managerial economics lecture introduction

8/8/2019 Managerial Economics Lecture Introduction

http://slidepdf.com/reader/full/managerial-economics-lecture-introduction 1/42

Managerial Economics

Lecture One:

Why economics matters to managers,marketers and accountants

Neoclassical theory of profit maximisation



Admin

• Purchase Reader

• Check subject outline• Assessment: 3 parts

– Group presentation in tutorials 20%

– Essay on group presentation topic 40%

– Exam 40%• My details

– Steve Keen

• 4620-3016

– 0425 248 089 in emergency • [email protected]

• Thursdays 1-3pm

mailto:[email protected]

mailto:[email protected]



Economics as the context of business

• Management, marketing & accounting focus on specifics

– How to manage a company…– How to market a product…

– How to quantify & compare corporate performance…

• Focus is your personal input to business

• Economics is the context of business– “Men make their own history, but they do not make it asthey please; they do not make it under self-selectedcircumstances, but under circumstances existing already,given and transmitted from the past”

• Focus on constraints on and circumstances of your input– Both opportunities & dilemmas

– Quick quiz: who made the above statement?




•Often the best wisdom in economicsisn’t found in standard textbooks!

•This subject takes a deeper look ateconomics you’ve already done (micro,macro); and

•considers theories & data youhaven’t seen before that are morerelevant to business




• A hierarchical view: starting from the bottom & working up– The firm– The market/industry– The economy– Finance– International business

• A critical view– Conventional theories of above

• Profit maximising behaviour, types of competition, Gametheory, IS-LM, Efficient Markets, Comparativeadvantage

– Different perspectives• Empirical data• Critiques of conventional theories• Alternative theories




• What matters most to your firm’s success may lie outside it:

– “For companies, a central message … is that many of acompany’s competitive advantages lie outside the firm…”(Porter 1998: xxiii)

• Understanding “what lies outside” may therefore be the mostimportant thing you can do to be a successful executive

– Economics as the study of “what lies outside”• Relationships with other firms

• Interaction with the market

• Market interaction with the macroeconomy

• Macroeconomy’s interaction with global economy; AND…• Theories about the economy! Because:




• Sometimes (not often enough!) theories explain how the realworld works

• Frequently (too often!) theories affect how people behave inthe economy

– Government follows economic advice

– Firms/unions think about economy in terms of economic

models– Government bodies (e.g. ACCC Australian Competition &

Consumer Commission ) apply economic theory in policies (e.g.competition policy, deregulation of telecommunications,

etc.)• So you have to understand economic theory even if it’s wrong !

– Which it frequently is…




• Emphasis in this course is on realism

– Theories presented; but also– Empirical data examined to see whether theories actuallywork

– Frequent conclusion: they don’t (but sometimes they do…)

• One consequence: can’t rely upon textbooks for thiscourse!

• Textbooks normally

– present theory uncritically

– only include “case studies” that confirm accepted

theory• frequently based on invented rather than real

data

– Normally don’t go beyond microeconomics




• This course

– Starts with micro (theory of firm…)– Progresses through theory of the market, economy, financeto international trade

– Based heavily on readings volume

• You must have a copy

• Tutorials and assessments based on contents



“The firm”: real world vs economic theory

• The real world: an incredible diversity

– Size: from corner store to Microsoft– Operations: from one outlet to almost all countries

– Diversity:

• from single product (wheat farm) to many (Sony)

• From one industry to many– Ownership: from sole proprietor to multinational listedcompany

– Structure:

• from one person operations to multi-department

• From sole operations (production to sale) tospecialisation in manufacturing, wholesale, retail,marketing, consulting…



Economics of the firm: statistics

• Firms in the Australian economy

– Range in size from sole proprietor/employee to multi-employee institutions

– From single product to diversified conglomerates

– Over 610 thousand “entities” in 2000 (ABS 8140.0)

• 3229 “large” entities employing 200 or more workers

• 607,663 “other” employing less

• “Average” employment 10.1 persons per firm

– “Average” large firm employed 750 workers

– “Average” other firm employed 6.5 workers

• Legal multitude of businesses masks much smaller numberof operating units: 15,870 units with 700,024 legalentities in 1998/99



