ECF2731 Final Revision

ECF2731 Final Revision
Table of Contents
Week 1 Introduction to Managerial Economic ............................................................................................ 6
How is Managerial Economics Useful .................................................................................................................... 6
Evaluating Choice Alternatives ........................................................................................................................................... 6
Making the Best Decisions ................................................................................................................................................. 6
Managerial Economics ....................................................................................................................................................... 6
Economic Concepts and Methods ...................................................................................................................................... 6
Theory of the Firm – The basic model of business ................................................................................................. 6
Expect Value Maximization................................................................................................................................................ 6
Constraints & the Theory of the Firm ................................................................................................................................. 6
Limitations of the Theory of the Firm................................................................................................................................. 7
The firm can be views as a series of contractual relationship .............................................................................................. 7
Profit Measurement .............................................................................................................................................. 7
Business vs. Economic Profit .............................................................................................................................................. 7
Variability of Business Profits ............................................................................................................................................. 7
Profits vary among firms – many firms experience significant economic profits/losses ........................................ 7
Disequilibrium profit theories ............................................................................................................................................ 7
Compensatory Profit Theories............................................................................................................................................ 7
Role of Profits in the Economy ........................................................................................................................................... 7
Role of Business in Society .................................................................................................................................... 7
Why Firms Exit? ................................................................................................................................................................. 7
Social Responsibility of Business ........................................................................................................................................ 7
Week 2 Economic Optimization / Demand & Supply ................................................................................... 8
Economic Optimization Process ............................................................................................................................ 8
Revenue Relations................................................................................................................................................. 8
Total Revenue (TR)............................................................................................................................................................. 8
Demand (D) ....................................................................................................................................................................... 8
Marginal Revenue (MR) ..................................................................................................................................................... 8
Revenue Maximization ...................................................................................................................................................... 8
Cost Relations........................................................................................................................................................ 8
Total Cost (TC) ................................................................................................................................................................... 8
Average Cost (AC) .............................................................................................................................................................. 8
Marginal Cost (MC) ............................................................................................................................................................ 8
Average Costs Minimization ............................................................................................................................................... 9
Profit Relations...................................................................................................................................................... 9
Total Profit (π) ................................................................................................................................................................... 9
Marginal Profit (Mπ) ........................................................................................................................................................... 9
Profit Maximization ........................................................................................................................................................... 9
Demand & Supply................................................................................................................................................ 10
Basis for Demand............................................................................................................................................................. 10
Market Demand Function.................................................................................................................................... 10
Determinants of Demand................................................................................................................................................. 10
Industry vs. Firm Demand ................................................................................................................................................ 10
Demand Curve..................................................................................................................................................... 10
Demand curve Determination .......................................................................................................................................... 10
Relationship between the Demand curve & Demand Function ......................................................................................... 10
Market Supply Function ...................................................................................................................................... 10
Determinants of Supply ................................................................................................................................................... 10
Industry vs. Firm Supply ................................................................................................................................................... 10
Supply Curve ....................................................................................................................................................... 11
Supply curve Determination............................................................................................................................................. 11
Relation between Supply Curve & Function...................................................................................................................... 11
Market Equilibrium ............................................................................................................................................. 11
Demand & Supply balance ............................................................................................................................................... 11
Surplus & Shortage .......................................................................................................................................................... 11
Comparative Statucs ........................................................................................................................................... 11
Change in Equilibrium ...................................................................................................................................................... 11
Comparative Statics ......................................................................................................................................................... 11
Week 3 Production Analysis....................................................................................................................... 12
Production Function ............................................................................................................................................ 12
Production Function ........................................................................................................................................................ 12
Properties of Production Functions .................................................................................................................................. 12
Returns to Scale & Returns to a Factor ............................................................................................................................. 12
Two Types of Graphs ....................................................................................................................................................... 12
Total, Marginal, and Average Product – Function................................................................................................ 12
Total Product (TP) ............................................................................................................................................................ 12
Marginal Product (MP)..................................................................................................................................................... 12
Average Product (AP) ....................................................................................................................................................... 12
Law of Diminishing Returns to a Factor ............................................................................................................... 12
Diminishing Returns to a Factor ....................................................................................................................................... 12
Input Combination Choice ................................................................................................................................... 13
Production Isoquant ........................................................................................................................................................ 13
Input Factor Substitution ................................................................................................................................................. 13
Marginal Rate of Technical Substitution.............................................................................................................. 13
Marginal Revenue Product & Optimal Employment............................................................................................ 14
Marginal Revenue Product (MRP) .................................................................................................................................... 14
Optimal Level of a Single Input ......................................................................................................................................... 14
Optimal Combination of Multiple Inputs............................................................................................................. 14
Budget Lines – Isocost curves ........................................................................................................................................... 14
Expansion Path ................................................................................................................................................................ 14
Illustration of Optimal Input Proportions.......................................................................................................................... 15
Optimal Levels of Multiple Inputs ....................................................................................................................... 15
Optimal Employment & Profit Maximization .................................................................................................................... 15
Returns to Scale .................................................................................................................................................. 15
Output Elasticity & Return to Scale .................................................................................................................................. 15
Returns to Scale Estimation ............................................................................................................................................. 15
Week 4 Cost Analysis ................................................................................................................................. 16
Economic & Accounting Costs ............................................................................................................................. 16
Historical vs. Current Costs .............................................................................................................................................. 16
Opportunity Costs............................................................................................................................................................ 16
Role of Time in Costs Analysis ............................................................................................................................. 16
Concept of Cost ............................................................................................................................................................... 16
Incremental Cost ............................................................................................................................................................. 16
Sunk Cost......................................................................................................................................................................... 16
Short-run & Long-run Costs.............................................................................................................................................. 16
Short-Run Cost Curve .......................................................................................................................................... 16
SR cost curve Categories .................................................................................................................................................. 16
SR cost Relations.............................................................................................................................................................. 16
SR cost curve & Productivity ............................................................................................................................................ 17
Long-Run Cost Curve ........................................................................................................................................... 17
LR Total Cost.................................................................................................................................................................... 17
Returns to Scale & Cost Curve .......................................................................................................................................... 17
Economies of Scale .......................................................................................................................................................... 17
Cost Elasticities & Economies of Scale .............................................................................................................................. 17
LR Average Cost ............................................................................................................................................................... 17
Minimum Efficient Scale (MES) ........................................................................................................................... 18
MES ................................................................................................................................................................................. 18
Competitive Implications of MES...................................................................................................................................... 18
Transportation Costs & MES ............................................................................................................................................ 18
Firm Size & Plant Size .......................................................................................................................................... 18
Multi-plant Economies & Diseconomies of Scale .............................................................................................................. 18
Plant Size & Flexibility ...................................................................................................................................................... 18
Figure 8.7 Plainfield Electronic: Single vs. Multi-plant Operation....................................................................................... 19
Learning Curves ................................................................................................................................................... 19
Learning curve Concept ................................................................................................................................................... 19
Strategic Implications....................................................................................................................................................... 19
Economies of Scope............................................................................................................................................. 19
Economies of Scope Concept ........................................................................................................................................... 19
Exploiting Scope Economies ............................................................................................................................................. 19
Week 5 Competitive Markets .................................................................................................................... 20
Competitive Environment ................................................................................................................................... 20
Market Structure ............................................................................................................................................................. 20
Vital Role of Potential Entrants ........................................................................................................................................ 20
Factors that Shape the Competitive Environment ............................................................................................... 20
Product Differentiation .................................................................................................................................................... 20
Production Methods ........................................................................................................................................................ 20
Entry & Exit Conditions .................................................................................................................................................... 20
Competitive Market Characteristics .................................................................................................................... 20
Basic Features.................................................................................................................................................................. 20
Examples of Competitive Markets .................................................................................................................................... 20
Profit Maximization in Competitive Markets ...................................................................................................... 20
Profit Maximization Imperative ........................................................................................................................................ 20
Role of Marginal Analysis ................................................................................................................................................. 20
Marginal Cost & Firm Supply ............................................................................................................................... 21
Short-Run Firm Supply ..................................................................................................................................................... 21
Long-Run Firm Supply ...................................................................................................................................................... 21
Competitive Market Supply Curve....................................................................................................................... 22
Market Sturcture with A Fixed number of competitors ..................................................................................................... 22
Market Structure with Entry & Exit................................................................................................................................... 22
Competitive Market Equilibrium ......................................................................................................................... 22
Balance of Supply & Demand ........................................................................................................................................... 22
Normal/stable profit Equilibrium ..................................................................................................................................... 22
Competitive Market Efficiency ............................................................................................................................ 23
Why is it called Perfect Competitive ................................................................................................................................. 23
Deadweight Loss Problem ................................................................................................................................................ 23
Market Failure ..................................................................................................................................................... 23
Structural Problems ......................................................................................................................................................... 23
Incentive Problems .......................................................................................................................................................... 23
Externalities ........................................................................................................................................................ 23
Externalities..................................................................................................................................................................... 23
Types of Externalities .......................................................................................................................................... 23
Week 6 Monopoly (Chapter 12, p447-465) ................................................................................................ 24
Monopoly Market Characteristics ....................................................................................................................... 24
Profit Maximization in Monopoly Markets.......................................................................................................... 24
Price-Output Decisions .................................................................................................................................................... 24
Competitive producer ...................................................................................................................................................... 24
Monopoly ........................................................................................................................................................................ 24
Social Costs of Monopoly .................................................................................................................................... 24
Monopoly Underproduction ............................................................................................................................................ 25
Deadweight Loss from Monopoly..................................................................................................................................... 25
Social Benefits of Monopoly................................................................................................................................ 25
Economies of Scale .......................................................................................................................................................... 25
Invention & Innovation .................................................................................................................................................... 25
Monopoly Regulation .......................................................................................................................................... 26
Dilemma of Natural Monopoly ......................................................................................................................................... 26
Utility Price & Profit Regulation........................................................................................................................................ 26
Monopsony ......................................................................................................................................................... 27
Buyer Power .................................................................................................................................................................... 27
Week 8-9 Monopolistic Competition & Oligopoly ...................................................................................... 28
Monopolistic Competition Characteristics........................................................................................................... 28
Monopolistic Competition Price-Output Decisions.............................................................................................. 28
Monopolistic Competition Process ...................................................................................................................... 28
Short-run Monopoly Equilibrum....................................................................................................................................... 28
Long-run High-price/ Low-output Equilibrium .................................................................................................................. 28
Long-run Low-price/ High-output Equilibrium .................................................................................................................. 29
Oligopoly Market Characteristics ........................................................................................................................ 30
Cartel & Collusion ................................................................................................................................................ 30
Overt & Cover Agreement................................................................................................................................................ 30
Enforcement Problem ...................................................................................................................................................... 30
Oligopoly Output-Setting Models........................................................................................................................ 30
Cournot Oligopoly............................................................................................................................................................ 30
Stackelberg Oligopoly ...................................................................................................................................................... 31
Oligopoly Price-Setting Models ........................................................................................................................... 31
Bertrand Oligopoly........................................................................................................................................................... 31
Types of Games ............................................................................................................................................................... 32
Role of Interdependence ................................................................................................................................................. 32
Strategic Considerations .................................................................................................................................................. 32
Prisoner’s Dilemma ............................................................................................................................................. 33
Classic Riddle ................................................................................................................................................................... 33
Application ...................................................................................................................................................................... 33
Nash Equilibrium ................................................................................................................................................. 33
Nash Equilibrium Concept ................................................................................................................................................ 33
Nash Bargaining ............................................................................................................................................................... 33
Infinitely Repeated Games .................................................................................................................................. 33
Role of Reputation ........................................................................................................................................................... 33
Product Quality Games .................................................................................................................................................... 34
Finitely Repeated Games..................................................................................................................................... 34
Uncertain Final Period ..................................................................................................................................................... 34
End-of-game Problem ...................................................................................................................................................... 34
First-Mover Advantages ................................................................................................................................................... 34
Week 11 Risk Analysis................................................................................................................................ 35
Concepts of Risk & Uncertainty ........................................................................................................................... 35
Economic risk & uncertainty ............................................................................................................................................ 35
General Risk Categories ................................................................................................................................................... 35
Special Risks of Global Operations.................................................................................................................................... 36
Probability Concepts ........................................................................................................................................... 36
Probability Distribution .................................................................................................................................................... 36
Expected Value ................................................................................................................................................................ 36
Utility Theory & Risk Analysis .............................................................................................................................. 37
Possible Risk Attitudes ..................................................................................................................................................... 37
Relation Between Money & Its Utility............................................................................................................................... 37
Adjusting the Valuation Model for Risk ............................................................................................................... 37
Basic Valuation Model ..................................................................................................................................................... 37
Risk-Adjusted Discount Rates ........................................................................................................................................... 39
Week 1 Introduction to Managerial Economic
How is Managerial Economics Useful
Identify ways to efficiently achieve goals
Evaluating Choice
Specify pricing & production strategies
Alternatives
Spell out production & marketing rules to maximize profits
Making the Best Managerial economics helps meet management objectives efficiently
Decisions Managerial economics shows the logic of consumer, firm, and government decisions
Applies (micro)economics principles to key management decisions
Managerial
Micro- provides a set of tools to understand & analyse human behaviour
Economics
Managerial eco- applies these tools to managerial decision making
Economic
Concepts and
Methods
Theory of the Firm – The basic model of business

