A challenge faced by firms in deciding what opportunities to pursue with their limited resources is that the sacrifice of limited resources is made in the present, but the hoped-for rewards do not arrive until some time or times in the future. In order to evaluate these in the decision-making process, discounting is used, which is the process of translating future cash flows into todayâ€™s equivalent amounts. Doing this accurately, as you will see in this weekâ€™s learning, is a very desirable and valuable skill to develop and apply.
In setting or changing the prices of goods and services being sold, firms need to start by estimating their demand. This by itself can be a particularly challenging process, especially for new goods and services and those inhabiting fast-changing environments. To start, we have individual demand. This is the amount that a person or organization will purchase at a particular price. Then there is aggregate demand. This is the total that will be purchased by all parties at a specific price. If marginal revenue is more than marginal cost, the price should be increased (eventually reducing demand). If marginal revenue is less than the marginal cost, the price should be decreased (this increases demand). The goal of all of this is to maximize total revenue at the point where the price of one more unit sold is equal to its cost, which means that marginal revenue and marginal cost are the same.
Anybody who goes to the gym and does lots of ambitious sets with increasing heavyweights will experience what economists call diminishing returns. This occurs when the marginal productivity decreases. In a firm, this means the extra outputs associated with extra inputs go down. At different points in the production and sales processes, varying levels of costs and revenues per unit are experienced. The goal in evaluating these when decisions are made, such as the terms of sales contracts, is to make sure we avoid terms that lead to losses and identify terms that maximize the benefits we experience. In doing this, it is important to have an understanding of economies of scale and economies of scope, along with techniques for how costs can be decreased and productivity can be increased to the maximum amounts possible.
Discuss the role of compounding and discounting.