Managerial Economic 322 Version 18 October 2007

Class Notes Houston H. Stokes

Managerial Economics Concerne! "it# t#e a$$lication o% economic $rinci$les an! met#o!s to t#e !ecision making $rocess un!er con!itions o% uncertaint&. '#eor& 'ools( Micro Economics) Statistics) Econometrics *O+S, So%t"are an! -ecision Su$$ort 'ools( E.cel) Matlab) /30S 1oal( -e2elo$ a s&stematic an! re$ro!ucible !ecision making strateg&. Common 'asks %acing a Mo!ern Manager( 3#et#er to lease or bu& e4ui$ment5 Ho" to !etermine t#e s#a$e o% t#e cost cur2e o% a $ro!uction $rocess. Ho" to $rice a $ro!uct. Ho" to estimate -eman! %or a $ro!uct. Ho" to %orecast -eman!. Ho" to estimate a $ro!uction %unction. Ho" a $ro!uction %unction can be use! to set "ages. Ho" to !etermine t#e a$$ro$riate le2el o% a!2ertising. Ho" to estimate t#e cost o% ser2ice o% a utilit&. Ho" to !etermine t#e minimum cost o% a !iet.

'#e ke& goal is to %acilitate sensiti2it& or 6"#at i%7 anal&sis. 8rom t#e class &ou "ill be able to mo!i%& t#e E.cel 9!ecision9 %iles to #an!le &our $roblems. Manager s#oul! be able to incor$orate business $ractice *suc# as marku$ $ricing, into :$$lie! Managerial Economic '#eor& Seek to establis# rules an! $rinci$les to %acilitate t#e attainment o% t#e !esire! economic goals o% management. ;ositi2e Economics( Normati2e Economics( Managerial Economics( Ho" economic agents o$erate *!escri$tion,. Ho" economic agents s#oul! o$erate *$rescri$tion,. Mostl& normati2e.

Mo!els !esigne! %or e.$lanator& $ur$oses an! are to be <u!ge! on t#e basis o% #o" "ell t#e& e.$lain realit&. Mo!els !esigne! %or $re!icti2e $ur$oses must be <u!ge! b& t#e accurac& o% t#eir $re!ictions.

Managerial Economic 322

Class Notes Houston H. Stokes

Simple Math Toolkit

Managerial Economic 322 1. y = a 2. y = ax

b

Class Notes Houston H. Stokes

dy = dx = 0 dy = dx = bax b1 dy = dx =

dy dz g dz dx dz 0. y = zx) x = f * z ,) dy = dx = z + x g dx >. Y = y1 + y2 ) y1 = f1 * x,) y2 = f 2 * x, 3. y = f * z ,) z = f * x ,) dy1 dy2 + dx dx ?. Y = y1 y2 ) y1 = f1 * x,) y2 = f 2 * x, dY = dx = dy dy dy = y2 1 + y1 2 dx dx dx y1 7. Y = ) y1 = f1 * x,) y2 = f 2 * x , y2 dY = dx y2 @ dy1 dy A y1@ 2 A dx dx 2 @ y2 A

8. Y = a log e bx dY ab a = = dx bx x Y = a log e f * x , dY f B* x , =a dx f * x, d u du e = eu dt dt d 1 dV f B*t , ln V = = dt V dt f *t , C. Y = a log10 bx dY 1 ab = ab log10 e = dx X x ln*10, log10 *e, 1= ln*10., 10. Y = aebx dY = baebx dx d f B*t , 11. log b f *t , = ) dt f *t ,ln*b,

d f *t , b = f B*t ,b f * t , ln*b, dt

Managerial Economic 322 'o %in! a ma. or min(

Class Notes Houston H. Stokes

1. Set %irst !eri2ati2e D 0.0 an! sol2e 2. Calculate secon! !eri2ati2e. E DF min) G DF ma. y = 32 + ? x 2 x 2 dy = dx = ? 0 x = 0 x = ? = 0 dy 2 = d 2 x = 0 => ma. = 32 + 3? = 0 72 =1? = 27.> y = 28 8 x + x 2 dy = dx = 8 + 2 x = 0 x = 0 dy 2 = d 2 x = 2 => min 28 32 + 1? = 12 y = 028> ?2> x + > x 2 dy = dx = ?2> + 10 x x = ?2.> dy 2 = d 2 x = 10 => min = 1>20?.2>

= TR TC
TR = 2>0Q 3Q 2 TC = 1>00 + >0Q + 2Q 3

= 2>0Q 3Q 2 1>00 >0Q 2Q 2

= 1>00 + 200Q >Q 2 d = dQ = 200 10Q = 0 => Q = 20 d 2 = d 2Q = 10 => ma. ;roblem coul! #a2e been sol2e! b& setting slo$es e4ual an! sol2ing 2>0 ?Q = >0 + 0Q => 10Q = 200 or Q = 20

Managerial Economic 322 ;roblems to test &our skills. :G2 1. 2. y = 3? + 0.> x3 y = x = 13.> x 2 y = 8 3z 2 z = 0 + 3x3 y = 8 3*0 + 3 x 3 , 2 = 8 3*1? + 20 x 3 + C x ? , = 8 08 72 x 3 27 x ? y = x = 21? x 2 1?2 x > 3. y = 7kx k = 3 2 x2 y = 7 x*3 2 x 2 , y = x = 7*3 2 x 2 , + 7 x*0 x, = 21 10 x 2 28 x 2 = 21 02 x 2 0. y = 1? + 0 j 2 ?k 3 j = 8 ?x2 k = 3 + 0 x 3 y = 1? + 0*8 ? x 2 , 2 ?* 3 + 0 x 3 ,3 y = x = 8*8 ? x 2 ,*12 x, 18*3 + 0 x 3 , 2 *12 x 2 , = C? x *8 ? x 2 , 21? x 2 *3 + 0 x 3 , = 7?8 x + >7 x 3 1C00 x 2 + >180 x > 30>? x8 >. y = 3m*0n 2 ,) m = ? + 2 x) n = 0 2 x 2 y = 3*? + 2 x,*0,*0 2 x 2 , 2 = 12*? + 2 x,*0 2 x 2 , 2 = *72 + 20 x,*0 2 x 2 , 2 y = x = 20*0 2 x 2 , 2 + *72 + 20 x,*8 x,*0 2 x 2 , 2 = 20*0 2 x 2 ,**0 2 x 2 , + *3 + x,*8 x,, = 20*0 2 x 2 ,*0 2 x 2 + 20 x 10 x 2 , = 380 11>2 x 2 + 080 x 0 + 2300 x 11>2 x 3 = C?* x 2 2,*> x 2 12 x 2,

Class Notes Houston H. Stokes

>

Managerial Economic 322 ?. y = 0e 2 x y = x = 8e 2 x 7. y = ? log e > x y = x = af B* x, = f * x, y = x = ?*> = > x, = ? = x Matlab $rograms to calculate roots o% t#ese ans"ers

Class Notes Houston H. Stokes

% Problems in Economics 322 developed by Houston Stokes % TR-TC q=linsp ce!"#$"%& % note '( due to sc ler

tr = 2)"*q 3*q'(2& tc = +)"" , )"*q , 2*q'(2& pro-it=tr-tc& plot!q#tr#q#tc% p use& plot!q#pro-it% % -2 . +3') * / ( 2. roots!0+3') " "1% % -2 b .-2+2*/(2-+22*/(). roots!0-+22#"#"#-2+2#"#"1% % -2 c .2+-$2*/(2. roots!0-$2#"#2+1% % -2 d .-324*/,)32*/(3-+5$$*/(2,)+4$*/()-3$)2*/(4. roots!0-3$)2#"#"#)+4$#"#)32#-+5$$#-3241% % -2 e .$4"*/($-++)2*/(3-++)2*/(2,23"$*/,34$. roots!0$4"#-++)2#-++)2#23"$#34$1%

Managerial Economic 322 :ns"ers

e3226+ ns = +3') * / ( 2 ns = " " ns = -2+2*/(2-+22*/() ns = " " -+'+""2 "'))"32 , "'5)3+4i "'))"32 "'5)3+4i ns = 2+-$2*/(2 ns = "'3"3++ -"'3"3++ ns = -324*/-+5$$*/(2,)32*/(3,)+4$*/()-3$)2*/(4 ns = "'5$543 , "'+"$")i "'5$543 "'+"$")i -"'2252 , "'42232i -"'2252 "'42232i -"'+))+ , "'34425i -"'+))+ "'34425i -"'33"22 ns = $4"*/($-++)2*/(3-++)2*/(2,23"$*/,34$ ns = 2'))2) -+'$+$2 +'$+$2 -"'+)2$3 di ry o--

Class Notes Houston H. Stokes

Managerial Economic 322

73$S Solution

Class Notes Houston H. Stokes

b3$se/ec m tri/& 89 Problems in Economics 322 developed by Houston Stokes 89 TR-TC

q=:rid!"'#$"'#'+%& tr = 2)"'*q 3'*q**2'& tc = +)""' , )"'*q , 2'*q**2'& pro-it=tr-tc& 89 c ll t bul te!q#tr#tc#pro-it%& c ll :r p;!q#pro-it <plottype /yplot%& c ll :r p;!q#tr#tc <plottype /yplot%& 89 -2 c ll print!.+3') * / ( 2.<%& c ll print!polyroot! rr y!<"'#"'#+3'2%%%& 89 -2 b c ll print!.-2+2*/(2-+22*/().<%& c ll print!polyroot! rr y!<"'#"'#-2+2'#"'#"'#-+22'%%%& 89 -2 c c ll print!.2+-$2*/(2.<%& c ll print!polyroot! rr y!<2"'#"'#-$2'%%%& 89 -2 d c ll print!.-324*/-+5$$*/(2,)32*/(3,)+4$*/()-3$)2*/(4.<%& c ll print!polyroot! rr y!<-324'#-+5$$'#)32'#"'#)+4$'#"'#"'#-3$)2'%%%& 89 -2 e c ll print!.$4"*/($-++)2*/(3-++)2*/(2,23"$*/,34$.<%& c ll print!polyroot! rr y!<34$'#23"$'#-++)2'#-++)2'#$4"'%%%& b3$srun&

Managerial Economic 322

= tri/ Comm nd' >ersion ?pril 2""+ =@ =@ =@ =@ =@ =@ =@ A=BRCD!"'#$"'#'+%9 TR = 2)"'*A TC = +)""' PREFCT=TR-TC9 C?GG BR?PH!A#PREFCT <PGETTHPE IHPGET%9 C?GG BR?PH!A#TR#TC <PGETTHPE IHPGET%9 , 3'*A**2'9 )"'*A , 2'*A**2'9

Class Notes Houston H. Stokes

C?GG PRCJT!.+3') * / ( 2.<%9

+3') * / ( 2 =@ C?GG PRCJT!PEGHREET!?RR?H!<"'#"'#+3'2%%%9

Comple/ ?rr y ! =@ "'""" #

o% !

2 "'""" # "'""" %

"'"""

C?GG PRCJT!.-2+2*/(2-+22*/().<%9

-2+2*/(2-+22*/() =@ C?GG PRCJT!PEGHREET!?RR?H!<"'#"'#-2+2'#"'#"'#-+22'%%%9

Comple/ ?rr y ! ! =@ "'""" -+'+"+ # #

o% % !

) "'""" # "'""" % ! "'))"3 # -"'5)32 % ! "'))"3 # "'5)32 %

"'""" "'"""

C?GG PRCJT!.2+-$2*/(2.<%9

2+-$2*/(2 =@ C?GG PRCJT!PEGHREET!?RR?H!<2"'#"'#-$2'%%%9

Comple/ ?rr y ! -"'25"+ =@ #

o% !