Expect Value Optimization of profits in light of uncertainty and the time value of money
Maximization Owner managers maximize short-run profits
Primary goal is long-term expected value maximization
The value of the firm: the present value of the firm’s expected future net cash flow
Constraints & the • Resource constraints
Theory of the • Social constraints
Firm.
Limitations of the • Alternative theory adds perspective
Theory of the • Competition forces efficiency
Firm • Hostile takeovers threaten inefficient managers
The firm can be
views as a series
of contractual
relationship
Profit Measurement
Business vs. Business (accounting) profit: residual of sales revenue – explicit accounting costs of
Economic Profit doing business
• Reflects explicit costs & revenue
Economic profit: business profit – the implicit costs of capital & any other owner
provided inputs
• Profit above a risk-adjusting normal return
• Considers cash & noncash items
Variability of • Business profits vary widely
Business Profits • Profit margin: accounting net income dived by sales
• Retune on Stockholder’s Equity (ROE): accounting net income divided by the
book value of total assets – total liabilities
Profits vary among firms – many firms experience significant economic profits/losses
Disequilibrium • Unexpected revenue growth/cost savings
profit theories Possible explanations of economic profits/losses:
• Fictional Profit Theory: abnormal profits observed following unanticipated
changes in demand or cost conditions
• Monopoly Profit Theory: above-normal profits caused by barriers to entry that
limits competition
Compensatory • Profits accrue to firms that are better/faster/cheaper than the competition
Profit Theories • Innovation-Profit Theory: describes above-normal profits that follow successful
invention or modernization
• Compensatory Profit Theory: above-normal rates of return that reward
efficiency
Role of Profits in • Economic profits play an important role in any market-based economy
the Economy • Above-normal profit à may signal that the firm/industry should increase output
Role of Business in Society
Why Firms Exit? • Businesses help satisfy consumer wants
• Businesses contributes to social welfare
Social • Serve customers
Responsibility of • Provide employment opportunity
Business • Obey laws & regulations
Week 2 Economic Optimization / Demand & Supply
Optimal decisions: best decision produces the result most consistent with managerial
objectives
Maximizing the value of the firm
Economic
• Produce what customers want
Optimization • Meet customer needs efficiently
Process • Simplest version of a firm’s goal: profit maximization
• Value of the firm is the present value of future profits
• Profits = Total Revenue – Total Costs
Revenue Relations
Total Revenue • The amount of combination by quantity and prices
(TR) • TR is a function of price and quantity 𝑇𝑅 = 𝑓(𝑃, 𝑄) à 𝑇𝑅 = 𝑃 × 𝑄
• Assume that the demand is downward-sloping à must ¯ P to Q sold
Demand (D) • Relationship between quantity demanded and price.
Marginal • The change in TR associated with a 1-unit change in quantity sold (Q).
,-./01 3/ 45 745
Revenue (MR) • 𝑀𝑅 = ,-./01 3/ 6 = 76
Revenue • Activity level that generates the highest revenue.
Maximization • TR is maximized when marginal value shifts from positive to negative à MR = 0
Cost Relations
Total Cost 𝑇𝐶 = 𝐹𝐶 + 𝑉𝐶
(TC) • Fixed Cost (FC): do not vary with output
• Variable Cost (VC): vary with output
Average Cost Total cost divided by the number of units produced.
(AC) 𝑇𝐶
𝐴𝐶 =
𝑄
Marginal Cost Change in TC associated with a change in quantity.
(MC). • Always positive because almost all goods & services entail at least some
labour/material…
74,
• 𝑀𝐶 = 76
Average Costs Activity level that generates the lowest AC. à AC minimized when MC = AC
Minimization • AC when MC < AC
• AC ¯ when MC > AC
Profit Relations
Total Profit The difference between TR and TC.
(π) 𝜋 = 𝑇𝑅 − 𝑇𝐶
Marginal The rate of change in TP as the rate of output changes.
Profit (Mπ) 𝛿𝜋
𝑀? = = 𝑀𝑅 − 𝑀𝐶
𝛿𝑄
Profit Assuming profit declines with further expansion in Q.
Maximization • π when Mπ > 0
• π ¯ when Mπ < 0
• π maximized when Mπ = MR – MC = 0 à 𝑴𝑹 = 𝑴𝑪
Demand & Supply
Basis for Demand Direct Demand: total quantity customers are willing and able to purchase under
various market condition
• Is the demand for consumption
Derived Demand: demand for inputs used in production
• Firms demand inputs that can be profitably employed
• Is derived from the demand of products they are used to provide
Market Demand Function
Determinants of Demand Function: relationship between quantity sold & factors influencing its level
Demand
𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝑌 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
= 𝑓 (𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑌, 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑟𝑒𝑙𝑎𝑡𝑒𝑑 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑠 𝑋, 𝑖𝑛𝑐𝑜𝑚𝑒, 𝑎𝑑𝑣𝑒𝑟𝑡𝑖𝑠𝑖𝑛𝑔 … )
𝑄 = 𝑎X 𝑃 + 𝑎Y 𝑃Z + 𝑎[ 𝐼 + 𝑎] 𝑃𝑜𝑝 + 𝑎^ 𝑖 + 𝑎_ 𝐴
o an – parameters of the demand function
o P – average price of new domestic cars (in $)
o Px – average price of new imported cars (in $)
o I – Disposable income per household (in $)
o Pop – population (in million)
o i – average interest rate in (%)
o A – industry advertising expenditures in (million $)
Industry vs. Firm • Industry Demand is subject to general economic conditions
Demand • Firm Demand is determined by economic conditions & competition
Demand Curve
Demand curve Relationship between price & quantity demanded, holding everything else constant
Determination
Relationship Change in Quantity Demanded: movement along a given demand curve reflecting a
between the change in price.
Demand curve & • Q ¯ if price
Demand Function • Q if price ¯
Shift in Demand: switch from one demand curve to another following a change in a
non-price determinant of demand
• Role of non-price variables: change in non-price variables will define a new
demand curve
Market Supply Function
Determinants of 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝑌 𝑆𝑢𝑝𝑝𝑙𝑖𝑒𝑑
Supply = 𝑓(𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑌, 𝑃𝑟𝑖𝑐𝑒𝑠 𝑜𝑓 𝑅𝑒𝑙𝑎𝑡𝑒𝑑 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑠 (𝑋), 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑆𝑡𝑎𝑡𝑒 𝑜𝑓 𝑇𝑒𝑐ℎ𝑛𝑜𝑙𝑜𝑔𝑦, 𝐼𝑛𝑝𝑢𝑡 𝑃
𝑄 = 𝑏X 𝑃 + 𝑏Y 𝑃efg + 𝑏[ 𝑊 + 𝑏] 𝑆 + 𝑏^ 𝐸 + 𝑏_ 𝑖
o P: Average price of new domestic cars (in $)
o PSUV: Average price of new SUV (in $)
o W: Hourly price of labour (wages in $ per hour)
o S: Average cost of steel ($ per ton)
o E: Average cost of energy ($ per mcf natural gas)
o i: Average interest rate (in %)
o bn: parameters of supply function
Industry vs. Firm • Firm supply is determined by economic conditions & competition
Supply. • Industry supply is the sum of firm supply
Supply Curve
Supply curve • All independent variables in the supply function except P are fixed at specified
Determination levels
Relation between Movement along supply curve
Supply Curve & • in price causes upward movement along a given supply curve
Function • ¯ in price causes downward movement along a given supply curve
Shifts in supply curve
• Supply if a non-price change allows more to profitably produced & sold
• Supply ¯ down if a non-price change causes less to be profitably produce & sold
Market Equilibrium
Demand & Supply • Equilibrium exists if perfect balance exists in the quantities D & S
balance • Equilibrium reflects productive and allocative efficiency
Surplus & • Surplus: excess supply
Shortage • Shortage: excess demand
Comparative Statucs
Change in • Equilibrium exists when there is no economic incentive for change in demand or
Equilibrium supply
• Changing demand/supply affects equilibrium
Comparative • Study of how equilibirum changes with changing demand or supply
Statics • Change continues until a new equilibrium is established
Week 3 Production Analysis
Production Function
Production Specifies the maximum output that can be produced for a given amount of input
Function • A basic two-input (X, Y) on-output (Q) system can be descried in the following
production function
𝑄 = 𝑓(𝑋, 𝑌)
Properties of Determined by technology, equipment and input prices etc.
Production Discrete production functions: production function with distinct input patterns
Functions • ‘lumpy’ patterns for input combinations
Continuous production function: where inputs can be varied in an unbroken marginal
fashion
• employ inputs in small increments
Returns to Returns to Scale: measures output effect of increasing ALL inputs
Scale & Returns to a Factor: measures output effect of increasing ONE input
Returns to a Hands-on-exercise in class: production of note-pads
Factor • No. of tools is fixed
• No. of labour (workers) can be increased
Two Types of
Graphs
(X, Y) (X & total/marginal product)

