Managerial Economics

Lecture One: Why economics matters to managers, marketers and accountants Neoclassical theory of profit maximisation

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• Purchase Reader • Check subject outline • 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

types of competition. IS-LM. Efficient Markets.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. Comparative advantage – Different perspectives • Empirical data • Critiques of conventional theories • Alternative theories . Game theory.

AND… • Theories about the economy! Because: .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.

competition policy.g.) • So you have to understand economic theory even if it’s wrong! – Which it frequently is… . deregulation of telecommunications. ACCC Australian Competition & Consumer Commission) apply economic theory in policies (e.g.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. etc.

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 .

finance to international trade – Based heavily on readings volume • You must have a copy • Tutorials and assessments based on contents .Economics as the context of business • This course – Starts with micro (theory of firm…) – Progresses through theory of the market. economy.

“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. consulting… . wholesale. retail. marketing.

1 persons per firm – “Average” large firm employed 750 workers – “Average” other firm employed 6.0) • 3229 “large” entities employing 200 or more workers • 607.024 legal entities in 1998/99 .Economics of the firm: statistics • Firms in the Australian economy – Range in size from sole proprietor/employee to multiemployee institutions – From single product to diversified conglomerates – Over 610 thousand “entities” in 2000 (ABS 8140.5 workers • Legal multitude of businesses masks much smaller number of operating units: 15.870 units with 700.663 “other” employing less • “Average” employment 10.

001) – Top 20 units responsible for 13.850 others responsible for remaining 86. “arms length” transactions .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.9% of sales – 15.Economics of the firm: statistics • Concentration obvious (ABS 8140.0.55.

.“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.g. sole proprietor – No internal structure considered – No specialisation: firm does everything from manufacturing to sales • Some generalisations allowed later (e. 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 .

10 5 2 . 10 4 1 .Economic theory of the firm • Graphing price as a function of quantity: a := 100 100 b := 1 2000 P ( Q) := a − b ⋅ Q 80 60 P (Q) 40 • Key consequence of “law of demand”: • Total revenue is price times quantity • Total revenue rises for a while as increase in Q more than outweighs decline in P • But ultimately fall in P overwhelms increase in Q: total revenue peaks and then falls… 20 Price as function of quantity 0 0 5 .5 . 10 5 . 10 Q 5 1.

10 Q 4 0 1 .000 = 2 . 10 5 Price (LH Scale) Revenue=Price x Quantity (RHS) • 60.5 .4 million 5 5 .000x60 20. market 6 2. 106 1 60 * 40. 10 4 6 .8 m 8 . 10 price is 80 – Total revenue = 6 80 * 20.000x80 4 .000x40 2 .6 million • 40.Economic theory of the firm TR ( Q) := P ( Q) ⋅ Q 100 80 60 P (Q) 40 20 0 0 Sl op e= 40 Slope=0 60.8 m/20.4 million – Change in revenue per unit zero – Change in unit revenue=$0. 10 4 • If firm produces 20.000 = $2. 10 – Change in total revenue $0. 6 1.000 units sold.5 . 10 price 60 TR ( Q ) – Total revenue = . 10 $1. price 40 – Total revenue $2.000 units sold.000=$40 . 10 4 40.000 units.

rent. factory construction. 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. etc. raw materials. intermediate goods. development.Economic theory of the firm • Change in revenue called “marginal revenue” • “In the limit”.)… . etc.) – Variable: costs that depend on level of output: wages.

each new worker hired (variable input) adds less to production than previous worker – With constant wage and diminishing output per worker. 10 f := 400000000 1 . 10 7 c := 30 d := 2 1 100000 3 VC ( Q) := c ⋅ Q + d ⋅ Q + f ⋅ Q Total Cost 2. 10 2 . 10 7 5 . 10 TC ( Q ) 7 FC ( Q ) 1.5 . 107 VC ( Q ) 1 . 10 7 Fixed Cost Variable Cost 2 . unit cost of output rises 5 5 • “Please explain”… 1. 10 Q 5 • Slope of total cost curve is marginal cost: TC ( Q) := FC ( Q) + VC ( Q) • Rises as output rises because of diminishing marginal productivity – After some point.Economic theory of the firm • Theory argues per unit costs rise as quantity offered for sale rises: k := 1000000 FC ( Q) := k 3 . 10 4 1 .5 . 10 6 0 0 5 .5 .

