You are on page 1of 50

MANAGERIAL ECONOMICS

CLASS-01

TERM 13-1
GY005 MANAGERIAL ECONOMICS:
Course Information
Teaching Team:
1. Dr. Ir. Leonard Tampubolon, MA (leonard@bappenas.go.id)
2. Ir. Tarcius Sunaryo,MA., Ph.D. (aryonaryo@yahoo.com)

Text :
1. Baye. M (2010). Managerial Economics, and Business Strategy,
(7
th
edition). McGraw-Hill.In
2. Besanko, D., Dranove, D., Schaefer, S. and Ark Shanley (2007).
Economics of Strategy (4
th
edition). John Wiley & Sons.

Assessment Description:
1. Class Paticipation 10%
2. Quizzess 20%
3. Mid Term Exam 30%
4. Final Exam 40%

MANAGERIAL ECONOMICS &
BUSINESS STRATEGY
Chapter 1:
The Fundamentals of Managerial
Economics
McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy

Copyright 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
OVERVIEW
I. Introduction
II. 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
1-4
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.

Efective Manager must:
1. Identify goals and constraints
2. Recognize the nature and imprtance of profits
3. understand incentives
4. understand markets
5. recognize the time value of money
6. use marginal anaysis

1-5
IDENTIFY GOALS AND CONSTRAINTS:
Sound decision making involves having
well-defined goals.
Leads to making the right decisions.
In striking to achieve a goal, we often
face constraints.
Constraints are an artifact of scarcity.
1-6
RECOGNIZE THE NATURE AND IMPRTANCE OF PROFITS:
Accounting Profits
Total revenue (sales) minus dollar cost of producing goods or
services.
Reported on the firms income statement.
Economic Profits
Total revenue minus total opportunity cost.
Accounting Costs
The explicit costs of the resources needed to produce produce goods or
services.
Reported on the firms income statement.
Opportunity Cost
The cost of the explicit and implicit resources that are foregone when a
decision is made.

1-7
ECONOMIC VS. ACCOUNTING PROFITS
The Five Forces Framework
1-8

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

-Entry Costs
-Speed of Adjustment
-Sunk Costs
-Economies of Scale
-Network Effects
-Reputation
-Switching Costs
-Government Restraints
Substitutes & Complements
-Price/Value of Surrogate Products or
Services
-Price/Value of Complementary
Products or Services
-Network Effects
-Government
Restraints
Industry Rivalry
-Switching Costs
-Timing of Decisions
-Information
-Government Restraints
-Concentration
-Price, Quantity, Quality, or Service
Competition
-Degree of Differentiation
PROFITS AS A SIGNAL
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.
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.

1-9
UNDERSTAND MARKETS:
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 the negotiating power of consumers 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.
1-10
RECOGNIZE 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:
( )
PV
FV
i
n
=
+ 1
Examples:
Lotto winner choosing between a single lump-sum payout of $104
million in the 1
st
year or $198 million in the 25
th
year.
Determining damages in a patent infringement case.
1-11
THE TIME VALUE OF MONEY
PRESENT VALUE VS. FUTURE VALUE
The present value (PV) reflects the difference between the
future value and the opportunity cost of waiting (OCW).
Succinctly, PV = FV OCW If i = 0, note PV = FV.
As i increases, the higher is the OCW and the lower the PV.
1-12
PRESENT VALUE OF A SERIES
Present value of a stream of future amounts (FV
t
) received
at the end of each period for n periods:


Equivalently,
( ) ( ) ( )
PV
FV
i
FV
i
FV
i
n
n
=
+
+
+
+ +
+
1
1
2
2
1 1 1
...
( )

=
+
=
n
t
t
t
i
FV
PV
1
1
NET PRESENT VALUE
Suppose a manager can purchase a stream of future receipts (FV
t
) by
spending C
0
dollars today. The NPV of such a decision is
( ) ( ) ( )
NPV
FV
i
FV
i
FV
i
C
n
n
=
+
+
+
+ +
+

1
1
2
2 0
1 1 1
...
Decision Rule: If NPV < 0: Reject project --- If NPV > 0: Accept project
1-13
PRESENT VALUE OF A PERPETUITY
An asset that perpetually generates a stream of cash flows (CF
i
) at the
end of each period is called a perpetuity.
The present value (PV) of a perpetuity of cash flows paying the same
amount (CF = CF
1
= CF
2
= ) at the end of each period is
( ) ( ) ( )
i
CF
i
CF
i
CF
i
CF
PV
Perpetuity
=
+
+
+
+
+
+
= ...
1 1 1
3 2
FIRM VALUATION AND PROFIT MAXIMIZATION
The value of a firm equals the present value of
current and future profits (cash flows).


