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Managerial Econom ics: A Problem -Solv ing Approach

ADDITIONAL CASE STUDIES

Chapter 2 Case study 2.4 CEO pay

Chapter 3 Case study 3.5 University fees - part 1




Case study 10.5 Burger price wars

Chapter 12 Case study 12.4 Rail safety

www.cambridge.org/wilkinson © Nick Wilkinson




CASE STUDY 2.4 CEO pay

Fa t cat s t u r n t o l ow f a t

Mar 3rd 2005From The Economist print edition, reprinted by permission

Bosses ' bonuses are boom ing , bu t tha t i s no t a l l bad

NOW is the season when American companies file their annual reports with theSecurities and Exchange Commission. Among other things, these documents givedetails of the pay of the companies' top executives. This year these closelywatched numbers are being translated into headlines about huge increases inbonuses for the people who run the world's biggest companies. A study by MercerHuman Resource Consulting for the Wall Street Journal shows that last year'sbonuses for the CEOs at 100 large American companies rose by 46.4%. Themedian bonus was $1.14m.

These are big bucks, and there are plenty of instances where the logic of therewards seems at best warped. Michael Eisner, for example, the controversialchief executive of Walt Disney, who was almost booted out of the job byshareholders last year, nevertheless received a bonus of $7.25m. But there areencouraging aspects to the figures. For a start, corporate profits in 2004 rosesignificantly—those of big quoted firms in the S&P 500 index by some 20%. If bosses' total pay is (as it should be) related to their companies' performance, thevariable part of that pay (which includes bonuses) could be expected to haverisen sharply during the year.

The other thing about the bonuses is that, to some extent, they are a reflection of a welcome decline in stock-option schemes. Bonuses are being granted in place of

these. A study by the Boston Consulting Group of public companies recently foundguilty of fraud calculates that the value of the stock options granted to the CEOsof those firms in the years before the frauds became public was 800% greaterthan those granted to the CEOs of comparable firms not found guilty of anywrongdoing. Nothing correlated so strongly with corporate fraud as the value of stock options—not the standard of the firms' governance, nor analysts' inflatedexpectations about their earnings, nor ego-boosting stories about their CEOs inthe press.

What's more, in the stockmarket's boom years stock options more or lessindiscriminately rewarded individuals with sums that frequently amounted to tensof millions of dollars (and sometimes hundreds of millions). In 2001 nine

executives cashed in stock options worth more than $100m, including LarryEllison, the boss of Oracle (who got the biggest bounty, $706m), and LouGerstner, the boss of IBM. Mr Eisner's bonus last year fades in comparison. In2002, the pay of top American CEOs was over 400 times average earnings; lastyear that figure is reckoned to have fallen close to 160.

Th e co m m i tm e n t o f com m i t t e e s

Bonuses are largely in the control of a company's compensation committee, asmall group of non-executive board directors. Nowadays many of thesecommittees are being encouraged to talk regularly with leading shareholders

about what are suitable levels of compensation for top executives, and they areincreasingly sensitive to the reaction to the amounts they award. In Europe, CEOs





are being advised that they will be excluded from much-coveted appointments inthe future if they have been too greedy during their executive careers.

There remains plenty of scope for compensation committees to improve. OnFebruary 22nd, Merck's board awarded a bonus of $1.4m to Raymond Gilmartin,its CEO. Yet Merck's share price fell by one-third last year and it was forced towithdraw the painkiller Vioxx, a potential blockbuster drug.

But even if all compensation committees were to behave impeccably from nowon, there will be legacy problems for some years to come. When earlier this yearCarly Fiorina was booted out as CEO of Hewlett-Packard (HP), supposedly afailure, she received a leaving present worth up to $42m. This was because of theterms of a contract signed five years earlier. Compensation committees have towean themselves off these kinds of pay deals, which lavish enormous amounts onexecutives even if they fail. Designing schemes that only reward success shouldnot be beyond the wit of directors, or the compensation consultants they employ.In a hurry to find her successor, HP looks in danger of making the same mistakeagain, while Ms Fiorina herself is being spoken of as a future head of the World

Bank. Change for the better? Maybe one should just watch those figures a whilelonger.

