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Managerial Economics: Concepts and Tools

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Managerial Economics
Concepts and Tools
Managerial Economics
Concepts and Tools

Prabhath Jayasinghe
Professor in Business Economics
University of Colombo
Managerial Economics: Concepts and Tools
Prabhath Jayasinghe
ISBN 978-955-1879-01-3

First Published in 2018

Copyright © Prabhath Jayasinghe

All rights reserved. No part of this publication may be reproduced, stored in a retrieval
system, or transmitted, in any form or by any means, electronic, mechanical, photocopying,
telepathically or otherwise, without the prior permission of the publishers.

Cover Design
Sithumini Rathnamalala

Printed by
Neptune Publications (Pvt) Ltd
No. 302, Pahalawela Road,
Pelawatta, Battaramulla, Sri Lanka.

Published by
Expographic Books Pvt Ltd
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 To
Professor W D Lakshman
and
Professor P S M Gunaratne
who believe in pursuing their visions
 Preface

This book is an outcome of teaching in the MBA program of the Faculty of

Management and Finance, University of Colombo for nearly a decade.

It is a fact that different managerial economics textbooks follow different conceptual

approaches. Variation in these different approaches can be viewed in terms of a few
aspects: the topics discussed in the text, the sub-disciplines of economics from which
the concepts are borrowed, the degree of emphasis on quantitative techniques, and the
degree to which the strategic element of decision making is incorporated. The first major
decision that I had to make with regard to writing a textbook in managerial economics
was to select an approach with the most appropriate combination of the above elements.

The second major decision was about presentation of the selected content. In
this regard, there were several characteristics of the intended readers that I had to
consider. Compared to teaching business and management undergraduate students,
I have always faced two difficulties when teaching MBA classes. To follow a proper
managerial economics course, a fair knowledge in the basic concepts of economics,
mathematics and econometrics is a prerequisite. However, given that MBA is an open
postgraduate program in terms of the academic background of students, an MBA class
always comprises a highly diverse group. The students who have an engineering or a
science background may not be familiar with basic economic concepts. Those with a
social science background may not be familiar with basic mathematical or econometric
concepts. Those who come from a humanities background have usually not been
exposed to any of these concepts. Making a teacher’s task even more difficult, there are
also students who had done their Bachelor’s degree in either business administration
or economics and had learned managerial economics earlier! Another difficulty that
I have faced is due to the fact that almost all MBA students are working and they do
their studies on a part time basis. A high percentage of these students work in private
organizations, most of them still in early midcareer positions with a heavy workload.
All this means that they have little time to allocate to studies. Most are reluctant to read
detailed textbooks that run into 700 plus pages.
 In this context, when I started writing this book, in addition to selecting a suitable
conceptual approach, I had two more challenges ahead of me: how to write a textbook
that would cater to all these diverse groups, and how to make it concise and easy to
understand without diluting the theoretical rigour of the lessons. Managerial Economics:
Concepts and Tools, is the result of my attempt at addressing these challenges.

Since Section 1.1 in Chapter 1 explains the conceptual approach I have chosen for
the book, it is not repeated here. In terms of style, throughout the book I have attempted
to be concise and precise in presenting the contents. The book generally follows a less
technical approach with prominence given to economic concepts. However, it does not
disregard the possibility of discussing the same topics in more technical terms. Therefore,
in some chapters, appendices are included introducing mathematical approaches to the
concepts discussed in the chapter. This gives an opportunity for course facilitators to
follow a more quantitative approach with the more mathematically inclined students.

The book also offers assistance to readers who are not familiar with the basics of one
or more of the three areas mentioned earlier. First, basic economic concepts discussed in
the first two chapters may help those who have not previously learned economics as a
subject. Second, for the benefit of those who do not have a math background, Appendix
A presents some basic mathematical concepts that are required. Third, Appendix B helps
those who are not familiar with econometrics with some basic econometric concepts
needed for proper understanding of some of the managerial economics concepts. In
addition, a feature titled ‘Managers’ Corner’ has been included at the end of each chapter
in order to highlight the key points and managerial implications of the chapter contents.