2 "'25"+ # "'""" %

"'"""

C?GG PRCJT!.-324*/-+5$$*/(2,)32*/(3,)+4$*/()-3$)2*/(4.<%9

-324*/-+5$$*/(2,)32*/(3,)+4$*/()-3$)2*/(4 =@ C?GG PRCJT!PEGHREET!?RR?H!<-324'#-+5$$'#)32'#"'#)+4$'#"'#"'#-3$)2'%%%9

Comple/ ?rr y ! -"'33"3 ! -"'+))+ =@

o% %

3 ! "'5$54 ! -"'2252 # # "'+"$" "'4223 % % ! "'5$54 ! -"'2252 # -"'+"$" # -"'4223 % % ! -"'+))+ # "'3443 %

# "'""" # -"'3443

C?GG PRCJT!.$4"*/($-++)2*/(3-++)2*/(2,23"$*/,34$.<%9

$4"*/($-++)2*/(3-++)2*/(2,23"$*/,34$ =@ C?GG PRCJT!PEGHREET!?RR?H!<34$'#23"$'#-++)2'#-++)2'#$4"'%%%9

Comple/ ?rr y ! -"'+)2) #

o% !

$ 2'))2 # "'""" % ! -+'$+$ # "'""" % ! +'$+$ # "'""" %

"'"""

Managerial Economic 322 /rie% Statistical notes( 3e use O+S to estimate !eman! cur2es.

Class Notes Houston H. Stokes

O+S can be estimate! "it# E.cel) /30S) S$eakeas& an! ot#er s&stems. He& terms( coe%%icient) SE) I2 See !ata on $age 173 on sales) $rice an! a!2ertising. Data from Douglas page 173 sales price advertisi ng 4.65 0.79 23000 3.02 0.99 18500 2.15 1.25 24600 4.4 0.89 26200 6.38 0.59 25100 5.5 0.45 16800 S !!"#$ % &' & Regression Statistics !ultiple 0.99295 # 7 # 0.98596 S(uare 3 "d)usted 0.97660 # 5 S(uare Standar 0.23838 d *rror 1 %+serva 6 tions ",%-" df #egressi on #esidual &otal SS MS F Significance F 2 11.9743 5.98716 105.360 0.00166 2 2 5 3 3 0.17047 0.05682 6 5 5 12.1448

10

Managerial Economic 322 Coeffici ents .ntercept 5.71802 2 / 05.80262 -aria+le 1 / 0.00015 -aria+le 3 2

Class Notes Houston H. Stokes

Standar t Stat P-value Lower Upper Lower Upper d Error 95% 95% 95 !% 95 !% 0.63579 8.99353 0.00290 3.69464 7.7414 3.69464 7.7414 3 2 2 4 4 0.39974 014.5157 0.00070 07.07479 04.53045 07.07479 04.53045 6 9 2.98*0 5.13983 0.01426 05 4 9 5.84*0 0.00024 05 8 5.84*0 0.00024 05 8

Sales rise i% $rice goes !o"n. Sales rise i% a!2ertising goes u$. :!<uste! IGs4uare is large. Matlab setu$ %or a more com$le. $roblem *see testols.m,. S#o"s mat# be#in! O+S. % m tl b re:ression E322 Problem //=0 + +$5'+$ '33223 '2+3$2 + +23'"5 '2552+ '55+$ + +)+'4 '2+$)$ ')"3$5 + +3)'25 '22253 '++25) + +22'3$ ')+3++ '2)"4) + +$)')3 '5454) '+234) + +23'4+ '25""4 '53555 + +3"'35 '$"54$ '33"++ + +34'+3 ')+32 '$"34) + +$+ '3442+ '+"+33 + +33'"5 '3)523 '332$ + +3$'+5 '334$4 '443"2 + +)"')4 ')3+23 '32)33 + +3$'"3 '335$$ '2""$$ + +2)'53 '5$"$3 '+)244 % // % Ke trunc te columns ;ere y=//& /=//& /!<#2%=01& y!<#+%=01& y!<#2<$%=01& % /# y b=inv!/.*/%*/.*y&
b

'22"3+& '3)3)+ '2"3+5 '25532 '5+))2 ')+452 '234$) '2)2)2 '35+) ')33)) '2$222 '"23$33 '3)4+2 '3))$ '"4"44)1&

& & & & & & & & & & & & &

11

Managerial Economic 322

Class Notes Houston H. Stokes

Iesults bD C8.C00? 20.8CC0 31.2?13 00.02C? /30S setu$ %or $roblem. 3e use a #ig#er le2el comman! as "ell as mat#. 1ra$#s s#o" results.

/$ Tests OLS for E322 b34sexec data; input obs y x1 x2 x3; datacards; 1 149.14 .77667 2 167.09 .29961 3 151.8 .61454 4 135.69 .26693 5 166.34 .51311 6 145.53 .98985 7 167.81 .69008 8 130.39 .40984 9 138.13 .5172 10 141 .78821 11 137.09 .75963 12 134.19 .33848 13 150.58 .53163 14 134.03 .73944 15 125.97 .94043 b34sreturn; b34srun; b34sexec reg; model y=x1 x2 x3; b34srun; b34sexec matrix; call loaddata; y=vfam(y);

.21742 .9914 .50349 .11695 .65085 .16785 .93999 .37011 .40385 .10173 .3724 .88302 .36573 .20044 .15688

.62031 .75751 .60719 .69936 .91552 .51892 .63845 .25652 .3915 .57355 .24666 .027473 .75816 .3554 .080885

12

Managerial Economic 322

Class Notes Houston H. Stokes

x=matrix(norows(y),4:); x(,1)=1.; x(,2)=vfam(x1); x(,3)=vfam(x2); x(,4)=vfam(x3); beta=inv(transpose(x)*x)*transpose(x)*y; yhat=x*beta; call print(beta); call tabulate(y yhat); /$ Do ols using built in commands call olsq(y x1 x2 x3 :print); call graph(%res); call graph(%y,%yhat); b34srun;
REB Comm nd' >ersion E+ Febru ry +553 24 re bein: used' I- 2

+"""""" double precision slots in sp ce#

Dependent v ri ble ?dLusted R**2 = St nd rd Error o- Estim te Sum o- Squ red Residu ls =odel Sum o- Squ res Tot l Sum o- Squ res F! 3# ++% F Si:ni-ic nce +8Condition o- IPI Jumber o- Ebserv tions Durbin-M tson > ri ble I+ I2 I3 CEJST?JT N N N N "O "O "O "O Coe--icient 2"'455323 3+'22+33) $"'"25225 54'5"")4)

H "'55$3225) +'"23)243 ++')2$222 2)32'+2"" 2)43'24$2 4+4'3)242 +'""""""" "'233333)$E-"2 +) +'"+2$$33 Std' Error +'$+332+2 +'"3)32)4 +'"32"534 +'3352344

t +$'343$+) 3"'+53)+4 33'3334"3 33'4$43)4

= tri/ Comm nd' >ersion ?pril 2""+ =@ =@ =@ =@ =@ =@ =@ =@ C?GG GE?DD?T?9 H=>F?=!H%9 I==?TRCI!JEREMS!H%#$<%9 I!#+%=+'9 I!#2%=>F?=!I+%9 I!#3%=>F?=!I2%9 I!#$%=>F?=!I3%9 7ET?=CJ>!TR?JSPESE!I%*I%*TR?JSPESE!I%*H9

13

Managerial Economic 322

Class Notes Houston H. Stokes

=@ =@

HH?T=I*7ET?9 C?GG PRCJT!7ET?%9

7ET?

= >ector o54'5""2 2"'455$

elements 3+'22+3 $"'"252

=@ Ebs

C?GG T?7PG?TE!H HH?T%9 H HH?T +$2'4 +22') +)+'4 +32'+ +22'2 +$)'2 +24'3 +25'3 +34'" +$+') +32'3 +3$'3 +)+'4 +3$'4 +22'3

+ 2 3 $ ) 2 3 4 5 +" ++ +2 +3 +$ +)

+$5'+ +23'+ +)+'4 +3)'3 +22'3 +$)') +23'4 +3"'$ +34'+ +$+'" +33'+ +3$'2 +)"'2 +3$'" +22'"

=@

C?GG EGSA!H I+ I2 I3 <PRCJT%9

Erdin ry Ge st Squ res Estim tion Dependent v ri ble H Centered R**2 Residu l Sum o- Squ res Residu l > ri nce Sum +2) ?bsolute Residu ls +8Condition IPI +2" ?bsolute Residu l = /imum Jumber o- Ebserv tions
+))

"'55))35$22)53324$ E322 Test =odel ++')2$22+232")45" +'"$32524352$+3+4 +"'"2"2$""52+23+2 2'33333)$"3422)23E-"3 2'33544$323"")"$3 +) SE +'$+332+2 +'"3)32)4 +'"32"534 +'3352344 t +$'343$+) 3"'+53)+4 33'3334"3 33'4$43)4

> ri ble I+ +)" I2 I3 +$) CEJST?JT

+$" +3) +3"

G : " " " "

Coe--icient 2"'455323 3+'22+33) $"'"25225 54'5"")4)

H H ? T

=@ =@

C?GG BR?PH!%RES%9 C?GG BR?PH!%H#%HH?T%9

2 $ 2 Ebs 4 +" +2 +$

73$S = tri/ Comm nd Endin:' G st Comm nd re c;ed' Sp ce v il ble in lloc tor Jumber v ri bles used
2 +') R E S + ') " -') -+ 2 $ 2

Residu ls o- ?bove =odel

443322# pe k sp ce $+# pe k number

used used

332" $+

10
4 Ebs +" +2 +$

Managerial Economic 322 Decision Tools Net ;resent Value

Class Notes Houston H. Stokes

-e%ine 8V i as %uture re2enue an! r D t#e interest rate an! c 0 as t#e initial cost. '#e net $resent 2alue o% a stream o% $a&ments is( NPV = FVi
i =1 n

FVi c0 *1 + r ,i

K% t#e $a&ments are m times a &ear PV = FVi = m *1 + r = m,i

'able /3 is %or !ail& $a&ments. 8ormulas suggest t#at a lan!lor! "ants mont#l& $a&ments not &earl& $a&ments at t#e en! o% t#e &ear. 8irm assigns $robabilities o% 2arious outcomes. ;roblem 1GC 6O.%or! E4ui$ment Com$an&7 is a tem$late case regar!ing lease 2s bu&. See E.am$le1..ls %or t#e E.cel Solution
'ro+lem 109 %1ford *(uipment 2ompan3 0 .n04ouse vs 2ontract out 2ost 8206000.00 8306000.00 8406000.00 8506000.00 8606000.00 *- of .n 9ouse %utside cost 'art + 0 &a+le 3<*'art c 0 cost < ta+le +2 =o outside>>> pro+a+ilit3 0.15 0.2 0.3 0.25 0.1 *8 36000.00 8 66000.00 8 126000.00 8 126500.00 8 66000.00 8 396500.00 8426000 8366673.25 85366521.747 &a+le +01 pa3:51;r7<<n pa3 interest nper rate &a+le +03 pa3 interest nper 'Sum pv 8 1.00 0.15 1 0.86956522 &a+le +02 pv5int6nper6pa37 pa3 interest nper pv 81.00 0.15 1 00.8695652

