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MANAGERIAL ECONOMICS
TEXTBOOK NOTES Demand Theory
Elements effecting demand: o Price Price of substitute products o Price of complementary products o o State of the economy Disposable personal income o Advertising expenditures o o Etc - Managers want to understand the impact of exogenous (out of control) variables on the product, so that he or she can make decisions on endogenous variable and plan a reactive strategy to changes in exogenous variables - Elasticity tells us how percentages of quantity change given a small percentage change in one of the listed variables o When the changed variable is the firm’s price, the elasticity also tells us how total revenue changes - Having estimates of elasticities can help managers make decisions about how to price their products and how to anticipate quantity and revenue changes when uncontrollable variables change -
The Market Demand Curve -
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Market demand schedule: a table that shows the total quantity of the good that would be purchased at
each price Market demand curve: a plot of the market demand schedule on a graph quantity of the good demanded per unit of time Horizontal axis — quantity Vertical axis — price price per unit of the good Factors effecting shape and curve of market demand curve: Most demand curves slop downward to the right o q uantity of laptops demanded increases as the price falls In the laptop example, the quantity o Any demand curve pertains to some time period, and its shape and position depend on the length and other characteristics of this period If consumers show an increasing preference for a product, p roduct, the demand curve shifts to the right o At each price, the consumer wants to buy more than they did previously, and for each quantity, consumers are willing to pay a higher hi gher price Opposite if there is a decrease in demand Level of consumer income o Depending on the product, the curve shifts to the right or left if the per capita income rises in the laptop example, an increase in per capita income shifts the curve to the right level of other prices o in the laptop example, the quantity of laptops demanded would increase if the price of software decreased size of the population in the relevant market o an increase in population could mean an increase in demand
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Industry and Firm Demand Functions -
market demand function (for a product): relationship between the quantity demanded o f the product
and the various factors that influence this quantity -
Quantity demanded of good X= Q= f (price of X, incomes of consumers, tastes of consumers, prices of other goods, population, advertising expenditures, etc)
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more specifically
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Q= b1P + b2 I + b3S + b4 A, where Q is the number of laptop computers demanded in a particular year, P
is the average price of laptops that tha t year, I is per capita disposable income, S is the average price, and an d A is the amount spent on advertising adv ertising by producers of laptops assumption that this is a linear equation necessary for managers and analysts to obtain numerical nu merical estimates of the values of b if Q= -700P + 200I + 500S + 0.01A, then a $1 increase in the price of a laptop results in a decrease in the quantity demanded of 700 units per year the market demand curve shows the relationship between Q and P when all other relevant variable are held constant
The Price and Elasticity of Demand -
for some goods, a small change in price results in a big change in quantity demanded, while for other goods, a big change in price results in a small change in quantity demanded price elasticity of demand: the percentage change in quantity demanded resulting from a 1 percent change in price a measure to indicate how sensitive quantity demanded is to changes in price o
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E.g. suppose a 1% reduction in the price of cotton shirts results in a 1.3 percent increase in the quantity demanded in the United States. If so, the price elasticity of demand for cotton shirts is -1.3 The price of elasticity of demand generally varies from one point to another on a demand curve For instance, the price of elasticity of demand may be higher in absolute value when the price of cotton shirts is high than when it is low Price elasticity of demand for a product must lie between b etween zero and negative infinity If it is zero, it is a vertical line and it is unaffected by price unlimited nlimited amount If it is negative infinity, the demand curve is a horizontal line and an u can be sold at a particular p articular price
Point and Arc Elasticities -
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If we have a market demand schedule showing the quantity of a commodity demanded in the market at various prices, how can we estimate the price p rice elasticity of market demand? Let ∆P be a change in the price of a good and ∆Q be the resulting change in its quantity demanded. If P is very small, we can compute the point elasticity of demand:
To avoid large differences in results, compute the arc elasticity of demand, which uses the average av erage values of P and Q:
