MANAGERIAL ECONOMICS

SUMMARY
An Economics Archive
Boonserm Booncharoenpol
2004
2
CONTENTS
1. Nature and Scope of Managerial
Economics
2. Economic Optimization
3. Demand and Supply
4. Demand Analysis
5.– 6.Demand Estimation
7. Production
8. Cost Analysis
9. Sorry! No Chapter 9
10. Perfect Competition and
Monopoly
3
11. Monopolistic Competition and
Oligopoly
12. Pricing Practices
13. Regulation of the Market Economy
14. Risk Analysis
4
1
Nature and Scope of Managerial
Economics
☻ Managerial economics : Applies
economics tools and techniques to business and
administrative decision making
⁄
⁄
⁄
Management Decision Problems
Managerial Economics
☻ Economic Concepts
☻ Quantitative Methods
Optimal Solutions
5
☻ Do managers try to optimize (seek the best
result) or to satisfice?
• No definitive answers, but to optimize is the
foundation of decisions.
☻ Business profit is the residual of sales revenue
minus the explicit accounting cost of doing business.
Economic profit is the business profit minus the
implicit costs of other owner-provided inputs. (Even
the firm has zero profit, it can be survived.)
☻ Why do businesses get profit? From frictional
profit theory :
• Profit from noncompetition
• Profit from innovation
• Profit from efficiency
6
2..
Economic Optimization
☻ What is optimization?
• Maximum or minimum, depending on certain
cases
☻ Types of optimization
• Linear : Linear Programming
• Nonlinear : Calculus
☻ Linear Programming
Max profit π = 5X1 + 4 X2
Subject to :
2 X1 + 10 X2 < 20
1 X1 + 5 X2 < 10
20 X1 + 2 X2 < 14
X1 ,X2 > 0
Either X1 or X2
has power 1.
7
☻ Calculus : Derivative
π = TR – TC
= 41.5Q – 1.1Q2 – (150 + 10Q
– 0.5Q2 + 0.02Q3)
= 41.5Q – 1.1Q2 – 150 - 10Q
+ 0.5Q2 - 0.02Q3
= 31.5Q – 0.6 Q2 - 0.02Q3 – 150
1st order condition dπ /dQ = 0 , that is, slope = 0 .
dπ /dQ = 31.5 –1.2Q – 0.06 Q2
31.5 –1.2Q – 0.06 Q2 = 0
Q = -35 (no) and 15 (OK)√
2nd order condition
d2π /dQ2 < 0 max, d2π /dQ2 > 0 min
d2π /dQ2 = -1.2 – 0.12Q = -3, max
π = 31.5Q – 0.6 Q2 - 0.02Q3 – 150
= 31.5*15 – 0.6 (15)2 - 0.02(15)3 – 150
= 120
☻ Marginal = dY/dX = derivative
Q = 15
8
• Marginal Cost = dTC/dQ
• Marginal Revenue = dTR/dQ
• Marginal Product dQ/dX
Where Q = Product, X = a factor of production
9
3.
Demand and Supply
☻ Demand is the quantity of a good or service that
customers are willing and able to purchase during a
specific period under a given set of economic
conditions.
☻ Demand function:
QD = a + bP + cPr + eI + fN + gR + hA
Advertisement
Price Interest rate
for consumption
Population
Income
Price of related goods
☻ Supply is the quantity of a good or service that
producers are willing and able to sell during a certain
period under a giving set of conditions.
10
☻ QS= j + kP + mPi + nT + pN + gC + hAP
Technology
Price Input price Constraint
Weather Alternative business
☻ Market equilibrium is the equality of the quantity
demanded and the quantity supplied in a market. (QE)
P QD QS Surplus or Shortage
5 15 7 Shortage
6 12 9 Shortage
7 10 10 Equilibrium
8 6 14 Surplus
Price
P1 D S
PE E
P2
QE Quantity
surplus
shortage
11
4.
Demand Analysis
☻ Utility function is the satisfaction derived from
consumption of goods or services.
☻ Marginal utility (MU) is the added utility derived
from increasing of consumption by one more unit
of good (or service).
☻ Low of diminishing marginal utility : Q↑ →
MU↓
☻ Indifference curve is a line of
equal satisfaction when one
consumes combinations of two goods
or services.
Q Pork
Q Chicken
Higher satisfaction
(utility)
12
☻ Lower price → Consume more
That is law of demand.
