1 Economics 411 Managerial Economics Instructor: Ken Troske 1
2 About the Course Business Economics applies basic economic principles to the types of problems faced by business decisionmakers. Particular attention is paid to the economics of organizations, to the economics of firm strategy, and to issues around compensation. 2
3 About the Course Topics covered include the nature of economic organizations, the make or buy decision and the vertical chain of production, distribution channels, external market structure, compensation issues, rivalry and strategy. 3
4 About the Course Grading: 20% class participation and quizzes 20% midterm exam (March 3, 2015) 30% research project (due May 5, 2015) 30% final exam (8am Tuesday, May 5, 2015) 4
5 About the Course Class Structure Cover new concepts and material in 2-3 lectures Followed by discussion section Discussion based on readings from various periodicals such as Wall Street Journal, New York Times, and Harvard Business Review I will direct the discussion, you will do much of the discussing Vital that you read the articles prior to class Start the class with short quiz over the readings 5
6 About the Course Class Structure The syllabus has links to all of the supplemental readings Username: be-web\eco411 Password: troske411! Let me know quickly if you cannot access the readings May have to type the password in several times Works better if you access the through the class webpage: 11/index.html 6
7 About the Course Class Structure Class participation is a major part of the course I will take attendance every period Show up on time You will receive a failing grade if you miss more than 5 scheduled class periods If you are going to miss class, let me know in advance 7
8 About the Course Class Structure Because attendance is mandatory I will make my powerpoint slides available on the class website after I have completed each lecture No class February 3, March 17 & 19 (spring break), and April 2. 8
9 About the Course Research project 8-10 page research report Based on materials covered in class Due the day on the final More details later 9
10 About the Course Office hours: 4:00-5:00pm T, Th and by appointment Office: 103 Mandrell Hall Office phone: Best way to contact me Class website: ng/eco411/index.html 10
11 About me Senior Associate Dean in the Gatton College of Business and Economics Research focuses on Labor Economics PhD from University of Chicago Previously worked at U.S. Census Bureau and University of Missouri Panel member on Congressional Oversight Panel Visiting scholar at IZA in Bonn and 11 Federal Reserve Bank of Cleveland
12 Goals of the Course Some of the fundamental issues faced by all businesses include: What to produce How to produce it How to price it How to pay employees In this course we begin to develop the tools you can use to answer these questions 12
13 Example: Porsche Cayenne Example: you are president of Porsche Motor company and are introducing a new car the Cayenne SUV. What do you want to know?
14 Porsche Example Demand Will it grow over time? Effected by price. How sensitive? How much can you charge?
15 Porsche Example How much does it cost to produce? How will cost change with the number made? With time? With other products you make? Do you make the parts yourself or buy them from other companies? Do you sell it directly to final consumers or through dealers? How do you ensure your employees will produce a quality product?
16 Porsche Example Finally, you want to know about the market you operate in. Competitive How hard is it to enter this new market? Have market power? How will your competitors respond (Mercedes, Lexus, BMW)? What price do you charge?
17 Theories and Models Economists use theories and models to describe how we think the world works, just like a physicist or a chemist. Set of basic rules and assumptions about how individual units behave. Theory of the Firm Theories and models are simplifications of the world. People are too complicated
18 Theories and Models Validate models through testing (called experiments in physical sciences). For much of what we are concerned about simple model of producer behavior and market structure works well. That s why we like them.