Economics of the firm: statistics

• Concentration obvious (ABS 8140.0.55.001)

– Top 20 units responsible for 13.9% of sales– 15,850 others responsible for remaining 86.1% of sales

• Economic theory abstracts from this concentration & diversity

– Claims firms share several essential common properties

• Profit maximising behaviour• Under conditions of diminishing marginal productivity

• Selling on “spot” market (no stocks) to anonymous buyers

– Only interest buyers have is in getting lowest price

– No interest in continuing relationship betweenbuyer/seller; “arms length” transactions



“The firm”: economic theory

• The economic simplification: diversity ignored to focus onalleged essence of profit maximising behavior:

– Basic model

• single industry & product

• one location

• privately owned, sole proprietor

– No internal structure considered

– No specialisation: firm does everything from manufacturingto sales

• Some generalisations allowed later (e.g., agency theory)

– But basic theory abstracts from these details

– Core model: profit maximising behaviour under conditionsof diminishing marginal productivity



Economic theory of the firm

• Profit maximising behavior:

– Seeking highest possible profit given constraints of• Falling price as quantity offered for sale rises

• Rising costs as quantity offered for sale rises

– Falling price as quantity offered for sale rises:

• “Law of demand”: can only sell additional units if price islowered

• Mathematically: a negative relationship between priceand quantity

– To ↑quantity sold must ↓price

– Simple example: linear demand curve P(Q) = a –b Q




• Graphing price as a function of quantity: • Key consequence of“law of demand”:

• Total revenue is pricetimes quantity

• Total revenue risesfor a while asincrease in Q morethan outweighsdecline in P

• But ultimately fall inP overwhelmsincrease in Q: totalrevenue peaks and

then falls…

a 100:= b 12000

:= P Q( ) a b Q⋅−:=

0 5 .104

1 .105

1.5 .105

2 .105

0

20

40

60

80

100

Price as function of quantity

P Q( )

Q



TR Q( ) P Q( ) Q⋅:=

0 2 .104

4 .104

6 .104

8 .104

1 .105

0

20

40

60

80

100

0

5 .105

1 .106

1.5 .106

2 .106

2.5 .106

Price (LH Scale)

Revenue=Price x Quantity (RHS)

P Q( ) TR Q( )

Q

Economic theory of the firm• If firm produces

20,000 units, market

price is 80– Total revenue =80 * 20,000 =$1.6 million

2 0

, 0 0 0 x 8 0

• 40,000 units sold,price 60

– Total revenue =60 * 40,000 =$2.4 million

– Change in total revenue $0.8 m

4 0 , 0 0 0 x 6 0

– Change in unit revenue=$0.8m/20,000=$40

60,000x40

• 60,000 units sold, price 40

– Total revenue $2.4 million

– Change in revenue per unit zero

S l o

p e = 4 0

S l o

p e = 4 0

Slope=0Slope=0




• Change in revenue called “marginal revenue”

• “In the limit”, marginal revenue equals slope of total revenue curve:

• Value of marginal revenue (x)equals slope of total revenuecurve at same point (o)

• Other side of profit equation is

costs:– Fixed: costs incurred

regardless of how many unitsproduced (research,development, factory

construction, rent, etc.)– Variable: costs that depend

on level of output: wages, rawmaterials, intermediategoods, etc.)…




• Theory argues per unit costs rise as quantity offered for sale rises:

• Slope of total cost curveis marginal cost:

• Rises as output risesbecause of diminishing marginal productivity

– After some point, eachnew worker hired(variable input) addsless to production thanprevious worker

– With constant wageand diminishing outputper worker, unit costof output rises

• “Please explain”…

k 1000000:= c 30:= d1

100000:= f

1

400000000:=

FC Q( ) k:= VC Q( ) c Q⋅ d Q2

⋅+ f Q3

⋅+:= TC Q( ) FC Q( ) VC Q( )+:=

0 5 .104

1 .105

1.5 .105

2 .105

0

5 .106

1.10

7

1.5 .107

2 .107

2.5 .107

3 .107

Total Cost

Fixed Cost

Variable Cost

TC Q( )

