MS-09: Managerial Economics2009

Assignment reference material only.

1. Managerial Economics serves as a “link between traditional economics and decision making
sciences.” Discuss.
Answer. Economics is one social science among several and has fields bordering on other areas,
including economic geography, economic history, public choice, energy economics, cultural economics,
and institutional economics.
Close interrelationship between management and economics has led to the development of managerial
economics. Managerial economics lies on the border line of management and economics. Management
deals with principles which help in decision making under uncertainty and improve effectiveness of
organization. Economics on the other hand provides a set of propositions for optimum allocation of
scarce resources to achieve the desired objectives. Managerial economics serves as “a link between
traditional economics and the decision sciences’.

The basic characteristics of Managerial economics can be enumerated as:

• � It is concerned with “decision making of economic nature”
• � It is “Micro-economic” in character.
• � It largely uses that body of economic concepts and principles which is known as “Theory of
the Firm” or “Economics of the Firm”.
• � It is “Goal oriented and perspective”
• � Managerial economics is both “Conceptual and Metrical”. It includes theory with
measurement.
Managerial economics should be thought of as applied micro-economics. Microeconomics focuses on
the behaviour of the individual actors on the economic stage: firms and individuals.
Decisions made by managers are crucial to the success or failure of a business. Roles played by business
managers are becoming increasingly more challenging as complexity in the business world grows.
Business decisions are increasingly dependent on constraints imposed from outside the economy in
which a particular business is based—both in terms of production of goods as well as the markets for the
goods produced. The impact of rapid technological change on innovation in products and processes, as
well as in marketing and sales techniques, figures prominently among the factors contributing to the
increasing complexity of the business environment. Moreover, because of increased globalization of the
marketplace, there is more volatility in both input and product prices. The continuous changes in the
economic and business environment make it ever more difficult to accurately evaluate the outcome of a
business decision. In such a changing environment, sound economic analysis becomes all the more
important as a basis of decision-making.
Managerial economics is a discipline that is designed to provide a solid foundation of economic
understanding in order for business managers to make well-informed and well-analyzed managerial
decisions.
NATURE OF MANAGERIAL ECONOMICS
There are a number of issues relevant to businesses that are based on economic thinking or analysis.
Examples of questions that managerial economics attempts to answer are: What determines whether an
aspiring business firm should enter a particular industry or simply start producing a new product or
service? Should a firm continue to be in business in an industry in which it is currently engaged or cut its
losses and exit the industry? Why do some professions pay handsome salaries, whereas some others pay
barely enough to survive? How can the business best motivate the employees of a firm? The issues
relevant to managerial economics can be further focused by expanding on the first two of the preceding
questions. Let us consider the first question in which a firm (or a would-be firm) is considering entering
an industry. For example, what led Frederick W. Smith the founder of Federal Express, to start his
overnight mail service? A service of this nature did not exist in any significant form in the United States,
and people seemed to be
doing just fine without overnight mail service provided by a private corporation. One can also consider
why there are now so many overnight mail carriers such as United Parcel Service and Airborne Express.
The second example pertains to the exit from an industry, specifically, the airline industry in the United
States. Pan Am, a pioneer in public air transportation, is no longer in operation, while some airlines such
as TWA (Trans World Airlines) are on the verge of exiting the airlines industry. Why, then, have many
airlines that operate on international routes fallen on hard times, while small regional airlines seem to be
doing just fine? Managerial economics provides answers to these questions.
In order to answer pertinent questions, managerial economics applies economic theories, tools, and
techniques to administrative and business decision-making. The first step in the decision-making process
is to collect relevant economic data carefully and to organize the economic information contained in data
collected in such a way as to establish a clear basis for managerial decisions. The goals of the particular
business organization must then be clearly spelled out. Based on these stated goals, suitable managerial
objectives are formulated. The issue of central concern in the decision-making process is that the desired
objectives be reached in the best possible manner. The term "best" in the decision-making context
primarily refers to achieving the goals in the most efficient manner, with the minimum use of available
resources—implying there be no waste of resources. Managerial economics helps the manager to make
good decisions by providing information on waste associated with a proposed decision.
