, because profits not only increase for each item, but increase more on a per item basis.

This basic assumption is difficult to reconcile with the concept of increasing marginal costs in several current markets.  Our supply curve assumptions lead us to assume increasing marginal costs that will be higher than average costs at the equilibrium point, and that companies will produce and sell to the point that marginal costs are equivalent to price.  However, in today’s economy multiple products do not follow this pattern.  Most of these examples have high initial start-up fixed costs with comparatively low variable costs later in production.  Airlines, for example, must absorb extremely high fixed costs to purchase a plane and fly it from airport to airport.  However, if a plane is already scheduled to fly, the marginal cost of one more passenger, assuming there’s a free seat, is next to nothing (53.7 cents to shred the boarding pass, says Kinsley).  After the first seat until the flight is full, marginal costs are extremely low, and never increase above average cost, but it is safe to assume that airlines will rarely charge a price equivalent to the 53.7 cent marginal cost (although a $1 ticket price would technically increase profits).  This poses problems for our basic upward-sloping supply curve assumption.

Prescription drugs and computer software are other examples.  There are high initial fixed costs associated with researching and developing new medications and software.  However, once the research is done, it costs very little to produce the millionth pill or write the millionth disc compared to the development costs of the first one.  While any price over the low marginal cost would increase profits and lower prices for everyone as development costs are absorbed, some buyers must pay relatively high prices or there would be no incentive to develop new drugs or software.

 Real-World Application

Another real-world application can be seen in the music industry (both online and CD’s). There are heavy start-up costs associated with recording an album and marketing both the music and the performer. It’s very difficult for the singer to become popular, but once he or she becomes popular and has put forth a new album there is very little cost associated with making more CD’s. If the artist decides to put their music online on software such as iTunes, there is absolutely no cost to selling another song (or album). In this situation, which is consistent with Kinsley’s argument, the marginal cost is not increasing at all, so the price of the song/album should not be equal to the marginal cost of creating another CD.

Posted by Helen, Jason and Maddie (Section 2)

Basic Market Structure and Perfect Competition

Discussion on “So What’s New? Is the “New Economy” really different from the old one?”  (Slate Magazine, Aug. 22, 2000)

 Summary

This article begins by comically comparing the economic model of supply and demand, with the Church and its use of the crucifix. It prefaces the argument by explaining the concepts of a market in equilibrium, as well as identifying other factors that affect the supply and demand model, such as marginal cost and the likeliness that it will eventually be equal to the price of a good as the market reaches equilibrium.

The author, Michael Kinsley, then explains that he has two concerns about the design of the model: 1. That marginal cost must be rising, and 2. That marginal cost must always be higher than average cost in order for a firm to cover all costs. He explains that in today’s economy, marginal costs are lower than average costs. He uses airline tickets as an example, saying that low priced tickets are used to cover the marginal costs, while identical tickets that are higher in price are covering all the other costs associated with operating the flight.

Kinsley explains that the basic concepts of supply, demand, and equilibrium do exist, but in today’s economy, there is no one making sure that market equilibrium is reached. This is what is causing the system to skew, and what is causing average costs to soar above marginal costs in many different markets. He identifies that in this day in age, marginal costs are not only not rising, some are in fact declining. As average costs and prices soar, marginal costs remain somewhat unaffected.

 Commentary

This article is slightly confusing (I’ve been talking myself in circles in my head!), because when we first learned of the supply curve, it was defined as amount that suppliers are willing to sell at a given point.  If a supplier can make more money per unit, the opportunity cost of producing an extra unit is greater than the gained utility of not producing the extra unit.  This is what makes the supply curve bend upward.

Understanding, though, that this assumes that marginal costs stays the same, the idea of decreasing marginal cost (due to economies of scale or other factors) adds complexity to the model.  Were marginal costs to stay the same the entire time, the increase in price would add an increasing amount of profits every time the price is raised.  Taking diminishing marginal cost into consideration, as price increases, units also increase, and as units increase, marginal costs decrease.  Thus, profits increase more in the second scenario than the first.  Suppliers are more willing to sell at a higher price point, and as an added bonus, the lower costs create more profits.  Thus, the curve still slants upward.