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Industry and Firm Demand Functions -
market demand function (for a product): relationship between the quantity demanded o f the product
and the various factors that influence this quantity -
Quantity demanded of good X= Q= f (price of X, incomes of consumers, tastes of consumers, prices of other goods, population, advertising expenditures, etc)
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more specifically
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Q= b1P + b2 I + b3S + b4 A, where Q is the number of laptop computers demanded in a particular year, P
is the average price of laptops that tha t year, I is per capita disposable income, S is the average price, and an d A is the amount spent on advertising adv ertising by producers of laptops assumption that this is a linear equation necessary for managers and analysts to obtain numerical nu merical estimates of the values of b if Q= -700P + 200I + 500S + 0.01A, then a $1 increase in the price of a laptop results in a decrease in the quantity demanded of 700 units per year the market demand curve shows the relationship between Q and P when all other relevant variable are held constant
The Price and Elasticity of Demand -
for some goods, a small change in price results in a big change in quantity demanded, while for other goods, a big change in price results in a small change in quantity demanded price elasticity of demand: the percentage change in quantity demanded resulting from a 1 percent change in price a measure to indicate how sensitive quantity demanded is to changes in price o
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E.g. suppose a 1% reduction in the price of cotton shirts results in a 1.3 percent increase in the quantity demanded in the United States. If so, the price elasticity of demand for cotton shirts is -1.3 The price of elasticity of demand generally varies from one point to another on a demand curve For instance, the price of elasticity of demand may be higher in absolute value when the price of cotton shirts is high than when it is low Price elasticity of demand for a product must lie between b etween zero and negative infinity If it is zero, it is a vertical line and it is unaffected by price unlimited nlimited amount If it is negative infinity, the demand curve is a horizontal line and an u can be sold at a particular p articular price
Point and Arc Elasticities -
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If we have a market demand schedule showing the quantity of a commodity demanded in the market at various prices, how can we estimate the price p rice elasticity of market demand? Let ∆P be a change in the price of a good and ∆Q be the resulting change in its quantity demanded. If P is very small, we can compute the point elasticity of demand:
To avoid large differences in results, compute the arc elasticity of demand, which uses the average av erage values of P and Q:
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Using the Demand Function to Calculate the Price and Elasticity of Demand -
The price elasticity of demand is
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If the demand curve is linear, the price elasticity approaches zero as P gets very small and approaches negative infinity as Q gets very small
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Price Elasticity and Total Money Expenditure -
In simpler words, demand for a product pr oduct can be said to be very inelastic if consumers will pay almost any price for the product, and very elastic if consumers consumer s will only pay a certain price, or a narrow range of prices, for the product. Inelastic demand means a producer can raise prices without much hurting demand for its product, and elastic demand means that consumers are sensitive to the price at which a product is sold and will not buy it if the price rises by what they consider to o much. o Drinking water is a good example of a good that has inelastic chara cteristics in that people will pay anything for it (high or low prices with relatively equivalent quantity demanded), so it is not elastic. On the other hand, demand for sugar is very elastic because as the price of sugar increases, there are many substitutions which consumers may switch to.
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When the demand for the product price is elastic, the price elasticity of demand is less than -1. The total amount of money spent by consumers on the product equals the quantity demanded times the price per unit. Here, is the price is reduced; the percentage increase in quantity demanded is greater than the percentage reduction in price. A price reduction must lead to an increase in the total amount spent by consumers on the commodity. Similarly, if the demand is price elastic, a price increase leads to a reduction in the amount of money spent on the commodity. If the demand for the product is price p rice inelastic, the price elasticity of demand is greater than -1. A price decrease leads to a reduction in the total amount spent on the commodity and a price increase leads to an increase in the amount spent on the commodity. If the demand is of unitary elasticity, the price p rice elasticity of demand equals -1. An increase or decrease in price has no effect on the amount spent on the commodity.