Total, Marginal, and Average Product – Function
Total Product Whole output from a production system
(TP)
Marginal The change in output associated with a change in single input.
Product (MP) • If If MPX = dQ/dX > 0, total product is rising.
• If MPX = dQ/dX < 0, total product is falling (rare)
Average The total product divided by the umber of units of input employed.
Product (AP) 𝑄
𝐴𝑃Z =
𝑋
Law of Diminishing Returns to a Factor
Diminishing As the quantity of a variable input increases, with the quantities of all other factors
Returns to a being held constant, the resulting increase in output eventually diminishes.
Factor. • Shows what happens to MPX as X usage grows
• MPX > 0 is common
• MPX < 0 implies irrational input use (rare)
• Dimishing returns to a factor concept
76i
• MPX shrinks as X usage grows 7j i < 0
• If MPX grew with use of X, there would be no limit to input usage
Input Combination Choice

Production Isoquant: different combinations of input choices used to efficiently produce a
Isoquant specified (same) output
• Show efficient input combinations
• Technical efficiency is least-cost production
Input Factor • Isoquant shape shows input substitutability
Substitution • The exchange rate between Y & X depends on the relative productivity
• The selection of efficient input employment depends on the ability of those
input to produce profit
Straight line isoquants L-shaped isoquants imply no C-shaped isoquants depict
depict perfect substitutability imperfect substitutes
substitutes
Marginal Rate of Technical Substitution

Marginal Rate of Technical Substitution (MRTS): amount of one input that must be substituted for
another to maintain constant output
• For every one unit decrease of input Y, it takes more additional units of input X to reach the same
output from C to D than from A to B due to the different level of productivity (diminishing return)
−𝑀𝑃Z 𝛿𝑌
𝑀𝑅𝑇𝑆Zm = = = 𝑠𝑙𝑜𝑝𝑒 𝑜𝑓 𝑎𝑛 𝑖𝑠𝑜𝑞𝑢𝑎𝑛𝑡
𝑀𝑃m 𝛿𝑋
Marginal Revenue Product & Optimal Employment
Marginal • Amount of revenue generated by emploting the last input unit
Revenue • MRPX is the net revenue gain after all variable costs except X costs
745
Product (MRP) • 𝑀𝑅𝑃Z = 𝑀𝑃Z × 𝑀𝑅6 = 7Z
Optimal Level • As long as MR > MC à π
of a Single • π maximized at MR = MC à as long as MRPY >MCY, π
Input • MCL if the cost of L, = PL
• Set MRPL = PL to get optimal employment.
• If MRPL = PL, then input marginal revenue = input marginal cost
Optimal Combination of Multiple Inputs
Budget Lines – Shows the various combinations of inputs Y can be purchased for a given budget B
Isocost curves 𝐵 = 𝑃Z 𝑋 + 𝑃m 𝑌
𝐵 𝑃Z
𝑌= − 𝑋
𝑃m 𝑃m
𝑃Z
𝑇ℎ𝑒 𝑆𝑙𝑜𝑝𝑒 𝑜𝑓 𝑎 𝐵𝑢𝑑𝑔𝑒𝑡 𝐿𝑖𝑛𝑒 = −
𝑃m
• Isocost curves: least-cost production occurs when

