Managerial Economics & Business Strategy. Final Exam Section 2 May 11 th 7:30 am-10:00 am HH 076

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1 Managerial Economics & Business Strategy Final Exam Section 2 May 11 th 7:30 am-10:00 am HH 076

2 Grading Scale 5% - Attendance 8% - Homework (Drop the lowest grade) 7% - Quizzes (Drop the lowest grade) 20% - Test 1 20% - Test 2 20% - Final exam 5 % - Discussion and participation 5% - Presentation 10%- Project report

3 Overview Cumulative 20 Multiple Choice Questions (40 points) 4 Essay Questions (60 points) 1 Bonus Question (4 points) Review questions, Final exam sheet, Lecture notes, (problems solved in class) and Quizzes

4 How can the manager maximize net benefits? Use marginal analysis Marginal benefit: MMMM QQ The change in total benefits arising from a change in the managerial control variable, QQ. Marginal cost: MMCC QQ The change in the total costs arising from a change in the managerial control variable, QQ. Marginal net benefits: MMMMMM QQ MMMMMM QQ = MMMM QQ MMMM QQ Economics of Effective Management Chapter 1: Using Marginal Analysis 1-4

5 Marginal principle Economics of Effective Management Chapter 1: Marginal Analysis Principle To maximize net benefits, the manager should increase the managerial control variable up to the point where marginal benefits equal marginal costs. This level of the managerial control variable corresponds to the level at which marginal net benefits are zero; nothing more can be gained by further changes in that variable. 1-5

6 Chapter 2: Demand Shifters Demand Income Normal good Inferior good Prices of related goods Substitute goods Complement goods Advertising and consumer tastes Population Consumer expectations Other factors 2-6

7 Chapter 2: Understanding the Linear Demand Demand Function The signs and magnitude of the αα coefficients determine the impact of each variable on the number of units of X demanded. QQ dd XX = αα 0 + αα XX PP XX + αα YY PP YY + αα MM MM For example: αα XX < 0 by the law of demand; αα YY > 0 if good Y is a substitute for good X; αα MM < 0 if good X is an inferior good. 2-7

8 Demand Chapter 2: Market Demand and Consumer Surplus Price per liter \$5 \$4 \$3 \$2 Consumer Surplus Consumer Surplus: 0.5(\$5 - \$3)x(2-0) = \$2 Total Consumer Value: 0.5(\$5 - \$3)x2+(3-0)(2-0) = \$8 Expenditures: \$(3-0) x (2-0) = \$6 \$1 Demand Quantity in liters 2-8

9 Chapter 2: Supply Shifters Supply Input prices Technology or government regulation Number of firms Entry Exit Substitutes in production Taxes Excise tax Ad valorem tax Producer expectations 2-9

10 Chapter 2: Understanding the Linear Supply Function The signs and magnitude of the ββ coefficients determine the impact of each variable on the number of units of X produced. QQ XX ss = ββ 0 + ββ XX PP XX + ββ WW WW + ββ tt PP tt For example: ββ XX > 0 by the law of supply. ββ WW < 0 increasing input price. ββ tt > 0 technology lowers the cost of producing good X. 2-10

11 Chapter 2: Producer Surplus in Action Supply Price \$400 PP XX = QQ XX SS Supply Producer surplus \$ Quantity 2-11

12 Comparative Statics Chapter 2: Comparative Statics Comparative static analysis The study of the movement from one equilibrium to another. Competitive markets, operating free of price restraints, will be analyzed when: Demand changes; Supply changes; Demand and supply simultaneously change. 2-12

13 Own Price Elasticity of Demand Chapter 3: Own Price Elasticity Own price elasticity of demand Measures the responsiveness of a percentage change in the quantity demanded of good X to a percentage change in its price. EE QQXX dd,pp XX = %ΔQQ XX dd %ΔPP XX Sign: negative by law of demand. Magnitude of absolute value relative to unity: EE QQXX dd,pp XX > 1: Elastic. EE QQXX dd,pp XX < 1: Inelastic. EE QQXX dd,pp XX = 1: Unitary elastic. 3-13

14 Chapter 3: Total Revenue Test When demand is elastic: A price increase (decrease) leads to a decrease (increase) in total revenue. When demand is inelastic: A price increase (decrease) leads to an increase (decrease) in total revenue. When demand is unitary elastic: Total revenue is maximized. Own Price Elasticity of Demand 3-14

15 Chapter 3: Factors Affecting the Own Price Elasticity Three factors can impact the own price elasticity of demand: Availability of consumption substitutes. Time/Duration of purchase horizon. Expenditure share of consumers budgets. Own Price Elasticity of Demand 3-15

16 Chapter 3: Cross-Price Elasticity Cross-price elasticity Measures responsiveness of a percent change in demand for good X due to a percent change in the price of good Y. EE dd QQXX,PP = %ΔQQ XX dd YY %ΔPP YY If EE QQXX dd,pp YY If EE QQXX dd,pp YY > 0, then XX and YY are substitutes. Cross-Price Elasticity < 0, then XX and YY are complements. 3-16

