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Introduction to Managerial Economics and Strategic Decision Making
Nikolas E. LionisUniversity of Athens
October 2006
Overview
1. Introduction2. The Nature of Industry3. Market Forces: Demand and Supply4. Quantitative Demand Analysis5. Market Structure6. Game Theory
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.
Economic vs. Accounting Profits
• Accounting Profits– Total revenue (sales) minus dollar cost of
producing goods or services.– Reported on the firm’s income statement.
• Economic Profits– Total revenue minus total opportunity cost.
Opportunity Cost• Accounting Costs
– The explicit costs of the resources needed to produce produce goods or services.
– Reported on the firm’s income statement.• Opportunity Cost
– The cost of the explicit and implicit resources that are foregone when a decision is made.
• Economic Profits– Total revenue minus total opportunity cost.
Market Interactions• Consumer-Producer Rivalry
– Consumers attempt to locate low prices, while producers attempt to charge high prices.
• Consumer-Consumer Rivalry– Scarcity of goods reduces the negotiating power of
consumers as they compete for the right to those goods.• Producer-Producer Rivalry
– Scarcity of consumers causes producers to compete with one another for the right to service customers.
• The Role of Government– Disciplines the market process.
The Nature of Industry
Industry Analysis• Basic Conditions
– Supply– Demand
• Market Structure– Number of firms.– Industry concentration.– Technological and cost conditions.– Demand conditions.– Ease of entry and exit.
• Conduct– Pricing.– Advertising.– R&D.– Merger activity.
• Performance– Profitability.– Social welfare.
Approaches to Studying Industry • The Structure-Conduct-Performance (SCP) Paradigm:
Causal ViewMarket Structure
Conduct Performance
• The Feedback Critique– No one-way causal link.– Conduct can affect market structure.– Market performance can affect
conduct as well as market structure.
Entry•Entry Costs•Speed of Adjustment•Sunk Costs•Economies of Scale
•Network Effects•Reputation•Switching Costs•Government Restraints
Relating the Five Forces to the SCP Paradigm and the Feedback Critique
Power ofBuyers
•Buyer Concentration•Price/Value of Substitute Products or Services•Relationship-Specific Investments•Customer Switching Costs•Government Restraints
Power ofInput Suppliers
•Supplier Concentration•Price/Productivity of Alternative Inputs•Relationship-Specific Investments•Supplier Switching Costs•Government Restraints
Level, Growth, and SustainabilityOf Industry Profits
Substitutes & Complements•Price/Value of Surrogate Products or Services•Price/Value of Complementary Products or Services
•Network Effects•Government Restraints
Industry Rivalry•Switching Costs•Timing of Decisions•Information•Government Restraints
ty,
ation
•Concentration•Price, Quantity, Qualior Service Competition•Degree of Differenti
Market Forces
• Market Demand Curve• Market Supply Curve • Market Equilibrium
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.
QuantityD
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
The Demand Function
• A general equation representing the demand curveQx
d = f(Px , PY , M, H,)
– Qxd = quantity demand of good X.
– Px = price of good X.– PY = price of a related good Y.
• Substitute good.• Complement good.
– M = income.• Normal good.• Inferior good.
– H = any other variable affecting demand.
Inverse Demand Function
• Price as a function of quantity demanded.• Example:
– Demand Function• Qx
d = 10 – 2Px
– Inverse Demand Function:• 2Px = 10 – Qx
d
• Px = 5 – 0.5Qxd
Change in Quantity DemandedPrice
Quantity
D0
4 7
6
A to B: Increase in quantity demanded
B
10A
Change in DemandPrice
Quantity
D0
D1
6
7
D0 to D1: Increase in Demand
13
Consumer Surplus:
• The value consumers get from a good but do not have to pay for.
I got a great deal!
• That company offers a lot of bang for the buck!
• Dell provides good value.• Total value greatly exceeds
total amount paid.• Consumer surplus is large.
I got a lousy deal!
• That car dealer drives a hard bargain!
• I almost decided not to buy it!
• They tried to squeeze the very last cent from me!
• Total amount paid is close to total value.
• Consumer surplus is low.
Consumer Surplus: The Discrete Case
Price
D
Consumer Surplus:The value received but notpaid for. Consumer surplus =(8-2) + (6-2) + (4-2) = $12.
10
8
6
4
2
1 2 3 4 5 Quantity
Consumer Surplus:The Continuous Case
Price $
D
10
8
6
4
Valueof 4 units = $24Consumer
Surplus = $24 - $8 = $16
Expenditure on 4 units = $2 x 4 = $8
2
1 2 3 4 5 Quantity
Market Supply Curve
• The supply curve shows the amount of a good that will be produced at alternative prices.
