Managerial Economics Introduction to the Course

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1 Managerial Economics Introduction to the Course Aalto University School of Science Department of Industrial Engineering and Management January 10 26, 2017 Dr. Arto Kovanen, Ph.D. Visiting Lecturer

2 A little bit about me I am a Finn, but I have spent over 30 years in the United States to study and work I received my doctorate in economics from Purdue University. I have also studied in Finland I have taught economics at universities in the U.S. and Finland Most of my career, I have spent in institutions that deal with economic policy issues, including Bank of Finland, the IMF, and the Institute of International Finance Currently, I own a consulting company and advise policy makers on macro- and monetary policy matters, conduct economic research, and teach economics

3 What are you in for? What kind of course is this? we apply economic thinking to everyday problems of firms Pre-requisite: principles of economics or similar, some basic math is also required The course is taught in English! What is expected of you in this course? Class participation / attendance is not monitored, but not everything is in the course textbook! Complete individual homework assignments on time! Do well in the final exam!

4 General information The course will comprise 6 lectures, on three Tuesdays and Thursdays, from (15 minutes break in the middle) There will be 2 individual homework exercises and a final exam FINAL EXAM: February 13 18, 2017 period (CONFIRM) Grades will be based on (maximum 100 points): Final exam: 60 points Individual exercises (2 exercises): 40 points (2 x 20 points) Minimum requirement to pass: 60 points, of which at least 20 points must come from homework! Grading scale: 5 90; 4 80; 3 70; 2 60; 1 50; 0 < 50

5 General information (cont.) Individual homework exercises: Goal: apply economic thinking to firm s decision-making Homework 1 is due Tuesday, January 17, 2017 in class (review session on Wednesday, January 18, 2017; time to be confirmed) Homework 2 is due Tuesday, January 24, 2017 in class (review session on Wednesday, January 25, 2017; time to be confirmed) No late submissions accepted (i.e., after the class) Must be completed/submitted individually Lecture slides and exercises will be posted on the web Assistant : Mr. Joosef Valli (joosef.valli@aalto.fi)

6 Content of the Course Course text: Managerial Economics; Economic Tools for Today s Decision Makers; 7 th Edition; Keat-Young-Erfle (earlier editions of the textbook are also fine) Additional material will be covered in the classroom Everything is not in the course textbook (so attend the class and read the additional handouts) The course is divided into three segments: Decision-making within the firm Competing with markets Decision-making applications and other topics

7 Content of the Course (cont.) Segment 1: Decision-making within the Firm Optimal decisions using marginal analysis (1 st week) Production and cost analysis (1 st week) Demand analysis and optimal pricing (1 st week) Estimating and forecasting demand (2 nd week) These topics roughly correspond to chapters 1 through 7 in the course textbook and will be covered during the first and second weeks of classes

8 Content of the Course (cont.) Segment 2: Competing with Markets Perfect competition (2 nd week) Monopoly and oligopoly (2 nd week) Game theory and competitive strategies (2 nd week) Market failure and government intervention (3 rd week) These topics roughly correspond to chapters 8 through 11, and 14 in the course textbook and will be covered during the second and third weeks of classes

9 Content of the Course (cont.) Segment 3: Decision-making Applications Linear programming (3 rd week) Asymmetric information (3 rd week) Decision-making under uncertainty (3 rd week) Segment 3 materials are not covered in the course textbook and will be covered during the third week of classes Other useful textbooks to read, to name a few: Hall Varian, Intermediate Microeconomics Thomas J. Webster, Managerial Economics Samuelson and Marks, Managerial Economics

10 What is managerial economics?

11 It is all about economics! Mankiw, Principles of Economics

12 What is managerial economics? Managerial economics is the application of economic concepts and economic analysis to the problems of the firm to formulate rational managerial decisions It is sometimes referred to as business economics and is a branch of economics that applies microeconomic analysis to decision methods of businesses and other managerial units It draws heavily on quantitative techniques including regression analysis, correlation and calculus It attempts to help businesses make decisions given their objectives and constraints