The problem with this model happens when price, not quantity, becomes the dependent variable.  At a higher number of units, a firm is willing to sell each individual unit for less money because the average cost per unit decreases as quantity increases.  Thus, a firm can still make a larger profit by charging less for each individual unit.

 Real World Application

An additional real-world application of the perfectly competitive market is in the fresh produce market. Traditionally known as the “classic case” of perfect competition, the fresh produce market was once characterized by a virtually unlimited number of producers selling identical goods to “large numbers of local and regional retail grocery chains” at market equilibrium prices. However, as the food industry (and the fresh produce market) have evolved over recent decades, the market has consolidated considerably with fewer, larger buyers mostly replacing the traditional local and regional grocery chains. As “value-oriented retailers,” such as Wal-Mart, and “upscale specialty stores,” such as Trader Joe’s and Whole Foods, have come to dominate the food market, most fresh produce is purchased directly from the producer by the retailer. In this market structure, producers are no longer perceived to be selling identical goods as specialty stores and value-oriented chains claim to be selling produce of varying quality. In addition, the transactions between producers and retailers now often include more than just the price of the produce. In today’s market, additional components are frequently included in fresh produce transactions, including “off-invoice fees” (rebates, discounts, and promotional fees), pre-negotiated volume commitments, and required “third-party food safety certification.” These additional components effectively limit entry into the fresh produce market, which is dominated by the mega retailers, violating the criteria of a perfectly competitive market. Once considered the best example of a perfectly competitive market, the fresh produce market has become far less competitive with the emergence of a few powerful retail chains that have altered the perception of seemingly identical producers and imposed restrictions on the entry of producers into the market.

Posted by Emma, Trevor, Elizabeth and Kristoff (Section 1)

Resources:

Dr. Roberta L. Cook. “Supermarket Challenges and Opportunities for Fresh Fruit and Vegetable Producers and Shippers: Lessons from the US Experience .” University of California, Davis. 24 May 2004. http://www.agmrc.org/media/cms/supermarketchallenges_01985EE36887A.pdf)

QUESTIONS FOR CLASSROOM DISCUSSION ON COST ANALYSIS

This time, our reading not only gives us a real-world example of cost-analysis, but also yields an excellent transition for our next discussion on the determination of price. As a result, consider the following:

  • The article states, “Bottle price is directly linked to cost of producing.” What is the economic reasoning behind this statement?
  • If we hold all things related to wine production constant, except for land, why might a winemaker pay more for a vineyard in Napa Valley (per acre) than for land in any other wine region?

Our classroom discussion will take place after spring break!  

Posted by Prof. C-S

Cost Analysis

Discussion on “The Price You Pay: Why Some Wines Cost More Than Others” (The Wall Street Journal, Sept. 12-13, 2009)

 Summary

The article, “The Price You Pay: Why Some Wines Cost More than Others,” explores the range of price differences in wine, which delves into the upcoming unit of Cost Analysis.  Brand name wines may not be the most delicious wines, according to the article, as much more than the name of the wine goes into the pricing of a bottle.  The difference between the inexpensive $5.00 bottles and the bottles that cost upward of $100 depend on costs like land and bottling systems.  Vineyards located in regions like Napa Valley have high real estate costs, with land priced at almost $300,000 per acre, along with five to ten thousand dollars per acre in upkeep a year.  Wines that are grown in regions that are less popular and recognized tend to have lower real estate costs, dropping the price of their bottles.  Also, grapes like Petite Sirah tend to be used for less expensive wines in comparison to Cabernet grapes.  Variable costs like corks and labels are relatively expensive, and the fixed costs associated with wine, like the French barrels and wine presses can cost over $20,000 in total.  Consumers are willing to pay top dollar for the prestigious image that some wines offer, yet there are still many more moderately priced alternatives that are still delicious. 

Commentary

Cost analysis helps to determine the cost of production, including implicit and explicit costs, that vary with output.  In class, we also touched upon returns to scale.  The wine bottles that cost $5-10 probably have increasing returns to scale.  They use less expensive inputs, such as the cheaper land and grapes, and over time, will be able to produce more wine for less.  These companies are able to invest in the same technologies that the expensive wine manufacturers are using, such as the bottling system, but they have cheaper variable costs due to the inexpensive land and grape breeds.  As a company produces more wine, the less it becomes to manufacture the bottles.  The lower priced bottles of wine will typically sell more as the quantity demanded rises, allowing these companies to cover their costs of production.

