Managerial Economics

Lecture One:
Why economics matters to managers,
marketers and accountants
Neoclassical theory of profit maximisation
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• Assessment: 3 parts
– Group presentation in tutorials 20%
– Essay on group presentation topic 40%
– Exam 40%
• My details
– Steve Keen
• 4620-3016
– 0425 248 089 in emergency
• S.keen@uws.edu.au
• Thursdays 1-3pm
 Economics as the context of business
• Management, marketing & accounting focus on specifics
– How to manage a company…
– How to market a product…
– How to quantify & compare corporate performance…
• Focus is your personal input to business
• Economics is the context of business
– “Men make their own history, but they do not make it as
they please; they do not make it under self-selected
circumstances, but under circumstances existing already,
given and transmitted from the past”
• Focus on constraints on and circumstances of your input
– Both opportunities & dilemmas
– Quick quiz: who made the above statement?
 Economics as the context of business

•Often the best wisdom in economics

isn’t found in standard textbooks!
•This subject takes a deeper look at
economics you’ve already done (micro,
macro); and
•considers theories & data you
haven’t seen before that are more
relevant to business
 Economics as the context of business
• A hierarchical view: starting from the bottom & working up
– The firm
– The market/industry
– The economy
– Finance
– International business
• A critical view
– Conventional theories of above
• Profit maximising behaviour, types of competition, Game
theory, IS-LM, Efficient Markets, Comparative
advantage
– Different perspectives
• Empirical data
• Critiques of conventional theories
• Alternative theories
 Economics as the context of business
• What matters most to your firm’s success may lie outside it:
– “For companies, a central message … is that many of a
company’s competitive advantages lie outside the firm…”
(Porter 1998: xxiii)
• Understanding “what lies outside” may therefore be the most
important thing you can do to be a successful executive
– Economics as the study of “what lies outside”
• Relationships with other firms
• Interaction with the market
• Market interaction with the macroeconomy
• Macroeconomy’s interaction with global economy; AND…
• Theories about the economy! Because:
 Economics as the context of business
• Sometimes (not often enough!) theories explain how the real
world works
• Frequently (too often!) theories affect how people behave in
the economy
– Government follows economic advice
– Firms/unions think about economy in terms of economic
models
– Government bodies (e.g. ACCC Australian Competition &
Consumer Commission) apply economic theory in policies (e.g.
competition policy, deregulation of telecommunications,
etc.)
• So you have to understand economic theory even if it’s wrong!
– Which it frequently is…
 Economics as the context of business
• Emphasis in this course is on realism
– Theories presented; but also
– Empirical data examined to see whether theories actually
work
– Frequent conclusion: they don’t (but sometimes they do…)
• One consequence: can’t rely upon textbooks for this
course!
• Textbooks normally
– present theory uncritically
– only include “case studies” that confirm accepted
theory
• frequently based on invented rather than real
data
– Normally don’t go beyond microeconomics
 Economics as the context of business
• This course
– Starts with micro (theory of firm…)
– Progresses through theory of the market, economy, finance
to international trade
– Based heavily on readings volume
• You must have a copy
• Tutorials and assessments based on contents
 “The firm”: real world vs economic theory
• The real world: an incredible diversity
– Size: from corner store to Microsoft
– Operations: from one outlet to almost all countries
– Diversity:
• from single product (wheat farm) to many (Sony)
• From one industry to many
– Ownership: from sole proprietor to multinational listed
company
– Structure:
• from one person operations to multi-department
• From sole operations (production to sale) to
specialisation in manufacturing, wholesale, retail,
marketing, consulting…
 Economics of the firm: statistics
• Firms in the Australian economy
– Range in size from sole proprietor/employee to multi-
employee institutions
– From single product to diversified conglomerates
– Over 610 thousand “entities” in 2000 (ABS 8140.0)
• 3229 “large” entities employing 200 or more workers
• 607,663 “other” employing less
• “Average” employment 10.1 persons per firm
– “Average” large firm employed 750 workers
– “Average” other firm employed 6.5 workers
• Legal multitude of businesses masks much smaller number
of operating units: 15,870 units with 700,024 legal
entities in 1998/99
 Economics of the firm: statistics
• Concentration obvious (ABS 8140.0.55.001)
– Top 20 units responsible for 13.9% of sales
– 15,850 others responsible for remaining 86.1% of sales
• Economic theory abstracts from this concentration & diversity
– Claims firms share several essential common properties
• Profit maximising behaviour
• Under conditions of diminishing marginal productivity
• Selling on “spot” market (no stocks) to anonymous buyers
– Only interest buyers have is in getting lowest price
– No interest in continuing relationship between
buyer/seller; “arms length” transactions
 “The firm”: economic theory
• The economic simplification: diversity ignored to focus on
alleged essence of profit maximising behavior:
– Basic model
• single industry & product
• one location
• privately owned, sole proprietor
– No internal structure considered
– No specialisation: firm does everything from manufacturing
to sales
• Some generalisations allowed later (e.g., agency theory)
– But basic theory abstracts from these details
– Core model: profit maximising behaviour under conditions
of diminishing marginal productivity
 Economic theory of the firm
• Profit maximising behavior:
– Seeking highest possible profit given constraints of
• Falling price as quantity offered for sale rises
• Rising costs as quantity offered for sale rises
– Falling price as quantity offered for sale rises:
• “Law of demand”: can only sell additional units if price is
lowered
• Mathematically: a negative relationship between price
and quantity
– To ↑quantity sold must ↓ price
– Simple example: linear demand curve P(Q) = a –b Q
 Economic theory of the firm
• Graphing price as a function of quantity: • Key consequence of
“law of demand”:
1
a := 100 b := P ( Q) := a − b ⋅ Q • Total revenue is price
2000 times quantity
100 • Total revenue rises
for a while as
increase in Q more
80
than outweighs
decline in P
60 • But ultimately fall in
P (Q) P overwhelms
40
increase in Q: total
revenue peaks and
then falls…
20