Quest ions

1 . Why are bonuses coming to replace stock options as a means of compensatingCEOs?

2 . The median bonus for CEOs at 100 large American companies in 2004 was$1.14 million. Why is this figure apparently large?

CASE STUDY 3.5 University fees – part 1

President Jones of Dana International University (DIU) in London is concernedabout the financial state of his institution. Last year there was a loss of £1.5million and the trustees are getting restless. Currently there are 1000 full-timestudents, 700 of whom are degree students and 300 of whom are study-abroadstudents from the US. The present level of fees, including tuition,room and board,is £18,000 per year, and Jones is proposing a 10% increase for next year. On thebasis of past experience he has estimated that the price elasticity of demand fordegree students is -1.2 and for study-abroad students is -1.6. He is particularlyworried about the effect of the fee increase on study-abroad students, since theexchange rate has changed from $1.70 to $1.90 since the current fee level wasset.

Jones is also considering a change in promotional expenditure. This currentlyamounts to 2% of total revenues and it is estimated that the promotionalelasticity of demand is 0.1. It is also estimated that variable costs per student are£8,000.

Quest ions

1 . Why might Jones’s estimates of the relevant price elasticities not be very

reliable?





2 . Estimate the effect of the proposed fee increase on the number of degreestudents and revenues from these students, stating any relevant assumptions.

3 . Estimate the effect of the proposed fee increase on the total number of students and on total revenues.

4 . Estimate how much would have to be spent on promotion to restore revenuesto their current level after the increase in fees.

5 . Compare the level of profit after the fee change, both with and without thechange in promotion, with the current situation.

CASE STUDY 6.5 University fees - part 2

Even when the increase in fees is combined with the increase in promotionalspending Jones realizes that DIU still cannot make a profit. He therefore plans acost-cutting programme. Tuition costs amount to 75% of variable costs and heproposes to reduce these by increasing average class size from 15 to 18 students.Fixed costs include accommodation and promotion. The reduction in the totalnumber of students means that he can reduce the fixed costs related toaccommodation by 10%.

Quest ions

1 . Estimate the cost function of DIU after the increase in fees and promotion butbefore the cost-cutting programme.

2 . Estimate the cost function of DIU after the cost-cutting programme.3 . Estimate the break-even outputs before and after the cost-cutting

programme.4 . Estimate the profit after the programme.


Jones now believes that he can turn around the finances of the institution andmake a profit, combining an increase in fees and promotion spending with thecost-cutting programme. However, he is not convinced that the best strategy is toincrease fees by 10%. Jones is now concerned with determining an optimizingstrategy, but realizes that he cannot presently increase promotion beyond thelimit needed to restore revenues to the original level with the 10% increase infees. He believes the exchange rate will stay at $1.90.

Quest ions

1 . Calculate the institution’s demand function, treating promotion as being fixedat the increased level, and using a single price and a single constant priceelasticity.

2 . Calculate the profit-maximizing level of fees with the cost-cutting programme.3 . Compare the maximum profit with the profit from the proposed 10% increase

in fees.






Jones finally finds a way to increase promotion beyond the limit described earlier.Now he can determine the optimizing levels of both price and promotion together.

Quest ions

1 . Calculate a demand function for the institution, treating both price andpromotion as variables and assuming constant elasticities.

2 . Why might it not be realistic to assume a constant promotional elasticity?3 . Calculate the profit-maximizing level of both fees and promotion under the

above assumptions.4 . Compare the new maximum profit with the profit when promotion was limited,

drawing any relevant conclusions.





CASE STUDY 10.5 Burger price wars

MCDONALD'S FALLS BACK TO PRICE-

CUTTING TACTICS

Regiona l , Nat iona l Moves Com e Even Af t e r I n t ro Of De luxe L ine

After months of emphasizing taste and “adult sophistication” as the central themein advertising, McDonald's Corp. has returned to its price-cutting roots.