OR
Q Pork Higher income consumes both more
→ Q Chicken
More budget →
Q Pork
Q Chicken
Lower price >>> consumes more (one
or two goods)
Lower price
P
Demand Curve
Q
Q
Demand Curve
P
13
This is “Demand Curve”
☻ Elasticity :
Percentage change in result
Percentage change in cause
• Price elasticity of demand =
Percentage change in quantity demanded
÷ Percentage change in its price
IEI > 1 : Elastic, IEI = 1 :
Unitary
IEI < 1 : Inelastic
☻ Optimal pricing policy (max
profit)
Q2 - Q1
__________
Q2 + Q1
Edp = ______________________
P2 - P1
__________
P2 + P1
14
• Cross-Price elasticity of demand
=
Percentage change in quantity demanded of Y
÷ Percentage change in price of X
MC
P = ________________
1
1 + _____
Edp
25
P = ________________ = 50
1
1 + _____
-2
QY2 - QY1
__________
QY2 + QY1
Edcp = ______________________
PX2 - PX1
__________
PX2 + PX1
15
IEI > 1 : Elastic: high
substitution,
IEI = 1 : Unitary
IEI < 1 : Inelastic : low
substitution
☻ It’s believed that advertisement
makes more demand. Yes, it is but it
may or may not make more profit.
Because we produce more goods,
make more income, and pay more
costs, including advertisement cost.
• Income elasticity of demand =
Advertisement
More demand
More revenue More cost
(Production + Advertisement)
(More revenue – More cost)
More or less profit
16
Percentage change in quantity demanded ÷
Percentage change in income
E > 0 : Normal good
E < 0 : Inferior good
Q2 - Q1
__________
Q2 + Q1
Edcp = ______________________
I2 - I1
__________
I2 + I1
17
5-6
Demand Estimation
☻ Demand estimation methods :
• Nonstatistical method
• Statistical method
☻ Nonstatistical method
• Customer Interviews :
Questioning customers or
potential customers to estimate
demand
• Market experiments : Set
environments and notice their
outcomes
• Reasoning from experiences
☻ Statistical method (consult
econometrics books or
teachers) : Trend regression and
Cause-effect
regression
18
• Trend regression : Time is the
only independent variable
QD = a + bT or QD = a + b eT
• Cause-effect regression : Many
cause-variables as independent
variable
QD = a + bP + cPr + dY + eA
☻ No method can make exactly right
estimation
19
7.
Production
☻ Production function is showing
what factors the output depends on.
Q = f(Capital, Labour)
☻ Return to scale : All inputs
(factors of production) are n times
(of the last production) make the
output be k times (of the last
production)
☻ Return to a factor : One input is n
times (of the last production) makes
the output be k times (of the last
production)
☻ Total product is whole output
from a production system.
20
☻ Marginal product (MP) = Change
in output asscociated with a one-unit
change in a single input
MP = ∂Q/∂X
☻ Average product (AP) = Total
output divided by a unit of an input
AP = Q/X
☻ Law of diminishing return :
X ↑ → MP↓
☻ Isoquant : Different input
combinations still make the same
output
Factor Y
Isoquant 2 : 20 pieces (More output)
Isoquant 1 : 10 pieces
Factor X
21
☻ Shapes of isoquant and
substitutions
Factor Y Factor Y
•
Factor X Factor X
Perfect substitution Combination not substitution
Factor Y
Imperfect substitution
22
8.
Cost Analysis
☻ Historical cost : Cost paid at time of buying
☻ Current cost : Cost paid at present
☻ Opportunity cost or implicit cost : Cost that is not
paid in cash for using a factor of production but we
lose (the highest) income from that factor, (no more
income when using that factor)
☻ Sunk cost : Cost paid for a factor of production
but that factor is not used for the production at all
☻ Short run : 1) There still be a fixed factor of
production
2) Considering at a point of time
☻ Long run : 1) No more fixed factor of production
2) Considering simultaneously at
several points of time
23
☻ Fixed cost : Expense that does not vary with
the amount of output
☻ Variable cost : Expense that varies with
the amount of output
☻ Short-Run Cost :
• Total Cost = TC = TFC + TVC
• Average Fixed Cost = AFC =
TFC / Q
• Average Variable Cost = AVC
= TVC / Q
• Average Cost = AC = TC / Q
• Marginal Cost = MC = ΔTC/Δ
Q
Also MC = ΔTVC/Δ Q (because ΔTC
= ΔTVC)
24
☻ Short-run cost curves
☻ Long-run cost curves
Cost
Q Output
Total Cost
Total Variable Cost
Total Fixed Cost
Cost
Q Output
ATC or
AC
MC AVC
AFC
AC
Output Q
Size 1
Size 2 Size 3 Size 4
Long-run Average Cost
25
☻ Cost Elasticity EC
= Percentage Change in TC /
Percentage Change in Q
☻ EC < 1 Decreasing AC at bigger scale :
Economies of Scale
EC > 1 Increasing AC at bigger scale :
Diseconomies of Scale
Economies of scale: All inputs are
increased Q↑ → AC↓
Note : Economies of scale aims at AC
where increasing returns to scale aims
at Q
☻ Learning curve : Experience ↑ →
AC↓
☻ Learning Rate = [1 - AC2/AC1] *
100
TC2 - TC1
TC2 + TC1
EC =
Q2 - Q1
Q2 + Q1
26
☻ Economies of Scope: Joint
production → AC1↓ AC2↓
☻ Degree of operating leverage =
Percentage Change in Profit / Percentage
Change in Output
(Aim at profit)
☻ Cost estimation
Data :
Selling price = Baht 2
Fixed cost = Baht 20,000
Variable cost = Baht 1.50*Q
Units sold
(Q)
Sales
(TR)
Baht
Cost
(TC)
Baht
Profit
()
Baht
20,000 40,000 50,000 -10,000
40,000 80,000 80,000 0
””””
120,000 240,000 200,000 40,000
27
9.