Price as function of quantity

0
4 5 5 5
0 5 . 10 1 . 10 1.5 . 10 2 . 10
Q
 Economic theory of the firm
TR ( Q) := P ( Q) ⋅ Q
• If firm produces
20,000 units, market
100 Slope=0 2.5 . 10
6
price is 80

40
– Total revenue =
e= 6 80 * 20,000 =
80 2 . 10
op

$1.6 million
Sl

6 • 40,000 units sold,

1.5 . 10
20,000x80

60
price 60
40,000x60

P (Q) TR ( Q )
. 6 – Total revenue =
40 1 10
60 * 40,000 =
$2.4 million
60,000x40
5
20 5 . 10
– Change in total
revenue $0.8 m
0 0
0
4
2 . 10
4
4 . 10
4
6 . 10
4
8 . 10
5
1 . 10
– Change in unit
Q
revenue=$0.8
m/20,000=$40
Price (LH Scale)
• 60,000 units sold, price 40
Revenue=Price x Quantity (RHS)
– Total revenue $2.4 million
– Change in revenue per unit zero
 Economic theory of the firm
• Change in revenue called “marginal revenue”
• “In the limit”, marginal revenue equals slope of total revenue curve:
• Value of marginal revenue (x)
equals slope of total revenue
curve at same point (o)
• Other side of profit equation is
costs:
– Fixed: costs incurred
regardless of how many units
produced (research,
development, factory
construction, rent, etc.)
– Variable: costs that depend
on level of output: wages, raw
materials, intermediate
goods, etc.)…
 Economic theory of the firm
• Theory argues per unit costs rise as quantity offered for sale rises:
1 1
k := 1000000 c := 30 d :=
100000
f :=
400000000
• Slope of total cost curve
FC ( Q) := k
2
VC ( Q) := c ⋅ Q + d ⋅ Q + f ⋅ Q
3
TC ( Q) := FC ( Q) + VC ( Q) is marginal cost:
7
3 . 10
• Rises as output rises
Total Cost because of diminishing
2.5 . 10
7 Fixed Cost marginal productivity
Variable Cost – After some point, each
7
2 . 10 new worker hired
TC ( Q )
(variable input) adds
FC ( Q ) 1.5 . 107 less to production than
VC ( Q ) previous worker
7
1 . 10
– With constant wage
6
and diminishing output
5 . 10
per worker, unit cost
of output rises
0
0
4
5 . 10 1 . 10
5
1.5 . 10
5
2 . 10
5
• “Please explain”…
Q
 Economic theory of the firm
• Rising marginal cost: the argument…
– Production occurs in “the short run”
– “Short run”: period in which at least one crucial input to
production can’t be varied (normally machinery)
– Therefore to increase output, more “variable factors” must
be added to the fixed factors
• Economic models normally consider just two factors:
– Labour
– “Capital”: grab-bag for all non-human inputs to
production
• Factory buildings
• Machine tools
• Electrical circuitry, computers
• Raw materials and intermediate inputs (e.g., car
stereo units for cars)
– As you add more & more variable factors to fixed factors…
 Economic theory of the firm
• There is some ideal worker:machine
ratio (e.g., one worker per jackhammer)
• In short run, firm has fixed
number of jackhammers ?