A bevy of regional and national spots for the burger giant have rolled out inrecent weeks promoting price breaks on mainstay products including Big Macs,Egg McMuffins and cheeseburgers.

Franchisees and industry analysts agree the move signals McDonald'sacknowledgment that last year's Deluxe line has failed to move the needle inboosting domestic sales performance.

2- FOR-2 SPECI ALS

A recent national spot from Leo Burnett USA, Chicago, for example, features NBAstars promoting McDonald's french fries and 2-for-2 specials, which include twoBig Macs or two Egg McMuffins for $2.

A similar campaign from Burrell Communications, Chicago, slated to break onnetwork TV Feb. 5, also leverages NBA stars to promote discounted Chicken

McNuggets.

Many of the promotions are local or regionally focused.

In Chicago, three Burnett spots feature kitschy footage and humorous “money-saving tips”, such as wearing rugs on your feet to avoid the cost of carpeting aroom. The spots then go on to promote $1.99 breakfast value meals, $2.99 BigMac value meals and 99-cent double cheeseburgers.

Likewise, some 500 McDonald's units in southern California are trying to counterBurger King Corp.'s successful 99-cent Whopper with a price-test of the Big & Tasty burger-a jazzed-up Quarter Pounder priced at 99 cents or as part of a

$2.99 value meal.

A local TV campaign from Davis, Ball & Colombatto, Los Angeles, supports.

VALUE EMPHASI S ‘CONTI NUES’

A McDonald's spokeswoman refused to comment or elaborate on the chain'srecent pricing push, saying only that “value has always been emphasized atMcDonald's and will continue to be so.”

Not all are convinced of the wisdom of the value-price strategy.

“I'm a zealot for not advertising just price. It's a hidden killer,” said Tom Lawson,managing partner-chief operating officer of Arnold Communications, Boston,





gearing up to break a regional branding effort for the fast-food giant's breakfastmenu.

“A high percentage of visitors come in for reasons other than price-convenience,for their kids-so with [price cutting] you're giving it away to others who wouldhave been there anyway,” he said.

The move back to price-promotion follows a December memo from McDonald'sUSA Chairman Jack Greenberg to franchisees emphasizing the need in 1997 to

“re-energize and focus . . . U.S. marketing efforts and develop a national valueproposition.''

That about-face came to the dismay of some franchisees, who say the wholereason for introducing the Deluxe line last year was to relieve profit-marginpressures and break the cycle of price-cutting.

“A year ago, franchisees were complaining that there was too much discounting

going on and they couldn't make money,” said a southern California franchisee. “So the company said, ‘OK, no more discounting, we're going to roll out theDeluxe sandwiches’.”

“Now that those aren't working like they thought they would, the company isback to discounting on a regional basis because franchisees aren't as organized” to protest.

DI SAGREEMENT AT M CD'S

Apparently there is disagreement within McDonald's corporate offices as well.

Senior VP-Marketing Brad Ball is said to favor brand-building over pricepromotion, but is being overruled by other senior executives pressured toimprove quarterly performance. Mr. Ball and other McDonald's executives wereunavailable for comment.

McDonald's spent an estimated $200 million on marketing the rollout of ArchDeluxe. Although McDonald's maintains the sandwiches have met their salestargets, bottom-line unit sales haven't reflected any significant bump for 1996.Domestic sales rose 3% to $16.4 billion, but the company acknowledged that gainwas solely due to restaurant openings.

Although it did not release specific percentages, McDonald's said comparable-store sales were down for the fourth straight quarter.

Reprinted with permission from the February 3, 1997 issue of Advertising Age. Copyright Crain Communications Inc 1997.

BURGER KING ADS TAKE SLAP AT MCD

I t ' s Doub le Suprem e Vs. B ig Mac, Whi le Pr ice Posi t ion in g Cont inues

Hoping to capitalize on a perceived weakness at McDonald's, No. 2 Burger King

has unleashed a string of ads that directly target the leader and turn up the heaton an already intense market battle.





