Upload
duongdan
View
313
Download
23
Embed Size (px)
Citation preview
EKONOMI MANAJERIAL
DOSEN:
DR. ARDITO BHINADI, SE., M.SI
JURUSAN ILMU EKONOMI, FAKULTAS EKONOMI, UPN “VETERAN” YOGYAKARTA
2013
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Managerial Economics & Business Strategy
Chapter 1The Fundamentals of Managerial
Economics
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
OverviewI. IntroductionII. The Economics of Effective Management
Identify Goals and ConstraintsRecognize the Role of ProfitsUnderstand IncentivesFive Forces ModelUnderstand MarketsRecognize the Time Value of MoneyUse Marginal Analysis
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Managerial Economics
• ManagerA person who directs resources to achieve a stated goal.
• EconomicsThe science of making decisions in the presence of scare resources.
• Managerial EconomicsThe study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Economic vs. Accounting Profits
• Accounting ProfitsTotal revenue (sales) minus dollar cost of producing goods or services.Reported on the firm’s income statement.
• Economic ProfitsTotal revenue minus total opportunity cost.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Opportunity Cost• Accounting Costs
The explicit costs of the resources needed to produce produce goods or services.Reported on the firm’s income statement.
• Opportunity CostThe cost of the explicit and implicit resources that are foregone when a decision is made.
• Economic ProfitsTotal revenue minus total opportunity cost.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Sustainable IndustryProfits
Power ofInput Suppliers
•Supplier Concentration•Price/Productivity of Alternative Inputs•Relationship-Specific Investments•Supplier Switching Costs•Government Restraints
Power ofBuyers
•Buyer Concentration•Price/Value of Substitute Products or Services•Relationship-Specific Investments•Customer Switching Costs•Government Restraints
Entry•Entry Costs•Speed of Adjustment•Sunk Costs•Economies of Scale
•Network Effects•Reputation•Switching Costs•Government Restraints
Substitutes & Complements•Price/Value of Surrogate Products or Services•Price/Value of Complementary Products or Services
•Network Effects•Government Restraints
Industry Rivalry•Switching Costs•Timing of Decisions•Information•Government Restraints
•Concentration•Price, Quantity, Quality, or Service Competition•Degree of Differentiation
The Five Forces Framework
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Market Interactions• Consumer-Producer Rivalry
Consumers attempt to locate low prices, while producers attempt to charge high prices.
• Consumer-Consumer RivalryScarcity of goods reduces the negotiating power of consumers as they compete for the right to those goods.
• Producer-Producer RivalryScarcity of consumers causes producers to compete with one another for the right to service customers.
• The Role of GovernmentDisciplines the market process.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
The Time Value of Money
• Present value (PV) of a lump-sum amount (FV) to be received at the end of “n” periods when the per-period interest rate is “i”:
( )PV
FVi n=
+1• Examples:
Lotto winner choosing between a single lump-sum payout of $104 million or $198 million over 25 years.Determining damages in a patent infringement case.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Present Value of a Series
• Present value of a stream of future amounts (FVt) received at the end of each period for “n” periods:
( ) ( ) ( )PV
FVi
FVi
FVin
n=+
++
+ ++
11
221 1 1
...
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Net Present Value• Suppose a manager can purchase a stream of
future receipts (FVt ) by spending “C0” dollars today. The NPV of such a decision is
( ) ( ) ( )NPV
FVi
FVi
FVi
Cnn=
++
++ +
+−1
12
2 01 1 1...
Decision Rule:If NPV < 0: Reject project
NPV > 0: Accept project
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Present Value of a Perpetuity• An asset that perpetually generates a stream of cash flows
(CF) at the end of each period is called a perpetuity.• The present value (PV) of a perpetuity of cash flows paying
the same amount at the end of each period is
( ) ( ) ( )
iCF
iCF
iCF
iCFPV Perpetuity
=
++
++
++
= ...111 32
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Firm Valuation• The value of a firm equals the present value of current and
future profits.PV = Σπt / (1 + i)t
• If profits grow at a constant rate (g < i) and current period profits are πο:
• If the growth rate in profits < interest rate and both remain constant, maximizing the present value of all future profits is the same as maximizing current profits.
0
0
1 before current profits have been paid out as dividends;
1 immediately after current profits are paid out as dividends.
Firm
Ex DividendFirm
iPVi g
gPVi g
π
π−
+=
−+
=−
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
• Control VariablesOutputPriceProduct QualityAdvertisingR&D
• Basic Managerial Question: How much of the control variable should be used to maximize net benefits?
Marginal (Incremental) Analysis
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Net Benefits
• Net Benefits = Total Benefits - Total Costs• Profits = Revenue - Costs
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Marginal Benefit (MB)
• Change in total benefits arising from a change in the control variable, Q:
• Slope (calculus derivative) of the total benefit curve.
QBMB
∆∆
=
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Marginal Cost (MC)
• Change in total costs arising from a change in the control variable, Q:
• Slope (calculus derivative) of the total cost curve
QCMC
∆∆
=
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Marginal Principle
• To maximize net benefits, the managerial control variable should be increased up to the point where MB = MC.
• MB > MC means the last unit of the control variable increased benefits more than it increased costs.
• MB < MC means the last unit of the control variable increased costs more than it increased benefits.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
The Geometry of Optimization
Q
Total Benefits& Total Costs
Benefits
Costs
Q*
B
CSlope = MC
Slope =MB
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Conclusion• Make sure you include all costs and benefits
when making decisions (opportunity cost).• When decisions span time, make sure you
are comparing apples to apples (PV analysis).
• Optimal economic decisions are made at the margin (marginal analysis).
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Managerial Economics & Business Strategy
Chapter 2 Market Forces: Demand and Supply
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Overview
III. Market EquilibriumIV. Price RestrictionsV. Comparative Statics
II. Market Supply CurveThe Supply FunctionSupply ShiftersProducer Surplus
I. Market Demand CurveThe Demand FunctionDeterminants of Demand Consumer Surplus
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Market Demand Curve
• Shows the amount of a good that will be purchased at alternative prices, holding other factors constant.
• Law of DemandThe demand curve is downward sloping.
QuantityD
Price
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Determinants of Demand
• IncomeNormal goodInferior good
• Prices of Related GoodsPrices of substitutes Prices of complements
• Advertising and consumer tastes
• Population• Consumer expectations
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
The Demand Function• A general equation representing the demand curve
Qxd = f(Px , PY , M, H,)
Qxd = quantity demand of good X.
Px = price of good X.PY = price of a related good Y.
• Substitute good.• Complement good.
M = income.• Normal good.• Inferior good.
H = any other variable affecting demand.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Inverse Demand Function
• Price as a function of quantity demanded.
• Example:Demand Function
• Qxd = 10 – 2Px
Inverse Demand Function:• 2Px = 10 – Qx
d
• Px = 5 – 0.5Qxd
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Change in Quantity DemandedPrice
Quantity
D0
4 7
6
A to B: Increase in quantity demanded
B
10A
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Price
Quantity
D0
D1
6
7
D0 to D1: Increase in Demand
Change in Demand
13
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Consumer Surplus:
• The value consumers get from a good but do not have to pay for.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
I got a great deal!
• That company offers a lot of bang for the buck!
• Dell provides good value.• Total value greatly exceeds
total amount paid.• Consumer surplus is large.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
I got a lousy deal!• That car dealer drives a
hard bargain! • I almost decided not to
buy it!• They tried to squeeze the
very last cent from me!• Total amount paid is
close to total value.• Consumer surplus is low.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Price
Quantity
D
10
8
6
4
2
1 2 3 4 5
Consumer Surplus:The value received but notpaid for. Consumer surplus =(8-2) + (6-2) + (4-2) = $12.
Consumer Surplus: The Discrete Case
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Consumer Surplus:The Continuous Case
Price $
Quantity
D
10
8
6
4
2
1 2 3 4 5
Valueof 4 units = $24Consumer
Surplus = $24 - $8 = $16
Expenditure on 4 units = $2 x 4 = $8
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Market Supply Curve
• The supply curve shows the amount of a good that will be produced at alternative prices.
• Law of SupplyThe supply curve is upward sloping.
Price
Quantity
S0
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Supply Shifters• Input prices• Technology or
government regulations• Number of firms
Entry Exit
• Substitutes in production• Taxes
Excise taxAd valorem tax
• Producer expectations
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
The Supply Function
• An equation representing the supply curve:Qx
S = f(Px , PR ,W, H,)
QxS = quantity supplied of good X.
Px = price of good X.PR = price of a production substitute.W = price of inputs (e.g., wages).H = other variable affecting supply.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Inverse Supply Function
• Price as a function of quantity supplied.
• Example:Supply Function
• Qxs = 10 + 2Px
Inverse Supply Function:• 2Px = 10 + Qx
s
• Px = 5 + 0.5Qxs
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Change in Quantity SuppliedPrice
Quantity
S0
20
10
B
A
5 10
A to B: Increase in quantity supplied
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Price
Quantity
S0
S1
8
75
S0 to S1: Increase in supply
Change in Supply
6
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Producer Surplus• The amount producers receive in excess of the amount
necessary to induce them to produce the good.Price
Quantity
S0
Q*
P*
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Market Equilibrium
• Balancing supply and demand
QxS = Qx
d
• Steady-state
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Price
Quantity
S
D
5
6 12
Shortage12 - 6 = 6
6
If price is too low…
7
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Price
Quantity
S
D
9
14
Surplus14 - 6 = 8
6
8
8
If price is too high…
7
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Price Restrictions• Price Ceilings
The maximum legal price that can be charged.Examples:• Gasoline prices in the 1970s.• Housing in New York City.• Proposed restrictions on ATM fees.
• Price FloorsThe minimum legal price that can be charged.Examples:• Minimum wage.• Agricultural price supports.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Price
Quantity
S
D
P*
Q*
P Ceiling
Q s
PF
Impact of a Price Ceiling
Shortage
Q d
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Full Economic Price
• The dollar amount paid to a firm under a price ceiling, plus the nonpecuniary price.
PF = Pc + (PF - PC) • PF = full economic price• PC = price ceiling• PF - PC = nonpecuniary price
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
An Example from the 1970s
• Ceiling price of gasoline: $1.• 3 hours in line to buy 15 gallons of gasoline
Opportunity cost: $5/hr.Total value of time spent in line: 3 × $5 = $15.Non-pecuniary price per gallon: $15/15=$1.
• Full economic price of a gallon of gasoline: $1+$1=2.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Impact of a Price FloorPrice
Quantity
S
D
P*
Q*
Surplus
PF
Qd QS
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Comparative Static Analysis• How do the equilibrium price and quantity
change when a determinant of supply and/or demand change?
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Applications of Demand and Supply Analysis
• Event: The WSJ reports that the prices of PC components are expected to fall by 5-8 percent over the next six months.
• Scenario 1: You manage a small firm that manufactures PCs.
• Scenario 2: You manage a small software company.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Use Comparative Static Analysis to see the Big Picture!
• Comparative static analysis shows how the equilibrium price and quantity will change when a determinant of supply or demand changes.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Scenario 1: Implications for a Small PC Maker
• Step 1: Look for the “Big Picture.”• Step 2: Organize an action plan (worry
about details).
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Priceof
PCs
Quantity of PC’s
S
D
S*
P0
P*
Q0 Q*
Big Picture: Impact of decline in component prices on PC market
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
• Equilibrium price of PCs will fall, and equilibrium quantity of computers sold will increase.
• Use this to organize an action plancontracts/suppliers?inventories?human resources?marketing?do I need quantitative estimates?
Big Picture Analysis: PC Market
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Scenario 2: Software Maker• More complicated chain of reasoning to
arrive at the “Big Picture.”• Step 1: Use analysis like that in Scenario 1
to deduce that lower component prices will lead to
a lower equilibrium price for computers.a greater number of computers sold.
• Step 2: How will these changes affect the “Big Picture” in the software market?
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Priceof Software
Quantity ofSoftware
S
D
Q0
D*
P1
Q1
Big Picture: Impact of lower PC prices on the software market
P0
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
• Software prices are likely to rise, and more software will be sold.
• Use this to organize an action plan.
Big Picture Analysis: Software Market
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Conclusion• Use supply and demand analysis to
clarify the “big picture” (the general impact of a current event on equilibrium prices and quantities).organize an action plan (needed changes in production, inventories, raw materials, human resources, marketing plans, etc.).
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Managerial Economics & Business Strategy
Chapter 3Quantitative Demand Analysis
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Overview
I. The Elasticity ConceptOwn Price ElasticityElasticity and Total RevenueCross-Price ElasticityIncome Elasticity
II. Demand FunctionsLinear Log-Linear
III. Regression Analysis
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
The Elasticity Concept
• How responsive is variable “G” to a change in variable “S”
If EG,S > 0, then S and G are directly related.If EG,S < 0, then S and G are inversely related.
SGE SG ∆
∆=
%%
,
If EG,S = 0, then S and G are unrelated.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
The Elasticity Concept Using Calculus
• An alternative way to measure the elasticity of a function G = f(S) is
GS
dSdGE SG =,
If EG,S > 0, then S and G are directly related.If EG,S < 0, then S and G are inversely related.If EG,S = 0, then S and G are unrelated.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Own Price Elasticity of Demand
• Negative according to the “law of demand.”
Elastic:
Inelastic:
Unitary:
X
dX
PQ PQE
XX ∆∆
=%
%,
1, >XX PQE
1, <XX PQE
1, =XX PQE
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Perfectly Elastic & Inelastic Demand
)( ElasticPerfectly , −∞=XX PQE
D
Price
Quantity
D
Price
Quantity
)0, =XX PQE( Inelastic Perfectly
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Own-Price Elasticity and Total Revenue
• Elastic Increase (a decrease) in price leads to a decrease (an increase) in total revenue.
• InelasticIncrease (a decrease) in price leads to an increase (a decrease) in total revenue.
