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1 Managerial Economics Comm295 Midterm Review Package October, Supply and Demand Elasticity Regression Analysis Consumer Choice Production Cost Concepts Profit Maximization Perfect Competition Monopoly Price Discrimination Oligopoly Game Theory Content:

2 Supply and Demand Slope of a demand curve is, meaning the higher the price, the the quantity. Movement along the demand curve is caused by Shift of the demand curve is caused by any other relative factor except for price (change in ) Slope of a supply curve is, meaning the higher the price, the the quantity. Movement along the supply curve is caused by Shift of the supply curve is caused by any other relative factor except for price (change of )

3 Market Equilibrium: Qs=Qd Example1: The demand function for muffins is given by Qd=185-30p. The supply function is given bt Qs=35+20p. What s the equilibrium price and quantity? Answer: p=3, q=95 Substitute goods goods that are in consumption (Tea and coffee) Complementary goods goods that are consumed (Pencils and erasers) Normal goods increase in income results in demand (Organic products) Inferior goods increase in income results in demand (Krafts Mac&Cheese) Example2: The cost of production of ethanol has gone up. Ethanol and Gasoline are substitutes. How does in affect consumption of Gasoline? Ethanol Gasoline

4 Example3: Tim- bits are considered an inferior good. The price of flour has gone up because of the recent drought, while wages in BC were raised by 10%. What s happening with consumption of tim- bits? Elasticity Price elasticity of demand is the percentage change in Q demanded divided by the percentage change in P. Arc elasticity elasticity calculated using E= (!!!!!)/(!"#\$) (!!!!!)/(!"#\$) Point elasticity elasticity evaluated at a Elasticity along the demand curve

5 Example4: The demand function for apples is given by Qd=10- P and supply is Qs=4P. Calculate the point elasticity of demand at the equilibrium point. Is demand elastic or inelastic at this point? Income elasticity of demand Ey=!"#\$"%&'("!!!"#\$!"!" =!/!!"#\$"%&'("!!!"#\$!"!"#\$%&!/! =!!!! Good is normal when Ey is Good in inferior when Ey is Cross price elasticity E=!"#\$"%&'("!!!"#\$!"!" =!"/!"!"#\$"%&'("!!!"#\$!"!"#\$%!"!"#\$!!"!""#!"/!" =!"!"!"!" Goods are complements if E is Goods are substitutes if E is

6 Regression Analysis is used to estimate the mathematical relationship between a dependent variable and one or more explanatory variables Simple Linear Regression one dependent variable depends on one explanatory variable (relationship is ) Random Error effects on demand which by explanatory variables Qd=a+bP+e Ordinary Least Squares Regression minimizes (the gap between predicted and actual value of the dependent variable). Rsquared Statistic - how much of dependent variable is explained by the. 0 <= R2<=1 Consumer Choice Utility happiness Law of diminishing marginal utility as you consumption of Good A, utility from each additional unit Indifference curve the set of all combinations of Goods A and B which Indifference map complete set of

7 Example5: How would indifference curve look like for a) substitutes b) complementary goods Marginal rate of Substitution Slope of the Indifference Curve MRS=!"!" =!"#!"#

8 Budget Constraints: Pb*Qb+Pa*Qa=Y Qb=Y/Pb- (Pa/Pb)*Qa Y/Pb y- intercept; - Pa/Pb slope Example6: What happens with budget line if income doubles? Example7: What happens with budget line if price of Good A doubles?

9 Consumer s optimal bundle (The last dollar rule) Slope of the Indifference Curve = Slope of the Budget Line MUa/MUb=Pa/Pb or MUa/Pa=MUb/Pb Example8: Alice consumes a combination of peanut- butter ice- cream and dark chocolate. However, recently she has noticed that MUi/Pi is less than MUc/Pc. What should Alice do?

10 Production Inputs: Production Function relationship between Q of inputs and maximum Q of outputs. Q = f(l,k) Marginal Product of Labor: MPL =! Diminishing Marginal Returns if a firm increases an input, holding other inputs constant, the corresponding increases in output Isoquant (similar to indifference curves) combination of labor and capital that can produce the same output. Production Optimal Bundle (Last dollar rule) Slope of the Isoquant = Slope of the Isocost (similar to budget line) MPL/MPk=w/r, where w hourly wage, r unit cost of capital or MPL/w=MPk/r Example9: What s the optimal point of production and why?!