• Law of Supply– The supply curve is upward sloping.
Price
Quantity
S0
Supply Shifters
• Input prices• Technology or government regulations• Number of firms
– Entry – Exit
• Substitutes in production• Taxes
– Excise tax– Ad valorem tax
• Producer expectations
The Supply Function
• An equation representing the supply curve:Qx
S = f(Px , PR ,W, H,)
– QxS = quantity supplied of good X.
– Px = price of good X.– PR = price of a production substitute.– W = price of inputs (e.g., wages).– H = other variable affecting supply.
Inverse Supply Function
• Price as a function of quantity supplied.• Example:
– Supply Function• Qx
s = 10 + 2Px
– Inverse Supply Function:• 2Px = 10 + Qx
s
• Px = 5 + 0.5Qxs
Change in Quantity Supplied
Price
Quantity
S0
20
10
B
A
5 10
A to B: Increase in quantity supplied
Change in Supply
Price
Quantity
S0
S1
8
75
S0 to S1: Increase in supply
6
Producer Surplus• The amount producers receive in excess of the amount
necessary to induce them to produce the good.Price
S0
P*
Q* Quantity
Market Equilibrium
• Balancing supply and demand– Qx
S = Qxd
• Steady-state
If price is too low…
Quantity
S
D
5
6 12
Shortage12 - 6 = 6
67
Price
If price is too high…
Quantity
S
D
9
14
Surplus14 - 6 = 8
6
8
8
7
Price
Price Restrictions• Price Ceilings
– The maximum legal price that can be charged.– Examples:
• Gasoline prices in the 1970s.• Housing in New York City.• Proposed restrictions on ATM fees.
• Price Floors– The minimum legal price that can be charged.– Examples:
• Minimum wage.• Agricultural price supports.
Impact of a Price Ceiling
Quantity
S
P*
Q*
P Ceiling
Q s
PF
Shortage
Q d
Price
D
Full Economic Price
• The dollar amount paid to a firm under a price ceiling, plus the nonpecuniary price.
PF = Pc + (PF - PC) • PF = full economic price• PC = price ceiling• PF - PC = nonpecuniary price
An Example from the 1970s
• Ceiling price of gasoline: $1.• 3 hours in line to buy 15 gallons of gasoline
– Opportunity cost: $5/hr.– Total value of time spent in line: 3 × $5 =
$15.– Non-pecuniary price per gallon:
$15/15=$1.• Full economic price of a gallon of gasoline:
$1+$1=2.
Impact of a Price Floor
Quantity
S
D
P*
Q*
Surplus
PF
Qd QS
Price
Quantitative Demand Analysis
The Elasticity Concept– Own Price Elasticity– Elasticity and Total Revenue– Cross-Price Elasticity– Income Elasticity
The Elasticity Concept
• How responsive is variable “G” to a change in variable “S”
SGE SG ∆
∆=
%%
,
If EG,S > 0, then S and G are directly related.If EG,S < 0, then S and G are inversely related.If EG,S = 0, then S and G are unrelated.
The Elasticity Concept Using Calculus
• An alternative way to measure the elasticity of a function G = f(S) is
GS
dSdGE SG =,
If EG,S > 0, then S and G are directly related.If EG,S < 0, then S and G are inversely related.If EG,S = 0, then S and G are unrelated.
Own Price Elasticity of Demand
X
dX
PQ PQE
XX ∆∆
=%
%,
• Negative according to the “law of demand.”
1, >XX PQE
1, <XX PQE
1, =XX PQE
Elastic:
Inelastic:
Unitary:
Perfectly Elastic & Inelastic Demand
Price Price
D
)( ElasticPerfectly , −∞=XX PQE
D
Quantity Quantity
)0, =XX PQE( Inelastic Perfectly
Own-Price Elasticity and Total Revenue
• Elastic – Increase (a decrease) in price leads to a decrease (an
increase) in total revenue.• Inelastic
– Increase (a decrease) in price leads to an increase (a decrease) in total revenue.
• Unitary– Total revenue is maximized at the point where
demand is unitary elastic.
