Introduction to Managerial Economics

Rudolf Winter-Ebmer Dep. of Economics

Preliminaries

Slides of presentation at my homepage on Tuesdays www.econ.jku.at/Winter You should read assigned text before the course exercises and examples will also be provided after the lectures 2 exams Watch out exact dates of lectures! 120 minute lecture each week 2 home assignments will be sent out by e-mail
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More preliminaries

Teaching Assistant:

Bernd Speta: bernd.speta@gmx.at

Phone: Ext. 8332

Office Hours: Tuesday, 17.00 - 18.00 Room: K 152D1

The teaching assistant shall be the first person to contact if you have problems understanding something and also for organizational issues.

We have 15 minutes break each lecture to have coffee and talk Textbook: Allen, Doherty, Weigelt and Mansfield Managerial Economics, 6th edition 7th edition is ok as well E-help quizzes, etc www.wwnorton.com/college/econ/mec6/
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Norton Media Library

W. Bruce Allen Neil A. Doherty Keith Weigelt Edwin Mansfield

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Grading

2 exams, 48 points each, mostly MC questions 2 homeworks during the term:

6 points for each homework possible to complete the course, at least 6 homework-points are necessary!

Total sum of points (including extra points) must be higher than 48 for a positive result

What is Managerial Economics?

Applied micro-economics, but with a focus on decision making What shall a manager do in this and that situation? Pricing decisions in different circumstances Market entry, innovation, auction theory Organization of the firm Personnel policy, how to motivate workers
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Theory of the firm

A theory indicating how a firm behaves and what its goals are

Value of the firm should be maximal:

The present value of the firms expected future cash flows
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Present value of expected future profits

TR t TC t t (1 + i) t =1
n

where: TRt = the firms Total Rev. in year t TCt = the firms Total Cost in year t i = the interest rate and t goes from 1 (next year) to n (the last year in the planning horizon)
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Economic profit concept

Profit the firm owner makes over and above what their labor and capital employed in the business could earn elsewhere. In competitive industries profits are zero Why? What are competitive industries? Are most industries competitive industries?
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Situations with positive profits

Innovations Market entry is not (easily) possible Risk involved Industry is not competitive
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Chapter 3 Demand Theory

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The market demand curve shows the total quantity of the good that would be purchased at each price
Market Demand for Personal Computers,

3200 3000 Price 2800 2600 2400 2200 2000 0 500 1000 qua ntity
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1500

2000

Other determinants of market demand besides the price

Consumer tastes and preferences Consumer incomes Level of other prices Size of consumer population Advertising

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Price elasticity of demand

The percentage change in quantity demanded resulting from a 1 percent change in price. Usually a negative figure.

Q P = P Q
(called eta)

Important for pricing decisions. (notation: sometimes eta is written with a positive sign; take care!)
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Calculating elasticities

Point estimate: (demand function is known); calculated at a specific point of demand. Use statistic regression analysis (ch.5)

Q P = P Q

Arc elasticity: uses average values of Q and P as reference points (if only a table is known)

Q ( P1 + P2 ) / 2 (Q2 Q1 ) ( P1 + P2 ) / 2 = = P (Q1 + Q2 ) / 2 ( P2 P1 ) (Q1 + Q2 ) / 2

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Price elasticity of demand and gross revenues

< -1 ==> an inverse relationship between price changes

and gross revenues. and gross revenues.

> -1 ==> a direct relationship between price changes = -1 ==> no change in gross revenues as price changes.
Important because of pricing decisions: is it useful to raise or lower prices?
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Total revenue, marginal revenue and price elasticity

Suppose P = a - bQ, (linear demand function)

then TR = aQ - bQ2 MR = dTR/dQ = a - 2bQ Since = (dQ/dP) . (P/Q)

1 (a bQ ) = b Q
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Total revenue, marginal revenue and price elasticity

Price a

< 1 = 1 > 1
a/2b a/b

Demand and MR
Quantity

Dollars

Total Revenue
Quantity

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Marginal Revenue, price and price elasticity

MR MR = d ( PQ ) ..... note dQ dP dQ P = P ( Q ) .... why ? Q dP = = P 1 + P dQ

= P + Q

1 = P + 1

If product is price elastic (<-1, marginal revenue must be positive) Example: what is MR if price is $10 and price elasticity is -2? 10(1+1/(-2)) = $5. Isnt this strange? Price is $10, you sell one piece more, but your revenues rise only by $5 ??? What if product is very price elastic (=-)?
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Determinants of price elasticity of demand

Elasticity is greater (in absolute values, i.e more elastic) when:

there are more substitutes for the product. the product is a more important part of a consumers budget. the time period under consideration is greater.
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Puzzle

A soccer promoter must allocate 40,000 seats in the stadium among the supporters of the two competing teams, the Wolverton Gladabouts and Manteca United. This promoter can set different prices for seating in the Wolverton and Manteca sections. If she sells W seats to Wolverton supporters, she will receive 20-W/2000 for each, while she can get 10 per ticket from Manteca supporters, regardless of the number of tickets she sells to them. Her objective is to allocate the 40,000 seats she has available to maximize her gate receipts. A fried suggests that an equal allocation of 20,000 seats to each side is best, since this will mean that the price of each ticket is the same, 10; at any other division, she would be making more per ticket on one team than on the other. Why is this friend wrong? 22

Price Elasticity versus Marginal Return

Price elasticity means how strongly do consumers react (by buying less) if you raise your price

You really should know this figure for your products Price elasticity is defined as the reaction of quantity on price

Marginal return is defined as the reaction of money on quantities sold

How do revenues increase if you sell one more unit MR = Marginal Revenue = Marginal Return

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Price setting: a simple rule

Do not set price so low that demand is price-inelastic (>-1):

Marg. Revenue is negative, i.e. by raising price, total revenue will increase and (!) costs will decrease.

MC = MR = P (1 +

) ... pricing rule price

1 P = MC 1 + 1 /

.... optimal

==> optimal price depends upon MC and price elasticity ==> The higher (the absolute value of) price elasticity, the lower the optimal price

Why is this so? In what market are you in?

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Income elasticity

The percentage change in quantity demanded resulting from a 1 percent change in consumer income (I)

Q I I = I Q
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Table 3.6 Income Elasticity of Demand, Selected Commodities, United States

Commodity Alcohol Housing, owner-occupied Furniture Dental services Restaurant meals Shoes Medical insurance Gasoline and oil Butter Coffee Margarine Flour Income elasticity of demand 1.54 1.49 1.48 1.42 1.40 1.10 0.92 0.48 0.42 0 -0.20 -0.36

Source: H. Houthakker and L. Taylor, Consumer Demand in the United States

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Cross price elasticity

The percentage change in quantity demanded of good X resulting from a 1 percent change in the price of good Y

X ,Y

Q X PY = PY QX

How does demand for your product react to other companies price hikes? How does demand for your products 2-n react to price changes of your product 1?
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Use elasticities for market forecasts

Price elasticity: what will happen to my demand if I change the price? ==> be careful, if elasticity of the whole industry or the specific firm is concerned

Income elasticity: given a forecast of GDP-growth is available, what is the growth prospect of my product? ==> you may want to target specific income groups

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Advertising elasticity
The percentage change in quantity demanded resulting from a 1 percent change in advertising expenditure

Q A A = A Q

Is it worth to spend more on advertising?

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