Managerial Economics

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Baye_9e_Chapter_01.pptx

The Fundamentals of Managerial Economics

Chapter 1

Learning Objectives

Summarize how goals, constraints, incentives, and market rivalry affect economic decisions.

Distinguish economic versus accounting profits and costs.

Explain the role of profits in a market economy.

Apply the five forces framework to analyze the sustainability of an industry’s profits.

Apply present value analysis to make decisions and value assets.

Apply marginal analysis to determine the optimal level of a managerial control variable.

Identify and apply six principles of effective managerial decision making.

The Manager

A person who directs resources to achieve a stated goal.

Directs the efforts of others.

Purchases inputs used in the production of the firm’s output.

Directs the product price or quality decisions.

1-3

Introduction

Economics

The science of making decisions in the presence of scarce resources.

Resources are anything used to produce a good or service, or achieve a goal.

Decisions are important because scarcity implies trade-offs.

1-4

Introduction

The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.

Should a firm purchase components – like disk drives and chips – from other manufacturers or produce them within the firm?

Should the firm specialize in making one type of computer or produce several different types?

How many computers should the firm produce, and at what price should you sell them?

1-5

Introduction

Managerial Economics Defined

Basic principles comprising effective management:

Identify goals and constraints

Recognize the nature and importance of profits

Understand incentives

Understand markets

Recognize the time value of money

Use marginal analysis

1-6

Economics of Effective Management

The Economics of Effective Management

Identify Goals and Constraints

Well-defined goals

Firm’s overall goal is to maximize profits

Constraints make it difficult to achieve goals

Available technology

Prices of inputs used in production

The Economics of Effective Management

Recognize the Nature and Importance of Profits

Accounting profit

Total amount of money taken in from sales (total revenue) minus the dollar cost of producing goods or services.

Economic profit

The difference between total revenue and cost opportunity cost.

Opportunity cost

The explicit cost of a resource plus the implicit cost of giving up its best alternative.

1-8

The Economics of Effective Management

The role of profits

Profits are a signal to resource holders where resources are most highly valued by society.

1-9

The Economics of Effective Management

Recognize the Nature and Importance of Profits

Five Forces and Industry Profitability

The Economics of Effective Management

Understand Incentives

Changes in profits provide an incentive to how resource holders use their resources.

Within a firm, incentives impact how resources are used and how hard workers work.

One role of a manager is to construct incentives to induce maximal effort from employees.

1-11

The Economics of Effective Management

Two sides to every market transaction: buyer and seller

Bargaining position of consumers and producers is limited by three rivalries in economic transactions:

Consumer-producer rivalry

Consumer-consumer rivalry

Producer-producer rivalry

Government and the market

1-12

The Economics of Effective Management

Understand Markets

Recognize the Time Value of Money

Often a gap exists between the time when costs are borne and benefits received.

Managers can use present value analysis to properly account for the timing of receipts and expenditures.

1-13

The Economics of Effective Management

Present Value Analysis 1

Present value of a single future value

The amount that would have to be invested today at the prevailing interest rate to generate the given future value:

Present value reflects the difference between the future value and the opportunity cost of waiting:

1-14

The Economics of Effective Management

Present Value Analysis II

Present value of a stream of future values

or,

1-15

The Economics of Effective Management

Consider a project that returns the following income stream:

Year 1, $10,000; Year 2, $50,000; and Year 3, $100,000.

At an annual interest rate of 3 percent, what is the present value of this income stream?

1-16

The Economics of Effective Management

The Time Value of Money in Action

Net Present Value

The present value of the income stream generated by a project minus the current cost of the project:

1-17

The Economics of Effective Management

Present value of decisions that indefinitely generate cash flows:

Present value of this perpetual income stream when the same cash flow is generated :

1-18

Economics of Effective Management

Present Value of Indefinitely Lived Assets

Profit maximization

Maximizing profits means maximizing the value of the firm, which is the present value of current and future profits.

1-19

Economics of Effective Management

Present Value and Profit Maximization

Present Value and Estimating Values of Firms I

The value of a firm with current profits , with no dividends paid out and expected, constant profit growth rate of (assuming ) is:

1-20

Economics of Effective Management

When dividends are immediately paid out of current profits, the present value of the firm is (at ex-dividend date):

1-21

Economics of Effective Management

Present Value and Estimating Values of Firms II

Short-term and long-term profits

If the growth rate in profits is less than the interest rate and both are constant, maximizing current (short-term) profits is the same as maximizing long-term profits.

1-22

Economics of Effective Management

Short-Term versus Long-Term Profits

Given a control variable, , of a managerial objective, denote the

total benefit as .

total cost as .

Manager’s objective is to maximize net benefits:

1-23

Economics of Effective Management

Use Marginal Analysis

How can the manager maximize net benefits?

Use marginal analysis

Marginal benefit:

The change in total benefits arising from a change in the managerial control variable, .

Marginal cost:

The change in the total costs arising from a change in the managerial control variable, .

Marginal net benefits:

1-24

Economics of Effective Management

Use Marginal Analysis

Marginal 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.

1-25

Economics of Effective Management

Use Marginal Analysis

Marginal Analysis In Action

It is estimated that the benefit and cost structure of a firm is:

Find the and functions.

What value of makes zero?

1-26

Economics of Effective Management

1-27

Quantity

(Control Variable)

Total benefits

Total costs

Slope =

Maximum total benefits

Maximum net

benefits

Economics of Effective Management

Determining the Optimal Level of a Control Variable

Determining the Optimal Level of a Control Variable II

1-28

Quantity

(Control Variable)

Net benefits

Maximum

net benefits

Slope =

Economics of Effective Management

1-29

Quantity

(Control Variable)

Marginal

benefits, costs

and net benefits

Maximum net

benefits

Economics of Effective Management

Determining the Optimal Level of a Control Variable III

Marginal Value Curves Are the Slopes of Total Value Curves

When the control variable is infinitely divisible, the slope of a total value curve at a given point is the marginal value at that point.

The slope of the total benefit curve at a given Q is the marginal benefit of that level of Q.

The slope of the total cost curve at a given Q is the marginal cost of that level of Q.

The slope of the net benefit curve at given Q is the marginal net benefit of that level of Q.

1-30

Economics of Effective Management

Marginal Value Curves Are the Slopes of Total Value Curves

A calculus alternative

Slope of a continuous function is the derivative /marginal value of that function:

1-31

Economics of Effective Management

Incremental revenues

The additional revenues that stem from a yes-or-no decision.

Incremental costs

The additional costs that stem from a yes-or-no decision.

“Thumbs up” decision

“Thumbs down” decision

1-32

Economics of Effective Management

Incremental Decisions

Learning Managerial Economics

Practice, practice, practice …

Learn terminology

Break down complex issues into manageable components.

Helps economics practitioners communicate efficiently.

1-33

Learning Managerial Economics

Baye_9e_Chapter_02.pptx

Market Forces: Demand and Supply

Chapter 2

Learning Objectives

Explain the laws of demand and supply, and identify factors that cause demand and supply to shift.

Calculate consumer surplus and producer surplus, and describe what they mean.

Explain price determination in a competitive market, and show how equilibrium changes in response to changes in determinates of demand and supply.

Explain and illustrate how excise taxes, ad valorem taxes, price floors, and price ceilings impact the functioning of a market.

Apply supply and demand analysis as a qualitative forecasting tool to see the “big picture” in competitive markets.

Market demand curve

Illustrates the relationship between the total quantity and price per unit of a good all consumers are willing and able to purchase, holding other variables constant.

Law of demand

The quantity of a good consumers are willing and able to purchase increases (decreases) as the price falls (rises).

Price and quantity demanded are inversely related.

2-3

Demand

Market Demand Curve

2-4

Quantity

(thousands per year)

Price ($)

Demand

$40

$30

$20

$10

Demand

Changing only price leads to changes in quantity demanded.

This type of change is graphically represented by a movement along a given demand curve, holding other factors that impact demand constant.

Changing factors other than price lead to changes in demand.

These types of changes are graphically represented by a shift of the entire demand curve.

2-5

Demand

Shift in Quantity Demanded versus a Shift in Demand

Changes in Demand

2-6

Quantity

Price

Increase

demand

Demand

Decrease

demand

Demand Shifters

Income

Normal good

Inferior good

Prices of related goods

Substitute goods

Complement goods

Advertising and consumer tastes

Informative advertising

Persuasive advertising

Population

Consumer expectations

Other factors

2-7

Demand

Advertising and the Demand for Clothing

2-8

Quantity of

high-style

clothing

$50

$40

50,000

Price of

high-style

clothing

60,000

Due to an

increase in

advertising

Demand

The Demand Function

The demand function for good X is a mathematical representation describing how many units will be purchased at different prices for X, the price of a related good Y, income and other factors that affect the demand for good X.

2-9

Demand

The Linear Demand Function

One simple, but useful, representation of a demand function is the linear demand function:

where:

is the number of units of good X demanded;

is the price of good X;

is the price of a related good Y;

is income;

is the value of any other variable affecting demand.

2-10

Demand

Understanding the Linear Demand Function

The signs and magnitude of the coefficients determine the impact of each variable on the number of units of X demanded.

For example:

by the law of demand;

if good Y is a substitute for good X;

if good X is an inferior good.

2-11

Demand

The Linear Demand Function in Action

Suppose that 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:

Question: How many of good X will consumers purchase when per unit, per unit, and ? Are goods X and Y substitutes or complements? Is good X a normal or an inferior good?

Answer:

units. Goods X and Y are substitutes. Good X is an inferior good.

2-12

Demand

Inverse Demand Function

By setting and and the demand function is

the linear demand function simplifies to

Solving this for in terms of results in

which is called the inverse demand function. This function is used to construct a market demand curve.

2-13

Demand

Graphing the Inverse Demand Function in Action

2-14

Quantity

Price

$2,020

6,060

Demand

Marketing strategies – like value pricing and price discrimination – rely on understanding consumer value for products.

Total consumer value is the sum of the maximum amount a consumer is willing to pay at different quantities.

Total expenditure is the per-unit market price times the number of units consumed.

Consumer surplus is the extra value that consumers derive from a good but do not pay extra for.

2-15

Consumer Surplus

Demand

Quantity

in liters

Price per

liter

Demand

Market Demand and Consumer Surplus in Action

2-16

Total Consumer Value:

0.5($5 - $3)x2+(3-0)(2-0) = $8

Expenditures:

$(3-0) x (2-0) = $6

Consumer Surplus:

0.5($5 - $3)x(2-0) = $2

Demand

Consumer Surplus

Market supply curve

A curve indicating the total quantity of a good that all producers in a competitive market would produce at each price, holding input prices, technology, and other variables affecting supply constant.

Law of supply

As the price of a good rises (falls), the quantity supplied of the good rises (falls), holding other factors affecting supply constant.

2-17

Supply

Changes in Quantity Supplied versus Changes in Supply

Changing only price leads to changes in quantity supplied.

This type of change is graphically represented by a movement along a given supply curve, holding other factors that impact supply constant.

Changing factors other than price lead to changes in supply.

These types of changes are graphically represented by a shift of the entire supply curve.

2-18

Supply

2-19

Changes in Supply

Quantity

Price

Decrease

in supply

Supply

Increase

in supply

Input prices

Technology or government regulation

Number of firms

Entry

Exit

Substitutes in production

Taxes

Excise tax: a tax on each unit of output sold, where tax revenue is collected from the supplier

Ad valorem tax: percentage tax

Producer expectations

2-20

Supply

Supply Shifters

2-21

A Per Unit (Excise) Tax

Quantity of

gasoline per

week

Price

gasoline

t = per unit tax of 20¢

Supply

S0+t

t = 20¢

$1.20

$1.00

Excise tax

2-22

An Ad Valorem Tax

Quantity of

backpacks per

week

Price

backpacks

Supply

S1 = 1.20 x S0

$24

$10

Ad valorem tax

$12

1,100

$20

2,450

The Supply Function

The supply function for good X is a mathematical representation describing how many units will be produced at alternative prices for X, alternative input prices W, and alternative values of other variables that affect the supply for good X.