19 Principles of Market Economies Property Rights A property right means the owner of a resource has the authority to determine how the resource is used Strong system of private property is a fundamental requirement for functioning capitalistic economic system 19
20 Principles of Market Economies Property Rights Must be able to Buy goods/resources from others Sell goods/resources to others Be confident that others/government will not steal or appropriate resources without payment 20
21 Principles of Market Economies Property Rights Governments sometimes set limits on property rights Labor Art Body parts 21
22 Principles of Market Economies Gains from Trade Individuals (firms, countries) trade in a market economy because doing so makes them better off than producing everything by themselves The amount individuals are better off is called the gains from trade Trade must be mutually beneficial 22
23 Example Gains from Trade Consider two people, Ken and Sue, in an economy with two goods, beer and pizza Ken can produce 2 pizzas or 1 bottle of beer per hour Sue can produce 1.5 pizzas or 2.5 bottles of beer per hour 23
24 Example Gains from Trade Number of Pizza Number of Pizza 60 Amount Ken produces working 30 hours Amount Sue produces working 30 hours Bottles of Beer 75 Bottles of Beer 24
25 Example Gains from Trade Number of Pizzas 105 G By specializing Ken and Sue can produce more output Ken F By trading with each other they can both consumer more pizza and beer than if they did not trade Sue E Bottles of Beer 25
26 Example Gains from Trade Gains from trade occur because of the concepts of specialization and comparative advantage Every hour Ken spends making pizzas it costs him 1 bottle of beer Every hour Su spends making pizzas it costs her 2.5 bottles of beer Ken has a comparative advantage making pizza; Sue has a comparative advantage making beer 26
27 Example Gains from Trade Even if one person has an absolute advantage in both tasks, they can only have a comparative advantage in one. Look at example in text People trade because they are made better off after the trade form of value creation The simple act of trading in the market creates value 27
28 Review Supply and Demand Review basics of supply and demand analysis Understand how the price of goods is determined Predict how changes in conditions effect prices Analyze the impact of government efforts to control prices.
29 Demand What affects your demand for some good such as coffee? Price; Price goes up drink less, price goes down drink more. Income; More income consume more. Price of related goods. Coke donuts
30 Demand Curve In order to graph a demand curve we need to focus on just one of the determinants of demand Price of the good. The demand curve shows how much of a good consumers are willing to buy as the price per unit changes holding non-price factors constant.
31 Demand Curve Price ($ per unit) Vertical axis measures price (P) paid per unit in dollars Horizontal axis measures quantity (Q) demanded in number of units per time period Quantity
32 Demand Curve Price ($ per unit) P 1 The demand curve slopes downward demonstrating that consumers are willing to buy more at a lower price as the product becomes relatively cheaper and the consumer s real income increases. P 2 D Q 1 Q 2 Quantity
33 Demand Curve Movements along the demand curve reflect changes in quantity demanded The negative slope shows that as the price of a good rises, the quantity demanded of the good falls. This is knows as the law of demand.
34 Shift in Demand We drew the demand curve holding other things, such as income, the prices of other goods and tastes constant. What happens if they change?
35 Shift in Demand Increase in price of Coke (a substitute) P D D Coffee demand curve shifts out. P 2 At P 1 increase demand from Q 1 to Q 2. P 1 Again, purchase more at any price on D. Q 0 Q 1 Q 2 Q
36 Substitutes When the change in the price of a good results in a similar change in the quantity demanded of another good, we call those two goods substitutes. Increase (decrease) in price of coke results in an increase (decrease) in the demand for coffee. Other examples: Beer and whiskey; steel and aluminum; cotton and polyester
37 Compliments When the change in the price of a good results in a opposite change in the quantity demanded of another good, we call those two goods compliments. Increase (decrease) in price of donuts results in an decrease (increase) in the demand for coffee. Other examples: Pizza and beer; steel and glass; memory chips and hard drives
38 Supply Now want to model supply and graph a supply curve. What affects the supply for some good such as coffee? Price; Price goes up supply more, price goes down supply less. Technology; changes in technology generally make it cheaper to produce goods. Price of inputs. Coffee beans Labor Equipment
39 Supply Curve In order to graph a supply curve we need to focus on just one of the determinants of supply Price of the good. The supply curve shows how much of a good producers are willing to sell at a given price holding the prices of other factors constant.
40 Supply Curve Price ($ per unit) Vertical axis measures price (P) received per unit in dollars Horizontal axis measures quantity (Q) supplied in number of units per time period Quantity
41 Supply Curve Price ($ per unit) S P 2 P 1 The supply curve slopes upward demonstrating that at higher prices firms will increase output Q 1 Q 2 Quantity
42 Supply Curve Movements along the supply curve reflect changes in quantity supplied. When price rises from P 1 to P 2 we say there is an increase in quantity supplied. The positive slope shows that as the price of a good rises, the quantity supplied of the good rises.
43 Shift in Supply Curve Again, changes in factors other than the price of the product results in shifts in the supply curve. What are some things that could shift the supply curve? Price of inputs or raw materials. Changes in government regulations. Technology. Shifts in the supply curve are called changes in supply.