If this sounds
weird to you,
good! You’re on
to something…
• To dig holes, firm has to hire workers
• 1st worker operates all six jackhammers at once: pretty inefficient!

• Additional workers might show increasing productivity per worker

for a while (two workers operating 3 jackhammers each less messy
than one operating 6, ditto three workers operating two each…)
 Economic theory of the firm
• Eventually ideal ratio reached
(6 workers for 6 jackhammers)

• Then to dig more holes, have to

have more than one worker ?
?

per jackhammer:
• More holes can be dug with
2 workers per jackhammer
than with one…
• But productivity of two
workers per jackhammer
less than one worker per
?

jackhammer…
?
 Economic theory of the firm
• So productivity per worker might rise for a while;
• But ultimately falls as more output can only be produced by
adding more variable inputs (labour) to fixed input (capital) past
ideal labour:capital ratio
– Addition to output from each additional worker falls (but
doesn’t become negative)
• “Diminishing marginal productivity” (DMP)
• DMP leads to rising marginal cost
• Example: “Cobb-Douglas production function”
Relative labor/capital
Q = α × L ×K β 1− β
product coefficient

Quantity produced No. workers

Technology coefficient Amount of capital
 Economic theory of the firm
β 1− β
α := 10 K := 100 β := .4 L := 0 , 0.1 .. 250 Θ ( K , L , α , β ) := α ⋅ L ⋅ K

• Cobb-Douglas production
Cobb-Douglas Production Function
function allegedly fits 1500

aggregate economic data With 250 workers,

output is 1,443
well (but see Shaikh, A.
With 100 workers,
M., (1974). “Laws of output is 1,000
Algebra and Laws of
1000

Production: The Humbug

Output
Θ (K , L , α , β )
Production Function”,
Review of Economics and 500

Statistics, 61: 115-20)

0o0r0f1 si 0ts01

t upuo ni egna hC
• Example with α =10,

4 si 052 t xen morf

t upuo ni egna hC
K=100, β =.4, L between 0

0 and 250:
0 50 100 150 200 250

1 m
L

Number of workers
 Economic theory of the firm
• Each additional worker adds to output, but adds less than
previous worker: diminishing marginal productivity
– As usual, this is slope of total product curve: (maths
unimportant, but here it is!):

Q = α × L ×Kβ 1− β
• Differentiate with respect to Labour…

dQ
= α × β × Lβ −1 × K 1 − β • Graphing marginal product:
dL
 Economic theory of the firm
β −1 1− β
• Output with 49 MP ( L) := α ⋅ β ⋅ L ⋅K

workers = 752 Cobb-Douglas Production Function

• Output with 50 1500
1400 Total Product (Q) LHS
15
14
workers = 758 1300 Marginal Product RHS 13

• Marginal product of 1200

1100
12
11
50th worker ≈ 6

Marginal Product
1000 10

– Using formula, it’s 900 9

Output
exactly 6.063
800 8
Θ (K , L , α , β ) MP ( L )
700 7

• Output with 99 600

500
6
5
workers = 996 400 4

• Output with 100 300

200
3
2
workers = 1000 100 1

• Marginal product of 0
0 50 100 150 200
0
250

100th worker ≈ 4.012 L

– Using formula, it’s Workers

exactly 4 • Diminishing marginal product

leads to rising marginal cost…
 Economic theory of the firm
• First step is to “flip the axes”: graph labour input (on Y axis) needed to produce output
(on X axis):