2-23

Supply

The Linear Supply Function

One simple, but useful, representation of a supply function is the linear supply function:

is the number of units of good X produced;

is the price of good X;

is the price of an input;

is price of technologically related goods;

is the value of any other variable affecting supply.

2-24

Supply

The signs and magnitude of the coefficients determine the impact of each variable on the number of units of X produced.

For example:

by the law of supply.

increasing input price.

technology lowers the cost of producing good X.

2-25

Supply

Understanding the Linear Supply Function

Your research department estimates that the supply function for televisions sets is given by:

Question: How many televisions are produced when , per unit, and ?

Answer:

television sets.

2-26

Supply

The Linear Supply Function in Action

Inverse Supply Function

By setting and in

the linear supply function simplifies to

Solving this for in terms of results in

which is called the inverse supply function. This function is used to construct a market supply curve.

2-27

Supply

Producer surplus: the amount producers receive in excess of the amount necessary to induce them to produce the good.

2-28

Supply

Producer Surplus

2-29

Producer Surplus in Action

Quantity

Price

Supply

$400

800

Supply

Producer surplus

Competitive Market Equilibrium

Determined by the intersection of the market demand and market supply curves.

A price and quantity such that there is no shortage or surplus in the market.

Forces that drive market demand and market supply are balanced, and there is no pressure on prices or quantities to change.

The equilibrium price is the price that equates quantity demanded with quantity supplied

2-30

Market Equilibrium

2-31

Quantity

Price

Supply

280

Demand

Surplus

Shortage

Market Equilibrium

Consider a market with demand and supply functions, respectively, as

and

A competitive market equilibrium exists at a price, , such that . That is,

and 6

units

2-32

Market Equilibrium in Action

Market Equilibrium

Price Restrictions and Market Equilibrium

In a competitive market equilibrium, price and quantity freely adjust to the forces of demand and supply.

Sometime government restricts how much prices are permitted to rise or fall.

Price ceiling

Price floor

2-33

Price Restrictions and Market Equilibrium

A Price Ceiling

2-34

Quantity

Price

Supply

280

Demand

Shortage

Priceceiling

Nonpecuniary price

Lost social welfare

Price Restrictions and Market Equilibrium

Price Ceiling in Action

Consider a market with demand and supply functions, respectively, as

and

Suppose a $1.50 price ceiling is imposed on the market.

units.

Since a shortage of units exists.

Full economic price of unit is , or . Of this,

$1.50 is the dollar price

$1 is the nonpecuniary price

2-35

Price Restrictions and Market Equilibrium

A Price Floor

2-36

Quantity

Price

Supply

280

Demand

Surplus

Pricefloor

Price Restrictions and Market Equilibrium

Cost of

purchasing

excess supply

Price Floor in Action

Consider a market with demand and supply functions, respectively, as

and

Suppose a $3.50 price floor is imposed on the market.

units

Since a surplus of units exists

The cost to the government of purchasing the surplus is .

2-37

Price Restrictions and Market Equilibrium

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

2-38

Comparative Statics

Increase in demand only

Increase equilibrium price

Increase equilibrium quantity

Decrease in demand only

Decrease equilibrium price

Decrease equilibrium quantity

Example of change in demand

Suppose that consumer incomes are projected to increase 2.5% and the number of individuals over 25 years of age will reach an all time high by the end of next year. What is the impact on the rental car market?

2-39

Changes in Demand

Comparative Statics

2-40

Effect of a Change in Demand for Rental Cars

Quantity

(thousands

rented per day)

Price

Supply

$45

104

Demand1

$49

Demand0

100

Comparative Statics

108

Increase in supply only

Decrease equilibrium price

Increase equilibrium quantity

Decrease in supply only

Increase equilibrium price

Decrease equilibrium quantity

Example of change in supply

Suppose that a bill before Congress would require all employers to provide health care to their workers. What is the impact on retail markets?

2-41

Changes in Supply

Comparative Statics

Effect of a Change in Supply

2-42

Quantity

Price

Supply0

Demand

Supply1

Comparative Statics

Simultaneous Shifts in Supply and Demand

Suppose that simultaneously the following events occur:

An earthquake hit Kobe, Japan and decreased the supply of fermented rice used to make sake wine.

The stress caused by the earthquake led many to increase their demand for sake, and other alcoholic beverages.

What is the combined impact on Japan’s sake market?

2-43

Comparative Statics

Simultaneous Shifts in Supply and Demand in Action

2-44

Quantity

Price

Supply0

Demand1

Supply1

Demand0

Comparative Statics

Japan’s Sake Market

Supply2

Baye_9e_Chapter_03.pptx

Quantitative Demand Analysis

Chapter 3

Learning Objectives

Apply various elasticities of demand as a quantitative tool to forecast changes in revenues, prices, and/or units sold.

Illustrate the relationship between the elasticity of demand and total revenues.

Discuss three factors that influence whether the demand for a given product is relatively elastic or inelastic.

Explain the relationship between marginal revenue and the own price elasticity of demand.

Show how to determine elasticities from linear and log-linear demand functions.

Explain how regression analysis may be used to estimate demand functions, and how to interpret and use the output of a regression.

The Elasticity Concept

Elasticity

A measure of the responsiveness of one variable to changes in another variable; the percentage change in one variable that arises due to a given percentage change in another variable.

3-3

The Elasticity Concept

The elasticity between two variables, and , is mathematically expressed as:

When a functional relationship exists, like , the elasticity is:

3-4

The Elasticity Concept

Measurement Aspects of Elasticity

Important aspects of the elasticity:

Sign of the relationship:

Positive

Negative

Absolute value of elasticity magnitude relative to unity:

is highly responsive to changes in .

is slightly responsive to changes in .

3-5

The Elasticity Concept

Own Price Elasticity of Demand

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.

Sign: negative by law of demand.

Magnitude of absolute value relative to unity:

: Elastic.

: Inelastic.

: Unitary elastic.

3-6

Own Price Elasticity of Demand

Linear Demand, Elasticity, and Revenue

3-7

Quantity

Price

Demand

$40

$20

$10

$15

$30

$25

$35

Linear Inverse Demand:

Demand:

Revenue = $

Elasticity:

Conclusion: Demand is elastic.

Revenue = $

Elasticity:

Conclusion: Demand is unitary elastic.

Revenue = $

Elasticity:

Conclusion: Demand is inelastic.

Observation: Elasticity varies along a linear (inverse) demand curve

Own Price Elasticity of Demand

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.

3-8

Own Price Elasticity of Demand

Perfectly Elastic and Inelastic Demand

3-9

Quantity

Demand

Price

Perfectly Inelastic

Demand

Perfectly

elastic

Own Price Elasticity of Demand

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

3-10

Own Price Elasticity of Demand

Marginal Revenue and the Own Price Elasticity of Demand

The marginal revenue can be derived from a market demand curve.

Marginal revenue measures the additional revenue due to a change in output.

This link relates marginal revenue to the own price elasticity of demand as follows:

When then, .

3-11

Own Price Elasticity of Demand

Demand and Marginal Revenue

2-12

Quantity

Price

Elastic

Demand

Own Price Elasticity of Demand

Inelastic

Unitary

Marginal Revenue (MR)

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.

If , then and are substitutes.

If , then and are complements.

3-13

Cross-Price Elasticity

Cross-Price Elasticity in Action

Suppose it is estimated that the cross-price elasticity of demand between clothing and food is -0.18. If the price of food is projected to increase by 10 percent, by how much will demand for clothing change?

That is, demand for clothing is expected to decline by 1.8 percent when the price of food increases 10 percent.

3-14

Cross-Price Elasticity

Cross-price elasticity is important for firms selling multiple products.

Price changes for one product impact demand for other products.

Assessing the overall change in revenue from a price change for one good when a firm sells two goods is:

3-15

Cross-Price Elasticity

Cross-Price Elasticity in Action

Suppose a restaurant earns $4,000 per week in revenues from hamburger sales (X) and $2,000 per week from soda sales (Y).

If the own price elasticity for burgers is and the cross-price elasticity of demand between sodas and hamburgers is , what would happen to the firm’s total revenues if it reduced the price of hamburgers by 1 percent?

That is, lowering the price of hamburgers 1 percent increases total revenue by $100.

3-16

Cross-Price Elasticity

Income Elasticity

Income elasticity

Measures responsiveness of a percent change in demand for good X due to a percent change in income.

If , then is a normal good.

If , then is an inferior good.

3-17

Income Elasticity

Income Elasticity in Action

Suppose that the income elasticity of demand for transportation is estimated to be 1.80. If income is projected to decrease by 15 percent,

what is the impact on the demand for transportation?

Demand for transportation will decline by 27 percent.

is transportation a normal or inferior good?

Since demand decreases as income declines, transportation is a normal good.

3-18

Income Elasticity

Other Elasticities

Own advertising elasticity of demand for good X is the ratio of the percentage change in the consumption of X to the percentage change in advertising spent on X.

Cross-advertising elasticity between goods X and Y would measure the percentage change in the consumption of X that results from a 1 percent change in advertising toward Y.

2-19

Other Elasticities

Elasticities for Linear Demand Functions

From a linear demand function, we can easily compute various elasticities.

Given a linear demand function:

Own price elasticity: .

Cross price elasticity: .

Income elasticity: .

3-20

Obtaining Elasticities From Demand Functions

Elasticities for Linear Demand Functions In Action

The daily demand for Invigorated PED shoes is estimated to be:

Suppose good X sells at $25 a pair, good Y sells at $35, the company utilizes 50 units of advertising, and average consumer income is $20,000. Calculate the own price, cross-price and income elasticities of demand.

units.

Own price elasticity: .

Cross-price elasticity: .

Income elasticity: .

3-21

Obtaining Elasticities From Demand Functions

Elasticities for Nonlinear Demand Functions

One non-linear demand function is the log-linear demand function:

Own price elasticity: .

Cross price elasticity: .

Income elasticity: .

3-22

Obtaining Elasticities From Demand Functions

Elasticities for Nonlinear Demand Functions In Action

An analyst for a major apparel company estimates that the demand for its raincoats is given by

where denotes the daily amount of rainfall and the level of advertising on good Y. What would be the impact on demand of a 10 percent increase in the daily amount of rainfall?

. So, .

A 10 percent increase in rainfall will lead to a 30 percent increase in the demand for raincoats.

3-23

Obtaining Elasticities From Demand Functions

Regression Analysis

How does one obtain information on the demand function?

Published studies

Hire consultant

Statistical technique called regression analysis using data on quantity, price, income and other important variables.

3-24

Regression Analysis

Regression Line and Least Squares Regression

True (or population) regression model

unknown population intercept parameter.

unknown population slope parameter.

random error term with mean zero and standard deviation .

Least squares regression line

least squares estimate of the unknown parameter .

least squares estimate of the unknown parameter.

The parameter estimates and , represent the values of and that result in the smallest sum of squared errors between a line and the actual data.

3-25

Regression Analysis

Excel and Least Squares Estimates

3-26

SUMMARY OUTPUT

Regression Statistics
Multiple R	0.87
R Square	0.75
Adjusted R Square	0.72
Standard Error	112.22
Observations	10.00

ANOVA
	Df	SS	MS	F	Significance F
Regression	1	301470.89	301470.89	23.94	0.0012
Residual	8	100751.61	12593.95
Total	9	402222.50

	Coefficients	Standard Error	t Stat	P-value	Lower 95%	Upper 95%
Intercept	1631.47	243.97	6.69	0.0002	1068.87	2194.07
Price	-2.60	0.53	-4.89	0.0012	-3.82	-1.37

Estimated Demand:

Regression Analysis

Evaluating Statistical Significance

Standard error

Measure of how much each estimated estimate varies in regressions based on the same true demand model using different data.

95 Percent Confidence interval rule of thumb

t-statistics rule of thumb

When , we are 95 percent confident the true parameter is in the regression is not zero.