• UnitaryTotal revenue is maximized at the point where demand is unitary elastic.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Elasticity, Total Revenue and Linear Demand
PTR
100
0 010 20 30 40 50
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Elasticity, Total Revenue and Linear Demand
PTR
100
0 10 20 30 40 50
80
800
0 10 20 30 40 50
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Elasticity, Total Revenue and Linear Demand
PTR
100
80
800
60 1200
0 10 20 30 40 500 10 20 30 40 50
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Elasticity, Total Revenue and Linear Demand
PTR
100
80
800
60 1200
40
0 10 20 30 40 500 10 20 30 40 50
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Elasticity, Total Revenue and Linear Demand
PTR
100
80
800
60 1200
40
20
0 10 20 30 40 500 10 20 30 40 50
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Elasticity, Total Revenue and Linear Demand
PTR
100
80
800
60 1200
40
20
Elastic
Elastic
0 10 20 30 40 500 10 20 30 40 50
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Elasticity, Total Revenue and Linear Demand
PTR
100
80
800
60 1200
40
20
Inelastic
Elastic
Elastic Inelastic
0 10 20 30 40 500 10 20 30 40 50
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Elasticity, Total Revenue and Linear Demand
P TR100
80
800
60 1200
40
20
Inelastic
Elastic
Elastic Inelastic
0 10 20 30 40 500 10 20 30 40 50
Unit elasticUnit elastic
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Factors Affecting Own Price Elasticity
Available Substitutes• The more substitutes available for the good, the more elastic
the demand.Time
• Demand tends to be more inelastic in the short term than in the long term.
• Time allows consumers to seek out available substitutes.Expenditure Share
• Goods that comprise a small share of consumer’s budgets tend to be more inelastic than goods for which consumers spend a large portion of their incomes.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Cross Price Elasticity of Demand
If EQX,PY> 0, then X and Y are substitutes.
If EQX,PY< 0, then X and Y are complements.
Y
dX
PQ PQE
YX ∆∆
=%
%,
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Predicting Revenue Changes from Two Products
Suppose that a firm sells to related goods. If the price of X changes, then total revenue will change by:
( )( ) XPQYPQX PERERRXYXX
∆×++=∆ %1 ,,
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Income Elasticity
If EQX,M > 0, then X is a normal good.
If EQX,M < 0, then X is a inferior good.
MQE
dX
MQX ∆∆
=%
%,
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Uses of Elasticities
• Pricing.• Managing cash flows.• Impact of changes in competitors’ prices.• Impact of economic booms and recessions.• Impact of advertising campaigns.• And lots more!
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Example 1: Pricing and Cash Flows
• According to an FTC Report by Michael Ward, AT&T’s own price elasticity of demand for long distance services is -8.64.
• AT&T needs to boost revenues in order to meet it’s marketing goals.
• To accomplish this goal, should AT&T raise or lower it’s price?
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Answer: Lower price!
• Since demand is elastic, a reduction in price will increase quantity demanded by a greater percentage than the price decline, resulting in more revenues for AT&T.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Example 2: Quantifying the Change
• If AT&T lowered price by 3 percent, what would happen to the volume of long distance telephone calls routed through AT&T?
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Answer• Calls would increase by 25.92 percent!
( )%92.25%
%64.8%3%3
%64.8
%%64.8,
=∆
∆=−×−−∆
=−
∆∆
=−=
dX
dX
dX
X
dX
PQ
Q
Q
Q
PQE
XX
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Example 3: Impact of a change in a competitor’s price
• According to an FTC Report by Michael Ward, AT&T’s cross price elasticity of demand for long distance services is 9.06.
• If competitors reduced their prices by 4 percent, what would happen to the demand for AT&T services?
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Answer• AT&T’s demand would fall by 36.24 percent!
%24.36%
%06.9%4%4
%06.9
%%06.9,
−=∆
∆=×−−∆
=
∆∆
==
dX
dX
dX
Y
dX
PQ
Q
Q
Q
PQE
YX
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Interpreting Demand Functions• Mathematical representations of demand curves.• Example:
• X and Y are substitutes (coefficient of PY is positive).
• X is an inferior good (coefficient of M is negative).
MPPQ YXd
X 23210 −+−=
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Linear Demand Functions
• General Linear Demand Function:
HMPPQ HMYYXXd
X ααααα ++++= 0
Own PriceElasticity
Cross PriceElasticity
IncomeElasticity
X
XXPQ Q
PEXX
α=,X
MMQ QME
Xα=,
X
YYPQ Q
PEYX
α=,
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Example of Linear Demand
• Qd = 10 - 2P.• Own-Price Elasticity: (-2)P/Q.• If P=1, Q=8 (since 10 - 2 = 8).• Own price elasticity at P=1, Q=8:
(-2)(1)/8= - 0.25.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
0ln ln ln ln lndX X X Y Y M HQ P P M Hβ β β β β= + + + +
M
Y
X
:Elasticity Income:Elasticity Price Cross :Elasticity PriceOwn
βββ
Log-Linear Demand
• General Log-Linear Demand Function:
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Example of Log-Linear Demand
• ln(Qd) = 10 - 2 ln(P).• Own Price Elasticity: -2.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
P
Q Q
D D
Linear Log Linear
Graphical Representation of Linear and Log-Linear Demand
P
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Regression Analysis
• One use is for estimating demand functions.• Important terminology and concepts:
Least Squares Regression: Y = a + bX + e.Confidence Intervals.t-statistic.R-square or Coefficient of Determination.F-statistic.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
An Example
• Use a spreadsheet to estimate the following log-linear demand function.
0ln lnx x xQ P eβ β= + +
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Summary OutputRegression Statistics
Multiple R 0.41R Square 0.17Adjusted R Square 0.15Standard Error 0.68Observations 41.00
ANOVAdf SS M S F Significance F
Regression 1.00 3.65 3.65 7.85 0.01Residual 39.00 18.13 0.46Total 40.00 21.78
Coefficients Standard Error t Stat P-value Lower 95% Upper 95%Intercept 7.58 1.43 5.29 0.000005 4.68 10.48ln(P) -0.84 0.30 -2.80 0.007868 -1.44 -0.23
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Interpreting the Regression Output
• The estimated log-linear demand function is:ln(Qx) = 7.58 - 0.84 ln(Px).Own price elasticity: -0.84 (inelastic).
• How good is our estimate?t-statistics of 5.29 and -2.80 indicate that the estimated coefficients are statistically different from zero.R-square of .17 indicates we explained only 17 percent of the variation in ln(Qx).F-statistic significant at the 1 percent level.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Conclusion
• Elasticities are tools you can use to quantifythe impact of changes in prices, income, and advertising on sales and revenues.
• Given market or survey data, regression analysis can be used to estimate:
Demand functions.Elasticities.A host of other things, including cost functions.
• Managers can quantify the impact of changes in prices, income, advertising, etc.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Managerial Economics & Business Strategy
Chapter 4The Theory of Individual
Behavior
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
OverviewI. Consumer Behavior
Indifference Curve AnalysisConsumer Preference Ordering
II. ConstraintsThe Budget ConstraintChanges in IncomeChanges in Prices
III. Consumer EquilibriumIV. Indifference Curve Analysis & Demand Curves
Individual DemandMarket Demand
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Consumer Behavior• Consumer Opportunities
The possible goods and services consumer can afford to consume.
• Consumer PreferencesThe goods and services consumers actually consume.
• Given the choice between 2 bundles of goods a consumer either
Prefers bundle A to bundle B: A f B.Prefers bundle B to bundle A: A p B.Is indifferent between the two: A ∼ B.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Indifference Curve Analysis
Indifference CurveA curve that defines the combinations of 2 or more goods that give a consumer the same level of satisfaction.
Marginal Rate of Substitution
The rate at which a consumer is willing to substitute one good for another and maintain the same satisfaction level.
I.II.
III.
Good Y
Good X
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Consumer Preference Ordering Properties
• Completeness• More is Better• Diminishing Marginal Rate of Substitution• Transitivity
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Complete Preferences• Completeness Property
Consumer is capable of expressing preferences (or indifference) between all possible bundles. (“I don’t know” is NOT an option!)
• If the only bundles available to a consumer are A, B, and C, then the consumer
– is indifferent between A and C (they are on the same indifference curve).
– will prefer B to A.– will prefer B to C.
I.II.
III.
Good Y
Good X
A
C
B
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
More Is Better!• More Is Better Property
Bundles that have at least as much of every good and more of some good are preferred to other bundles.
• Bundle B is preferred to A since B contains at least as much of good Y and strictly more of good X.
• Bundle B is also preferred to C since B contains at least as much of good X and strictly more of good Y.
• More generally, all bundles on ICIII are preferred to bundles on ICII or ICI. And all bundles on ICII are preferred to ICI.
I.II.
III.
Good Y
Good X
A
C
B
1
33.33
100
3
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Diminishing Marginal Rate of Substitution
• Marginal Rate of SubstitutionThe amount of good Y the consumer is willing to give up to maintain the same satisfaction level decreases as more of good X is acquired.The rate at which a consumer is willing to substitute one good for another and maintain the same satisfaction level.
• To go from consumption bundle A to B the consumer must give up 50 units of Y to get one additional unit of X.
• To go from consumption bundle B to C the consumer must give up 16.67 units of Y to get one additional unit of X.
• To go from consumption bundle C to D the consumer must give up only 8.33 units of Y to get one additional unit of X.
I.II.
III.
Good Y
Good X1 3 42
100
50
33.3325
A
B
CD
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Consistent Bundle Orderings• Transitivity Property
For the three bundles A, B, and C, the transitivity property implies that if C f B and B f A, then C fA.Transitive preferences along with the more-is-better property imply that
• indifference curves will not intersect.
• the consumer will not get caught in a perpetual cycle of indecision.
I.II.
III.
Good Y
Good X21
100
5
50
7
75
A
B
C
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
The Budget Constraint• Opportunity Set
The set of consumption bundles that are affordable.
• PxX + PyY ≤ M.
• Budget LineThe bundles of goods that exhaust a consumers income.
• PxX + PyY = M.
• Market Rate of SubstitutionThe slope of the budget line
• -Px / Py
Y
X
The Opportunity Set
Budget Line
Y = M/PY – (PX/PY)XM/PY
M/PX
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Changes in the Budget Line
• Changes in IncomeIncreases lead to a parallel, outward shift in the budget line (M1 > M0).Decreases lead to a parallel, downward shift (M2 < M0).
• Changes in PriceA decreases in the price of good X rotates the budget line counter-clockwise (PX0
> PX1
).An increases rotates the budget line clockwise (not shown).
X
Y
X
YNew Budget Line for a price decrease.
M0/PY
M0/PX
M2/PY
M2/PX
M1/PY
M1/PX
M0/PY
M0/PX0M0/PX1
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Consumer Equilibrium
• The equilibrium consumption bundle is the affordable bundle that yields the highest level of satisfaction.
Consumer equilibrium occurs at a point where
MRS = PX / PY.
Equivalently, the slope of the indifference curve equals the budget line. I.
II.
III.
X
Y
Consumer Equilibrium
M/PY
M/PX
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Price Changes and Consumer Equilibrium
• Substitute GoodsAn increase (decrease) in the price of good X leads to an increase (decrease) in the consumption of good Y.
• Examples: – Coke and Pepsi.– Verizon Wireless or T-Mobile.
• Complementary GoodsAn increase (decrease) in the price of good X leads to a decrease (increase) in the consumption of good Y.
• Examples:– DVD and DVD players.– Computer CPUs and monitors.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Complementary Goods
When the price of good X falls and the consumption of Y rises, then X and Y are complementary goods. (PX1
> PX2)
Pretzels (Y)
Beer (X)
II
I0
Y2
Y1
X1 X2
A
B
M/PX1M/PX2
M/PY1
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Income Changes and Consumer Equilibrium
• Normal GoodsGood X is a normal good if an increase (decrease) in income leads to an increase (decrease) in its consumption.
• Inferior GoodsGood X is an inferior good if an increase (decrease) in income leads to a decrease (increase) in its consumption.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Normal Goods
An increase in income increases the consumption of normal goods.
(M0 < M1).
Y
II
I
0
A
B
X
M0/Y
M0/X
M1/Y
M1/XX0
Y0
X1
Y1
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Decomposing the Income and Substitution Effects
Initially, bundle A is consumed. A decrease in the price of good X expands the consumer’s opportunity set.
The substitution effect (SE) causes the consumer to move from bundle A to B.
A higher “real income” allows the consumer to achieve a higher indifference curve.
The movement from bundle B to C represents the income effect (IE). The new equilibrium is achieved at point C.
Y
II
I
0
A
X
C
B
SE
IE
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Individual Demand Curve
• An individual’s demand curve is derived from each new equilibrium point found on the indifference curve as the price of good X is varied.
X
Y
$
X
D
II
I
P0
P1
X0 X1
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Market Demand• The market demand curve is the horizontal
summation of individual demand curves.• It indicates the total quantity all consumers would
purchase at each price point.
Q
$ $
Q
50
40
D2D1
Individual Demand Curves
Market Demand Curve
1 2 1 2 3 DM
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Other goods (Y)
II
I
0
A
C
B F
DE
Pizza (X)
0.5 1 2
A buy-one, get-one free pizza deal.
A Classic Marketing Application
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Conclusion
• Indifference curve properties reveal information about consumers’ preferences between bundles of goods.
Completeness.More is better.Diminishing marginal rate of substitution.Transitivity.
• Indifference curves along with price changes determine individuals’ demand curves.
• Market demand is the horizontal summation of individuals’ demands.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Managerial Economics & Business Strategy
Chapter 5The Production Process and Costs
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
OverviewI. Production Analysis
Total Product, Marginal Product, Average ProductIsoquantsIsocostsCost Minimization
II. Cost AnalysisTotal Cost, Variable Cost, Fixed CostsCubic Cost FunctionCost Relations
III. Multi-Product Cost Functions
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Production Analysis
• Production FunctionQ = F(K,L)The maximum amount of output that can be produced with K units of capital and L units of labor.
• Short-Run vs. Long-Run Decisions• Fixed vs. Variable Inputs
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Total Product
• Cobb-Douglas Production Function• Example: Q = F(K,L) = K.5 L.5
K is fixed at 16 units. Short run production function:
Q = (16).5 L.5 = 4 L.5
Production when 100 units of labor are used?