 Real World Application

McDonald’s is one of the world’s largest fast food restaurants and its success can largely be attributed to its ability to control costs.  The restaurant is able to deliver food in a very short amount of time and for a comparatively low price—two aspects of the business that have made it so successful to date.

Much of McDonald’s success can be attributed to its economies of scale. The company’s competitive advantage with respect to sit-down restaurants is obviously its price point. The firm is so large in size, has such easy access to capital markets, and great bargaining power with suppliers that it is able to purchase production inputs at a drastically lower price than family owned restaurants.  This in turn affords McDonalds the ability to charge low prices and attract a large consumer base—something that has been imperative in its growth. 

Another manner in which McDonalds controls costs and thus has been able to stand out in the fast food space, is through low labor costs.  Because McDonalds has done such a wonderful job in streamlining the making of its various products, McDonalds does not need the skilled chefs that other restaurants would require to remain in business.  Through years of experimentation, McDonalds has the process down so well that nearly anyone can learn how to make a hamburger in a short amount of time (similar to Toyota’s lean manufacturing idea).  Restaurants in South Bend, such as the Mark in Eddy Street, require highly skilled chefs to produce the food that is on their menu.  More highly skilled chefs obviously have to be compensated accordingly and thus the Mark may have a more difficult time controlling labor inputs than McDonalds. 

Overall, McDonalds has been a highly successful franchise for over 50 years and it is imperative to recognize their cost control ability as a key driver in this success.  Their economies have scale have allowed them to purchase inputs at a much lower price than family owned restaurants and their ability to streamline the production process has allowed them to pay their workers comparatively less than other stand-alone restaurants.  

Posted by Lexi, Hannah and Ryan (Section 3)

Cost Analysis Real World Application Blog Post

Discussion on “The Price You Pay: Why Some Wines Cost More Than Others” (The Wall Street Journal, Sept. 12-13, 2009)

 Summary

The Price You Pay: Why Some Wines Cost More Than Others explores both the supply and demand side determinants of wine pricing.  Anyone who has ever purchased wine has most likely been faced with confusion over the vast discrepancies between cheap “two buck chuck” wines and wines that are priced into the hundreds.  According to the article, the expensive wines aren’t simply taking in massive profit margins based on brand name.  In reality, the land that the brand name grapes are grown on can cost $300,000 per acre with $5-10000 per acre per year in upkeep.  Moreover, a barrel can cost $1000 and a tank $10000.  Many other fixed costs such as bottling systems and variable costs such as corks and labels also contribute to the price of wine.  On the other hand, some regions which lack the brand name command cheaper real estate prices.   The article notes, however, that there are plenty of cheaper wines that taste good and more expensive wines that aren’t much better than the cheap stuff.  This all relates directly to classroom production theory, consumer theory, and supply demand equilibrium- wealthy wine consumers are willing to pay top dollar for the prestige and brand image of some grapes and that drives these grape’s prices sky high.  On the other hand, people just looking for a cheap bottle of wine are willing to settle for whatever is reasonable – keeping that vineyard land low priced.

 Commentary

The article notes the extremely high fixed costs of producing wine.  As mentioned earlier, barrels and tanks as well as bottling systems cost tens of thousands of dollars.  How, then, are some brands of wine so cheap?  The answer is that these wines are from lesser known regions where land is cheaper.  In addition, these suppliers take advantage of economies of scale in order to pay less cost per bottle of wine.  The article doesn’t mention this but they are also most likely aged less since aging has a high accounting and opportunity costs by holding them in barrels for so long.