FC Q( )

VC Q( )

Q




• Rising marginal cost: the argument…– Production occurs in “the short run”– “Short run”: period in which at least one crucial input to production can’t be varied (normally machinery)

– Therefore to increase output, more “variable factors” mustbe added to the fixed factors

• Economic models normally consider just two factors:– Labour– “Capital”: grab-bag for all non-human inputs to

production• Factory buildings

• Machine tools• Electrical circuitry, computers• Raw materials and intermediate inputs (e.g., car

stereo units for cars)

– As you add more & more variable factors to fixed factors…




• There is some ideal worker:machineratio (e.g., one worker per jackhammer)

• In short run, firm has fixednumber of jackhammers

• To dig holes, firm has to hire workers• 1st worker operates all six jackhammers at once : pretty inefficient!

?

If this soundsweird to you,good! You’re onto something…

• Additional workers might show increasing productivity per workerfor a while (two workers operating 3 jackhammers each less messythan one operating 6, ditto three workers operating two each…)




• Eventually ideal ratio reached(6 workers for 6 jackhammers)

? ?

• Then to dig more holes, have tohave more than one worker per jackhammer:

??

• More holes can be dug with

2 workers per jackhammerthan with one…

• But productivity of twoworkers per jackhammerless than one worker per

jackhammer…




• So productivity per worker might rise for a while;

• But ultimately falls as more output can only be produced byadding more variable inputs (labour) to fixed input (capital) pastideal labour:capital ratio

– Addition to output from each additional worker falls (butdoesn’t become negative)

• “Diminishing marginal productivity” (DMP)• DMP leads to rising marginal cost

• Example: “Cobb-Douglas production function”

1

Q L K

β β

α

−

= × ×Quantity producedQuantity produced

Technology coefficientTechnology coefficient

No. workersNo. workers

Amount of capitalAmount of capital

Relative labor/capitalRelative labor/capital

product coefficientproduct coefficient



α 10:= K 100:= β .4:= L 0 0.1, 250..:= Θ K L, α, β,( ) α Lβ

⋅ K1 β−

⋅:=

0 50 100 150 200 2500

500

1000

1500 Cobb-Douglas Production Function

Number of workers

O u t p u t

Θ K L, α, β,( )

L


• Cobb-Douglas production

function allegedly fitsaggregate economic datawell (but see Shaikh, A.M., (1974). “Laws ofAlgebra and Laws ofProduction: The HumbugProduction Function”,Review of Economics and Statistics , 61: 115-20)

• Example with α =10,K=100, β =.4, L between0 and 250:

With 100 workers,output is 1,000

With 250 workers,output is 1,443

Chan

geinouput

from

1

st

100

is1000

Cha

ngeinou

put

from

next250

is44




• Each additional worker adds to output, but adds less thanprevious worker: diminishing marginal productivity

– As usual, this is slope of total product curve: (mathsunimportant, but here it is!):

1Q L K β β α −= × ×

1 1dQ L K dL

β β α β − −= × × ×

• Differentiate with respect to Labour…

• Graphing marginal product:



MP L( ) α β⋅ Lβ 1−

⋅ K1 β−

⋅:=

0 50 100 150 200 2500

100

200

300

400

500

600

700800

900

1000

1100

1200

1300

14001500

01

2

3

4

5

6

78

9

10

11

12

13

1415

Total Product (Q) LHS

Marginal Product RHS

Cobb-Douglas Production Function

Workers

O u t p u t

M a r g i n a l P

r o d u c t

Θ K L, α, β,( ) MP L( )

L


• Output with 49workers = 752


• Marginal product of50th worker ≈ 6– Using formula, it’s

exactly 6.063

• Diminishing marginal product

leads to rising marginal cost…


• Output with 100

workers = 1000• Marginal product of100th worker ≈ 4.012– Using formula, it’s

exactly 4



Q 0 1500..:=L Q( )