Q = 4 (100).5 = 4(10) = 40 units
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Marginal Productivity Measures
• Marginal Product of Labor: MPL = ∆Q/∆LMeasures the output produced by the last worker.Slope of the short-run production function (with respect to labor).
• Marginal Product of Capital: MPK = ∆Q/∆KMeasures the output produced by the last unit of capital.When capital is allowed to vary in the short run, MPK is the slope of the production function (with respect to capital).
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Average Productivity Measures
• Average Product of LaborAPL = Q/L.Measures the output of an “average” worker.Example: Q = F(K,L) = K.5 L.5
• If the inputs are K = 16 and L = 16, then the average product oflabor is APL = [(16) 0.5(16)0.5]/16 = 1.
• Average Product of CapitalAPK = Q/K.Measures the output of an “average” unit of capital.Example: Q = F(K,L) = K.5 L.5
• If the inputs are K = 16 and L = 16, then the average product oflabor is APL = [(16)0.5(16)0.5]/16 = 1.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Q
L
Q=F(K,L)
IncreasingMarginalReturns
DiminishingMarginalReturns
NegativeMarginalReturns
MP
AP
Increasing, Diminishing and Negative Marginal Returns
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Guiding the Production Process
• Producing on the production functionAligning incentives to induce maximum worker effort.
• Employing the right level of inputsWhen labor or capital vary in the short run, to maximize profit a manager will hire
• labor until the value of marginal product of labor equals the wage: VMPL = w, where VMPL = P x MPL.
• capital until the value of marginal product of capital equals the rental rate: VMPK = r, where VMPK = P xMPK .
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Isoquant
• The combinations of inputs (K, L) that yield the producer the same level of output.
• The shape of an isoquant reflects the ease with which a producer can substitute among inputs while maintaining the same level of output.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Marginal Rate of Technical Substitution (MRTS)
• The rate at which two inputs are substituted while maintaining the same output level.
K
LKL MP
MPMRTS =
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Linear Isoquants
• Capital and labor are perfect substitutes
Q = aK + bLMRTSKL = b/aLinear isoquants imply that inputs are substituted at a constant rate, independent of the input levels employed.
Q3Q2Q1
Increasing Output
L
K
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Leontief Isoquants
• Capital and labor are perfect complements.
• Capital and labor are used in fixed-proportions.
• Q = min {bK, cL}• Since capital and labor are
consumed in fixed proportions there is no input substitution along isoquants (hence, no MRTSKL).
Q3
Q2
Q1
K
Increasing Output
L
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Cobb-Douglas Isoquants
• Inputs are not perfectly substitutable.
• Diminishing marginal rate of technical substitution.
As less of one input is used in the production process, increasingly more of the other input must be employed to produce the same output level.
• Q = KaLb
• MRTSKL = MPL/MPK
Q1
Q2
Q3
K
L
Increasing Output
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Isocost• The combinations of inputs that
produce a given level of output at the same cost:
wL + rK = C• Rearranging,
K= (1/r)C - (w/r)L• For given input prices, isocosts
farther from the origin are associated with higher costs.
• Changes in input prices change the slope of the isocost line.
K
LC1
L
KNew Isocost Line for a decrease in the wage (price of labor: w0 > w1).
C1/r
C1/wC0
C0/w
C0/r
C/w0 C/w1
C/r
New Isocost Line associated with higher costs (C0 < C1).
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Cost Minimization
• Marginal product per dollar spent should be equal for all inputs:
• But, this is justrw
MPMP
rMP
wMP
K
LKL =⇔=
rwMRTSKL =
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Cost Minimization
Q
L
K
Point of Cost Minimization
Slope of Isocost=
Slope of Isoquant
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Optimal Input Substitution • A firm initially produces Q0
by employing the combination of inputs represented by point A at a cost of C0.
• Suppose w0 falls to w1.The isocost curve rotates counterclockwise; which represents the same cost level prior to the wage change.To produce the same level of output, Q0, the firm will produce on a lower isocost line (C1) at a point B.The slope of the new isocost line represents the lower wage relative to the rental rate of capital.
Q0
0
A
L
K
C0/w1C0/w0 C1/w1L0 L1
K0
K1B
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Cost Analysis
• Types of CostsFixed costs (FC)Variable costs (VC)Total costs (TC)Sunk costs
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Total and Variable Costs
C(Q): Minimum total cost of producing alternative levels of output:
C(Q) = VC(Q) + FC
VC(Q): Costs that vary with output.
FC: Costs that do not vary with output.
$
Q
C(Q) = VC + FC
VC(Q)
FC
0
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Fixed and Sunk Costs
FC: Costs that do not change as output changes.
Sunk Cost: A cost that is forever lost after it has been paid.
$
Q
FC
C(Q) = VC + FC
VC(Q)
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Some Definitions
Average Total CostATC = AVC + AFCATC = C(Q)/Q
Average Variable CostAVC = VC(Q)/Q
Average Fixed CostAFC = FC/Q
Marginal CostMC = ∆C/∆Q
$
Q
ATCAVC
AFC
MC
MR
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Fixed Cost
$
Q
ATC
AVC
MC
ATC
AVC
Q0
AFC Fixed Cost
Q0×(ATC-AVC)
= Q0× AFC
= Q0×(FC/ Q0)
= FC
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Variable Cost
$
Q
ATC
AVC
MC
AVCVariable Cost
Q0
Q0×AVC
= Q0×[VC(Q0)/ Q0]
= VC(Q0)
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
$
Q
ATC
AVC
MC
ATC
Total Cost
Q0
Q0×ATC
= Q0×[C(Q0)/ Q0]
= C(Q0)
Total Cost
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Cubic Cost Function
• C(Q) = f + a Q + b Q2 + cQ3
• Marginal Cost?Memorize:
MC(Q) = a + 2bQ + 3cQ2
Calculus:
dC/dQ = a + 2bQ + 3cQ2
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
An ExampleTotal Cost: C(Q) = 10 + Q + Q2
Variable cost function:VC(Q) = Q + Q2
Variable cost of producing 2 units:VC(2) = 2 + (2)2 = 6
Fixed costs:FC = 10
Marginal cost function:MC(Q) = 1 + 2Q
Marginal cost of producing 2 units:MC(2) = 1 + 2(2) = 5
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Economies of Scale
LRAC
$
Q
Economiesof Scale
Diseconomiesof Scale
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Multi-Product Cost Function
• C(Q1, Q2): Cost of jointly producing two outputs.
• General function form:
( ) 22
212121, cQbQQaQfQQC +++=
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Economies of Scope
• C(Q1, 0) + C(0, Q2) > C(Q1, Q2).It is cheaper to produce the two outputs jointly instead of separately.
• Example:It is cheaper for Time-Warner to produce Internet connections and Instant Messaging services jointly than separately.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Cost Complementarity
• The marginal cost of producing good 1 declines as more of good two is produced:
∆MC1(Q1,Q2) /∆Q2 < 0.
• Example:Cow hides and steaks.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Quadratic Multi-Product Cost Function
• C(Q1, Q2) = f + aQ1Q2 + (Q1 )2 + (Q2 )2
• MC1(Q1, Q2) = aQ2 + 2Q1
• MC2(Q1, Q2) = aQ1 + 2Q2
• Cost complementarity: a < 0• Economies of scope: f > aQ1Q2
C(Q1 ,0) + C(0, Q2 ) = f + (Q1 )2 + f + (Q2)2
C(Q1, Q2) = f + aQ1Q2 + (Q1 )2 + (Q2 )2
f > aQ1Q2: Joint production is cheaper
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
A Numerical Example:
• C(Q1, Q2) = 90 - 2Q1Q2 + (Q1 )2 + (Q2 )2
• Cost Complementarity?Yes, since a = -2 < 0MC1(Q1, Q2) = -2Q2 + 2Q1
• Economies of Scope?Yes, since 90 > -2Q1Q2
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Conclusion• To maximize profits (minimize costs) managers
must use inputs such that the value of marginal of each input reflects price the firm must pay to employ the input.
• The optimal mix of inputs is achieved when the MRTSKL = (w/r).
• Cost functions are the foundation for helping to determine profit-maximizing behavior in future chapters.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Managerial Economics & Business Strategy
Chapter 6The Organization of the Firm
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
OverviewI. Methods of Procuring Inputs
Spot Exchange Contracts Vertical Integration
II. Transaction CostsSpecialized Investments
III. Optimal Procurement InputIV. Principal-Agent Problem
Owners-ManagersManagers-Workers
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Manager’s Role• Procure inputs in the least
cost manner, like point B.• Provide incentives for
workers to put forth effort.• Failure to accomplish this
results in a point like A.• Achieving points like B
managers mustUse all inputs efficiently.Acquire inputs by the least costly method.
$10080
100Q
Costs
A
B
C(Q)
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Methods of Procuring Inputs
• Spot ExchangeWhen the buyer and seller of an input meet, exchange, and then go their separate ways.
• ContractsA legal document that creates an extended relationship between a buyer and a seller.
• Vertical IntegrationWhen a firm shuns other suppliers and chooses to produce an input internally.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Key Features• Spot Exchange
Specialization, avoids contracting costs, avoids costs of vertical integration.Possible “hold-up problem.”
• ContractingSpecialization, reduces opportunism, avoids skimping on specialized investments.Costly in complex environments.
• Vertical IntegrationReduces opportunism, avoids contracting costs.Lost specialization and may increase organizational costs.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Transaction Costs• Costs of acquiring an input over and above
the amount paid to the input supplier.• Includes:
Search costs.Negotiation costs.Other required investments or expenditures.
• Some transactions are general in nature while others are specific to a trading relationship.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Specialized Investments• Investments made to allow two parties to exchange
but has little or no value outside of the exchange relationship.
• Types of specialized investments:Site specificity.Physical-asset specificity.Dedicated assets.Human capital.
• Lead to higher transaction costsCostly bargaining.Underinvestment. Opportunism and the hold-up problem.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Specialized Investments and Contract Length
MB0
L0
$
Contract Length0 L1
MC
MB1
Longer Contract
Due to greater need for specialized investments
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Optimal Input Procurement
Substantial specialized investments relative to contracting costs?
Spot ExchangeNo
Complex contracting environment relative to costs of integration?
Yes
Vertical Integration
Yes
Contract
No
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
The Principal-Agent Problem• Occurs when the principal cannot observe the effort of
the agent.Example: Shareholders (principal) cannot observe the effort of the manager (agent).Example: Manager (principal) cannot observe the effort of workers (agents).
• The Problem: Principal cannot determine whether a bad outcome was the result of the agent’s low effort or due to bad luck.
• Manager’s must recognize the existence of the principal-agent problem and devise plans to align the interests of workers with that of the firm.
• Shareholders must create plans to align the interest of the manager with those of the shareholders.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Solving the Problem Between Owners and Managers
• Internal incentivesIncentive contracts.Stock options, year-end bonuses.
• External incentivesPersonal reputation.Potential for takeover.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Solving the Problem Between Managers and Workers
• Profit sharing• Revenue sharing• Piece rates• Time clocks and spot checks
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Conclusion
• The optimal method for acquiring inputs depends on the nature of the transactions costs and specialized nature of the inputs being procured.
• To overcome the principal-agent problem, principals must devise plans to align the agents’ interests with the principals.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc. , 2006
Managerial Economics & Business Strategy
Chapter 7The Nature of Industry
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc. , 2006
OverviewI. Market Structure
Measures of Industry Concentration
II. ConductPricing BehaviorIntegration and Merger Activity
III. PerformanceDansby-Willig IndexStructure-Conduct-Performance Paradigm
IV. Preview of Coming Attractions
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc. , 2006
Industry Analysis• Market Structure
Number of firms.Industry concentration.Technological and cost conditions.Demand conditions.Ease of entry and exit.
• ConductPricing.Advertising.R&D.Merger activity.
• PerformanceProfitability.Social welfare.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc. , 2006
Approaches to Studying Industry
• The Structure-Conduct-Performance (SCP) Paradigm: Causal View
Market Structure
Conduct Performance
• The Feedback CritiqueNo one-way causal link.Conduct can affect market structure.Market performance can affect conduct as well as market structure.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc. , 2006
Power ofInput Suppliers
•Supplier Concentration•Price/Productivity of Alternative Inputs•Relationship-Specific Investments•Supplier Switching Costs•Government Restraints
Power ofBuyers
•Buyer Concentration•Price/Value of Substitute Products or Services•Relationship-Specific Investments•Customer Switching Costs•Government Restraints
Entry•Entry Costs•Speed of Adjustment•Sunk Costs•Economies of Scale
•Network Effects•Reputation•Switching Costs•Government Restraints
Substitutes & Complements•Price/Value of Surrogate Products or Services•Price/Value of Complementary Products or Services
•Network Effects•Government Restraints
Industry Rivalry•Switching Costs•Timing of Decisions•Information•Government Restraints
•Concentration•Price, Quantity, Quality, or Service Competition•Degree of Differentiation
Level, Growth, and SustainabilityOf Industry Profits
Relating the Five Forces to the SCP Paradigm and the Feedback Critique
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc. , 2006
Industry Concentration
• Four-Firm Concentration RatioThe sum of the market shares of the top four firms in the defined industry. Letting Si denote sales for firm i and ST denote total industry sales
• Herfindahl-Hirschman Index (HHI)The sum of the squared market shares of firms in a given industry, multiplied by 10,000: HHI = 10,000 × Σ wi
2, where wi = Si/ST.
T
i
SSwwherewwwwC =+++= 143214 ,
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc. , 2006
Example
• There are five banks competing in a local market. Each of the five banks have a 20 percent market share.
• What is the four-firm concentration ratio?
• What is the HHI?
8.02.02.02.02.04 =+++=C
( ) ( ) ( ) ( ) ( )( ) 000,22.2.2.2.2.000,10 22222 =++++=HHI
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc. , 2006
Limitation of Concentration Measures
• Market Definition: National, regional, or local?• Global Market: Foreign producers excluded.• Industry definition and product classes.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc. , 2006
Measuring Demand and Market Conditions
• The Rothschild Index (R) measures the elasticity of industry demand for a product relative to that of an individual firm:
R = ET / EF .ET = elasticity of demand for the total market.EF = elasticity of demand for the product of an individual firm.The Rothschild Index is a value between 0 (perfect competition) and 1 (monopoly).