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.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.. car stereo units for cars) – As you add more & more variable factors to fixed factors… .g. computers • Raw materials and intermediate inputs (e.

ditto three workers operating two each…) . firm has fixed number of jackhammers ? If this sounds weird to you.g. good! You’re on to something… • To dig holes.Economic theory of the firm • There is some ideal worker:machine ratio (e. one worker per jackhammer) • In short run.. 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.

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 • Eventually ideal ratio reached (6 workers for 6 jackhammers) • Then to dig more holes.

• 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” Q = α × L ×K β 1− β Relative labor/capital product coefficient Quantity produced No. workers Amount of capital Technology coefficient .Economic theory of the firm • So productivity per worker might rise for a while.

output is 1. L between 0 and 250: α := 10 K := 100 β := . α . (1974). L . A.000 Output Θ (K .443 With 100 workers. β ) 500 t upuo n egna hC i 1 m001 s 0s01 0orf i t 0 0 50 100 L 150 200 t upuo n egna hC i 4 s 052 t xen m rf i o 250 Number of workers .. Review of Economics and Statistics.1 . 0.Economic theory of the firm • Cobb-Douglas production function allegedly fits aggregate economic data well (but see Shaikh.. K=100. β =.4.4 L := 0 . M. 250 Θ ( K . L . α . output is 1. β ) := α ⋅ L ⋅ K β 1− β Cobb-Douglas Production Function 1500 1000 With 250 workers. “Laws of Algebra and Laws of Production: The Humbug Production Function”. 61: 115-20) • Example with α =10.

but adds less than previous worker: diminishing marginal productivity – As usual.Economic theory of the firm • Each additional worker adds to output. but here it is!): • Differentiate with respect to Labour… Q = α × L ×K dQ = α × β × Lβ −1 × K 1 − β • Graphing marginal product: dL β 1− β . this is slope of total product curve: (maths unimportant.

β ) 800 700 600 500 400 300 200 100 0 0 50 100 L 150 200 15 Total Product (Q) LHS Marginal Product RHS 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0 250 MP ( L ) Workers • Diminishing marginal product leads to rising marginal cost… Marginal Product . it’s exactly 4 Output MP ( L) := α ⋅ β ⋅ L β −1 ⋅K 1− β Cobb-Douglas Production Function 1500 1400 1300 1200 1100 1000 900 Θ (K . L .Economic theory of the firm • Output with 49 workers = 752 • Output with 50 workers = 758 • Marginal product of 50th worker ≈ 6 – Using formula. α . it’s exactly 6.012 – Using formula.063 • Output with 99 workers = 996 • Output with 100 workers = 1000 • Marginal product of 100th worker ≈ 4.

– 100 workers needed • To get total (variable) cost..000 units of output desired. multiply Y axis by wage rate (say $12 an hour)… 1  Q   L ( Q) :=   α ⋅ K1− β    300 β Q := 0 .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. 1500 Workers needed given desired output 250 Workers needed 200 L ( Q ) 150 100 50 0 0 500 Q 1000 1500 Output .

Economic theory of the firm • Rate of change of w := 12 variable cost is marginal cost 3500 • • Rising because of 3000 diminishing marginal productivity… 2500 • • So firm trying to 2000 VC ( Q ) maximise profits is 1500 (according to economic theory) faced with 1000 – Falling price 500 – Rising cost… 0 0 • How to maximise profit? • Find biggest gap between revenue and cost Total variable cost VC ( Q) := w ⋅ L ( Q) MC ( Q) := d dQ VC ( Q) Variable cost of desired output 3 MC ( Q ) 2 1 500 Q 1000 0 1500 Output Marginal cost Production level of 1000 units has variable costs of $1200 Marginal cost of 1000th units is about $3 6 5 4 .

