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Introduction to Managerial Economics

Rudolf Winter-Ebmer

Dep. of Economics

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Preliminaries

Slides of presentation at my homepage on Tuesdayswww.econ.jku.at/Winter

You should read assigned text before the course exercises and examples will also be provided after the lectures 2 examsWatch out exact dates of lectures! – 120 minute lecture each week2 home assignments will be sent out by e-mail

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More preliminariesTeaching Assistant:

Bernd Speta: bernd.speta@gmx.atPhone: Ext. 8332

Office Hours:Tuesday, 17.00 - 18.00Room: K 152D1

The teaching assistant shall be the first person to contact if you have problems understanding something and also for organizational issues.

We have 15 minutes break each lecture to have coffee and talk …

Textbook: Allen, Doherty, Weigelt and Mansfield “Managerial Economics, 6th edition7th edition is ok as well

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

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Norton Media Library

W. Bruce AllenNeil A. Doherty

Keith WeigeltEdwin Mansfield

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Grading2 exams, 48 points each, mostly MC questions

2 homeworks during the term: 6 points for each homework possibleto complete the course, at least 6 homework-points are

necessary!

Total sum of points (including extra points) mustbe higher than 48 for a positive result

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What is Managerial Economics?

Applied micro-economics, but with a focus on decision making„What shall a manager do in this and that situation?“Pricing decisions in different circumstancesMarket entry, innovation, auction theoryOrganization of the firmPersonnel policy, how to motivate workers

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Theory of the firm

A theory indicating how a firm behaves and what its goals are

Value of the firm should be maximal:

The present value of the firm’s expected future cash flows …

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Present value of expected future profits

where: TRt = the firm’s Total Rev. in year tTCt = the firm’s Total Cost in year ti = the interest rate

and t goes from 1 (next year) to n (the last year in the planning horizon)

nt t

tt 1

TR TC(1 i)=

−+∑

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Economic profit conceptProfit the firm owner makes over and above what their labor and capital employed in the business could earn elsewhere.

In competitive industries profits are zeroWhy? What are competitive industries?

Are most industries competitive industries?

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Situations with positive profits

Innovations

Market entry is not (easily) possible

Risk involved

Industry is not competitive

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Chapter 3Demand Theory

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Market Demand for Personal Computers,

2000

2200

2400

2600

2800

3000

3200

0 500 1000 1500 2000

quantity

Pric

e

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

at each price

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Other determinants of market demand besides the price

Consumer tastes and preferencesConsumer incomesLevel of other prices

Size of consumer populationAdvertising

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Price elasticity of demand

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

(called eta)

Important for pricing decisions.

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

QP

PQ

∂∂

=η

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Calculating elasticities

Point estimate: (demand function is known); calculated at a specific point of demand.

Use statistic regression analysis (ch.5)

Arc elasticity: uses average values of Q and P as reference points (if only a table is known)

QP

PQ

∂∂

=η

2/)(2/)(

)()(

2/)(2/)(

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12

12

21

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QQPP

PPQQ

QQPP

PQ

++

−−

=++

∆∆

=η

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Price elasticity of demand and gross revenues

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

η > -1 ==> a direct relationship between price changes and gross revenues.

η = -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 revenue and price elasticity

Suppose P = a - bQ, (linear demand function)

then TR = aQ - bQ2

MR = dTR/dQ = a - 2bQ

Since η = (dQ/dP) . (P/Q)

QbQa

b)(1 −

−=η

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Quantity

Price

Quantity

Dollars

a

a/ba/2b

TotalRevenue

Demandand MR

η < −1

η > −1

η = −1

Total revenue, marginal revenue and price elasticity

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Marginal Revenue, priceand price elasticity

If product is price elastic (η<-1, marginal revenue must be positive)Example: what is MR if price is $10 and price elasticity is -2? 10(1+1/(-2)) = $5.

Isn‘t this strange? Price is $10, you sell one piece more, but yourrevenues rise only by $5 ???

What if product is very price elastic (η=-∞)?

⎟⎟⎠

⎞⎜⎜⎝

⎛+=

=⎥⎦

⎤⎢⎣

⎡+=+=

==

η11

1

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

P

dQdP

PQP

dQdPQPMR

whyQPPnotedQPQdMR

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Determinants of price elasticity of demand

Elasticity is greater (in absolute values, i.e more elastic) when:

there are more substitutes for the product.the product is a more important part of a consumer’s budget.the time period under consideration is greater.

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Puzzle

A soccer promoter must allocate 40,000 seats in the stadium among the supporters of the two competing teams, the Wolverton Gladabouts and Manteca United. This promoter can set different prices for seating in the Wolverton and Manteca sections. If she sells W seats to Wolvertonsupporters, she will receive £20-W/2000 for each, while she can get £10 per ticket from Manteca supporters, regardless of the number of tickets she sells to them. Her objective is to allocate the 40,000 seats she has available to maximize her gate receipts. A fried suggests that an equal allocation of 20,000 seats to each side is best, since this will mean that the price of each ticket is the same, £10; at any other division, she would be making more per ticket on one team than on the other. Why is this friend wrong?

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Price Elasticity versus Marginal Return

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

You really should know this figure for your productsPrice 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 unitMR = Marginal Revenue = Marginal Return

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

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

==> optimal price depends upon MC and price elasticity==> The higher (the absolute value of) price elasticity, the lower the optimal price

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

priceoptimalMCP

rulepricingPMRMC

..../11

1

...)11(

⎟⎟⎠

⎞⎜⎜⎝

⎛+

=⇒

+==

η

η

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Income elasticity

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

IQ II Q

η ∂=

∂

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1.541.491.481.421.401.100.920.480.420-0.20-0.36

AlcoholHousing, owner-occupiedFurnitureDental servicesRestaurant mealsShoesMedical insuranceGasoline and oilButterCoffeeMargarineFlour

Income elasticity of demandCommodity

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

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

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

resulting from a 1 percent change in the price of good Y

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

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

,X Y

X YY X

Q PP Q

δηδ

=

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Use elasticities for marketforecasts

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

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

Income elasticity: given a forecast of GDP-growth isavailable, 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

• Is it worth to spend more on advertising?

QA

AQ

A ∂∂

=η

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