17 Chapter 3: Income Elasticity Income elasticity Measures responsiveness of a percent change in demand for good X due to a percent change in income. EE dd QQXX,MM = %ΔQQ XX dd %ΔMM If EE QQXX dd,mm If EE QQXX dd,mm > 0, then XX is a normal good. < 0, then XX is an inferior good. Income Elasticity 3-17

18 Chapter 3: Elasticities for Linear Demand Functions From a linear demand function, we can easily compute various elasticities. Given a linear demand function: QQ dd XX = αα 0 + αα XX PP XX + αα YY PP YY + αα MM MM + αα HH PP HH Own price elasticity: αα XX PP XX QQ XX dd. Cross price elasticity: αα YY PP YY QQ XX dd. Income elasticity: αα MM MM QQ XX dd. Obtaining Elasticities From Demand Functions 3-18

19 Chapter 3: Elasticities for Nonlinear Demand Functions One non-linear demand function is the loglinear demand function: ln QQ XX dd Obtaining Elasticities From Demand Functions = ββ 0 + ββ XX ln PP XX + ββ YY ln PP YY + ββ MM ln MM + ββ HH ln HH Own price elasticity: ββ XX. Cross price elasticity: ββ YY. Income elasticity: ββ MM. 3-19

20 Chapter 4: Properties of Consumer Consumer Behavior Preferences Completeness: For any two bundles of goods either: AA BB. BB AA. AA BB. More is better If bundle AA has at least as much of every good as bundle BB and more of some good, bundle AA is preferred to bundle BB. Diminishing marginal rate of substitution As a consumer obtains more of good X, the amount of good Y the individual is willing to give up to obtain another unit of good X decreases. Transitivity: For any three bundles, AA, BB, and CC, either: If AA BB and BB CC, then AA CC. If AA BB and BB CC, then AA CC. 4-20

21 Constraints Chapter 4: The Budget Constraint Good YY MM PP YY Slope PP XX PP YY Bundle H Budget set: YY MM PP YY PP XX PP YY XX Budget line: YY = MM PP YY PP XX PP YY XX Bundle G 0 MM PP XX Good XX 4-21

22 Chapter 4: Consumer Equilibrium Consumer equilibrium occurs at a point where MRS =P X / P Y. Equivalently, the slope of the indifference curve equals the slope of the budget line.

23 Chapter 5: Relation between Productivity Measures Total product Average product Marginal product Increasing marginal returns to labor Decreasing marginal returns to labor Negative marginal returns to labor The Production Function Total product (TP) Average product (AP L ) 0 Marginal product (MP L ) Labor input (holding capital constant) 5-23

24 Chapter 5: Profit Maximizing Input Usage When labor or capital vary in the short run, to maximize profit a manager will hire Labor until the value of marginal product of labor equals the wage: VMP L = w, where VMP L = P x MP L. Capital until the value of marginal product of capital equals the rental rate of capital: VMP K = r, where VMP K = P x MP K.

25 Chapter 5: Isoquants and Marginal Rate of Technical Substitution Isoquants capture the tradeoff between combinations of inputs that yield the same output in the long run, when all inputs are variable. Marginal rate of technical substitutions (MRTS) The rate at which a producer can substitute between two inputs and maintain the same level of output. Absolute value of the slope of the isoquant. MMMMMMMM KKKK = MMMM LL MMMM KK The Production Function 5-25

26 Chapter 5: Cost Minimization A firm minimizes the costs of producing q0 units of output by using the capitallabor combination at point P, where the isoquant is tangent to the isocost. All other capital-labor combinations (such as those given by points A and B) lie on a higher isocost curve.

27 Chapter 5: Cost Minimization Marginal product per dollar spent should be equal for all inputs: MP w But, this is just MP r MP MP L = K L = K MRTS KL = w r w r

28 Chapter 5: The Cost Function The Cost Function Mathematical relationship that relates cost to the cost-minimizing output associated with an isoquant. Short-run costs Fixed costs: FFCC Sunk costs Short-run variable costs: VVVV QQ Short-run total costs: TTCC QQ = FFFF + VVVV QQ Long-run costs All costs are variable No fixed costs 5-28

29 The Cost Function Chapter 5: Short-Run Costs in Action Total costs Variable costs Fixed costs TTTT QQ = FFFF + VVVV QQ VVVV QQ FFFF FFFF FFFF 0 Output 5-29

30 Chapter 5: The Relationship between Average ATC, AVC, AFC and MC (\$) and Marginal Costs in Action Minimum of ATC MMCC The Cost Function AAAAAA AVVVV 0 Minimum of AVC AAFFFF Output 5-30

31 Chapter 5: Economies of Scale The Cost Function Economies of scale Portion of the long-run average cost curve where long-run average costs decline as output increases. Diseconomies of scale Portion of the long-run average cost curve where long-run average costs increase as output increases. Constant returns to scale Portion of the long-run average cost curve that remains constant as output increases. 5-31