(Sorry! No Chapter 9)
Cost, Revenue
250
200
150
100
50
0 0 20 40 60 80 100 120 Q
Total revenue
Total cost
Fixed cost
Breakeven
28
10..
Perfect Competition
and Monopoly
☻ Market : An activity that firm and
individual buy and sell a given
product
☻ Perfect competition : No one can
dominate market price. Everybody
is a price taker (accept the price
created by market).
☻ Monopoly : One seller of a
product (All buyers have to buy a
product from the only one buyer.)
☻ Level of competition (seller side)
☻ ☻☻ ☻☻☻ ☻☻☻☻☻☻☻☻☻ ☻☻☻☻☻☻☻☻☻☻☻☻☻☻☻
Monopoly Duopoly Oligopoly Monopolistic-Competition
Perfect Competition
29
☻ Factors that determine the level of
competition
• Product characteristics
• Production characteristics
• Barrier to entry
• Buyers
☻ Price-Output Decisions in
Perfectly Competitive Markets: At P
= AR = MR
(In perfectly competitive markets:
AR = MR)
SHORT RUN
Cost, Price, Revenue
Q Output
Profit MC AC
P, AR, MR
LONG RUN
Cost, Price, Revenue
P*
Q Output
Q*
MC AC No Profit
P, AR, MR
30
Q*
• In short run, even under perfect
competition , a firm may has
profit from better efficiency
than other firms (receive
economic rent), or good luck
due to higher demand or lower
cost when the market is being
adjusted to equilibrium
(economic luck) .
• In long run, under perfect
competition , there is no profit.
No one has better efficiency
than other.
• Sorry! No perfect competitive
market in this world.
☻ Supply curve of a firm in perfectly
competitive market(ONLY!!!) : It is
MC that lies above the AVC because
it makes MC = MR along this curve,
a curve of maximum profit.
31
☻ Perfect competition and monopoly
market
structure (sellers’ side)
Points to discuss Perfect
Competition
Monopoly
Number of sellers Many small sellers A single seller
Product Identical High product
differentiation
Information Complete information
on price and product
quality
Restricted
Entry and exit Free to entry or exit Very high barriers
from large amount of
capital, patents,
copyrights, etc.
Profit No, except in short
run
Yes, both short run
and long run
Example None Electric utilities
LONG RUN
Cost, Price, Revenue
Q Output
Price, Cost, Revenue
AC
AVC
MC
Q, OUTPUT
Supply curve in perfectly
competitive market
32
11.
Monopolistic
Competition and
Oligopoly
☻ Monopolistic competition : A
market structure characterized by
many sellers with differentiated
products
☻ Oligopoly : A market structure
characterized by few sellers with
same or similar products
☻ Characteristics of
Monopolistically competitive market
:
• Large numbers of sellers
• Product difference
• Easy but not free to entry and
exit
33
• Partially restrictive information
on price and product quality
Points to
discuss
Monopolistic Competition
Number of sellers Many small and big sellers
Product Identical or different
Information Partially restrictive information on
price and product quality
Entry and exit Easy but not free to entry or exit
Profit Yes Also may be loss
Example Most firms in these days
☻ Price – output decisions of firms under
monopolistic competition : At MC = MR. See down
below.