𝑃Z 𝑀𝑃Z
=
𝑃m 𝑀𝑃m
𝑀𝑃Z 𝑀𝑃m
=
𝑃Z 𝑃m
Expansion Path Optimal input combinations as the
scale of production expands
• Shows efficient input
combinations as output grow
Illustration of • Input proportions are optimal when no additional output could be produce for the
Optimal Input same cost
Proportions • Optimal input proportions is a necessary but not sufficient cost for profit
maximization
Optimal Levels of Multiple Inputs
Optimal • Profits are maximized when MRPi = Pi for all inputs
Employment & o PX = MPX * MRQ = MRPX
Profit o PY = MPY * MRQ = MRPY
Maximization • Profit maximization requires optimal input proportions + an optimal level of output
• Profit maximization means efficiently producing what customers want
Returns to Scale
Output Increasing returns to scale: when the
Elasticity & proportional increase in output is larger
Return to Scale than an underlying proportional increase
in input
Constant returns to scale: when a given
percentage increase in all inputs leads to
an identical percentage increase in
output
Decreasing returns to scale: when output
increases at a rate less than the
proportionate increase in input
• Point Output Elasticity
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑂𝑢𝑡𝑝𝑢𝑡 (𝑄) 𝛿𝑄/𝑄
∈6 = =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐴𝑙𝑙 𝐼𝑛𝑝𝑢𝑡 (𝑋3 ) 𝛿𝑋𝑖/𝑋𝑖
Where Xi is all inputs (labor, capital, etc.)
If Then Returns to Scale are
% change in Q > % change in X ÎQ > 1 Increasing
% change in Q = % change in X ÎQ = 1 Constant
% change in Q < % change in X ÎQ < 1 Decreasing
Returns to • Assume that all inputs in the unspecified production function 𝑄 = 𝑓(𝑋, 𝑌, 𝑍) are
Scale increased by using the constant factor k. where k =1.01 for 1% increase
Estimation • h is the proportional increase in Q resulting from a k-fold increase in each input
factor
• ℎ𝑄 = (𝑘𝑋, 𝑘𝑌, 𝑘𝑍)
Week 4 Cost Analysis
Economic & Accounting Costs
Historical vs. Historical cost is the actual cash outlay
Current Costs Current cost is the present cost of previously acquired items
• Current costs for tangible assets typically exceed historical costs because of
inflation
• Replacement Cost is the relevant cost for decision-making. It is the cost of
duplicating the productive capability using current technology
• Determines the current cost for computers & electronic equipment
Opportunity Foregone value associated with current rather than next-best use of an asset
Costs • Explicit costs are out-of-pocket/cash expenses
• Implicit costs are noncash expenses
• 𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑅 − 𝐸𝑥𝑝𝑙𝑖𝑐𝑖𝑡 𝐶𝑜𝑠𝑡𝑠 − 𝐼𝑚𝑝𝑙𝑖𝑐𝑖𝑡 𝐶𝑜𝑠𝑡𝑠
Role of Time in Costs Analysis
Concept of • Costs can be measured in different ways, depending on the purpose for which the
Cost cost figures are used.
• The costs appropriate for financial reporting purposes are not always appropriate
for decision making purposes
• The relevant cost in economic decision making is opportunity cost
• Sunk costs, which are incurred regardless of the alternative action chosen, should
seldom be considered in making operating decisions.
Incremental The change in cost caused by a given managerial decision
Cost • Typically involve multiple units of output, while MC involves a single unit of output
Sunk Cost Cost that does not vary across decision alternatives
• Irreversible expenses incurred previously
• Sunk costs are irrelevant to present decisions
• Do not play a role in determining the optimal course of action
Short-run & Short Run • Operating decisions are made
Long-run Costs • At least one input is fixed
Long Run • Planning decisions are made
• All inputs are variable.
• No Fixed costs
Fixed and Variable Costs • Fixed cost is a short-run concept.
• All costs are variable in the long run
Short-Run Cost Curve
SR cost curve • Total Cost: TC = TFC + TVC
Categories. • Average Fixed Cost: AFC = TFC/Q
• Average Variable Cost: AVC = TVC/Q
• Average Total Cost: ATC = AFC + AVC
• Marginal Cost: MC = dTC/dQ
SR cost • Short-run cost curves show
Relations. minimum cost in a given
production environment
• MC are independent of FC
àFC merely shift the TC curve to
higher level
SR cost curve
& Productivity
Long-Run Cost Curve

LR Total Cost Long-run total cost curves: cost-output relation for the optimal plant in the present
operating environment
• Shows minimum total cost in an ideal environment
Returns to
Scale & Cost
Curve
Economies of Decreasing long-run average costs as output expands

Scale • Increasing returns to scale à falling AC
• Constant returns to scale à constant AC
• Decreasing returns to scale à rising AC
Cost Cost elasticity (ÎC) measures the percentage change in cost following a one percent
Elasticities & change in output
Economies of 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 (𝑇𝐶 )
∈, =
Scale 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑜𝑢𝑡𝑝𝑢𝑡 (𝑄)
𝛿𝑇𝐶/𝑇𝐶
∈, =
𝛿𝑄/𝑄
LR Average Starting from M, ACB > ACA, continue to produce at plant B instead of A from M, etc.
Cost
SR Cost Curve for Different Scales Combining SR & LR Cost Curve
Minimum Efficient Scale (MES)
MES The output level at which long-run average costs are minimized
Competitive • MES is the ‘corner point’ on an L-shaped LRAC curve
Implications of • MES is the minimum point on an U-shaped LRAC curve
MES • Competition is most vigorous when
• MES is small in absolute terms
• MES is a small share of industry output
• Cost disadvantage to small scale is modest
Transportation Transportation Costs:
Costs & MES • Terminal charges are the
cost of loading & unloading
that do not vary with the
distance shipped
• Line-haul costs are
expenses of moving goods,
i.e. equipment, labour, fuel
cost etc.
• Inventory costs are shipping
costs tied to time in transit
High transport costs reduce MES impact

• Location near customers can offset scale disadvantages
Firm Size & Plant Size
Multi-plant Multi-plant Economies of scale are cost advantages from operating multiple facilities in
Economies & the same line of business/industry
Diseconomies Multi-plant diseconomies of scale are cost disadvantages from operating multiple…
of Scale • Coordination costs from operating several plants
Three Possible LRAC Curves for a Multi-Plant Firm
(a) Constant costs characterize a multi-plant facility that has neither economies nor
diseconomies of scale
(b) AC decline if a multi-plant firm is more efficient than a single-plant firm
(c) AC of operating several plants can eventually rise when coordinating costs
overcome multi-plant economies
Plant Size & • Big plants can offer lower AC
Flexibility. • Smaller plants can make it easier to add/or subtract capacity
Figure 8.7 • In this example, profit is maximized
Plainfield at a production level well beyond
Electronic: that at which average cost is
Single vs. minimized for a single plant.
Multi-plant • Profits are greater with four plants
Operation because output can then be
produced at minimum cost
Learning Curves
Learning curve Advantages to learning are present when
Concept AC fall with greater production experience.
• Learning causes an inward shift in the
LRAC curve due to better production
knowledge.
• Learning is often mistaken for scale
economies
Strategic If learning results in 20% to 30% cost savings, it becomes a key part of competitive
Implications strategy
Economies of Scope
Economies of • Economies of scope exist when the cost of joint production is less than the cost of
Scope Concept producing multiple outputs separately
o Explains why firms typically produce multiple products
• Force management to consider direct and indirect benefits associated with
individual lines of business
• Scope economies are cost advantages that stem from producing multiple outputs.
• Big scope economies explain the popularity of multi-product firms.
• Without scope economies, firms specialize
Exploiting • Economies of scope are important because they permit a firm to translate superior
Scope skill in a given product line into unique advantages in the production of
Economies complementary products.
• Scope economics often shape competitive strategy for new products
Week 5 Competitive Markets
Competitive Environment
Market Describes the competitive environment in terms of
Structure • Number of buyers & sellers
• Potential entrants
Vital Role of Person/firm posing a sufficiently credible threat of market entry to affect market price-
Potential output decisions
Entrants • Actual & potential competitors are important
• Potential entrants often affect price/output decision
• Barriers to entry & exit, etc.
Factors that Shape the Competitive Environment
Product Real or perceived differences in the quality of goods & services
Differentiatio • R&D & innovation lead to distinctive products
n • Advertising build brand awareness
Production • Scale economies can preclude small firm size

Methods • Scope economies give multi-product advantages
Entry & Exit Barrier to entry: any factor or industry characteristic that creates an advantage for
Conditions incumbents over new arrivals.
Barrier to mobility: any factor or industry characteristic that creates an advantage for
large leading firms over smaller non-leading rivals
Barrier to exit: any restriction on the ability of incumbents to redeploy assets from one
industry or line of business to another
• Barriers to entry & exit can shelter incumbents from potential entrants
• Powerful buyers can limit seller power
Competitive Market Characteristics
Basic • Profit maximiser
Features • Very small share of the market
• Price-taker: buyers and sellers that accept market prices as given and devise their
buying and selling strategies accordingly
• Product homogeneous
• Perfect information
• No barriers to entry (legal, technological, or resource)/free entry or exit
• No technical progress
• No investment lag - Immediate implementation of production decisions)
• Many buyers and sellers.
• Opportunity for normal profits in long-run equilibrium
Examples of • Agricultural commodities e.g. cotton
Competitive • Prominent markets for intermediate goods & services, e.g. discount retailing
Markets • Unskilled labour market
Profit Maximization in Competitive Markets
Profit • Normal profit: rate of return necessary to attract and retain capital
Maximization o Is necessary to attract & maintain capital investment
Imperative • Efficient firms can earn normal profit
• Inefficient firms suffer losses
Role of • Set 𝑀? = 𝑀𝑅 − 𝑀𝐶 = 0 to maximize profits
Marginal • Profit maximization occurs when P = MR = MC
Analysis.
Marginal Cost & Firm Supply