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Total Revenue, Marginal Revenue, and Price Elasticity -
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To its producers, the total amount of money spent on a product equals equ als their total revenue Suppose the demand curve for a firm’s product is linear P = a - bQ Firm’s total revenue equals TR = PQ = (a-bQ)Q =aQ – bQ2 Marginal revenue
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Comparing the demand curve and the marginal revenue curve, we see that both have the same intercept on the vertical axis (this intercept being a) but the marginal revenue curve has a slope that is twice that of the demand curve The price elasticity of demand
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Therefore, whether is greater than, equal to, or less than -1 depends on whether Q is greater than, equal to or less than a/2b Elastic if Q a/2b Unitary elasticity if Q = a/2b Inelastic if Q a/2b At quantities where marginal revenue is positive, increase in quantity result in higher total revenue At quantities where marginal revenue is negative, increases in quantity result in lower total revenue This is expected because marginal revenue is the derivative of total revenue with respect to quantity So if marginal revenue is positive (negative), increases in quantity must increase (decrease) total o revenue At quantities where price is elastic, marginal revenue is positive At quantities where it is of unitary elasticity, marginal revenue is zero At quantities where price is inelastic, marginal revenue is ne gative
-1, marginal revenue must be positive -1, marginal revenue must be negative = -1, marginal revenue must be zero
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Using Price Elasticity of Demand: Application to Philip Morris -
1993 Philip Morris cut cigarette prices by 18% Quantity sold increase by 12.5% Profits fell by 25% as a result of bad pricing strategy Estimate of the elasticity of demand (%∆Q/∆P) is 12.5%/-18%=-0.694… it is inelastic o o Cutting the price when demand is inelastic decreases total revenues Since output increased by 12.5%, total cost increased o
Using Price Elasticity of Demand: Public Transit -
The price elasticity for public transportation service in the US is about -0.3 (fairly inelastic) All transit systems in the US lose money and keeping the deficit under control is difficult because of subsidizers How does the general manager of a transit system raise needed revenues? With an inelastic demand, raising fares increases revenues o o Raising fares decreases ridership, hence, decreasing the cost
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Determinants of the Price Elasticity of Demand -
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Price elasticity depends heavily upon the number and closeness of the substitutes available o If a product has a lot of close substitutes, its demand is likely to be price elastic… consumers will choose the cheapest choice As the definition of a product becomes narrower and more specific, the product would be o expected to have more close substitutes, and its demand would be more price elastic The demand for a particular brand of gasoline is likely to be more price elastic than the overall demand for gasoline The price elasticity of demand for a product may depend on the importance of the product on the consumers’ budgets, e.g. the demand for rubber bands may be quite small since the consumer spends a small fraction o of his or her income on such goods o e.g. for products that bulk larger in the t ypical consumer’s budget, like major appliances, the elasticity of demand may tend to be higher, since consumers may be more conscious of and influenced by price changes in the case of goods that require larger outlays the price elasticity of demand for a product is likely to depend on the length of the period to which the demand curve pertains demand is likely to be more elastic or less inelastic over a long period of time than over a short o period of time, because the longer the period of time, the easier it is for consumers and firms to substitute one good for another e.g. if the price of oil should decline relative to other fuels, the consumption of oil in that day o after the decline would probably increase very little. Over a period of several years, people would have an opportunity to take account of the price decline in choosing the type of fuel to be used in new houses, etc. in the longer period of several years, the price decline would have greater effect on the consumption of oil than in the shorter period of one day
Uses of the Price of Elasticity and Demand -
managers pay close attention to the price elasticity of demand of their products because it is useful when it comes to the pricing of their goods no manager interested in maximizing profit will set the price at a point where the demand for his or her product is price inelastic marginal revenue must be negative if demand of price is inelastic o o if marginal revenue is negative, a firm can increase its profit by raising its price and lowering its output because its total revenue will increase if it sells less (this is what it means to say that marginal revenue is negative
Price Elasticity and Pricing Policy -
marginal revenue equals marginal cost if a firm is maximizing profit, which means that if
Then, So,
When solving for P,
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suppose the marginal cost of a shirt is $10 and its price elasticity of demand equals -2, the optimal price is
