Managerial Economics

Topic 1: Value creation & capture

Topics for today’s lecture . . .

1. Economics in business

2. Creating value

3. Buyer-seller bargaining

4. Competition

5. The law of one price

6. Competitive equilibrium
Economics in business
The economics toolkit: What problems is economics best at solving?

Evaluating business decisions: Economics provides the most comprehensive toolkit for
evaluating the opportunity cost and benefit associated with a decision.

The importance of incentives: Economics demonstrates how the incentives people face drive
their decisions.

Price formation: Economics explains how prices form in markets, the relationship between
prices and the competitive environment, and the way in which prices respond to various
events.

Strategic analysis: Economics uses game theory to analyse markets in which each firm’s
actions have a significant impact on the profits of their rivals.
Definition: Positive analysis

Using objective, testable methods to describe the way the world is.

Positive economic analysis alone, cannot guide decision-making as it does not inherently value
one outcome over another.
Definition: Normative analysis

Determining the relative desirability of different courses of action based on which will best
achieve a desired outcome.

The question of ‘what you should do’, naturally depends on what it is you are trying to
achieve.
Two perspectives for normative analysis

In this course we will be particularly interested in the objectives of business and government
decision-makers.

Profit maximisation: We will typically assume that managers are seeking to maximise the
profits of their business (or equivalently, the return to its owners).

Social welfare: An idealised view of a government’s objective is that it seeks to maximise the
combined welfare of all market participants; businesses and consumers.

These descriptions of business and government objectives are somewhat stylised. In reality,
both business and government may have additional objectives that need to be accounted for.
Discussion

1. Why should business students care about the social welfare objectives of governments?

2. What are some other objectives that a business might pursue?

3. What are some other objectives that decision-makers in government might pursue?
Creating value
A simple exchange

David is looking to sell a rare painting by the early 20th century Australian tonalist artist,
Clarice Beckett.

• David values his painting at $20,000.

Bryn would like to add one of Beckett’s works to his collection.

• Bryn values David’s painting at $50,000.

Make a prediction: Will David sell his painting to Bryn? If so, what price would you expect
for the painting?
Creating value

Value is created when a good or service is sold by a seller to a buyer.

The amount of value created in the transaction is the buyer’s valuation for the good or
service, minus the seller’s valuation.

• Value created is also referred to as the gains from trade in the economics literature.

• Value is measured in monetary units (such as dollars).

Key insight: In order for value to be created, a buyer must value a good or service more than
its seller.
Quiz 1

How much value is created if David sells

his painting to Bryn?

a. $20,000

b. $30,000

David’s Bryn’s c. $50,000

valuation valuation
$20,000 $50,000 d. $70,000
Value capture

The division of the value created, between the buyer and seller, is determined by the price at
which the transaction occurs.

• The seller’s surplus is the price the seller receives minus the seller’s valuation.

• The buyer’s surplus is the buyer’s valuation minus the price the buyer pays.

Notice that the sum of the buyer and seller surpluses is equal to the value created,

buyer surplus + seller surplus = (buyer valuation − price) + (price − seller valuation)
= buyer valuation − seller valuation
= value created
Exercise: Capturing value

Suppose that Bryn purchases the painting

from David at a price of $40,000.

• How much value does David capture

from the transaction?

• How much value does Bryn capture?

David’s Bryn’s
valuation valuation Repeat the exercise for the prices $20,000
$20,000 $50,000 and $55,000.
Exercise solutions

David’s surplus is the price at which he sells the painting ($40,000) less his valuation for the
painting ($20,000),

David’s surplus = $40,000 − $20,000 = $20,000.

Bryn’s surplus is his valuation for the painting ($50,000) less the price he pays for the
painting ($40,000),

Bryn’s surplus = $50,000 − $40,000 = $10,000.

Exercise solutions cont.

If the price of the painting is $20,000 then the two surpluses are,

David’s surplus = $20,000 − $20,000 = $0,

Bryn’s surplus = $50,000 − $20,000 = $30,000.

