Managerial Economics
Tew 2e Bachelor
Mieke Simons
2
Introduction
C1: Introduction to Managerial Economics
what is managerial economics
Managerial economics is the science of directing scarce resources to manage cost more effectively
ð Managers must make the best of scarce resources
Introduction: Airbus vs Boeing
· Did Airbus respond correctly to Boeing’s new launche?
· Should Boeing proceed with the development?
· …
New economy vs old economy
· Most things similar
· Main differences
o Network effects in demand
o Importance of scale and scope
Scalability of Google vs scalability of traditional library
Preliminaries
Scope
· Microeconomics : The study of individual economic behavior where resources are costly
· Macroeconomics : The study of aggregate economic variables
· Managerial economics : The application of microeconomics to managerial issues
Methodology
· Economic behavior is systematically
· An economic model
= A concise description of behavior and outcomes
· Focus on a few key variables
· Similar with a map
Marginal vs average
· Marginal value :The change in the variable associated with a unit increase in a driver
· Average value :The total value of the variable divided by the total quantity of a driver
Stocks and flows
· A stock : The quantity of a given item at a specific point of time
· A flow : The change in a given item over a period of time
Other things equal
The assumption that all other relevant factors do not change, made so that changes due to the factor
being studied may be examined independently of those other factors
Timing
Discounting
A procedure used to transform future dollars into an equivalent number of present dollars.
Net present value
The sum of the discounted values of a series of inflows and outflows over time
The current valuation of a flow of dollars over time
NPV=B0-C0+B1-C11+d+B2-C21+d2+…+Bn-Cn1+dn
Bt=inflows at period t en Ct=outflows at period t
Read “internal rate of return” p 18
Organization
Organizational boundaries
· Vertical boundaries : Delineate activities closer to or further from the end user
o Example: automobile industry: from production of steel to vehicle distribution
o Example: America Online wider vertically than Google
· Horizontal boundaries : Are defined by the scale and scope of an organization’s operations
o Scale : the rate of production/ delivery
o Scope : the range of different items
Individual behavior
· Bounded rationality: they have limited cognitive abilities and cannot fully exercise self-control
o Causing people to adopt simplified rules for decision-making
o Lack of self-control: people having difficulties postponing
· 2 implications for managerial economics
o People relatively sluggish (traag) in responding to changes
o Now also has an important role in correcting systematic biases
Markets
A market: consists of the buyers and sellers that communicate with one another for voluntary exchange
· Markets for consumer products Household buyers, businesses sellers
· Markets for industrial products Businesses buyers and sellers
· Markets for human resources Businesses buyers, households sellers
An industry: consists of the businesses engaged in the production/ delivery of the same/ similar items
Competitive markets (demand-supply model)
· Many buyers and many sellers
· No room for managerial strategizing
· Achieves economic efficiency
Market power
· Market power : The ability of a buyer or seller to influence market conditions
· Seller with market power must manage his demand
Costs | pricing | advertising | strategy towards competitors | …
Imperfect markets
· Imperfect market
o One party directly conveys a benefit/ cost to others
o One party has better information than others
· Managers in imperfect markets need to think strategically
global integration
Communications and trade barriers
· Costs of international transport and communication have fallen
· Barriers to trade have been reduced
· Regional free trade areas
EU | ASEAN | …
· Markets became more integrated across geographical boundaries
Outsourcing
The purchase of services or supplies from external sources
Summary + Key Concepts p. 15
Review Questions p. 16
2
Introduction
C2: Demand
introduction
Introduction: Rising gasoline prices
· Lutz: “it sounds cavalier, but in any household budget, gasoline isn’t a factor.”
· Wrong! Gasoline prices rose very sharp:
o Sales of full-size SUVs dropped!
o Sales of hybrid gasoline-electric vehicle soared!
Individual demand
Construction
· Other things equal, how many… would you buy at a price of…?
