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Introduction to Introduction to Managerial EconomicsManagerial EconomicsManagerial EconomicsManagerial Economics
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Plan for this eekPlan for this week
Course introduction Course: scope goals and topics Course: scope, goals, and topics Preliminaries: background concepts
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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/
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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
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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
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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
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Source: AirbusReproduced with permission
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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%
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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
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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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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
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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
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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)
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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
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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.
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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
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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
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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
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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
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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
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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
94(c) 1999-2007, I.P.L. Png & D.E. Lehman