Short-Run • Competitive market
Firm Supply price (P) is hown as a
horizontal line because
P = MR
• Firm’s MC curve shows
the amount of output
the firm would be
willing to supply at any
market price
• MC curve is the short-
run supply curve so
long as P > AVC
• In the short run, firms
supply output so long as
MR > AVC, and a profit
contribution is earned
Rule: Set P = MC, provided P > AVC
• Step1: set P = MC, give supply curve
• Step2: verify P > AVC (P > AVC à opimal output, P < AVC à not optimal)
Long-Run • In long run, firm must
Firm Supply cover all necessary costs
(TC) of production & earn
a normal profit
• MC curve is the long-run
supply curve so long as P
> ATC
• In the long run, firms
supply output so long as
revenues meet or exceed
TC, and at least a risk-
adjusted normal rate of
profit is earned
Rule: Set P = MC, provided P > ATC

• Step1: set P = MC, give supply curve
• Step2: verify P > ATC at Q
• If P > ATC, there is positive economic profit, more firms will enter the market as it
is perfectly competitive, either price will go down or costs will increase until the
point P = ATC where firms have normal economic profit
Competitive Market Supply Curve
Market Supply is the sum of competitor output
Sturcture If market price exceeds average variable The market supply curve is found by adding
with A Fixed cost, each firm’s AC curve is its supply up quantities supplied by all competitors
number of curve
competitors
Market • Entry results in a rightward shift in the supply curve

Structure à drives down prices & profits
with Entry & • Exit shifts the supply curve left ward
Exit à allows price & profits to rise for remaining competitors
Competitive Firm’s supply output at The LR Competitive Market Supply Curve
Minimum ATC is a Horizontal Line = the Market Price
Entry & Exit causes the market price =
minimum point on each competitive firm’s
ATC curve
Competitive Market Equilibrium

Balance of Equilibrium is a balance of supply & Demand
Supply &
Demand
Normal/stabl • There are no economic profits in competitive equilibrium; firms earn a normal rate of
e profit return
Equilibrium • Profit maximizing condition: MR = MC
• Competitive firm with a horizontal market demand curve: P = MR = AR
• Normal profits/zero economic profits = P = AC, hence in competitive equilibrium
à P = MR = MC = ATC
For Solving:
• Set MC = AC, and solve for Q
• Set P = AC, and solve for P, using Q above
Competitive Market Efficiency
Why is it • Competitive markets balance supply & demand
called Perfect • Competitive markets maximize social welfare (material well-being of society)
Competitive • Social welfare is the sum of consumer and producer surplus
Deadweight Decline in social welfare due to competitive market distortion
Loss Problem • Deadweight losses occur when market imperfections reduce transaction volume
• Any benefit enjoyed by consumers or producers that is not transferred but lost due
to market imperfections is a deadweight loss
Market Failure
Structural Situation when competitive markets malfunction because of market power
Problems • Failure can occur in markets with few participants
• If above-normal profits reflect the raw exercise of market power they can be
unwarranted
Incentive Situation when competitive markets malfunction because of externalities
Problems Incentive problem: Uncompensated benefits or costs tied to production or consumption
• A negative externality is an unpaid cost
• A positive externality is an unrewarded benefit
Externalities
Externalities Refers to the uncompensated impact of one person’s actions on the wellbeing of a
bystander
• Externalities cause markets to be inefficient, and thus fail to maximize total surplus
• An externality arises when a person engages in an activity that influences the
wellbeing of a bystander & yet the person neither pays nor receives any
compensation for that effect
Negative externalities have an • Air pollution (car, plants)/Cigarette smoke
adverse effect on the bystander • Noise (lawn mowers, customers leaving a pub)
Positive externalities have a • Immunisations/Education
beneficial effect on the bystander • Restored historic buildings
• Research into new technologies
• Asking questions during the lecture
Types of Externalities
Source Affected Bystander:
Effect
Production Consumption
Production Negative Upstream vs. downstream Plant emissions & respiratory
production diseases
Production Positive Results from basic research Landscape conservation of farmers
Consumption Negative Upstream vs. downstream Unkempt garden & real estate prices
household effluents
Consumption Positive Private renovation of house front Surfing at Bell’s Beach
Week 6 Monopoly (Chapter 12, p447-465)
Monopoly Market Characteristics
• A single seller: a single firm produces all industry output, the monopoly is the • Profit
industry maximiser
• Unique product with no close substitutes: monopoly output is perceived by • Faces market
customer to be distinctive and preferable to its imperfect substitutes demand
• Blockaded entry and/or exit: firms are heavily restricted from entering or leaving curve
the industry • Price-maker
• Imperfect dissemination of information: cost, price & product quality • No restriction
information is withheld from uninformed buyers on resources
• Opportunity for long-run economic profits: distinctive products allow P > MC & P
= AR > AC for efficient monopoly firms
Profit Maximization in Monopoly Markets
Price- Profit maximization: MR = MC
Output • P > MR, given a downward-sloping monopoly demand curve, P always exceed MR under
Decisions monopoly, P = AR à P = AR > MR
o the monopoly demand curve is always above the MR curve
• P > AC, barriers to entry make above-normal profits possible & P > AC in the long-run
equilibrium
Set MC = MR, solve for the profit
maximizing Q & P
• TRM = PMQ
• TCM = ATCMQ
• p = PMBCD
Competitive producer Monopoly