10 6 0 0 5 .5 . 10 5 2 . 10 7 Total Cost Profit 2 .5 . 10 5 . 10 TR ( Q ) TC ( Q ) 1. 10 7 Total Revenue 2. it’s easy: (using earlier example) Profit( Q) := TR ( Q) − TC ( Q) 3 . 10 4 1 .Economic theory of the firm • Graphically. 10 7 • But economists prefer to make it complicated by working in average & marginal revenue & cost • Converting diagrams to averages by dividing by quantity gives us: 5 . 10 Q 5 1.5 . 10 7 7 Profit ( Q ) 1 .

10 4 1 .5 . 10 5 . 10 Q 5 1. 10 5 2 .Economic theory of the firm • As economists like to show it: • What it means: “maximise profit by finding the biggest gap between “maximise profit by equating revenue and cost” marginal revenue and marginal cost” • Gap between curves is biggest when tangents (marginal revenue & d marginal cost) are parallel: MC ( Q) := VC ( Q) AC ( Q) := TC ( Q) ÷ Q dQ 200 Marginal Cost Average Cost 150 MC ( Q ) AC ( Q ) P (Q) MR ( Q ) 50 100 Price Marginal Revenue 0 0 5 .

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”: .

MR < P dQ Demand dP = 0. MR = P dq Pe Qe Quantity qe quantity .Economic theory of the firm • “Perfect competition” Price Downward sloping market demand curve Horizontal demand curve for single firm Price Supply Marginal Cost Pe dP < 0.

Boston) summarises it: . McGraw-Hill.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.

500): • And a real pain for oligopoly (p. 450): • A bit more complicated for monopoly (p. 560)… .Economic theory of the firm • It’s a breeze for competitive industries (p.

Economic theory of the firm • What to do? So many choices… • How does theory stack up against reality? .

g. not down… – “Price stickiness” %change P = ∆P P = Q ∆P . 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. – Firms should have rising marginal costs – Competitive firms should have elastic demand curves: • Elasticity: how much demand changes for a change in %changeQ ∆Q Q P ∆Q price: E = – Value of E can be low (less than 1) for an industry.Economic facts of the firm • Theory makes many predictions. e.

supply Price Supply Demand Qe Quantity Pe • Economic problems caused by government.g. wages) more rigid than others . union. monopoly behavior that makes some prices (e.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.

g. 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. (1998). Russell Sage Foundation. Asking About Prices: a new approach to understanding price stickiness.Economic facts of the firm – Keynesians/Mixed economy supporters believe “sticky” • Prices adjust sluggishly • Key markets (e. Blinder et al. • • • • • .. government intervention needed for full employment Ideological dispute continues. New York. Alan Blinder (in Readings) decided to ask firms “Why?” – Alan S. labour) can’t be “cleared” (unemployment eliminated) simply by price movements • Can have underemployment for substantial time.

• How behavior compares to different theories of price stickiness .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.

interpretation . 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. 20% Manager) by Economics PhD students • Questionnaire taken seriously.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.

Economic facts of the firm – Sample representative of private. for profit. 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. unregulated. of those approached 61% took part to yield 200 firms—high response rate .

6% of US GDP – “we interviewed an astounding 10 to 15 per cent of the target population—a large fraction by any standard.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.Economic facts of the firm • Distribution of sample differs from GDP with respect to firm size: Size Sample GDP < $10 m $10-$25 m $25-$50 m > $50 m 0% 22.5% 13.4% 7.1% 12.7% 67% • But big firms overwhelmingly important component: – Average sales of firms surveyed $3.5% 64% 26.” (68) .

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

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