ECONOMIC CONCEPTS USED IN MANAGERIAL ECONOMICS
Managerial economics uses a wide variety of economic concepts, tools, and techniques in the decision-
making process. These concepts can be placed in three broad categories: (1) the theory of the firm, which
describes how businesses make a variety of decisions; (2) the theory of consumer behavior, which
describes decision making by consumers; and (3) the theory of market structure and pricing, which
describes the structure and characteristics of different market forms under which business firms operate.
TOOLS OF DECISION SCIENCES AND MANAGERIAL ECONOMICS
Managerial decision making uses both economic concepts and tools, and techniques of analysis provided
by decision sciences. The major categories of these tools and techniques are: optimization, statistical
estimation, forecasting, numerical analysis, and game theory. While most of these methodologies are
fairly technical, the first three are briefly explained below to illustrate how tools of decision sciences are
used in managerial decision making.
Optimization techniques are probably the most crucial to managerial decision making. Given that
alternative courses of action are available, the manager attempts to produce the most optimal decision,
consistent with stated managerial objectives. Thus, an optimization problem can be stated as maximizing
an objective (called the objective function by mathematicians) subject to specified constraints. In
determining the output level consistent with the maximum profit, the firm maximizes profits, constrained
by cost and capacity considerations. While a manager does not solve the optimization problem, he or she
may use the results of mathematical analysis. In the profit maximization example, the profit maximizing
condition requires that the firm choose the production level at which marginal revenue equals marginal
cost. This condition is obtained from an optimization exercise. Depending on the problem a manager is
trying to solve, the conditions for the optimal decision may be different.
Statistical Estimation: A number of statistical techniques are used to estimate economic variables of
interest to a manager. In some cases, statistical estimation techniques employed are simple. In other
cases, they are much more advanced. Thus, a manager may want to know the average price received by
his competitors in the industry, as well as the standard deviation (a measure of variation across units) of
the product price under consideration. In this case, the simple statistical concepts of mean (average) and
standard deviation are used.
Estimating a relationship among variables requires a more advanced statistical technique. For example, a
firm may want to estimate its cost function, the relationship between a cost concept and the level of
output. A firm may also want to know the demand function of its product, that is, the relationship
between the demand for its product and different factors that influence it. The estimates of costs and
demand are usually based on data supplied by the firm. The statistical estimation technique employed is
called regression analysis, and is used to develop a mathematical model showing how a set of variables
are related. This mathematical relationship can also be used to generate forecasts.
An automobile industry example can be used for the purpose of illustrating the forecasting method that
employs simple regression analysis. Suppose a statistician has data on sales of American-made
automobiles in the United States for the last 25 years. He or she has also determined that the sale of
automobiles is related to the real disposable income of individuals. The statistician also has available the
time series (for the last 25 years) on real disposable income. Assume that the relationship between the
time series on sales of American-made automobiles and the real disposable income of consumers is
actually linear and it can thus be represented by a straight line. A fairly rigorous mathematical technique
is used to find the straight line that most accurately represents the relationship between the time series on
auto sales and disposable income.
Forecasting is a method or a technique used to predict many future aspects of a business or any other
operation. For example, a retailing firm that has been in business for the last 25 years may be interested
in forecasting the likely sales volume for the coming year. There are numerous forecasting techniques
that can be used to accomplish this goal. A forecasting technique, for example, can provide such a
projection based on the experience of the firm during the last 25 years; that is, this forecasting technique
bases the future forecast on the past data.
While the term "forecasting" may appear to be rather technical, planning for the future is a critical aspect
of managing any organization—business, nonprofit, or otherwise. In fact, the long-term success of any
organization is closely tied to how well the management of the organization is able to foresee its future
and develop appropriate strategies to deal with the likely future scenarios. Intuition, good judgment, and
an awareness of how well the economy is doing may give the manager of a business firm a rough idea (or
"feeling") of what is likely to happen in the future. It is not easy, however, to convert a feeling about the
future outcome into a precise number that can be used, for instance, as a projection for next year's sales
volume. Forecasting methods can help predict many future aspects of a business operation, such as
forthcoming years' sales volume projections.