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the central point to note is that the optimal price depends heavily on the price elasticity of demand holding constant the value of marginal cost, a product’s optimal price is inversely related to its price elasticity of demand therefore, if the shirt’s price elasticity of demand were -5 rather than -2, its optimal price would be
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The Income Elasticity of Demand -
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a factor besides price influencing demand is the level of money income among the consumers in the market Income elasticity of demand: the percentage change in quantity demanded resulting from a 1 percent change in consumers’ income. It equals
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Where Q is quantity demanded and I is consumers’ income For some products, the income elasticity of demand is positive, indicating that increases in consumers’ money income result in increases in the amount of the good consumed o E.g. luxury items like gourmet food are expected to have positive income elasticities Other goods have negative income elasticities, indicating that increases in money income result in decreases in the amount of the good consumed o E.g. inferior grades of vegetables and clothing might hav e negative income elasticities In calculating the income elasticity of demand it is assumed that prices of commodities are held constant E.g. if the income elasticity of demand for milk is 0.5, it means that a 1% increase in disposable income is associated with about a 0.5% increase in the quantity demanded for milk E.g. if the income elasticity of demand for bread is -0.17, it means that a 1% increase in disposable income is associated with about a 0.17% decrease in the quantity demanded for bread
Using the Demand Function to Calculate the Income Elasticity of Demand -
Calculating income elasticity of demand Demand function for good X is
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Q is the quantity demanded of good X, Px is the price of the good X, Py is the price of good Y and I is per capita disposable income The income elasticity of demand is
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()( ) ( ) ()
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If I=10,000 and Q=1,600
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The income elasticity of demand equals 0.25, which means that a 1% increase in per capita disposable income is associated with a 0.25 percent increase in the quantity demanded of good X
Cross Elasticities of Demand -
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Price of other commodities also affects demand When the price of the product is held constant and allowing the prices of other products to vary shows important effects on the quantity demanded o By observing these effects we can classify commodities as substitutes or complements and we can measure how close the relationship is Cross elasticity of demand: the percentage change in the quantity demanded of good X resulting from a 1 percent change in the price of good Y
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X and Y are substitutes if the cross elasticity of demand is positive o E.g. an increase in the price of wheat when the price of corn remains constant tends to increase the quantity of corn demanded. is positive and they are substitutes X and Y are complements if the cross elasticity of demand is negative o E.g. an increase in the price of software may tend to decrease the purchase of personal computers when the price of personal computer remains constant. is negative and they are complements
The Advertising Elasticity of Demand -
Advertising elasticity: the percentage change in the quantity demanded of the product resulting from a
1% change in advertising expenditure
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The Constant-Elasticity Demand Function -
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A mathematical form frequently used is constant-elasticity demand function If quantity demanded Q depends only on the product’s price P and consumer income I, this mathematical form is
An important property of this demand function is that the price elastic of demand equals – b1, regardless of the value of P or I o To see this let us differentiate Q with respect to price
Therefore
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()() ( )()
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The price elasticity of demand equals – b1, a constant whose value does not depend on P or I Differentiate Q with respect to income
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Therefore
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Income elasticity of demand equals b2, another constant whose value does not depend on P or I Constant-elasticity demand function is often used by managers and managerial economists: o In contrast to the linear demand function, this mathematical form reco gnizes that the effect of price on quantity depends on the level of the price The multiplicative relationship is often more realistic than the additive one The constant-elasticity demand function is relatively easy to estimate o If we take logarithms of both sides,
Since the equation is linear in logarithms, the parameters (a, b1 and b2) can readily be estimated by regression analysis
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Consumer Behaviour and Rational Choice -