32 Chapter 5: Multiple-Output Cost Function Economies of scope Multiple-Output Cost Function Exist when the total cost of producing QQ 1 and QQ 2 together is less than the total cost of producing each of the type of output separately. CC QQ 1, 0 + CC 0, QQ 2 > CC QQ 1, QQ 2 Cost complementarity Exist when the marginal cost of producing one type of output decreases when the output of another good is increased. MMMM 1 QQ 1, QQ 2 QQ 2 <

33 Perfect Competition Chapter 8: Perfect Competition To maximize short-run profits, a perfectly competitive firm should produce in the range of increasing marginal cost where PP = MMMM, provided that PP AAAAAA. If PP < AAAAAA, the firm should shut down its plant to minimize it losses. 8-33

34 Chapter 8: Short-Run Firm Supply Curve In PP 1 \$ Action Short-run supply curve for individual firm Perfect Competition MMMM AAAAAA PP 0 0 QQ 0 QQ 1 Firm s output 8-34

35 Chapter 8: Long-Run Competitive Equilibrium In the long run, perfectly competitive firms produce a level of output such that PP = MMMM PP = mmmmmmmmmmmmmm oooo AAAA Perfect Competition 8-35

36 Chapter 8: Profit-Maximizing Output Decision The firm must produce at a level at which MR = MC. For a competitive firm MR = P, thus to maximize profits the firm should produce the output at which P = MC. For a monopoly the rule is MR=MC

37 Chapter 8: Monopoly (Pricing Rule) Given the level of output, QQ MM, that maximizes profits, the monopoly price is the price on the demand curve corresponding to the QQ MM units produced: PP MM = PP QQ MM Monopoly 8-37

38 Monopolistic Competition Chapter 8: Monopolistic Competition To maximize profits, a monopolistically competitive firm produces where its marginal revenue equals marginal cost. The profit-maximizing price is the maximum price per unit that consumers are willing to pay for the profit-maximizing level of output. The profit-maximizing output, QQ, is such that MMMM QQ = MMMM QQ and the profit-maximizing price is PP = PP QQ. 8-38

39 Price MC Monopolistic Competition Chapter 8: Long-Run Monopolistically Competitive Equilibrium In Action Long-run monopolistically competitive equilibrium ATC PP Demand 1 QQ MR 1 Quantity of Brand X 8-39

40 Chapter 8: Long-Run and Monopolistic Competition In the long run, monopolistically competitive firms produce a level of output such that: PP > MMMM PP = AAAAAA > mmmmmmmmmmmmmm oooo aaaaaaaaaaaaaa cccccccccc Monopolistic Competition 8-40

41 Chapter 9: Basic Oligopoly Profit Maximization in Four Oligopoly Settings Cournot Model Stackelberg Model Bertrand Model Collusion

42 Chapter 9 Different oligopoly scenarios give rise to different optimal strategies and different outcomes. Your optimal price and output depends on Beliefs about the reactions of rivals. Your choice variable (P or Q) and the nature of the product market (differentiated or homogeneous products). Your ability to credibly commit prior to your rivals. 9-42

43 Chapter 10 Game Theory Game theory is the study of how people behave in strategic situations. Strategic decisions are those in which each person, in deciding what actions to take, must consider how others might respond to that action. Copyright 2014 by the McGraw-Hill Companies, Inc. All rights reserved. 2-43

44 What is a Game? A game is a situation where the participants payoffs depend not only on their decisions, but also on their rivals decisions. i.e. My optimal decisions will depend on what others do in the game. Copyright 2014 by the McGraw-Hill Companies, Inc. All rights reserved. 2-44

45 Elements to describe a game A set of players A set of actions- action or strategy set for each player Payoffs ranking of the possible outcomes Copyright 2014 by the McGraw-Hill Companies, Inc. All rights reserved. 2-45

46 Forms Strategic Form (Normal Form) Extensive Form (Game Tree) Copyright 2014 by the McGraw-Hill Companies, Inc. All rights reserved. 2-46

47 Normal-Form Game Simultaneous-Move, One-Shot Games Set of players Player B s strategies Player A Player B Strategy Left Right Up 10, 20 15, 8 Down -10, 7 10, 10 Player B s possible payoffs from strategy right Player A s strategies Player A s possible payoffs from strategy down 10-47

48 Multistage Games Extensive-Form Game Player A payoff Player B payoff Decision node for player A denoting the beginning of the game B (10,15) A (5,5) (0,0) Player A feasible strategies: Up B Down Player B s decision nodes Player B feasible strategies: Up, if player A plays Down and Down, if player A plays Down Up, if player A plays Up and Down, if player A plays Up (6,20) 10-48

49 Dominant strategy Possible Strategies A strategy that results in the highest payoff to a player regardless of the opponent s action. Nash equilibrium strategy Simultaneous-Move, One-Shot Games A condition describing a set of strategies in which no player can improve her payoff by unilaterally changing her own strategy, given the other players strategies

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