Production where MR = MC Production where MR = MC
P = MR = MC P > MC; P > MR
No entry barrier Entry barriers
Social Costs of Monopoly
Monopoly Tendency for monopoly firms to restrict output to increase prices & earn economic
Underproduction profits.
• Monopolists produce too little output
• Monopolists charge prices that are too high, P > MC
• Marginal value of resources employed (MC) < the marginal social benefit (P that
customers are willing to pay for additional output)
Deadweight Loss Deadweight loss: Decline in social welfare due to the drop in mutually beneficial
from Monopoly trade activity caused by monopoly.
Solving for Deadweight Loss from Monopoly:
• Set Optimal price-output combination: MR=MC=Market Supply
• Solve for Q, calculate the P at Q
• Consumer/Producer Deadweight Loss = ½(base*height)
• Total Deadweight Loss = Consumer + Producer Deadweight Loss
There is also a wealth transfer problem associated with monopoly; significant
transfer of consumer surplus to producer surplus.
• Is seen as an issue of equity or fairness because it involves the distribution of
income or wealth in the economy
Social Benefits of Monopoly
Economies of Natural Monopoly: market in which the market-clearing price (where P=MC) occurs
Scale at a point at which the monopolist’s long-run average costs are still declining.
• Doesn’t arise from gov. intervention/artificial barriers to entry
• Naturally evolves in markets subject to overwhelming economies of scale in
production created by extremely large capital requirements, scarce inputs,
insufficient natural resources…
• LRAC declines continuously
• One firm is most efficient à Market demand is insufficient to justify full
utilization of even one minimum-efficient-scale plant, a single monopolist can
produce the total market supply at a lower TC than could any other number of
smaller firms)
From the standpoint of society in general:
• Positive development à reflect the successful growth & development of a
uniquely capable competitor
• Risk: incentives to use its dominance of the marketplace to unfairly restrict
production & raise prices to generates unwarranted economic profits
• Economic efficiency can sometimes be enhanced by allowing a single firm to
dominate an industry
In the public utility sector:
• Public utility regulation has been justified as a means to maintain reasonable
prices & profits
• Many real-world monopolies are government-created or government-
maintained barriers to entry
Invention & Public policy sometimes confers explicit monopoly rights to spur productivity to
Innovation. achieve the benefits flowing from dynamic, innovative, leading firms. Important to
recognize that:
• Monopoly is not always socially harmful, monopoly profits could be the just
rewards flowing from truly important contributions of unique firms & individuals
• Monopoly profits are often fleeting, the tremendous social value of invention
and innovation often remains long after early monopoly profits have dissipated
E.g. Patents:
• Patents grant an exclusive right to produce, use or sell an invention/innovation
for a limited period of time
• In granting patents, the public confers a limited opportunity for monopoly
profits to stimulate research activity & economic growth
• By limiting the patent monopoly, competition is encouraged to extend &
develop the common body of knowledge
Monopoly Regulation
Dilemma of • Monopoly has the potential for greatest efficiency
Natural Monopoly • Unregulated monopoly can lead to economic profits and underproduction
• One possible solution is to allow natural monopoly to persist but to impose price
& profit regulations
Unregulated: MR > MC
Monopoly p = PP’C’C
Utility Price & • The most common method of monopoly regulation, result in larger output
Profit Regulation quantities & lower profits than unrestricted monopoly
• Regulation is sometimes used to improve monopoly market performance
• Substituting bureaucratic decisions for market interactions is risky & costly
Problems with utility price & profit regulation:
• Impossible to exactly determine cost & demand schedules, or the minimum
investment required to support a given level of output in practice
• Many different rate schedules would produce the desired profit level because
utilities serve several classes of customer
• Mistakes with regards to the optimal level & growth of service
o Excessive rate à system will grow at faster-than-optimal rate
o Prices allowed are too low à encourage higher consumption while
producers will limit production and cause shortage
• Regulatory lag: delay between when a change in regulation is appropriate and
the date it becomes effective
• Traditional forms of regulation could also lead to inefficiency
Government imposes a price ceiling at
P2, Monopoly change its role from a
price maker to a price taker, can sell as
much as they want at P2
• Whenever you are a price taker,
MR = price curve (P2)
MRR curve: P2A à L
• new MR curve under regulation
is the price curve up to intersection
with Demand curve (P2 till A), and then
continues with original MR curve
• Kinked MR Curve
𝜋x10yz.{1| = 𝑃Y 𝐴𝐸𝐶Y
Monopsony
Buyer Power • Oligopsony describes market demand dominated by a few/a handful of buyers.
• Monopsony: market in which there is a single buyer of a desired product or
input.
• Monopsony power: ability to obtain prices below those that exist in a
competitive market.
• When a single buyer is confronted in a market with many seller, monopsony
power enables the buyer to obtain lower than competitive market prices
o E.g. the federal government is monopsony buyer of military weapons and
equipment, major retailers such as Walmart, Target and Sears all enjoy
monopsony power in the purchase of apparel, appliances, auto parts and
other consumer products
• Monopsony is more common in factor input markets than in markets for final
demand
• Monopsony is least harmful & sometimes beneficial for economic efficiency
Week 8-9 Monopolistic Competition & Oligopoly
Monopolistic Competition Characteristics
• Large numbers of buyers and sellers: • Product differentiation/heterogeneity
each firm produces a small portion of o The most distinctive characteristic of
industry output & each customer buys monopolistic competition, each firm is able to
only a small part of the total differentiate its product from those of its
• No entry and exit cost in the long run adversaries
(But not totally free entry and exit in o Many forms, quality/packaging/credit
short run) terms/superior maintenance service
• Imperfect Information: Buyers & o Effect: to create downward-sloping firm demand
Sellers don’t have perfect information curves in monopolistically competitive markets,
• Opportunity for normal profits in the degree of price flexibility depends on the
long-run equilibrium: distinctive strength of product differentiation
products allow P>MC, but vigorous à stronger product differentiation, lower
price & product-quality price substitutability, greater customer loyalty, better
competition keeps P=AC control over price, steeper demand curve
Monopolistic Competition Price-Output Decisions
• The monopoly • D1 for highly differentiated
characteristic of product (P1, Q1)
monopolistic competition • Short-run monopoly profits
market is typically attract new competitors
observed in the short run who offer close (but
• The price-output imperfect) substitutes
combination describes a shifting D1 to D2 (P2, Q2 à
monopolistically high-differentiation
competitive market equilibrium)
equilibrium characterized • Market share and profits of
by a high degree of incumbent firm decrease,
product differentiation but firm still faces a
• Set Mp = MR - MC = 0 to to downward sloping demand curve.
find the profit-maximizing • If new entrants offered perfect rather than close substitutes, each
activity level firm’s long-run demand curve would become more nearly
• Point price elasticity: horizontal (perfect competitive equilibrium P3, D3 à non-
~6 } differentiation equilibrium)
∈} = ~} × 6
• Firms in a monopolistic competitive market produce at a point
• No durable economic
where price equals average cost but operates at some point above
profits because P=AR=AC
minimum average cost
Monopolistic Competition Process
Short-run • Monopolistically competitive firms take full advantage of short-run monopoly.
Monopoly • In short run, MR = MC, P > AC, and p > 0.
Equilibrum • Set MR=MC and solve for Q
Long-run In monopolistic competition, where differentiated products allow P > MC but P = AR = AC
High-price/ The high-price/low-output equilibrium is identified by the point of tangency between the
Low-output firm’s AC curve & a new demand curve reflecting a parallel leftward shift in demand which
Equilibrium assumes high differentiation in the long run (D2)
• Parallel demand curves à slope of new D = slope of old D
à in equilibrium, slope of new demand curve = slope of AC curve
• With differentiated products, MR = MC & P = AR = AC at a point above minimum LRAC
• No excess profits exist, so π = 0.
Long-run in monopolistic competition, where entry of identical products drives prices down to
Low-price/ where P = MR = MC = AC (the competitive market solution)
High-output • Assumes no residual product differentiation in the long run & it is identified by the
Equilibrium point of tangency between the AC curve & a new horizontal firm demand curve (D3) à
also the perfectly competitive equilibrium price-output combination
• Low-cost/high-output Equilibrium occurs when P = MR = MC = AC (reflects perfectly
horizontal demand curve & AC is minimized)
o With homogeneous products, MR = MC and P=AC at minimum LRAC.
o No excess profits exist, so π = 0. The same result as the competitive market
equilibrium.
• To find the output level of minimum AC, set MC = AC and solve for Q
Oligopoly Market Characteristics
• Few sellers: a handful of firms produce the • Imperfect dissemination of information: cost,
bulk of industry output, competing firms price & product quality info is withheld from
typically recognize their interdependence in uninformed buyers
price-output decisions • Opportunity for above-normal (economic)
• Homogeneous or unique products: oligopoly profits in long-run equilibrium: competitive
output can be identical or distinctive advantages keep P > MC and P = AR > AC for
• Blockaded entry and exit: firms are heavily efficient firms
restricted from entering or leaving the industry • There is an interdependence in decision-
making
Cartel & Collusion
Overt & Cartel: firms operating with a formal agreement to fix prices & output
Cover • Legal in some parts of the world, several important domestic markets are also
Agreement dominated by producer associations that operate like cartels & appear to flourish
without government interference
• A cartel that has absolute control over all firms in an industry can operate as a
monopoly
• Equating the cartel’s total MC with the industry MR determines the profit-
maximizing Q & P to be charged, each individual firm finds its optimal Q by equating
its own MC to the profit-maximizing industry MC
Collusion: an informal covert agreement among firms in an industry to fix prices &
output levels
Overt agreements create cartels that operate like monopoly.
Collusion exists when firms reach secret, covert agreements
Enforcement • Cartels are typically short-lived not only because the long-run problems of changing
Problem products & of entry into the market by new producers, but also coordination
problems that often lead to cheating/subvert the cartel agreement
• Cartel subversion can be extremely profitable.
• Cheating under few-firm cartel is extremely difficult as any lose in profits or market
share could easily detected, conversely, under cartel with more members, profits
and market share gains to successful cheaters
• Detecting the source of secret price concessions can be extremely difficult.
• Cartels including more than a very few members have difficulty policing &
maintaining member compliance
Oligopoly Output-Setting Models
Cournot • Cournot Model: theory that firms in oligopoly markets make simultaneous &
Oligopoly independent output decision
• Each firm takes output of competitor as fixed, and then makes its own output
decision à oligopoly demand curves are stable
• Output-Reaction Curve: relation between an oligopoly firm’s profit-maximizing
output & rival output à shows how oligopoly firms react to competitor production
decisions
• The profit-maximizing output level for firm A could be found by setting MRA = MCA,
it also depends upon the level of output produced by itself & firm B, similar for firm B
• Cournot equilibrium output is found by simultaneously solving output-reaction
curves for both competitors
• Insert the QB to QA equation and solve for QA, similarly, insert QA to QB equation to
solve for QB, add up for Cournot Equilibrium Output
• Cournot equilibrium output exceeds monopoly output but is less than competitive
output, Cournot equilibrium results in less than monopoly profit
Stackelberg Stackelberg Model: theory of sequential output decisions in oligopoly markets
Oligopoly • Posits a First-Mover Advantage: competitive advantage for the oligopoly firm that
initiates the process of determining market output
• Assuming the leading firm takes into account the expected output reaction of its
following firm rival
Stackelberg equilibrium:
• Market output is greater than Cournot equilibrium output because the first mover
produces more output while the follower produces less
• Market price is lower than Cournot equilibrium price
• Price wars can break out with the potential to severely undermine the profitability
for both leading and following firms, if firms cannot agree on the positions
Oligopoly Price-Setting Models
Bertrand Bertrand Model: theory that firms in oligopoly markets make simultaneous and
Oligopoly independent price decisions
Bertrand Oligopoly: Identical Products:
• The Bertrand model focuses on price reactions, Bertrand equilibrium is reached
when no firm can achieve higher profits by charging a different price
• The Bertrand model predicts a competitive market price-output solution in oligopoly
markets with identical products:
o all customers will purchase from the firm selling at the lowest possible price
for identical products
o PA = PB = MC, economic profits = 0
• Critics: implausible Bertrand’s prediction of a competitive market equilibrium in
oligopoly markets that offer homogeneous products,
o with only a few number of firms, competitors may eventually recognize & act
upon their mutual interest in higher price,
o also, oligopoly market prices often change with demand conditions & the
number of competitors, not just with changes in costs
• Contestable markets theory: hypothesis that oligopoly firms will behave much like
perfectly competitive firms when sunk costs are minor
Bertrand Oligopoly: Differentiated Products
• Many economists believe that price-setting models are more plausible than quantity-
setting models
o If oligopoly firms set prices for differentiated products, then consumers set
market quantities by deciding how much to buy à not clear how market
prices would be determined for differentiated products if firms merely set Q
• The Bertrand model demonstrates how price-setting oligopolies can profit by selling
differentiated products à explains why firms spend on maintaining product
differentiation in the eyes of consumers
o Price-Reaction Curve: relation between an oligopoly firm’s profit-maximizing
price & rival price
o à shows how the oligopoly firm reacts to competitor pricing decisions
• The profit-maximizing price for Firm A depends upon the price charged by firm B,
similar for firm B
o Insert PB into firm A’s price-reaction curve and solve for PA, similar for firm B
o Insert PA, PB to solve for the demand Q
• Stable equilibrium because given the competitor price, neither firm has any incentive
to change prices
Week 10 Game Theory

