Managerial

Economics
Dony Abdul Chalid, Ph.D.

Session 1
About The Course
• Objectives:
 Providing students with the tools from microeconomics, game theory, and industrial organization that
they need to make sound managerial decisions

• Topics:
 Production Function, Cost Function, Supply and Demand Market Structure, Pricing Strategy,
Competition.
 Managerial Economics
• Manager
 A person who directs resources to achieve a stated goal.

• Economics
 The science of making decisions in the presence of scare resources.

• Managerial Economics
 The study of how to direct scarce resources in the way that most efficiently achieves a
managerial goal.
 Managerial
Economics
Strategic
Economics
Management
Organization Internal
Economics organization

Industrial
Competition
Economics

Theoretical/ Empirical
Mathematical
Overview
The Economics of Effective Management
 Identify Goals and Constraints
 Recognize the Role of Profits
 Five Forces Model
 Understand Incentives
 Understand Markets
 Recognize the Time Value of Money
 Use Marginal Analysis
Identify Goals and Constraints
• Sound decision making involves having well-
defined goals.
 Leads to making the “right” decisions.

• Instriking to achieve a goal, we often face

constraints.
 Constraints are an artifact of scarcity.
 Economic vs. Accounting Profits
• Accounting Profits
 Total revenue (sales) minus dollar cost of producing goods or services.
 Reported on the firm’s income statement.

• Economic Profits
 Total revenue minus total opportunity cost.
 Opportunity Cost
 The cost of the explicit and implicit resources that are foregone when a decision is made.

• Profits signal to resource holders where resources are most highly valued by society.
 Resources will flow into industries that are most highly valued by society.
The Five Forces Framework
•Entry Costs
•Speed of Adjustment
•Sunk Costs
•Economies of Scale
Entry •Network Effects
•Reputation
•Switching Costs
•Government Restraints

Power of Power of
Input Suppliers Buyers
•Supplier Concentration •Buyer Concentration
•Price/Productivity of Sustainabl •Price/Value of Substitute
Alternative Inputs Products or Services
e Industry
•Relationship-Specific •Relationship-Specific
Investments Profits Investments
•Supplier Switching Costs •Customer Switching Costs
•Government Restraints •Government Restraints

Industry Rivalry Substitutes & Complements

•Concentration •Switching Costs •Price/Value of Surrogate Products •Network Effects
•Price, Quantity, Quality, or •Timing of Decisions or Services •Government
Service Competition •Information •Price/Value of Complementary Restraints
•Degree of Differentiation •Government Restraints Products or Services
Understanding Firms’ Incentives
• Incentives play an important role within the firm.
• Incentives determine:
 How resources are utilized.
 How hard individuals work.

• Managers must understand the role incentives

play in the organization.
• Constructing proper incentives will enhance
productivity and profitability.
 Market Interactions
• Consumer-Producer Rivalry
 Consumers attempt to locate low prices, while producers attempt
to charge high prices.
• Consumer-Consumer Rivalry
 Scarcity of goods reduces consumers’ negotiating power as they
compete for the right to those goods.
• Producer-Producer Rivalry
 Scarcity of consumers causes producers to compete with one
another for the right to service customers.
• The Role of Government
 Disciplines the market process.
The Time Value of Money
• Present value (PV) of a future value (FV)
lump-sum amount to be received at the
end of “n” periods in the future when the
per-period interest rate is “i”:
FV
PV =
(1 + i ) n
Firm Valuation and Profit
Maximization
• Thevalue of a firm equals the present
value of current and future profits (cash
flows).
1

2 t
PVFirm =  0 + + + ... = 
(1 + i ) (1 + i ) t =1 (1 + i )t

•A common assumption among economist is

that it is the firm’s goal to maximization
profits.
 This means the present value of current and future profits, so the firm is
maximizing its value.
Marginal (Incremental) Analysis
• Control Variable Examples:
 Output
 Price
 Product Quality
 Advertising
 R&D

