Managerial Economics & Overview

I. Consumer Behavior
Business Strategy Indifference Curve Analysis
Consumer Preference Ordering
Baye Chapters 4-5

II. Constraints
Edited by DF 10/12 The Budget Constraint
Changes in Income
Changes in Prices
III. Consumer Optimum
IV. Generating Demand Curves
Individual Demand
Market Demand

Michael R. Baye, Managerial Economics and Business Strategy, 5e.

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Consumer Behavior Indifference Curve Analysis

Consumer Opportunities Indifference Curve
The possible goods and services consumer can afford to A curve that defines the combinations
Good Y
of 2 or more goods that give a
consume. consumer the same level of III.
Consumer Preferences satisfaction.
II.
Represented by U(X,Y), whose
The goods and services consumers actually consume. I.

partial derivatives are denoted UX, UY
Given the choice between 2 bundles of Marginal Rate of Substitution
goods a consumer either The rate at which a consumer is
willing to substitute one good for
Prefers bundle A to bundle B: A B, or U(A)>U(B) another and maintain the same
Prefers bundle B to bundle A: A B, or U(A)<U(B) satisfaction level.
MRS = UX/UY
Is indifferent between the two: A B, or U(A)=U(B)
Good X

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Consumer Preference Ordering Complete Preferences

Properties
Completeeverything can be compared Completeness Property Good Y
Consumer is capable of
MonotoneMore is Better expressing preferences (or III.
indifference) between all possible II.
Diminishing Marginal Rate of Substitution bundles. ( I don t know is NOT
I.
an option!)
Transitive If the only bundles available
A
B

to a consumer are A, B, and

C, then the consumer
is indifferent between A and C
C (they are on the same
indifference curve).
will prefer B to A.
will prefer B to C. Good X

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1
 Diminishing Marginal Rate of
More Is Better!
Substitution
More Is Better Property Marginal Rate of Substitution
Good Y The amount of good Y the consumer is Good Y
Bundles that have at least as much of willing to give up to maintain the same
every good and more of some good satisfaction level decreases as more of
are preferred to other bundles.
III. good X is acquired. III.
Bundle B is preferred to A since The rate at which a consumer is willing to
II. II.

substitute one good for another and
B contains at least as much of maintain the same satisfaction level.
good Y and strictly more of good I. I.
To go from consumption bundle A to
X. B the consumer must give up 50 units 100 A
Bundle B is also preferred to C A B of Y to get one additional unit of X.
100
since B contains at least as much To go from consumption bundle B to
of good X and strictly more of B
C the consumer must give up 16.67 50
good Y. units of Y to get one additional unit of C
C 33.33 D
More generally, all bundles on 33.33 X. 25
ICIII are preferred to bundles on To go from consumption bundle C to
ICII or ICI. And all bundles on D the consumer must give up only
ICII are preferred to ICI. 1 3 8.33 units of Y to get one additional
Good X unit of X. 1 2 3 4 Good X

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Consistent Bundle Orderings The Budget Constraint

Opportunity Set Y The Opportunity Set
Transitivity Property Good Y The set of consumption bundles
For the three bundles A, B, and C,
the transitivity property implies III. that are affordable. Budget Line
that if C B and B A, then C II. PxX + PyY M. M/PY
Y = M/PY (PX/PY)X
A.
I.
Transitive preferences along with Budget Line
A
the more-is-better property imply 100 The bundles of goods that exhaust a
C
that 75 consumers income.
B
indifference curves will not 50
PxX + PyY = M.
intersect.
the consumer will not get Market Rate of Substitution M/PX
caught in a perpetual cycle of X
indecision.
The slope of the budget line
1 2 5 7 Good X
-Px / Py

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Changes in the Budget Line

Y Consumer Optimum
M1/PY
Changes in Income
Y
Increases lead to a parallel, M0/PY The optimal bundle is
outward shift in the budget an affordable bundle Consumer
line (M1 > M0). M/PY

Decreases lead to a parallel,

M2/PY that yields the highest Equilibrium
level of satisfaction.

downward shift (M2 < M0).