There must be one final word for the users of this book. Irrespective of whatever
the efforts made by an author of a textbook to make the learning task easier, successful
and productive learning requires a high degree of involvement and commitment on the
part of the reader. With such application of yourself, I hope you will be able to get the
maximum out of this book
Bon learning Voyage!
Prabhath Jayasinghe
Brief Contents

Part I: Basic Concepts

1. Introductory Remarks 3
2. The Market Mechanism 19
Part II: Analysis of Demand 57
3. Economists’ View of Consumer Behaviour 59
Appendix to Chapter 3 89
4. Demand Elasticities 93
5. Demand Estimation and Forecasting 117
Part III: Analysis of Production and Cost 161
6. Production 163
Appendix to Chapter 6 187
7. Costs 195
Appendix to Chapter 7 223
Part IV: Analysis of Market Structures 227
8. Introduction to Market Structures 229
Appendix to Chapter 8 248
9. Firms’ Decision Making in Highly Competitive Markets 253
10. A Firm’s Decision Making as a Monopolist 277
11. Firms’ Decision Making in Markets between
Competition and Monopoly 295
12. Game theory and Strategic Decision Making 323
Part V: Other Topics in Managerial Economics 373
13. Decision Making with Asymmetric Information 375
14. Complicated Pricing and Output Decisions 399
15. Government and Business 433
Appendices 459
Appendix A – Some Basic Mathematical Concepts 461
Appendix B – Some Basic Econometric Concepts 473
Appendix C – Statistical Tables 488
References 494
Index 499
Contents
Part I: Basic Concepts 1
Chapter 1 Introductory Remarks 3
1.1 What is Managerial Economics? 3
1.2 Why Learn Managerial Economics 5
1.3 Why Assume Profit Maximization 8
1.4 A Crash Course in Basic Economic Concepts 10
Scarcity, Choice and Opportunity Cost 10
Factors of Production 11
Goods, Services and Products 11
Basic Economic Questions 12
Markets 12
Variables 12
The Role of Assumptions 13
Decisions Based on Marginal Values 14
Responding to Incentives 15
1.5 Overview of the Chapters 16
Chapter 2 The Market Mechanism 19
2.1 Demand 20
Determinants of Demand 20
The Law of Demand 22
Why the Demand Curve Slopes Downward 25
Demand and Quantity Demanded 26
Individual Demand and Market Demand 27
2.2 Supply 27
Determinants of Supply 28
Law of Supply 29
Why the Supply Curve Slopes Upward 31
Supply and Quantity Supplied 32
A Firm’s Supply and Market Supply 33
2.3 Equilibrium 33
2.4 Changes in Equilibrium 37
Changes in Demand 37
Changes in Supply 39
Changes in Demand and Supply in the Same Direction 40
Changes in Demand and Supply in Opposite Directions 41
 2.5 How the Market Mechanism Solves Basic Economic Questions 44
2.6 Social Surplus: Gains from Voluntary Trading 44
2.7 Government Intervention 47
Price Ceilings 48
Price Floors 50
Taxes 51
Subsidies 53
Managers’ Corner 54
Part II: Analysis of Demand 57
Chapter 3 Economists’ View of Consumer Behaviour 59
3.1 Basic Concepts 59
Two Concepts from Marginal Utility Analysis 60
Ordinal Measurability of Utility 62
Indifference Curves 64
Budget Line 68
3.2 How the Consumer Makes the Buying Decision 70
3.3 Deriving the Demand Curve 73
3.4 Income and Substitution Effects 74
3.5 Price Consumption Curve 76
3.6 A Few Applications of the Economists’ View of Consumer
Behaviour 77
Choice between Product Attributes 77
Choice between Price and Quality 79
Choosing the Optimal Portfolio 82
Understanding a Simple Marketing Strategy 84
Managers’ Corner 86
Appendix to Chapter 3 89
Chapter 4 Demand Elasticities 93
4.1 Price Elasticity of Demand 93
Basic Features of the Price Elasticity of Demand 93
