MGEC

8/2/2019 MGEC

1/8

GYAAN KOSH

TERM 1Learning and

Development

Council, CAC

Managerial Economics

This document covers the basic concepts of Managerial

Economics covered in Term 1. The document only

summarizes the main concepts and is not intended to be an

instructive material on the subject.

8/2/2019 MGEC

2/8

Gyaan Kosh Term 1 MGEC Learning & Development Council, CAC

Opportunity cost: Taken into account for economic decisions. Opportunity Cost is

the next best or alternative benefit from an investment

Sunk costs: Never taken into account for economic decisions.

Marginal Analysis: Used for profit maximization (deciding how much to produce)

where TR and TC are functions of quantity. To maximize profits we take

derivative=0

For profit maximization, marginal revenue should be equal to marginal costs for EACH activity.

If MR > MC increase production

If MR < MC decrease production

Demand Curve is the Marginal Benefit curve

Consumer Surplus = Net benefit to customers = Willingness to pay total paid. (Area under the demand curve

above the price line)

Demand and elasticity

Demand shows quantity purchased as a function of price.

Managers Knowledge of demand is critical because it helps in:

Making production decisions Defining market structure Taking strategic and operational decisions

P r o f it M a x im iz a tio n G r a p h

8/2/2019 MGEC

3/8

8/2/2019 MGEC

4/8


Supply

The supply curve is the MC curve above the shutdown point. The shutdown point in case of unavoidable cost is

given by the lowest point of average variable cost. And the shutdown point in case of avoidable costs is given by the

lowest point of average total cost.

Types of market competition

Number of Firms

Monopoly: One Firm Competition: Many Firms Other cases, duopoly

8/2/2019 MGEC

5/8


Barriers to Entry

Monopoly high barriers to new entry

Competition free entryShort run (SR)

Due to frictions, firm can only adjust some inputs for which it occurs variable costs Other inputs cannot be adjusted, for which it incurs fixed costs

Long run (LR)

Enough time passes for the firm to adjust all inputs All costs are variable

Economies of Scale

AC decreases as X increases Quantity discounts on purchases are one way of realizing such economies

Economies of Scope

Joint production cost of multiple products is less than cost of producing each individually

Market efficiency & distortions

Pareto Efficiency: No reallocation would make one person better off without making someone else worse off. So in

order to maximize net gain to society we need to maximize sum of Consumer Surplus and Producer Surplus; otherwise,

there will be a Deadweight Loss (DWL)

Antitrust laws: Promote a competitive economy competition benefits consumers

Possible Prohibitions as a result of antitrust laws

Prohibit anti-competitive contracts and agreements Exclusive contracts, tying, etc. Prohibit abuse of dominant position: Collusion/Cartelization - Explicit or Implicit Predatory pricing Bid rigging

Attempt to monopolize a market through M&A activity

Note: Cognizance of all the above situations can help in finding out possible antitrust violations in case analyses.

8/2/2019 MGEC

6/8


Consumer behavior

The driving assumption for consumers preferences is that we are rational. Being rational entails:

Completeness: consumers can compare and rank all possible baskets. Transitivity: (A > B) and (B > C) (A >C) * Consistency More is better than less

Indifference Curve: It is a graphical representation of consumers preferences and represents all combinations of

market baskets that provide a person with the same level of satisfaction. The shape of IC indicates tradeoffs.

Marginal Rate of Substitution: Measures the value of 1 extra unit of a good in terms of another

Substitution effect: Buy more of the relatively cheaper good and less of the relatively expensive good.

Income effect: Consumers enjoy an increase in purchasing power because one of the goods is now cheaper

They occur simultaneously but in opposite directions

Budget line: It is the amount of good that I can buy given a particular income. At some prices of goods Pa and Pb, a

consumer can buy a maximum of I/Pa (all goods A) or I/Pb (all goods B). The line joining these two points is called the

budget line. Any point on this line represents a combination of two goods that can be bought at the given prices and

income levels.

Special case: Giffen goods: Income effect is larger than substitution effect. Demand is upward sloping.

GAME THEORY: Simultaneous games

Assumptions:

Buyer is able to assign a monetary value to each transaction and product: reservation price (RP). This is themaximum price that a buyer is willing to pay for a product

A buyer evaluates a transaction in terms of its consumer surplusAlthough game theory began as applied mathematics, it has become a dominant mode of reasoning in business and

economics. Game Theory improves strategic decision-making. It makes one aware of which strategy matters in what

situation, to say nothing of the strategic nuances on the part of one's competitors or opponents. It can improve one's

ability to run a business or to evaluate changes in policy. Phrases such as "Competitive Advantage", "Winner's Curse",

"Everyday Low Prices", "First Mover Advantage", "Market Failure", "Credibility", "Incentive Contracts", "Hostile

Takeover", "Coalition Building", "Cartelization", "Mutually Assured Destruction", make a lot more sense when they

are strategically explained using game theory.