Consumer equilibrium
Changes in Price M2/PX M0/PX M1/PX
X
occurs at a point where
Y
A decreases in the price of New Budget Line for MRS = PX / PY.
good X rotates the budget M0/PY a price decrease. Equivalently, the slope of III.
line counter-clockwise (PX0 > the indifference curve
equals the budget line. II.
PX1).
An increases rotates the Or else the optimum is at a I.
budget line clockwise (not corner M/PX
X
shown). X
M0/PX0 M0/PX1
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

2
 Price Changes and Consumer
Equilibrium Complementary Goods
Substitute Goods
An increase (decrease) in the price of good X leads to When the price of
Pretzels (Y)
an increase (decrease) in the consumption of good Y. good X falls and the
Examples: consumption of Y
Coke and Pepsi. rises, then X and Y M/PY
1
are complementary
Verizon Wireless or AT&T.
goods. (PX1 > PX2)
Complementary Goods
B
An increase (decrease) in the price of good X leads to a Y2
decrease (increase) in the consumption of good Y. Y1 A II
Examples:
DVDs and DVD players. I
0 X1 M/PX1 X2 M/PX2 Beer (X)
Computer CPUs and monitors.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Income Changes and Consumer

Equilibrium Normal Goods
Normal Goods Y
An increase in
Good X is a normal good if an increase (decrease) in
income increases
income leads to an increase (decrease) in its the consumption of M1/Y
consumption. normal goods.

Inferior Goods (M0 < M1).

Good X is an inferior good if an increase (decrease) in B
income leads to a decrease (increase) in its Y1
M0/Y
consumption. II
A
Y0
I
X0 M0/X X1 M1/X X
0

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Decomposing the Income and Individual Demand Curve

Substitution Effects Y

Initially, bundle A is consumed. Y An individual s

A decrease in the price of good demand curve is
X expands the consumer s derived from each new II
opportunity set.
equilibrium point I
The substitution effect (SE) C
causes the consumer to move found on the $ X

from bundle A to B. A II indifference curve as

A higher real income allows B the price of good X is P0
the consumer to achieve a varied.
higher indifference curve. P1 D
I
The movement from bundle B to X0 X1 X
C represents the income effect 0
IE X
(IE). The new equilibrium is SE
achieved at point C.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

3
 Market Demand A Classic Marketing
The market demand curve is the horizontal Application
Other
summation of individual demand curves. goods
(Y)
It indicates the total quantity all consumers would
purchase at each price point. A
A buy-one,
$ Individual Demand $ Market Demand Curve C E
Curves
get-one free
D
50 pizza deal. II
I
40

D1 D2 DM 0 0.5 1 2 B F Pizza
1 2 Q 1 2 3 Q (X)

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Conclusion Production and Cost: Overview

I. Production Analysis
Indifference curve properties reveal information Total Product, Marginal Product, Average Product
about consumers preferences between bundles of Isoquants
goods. Isocosts
Completeness. Cost Minimization
More is better.
Diminishing marginal rate of substitution. II. Cost Analysis
Transitivity. Total Cost, Variable Cost, Fixed Costs
Indifference curves along with price changes Cubic Cost Function
determine individuals demand curves. Cost Relations
Market demand is the horizontal summation of III. Multi-Product Cost Functions
individuals demands.
IV. Learning Curve

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Production Analysis Total Product

Production Function Cobb-Douglas Production Function
Q = F(K,L) Example: Q = F(K,L) = K.5 L.5
The maximum amount of output that can be K is fixed at 16 units in short run.
produced with K units of capital and L units of Short run production function:
labor. Q = (16).5 L.5 = 4 L.5
Short-Run vs. Long-Run Decisions Output when 100 units of labor are used?