3-27

Regression Analysis

Excel and Least Squares Estimates

3-28

SUMMARY OUTPUT

Regression Statistics
Multiple R	0.87
R Square	0.75
Adjusted R Square	0.72
Standard Error	112.22
Observations	10.00

ANOVA
	Df	SS	MS	F	Significance F
Regression	1	301470.89	301470.89	23.94	0.0012
Residual	8	100751.61	12593.95
Total	9	402222.50

	Coefficients	Standard Error	t Stat	P-value	Lower 95%	Upper 95%
Intercept	1631.47	243.97	6.69	0.0002	1068.87	2194.07
Price	-2.60	0.53	-4.89	0.0012	-3.82	-1.37

Regression Analysis

, the intercept is different

from zero.

, the intercept is different

from zero.

Evaluating the Overall Fit of the Regression Line

R-Square

Also called the coefficient of determination.

Fraction of the total variation in the dependent variable that is explained by the regression.

Ranges between 0 and 1.

Values closer to 1 indicate “better” fit.

3-29

Regression Analysis

Evaluating the Overall Fit of the Regression Line

Adjusted R-Square

A version of the R-square that penalize researchers for having few degrees of freedom.

is total observations.

is the number of estimated coefficients.

is the degrees of freedom for the regression.

3-30

Regression Analysis

Evaluating the Overall Fit of the Regression Line

The F- Statistic

A measure of the total variation explained by the regression relative to the total unexplained variation.

The greater the F-statistic, the better the overall regression fit.

Equivalently, the P-value is another measure of the F-statistic.

Lower P-values are associated with better overall regression fit.

3-31

Regression Analysis

Excel and Least Squares Estimates

3-32

SUMMARY OUTPUT

Regression Statistics
Multiple R	0.87
R Square	0.75
Adjusted R Square	0.72
Standard Error	112.22
Observations	10.00

ANOVA
	Df	SS	MS	F	Significance F
Regression	1	301470.89	301470.89	23.94	0.0012
Residual	8	100751.61	12593.95
Total	9	402222.50

	Coefficients	Standard Error	t Stat	P-value	Lower 95%	Upper 95%
Intercept	1631.47	243.97	6.69	0.0002	1068.87	2194.07
Price	-2.60	0.53	-4.89	0.0012	-3.82	-1.37

Regression Analysis

Regression for Nonlinear Functions and Multiple Regression

Regression techniques can also be applied to the following settings:

Nonlinear functional relationships:

Nonlinear regression example:

Functional relationships with multiple variables:

Multiple regression example:

3-33

Regression Analysis

Excel and Least Squares Estimates

3-34

SUMMARY OUTPUT

Regression Statistics
Multiple R	0.89
R Square	0.79
Adjusted R Square	0.69
Standard Error	9.18
Observations	10.00

ANOVA
	Df	SS	MS	F	Significance F
Regression	3	1920.99	640.33	7.59	0.182
Residual	6	505.91	84.32
Total	9	2426.90

	Coefficients	Standard Error	t Stat	P-value	Lower 95%	Upper 95%
Intercept	135.15	20.65	6.54	0.0006	84.61	185.68
Price	-0.14	0.06	-2.41	0.0500	-0.29	0.00
Advertising	0.54	0.64	0.85	0.4296	-1.02	2.09
Distance	-5.78	1.26	-4.61	0.0037	-8.86	-2.71

Regression Analysis

Baye_9e_Chapter_04.pptx

The Theory of Individual Behavior

Chapter 4

Learning Objectives

Explain four basic properties of a consumer’s preference ordering and their ramifications for a consumer’s indifference curves.

Illustrate how changes in prices and income impact an individual’s opportunities.

Illustrate a consumer’s equilibrium choice and how it changes in response to changes in prices and income.

Separate the impact of a price change into substitution and income effects.

Show how to derive an individual’s demand curve from indifference curve analysis and market demand from a group of individuals’ demands.

Illustrate how “buy one, get one-free” deals and gift certificates impact a consumer’s purchase decisions.

Apply the income-leisure choice framework to illustrate the opportunities, incentives, and choices of workers and managers.

Consumer Behavior

Consumer opportunities

Set of possible goods and services consumers can afford to consume.

Consumer preferences

Determine which set goods and services will be consumed.

4-3

Consumer Behavior

Properties of Consumer Preferences

Property 1- Completeness: For any two bundles of goods either:

Property 2- More is better

If bundle has at least as much of every good as bundle and more of some good, bundle is preferred to bundle .

Property 3- 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.

Property 4- Transitivity: For any three bundles, , , and , either:

If and , then .

4-4

Consumer Behavior

Constraints

While any decision-making environment faces a host of constraints, the focus of managerial economics is to examine the role prices and income play in constraining consumer behavior.

4-5

Constraints

The Budget Constraint

Budget constraint

Restriction set by prices and income that limits bundles of goods affordable to consumers.

Budget set:

Budget line:

4-6

Constraints

The Budget Constraint In Action

4-7

Good

Budget line:

Slope

Bundle G

Bundle H

Budget set:

Constraints

The Market Rate of Substitution

4-8

Good

Budget line:

Market rate of substitution :

Constraints

Changes in Income Shrink or Expand Opportunities

4-9

Good

Constraints

A Decrease in the Price of Good X

4-10

Good

New budget line

Initial budget

line

Constraints

The Budget Constraint in Action

Consider the following budget line:

What is the maximum amount of X that can be consumed?

What is the maximum amount of Y that can be consumed?

What is rate at which the market trades goods X and Y?

4-11

Constraints

The Budget Constraint in Action

Answers:

Maximum X is: units

Maximum Y is: units

Market rate of substitution:

4-12

Constraints

Consumer Equilibrium

Consumer equilibrium

Consumption bundle that is affordable and yields the greatest satisfaction to the consumer.

Consumption bundle where the rate a consumer choses (marginal rate of substitution) to trade between goods X and Y equals the rate at which these goods are traded in the market (market rate of substitution).

4-13

Consumer Equilibrium

4-14

Good

Consumer equilibrium

III

Consumer Equilibrium

Price Changes and Consumer Behavior

Price and income changes impact a consumer’s budget set and level of satisfaction that can be achieved.

This implies that price and income changes will lead to consumer equilibrium changes.

4-15

Comparative Statics

Price Changes and Equilibrium

Price increases (decreases) reduce (expand) a consumer’s budget set.

The new consumer equilibrium resulting from a price change depends on consumer preferences:

Goods X and Y are:

substitutes when an increase (decrease) in the price of X leads to an increase (decrease) in the consumption of Y.

complements when an increase (decrease) in the price of X leads to a decrease (increase) in the consumption of Y.

4-16

Comparative Statics

Price Changes and Equilibrium in Action

4-17

Good

Point A: Initial consumer equilibrium

Price of good X decreases:

Point B: New consumer equilibrium

Since when :

Conclude that goods and are

substitutes

Comparative Statics

Income Changes and Consumer Behavior

Income increases (decreases) reduce (expand) a consumer’s budget set.

The new consumer equilibrium resulting from an income change depends on consumer preferences:

Good X is:

a normal good when an increase (decrease) in income leads to an increase (decrease) in the consumption of X.

an inferior good when an increase (decrease) in income leads to a decrease (increase) in the consumption of X.

4-18

Comparative Statics

Income Changes and Consumption

4-19

Good

Point A: Initial consumer equilibrium

Price of income increases:

Point B: New consumer equilibrium

Since more of both goods are consumed

when : Conclude that goods

and are normal goods.

Comparative Statics

Substitution and Income Effects

Moving from one equilibrium to another when the price of one good changes can be broken down into two effects:

Substitution effect: The movement along a given indifference curve that results from a change in the relative prices of goods, holding real income constant.

Income effect: The movement from one indifference curve to another that results from the change in real income caused by a price change.

4-20

Comparative Statics

Substitution and Income Effects in Action

4-21

Good

Point A: Initial consumer equilibrium

Price of good X increases:

Point B: substitution effect

Point C: income effect and new

consumer equilibrium

Substitution

effect

Income

effect

Comparative Statics

Applications of Indifference Curve Analysis

Choices by consumers

Buy one, get one free

Cash gifts, in-kind gifts, and gift certificates

Choices by workers and managers

Income-leisure choice

Managers preferences

Applications of Indifference Curves Analysis

Consumer Choice with a Gift Certificate

4-23

Good X

Point A: Initial consumer equilibrium

Receive a $10 gift certificate for good :

Point B: higher utility holding

consumption at initial level

Point C: new consumer equilibrium

when and are normal

goods

Good Y

Applications of Indifference Curves

Labor-Leisure Choice Model

4-24

Leisure

(hours per day)

Income

(per day)

16 hours of leisure

8 hours of work

Worker equilibrium

Applications of Indifference Curves

III

Labor-Leisure Budget Set in Action

What is the budget set for a worker who receives $5 per hour of work and a fixed payment of $40? Let denote the worker’s total earnings and the number of leisure hours in a 24-hour day.

4-25

Applications of Indifference Curves

Indifference and Demand Curves

Indifference curves along with price changes determine individuals’ demand curves.

Market demand is the horizontal summation of individuals’ demands.

4-26

The Relationship Between Indifference Curve Analysis and Demand Curves

From Indifference Curves to Individual Demand

4-27

Good

Price of

good

Demand

The Relationship Between Indifference Curve Analysis and Demand Curves

Good

Price of

good

Demandmkt

Price of

good

A+B

DemandB

DemandA

From Individual to Market Demand

The Relationship Between Indifference Curve Analysis and Demand Curves

Baye_9e_Chapter_05.pptx

The Production Process and Costs

Chapter 5

Learning Objectives

Explain alternative ways of measuring the productivity of inputs and the role of the manager in the production process.

Calculate input demand and the cost-minimizing combination of inputs and use isoquant analysis to illustrate optimal input substitution.

Calculate a cost function from a production function and explain how economic costs differ from accounting costs.

Explain the difference between and the economic relevance of fixed costs, sunk costs, variable costs, and marginal costs.

Calculate average and marginal costs from algebraic or tabular cost data and illustrate the relationship between average and marginal costs.

Distinguish between short-run and long-run production decisions and illustrate their impact on costs and economies of scale.

Conclude whether a multiple-output production process exhibits economies of scope or cost complementarities and explain their significance for managerial decisions.

The Production Function

Mathematical function that defines the maximum amount of output that can be produced with a given set of inputs.

is the level of output.

is the quantity of capital input.

is the quantity of labor input.

5-3

The Production Function

Short-Run versus Long-Run Decisions: Fixed and Variable Inputs

Short-run

Period of time where some factors of production (inputs) are fixed, and constrain a manager’s decisions.

Long-run

Period of time over which all factors of production (inputs) are variable, and can be adjusted by a manager.

5-4

The Production Function

Measures of Productivity

Total product (TP)

Maximum level of output that can be produced with a given amount of inputs.

Average product (AP)

A measure of the output produced per unit of input.

Average product of labor:

Average product of capital:

Marginal product (MP)

The change in total product (output) attributable to the last unit of an input.

Marginal product of labor:

Marginal product of capital:

5-5

The Production Function

Measures of Productivity in Action

Consider the following production function when 5 units of labor and 10 units of capital are combined produce: .

Compute the average product of labor.

units per worker

Compute the average product of capital.

units capital unit

5-6

The Production Function

Increasing, Decreasing, and Negative Marginal Returns

5-7

Labor input

(holding capital constant)

Total product

Average product

Marginal product

Total product (TP)

Average product (APL)

Marginal product (MPL)

Increasing

marginal

returns to labor

Decreasing

marginal

returns to labor

Negative

marginal

returns to labor

The Production Function

The Role of the Manager in the Production Process

Produce output on the production function.

Aligning incentives to induce maximum worker effort.

Use the right mix of inputs to maximize profits.

To maximize profits when labor or capital vary in the short run, the manager will hire:

Labor until the value of the marginal product of labor equals the wage rate: , where

Capital until the value of the marginal product of capital equals the rental rate: , where

5-8

The Production Function

The Role of the Manager in the Production Process

Value marginal product: The value of the output produced by the last unit of an input.

Law of diminishing returns: The marginal product of an additional unit of output will at some point be lower than the marginal product of the previous unit.

