introduction to managerial economics - web.uvic.caweb.uvic.ca/~pcourty/chap 1-3.pdf · introduction...

Introduction to Introduction to Managerial EconomicsManagerial EconomicsManagerial EconomicsManagerial Economics

Plan for this eekPlan for this week

Course introduction Course: scope goals and topics Course: scope, goals, and topics Preliminaries: background concepts

2(c) 1999-2007, I.P.L. Png & D.E. Lehman

Who am I?Who am I?

Name: Pascal Courty Name: Pascal Courty Nationality: French

f f PhD in Economics from University of Chicago Research: pricing policies (industrial

i ti ) i ti tiorganization), incentive compensation (personnel economics)Y t t l b t You want to learn more about me http://web.uvic.ca/~pcourty/

3(c) 1999-2007, I.P.L. Png & D.E. Lehman

Co rse descriptionCourse description

This is a course in applied microeconomics This is a course in applied microeconomics with a primary focus on the needs of managersmanagers

We study firms and markets, how they operate and how the market mechanismoperate and how the market mechanism works

The goal is to provide a range of economic The goal is to provide a range of economic tools and concepts to analyze market outcomes, and then help understand how to

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apply them in practice

Course ContentCourse Content

1 Introduction1. Introduction2. Demand3. Elasticity 4. Supply

Microeconomics Tool Kit4. Supply

5. Competitive Mkts6. Economic Efficiency8. Monopoly

Tool Kit

p y9. Pricing Policy10. Strategic Thinking11. Oligopoly

StrategyTool Kit

12. Externalities13. Asymmetric Information14. Incentive and Organization15 R l ti

Business and Government

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15. Regulation

Co rse req irementsCourse requirements

3 problem sets based on a real world case 3 problem sets based on a real world case study and formal exercises (25%)

iClicker (10%) iClicker (10%) 2 midterm exam on October 4th and

November 2th (20% each)November 2th (20% each) Industry project (25%)

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What does microeconomics brings to management education?

Formal models (= Stylised descriptions) Role of assumptions is to abstract from irrelevant p

details Models provide an explicit analysis using a

transparent and logical methodtransparent and logical method

Useful frameworks to discuss management problemsp Language to discuss business situations One of the intellectual foundation for management

education

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education

Source: AirbusReproduced with permission

Airbus vs BoeingAirbus vs Boeing

Airbus: Until 2001, established under French law as a “Groupe d’Intérêt Economique”

Boeing: Listed company

April 2004

Dec. 2004

Dec. 2005

June 2006

Airbus launches

Boeing launches

2005 sales Airbus: 1111

Airbus delays A380; shares

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launches A350

launches 787

Airbus: 1111 Boeing: 1029

A380; shares fall 26%

Airbus vs BoeingAirbus vs Boeing

Why did Airbus corporatize in 2001? What are benefits from corporatization?

Why did Airbus Chief Commercial Officer John Leahy remark that A350 would “put a hole in Boeing’s Christmas stocking”?

How should Boeing respond?

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Managerial economicsManagerial economics

Science of directing scarce resources resources – financial, human, physicalp ymanagement of customers, suppliers,

competitors, internal organization setting – business, nonprofit, household

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Preliminaries: ScopePreliminaries: Scope

Managerial economics based on microeconomics

i i di id l i b h i micro – individual economic behavior macro – aggregate economic behavior Example: increase in oil price Example: increase in oil price

≫ micro effects – vehicle users, electric power generators

≫ macro effects – inflation, unemployment

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Preliminaries: MethodologyPreliminaries: Methodology

Economic model – concise abstraction of behavior and outcomes

Marginal vis-à-vis average Stock vis-à-vis flow Other things equal

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Preliminaries: MethodologyPreliminaries: Methodology

Timing static model – single point in timeg p dynamic model – focus on sequence of actions

and payments

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OrganizationOrganization

Vertical boundaries – closer to or further from end user

Samsung Electronics – vertical boundaries longer than Intel – specializes in semiconductors

(upstream)M l i li i bil hMotorola – specializes in mobile phones (downstream)

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OrganizationOrganization

Horizontal boundaries – scale and scope of activities

Samsung Electronics – horizontal boundaries broader than LG.Philips LCD – specializes in LCDMotorola – specializes in mobile phones

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Individual behaviorIndividual behavior

Bounded rationality: individuals have limited cognitive abilities and cannot fully exercise self-control

S t ti f diff t t i f b fit Separate accounting for different categories of benefits and costs

Lack self-control: addictive behavior and difficulty ypostponing immediate gratification for longer-term benefits

More sensitive to losses than to gains More sensitive to losses than to gains Decisions may depend on how choices are “framed”

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MarketMarket

Definition: Buyers and sellers communicate with one another for voluntary exchange