Suppose that a forecast expert has been asked to provide quarterly estimates of the sales volume for a
particular product for the next four quarters. How should one go about preparing the quarterly sales
volume forecasts? One will certainly want to review the actual sales data for the product in question for
past periods. Suppose that the forecaster has access to actual sales data for each quarter during the 25-
year period the firm has been in business. Using these historical data, the forecaster can identify the
general level of sales. He or she can also determine whether there is a pattern or trend, such as an increase
or decrease in sales volume over time. A further review of the data may reveal some type of seasonal
pattern, such as, peak sales occurring around the holiday season. Thus by reviewing historical data, the
forecaster can often develop a good understanding of the pattern of sales in the past periods.
Understanding such a pattern can often lead to better forecasts of future sales of the product. In addition,
if the forecaster is able to identify the factors that influence sales, historical data on these factors
(variables) can also be used to generate forecasts of future sales.
CASE STUDY 1: THE UPS AND DOWNS OF THE WALT DISNEY COMPANY
To illustrate the sorts of problem that managerial economies can help you solve, consider the company
founded in 1929 by the great artist and entrepreneur Walt Disney. After this death in 1966, the firm
seemed to lose much id its viability and direction, although there was continued emphasis on quality of
product. While the company is famous for its movies (such as Snow White, Mary Poppins, and The Lion
King), the bulk of its revenues came from its theme parks, such as Disneyland in Anaheim, California
and Walt Disney World in Orlando, Florida. In the early 1980s, attendance at its theme parks fell (from
11.5 million people in 1980 to 9.9 million people in 1984), and both management and outside investors
became seriously concerned about the firm’s prospects. The entertainment business is notoriously risky,
and it is easy for even a leading firm to begin to lose money.
In 1984 Michael D. Eisner, a paramount executive was brought in as CEO (chief executive officer) to
lead the firm in a variety of new directions. One problem he had to deal with was the decline of
attendance at the theme parks. To what extent was it due to increases in the average age of the population
and decreases in average family size? What could be done about it? Another related question was should
prices at the theme parks be raised? Some Disney executives had made this recommendation for years,
but their bosses had votoed the idea.
Using many of the technique of managerial economies, Eisner and his colleagues attacked these problems
with vigor. For example, after studies indicated that increases in advertising would raise theme park
attendance and raise profits, they launched a series of successful advertising campaigns. During the late
1980s and early 1990s, the firm performed brilliantly, Profits rose from about $100 million in 1984 to
about $800 million in 1993. But in 1992 Disney opened a new theme park outside Paris –– Euro
Disneyland –– which was a severe financial disappointment in 1993 and 1994 –– and a reminder that
managerial economics, while useful, is no guarantee of unbroken success in an industry as risky as the
entertainment business.
2. “The main determinant of elasticity is the availability of substitutes.” Explain this statement in
the context of price elasticity of demand.
Answer. The degree of responsiveness of demand to the changes in its determinants is called elasticity of
demand. The concept of elasticity of demand plays a crucial role in business-decisions regarding
maneuvering of prices with a view to making large profits. For example, when cost of production is
increasing, the firm would want to pass the rising cost on to consumer by raising the price. Firms may
decide to change the price even without any change in the cost of production.
Price elasticity of demand is the quantitive measure of consumer behavior that indicates the quantity of
demand of a product or service depending on its increase or decrease in price. Price elasticity of demand
can be calculated by the percent change in the quantity demanded by the percent change in price. Price
elasticity of demand is determined by the price of the item or service, availability of alternative goods,
amount of time being measured, consumer income and whether the item or service is considered to be a
necessity or a luxury.
A measure of the responsiveness of the quantity demanded of a good to a change in its price. It is
calculated as:
% Change in Quanlity Demanded
=
% change in price
Determinants of Elasticity
• Necessities versus Luxuries - It is harder to find substitutes for necessities so quantity demanded will
change less.
