Managerial Economics Lecture Introduction

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?
Often the best wisdom in economics
isnt found in standard textbooks!
This subject takes a deeper look at
economics youve already done (micro,
macro); and
considers theories & data you
havent seen before that are more
relevant to 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
What matters most to your firms success may lie outside it:
For companies, a central message is that many of a
companys 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
Macroeconomys interaction with global economy; AND
Theories about the economy! Because:
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 its wrong!
Which it frequently is
Emphasis in this course is on realism
Theories presented; but also
Empirical data examined to see whether theories actually
work
Frequent conclusion: they dont (but sometimes they do)
One consequence: cant 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 dont go beyond microeconomics
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
Graphing price as a function of quantity:
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
a 100 := b
1
2000
:= P Q ( ) a b Q :=
0 5
.
10
4
1
.
10
5
1.5
.
10
5
2
.
10
5
0
20
40
60
80
100
Price as function of quantity
P Q ( )
Q
TR Q ( ) P Q ( ) Q :=
0 2
.
10
4
4
.
10
4
6
.
10
4
8
.
10
4
1
.
10
5
0
20
40
60
80
100
0
5
.
10
5
1
.
10
6
1.5
.
10
6
2
.
10
6
2.5
.
10
6
Price (LH Scale)
Revenue=Price x Quantity (RHS)
P Q ( ) TR Q ( )
Q
If firm produces
20,000 units, market
price is 80
Total revenue =
80 * 20,000 =
$1.6 million
2
0
,
0
0
0
x
8
0

40,000 units sold,
price 60
Total revenue =
60 * 40,000 =
$2.4 million
Change in total
revenue $0.8 m
4
0
,
0
0
0
x
6
0

Change in unit
revenue=$0.8
m/20,000=$40
60,000x40
60,000 units sold, price 40
Total revenue $2.4 million
Change in revenue per unit zero
Slope=0
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.)
Theory argues per unit costs rise as quantity offered for sale rises:
Slope of total cost curve
is marginal cost:
Rises as output rises
because of diminishing
marginal productivity
After some point, each
new worker hired
(variable input) adds
less to production than
previous worker
With constant wage
and diminishing output
per worker, unit cost
of output rises
Please explain
k 1000000 := c 30 := d
1
100000
:= f
1
400000000
:=
FC Q ( ) k := VC Q ( ) c Q d Q
2
+ f Q
3
+ := TC Q ( ) FC Q ( ) VC Q ( ) + :=
0 5
.
10
4
1
.
10
5
1.5
.
10
5
2
.
10
5
0
5
.
10
6
1
.
10
7
1.5
.
10
7
2
.
10
7
2.5
.
10
7
3
.
10
7
Total Cost
Fixed Cost
Variable Cost
TC Q ( )
FC Q ( )
VC Q ( )
Q
Rising marginal cost: the argument
Production occurs in the short run
Short run: period in which at least one crucial input to
production cant 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
There is some ideal worker:machine
ratio (e.g., one worker per jackhammer)
In short run, firm has fixed
number of jackhammers
To dig holes, firm has to hire workers
1
st
worker operates all six jackhammers at once: pretty inefficient!
?
If this sounds
weird to you,
good! Youre on
to something
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)
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
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
doesnt become negative)
Diminishing marginal productivity (DMP)
DMP leads to rising marginal cost
Example: Cobb-Douglas production function
1
Q L K
| |
o

=
Quantity produced
Technology coefficient
No. workers
Amount of capital
Relative labor/capital
product coefficient
o 10 := K 100 := | .4 := L 0 0.1 , 250 .. := O K L , o , | , ( ) o L
|
K
1 |
:=
0 50 100 150 200 250
0
500
1000
1500
Cobb-Douglas Production Function
Number of workers
O
u
t
p
u
t
O K L , o , | , ( )
L
Cobb-Douglas production
function allegedly fits
aggregate economic data
well (but see Shaikh, A.
M., (1974). Laws of
Algebra and Laws of
Production: The Humbug
Production Function,
Review of Economics and
Statistics, 61: 115-20)
Example with o=10,
K=100, |=.4, L between 0
and 250:
With 100 workers,
output is 1,000
With 250 workers,
output is 1,443
C
h
a
n
g
e

i
n

o
u
p
u
t

f
r
o
m

1
s
t

1
0
0

i
s

1
0
0
0

C
h
a
n
g
e

i
n

o
u
p
u
t

f
r
o
m

n
e
x
t

2
5
0

i
s

4
4
3

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!):
1
Q L K
| |
o

=
1 1
dQ
L K
dL
| |
o |

=
Differentiate with respect to Labour
Graphing marginal product:
MP L ( ) o | L
| 1
K
1 |
:=
0 50 100 150 200 250
0
100
200
300
400
500
600
700
800
900
1000
1100
1200
1300
1400
1500
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Total Product (Q) LHS
Marginal Product RHS
Cobb-Douglas Production Function
Workers
O
u
t
p
u
t
M
a
r
g
i
n
a
l