'resent value +ased on dail3 81.00 0.15 1 0.92843668 0.92843668

1>

Managerial Economic 322

Class Notes Houston H. Stokes

Consult t#e bottom o% t#is E.cel %ile %or t#e 8earless :mbition Iacing 'eam ;roblem Decision Making Under Uncertainty G K!enti%& courses o% action G IecogniLe $ossible outcomes %rom eac# action G :ssign $robabilities G :$$l& !ecision criterion DF ;ro$erl& traine! lea!ers "ill come to t#e same conclusion. '#e !ecision making ste$s can be re$licate! an! im$ro2e! o2er time. Maximize expected value criterion D Ri Pi "#ere Ri = return %or e2ent i) Pi = $robabilit& it# e2ent ll occur Minimax Criterion loses &ou t#e least. +ist t#e "orst outcomes o% all $ro$ose! courses o% action. Select t#e one t#at

Maximax Criterion +ist t#e best outcomes o% all $ro$ose! courses o% action. Select t#e one t#at "ill gi2e &ou t#e biggest $a&o%% i% all comes out "ell. Certainty Equivalent Criterion '#e amount o% mone& t#at "oul! make t#e !ecision maker in!i%%erent bet"een un!ertaking t#e act) or recei2ing t#at sum o% mone&. He& $oint E.$ecte! 2alue is an a2erage conce$t) not goo! %or one s#ot !eals. 8or one s#ot !eals t#e certaint& e4ui2alent EV EV not a goo! "a& to !eci!e "#o to marr&. EV ma& be a "a& to $rocee! to get a !ate. : %ormer $resi!entMs "i%e marrie! a ric# ol! man $resumabl& on t#e basis o% a CEC calculation. Certaint& e4ui2alent criterion makes a $erson access attitu!e to"ar! risk. Decision Trees allo" !ecision making un!er uncertaint&. -ecision trees s#o" cost an! re2enue conse4uences o% eac# $ossible !ecision. Evaluation o! Decisions" 8or a gi2en risk "ant to ma.imiLe return. 8or a gi2en return "ant to minimiLe risk. E2aluate !ecisions( G 3as su%%icient searc# acti2it& un!ertaken5 G 3as in%ormation obtaine! use! $ro$erl&5

1?

Managerial Economic 322 G 3as t#e a$$ro$riate !ecision a$$lie!5

Class Notes Houston H. Stokes

G 3as sensiti2it& anal&sis use! to !etermine "#at assum$tions are most critical. K. e. #o" sensiti2e is t#e !ecision to t#e assum$tion use!5 '#ings to consi!er( G '#e more %re4uent one is con%ronte! "it# a !ecision DF can calculate t#e outcome "it# more certaint&. G Magnitu!e o% t#e gamble G Can &ou a%%or! t#e ma.imum loss5 G 3#at is &our attitu!e to"ar!s risk5 Standard Deviation

* x EPV ,
i =1 i

pi

Coe!!icient o! #ariation mean $ Standard Deviation NonGeconomic 8actors G -oes t#e %irm #a2e t#e same interests as t#e !ecision maker5 K% t#e CEO is $ai! as a %unction o% t#e siLe o% t#e com$an& "ill t#e same !ecision be ma!e as i% #e=s#e "as an o"ner5 Value o% Kn%ormation G -i%%erence bet"een "#at &ou can earn "it# t#e in%ormation &ou alrea!& #a2e an! "#at &ou coul! earn i% &ou kne" "it# certainl& t#e outcome $rior to t#e !ecision. '#is is not al"a&s $ossible. :ssume &ou are consi!ering selling ice cream or #ot !ogs "#ere "eat#er is 1>N rain) >>N clou!&) an! 30N sunn&. E.$ecte! 2alue o% regret E.$ecte! cost o% not kno"ing e.actl& "#at "eat#er con!itions "ill occur. '#e e.$ecte! 2alue o% regret is e4ual to t#e 2alue o% in%ormation. Stu!& $ages 33G3C an! look at e3222!1..ls an! e322c#2..ls '#ese $ro2i!e a tem$late %or a large=small mac#ine !ecision tree

17

Managerial Economic 322 Characteristics o! Decision Maker Iisk a2ersion Iisk $re%erence Iisk neutral

Class Notes Houston H. Stokes

DF ;s&c#ic !issatis%action or !isutilit& cause! b& uncertaint&. DF Iisk is 2ie"e! as utilit& $ro!ucing. DF ;erson is in!i%%erent bet"een !i%%erent le2els o% risk.

Ma.imin DF since "orst case %or t#e large mac#ine *GO2083, an! t#e "orst case %or t#e smallest mac#ine *O8?1, an! bu& t#e smallest mac#ine. Nee! to resol2e large 2s small mac#ine case "it#( G :lternati2e assum$tions on sales = $ro%it G :lternati2e interest rates. 3#at are t#e ke& assum$tions5 EEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEE /asic 'ools to use Micro to unco2er $re%erences( '#eor& o% Economic Consumer /e#a2ior( Kn!i%%erence Cur2e /u!get line :ssum$tions( Consumers can rank or!er $re%erences. ;re%erences are trans%erable) or i% : F / an! / F C t#ere%ore : F C Consumers $re%ers more to less o% a goo! or no satiation. Consumers e.$erience !iminis#ing MP %or all goo!s. Marginal rate o% substitution *assuming Q on Q a.isRR, D Y = X MIS !ecreases as "e mo2e !o"n in!i%%erence cur2e because gi2e u$ less o% Q an! get more o% S to remain at same le2el o% #a$$iness. DF locus o% $oints to "#ic# t#e consumer is in!i%%erent. DF locus o% $oints "#ere e.$en!iture is %i.e! at = Px X + PyY

18

Managerial Economic 322 M M

Class Notes Houston H. Stokes

MR! =

X Y n

Kn general bu!get constraint is = PQ i i

i =1

8or t"o goo! case) = Px X + PyY

= PY PX = = PX PY M X PX M 1 M 2 M n = = =L= MISDSlo$e o% bu!get line DF or in n goo! case M Y PY P P2 Pn 1

Slo$e o% bu!get constraint is 8rom bu!get lines an! in!i%%erence cur2es "e can obtain a !eman! cur2e. Once "e kno" t#is cur2e "e can get a !eman! cur2e. '#e interce$t o% t#is cur2e an! t#e su$$l& cur2e can be c#ange!. Sol2e sim$le s&stem( TsD 1800 E 200; T!D 3>>0 G 2??; Kn e4uilibrium T! D Ts. or 1800 E 200; D 3>>0 G 2??; >0?; D 17>0 DF ; D O3.0? an! T D 1800 E *17>0=>0?,U200 D 2?30 E.cel %ile c#2V1..ls sol2es t#is s&stem. Psing t#is tec#nolog&. Sol2e t#e s&stem assuming( :n a!2ertising cam$aign raises 3>>0 to 0023. : lack o% rain%all lo"ers 1800 to 1>00 : c#ange in taste c#anges 2?? to 280

'#is is t#e basic tem$late %or micro anal&sis o% su$$l& an! !eman!. : ma<or researc# ob<ecti2e is to !etermine "#at "ill c#ange a) aB) 1)W0. Kt "ill be ma!e more com$le. as "e mo2e %or"ar!. E! D D D D elasticit& o% !eman! *NT,=*N;, *T=T,=*;=;, *T=;,U*;=T,

Psuall& ! is use! in $lace o% E!. '#e $rice elasticit& is measure! at a $oint. On a linear !eman! cur2e t#e slo$e *T=;, is constant.

1C

Managerial Economic 322 T D 8G2; :s T 0 :s ; 0 K% XE!X F 1 'I D ; U T : %irm s#oul! ne2er o$erate "#ere XE!X Y 1. DF DF DF DF *T=;, D G2 E ! G E! 0 ; DF Total %evenue *'I, u$.

Class Notes Houston H. Stokes

:!2ertising is !esigne! to make XE!X !ecrease !or every price. :%ter a success%ul a!2ertising cam$aign t#e %irm "ill #a2e more $ro!uct !i%%erentiation an! can eit#er raise $rice or increase sales at t#e current $rice. Care%ul anal&sis "ill tell us "#at to !o.

20

Managerial Economic 322

Class Notes Houston H. Stokes

8irm starte! "it# !eman! cur2e a e "#ic# im$lie! $rice ; 1 an! T1. : ma<or a!2ertising cam$aign mo2e! t#e !eman! cur2e %rom a e to b %. 8or $ur$oses o% t#is e.am$le a e is X X to b %. ;rice rises to ;2. ;roo% t#at X! X at ! is more inelastic t#an at c. :t c ! D *T=T,=*;=;, D *T1e=OT1,=*O;1=O;1, D *T1e=OT1, D ce = ac :t ! ! *X X lines $ro!uce $ro$ortionate segments,

D *T=T,=*;=;, D !% = b!

21

Managerial Economic 322

Class Notes Houston H. Stokes

Since !% D ce an! b! F ac D F at ! X!X is less t#an at c Note t#at at a ! D G "#ile at e ! D 0. & parallel shi!t right o! a demand curve makes is more inelastic at each price" 'ncome elasticity measures t#e $ercent c#ange in t#e 4uantit& o% a goo! %or a $ercent c#ange in income. EK K D *T=T,=*K=K, D *T=K,*K=T,

: goo! is normal i% K F 0 an! in!erior i% K Y 0 . /ake! beans are t#e classic in%erior goo! an! t#e /M3 car a classic normal goo!. :ssume an in!i2i!ual %aces goo!s a to n. +et ;a be t#e $rice o% goo! a) ;b be t#e $rice o% goo! b. +et : be t#e c#ange in t#e amount o% : boug#t an! / be t#e c#ange in t#e amount o% / boug#t. :ssume t#e in!i2i!ual gets an increase in income K. ;a : E ;b/ E W.. E ;nN D K

K% "e assume K D 0) t#e abo2e e4uation !e%ines t#e (udget line "#ic# "ill be use! in in!i%%erence cur2e anal&sis. -i2i!e abo2e e4uation t#roug# b& K an! t#en multi$l&ing all terms on t#e le%t b& K : = K : gi2es a ke& e.$ression. Kn ste$s @ Pa " = # A + @ Pb $ = # A+ )...)@ Pn N = # A = @ # = # A @ Pa " "# = # "# A + @ Pb $ $# = # $# A+ )...)@ Pn N N# = # N# A = @ # = # A 8inall& % aa# + % bb# + L + % nn# = 1 Or t#e sum o% t#e "eig#te! income elasticities D 1 '#e cross price elasticity o! demand "P$ measures t#e e%%ect o% t#e $rice o% goo! / on t#e 4uantit& o% goo! :.

"Pb = * " = ", =* P$ = P$ ,

22

Managerial Economic 322

Class Notes Houston H. Stokes

K% : is a substitute %or /) t#en "P$ is F 0 or an increase in t#e $rice o% / DF t#e 4uantit& o% : . K% : is a com$lement o% / t#en "P$ is Y 0. Coke is a substitute %or ;e$si "#ile gas is a com$lement %or an auto. Kn t#e long run !eman! is usuall& more elastic. 3#en t#e $rice o% gas "ent u$ in t#e 70Bs $eo$le !i! not <ust !um$ t#eir cars t#at got $oor gas mileage /P' "#en t#e& re$lace! t#em t#e& ma!e sure t#e& got a car "it# a #ig#er M;1 rating. Kn t#e long run t#e su$$l& o% a $ro!uct is usuall& more elastic t#an in t#e short run since in t#e long run %i.e! %actors can be c#ange!. 1i2en T- D a G b; TS D c E !; :n! ;U an! TU are e4uilibrium ; an! T) t#en at e4uilibrium t#e elasticit& o% !eman! - an! elasticit& o% su$$l& S are S D D Gb*;U=TU, !*;U=TU,

DF i% "e kno" - ) S) ;U an! TU "e can get t#e su$$l& cur2e an! t#e !eman! cur2e. Kn t#e market "e obser2e ;U an! TU. ;U an! TU are O.7> an! 7.> million - ) S are G.8 an! 1.? res$ecti2el&. 8rom t#e abo2e e4uations "e get Gb D *G.8, U *7.>=.7>, D G8. an! ! D *1.?,U*7>=.7>, D 1?. E.cel %ile c#2V2..ls sol2es t#e general case o% !etermining t#e su$$l& an! !eman! %unctions gi2en t#e elasticit& an! ;U an! TU. Kn t#e long run su$$l& an! !eman! are usuall& more elastic. 3#en O;EC raise! $rice DF !isco2eries "ent u$. Psers s#i%te! to more e%%icient cars o2er time. :n e%%ecti2e $rice control "ill cause a s#ortage. K% t#e su$$l& cur2e is NO' 2ertical) t#e total consume! "ill go !o"n. ;roblem 1 ; ?0 80 100 120 T! 22 20 18 1? Ts 10 1? 18 20

23

Managerial Economic 322 ! D *T=;,U*;=T, T=; G2=20 DF at 100 ! D *G.1,U*80=20, ! D *G.1,U*100=18, D D G.00 G.>?