• Availability of Close Substitutes - If there are close substitutes, buyers will move away from more
expensive items and demand will be elastic.
• Definition of the Market - The more broadly we define an item, the more possible substitutes and the
more elastic the demand.
• Time Horizon - The longer the time available, the easier to find substitutes and the more elastic the
demand.
• Relative Size of Purchase - Purchases which are a very small portion of total expenditure tend to be
more inelastic, because consumers are not worried about the extra expenditure.
Substitute Goods
In economics, one kind of good (or service) is said to be a substitute good for another kind in so far as the
two kinds of goods can be consumed or used in place of one another in at least some of their possible
uses.
Examples
Classic examples of substitute goods include margarine and butter, or petroleum and natural gas (used for
heating or electricity). The fact that one good is substitutable for another has immediate economic
consequences: insofar as one good can be substituted for another, the demand for the two kinds of good
will be bound together by the fact that customers can trade off one good for the other if it becomes
advantageous to do so.
The main determinant of elasticity is the availability of substitutes. Some products, such as margarine,
cabbage, coca cola, and the Peugeot 406, have quite close substitutes- butter, other green vegetables,
Pepsi, and the VW Passat. When the price of any one of these product changes, the prices of the
substitutes remaining constant, consumers will substitute one product for another. When the price falls
consumers buy more of the product and less of its substitutes. When the price rises, consumers buy less
of the product and more of its substitutes. More broadly defined products such as all foods, all clothing,
tobacco, have few if any satisfactory substitutes. A rise in their price can be expected to cause a smaller
fall in quantity demanded than would be the case if close substitutes were available.
A product with close substitutes tends to have an elastic demand, one with no close substitutes tends to
have an inelastic demand.
Closeness of substitutes-and therefore measured elasticity-depends both on how the product is defined
and on the time-period under consideration.
There is no substitute for food, it is necessity of life. Thus, for food taken as whole demand is inelastic
over a large price range. It does not follow, however, that any one food say Weetabix or Heinz tomato
soup- is a necessity in the same sense.
Each of these has close substitutes, such as Kellogg’s Cornflakes and Campbell’s tomato soup. Individual
food products can have quite elastic demands.
Durable goods provide a similar example, Durables as a whole have less elastic demands than do
individual durable goods. For example, after a rise in price of TV sets, some people may replace their
personal computer or their hi-fi system instead of buying a new TV. Thus, although their purchases of
TV falls, their total purchases of durablles fall by much less.
Because many specific manufactured goods have close substitutes, they tend to have price-elastic
demands. A particular Marks and Spencer own-brand raincoat could be expected to be price elastic, but
all clothing taken together will be inelastic. This is because, while it is easy to substitute a Marks and
Spencer raincoat with a John Lewis. But you cannot avoid waring clothing altogether when its price in
general rises.
3. Find (i) the marginal and (2) the average cost functions for the following total cost function.
Calculate them at Q = 4 and Q = 6.
TC= 3Q2+ 7Q +12

Answer.

TC= 3Q2+ 7Q +12

= 3(4) 2 + 7(4) + 12
= 48 + 28 + 12
= 88
TC= 3(6) 2 + 7(6) + 12
= 108 + 42 + 12
= 162

Q TC MC AC
3 60 - 20
4 88 28 22
5 122 34 24.4
6 162 40 27
4. “Oligopoly is the most prevalent form of market structure in the manufacturing sector.”
Describe this statement with the help of an example.
Answer. An oligopoly is an intermediate market structure between the extremes of perfect competition
and monopoly. Oligopoly firms might compete (noncooperative oligopoly) or cooperate (cooperative
oligopoly) in the marketplace. Whereas firms in an oligopoly are price makers, their control over the
price is determined by the level of coordination among them.
Oligopoly is the most prevalent form of market organization in the manufacturing sector of
industrial nations, including the United States. Some oligopolistic industries in the United States are
automobiles, primary aluminum, steel, electrical equipment, glass, breakfast cereals soaps etc. Aluminum
and steel are homogenous while other products like automobiles and other products are differentiated.