Fixed vs. Variable Inputs Q = 4 (100).5 = 4(10) = 40 units

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

4
 Marginal Productivity Measures
Marginal Product of Labor: MPL = dQ/dL
Measures the output produced by the last worker.
Slope of the short-run production function (with respect
to labor).
Marginal Product of Capital: MPK = dQ/dK
Measures the output produced by the last unit of
capital.
When capital is allowed to vary in the short run, MPK is
the slope of the production function (with respect to
capital).
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Increasing, Diminishing and
Negative Marginal Returns
Increasing Diminishing
Q Marginal Marginal
Returns Returns
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Isoquant
The combinations of inputs (K, L) that
yield the producer the same level of output.
The shape of an isoquant reflects the ease
with which a producer can substitute
among inputs while maintaining the same
level of output.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Average Productivity Measures
Average Product of Labor
APL = Q/L.
Measures the output of an average worker.
Example: Q = F(K,L) = K.5 L.5
If the inputs are K = 16 and L = 16, then the average product of
labor is APL = [(16) 0.5(16)0.5]/16 = 1.
Average Product of Capital
APK = Q/K.
Measures the output of an average unit of capital.
Example: Q = F(K,L) = K.5 L.5
If the inputs are K = 16 and L = 16, then the average product of
labor is APL = [(16)0.5(16)0.5]/16 = 1.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Guiding the Production Process
Negative Producing on the production function
Marginal Aligning incentives to induce maximum sustainable worker effort.
Returns
Employing the right level of inputs
When labor or capital vary in the short run, to maximize profit a
manager will hire
Q=F(K,L) labor until the value of marginal product of labor equals the
wage: VMPL = w, where VMPL = P x MPL.
capital until the value of marginal product of capital equals the
rental rate: VMPK = r, where VMPK = P x MPK .
AP
L
MP
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Marginal Rate of Technical
Substitution (MRTS)
The rate at which two inputs are substituted
while maintaining the same output level.
MPL
MRTS KL =
MPK
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5
 Linear Isoquants Leontief Isoquants
Q3
Capital and labor are Capital and labor are perfect K
K Q2
perfect substitutes complements.
Increasing Q1 Increasing
Q = aK + bL Output Capital and labor are used in Output
MRTSKL = b/a fixed-proportions.
Linear isoquants imply that Q = min {bK, cL}
inputs are substituted at a
Since capital and labor are
constant rate, independent
of the input levels consumed in fixed
employed. proportions there is no input
Q1 Q2 Q3 substitution along isoquants
L (hence, no MRTSKL). L

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Isocost
Cobb-Douglas Isoquants The combinations of inputs that K New Isocost Line
produce a given level of output associated with higher
C1/r costs (C0 < C1).
K
at the same cost:
Inputs are not perfectly
Q3 wL + rK = C C0/r
substitutable. Increasing
Q2 Rearranging,
Diminishing marginal rate Output
C0 C1
Q1 K= (1/r)C - (w/r)L
of technical substitution. C0/w C1/w L
As less of one input is used in For given input prices, isocosts K
the production process, New Isocost Line for
increasingly more of the other
farther from the origin are
C/r a decrease in the
input must be employed to associated with higher costs. wage (price of labor:
produce the same output level. w0 > w1).
Changes in input prices change
Q = KaLb the slope of the isocost line.
MRTSKL = MPL/MPK
L L
C/w0 C/w1

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Cost Minimization Cost Minimization

K
Marginal product per dollar spent should be
equal for all inputs used: Point of Cost
Minimization
Slope of Isocost
MPL MPK MPL w =
= = Slope of Isoquant
w r MPK r
But, this is just
Q
w
MRTS KL =
r

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

6
 Optimal Input Substitution Cost Analysis
A firm initially produces Q0 K
by employing the
combination of inputs Types of Costs
represented by point A at a
cost of C0. Fixed costs (FC)
Suppose w0 falls to w1. Variable costs (VC)
A
The isocost curve rotates K0
counterclockwise; which
represents the same cost level Total costs (TC)
prior to the wage change. B
To produce the same level of K1 Sunk costs
output, Q0, the firm will produce
on a lower isocost line (C1) at a
point B. Q0
The slope of the new isocost
line represents the lower wage
relative to the rental rate of
capital. 0 L0 L1 C0/w0 C1/w1 C0/w1 L

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Total and Variable Costs

Fixed and Sunk Costs
C(Q): Minimum total cost $
FC: Costs that do not $
of producing alternative C(Q) = VC + FC
levels of output: change as output C(Q) = VC + FC

