MANAGERIAL ECONOMICS EC 952

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1 MANAGERIAL ECONOMICS EC 952 Your instructor: Dmitri Nizovtsev Office: 310N in Henderson Phone: Office Hours: M 2:30 4pm, W 11am 12:30pm, R 4 5:30pm + Open door policy Course Web page:

2 Textbook: Baye, Managerial Economics and Business Strategy, 7e. Grading: Problem sets and writing assignments : 25% Two Midterms: 17.5 x 2 = 35% Group project: 15% Final: 25%

3 Cornerstones of (managerial) economics 1. Opportunity cost The Opportunity cost (of a product, action etc.) is the value of the next best alternative that has to be forgone in order to obtain it. The total economic cost consists of explicit (out of pocket, monetary) and implicit (measured in lost opportunities) costs. A good manager has to recognize both.

4 2. Cost/benefit comparison. Net benefit is the difference between benefits and costs. Example: PROFIT (1+2): The concept of economic profit (takes both explicit and implicit costs into account)

5 3. Marginal analysis Instead of looking at the overall costs and benefits, one can look at how costs and benefits change as a result of the action that is being evaluated. Benefits increased more than costs your company is better off

6 Demand, Supply, and Market Equilibrium We often hear that prices are governed by forces of supply and demand. That is to a large extent true. (And not only prices, but quantities, too!) It is important for a manager to understand how those forces work, be able to predict their direction, and in some cases maybe even affect them. Ideally, it should work in the following way: Step 1: Look at the Big Picture (S-D analysis) Step 2: What does that mean for your company? Step 3: Worry about details (create an action plan) First, let us see if we agree on what supply and demand are.

7 Demand is a relationship between the price of a good and the quantity of the good consumers are expected to purchase (a. k. a. quantity demanded ) relationship = a function, a graph, a formula, etc. What is the shape of a demand relationship? Law of Demand : the higher the price of a good, the smaller the quantity demanded Why so? Diminishing marginal utility

8 Supply is a relationship between the price of a good and the quantity of the good producers/sellers will be willing and able to deliver to the market (a. k. a. quantity supplied ) The shape? Slopes upwards (a higher selling price induces a greater output quantity) Why? Increasing marginal cost

9 P Market equilibrium When put on the same graph, supply and demand curves usually intersect. P E Equilibrium price Q E The point where the two curves intersect is called the market equilibrium. It is characterized by a price and a quantity.

10 In perfect markets large number of buyers and sellers; goods offered by different sellers are identical; sellers can freely enter and exit the market; everyone has perfect information about all the transactions (prices, quantity, etc.), prices charged by different sellers are usually closely clustered around the equilibrium price. It can be shown by using common sense that it is in no one s interest to try to ask or offer a price different from the equilibrium price. In such markets, prices can change only as a result of changes ( shifts ) in supply and/or demand.

11 P All the graphs are for the chicken meat market!!! P Q Q P CH decreases, Q CH decreases A. The price of pork decreases P CH increases, Q CH decreases B. It is getting harder to find workers willing to work in the chicken meat industry

12 P P Q Q P CH decreases, Q CH increases C. A new feed formula helps birds gain weight 50% faster than before P CH increases, Q CH increases D. Chicken meat is scientifically proven to have substantial health benefits

13 Factors that can shift demand (also called determinants, or shifters ): P of a substitute good increases Demand for our good increases (shifts to the right) P of a complementary good increases Demand for our good decreases (shifts to the left)

14 Consumer income increases Demand for our good. INCREASES DECREASES if it is a normal good. if it is an inferior good. Price of a good is expected to go up in the near future Demand for the good today INCREASES There are many other, more trivial factors (# of consumers, information about the good, prior experience with the good, consumer demographics, time of the year, etc.)

15 Factors that can shift supply: Increase in costs (higher input prices, tax on producers, etc.) Supply DECREASES (shifts left) Decrease in costs (cheaper inputs, subsidy to producers, technol. progress, etc.) Supply INCREASES (shifts right) Increase in the number of firms in the market Supply INCREASES

16 Prices of other goods (Y) that can be produced instead of the good of interest (X), substitutes in production Logic: Price of Y goes up Resources shift Or: Price of Y goes up The opp.cost of X.

17 Prices of other goods (Y) that can be produced instead of the good of interest (X), substitutes in production Logic: Price of Y goes up Resources shift from X into Y Or: Price of Y goes up The opp.cost of X.

18 Prices of other goods (Y) that can be produced instead of the good of interest (X), substitutes in production Logic: Price of Y goes up Resources shift from X into Y Less X is produced Or: Price of Y goes up The opp.cost of X.

19 Prices of other goods (Y) that can be produced instead of the good of interest (X), substitutes in production Logic: Price of Y goes up Resources shift from X into Y Less X is produced a decrease in supply of X Or: Price of Y goes up The opp.cost of X.