P
r
o
d
u
c
t
O K L , o , | , ( ) MP L ( )
L
Output with 49
workers = 752
Output with 50
workers = 758
Marginal product of
50
th
worker ~ 6
Using formula, its
exactly 6.063
Diminishing marginal product
leads to rising marginal cost
Output with 99
workers = 996
Output with 100
workers = 1000
Marginal product of
100
th
worker ~ 4.012
Using formula, its
exactly 4
Q 0 1500 .. :=
L Q ( )
Q
o K
1 |
\
|
|
|
.
1
|
:=
0 500 1000 1500
0
50
100
150
200
250
300
Workers needed given desired output
Output
W
o
r
k
e
r
s

n
e
e
d
e
d
L Q ( )
Q
First step is to flip the axes: graph labour input (on Y axis)
needed to produce output (on X axis):

Just reads in reverse:
1,000 units of output
desired;
100 workers needed
To get total (variable)
cost, multiply Y axis by
wage rate (say $12 an
hour)
Rate of change of
variable cost is marginal
cost
Rising because of
diminishing marginal
productivity
So firm trying to
maximise profits is
(according to economic
theory) faced with
Falling price
Rising cost
How to maximise profit?
Find biggest gap
between revenue and
cost
w 12 := VC Q ( ) w L Q ( ) := MC Q ( )
Q
VC Q ( )
d
d
:=
0 500 1000 1500
0
500
1000
1500
2000
2500
3000
3500
0
1
2
3
4
5
6
Variable cost of desired output
Output
T
o
t
a
l

v
a
r
i
a
b
l
e

c
o
s
t
M
a
r
g
i
n
a
l

c
o
s
t
VC Q ( ) MC Q ( )
Q
Production level of 1000
units has variable costs
of $1200
Marginal cost of 1000
th

units is about $3
Profit Q ( ) TR Q ( ) TC Q ( ) :=
0 5
.
10
4
1
.
10
5
1.5
.
10
5
2
.
10
5
0
5
.
10
6
1
.
10
7
1.5
.
10
7
2
.
10
7
2.5
.
10
7
3
.
10
7
Total Revenue
Total Cost
Profit
TR Q ( )
TC Q ( )
Profit Q ( )
Q
Graphically, its easy: (using earlier example)
But economists
prefer to make it
complicated by
working in average &
marginal revenue &
cost
Converting diagrams
to averages by
dividing by quantity
gives us:
As economists like to show it:
maximise profit by equating
marginal revenue and marginal
cost
MC Q ( )
Q
VC Q ( )
d
d
:= AC Q ( ) TC Q ( ) Q :=
0 5
.
10
4
1
.
10
5
1.5
.
10
5
2
.
10
5
0
50
100
150
200
Marginal Cost
Average Cost
Price
Marginal Revenue
MC Q ( )
AC Q ( )
P Q ( )
MR Q ( )
Q
What it means: maximise profit
by finding the biggest gap
between revenue and cost
Gap between curves is biggest
when tangents (marginal revenue &
marginal cost) are parallel:
So its 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, its 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:
Perfect competition
Demand
Supply
Q
e
P
e
Marginal Cost
quantity
P
r
i
c
e

q
e

P
e
Downward sloping market demand
curve
Horizontal demand curve for single
firm
< < 0,
dP
MR P
dQ
= = 0,
dP
MR P
dq
Quantity
P
r
i
c
e

So the economic theory rules are:
If youre a monopoly or oligopoly
Work out your marginal cost and marginal revenue
Produce the output level at which they are equal
If youre in a competitive industry
Work out your marginal cost
Produce output level at which marginal cost equals price
If youre 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:
Its a breeze for
competitive
industries (p.
450):
A bit more
complicated for
monopoly (p. 500):
And a real pain
for oligopoly (p.
560)
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: %
% P
Q Q changeQ P Q
E
change P P Q P
A A
= = =
A A
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
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
Demand
Supply
Quantity
P
r
i
c
e

Q
e
P
e
Economic problems caused by
government, union, monopoly
behavior that makes some prices
(e.g. wages) more rigid than others
Keynesians/Mixed economy supporters believe sticky
Prices adjust sluggishly
Key markets (e.g. labour) cant 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.
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
Blinders 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
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 firmshigh response rate
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
populationa large fraction by any standard. (68)
Blinders 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

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