Determinants of the Price Elasticity of Demand 98
Price Elasticity of Demand and Revenue 101
Some Applications 106
4.2 Income Elasticity of Demand 108
4.3 Cross Price Elasticity of Demand 111
Managers’ Corner 114
Chapter 5 Demand Estimation and Forecasting 117
5.1 Introduction 117
5.2 Demand Estimation 118
Specifying the Demand Function 119
Collecting Data 124
Estimation 125
Interpreting Results 126
Market-Determined Vs Firm-Determined Prices 126
An Example of Demand Estimation 128
5.3 Demand Forecasting 135
Smoothing Techniques 135
Trend Forecasting 140
Capturing Seasonal Variation 143
Univariate Time Series Models 150
Structural Models 153
Managers’ Corner 156
Part III: Analysis of Production and Cost 161
Chapter 6 Production 163
6.1 Basic Concepts 163
Production Function 164
Variable and Fixed Inputs 165
Short-Run and Long-Run 166
6.2 Production in the Short-Run 167
Total Product, Marginal Product and Average Product 167
Three Stages of Production 170
Why Increasing and Decreasing Returns 171
Where Does a Rational Producer Operate? 172
6.3 Production in the Long-Run 175
Isoquants 175
Isocost Curve 179
How Producers Find the Optimal Combination of Inputs 181
Expansion Path 183
Different Production Decisions 184
Managers’ Corner 185
Appendix to Chapter 6 187
Chapter 7 Costs 195
7.1 Basic Concepts 195
 Market-Supplied Resources and Owner-Supplied Resources 195
Explicit Costs and Implicit Costs 197
Economic Profits and Accounting Profits 197
Variable and Fixed Costs 199
7.2 Short-Run Costs 200
Short-Run Cost Concepts 200
Relationship between Various Short-Run Cost Concepts 204
7.3 Relationship between Short-run
Production and Cost Concepts 206
Average Product and Average Variable Cost 207
Marginal Product and Marginal Cost 207
All Four Average and Marginal Concepts Taken Together 208
Total Product and Total Variable Cost 209
7.4 Long-Run Costs 211
7.5 Factors that may Influence Long-Run Cost 213
Economies and Diseconomies of Scale 213
Economies of Scope 216
Purchasing Economies 216
Learning Curve Economies 217
7.6 Relationship between Long-Run and Short-Run Average Costs 218
Managers’ Corner 220
Appendix to Chapter 7 223
Part IV: Analysis of Market Structures 227
Chapter 8 Introduction to Market Structures 229
8.1 Which Profit to Maximize? 230
8.2 Marginal Analysis of Profit Maximization 232
8.3 Market Power and Barriers to Entry 236
What Gives Rise to Market Power? 236
Economies of Scale 238
Absolute Cost Advantages 238
Brand Loyalty 239
Advertising 239
Consumer Lock-in 239
Network Externalities 240
Warranties 240
Barriers Created by the Government 240
Barriers to Exit and Sunk Costs 241
 Strategic Entry Deterrence 241
A Final Word on Entry Barriers 241
8.4 Market power and Product Differentiation 242
8.5 Classifying Market Structures 243
Managers’ Corner 247
Appendix to Chapter 8 248
Chapter 9 Firms’ Decision Making in Highly Competitive Markets 253
9.1 Features of a Perfectly Competitive Market 253
9.2 Maximizing Profit in the Short-run 255
Making the Output Decision 255
The Highest Profit or the Highest Profit Margin? 265
Relaxing the Representative Firm Assumption 266
Deriving the Firm’s Supply Curve 267
9.3 Maximizing Profit in the Long-run 268
Making the Output Decision 268
Expansion of Industries in the Long-Run 271
Managers’ Corner 274
Chapter 10 A Firm’s Decision Making as a Monopolist 277
10.1 Features of a Monopolistic Market 277
10.2 A few Measures of Market Power 279
10.3 Maximizing Profit in the Short-run 281
10.4 Maximizing Profit in the Long-Run 286
10.5 Natural Monopolies 287
10.6 Does a Monopolist have a Supply Curve? 289