• When an industry is composed of many firms, each producing similar products, the Rothschild index will be close to zero.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc. , 2006
Own-Price Elasticities of Demand and Rothschild Indices
IndustryElasticityof MarketDemand
Elasticityof Firm’sDemand
RothschildIndex
Food -1.0 -3.8 0.26Tobacco -1.3 -1.3 1.00Textiles -1.5 -4.7 0.32Apparel -1.1 -4.1 0.27Paper -1.5 -1.7 0.88Chemicals -1.5 -1.5 1.00Rubber -1.8 -2.3 0.78
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc. , 2006
Market Entry and Exit Conditions
• Barriers to entryCapital requirements.Patents and copyrights.Economies of scale.Economies of scope.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc. , 2006
Conduct: Pricing Behavior• The Lerner Index
L = (P - MC) / PA measure of the difference between price and marginal cost as a fraction of the product’s price.The index ranges from 0 to 1.
• When P = MC, the Lerner Index is zero; the firm has no market power.
• A Lerner Index closer to 1 indicates relatively weak price competition; the firm has market power.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc. , 2006
Markup Factor
• From the Lerner Index, the firm can determine the factor by which it should over MC. Rearranging the Lerner Index
• The markup factor is 1/(1-L).When the Lerner Index is zero (L = 0), the markup factor is 1 and P = MC.When the Lerner Index is 0.20 (L = 0.20), the markup factor is 1.25 and the firm charges a price that is 1.25 times marginal cost.
MCL
P ⎟⎠⎞
⎜⎝⎛−
=1
1
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc. , 2006
Lerner Indices & Markup Factors
Industry Lerner Index Markup FactorFood 0.26 1.35Tobacco 0.76 4.17Textiles 0.21 1.27Apparel 0.24 1.32Paper 0.58 2.38Chemicals 0.67 3.03Petroleum 0.59 2.44
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc. , 2006
Integration and Merger Activity
• Vertical IntegrationWhere various stages in the production of a single product are carried out by one firm.
• Horizontal IntegrationThe merging of the production of similar products into a single firm.
• Conglomerate MergersThe integration of different product lines into a single firm.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc. , 2006
DOJ/FTC Horizontal Merger Guidelines
• Based on HHI = 10,000 Σ wi2, where
wi = Si /ST.• Merger may be challenged if
• HHI exceeds 1800, or would be after merger, and• Merger increases the HHI by more than 100.
• But...Recognizes efficiencies: “The primary benefit of mergers to the economy is their efficiency potential...which can result in lower prices to consumers...In the majority of cases the Guidelines will allow firms to achieve efficiencies through mergers without interference...”
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc. , 2006
Performance
• Performance refers to the profits and social welfare that result in a given industry.
• Social Welfare = CS + PSDansby-Willig Performance Index measure by how much social welfare would improve if firms in an industry expanded output in a socially efficient manner.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc. , 2006
Dansby-WilligPerformance IndexIndustry Dansby-Willig Index
Food 0.51Textiles 0.38Apparel 0.47Paper 0.63Chemicals 0.67Petroleum 0.63Rubber 0.49
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc. , 2006
Preview of Coming Attractions
• Discussion of optimal managerial decisions under various market structures, including:
Perfect competitionMonopolyMonopolistic competitionOligopoly
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc. , 2006
Conclusion• Modern approach to studying industries involves
examining the interrelationship between structure, conduct, and performance.
• Industries dramatically vary with respect to concentration levels.
The four-firm concentration ratio and Herfindahl-Hirschman index measure industry concentration.
• The Lerner index measures the degree to which firms can markup price above marginal cost; it is a measure of a firm’s market power.
• Industry performance is measured by industry profitability and social welfare.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Managerial Economics & Business Strategy
Chapter 8Managing in Competitive, Monopolistic,
and Monopolistically Competitive Markets
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
OverviewI. Perfect Competition
Characteristics and profit outlook.Effect of new entrants.
II. MonopoliesSources of monopoly power.Maximizing monopoly profits.Pros and cons.
III. Monopolistic CompetitionProfit maximization.Long run equilibrium.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Perfect Competition Environment
• Many buyers and sellers.• Homogeneous (identical) product.• Perfect information on both sides of market.• No transaction costs.• Free entry and exit.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Key Implications
• Firms are “price takers” (P = MR).• In the short-run, firms may earn profits or
losses.• Long-run profits are zero.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Unrealistic? Why Learn?• Many small businesses are “price-takers,” and decision
rules for such firms are similar to those of perfectly competitive firms.
• It is a useful benchmark.• Explains why governments oppose monopolies.• Illuminates the “danger” to managers of competitive
environments.Importance of product differentiation.Sustainable advantage.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Managing a Perfectly Competitive Firm
(or Price-Taking Business)
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Setting Price
FirmQf
$
Df
MarketQM
$
D
S
Pe
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Profit-Maximizing Output Decision
• MR = MC.• Since, MR = P, • Set P = MC to maximize profits.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Graphically: Representative Firm’s Output Decision
$
Qf
ATC
AVC
MC
Pe = Df = MR
Qf*
ATC
Pe
Profit = (Pe - ATC) × Qf*
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
A Numerical Example• Given
P=$10C(Q) = 5 + Q2
• Optimal Price?P=$10
• Optimal Output?MR = P = $10 and MC = 2Q10 = 2QQ = 5 units
• Maximum Profits?PQ - C(Q) = (10)(5) - (5 + 25) = $20
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
$
Qf
ATC
AVC
MC
Pe = Df = MR
Qf*
ATCPe
Profit = (Pe - ATC) × Qf* < 0
Should this Firm Sustain Short Run Losses or Shut Down?
Loss
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Shutdown Decision Rule
• A profit-maximizing firm should continue to operate (sustain short-run losses) if its operating loss is less than its fixed costs.
Operating results in a smaller loss than ceasing operations.
• Decision rule:A firm should shutdown when P < min AVC.Continue operating as long as P ≥ min AVC.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
$
Qf
ATC
AVC
MC
Qf*
P min AVC
Firm’s Short-Run Supply Curve: MC Above Min AVC
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Short-Run Market Supply Curve
• The market supply curve is the summation of each individual firm’s supply at each price.
Firm 1 Firm 2
5
10 20 30
Market
Q Q Q
PP P
15
18 25 43
S1 S2
SM
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Long Run Adjustments?
• If firms are price takers but there are barriers to entry, profits will persist.
• If the industry is perfectly competitive, firms are not only price takers but there is free entry.
Other “greedy capitalists” enter the market.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Effect of Entry on Price?
FirmQf
$
Df
MarketQM
$
D
S
Pe
S*
Pe* Df*
Entry
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Effect of Entry on the Firm’s Output and Profits?
$
Q
ACMC
Pe Df
Pe* Df*
Qf*QL
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Summary of Logic• Short run profits leads to entry.• Entry increases market supply, drives down
the market price, increases the market quantity.
• Demand for individual firm’s product shifts down.
• Firm reduces output to maximize profit.• Long run profits are zero.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Features of Long Run Competitive Equilibrium
• P = MCSocially efficient output.
• P = minimum ACEfficient plant size.Zero profits • Firms are earning just enough to offset their opportunity
cost.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Monopoly Environment
• Single firm serves the “relevant market.”• Most monopolies are “local” monopolies.• The demand for the firm’s product is the
market demand curve.• Firm has control over price.
But the price charged affects the quantity demanded of the monopolist’s product.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
“Natural” Sources ofMonopoly Power
• Economies of scale• Economies of scope• Cost complementarities
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
“Created” Sources of Monopoly Power
• Patents and other legal barriers (like licenses)
• Tying contracts• Exclusive contracts• Collusion
Contract...I.
II.
III.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Managing a Monopoly
• Market power permits you to price above MC
• Is the sky the limit?• No. How much you sell
depends on the price you set!
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
A Monopolist’s Marginal Revenue
PTR
100
0 010 20 30 40 50 10 20 30 40 50
800
60 1200
40
20
Inelastic
Elastic
Elastic Inelastic
Unit elastic
Unit elastic
MR
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Monopoly Profit Maximization
$
Q
ATCMC
D
MRQM
PM
Profit
ATC
Produce where MR = MC.Charge the price on the demand curve that corresponds to that quantity.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Useful Formulae
• What’s the MR if a firm faces a linear demand curve for its product?
• Alternatively,
bQaP +=
.0,2 <+= bwherebQaMR
⎥⎦⎤
⎢⎣⎡ +
=E
EPMR 1
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
A Numerical Example• Given estimates of
• P = 10 - Q• C(Q) = 6 + 2Q
• Optimal output?• MR = 10 - 2Q• MC = 2• 10 - 2Q = 2• Q = 4 units
• Optimal price?• P = 10 - (4) = $6
• Maximum profits?• PQ - C(Q) = (6)(4) - (6 + 8) = $10
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Long Run Adjustments?
• None, unless the source of monopoly power is eliminated.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Why Government Dislikes Monopoly?
• P > MCToo little output, at too high a price.
• Deadweight loss of monopoly.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
$
Q
ATCMC
D
MRQM
PM
MC
Deadweight Loss of Monopoly
Deadweight Loss of Monopoly
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Arguments for Monopoly
• The beneficial effects of economies of scale, economies of scope, and cost complementarities on price and output may outweigh the negative effects of market power.
• Encourages innovation.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Monopoly Multi-Plant Decisions
• Consider a monopoly that produces identical output at two production facilities (think of a firm that generates and distributes electricity from two facilities).
Let C1(Q2) be the production cost at facility 1.Let C2(Q2) be the production cost at facility 2.
• Decision Rule: Produce output whereMR(Q) = MC1(Q1) and MR(Q) = MC2(Q2)
Set price equal to P(Q), where Q = Q1 + Q2.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Monopolistic Competition: Environment and Implications
• Numerous buyers and sellers• Differentiated products
Implication: Since products are differentiated, each firm faces a downward sloping demand curve.
• Consumers view differentiated products as close substitutes: there exists some willingness to substitute.
• Free entry and exitImplication: Firms will earn zero profits in the long run.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Managing a Monopolistically Competitive Firm
• Like a monopoly, monopolistically competitive firms
have market power that permits pricing above marginal cost.level of sales depends on the price it sets.
• But …The presence of other brands in the market makes the demand for your brand more elastic than if you were a monopolist. Free entry and exit impacts profitability.
• Therefore, monopolistically competitive firms have limited market power.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Marginal Revenue Like a Monopolist
PTR
100
0 010 20 30 40 50 10 20 30 40 50
800
60 1200
40
20
Inelastic
Elastic
Elastic Inelastic
Unit elastic
Unit elastic
MR
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Monopolistic Competition: Profit Maximization
• Maximize profits like a monopolistProduce output where MR = MC.Charge the price on the demand curve that corresponds to that quantity.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Short-Run Monopolistic Competition
$ATC
MC
D
MRQM
PM
Profit
ATC
Quantity of Brand X
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Long Run Adjustments?
• If the industry is truly monopolistically competitive, there is free entry.
In this case other “greedy capitalists” enter, and their new brands steal market share. This reduces the demand for your product until profits are ultimately zero.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
$AC
MC
D
MR
Q*
P*
Quantity of Brand XMR1
D1
Entry
P1
Q1
Long Run Equilibrium(P = AC, so zero profits)
Long-Run Monopolistic Competition
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Monopolistic Competition
The Good (To Consumers)Product Variety
The Bad (To Society)P > MCExcess capacity
• Unexploited economies of scale
The Ugly (To Managers)P = ATC > minimum of average costs.
• Zero Profits (in the long run)!
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Optimal Advertising Decisions
• Advertising is one way for firms with market power to differentiate their products.
• But, how much should a firm spend on advertising?Advertise to the point where the additional revenue generated from advertising equals the additional cost of advertising.Equivalently, the profit-maximizing level of advertising occurs where the advertising-to-sales ratio equals the ratio of the advertising elasticity of demand to the own-price elasticity of demand.
PQ
AQ
EE
RA
,
,
−=
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Maximizing Profits: A Synthesizing Example
• C(Q) = 125 + 4Q2
• Determine the profit-maximizing output and price, and discuss its implications, if
You are a price taker and other firms charge $40 per unit;You are a monopolist and the inverse demand for your product is P = 100 - Q;You are a monopolistically competitive firm and the inverse demand for your brand is P = 100 – Q.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Marginal Cost
• C(Q) = 125 + 4Q2,• So MC = 8Q.• This is independent of market structure.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Price Taker• MR = P = $40.• Set MR = MC.
• 40 = 8Q.• Q = 5 units.
• Cost of producing 5 units.• C(Q) = 125 + 4Q2 = 125 + 100 = $225.
• Revenues:• PQ = (40)(5) = $200.
• Maximum profits of -$25.• Implications: Expect exit in the long-run.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Monopoly/Monopolistic Competition• MR = 100 - 2Q (since P = 100 - Q).• Set MR = MC, or 100 - 2Q = 8Q.
Optimal output: Q = 10.Optimal price: P = 100 - (10) = $90.Maximal profits:
• PQ - C(Q) = (90)(10) -(125 + 4(100)) = $375.
• ImplicationsMonopolist will not face entry (unless patent or other entry barriers are eliminated).Monopolistically competitive firm should expect other firms to clone, so profits will decline over time.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Conclusion
• Firms operating in a perfectly competitive market take the market price as given.
Produce output where P = MC.Firms may earn profits or losses in the short run.… but, in the long run, entry or exit forces profits to zero.
• A monopoly firm, in contrast, can earn persistent profits provided that source of monopoly power is not eliminated.
• A monopolistically competitive firm can earn profits in the short run, but entry by competing brands will erode these profits over time.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Managerial Economics & Business Strategy
Chapter 9Basic Oligopoly Models
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
OverviewI. Conditions for Oligopoly?II. Role of Strategic InterdependenceIII. Profit Maximization in Four Oligopoly
SettingsSweezy (Kinked-Demand) ModelCournot ModelStackelberg Model Bertrand Model
IV. Contestable Markets
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Oligopoly Environment
• Relatively few firms, usually less than 10.Duopoly - two firmsTriopoly - three firms
• The products firms offer can be either differentiated or homogeneous.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Role of Strategic Interaction
• Your actions affect the profits of your rivals.