 Another Application

In this article, Eric Bleeker discusses the cost of the iPad 3 and argues that it will remain at the same entry-level price as the iPad 2.  Even though the iPad 3 will consist of more advanced technology, Bleeker suggests that Apple will keep the entry-level cost the same because there is too much risk to raising the price.  There are many arguments as to why Apple must raise the price of the iPad 3.  For example, the iPad 2’s display was 39% of total material costs.  It is almost basically confirmed that the iPad 3 will have a retina display, which includes two to three times the pixels per inch which would obviously drive the costs up.  Bleeker points out that Apple could make the price more expensive than the iPad 2 because they have used a very aggressive pricing strategy since its introduction.  He also notes that the iPad has commanded a comfy profit margin, but it was priced at a level that sacrificed margins for rolling up market share.  However, companies do not always make more profit by placing a higher price on their products.  There is risk to that strategy.  If Apple did end up pricing the iPad 3 higher, it would only widen the gap between the iPad and lower-priced tablets such as the Kindle or Nook.  Further, Apple has not yet completed their full transition into the tablet market as they believe to still be in the very early stages of a shift.  That being said, Apple’s long terms goals would best be suited towards concentrating on that shift using strategically competitive pricing.

Posted by James and Jordan (Section 4)

Resources:

“The Top 3 iPad 3 Storylines: First, How Much Will It Cost?” – Eric Bleeker, The Motley Fool, financedaily.com

Cost Analysis

Discussion on “The Price You Pay: Why Some Wines Cost More Than Others” (The Wall Street Journal, Sept. 12-13, 2009)

 Summary

The article found in the Wall Street Journal discuses wine and why there is a large variation in the price of various bottles. The author states that economies of scale are the main factors for the price variation found in the wine industry. The price of wine is based on more than the flavor. The value of wine is a result of the costs of production as well. The article describes various costs including fixed costs, such as land. Land is one of the higher expenses that wine makers must incur. The cost of land varies depending on the location of vineyards. Lower priced wine typically comes from regions that are not famous for growing grapes.

There are other variable costs incurred such as the amount and type of grapes used in the production of wine. The price of grapes is very volatile and the swings in price affect the price of wine.  In order to make wine, winemakers need more than grapes and a lot of various costs arise from the need of equipment. Barrels, bottles, corks, labels, bottling fees, and maintenance are some of the other variable costs in the production of wine.

Economies of scale allow some wines to be cheaper than others. Economies of scale increases the efficiency of production allowing companies to lower their cost per unit by increasing production and distributing costs amongst a higher number of goods. The average price of wine decreases as the production increases. Thus internal economies of scale exist in the wine industry because the larger the individual firm is the lower their costs per unit are.

Commentary

The first question posed within this article asks why some wines cost $100 and other wines cost $10, with some wines even being as cheap s $5 a bottle. This may initially seem confusing, especially because of all the components that go into the production of a bottle of wine, such as agriculture, barrels, corks, bottles, labels, bottling fees, tanks, and other various costs that go into the production of one bottle of wine. With all of these costs, it makes sense that various bottles of wine are fairly expensive. In the Napa region, for example, land in which grapes are grown can go for as much as $300,000 per acre, with maintenance costs ranging from $5,000 to $10,000 per year. Barrels can also cost as much as $1,000, and stainless steel tanks can cost between $10,000 and $20,000 as well, with bottling lines possibly costing up to half a million dollars. With all of these costs, it seems near impossible for bottles of wine to be cheap.

However, the main reasons bottles of wine can cost only $5 comes in the nature of economies of scale. As the article states, if a company has a large amount of capital already invested into the production of wines, they have the capability to, over time, decrease their average costs through the mass production of wines. If a winery can produce a lot more than another winery, it can lower its prices in order to sell more wine and eventually cover all of its costs, which is contingent on the increased sales. Another reason that some wines can be as cheap as $5 a bottle is because different wines use different grapes, and some wineries are in less popular areas than others. Certain grapes such as Chenin Blanc and Petite Sirah cost less than other grapes such as Chardonnay and Cabernet. Also, because certain grapes are grown in vineyards in different regions, the cost of acquiring/maintaining these lands are a lot cheaper. Vineyards that are not located within that Napa region, for example, will be a lot cheaper to acquire than lands within the Napa region. The wineries that have these locations also have the advantage of having lower fixed costs, which further creates an advantage with economies of scale—since the costs are lower, they can lower the prices of the bottles without losing nearly as much profit.

Description of a real world application

IKEA is renowned for being a leader in the home furnishing sphere. This is because of their ability to sell decent furniture at a much lower price as compared to traditional furniture stores. Two main factors can be contributed for this success.