11 Constant Returns to Scale: F(a*L, a*k) a*f(l,k)=a*q Increasing Returns to Scale: F(a*L, a*k) a*f(l,k)=a*q Decreasing Returns to Scale: F(a*L, a*k) a*f(l,k)=a*q Example10: Bicycles are produced using labor (L) and capital (K). Q is the number of bicycles produced each day. L=1 L=2 L=3 L=4 K=2 Q=10 Q=14 Q=17 Q=19 K=4 Q=14 Q=20 Q=25 Q=28 What can we infer about marginal product of labor and returns to scale? Cost Concepts Opportunity Cost the value of Sunk Cost a past expenditure which Fixed Cost (FC) with level of output Variable Cost (VC) with level of output Average Fixed Cost: AFC=FC/Q (As Q increases, AFC ) Average Variable Cost: AVC=VC/Q Average Cost: AC=AVC+AFC Marginal Cost: MC =! =!" =!"#!!!"

12 Marginal Cost intercepts ATC and AVC at their minimum. Economies of Scale Constant Costs Diseconomies of Scale ATC as Q ATC is as ATC as increases Q increases Q increases Example 11: True or False? If MC is greater than ATC then MC must be rising If MC is positive then AC must be strictly greater than AVC If MC is rising then AC must be also rising Example 12: The TC for the firm is C=100+10q+q^2. Derive the MC and AC curves. When is AC minimized?

13 Example 13: If a firm is currently operating at an output level where MC=\$50 and AC=\$75, what can we say about economies of scale at this level? Example 14: True or False? Expecting the price of apples to rise, Johnny purchased a 10 year supply at 2\$ per pound. Due to favorable economic conditions, apples sell at 1.5\$ per pound. Johnny s opportunity cost for pound of apples is 2\$ Sunk costs are not relevant; therefore Johnny has no sunk costs Johnny s opportunity cost for consuming a pound of apple is the difference between the price he paid (2\$) and the current market price (1.5\$)

14 Profit Maximization Profits=Revenue- Cost Marginal Profits = Output rule: The firm sets its output where its profit is maximized. Profits are maximized when (1) Marginal Profits = or (2) Marginal Revenue = Shutdown rule: The firm shuts down if its revenue is less than its Agency problem: when owners and managers of companies pursue different goals (solution profit sharing). Example 15: The Irresistible produces a perfume Smell me whose demand is given by Qd=1000-2*P. The cost of production is 10\$ per unit. Fixed costs are 10,000\$. Which level of output will maximize profits? Example 16: The owner of a company delegates the production decision of Q to the manager. Which of the following compensation packages will eliminate agency problem?

15 Profit sharing: 10% of the profits to the manager Revenue sharing: 15% of the total revenues to the manager Cost sharing: 3% of total costs will be subtracted from manager s base salary Profit sharing: 1% of the profits to the manager? Example 17: A firm s inverse demand curve is given by p=70- Q. Total cost is given by C= Q. Assuming that the fixed cost of 1000\$ is avoidable in the long run, what should company do to maximize profits? Perfect Competition Large number of Buyers and Sellers Identical Products Free Entry and Exit Demand curve = P = MR Supply Curve (individual firm) = MC Supply Curve (market) = MC1+MC2+MC3+.+MCn => slope=0 No deadweight loss social surplus is maximized!

16 Profits are maximized when MC=Price Example 18: Firm has a cost function C=400+Q^2 (fixed cost is not avoidable). Current market price is 50\$. What should be firm s output to maximize profits? What happens to optimal quantity if price drops to 32\$?

17 Example 19: A government has imposed quota on a competitive market that reduced output from Q1 to Q2. What s the DWL? What are the new CS and PS? Example 20: A government has imposed tax on competitive market. What s the dwl?

18 Example 21: A government has imposed a price ceiling on a competitive market. Monopoly One seller, multiple buyers High barriers to entry (natural monopolies) Highly differentiated product Market power

19 Demand downward sloping = AR Supply = MC Profits are maximized when MC=MR (Producing at Qm) Example22: Shrek has invented a new dessert called yummy tummy which has a constant marginal cost of \$100 and no fixed costs. With the help of the donkey Shrek has estimated the demand function to be P=440-5Q. Shrek has proprietary rights on his dessert. a) Donkey has read in his Econ101 book that revenue will be maximized when elasticity is equal to - 1. Is Donkey correct?