Class Notes Houston H. Stokes

;roblem 2. ' or 8 9Since tuition #as !ouble! in real terms in t#e last 1> &ears t#is im$lies t#e !eman! cur2e %or e!ucation is 2ertical.9 8:+SE ma& be seeing s#i%ts o% bot# su$$l& an! !eman!. Consumer )ehavior *ey &ssumptions o! Theory o! Consumer )ehavior+ ;re%erences are complete ,- Consumers can rank market baskets" ;re%erences are transitive ,- K% consumer $re%ers basket : to / an! / to C t#en t#e consumer $re%ers : to C. More o% an& goo! is al"a&s better. 'ndi!!erence Curve G +ocus o% $oints s#o"ing !i%%erent combinations o% goo!s to "#ic# t#e consumer is in!i%%erent.

20

Managerial Economic 322

Class Notes Houston H. Stokes

Consumer starts "it# a o% S an! b o% Q. ;oints in K DF more satis%action. ;oints is KKK DF less satis%action. Kn!i%%erence cur2es must be in KK an! KV. : straig#t line in!i%%erence cur2e in KK an! KV DF substitutes : rig#t angle in!i%%erence cur2e DF com$lements

2>

Managerial Economic 322

Class Notes Houston H. Stokes

Kn!i%%erence cur2es cannot cross unless t#ere is a c#ange in tastes. .rdinal ranking Cardinal ranking DF : is better t#an / but cannot tell b& #o" muc#. DF Can tell #o" muc# better : is t#an /.

Slo$e o% in!i%%erence cur2e measure marginal rate o! su(stitution (et/een goods. Kn terms o% abo2e e.am$le D * Y = X , assuming Q on Q a.is. :s *Y = X , => * Y = X , or in "or!s &ou get more an! more Q %or e2er& S unit gi2en u$. 1i2en &ou #a2e relati2el& more S t#an Q DF "ill gi2e less Q %or e2er& a!!itional S. )udget line , locus o% $oints s#o"ing !i%%erent combinations o% goo!s t#at can be boug#t gi2en income. 3#ere bu!get lines is tangent to #ig#est in!i%%erence cur2e DF !esire! $oint *e,. B aD K = ;&) b D K = ;. an! c = # = Px . :%ter t#e $rice o% S %alls mo2e to #ig#er in!i%%erence cur2e an! go to $oint !. :t e MIS D Q=S D;. = ;&

i% income increases bu!get line mo2es out an! is $arallel to t#e ol!er bu!get line. 2?

Managerial Economic 322

Class Notes Houston H. Stokes

K% $rice o% S %alls bu!get line rotates %rom ab to ac. 'otal s$en!ing %i.e! along bu!get line. Ob<ect is to reac# #ig#est Kn!i%%erence cur2e *not !ra"n,. Pnless t#ere is a corner solution) MIS D ;. = ;&. O% in "or!s slo$e o% t#e in!i%%erence cur2e D slo$e o% bu!get line. Corner solution DF consume onl& one goo! Utility D satis%action one gets %or consuming a goo!. Marginal Ptilit& !eclines as consum$tion o% a goo! increases unless lum$&ness $roblem *0 tires on a car,. MIS.& D MP. = MP& Kn e4uilibrium MP. = MPQ MP. = ;S *MP. = ;S, F *MPQ = ;Q, D D ;S = ;Q MPQ = ;Q

DF Ha2e too muc# Q relati2e to S

Marginal utility per dollar last dollar spent must (e the same !or all goods. '#e +as$e&rse $rice in!e. is !e%ine! as

Pt = pti &1i = p1i &1i

i =1 i =1

"#ic# overstates t#e amount o% a $rice increase because t#e $erson is gi2en enoug# mone& to bu& t#eir ol! bun!le e2en t#oug# t#is is NO' "#at t#e& "ill bu& since relati2e $rices #a2e c#ange!. :lternati2e situations( :l likes beer) #ates #amburgers. Ho" "oul! "e !ra" t#e in!i%%erence curce5 /ett& in!i%%erent bet"een 3 beers or 2 #amburgers. Not#ing c#anges no matter "#at t#e le2el o% consum$tion. C#ris eats one #amburger an! one beer in %i.e! $ro$ortions.

27

Managerial Economic 322 Casae(

Class Notes Houston H. Stokes

:ntonio bu&s 8 ne" college te.tbooks at a cost o% O>0.00 eac#. Pse! books "ere O30.00 eac#. Ne.t &ear $rices %or ne" books go u$ 20N an! use! books go u$ 10N. :ntonioBs -a! sent #im O80.00 more. Ks #e better o%%5 Cost last &ear %or ne" books 8 U O>0.00 D O000.00 Cost last &ear %or use! books 8 U O30.00 D O200.00 Ielati2e $rice o% ne" an! use! books last &ear >0=30 D 1.?7 Ielati2e $rice o% ne" an! use! books t#is &ear *>0U1.20,=*30U1.1, D ?0 = 33 D 1.82 Ne" books are relati2e more costl&. Cost t#is &ear %or t#e t"o c#oices "oul! be 8U?0 8U33 D O080 D O2?0

-a! ga2e #im mone& to bu& 8 ne" books t#is &ear. 3ill #e still bu& t#is bun!le no" t#at $rices o% ne" books are relati2el& #ig#er5 Zane #as a utilit& %unction P*8)c, D 8C. Set u$ a table %or PD12 an! P D 20 Su$$ose Zane #as O12.00 to s$en! an! ;% D O1.00 an! ;c D O3.00 S#o" bu!get line 3#at s#oul! s#e bu&5 *8D? C D2 ,.

P*8)C, D 8C 8 1 1.> 2 3 0 ? 8 12 C 12 8 ? 0 3 2 1.> 1

; %oo! PD12 Cost 37 2>.> 20 1> 13 12 12.> 1>

1 ; Clot# 8 1 2 3 0 ? 8 12 20

3 PD20 C 20 12 8 ? 0 3 2 1 Cost 73 38 27 22 18 17 18 27

/u!get line is Q D ;% U 8 E ;c U C MIS D G1=3

28

Managerial Economic 322

Class Notes Houston H. Stokes

'ndividual Market Demand Demand Curve holds constant+ 0rices o! other goods 'ncome Tastes

:ssume Kncome a2ailable is K( : D K =;1& ) / D K = ;1.) C D K = ;2.) - D K = ;3.

:s ;. %alls t#e bu!get line mo2es %rom :/ to :C to :-. '#e $ossible set o% goo!s increases. '#e consumer increases . $urc#ases and Q $urc#ases. '#e abo2e !iagram is same as %igure 0.1. ;oints to remember( :s $rice o% S %alls t#ere is a su(stutution e!!ect t#at is !ue to t#e relati2e $rice c#ange an! an income e!!ect "#ic# is !ue to t#e increase in real income !ue to t#e $rice !ecrease. K% t#e $rice o% S %alls) t#e consum$tion o% Q can increase) or !ecrease.

2C

Managerial Economic 322

Class Notes Houston H. Stokes

'ncome Consumption Curve 'races out $oints o% consum$tion o% S an! Q t#at occurs as income increases. K% S an! Q are bot# su$erior goo!s) as K increases t#e consum$tion o% S an! Q increases. DF -eman! cur2es %or bot# goo!s s#i%t rig#t. K% S is in%erior at #ig# income D F as K increases) consum$tion o% S e2entuall& %alls. :s Kncome rises S consum$tion %irst increases) t#en %alls. :s income rises t#e consum$tion o% Q increases. Q is a normal good. S is a normal goo! %or lo" incomes) an in!erior good %or #ig# $rices. Kn an N goo! "orl! all goo!s can be normal goo!s. :s a u$$er limit onl& NG1 can be in%erior. DF Kn a 2 goo! "orl! cannot #a2e t"o in%erior goo!s. Kncome an! substitution e%%ects can be !ra"n 0 "a&s %or a $rice %all an! 0 "a&s %or a $rice rise assuming normal goo!s. 8or t#e in%erior not gi%%en an! in%erior gi%%en t#ere are 8 ot#er "a&s eac#. 'otal number o% cases D 20. 'n!erior not 1i!!en D F goo! is in%erior but not so in%erior t#at t#e income e%%ect out "eig#s substitution e%%ect. 8our "a&s to !ra" cases( Hicks met#o! *:merican assum$tions,. DF :ssume base case. ;rices c#ange causing t#e bu!get line to rotate. Hel$ing bu!get line !ra"n tangent to ol! in!i%%erence cur2e but $arallel to ne" bu!get line. Slutsk& met#o! *:merican assum$tions, DF :ssume base case. ;rices c#ange causing t#e bu!get line to rotate . Hel$ing bu!get line !ra"n t#roug# ol! basket but $arallel to ne" bu!get line. Hicks met#o! *Euro$ean :ssum$tions,. DF :ssume base case. ;rices c#ange causing t#e bu!get line to rotate . Hel$ing bu!get line !ra"n tangent to ne" in!i%%erence cur2e but $arallel to ol! bu!get line. Slutsk& met#o! *Euro$ean :ssum$tions, DF :ssume base case. ;rices c#ange causing t#e bu!get line to rotate . Hel$ing bu!get line !ra"n t#roug# ne" basket but $arallel to ol! bu!get line. 8or a $rice %all Hicks *Slutsk&, met#o! "it# :merican assum$tions looks like a $rice increase %or Hicks *Slutsk&, "it# Euro$ean assum$tions. 3e assume income is %i.e!. Original bu!get line is ac. Consumer consumes : o% S. ;rice %alls DF bu!get line s#i%ts out to a!. Consumer no" obtains C o% S. Hicks met#o! !ra"s #el$ing bu!get line 1 tangent to ol! in!i%%erence cur2e K but $arallel to ne" bu!get line. :C broken into :/ *Hicks substitution e%%ect, an! /C Hicks income e%%ect.