Q

α K1 β−

⋅

1

β

:=

0 500 1000 15000

50

100

150

200

250

300

Workers needed given desired output

Output

W

o r k e r s n e e d e d

L Q( )

Q


• First step is to “flip the axes”: graph labour input (on Y axis) needed to produce output(on X axis):

• Just reads in reverse:

– 1,000 units of outputdesired;

– 100 workers needed

• To get total (variable)cost, multiply Y axis bywage rate (say $12 anhour)…




• Rate of change ofvariable cost is marginalcost

• Rising because ofdiminishing marginalproductivity…

• So firm trying tomaximise profits is(according to economictheory) faced with

– Falling price

– Rising cost…

• How to maximise profit?

• Find biggest gapbetween revenue and

cost

w 12:= VC Q( ) w L Q( )⋅:= MC Q( )Q

VC Q( )d

d:=

0 500 1000 15000

500

1000

1500

2000

2500

3000

3500

0

1

2

3

4

5

6

Variable cost of desired output

Output

T o t a l v a r i a b l e

c o s t

M a r g i n a l c o s t

VC Q( ) MC Q( )

Q

• Production level of 1000Production level of 1000units has variable costsunits has variable costsof $1200of $1200

• Marginal cost of 1000Marginal cost of 1000thth

units is about $3units is about $3



Profit Q( ) TR Q( ) TC Q( )−:=

0 5 .104

1 .105

1.5 .105

2 .105

0

5 .106

1 .107

1.5 .107

2 .107

2.5 .107

3 .107

Total Revenue

Total Cost

Profit

TR Q( )

TC Q( )

Profit Q( )

Q


• Graphically, it’s easy: (using earlier example)• But economists

prefer to make itcomplicated byworking in average &marginal revenue &cost

• Converting diagramsto averages bydividing by quantitygives us:




• As economists like to show it:“maximise profit by equating

marginal revenue and marginalcost”

MC Q( )Q

VC Q( )d

d:= AC Q( ) TC Q( ) Q÷:=

0 5 .104

1 .105

1.5 .105

2 .105

0

50

100

150

200

Marginal Cost

Average Cost

Price

Marginal RevenueMC Q( )

AC Q( )

P Q( )

MR Q( )

Q

• What it means: “maximise profitby finding the biggest gap between

revenue and cost”• Gap between curves is biggestwhen tangents (marginal revenue &marginal cost) are parallel:




• So it’s “really easy” to manage a firm:

– Objective is to maximise profits

– Procedure is

• (1) Work out marginal cost

• (2) Work out marginal revenue

• (3) Choose output level that equates the two• For competitive firms, it’s even easier…

– Competitive firms are “price takers”

• Too small to affect market price/take price as “given”

• Marginal revenue therefore equals price– (MR less than price for less competitive industries)

– Profit maximisation rule is “produce output level at whichmarginal cost equals price”:




• “Perfect competition”

Demand

Supply

Qe

Pe

Marginal Cost

quantity

Price

qe

Pe

Downward sloping market

demand curve

Horizontal demand curve for

single firm

< <0,dP MR P dQ = =0,dP MR P dq

Quantity

Price




• So the economic theory rules are:

– If you’re a monopoly or oligopoly

• Work out your marginal cost and marginal revenue

• Produce the output level at which they are equal

– If you’re in a competitive industry

• Work out your marginal cost

• Produce output level at which marginal cost equals price

– If you’re in an industry with a small number of large firms

• More complicated: game theory…

– More on this later– As a typical text (Thomas & Maurice 2003, Managerial Economics , McGraw-Hill, Boston) summarises it:




• It’s a breeze forcompetitive

industries (p.450):

• A bit morecomplicated formonopoly (p. 500):

• And a real pain foroligopoly (p. 560)…




• What to do? So many choices…

• How does theory stack up against

reality?



Economic facts of the firm

• Theory makes many predictions; e.g.

