Chapter 1 Basic Microeconomic Principles Prof. Jepsen ECO 610 Lecture 1 December 3, 2012 copyright John Wiley and Sons
Outline Course outline Economics review (Chapter 1) Costs Demand Profit maximization Game theory
About the Course Goal of course (from syllabus): We will apply economic theory to managerial decision making. We will employ many of the traditional tools of microeconomics and see how they can be used to analyze practical business problems Grading: 30% group projects 30% midterm exam (Monday, December 10) 40% final exam (Saturday, December 29)
Topics Covered in Course Today Intro and Economies of Scale/Scope Tuesday Make or Buy Wednesday Incentives in Firms Thursday Competitors and Competition Friday Strategic Commitment Monday midterm exam (6pm to 8:30pm) Tuesday Dynamics of Pricing Rivalries Wednesday Entry and Exit Thursday Industry Analysis
Economics Review Costs Managers are most familiar with two ways to present costs Income statement Statement of costs of goods Managers should be interested in total costs Useful for understanding effects of price change on profits
Total Cost Total Costs TC(Q) Q (Output)
Fixed and Variable Costs Fixed costs do not vary with the amount produced Example: price of land for factory Variable costs do vary with the amount produced Example: raw materials Some costs are semi-fixed
Average Cost Average Cost Function AC(Q) = TC(Q)/Q Q (Output)
Marginal Cost Marginal cost (MC) = increase in cost from producing marginally more of the output Often easier to think of producing one more unit of output: MC(Q) = TC(Q+1) TC(Q) MC often depends on the total volume of output
Cost Relationship between Marginal Cost and Average Cost Marginal cost Average cost MC < AC MC > AC Q* Q
Long Run versus Short Run Short run Firm cannot change production level Long run Firm can choose level of production Long-run cost curve is lower envelope of shortrun cost curves (for different production levels)
Sunk versus Avoidable Costs Sunk costs Costs that cannot be avoided Example: inventory that has already been purchased (and cannot be returned) Avoidable costs Costs that can be avoided Example: future inventory purchases
Economic Costs and Profits Managers should consider economic costs, not accounting costs Main difference is that economic costs consider the opportunity costs Opportunity cost: What is the next best use of the money / resources? Accounting cost: dollar amount spent Economic profit = sales revenue economic cost
Demand Curves Relates quantity sold to price (or other attribute) Slopes down As price increases, quantity demanded decreases Quantity
Price Elasticity of Demand Elasticity = % change in quantity Elastic = elasticity > 1 Inelastic = elasticity < 1 ------------------------- % change in price Firm-level elasticity is usually greater than industry-level elasticity
Total Revenue and Marginal Revenue Total revenue = Price * Quantity TR(Q) = P(Q) * Q Marginal revenue (MR) = increase in revenue from producing marginally more of the output Often easier to think of producing one more unit of output: MR(Q) = TR(Q+1) TR(Q) Analogous to marginal cost discussed earlier
Price, Marginal Revenue Marginal Revenue and Demand Demand Marginal Revenue Quantity
Pricing and Output Decisions To maximize profits, firm should produce quantity (Q) where marginal revenue (MR) is equal to marginal cost (MC) MR = MC If MR > MC, firm can increase profit by lowering its price (and selling more) If MR < MC, firm can increase profit by raising its (and selling less)
Price, Marginal Revenue Optimal Output and Price Marginal Cost Demand Q* Marginal Revenue Quantity
Perfect Competition Many producers with identical products Free entry and exit of firms In long-run, economic profits are zero No markets are perfectly competitive, but many are close Book examples: aluminum smelting, copper mining
Price, Marginal Cost Perfect Competition (Cont d) P = MR in perfect competition In other words, each firm s demand curve is flat Marginal Cost Demand Quantity
Game Theory An important point of managerial economics is to develop optimal response to rivals, as well as to predict how rivals will respond to your actions Game theory provides a framework for predicting responses Easiest way to explain is through an example:
Game Theory Example Airbus and Boeing are both considering expanding their capacity. Their profits depend on whether they expand, as well as whether their rival expands. Thus, there are four possible scenarios
Game Theory Example (Cont d) Suppose the profits from the four scenarios are (in millions of euros): Airbus expands and Boeing does not: 20 for Airbus, 15 for Boeing Airbus and Boeing expand: 16 for each Airbus does not expand and Boeing does: 15 for Airbus, 20 for Boeing Airbus and Boeing do not expand: 18 for each
Game Theory Example (Cont d) For each firm, the largest payoff is if they expand and their rival does not The smallest payoff is if they do not expand and their rival does What should each firm do? To answer this question, consider Airbus optimal strategy for each possible outcome (expand or not) for Boeing
Game Theory Example (Cont d) Suppose Boeing expands: If Airbus expands, their profits are 16 If Airbus does not expand, their profits are 15 Therefore, their dominant strategy is to expand regardless of whether or not Boeing expands. Using similar logic, Boeing s dominant strategy is also to expand Therefore, the equilibrium is that both firms expand
Game Theory Example (Cont d) Another way to see this is by constructing a game matrix: Boeing Do Not Expand Expand Do Not Expand 18, 18 15, 20 Expand 20, 15 16, 16 First number is for Airbus; 2 nd is for Boeing
Sequential Game Previous example assumed that both firms made their expansion decisions at the same time Suppose instead that the expansion decisions were sequential Airbus decides first, then Boeing reacts Also suppose that there are three choices: no expansion, small expansion, large expansion
Sequential Game (Continued) Do not expand (18, 18) Boeing Small (15, 20) Large (9, 18) Do not expand (20, 15) Airbus Small Boeing Small (16, 16) Large (8, 12) Do not expand (18, 9) Boeing Small (12, 8) Large (0, 0)
Sequential Game (Continued) To find equilibrium, consider Boeing s response: If Airbus does not expand, Boeing s optimal choice is small expansion If Airbus chooses small expansion, Boeing s optimal choice is small expansion If Airbus chooses large expansion, Boeing s optimal choice is to not expand
Sequential Game (Continued) Because Airbus knows Boeing s optimal response, it can choose the optimal expansion decision: If Airbus does not expand, Boeing will choose small and Airbus profits are 15 If Airbus chooses small, Boeing will choose small and Airbus profits are 16 If Airbus chooses large, Boeing will choose not to expand and Airbus profits are 18
Sequential Game (Continued) In this case, Airbus will choose large expansion because it has the largest profits for them (18) This equilibrium is called subgame perfect Note that the first mover Airbus in this case has a distinct advantage
Sequential Game (Continued) Do not expand (18, 18) Boeing Small (15, 20) Large (9, 18) Do not expand (20, 15) Airbus Small Boeing Small (16, 16) Large (8, 12) Do not expand (18, 9) Boeing Small (12, 8) Large (0, 0)