Slope
· Individual demand curve shows
o The quantity the buyer will purchase at every possible price
o The maximum price the buyer is willing to pay
· Marginal Benefit: The benefit provided by an additional unit of the item
· Diminishing MB: Each additional unit provides less benefit then the preceding unit
Preferences
· The consumer’s preferences may change => demand curve will change
· Different customers: different preferences => demand curves different
demand and income
Income changes
· Change in price : movement along the curve
· Change in income : movement of the entire curve
Normal vs inferior products
· Normal products : Demand increases with income
o Broad categories
o Movies in general, transportation services,…
· Inferior products : Demand falls with income
o Particular products within the categories
o Afternoon matinees, public transport,…
· Important distinction for
o Business strategy Growing economy vs recession
o International business Rich country vs poor country
Others factors in demand
Complements and substitutes
· Complements : increase in p1causes a fall in q2
· Substitutes : increase in p1causes an increase in q2
Advertising
· Informative or persuasive
· Demand increases with advertising
· Effect depends on medium
Durable goods
3 factors particularly significant in demand for durable goods
· Expectations about future prices and incomes
· Interest rates
· Price of used models
Market demand
The market demand: graph showing the quantity that all buyers will purchase at every possible price
Construction
· Horizontal summation of the individual demand curves
Other factors
· Change in price : movement along the curve
· Change in other factors : movement of the entire curve
· Measure incomes in different countries
o With GDP and GNP
o GNP = GDP + net income from foreign sources
Income distribution
· Average income when estimating market demand
· Ignores the distribution of income!
Buyer surplus
Benefit
· Total benefit: benefit yielded by all the units that the buyer purchases
· Graphically: area under the demand curve up to the last unit purchased
Benefit vs price
· Buyer surplus: total benefit – actual expenditure
Price changes
· Price reduction: buyer gains in 2 ways
o Lower price for original quantity
o Will by more
· Price increase: buyer loses in 2 ways
o Higher price for original quantity
o Will by less
Package deals and two-part pricing
· To take the buyer surplus
o Package deals (ex p.41)
o Two-part price: fixed payment + charge based on usage
Market buyer surplus
· The same principles as those for the individual buyer surplus
Business demand
In many ways the principles are the same as for the consumer demand. The most important differences between consumers (C) and businesses (B):
Inputs
· C: buy goods and services for final consumption or usage
· B: buy goods and services to use them as inputs
Demand
· C: MB: The benefit provided by an additional unit of the item
· B: MB: The increase in revenue arising from an additional unit of the input
· Business demand: the input that the B will purchase at every possible price
o Diminishing MB
o Curve slopes downward
Factors in demand
· Change in price : movement along the curve
· Change in other factors : movement of the entire curve
Summary + Key Concepts p. 44
Review Questions p. 45
17
Part I : Competitive Markets
C3: Elasticity
Introduction
Introduction: MTA
· Fares and tolls raised => Increase in prices
· The effect of the increase in prices?
Elasticity of demand
· The responsiveness of demand to changes in an underlying factor
Own-price elasticity
When p rises by 1%, what is the percentage of change for q?
% change in q% change in p or proportionate change in qproportionate change in p
Construction
· Arc approach
o From the average values of observed p and q
o proportionate change in q/p= change in q/paverage q/p
o Between 2 points
· Point approach
o From a mathematical equation, in which q is a function of p and other variables
o At a specific point
Properties
· It’s a negative number
· It’s a pure number that does not depend on units or measure
· -∞ ≤ εpD ≤ 0
o Elastic if a 1% increase in p leads to more than a 1% drop in q : |εpD|>1
o Inelastic if a 1% increase in p leads to less than a 1% drop in q : |εpD|<1
Intuitive factors
· Availability of (in)direct substitutes
o More substitutes, more elastic
o Specific product more elastic than product category
· Buyer’s prior commitments
· Benefits/ costs of economizing
Elasticity and slope
· Demand curve steeper => demand is less elastic
· Elasticity and slope are related, but not equivalent!!