Market need not be physical Industry – businesses engaged in the y g g

production or delivery of the same or similar items

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Competitive marketCompetitive market

Benchmark for managerial economics Extremely competitive market y p

≫many buyers and many sellers ≫no room for managerial strategizing

Achieves economic efficiency

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Competitive marketCompetitive market

Model: demand supplymarket equilibrium

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Market powerMarket power

Definition – ability of a buyer or seller to influence market conditions

Seller with market power must manage costs pricing advertising expenditure R&D expenditure strategy toward competitors

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Market power:Prozac

August 2001: US Court of Appeals limited Prozac patent Lilly market value dropped $36 billion Barr market value rose $1.1 billion

Huge discrepancy in impact – why?

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Imperfect marketImperfect market

Definition: where one party directly conveys a benefit or cost to p y y y

others, or one party has better information than others

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DemandDemand

OutlineOutline

Individual demand Demand and income Other demand factors Market demand Market demand Buyer surplus Business demand Business demand

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Individual demandIndividual demand

Definition: graph of quantity that buyer will purchase at every possible price Construction – “Other things equal, how many would you buy at a price of ….?’’

vertical axis – price horizontal axis – quantity

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Individual demandIndividual demand

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Individual demandIndividual demand

Two views of demand curve For every possible price, demand curve shows y p p

the quantity demanded For each unit of item, demand curve shows

th i i th t th b i illi tthe maximum price that the buyer is willing to pay

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Individual demand: Marginal benefit

Definition: benefit provided by additional unit of item

Diminishing marginal benefit – each additional unit of consumption/usage provides less benefit than the preceding unit demand curve slopes downward

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Individual demand:Consumer differences

Individual preferences different demand curves Changes in consumer's preferences, eg, ageDifferent consumers

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OutlineOutline

Individual demand Demand and income Other demand factors Market demand Market demand Buyer surplus Business demand Business demand

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Demand and incomeDemand and income

Construction – “Suppose that your income is […] per year. Other things equal, how many would you buy at a price of ….?’’ vertical axis – price horizontal axis – quantity

Different demand curve for each income level

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Demand and incomeDemand and income

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Demand and incomeDemand and income

Changes in price vis-a-vis incomeNormal product – demand increases with p

income Inferior product – demand falls with income

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OutlineOutline

Individual demand Demand and income Other demand factors Market demand Market demand Buyer surplus Business demand Business demand

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Other demand factors: Complements

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Other demand factors: SubstitutesOther demand factors: Substitutes

DirectMBA education: Dartmouth / NYU / USC Transportation: American Airlines / British

Airways

FunctionalMBA education – residential / distance learning Security: Lock and key / biometric / password Communication: airline / train / video-

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conferencing / mail

Other demand factors: Hardware-software complements

Shaver – blade Printer – cartridges g Wheels – tires Packaging machine – supplies Packaging machine supplies Water purification equipment – chemicals Machinery – maintenance service Machinery – maintenance service

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Convergence of di it lconsumer digital

devices Substitutes? Substitutes? Complements?

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Other demand factors: ComplementsOther demand factors: Complements

Internal provision Even for individual personsp

≫Entertainment ≫Wealth management≫Tax reporting

Especially for business customers – “Make or b ”buy”≫Physical inputs – vertical integration≫Services – HR payroll finance IT

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≫Services – HR, payroll, finance, IT

Other demand factors:Durable goods

Expectations about future prices and income Financing costsg Prices of used models

substitute for new good substitute for new good future value of new good

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OutlineOutline

Individual demand Demand and income Other demand factors Market demand Market demand Buyer surplus Business demand Business demand

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Market demandMarket demand

k d d h lMarket demand = horizontal summation of individual demands

Price Joy Max Lucas Market

$10 0 0 0 0

$7.50 1 0 0 1

$5 2 1 0 3

$2.50 4 2 3 9

$0 7 6 4 17

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Market demand: ConstructionMarket demand: Construction

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Market demand: Macro factorsMarket demand: Macro factors

Income AveragegDistribution

Demographicg p Population Age structureg Urban-rural

Cultural-social

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Market demand: Micro factorsMarket demand: Micro factors

Price Advertisingg R&D

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OutlineOutline

Individual demand Demand and income Other demand factors Market demand Market demand Buyer surplus Business demand Business demand

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Buyer surplusBuyer surplus

Individual buyer surplus: buyer’s benefit minus price must pay for the item

Market buyer surplus: sum of individual buyer surpluses.