VC(Q) changes.
VC(Q)
C(Q) = VC(Q) + FC
Sunk Cost: A cost that is
VC(Q): Costs that vary forever lost after it has
with output. FC been paid.
FC

FC: Costs that do not vary 0 Q

Avoidable FC is the rest.
with output. Q
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Some Definitions Fixed Cost

Q0(ATC-AVC)
Average Total Cost MC
ATC = AVC + AFC $ $ = Q0 AFC
MC ATC ATC
ATC = C(Q)/Q AVC
= Q0(FC/ Q0) AVC
Average Variable Cost = FC
AVC = VC(Q)/Q
MR ATC
Average Fixed Cost AFC Fixed Cost
AFC = FC/Q AVC

Marginal Cost AFC

MC = C/Q Q0 Q

Q
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7
 Variable Cost Total Cost
Q0ATC
Q0AVC MC MC
$ $
ATC = Q0[C(Q0)/ Q0] ATC
= Q0[VC(Q0)/ Q0]
AVC = C(Q0) AVC
= VC(Q0)

ATC

AVC Total Cost

Variable Cost

Q0 Q Q0 Q

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

An Example
Cubic Cost Function
Total Cost: C(Q) = 10 + Q + Q2
Variable cost function:
C(Q) = f + a Q + b Q2 + cQ3 VC(Q) = Q + Q2
Marginal Cost? Variable cost of producing 2 units:
Memorize: VC(2) = 2 + (2)2 = 6
MC(Q) = a + 2bQ + 3cQ2 Fixed costs:
Calculus: FC = 10
Marginal cost function:
dC/dQ = a + 2bQ + 3cQ2 MC(Q) = 1 + 2Q
Marginal cost of producing 2 units:
MC(2) = 1 + 2(2) = 5

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Economies of Scale Multi-Product Cost Function

$
C(Q1, Q2): Cost of jointly producing two
outputs.
LRAC
General function form:

C (Q1 , Q2 ) = f + aQ1Q2 + bQ12 + cQ22

Economies Diseconomies
of Scale of Scale
Q

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

8
 Economies of Scope Cost Complementarity
C(Q1, 0) + C(0, Q2) > C(Q1, Q2). The marginal cost of producing good 1
It is cheaper to produce the two outputs jointly instead declines as more of good two is produced:
of separately.


Example:
It is cheaper for Big Creek Lumber to produce 2x4s and MC1(Q1,Q2) /Q2 < 0.
sawdust mulch jointly than separately.

Example:
Cow hides and steaks.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Quadratic Multi-Product Cost

Function A Numerical Example:
C(Q1, Q2) = f + aQ1Q2 + (Q1 )2 + (Q2 )2 C(Q1, Q2) = 90 - 2Q1Q2 + (Q1 )2 + (Q2 )2
MC1(Q1, Q2) = aQ2 + 2Q1 Cost Complementarity?
MC2(Q1, Q2) = aQ1 + 2Q2 Yes, since a = -2 < 0
Cost complementarity: a<0 MC1(Q1, Q2) = -2Q2 + 2Q1
Economies of scope: f > aQ1Q2 Economies of Scope?
C(Q1 ,0) + C(0, Q2 ) = f + (Q1 )2 + f + (Q2)2 Yes, since 90 > -2Q1Q2
C(Q1, Q2) = f + aQ1Q2 + (Q1 )2 + (Q2 )2
f > aQ1Q2: Joint production is cheaper
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Conclusion
Learning Curve
To maximize profits (minimize costs) managers
Cost declines with accumulated output A must use inputs such that the value of marginal of
A = Qs, s=0 to t. each input reflects price the firm must pay to
Idea: efficiency improves with experience due to employ the input.
individual learning and better team coordination.
Original examples: aircraft and ship building in The optimal mix of inputs is achieved when the
WWII. MRTSKL = (w/r).
Recent examples: microprocessors, fuel cells Cost functions are the foundation for helping to
ln MC = a b ln A is usual functional form determine profit-maximizing behavior in future
The incremental cost decreases b% when chapters.
accumulated output increases 1%

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.