· Elasticity can also vary with changes in price, demand,…
Forecasting quantity demanded and expenditure
Quantity demanded
· How will a … % in p affect q?
Expenditure
· Buyer expenditure = q*p
· Demand is price elastic
o p↑ will reduce expenditure : q↓↓ *p↑
· Demand is price inelastic
o p↑ will increase expenditure : q↓ *p↑↑
Accuracy
· εpD may vary along a demand curve
· Forecast using εpD is less precise as a forecast directly from the demand curve
Other elasticities
Income elasticity
· When the income rises by 1%, what is the percentage of change for q?
· % change in q% change in y
· + for normal products
– for inferior products
· Pure number
· -∞≤εyD≤+∞
o Elastic if a 1% increase in y leads to more than a 1% change in q : εyD>1
o Inelastic if a 1% increase in y leads to less than a 1% change in q : εyD<1
· Demand for necessities is less income elastic than the demand for discretionary items
Cross-price elasticity
· When p1 rises by 1% , what is the percentage of change for q2?
· + for substitutes
– for complements
· -∞≤εxyD≤+∞
Advertising elasticity
· When advertising expenditure rises by 1% , what is the percentage of change for q?
· Bigger for individual demand than for market demand (competitors)
Forecasting the effects of multiple factors
· % change in q due to changes in multiple factors
= sum of % changes due to each separate factor
Adjustment time
· The short run : buyer cannot adjust at least one item of consumption or usage
· The long run : buyer can adjust all items of consumption or usage
Nondurables
· Cigarettes, liquor, bus, subway,…
· More elastic in the long run than in the short run
Durables
· Cars, refrigerators, furniture,…
· Balance between 2 effects
o Adjustment time: more elastic in LR
o Replacement frequency effect: more elastic in SR
Forecasting demand
· By using LR-elasticities instead of SR-elasticities
Estimating elasticities
Data
· Records of past experience
Surveys and experiments
· Time series : a record of changes over time in 1 market
Cross section : a record of data at one time over several markets
Specification
· Dependent variable : whose changes are to be explained
· Independent variable : a factor affecting the dependent variable
· D=b0+b1*p+b2*N+b3*A+b4*c+u
Multiple regression
· Statistical technique to estimate the separate effect of each independent variable on the dependent
ð So makes the “other things equal” condition count
· Residual = difference between predicted value and actual D
· u=D-b0+b1*p+b2*N+b3*A+(b4*c)
o u=+ when actual quantity exceeds the predicted value
o u=- when actual quantity is less than the predicted value
· Method of least squares
ð Minimize the sum of the squares of the residuals
Interpretation
· Using estimates to calculate elasticities
· εxD=∂q∂x . x*q*
· Results => ∂q∂x
Statistical significance
F statistic
· Assumption: coefficients all 0
· 0≤F≤∞
· Estimates statistical significant when
o Probability of value below specific benchmark
R² statistic
· Variations of the dep.var. caused by the indep.var.?
· 0≤R2≤1
o 0: indep.var. account for none of the variation in the dep.var.
o 1: all residuals are exactly 0
t-statistic and p-value
· T-statistic
o Evaluate the significance of a particular indep.var.
o -∞≤t≤+∞
· P-value
o Probability that estimated coefficient could be the result of chance (when coeff = 0)
o Statistical significant when below specific benchmark
Summary + Key Concepts p. 77
Review Questions p. 78
17
Part I : Competitive Markets
C4: Supply
Introduction
Introduction: furniture manufacturer Bestar
· How do changes in the prices of lumber and wood affect the furniture industry?
· How do competitors affect the supply?
· Shut down or continue?
short-run costs
· The short run : seller cannot adjust at least one input
· The long run : seller can adjust all inputs
Fixed vs variable costs
· Fixed cost : cost of inputs that do not change with the production rate
· Variable cost : cost of inputs that change with the production rate