30

Managerial Economic 322

Class Notes Houston H. Stokes

Slutsk& met#o! !ra"s #el$ing bu!get line 2 t#roug# ol! $oint. Consumer is o2ercom$ensate! an! substitution e%%ect is no" :/U an! income e%%ect /UC. Slutsk& :merican met#o! is #o" +as$erse $rice in!e. * Pjt Q j1 = Pj1Q j1 , is constructe!. Slutsk& Euro$ean met#o! is #o" ;aasc#e $rice in!e. * Pjt Q jt = Pj1Q jt , is constructe!. :ssume Q on Q a.is an! S on S a.is. :long an in!i%%erence cur2e "e #a2e X Px = Y Py . '#is can be trans%orme!( X Y = Py Px X Px Py X P Y = YPy x X Py Y Px

XPx xPy = YPy yPx % x xPy = % y yPx an! slo"s #o" t#e 9Hicks9 cross elasticities are relate! to t#e $ro$ortion s$ent on t#e goo!R 3e no" $rocee! to s#o" #o" t#ese can be estimate!R

31

Managerial Economic 322

Class Notes Houston H. Stokes

Start at e. S goo! %alls in $rice an! bu!get line mo2es out. Mo2e to # "#ere utilit& #as increase! %rom P1 to P0. P1GP0 allo"s us to measure total e%%ect D * "3 "1, = " . Kncome e%%ect "#ic# is biase! !o"n"ar! is * "2 "3, = " . Substitution e%%ect) is !etermine! b& t#e s#a$e o% t#e in!i%%erence cur2e) is * "2 "1, = U " 8rom "#ic# "e !e%ine " = " + U " Or t#e total e%%ect D t#e income e%%ect $lus t#e substitution e%%ect. Marginal $ro$ensit& to s$en! M a = Pa U " Pa "U "# = = % a # # # #"

32

Managerial Economic 322

Class Notes Houston H. Stokes

U " =

M a # Pa

3#ic# "#en "e note t#at # = " Pa can be "ritten as U " = M a "Pa Pa Pa "Pa

Multi$l& b&

"Pa "Pa U "Pa = + "Pa "Pa "Pa

M a Pa "Pa "Pa Pa

= Ma = % a #
8rom elasticit&) an! income elasticit& an! $ro$ortion s$ent on goo! can in!irectl& get in!i%%erence cur2e. Can use similar logic to get cross e%%ects. " = " + U " "Pb "Pb U "Pb = + "Pb "Pb "Pb

aPb = aPb
U " =

M a Pb "Pb "Pb Pb

M a $Pb Pa

= Ma = % b #
Since U "Pb $Pb # U " = = % b#a "Pb # #"

33

Managerial Economic 322

Class Notes Houston H. Stokes

Market !eman! D sum o% all $ri2ate !eman!s ;rice 1 2 3 0 > : ? 0 2 0 0 / 10 8 ? 0 2 C 1? 13 10 7 0 Market 32 2> 18 11 ?

:t $rice F 3 consumer : is out o% t#e market. :ssuming !eman! cur2e is elastic *inelastic, DF $rice %all im$lies t#at re2enue increases *!ecreases,. 0oint elasticity D *;=T,U*1=slo$e,

8or straig#t line !eman! cur2es elasticit& D $oint elasticit&. 2ot all demand curves are straight lines" &rc elasticity &rc 'ncome elasticity , , * Q = P ,* P = Q , * Q = # ,* # = Q ,

-eman! cur2es #a2e kinks as consumers <um$ into t#e market. Value o% clean air( 3oul! consumers maintain t#eir cars better i% t#e e.#aust "as on %ront o% car5 3#&5 )and/agon e!!ect ,- Qou like t#e goo! better i% ot#ers get it. /an!"agon e%%ect makes market more elastic. Ietail marketing base! on creating ban!"agon e%%ect. MZ $ai! to "ear a s$ecial s#oe. Sno( E!!ect !eman! less elastic. ,- Qou like t#e goo! less t#e more ot#ers #a2e it. Snob e%%ect makes market

Sall& Henin #as an arc $rice elasticit& o% !eman! %or gasoline o% G.8. Her income elasticit& %or gas is . >. Sall& #as a current income o% O00)000 $er &ear an! s$en!s O800 $er &ear %or %or gas. '#e current $rice o% gas is O1.00. a. '#e go2ernment is concerne! about energ& usage an! is contem$lating an e.cise ta. "#ic# "ill cause gas $rices to increase to O1.00. 3#at "ill #a$$en to Sall&Bs consum$tion5 b. '#e 1o2ernment is consi!ering a O200.00 ta. rebate. Ho" "ill t#is im$act Sall&5 30

Managerial Economic 322

Class Notes Houston H. Stokes

c. :ssume bot# t#e ta. an! t#e rebate are im$lemente!. Ks Sall& "orse o%% or not5 a. Sol2e arc elasticit& %ormula %or ne" T b. Psing ne" T an! arc income elasticit& %ormula sub in ne" income an! recalculate T c. See #o" muc# s#e s$en!s be%ore an! a%ter .8 = *Q2 800, = *100 . 100 . ,**100 . + 100 . , = *Q2 + 800,, .8* Q2 + 800, = *Q2 800,? ?.80Q2 = 01?0 Q2 = ?11.7? ?12 .> = **Q3 ?12, = *00)200 00)000,,**00000 + 00200, = *Q3 + ?12,, .>* Q3 + ?12, = *Q3 ?12,001 000.>Q3 = 30? + 20>012 Q3 = ?13>3 . On %inal in!i%%erence cur2e s#e s$en!s ?13.>3 U 1.00 D O858.94 . 3it# #er income an! t#e rebate s#e "oul! #a2e 00200G8>8.C0 D O3C)301 to s$en! on goo!s. K% s#e boug#t ?10 at t#e ol! $rice s#e "oul! #a2e #a! 00000G?10 D O3C38? Sall& is NO' #a$$& "it# t#e go2ernmentRR ;roblem [ 2 '#e San 8rancisco C#ronicle re$orte! t#at t#e toll on t#e 1ol!en gate bri!ge "as raise! %rom O2.00 to O3.00. 8ollo"ing t#e toll increase tra%%ic %ell >N. 3#at is t#e $oint $rice elasticit& o% !eman!5 Ste2e +eonou!akis c#airmen o% t#e bri!geBs %inance au!iting committee "arne! t#at t#e toll increase coul! cause toll re2enues to !ecrease b& O2.8 million $er &ear. Ks t#is statement consistent "it# Economic '#eor&5 Elasticit& D *Q = Q,* P = P, D G.0>=.>0 D G.1 or inelastic !eman! Ste2e is "rong. Knelastic !eman! DF re2enue increases as $rice increases. 0roduction 8irms turn inputs or !actors o! production into outputs 2ia a production !unction TD8*H)+," : $ro!uction %unction im$lies a gi2en tec#nolog&.

3>

Managerial Economic 322

Class Notes Houston H. Stokes

8irm uses eac# in$ut as e%%icientl& as $ossible. 'soquant *$ro!uction in!i%%erence cur2es, s#o" !i%%erent 4uantities o% in$uts *sa& + an! H, suc# t#at out$ut is %i.e!. Kn short run not all in$uts can be c#ange!. Kn t#e long run all in$uts can be c#ange!. 1i2en H) &verage product D T=+) Marginal product D T=+. T D Total product. 3#en Marginal ;ro!uct F :2erage ;ro!uct DF a2erage $ro!uct is increasing. M; reac#es a $eak at $oint o% in%lection on '; cur2e. 3a/ o! diminishing returns DF "it# ot#er in$uts %i.e!) M; o% an in$ut !eclines as t#e amount o% t#at in$ut use! increases. Malt#us belie2e! t#at t#e eart# "oul! not su$$ort $o$ulation gro"t#. 'o !ate #e #as been "rong. : tec#nological c#ange raises t#e $ro!uction %unction. Here it is occurring o2er time. Q = "e t ' % Kn an& $articular &ear t#e aggregate 2alue o% goo!s an! ser2ices $ro!uce! b& en econom& is e4ual to t#e $a&ments ma!e to all %actors o% $ro!uction. Marginal rate o! technical su(stitution D % = ' %or a gi2en T *H on 2ertical a.is,. MRT! = % = ' = * MP' = MP% , since along iso4uant * MP' ,* ', + * MP% ,* % , = 0 3#en in$uts are substitutes DF iso4uants are straig#t lines. 3#en in$uts are com$lements DF iso4uants are rig#t angles :ssuming a CobbG-ouglas $ro!uction %unction sum o% coe%%icients !etermines returns to scale. :ssume all in$uts increase b& . 1et QU = ae t *', a *% , = ae t * a + , 'a % = * a + , Q E.am$le( M;+D >0) MI'S D .2>. 3#at is M;H5 .2> = MP' = MPk = >0 = MPk . DF MP% = 200 E.am$le( -etermine "#et#er !ecreasing) constant or increasing returns.

3?

Managerial Economic 322

Class Notes Houston H. Stokes

:. Q =.>%') QU =.>* % ,* ',) QU = Q2 or increasing returns. /. Q = 2 % + 3') QU = 2 % + 3 ' = Q or constant returns. E.am$le( :ssuming TD100*H.8+.2, starting HD0 an! +D0C s#o" M; o% labor an! H are !eclining % = 0) ' = 0C) => Q = 100 U 0.8 U 0C.2 = ??0.21 % = >) ' = 0C) => Q = 100 U >.8 U 0C.2 = 78C.2>) => MP% = 12C.00 % = ?) ' = 0C) => Q = 100 U ?.8 U 0C.2 = C131C . ) => MP% = 123.C0 % = 7) ' = 0C) => Q = 100 U 7.8 U 0C.2 = 1033.00) => MP% = 11C.8> % = 0) ' = 0C) => Q = 100 U 0.8 U 0C.2 = ??0.21 % = 0) ' = >0) => Q = 100 U 0.8 U >0.2 = ??2.8C) => MP' = 2.?8 % = 0) ' = >1) => Q = 100 U 0.8 U >1.2 = ??>>2 . ) => MP' = 2.?3 .8 .2 % = 0) ' = >2) => Q = 100 U 0 U >2 = ??811 . ) => MP' = 2.>C

37

Managerial Economic 322

Class Notes Houston H. Stokes

Cost o! 0roduction &ccounting Cost concerne! "it# #istorical e.$en!itures. Economic Cost takes into account opportunity cost t#at #as to be taken into consi!eration in t#e !ecision $rocess *Kt is more costl& %or a !octor to mo" t#e la"n on Mon!a& at 10(00 t#an a <anitor," Sunk costs costs t#at cannot be reco2ere!.

Valuable :lternati2e use o% lan! DF #ig# o$$ortunit& cost o% $resent use. \oning in man& cases re!uces o$$ortunit& cost. Total Cost 4TC5 , #aria(le Cost 4#C5 6 7ixed Cost 47C5 Marginal Cost 4MC5 , VC = Q = TC = Q &verage Cost 4&C5 , TC = Q Kn t#e s#ort run can c#ange labor to increase out$ut. 1i2en t#e "age ( ) MC = VC = Q = (' = Q = ( = MP' :ssuming labor is t#e onl& 2ariable in$ut "VC = (' = Q = ( = "P' "#ere "P' is t#e a2erage $ro!uct o% labor. '#e MC cur2e goes t#roug# t#e minimum o% t#e :'C an! :VC but not t#e :8C. :s Q ) "FC 0 . Kn t#e long run all in$uts are 2ariable. 'socost line *D $ro!uction bu!get line, is locus o% $oints s#o"s !i%%erent combinations o% in$uts suc# t#at cost is %i.e!. C = (' + r% sol2ing %or H gi2es % = *C = r , ** ( = r , ',

38

Managerial Economic 322

Class Notes Houston H. Stokes

Ksocost slo$e % = ' = * ( = r , o% ratio o% "age rate to rental cost o% ca$ital. 3ant to ma.imiLe $ro!uction %or a gi2en total cost 'C. '#e MRT! = % = ' = MP' = MP% . Kn e4uilibrium t#e slo$e o% t#e isocost P' = P% D MI'S MP' = MPk = P' = P% = ( = r or MP' = ( = MP% = r