Profit-Maximization input usage

To maximize profits, use input levels at which marginal benefit equals marginal cost

When the cost of each additional unit of labor is w, the manager should continue to employ labor up to the point where VMPL = w in the range of diminishing marginal product.

5-9

The Production Function

Algebraic Forms of Production Functions

Commonly used algebraic production function forms:

Linear: Assumes a perfect linear relationship between all inputs and total output

, where and are constants.

Leontief: Assumes that inputs are used in fixed proportions

, where and are constants.

Cobb-Douglas: Assumes some degree of substitutability among inputs

, where and are constants.

5-10

The Production Function

Algebraic Forms of Production Functions in Action

Suppose that a firm’s estimated production function is:

How much output is produced when 3 units of capital and 7 units of labor are employed?

units

5-11

The Production Function

Algebraic Measures of Productivity

Given the commonly used algebraic production function forms, we can compute the measures of productivity as follows:

Linear:

Marginal products: and

Average products: and

Cobb-Douglas:

Marginal products: and

Average products: and

5-12

The Production Function

Algebraic Measures of Productivity in Action

Suppose that a firm produces output according to the production function

Which is the fixed input?

Capital is the fixed input.

What is the marginal product of labor when 16 units of labor is hired?

5-13

The Production Function

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.

5-14

The Production Function

Isoquants and Marginal Rate of Technical Substitution in Action

5-15

Labor Input

=100 units of output

Substituting labor for capital

200 units of output

300 units of output

Increasing output

Capital Input

The Production Function

Diminishing Marginal Rate of Technical Substitution

5-16

Labor Input

=100 units

Capital Input

Slope:

The Production Function

Isocost and Changes in Isocost Lines

Isocost

Combination of inputs that yield cost the same cost.

or, re-arranging to the intercept-slope formulation:

Changes in isocosts

For given input prices, isocosts farther from the origin are associated with higher costs.

Changes in input prices change the slopes of isocost lines.

5-17

The Production Function

Isocosts

5-18

Labor Input

Capital Input

The Production Function

Changes in the Isocosts

5-19

Labor Input

Capital Input

The Production Function

Less expensive input

bundles

More expensive input

bundles

Changes in the Isocost Line

5-20

Labor Input

Capital Input

The Production Function

Due to increase in wage rate

Cost Minimization and the Cost-Minimizing Input Rule

Cost minimization

Producing at the lowest possible cost.

Cost-minimizing input rule

Produce at a given level of output where the marginal product per dollar spent is equal for all input:

Equivalently, a firm should employ inputs such that the marginal rate of technical substitution equals the ratio of input prices:

5-21

The Production Function

Cost-Minimization Input Rule in Action

5-22

Labor Input

=100 units

Capital Input

The Production Function

Optimal Input Substitution

To minimize the cost of producing a given level of output, the firm should use less of an input and more of other inputs when that input’s price rises.

The Production Function

Optimal Input Substitution in Action

5-24

Labor Input

Capital Input

New cost-minimizing

point due to higher wage

Initial point of cost minimization

The Production Function

The Cost Function

Mathematical relationship that relates cost to the cost-minimizing output associated with an isoquant.

Short-run costs

Fixed costs (): do not change with changes in output; include the costs of fixed inputs used in production

Sunk costs

Variable costs []: costs that change with changes in outputs; include the costs of inputs that vary with output

Total costs:

Long-run costs

All costs are variable

No fixed costs

5-25

The Cost Function

Short-Run Costs

5-26

Output

Total costs

Variable costs

Fixed costs

The Cost Function

Average and Marginal Costs

Average costs

Average fixed cost:

Average variable costs:

Average total cost:

Marginal cost (MC)

The (incremental) cost of producing an additional unit of output.

5-27

The Cost Function

The Relationship between Average and Marginal Costs

5-28

Output

ATC, AVC, AFC

and MC ($)

Minimum of ATC

Minimum of AVC

The Cost Function

Fixed and Sunk Costs

Fixed costs

Cost that does not change with output.

Sunk cost

Cost that is forever lost after it has been paid.

Irrelevance of Sunk Costs

A decision maker should ignore sunk costs to maximize profits or minimize loses.

5-29

The Cost Function

Algebraic Forms of Cost Functions

The cubic cost function: costs are a cubic function of output; provides a reasonable approximation to virtually any cost function.

C(Q) – F + aQ + bQ2 + cQ3

where a, b, c, and f are constants and f represents fixed costs

Marginal cost function is:

MC(Q) = a + 2bQ + 3cQ2

The Cost Function

Long-Run Costs

In the long run, all costs are variable since a manager is free to adjust levels of all inputs.

Long-run average cost curve

A curve that defines the minimum average cost of producing alternative levels of output allowing for optimal selection of both fixed and variable factors of production.

5-31

The Cost Function

Long-Run Average Cost

5-32

Output

LRAC ($)

The Cost Function

Economies of Scale

Economies of scale

Declining portion of the long-run average cost curve as output increase.

Diseconomies of scale

Rising portion of the long-run average cost curve as output increases.

Constant returns to scale

Portion of the long-run average cost curve that remains constant as output increases.

5-33

The Cost Function

Economies and Diseconomies of Scale

5-34

Output

LRAC ($)

The Cost Function

Economies of scale

Diseconomies of scale

Constant Returns to Scale

5-35

Output

LRAC ($)

The Cost Function

Multiple-Output Cost Function

Economies of scope

Exist when the total cost of producing and together is less than the total cost of producing each of the type of output separately.

Cost complementarity

Exist when the marginal cost of producing one type of output decreases when the output of another good is increased.

5-36

Multiple-Output Cost Function

Algebraic Form for a Multiproduct Cost Function

For this cost function:

MC1 = aQ2 + 2Q1

When a < 0, an increase in Q2 reduces the marginal cost of producing product 1.

If a < 0, this cost function exhibits cost complementarity

If a > 0, there are no cost complementarities

Exhibits economies of scope whenever f - > 0

5-37

Multiple-Output Cost Function

Baye_9e_Chapter_06.pptx

The Organization of the Firm

Chapter 6

Learning Objective

Discuss the economic trade-offs associated with obtaining inputs through spot exchange, contract, or vertical integration.

Identify four types of specialized investments, and explain how each can lead to costly bargaining, underinvestment, and/or a “hold-up problem.”

Explain the optimal manner of procuring different types of inputs.

Describe the principle-agent problem as it relates to owners and managers.

Discuss three forces that owners can use to discipline managers.

Describe the principal-agent problem as it relates to managers and workers.

Discuss four tools the manager can use to mitigate incentive problems in the workplace.

Management’s Role

6-3

Output

Costs

($)

Minimum

cost function

$80

$100

Introduction

Producing at Minimum Cost

Methods of Procuring Inputs

Spot exchange

An informal relationship between a buyer and seller in which neither party is obligated to adhere to specific terms for exchange.

Contract

A formal relationship between a buyer and seller that obligates the buyer and seller to exchange at terms specified in a legal document.

Produce inputs internally (vertical integration)

A situation where a firm produces the inputs required to make its final product.

6-4

Methods of Procuring Inputs

Methods of Procuring Inputs In Action

Determine whether the following transactions involve spot exchange, a contract, or vertical integration:

Clone 1 PC is legally obligated to purchase 300 computer chips each year for the next 3 years from AML. The price paid in the first year is $200 per chip, and the price rises during the second and third years by the same percentage by which the wholesale price index rises during those years.

Clone 2 PC purchased 300 computer chips from a firm that ran an advertisement in the back of a computer magazine.

Clone 3 PC manufactures its own motherboards and computer chips for its personal computers.

Answers:

Clone 1 PC is using a contract.

Clone 2 PC used the spot exchange.

Clone 3 PC uses vertical integration.

6-5

Methods of Procuring Inputs

Transaction Costs

Cost associated with acquiring an input that is in excess of the amount paid to the input supplier.

Types of “obvious” transaction costs

Cost of searching for a supplier.

Cost of negotiating a price.

Investments and expenditures required to facilitate exchange.

6-6

Transaction Costs

Types of “Hidden” Transaction Costs

Specialized investment

Expenditure that must be made to allow two parties to exchange but has little or no value in any alternative use.

Relationship-specific exchange

A type of exchange that occurs when the parties to a transaction have made specialized investments.

6-7

Transaction Costs

Types of Specialized Investments

Types of specialized investments

Site specificity

Physical-asset specificity

Dedicated assets

Human capital

6-8

Transaction Costs

Implications of Specialized Investments

Implications of specialized investments

Costly bargaining

Underinvestment

Opportunism and the “hold-up problem”

6-9

Transaction Costs

Optimal Input Procurement

How should a manager acquire inputs to minimize costs?

Depends on the extent of the relationship-specific exchange.

6-10

Optimal Input Procurement

Spot Exchange

Characteristics of the spot exchange:

No relationship-specific investment.

Absence of transaction costs, and many buyers and sellers, imply that the market price is determined by the intersection of demand and supply.

Opportunism

Underinvestment in specialized investments

6-11

Optimal Input Procurement

Contracts

Characteristics of contracts:

Use when inputs require a substantial specialized investment.

Typically requires substantial up-front expenditures.

Specifies prices of inputs prior to making specialized investments.

Reduces likelihood of opportunism.

Reduces likelihood to skimp on specialized investment.

Requires decision on optimal contract length.

6-12

Optimal Input Procurement

Optimal Contract Length

6-13

Contract Length

(in years)

MB, MC

($)

Optimal Input Procurement

Specialized Investments and Contract Length

6-14

Contract Length

MB, MC

($)

MB0

MB1

Longer contract

Greater need for

specialized investment

Optimal Input Procurement

Contracting Environment and Contract Length

6-15

Contract Length

MB, MC

($)

MC0

Shorter contract

More complex

contracting

environment

MC1

MC2

Longer contract

Less complex

contracting

environment

Optimal Input Procurement

Vertical Integration

Produce inputs internally

Use when inputs require

a substantial specialized investment.

generate significant transaction cost.

complex contracting or uncertain economic environments.

Advantages:

“Skips the middleman”

Reduces opportunism

Mitigates transaction costs

Disadvantages:

Managers must create an internal regulatory mechanism

Bear the cost of setting up production facilities

No longer specialized in producing its output

6-16

Optimal Input Procurement

Optimal Procurement of Inputs

6-17

Optimal Input Procurement

Managerial Compensation and the Principal-Agent Problem

The primary obstacle is the separation of ownership and control.

Principal-agent (P-A) problem: if the owner is not present to monitor the manager, how can she get the manager to do what is in her best interest?

Owners have to incent managers since they are not present to monitor.

6-18

Managerial Compensation and the Principal Agent Problem

Managers’ Compensation Mechanisms

Manager’s economic trade-off

Leisure.

Labor

Fixed salary

Receives wage independent of labor hours and effort.

No strong incentive to monitor other employees labor hours and effort.

Adversely impacts firm performance.

Incentive contract

Tie manager wage to firm performance (like profits).

Manager makes labor-leisure choice and is accordingly compensated.

6-19

Managerial Compensation and the Principal Agent Problem

Incentive Contracts

A way to align owners’ interests with that of the actions of its manager.

Examples include:

Stock option

Other bonuses directly related to profits.

6-20

Forces that Discipline Managers

External Incentives

Outside forces can provide manages with the incentive to maximize profits, and include:

Reputation

Takeover threat

6-21

Forces that Discipline Managers

The Manager-Worker Principal-Agent Problem

The owner-manager, principal-agent problem is not unique.

A similar problem exists between the firm’s managers and the employees he or she supervises.

6-22

The Manager-Worker Principal-Agent Problem

Solutions to the Manager-Worker Principal-Agent Problem

Manager-worker principal-agent problem solutions:

Profit sharing

Revenue sharing

Piece rates

Time clocks and spot checks

6-23

The Manager-Worker Principal-Agent Problem

Conclusion

The optimal method for acquiring inputs depends on the nature of the transaction costs and specialized nature of the inputs being produced.

To overcome the owner-manager and manager-worker principal-agent problems, principals must align the agents’ interests with the principals’ interests.

6-24

Baye_9e_Chapter_07.pptx

The Nature of Industry

Chapter 7

Learning Objectives

Calculate alternative measures of industry structure, conduct, and performance, and discuss their limitations.