• BasicManagerial Question: How much of the

control variable should be used to maximize net
benefits?
 Net Benefits
• Net Benefits = Total Benefits - Total Costs
• Profits = Revenue - Costs
 Marginal Benefit (MB)
• Change in total benefits arising from a change in
the control variable, Q:
B
MB =
Q

• Slope(calculus derivative) of the total benefit

curve.
 Marginal Cost (MC)
• Change in total costs arising from a change in
the control variable, Q:

C
MC =
Q

• Slope(calculus derivative) of the total cost

curve.
 Marginal Principle
• Tomaximize net benefits, the managerial
control variable should be increased up to the
point where MB = MC.
• MB > MC means the last unit of the control
variable increased benefits more than it
increased costs.
• MB < MC means the last unit of the control
variable increased costs more than it
increased benefits.
 The Geometry of Optimization: Total
Benefit and Cost
Total Benefits Costs
& Total Costs
Benefits
Slope =MB

B
Slope = MC
C

Q* Q
 The Geometry of Optimization: Net
Benefits
Net Benefits

Maximum net benefits

Slope = MNB

Q
Q*
 Conclusion
• Make
sure you include all costs and benefits
when making decisions (opportunity cost).
• When
decisions span time, make sure you are
comparing apples to apples (PV analysis).
• Optimal
economic decisions are made at the
margin (marginal analysis).
Market Demand Curve
• Shows the amount of a good that will be
purchased at alternative prices, holding
other factors constant.
• Law of Demand
 The demand curve is downward sloping.

Price

Quantity
Determinants of Demand
• Income
 Normal good
 Inferior good
• Prices of Related Goods
 Prices of substitutes
 Prices of complements
• Advertising and consumer tastes
• Population
• Consumer expectations
The Demand Function
•Ageneral equation representing the
demand curve
Qxd = f(Px , PY , M, H,)
 Qxd = quantity demand of good X.
 Px = price of good X.
 PY = price of a related good Y.
 Substitute good.
 Complement good.
 M = income.
 Normal good.
 Inferior good.
 H = any other variable affecting demand.
 Inverse Demand Function

• Price as a function of quantity demanded.

• Example:
 Demand Function
 Qxd = 10 – 2Px
 Inverse Demand Function:
 2Px = 10 – Qxd
 Px = 5 – 0.5Qxd
Change in Quantity Demanded
Price
A to B: Increase in quantity demanded

A
10

B
6

D0

4 7 Quantity
 Change in Demand
Price
D0 to D1: Increase in Demand

6
D1

D0

7 13 Quantity
Consumer Surplus
• Thevalue consumers get from a good
but do not have to pay for.
• Consumer surplus will prove
particularly useful in marketing and
other disciplines emphasizing strategies
like value pricing and price
discrimination.
I got a great deal!
• That company offers a
lot of bang for the buck!
• Dell
provides good
value.
• Totalvalue greatly
exceeds total amount
paid.
• Consumer surplus is
large.
I got a lousy deal!
• That car dealer drives a
hard bargain!
• I almost decided not to buy
it!
• They tried to squeeze the
very last cent from me!
• Total amount paid is close
to total value.
• Consumer surplus is low.
Market Supply Curve
• The supply curve shows the amount of a
good that will be produced at alternative
prices.
• Law of Supply
 The supply curve is upward sloping.

Price
S0

Quantity
Supply Shifters
• Input prices
• Technology or government
regulations
• Number of firms
 Entry
 Exit

• Substitutes in production
• Taxes
 Excise tax
 Ad valorem tax

• Producer expectations
The Supply Function
• An equation representing the supply curve:

QxS = f(Px , PR ,W, H,)

 QxS = quantity supplied of good X.

