2010 Managerial Economics

Helsinki University of Technology
Spring 2007

by Hannele Wallenius

Grades will be based on

  

performance in the final exam homework computer exercises

70 % 10 % 20 %

Table of Contents
Lecture 1 and Lecture 2 Introduction: What is Managerial Economics? The Goals of a Firm: Economic and Non-economic Goals Optimal Decision Making Demand Estimation: From Theory to Practice - Market Studies and Experiments - Regression Analysis The Theory of Production: Production Functions The Theory of Production :Optimal Combination of Inputs Returns to Scale

Lecture 3 Lecture 4 and

Lecture 5 Cost: Relationship between Production and Cost; Economies of Scale and Scope Lecture 6 The Estimation of Production and Cost Functions

Lecture 7 Linear Programming: A Mechanism for Resource Allocation Lecture 8 Using Simplex Algorithm and Excel for Solving LPProblems Lecture 9 Market Structure and Output and Pricing Decisions Lecture 10 Special Pricing Practices E-products in Information Economy and Electronic Market Places

Course Objectives

To present the core of microeconomic theory To show how the theoretical concepts can actually be implemented To demonstrate the relation of managerial economics to the other courses in business

How does managerial economics differ from “regular” economics? There is no difference in the theory; standard economic theory provides the basis for managerial economics. The difference is in the way the economic theory is applied.

What is managerial economics?

Managerial economics is the use of economic analysis to make business decisions involving the best use (allocation) of an organization’s scarce resources Managerial economics is (mostly) applied microeconomics (normative microeconomics)

Managerial economics deals with
“How decisions should be made by managers to achieve the firm’s goals - in particular, how to maximize profit.” (Also government agencies and nonprofit institutions benefit from knowledge of economics, i.e. efficient recourse allocation is important for them too...)

Relationship between Managerial Economics and Related Disciplines Management Decision Problems Economic Concepts Decision Sciences Managerial Economics Optimal Solutions to Managerial Decision Problems

Management Decision Problems

Economic Concepts

Decision Sciences

Managerial Economics Optimal Solutions to Managerial Decision Problems

Management Decision Problems

     

Product Price and Output Make or Buy Production Technique Stock Levels Advertising Media and Intensity Labor Hiring and Training Investment and Financing

Management Decision Problems

Economic Concepts

Decision Sciences

Managerial Economics Optimal Solutions to Managerial Decision Problems

Decision Sciences
     

Tools and Techniques of Analysis
Numerical Analysis Statistical Estimation Forecasting Game Theory Optimization Simulation

Management Decision Problems

Economic Concepts

Decision Sciences

Managerial Economics Optimal Solutions to Managerial Decision Problems

Economic Concepts
Framework for Decisions  Theory of Consumer Behaviour  Theory of the Firm  Theory of Market Structure and Pricing

Management Decision Problems

Economic Concepts

Decision Sciences

Managerial Economics Optimal Solutions to Managerial Decision Problems

Managerial Economics

Use of Economic Concepts and Decision Science Methodology to Solve Managerial Decision Problems

Economic Goals: Maximizing or Satisficing
1. 2. 3. 4. 5. 6. 7. Profit Market share Revenue growth Return on investment Technology Customer satisfaction Shareholder value

THE GOALS OF A FIRM continued Non-economic Objectives:
1. “A good place for our employees to work” 2. “Provide good products/services to our customers” 3. “Act as a good citizen in our society”

Optimal Decision:
Given the goal(s) that the firm is pursuing, the optimal decision in managerial economics is one that brings the firm closest to this goal.

Roles of Managers: Making decisions and processing information are the two primary tasks of managers.

• Whether

or not to close down a branch of the firm? or not a store or restaurant should stay open more hours a day? a hospital can treat more patients without a decrease in patient care?

• Whether

• How

Role of Managers continued
 How

a government agency can be reorganized to be more efficient? to install an in-house computer rather than pay for outside computing services?

 Whether

All these, as well as many other managerial decisions require the use of basic economics. Economic theory helps decision makers to know what information is necessary in order to make the decision and how to process and use that information.

Questions that managers must answer:
♦ ♦ ♦

Should our firm be in this business? If so, what price and output levels achieve our goals? How can we maintain a competitive advantage over our competitors?
    

Cost-leader? Product Differentiation? Market Niche? Outsourcing, alliances, mergers, acquisitions? International Dimensions?

Questions that managers must answer:

What are the economic conditions in a particular market?
      

Market Structure? Supply and Demand Conditions? Technology? Government Regulations? International Dimensions? Future Conditions? Macroeconomic Factors?

