Managerial Economics

Overview Summary

Recapitulation

The Economics of Effective Management

• Identify Goals and Constraints• Recognize the Role of Profits• Five Forces Model• Understand Incentives • Understand Markets• Recognize the Time Value of Money• Use Marginal Analysis

Managerial Economics• Manager

– A person who directs resources to achieve a stated goal.

• Economics– The science of making decisions in the presence of

scare resources.• Managerial Economics

– The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.

Take Aways

• Make sure you include all costs and benefits when making decisions (opportunity cost).

• When decisions span time, make sure you are comparing apples to apples (PV analysis).

• Optimal economic decisions are made at the margin (marginal analysis).

Supply & Demand

I. Market Demand Curve– The Demand Function– Determinants of Demand – Consumer Surplus

II. Market Supply Curve– The Supply Function– Supply Shifters– Producer Surplus

III. Market EquilibriumIV. Price RestrictionsV. Comparative Statics

Market Demand Curve• Shows the amount of a good that will be

purchased at alternative prices, holding other factors constant.

• Law of Demand – The demand curve is downward sloping.

Quantity

D

Price

Determinants of Demand

• Income– Normal good– Inferior good

• Prices of Related Goods– Prices of substitutes – Prices of complements

• Advertising and consumer tastes

• Population• Consumer expectations

Supply & Demand Conclusion• Use supply and demand analysis to

– clarify the “big picture” (the general impact of a current event on equilibrium prices and quantities).

– organize an action plan (needed changes in production, inventories, raw materials, human resources, marketing plans, etc.).

ElasticityI. The Elasticity Concept

– Own Price Elasticity– Elasticity and Total Revenue– Cross-Price Elasticity– Income Elasticity

II. Demand Functions– Linear – Log-Linear

III. Regression Analysis

Elasticity, Total Revenue and Linear Demand

QQ

PTR

100

80

800

60 1200

40

20

Elastic

Elastic

0 10 20 30 40 500 10 20 30 40 50

Quantitative Demand Function• Elasticities are tools you can use to quantify the

impact of changes in prices, income, and advertising on sales and revenues.

• Given market or survey data, regression analysis can be used to estimate:– Demand functions.– Elasticities.– A host of other things, including cost functions.

• Managers can quantify the impact of changes in prices, income, advertising, etc.

ConsumersI. Consumer Behavior

– Indifference Curve Analysis.– Consumer Preference Ordering.

II. Constraints– The Budget Constraint.– Changes in Income.– Changes in Prices.

III. Consumer EquilibriumIV. Indifference Curve Analysis & Demand Curves

– Individual Demand.– Market Demand.

Indifference Curve Analysis

Indifference Curve– A curve that defines the

combinations of 2 or more goods that give a consumer the same level of satisfaction.

Marginal Rate of Substitution– The rate at which a consumer is

willing to substitute one good for another and maintain the same satisfaction level.

I.II.

III.

Good Y

Good X

Individual Demand and Behavior

• Indifference curve properties reveal information about consumers’ preferences between bundles of goods.– Completeness.– More is better.– Diminishing marginal rate of substitution.– Transitivity.

• Indifference curves along with price changes determine individuals’ demand curves.

• Market demand is the horizontal summation of individuals’ demands.

The FirmI. Production Analysis

– Total Product, Marginal Product, Average Product.– Isoquants.– Isocosts.– Cost Minimization

II. Cost Analysis– Total Cost, Variable Cost, Fixed Costs.– Cubic Cost Function.– Cost Relations.

III. Multi-Product Cost Functions

Production Analysis• Production Function

– Q = F(K,L)• Q is quantity of output produced.• K is capital input.• L is labor input.• F is a functional form relating the inputs to output.

– The maximum amount of output that can be produced with K units of capital and L units of labor.

• Short-Run vs. Long-Run Decisions• Fixed vs. Variable Inputs

The Firm Take Aways

• To maximize profits (minimize costs) managers must use inputs such that the value of marginal of each input reflects price the firm must pay to employ the input.

• The optimal mix of inputs is achieved when the MRTSKL = (w/r).

• Cost functions are the foundation for helping to determine profit-maximizing behavior in future chapters.

ProductionI. Methods of Procuring Inputs

– Spot Exchange – Contracts – Vertical Integration

II. Transaction Costs– Specialized Investments

III. Optimal Procurement InputIV. Principal-Agent Problem

– Owners-Managers– Managers-Workers

Production and Agency Issues

• The optimal method for acquiring inputs depends on the nature of the transactions costs and specialized nature of the inputs being procured.

• To overcome the principal-agent problem, principals must devise plans to align the agents’ interests with the principals.

Nature of Industry

I. Market Structure– Measures of Industry Concentration

II. Conduct– Pricing Behavior– Integration and Merger Activity

III. Performance– Dansby-Willig Index– Structure-Conduct-Performance Paradigm

IV. Preview of Coming Attractions

Relating the Five Forces to the SCP Paradigm and the Feedback Critique

Power of Input Suppliers

Supplier ConcentrationPrice/Productivity of Alternative InputsRelationship-Specific InvestmentsSupplier Switching CostsGovernment Restraints

Power ofBuyers

Buyer ConcentrationPrice/Value of Substitute Products or ServicesRelationship-Specific InvestmentsCustomer Switching CostsGovernment Restraints

EntryEntry CostsSpeed of AdjustmentSunk CostsEconomies of Scale

Network EffectsReputationSwitching CostsGovernment Restraints

Substitutes & ComplementsPrice/Value of Surrogate Products or ServicesPrice/Value of Complementary Products or Services

Network EffectsGovernment Restraints

Industry RivalrySwitching CostsTiming of DecisionsInformationGovernment Restraints

ConcentrationPrice, Quantity, Quality, or Service CompetitionDegree of Differentiation

Level, Growth, and SustainabilityOf Industry Profits

Industry Analysis• Modern approach to studying industries involves

examining the interrelationship between structure, conduct, and performance.

