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Intro to Managerial Economics

 

Managerial economics is the science of directing scarce resources to manage cost effectively. It consists of three branches: competitive markets, market power, and imperfect markets. A market consists of buyers and sellers that communicate with each other for voluntary exchange. Whether a market is local or global, the same managerial economics principles apply.

A seller with market power will have freedom to choose suppliers, set prices, and use advertising to influence demand. A market is imperfect when one party directly conveys a benefit or cost to others, or when one party has better information than others.

An organization must decide its vertical and horizontal boundaries. For effective management, it is important to distinguish marginal from average values, stocks from flows, and to consider the timings of actions. Managerial economics applies models that are necessarily less than completely realistic. Typically, a model focuses on one issue, holding other things equal.

 

 

Ch1 Introduction: Examples

 

 

Demand

 

A demand curve shows the quantity demanded as a function of price, other things equal. Generally, the demand curve slopes downward. Changes in price are represented by movements along the demand curve, while changes in other factors, such as income, the prices of related products, and advertising, are represented by shifts of the entire demand curve. The market demand curve is the horizontal summation of the individual demand curves of the various buyers.

 

Buyer surplus is the difference between a buyer’s total benefit from some quantity of purchases and his or her actual expenditures. Changes in price affect buyer surplus through the price changes themselves as well as through changes in the quantity demanded.

 

 

 

Ch2 Demand: Examples

 

 

 

Elasticity

 

The elasticity of demand measures the responsiveness of demand to changes in a factor that affects demand. Elasticities can be estimated for price, income, prices of related products, and advertising expenditures. The own-price elasticity is the ratio of the percentage change in quantity demanded to the percentage change in price, and is a negative number. Demand is price elastic if a 1% increase in price leads to more than a 1% drop in quantity demanded, and inelastic if it leads to less than a 1% drop in quantity demanded.

 

The own-price elasticity can be used to forecast the effects of price changes on quantity demanded and buyer expenditure. Elasticities can be used to forecast the effects on demand of simultaneous changes in multiple factors. All elasticities vary with adjustment time. The long-run demand is generally more elastic than the short-run demand in the case of nondurables, but not necessarily for durables.

 

Elasticities can be estimated from records of past experience or test markets using the statistical technique of multiple regression.

 

 

 

Ch3 Elasticity: Examples

 

 

 

Supply

 

A small seller, which cannot affect the market price, maximizes profit by producing at a rate where its marginal cost equals the price. (For a small seller, the price equals marginal revenue.) In the short run, at least one input is fixed and therefore cannot be adjusted. The business breaks even when total revenue covers variable cost. In the long run, the business can adjust all inputs and leave or enter the industry. It breaks even when total revenue covers total cost.

 

The supply curve shows the quantity supplied as a function of price, other things equal. The effect of a change in price is represented by a movement along the supply curve to a new quantity. Changes in other factors such as wages and the prices of other inputs are represented by shifts of the entire supply curve.

 

Seller surplus is the difference between revenue from some production rate and the minimum amount necessary to induce the seller to produce that quantity. Elasticities of supply measure the responsiveness of supply to changes in underlying factors that affect supply.

 

 

Ch4 Supply: Examples

 

Competitive Markets

 

How will an increase in demand and a reduction in marginal costs affect the market for an item? Questions such as these are commonplace. The answers, however, are not so simple.

 

To understand the complete effect of a shift in demand or supply, it is necessary to consider both sides of the market. Generally, the effect of any change in demand or supply depends on the elasticities of both demand and supply.

 

The time horizon is a key factor affecting elasticities of demand and supply. Prices are more volatile and quantity adjustment takes relatively longer in industries where production involves substantial sunk costs.

 

Ch5 Competitive Markets: Examples

 

 

 

Economic Efficiency

 

The central idea in this chapter was Adam Smith’s invisible hand. Free-market competition will ensure that the allocation of resources is economically efficient. Although the buyers and sellers act selfishly, the net outcome is at least as good as the best efforts of the most enlightened and well-informed central planner.