• Your rivals’ actions affect your profits.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
An Example
• You and another firm sell differentiated products.
• How does the quantity demanded for your product change when you change your price?
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
P
Q
D1 (Rival holds itsprice constant)
P0
PL
D2 (Rival matches your price change)
PH
Q0 QL2 QL1QH1 QH2
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
P
Q
D1
P0
Q0
D2 (Rival matches your price change)
(Rival holds itsprice constant)
D
Demand if Rivals Match Price Reductions but not Price Increases
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Key Insight• The effect of a price reduction on the quantity
demanded of your product depends upon whether your rivals respond by cutting their prices too!
• The effect of a price increase on the quantity demanded of your product depends upon whether your rivals respond by raising their prices too!
• Strategic interdependence: You aren’t in complete control of your own destiny!
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Sweezy (Kinked-Demand) Model
• Few firms in the market serving many consumers.• Firms produce differentiated products.• Barriers to entry.• Each firm believes rivals will match (or follow)
price reductions, but won’t match (or follow) price increases.
• Key feature of Sweezy ModelPrice-Rigidity.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Sweezy Demand and Marginal Revenue
P
Q
P0
Q0
D1(Rival holds itsprice constant)
MR1
D2 (Rival matches your price change)
MR2
DS: Sweezy Demand
MRS: Sweezy MR
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Sweezy Profit-Maximizing Decision
P
Q
P0
Q0
DS: Sweezy DemandMRS
MC1MC2
MC3
D2 (Rival matches your price change)
D1 (Rival holds price constant)
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Sweezy Oligopoly Summary
• Firms believe rivals match price cuts, but not price increases.
• Firms operating in a Sweezy oligopoly maximize profit by producing where
MRS = MC.The kinked-shaped marginal revenue curve implies that there exists a range over which changes in MC will not impact the profit-maximizing level of output.Therefore, the firm may have no incentive to change price provided that marginal cost remains in a given range.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Cournot Model• A few firms produce goods that are either
perfect substitutes (homogeneous) or imperfect substitutes (differentiated).
• Firms set output, as opposed to price.• Each firm believes their rivals will hold output
constant if it changes its own output (The output of rivals is viewed as given or “fixed”).
• Barriers to entry exist.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Inverse Demand in a Cournot Duopoly
• Market demand in a homogeneous-product Cournot duopoly is
• Thus, each firm’s marginal revenue depends on the output produced by the other firm. More formally,
212 2bQbQaMR −−=
121 2bQbQaMR −−=
( )21 QQbaP +−=
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Best-Response Function
• Since a firm’s marginal revenue in a homogeneous Cournot oligopoly depends on both its output and its rivals, each firm needs a way to “respond” to rival’s output decisions.
• Firm 1’s best-response (or reaction) function is a schedule summarizing the amount of Q1 firm 1 should produce in order to maximize its profits for each quantity of Q2 produced by firm 2.
• Since the products are substitutes, an increase in firm 2’s output leads to a decrease in the profit-maximizing amount of firm 1’s product.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Best-Response Function for a Cournot Duopoly
• To find a firm’s best-response function, equate its marginal revenue to marginal cost and solve for its output as a function of its rival’s output.
• Firm 1’s best-response function is (c1 is firm 1’s MC)
• Firm 2’s best-response function is (c2 is firm 2’s MC)
( ) 21
211 21
2Q
bcaQrQ −
−==
( ) 12
122 21
2Q
bcaQrQ −
−==
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Graph of Firm 1’s Best-Response Function
Q2
Q1
(Firm 1’s Reaction Function)
Q1M
Q2
Q1
r1
(a-c1)/b Q1 = r1(Q2) = (a-c1)/2b - 0.5Q2
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Cournot Equilibrium
• Situation where each firm produces the output that maximizes its profits, given the the output of rival firms.
• No firm can gain by unilaterally changing its own output to improve its profit.
A point where the two firm’s best-response functions intersect.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Graph of Cournot Equilibrium
Q2*
Q1*
Q2
Q1
Q1M
r1
r2
Q2M
Cournot Equilibrium
(a-c1)/b
(a-c2)/b
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Summary of Cournot Equilibrium
• The output Q1* maximizes firm 1’s profits,
given that firm 2 produces Q2*.
• The output Q2* maximizes firm 2’s profits,
given that firm 1 produces Q1*.
• Neither firm has an incentive to change its output, given the output of the rival.
• Beliefs are consistent: In equilibrium, each firm “thinks” rivals will stick to their current output – and they do!
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Firm 1’s Isoprofit Curve
• The combinations of outputs of the two firms that yield firm 1 the same level of profit
Q1Q1
M
r1
π1 = $100
π1 = $200
Increasing Profits for
Firm 1D
Q2
A
BC
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Another Look at Cournot Decisions
Q2
Q1Q1
M
r1
Q2*
Q1*
Firm 1’s best response to Q2*
π 1 = $100
π 1 = $200
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Another Look at Cournot Equilibrium
Q2
Q1Q1
M
r1
Q2*
Q1*
Firm 1’s Profits
Firm 2’s Profits
r2
Q2M Cournot Equilibrium
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Impact of Rising Costs on the Cournot Equilibrium
Q2
Q1
r1**
r2
r1*
Q1*
Q2*
Q2**
Q1**
Cournot equilibrium prior to firm 1’s marginal cost increase
Cournot equilibrium afterfirm 1’s marginal cost increase
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Collusion Incentives in Cournot Oligopoly
Q2
Q1
r1
Q2M
Q1M
r2
Cournot2π
Cournot1π
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Stackelberg Model• Firms produce differentiated or homogeneous
products.• Barriers to entry.• Firm one is the leader.
The leader commits to an output before all other firms.
• Remaining firms are followers.They choose their outputs so as to maximize profits, given the leader’s output.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Stackelberg Equilibrium
Q1Q1
M
r1
Q2C
Q1C
r2
Q2
Q1S
Q2S
Follower’s Profits Decline
Stackelberg Equilibrium
πLS
π1C
πFS
π2C
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Stackelberg Summary• Stackelberg model illustrates how
commitment can enhance profits in strategic environments.
• Leader produces more than the Cournot equilibrium output.
Larger market share, higher profits.First-mover advantage.
• Follower produces less than the Cournot equilibrium output.
Smaller market share, lower profits.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Bertrand Model• Few firms that sell to many consumers.• Firms produce identical products at constant marginal
cost.• Each firm independently sets its price in order to
maximize profits.• Barriers to entry.• Consumers enjoy
Perfect information. Zero transaction costs.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Bertrand Equilibrium• Firms set P1 = P2 = MC! Why?• Suppose MC < P1 < P2.• Firm 1 earns (P1 - MC) on each unit sold, while
firm 2 earns nothing.• Firm 2 has an incentive to slightly undercut firm
1’s price to capture the entire market.• Firm 1 then has an incentive to undercut firm 2’s
price. This undercutting continues...• Equilibrium: Each firm charges P1 = P2 = MC.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Contestable Markets• Key Assumptions
Producers have access to same technology.Consumers respond quickly to price changes.Existing firms cannot respond quickly to entry by lowering price.Absence of sunk costs.
• Key ImplicationsThreat of entry disciplines firms already in the market.Incumbents have no market power, even if there is only a single incumbent (a monopolist).
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Conclusion• Different oligopoly scenarios give rise to
different optimal strategies and different outcomes.
• Your optimal price and output depends on …Beliefs about the reactions of rivals.Your choice variable (P or Q) and the nature of the product market (differentiated or homogeneous products).Your ability to credibly commit prior to your rivals.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Managerial Economics & Business Strategy
Chapter 10Game Theory: Inside Oligopoly
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Overview
I. Introduction to Game TheoryII. Simultaneous-Move, One-Shot GamesIII. Infinitely Repeated GamesIV. Finitely Repeated GamesV. Multistage Games
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Normal Form Game
• A Normal Form Game consists of:Players.Strategies or feasible actions.Payoffs.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
A Normal Form Game
Strategy A B Cabc
Player 2
Play
er 1 12,11 11,12 14,13
11,10 10,11 12,1210,15 10,13 13,14
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Normal Form Game:Scenario Analysis
• Suppose 1 thinks 2 will choose “A”.
Strategy A B Cabc
Player 2
Play
er 1 12,11 11,12 14,13
11,10 10,11 12,1210,15 10,13 13,14
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Normal Form Game:Scenario Analysis
• Then 1 should choose “a”. Player 1’s best response to “A” is “a”.
Strategy A B Cabc
Player 2
Play
er 1 12,11 11,12 14,13
11,10 10,11 12,1210,15 10,13 13,14
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Normal Form Game:Scenario Analysis
• Suppose 1 thinks 2 will choose “B”.
Strategy A B Cabc
Player 2
Play
er 1 12,11 11,12 14,13
11,10 10,11 12,1210,15 10,13 13,14
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Normal Form Game:Scenario Analysis
• Then 1 should choose “a”.Player 1’s best response to “B” is “a”.
Strategy A B Cabc
Player 2
Play
er 1 12,11 11,12 14,13
11,10 10,11 12,1210,15 10,13 13,14
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Normal Form GameScenario Analysis
• Similarly, if 1 thinks 2 will choose C…Player 1’s best response to “C” is “a”.
Strategy A B Cabc
Player 2
Play
er 1 12,11 11,12 14,13
11,10 10,11 12,1210,15 10,13 13,14
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Dominant Strategy• Regardless of whether Player 2 chooses A, B, or
C, Player 1 is better off choosing “a”!• “a” is Player 1’s Dominant Strategy!
Strategy A B Cabc
Player 2
Play
er 1 12,11 11,12 14,13
11,10 10,11 12,1210,15 10,13 13,14
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Putting Yourself in your Rival’s Shoes
• What should player 2 do?2 has no dominant strategy!But 2 should reason that 1 will play “a”.Therefore 2 should choose “C”.
Strategy A B Cabc
Player 2
Play
er 1 12,11 11,12 14,13
11,10 10,11 12,1210,15 10,13 13,14
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
The Outcome
• This outcome is called a Nash equilibrium:“a” is player 1’s best response to “C”.“C” is player 2’s best response to “a”.
Strategy A B Cabc
Player 2
Play
er 1 12,11 11,12 14,13
11,10 10,11 12,1210,15 10,13 13,14
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Key Insights
• Look for dominant strategies.• Put yourself in your rival’s shoes.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
A Market-Share Game
• Two managers want to maximize market share.
• Strategies are pricing decisions.• Simultaneous moves.• One-shot game.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
The Market-Share Game in Normal Form
Strategy P=$10 P=$5 P = $1P=$10 .5, .5 .2, .8 .1, .9P=$5 .8, .2 .5, .5 .2, .8P=$1 .9, .1 .8, .2 .5, .5
Manager 2
Man
ager
1
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Market-Share Game Equilibrium
Strategy P=$10 P=$5 P = $1P=$10 .5, .5 .2, .8 .1, .9P=$5 .8, .2 .5, .5 .2, .8P=$1 .9, .1 .8, .2 .5, .5
Manager 2
Man
ager
1
Nash Equilibrium
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Key Insight:
• Game theory can be used to analyze situations where “payoffs” are non monetary!
• We will, without loss of generality, focus on environments where businesses want to maximize profits.
Hence, payoffs are measured in monetary units.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Examples of Coordination Games
• Industry standardssize of floppy disks.size of CDs.
• National standardselectric current.traffic laws.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
A Coordination Game in Normal Form
Strategy A B C1 0,0 0,0 $10,$102 $10,$10 0,0 0,03 0,0 $10,$10 0,0
Player 2
Play
er 1
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
A Coordination Problem: Three Nash Equilibria!
Strategy A B C1 0,0 0,0 $10,$102 $10,$10 0,0 0,03 0,0 $10, $10 0,0
Player 2
Play
er 1
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Key Insights:
• Not all games are games of conflict. • Communication can help solve coordination
problems.• Sequential moves can help solve coordination
problems.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
An Advertising Game
• Two firms (Kellogg’s & General Mills) managers want to maximize profits.
• Strategies consist of advertising campaigns.• Simultaneous moves.
One-shot interaction.Repeated interaction.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
A One-Shot Advertising Game
Strategy None Moderate HighNone 12,12 1, 20 -1, 15
Moderate 20, 1 6, 6 0, 9High 15, -1 9, 0 2, 2
General Mills
Kel
logg
’s
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Equilibrium to the One-Shot Advertising Game
Strategy None Moderate HighNone 12,12 1, 20 -1, 15
Moderate 20, 1 6, 6 0, 9High 15, -1 9, 0 2, 2
General Mills
Kel
logg
’s
Nash Equilibrium
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Can collusion work if the game is repeated 2 times?
Strategy None Moderate HighNone 12,12 1, 20 -1, 15
Moderate 20, 1 6, 6 0, 9High 15, -1 9, 0 2, 2
General Mills
Kel
logg
’s
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
No (by backwards induction).• In period 2, the game is a one-shot game, so
equilibrium entails High Advertising in the last period.
• This means period 1 is “really” the last period, since everyone knows what will happen in period 2.
• Equilibrium entails High Advertising by each firm in both periods.
• The same holds true if we repeat the game any known, finite number of times.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Can collusion work if firms play the game each year, forever?
• Consider the following “trigger strategy”by each firm:
“Don’t advertise, provided the rival has not advertised in the past. If the rival ever advertises, “punish” it by engaging in a high level of advertising forever after.”
• In effect, each firm agrees to “cooperate”so long as the rival hasn’t “cheated” in the past. “Cheating” triggers punishment in all future periods.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Suppose General Mills adopts this trigger strategy. Kellogg’s profits?
ΠCooperate = 12 +12/(1+i) + 12/(1+i)2 + 12/(1+i)3 + …= 12 + 12/i
Strategy None Moderate HighNone 12,12 1, 20 -1, 15
Moderate 20, 1 6, 6 0, 9High 15, -1 9, 0 2, 2
General Mills
Kel
logg
’s
Value of a perpetuity of $12 paidat the end of every year
ΠCheat = 20 +2/(1+i) + 2/(1+i)2 + 2/(1+i)3 + …= 20 + 2/i
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Kellogg’s Gain to Cheating:• ΠCheat - ΠCooperate = 20 + 2/i - (12 + 12/i) = 8 - 10/i
Suppose i = .05
• ΠCheat - ΠCooperate = 8 - 10/.05 = 8 - 200 = -192• It doesn’t pay to deviate.