3C

Managerial Economic 322

Class Notes Houston H. Stokes

Expansion path s#o"s t#e amounts o% labor an! ca$ital use! as %irm gro"s '#is is a long run conce$t. Economies o! scale inclu!es increasing returns to scale as a s$ecial case. Kncreasing returns to scale re4uires in$uts be use! in %i.e! $ro$ortions. Economies o% scale allo"s t#e ratio o% in$uts to c#ange. :t minimum $oint o% +:C t#e +MC an! SMC intersect. Economics o% scale DF MC Y :C. -iseconomies o% scale DF MC F :C. -e%ine EC D elasticity o! total cost

EC = @ TC = TC A = @ Q = QA = @ TC = QA = @ TC = QA = MC = "C Economics o! scale ,- Ec < 1) o% MC Y :C. Economies o! scope are $resent "#en <oint out$ut o% a single %irm $ro!ucing t"o $ro!ucts is greater t#at t#e out$ut o% t"o %irms eac# $ro!ucing one $ro!uct. -e%ine C *Qi , as cost o% $ro!ucing Qi o% t#e it# goo!. Economies o% sco$e DF SC F 0 !C = @ C *Qi , C *Q1 )...) Qn ,A = C *Q1 )...) Qn ,
i

Diseconomies o! scope SC 8 9 3earning Curve DF O2er time labor costs go !o"n as more units are $ro!uce!. -e%ine + as labor $er unit) :F 0) /F0) 0Y Y1 an! N D [ o% units $ro!uce!. +earning cur2e im$lies ' = " + $N :s N ) ' " K% N)1 t#en ')"*$+ or t#e amount o% labor %or %irst unit. K% = 0 t#ere is no learning. 3#en > 0 $ t#en secon! unit costs " + "#ic# con2erges to " as N+increases. 2 Costs can !ecline because o% increasing returns to scale or learning. Estimating a cost curve 3inear Model use! i% MC is constant at . MC = VC = Q

00

Managerial Economic 322

Class Notes Houston H. Stokes

:uadratic Model use! i% #a2e straig#t line MC. MC = + 2Q. VC = Q + Q 2 Cu(ic cost !unction use! i% #a2e P s#a$e! MC cur2e o% %orm MC = + 2Q + 3Q 2 VC = Q + Q 2 + Q 3 Can use E.cel an! ot#er so%t"are to estimate t#e MC cur2e. Com$uter %irm cost is "C = 10.1*CQ, +.3Q "#ere CT is cumulati2e 4uantit&) an! T is 4uantit& $er &ear. a. '#ere is a learning cur2e e%%ect since G.1 b. '#ere is !ecreasing returns to scale5 TC = 10Q .1*CQ,*Q, +.3Q 2 MC = TC = Q = 10.1*CQ, +.?Q Since .?Q >.3Q DF !ecreasing returns to scale c. CTtD00)000) Tt D 10)000) TtE1D 12)000 "Ct = 10.1*00, +.3*10, = C.) "Ct +1 = 10.1*>0, +.3*12, = 8.?

:ssume TC = a + bQ + cQ 2 + dQ 3 ) MC = *TC , = Q = b + 2cQ + 3dQ 2 "C = @a = QA + b + cQ + dQ 2 . :C not !e%ine! %or TD0. 8or a P s#a$e! cost cur2e "e "ant cY0 an! !F0. :t minimum $oint o% :C) MCD:C. Set+aD0 to normaliLe & a.is an! e4uate MCD:C. DF b + 2cQ + 3dQ 2 = b + cQ + dQ 2 or c = 2dQ . K% c)G1 an! dD1 t#en TD1=2

01

Managerial Economic 322

Class Notes Houston H. Stokes

*ey :uestion+ ;o/ do /e use this theory to solve a practical pro(lem< 8irm #as a $ro!uction %unction F * % ) ', = "% ' "#ic# coul! be estimate! using E.cel "#en "e note t#at log@ F * ') % ,A = log* ", + log* % , + log* ', . 3ant to !etermine a general case t#at s#o"s t#e o$timum % an! ' gi2en t#e cost o% ca$ital r an! t#e "age+(. Kn e4uilibrium "e note t#at *1, *1/, @ MP% = MP' A = r = ( MP% MP' MP% MP' = => = P% P' r

1i2en t#e $ro!uction %unction *2, Q0 = "% ' @ "% 1 ' = "% ' 1 A = @r = (A @' = % A = r = ( ' = @r% = (A

*3, *0, *>,

Substituting *>, into t#e $ro!uction %unction *2, gi2es *?, *7, Q0 = @ "% r % = ( A % * + , = *( = r , Q0 = "

'#e e4uilibrium amount o% ca$ital is *8, % = @*( = r , =* + , A* Q0 = ",1=* + ,

K% t#e cost o% ca$ital) r) increases or t#e marginal $ro!uct o% ca$ital) ) %alls H "ill %all. -irect substitution o% *8, into *>, gi2es *C, ' = @* r = (, * =* + ,, A*Q0 = ", *1=* + ,,

K% t#e "age rate) () increases or t#e marginal $ro!uct o% labor) ) %alls t#en less labor "ill be use!. '#e %irms cost %unction is *10, :t e4uilibrium 02 C = (' + r%

Managerial Economic 322

Class Notes Houston H. Stokes

*11,

C = ( * =* + ,, r * =* + ,, @* = , * =* + ,, + * = , * =* + ,, A*Q = ", *1=* + ,,

E4uation *11, s#o"s #o" C is relate! to "ages) () cost o% ca$ital) r) an! returns to scale * + , . *11, is obtaine! b& substituting *8, an! *C, in *10,. M:'+:/ can be use! to calculate t#e a$$ro$riate !eri2ati2es. E4uation *11, s#o"s #o" costs are relate! to t#e $ro!uction %unction o% t#e %irm as "ell an! in$ut costs. '#e E.cel %ile sta%%ing..ls "ill allo" use o% t#is t#eor&. *1, can be sim$li%ie! i% + = 1 .

2ost of 'roduction given 'roduction function6 ? interest and @. "ssumes outputAconstant<BCalp4a<DC+eta 2ostAEage<D;interest<F !odel determines staffing 5D7 and 2apital StocB

"lp4a 0 2apital 2oef Geta 0 Da+or 2oef alp4a ; +eta %utput Eage interest 2onst &erm 1 &erm 2 &erm 3 2ost

0.2 0.8 1 10 81.00 0.05 1 0.54928 1.649385 10 9.059746

2apital Da+or

36.23898 7.247797

#everse 2ase 0 given cost E4at is output6 la+or and 2apitalH 2ost %utput 2apital Da+or 0.905975 1 3.6239 0.72478

03

Managerial Economic 322

Class Notes Houston H. Stokes

0ro!it Maximization and Competitive Supply

8irms "ant to ma.imiLe re2enue. Com$etiti2e su$$l& DF man& %irms) all $rice takers) no $ro!uct !i%%erentiation) %ree entr& 0ro!it is t#e !i%%erence bet"een re2enue an! cost %or a gi2en le2el o% out$ut 4. *1,

*& , = R*& , C *& ,

'o ma.imiLe $ro%it !i%%erentiate an! set to Lero. DF MI*4, D MC*4, *2, = & = *TR , = Q *TC , = Q = 0

8or a com$etiti2e %irm ; is gi2en DF d = an! ;DMI. Kt can be $ro2e! t#at *3, *0, MR = "R@1 + *1 = d ,A = P@1 + *1 = d ,A TR = & = @*&p + p& , = & A = p@* &p + p& , = &p A = p@1 + * p& = &p,A = p@1 + *1 = d ,A Kn long run ne" %irms "ill enter an! %irm "ill earn normal pro!its or t#ose $ro%its suc# t#at no %irms enter or no %irms lea2e in!ustr&. K% an in$ut increases in $rice DF :C cur2e s#i%ts u$ DF MC cur2e s#i%ts u$ an! %irm $ro!uces less out$ut. Kn!ustr& su$$l& cur2e is t#e sum o% %irm MC cur2es in t#e s#ort run. 0roducer Surplus , area abo2e %irm su$$l& cur2e an! belo" $rice. See %igure 8.11. Kn long run %irm can alter all in$uts. K% in!ustr& is making e.tra normal $ro%its in t#e s#ort run DF ne" %irms "ill enter suc# t#at in t#e long run all %irms are making normal $ro%its. '#e long run com$etiti2e e4uilibrium $oint is ;DSMCD+MC. 8irm is at t#e minimum $oint o% its :C cur2e. 1i2en t#e %irmBs tec#nolog&) it is most e%%icient. Kt earns economic $ro%it *normal $ro%it,. Kn long run %irm tries to e4uate +IMC to $rice )UT ne" %irms can enter t#e in!ustr& an! !ri2e !o"n $rice. Economic pro!it D I G (+ G rH "#ere rH is t#e o$$ortunit& cost o% ca$ital. : %irm making Lero economic $ro%its ma& still sta& in business.

00

Managerial Economic 322

Class Notes Houston H. Stokes

Economic rent D return to %actors o% $ro!uction in limite! su$$l&. MZ earns economic rent. Songs an! books are co$&rig#te! to allo" economic rent to be earne! %or a limite! number o% &ears. '#e long run su$$l& o% a constant cost industry is a straig#t line. '#is is a partial equili(rium argument. :s T increases in$ut $rices "ill increase at some time. 1eneral Equili(rium #as all assum$tions 2ariable. Some in!ustries are so small t#at t#e& can be assume! to #a2e no e%%ect on in$ut $rices. 'ncreasing Cost Case DF K% e.tra normal $ro%its are earne! ne" %irms "ill enter t#e in!ustr& an! in$ut $rices "ill increase. Taxes. :n output tax raises t#e MC cur2e. : 3ump Sum Tax *suc# as a li4uor license, !oes not c#ange t#e MC since it is $ai! no matter "#at. '#e e%%ect o% a n out$ut ta. in t#e long run is to reduce industry supply. 0er!ectly Competitive Markets &ssume( ;rice 'aking ;ro!uct Homogeneit& ;er%ect Mobilit& o% :ssets ;er%ect Kn%ormation

E2en i% onl& one %irm in t#e market it ma& $a& to act as i% t#e %irm "as in a com$etiti2e market since e.tra normal $ro%its DF ot#ers %irms ma& enter to bi! a"a& $ro%it. ;roblem [ 1 '#e Conigan bo. com$an& is in a com$etiti2e market. Kt sells bo.es in batc#es o% 100 %or O100.00. TC = 3)000)000+.001Q 2 . 3#at is $ro%it ma.imiLing out$ut5 3ant MCDMID:I. DF 100 =.002Q) => Q = >0)000 3#at is $ro%it5

= TR TC ) = 100 U*>0000, *3000000+.001 U*>0000, 2 = O>00)000

S#oul! %irm sta& in business since :VC Y ;( "VC = TVC = Q) TVC = TC = TFC ) TVC = >)>)00)000 3)000)000 = 2)>00)000 "VC = *2)>00)000, = >0)000 = O>0 ;roblem [ 2 Com$etiti2e market #as a market !eman! cur2e o% P = 7> 1> .Q an! su$$l& cur2e o% 0>

Managerial Economic 322

Class Notes Houston H. Stokes

P = 2>.+.>Q "#ere T D "#ere a t&$ical %irm #as MC = 2.> + 10& . 3#at is market $rice an! rate o% sales5 3e set S D - or 2>+.>Q = 7> 1> . Q) => Q = 2>) P = 7> 1> . U 2> = O37.> Eac# %irm sells "#ere MI D MC . Since $er%ect com$etition MID:ID;DO37.>0 37.> = 2.> + 10& ) => & = 3> . Note( K% &ou use c#2V1..ls tem$late to sol2e s&stem remember t#at t#e tem$late is set u$ as( Q , = f * P ,) Q d = f U * P , ) => Q , = >0 + 2 P) Q d = >0 *1=1.>, P

0?