Firstly, IKEA has been able to reduce a bulk of its cost through economies of scale. IKEA utilizes its massive economies of scale to secure long term contracts with manufacturers. They also reduce cost of raw materials through bulk buying. The massive size of the company means that they can demand lower prices for material which suppliers can and are willing to give as it guarantees them steady income.

Secondly, all the furniture sold in IKEA is designed to be self assembled. This also helps to reduce cost and the use of packaging. For example, the volume of a bookcase case is significantly less when it is not assembled as compared to when it is assembled, as the volume dictates the price in shipping. Also IKEA only rely on the cheaper cargo container for transportation, totally avoiding the more expensive air shipping. Selling unassembled pieces of furniture definitely help to reduce shipping cost for IKEA. Furthermore, this idea works with the consumers. This is because, the steps to assemble to furniture is easily understood and also most of the consumers, especially in Europe, rely on public transportation which means that the flat pack methods allow for easier transportation.

IKEA has always been a forerunner in cost analysis. This is because through cost analysis and the subsequent cost cutting, they are able to sell their product at a advantageous cost and as such attract more customers. All in all, this results in the increase of the productivity of IKEA.  

Posted by Brian, Eddie, Jazmin and Dorothy (Section 2)

Cost Analysis

Discussion on “The Price You Pay: Why Some Wines Cost More Than Others” (The Wall Street Journal, Sept. 12-13, 2009)

 Summary

The article “The Price You Pay: Why Some Wines Cost More than Others” discusses why there are such variances in the cost of a bottle of wine. The price of a bottle of wine is not merely based off what it tastes like; there are many other factors to consider. The grapes used to make the wine have a large impact on the final price. The value of grapes depends on the location and the value of the land which they are grown on. If the grapes are from a vineyard in Napa Valley, they are more likely to have a higher value, thus raising the price of a bottle. In this sense, location of the vineyard is similar to real estate, for perception is related to value. Different varieties of grapes also impact the final price. Popular and well enjoyed grapes will often have a higher price. There are also many other costs of productions that affect the cost of a bottle of wine. Producers must consider the cost of labels, corks, bottles, barrels, tanks, and other inputs as they price the bottle. Economies of scale also play a large factor in bottle price. As more bottles of wine are produced, the unit cost of producing a bottle decreases, making it possible to still have reasonably priced bottles of wine. These factors influence wine bottles’ large range of prices. The article advises that consumers with a more modest budget look for alternative and wine regions and grapes. This article is relevant to classroom theory because it is about the cost of production. There are many costs to consider when producing and pricing a bottle of wine. This article also deals with implicit costs, which are the next best alternative that the resources used in production could have produced instead. An example of an implicit cost in the article would be foregoing one type of grape in favor of another type.

 Commentary

There are several factors that influence the price of a bottle of wine. One determinant is the types of barrels you use in the aging process. A typical French barrel, which holds up to 23 cases of wine, costs you $1,000, while a stainless steel tank can range from $10,000 to $20,000. And a new state of the art bottling line can put you back up to $500,000. In addition, high quality labels and corks can cost from $0.50 to $1.00 each. This large disparity in fixed costs play a huge factor in the price you charge to consumers. Even with the high fixed costs of starting your own vineyard, economies of scale (in the long run) allow for reasonable prices.

 Real World Application

One of the concepts mentioned in this article mentioned how the particular inputs of the product impacted the overall cost of production. Pointing to the idea that wine which is priced ten times higher than another wine may not necessarily taste ten times better; rather it is the consumer perception of the inputs placed into the production process. Real estate is an example that is both mentioned in this article, and is a great example of what we are seeing with the varying wine prices. Two different apartments–both built with very similar size, layouts/floor plans, quality, and features, have an extreme variance in listing price. The variance may be almost exclusively due to their relative locations. Apartment one may be located in a highly valued area in New York City, Chicago, etc. Whereas the other apartment unit may be located in the outskirts of those cities or even in the downtown area of a much smaller city. The difference in listing prices in this case is mostly dependent on the consumer perception of what may be more valuable or preferred.

Posted by Nick, Coley and Jenna (Section 1)