Collusion is a Nash equilibrium in the infinitely repeated game!
Strategy None Moderate HighNone 12,12 1, 20 -1, 15
Moderate 20, 1 6, 6 0, 9High 15, -1 9, 0 2, 2
General Mills
Kel
logg
’s
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Benefits & Costs of Cheating• ΠCheat - ΠCooperate = 8 - 10/i
8 = Immediate Benefit (20 - 12 today)10/i = PV of Future Cost (12 - 2 forever after)
• If Immediate Benefit - PV of Future Cost > 0Pays to “cheat”.
• If Immediate Benefit - PV of Future Cost ≤ 0Doesn’t pay to “cheat”.
Strategy None Moderate HighNone 12,12 1, 20 -1, 15
Moderate 20, 1 6, 6 0, 9High 15, -1 9, 0 2, 2
General Mills
Kel
logg
’s
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Key Insight
• Collusion can be sustained as a Nash equilibrium when there is no certain “end”to a game.
• Doing so requires:Ability to monitor actions of rivals.Ability (and reputation for) punishing defectors.Low interest rate.High probability of future interaction.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Real World Examples of Collusion
• Garbage Collection Industry• OPEC• NASDAQ• Airlines
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Normal Form Bertrand Game
Strategy Low Price High PriceLow Price 0,0 20,-1High Price -1, 20 15, 15
Firm 1
Firm 2
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
One-Shot Bertrand (Nash) Equilibrium
Strategy Low Price High PriceLow Price 0,0 20,-1High Price -1, 20 15, 15
Firm 1
Firm 2
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Potential Repeated Game Equilibrium Outcome
Strategy Low Price High PriceLow Price 0,0 20,-1High Price -1, 20 15, 15
Firm 1
Firm 2
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Simultaneous-Move Bargaining• Management and a union are negotiating a wage
increase.• Strategies are wage offers & wage demands.• Successful negotiations lead to $600 million in surplus,
which must be split among the parties.• Failure to reach an agreement results in a loss to the
firm of $100 million and a union loss of $3 million.• Simultaneous moves, and time permits only one-shot at
making a deal.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
The Bargaining Gamein Normal Form
Strategy W = $10 W = $5 W = $1W = $10 100, 500 -100, -3 -100, -3W=$5 -100, -3 300, 300 -100, -3W=$1 -100, -3 -100, -3 500, 100
Union
Man
agem
ent
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Three Nash Equilibria!
Strategy W = $10 W = $5 W = $1W = $10 100, 500 -100, -3 -100, -3W=$5 -100, -3 300, 300 -100, -3W=$1 -100, -3 -100, -3 500, 100
Union
Man
agem
ent
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Fairness: The “Natural” Focal Point
Strategy W = $10 W = $5 W = $1W = $10 100, 500 -100, -3 -100, -3W=$5 -100, -3 300, 300 -100, -3W=$1 -100, -3 -100, -3 500, 100
Union
Man
agem
ent
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Lessons in Simultaneous Bargaining
• Simultaneous-move bargaining results in a coordination problem.
• Experiments suggests that, in the absence of any “history,” real players typically coordinate on the “fair outcome.”
• When there is a “bargaining history,” other outcomes may prevail.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Single Offer Bargaining
• Now suppose the game is sequential in nature, and management gets to make the union a “take-it-or-leave-it” offer.
• Analysis Tool: Write the game in extensive form
Summarize the players. Their potential actions. Their information at each decision point. Sequence of moves.Each player’s payoff.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Firm
10
5
1
Step 1: Management’s Move
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Firm
10
5
1
Union
Union
Union
Accept
Reject
Accept
Accept
Reject
Reject
Step 2: Add the Union’s Move
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Firm
10
5
1
Union
Union
Union
Accept
Reject
Accept
Accept
Reject
Reject
Step 3: Add the Payoffs
100, 500
-100, -3
300, 300
-100, -3
500, 100
-100, -3
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Firm
10
5
1
Union
Union
Union
Accept
Reject
Accept
Accept
Reject
Reject
The Game in Extensive Form
100, 500
-100, -3
300, 300
-100, -3
500, 100
-100, -3
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Step 4: Identify the Firm’s Feasible Strategies
• Management has one information set and thus three feasible strategies:
Offer $10.Offer $5.Offer $1.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Step 5: Identify the Union’s Feasible Strategies
• The Union has three information set and thus eight feasible strategies:
Accept $10, Accept $5, Accept $1Accept $10, Accept $5, Reject $1Accept $10, Reject $5, Accept $1Accept $10, Reject $5, Reject $1 Reject $10, Accept $5, Accept $1Reject $10, Accept $5, Reject $1Reject $10, Reject $5, Accept $1Reject $10, Reject $5, Reject $1
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Step 6: Identify Nash Equilibrium Outcomes
• Outcomes such that neither the firm nor the union has an incentive to change its strategy, given the strategy of the other.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Finding Nash Equilibrium Outcomes
Accept $10, Accept $5, Accept $1Accept $10, Accept $5, Reject $1Accept $10, Reject $5, Accept $1Reject $10, Accept $5, Accept $1Accept $10, Reject $5, Reject $1Reject $10, Accept $5, Reject $1Reject $10, Reject $5, Accept $1Reject $10, Reject $5, Reject $1
Union's Strategy Firm's Best Response
Mutual Best Response?
$1 Yes$5$1$1$10
YesYesYesYes
$5 Yes$1
NoYes
$10, $5, $1
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Step 7: Find the Subgame Perfect Nash Equilibrium
Outcomes• Outcomes where no player has an incentive
to change its strategy, given the strategy of the rival, and
• The outcomes are based on “credible actions;” that is, they are not the result of “empty threats” by the rival.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Checking for Credible Actions
Accept $10, Accept $5, Accept $1Accept $10, Accept $5, Reject $1Accept $10, Reject $5, Accept $1Reject $10, Accept $5, Accept $1Accept $10, Reject $5, Reject $1Reject $10, Accept $5, Reject $1Reject $10, Reject $5, Accept $1Reject $10, Reject $5, Reject $1
Union's StrategyAre all Actions
Credible?YesNoNoNoNoNoNoNo
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
The “Credible” Union Strategy
Accept $10, Accept $5, Accept $1Accept $10, Accept $5, Reject $1Accept $10, Reject $5, Accept $1Reject $10, Accept $5, Accept $1Accept $10, Reject $5, Reject $1Reject $10, Accept $5, Reject $1Reject $10, Reject $5, Accept $1Reject $10, Reject $5, Reject $1
Union's StrategyAre all Actions
Credible?YesNoNoNoNoNoNoNo
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Finding Subgame Perfect Nash Equilibrium Strategies
Accept $10, Accept $5, Accept $1Accept $10, Accept $5, Reject $1Accept $10, Reject $5, Accept $1Reject $10, Accept $5, Accept $1Accept $10, Reject $5, Reject $1Reject $10, Accept $5, Reject $1Reject $10, Reject $5, Accept $1Reject $10, Reject $5, Reject $1
Union's Strategy Firm's Best Response
Mutual Best Response?
$1 Yes$5$1$1$10
YesYesYesYes
$5 Yes$1
NoYes
$10, $5, $1
Nash and Credible Nash Only Neither Nash Nor Credible
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
To Summarize:
• We have identified many combinations of Nash equilibrium strategies.
• In all but one the union does something that isn’t in its self interest (and thus entail threats that are not credible).
• Graphically:
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Firm
10
5
1
Union
Union
Union
Accept
Reject
Accept
Accept
Reject
Reject
There are 3 Nash Equilibrium Outcomes!
100, 500
-100, -3
300, 300
-100, -3
500, 100
-100, -3
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Firm
10
5
1
Union
Union
Union
Accept
Reject
Accept
Accept
Reject
Reject
Only 1 Subgame-Perfect Nash Equilibrium Outcome!
100, 500
-100, -3
300, 300
-100, -3
500, 100
-100, -3
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Bargaining Re-Cap
• In take-it-or-leave-it bargaining, there is a first-mover advantage.
• Management can gain by making a take-it-or-leave-it offer to the union. But...
• Management should be careful; real world evidence suggests that people sometimes reject offers on the the basis of “principle”instead of cash considerations.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Pricing to Prevent Entry: An Application of Game Theory
• Two firms: an incumbent and potential entrant.• Potential entrant’s strategies:
Enter.Stay Out.
• Incumbent’s strategies: {if enter, play hard}.{if enter, play soft}.{if stay out, play hard}.{if stay out, play soft}.
• Move Sequence: Entrant moves first. Incumbent observes entrant’s action and selects an action.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
The Pricing to Prevent EntryGame in Extensive Form
EntrantOut
Enter
Incumbent
Hard
Soft
-1, 1
5, 5
0, 10
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Identify Nash and SubgamePerfect Equilibria
EntrantOut
Enter
Incumbent
Hard
Soft
-1, 1
5, 5
0, 10
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Two Nash Equilibria
EntrantOut
Enter
Incumbent
Hard
Soft
-1, 1
5, 5
0, 10
Nash Equilibria Strategies {player 1; player 2}:{enter; If enter, play soft}{stay out; If enter, play hard}
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
One Subgame Perfect Equilibrium
EntrantOut
Enter
Incumbent
Hard
Soft
-1, 1
5, 5
0, 10
Subgame Perfect Equilibrium Strategy:{enter; If enter, play soft}
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Insights
• Establishing a reputation for being unkind to entrants can enhance long-term profits.
• It is costly to do so in the short-term, so much so that it isn’t optimal to do so in a one-shot game.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Managerial Economics & Business Strategy
Chapter 11Pricing Strategies for Firms with
Market Power
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
OverviewI. Basic Pricing Strategies
Monopoly & Monopolistic Competition Cournot Oligopoly
II. Extracting Consumer SurplusPrice Discrimination Two-Part PricingBlock Pricing Commodity Bundling
III. Pricing for Special Cost and Demand StructuresPeak-Load Pricing Price MatchingCross Subsidies Brand LoyaltyTransfer Pricing Randomized Pricing
IV. Pricing in Markets with Intense Price Competition
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Standard Pricing and Profits for Firms with Market Power
Price
Quantity
P = 10 - 2Q
10
8
6
4
2
1 2 3 4 5
MC
MR = 10 - 4Q
Profits from standard pricing= $8
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
An Algebraic Example• P = 10 - 2Q• C(Q) = 2Q• If the firm must charge a single price to all
consumers, the profit-maximizing price is obtained by setting MR = MC.
• 10 - 4Q = 2, so Q* = 2.• P* = 10 - 2(2) = 6.• Profits = (6)(2) - 2(2) = $8.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
A Simple Markup Rule• Suppose the elasticity of demand for the
firm’s product is EF.• Since MR = P[1 + EF]/ EF.• Setting MR = MC and simplifying yields
this simple pricing formula:P = [EF/(1+ EF)] × MC.
• The optimal price is a simple markup over relevant costs!
More elastic the demand, lower markup.Less elastic the demand, higher markup.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
An Example• Elasticity of demand for Kodak film is -2.• P = [EF/(1+ EF)] × MC• P = [-2/(1 - 2)] × MC• P = 2 × MC• Price is twice marginal cost.• Fifty percent of Kodak’s price is margin
above manufacturing costs.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Markup Rule for Cournot Oligopoly
• Homogeneous product Cournot oligopoly.• N = total number of firms in the industry.• Market elasticity of demand EM .• Elasticity of individual firm’s demand is given
by EF = N x EM.• Since P = [EF/(1+ EF)] × MC,• Then, P = [NEM/(1+ NEM)] × MC.• The greater the number of firms, the lower the
profit-maximizing markup factor.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
An Example• Homogeneous product Cournot industry, 3 firms.• MC = $10.• Elasticity of market demand = - ½.• Determine the profit-maximizing price?• EF = N EM = 3 × (-1/2) = -1.5.• P = [EF/(1+ EF)] × MC.• P = [-1.5/(1- 1.5] × $10.• P = 3 × $10 = $30.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
First-Degree or Perfect Price Discrimination
• Practice of charging each consumer the maximum amount he or she will pay for each incremental unit.
• Permits a firm to extract all surplus from consumers.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Perfect Price Discrimination
Price
Quantity
D
10
8
6
4
2
1 2 3 4 5
Profits*:.5(4-0)(10 - 2)
= $16
Total Cost* = $8
MC
* Assuming no fixed costs
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Caveats:
• In practice, transactions costs and information constraints make this difficult to implement perfectly (but car dealers and some professionals come close).
• Price discrimination won’t work if consumers can resell the good.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Second-Degree Price Discrimination
• The practice of posting a discrete schedule of declining prices for different quantities.
• Eliminates the information constraint present in first-degree price discrimination.
• Example: Electric utilities
Price
MC
D
$5
$10
4 Quantity
$8
2
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Third-Degree Price Discrimination• The practice of charging different groups
of consumers different prices for the same product.
• Group must have observable characteristics for third-degree price discrimination to work.
• Examples include student discounts, senior citizen’s discounts, regional & international pricing.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Implementing Third-Degree Price Discrimination
• Suppose the total demand for a product is comprised of two groups with different elasticities, E1 < E2.
• Notice that group 1 is more price sensitive than group 2.
• Profit-maximizing prices?• P1 = [E1/(1+ E1)] × MC• P2 = [E2/(1+ E2)] × MC
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
An Example• Suppose the elasticity of demand for Kodak film in
the US is EU = -1.5, and the elasticity of demand in Japan is EJ = -2.5.
• Marginal cost of manufacturing film is $3.• PU = [EU/(1+ EU)] × MC = [-1.5/(1 - 1.5)] × $3 = $9• PJ = [EJ/(1+ EJ)] × MC = [-2.5/(1 - 2.5)] × $3 = $5• Kodak’s optimal third-degree pricing strategy is to
charge a higher price in the US, where demand is less elastic.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Two-Part Pricing
• When it isn’t feasible to charge different prices for different units sold, but demand information is known, two-part pricing may permit you to extract all surplus from consumers.