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Buyer surplus: IndividualBuyer surplus: Individual

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Buyer surplus:Gains from price cut

Lower price on the quantity that he/she would have purchased at the original price (infra-marginal units)

He/she can buy more (marginal units)

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Buyer surplus: Package dealBuyer surplus: Package deal

Charge buyer just a little less than her/his total benefit

Leave buyer with almost zero surplus

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Buyer surplus:Two-part pricing

fixed payment usage chargeg g

fixed payment

usage charge

payment

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Buyer surplus: Two-part pricingBuyer surplus: Two-part pricing

Business Provider Fixed Fee Usage Fee

Broadband access, Hong

PCCW Netvigator 3M Single User

HK$298 per month

HK$2 per additionalaccess, Hong

Kong3M Single User Plan

month (incl. 100 free hrs)

additional hr

Mobile telephone Etisalat 125 dirham 0 24/0 18Mobile telephone service, UAE

Etisalat Corporation, GSM Standard Service

125 dirham connection fee; 60 dirham per

0.24/0.18 dirham per min (peak/

offpeak)Se ce d a peqtr

offpeak)

54(c) 1999-2007, I.P.L. Png & D.E. Lehman

Buyer surplus: Two-part pricingBuyer surplus: Two-part pricing

Business Provider Fixed Fee Usage Fee

Check-writing bank

Bank of America

nil US$2 per tellerbank

account, California

America, VERSATEL Checking

teller transaction

Weekday car rental,

Airport RentaCar,

A$70 for one day (incl. 100

A$0.25 per additional km

Melbourne Toyota Camry free km)

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OutlineOutline

Individual demand Demand and income Other demand factors Market demand Market demand Buyer surplus Business demand Business demand

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Business demandBusiness demand

Business demands items as inputs into further production, not for consumption finished/semi-finished components -- raw materials and energy labor and other services capital

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Business demandBusiness demand

Demand for inputs depends on quantity of final outputq y p prices of complements and substitutes in

production

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Business demandBusiness demand

Marginal benefit = increase in revenue arising from an additional unit of the input

Diminishing marginal benefit downward-sloping demand

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Automated teller machinesAutomated teller machines

Increase in wages teller service became increasingly costly

Banks used ATMs to substitute for tellers compare use of ATMs in U.S. vs India

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GM: What metal to use?GM: What metal to use?

Aluminium vis-à-vis steel auto weight

≫fuel consumption ≫emissions

price

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SummarySummary

Individual demand Demand and income Other demand factors Market demand Market demand Buyer surplus Business demand Business demand

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El ti itEl ti itElasticityElasticity

New York City Transit AuthorityNew York City Transit Authority

May 2003: projected deficit of $1 billion over following two years Raised single-ride fares from $1.50 to $2 Raised discount fares

≫One-day unlimited pass from $4 to $7≫30-day unlimited pass from $63 to $70

Increased pay-per-ride MetroCard discount from 10% bonus for purchase of $15 or more to 20% for purchase of $10 or more

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to 20% for purchase of $10 or more.

OutlineOutline

Own-price elasticity Forecasting quantity demanded and g q y

expenditure Other elasticities Adjustment time

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Own-price elasticityOwn-price elasticity

Definition: percentage change in quantity demanded resulting from 1% increase in price of the item.

Alternatively,

_demandedn_quantity%_change_i

n_price%_change_i

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Own-price elasticity: CalculationOwn-price elasticity: Calculation

% change in qty = (1.44- g q y (1.5)/1.47 x 100 = -4.1%

% change in price = (1.10-1)/1.05 x 100 = 9.5%

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Own-price elasticityOwn-price elasticity

Elastic: 1% price increase leads to more than 1% drop in quantity demanded.

Inelastic: 1% price increase leads to less than 1% drop in quantity demanded.

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Own-price elasticity:EstimatesItem Market ElasticityConsumer productsCoffee U.S. -3.06Cigarettes U.S. -0.2, -0.4Soft drinks U.S. -3.09Liquor U.S. -0.2

ServicesEl t i it ( id ti l) Q b 0 7Electricity (residential) Quebec -0.7Water (residential) U.S. -0.2, -0.3Water (industrial) U S 0 7 1 0

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Water (industrial) U.S. -0.7, -1.0

Own-price elasticity: FactorsOwn-price elasticity: Factors

Availability of substitutes Direct Indirect (functional)

≫human teller / ATM≫email / postal service≫email / postal service≫system security / lock≫CCTV / guard/ g

Cost / benefit of economizing – buyer’s “involvement”

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Own-price elasticity: FactorsOwn-price elasticity: Factors

Buyer’s prior commitments learningg

complementary purchases – spare parts, customization

taste

Separation of buyer and payeep y p y

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Own-price pelasticity

“Extensive researchExtensive research and many years of experience have t ht th ttaught us that business travel demand is quitedemand is quite inelastic… On the other hand, pleasure t l h b t ti ltravel has substantial elasticity.”