While entry into an oligopolistic industry is possible but it is not easy. Oligopoly also occurs when
transportation costs limit the market area; for example, there are many cement producers in the United
States; competition is limited to a few producers in a particular area. The distinguishing characteristic of
an oligopoly is that there are a few mutually interdependent firms that produce either identical products
(homogeneous oligopoly) or heterogeneous products (differentiated oligopoly).
Mutual interdependence means that firms realize the effects of their actions on rivals and the reactions
such actions are likely to elicit. For instance, a mutually interdependent firm realizes that its price drops
are more likely to be matched by rivals than its price increases. This implies that an oligopolist,
especially in the case of a homogeneous oligopoly, will try to maintain current prices, since price changes
in either direction can be harmful, or at least nonbeneficial. Consequently, there is a kink in the demand
curve because there are asymmetric responses to a firm's price increases and to its price decreases; that is,
rivals match price falls but not price increases. This leads to "sticky prices," such that prices in an
oligopoly turn out to be more stable than those in monopoly or in competition; that is, they do not change
every time costs change. On the flip side, the sticky-price explanation (formally, the kinked demand
model of oligopoly) has the significant drawback of not doing a very good job of explaining how the
initial price, which eventually turns out to be sticky, is arrived at. Airline markets and automobile
markets are prime examples of oligopolies. We see that as the new auto model year gets under way in the
fall, one car manufacturer's reduced financing rates are quickly matched by the other firms because of
recognized mutual interdependence. Airlines also match rivals' fares on competing routes.
In oligopolies, entry of new firms is difficult because of entry barriers. These entry barriers may be
structural (natural), such as economies of scale, or artificial, such as limited licenses issued by
government. Firms in an oligopoly, known as oligopolists, choose prices and output to maximize profits.
However, firms could compete along other dimensions as well, such as advertising, location, research and
development (R&D) and so forth. For instance, a firm's research or advertising strategies are influenced
by what its rivals are doing. When one restaurant advertises that it will accept rivals' coupons, others are
compelled to follow suit. The rivals' responses in an oligopoly can be modeled in the form of reaction
functions. Sophisticated firms anticipating rivals' behavior might appear to act in concert (conscious
parallelism) without any explicit agreement to do so. Such instances pose problems for antitrust
regulators. Mutually interdependent firms have a tendency to form cartels, enabling them to coordinate
price and quantity actions to increase profits. Besides facing legal obstacles, cartels are difficult to sustain
because of free-rider problems. Shared monopolies are extreme cases of cartels that include all the firms
in the industry.
Given that mutual interdependence can exist along many dimensions, there is no single model of
oligopoly. Rather, there are numerous models based on different behavior, ranging from the naive
Cournot models to more sophisticated models of game theory. An equilibrium concept that incorporates
mutual interdependence was proposed by John Nash and is referred to as Nash equilibrium. In a Nash
equilibrium, firms' decisions (i.e., price-quantity choices) are their best responses, given what their rivals
are doing. For example, McDonald's charges $2.99 for a Value Meal based on what Burger King and
Wendy's are charging for a similar menu item. McDonald's would reconsider its pricing if its rivals were
to change their prices.
The level of information that firms have has a major influence on their behavior in an oligopoly. For
instance, when mutually interdependent firms have asymmetric information and are unable to make
credible commitments regarding their behavior, a "prisoner's dilemma" type of situation arises where the
Nash equilibrium might include choices that are suboptimal. For instance, individual firms in a cartel
have an incentive to cheat on the previously agreed-upon priceoutput levels. Since cartel members have
nonbinding commitments on limiting production levels and maintaining prices, this results in widespread
cheating, which in turn leads to an eventual breakdown of the cartel. Therefore, while all firms in the
cartel could benefit by cooperating, lack of credible commitments results in cheating being a Nash
equilibrium strategy—a strategy that is suboptimal from the individual firm's standpoint.
Models of oligopoly could be static or dynamic depending upon whether firms take intertemporal
decisions into account. Significant models of oligopoly include Cournot, Bertrand, and Stackelberg.