• Just reads in reverse:

1
β Q := 0 .. 1500
 Q 
L ( Q) := 
– 1,000 units of output  α ⋅ K1− β 
 

desired; Workers needed given desired output

– 100 workers needed

300

• To get total (variable) 250

cost, multiply Y axis by

Workers needed
200

wage rate (say $12 an

hour)… L ( Q ) 150

100

50

0
0 500 1000 1500
Q

Output
 Economic theory of the firm
• Rate of change of w := 12 VC ( Q) := w ⋅ L ( Q) MC ( Q) :=
d
VC ( Q)
dQ
variable cost is marginal
cost Variable cost of desired output
3500 6

• Rising because of • Production level of 1000

diminishing marginal 3000 units has variable costs 5
of $1200
productivity… 2500
• Marginal cost of 1000th

Total variable cost

4
• So firm trying to units is about $3

Marginal cost
2000
maximise profits is VC ( Q ) 3 MC ( Q )

(according to economic 1500

theory) faced with 1000

2

– Falling price 500

1

– Rising cost…
0 0
• How to maximise profit? 0 500
Q
1000 1500

• Find biggest gap Output

between revenue and
cost
 Economic theory of the firm
• Graphically, it’s easy: (using earlier example)
• But economists
Profit( Q) := TR ( Q) − TC ( Q) prefer to make it
7
complicated by
3 . 10
working in average &
Total Revenue
marginal revenue &
2.5 . 10
7 Total Cost
Profit
cost
7 • Converting diagrams
2 . 10
TR ( Q ) to averages by
TC ( Q ) 7
dividing by quantity
1.5 . 10
gives us:
Profit ( Q )
7
1 . 10

6
5 . 10

0
4 5 5 5
0 5 . 10 1 . 10 1.5 . 10 2 . 10
Q
 Economic theory of the firm
• As economists like to show it: • What it means: “maximise profit
“maximise profit by equating by finding the biggest gap between
marginal revenue and marginal revenue and cost”
cost” • Gap between curves is biggest
when tangents (marginal revenue &
MC ( Q) :=
d
VC ( Q) AC ( Q) := TC ( Q) ÷ Q marginal cost) are parallel:
dQ

200

Marginal Cost
Average Cost
150 Price
Marginal Revenue
MC ( Q )

AC ( Q )
100
P (Q)

MR ( Q )

50

0
4 5 5 5
0 5 . 10 1 . 10 1.5 . 10 2 . 10
Q
 Economic theory of the firm
• So it’s “really easy” to manage a firm:
– Objective is to maximise profits
– Procedure is
• (1) Work out marginal cost
• (2) Work out marginal revenue
• (3) Choose output level that equates the two
• For competitive firms, it’s even easier…
– Competitive firms are “price takers”
• Too small to affect market price/take price as “given”
• Marginal revenue therefore equals price
– (MR less than price for less competitive industries)
– Profit maximisation rule is “produce output level at which
marginal cost equals price”:
 Economic theory of the firm
• “Perfect competition”
Downward sloping market Horizontal demand curve for
demand curve single firm
Price

Price
Supply Marginal Cost

dP dP
< 0, MR < P = 0, MR = P
Pe
dQ dq
Pe
Demand

Qe qe

Quantity
quantity
 Economic theory of the firm
• So the economic theory rules are:
– If you’re a monopoly or oligopoly
• Work out your marginal cost and marginal revenue
• Produce the output level at which they are equal
– If you’re in a competitive industry
• Work out your marginal cost
• Produce output level at which marginal cost equals price
– If you’re in an industry with a small number of large firms
• More complicated: game theory…
– More on this later
– As a typical text (Thomas & Maurice 2003, Managerial
Economics, McGraw-Hill, Boston) summarises it:
 Economic theory of the firm
• It’s a breeze for
competitive
industries (p.
450):

• A bit more
complicated for
monopoly (p. 500):