 

The same principle applies within an organization. Through decentralization, management can achieve efficient use of scarce internal resources. This means charging a transfer price for items produced and consumed within the organization.

 

It is important to distinguish a payment or receipt from incidence. A payment or receipt can be shifted from one to the other side of the market. Incidence is fundamental and depends only on the elasticities of demand and supply. As an example, the incidence of taxes generally does not depend on whether the tax is collected from the buyers or the sellers in a market. It will be shared, according to the relatively elasticities of demand and supply, in either case.

 

 

Ch6 Economic Efficiency: Examples

 

Costs

Conventional accounting statements do not always provide all the information on costs necessary for effective business decisions. Managers should use the principles presented in this chapter to develop accurate information about costs.

 

Economies of scale arise from either significant fixed costs or variable costs that diminish with the scale of production. An industry where businesses exhibit scale economies will tend to be concentrated. Economies of scope arise from significant joint costs across the production of two or more items. Scope economies drive businesses to supply multiple products. The experience curve shows how average costs decline with cumulative production.

 

Opportunity cost is the net revenue from the best alternative course of action. Sunk costs are costs that have been committed and cannot be avoided. For effective business decisions,

managers should consider opportunity costs and ignore sunk costs. The transfer price of an item within an organization should be set equal to the marginal cost.

 

Ch7 Costs: Examples

 

 

Monopoly

Market power arises from unique resources, intellectual property, scale and scope economies, product differentiation, or regulation.

 

A seller with market power restrains sales to raise the market price above the competitive level and so, extract higher profits. It maximizes profit by operating at a scale where marginal revenue equals marginal cost. The extent to which a monopoly should adjust the price and scale in response to changes in demand or costs depends on the shapes of both the marginal revenue and the marginal cost curves.

 

The profit-maximizing advertising–sales ratio is the incremental margin percentage multiplied by the advertising elasticity of demand. The profit-maximizing R&D–sales ratio is the incremental margin percentage multiplied by the R&D elasticity of demand.

 

A buyer with market power restrains purchases to depress the price below the competitive level and so, raise its net benefit.

 

 

Ch8 Monopoly: Examples

 

 

 

Pricing

The simplest way to set price is through uniform pricing. At the profit-maximizing uniform price, the incremental margin percentage equals the reciprocal of the absolute value of the price elasticity of demand. The most profitable pricing policy is complete price discrimination, where each unit is priced at the benefit that the unit provides to its buyer. To implement this policy, however, the seller must know each potential buyer’s individual demand curve and be able to set different prices for every unit of the product.

 

The next most profitable pricing policy is direct segment discrimination. For this policy, the seller must be able to directly identify the various segments. The third most profitable policy is indirect segment discrimination. This involves structuring a set of choices around some variable to which the various segments are differentially sensitive. Uniform pricing is the least profitable way to set a price.

 

A commonly used basis for direct segment discrimination is location. This exploits a difference between free on board and cost including freight prices. A commonly used method of indirect segment discrimination is bundling. Sellers may apply either pure or mixed bundling.

 

 

 

Ch9 Pricing: Examples

 

 

 

Strategic Thinking

 

In strategic situations, when the parties move simultaneously, there are several useful principles to follow: avoid using dominated strategies, focus on Nash equilibrium strategies, and consider randomizing. When the parties move sequentially, a strategy should be worked out by looking forward to the final nodes and reasoning back to the initial node.

 

Through conditional or unconditional strategic moves, it may be possible to influence the beliefs or actions of other parties. In some settings, the first mover has the advantage; in others, the first mover is at a disadvantage. Finally, it is important to consider whether the situation will be played just once or repeated. The range of possible strategies is wider in a repeated situation.

 

In a zero-sum game, one party can become better off only if another is made worse off. In a positive-sum game, one party can become better off without another being made worse off.

 

 

Ch10 Strategic Thinking: Examples

 

 

Oligopoly

 

Prices are strategic complements. In an oligopoly, where sellers compete on price, if one seller raises or lowers its price, then others will adjust prices in the same direction. Sellers can dampen price competition by differentiating their products.