– Firms should have rising marginal costs

– Competitive firms should have elastic demand curves:

• Elasticity: how much demand changes for a change inprice: %

% P

Q Q changeQ P Q E

change P P Q P

∆ ∆= = =

∆ ∆– Value of E can be low (less than 1) for an industry, but in limit isinfinity for competitive firms (horizontal demand curve…)

– Relative prices should move frequently as supply & demand shift

• Problem: not observed in reality

– Relative prices seem stable

– Money prices tend to move up, not down…

– “Price stickiness”




• Dispute in economics over whether prices “sticky” or“flexible”

• Ideological division in dispute– Neoclassicals/Free marketeers believe prices

“flexible”

• Prices adjust rapidly to changes in demand,supply

Demand

Supply

Quantity

Price

Qe

Pe

• Economic problems caused bygovernment, union, monopolybehavior that makes some prices(e.g. wages) more rigid than others




– Keynesians/Mixed economy supporters believe “sticky”

• Prices adjust sluggishly

• Key markets (e.g. labour) can’t be “cleared”(unemployment eliminated) simply by price movements

• Can have underemployment for substantial time;government intervention needed for full employment

• Ideological dispute continues, but statistical results imply“sluggish” price adjustments the rule

• Theory implies rapid adjustments should occur

• Why the difference?

• Plenty of theories as to why prices are sticky;• Alan Blinder (in Readings ) decided to ask firms “Why?”

– Alan S. Blinder et al., (1998). Asking About Prices: a new approach to understanding price stickiness, Russell Sage

Foundation , New York.




• Enormous volume of theoretical research in economics

• Huge amount of statistical (“econometric ”) research too

• Relatively little empirical research

– Finding out what actually happens at firm/consumer level

– Also asking firms why they do what they do

• Frequency and rapidity of price changes etc.

• How behavior compares to different theories of pricestickiness




• Blinder’s procedure

– Survey random sample of GDP so that results statisticallyapplicable to whole US economy

• 200 firms surveyed

– Structured survey to ensure objectivity

• Questions tailored to test economic theory

• Key economists consulted on design of questions

– Face to face interviews of top executives (25%President/CEO, 45% Vice President, 20% Manager) byEconomics PhD students

• Questionnaire taken seriously, informed answers• Interviewers could help clarify questions

• Interviews took 45-70 minutes for 30 questions

• Trial surveys undertaken prior to real thing to improve

uniformity of presentation, interpretation

E




– Sample representative of private, for profit, unregulated,non-farm industry (71% of US GDP)

• Reflects relative weight of industries in US GDP• Excluded companies with < $10 million in sales

– Excluded group represents 25-50% of GDP

– Weight of industries in which small firms common

increased to compensate• Farms excluded because “no-one believes farm prices to

be sticky” (60)

– Perhaps price dynamics of farm sector different to

manufacturing?– Random sample selected, of those approached 61% took

part to yield 200 firms—high response rate

E f f h f




• Distribution of sample differs from GDP with respect to firmsize:

Size Sample GDP< $10 m 0% 26.4%

$10-$25 m 22.5% 7.1%

$25-$50 m 13.5% 12.7%

> $50 m 64% 67%

• But big firms overwhelmingly important component:

– Average sales of firms surveyed $3.2 billion !

• (even though 36% of surveyed firms had sales < $ 50 m)

• 7 biggest firms had sales > $20 billion each & represented 58per cent of total sales by sample

– Firms surveyed represent 7.6% of US GDP

– “we interviewed an astounding 10 to 15 per cent of the targetpopulation—a large fraction by any standard.” (68)

E f f h f




• Blinder’s survey serious coverage of US economy• Results give serious evaluation of economic theory

• If survey results consistent with theory, theory a good guideto functioning of economy & to how managers should manage

• If survey results inconsistent with theory, relevance ofeconomic theory seriously jeopardised: could be irrelevant tofunctioning of economy (& how managers should manage)

• Results contradict most of economic theory

– Most sales to other businesses, not end consumers– Most sales to repeat customers, not “impersonal”

– Marginal costs fall for most firms, not rise

– Most firms face inelastic demand (E<1), not elastic

managerial economics lecture introduction

Documents