Introduction to ManagerialIntroduction to Managerial Economics

Christine Zulehner

Department of Economics

Johannes Kepler University Linz

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Aim of this course

Introduction into economic topics which are important for business students and applied p ppeconomists

How can rigorous modeling help to understand important phenomena in business enterprises?important phenomena in business enterprises?

How can economic principles assist in focusing and organizing ideas, explain real world behavior and make well informed decisions?make well-informed decisions?

(Course is based on Microeconomics)

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Topics

Industrial Organization Industrial Organization Business strategy in different market structures: competition,

monopoly and oligopoly Special topics of multi-plant firms transfer prices Special topics of multi plant firms, transfer prices Game theory, organization of markets, market entry Theories of choice, uncertainty, risk and intertemporal decisions

Topics from Organization and Management of Firms Topics from Organization and Management of Firms Organization principles, efficiency, transaction costs Problems of private information: insurance, moral hazard, adverse

selection, signalingselection, signaling Performance incentives, Principal-Agent Problems Personnel and Human Resources Management, Compensation

systems and motivation

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Preliminaries

we meet each week: Thursday 10.15-11.45 HS 1 only April 14 and May 26 at 12.00-13.30 HS 10

slides of presentation are available at my homepage www.econ.jku.at/Christine.Zulehnerwww.econ.jku.at/Christine.Zulehner

you should read assigned text before the course exercises and examples will also be provided after the exercises and examples will also be provided after the

lectures

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More preliminaries Teaching Assistants:

Bernd Speta: bernd speta (at) gmx at Office Hours: Tuesday 16 00 - 17 00 Bernd Speta: bernd.speta (at) gmx.at, Office Hours: Tuesday, 16.00 17.00 Klara Alkin: lara.alkin (at) gmx.at , Office Hours: Wednesday, 14.00-15.00

Room: K 257C Phone: Ext. 5146

Pl t t f th t hi i t t fi t if h bl d t di thi Please contact one of the teaching assistants first if you have problems understanding something as well as for organizational issues.

If there are questions, there is always the possibility to talk after the lecture and during office hoursoffice hours. Office hours: Wednesday, 14.30 - 16.00 Email: christine.zulehner@jku.at

Textbook: Allen Doherty Weigelt and Mansfield “Managerial Economics 6th edition Textbook: Allen, Doherty, Weigelt and Mansfield Managerial Economics, 6th edition

E-help … quizzes, etc … www.wwnorton.com/college/econ/mec6/

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Norton Media Libraryy

W Bruce AllenW. Bruce AllenNeil A. Doherty

Keith Weigelt

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gEdwin Mansfield

Grading 2 exams, 48 points each, mostly MC questions 2 problem sets during the term: 2 problem sets during the term:

6 points for each problem set possible to complete the course, at least 6 problem set-points are

necessary! further points are counted as extra pointsnecessary! further points are counted as extra points total sum of points (including extra points) must be

higher than or equal to 48 for a positive resultg q p (not more than 6 points from the problem sets are accounted

for the total number of points)1: 85 96; 2: 73 84; 3: 61 72; 4: 48 60; 5: 0 47 1: 85-96; 2: 73-84; 3: 61-72; 4: 48-60; 5: 0-47

make-up exam (Nachklausur): on July 6 (updated) replaces the midterm exam and the endterm exam, 96 points

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replaces the midterm exam and the endterm exam, 96 points

Problem sets and exams Midterm exam

30 minutes 30 minutes 8 multiple choice questions, 6 points each

Endterm exam 40 minutes 6 multiple choice questions, 3 á 6 points and 3 á 7 points

one open question 9 points one open question, 9 points

Problem sets: similar to questions in the exams similar to questions in the exams for each problem set there is four weeks time

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Course outline and readings in detail

10/03/11: Introduction and Demand Theory (Chapter 3) 17/03/11: Estimation of Demand Functions (Chapter 5), Technological Change and Industrial Innovation

(Chapter 8)(Chapter 8) 24/03/11: Perfect Competition, Monopoly, and Monopolistic Competition (Chapter 10)

Homework 1 is given out 31/03/11: More on monopoly pricing (Chapter 12)

07/04/11: Oligopoly Product Differentiation in Monopolistic Competition and Oligopoly (Chapter 13) 07/04/11: Oligopoly, Product Differentiation in Monopolistic Competition and Oligopoly (Chapter 13) 14/14/11 (ATTENTION 12.00-13.30 HS 10): Game Theory (Chapter 14)

Deadline Homework 1 05/05/11: Midterm Exam

12/05/11 Ri k A l i (Ch t 15) 12/05/11: Risk Analysis (Chapter 15) 19/05/11: Auctions (Chapter 16)

Homework 2 is given out 26/05/11 (ATTENTION 12.00-13.30 HS 10): Moral Hazard (Chapter 17)

09/06/11 Ad S l i (Ch 18) 09/06/11: Adverse Selection (Chapter 18) 16/06/11: Government and Business (Chapters 19 and 20)

Deadline Homework 2 30/06/11: Endterm Exam 07/07/11: Makeup Exam

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What is Managerial Economics?