If the price of the painting is $55,000 then the two surpluses are,

David’s surplus = $55,000 − $20,000 = $35,000,

Bryn’s surplus = $50,000 − $55,000 = −$5,000.

Buyer-seller bargaining
Where do prices come from?

A central theme of this course is that the price at which a transaction takes place depends on
the competitive environment in which it occurs.

In our example, there is no competition on either side of the market as David is the only seller
and Bryn is the only buyer. Therefore, David and Bryn must bargain over the price.

To begin our analysis of bargaining we will identify the range of prices that are feasible given
that:

1. Both the buyer and the seller must agree to a price for a transaction to take place.

2. A buyer or seller will only agree to a price if it is in their individual interest to do so.
Definition: Willingness-to-sell

The minimum price a seller is willing to accept for a good or service.

When the price of a good or service is equal to a seller’s willingness-to-sell they will be
indifferent between selling and exercising their outside option.
David’s willingness-to-sell

If David does not agree to a price then his outside option is to keep his painting.

• David would continue to enjoy the benefits of owning the painting which he values at
$20,000.

Conversely, if David agrees to a price then he gains the value of the money he receives, but
loses the value he derived from the painting.

• David’s surplus from the transaction would be the price he receives minus his $20,000
valuation for the painting.

David is better off selling the painting if the price is above his valuation, and worse off if the
price is below his valuation. Therefore, his willingness-to-sell is equal to his valuation.
Definition: Willingness-to-pay

The maximum price a buyer is willing to pay for a good or service.

When the price of a good or service is equal to a buyer’s willingness-to-pay they will be
indifferent between buying and exercising their outside option.
Exercise: Bryn’s willingness-to-pay

1. Would Bryn be willing to pay $55,000 for the painting? Explain with reference to Bryn’s
outside option. (Recall that Bryn values the painting at $50,000.)

2. What is Bryn’s willingness-to-pay? Explain.

3. What range of prices are feasible in the sense that both David and Bryn are willing to
accept them?
Exercise solutions

Question 1

If Bryn does not purchase the painting then he gains no value from the painting, but he keeps
his money. His surplus would be equal to $0, his outside option.

If Bryn purchases the painting for the price $55,000 then his surplus is −$5,000 (see the
previous exercise).

As this is worse than his outside option, Bryn would not be willing to pay $55,000 for the
painting.
Exercise solutions cont.

Question 2
Bryn has a positive surplus if he buys at a price that is less than his valuation for the painting,
and a negative surplus if the price is lower than his valuation. Therefore, his
willingness-to-pay will be equal to his valuation of $50,000.

Question 3
David will accept prices that are greater than or equal to $20,000. Bryn will accept prices
that are less than or equal to $50,000. This is the range of feasible prices.

Key insight: A transaction is only feasible if the buyer’s willingness-to-pay is greater than (or
equal to) the seller’s willingness-to-sell. (Equivalently, if the transaction creates value.)
Bargaining power

Within the range of feasible prices, the interests of the buyer and seller are in tension.

• David (the seller) always prefers a higher price, while Bryn (the buyer) always prefers a
lower price.

The outcome of buyer-seller negotiations depends on a range of idiosyncratic characteristics

which may include:

• Patience: The longer a buyer or seller is willing to wait before reaching an agreement,
the more favourable the price is likely to be.

• Persuasion: A particularly persuasive buyer or seller may be able to convince their

counter part to accept a less favourable price.
Competition
Buyer-seller bargaining with 2 buyers

Suppose that along with Bryn a second

buyer, Ingrid, is also interested in
purchasing David’s painting.

• Ingrid values the painting at $45,000.

Make a prediction: Who will purchase

David’s Bryn’s Ingrid’s David’s painting, what is the range of
valuation valuation valuation feasible prices, and what is the value
$20,000 $50,000 $45,000 created?
Competition between buyers

Suppose that Ingrid offers David $30,000

for the painting.

Bryn’s willingness-to-pay is higher than

$30,000 so he will make a counter-offer,
say $35,000.