• Two-part pricing consists of a fixed fee and a per unit charge.
Example: Athletic club memberships.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
How Two-Part Pricing Works
1. Set price at marginal cost.2. Compute consumer surplus.3. Charge a fixed-fee equal to
consumer surplus.
Quantity
D
10
8
6
4
2
1 2 3 4 5
MC
Fixed Fee = Profits = $16
Price
Per UnitCharge
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Block Pricing• The practice of packaging multiple units of
an identical product together and selling them as one package.
• ExamplesPaper.Six-packs of soda.Different sized of cans of green beans.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
An Algebraic Example
• Typical consumer’s demand is P = 10 - 2Q• C(Q) = 2Q• Optimal number of units in a package?• Optimal package price?
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Optimal Quantity To Package: 4 UnitsPrice
Quantity
D
10
8
6
4
2
1 2 3 4 5
MC = AC
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Optimal Price for the Package: $24 Price
Quantity
D
10
8
6
4
2
1 2 3 4 5
MC = AC
Consumer’s valuation of 4units = .5(8)(4) + (2)(4) = $24Therefore, set P = $24!
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Costs and Profits with Block PricingPrice
Quantity
D
10
8
6
4
2
1 2 3 4 5
MC = AC
Profits = [.5(8)(4) + (2)(4)] – (2)(4)= $16
Costs = (2)(4) = $8
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Commodity Bundling• The practice of bundling two or more
products together and charging one price for the bundle.
• ExamplesVacation packages.Computers and software.Film and developing.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
An Example that Illustrates Kodak’s Moment
• Total market size for film and developing is 4 million consumers.
• Four types of consumers25% will use only Kodak film (F).25% will use only Kodak developing (D).25% will use only Kodak film and use only Kodak developing (FD).25% have no preference (N).
• Zero costs (for simplicity).• Maximum price each type of consumer will pay is
as follows:
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Reservation Prices for Kodak Film and Developing by Type of
Consumer
Type Film DevelopingF $8 $3
FD $8 $4D $4 $6N $3 $2
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Optimal Film Price?
Type Film DevelopingF $8 $3
FD $8 $4D $4 $6N $3 $2
Optimal Price is $8; only types F and FD buy resulting in profits of $8 x 2 million = $16 Million.At a price of $4, only types F, FD, and D will buy (profits of $12 Million).At a price of $3, all will types will buy (profits of $12 Million).
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Optimal Price for Developing?
Type Film DevelopingF $8 $3
FD $8 $4D $4 $6N $3 $2
Optimal Price is $3, to earn profits of $3 x 3 million = $9 Million.
At a price of $6, only “D” type buys (profits of $6 Million).
At a price of $4, only “D” and “FD” types buy (profits of $8 Million).
At a price of $2, all types buy (profits of $8 Million).
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Total Profits by Pricing Each Item Separately?
Type Film DevelopingF $8 $3
FD $8 $4D $4 $6N $3 $2
Total Profit = Film Profits + Development Profits = $16 Million + $9 Million = $25 Million
Surprisingly, the firm can earn even greater profits by bundling!
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Pricing a “Bundle” of Film and Developing
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Consumer Valuations of a Bundle
Type Film Developing Value of BundleF $8 $3 $11
FD $8 $4 $12D $4 $6 $10N $3 $2 $5
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
What’s the Optimal Price for a Bundle?
Type Film Developing Value of BundleF $8 $3 $11
FD $8 $4 $12D $4 $6 $10N $3 $2 $5
Optimal Bundle Price = $10 (for profits of $30 million)
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Peak-Load Pricing
• When demand during peak times is higher than the capacity of the firm, the firm should engage in peak-load pricing.
• Charge a higher price (PH) during peak times (DH).
• Charge a lower price (PL) during off-peak times (DL).
Quantity
PriceMC
MRL
PL
QL QH
DH
MRH
DL
PH
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Cross-Subsidies
• Prices charged for one product are subsidized by the sale of another product.
• May be profitable when there are significant demand complementarities effects.
• ExamplesBrowser and server software.Drinks and meals at restaurants.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Double Marginalization• Consider a large firm with two divisions:
the upstream division is the sole provider of a key input.the downstream division uses the input produced by the upstream division to produce the final output.
• Incentives to maximize divisional profits leads the upstream manager to produce where MRU = MCU.
Implication: PU > MCU.• Similarly, when the downstream division has market
power and has an incentive to maximize divisional profits, the manager will produce where MRD = MCD.
Implication: PD > MCD.• Thus, both divisions mark price up over marginal cost
resulting in in a phenomenon called double marginalization.
Result: less than optimal overall profits for the firm.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Transfer Pricing
• To overcome double marginalization, the internal price at which an upstream division sells inputs to a downstream division should be set in order to maximize the overall firm profits.
• To achieve this goal, the upstream division produces such that its marginal cost, MCu, equals the net marginal revenue to the downstream division (NMRd):
NMRd = MRd - MCd = MCu
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Upstream Division’s Problem
• Demand for the final product P = 10 - 2Q.• C(Q) = 2Q.• Suppose the upstream manager sets MR = MC to
maximize profits.• 10 - 4Q = 2, so Q* = 2.• P* = 10 - 2(2) = $6, so upstream manager charges
the downstream division $6 per unit.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Downstream Division’s Problem
• Demand for the final product P = 10 - 2Q.• Downstream division’s marginal cost is the $6
charged by the upstream division.• Downstream division sets MR = MC to maximize
profits.• 10 - 4Q = 6, so Q* = 1.• P* = 10 - 2(1) = $8, so downstream division
charges $8 per unit.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Analysis• This pricing strategy by the upstream division results
in less than optimal profits!• The upstream division needs the price to be $6 and
the quantity sold to be 2 units in order to maximize profits. Unfortunately,
• The downstream division sets price at $8, which is too high; only 1 unit is sold at that price.
Downstream division profits are $8 × 1 – 6(1) = $2.
• The upstream division’s profits are $6 × 1 - 2(1) = $4 instead of the monopoly profits of $6 × 2 - 2(2) = $8.
• Overall firm profit is $4 + $2 = $6.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Upstream Division’s “Monopoly Profits”
Price
Quantity
P = 10 - 2Q
10
8
6
4
2
1 2 3 4 5
MC = AC
MR = 10 - 4Q
Profit = $8
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Upstream’s Profits when Downstream Marks Price Up to $8
Price
Quantity
P = 10 - 2Q
10
8
6
4
2
1 2 3 4 5
MC = AC
MR = 10 - 4Q
Profit = $4DownstreamPrice
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Solutions for the Overall Firm?
• Provide upstream manager with an incentive to set the optimal transfer price of $2 (upstream division’s marginal cost).
• Overall profit with optimal transfer price:
8$22$26$ =×−×=π
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Pricing in Markets with Intense Price Competition
• Price MatchingAdvertising a price and a promise to match any lower price offered by a competitor.No firm has an incentive to lower their prices.Each firm charges the monopoly price and shares the market.
• Randomized PricingA strategy of constantly changing prices.Decreases consumers’ incentive to shop around as they cannot learn from experience which firm charges the lowest price.Reduces the ability of rival firms to undercut a firm’s prices.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Conclusion• First degree price discrimination, block pricing, and
two part pricing permit a firm to extract all consumer surplus.
• Commodity bundling, second-degree and third degree price discrimination permit a firm to extract some (but not all) consumer surplus.
• Simple markup rules are the easiest to implement, but leave consumers with the most surplus and may result in double-marginalization.
• Different strategies require different information.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Managerial Economics & Business Strategy
Chapter 12The Economics of Information
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
OverviewI. The Mean and the VarianceII. Uncertainty and Consumer BehaviorIII. Uncertainty and the FirmIV. Uncertainty and the MarketV. Auctions
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
The Mean • The expected value or average of a random variable.• Computed as the sum of the probabilities that different
outcomes will occur multiplied by the resulting payoffs:
E[x] = q1 x1 + q2 x2 +…+qn xn,
where xi is payoff i, qi is the probability that payoff ioccurs, and q1 + q2 +…+qn = 1.
• The mean provides information about the average value of a random variable but yields no information about the degree of risk associated with the random variable.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
The Variance & Standard Deviation
• VarianceA measure of risk.The sum of the probabilities that different outcomes will occur multiplied by the squared deviations from the mean of the random variable:
s2 = q1 (x1- E[x])2 + q2 (x2- E[x])2 +…+qn(xn- E[x])2
• Standard DeviationThe square root of the variance.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Uncertainty and Consumer Behavior
• Risk AversionRisk Averse: An individual who prefers a sure amount of $M to a risky prospect with an expected value, E[x], of $M.Risk Loving: An individual who prefers a risky prospect with an expected value, E[x], of $M to a sure amount of $M.Risk Neutral: An individual who is indifferent between a risky prospect where E[x] = $M and a sure amount of $M.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Examples of How Risk Aversion Influences Decisions
• Product qualityInformative advertisingFree samplesGuarantees
• Chain stores• Insurance
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Price Uncertainty and Consumer Search
• Suppose consumers face numerous stores selling identical products, but charge different prices.
• The consumer wants to purchase the product at the lowest possible price, but also incurs a cost, c, to acquire price information.
• There is free recall and with replacement.Free recall means a consumer can return to any previously visited store.
• The consumer’s reservation price, the at which the consumer is indifferent between purchasing and continue to search, is R.
• When should a consumer cease searching for price information?
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Consumer Search Rule• Consumer will search until
• Therefore, a consumer will continue to search for a lower price when the observed price is greater than R and stop searching when the observed price is less than R.
( ) .cREB =
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Consumer Search
The Optimal Search Strategy.
c c
EB
Reservation Price
Accept RejectR
$
P0
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Consumer Search: Rising Search Costs
c c
EB
R
$
P0
An increase in search costs raises the reservation price.
R*
c*c*
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Uncertainty and the Firm
• Risk AversionAre managers risk averse or risk neutral?
• Diversification“Don’t put all your eggs in one basket.”
• Profit MaximizationWhen demand is uncertain, expected profits are maximized at the point where expected marginal revenue equals marginal cost: E[MR] = MC.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Example: Profit-Maximization in Uncertain Environments
• Suppose that economists predict that there is a 20 percent chance that the price in a competitive wheat market will be $5.62 per bushel and an 80 percent chance that the competitive price of wheat will be $2.98 per bushel. If a farmer can produce wheat at cost C(Q) = 20+0.01Q, how many bushels of wheat should he produce? What are his expected profits?
• Answer:E[P] = 0.2 x $5.62 + 0.8 x $2.98 = $3.508In a competitive market firms produce where E[P] = MC. Or, 3.508 = 0.01Q. Thus, Q = 350.8 bushels.Expect profits = (3.508 x 350.8) – [1000 + 0.01(350.8)] = 1230.61-1000-3.508 = $227.10.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Asymmetric Information
• Situation that exists when some people have better information than others.
• Example: Insider trading
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Two Types of Asymmetric Information
• Hidden characteristicsThings one party to a transaction knows about itself, but which are unknown by the other party.
• Hidden actionsActions taken by one party in a relationship that cannot be observed by the other party.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Adverse Selection
• Situation where individuals have hidden characteristics and in which a selection process results in a pool of individuals with undesirable characteristics.
• ExamplesChoice of medical plans.High-interest loans.Auto insurance for drivers with bad records.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Moral Hazard
• Situation where one party to a contract takes a hidden action that benefits him or her at the expense of another party.
• ExamplesThe principal-agent problem.Care taken with rental cars.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Possible Solutions
1. SignalingAttempt by an informed party to send an observable indicator of his or her hidden characteristics to an uninformed party.To work, the signal must not be easily mimicked by other types. Example: Education.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Possible Solutions
2. ScreeningAttempt by an uninformed party to sort individuals according to their characteristics.Often accomplished through a self-selection device
• A mechanism in which informed parties are presented with a set of options, and the options they choose reveals their hidden characteristics to an uninformed party.
Example: Price discrimination
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Auctions
• UsesArtTreasury billsSpectrum rightsConsumer goods (eBay and other Internet auction sites)Oil leases
• Major types of AuctionEnglishFirst-price, sealed-bidSecond-price, sealed-bidDutch
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
English Auction
• An ascending sequential bid auction.
• Bidders observe the bids of others and decide whether or not to increase the bid.
• The item is sold to the highest bidder.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
First-Price, Sealed-bid
• An auction whereby bidders simultaneously submit bids on pieces of paper.
• The item goes to the highest bidder.
• Bidders do not know the bids of other players.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Second-Price, Sealed-bid
• The same bidding process as a first price auction.
• However, the high bidder pays the amount bid by the 2nd highest bidder.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Dutch Auction
• A descending price auction.
• The auctioneer begins with a high asking price.
• The bid decreases until one bidder is willing to pay the quoted price.
• Strategically equivalent to a first-price auction.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Information Structures• Perfect information
Each bidder knows exactly the items worth.
• Independent private valuesBidders know their own valuation of the item, but not other bidders’valuations.Bidders’ valuations do not depend on those of other bidders.
• Affiliated (or correlated) value estimatesBidders do not know their own valuation of the item or the valuations of others.Bidders use their own information to form a value estimate.Value estimates are affiliated: the higher a bidder’s estimate, the more likely it is that other bidders also have high value estimates. Common values is the special case in which the true (but unknown) value of the item is the same for all bidders.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Optimal Bidding Strategy in an English Auction
• With independent private valuations, the optimal strategy is to remain active until the price exceeds your own valuation of the object.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Optimal Bidding Strategy in a Second-Price Sealed-Bid Auction
• The optimal strategy is to bid your own valuation of the item.
• This is a dominant strategy.You don’t pay your own bid, so bidding less than your value only increases the chance that you don’t win.If you bid more than your valuation, you risk buying the item for more than it is worth to you.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Optimal Bidding Strategy in a First-Price, Sealed-Bid Auction
• If there are n bidders who all perceive valuations to be evenly (or uniformly) distributed between a lowest possible valuation of L and a highest possible valuation of H, then the optimal bid for a risk-neutral player whose own valuation is v is
b vv L
n= −
−.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Example
• Two bidders with independent private valuations (n = 2).