Robert L. Crandall, CEO,

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Robert L. Crandall, CEO, American Airlines, 1989

Own-price elasticity:AAdvantage

1981: American Airlines pioneered frequent flyer program buyer commitment

business executives fly at the expense of others

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Own-price elasticity: SlopeOwn-price elasticity: Slope

Steeper demand Steeper demand curve means demand less elastic

But slope not same as elasticityy

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OutlineOutline

Own-price elasticity Forecasting quantity demanded and g q y

expenditure Other elasticities Adjustment time

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Forecasting:When to raise price

CEO: “Profits are low. We must raise prices.”

Sales Manager: “But my sales would fall!” Sales Manager: But my sales would fall!

Real issue: How sensitive are buyers to price changes?changes?

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ForecastingForecasting

Forecasting quantity demanded Change in quantity demanded = price g q y p

elasticity of demand x change in price

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Forecasting:Price increase

If demand elastic, price increase leads to proportionately greater reduction in purchases p p y g p lower expenditure

If demand inelastic, price increase leads to , p proportionately smaller reduction in purchases higher expenditure higher expenditure

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Forecasting:Price increase

If demand inelastic, price increase leads to proportionately smaller reduction in purchases p p y p lower cost

higher expenditure = higher revenue higher profit

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Forecasting:k iCoke vs Pepsi,

Nov. 1999

Coke raised pricep increased

advertising

Pepsi followed Both increased profit

(demand was inelastic)

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OutlineOutline

Own-price elasticity Forecasting quantity demanded and g q y

expenditure Other elasticities Adjustment time

81(c) 1999-2007, I.P.L. Png & D.E. Lehman

Income elasticityIncome elasticity

Definition: percentage change in quantity demanded resulting from 1% increase in income.

Alternatively,

n income% change i

_demandedn_quantity%_change_i

n_income%_change_i

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Income elasticity: EstimatesIncome elasticity: Estimates

Item Market ElasticityItem Market Elasticity

Consumer products

Cigarettes U S 0 1Cigarettes U.S. 0.1

Liquor U.S. 0.2

ServicesServices

Electricity (residential) Quebec 0.1

T l h S i 0 5Telephone Spain 0.5

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Cross elasticity: EstimatesCross elasticity: Estimates

Automobiles Market ElasticityAutomobiles Market Elasticity

Domestic/other brands U.S. 0.28

European/other brands U S 0 76European/other brands U.S. 0.76

Asian/other brands U.S. 0.61

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Advertising elasticity

direct effect – raises demanddemand

indirect effect –makes demand lessmakes demand less sensitive to price

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Advertising elasticity: EstimatesAdvertising elasticity: Estimates

Item Market ElasticityItem Market Elasticity

Beer U.S. 0

Wi U S 0 08Wine U.S. 0.08

Cigarettes U.S. 0.04

If advertising elasticities are so low, why do manufacturers of beer, wine, cigarettes advertise so heavily?

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OutlineOutline

Own-price elasticity Forecasting quantity demanded and g q y

expenditure Other elasticities Adjustment time

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Adjustment timeAdjustment time

Definitions Short run: buyer cannot adjust at least one y j

item of consumption or usage Long run: long enough time for buyer to

dj t ll itadjust all items

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Adjustment timeAdjustment time

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Adjustment time:Two factors

Is demand more or less elastic in long run? Does price change lead to bigger or smaller

Longer time Replacement

effect on quantity in long run?

Longer time more flexibility to adjust

Replacement frequency sharp change

non-durables yes no

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durables yes yes

Adjustment time:Short/long run elasticities

Item Factor Market Short-run

Long-run

Cigarettes price U.S. -0.2 -3.3

Gasoline price intern’l -0.23 -0.43

Gasoline income intern’l 0.39 0.81

Electricity price N.Z. -0.18 -0.44

Automobiles price U.S. -0.2 -0.5

Automobiles income U.S. 3.0 1.4

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Automobiles income U.S. 3.0 1.4

Bob LutzBob Lutz

May 31, 2004: “It sounds cavalier, but in any household budget, gasoline isn't a factor”, Business Week.Week.

July 1, 2005: “The demise of the full-size truck is a figment of the imagination of the popular press. Everybody assumes it is true but the market is stillEverybody assumes it is true but the market is still buying”, Reuters.

“The effect will decrease over time as people adjust to the thought of $3 a gallon, just as they did when it was $2 a gallon and just as they did when it was $1 a gallon”, New York Times.

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Bob LutzBob Lutz

Cross-elasticity of demand for SUVs with respect to price of oil Short run Long run

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SummarySummary

Own-price elasticity Forecasting quantity demanded and g q y

expenditure Other elasticities Adjustment time

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