• And a real pain for

oligopoly (p. 560)…
 Economic theory of the firm
• What to do? So many choices…

• How does theory stack up against

reality?
 Economic facts of the firm
• Theory makes many predictions; e.g.
– Firms should have rising marginal costs
– Competitive firms should have elastic demand curves:
• Elasticity: how much demand changes for a change in
price: %changeQ ∆Q Q P ∆Q
E = = =
%change P ∆P P Q ∆P
– Value of E can be low (less than 1) for an industry, but in limit is
infinity for competitive firms (horizontal demand curve…)
– Relative prices should move frequently as supply & demand shift
• Problem: not observed in reality
– Relative prices seem stable
– Money prices tend to move up, not down…
– “Price stickiness”
 Economic facts of the firm
• Dispute in economics over whether prices “sticky” or
“flexible”
• Ideological division in dispute
– Neoclassicals/Free marketeers believe prices
“flexible”
• Prices adjust rapidly to changes in demand,
supply
Price

Supply • Economic problems caused by

government, union, monopoly
Pe
Demand behavior that makes some prices
(e.g. wages) more rigid than others
Qe Quantity
 Economic facts of the firm
– Keynesians/Mixed economy supporters believe “sticky”
• Prices adjust sluggishly
• Key markets (e.g. labour) can’t be “cleared”
(unemployment eliminated) simply by price movements
• Can have underemployment for substantial time;
government intervention needed for full employment
• Ideological dispute continues, but statistical results imply
“sluggish” price adjustments the rule
• Theory implies rapid adjustments should occur
• Why the difference?
• Plenty of theories as to why prices are sticky;
• Alan Blinder (in Readings) decided to ask firms “Why?”
– Alan S. Blinder et al., (1998). Asking About Prices: a new
approach to understanding price stickiness, Russell Sage
Foundation, New York.
 Economic facts of the firm
• Enormous volume of theoretical research in economics
• Huge amount of statistical (“econometric”) research too
• Relatively little empirical research
– Finding out what actually happens at firm/consumer level
– Also asking firms why they do what they do
• Frequency and rapidity of price changes etc.
• How behavior compares to different theories of price
stickiness
 Economic facts of the firm
• Blinder’s procedure
– Survey random sample of GDP so that results statistically
applicable to whole US economy
• 200 firms surveyed
– Structured survey to ensure objectivity
• Questions tailored to test economic theory
• Key economists consulted on design of questions
– Face to face interviews of top executives (25%
President/CEO, 45% Vice President, 20% Manager) by
Economics PhD students
• Questionnaire taken seriously, informed answers
• Interviewers could help clarify questions
• Interviews took 45-70 minutes for 30 questions
• Trial surveys undertaken prior to real thing to improve
uniformity of presentation, interpretation
 Economic facts of the firm
– Sample representative of private, for profit, unregulated,
non-farm industry (71% of US GDP)
• Reflects relative weight of industries in US GDP
• Excluded companies with < $10 million in sales
– Excluded group represents 25-50% of GDP
– Weight of industries in which small firms common
increased to compensate
• Farms excluded because “no-one believes farm prices to
be sticky” (60)
– Perhaps price dynamics of farm sector different to
manufacturing?
– Random sample selected, of those approached 61% took
part to yield 200 firms—high response rate
 Economic facts of the firm
• Distribution of sample differs from GDP with respect to firm
size:
Size Sample GDP
< $10 m 0% 26.4%
$10-$25 m 22.5% 7.1%
$25-$50 m 13.5% 12.7%
> $50 m 64% 67%

• But big firms overwhelmingly important component:

– Average sales of firms surveyed $3.2 billion!
• (even though 36% of surveyed firms had sales < $ 50 m)
• 7 biggest firms had sales > $20 billion each & represented 58
per cent of total sales by sample
– Firms surveyed represent 7.6% of US GDP
– “we interviewed an astounding 10 to 15 per cent of the target
population—a large fraction by any standard.” (68)
 Economic facts of the firm
• Blinder’s survey serious coverage of US economy
• Results give serious evaluation of economic theory
• If survey results consistent with theory, theory a good guide
to functioning of economy & to how managers should manage
• If survey results inconsistent with theory, relevance of
economic theory seriously jeopardised: could be irrelevant to
functioning of economy (& how managers should manage)

• Results contradict most of economic theory

– Most sales to other businesses, not end consumers
– Most sales to repeat customers, not “impersonal”
– Marginal costs fall for most firms, not rise
– Most firms face inelastic demand (E<1), not elastic
– Fixed costs more important than variable costs