Managerial Economic 322

Class Notes Houston H. Stokes

Market 0o/er+ Monopoly and Monopsony Mono$ol& DF One $ro!ucer MI :I. Mono$son& DF One bu&er :ssuming ;D?GT ; ? > 0 3 2 1 T 0 1 2 3 0 > 'I 0 > 8 C 8 > MI G > 3 1 G1 G3 :I G > 0 3 2 1 G in% G0 G1.> G.??7 G.2> 'I 0 > 8 C 8 >

He& 8ormulas(

MR = "R@1 + *1 = ,A

= @ "R = * MR "R ,A
K% XX Y 1 DF as 4uantit& increases 'I !ecreases. E4uilibrium at ma. $ro%it re4uires MCDMI "#ere MC #its MI %rom belo". Various $oints( K% normal $ro%its are ma!e DF :C cur2e "ill be tangent to :I cur2e at a $oint to le%t o% minimum $oint. Normal $ro%its "it# MI Y :I DF operating at less than optimum capacity" K% MID:I DF $er%ect com$etition. Can #a2e t#ree cases( 1. K% making loss in s#ort run DF less t#an o$timum ca$acit&. 2. K% making normal $ro%its DF at minimum $oint o% :C cur2e. 3. K% making e.tra normal $ro%its DF o$erating at greater t#an o$timum ca$acit&. K% MI Y :I can

;ossible Cases 'able( Stu!& belo" liste! tables an! be able to !ra" all $ossible cases an! $ro2e t#at t#e K cases are not $ossible. MID:I MCDMI

07

Managerial Economic 322

Class Notes Houston H. Stokes

MCY:C MCD:C MCF:C VVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVV :CF:I Case 1 ; Case 2 K Case 3 K :CD:I Case 0 K Case > ; Case ? K

:CY:I Case 7 K Case 8 K Case C ; VVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVV

MIY:I MCDMI MCY:C MCD:C MCF:C VVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVV :CF:I Case 10 ; Case 11 K Case 12 K :CD:I Case 13 ; Case 10 K Case 1> K

:CY:I Case 1? ; Case 17 ; Case 18 ; VVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVV : %irm is at less t#an o$timum ca$acit& *MCY:C,) at o$timum ca$acit& *MCD:C, or greater t#an o$timum ca$acit& *MCF:C,. Mono$ol& $o"er occurs i% MIY:I. K %irm is in a com$etiti2e market i% :IDMI. Kn a com$etiti2e market t#e %irm can sell as muc# as it can "it#out t#e $rice %alling. : %irm al"a&s ma.imiLes $ro%it i% MCDMI an! MC #its MI %rom belo". : %irm makes an e.tra normal $ro%it i% :IF:C) a normal $ro%it i% :ID:C an! a s#ort term loss i% :IY:C.

08

Managerial Economic 322

Class Notes Houston H. Stokes

0ricing /ith Market 0o/er : %irm t#at $ractices !irst degree price discrimination c#arges eac# customer #is=#er reservation price o% t#e ma.imum t#at consumer "oul! $a&. Kn t#is "or! all consumer surplus is captured (y the !irm. Kn $ractice t#is is #ar! to !o. Pni2ersities tr& to $ractice t#is a$$roac# b& gi2ing =ust enough aid to get t#e stu!ent. Second degree price discrimination occurs "#en $rice is re!uce! i% a!!itional amounts are boug#t. Third degree price discrimination occurs "#en %irm $ackages same $ro!uct un!er t"o !i%%erent labels an! sells at a !i%%erent $rice. Psing %ormula MRi = Pi @1 + *1 = di ,A an! MC = MR1 = MR2 ) t#en @P 1=P 2 A = @1 + *1= d 2 ,A=@1 + *1= d 1 ,A '#ere is e2i!ence to suggest t#at cou$on users #a2e #ig#er elasticit& o% !eman! t#an non cou$on users. :ssume t#e non cou$on users #a2e elasticit& o% !eman! d 1 " K% +P1 D P2) an! V D 2alue o% cou$on) t#en in an o$timum "orl! @* P 1 V , = P 2 A = @1 + *1= d 2 ,A=@1 + *1= d 1 ,A :irlines $rice !iscriminate. 'ntertemporal 0rice Discrimination ,- %irm c#arges %irst consumers more. Har! co2er e!ition o% a book comes out %irst. /e%ore too long so%t co2er comes out at a lo"er $rice. +ibrar& bu&s #ar! co2er. 0eak 3oad 0ricing DF c#arge more at a certain time in t#e !a&. T/o 0art Tari!! ,- $a& to get into 1reat :merica) t#en) $a& %or eac# ri!e. ;olaroi! Camera cost "as entr& %ee. 8ilm "as $rice. )undling. 3#en customers #a2e heterogeneous demands that are negatively correlated DF $a&s to bun!le $ro!ucts. E%%ecti2eness o% bun!ling !e$en!s on #o" negati2el& $ro!ucts are relate!. Mi.e! bun!ling. Sell as a $ackage or alone. MS O%%ice C7 is sol! t#is "a&. 8igure 11.18 s#o"s t#at "it# Lero MC t#is is e2en more $ro%itable. +u.ur& cars are sol! "it# stan!ar! o$tions bun!le! into t#e car. Vacation $ackage anot#er e.am$le. Iestaurants sell items a la carte an! as !inners. Tying ,- %orce customer to bu& all items %rom one source. Mc-onal!s at one time re4uire! o"ners to get su$$lies %rom one source. 1as station #as to carr& %ull range o% $ro!ucts. 0C

Managerial Economic 322

Class Notes Houston H. Stokes

&dvertising. 3ant marginal re2enue o% an a!!itional !ollar s$ent on a!2ertising to e4ual %ull marginal cost o% t#at a!2ertising. 3e !e%ine $ro%it as a %unction o% amount sol! Q an! a!2ertising "-

*Q) ", = PQ* P ) ", C *Q, "

= " = P *Q = ", MC *Q = ", 1 = 0 3e rearrange an! get t#e marginal re2enue %rom a!2ertising. MR a d , = P *Q = ", = 1 + MC *Q = ", @ P MC A@ Q = "A = 1) => @* P MC , = P A@* "Q, = *Q",A = @ " = PQA 1i2en elasticit& o% !eman! D @* "Q, = * Q",A = " ) in e4uilibrium t#en @* P MC , = PAa = @ " = PQA MC = P@1 + 1 1 A => @* P MC , = PA = p p

@ " = PQA = @ " = P A '#e more inelastic t#e !eman! %or t#e %irmBs out$ut) t#e more a!2ertising. Kn $er%ect com$etition since p = ) no a!2ertising is !one. Monopolistic Competition and .ligopoly Monopolistic Competition ,- +arge number o% sellers eac# "it# some market $o"er !ue to selling a di!!erentiated product. :t t#e mo!el le2el in t#e automoti2e in!ustr& "e #a2e mono$olistic com$etition. d < in mono$olistic com$etition. Man& sellers Eac# seller selling a slig#tl& !i%%erentiate! $ro!uct Entr& b& ne" %irms is NO' restricte!

.ligopoly DF 8e" sellers eac# "it# market $o"er. K% one %irm in an oligo$ol& market "ere to raise $rice) t#e ot#ers "oul! not %ollo" an! t#at %irm "oul! %in! sales %all o%% ra$i!l&. K% t#e same %irm "ere to lo"er $rice #o$ing to increase sales at t#e e.$ense o% t#e ot#er %irms) t#en all ot#er %irms "oul! lo"er $rice an! t#e e.$ecte! increase in sales "oul! not be realiLe!. 8e" sellers Eac# seller selling a !i%%erentiate! $ro!uct.

>0

Managerial Economic 322

Class Notes Houston H. Stokes

Eac# "it# substantial market $o"er Entr& is restricte! b& barriers *e.am$le aircra%t in!ustr&,

Cartel,- 8irms "ork toget#er. *1E in >0Bs until t#e& got caug#t., +ike a mono$ol& /P' members tem$te! to c#eat. Cartel usuall& !oes not control com$lete market

Pn!er Mono$olistic Com$etition %ree entr& DF No e.tra normal $ro%its in long run. 8irms in long run o$erate at less t#an o$timum *minimum a2erage cost, ca$acit& *see case 13,.

Kn $er%ect com$etition an! mono$olistic com$etition >hen a market is in equili(rium !irms are doing the (est they can and have no reason to change their price or output" Kn oligo$ol& each !irm is doing the (est it can? given /hat its competitors are doing" 0risoners Dilemma Nas# e4uilibrium is a noncooperative equili(rium. K% &ou #o$e t#at %irm "ill set $rice at collusi2e le2el) t#e ot#er %irm "ill %in! t#at it $a&s NO' to set at t#is le2el. Veri%& t#at c#12V1 s#o"s t#at i% %irm [ 2 sets O0.00 an! %irm [ 1 sets O?.00 *collusi2e $rice, t#en %irm [ 2 makes O20.00 an! %irm makes O0.00. Pse t#e tem$late to 2eri%& 8irm [ 2 O0.00 O12)O12 O0)O20 GO20)O28 8irm [ 2 O?.00 O20)O0 O1?)O1? GO0)O28 8irm [ 2 O8.00 O28)GO20 O28)GO0. O12)O12

8irm [ 1 O0.00 8irm [ 1 O?.00 8irm [ 1 O8.00

3it# O?) O? t#e total $ro%it is #ig#est *O32.00,. /ut eac# %irm "ill look at situation as 9K% K c#arge O0.00 K "ill !o 9best9 *i.e. make O12.00,.9 Eac# %irm !oes not !are trust t#e ot#er %irm to c#arge t#e #ig#er $riceRR Kn Oligo$ol& t#ere is an incenti2e to kee$ $rice %i.e!. 8igure 12.7 illustrates t#e kinked demand curve. MC can mo2e insi!e !iscontinuous section an! t#ere is no incenti2e to c#ange $rice or 4uantit&. DF .ligopolistic !irms have price rigidity

>1

Managerial Economic 322

Class Notes Houston H. Stokes

0rice signaling %irm suc# as :merican :irlines announces it is raising its $rice. 8irm #o$es t#at suc# price leadership "ill result in t#e ot#ers %ollo"ing. *'#is seems to be t#e case in H&!e ;ark bet"een S#ell an! :moco stations "#ic# B$ostB $rices t#at seem to agree all t#e time., /anks o$erate using $rice signaling as t#e& 9res$on!9 to c#anges at t#e 8e!. Dominant 7irm Model" 8igure 12.C s#o"s !ominant %irm mo!el. -ominant %irm takes !eman! cur2e -- as -- D Market !eman! G 8ringe 8irm Su$$l&. -ominant %irm !ra"s MI on t#is derived demand curve an! sets $rice. 8ringe %irms take t#is $rice as gi2en. Oil Cartel "oul! not be legal in t#e PS. 8igure 12.10 s#o"s situation. Here O;EC !eri2es a !eman! cur2e -O;EC an! !ra"s a marginal re2enue cur2e. ;rice is set at ;U "#ere MIO;EC D MCO;EC. K% O;EC "ere not a cartel) O;EC $rice "oul! be at ;c. Pni2ersities "ork toget#er to kee$ at#letics 9amateur9 b& $a&ing $la&ers nothing. Some#o" t#e& get a"a& "it# itRR

>2

Managerial Economic 322

Class Notes Houston H. Stokes

1ame Theory 1ame Theory 9K% K belie2e t#at m& com$etitors are rational an! act to ma.imiLe t#eor o"n $ro%its) #o" s#oul! K take t#eir be#a2ior into account "#en making m& O"n $ro%itGma.imiLing !ecisions59 Cooperative game DF $la&ers can negotiate bin!ing contracts an! en%orce t#em 2oncooperative game DF $la&ers cannot negotiate an! cannot en%orce contracts >ant to understand your opponent@s point o! vie/ and assuming your opponent is rational deduce ho/ he or she is likely to respond to your actions" ;roblem. Com$an& : *ac4uirer, consi!ering bi!!ing %or Com$an& ' *target,. Com$an& ' is e.$loring %or oil an! kno"s "#at it #as %oun!. Kt is assume! t#at a s#are $rice o% O0.00 G O100.00 %or com$an& ' un!er its o"n management is e4uall& likel&. K% : bu&s ') ' "ill make >0N more mone&. : t#us can make an o%%er bet"een O0GO1>0 a s#are an! ' "ill acce$t i% t#e o%%er is greater t#an or e4ual to t#e current s#are $rice. 3#at is t#e o$timum o%%er5 :ns"er. O%%er O0.00. :ssume : o%%ers O>0.00. '#is suggests t#at t#e s#are $rice is bet"een 0G>0. Kts e.$ecte! 2alue is O2>.00. 3it# :Bs management t#e 2alue "ill rise to O37.>0 *1.>U2>, "#ic# is less t#an t#e o%%erRR Dominant Strategy one t#at is o$timal %or a $la&er no matter "#at an o$$onent !oes 8irm : 8irm : :!2ertise No :! 8irm / :!2ertise 10)> ?)8 8irm / No :! 1>)0 10)2

-ominant tGstrateg& is %or : an! / is to a!2ertise 8irm / :!2ertise 10)> ?)8 8irm / No :! 1>)0 20)2

8irm : 8irm :

:!2ertise No :!