20 b) How much consumer surplus is lost due to the fact that the market for yummy tummy desserts is a monopoly and not perfectly competitive? Is this amount equal to DWL? Example23: True or False A monopolist with a constant MC of production equal to 10\$ maximizes its profit by choosing to produce where elasticity of its demand is equal to - 3/2. Remember that relationship between MR and price is given by MR=p*(1+1/E). Revenues for the monopolist will increase if price is increased by a small amount The price set by the monopolist is equal to 30 Price and marginal revenue are both greater than MC

21 Price discrimination: Perfect price discrimination consumers pay their Example24: Consider a monopoly that serves a large number of different consumers. Assume the monopoly can prevent sale. Relative to standard uniform monopoly pricing, perfect price discrimination: Increases profits Raises the sum of consumer surplus Increases the quantity sold Causes some consumers to pay higher prices Quantity- based price discrimination price the customer pays varies with Example25: True or False A consumer has a demand curve given by p=90- q. Panel (a) shows the consequences of quantity discrimination if the firm charges 70\$ each for the first 20 units and 50\$ each for any additional units. Panel (b) illustrates profit- maximizing uniform monopoly pricing.

22 Quantity discrimination is better for consumers that uniform monopoly pricing Profits are higher under monopoly than with quantity discrimination DWL is higher under uniform monopoly pricing than under quantity discrimination Peak- Load Pricing charging higher prices during periods of peak demand than in other periods Example 26: True or False Consider a hotel that has high demand in the summer and low demand in the winter. The hotel s maximizing peak load pricing strategy is illustrated below. MC Ph PL m MR QL Qh

23 The firm sets prices such that MR>m in the summer and MR=m in the winter The firm has excess capacity in both periods We cannot tell which season has higher price Two- part pricing a firm charges each consumer a lump- sum access fee and per unit price. Example 27: Joanna has moved to a small town with one tennis club. Her inverse demand function per year is given by p=95-3q. The marginal cost to the club of one session is 5\$. What two part- pricing strategy would maximize profit obtained from Joanna? Bundling selling multiple goods or services for a single price Example28: Cactus Club is trying to decide whether to have a bundle price for a buffet dinner and dancing combined or whether to charge stand- alone prices for dinner and dancing. There are three types of customers with an equal number of each type. The table below shows the willingness to pay of the three different consumer types. Assume the marginal costs of zero.

24 Consumer type Dinner Dancing Bundle A B C Determine the maximum profit under stand- alone pricing, pure bundling and mixed bundling. What s the best approach? Oligopoly A few sellers Limited entry Cartels oligopolies which over prices and quantities so as to increase their profits (illegal in USA/Canada, likely to cheat and fall apart). Cournot Oligopoly Firms set Q independently and simultaneously Firms have identical costs Firms sell identical products There are two firms and no one else can enter the market

25 Example29: AMD and Intel are the only 2 firms that produce CPUs. The inverse demand for CPUs is given by P=520- Q. Each firm has MC=40 and fixed costs are equal to zero. Output of AMD is Qa, output of Intel is Qi. Derive the Cournot best response functions for AMD and Intel. Solve for the Cournot Equilibrium price and quantities. Game Theory: Static game each player acts and the players act Dominant strategy strategy that produces a that any other strategy the player can use no matter what its rivals do. Prisoner s dilemma all players have dominant strategies that lead to a to what they could achieve if they cooperated. Best response a strategy that given its beliefs about rivals strategies.

26 Nash equilibrium no player can obtain a by choosing a different strategy. Pure strategy each player chooses a particular strategy Pareto criterion selecting a solution that it is Example 30: The market for milk chocolate is dominated by two firms (Milka and Hershey). Their payoffs from advertising or not advertising can be shown in the following table. This is a static game. Number on the left is the payoff for Hershey. Milka Do Not Advertise Advertise Hershey Do Not Advertise 10, 11 8, 10 Advertise 12, 4 11, 11 Does either firm have a dominant strategy? Is there a Nash Equilibrium? Is this prisoners dilemma?

27 Example31: Two friends are deciding what to do for the day. They have to make simultaneous and independent decisions. If they choose the same activity, they will meet and do it together. Otherwise they will each be alone. Michael Movie Biking Sarah Movie 6,6 3,2 Biking 2,3 8,7 Find any dominant strategies and any Nash equilibrium in this game. Could pre- play or Pareto criterion have any relevance here?

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