Elasticity, Total Revenue and Linear Demand
PTR
100
QQ0 030 40 5010 20
Elasticity, Total Revenue and Linear Demand
P
TR100
0 10 20 30 40 50
80
800
10 30 40 500 20
Elasticity, Total Revenue and Linear Demand
P
TR100
80
800
60 1200
30 40 500 10 200 10 20 30 40 50
Elasticity, Total Revenue and Linear Demand
P
TR100
80
800
60 1200
40
30 40 500 10 200 10 20 30 40 50
Elasticity, Total Revenue and Linear Demand
P
TR100
80
800
60 1200
40
20
30 40 500 10 200 10 20 30 40 50
Elasticity, Total Revenue and Linear Demand
P
Elastic
TR100
80
800
60 1200
40
20
30 40 500 10 20
Elastic
0 10 20 30 40 50
Elasticity, Total Revenue and Linear Demand
P
Inelastic
Elastic
TR100
80
800
60 1200
40
20
30 40 500 10 20
Elastic Inelastic
0 10 20 30 40 50
Elasticity, Total Revenue and Linear Demand
P TR
Inelastic
ElasticUnit elastic
100
80
800
60 1200
40
20
30 40 50
Unit elastic
0 10 20
Elastic Inelastic
0 10 20 30 40 50
Factors Affecting Own Price Elasticity
• Available Substitutes– The more substitutes available for the good, the more elastic
the demand.
• Time– Demand tends to be more inelastic in the short term than in
the long term.– Time allows consumers to seek out available substitutes.
• Expenditure Share– Goods that comprise a small share of consumer’s budgets
tend to be more inelastic than goods for which consumers spend a large portion of their incomes.
Cross Price Elasticity of Demand
Y
dX
PQ PQE
YX ∆∆
=%
%,
If EQX,PY> 0, then X and Y are substitutes.
If EQX,PY< 0, then X and Y are complements.
Income Elasticity
MQE
dX
MQX ∆∆
=%
%,
If EQX,M > 0, then X is a normal good.
If EQX,M < 0, then X is a inferior good.
Uses of Elasticities
• Pricing.• Managing cash flows.• Impact of changes in competitors’ prices.• Impact of economic booms and recessions.• Impact of advertising campaigns.• And lots more!
Example 1: Pricing and Cash Flows
• According to an FTC Report by Michael Ward, AT&T’s own price elasticity of demand for long distance services is -8.64.
• AT&T needs to boost revenues in order to meet it’s marketing goals.
• To accomplish this goal, should AT&T raise or lower it’s price?
Answer: Lower price!
• Since demand is elastic, a reduction in price will increase quantity demanded by a greater percentage than the price decline, resulting in more revenues for AT&T.
Example 2: Quantifying the Change
• If AT&T lowered price by 3 percent, what would happen to the volume of long distance telephone calls routed through AT&T?
Answer• Calls would increase by 25.92 percent!
( )%92.25%
%64.8%3%3
%64.8
%%64.8,
=∆
∆=−×−−∆
=−
∆∆
=−=
dX
dX
dX
X
dX
PQ
Q
Q
Q
PQE
XX
Example 3: Impact of a change in a competitor’s price
• According to an FTC Report by Michael Ward, AT&T’s cross price elasticity of demand for long distance services is 9.06.
• If competitors reduced their prices by 4 percent, what would happen to the demand for AT&T services?
Answer• AT&T’s demand would fall by 36.24 percent!
%24.36%
%06.9%4%4
%06.9
%%06.9,
−=∆
∆=×−−∆
=
∆∆
==
dX
dX
dX
Y
dX
PQ
Q
Q
Q
PQE
YX
Market Structure
Market StructureI. Perfect CompetitionII. MonopoliesIII. Monopolistic CompetitionIV. Oligopoly
Perfect Competition Environment
• Many buyers and sellers.• Homogeneous (identical) product.• Perfect information on both sides of market.• No transaction costs.• Free entry and exit.
Key Implications
• Firms are “price takers” (P = MR).• In the short-run, firms may earn profits or
losses.• Long-run profits are zero.
Unrealistic? Why Learn?• Many small businesses are “price-takers,” and decision
rules for such firms are similar to those of perfectly competitive firms.
• It is a useful benchmark.• Explains why governments oppose monopolies.• Illuminates the “danger” to managers of competitive
environments.– Importance of product differentiation.– Sustainable advantage.
Monopoly Environment
• Single firm serves the “relevant market.”• Most monopolies are “local” monopolies.• The demand for the firm’s product is the
market demand curve.• Firm has control over price.
– But the price charged affects the quantity demanded of the monopolist’s product.
Monopolistic Competition
• Numerous buyers and sellers• Differentiated products
– Implication: Since products are differentiated, each firm faces a downward sloping demand curve.
• Consumers view differentiated products as close substitutes: there exists some willingness to substitute.
• Free entry and exit– Implication: Firms will earn zero profits in the
long run.
Comments
• 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.
Oligopoly Environment
• Relatively few firms, usually less than 10.– Duopoly - two firms– Triopoly - three firms
• The products firms offer can be either differentiated or homogeneous.
Role of Strategic Interaction
• Your actions affect the profits of your rivals.
• Your rivals’ actions affect your profits.