Game Theory Basics
Types of Games • Game theory is a method for the study of rational behaviour by individuals and
firms involved with interactive decision problems
• Is applied during situations in which decision-makers must take into account the
reasoning of other decision-makers à has been used to determine the formation
of business and political coalitions, optimum price, the best site for a
manufacturing plant & even the behaviour of certain species in the struggle for
biological survival
• In economics & business, game theory seeks to logically determine the strategies
that individuals and firms should take to secure the best outcomes for
themselves in a wide array of competitive circumstances
• All economic & business games share the common feature of interdependence
• In competitive games, the outcome for each firm depends upon the strategies
conducted by all competitors
• Zero-sum game: one players’ gain is another player’s loss
• Positive sum game: engaging parties holds potential for mutual gain
• Negative-sum game: when conflict holds the potential for mutual loss.
• Cooperative games: where joint action is favoured
Role of Sequential games: each player moves in succession, and each player is aware of all
Interdependence prior moves
• General principle for players in a sequential game is to look ahead & extrapolate
back (to anticipate rational countermoves in initial decisions)
• In business decision-making, firms make their best strategic decision based on
the premise that their initial decision will trigger a sequence of rational decision
responses from competitors
• End after a finite sequence of moves, can be solve completely at least in principle
• Could be solved simple like children’s game of tic-tac-toe, or more complexly
involving millions of calculations and becomes daunting even with high-speed
computers, like chess
Simultaneous-move games: players move without specific knowledge of
countermoves by other players, incorporate coincident moves
• Players act at the same point in time & must make their initial moves in isolation
without any direct knowledge of moves made by other players’
Equilibrium outcome: the payoff to no player can be improved by unilateral action/a
given allocation of payoffs that no player can gain from unilaterally switching to
another game-theory strategy
• Various strategies result in different payoffs in any strategic game
• Only reasonable & stable outcomes for games because they represent the best
possible outcome under a given set of conditions
Strategic • Firms often use threats & promises to alter the expectations & actions of other
Considerations. firms, to succeed, threats & promises must be credible
• To successful implement game theory concepts, decision0makers must
understand the benefits to be obtained from concealing or revealing useful info
Prisoner’s Dilemma
Classic Riddle • A game is described by listing the alternative choices or strategies available to
each player
• Games are analysed using a payoff matrix
o The strategies available to the first player form the first & second row &
the strategies available to the second player forms the first and second
column
o Player rewards from selected strategy
• The Prisoner’s Dilemma is the most famous simultaneous-move one-shot game
• Rational individual behavior can give suboptimal group result.
• Rationality can hamper beneficial cooperation.
Time:
• One-shot game: the underlying interaction between players occurs only once.
• Repeated game: Ongoing interaction between players
Application • Dominant strategy: decision that gives best result for either party regardless of
moves by the other
• Secure strategy (the maximin strategy): decision that guarantees the best
possible result assuming the worst possible scenario
Nash Equilibrium
Nash Equilibrium Nash equilibrium: set of decision strategies where no player can improve through a
Concept unilateral change in strategy
• Neither player can improve their payoff through a unilateral change in strategy.
• Nash equilibrium concept is broader than the concept of a dominant strategy
equilibrium.
o Every dominant strategy equilibrium is also a Nash equilibrium.
• Nash equilibrium can exist where there is no dominant strategy equilibrium
Randomized strategies: Haphazard actions to keep rivals from being able to predict
strategic moves
• In some instances, two-party games have no stable Nash equilibrium because a
player’s preferred strategy changes once the rival’s strategy has been adapted;
e.g. workers will perform as expected if the manager choose to monitor
Nash Bargaining Nash Bargaining: where two competitors haggle/’bargain’ over some item of value
• Another application of the simultaneous-move, one-shot game
• The player have only one chance to reach an agreement
How to find the Nash Equilibria?
• Optimize the decision of Company B given each fixed strategy of Company A.
Select the highest payoff under each strategy.
• Repeat step 1 for Company A
Infinitely Repeated Games
Role of Infinitely repeated games: a competitive game that is repeated over and over again
Reputation. without boundary or limit
• Firms receive sequential payoffs that shape current and future strategies.
• The repeat nature of competitor interactions can sometimes harm, but can also
be helpful to consumers
o Repetitive interactions provide the necessary incentives for firms to
produce high-quality goods
o Reputations for high quality give consumers confidence for repeat
transactions
Product Quality • In a one-shot game, poor quality can fool customers.
Games • In an infinitely repeated game, poor quality is shunned by customers
• Consistency and reliability are cherished commodities
• The theory of infinitely repeated games can be used to show the desirability of
maintaining a reputation for selling high-quality goods
Finitely Repeated Games
Uncertain Final Finitely repeated game: game that occurs only a limited number of times, or has
Period limited duration in time
• Finitely repeated games have limited duration
• With end point uncertainty, a finitely repeated game mirrors an infinitely
repeated game
Trigger strategy: system of behavior that remains the same until another player
takes some course of action that precipitates a different response
• Can be used In a finitely repeated game with an uncertain final period, and in
infinitely repeated games
• To ensure that the costs of breaking agreements exceed any resulting benefits,
where both costs and benefits are measured in present value terms
End-of-game • End-of-game problem: difficulty tied to inability to punish/reward final-period
Problem behaviour
• Enforcing end-of-game performance is difficult.
• Solution: simply extend the game
First-Mover Multistage Games: games where payoffs and strategy are shaped by the order in
Advantages which various players make their moves
• Involve special considerations
• The timing of player moves becomes important
First-Mover Advantage: benefit earned by the player able to make the initial move
in a sequential move or multistage game
In practice, multistage games & the assertion of first-mover advantages are
complicated by the difficulty of making credible threats, especially between
strangers
• Without prior experience, the dealer or potential customer are not able to judge
the sincerity of any threats
• If the threats are not sincerity, they simply represent the opening bid in an
ongoing repeated game of uncertain duration
Week 11 Risk Analysis
Concepts of Risk & Uncertainty
Economic risk • Economic risk: the chance of loss due to the fact that all possible outcomes and
& uncertainty their probability of occurrence are unknown.
o Actions taken in such a decision environment are purely speculative
o All decision makers are equally likely to win or lose.
o Examples: Buy or sell decisions by speculators in the options market.
• Uncertainty: when the outcomes of managerial decisions cannot be predicted with
absolute accuracy, but all possibilities and their associated probabilities of
occurrence are known
o Under conditions of uncertainty, informed managerial decisions are
possible, experience, insight, and prudence allow investment managers to
devise strategies for minimizing the chance of failing to meet business
objectives
• When the level of risk and the attitudes toward risk taking are known, the effects of
uncertainty can be directly reflected in the basic valuation model of the firm
o Certainty equivalent method: converts expected risky profit streams to their
certain sum equivalents to eliminate value difference that result from
different risk levels à risky stream is of less value than a certain stream for
risk-adverse decision-makers, but of greater value for risk-seeking ones
o Risk-adjust discount rate approach: the interest rate used in the
denominator of the basic valuation model depends on the level of risk à
higher discount rate is employed for highly risk-adverse decision-makers &
lower discount rate is employed for less risk-adverse ones
§ Using this technique, discounted expected profit streams reflect
differences & become directly comparable
General Risk Business risk Chance of loss associated with a given managerial decision
Categories Market risk Chance that a portfolio of investments can lose money because of
swings in the financial markets as a whole
Inflation risk Danger that a general increase in the price level will undermine the
real economic value of any legal agreement that involves a fixed
promise to pay over an extended period
Interest-Rate Market risk that stems from the fact that changing interest rates affect
risk the value of any agreement that involves a fixed promise to pay over a
specified period
Credit risk Chance that another party will fail to abide by its contractual
obligations
Liquidity risk Difficulty of selling corporate assets or investments that have only a
few willing buyers or arc otherwise not easily transferable at
favourable prices under typical market conditions
Derivative Chance that volatile financial derivatives such as commodities futures
Risk and index options could create losses in underlying investments by
increasing rather than decreasing price volatility
Special Risks of Cultural risk Chance of loss because of product market differences due to
Global distinctive social customs.
Operations • Is borne by companies that pursue a global investment strategy
• Produce market differences due to distinctive social customs make
it difficult to predict which products might do well in foreign
markets
Currency risk Loss due to changes in the domestic-currency value of foreign profits
• Important danger because most companies wish to eventually
repatriate/transfer foreign earnings back to the domestic parent
• Price swings in the relative value of currencies are unpredictable
and can be significant, many multinational firms hedge against
currency price swings using financial derivatives in the foreign
currency market à expensive and risky during volatile markets.
Government Chance of loss because foreign government grants of monopoly
policy risk franchises, tax abatements, and favoured trade status can be tenuous
Expropriation Danger that business property located abroad might be seized by host
risk governments.
Probability Concepts
Probability • Probability of an event is the chance that the
Distribution incident will occur.
• Probability distribution is the list of possible
events and probabilities
• Payoff Matrix: tables that shows outcomes
with each possible state of nature.
• E.g. Firm can choose between two investment
projects (A, B)
o Projects provide different profits depending on the state of nature (e.g.
State of the Economy)
Expected Expected value is the anticipated realization from a given payoff matrix and probability
Value. distribution.
𝐸 (𝑋) = • 𝑋3 × 𝑃3
€
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝐸 (p) = • p3 × 𝑝3