Burger King Corp.'s latest TV campaign, from Ammirati Puris Lintas, New York,pits its Double Supreme cheeseburger against McDonald Corp.'s Big Mac. One 30-second spot touts the Double Supreme's 75% more beef and asks if Big Maclovers are “ready for a new relationship?”

Another spot focuses on a teen who describes how Burger King's product is biggerand tastes better than the Big Mac. The camera then pulls back to show that theteen is a McDonald's crew person.

Both spots promote Burger King's $2.99 value meal.

The two burger giants have been fighting fiercely of late. An Inauguration Dayprint ad and TV spot last month urged President Clinton to abandon the Big Macin favor of the Whopper. McDonald's responded with a letter in USA Today Jan. 24thanking the president for his devotion to McDonald's.

BURGER KI NG EMBOLD ENED

Analysts and other industry insiders say Burger King has been emboldened by itsown strong sales in 1996, as well as McDonald's domestic sales difficulties.

“Burger King is a little cocky right now. They're looking to capitalize onMcDonald's perceived vulnerability,” said one analyst.

Jeff Bonasia, director of brand communications at Burger King, denied thatattitude exists: “McDonald's current state of business has zero to do with ourcurrent marketing and our marketing in the future.”

“All three major brands share consumers, and we're always looking for the

opportunity to steal consumers from our competitors,” said Matt Heller, seniorVP-group director at Ammirati.

Although Burger King hopes to enjoy a short-term sales bump from DoubleSupreme, Mr. Heller said the Whopper will remain the focus of the chain's $300million 1997 ad budget.

Of the top three chains, both Burger King and Wendy's International increasedsame-store sales last year, mostly at the expense of McDonald's. Burger Kinggrew an estimated 2.6%, while Wendy's grew approximately 7.5%.

While acknowledging that domestic sales were down in '96, McDonald's did not

quantify the loss.

McDonald's holds an estimated 40% share of the about $50 billion fast-foodburger-chain market, compared with Burger King's 17% and 15% for Wendy's.

Burger King has run comparative ads in the past. A 1995 Ammirati campaigncompared Burger King's hamburgers with those of both McDonald's and Wendy's.Also, Burger King's first introduction of the Double Supreme cheeseburger inJanuary 1996 featured a supposed McDonald's employee eating the burger.





BK PRI CE PROMOTI ON

Although Burger King has “been hammering food attributes” in its marketing, itscurrent success is still largely attributable to aggressive price promotion,specifically the 99 cents Whopper, said Paul Westra, analyst with Salomon Bros.

“At this stage, McDonald's is playing defense -trying to slow [Burger King's]momentum,” he said.

McDonald's in recent weeks has returned to a discounting strategy (AA, Feb. 3).

No. 3-ranked Wendy's also has stepped up discounting, promoting 99 centschicken nuggets and 99 cents Double-Stack cheeseburgers in some markets.

The long-term impact of the burger segment's price wars is detrimental, Mr.Westra said.

“The underlying business has suffered greatly on the pricing and margin sides,''he said. “The name of the game isn't yardage, it's points. Sure, they're stealingsales from each other, but can they make a profit?”

As the top three hammer at each other, the near-term winners might be smaller,regional burger chains such as Sonic Drive-Ins, Jack in the Box and Carl's Jr.

Using quirky ads and differentiated product offerings, each has positioned itself as “an answer to the sameness and bigness and blandness of the other threebrands,” said John Weiss, analyst for Montgomery Securities.

Reprinted with permission from the February 10, 1997 issue of Advertising Age. Copyright Crain Communications Inc 1997.

Quest ions

1 . Explain what is meant by a ‘value-price’ strategy, in terms of the behaviouralmodel.

2 . Explain Tom Lawson’s reservations regarding such a strategy for McDonalds.

3 . Explain the difference between a brand-building and a price promotionstrategy,in the context of McDonalds.