 Px = price of good X.
 PR = price of a production substitute.
 W = price of inputs (e.g., wages).
 H = other variable affecting supply.
 Inverse Supply Function
• Price as a function of quantity supplied.
• Example:
 Supply Function
 Qxs = 10 + 2Px
 Inverse Supply Function:
 2Px = 10 + Qxs
 Px = 5 + 0.5Qxs
Change in Quantity Supplied
Price A to B: Increase in quantity supplied

S0
B
20

A
10

5 10 Quantity
Change in Supply
S0 to S1: Increase in supply
Price

S0

S1

5 7 Quantity
 Producer Surplus
• The amount producers receive in excess of the
amount necessary to induce them to produce
the good.
Price

S0
P*

Q* Quantity
Market Equilibrium

• ThePrice (P) that

Balances supply and
demand
 QxS = Qxd
 No shortage or surplus

• Steady-state
If price is too low…
Price
S

7
6

Shortage D
12 - 6 = 6
6 12 Quantity
 If price is too high…
Surplus
Price 14 - 6 = 8
S
9
8
7

6 8 14 Quantity
Price Restrictions
• Price Ceilings
 The maximum legal price that can be charged.
 Examples:
 Gasoline prices in the 1970s.
 Housing in New York City.
 Proposed restrictions on ATM fees.

• Price Floors
 The minimum legal price that can be charged.
 Examples:
 Minimum wage.
 Agricultural price supports.
 Impact of a Price Ceiling
Price S

PF

P*

P Ceiling

Shortage D

Qs Qd Quantity
Q*
 Full Economic Price

• The dollar amount paid to a firm under a

price ceiling, plus the non-pecuniary price.

PF = Pc + (PF - PC)
 PF = full economic price
 PC = price ceiling
 PF - PC = nonpecuniary price
An Example from the 1970s
• Ceiling price of gasoline: $1.
•3 hours in line to buy 15 gallons of
gasoline:
 Opportunity cost: $5/hr.
 Total value of time spent in line: 3  $5 = $15.
 Non-pecuniary price per gallon: $15/15=$1.
• Full
economic price of a gallon of
gasoline: $1+$1=2.
Impact of a Price Floor
Price Surplus S
PF

P*

Qd Q* QS Quantity
Comparative Static Analysis
• Howdo the equilibrium price and
quantity change when a determinant of
supply and/or demand change?
Applications: Demand and Supply
Analysis
• Event:The WSJ reports that the prices of
PC components are expected to fall by 5-8
percent over the next six months.
• Scenario
1: You manage a small firm that
manufactures PCs.
• Scenario
2: You manage a small software
company.
 Use Comparative Static Analysis
to see the Big Picture!
• Comparative static analysis shows how
the equilibrium price and quantity will
change when a determinant of supply or
demand changes.
Scenario 1: Implications for a
Small PC Maker
• Step 1: Look for the “Big Picture.”
• Step
2: Organize an action plan (worry
about details).
 Big Picture: Impact of decline in
component prices on PC market
Price
S
of
PCs S*

P0
P*

Q0 Q* Quantity of PC’s
Big Picture Analysis: PC Market
• Equilibrium price of PCs will fall, and
equilibrium quantity of computers sold
will increase.
• Use this to organize an action plan:
 contracts/suppliers?
 inventories?
 human resources?
 marketing?
 do I need quantitative estimates?
Scenario 2: Software Maker
• More complicated chain of reasoning to
arrive at the “Big Picture.”
• Step 1: Use analysis like that in Scenario
1 to deduce that lower component prices
will lead to
 a lower equilibrium price for computers.
 a greater number of computers sold.

• Step2: How will these changes affect the

“Big Picture” in the software market?
 Big Picture: Impact of lower PC
prices on the software market
Price
S
of Software

P1
P0

D*

Quantity of
Q0 Q1 Software
Big Picture Analysis:
Software Market
• Softwareprices are likely to rise, and
more software will be sold.
• Use this to organize an action plan.
Conclusion
• Use supply and demand analysis to
 clarify the “big picture” (the general impact of a current event on
equilibrium prices and quantities).
 organize an action plan (needed changes in production, inventories, raw
materials, human resources, marketing plans, etc.).