44 Shift in Supply Curve The cost of raw materials falls P S S Supply curve shifts right from S to S At P 1, increase production from Q 1 to Q 2 P 1 More produced at any price on S than on S P 2 Q 0 Q 1 Q 2 Q
45 Market Equilibrium We say a market is in equilibrium when the quantity demanded equals the quantity supplied
46 Market Equilibrium Price ($ per unit) S P 0 The curves intersect at equilibrium, or marketclearing, price. At P 0 the quantity supplied is equal to the quantity demanded at Q 0. D Q 0 Quantity
47 Market Equilibrium Characteristics of the equilibrium or market clearing price: Q D = Q S No shortage No excess supply No pressure on the price to change
48 Market Equilibrium Surplus Price ($ per unit) P 1 P 2 Surplus S Assume the price is P 1, then: 1) Q s : Q 2 > Q d : Q 1 2) Excess supply is Q 2 Q 1. 3) Producers lower price. 4) Quantity supplied decreases and quantity demanded increases. 5) Equilibrium at P 2, Q 3 D Q 1 Q 3 Q 2 Quantity
49 Market Equilibrium Shortage Price ($ per unit) S P 3 P 2 Shortage Assume the price is P 2, then: 1) Q d : Q 2 > Q s : Q 1 2) Shortage is Q 2 Q 1. 3) Producers raise price. 4) Quantity supplied increases and quantity demanded decreases. 5) Equilibrium at P 3, Q 3 D Q 1 Q 3 Q 2 Quantity
50 Market Equilibrium Supply and demand interact to determine the market-clearing price. We say the market is in equilibrium when quantity demanded equals quantity supplied. When not in equilibrium, the market will adjust to alleviate a shortage or surplus and return the market to equilibrium.
51 Market Equilibrium Up to now we have done everything graphically. Now solve for equilibrium using the equations. Suppose we have a demand curve given by Q D = P or P=7-(1/50)Q D
52 Market Equilibrium Suppose we have a supply curve given by Q s = P or P=1 + (1/50)Q s. How do we find the equilibrium price and quantity. Know in equilibrium Q D =Q S.
53 Market Equilibrium Q= Q SinceQ D = Q just substitute for Q S Q 2 50 Q = 6 * * = 150 P = 4
54 Elasticities of Supply and Demand Want some way to measure the shape of the demand and supply curve. Use the elasticity. Elasticity is a measure of the sensitivity of one variable to another.
55 Price Elasticity of Demand The price elasticity of demand is: E D = (% Q D )/(% P)
56 Price Elasticity of Demand If E D > 1, the percent change in quantity is greater than the percent change in price. We say the demand is price elastic. Note, E D is negative If E D < 1, the percent change in quantity is less than the percent change in price. We say the demand is price inelastic.
57 Price Elasticity of Supply The price elasticity of supply is: E S = (% Q S )/(% P)
58 Prices as Social Coordinators What happens when we have high gas prices Spend more money on searching for oil Drill oil in more expensive locations Search for alternative energy sources Drive more fuel efficient vehicles Prices tell people and businesses how to allocate scarce resources 58
59 Use demand and supply curve to measure gains from trade Price Consumer Surplus Green triangle measures gains consumers get from trading in the market S P* Total gains from trade is sum of two triangles Producer Surplus Orange triangle measures gain producers get from trading in the market D 0 Q* Quantity
60 Evaluating the Gains and Losses from Government Interventions in the Market To determine the welfare effect of a government intervention we can measure the gain or loss in consumer and producer surplus. Often governments impose caps or floors on prices Caps on rents, price of consumer goods such as bread or food Floors on prices such as minimum wages
61 Evaluating the Gains and Losses from Government Interventions in the Market Price Ceiling Price P 0 P max A Suppose the government imposes a price ceiling P max on gasoline which is below the market-clearing price P 0. C B Deadweight Loss D S The gain to consumers is the difference between the rectangle A and the triangle B. Excess demand (shortage) for gasoline The loss to producers is the sum of rectangle A and triangle C. Triangle B and C together measure the deadweight loss. Q 1 Q 2 Q 0 Quantity
62 Evaluating the Gains and Losses from Government Interventions in the Market The deadweight loss is the inefficiency of the price controls. The loss of producer surplus exceeds the gain from consumer surplus.