Here : !oes not #a2e a !ominant strateg&. -e$en!ing on "#at / !oes) : "ill eit#er a!2ertise an! get 1> or not a!2ertise an! get 20. /ut / #as a !ominant strateg& "#ic# si to a!2ertise. DF : "ill %igure t#at / "ill !etermine t#is an! "ill a!2ertise. 2ash equili(rium ' am doing the (est ' can given /hat you are doing" Aou are doing the (est you can given /hat ' am doing" Dominant Strategy ' am doing the (est ' can no matter /hat you do? Aou are doing the (est you can no matter /hat ' do"

>3

Managerial Economic 322

Class Notes Houston H. Stokes

Markets !or 7actor 'nputs 8irms !eman!s %or in$uts are 9!eri2e!9 in t#at t#e& are t#e result o% $ro!uction !ecisions !ue to market !eman! %or t#e %inal $ro!uct. Marginal revenue product D a!!e! re2enue %rom one more unit o% in$ut K in t#e $ro!uction o% goo! .. Kn general case MRPi = MPPi MRx Kn $er%ect com$etition since %irm %aces x = ) => MRx = Px . '#eor& suggests t#at !eman! %or labor o% a %irm "it# mono$ol& "it# #a2e a lo"er MI; t#an a $er%ectl& com$etiti2e %irm. Kn e4uilibrium "#ere i D labor MRPi = ( or MRx = ( = MPPi :s ot#er in$uts increase) M;;+ increases "#ic# s#i%ts t#e MI; cur2e to t#e rig#t Eac# %irm takes t#e su$$l& $rice o% in$uts as gi2en. :s a grou$ i% aggregate !eman! increases t#e $rice o% in$uts "ill increase. '#e su$$l& o% labor is usuall& u$"ar! slo$ing. K% "ages increase) more labor "ill be su$$lie!. :bo2e some "age) t#e number o% #ours su$$lie! ma& !ecrease as $otential "orkers c#ose leisure o2er "ork. Economic rent ,- !i%%erence bet"een t#e $a&ments ma!e to a %actor o% $ro!uction an! t#e minimum amount t#at must be s$ent to obtain t#e use o% t#at %actor. Monopsony 0o/er occurs "#en a %irm #as $o"er o2er t#e cost on an in$ut. Kn a com$etiti2e market t#e marginal expenditure 4ME5 %or an in$ut is e4ual to t#e average expenditure 4&E5. 3it# mono$son& "Ei < MEi Kn e4uilibrium MEi = MRPix

>0

Managerial Economic 322

Class Notes Houston H. Stokes

"#ere MRPix D marginal re2enue $ro!uct o% in$ut K in t#e $ro!uction o% goo! .. K% unions restrict t#e number o% "orkers) t#en t#e "ages o% t#ose in t#e tra!e "ill be abo2e t#e "age t#at "oul! occur i% t#ere "as %ree entr&. '#e "ages o% "orkers in t#e non union labor market "ill %all !ue to t#e increase! "orkers looking %or "ork. Kn realit& man& union "orkers "ork o%% t#e books on t#e "eeken!s an! nig#ts. :t uni2ersit& tenure! %acult& are not allo"e! to lo"er t#eir "ages %or t#e summer. Kn $erio! t#e relati2e [Bs o% union "orkers #a2e !ecrease!. 3ages #a2e not risen as e.$ecte! !ue to t#e increase! substitution o% ca$ital %or labor. :ssuming a $ro!uction %unction o% t#e %orm Q = e t ' % t#en MPP' = e t ' 1 % = Q = ' '#ere "ill be increasing returns) constant returns or !ecreasing returns !e$en!ing on "#et#er * + , > 1) * + , = 1) or * + , < 1 . 3inear 0rogramming 1oal+ 'o e4ui$ &ou to sol2e a number o% $roblems relating to t#e organiLation o% $ro!uction an! t#e $urc#ase o% in$uts. Discussion Example :ssume &ou are $lace! in c#arge o% a %actor& $acking %is# $ro!ucts. '"o $ro!ucts are $ro!uce!( !ish cakes *%or #uman consum$tion, an! !ish meal *%or animal consum$tion,. '#e $ro!uction $rocess in2ol2es Separating *take lig#t meat o%% %is# %or cakes,) shredding) packing an! canning. 3orkers are traine! %or eac# task. '#e sales $rice o% %is# cakes is O.80 $er $oun! an! %is# meal is O.70 $er $oun!. +abor re4uirements $er 1)000 lb are( Se$arating S#re!!ing ;acking Canning Hours :2ailable 20> 10? 188 ?> Ie4. 8is# Cakes 22.78 10.?0 10.0? >.00 Ie4. 8is# Meal 13.?7 8.83 17.0C >.00

:s manager &ou "ant to kno" #o" to ma.imiLe $ro%it b& !etermining #o" man& %is# cakes an! %is# mean $oun!s to $ro!uce. Kn a!!ition &ou "ant to kno" #o" muc# $ro%it "oul! c#ange i% &ou "ere to retrain "orkers %rom se$arating to s#re!!ing etc. '#e rea!ing lists s#o"s 2arious "a& to setu$ t#e $roblem.

>>

Managerial Economic 322

Class Notes Houston H. Stokes

Setu$ Max = .80C +.70 M ,. t . 22.78C + 13.?7 M 10.?0C + 8.83 M 10.0?C + 17.0C M >.00C + >.00 M

20> 10? 188 ?>

'#e b30s setu$ %or t#is $roblem *comments begin "it# =O, is(
/$ b34s program to solve /$ Fish Packing Problem /$ /$ Max .80C + .70M /$ st /$ /$ 22.78C + 13.67M LE 205 /$ 10.60C + 8.83M LE 106 /$ 14.46C + 17.09M LE 188 /$ 5.00 + 5.00M LE 65 /$ b34sexec lpmax n=2,m1=4,m2=0; amatrix(22.78, 13.67, 10.60, 8.83, 14.46, 17.09, 5.00, 5.00 ); bvector(205., 106., 188., 65.); cvector( .80, .70 ); b34srun;

With answers:
LPMAX Command. Version 1 September 1997 93 are being used.

Of 2000000 double precision slots in space, Number of activities (X) 2 Number of constraints (m1+m2) 4 Number of inquality constraints (m1) 4 Number of equality constraints (m2) 0 Constraint Matrix (A) 1 1 2 3 4 22.7800 10.6000 14.4600 5.00000 2 13.6700 8.83000 17.0900 5.00000

>?

Managerial Economic 322

Constraint vector (B) 205.000 Cost vector (C) 0.800000 0.700000 106.000 188.000

Class Notes Houston H. Stokes

65.0000

Objective function maximized at Primal values 2.83325 Dual values 0.00000 0.663896E-01 8.60335

8.288942665534615

0.665767E-02

0.00000

'#e ans"ers in!icate t#at $ro%it D O8)288.C0 an! t#e $ro!uction o% %is# cakes an! %is# meal s#oul! be 2.8332> an! 8.?033> t#ousan! $oun!s res$ecti2el&. Since t#e s#a!o" $rice o% se$arating labor an! canning labor "as 0.0) t#is suggests t#at a!!ing more labor in t#is area is not nee!e!. -e$en!ing on t#e $rices o% labor in s#re!!ing an! $acking) more labor coul! be a!!e! $ro2i!e! t#at t#e cost o% t#e labor is less t#an t#e s#a!o" $rice. 1i2en t#e base case D 8.288C02??>>30?1>. K% one more #our o% s#re!!ing is allo"e!) D 8.3>>332303>10723. Note t#at $ro%it #as increase! b& t#e s#a!o" $rice o% .0??38C. K% one more #our o% canning is a!!e!) t#en t#e ob<ecti2e %unction mo2es u$ .00??>7?7 to 8.2C>?00330?3C0CC. '#e rea!er is encourage! to run t#e <ob %is#.b30 to 2eri%& t#ese numbers. K% t#e primal is Max = CX ,. t . "x $ t#e !ual is Min V = $( ,. t . "B ( C

Kn e4uilibrium it can be s#o"n t#at V = . '#e ob<ect it to organiLe $ro!uction to t#at t#e $ro%it is ma.imiLe!. '#e $ 2ector is t#e numbers o% in$uts a2ailable. ;ro!uction s#oul! be organiLe! so as to minimiLe bottle necks. '#e s#a!o" $rice o% remo2ing a constraint) (.+is sol2e! %rom t#e !ual. :s s#o"n abo2e (/i0 is t#e increase in t#at "oul! occur i% one more unit o% t#e it# in$ut "as obtaine!. Sam$le +; $rograms(

>7

Managerial Economic 322 Max = >x + 3z ,. t 3x + >z 1> >x + 2 z 10 Veri%& t#at at t#e solution = 12.3?80210>2?31>8) . D 1.0>2?3 2.3?802 " D 0.2?31>8 0.80210>

Class Notes Houston H. Stokes

: linear $rogramming setu$ can #a2e a number o% $roblems. '#ere "ill be no unique solution i% a constraint is $arallel to t#e ob<ecti2e %unction suc# as( Max = 2.>x + z ,. t . 3x + >z 1> 3x + 2 z 10 : minimum $roblem suc# as Min V = 2 x + 3 y x + y 0 ?x + 2 y 8 x + >y 0 x 3 y 3 can be (ritten a, Max V = 2 x + 3 y x+ y 0 ? x 2 y 8 x >y 0 x 3 y 3

Veri%& t#at at t#e solution V D G0.0) t#e $rimal is * 1.1028? ) 0.>7102C, an! t#e !ual is * 0.0) 0.2>) 0.>0) 0.0) 0.0,.

>8

Managerial Economic 322

Class Notes Houston H. Stokes

-i%%iculties t#at in!icate an error "as ma!e in setting u$ a +; $roblem inclu!e inconsistent constraints? no !easi(le solution and un(ounded solution" Kt is be&on! t#is course to !iscuss t#ese $roblems at t#is time. Summar&( +; anal&sis can be use! to allo" micro t#eor& to be use! to sol2e real "orl! $roblems. Kn t#e oil in!ustr& an! t#e airline in!ustr&) $roblems "it# F t#an >0)000 2ariables are common.

>C