We assume the consumer is rational and wishes to maximize his or her well-being Well being is a function of the goods one consumes The amount of goods he or she can consume is constrained by income A consumer’s demand curve is derived from the rational behavior of an individual who maximizes his or her well-being given the prices of goods, personal tastes and preferences for goods and income
Indifference Curves -
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Here we only look at food and clothing as commodities Indifference curve: contains point representing market baskets among which the consumer is indifferent Certain market baskets (certain combinations of food and clothing) are equally desirable for a consumer The consumer may be indifferent between a market basket containing 50 pounds of food and five o pieces of clothing and a market basket containing 100 pounds of food and 2 pieces of clothing (2 different points on a curve) When all of the points are connected, we get a curve that represents market baskets that are o equally desirable to the consumer Important things to note about any consumer’s indifference curve: o A consumer has many indifference curves, not just one We will assume, however, that consumers prefer market baskets on h igher indifference curves than markets on lower indifference curves because consumers will prefer to more food and clothing Every indifference curve must slope downward and to the right, so as long as the consumer o prefers more of each commodity to less If one market basket has more of one commodity than a second market basket, it was have less of the other commodity, assuming that the two market baskets yield equal satisfaction to the consumer Indifference curves cannot intersect o If they did, it would contradict the assumption that more of a commodity is preferred to less
The Marginal Rate of Substitution -
Different consumers value different things. One consumer might be willing to give up a lot for one more unit of a certain commodity, while another might give up very little Marginal rate of substitution: number of units of good Y that must be given up if the consumer, after receiving an extra unit of good X, is to maintain a constant level of satisfaction o The larger the number of units of good Y that the consumer is willing to give up to get an extra unit of good X, the more important good X is, relative to good Y, to the consumer To measure the marginal rate of substitution, take the slope of the consumer’s indifference curve o and multiply this slope by -1 This gives us the number of units of good Y that the consumer is willing to give up for an extra unit of good X High marginal rate of substitution indifference curves are steep, slope is large Low marginal rate of substitutionindifference curves are flat, slope is small
The Concept of Utility -
Indifference curves are representative of a consumer’s tastes
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Given all the indifference curves of a consumer we attach a number, a utility to each of the market baskets that might confront him or her The utility indicates the level of enjoyment or preference attached by this consumer to this o market basket Summarized preference ranking of market baskets Since all market baskets in a given indifference curve yield the same amount of satisfaction, they would have the same utility Market baskets on higher indifference curves would have higher utilities than market baskets on lower indifference curves
The Budget Line -
The consumer would like to maximize his or her utility, which means that he or she wants to achieve the highest possible indifference curve Whether a particular indifference curve is attainable depends on the consumers income and commodity prices Budget line: shows the market baskets that he or she can purchase, given the consumer’s income and prevailing market prices If one makes $600 per week and a pound of food costs $3 and a piece of clothing $60, there are o multiple combinations of food and clothing the con sumer can purchase… this line when graphed is the budget line o
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Where Y is the amount of food she buys, X is the amount of clothing she buys, Pf is the price of food, Pc is the price of clothing, and I is her income The left-hand side of the equation represent what she spends on food and clothing and here we assume she saves nothing Rearrange to get the equation of the budget line
A shift occurs in the consumers budget line if changes occur in the consumer’s money income or commodity prices Increase in income means the budget line rises and a decrease in income means it falls Moves parallel to the original line because change in income doesn’t alter slope Change in price of commodity alters the slope Slope of the budget line equals – Pc/Pf
The Equilibrium Market Basket -
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Given the consumer’s indifference curves and bud get line, we are in a position to determine the consumer’s equilibrium market basket… the basket that: The consumer can purchase o Yields the maximum utility o Graph the consumer’s indifference curves and budget line on the same graph Choose the market basket on the budget line that is on the highest indifference curve… the equilibrium market basket
Maximizing Utility: A Closer Look -
Since the slope of the indifference curve equals -1 times the marginal rate of substitution of clothing for food and the slope of the budget line is – Pc/Pf,