Cournot oligopoly is the simplest model of oligopoly in that firms are assumed to be naive when they
think that their actions will not generate any reaction from the rivals. In other words, according to the
Cournot model, rival firms choose not to alter their production levels when one firm chooses a different
output level. Cournot thus focuses on quantity competition rather than price competition. While the naive
behavior suggested by Cournot might seem plausible in a static setting, it is hard to image real-world
firms not learning from their mistakes over time. The Bertrand model's significant difference from the
Cournot model is that it assumes that firms choose (set) prices rather than quantities. The Stackelberg
model deals with the scenario in which there is a leader firm in the market whose actions are imitated by
a number of follower firms.
The leader is sophisticated in terms of taking into account rivals' reactions, while the followers are naïve,
as in the Cournot model. The leader might emerge in a market because of a number of factors, such as
historical precedence, size, reputation, innovation, information, and so forth. Examples of Stackelberg
leadership include markets where one dominant firm dictates the terms, usually through price leadership.
Under price leadership, the leader firm's pricing decisions are consistently followed by rival firms.
Since oligopolies come in various forms, the performance of such markets also varies a great deal. In
general, the oligopoly price is below the monopoly price but above the competitive price. The oligopoly
output, in turn, is larger than that of a monopolist but falls short of what a competitive market would
supply. Some oligopoly markets are competitive, leading to few welfare distortions, while other
oligopolies are monopolistic, resulting in dead weight losses. Furthermore, some oligopolies are more
innovative than others. Whereas the price-quantity rankings of oligopoly vis-à-vis other markets are
relatively well established, how oligopoly fares with regard to R and D and advertising is less clear.
Oligopoly is the most prevalent form of market structure in the manufacturing sector because
-barriers to entry. The most common barriers to entry include
-patents,
-resource ownership,
-government franchises,
-start-up cost,
-brand name recognition, and
-decreasing average cost.
Each of these make it extremely difficult, if not impossible, for potential firms to enter an industry.
Examples
In the United Kingdom, the four-firm concentration ratio of the supermarket industry is 74.4%; the
British brewing industry has a staggering 85% ratio. In the U.S.A., oligopolistic industries include the oil,
beer, tobacco, accounting and audit services, aircraft, military equipment, and motor vehicle industries.
Many media industries today are essentially oligopolies. Six movie studios receive 90 percent of
American film revenues, and four major music companies receive 80 percent of recording revenues.
There are just six major book publishers, and the television industry was an oligopoly of three networks –
ABC, CBS, and NBC –from the 1950s through the 1970s. Television has diversified since then,
especially because of cable, but today it is still mostly an oligopoly (due to concentration of media
ownership) of five companies: Disney/ABC, CBS Corporation, NBC, Universal, Time Warner, and News
Corporation.
In industrialized countries oligopolies are found in many sectors of the economy, such as cars, auditing,
consumer goods, and steel production. Unprecedented levels of competition, fueled by increasing
globalisation, have resulted in the emergence of oligopoly in many market sectors, such as the aerospace
industry. Market shares in oligopoly are typically determined on the basis of product development and
advertising. There are now only a small number of manufacturers of civil passenger aircraft, though
Brazil (Embraer) and Canada (Bombardier) have fielded entries into the smaller-market passenger
aircraft market sector. A further instance arises in a heavily regulated market such as wireless
communications. In some cases states have licensed only two or three providers of cellular phone
services.
OPEC is another example of an oligopoly, although on the level of national bodies instead of corporate
bodies. There are a few countries that try to control the production of oil.
A further example are the three leading food processing companies, Kraft Foods, PepsiCo and Nestle.
Together these three corporations account for a large percentage of overall global processed food sales.
These three companies are often used as an example of "The rule of 3", which states that markets and
industries often become dominated by three major oligopolistic firms.
Australia has two very good examples of oligoplies. One is its media outlets, mostly owned by either
News Corporation or Fairfax Media. Likewise, Australia's retailing industry is dominated by two
companies, Coles-Myer and Woolworths.