10.7 Maximizing Profit, Sales or Revenue? 290
10.8 Costs and Benefits of Monopoly 291
Managers’ Corner 292
Chapter 11 Firms’ Decision Making in Markets between
Competition and Monopoly 295
11.1 Monopolistic Competition 296
Features of Monopolistic Competition 296
Maximizing Profits in the Short-Run and the Long-Run 298
Relevance of the Profit Maximizing Rule 302
Are Entry Barriers Absent Altogether? 303
Excess Capacity 304
11.2 Oligopoly 306
Features of Oligopoly 306
 Kinked-Demand Curve Model 310
Cartels 311
Price Leadership 313
Revenue Maximization Model 314
Contestable Markets and Entry Deterrence 315
A Common Feature of the Oligopolistic Models Discussed 317
Edgeworth Model of Duopoly 317
Managers’ Corner 319
Chapter 12 Game theory and Strategic Decision Making 323
12.1 Introduction 323
12.2 Simultaneous Decision Making Situations 326
Prisoners’ Dilemma 327
Firms’ Dilemma 329
Decision Making Situations with One Dominant Strategy 331
Nash Equilibrium 333
Decision Making Situations with Multiple Nash Equilibria 337
Absence of Nash Equilibrium 339
Best Response Curves 340
12.3 Sequential Decision Making Situations 342
Introducing Promotions 344
Entry Deterrence 346
First-Mover and Second-Mover Advantages 347
12.4 Strategic Moves 350
Commitments 350
Threats 353
Promises 355
12.5 Repeated Decision Making Situations 358
12.6 Cooperative Decision Making Situations 362
12.7 A Final Word 365
Managers’ Corner 366
Part V: Other Topics in Managerial Economics 373
Chapter 13 Decision Making with Asymmetric Information 375
13.1 Introduction 375
13.2 Adverse Selection 377
The Lemons Problem 378
Signaling 380
Screening 383
 13.3 Moral Hazard 385
Moral Hazard in Insurance 385
Principle-Agent Problem 391
13.4 Other Consequences of Asymmetric Information 392
Lower Quality Products 392
Market Power due to Lack of Information 393
More Complicated Decision Making Situations 394
Managers’ Corner 396
Chapter 14 Complicated Pricing and Output Decisions 399
14.1 Introduction 399
14.2 Selling in Different Markets at Different Prices 400
First Degree Price Discrimination 401
Second Degree Price Discrimination 402
Third Degree Price Discrimination 405
14.3 Producing in Two Plants and Selling in One Market 407
14.4 Producing Substitutes or Complements in Consumption 410
14.5 Producing Substitutes in Production 411
14.6 Producing Complements in Production 415
14.7 Transfer pricing 417
Without External Markets 417
With External Markets 418
14.8 Peak-Load Pricing 420
14.9 Bundling 421
Pure Bundling 422
Mixed Bundling 426
14.10 Non-Marginal Pricing 427
Managers’ Corner 429
Chapter 15 Government and Business 433
15.1 Introduction 433
15.2 Policies to Handle Externalities 436
Imposing Taxes on External Costs 439
Using Property Rights 440
Offering Subsidies for External Benefits 441
Encouraging Merit Goods and Discouraging Demerit Goods 442
15.3 Provision of Public Goods 443
15.4 Competition Policy 444
 Monopoly Policy 446
Restrictive Practices Policy 447
Merger Policy 448
Consumer Affairs Authority in Sri Lanka 448
A Remark on Natural Monopolies 449
15.5 Policies to Handle Asymmetric Information 449
15.6 R&D Related Policies 451
15.7 Industrial Policy 451
15.8 Other Government Policies Related to Business 453
Demand Management Policies 453
Supply-Side Policies 454
15.9 Government Failure 455
Managers’ Corner 456
Appendices 459
Appendix A – Some Basic Mathematical Concepts 461
Appendix B – Some Basic Econometric Concepts 473
Appendix C – Statistical Tables 488
References 495
Index 499


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