13 Managerial economics (cont.) Economics is relevant for business decisions: What is the demand for firm s product? How much to charge from customers? What are the relevant costs of production? Should the firm enter into a new market? Economic practice involves principles and modeling for specific answers: analysis and prediction A range of economic fields come together: finance, marketing, industrial organization, labor economics, macroeconomics (public policy making), statistics

14 Decision-making Decision-making lies at the heart of business activity The range of business decisions is vast, for instance: Should a high-tech company undertake expensive research to develop new products (pros and cons, and potential risks)? How much to bid for a government contract (e.g., build a bridge or school)? How much to adjust the product price in response to new competitor s entry in the market? The best way to become familiar with managerial economics is to study real-world decision-making!

15 Decision-making (cont.) Steps to decision-making (in general): Define the problem facing the management What are the key objectives (profits, revenues)? What are the possible courses of action and what parameters can the decision-maker control? What are the consequences of each alternative action and how would the outcome change if the conditions change? What is the preferred course of action (is it optimal)? Perform sensitivity analysis (underscores uncertainty about the future)

16 Economics and choice Choice is an essential element of human decisions Economics is the study of understanding how we make choices and how choices influence the outcomes It seeks to build a theoretical model or roadmap for rational choices, to explain and evaluate the social interaction Choices that the society must make (e.g., healthcare services): What goods to produce? What is the best way to produce them? Who will produce them (e.g., public/private sector)? For whom to produce?

17 Scarcity and decision making Scarcity and choice are central for decision making and the discipline of economics Individuals and societies cannot have everything they desire because resources are limited choices are necessary Goods and services, and productive resources that are scarce have positive prices, which results from the interaction between supply and demand for them Examples of scarce goods: natural resources, labor, land, physical capital, financial resources Are there any goods that are free? Is clean air free? What would it mean for their consumption? Would we want to have unlimited consumption of air or not?

18 How does scarcity influence business decisions? How business constraints limit firm s operations? Examples: Scarcity (cont.) How much to produce? What limits output in practice? Should a firm make its own spare parts or buy them from an outside vendor (i.e., outsource)? Should a firm buy or lease office space it uses for its business? Does it matter and why? Should a firm expand to international markets/export? What issues does this involve? Should a firm hire more labor or invest in machines?

19 Importance of markets Mankiw: Principles of Economics

20 Importance of markets (cont.) What is a market? A place? A product or service? Who are the sellers? Who are the buyers? Demand substitutability / differentiation important Products or services are considered in the same market if they are similar in the eyes of BUYERS Number of existing and potential buyers matters Number of existing and potential sellers matters Ease of entry and exit matters Can producers and consumers influence prices (market power)?

21 Importance of markets (cont.) MIT

22 Importance of markets (cont.) Trading has to be beneficial for all parties! In a free and voluntary exchange, both parties (producers and consumers) must gain, or at least one gains while the other is no worse off, for a trade to take place Having a good product does not necessarily sell if there is no demand for it (e.g., nobody uses typewriters anymore) Markets tend to exploit all mutually beneficial trades (this is seen in efficient markets, e.g. for financial instruments) Issues that matter: The law of one price (in equilibrium; information efficiency) Market power Symmetry of information (or the lack of it) Are externalities present (i.e., one s action affects others)?

23 Role of government policies Mankiw 2009.

24 Government policies (cont.) Demand and supply are also influenced by economic policy decisions of the government and central bank Decisions about fiscal, monetary, exchange rate, and income policies important for consumers and firms They influence expectations and behavior E.g., investment decisions are affected by the cost and availability of credit; employment decisions are influenced by labor market policies and taxation Aggregate demand: Y = C P + I P + e*(x M) + (C G + I G ) Aggregate supply: Y = f(l(w), K, I(r).)

25 Government policies (cont.) Note that government s policy objectives differ from those of the private sector Private sector maximizes profits/value of the firm Government has also broader objectives, e.g., to promote social welfare and full employment Government often tries to balance benefits and costs of its decisions to the society (cost-benefit analysis more important that making profits) Government also considers distributional effects For instance, how are costs and benefits distributed (e.g., building a public road, healthcare, education)?