Applied micro-economics, but with a focus on decision makingdecision making

„What shall a manager do in this and that situation?“ Pricing decisions in different circumstances Pricing decisions in different circumstances Market entry, innovation, auction theory Organization of the firmg Personnel policy, how to pay managers or motivate workers

How can we use economic theory and empirical evidence to make our decisions?

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Theory of the firm

A theory indicating how a firm behaves and what its goals areand what its goals are What is the objective of the firm?

Value of the firm should be maximal Value of the firm should be maximal Firms maximize their profits, i.e. revenues

minus cost another objective could be to maximize a firm’s

growth, i.e. sales only – empire builders The present value of the firm’s expected The present value of the firm s expected

future cash flows …

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Present value of expectedPresent value of expected future profitsu u e p o s

nt tTR TC t t

tt 1 (1 i)

where: TRt = the firm’s total rev. in year tTC = the firm’s total cost in year tTCt = the firm s total cost in year ti = the interest rate

d t f 1 ( t ) t (th l t iand t goes from 1 (next year) to n (the last year in the planning horizon)

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Principle-agent problem Firms are not always led by their owners

How can we make sure that managers act in the interest ofHow can we make sure that managers act in the interest of their owners?

Is it possible to write incentive compatible contracts? If yes, how do these contracts look like?If yes, how do these contracts look like? One way to write incentive compatible contracts is the use

of stock options Mr Eisner CEO at Disney Mr. Eisner, CEO at Disney

Some basic salary + options on 2 millions shares of stock During a period of five years he could purchase them from

the firm at a price of only 14$ per sharethe firm at a price of only 14$ per share In 1993, his total compensation was $202 million A share holder who invested $100 at the beginning of

Eisner’s tenure would have gained $1460 in 1994

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Eisner s tenure would have gained $1460 in 1994.

Determinants of profits Revenues

How many items can the firm sell?How many items can the firm sell? How many consumers are willing to buy the firm’s output? What is the consumers’ willingness to pay?

Cost structure Cost structure Relation between input and output How much input is necessary to produce a certain amount of

output?output? How efficient can a firm use its inputs?

Number of firms in the industry the more firms are in the market the lower the profits will be

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Demand and supply Demand

if prices increase, less consumers want to buy a goodif prices increase, less consumers want to buy a good Supply

if prices increase, more firms want to produce the good and each firm wants to sell more of the goodeach firm wants to sell more of the good

Equilibrium demand meets supply and prices are determined

Demand and supply shifters Income shocks, price of a substitute good changes, … Shock in input prices, change in environment (Russia after S oc pu p ces, c a ge e o e ( uss a a e

the cold war did not need aluminum for military anymore, but started to export to the international market), …

Baseball tickets or sport event tickets in general

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p g react to differences in demand with different prices

Economic profit concept Profit the firm owner makes over and above what

their labor and capital employed in the business p p ycould earn elsewhere. It could be that a firm makes accounting profits, but

economic profits are negative, i.e. there is another p g ,opportunity using the same inputs but with higher economic profits

In competitive industries profits are zerop p What are competitive industries?

Standardized products, no risk involved, etc..Are most industries competitive industries? Are most industries competitive industries? Pharmaceutical industry, car industry, aircraft building

industry, oil producing industry

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Situations with positive profits

Innovations Pharmaceutical industry: patents make firms to part-time

monopolists

Market entry is not (easily) possible Market entry is not (easily) possible Car industry: knowledge to build cars, set up production

facilities

Risk involved Aircraft building industry

Industry is not competitive Oil producing industry: cartell (OPEC)

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g

In the medium or long-term

Economic profits may disappear Patents expire Market entry is possible

Ri k di l Risk dissolves Cartels are broken up

Still li t i Still, a monopolist recognizes that the more she produces the lower the price and will thus

limit her outputlimit her output.

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Chapter 3Chapter 3Demand Theoryy

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Questions

What happens if a firms increases the price of its What happens if a firms increases the price of its product?

Does the firm lose costumers? If yes, how many costumers does the firm lose and

how are its revenues and profits affected? How can we answer these questions?

We need to know the costumers’ demand How can we obtain knowledge about costumers’ How can we obtain knowledge about costumers demand?