3•X
• E(p) = a weighted average of possible outcomes, with
each outcome’s weighted equal to its probability of
occurrence
• pI = the profit level associated with ith outcome
• pi = probability that outcome i will occur
• N = the number of possible outcomes (e.g. states of the
economy)
• E.g. 𝐸 (p‚ ) = ∑[3•X p3 × 𝑝[ = pX × 𝑝X + pY × 𝑝Y + p[ × 𝑝[ =
$4000(0.2) + $5000(0.6) + $6000(0.2) = $5000
• Graph of the probability distribution of returns for project A
& B (figure 16.1)
o The more loose the probability distribution, the less likely it is that
actual outcomes will be close to expected values
• Because A has a relatively tight probability distribution, its actual profit is more
likely to be close to its expected value than is that of project B
Utility Theory & Risk Analysis
Possible Risk Risk Aversion Desire to avoid or minimize uncertainty/risk
Attitudes A risk averter selects the less risky investment
Risk Neutrality Focus on expected values, not return dispersion(risk)/disregard risk
Indifferent between the two investment projects
Risk Seeking Preference for speculation
A risk seeker selects the risker investment
Relation • Diminishing Marginal Utility: when additional increments of money bring ever
Between smaller increments of added benefit à at the heart of risk aversion
Money & Its • Risk aversion implies DMU for money (diminishing) à less than proportional
Utility relation
• Risk neutrality implies CMU for money (constant) à strictly proportional r/ship
• Risk seeking implies IMU for money (increasing) à more than proportional relation
Risk Aversion
Adjusting the Valuation Model for Risk

Basic Valuation • Recall the basic model of the value of the firm (Chapter 1)
€
Model p{
𝑉=•
(1 + 𝑖){
{•X
o V - Value of the firm
o p - Profit
o t - Time period (e.g. year)
o i - discount (interest) rate
• This model states that the value of the firm is equal to the discounted present
worth of the future profits
• Under conditions of uncertainty, the profits shown in the numerator of the
valuation model as p = expected value of profits during each future period, which is
the best available estimate of the amount to be earned during any given period
• Profits cannot be predicted with absolute precision, some variability is to be
anticipated, an appropriate ranking of projects with different expect profit and
rusks is possible only if each investment project can be adjusted for both the tie
value of money & risk
• Two popular methods for adjusting the time value of money & risk
o In the first, expected profits are adjusted to account for risk
o In the second, the interest rate used in the denominator of the valuation
model is increased to reflect risk considerations
o Either method can be used to ensure value-maximizing decisions are made
• Certainty equivalent method is an adjustment to the numerator of the basic
valuation model to account for risk
• Basic Intuition:
o Decision maker compares utilities provided by a certain & uncertain
outcome
o Decision maker specifies a certain sum that is regarded as comparable to
the expected value of a risky investment alternative
• Certainty equivalent typically differs in dollar terms but not in utility term
• Example - Decision maker has two choices:
o Invest $ 100,000 in risky project
§ p = 0.5: profit of $ 0
§ p = 0.5: profit of $ 1,000,000
§ Expected value: $ 500,000
o You do not invest and keep $100,000
o If you are indifferent between the two options (e.g. both provide the same
utility) your certainty equivalent value for the risky expected return of
$500,000 is $100,000 (50/50 chance to earn $1000,000 or $0) à indifferent
between the two alternatives
o Any certainty equivalent value of less than $500,000 indicates risk aversion.
o If the maximum amount you are willing to invest in the project is only
$100,000 à exhibiting very risk-adverse behavior, you will value each dollar
from the certain option 5 times higher than a dollar from the risky option
• Any expected risky amount can be converted to an equivalent certain sum using
the certainty equivalent adjustment factor a à the ratio of a certain sum divided
by an expected risky amount, where both dollar value provide the same level of
utility
𝑬𝒒𝒖𝒊𝒗𝒂𝒍𝒆𝒏𝒕 𝑪𝒆𝒓𝒕𝒂𝒊𝒏 𝑺𝒖𝒎
𝑪𝒆𝒕𝒓𝒊𝒏𝒂𝒕𝒚 𝑬𝒒𝒖𝒊𝒗𝒂𝒍𝒆𝒏𝒕 𝑨𝒅𝒋𝒖𝒔𝒕𝒎𝒆𝒏𝒕 𝑭𝒂𝒄𝒕𝒐𝒓 = 𝜶 =
𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝑹𝒊𝒔𝒌𝒚 𝑺𝒖𝒎
If Then Implies
Equivalent certain sum < Expected risky sum a<1 Risk aversion
Equivalent certain sum = Expected risky sum a=1 Risk indifference
Equivalent certain sum > Expected risky sum a>1 Risk preference
• The certain sum numerator and expected return denominator may vary in dollar
terms, but they provide the exact same reward in terms of utility
• The risk-adjusted valuation model reflects time-value and risk considerations
€
∝ 𝐸(p{ )
𝑉=•
(1 + 𝑖){
{•X
• In this risk-adjusted valuation model, expected future profits, E(pi), are converted
to their certainty equivalents, aE(pi), and are discounted at a risk-free rate, i, to
obtain the risk-adjusted present value of a firm or project
• To use for real-world decision-making, managers must estimate appropriate as for
various investment opportunities
Risk-Adjusted • Risk-adjusted discount rates: risk-free rate of return plus the required risk
Discount Rates premium
o Are based on the trade-off between risk & return for individual investors
• Risk-Adjusted Discount Rates method is an adjustment to the discount rate
(denominator) of the basic valuation model to account for risk.
• Risk premium (RP): Added expected return for a risky asset over that of a risk-free
asset (RF).
o In most cases, the required risk premium is directly related to the level of
risk associated with a particular investment
€
𝐸(p{ )
𝑉=•
(1 + 𝑘){
{•X
• The risk-adjusted discount rate k is the sum of the risk free rate of return RF, and
the required risk premium, RP
𝑘 = 𝑅} + 𝑅¤

ECF2731 Final Revision

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

ECF2731 Final Revision

Uploaded by

Copyright:

Available Formats

ECF2731 Final Revision

Theory of the Firm – The basic model of business

(X, Y) (X & total/marginal product)

Input Combination Choice

Marginal Rate of Technical Substitution

• Isocost curves: least-cost production occurs when

Long-Run Cost Curve

Economies of Decreasing long-run average costs as output expands

High transport costs reduce MES impact

Production • Scale economies can preclude small firm size

Marginal Cost & Firm Supply

Rule: Set P = MC, provided P > ATC

Market • Entry results in a rightward shift in the supply curve

Competitive Market Equilibrium

Competitive producer Monopoly

Week 10 Game Theory

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝐸 (p) = • p3 × 𝑝3

Adjusting the Valuation Model for Risk

You might also like