8/2/2019 MGEC

7/8


Examples of application of game theory:

Prisoner's dilemma: Cigarette Advertising on TV: In 1971, when advertising for cigarettes on television was banned, the

profits of the cigarette companies wentup.

Folk theorem: Do firms always conspire to monopolize the market? Game theory says that in a continuously repeated

game, competition leads to collaboration. That is why some times the biggest competitors appear to be colluding even

when they are not doing so.

Stag Hunt: In early societies, people formed alliances to hunt deer. If even one person in the group did not help in the

hunt, the deer would be lost. The hunters were sometimes tempted to leave the hunt by seeing rabbits, but they

preferred deer to rabbit. However, only one person was needed to catch a rabbit. From a game theory perspective, the

best strategy is to hunt the deer, but people may decide to hunt the rabbit because they believe others may defect

from the hunt also.

Countries face the same dilemma in situations involving nuclear weapons. Each country generally believes that the

world would be better if no countries possessed nuclear weapons. However, the temptation to build up a nuclear

arsenal arises because each country is afraid that other countries may stash nuclear warheads and undermine

international security.

Centipede game: Following the designation of Mr. Bush as President-Elect and the election of the new Congress, the

smart money seemed to be betting that Bush would have been a one-term President and that the Democrats would

have an excellent chance of retaking the Congress in '02. Centipede game explained how the Republicans were likely to

respond - assuming that the corporate Republican Party would have acted as a rational, self-interested agent as those

terms were understood in game theory.

Hotelling law: The observation by Hotelling was that in many markets it is rational for all the producers to make their

products as similar as possible. Suppose, for example, there are two newsagents in a street, both want to maximize

their share of local business by locating their shop so that it is the nearest newsagent for as much of the trade visiting

the street as possible. In this situation, both newsagents will position themselves in the middle of the street

guaranteeing themselves half the market. It would be socially more desirable for them to separate themselves, and sit

a third of the way along the street from different ends. Unfortunately, if one newsagent did this, the other could

position himself so as to capture more than half the total market. Too little variety results from the process. Hotelling's

law manifests itself in numerous markets - competing airline operators scheduling their airlines to run at the same time

for example.

Nash Equilibrium in Game Theory is a pair of strategies that forms a self-enforcing agreement i.e.

when both players choose a strategy which is their best response to the opponent Neither is made better off by unilaterallyswitching to another strategy

Mixed Strategies: Strategies in which players make random choices among possible actions based on set of chosen

probabilities

Repetitive game: Only a small number of sellers are sufficient to have benefits of competition. When games are

indefiniteanything can happen rivals could end up charging low prices in each round, high prices in each round, or

anything in between. In repeated play of PD, a strategy is no longer what price you pick in each round but rather a rule

you use to select price in each round

8/2/2019 MGEC

8/8


Three examples of such rules:

Choose the low price in each round (regardless) Grim trigger rule: choose a high price in the first round. In subsequent rounds choose high price if rival

chose high price in previous round. If rival chose low price in previous round then choose low price inevery round thereafter

Tit-for-tat: choose a high price in the first round. In subsequent rounds choose the price that rival chose inprevious round.

Predatory pricing drive rivals out and creates a reputation for toughness to deter future entry, thus allowing the firm

to raise prices.

Competition in capacity

Cournot Model: This is the traditional model of competition in capacity/ quantity. The strategy consists of making

simultaneous quantity choices. Both the firms have same information, and no cooperation is allowed.

StackelbergModel: This model supports the concept of first mover advantage.

Differentiation

Vertical: when your product is superior to your competitors product for allbuyers. This superiority allows oneto extract price premium.

Horizontal: Different products both of which are neither superior nor inferior. For e.g. red vs. blue widgets. Thisallows firms to price above cost because there will be different buyers in the market willing to pay some price

for their preferred widgets.

Differentiation softens price competition

Information asymmetry and moral hazard

Information asymmetry: Sellers know more than buyers

Buyerseller information asymmetry (BSIA) is a growingproblem. Application

Second Hand Market Auction Flea Markets Insurance

Market for Lemons: Also called ADVERSE SELECTION: Because of information asymmetry, low quality goods drive outhigh quality goods. That is why markets sometime break down

Signaling in the Market:- Firms with better quality products can use strong signals of quality to convey their superiority.

E.g. warranties.

Moral Hazard: When actions are unobserved i.e. people cant be monitored they might become careless and raise

costs. E.g. Behaviour after insurance.

Documents

MGEC