Describe examples of vertical, horizontal, and conglomerate mergers, and explain the economic basis for each type of merger.

Explain the relevance of Herfindahl-Hirschman index for antitrust policy under the horizontal merger guidelines.

Describe the structure-conduct-performance paradigm, the feedback critique, and their relation to the five forces framework.

Identify whether an industry is best described as perfectly competitive, a monopoly, monopolistically competitive, or an oligopoly.

Market Structure

Market structure factors that impact managerial decisions:

Number of firms competing in an industry

Relative size of firms (concentration)

Technological and cost conditions

Demand conditions

Ease of firm exit or entry

7-3

Market Structure

Industry Concentration

Measures the size distribution of firms within an industry.

Are there many small firms?

Are there only a few large firms?

7-4

Market Structure

Measuring Industry Concentration

Measures of industry concentration

Four-firm concentration ratio:

Herfindahl-Hirschman index (HHI):

7-5

Market Structure

Measuring Industry Concentration in Action

Suppose an industry is composed of six firms. Four firms have sales of $10 each, and two firms haves sales of $5 each. What is the four-firm concentration ratio for this industry?

Answer:

Total industry sales are .

Sales of the four largest firms are $40.

The four-firm concentration ratio is:

The four largest firms in the industry account for 80 percent of total industry output.

7-6

Market Structure

7-7

Market Structure

Limitations of Concentration Measures

Factors that impact and limit industry concentration measures include:

Global markets

National, regional and local markets

Industry definitions and product classes

7-8

Market Structure

Technology

Industries differ in regard to the technologies used to produce goods and services.

Labor-intensive industries

Capital-intensive industries

Within a given industry if the available technology is:

the same, firms will likely have similar cost structures.

different, one firm will likely have a cost advantage.

7-9

Market Structure

Demand and Market Conditions

Industries with

low demand may imply few firms.

high demand may imply many firms.

Elasticity of demand varies from industry to industry.

The Rothschild index measures the sensitivity to price of a product group as a whole relative to the sensitivity of the quantity demanded of a single firm to a change in its price.

7-10

Market Structure

Demand and Market Conditions in Action

The industry elasticity of demand for airline travel is -3, and the elasticity of demand for an individual carrier is -4. What is the Rothschild index for this industry?

Answer:

The Rothschild index is:

7-11

Market Structure

7-12

Market Structure

Potential for Entry

Optimal decisions by firms in an industry will depend on the ease with which new firms can enter the market.

Several factors can create barriers to entry (or make entry difficult).

Capital requirements

Patents

Economies of scale

7-13

Market Structure

Conduct

Behavior of firms:

Price markup over costs

Integration and merger

Advertising expenditures

Research and development expenditures

7-14

Conduct

Pricing Behavior

Lerner index

A measure of the difference between price and marginal cost as a fraction of the product’s price.

rearranging this equation yields

where is the markup factor over marginal costs.

7-15

Conduct

Pricing Behavior in Action

A firm in the airline industry has a marginal cost of $200 and charges a price of $300. What are the Lerner index and markup factor?

The Lerner index is

The markup factor is

7-16

Conduct

7-17

Conduct

Integration and Merger Activity

Integration

Uniting productive resources of firms.

Can occur during the formation of a firm.

Merger

Two or more existing firms “unite,” or merge, into a single firm.

Reasons firms merge:

Reduce transaction costs.

Reap benefits of economies of scale and scope.

Increase market power.

Gain better access to capital markets.

7-18

Conduct

Types of Integration

Vertical integration

Various stages in the production of a single product are carried out in a single firm.

Horizontal integration

Merging two or more similar final products into a single firm.

Conglomerate mergers

Integration of two or more different product lines into a single firm.

7-19

Conduct

Research and Development

Research and development

Expenditures made by firms to gain a technological advantage, with the aim of acquiring a patent.

7-20

Company	Industry	R&D as Percentage of Sales
Bristol-Meyers Squibb	Pharmaceuticals	19.7
Ford	Motor vehicle and parts	4.1
Goodyear Tire and Rubber	Rubber and plastic parts	2.0
Kellogg	Food	1.5
Proctor & Gable	Soaps and cosmetics	2.5

Conduct

Expenditures made by firms to inform or persuade consumers to purchase their products.

7-21

Company	Industry	Advertising as Percentage of Sales
Bristol-Meyers Squibb	Pharmaceuticals	4.9
Ford	Motor vehicle and parts	3.2
Goodyear Tire and Rubber	Rubber and plastic parts	2.5
Kellogg	Food	9.2
Proctor & Gable	Soaps and cosmetics	11.7

Conduct

Performance

Refers to the profits and social welfare that result in a given industry

Performance

Dansby-Willig Performance Index

Ranks industries according to how much social welfare would improve if the output in an industry were increased by a small amount.

7-23

Industry	Dansby-Willig Index
Food	0.51
Rubber	0.49
Textiles	0.38
Apparel	0.47
Paper	0.63
Chemicals	0.67
Petroleum	0.63

Performance

The Structure-Conduct-Performance Paradigm

Structure:

Factors like technology, concentration and market conditions.

Conduct:

Individual firm behavior in the market. Behavior includes pricing decisions, advertising decisions and R&D decisions, among other factors.

Performance:

Resulting profit and social welfare that arise in the market.

Structure-conduct-performance paradigm

Model that views these three aspects of industry as being integrally related.

7-24

The Structure- Conduct-Performance Paradigm

The Casual View

Market structure “causes” firms to behave in a certain way.

… this behavior, or conduct, “causes” resources to be allocated in certain ways.

… this resource allocation leads to “good” or “bad” performance.

7-25

The Structure- Conduct-Performance Paradigm

The Feedback Critique

There is no one-way causal link among structure, conduct and performance.

Firm conduct can affect market structure;

Market performance can affect conduct and market structure.

7-26

The Structure- Conduct-Performance Paradigm

Five Forces Framework

7-27

The Structure- Conduct-Performance Paradigm

Looking Ahead

Perfect competition

Many, small firms and consumers relative to market.

Firms produce very similar products.

No market power (P = MC).

Monopoly

Sole producer of good or service.

Market power (P > MC).

Monopolistic competition

Many, small firms and consumers relative to market.

Firms produce slightly different products.

Limited market power.

Oligopoly

Few, large firms tend to dominate market.

Price/marketing strategies are mutually interdependent with other firms in the industry.

7-28

Overview of the Remainder of the Book

Baye_9e_Chapter_08.pptx

Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets

Chapter 8

Learning Objectives

Identify the conditions under which a firm operates as perfectly competitive, monopolistically competitive, or a monopoly.

Identify sources of (and strategies for obtaining) monopoly power.

Apply the marginal principle to determine the profit-maximizing price and output.

Show the relationship between the elasticity of demand for a firm’s product and its marginal revenue.

Explain how long-run adjustments impact perfectly competitive, monopoly, and monopolistically competitive firms; discuss the ramifications of each of these market structures on social welfare.

Decide whether a firm making short-run losses should continue to operate or shut down its operations.

Illustrate the relationship between marginal cost, a competitive firm’s short-run supply curve, and the competitive industry supply; explain why supply curves do not exist for firms that have market power.

Calculate the optimal output of a firm that operates two plants and the optimal level of advertising for a firm that enjoys market power.

Perfect Competition

Perfectly competitive markets are characterized by:

The interaction between many buyers and sellers that are “small” relative to the market.

Each firm in the market produces a homogeneous (identical) product.

Buyers and sellers have perfect information.

No transaction costs.

Free entry into and exit from the market.

The implications of these conditions are:

a single market price is determined by the interaction of demand and supply

firms earn zero economic profits in the long run.

8-3

Perfect Competition

Demand at the Market and Firm Levels Under Perfect Competition

8-4

Perfect Competition

Market

output

Price

Firm’s

output

Market

Firm

Short-Run Output Decisions

The short run is a period of time over which some factors of production are fixed.

To maximize short-run profits, managers must take as given the fixed inputs (and fixed costs), and determine how much output to produce by changing the variable inputs.

8-5

Perfect Competition

Revenue, Costs, and Profits for a Perfectly Competitive Firm

8-6

Perfect Competition

Firm’s output

Revenue

Slope of

Costs

Slope of

Maximum

profits

Competitive Firm’s Demand

The demand curve for a competitive firm’s product is a horizontal line at the market price. This price is the competitive firm’s marginal revenue.

8-7

Perfect Competition

Profit Maximization under Perfect Competition

8-8

Perfect Competition

Firm’s output

Profits

Competitive Output Rule

To maximize profits, a perfectly competitive firm produces the output at which price equals marginal cost in the range over which marginal cost is increasing.

8-9

Perfect Competition

Competitive Output Rule In Action

The cost function for a firm is .

If the firm sells output in a perfectly competitive market and other firms in the industry sell output at a price of $20, what price should the manager of this firm charge? What level of output should be produced to maximize profits? How much profit will be earned?

Answer:

Charge $20.

Since marginal cost is , equating price and marginal cost yields: units.

Maximum profits are: .

8-10

Perfect Competition

Short-Run Loss Minimization

8-11

Perfect Competition

Firm’s output

Loss

The Shut-Down Case

8-12

Perfect Competition

Firm’s output

Fixed Cost

Loss if produce

Loss if shut down

Short-Run Output Decision Under Perfect Competition

To maximize short-run profits, a perfectly competitive firm should produce in the range of increasing marginal cost where , provided that . If , the firm should shut down its plant to minimize it losses.

8-13

Perfect Competition

Short-Run Firm Supply Curve for a Competitive Firm

8-14

Perfect Competition

Firm’s output

Short-run supply

curve for individual firm

The Short-Run Firm and Industry Supply Curves

The short-run supply curve for a perfectly competitive firm is its marginal cost curve above the minimum point on the curve.

8-15

Perfect Competition

The Market Supply Curve

8-16

Perfect Competition

Market output

$10

$12

Market supply

curve

Individual firm’s

supply curve

500

Long-Run Decisions: Entry and Exit The Market and Firm’s Demand

8-17

Perfect Competition

Market

output

Price

Firm’s

output

Exit

Entry

Long-Run Competitive Equilibrium

8-18

Perfect Competition

Firm’s output

Long-run competitive

equilibrium

Long-Run Competitive Equilibrium

In the long run, perfectly competitive firms produce a level of output such that

8-19

Perfect Competition

Monopoly and Monopoly Power

Monopoly: A market structure in which a single firm serves an entire market for a good that has no close substitutes.

Sole seller of a good in a market gives that firm greater market power than if it competed against other firms.

Implication:

market demand curve is the monopolist’s demand curve.

However, a monopolist does not have unlimited market power.

8-20

Monopoly

The Monopolist’s Demand

8-21

Monopoly

Output

Price

Monopolist’s power is constrained

by the demand curve.

Sources of Monopoly Power

Economies of scale: exist whenever long-run average costs decline as output increases.

Diseconomies of scale: exist whenever long-run average costs increase as output increases.

Economies of scope: exist when the total cost of producing two products within the same firm is lower than when the products are produced by separate firms.

Cost complementarity: exist when the marginal cost of producing one output is reduced when the output of another product is increased.

Patents and other legal barriers

8-22

Monopoly

Elasticity of Demand and Total Revenues

8-23

Monopoly

Revenue

Price

Firm’s

output

Unitary

Elastic

Inelastic

Elastic

Maximum revenues

Marginal Revenue and Elasticity

The monopolist’s marginal revenue function is

, where is the elasticity of demand for the monopolist’s product and is the price charged.

For

when .

8-24

Monopoly

Marginal Revenue and Linear Demand

Given an linear inverse demand function

, where , the associated marginal revenue is

8-25

Monopoly

Marginal Revenue In Action

Suppose the inverse demand function for a monopolist’s product is given by . What is the maximum price per unit a monopolist can charge to be able to sell 3 units? What is marginal revenue when ?

Answer:

The maximum price the monopolist can charge for 3 units is: .

The marginal revenue at 3 units for this inverse linear demand is: .