• Lowest perceived valuation is unity (L = 1).• Optimal bid for a player whose valuation is
two (v = 2) is given by
b vv a
n= −
−= −
−=2
2 12
50$1.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Optimal Bidding Strategies with Affiliated Value Estimates• Difficult to describe because
Bidders do not know their own valuations of the item, let alone the valuations others.The auction process itself may reveal information about how much the other bidders value the object.
• Optimal bidding requires that players use any information gained during the auction to update their own value estimates.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
The Winner’s Curse• In a common-values auction, the winner is
the bidder who is the most optimistic about the true value of the item.
• To avoid the winner's curse, a bidder should revise downward his or her private estimate of the value to account for this fact.
• The winner’s curse is most pronounced in sealed-bid auctions.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Expected Revenues in Auctions with Risk Neutral Bidders
• Independent Private ValuesEnglish = Second Price = First Price = Dutch.
• Affiliated Value EstimatesEnglish > Second Price > First Price = Dutch.Bids are more closely linked to other players information, which mitigates players’ concerns about the winner’s curse.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Conclusion
• Information plays an important role in how economic agents make decisions.
When information is costly to acquire, consumers will continue to search for price information as long as the observed price is greater than the consumer’s reservation price.When there is uncertainty surrounding the price a firm can charge, a firm maximizes profit at the point where the expected marginalrevenue equals marginal cost.
• Many items are sold via auctions English auctionFirst-price, sealed bid auctionSecond-price, sealed bid auctionDutch auction
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
Managerial Economics & Business Strategy
Chapter 13Advanced Topics in Business
Strategy
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
OverviewI. Limit Pricing to Prevent EntryII. Predatory Pricing to Lessen CompetitionIII. Raising Rivals’ Costs to Lessen CompetitionIV. Price Discrimination as a Strategic ToolV. Changing the Timing of DecisionsVI. Penetration Pricing to Overcome Network
Effects
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
Limit Pricing
• Strategy where an incumbent (existing firm) prices below the monopoly price in order to keep potential entrants out of the market.
• Goal is to lessen competition by eliminating potential competitors’ incentives to enter the market.
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
Monopoly Profits• This monopolist is
earning positive economic profits.
• These profits may induce other firms to enter the market.
• Questions:Can the monopolist prevent entry?If so, is it profitable to do so?
Q
$
Q M
P M
AC
MC
MR
D MAC M
Π M
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
Limit Pricing• Incumbent produces QL
instead of monopoly output (QM).
• Resulting price, PL, is lower than monopoly price (PM).
• Residual demand curve is the market demand (DM) minus QL .
• Entry is not profitable because entrant’s residual demand lies below AC.
• Optimal limit pricing results in a residual demand such that, if the entrant entered and produced Q units, its profits would be zero.
Quantity
$
Q M
P M
AC
Entrant's residualdemand curve
D MP = AC
P L
Q LQ
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
Potential Problems with Limit Pricing
• It isn’t generally profitable for the incumbent to maintain an output of QL once entry occurs.
• Rational entrants will realize this and enter.• Solution: Incumbent must link its pre-entry price to
the post-entry profits of the potential entrant.• Possible links:
Commitments by incumbents.Learning curve effects.Incomplete information.Reputation effects.
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
Potential Problems with Limit Pricing (Continued)
• Even if a link can be forged, it may not be profitable to limit price! Limit pricing is profitable only if the present value of the benefits of limit pricing exceed the up front costs:
( ).
L DM L
iπ π
π π−
> −
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
Predatory Pricing
• Strategy of pricing below marginal cost to drive competitors out of business, then raising price to enjoy the higher profits resulting from lessened competition.
• Goal is to lessen competition by eliminating existing competitors.
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
Potential Problems with Predatory Pricing
• Counter strategies:Stop production.Purchase from the predator at the reduced price and stockpile until predatory pricing is over.
• Rivals can sue under the Sherman ActBut it is often difficult for rivals to prove their case.
• Upfront losses incurred to drive out rivals may exceed the present value of future monopoly profits.
• Predator must have deeper pockets than prey.
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
Raising Rivals’ Costs
• Strategy where a firm increases the marginal or fixed costs of rivals to distort their incentives.
• Not always profitable, but may be profitable as the following example shows.
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
Raising a Rival’s Marginal Cost
• Cournot duopoly.• Initial equilibrium at
point A.• Firm 1 raises the
marginal cost of Firm 2, moving equilibrium to point B.
• Firm 1 gains market share and profits.
A
B
Q 2
Q 1
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
Other Strategies to Raise Rivals’Costs
• Raise fixed costs in the industry.• If vertically integrated, increase input prices in
the upstream market.Vertical Foreclosure: Integrated firm charges rivals prohibitive price for an essential input.The Price-Cost Squeeze: Integrated firm raises input price and holds the final product price constant.
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
Price Discrimination as a Strategic Tool
• Price discrimination permits a firm to “target”price cuts to those consumers or markets that will inflict the most damage to the rival (in the case of predatory pricing) or potential entrants (in the case of limit pricing).
• Meanwhile, it can continue to charge the monopoly price to its other customers.
• Thus, price discrimination may enhance the value of other pricing strategies.
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
Changing the Timing of Decisions or the Order of Moves
• Sometimes profits can be enhanced by changing the timing of decisions or the order of moves.
When there is a first-mover advantage, it pays to commit to a decision first.When there is a second-mover advantage, it pays to let the other player move first.
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
Examples of Games with First and Second-Mover Advantages
• Example 1: Player naming the smaller natural number gets $10, the other players get nothing.– First-mover always earns $10.
• Example 2: Player naming the larger natural number gets $10, the other players get nothing.– Last-mover always earns $10
• Practical Examples?
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
If Firms A and B Make Production Decisions Simultaneously
• Firm A earns $10 by playing its dominant strategy, which is “Low Output.”
Firm A
Firm B
Strategy Low Output High Output
Low Output
High Output
$30, $10 $10, $15
$20, $5 $1, $2
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
But if A Moves First:
• Firm A can earn $20 by producing a high output!
• RequiresCommitment to a high output.Player B observes A’s commitment prior to making its own production decision.
Low Output ($30, $10)
Low Output
High Output ($10, $15)
Low Output ($20, $5)
High Output
High Output ($1, $2)
A
B
B
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
Networks
• A network consists of links that connect different points in geographic or economic space.
• One-way Network – Services flow in only one direction.
Examples: water, electricity.
• Two-way Network – Value to each user depends directly on how many other people use the network.
Examples: telephone, e-mail.
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
Example: A Two-Way Star Network Linking 7 Users
• Point H is the hub.• Points C1 through C7 are
nodes representing users.
• Total number of connection services is n(n - 1) = 7(7-1) = 42.
H C1
C7
C6
C5
C3
C4C2
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
Network Externalities• Direct Network Externality – The direct value
enjoyed by the user of a network because other people also use the network.
• Indirect Network Externality – The indirect value enjoyed by the user of a network because of complementarities between the size of the network and the availability of complementary products or services.
• Negative Externalities such as congestion and bottlenecks can also arise as a network grows.
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
Penetration Pricing to Overcome Network Effects
• Problem: Network externalities typically make it difficult for a new network to replace or compete with an existing network.
• Solution: Penetration Pricing– The new network can charge an initial price that is
very low, give the product away, or even pay consumers to try the new product to gain users.
– Once a critical mass of users switch to the new network, prices can be increased.
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
The New Network GameWithout Penetration Pricing
• Coordination Problem Neither user has an incentive to unilaterally switch to H2, even though both users would benefit if they simultaneously switched.With many users, it is difficult to coordinate a move to the better equilibrium.Users may stay locked in at the red equilibrium instead of moving to green one.
Network Provider H1 H2
H1
H2
User 2
User 1 $0, $0$10, $10
$20, $20$0, $0
Table 13-2 A Network Game
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
The New Network GameWith Penetration Pricing
Network Provider H1 H1 & H2
H1
H1 & H2
User 2
User 1 $10, $11$10, $10
$21, $21$11, $10
Table 13-3 The Network Game with Penetration Pricing
• Network provider H2 pays consumers $1 to try its network; consumers have nothing to lose in trying both networks. The green cell is the equilibrium.
• Users will eventually realize that H2 is better than H1 and that other users have access to this new network.
• Users will eventually quit using H1, at which point provider H2 can eliminate $1 payment and start charging for network access.
Michael R. Baye, Managerial Economics and Business Strategy, 5e, ©The McGraw-Hill Companies, Inc., 2006
Conclusion
• A number of strategies may enhance profits:Limit pricing.Predatory pricing.Raising rivals’ costs.Exercising first- or second-mover advantages.Penetration pricing.
• These strategies are not always the best ones, though, and care must be taken when using any of the above strategies.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Managerial Economics & Business Strategy
Chapter 14A Manager’s Guide to
Government in the Marketplace
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
OverviewI. Market Failure
Market PowerExternalitiesPublic GoodsIncomplete Information
II. Rent SeekingIII. Government Policy and International Markets
QuotasTariffsRegulations
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Market Power • Firms with market
power produce socially inefficient output levels.
Too little outputPrice exceeds MCDeadweight loss
• Dollar value of society’s welfare loss
MR
PM
QM
MC
D
Q
P
MC
PC
QC
Deadweight Loss
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Antitrust Policies• Administered by the DOJ and FTC• Goals:
To eliminate deadweight loss of monopoly and promote social welfare.Make it illegal for managers to pursue strategies that foster monopoly power.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Sherman Act (1890)
• Sections 1 and 2 prohibits price-fixing, market sharing and other collusive practices designed to “monopolize, or attempt to monopolize” a market.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
United States v. Standard Oil of New Jersey (1911)
• Charged with attempting to fix prices of petroleum products. Methods used to enhance market power:
Physical threats to shippers and other producers.Setting up artificial companies.Espionage and bribing tactics.Engaging in restraint of trade.Attempting to monopolize the oil industry.
• Result 1: Standard Oil dissolved into 33 subsidiaries.• Result 2: New Supreme Court Ruling the rule of reason.
Stipulates that not all trade restraints are illegal, only those that are unreasonable are prohibited.
• Based on the Sherman Act and the rule of reason, how do firms know a priori whether a particular pricing strategy is illegal?
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Clayton Act (1914)
• Makes hidden kickbacks (brokerage fees) and hidden rebates illegal.
• Section 3 Prohibits exclusive dealing and tying arrangements where the effect may be to “substantially lessen competition.”
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Cellar-Kefauver Act (1950)
• Amends Section 7 of Clayton Act.• Strengthens merger and acquisition policies.• Horizontal Merger Guidelines
Market Concentration• Herfindahl-Hirschman Index: HHI = 10,000 Σ wi
2
• Industries in which the HHI exceed 1800 are generally deemed “highly concentrated”.
• The DOJ or FTC may, in this case, attempt to block a merger if it would increase the HHI by more than 100.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Regulating Monopolies: Marginal-Cost Pricing
P
Q
PM
PC
QCQM
Effective Demand
MR
MC
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Problem 1 with Marginal-Cost Pricing: Possibility of ATC > PC
P
Q
PC
QCQM
MR
MC
ATCATCPM
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Problem 2 with Marginal-Cost Pricing: Requires Knowledge of MC
P
Q
PM
QReg QM
MR
MC
Q*
Shortage
Deadweight loss prior to regulation
Deadweight loss after regulation
PReg
Effective Demand
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Externalities• A negative externality is a cost borne by
people who neither produce nor consume the good.
• Example: PollutionCaused by the absence of well-defined property rights.
• Government regulations may induce the socially efficient level of output by forcing firms to internalize pollution costs
The Clean Air Act of 1970
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Socially Efficient Equilibrium: Internal and External Costs
Q
P
D
MC external
MC internal
MC external + internal
QC
PC
QSE
PSE
Socially efficient equilibrium
Competitive equilibrium
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Public Goods• A good that is nonrival and nonexclusionary in
consumption. Nonrival: A good which when consumed by one person does not preclude other people from also consuming the good.
• Example: Radio signals, national defenseNonexclusionary: No one is excluded from consuming the good once it is provided.
• Example: Clean air
• “Free Rider” ProblemIndividuals have little incentive to buy a public good because of their nonrival & nonexclusionary nature.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Public Goods
Streetlights
$
Total demand for streetlights
Individual Consumer Surplus
90
54
30
18
0 12 30
MC of streetlights
Individual demand for streetlights
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Incomplete Information• Participants in a market that have
incomplete information about prices, quality, technology, or risks may be inefficient.
• The Government serves as a provider of information to combat the inefficiencies caused by incomplete and/or asymmetric information.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Government Policies Designed to Mitigate Incomplete
Information• OSHA• SEC• Certification• Truth in lending• Truth in advertising• Contract enforcement
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Rent Seeking
• Government policies will generally benefit some parties at the expense of others.
• Lobbyists spend large sums of money in an attempt to affect these policies.
• This process is known as rent-seeking.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
An Example: Seeking Monopoly Rights
• Firm’s monetary incentive to lobby for monopoly rights: A
• Consumers’ monetary incentive to lobby against monopoly: A+B.
• Firm’s incentive is smaller than consumers’ incentives.
• But, consumers’ incentives are spread among many different individuals.
• As a result, firms often succeed in their lobbying efforts.
QM QC
PM
PC
P
Q
MC
DMR
Consumer Surplus
A B
A = Monopoly Profits
B = Deadweight Loss
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Quotas and TariffsQuota
Limit on the number of units of a product that a foreign competitor can bring into the country.
• Reduces competition, thus resulting in higher prices, lower consumer surplus, and higher profits for domestic firms.
TariffsLump sum tariff: a fixed fee paid by foreign firms to enter the domestic market.Excise tariff: a per unit fee on each imported product.
• Causes a shift in the MC curve by the amount of the tariff which in turn decreases the supply of all foreign firms.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Conclusion
• Market power, externalities, public goods, and incomplete information create a potential role for government in the marketplace.
• Government’s presence creates rent-seeking incentives, which may undermine its ability to improve matters.