A common assumption among economist is that it is
the firms goal to maximization profits.
This means the present value of current and future profits, so the firm
is maximizing its value.

( ) ( )
( )

=
+
= +
+
+
+
+ =
1
2 1
0
1
...
1 1
t
t
t
Firm
i
i i
PV
t t t
t
1-14
Control Variable Examples:
Output
Price
Product Quality
Advertising
R&D
Basic Managerial Question: How much of the control
variable should be used to maximize net benefits?
USE MARGINAL ANAYSIS:
1-15
NET BENEFITS
Net Benefits = Total Benefits - Total Costs
Profits = Revenue - Costs
MARGINAL (INCREMENTAL) ANALYSIS
1-16
MARGINAL BENEFIT (MB)
Change in total benefits arising from a change in the
control variable, Q:



Slope (calculus derivative) of the total benefit curve.
Q
B
MB
A
A
=
MARGINAL COST (MC)
Change in total costs arising from a change in the
control variable, Q:



Slope (calculus derivative) of the total cost curve
Q
C
MC
A
A
=
MARGINAL PRINCIPLE
To maximize 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.
1-17
THE GEOMETRY OF OPTIMIZATION:
TOTAL BENEFIT AND COST




Q
Total Benefits
& Total Costs
Benefits
Costs
Q*
B
C
Slope = MC
Slope =MB
1-18
THE GEOMETRY OF OPTIMIZATION:
NET BENEFITS




Q
Net Benefits
Maximum net benefits
Q*
Slope = MNB
1-19
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).

1-20
MANAGERIAL ECONOMICS &
BUSINESS STRATEGY
Chapter 2
Market Forces: Demand and Supply
McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy

Copyright 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
OVERVIEW
III. Market Equilibrium
IV. Price Restrictions
V. Comparative Statics
II. Market Supply Curve
The Supply Function
Supply Shifters
Producer Surplus
I. Market Demand Curve
The Demand Function
Determinants of Demand
Consumer Surplus
2-22
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.
Quantity
D
Price
2-23
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
A general equation representing the demand curve
Q
x
d
= f(P
x
,

P
Y
, M, H,)

Q
x
d
= quantity demand of good X.
P
x
= price of good X.
P
Y
= price of a related good Y.
Substitute good.
Complement good.
M = income.
Normal good.
Inferior good.
H = any other variable affecting demand.
2-24
INVERSE DEMAND FUNCTION
Price as a function of quantity
demanded.
Example:
Demand Function
Q
x
d
= 10 2P
x
Inverse Demand Function:
2P
x
= 10 Q
x
d
P
x
= 5 0.5Q
x
d

2-25
CHANGE IN QUANTITY DEMANDED
Price
Quantity
D
0

4 7
6
A to B: Increase in quantity demanded
B
10
A
2-26
Price
Quantity
D
0

D
1

6
7
D
0
to D
1
: Increase in Demand
CHANGE IN DEMAND
13
2-27
CONSUMER SURPLUS
The value 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.
2-28
Price
Quantity
D
10
8
6
4
2
1 2 3 4 5
Consumer Surplus:
The value received but not
paid for. Consumer surplus =
(8-2) + (6-2) + (4-2) = $12.
CONSUMER SURPLUS:
THE DISCRETE CASE
2-29
Consumer Surplus
1 2 3 4 5
5
6
7
8
9
10
Market Price = 5