8-26

Monopoly

Monopoly Output Rule

A profit-maximizing monopolist should produce the output, , such that marginal revenue equals marginal cost:

8-27

Monopoly

Costs, Revenues, and Profits Under Monopoly

8-28

Monopoly

Output

Cost function

Slope of

Revenue function

Maximum

profit

Price

Quantity

Demand

ATC

)

Profits

Profit Maximization Under Monopoly

8-29

Monopoly

Monopoly Pricing Rule

Given the level of output, , that maximizes profits, the monopoly price is the price on the demand curve corresponding to the units produced:

8-30

Monopoly

Monopoly In Action

Suppose the inverse demand function for a monopolist’s product is given by and the cost function is . Determine the profit-maximizing price, quantity and maximum profits.

Answer:

Profit-maximizing output is found by solving: .

The profit-maximizing price is: .

Maximum profits are: .

8-31

Monopoly

The Absence of a Supply Curve

Recall, firms operating in perfectly competitive markets determine how much output to produce based on price ().

Thus, a supply curve exists in perfectly competitive markets.

A monopolist’s market power implies .

Thus, there is no supply curve for a monopolist, or in markets served by firms with market power.

8-32

Monopoly

Multiplant Decisions

Often a monopolist produces output in different locations.

Implications: manager has to determine how much output to produce at each plant.

Consider a monopolist producing output at two plants:

The cost of producing units at plant 1 is , and the cost of producing at plant 2 is .

When the monopolist produces a homogeneous product, the per-unit price consumers are willing to pay for the total output produced at the two plants is , where .

8-33

Monopoly

Multiplant Output Rule

Let be the marginal revenue of producing a total of units of output. Suppose the marginal cost of producing units of output in plant 1 is and that of producing units in plant 2 is . The profit-maximizing rule for the two-plant monopolist is to allocate output among the two plants such that:

8-34

Monopoly

Implications of Entry Barriers

A monopolist may earn positive economic profits, which in the presence of barriers to entry prevents other firms from entering the market to reap a portion of those profits.

Implication: monopoly profits will continue over time provided the monopoly maintains its market power.

Monopoly power, however, does not guarantee positive profits.

8-35

Monopoly

Price

Quantity

Demand

ATC

A Monopolist Earning Zero Profits

8-36

Monopoly

Deadweight Loss of Monopoly

The consumer and producer surplus that is lost due to the monopolist charging a price in excess of marginal cost.

8-37

Monopoly

Price

Quantity

Demand

Deadweight Loss of Monopoly

8-38

Monopoly

Deadweight loss

Monopolistic Competition

An industry is monopolistically competitive if:

There are many buyers and sellers.

Each firm in the industry produces a differentiated product.

There is free entry into and exit from the industry.

A key difference between monopolistically competitive and perfectly competitive markets is that each firm produces a slightly differentiated product.

Implication: products are close, but not perfect, substitutes; therefore, firm’s demand curve is downward sloping under monopolistic competition.

8-39

Monopolistic Competition

Price

Quantity

Demand

ATC

Profit-Maximization under Monopolistic Competition

8-40

Monopolistic Competition

Profits

Profit-Maximization Rule for 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, , is such that and the profit-maximizing price is .

8-41

Monopolistic Competition

Long-Run Equilibrium

If firms in monopolistically competitive markets earn short-run

profits, additional firms will enter in the long run to capture some of those profits.

losses, some firms will exit the industry in the long run.

8-42

Monopolistic Competition

Price

Quantity of Brand X

Demand0

MR0

ATC

Effect of Entry on a Monopolistically Competitive Firm’s Demand

8-43

Monopolistic Competition

Demand1

MR1

Due to entry of new

firms selling other brands

Price

Quantity of Brand X

ATC

Long-Run Equilibrium under Monopolistic Competition

8-44

Monopolistic Competition

Demand1

MR1

Long-run monopolistically

competitive equilibrium

The Long-Run and Monopolistic Competition

In the long run, monopolistically competitive firms produce a level of output such that:

8-45

Monopolistic Competition

Implications of Product Differentiation

The differentiated nature of products in monopolistically competitive markets implies that firms in these industries must continually convince consumers that their products are better than their competitors.

8-46

Monopolistic Competition

Implications of Product Differentiation

Two strategies monopolistically competitive firms use to persuade consumers:

Comparative advertising: form of advertising where a firm attempts to increase the demand for its brand by differentiating its product from competing brands

Brand equity

Niche marketing: a marketing strategy where goods and services are tailored to meet the needs of a particular segment of the market.

Green marketing

Successful differentiation and branding strategies can make managers brand myopic, resting on the brand’s past laurels and in doing so missing opportunities to enhance its brand

Monopolistic Competition

Optimal Advertising Decisions

How much should a firm spend on advertising to maximize profits?

Depends, in part, on the nature of the industry.

The optimal amount of advertising balances the marginal benefits and marginal costs.

Profit-maximizing advertising-to-sales ratio is:

8-48

Optimal Advertising Decisions

Baye_9e_Chapter_09.pptx

Basic Oligopoly Models

Chapter 9

Learning Objectives

Explain how beliefs and strategic interaction shape optimal decisions in oligopoly environments.

Identify the conditions under which a firm operates in a Sweezy, Cournot, Stackelberg, or Bertrand oligopoly, and the ramifications of each type of oligopoly for optimal pricing decisions, and firm profits.

Apply reaction (or best-response) functions to identify optimal decisions and likely competitor responses in oligopoly settings.

Identify the conditions for a contestable market, and explain the ramifications for market power and the sustainability of long-run profits.

Conditions for Oligopoly

Oligopoly market structures are characterized by only a few firms, each of which is large relative to the total industry.

Typical number of firms is between 2 and 10.

Products can be identical or differentiated.

An oligopoly market composed of two firms is called a duopoly.

Oligopoly settings tend to be the most difficult to manage since managers must consider the likely impact of his or her decisions on the decisions of other firms in the market.

9-3

Conditions for Oligopoly

Strategic Interaction: A Firm’s Demand Depends on Actions of Rivals

9-4

Role of Beliefs and Strategic Interaction

Output

Price

Demand1

Demand2

Demand if rivals

match price changes

Demand if rivals do not

match price changes

Sweezy Oligopoly

Sweezy oligopoly characteristics:

There are few firms in the market serving many consumers.

The firms produce differentiated products.

Each firm believes its rivals will cut their prices in response to a price reduction but will not raise their prices in response to a price increase.

Barriers to entry exist.

9-5

Profit Maximization in Four Oligopoly Settings

Sweezy Oligopoly

9-6

Output

Price

MR2

Demand2

(rival matches price change)

MC1

MR1

MC0

Demand1

(rival holds price constant)

Sweezy Demand

Profit Maximization in Four Oligopoly Settings

Cournot Oligopoly

Cournot oligopoly characteristics

There are few firms in the market serving many consumers.

The firms produce either differentiated or homogeneous products.

Each firm believes rivals will hold their output constant if it changes its output.

Barriers to entry exist.

9-7

Profit Maximization in Four Oligopoly Settings

Cournot Oligopoly: Reaction Functions

Consider a Cournot duopoly. Each firm makes an output decision under the belief that is rival will hold its output constant when the other changes its output level.

Implication: Each firm’s marginal revenue is impacted by the other firms output decision.

The relationship between each firm’s profit-maximizing output level is called a best-response or reaction function.

9-8

Profit Maximization in Four Oligopoly Settings

Cournot Oligopoly: Reaction Functions Formula

Given a linear (inverse) demand function

and cost functions,

the reactions functions are:

9-9

Profit Maximization in Four Oligopoly Settings

Cournot Reaction Functions

9-10

Quantity2

Quantity1

Firm 2’s Reaction Function

Firm 1’s Reaction Function

Cournot equilibrium

Profit Maximization in Four Oligopoly Settings

Cournot Oligopoly: Equilibrium

A situation in which neither firm has an incentive to change its output given the other firm’s output.

9-11

Profit Maximization in Four Oligopoly Settings

Cournot Oligopoly: Isoprofit Curves

A function that defines the combinations of outputs produced by all firms that yield a given firm the same level of profits.

9-12

Profit Maximization in Four Oligopoly Settings

Isoprofit Curves for Firm 1

Every point on a given isoprofit curve yields Firm 1 the same level of profits.

Isoprofits curves tat lie closer to Firm 1’s monopoly output are associated with higher profits for that firm.

The isoprofit curves for Firm 1 reach their peak where they intersect Firm 1’s reaction function.

The isoprofit curves do not interest one another.

Profit Maximization in Four Oligopoly Settings

Firm 1’s Best Response to Firm 2’s Output

9-14

Quantity2

Quantity1

Firm 1’s profit increases as isoprofit

curves move toward

(Firm 1’s reaction function)

Profit Maximization in Four Oligopoly Settings

Quantity2

Quantity1

Firm 2’s profit increases as isoprofit

curves move toward

Firm 2’s Reaction Function and Isoprofit Curves

Monopoly point for firm 2

(Firm 2’s reaction function)

9-15

Profit Maximization in Four Oligopoly Settings

Quantity2

Quantity1

Cournot Equilibrium

9-16

Profit Maximization in Four Oligopoly Settings

Quantity2

Quantity1

Effect of Decline in Firm 2’s Marginal Cost on Cournot Equilibrium

Due to decline in

firm 2’s marginal cost

9-17

Profit Maximization in Four Oligopoly Settings

Cournot Oligopoly: Collusion

Markets with only a few dominant firms can coordinate to restrict output to their benefit at the expense of consumers.

Restricted output leads to higher market prices.

Such acts by firms is known as collusion.

Collusion, however, is prone to cheating behavior.

Since both parties are aware of these incentives, reaching collusive agreements is often very difficult.

9-18

Profit Maximization in Four Oligopoly Settings

Incentive to Collude in a Cournot Oligopoly

9-19

Quantity2

Quantity1

Collusion outcome

Profit Maximization in Four Oligopoly Settings

Incentive to Renege on Collusive Agreements in Cournot Oligopoly

9-20

Quantity2

Quantity1

Profit Maximization in Four Oligopoly Settings

Stackelberg Oligopoly

Stackelberg oligopoly characteristics:

There are few firms serving many consumers.

Firms produce either differentiated or homogeneous products.

A single firm (the leader) chooses an output before all other firms choose their outputs.

All other firms (the followers) take as given the output of the leader and choose outputs that maximize profits given the leader’s output.

Barriers to entry exist.

9-21

Profit Maximization in Four Oligopoly Settings

Stackelberg Equilibrium

9-22

Quantity Follower

Quantity Leader

Profit Maximization in Four Oligopoly Settings

Stackelberg Oligopoly: Equilibrium Output Formulae

Given a linear (inverse) demand function

and cost functions and .

The follower sets output according to the reaction function

The leader’s output is

9-23

Profit Maximization in Four Oligopoly Settings

Stackelberg Oligopoly In Action: Problem

Suppose the inverse demand function for two firms in a homogeneous-product, Stackelberg oligopoly is given by

and their costs are $2. Firm 1 is the leader, and firm 2 is the follower.

What is firm 2’s reaction function?

What is firm 1’s output?

What is firm 2’s output?

What is the market price?

9-24

Profit Maximization in Four Oligopoly Settings

Stackelberg Oligopoly In Action: Answer

The follower’s reaction function is: .

The leader’s output is: .

The follower’s output is: .

The market price is: .

9-25

Profit Maximization in Four Oligopoly Settings

Bertrand Oligopoly

Bertrand oligopoly characteristics

There are few firms in the market serving many consumers.

Firms produce identical products at a constant marginal cost.

Firms engage in price competition and react optimally to prices charged by competitors.

Consumers have perfect information and there are no transaction costs.

Barriers to entry exist.

9-26

Profit Maximization in Four Oligopoly Settings

Bertrand Oligopoly: Equilibrium

The conditions for a Bertrand oligopoly imply that firms in this market will undercut one another to capture the entire market leaving the rivals with no profit. All consumers will purchase at the low-price firm.

This “price war” would come to an end when the price each firm charged equaled marginal cost.

In equilibrium, .

Socially efficient level of output.