4 . “The name of the game isn't yardage, it's points.” Explain this statement inthe context of the price war between McDonalds and Burger King.

5 . Explain the implications in terms of market positioning for the smaller burgerchains.





CASE STUDY 12.4 Rail Safety

The p r i ce o f sa fe ty Nov 23rd 2000

From The Economist print edition, reprinted by permission

Br i ta in spends too mu ch money , no t t oo l i t t l e , mak ing i t s r a i lw ays sa fe

ON OCTOBER 17th, a train from King’s Cross to Leeds crashed at Hatfield inHertfordshire. Four people were killed and 34 injured. Next morning, Railtrack,the company that runs Britain’s railways, attributed the crash to a broken rail.There was an outcry in the newspapers: Railtrack was paying more attention toits shareholders’ dividends than to lives, the government had failed to ensure thatRailtrack invested in its passengers’ safety, and a crash like that must never beallowed to happen again.

The government left no doubt that it agreed with the newspapers; and, in the fiveweeks since the crash, Railtrack has done its utmost to prove its concern for itscustomers’ safety. Rails have been ripped up all over the country, the networkhas descended into chaos, and the length of many journeys has doubled as thecompany tries to sort the problem out. Yet surely it is worth all the trouble, if even one life is saved?

No, it is not. The pictures of mangled carriages are ghastly; the interviews withbereaved relatives heart-rending. But life involves risk, and calculations abouthow much money to spend on reducing danger have to be made in cold blood—orat least with a cool head. Governments, which invest in risk-reduction through,for instance, road-safety measures, and which legislate to require companies to

spend on risk-reduction, have to ask how many lives a given amount of moneycan be expected to save—they must, in other words, set a price on life.

How much might that be? A worker’s probable earnings? What a mother wouldpay to keep her son alive? What a son would pay to keep his mother alive? Thereare no objective grounds for determining the price of life, so academics and civilservants have resorted to asking people how much they would pay to avoidcertain risks. In Britain, this process produces a broad average price of £1m($1.4m) per life. The figure varies little, from risk to risk. A life is a life, peoplereckon, however it is lost or saved.

But the government, it seems, is not as rational as the people. Although deaths

on the roads vastly outnumber deaths on the railways (by 3,423 to 33 in 1999)the railways command disproportionately high spending on safety. The advancedtrain protection system, which is installed on some routes, would cost more than£2 billion to install nationally, implying a price on each life saved of more than£15m. The slightly more economical train warning protection system prices life at£5m. The transport department’s guidelines on road safety spending set a priceof just over £1m per life. But the figure that represents the reality of investmentin road safety, the one implied by local authorities’ spending on, for instance,measures to slow traffic down, or to provide pedestrians with safe places to crossroads, is a miserly £100,000 per life.





Save l i ves, no t po l i t i c ians ’ faces

From the politicians’ point of view, this may be rational. Nobody notices roaddeaths, but each rail crash generates a frenzy of Something-Must-Be-Doneeditorials. So each time, in order to be seen to be doing something, thegovernment prods the railways into extra safety spending.

It may be rational from Railtrack’s point of view, too. Even though Railtrack is aprivate-sector company these days, it is still a regulated monopoly, so the level of its future profits will be determined at least in part by the government. There isno reason to resist government calls for greater safety: the government will pay.So, when it prods, Railtrack jumps.

From society’s point of view, though, it is far from rational to spend 150 times asmuch on saving a life on the railways as on saving a life on the roads. A bereavedmother cares little how her child was killed. Many more lives could be saved if themoney currently being poured into avoiding spectacular but rare railway crasheswere spent instead on avoiding the tragedies that happen ten times every day onthe roads.

Quest ions

1 . How is it possible to value human life?

2 . Why has the government placed a much higher value on rail safety than roadsafety?

3 . What are the costs to society of incorrectly valuing human life in the abovescenario?

4 . What economic principle should a government apply in trying to find anoptimal allocation of its spending on safety measures?

5 . How is the valuation of life important to business managers?


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