The 1
st
good:
The Value for consumer = 9
The consumer surplus = 9-5 = 4

The 2nd good:
The Value for consumer = 8
The consumer surplus = 8-5 = 3

The 3rd good:
The Value for consumer =7
The consumer surplus = 7-5 = 2

The 4th good:
The Value for consumer = 6
The consumer surplus = 6-5 = 1


Q
P
D
S
CS= (5X5)/2 =12.5
CONSUMER SURPLUS:
THE CONTINUOUS CASE
Price $
Quantity
D
10
8
6
4
2
1 2 3 4 5
Value
of 4 units = $24
Consumer
Surplus =
$24 - $8 =
$16
Expenditure on 4 units =
$2 x 4 = $8
2-31
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
Quantity
S
0

2-32
SUPPLY SHIFTERS
Input prices
Technology or
government regulations
Number of firms
Entry
Exit
Substitutes in production
Taxes
Excise tax
Ad valorem tax
Producer expectations
2-33
THE SUPPLY FUNCTION
An equation representing the supply curve:
Q
x
S
= f(P
x
,

P
R
,W, H,)

Q
x
S
= quantity supplied of good X.
P
x
= price of good X.
P
R
= price of a production substitute.
W = price of inputs (e.g., wages).
H = other variable affecting supply.
2-34
INVERSE SUPPLY FUNCTION
Price as a function of quantity
supplied.
Example:
Supply Function
Q
x
s
= 10 + 2P
x
Inverse Supply Function:
2P
x
= 10 + Q
x
s
P
x
= 5 + 0.5Q
x
s

2-35
CHANGE IN QUANTITY SUPPLIED
Price
Quantity
S
0

20
10
B
A
5
10
A to B: Increase in quantity supplied
2-36
Price
Quantity
S
0

S
1

8
7 5
S
0
to S
1
: Increase in supply

CHANGE IN SUPPLY
6
2-37
PRODUCER SURPLUS
The amount producers receive in excess of the amount
necessary to induce them to produce the good.
Price
Quantity
S
0

Q
*

P
*

2-38
Producer Surplus
1 2 3 4 5
5
1
2
3
4
P
Q
D
S
Market Price = 5

The 1
st
good:
The cost for Producer = 1
The producer surplus = 5-1 = 4

The 2nd good:
The cost for producer = 2
The producer surplus = 5-2 = 3

The 3rd good:
The cost for producer =3
The producer surplus = 5-3 = 2

The 4th good:
The cost for producer = 4
The producer surplus = 5-4 = 1


PS= (5X5)/2 =12.5
MARKET EQUILIBRIUM
The Price (P) that Balances
supply and demand
Q
x
S
= Q
x
d

No shortage or surplus
Steady-state
2-40
Price
Quantity
S
D
5
6
12
Shortage
12 - 6 = 6
6
If price is too low
7
2-41
Price
Quantity
S
D
9
14
Surplus
14 - 6 = 8
6
8
8
If price is too high
7
2-42
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.

2-43
Price
Quantity
S
D
P*
Q*
P
Ceiling
Q
s

P
F

IMPACT OF A PRICE CEILING
Shortage
Q
d
2-44
Suppose the equilibrium
price for the product is $5

1. What will be happened if
government determined
the ceiling price for this
product is $3?

2. What will be happened if
government determined
the ceiling price for this
product is $7?
FULL ECONOMIC PRICE
The dollar amount paid to a firm under a price
ceiling, plus the nonpecuniary price.
P
F
= P
c
+ (P
F
- P
C
)
P
F
= full economic price
P
C
= price ceiling
P
F
- P
C
= nonpecuniary price
2-45
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.
2-46
IMPACT OF A PRICE FLOOR
Price
Quantity
S
D
P*
Q*
Surplus
P
F

Q
d
Q
S

2-47
Suppose the equilibrium
price for the product is $5

1. What will be happened if
government determined
the price floor for this
product is $3?

2. What will be happened if
government determined
the price floor for this
product is $7?
COMPARATIVE STATIC ANALYSIS
How do the equilibrium price and quantity
change when a determinant of supply and/or
demand change?
Comparative static analysis shows how the
equilibrium price and quantity will change
when a determinant of supply or demand
changes.

2-48
Price
of
PCs
Quantity of PCs
S
D
S*
P
0

P*
Q
0

Q*
SUPPLY CHANGE
2-49
Price
of Software
Quantity of
Software
S
D
Q
0

D*
P
1

Q
1

DEMAND CHANGE
P
0

2-50