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The market demand curve shows the total quantity of the good that would be purchasedquantity of the good that would be purchased

at each price

Market Demand for Personal Computers,

3000

3200

2600

2800

3000

Pric

e

2200

2400

2600P

2000

2200

0 500 1000 1500 2000

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quantity

Other determinants of market demand besides the p icebesides the price

Consumer tastes and preferencesConsumer tastes and preferencesConsumer incomesLevel of other prices

Size of consumer populationSize of consumer populationAdvertising

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Demand shifters Change in disposable income Changes in tastes and preferences Changes in tastes and preferences

tastes and preferences are assumed to be fixed in the short-run. Thi ti f fi d f i This assumption of fixed preferences is a necessary condition for aggregation of individual demand curves to derive market demand.

Changes in expectations. Changes in the prices of related goods (substitutes

and complements)and complements) Population size and composition

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Demand function and demand curve

Q= b1 x Price + b2 x Income + b3 x Price of Software + b4 x Price of Laptop + b5 x Advertising

Example: Q = -700 x P + 200 x I – 500 x S + 300 x L+ 0.01 x A a 1$ increase in the price of a computer results in a decrease in the quantity

demanded of 700 units per year; 1$ i i it di bl i lt i 200 it i i th a 1$ increase in per capita disposable income results in a 200-unit increase in the

quantity demanded; a 1$ increase in the price of software reduces the quantity demanded by 500 units per

year (software is a complement) a 1$ increase in the price of laptops increases the quantity demanded by 500 units per

year (laptops are substitutes) a 1$ increase in advertising raises the quantity demanded by 0.01 units a year

Demand curve: Demand curve: Q = -700x P + 200 (13,000) – 500 (400) + 300 (1000) + 0.01 (50,000,000)

Industry vs. firm demand Inverse demand function: P = f(Q I A S) Inverse demand function: P = f(Q, I, A, S)

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Determinants of demandDeterminants of demand

Some circumstances which can cause the demand curve to shift outwards include: increase in price of a substitute decrease in price of complement increase in income if good is a normal good g g decrease in income if good is an inferior good

Some circumstances which can cause the demand curve to shift inwards include:inwards include: decrease in price of a substitute increase in price of a complement

decrease in income if good is normal good decrease in income if good is normal good increase in income if good is inferior good

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Price elasticity of demand

The percentage change in quantity demanded resulting from The percentage change in quantity demanded resulting from a 1 percent change in price. Usually a negative figure.

PQQP

PQ

(called eta)

Important for pricing decisions.Important for pricing decisions.

(notation: sometimes eta is written with a positive sign; take care!)

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care!)

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Calculating elasticities Point estimate: (demand function is known); calculated

at a specific point of demandat a specific point of demand.

Use statistic regression analysis (ch.5) QP

PQ

Use statistic regression analysis (ch.5)

Arc elasticity: uses average values of Q and P as

Q

y g Qreference points (if only a table is known)

2/)()(2/)( PPQQPPQ 2/)(2/)(

)()(

2/)(2/)(

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21

12

12

21

21

QQPP

PPQQ

QQPP

PQ

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Price elasticity of demandPrice elasticity of demand and gross revenues

< -1 ==> an inverse relationship between price changes < -1 ==> an inverse relationship between price changes and gross revenues.

1 d l h b h > -1 ==> a direct relationship between price changes and gross revenues.

= -1 ==> no change in gross revenues as price changes.

Important because of pricing decisions: is it useful to raise or lower prices?

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Total revenue marginal revenueTotal revenue, marginal revenue and price elasticity

Suppose P = a – b*Q (linear demand function)pp Q ( )

then TR =P*Q= a*Q – b*Q2

MR = dTR/dQ = a - 2b*Q

Since =(dQ/dP)*(P/Q)=-(1/b)*(P/Q) and Q=(a/b) – (1/b)*P

QbQa

b)(1

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Total revenue marginal revenueTotal revenue, marginal revenue and price elasticity

Price aDemand

and MR

Quantitya/ba/2b

Dollars/

TotalRRevenue

31Quantity

Marginal Revenue priceMarginal Revenue, priceand price elasticity

?....)(.....)( whyQPPnotedQPQdMR

1

dQdP

PQP

dQdPQPMR

11P

If product is price elastic (<-1, marginal revenue must be positive) Example: what is MR if price is $10 and price elasticity is -2?

10(1+1/(-2)) = $5. What if product is very price elastic (=-)?

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Determinants of the priceDeterminants of the price elasticity of demand

Elasticity is greater (in absolute values, i.e more elastic) when:more elastic) when: there are more substitutes for the product. the product is a more important part of a the product is a more important part of a

consumer’s budget. the time period under consideration is greater.

cell phone contracts: in the short run your are locked in – inelastic demand

gasoline prices: in the long run you may switch to public gasoline prices: in the long run you may switch to public transport

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Price Elasticity vs Marginal ReturnPrice Elasticity vs. Marginal Return

Price elasticity means how strongly do consumers Price elasticity means … how strongly do consumers react (by buying less) if you raise your price

You really should know this figure for your products Price elasticity is defined as the reaction of quantity on price

Marginal return is defined as the reaction of money on quantities sold How do revenues increase if you sell one more unit MR = Marginal Revenue = Marginal Return

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Price setting: a simple rule Do not set price so low that demand is price-inelastic (>-1):

Marg. Revenue is negative, i.e. by raising price, total revenue will increase and (!) costs will decrease.