Likewise, $35,000 is less than Ingrid’s

willingness-to-pay so she will come back
David’s Bryn’s Ingrid’s with a new offer, say $40,000.
valuation valuation valuation
$20,000 $50,000 $45,000 Competition between Bryn and Ingrid
ends when the price exceeds Ingrid’s
willingness-to-pay.
Definition: Excluded buyer

Any buyer who misses out on purchasing a good due to limited supply and low
willingness-to-pay.

Excluded buyers have no effect on the value created in a transaction, but may influence the
division of that value between buyer and seller.
Excluded buyers

Bryn will purchase David’s painting due to

his higher valuation.
Feasible
Value Ingrid is an excluded buyer.
Prices
Created
$30,000 The value created remains $30,000.

The range of feasible prices becomes

$45,000 to $50,000.
David’s Bryn’s Ingrid’s
valuation valuation valuation David is guaranteed $25,000 of the value
$20,000 $50,000 $45,000 created, and bargains with Bryn over the
remaining $5,000.
The value of excluded buyers to sellers

Sellers benefit when there is competition between buyers for their products.

• The price must be greater than the willingness-to-pay of each excluded buyer.

• If the highest valuation of an excluded buyer is higher than the seller’s valuation then the
seller is guaranteed to capture a part of the value created.

• The seller is less reliant on bargaining power to capture value.

Example: Realestate agents try to have lots of bidders at an auction even though they are
only selling one property.

Example: Artists produce limited edition prints of their works to ensure that buyers must
compete for a copy.
Exercise: Competition between identical buyers

Suppose that Ingrid valued David’s

painting at $50,000 (the same as Bryn’s
valuation).

Who will purchase the painting?

What is the range of feasible prices?

David’s Bryn’s Ingrid’s
valuation valuation valuation What is David’s share of the surplus?
$20,000 $50,000 $50,000
Exercise solutions

Given that Bryn and Ingrid have the same

$50,000
valuation, one will buy the painting and
Value the other will be excluded.
Created
$30,000 The price cannot be greater than the
willingness-to-pay of the buyer, and
cannot be less than the willingness-to-pay
of the excluded buyer.
David’s Bryn’s Ingrid’s
valuation valuation valuation
Therefore, the price will be $50,000 and
$20,000 $50,000 $50,000
David will capture all of the value created.
Buyer-seller bargaining with 2 sellers

Suppose that Andrea also has a Painting

by Clarice Beckett to sell.

• Andrea values her painting at

$35,000.

• Bryn values both paintings at

$50,000, but only want to purchase
one painting.
David’s Andrea’s Bryn’s
valuation valuation valuation Make a prediction: Who will Bryn
$20,000 $35,000 $50,000 purchase from, what is the range of
feasible prices, and what is the value
created?
Competition between sellers

David will sell his painting as he is willing

to accept a lower price.

Feasible • Andrea will be excluded.

Prices Value
Created
The value created remains $30,000.
$30,000
Competition between sellers ensures that
the price will not be greater than
David’s Andrea’s Bryn’s $35,000. (Why?)
valuation valuation valuation
$20,000 $35,000 $50,000 Bryn is guaranteed $15,000 of surplus,
and bargains with David over the
remaining $15,000.
The value of excluded sellers to buyers

Buyers benefit when there is competition between sellers for their purchases.

• The price must be less than the willingness-to-sell of each excluded seller.

• If the lowest valuation of an excluded seller is lower than the buyer’s valuation then the
buyer is guaranteed to capture a part of the value created.

• The buyer is less reliant on bargaining power to capture value.

Example: Many business have internal procurement policies requiring them to obtain multiple
quotes before purchasing from a supplier.

Example: Major government contracts are put out to tender, eliciting competing bids from
multiple vendors.
The law of one price
Buyer-seller bargaining with 2 buyers and 2 sellers

Suppose that we have two people, David

and Andrea, with paintings to sell.

And two buyers, Bryn and Ingrid,

interested in purchasing a painting.