9-27

Profit Maximization in Four Oligopoly Settings

Comparing Oligopoly Models

Consider the following inverse market demand function:

and the cost function for each firm in this market is identical, and given by

Under these condition, the different oligopoly outputs, prices and profits are examined.

9-28

Comparing Oligopoly Models

Comparing Oligopoly: Cournot

The Cournot oligopoly reaction functions are

These reaction functions can be solved for the equilibrium output. These quantities can be used to compute price and profit.

9-29

Comparing Oligopoly Models

Comparing Oligopoly: Stackelberg

The Stackelberg leader’s output is

The market price is:

9-30

Comparing Oligopoly Models

Comparing Oligopoly: Bertrand

Since , .

Total output is found by:

Solving yields:

Given symmetric firms, each firm gets half the market, or 498 units.

9-31

Comparing Oligopoly Models

Comparing Oligopoly: Collusion

Since the output associated with collusion is the same as monopoly output, the inverse market demand function implies that monopoly marginal revenue function is:

Setting marginal revenue equal to marginal cost yields:

Solving this: units. Each firm will produce half of these units.

Price is:

Each firm earns profits of .

9-32

Comparing Oligopoly Models

Contestable Markets

Contestable markets involve strategic interaction among existing firms and potential entrants into a market.

A market is contestable if:

All producers have access to the same technology.

Consumers respond quickly to price changes.

Existing firms cannot respond quickly to entry by lowering price.

There are no sunk costs.

If these conditions hold, incumbent firms have no market power over consumers.

9-33

Contestable Markets

Baye_9e_Chapter_10.pptx

Game Theory: Inside Oligopoly

Chapter 10

Learning Objectives

Apply normal form and extensive form representations of games to formulate decisions in strategic environments that include pricing, advertising, coordination, bargaining, innovation, product quality, monitoring employees, and entry.

Distinguish among dominant, secure, Nash, mixed, and subgame perfect equilibrium strategies, and identify such strategies in various games.

Identify whether cooperative (collusive) outcomes may be supported as a Nash equilibrium in a repeated game, and explain the roles of trigger strategies, the interest rate, and the presence of an indefinite or uncertain final period in achieving such outcomes.

Overview of Games and Strategic Thinking

Game theory is a general framework to aid decision making when agents’ payoffs depends on the actions taken by other players.

Games consist of the following components:

Players or agents who make decisions.

Planned actions of players, called strategies.

Payoff of players under different strategy scenarios.

A description of the order of play.

A description of the frequency of play or interaction.

10-3

Overview of Games and Strategic Thinking

Order of Decisions in Games is Important

Simultaneous-move game

Game in which each player makes decisions without the knowledge of the other players’ decisions.

Bertrand duopoly game

Sequential-move game

Game in which one player makes a move after observing the other player’s move.

10-4

Overview of Games and Strategic Thinking

Frequency of Interaction in Games

One-shot game

Game in which players interact to make decisions only once.

Repeated game

Game in which players interact to make decisions more than once.

10-5

Overview of Games and Strategic Thinking

Simultaneous-Move, One-Shot Games: Theory

Strategy

Decision rule that describes the actions a player will take at each decision point.

Normal-form game

A representation of a game indicating the players, their possible strategies, and the payoffs resulting from alternative strategies.

10-6

Simultaneous-Move, One-Shot Games

Normal-Form Game

10-7

Simultaneous-Move, One-Shot Games

Player A	Player B
	Strategy	Left	Right
	Up	10, 20	15, 8
	Down	-10 , 7	10, 10

Set of players

Player A’s strategies

Player B’s strategies

Player A’s possible payoffs

from strategy “down”

Player B’s

possible

payoffs

from

strategy

“right”

Possible Strategies

Dominant strategy

A strategy that results in the highest payoff to a player regardless of the opponent’s action.

Secure strategy

A strategy that guarantees the highest payoff given the worst possible scenario.

Nash equilibrium strategy

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.

10-8

Simultaneous-Move, One-Shot Games

Dominant Strategy

10-9

Simultaneous-Move, One-Shot Games

Player A	Player B
	Strategy	Left	Right
	Up	10, 20	15, 8
	Down	-10 , 7	10, 10

Player A has a dominant strategy: Up

Player B has no dominant strategy

Player A	Player B
	Strategy	Left	Right
	Up	10, 20	15, 8
	Down	-10 , 7	10, 10

Secure Strategy

10-10

Simultaneous-Move, One-Shot Games

Player A	Player B
	Strategy	Left	Right
	Up	10, 20	15, 8
	Down	-10 , 7	10, 10

Player A’s secure strategy: Up … guarantees at least a $10 payoff

Player B’s secure strategy: Right … guarantees at least an $8 payoff

Player A	Player B
	Strategy	Left	Right
	Up	10, 20	15, 8
	Down	-10 , 7	10, 10

Player A	Player B
	Strategy	Left	Right
	Up	10, 20	15, 8
	Down	-10 , 7	10, 10

Nash Equilibrium Strategy

10-11

Simultaneous-Move, One-Shot Games

Player A	Player B
	Strategy	Left	Right
	Up	10, 20	15, 8
	Down	-10 , 7	10, 10

A Nash equilibrium results when Player A’s plays “Up”

and Player B plays “Left”

Player A	Player B
	Strategy	Left	Right
	Up	10, 20	15, 8
	Down	-10 , 7	10, 10

Application of One-Shot Games: Pricing Decisions

10-12

Simultaneous-Move, One-Shot Games

Firm A	Firm B
	Strategy	Low price	High price
	Low price	0, 0	50, -10
	High price	-10 , 50	10, 10

A Nash equilibrium results when both players charge “Low price”

Firm A	Firm B
	Strategy	Low price	High price
	Low price	0, 0	50, -10
	High price	-10 , 50	10, 10

Payoffs associated with the Nash equilibrium is inferior from the

firms’ viewpoint compared to both “agreeing” to charge

“High price”: hence, a dilemma.

Application of One-Shot Games: Advertising and Quality Decisions

10-13

Simultaneous-Move, One-Shot Games

Firm A	Firm B
	Strategy	Low price	High price
	Advertise	$4, $4	$2, $1
	Don’t Advertise	$1 , $20	$10, $10

A Nash equilibrium results when both firms “Advertise”

Firm A	Firm B
	Strategy	Low price	High price
	Advertise	$4, $4	$20, $1
	Don’t Advertise	$1 , $20	$10, $10

Collusion would not work because this is a one-shot game; if you

and your rival “agreed” not to advertise each of you would have an

incentive to cheat on the agreement.

Application of One-Shot Games: Coordination Decisions

10-14

Simultaneous-Move, One-Shot Games

Firm A	Firm B
	Strategy	120-Volt Outlets	90-Volt Outlets
	120-Volt Outlets	$100, $100	$0, $0
	90-Volt Outlets	$0 , $0	$100, $100

There are two Nash equilibrium outcomes associated with this game:

Equilibrium strategy 1: Both players choose 120-volt outlets

Firm A	Firm B
	Strategy	120-Volt Outlets	90-Volt Outlets
	120-Volt Outlets	$100, $100	$0, $0
	90-Volt Outlets	$0 , $0	$100, $100

Equilibrium strategy 2: Both players choose 90-volt outlets

Firm A	Firm B
	Strategy	120-Volt Outlets	90-Volt Outlets
	120-Volt Outlets	$100, $100	$0, $0
	90-Volt Outlets	$0 , $0	$100, $100

Ways to coordinate on one equilibrium:

1) permit player communication

2) government set standard

Application of One-Shot Games: Monitoring Employees

10-15

Simultaneous-Move, One-Shot Games

Manager	Worker
	Strategy	Monitor	Don’t Monitor
	Monitor	-1, 1	1, -1
	Don’t Monitor	1, -1	-1, 1

There are no Nash equilibrium outcomes associated with this game.

Q: How should the agents play this type of game?

A: Play a mixed (randomized) strategy, whereby a player randomizes

over two or more available actions in order to keep rivals from

being able to predict his or her actions.

Application of One-Shot Games: Nash Bargaining

10-16

Simultaneous-Move, One-Shot Games

Management	Union
	Strategy	0	50	100
	0	0, 0	0, 50	0, 100
	50	50 , 0	50, 50	-1, -1
	100	100, 0	-1, -1	-1, -1

There three Nash equilibrium outcomes associated with this game:

Equilibrium strategy 1: Management chooses 100, union chooses 0

Equilibrium strategy 2: Both players choose 50

Equilibrium strategy 3: Management chooses 0, Union chooses 100

Infinitely Repeated Games: Theory

An infinitely repeated game is a game that is played over and over again forever, and in which players receive payoffs during each play of the game.

Disconnect between current decisions and future payoffs suggest that payoffs must be appropriately discounted.

10-17

Infinitely Repeated Games

Review of Present Value

When a firm earns the same profit, , in each period over an infinite time horizon, the present value of the firm is:

10-18

Infinitely Repeated Games

Supporting Collusion with Trigger Strategies

10-19

Infinitely Repeated Games

Firm A	Firm B
	Strategy	Low price	High price
	Low price	0, 0	50, -40
	High price	-40 , 50	10, 10

The Nash equilibrium to the one-shot, simultaneous-move

pricing game is: Low, Low

When this game is repeatedly played, it is possible for firms to

collude without fear of being cheated on using trigger strategies.

Trigger strategy: strategy that is contingent on the past play of a

game and in which some particular past action “triggers” a different

action by a player.

Supporting Collusion with Trigger Strategies

10-20

Infinitely Repeated Games

Firm A	Firm B
	Strategy	Low price	High price
	Low price	0, 0	50, -40
	High price	-40 , 50	10, 10

Trigger strategy example: Both firms charge the high price, provided

neither of us has ever “cheated” in the past (charge low price).

If one firm cheats by charging the low price, the other player will

punish the deviator by charging the low price forever after.

When both firms adopt such a trigger strategy, there are conditions

under which neither firm has an incentive to cheat on the collusive

outcome.

Sustaining Cooperative Outcomes with Trigger Strategies

Suppose a one-shot game is infinitely repeated and the interest rate is . Further, suppose the “cooperative” one-shot payoff to a player is , the maximum one-shot payoff if the player cheats on the collusive outcome is , the one-shot Nash equilibrium payoff is , and .

Then the cooperative (collusive) outcome can be sustained in the infinitely repeated game with the following trigger strategy: “Cooperate provided that no player has ever cheated in the past. If any player cheats, “punish” the player by choosing the one-shot Nash equilibrium strategy forever after.

10-21

Infinitely Repeated Games

Supporting Collusion with Trigger Strategies In Action

10-22

Infinitely Repeated Games

Firm A	Firm B
	Strategy	Low price	High price
	Low price	0, 0	50, -40
	High price	-40 , 50	10, 10

Suppose firm A and B repeatedly play the game above, and the

interest rate is 40 percent. Firms agree to charge a high price in

each period, provided neither has cheated in the past.

Q: What are firm A’s profits if it cheats on the collusive agreement?

A: If firm B lives up to the collusive agreement but firm A cheats,

firm A will earn $50 today and zero forever after.

Supporting Collusion with Trigger Strategies in Action

10-23

Infinitely Repeated Games

Firm A	Firm B
	Strategy	Low price	High price
	Low price	0, 0	50, -40
	High price	-40 , 50	10, 10

Q: What are firm A’s profits if it does not cheat on the collusive

agreement?

Supporting Collusion with Trigger Strategies in Action

10-24

Infinitely Repeated Games

Firm A	Firm B
	Strategy	Low price	High price
	Low price	0, 0	50, -40
	High price	-40 , 50	10, 10

Q: Does an equilibrium result where the firms charge the high price

in each period?

A: Since , the present value of firm A’s profits are higher

if A cheats on the collusive agreement. In equilibrium both firms

will charge low price and earn zero profit each period.

Factors Affecting Collusion in Pricing Games

Sustaining collusion via trigger strategies is easier when firms know:

who their rivals are, so they know whom to punish, if needed.

who their rival’s customers are, so they can “steal” those customers with lower prices.

when their rivals deviate, so they know when to begin punishment.

be able to successfully punish rival.