20 Prices of other goods (Y) that can be produced instead of the good of interest (X), substitutes in production Logic: Price of Y goes up Resources shift from X into Y Less X is produced a decrease in supply of X Or: Price of Y goes up The opp.cost of X increases

21 Prices of other goods (Y) that can be produced instead of the good of interest (X), substitutes in production Logic: Price of Y goes up Resources shift from X into Y Less X is produced a decrease in supply of X Or: Price of Y goes up The opp.cost of X increases a decrease in supply of X

22 Important things to keep in mind in S-and-D analysis: When both curves (supply AND demand) shift, and we are asked about the direction of change in price and quantity, we will be able to predict only one of the two. The other one will be indeterminate. A common mistake is shifting too many curves too many times (in most cases, one event causes only one shift). A shift in a curve should occur only if we are dealing with one of the shifters listed above. A change in the price of the good in question doesn t cause a shift! Buyers and sellers do react to the price of the good but that reaction is illustrated by movement along a curve.

23 Why care about supply-and-demand analysis? Example: You manage a small firm that manufactures PCs. Event: The WSJ reports that the prices of PC components are expected to fall by 5-8 percent over the next six months. Step 1: Look at the Big Picture (S-D analysis) Step 2: What does that mean for your company? Step 3: Worry about details (create an action plan)

24 Why care about supply-and-demand analysis? Example: You manage a small firm that manufactures PCs. Event: The WSJ reports that the prices of PC components are expected to fall by 5-8 percent over the next six months. P Increase in supply of PCs Market price of PCs will decrease, Overall market Q will increase Q

25 The action plan: What is your best strategy buying the components? Should you continue pricing your computers the same? Should you maintain the same inventory? Do you want to preserve your market share? What do you need to do for that? Are you prepared to produce a larger quantity of output? What needs to be done? - components/parts; - personnel decisions; - complements in production (software); - etc.

26 Often, quantitative analysis of market environment allows to present supply and demand relationships in the form of equations, such as Q D,X = F(Px, Py, M, H D, ), where Q D,X = quantity demanded of good X; Px = price of good X; Py = price of a related good Y(can be substitute or complement); M = consumers income; H D = any other variables affecting demand Similarly, Q S,X = F(Px, Py, H S, )

27 Example (from p.42 in the text): An economic consultant for X Corp. recently provided the firm s marketing manager with this estimate of the demand function for the firm s product (A X represents spending on advertising good X): Q D,X = 12,000 3 P X + 4 P Y M + 2 A X Are goods X and Y substitutes or complements? Look at the sign next to the P Y term. As P Y increases, the entire right-hand side (and therefore Q D,X ) will increase. Therefore, goods X and Y are substitutes.

28 Example (from p.42 in the text): An economic consultant for X Corp. recently provided the firm s marketing manager with this estimate of the demand function for the firm s product (A X represents spending on advertising good X): Q D,X = 12,000 3 P X + 4 P Y M + 2 A X Is good X a normal or an inferior good? As consumer income, M, increases, the entire Q D,X expression decreases. Therefore, good X is an inferior good.

29 Q D,X = 12,000 3 P X + 4 P Y M + 2 A X Currently, good Y sells for $15 per unit, the company spends $2000 on advertising, and the average consumer income is $10,000. If the price for good X is set at $200 per unit, how much of good X will consumers purchase? Let s do it in two steps: 1. Plug in the values for all variables except own price: Q D,X = 12,000 3 P X , = = 6,060 3 P X We now have the clean demand equation that connects only price and quantity.

30 Q D,X = 6,060 3 P X This form is easier to work with and still allows us to answer interesting and important questions but for the time being 2. If the price for good X is set at $200 per unit, how much of good X will consumers purchase? Q D,X = 6, = 5,460

31 When equations for supply and demand are available, we can make fairly accurate predictions regarding price and quantity. (Where those equations may come from will be discussed next week.) Example: Demand: Q D = P Supply: Q S = 200 P 500 Can we tell what the equilibrium price and quantity are? Hint: Set QD = QS and solve for P. Then plug P into any of the equations.

32 Normally, supply and demand equations are given in the form similar to the one above, where quantity is expressed as a function of price. On some occasions, we will need a different form, known as inverse supply/demand, when price is a function of quantity (price is on the left side of the equation). For example, the demand equation obtained earlier can be rewritten as Q D,X = 6,060 3 P X regular demand form 3 P X = 6,060 Q D,X P X = 2,020 ⅓ Q D,X inverse demand

1. Demand: willingness to buy a good or service and the ability to pay for it; how much of an item an individual is willing to purchase at each price

1. Demand: willingness to buy a good or service and the ability to pay for it; how much of an item an individual is willing to purchase at each price 2. The two things needed for demand to exist are: willingness