 

Production capacities are strategic substitutes. In an oligopoly, where sellers compete on production capacity, if one seller raises or lowers capacity, then, others will adjust capacities in the opposite direction.

 

If a seller can commit to its production capacity before others, then it will gain a firstmover advantage. If the leader commits to sufficient production capacity, it can even exclude all potential entrants.

 

Competing sellers can increase profit by restraining competition –either through agreement or horizontal integration. Antitrust (competition) authorities consider the industry Herfindahl–Hirschman Index in deciding whether to investigate mergers.

 

Ch11 Oligopoly: Examples

 

 

 

Externalities

 

An externality arises when one party directly conveys a benefit or cost to others. A network effect arises when a benefit or cost depends on the total number of other users. A network externality is a network effect that is directly conveyed and not through a market. An item is a public good if one person’s increase in consumption does not reduce the quantity available to others. Equivalently, a public good provides nonrival consumption.

 

The benchmark for externalities and public goods is economic efficiency. At that point, all parties maximize their net benefits. Externalities can be resolved through merger or joint action, but resolution may be hampered by differences in information and free riding. Similarly, the commercial provision of a public good depends on being able to exclude free riders. Excludability depends on law and technology.

 

Markets with network effects differ from conventional markets in several ways. Demand is insignificant until a critical mass of users is established. Expectations of potential users help to determine the attainment of critical mass. When the demand for competing services are close to critical mass, a small shift in demand towards one service can tip all other users toward that service.

 

Ch12 Examples: Externalities

 

 

 

Asymmetric Information

In situations of asymmetric information, the allocation of resources will not be economically efficient. The asymmetry can be resolved directly through appraisal or indirectly through screening, signaling, or contingent payments. The indirect methods depend on inducing selfselection among parties with different characteristics. Screening is an initiative of the party with less information, while signaling is an initiative of the party with better information.

 

A key business application of screening is indirect segment discrimination in pricing. A related application is auctions, which exploit strategic interaction among competing bidders to force bidders with higher values to pay higher prices.

 

When the distribution of information is asymmetric, one or more parties will have imperfect information and hence bear risk. The distribution of risk may conflict with the self-selection needed to resolve the asymmetric information.

 

 

 

 

Ch13 Asymmetric Information: Examples

 

Incentives and Organization

 

The architecture of an organization comprises the distribution of ownership, incentive schemes, and monitoring systems. Ownership means the rights to residual control. Incentive schemes and monitoring systems are related as incentives must be based on behavior that can be observed. An efficient incentive scheme balances the incentive for effort with the cost of risk.

 

An efficient organizational architecture resolves four internal issues – holdup, moral hazard, monopoly power, and economies of scale and scope, and how these can be resolved.

 

Holdup and moral hazard arise between parties with a conflict of interest. Additionally, moral hazard depends on one party not being able to observe the actions of the other. Holdup can also be resolved through more detailed contracts, moral hazard through incentive schemes and monitoring systems, and internal monopoly power through outsourcing.

 

 

 

 

Ch14 Incentives and Organization: Examplesvarennes.jpg

 

 

 

Regulation

The marginal benefit of an item may diverge from the marginal cost for three basic reasons: market power, asymmetric information, and externalities and public goods. This divergence results in economic inefficiency. Government regulation may help where private action fails to resolve the economic inefficiency.

 

Generally, the government can regulate conduct, information, and structure. Specifically, the conduct of a franchised monopoly may be regulated directly through price or indirectly through the rate of return. Competition law regulates the conduct and structure of businesses in general. In situations of asymmetric information, mandatory disclosure is one form of regulation.

 

Externalities may be regulated through fees or standards. The efficient degree of an externality depends on location and time. The government can help to resolve inefficiency in accidents and public goods by providing an appropriate legal framework. The laws

regarding copyrights and patents must balance the incentive for new research against inefficient use of existing knowledge.

 

 

Ch15 Regulation: Examples

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Comments (1)

Md. khairul Islam said

at 4:10 am on Jun 4, 2012

Sir,
I mistakenly request access to this Managerial Economics page. I was suppose to request access to econ509. I am really sorry for my mistake.

Khairul
ID: 112112014

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