10-25

Infinitely Repeated Games

Factors Affecting Collusion in Pricing Games

Number of firms in the market

Firm size

History of the market

Punishment mechanisms

10-26

Infinitely Repeated Games

Finitely Repeated Games

Finitely repeated games are games in which a one-shot game is repeated a finite number of times.

Variations of finitely repeated games: games in which players

do not know when the game will end

know when the game will end

10-27

Finitely Repeated Games

Games with an Uncertain Final Period

10-28

Finitely Repeated Games

Firm A	Firm B
	Strategy	Low price	High price
	Low price	0, 0	50, -40
	High price	-40 , 50	10, 10

Suppose the probability that the game will end after a given play is

, where .

An uncertain final period mirrors the analysis of infinitely repeated

games. Use the same trigger strategy.

No incentive to cheat on the collusive outcome associated with a

finitely repeated game with an unknown end point above, provided:

Repeated Games with a Known Final Period: End-of-Period Problem

10-29

Finitely Repeated Games

Firm A	Firm B
	Strategy	Low price	High price
	Low price	0, 0	50, -40
	High price	-40 , 50	10, 10

When this game is repeated some known, finite number of times

and there is only one Nash equilibrium, then collusion cannot work.

The only equilibrium is the single-shot, simultaneous-move Nash

equilibrium; in the game above, both firms charge low price.

Applications of the End-of-Period Problem

Resignations and Quits

The “Snake-Oil” Salesman

Finitely Repeated Games

Multistage Games: Theory

Multistage games differ from the previously examined games by examining the timing of decisions in games.

Players make sequential, rather than simultaneous, decisions.

Represented by an extensive-form game.

Extensive form game

A representation of a game that summarizes the players, the information available to them at each stage, the strategies available to them, the sequence of moves, and the payoffs resulting from alternative strategies.

10-31

Multistage Games

Theory: Sequential-Move Game in Extension Form

10-32

Multistage Games

Down

Decision node

denoting the

beginning of the

game

Player B’s decision nodes

Player A payoff

Player B payoff

Player A feasible strategies:

Player B feasible strategies:

Down

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

Equilibrium Characterization

10-33

Multistage Games

Down

Nash Equilibrium

Player A: Down

Player B: Down, if player A chooses Up,

and Down if Player A chooses Down

Is this Nash equilibrium reasonable?

No! Player B’s strategy involves a non-credible threat since if A plays Up,

B’s best response is Up too!

Subgame Perfect Equilibrium

A condition describing a set of strategies that constitutes a Nash equilibrium and allows no player to improve his own payoff at any stage of the game by changing strategies.

10-34

Multistage Games

Equilibrium Characterization

10-35

Multistage Games

Down

Subgame Perfect Equilibrium

Player A: Up

Player B: Up, if player A chooses Up,

and Down if Player A chooses Down

Application of Multistage Games: The Entry Game

10-36

Multistage Games

Hard

Soft

Out

Nash Equilibrium I:

Player A: Out

Player B: Hard, if player A chooses In

Non-credible, threat since if A plays

In, B’s best response is Soft

Nash Equilibrium II:

Player A: In

Player B: Soft, if player A chooses In

Credible. This is subgame perfect equilibrium.

Baye_9e_Chapter_11.pptx

Pricing Strategies for Firms with Market Power

Chapter 11

Learning Objectives

Apply simple elasticity-based markup formulas to determine profit-maximizing prices in environments where a business enjoys market power, including monopoly, monopolistic competition, and Cournot oligopoly.

Formulate pricing strategies that permit firms to extract additional surplus from consumers—including price discrimination, two-part pricing, block pricing, and commodity bundling—and explain the conditions needed for each of these strategies to yield higher profits than standard pricing.

Formulate pricing strategies that enhance profits for special cost and demand structures—such as peak-load pricing, cross-subsidies, and transfer pricing—and explain the conditions needed for each strategy to work.

Explain how price-matching guarantees, brand loyalty programs, and randomized pricing strategies can be used to enhance profits in markets with intense price competition.

Review of Basic Profit Maximization

Firms with market power face a downward-sloping demand.

Implication: there is a trade-off between selling many units at a low price and selling a few units at a high price.

Managers of firms with market power balance these competing forces by selecting the quantity that equates marginal revenue and marginal cost , and charging the maximum price that consumer will pay for this level of output.

11-3

Basic Pricing Strategies

Basic Profit Maximization In Action

Suppose the (inverse) demand for a firm’s product is given by and the cost function is . What is the profit-maximizing level of output and price for this firm?

Answer:

The marginal revenue function is: .

The marginal cost function is: .

Equating these two functions yields , so . The profit-maximizing price is .

11-4

Basic Pricing Strategies

Simple Pricing Rule: Monopoly and Monopolistic Competition

What if estimates of the demand and cost functions are not available?

Managers have a “crude” estimate of

marginal cost; the price paid to a supplier.

the price elasticity of demand, since it is typically available for a representative firm in an industry.

With this information, the monopoly and monopolistically competitive firm’s profit-maximizing price (markup) is computed from: MC =

, where .

So, set price such that: .

11-5

Basic Pricing Strategies

Simple Pricing Rule In Action: Problem

The manager of a convenience store competes in a monopolistically competitive market and buys cola from a supplier at a price of $1.25 per liter. The manager thinks that because there are several supermarkets nearby, the demand for cola sold at her store is slightly more elastic than the elasticity for the representative food store. Specifically, the elasticity of demand for cola sold by her store is . What price should the manager charge for a liter of cola to maximize profits?

11-6

Basic Pricing Strategies

Simple Pricing Rule In Action: Answer

The marginal cost of cola to the firm is , or per liter, and the markup factor is .

The profit-maximizing pricing rule for a monopolistically competitive firm is:

, or about per liter.

11-7

Basic Pricing Strategies

Simple Pricing Rule for Cournot Oligopoly

When each of the firms operating in a Cournot oligopoly has identical cost structures and produces similar products, the simple profit-maximizing price (markup) in Cournot equilibrium is:

, where is the market elasticity of demand.

11-8

Basic Pricing Strategies

Beyond the Single-Price-Per-Unit Model

In some markets, managers can enhance profits beyond those resulting from charging all consumers a single, per-unit price.

Models that yield greater profits fall into three categories:

Pricing strategies:

that extract surplus from consumers.

for special cost and demand structures.

in markets with intense price competition.

11-9

Strategies that Yield Even Greater Profits

Models that Extract Surplus from Consumers

Strategies for surplus extraction:

Price discrimination (first, second and third degrees)

Two-part pricing

Block pricing

Commodity bundling

Each strategy is appropriate for firms with various cost structures and degrees of market interdependence.

11-10

Strategies that Yield Even Greater Profits

Surplus Extraction: First-Degree Price Discrimination

Price discrimination is the practice of charging different prices to consumers for the same good or service.

First-degree price discrimination is the practice of charging each consumer the maximum price he or she would be willing to pay for each unit of the good purchased.

Implication: the firm extracts all surplus from consumers and earns the highest possible profit.

Problem: managers rarely know each consumers’ maximum willingness to pay for each unit of the product.

11-11

Strategies that Yield Even Greater Profits

First-Degree Price Discrimination

11-12

Strategies that Yield Even Greater Profits

Price

Quantity

Demand

Firm profit under first-degree

price discrimination

Surplus Extraction: Second-Degree Price Discrimination

Second-degree price discrimination is the practice of posting a discrete schedule of declining prices for different ranges of quantity.

Implication: firm extracts some surplus from consumers without needing to know the identity of various consumers’ demand.

11-13

Strategies that Yield Even Greater Profits

Second-Degree Price Discrimination

11-14

Strategies that Yield Even Greater Profits

Price

Quantity

Demand

Contribution to profits under

second-degree price discrimination

Surplus Extraction: Third-Degree Price Discrimination

Third-degree price discrimination is the practice of charging different prices based on systematic differences in demand across demographic consumer groups.

Implication: marginal revenue will be different for each group. That is, if there are two groups, , for example.

11-15

Strategies that Yield Even Greater Profits

Surplus Extraction: Third-Degree Price Discrimination Rule

To maximize profits, a firm with market power produces the output at which the marginal revenue (left-hand side of the following equations) to each group equals marginal cost.

11-16

Strategies that Yield Even Greater Profits

Third-Degree Price Discrimination Rule In Action:

You are the manager of a pizzeria that produces at a marginal cost of $6 per pizza. The pizzeria is a local monopoly near campus. During the day, only students eat at your restaurant. In the evening, while students are studying, faculty members eat there. If students have an elasticity of demand for pizza of and faculty has an elasticity of demand of , what should your pricing policy be to maximize profits?

11-17

Strategies that Yield Even Greater Profits

Third-Degree Price Discrimination Rule In Action:

Assuming faculty would be unwilling to purchase cold pizzas from students, the conditions for effective third-degree price discrimination hold. It will be profitable to charge a “lunch menu” price and a “dinner menu” price. These prices are determined as follows:

Solving these equations yield, and .

11-18

Strategies that Yield Even Greater Profits

Surplus Extraction: Two-Part Pricing

Two-part pricing is a pricing strategy whereby a firm with market power charges a fixed fee for the right to purchase its goods, plus a per-unit charge for each unit purchased.

11-19

Strategies that Yield Even Greater Profits

Two-Part Pricing

11-20

Strategies that Yield Even Greater Profits

Price

Quantity

Demand

MC = AC

Fixed fee = $32 = profits

Consumer surplus = $0

Per-unit fee = $2

Surplus Extraction: Block Pricing

Block pricing is a pricing strategy in which identical products are packaged together in order to enhance profits by forcing customers to make an all-or-none decision to purchase.

The profit-maximizing price on a package is the total value the consumer receives for the package.

11-21

Strategies that Yield Even Greater Profits

Block Pricing

11-22

Strategies that Yield Even Greater Profits

Price

Quantity

Demand

MC = AC

Profit with block pricing = $32

Price charged for a block of 8 units = $48

Surplus Extraction: Commodity Bundling

Commodity bundling is the practice of bundling several different products together and selling them at a single “bundle price.”

Key assumption: Consumers differ with respect to the amounts they are willing to pay for multiple products sold by a firm.

Managers cannot observe different consumers’ valuations.

11-23

Strategies that Yield Even Greater Profits

Pricing Strategies for Special Cost and Demand Structures: Peak-Load Pricing

Peak-load pricing is a pricing strategy in which higher prices are charged during peak hours than during off-peak hours.

11-24

Strategies that Yield Even Greater Profits

Project	Boom (90%)	Recession (10%)	Mean	Standard Deviation
Bologna	-$10,000	$12,000	-$7,800	$6,600
Caviar	20,000	-8,000	17,200	8,400
Joint	10,000	4,000	9,400	1,800
Safe (T-Bill)	3,000	3,000	3,000	0

Project	Boom (90%)	Recession (10%)	Mean	Standard Deviation
Bologna	-$10,000	$12,000	-$7,800	$6,600
Caviar	20,000	-8,000	17,200	8,400
Joint	10,000	4,000	9,400	1,800
Safe (T-Bill)	3,000	3,000	3,000	0

Information structure	Expected revenues
Independent private values	English=Second-price = First-Price = Dutch
Affiliated value estimates	English > Second-price > First-price = Dutch

Firm A	Firm B
	Strategy	Low output	High output
	Low output	$30, $10	$10, $15
	High output	$20 , $5	$1, $2

Firm A	Firm B
	Strategy	Low output	High output
	Low output	$30, $10	$10, $15
	High output	$20 , $5	$1, $2

Managerial Economics

Baye_9e_Chapter_02.pptx

Baye_9e_Chapter_03.pptx

Baye_9e_Chapter_04.pptx

Baye_9e_Chapter_05.pptx

Baye_9e_Chapter_06.pptx

Baye_9e_Chapter_07.pptx

Baye_9e_Chapter_08.pptx

Baye_9e_Chapter_09.pptx

Baye_9e_Chapter_10.pptx

Baye_9e_Chapter_11.pptx

Baye_9e_Chapter_12.pptx

Baye_9e_Chapter_13.pptx

Baye_9e_Chapter_14.pptx