• Industries dramatically vary with respect to concentration levels.– The four-firm concentration ratio and Herfindahl-

Hirschman index measure industry concentration.• The Lerner index measures the degree to which

firms can markup price above marginal cost; it is a measure of a firm’s market power.

• Industry performance is measured by industry profitability and social welfare.

CompetitionI. Perfect Competition

– Characteristics and profit outlook.– Effect of new entrants.

II. Monopolies– Sources of monopoly power.– Maximizing monopoly profits.– Pros and cons.

III. Monopolistic Competition– Profit maximization.– Long run equilibrium.

Market Power

• Firms operating in a perfectly competitive market take the market price as given.– Produce output where P = MC.– Firms may earn profits or losses in the short run.– … but, in the long run, entry or exit forces profits to zero.

• A monopoly firm, in contrast, can earn persistent profits provided that source of monopoly power is not eliminated.

• A monopolistically competitive firm can earn profits in the short run, but entry by competing brands will erode these profits over time.

Role of Strategic Interaction

• Your actions affect the profits of your rivals.

• Your rivals’ actions affect your profits.

• How will rivals respond to your actions?

Conclusion

• Different oligopoly scenarios give rise to different optimal strategies and different outcomes.

• Your optimal price and output depends on …– Beliefs about the reactions of rivals.– Your choice variable (P or Q) and the nature of the

product market (differentiated or homogeneous products).

– Your ability to credibly commit prior to your rivals.

Game Theory

I. Introduction to Game TheoryII. Simultaneous-Move, One-Shot GamesIII. Infinitely Repeated GamesIV. Finitely Repeated GamesV. Multistage Games

Two-Player Nash Equilibrium

• The Nash equilibrium is a condition describing the set of strategies in which no player can improve her payoff by unilaterally changing her own strategy, given the other player’s strategy.

• Formally,– π1(s1

*,s2*) ≥ π1(s1,s2

*) for all s1.

– π1(s1*,s2

*) ≥ π1(s1*,s2) for all s2.

Key Insights• Look for dominant strategies.• Put yourself in your rival’s shoes.

Coordination Games

• In many games, players have competing objectives: One firm gains at the expense of its rivals.

• However, some games result in higher profits by each firm when they “coordinate” decisions.

Examples of Coordination Games

• Industry standards– size of floppy disks.– size of CDs.

• National standards– electric current.– traffic laws.

Pricing OverviewI. Basic Pricing Strategies

– Monopoly & Monopolistic Competition – Cournot Oligopoly

II. Extracting Consumer Surplus– Price Discrimination Two-Part Pricing– Block Pricing Commodity Bundling

III. Pricing for Special Cost and Demand Structures– Peak-Load Pricing Transfer Pricing– Cross Subsidies

IV. Pricing in Markets with Intense Price Competition– Price Matching Randomized Pricing– Brand Loyalty

Standard Pricing and Profits for Firms with Market Power

Price

Quantity

P = 10 - 2Q

10

8

6

4

2

1 2 3 4 5

MC

MR = 10 - 4Q

Profits from standard pricing= $8

Uncertainty and Consumer Behavior

• Risk Aversion– Risk Averse: An individual who prefers a sure amount of

$M to a risky prospect with an expected value, E[x], of $M.

– Risk Loving: An individual who prefers a risky prospect with an expected value, E[x], of $M to a sure amount of $M.

– Risk Neutral: An individual who is indifferent between a risky prospect where E[x] = $M and a sure amount of $M.

Asymmetric Information

• Situation that exists when some people have better information than others.

• Example: Insider trading

Moral Hazard

• Situation where one party to a contract takes a hidden action that benefits him or her at the expense of another party.

• Examples– The principal-agent problem.– Care taken with rental cars.

Auctions

• Uses– Art– Treasury bills– Spectrum rights– Consumer goods (eBay and other Internet auction sites)– Oil leases

• Major types of Auction– English– First-price, sealed-bid– Second-price, sealed-bid– Dutch

Asymmetric Information

• Information plays an important role in how economic agents make decisions.– When information is costly to acquire, consumers will continue to

search for price information as long as the observed price is greater than the consumer’s reservation price.

– When there is uncertainty surrounding the price a firm can charge, a firm maximizes profit at the point where the expected marginal revenue equals marginal cost.

• Many items are sold via auctions – English auction– First-price, sealed bid auction– Second-price, sealed bid auction– Dutch auction

Government’s Role

I. Market Failure– Market Power– Externalities– Public Goods– Incomplete Information

II. Rent SeekingIII. Government Policy and International Markets

– Quotas– Tariffs– Regulations

Antitrust Policies

• Administered by the DOJ and FTC• Goals:

– To eliminate deadweight loss of monopoly and promote social welfare.

– Make it illegal for managers to pursue strategies that foster monopoly power.

Sherman Act (1890)

• Sections 1 and 2 prohibits price-fixing, market sharing and other collusive practices designed to “monopolize, or attempt to monopolize” a market.

Government Policies Designed to Mitigate Incomplete Information

• OSHA• SEC• Certification• Truth in lending• Truth in advertising• Contract enforcement

Conclusion

• Market power, externalities, public goods, and incomplete information create a potential role for government in the marketplace.

• Government’s presence creates rent-seeking incentives, which may undermine its ability to improve matters.

Congratulations!!