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Where MRS is the marginal rate of substitution of clothing for food o E.g. if the marginal rate of substitution is 4, the consumer is willing to give up 4 pounds of food to obtain one more piece of clothing Pc/Pf is the rate at which the consumer is able to substitute clothing for food o E.g. if Pc/Pf is 3, he or she must give up 3 pounds of food to obtain one more piece of clothing This equation is saying: the rate at which the consumer is willing to substitute clothing for food (holding satisfaction constant) must equal the rate at which he or she is able to substitute clothing for food. Otherwise it is always possible to find another market basket that increases satisfaction. And this means that the present market basket is not the one that maximizes consumer satisfaction. When the marginal rate of substitution (4) exceeds the price ratio (3), she can increase satisfaction by substituting clothing for food If the marginal rate of substitution is less than the price ratio, she can increase satisfaction by substituting food for clothing When the marginal rate of substitution equals the price ratio, her market basket maximizes her utility
Corner Solutions -
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Budget line will not always be tangent to the indifference curve Consumers may consume none of some goods because even tiny amounts of them are worth less o to the consumer than they cost E.g. even if one can afford Beluga caviar, she may not buy it In figure 4.8, she would maximize her utility by choosing a market basket that co ntains all pizza and no caviar o It maximizes her utility because it is on a higher indifference curve than any other market basket on the budget line It is a corner solution, in which the budget line touches the highest achievable indifference o curve along an axis
Representing the Process of Rational Choice -
The economist’s model of consumer behavior can help people and organizations where to allocate their funds This is much more than a theory of consumer behavior; it is a theory of rational choice
Deriving the Individual Demand Curve -
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A consumer’s individual demand curve shows how much he or she would purchase of the good in question at various prices of this good (when the other prices and the consumer’s income are held constant) If you look at a certain consumer’s individual demand curve for food, you would find two different market baskets if the price of food changed from $3 per pound to $6 per pound To obtain more points on her individual demand curve for food, allow the price of food to vary o and hold the price of clothing and her income constant The individual demand curve for food shows the amount of food she would buy at various prices
Deriving the Market Demand Curve -
to derive the market demand curves, we obtain the horizontal sum of all of the individual demand curves to find the total quantity demanded in the market at a certain price, we add up the quantities o demanded by all the individual consumers at that price
Consumer Surplus
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consumer’s reservation price: the price value for each number of units demanded consumer surplus: the difference between what an individual is willing to pay and what that individual
has to pay for a good it is the actual price paid subtracted from the reservation p rice o when a market price is determined, the last individual/set of individuals to purchase the good is the individual whose reservation price just equals the market price all other purchasers have reservation prices which exceeds the market price and have therefore ―gained‖ consumer surplus since they were willing to pay more for the good than they actually did when you total all the individuals’ consumer surpluses, we h ave the consumer surplus for the good at that price consumer surplus is the area below the demand curve but above the price charged o
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Introduction Introduction -
managerial economics uses formal models to analyze mana gerial actions and their effect on firm performance differs significantly from microeconomics focus of analysis is different many times the analysis if microeconomics is at market level, not firm level o the focus of managerial economics is on behaviour managerial describes behaviour as micro would describe the environment o
The Theory of the Firms -
little variance in the goals of managers from around the globe choose actions they believe will increases the value of their organization managers in profit-oriented organizations try to increase the net present val ue of expected future cash flows
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where is the expected profit in year t, i is the interest rate, and t goes from1 (next year) to n (the last year) what complicates the managerial life or the operating constraints managers face most resources are scarce o o legal or contractual o must pay taxes in accord with federal, state and local laws managers must comply with contract with customers and suppliers o
What is Profit? -
Profit: when economists speak of profit, they mean profit over and above what the owner’s labour and
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capital employed in the business could earn elsewhere Accountant is concerned with controlling the firm’s day to say operations Economist is concerned with decision making and rational choice among strategies
Reasons for the Existence of Profit -
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Fertile profit-generating areas used by managers risk, operation, power Product innovations push the frontier relative to existing products in terms of functionality, technology and style E.g. iPhone, 787 Dreamliner from Boeing (plane) o A hallmark of managerial decision making is the need to make risky choices Profit is the reward for those who bear risk well o Managers also earn profit by exploiting market inefficiencies o