63 Effect of price controls depends on elasticity of supply and demand Price D If demand is sufficiently Inelastic and supply sufficiently elastic, triangle B can be larger than rectangle A and the consumer suffers a net loss from price controls. S B P 0 P max A C Example Oil price controls and gasoline shortages in the U.S. in 1979 Q 1 Q 2 Quantity
64 Evaluating the Gains and Losses from Government Interventions in the Market Price Ceiling Minimum Wage w Suppose the government does not allow firms to pay a wage less than w min. S w min w 0 A B C The deadweight loss is given by triangles B and C. Unemployment L 1 L 0 L 2 D L
65 Externalities, Coase Theorem, Transaction Costs Externalities occur when the actions of one party impose costs on another, unrelated, party Actor taking the action does not consider the costs on others of the action Pollution by a firm Typical solution is for the government to impose a tax
66 Externalities, Coase Theorem, Transaction Costs Ronald Coase If actors can trade in the market then we should reach the efficient outcome Property rights must be well defined and we must be able to trade property rights Cost of transacting in the market must be low Gains from trade means that individuals have the incentive to reach the efficient outcome
67 Markets vs. Central Planning Advantages of free market system 1. Prices provide signals, so when prices rise this increases the demand for inputs whose prices also rise 2. Reduces the cost of state planning 3. Motivates firms to produce products people want at a lower cost and/or higher quality than their competitors 67
68 Markets vs. Central Planning Advantages of free market system 4. Produces a greater range of products and consumer choices 5. Leads factors of production to be put to their highest valued use; including people 6. Because of the pressure to reduce costs, eventually even the poorest consumers can consume innovative products 68
69 Markets vs. Central Planning Disadvantages of free market system 1. Results in larger (explicit) inequalities in income 2. Under-provision of public goods 3. Can lead to monopolies which charge monopoly prices and produce lower quality goods 4. More difficult to deal with externalities 69
70 Coase Theory of the Firm How do mangers decide what to produce within a firm and what to purchase from the market? Cost of purchasing from the market transaction costs (contracting costs) Cost of producing within a firm Organizational costs Allocation costs no prices Influence costs 70
71 Present Value Basic decision about investing involves comparing costs incurred today with benefits received in the future. Need to be able to compare costs and benefits in common dollars. Use the concept of present value to make these comparisons. Briefly review present value. 71
72 Present Value For most people it is true that $100 received today is worth more than $100 next year. Can always invest the $100 and have even more next year. Suppose you can invest $100 and get a 5% return (rate of interest is 5%). Then $100 today is worth $105 next year 105=100*(1+0.05) 72
73 Present Value Alternatively, if you invested $95.24 today you would have $100 in one year. 100=95.24*(1.05) or 95.24=100/(1.05). This shows that $100 in one year is worth today or the present value of $100 in one year is $
74 Present Value The present value (PV) of the payment of y dollars in one year is given by: PV y = 1 + r Here r is the rate of interest. 74
75 Present Value Using similar logic we know that a payment of $100 two years from now is worth less today than a payment of $100 one year from now. $100 invested today would be worth $100*(1+0.05)*(1+0.05) or $100*(1.05) 2 in two years. 75
76 Present Value The present value (PV) of the payment of y dollars in two years is given by: PV = y (1 + r) 2 76
77 Present Value The present value (PV) of the payment of y dollars in t years is given by: PV = y (1 + r) t 77
78 Present Value Now suppose that you have an investment that pays Y 1 next year, Y 2 the year after and so forth for T years. Then the present value of this investment is given by: PV Y Y Y Y = T (1 + r) (1 + r) 2 (1 + r) 3 (1 + r) T 78
79 Summary The quantity demanded and supplied of any product depends on the price of the product. The demand function shows how the quantity demanded varies with the price of the product. The law of demand states that the quantity demanded is inversely related to the price of the product. A change in income, tastes, or the prices of compliments or substitutes leads to a shift the demand curve.
80 Summary The market supply function shows how the quantity supplied changes as the price changes. The supply function shifts if the price of an input changes or there is a change in the technology used to produce the product. The market equilibrium is where the market price equates the supply and demand for the product.
81 Summary Elasticities describe the responsiveness of supply and demand to changes in price, income, and other variables. Present value allows us to compare dollars received in the future with today s dollars