☻ Characteristics of oligopoly:
Points to
discuss
Oligopoly
Number of sellers Few sellers
Product Unique or almost unique product
Price, cost, revenue
MC
Sell at
this Price AC
AC
MR AR
Produce at this Quantity
Q, Output
Monopoly, Monopolistic Competition,
and Oligopoly have all this same graph.
Profit
MC=MR
34
Information Restrictive information on price and
product quality
Entry and exit Blocked entry or exit
Profit Yes Also may be loss
Example Carrefour, Tesco, Big C
☻ Price leadership : One firm is a leader on price
and all other firms accept the price.
☻ Kinked demand curve : A
demand when price cuts are followed
but price increases are not
☻ Optimal level of advertising :
MR derived from Advertising = MC
occurred from advertising
☻ Advertising and quality
improvements are alternatives to
price cutting.
Price, Cost, Revenue
MR MC1
Price* MC2
Demand, AR
MR
Demand of buyers for product of this
oligopolistic firm
35
12.
PRICING PRACTICES
☻ Markup pricing : Setting prices (to
cover average cost and get profit)
• Markup on cost : setting price for profit as a
percentage of average cost
Markup on cost = (Price – AC) / AC
• Markup on price : setting price for profit as a
percentage of price
Markup on price = (Price – AC) / Price
☻ Optimal price : Price that makes
maximum profit by considering
demand and cost
P* = [EP/(1 + EP)] * MC
Price-elasticity
of Demand
Marginal
Cost
36
See Graph
• Higher or lower price setting does
not make maximum profit.
☻ Price discrimination : Setting the
same kind of product at different
prices in different markets in order to
get maximum profit. It’s unfair
practice but they do in capitalism.
☻ To get maximum profit, the seller
adjusts price and quantity of the same
goods in different markets until
MR at market A
= MR at market B
37
= MR at market C
= MC (all of product were
produced at same
factory)
☻ First-degree price discrimination :
Charging different prices to different
customers
Second-degree price discrimination
: Charging different prices based on
quantities purchased
Third-degree price discrimination :
Charging different prices to each
customer class
38
☻ Odd number pricing as baht 99
istead of baht 100 : Sellers think that
they can lure buyers to think that it is
just ninety !!! ??? But clever buyers
know that it is just a trick to persuade
the fools.
Graph for cost, revenue, and profit … (back)
13.
Regulation of the Market Economy
Price, cost, revenue
MC
Sell at
this Price AC
AC
MR AR
Produce at this Quantity Q,
Output
Monopoly, Monopolistic Competition,
and Oligopoly have all this same graph.
Profit
MC=MR
39
☻ Why economic regulation necessary? : Because of market
imperfections that lead to inefficiency and fairness (competition is
impossible without regulation)
☻ Examples of economic regulations : consumer protection,
concentration limit (not too big), property right, patents, subsidy, tax,
operating control, etc.
☻ Tax and burden : The less power people pay more tax burden
(who has less price elasticity takes more burden)
Price Price S2
Demand S2 S1
S1
Demand
Quantity Quantity
AB
A : Seller has more bargaining power (more price elasticity) than buyer
Buyer takes more burden than seller
B : Buyer has more bargaining power (more price elasticity) than seller
Seller takes more burden than buyer
Total Tax-Burden
for one unit
Total Tax-
Burden for
one unit
Buyer’s Tax-Burden
for one unit
Buyer’s Tax -
Burden for one Unit
40
☻ Antitrust law : Laws that prevent monopoly and
promote competition
14.
Risk Analysis
☻ Economic risk : Chance of loss due to
unknown causes
☻ Expected value (E(X)) :
Expected value of X = p1*X1 + p2*X2 + … + pn*Xn
pi are probabilities of events to occur
☻ Relative risk : Variation in possible returns
compared with the expected value, popular method is
Coefficient of Variation, CV = Standard Deviation / Mean
☻ Risk attitudes :
• Risk aversion : A person who avoid loss
41
• Risk seeking : A person who prefer risk
and is not afraid of loss
☻ Decision trees : A decision making process
which summing up the multiplications of probability of
occurrence and outcome
Prob .25 High demand profit 5 m
Prob .35 Medium demand profit 3 m
Build big plant Prob .40 Low demand profit 1 m
Decision Build small plant Prob .25 High demand profit 4 m
Prob .35 Medium demand profit 3 m
Prob .40 Low demand profit 2 m
Decision Outcome (output and probability)
Expected value of building big plant = 0.25*5 + 0.35*3 + 0.40*1 = 2.70
Expected value of building big plant = 0.25*4 + 0.35*3+ 0.40*2 = 2.85
Decision : Build small plant