DMs Optimize
We should emphasize that practically in all managerial decisions the task of the manager is the same! Namely, each goal involves an optimization problem.

The manager attempts either to maximize or minimize some objective function, frequently subject to some constraint(s). And, for all goals that involve an optimization problem, the same general economic principles apply!

“Economic analysis begins and ends with demand and supply.” The primary importance of demand and supply is the way they determine prices and quantities sold in the market. Managers are extremely interested in forecasting future prices and output, both for the goods and services they sell and for the inputs they use.


Elasticity measures the sensitivity of the quantity demanded to changes in the determinants of demand (supply).

Some elasticity concepts: • price elasticity of demand • elasticity of derived demand • cross-elasticity of demand • income elasticity of demand • elasticity of supply

Determinants of Price Elasticity of Demand
1. The number and availability of substitutes 2. The expenditure on the commodity in relation to the consumer’s budget 3. The durability of the product 4. The length of the time period under consideration 5. Consumer’s preferences

Short-Run vs. Long-Run Elasticity
 A long-run demand curve will generally be more elastic than a short-run curve P
As the time period lengthens consumers find way to adjust to the P price change, 2 P1 via substitution or shifting consumption

DS5 D S4 DS3 DS2 f DS1 e d c b a DL Q3 Q2 Q1 Q

Elasticity of Derived Demand

The demand for components of final products is called derived demand The derived demand curve will be the more inelastic:
1. The more essential is the component in question. 2. The more inelastic is the demand for the final product. 3. The smaller is the fraction of total cost going to this component. 4. The more inelastic is the supply curve of cooperating factors. 5. The shorter the time period under consideration.

The Relationship between Elasticity and

Total Revenue
IF DEMAND IS P ↓ Q ↑ elastic if P ↓ Q ↑ inelastic if P ↑ Q ↓ elastic if P ↑ Q ↓ inelastic if

TR ↑ (relative TR ↓ (relative TR ↓ (relative TR ↑ (relative

∆ Q> relative ∆ P) ∆ Q< relative ∆ P) ∆ Q> relative ∆ P) ∆ Q< relative ∆ P)

Demand, Total Revenue, Marginal Revenue, and Elasticity
Price and marginal revenue ($)

D p0 0


E=1 E<1

q0 M R Quantity

Total Revenue ($)




The Cross-Elasticity of Demand
Cross-price elasticity measures the relative responsiveness of the quantity purchased of some good when the price of another good changes, holding the price of the good and money income constant.

It is, therefore, the percentage change in quantity demanded in response to a given percentage change in the price of another good.

%∆QA EX = % ∆ PB

Cross-elasticity can be either positive or negative. In particular, cross-elasticity is positive for substitutes and negative for complements.

Categories of Income Elasticity
Superior Normal Inferior Y
  


Income elasticity > 1: superior goods Income elasticity > 0, and <1: normal goods Income elasticity < 0: inferior goods

Applications of Supply and Demand

Interference with the Price Mechanism:
• the • the • the • the effect of a price ceiling effect of a price floor effect of a subsidy incidence of taxes

The Effect of a Price Ceiling on Quantity of Supply and Demand

P P2 P0 P1 D 0 Q1 Q0 Q2



The Effect of a Price Floor on Supply and Demand

W W1 W0


D 0 Q1 Q0 Q2 Q

The Use of Price Supports
Surplus (Q2-Q1) bought P

Production quota introduced by the P government P1

by the government

P1 P0


D 0 Q1 Q2 Q 0 Q1 Q3




 The Incidence of Taxes
 effect of demand elasticity  effect of supply elasticity

 Imposition of a Voluntary Export Quota  Shift in Demand as Consumer Tastes Change

Demand Elasticity and Tax Incidence
More elastic demand shifts the tax burden more to the supplier. P S P S’ S



D’ 0

D’ Q

The more elasticand Tax Incidence more Supply Elasticity the supply, the heavily consumers will bear the burden of the tax. P S1’


S’ S

P1 P2 P*

D Q1 Q2 Q* Q

Imposition of a Voluntary Export Quota
P P’’ P P1 P0 D 0 Q1 Q0 Q 0 Q’ Q’’ b) D & S of other cars S1 P’ S0 D’ Q D’’ S’

a)D & S of Japanese cars
in USA before 1981

The Downward Shift in Beef Demand
Decrease in the demand of beef will, over time, shift resources out of beef production. S1 P P0 P1 D1 0 Q1 Q0 D2 D0 S0


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