1

priceoptimalMCP

rulepricingPMRMC

..../11

1

...)11(

==> optimal price depends upon MC and price elasticity> Th hi h (th b l t l f) i l ti it th l th ti l i

pp/11

==> The higher (the absolute value of) price elasticity, the lower the optimal price

• Why is this so? In what market are you in?

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Elasticity in Usey

Retailer: prices for the exact item may differ substantially in stores of the same chain; why?; y

Elasticity of demand is used to generate optimal prices Rather than marking up cost, benchmarking or guessing,

price optimization models use data mining techniques Scanned transaction prices allow estimating a demand curve

for each productfor each product Assuming that the marginal cost is equal across locations,

we can equate marginal revenues:we can equate marginal revenues: MR1=P1[1+(1/µ1)]=P2[1+1/µ2)]=MR2=(MC) If the marginal revenue is larger in shop 2 than in shop 1, you would

like to shift some sales from shop 1 to shop 2

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like to shift some sales from shop 1 to shop 2 Two periods over time, two seats in an airplane, etc.

Example: Price settingExample: Price setting

VW’s entry in the North American Market VW s entry in the North American Market In the beginning VW had no dealer network Provided sales and services only sold at some docks Started with a low price to enter the market Price was set in the inelastic part of the demand function After the beetle was known, VW increased the prices and After the beetle was known, VW increased the prices and

gained revenues and profits Establishment of dealer network shift in demand

Old price was again in the inelastic part of the demand Old price was again in the inelastic part of the demand Prices increases higher revenues and profits

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Income elasticityy

The percentage change in quantity The percentage change in quantity demanded resulting from a 1 percent h i i (I)change in consumer income (I)

I

Q II Q

I Q

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Table 3.6 Income Elasticity of Demand, Selected Commodities, United States

Commodity Income elasticity of demand

Alcohol 1.54AlcoholHousing, owner-occupiedFurnitureDental services

1.541.491.481.42Dental services

Restaurant mealsShoesMedical insurance

1.421.401.100 92Medical insurance

Gasoline and oilButterCoffee

0.920.480.420Coffee

MargarineFlour

0-0.20-0.36

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Source: H. Houthakker and L. Taylor, Consumer Demand in the United States

Firms´opportunities and ppproblems

Whether the income elasticity of demand for a firm‘s product is high or low can have great impact on the firm‘s opportunity andhigh or low can have great impact on the firm s opportunity and problems

Firms making products with high income elasticities are likely to l ti l idl i i i digrow relatively rapidly as income rises in an expanding economy

Firms making products with low income elasticities are likely to experience more modest expansionp p

On the other hand, if the economy is in a depression, firms making products with low income elasticities are less likely to experience less of a decrease in output than those makingexperience less of a decrease in output than those making products with high income elasticities

Thus, income elasticities are also helpful for portfolio decisions

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Estimating the demand for rail gpassengers business

Amtrek estimated a demand function for its businessP il f( i di bl i Passenger miles=f(own average price, disposable income, ratio to airline prices, retail gasoline price, seasonal dummy variables )

Most important determinant: income Income elasticity: 1.8, i.e. a 1% increase in income is

f ll d b 1 8% i i ilfollowed by a 1.8% increase in passenger miles.

Although income increased throughout the 2000s, Amtrak‘s market share decreasedAmtrak s market share decreased

What is a possible explanation?

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Cross price elasticityp y• The percentage change in quantity demanded of good X

lti f 1 t h i th i f d Yresulting from a 1 percent change in the price of good Y

Q P,

X YX Y

Y X

Q PP Q

• How does demand for your product react to other companies’ p ice hikes?companies’ price hikes?

• How does demand for your products 2-n react to price changes of your product 1?

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changes of your product 1?

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Use elasticities for marketUse elasticities for market forecastso a

Price elasticity: what will happen to my demand if I change the price?change the price?

==> be careful, if elasticity of the whole industry or the , y yspecific firm is concerned

I l ti it i f t f GDP th i Income elasticity: given a forecast of GDP-growth is available, what is the growth prospect of my product?

==> you may want to target specific income groups

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Advertising elasticity

• The percentage change in quantity demanded resulting from a 1 percent change in advertising expenditure

QA

AQ

A

QAA

• Is it worth to spend more on advertising?

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