Make a prediction: Which buyer will trade

David’s Andrea’s Bryn’s Ingrid’s with each seller, what is the range of
valuation valuation valuation valuation feasible prices for each transaction, and
$20,000 $35,000 $50,000 $45,000 what is the value created?
Value created by 2 buyers and 2 sellers

Bryn has the highest buyer valuation, and

David has the lowest seller valuation.

• If they trade they create $30,000 of

Value $10,000 value.
Created
$30,000 Ingrid’s valuation is higher than Andrea’s.

• If they trade they create an

David’s Bryn’s Andrea’s Ingrid’s additional $10,000 of value.
valuation valuation valuation valuation
$20,000 $50,000 $35,000 $45,000 The same total value is created if Bryn
buys from Andrea, and Ingrid from David.
(You should check this.)
Price interdependence

Even though Bryn and David are participating in a different transaction to Ingrid and Andrea,
the prices of the two transactions are interdependent.

To see this, suppose that David and Bryn agree to the price $35,000, and that Ingrid and
Andrea agree to the price $40,000.

At first glance these prices appear to be feasible; the prices lie between that
willingness-to-pay and willingness-to-sell in each transaction.

However, there is a counter-offer that could be made here, that will increase the surpluses of
the buyer and seller involved. Can you spot it?
Arbitrage in bargaining

Under the proposed prices, Ingrid pays

$40,000 and David receives $35,000.
$40,000
Value $10,000 • David’s surplus is $15,000.
$35,000
Created
$30,000 • Ingrid’s surplus is $5,000.

If, instead, Ingrid offers David a price of

$37,500, David’s surplus increases to
David’s Bryn’s Andrea’s Ingrid’s
$17,500, and Ingrid’s to $7,500.
valuation valuation valuation valuation
$20,000 $50,000 $35,000 $45,000
Key insight: All transactions must take
place at the same price.
Summary: Feasible prices

• All transactions must take place at the same price.

• The price must not be greater than the willingness-to-pay of all included buyers.

• The price must not be greater than the willingness-to-sell of all excluded sellers.

• The price must not be less than the willingness-to-sell of all included sellers.

• The price must not be less than the willingness-to-pay of all excluded buyers.
Competitive equilibrium
Constructing a demand curve

P
$50,000
$45,000
A demand curve shows the relationship
$35,000 between the price of a good and the
$30,000 quantity demanded by buyers.

We can construct the demand curve by

ordering buyer willingness-to-pay from
highest to lowest.

0 1 2 3 Q
Constructing a supply curve

P
$50,000
A supply curve shows the relationship
$45,000
between the price of a good and the
$40,000
quantity supplied buy sellers.
$35,000
$30,000 We can construct the supply curve by
$25,000 ordering seller willingness-to-sell from
lowest to highest.
$15,000
$10,000 Explain why three units will be traded in
this market?

0 1 2 3 Q
Quiz 2

P
$50,000
What is the highest feasible price in this
$45,000
market?
$40,000
$35,000
a. $25,000
$30,000
$25,000 b. $30,000

$15,000 c. $35,000
$10,000
d. $40,000

0 1 2 3 Q
Quiz 3

P
$50,000
What is the lowest feasible price in this
$45,000
market?
$40,000
$35,000
a. $25,000
$30,000
$25,000 b. $30,000

$15,000 c. $35,000
$10,000
d. $40,000

0 1 2 3 Q
Buyer and seller surpluses

P The total value created in this market is

the area between the demand curve and
supply curve.

Supply The market price divides this value

Buyer surplus
between buyers and sellers.
Price

Demand The area between the demand curve and

Seller surplus the price is the buyer surplus (also known
as consumer surplus).

The area between the supply curve and

the price is the seller surplus (also known
as producer surplus).
0 1 2 3 Q
Competitive markets

P A competitive market is a market with a

large number of small buyers and sellers,
all trading similar goods or services.

The market is in equilibrium when the

Equilibrium
quantity supplied is equal to the quantity
Supply
demanded.

P∗
• This is called the equilibrium quantity
(Q ∗ ).

Demand Key insight: The equilibrium price (P ∗ ) is

the unique feasible price.
0 Q∗ Q
Questions?
Quiz solutions

1. b

2. c

3. b