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Good managers understand how to create inefficiencies to give their firm a sustainable competitive advantage
Managerial Interests and the Principal-Agent Problem -
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Managers have goals besides a profit that might enhance a firm’s long term value i.e. building market share, establishing a brand name o besides long-term value might be increasing managerial compensation some managers take the selfish route when makin g the choice to maximize a firm’s value or increase the payoffs to a single manager or management team self-interest is of growing importance because the separation between ownership and management of firms is continuing to increase on a global scale owners have little detailed knowledge on the firm’s operation o o lots of freedom to managers firm behaviour may be driven by nonowner management groups o principal agent problem: when managers pursue their own objectives, even though this decreases, the profit of the owners managers are shareholders or principals o to deal with this problem, owners often use contracts to converge their preferences and those of their agents o E.g. rewards for firm success or ability to purchase shares at less than market price
Demand and Supply -
Market: a group of firms and individuals that interact with each other to buy or sell a good
A market exists when there is an economic exchange... multiple parties enter binding contracts All markets follow general principles
The Demand Side of a Market -
Every market has demanders and suppliers Manager needs to know how potential customers value a product or service and must be able to estimate the quantity or goods demanded at various prices One goal of a manager is to maximize a firm’s profit Revenue is the number of units sold (Q) multiplied by the price (P)... TR=P x Q Association of price and quantity demanded depends on many variables income, taste, price of substitutes and complements, advertising dollars, product quality, governmental fiat Demand function: quantity demanded relative to price, holding other po ssible influences constant Demand curves for commodities usually slop downward to the right o An increase in a good’s price results in a smaller quantity demanded Influences like tastes and incomes are held constant, but if they were to change then the demand curve would shift
The Supply Side of a Market
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Graph shows how many units of a commodity sellers will offer at any price Higher prices provide an incentive to suppliers to p roduce more of the good to sell We assume that the cost of technology (if lower cost production technology is developed) is held constant, or else supply curve shifts Supply curve for a product is affected by the cost of production inputs When production costs go down, managers realize lower production costs and are willing to o supply a given amount at a lower price Decrease in cost of inputs causes supply curve to shift to the right Increase in costs of inputs causes supply curve to shift to the left
Equilibrium Price -
We can determine market behaviour at various prices when we overlap supply and demand curves You can see areas of excess supply and demand A price is sustainable when the quantity demanded equals the quantity supplied at that price Equilibrium: when the market is in balance because everyone who wants to purchase the good can and every seller who wants to sell the good can Where the two curves intersect o
Actual Price -
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In general economists assume the actual price approximates the equilibrium price, which seems reasonable because the actual forces at work tend to push the actual price toward the equilibrium price Therefore, if conditions remain fairly stable, the actual price should move toward the equilibrium o price As long as the actual price is greater than the equilibrium price, there is down ward pressure on price As long as the actual price is less than the equilibrium price, there is upward pressure on p rice o Always a tendency for the actual price to move toward the equilibrium price Speed varies Invisible hand: when no governmental agency is needed to induce producers to drop or increase their prices
What if the Demand Curve shifts? -
Supply and demand curves are not static Shift in reaction to changes in the environment o Managers need to anticipate and forecast changes in price A rightward shift in the demand curve results in an increase in equilibrium price A leftward shift in the demand curve results in a decrease in the equilibrium price
What if the Supply Curve shifts? -
A leftward shift in the supply curve results in an increase in the equilibrium price A rightward shift in the supply curve results in a decrease in the equilibrium price
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Optimization Techniques -
Virtually all the rules we study about optimal behaviour of firms and individuals are driven by the concept of marginal analysis Differentiation tells us what changes will occur in one variable (the dependent variable) when a small (marginal) change is made in another variable (the independent variable) We also look at constrained optimization Maximization and minimization i soften subject to constraints o
Functional Relationships -
Relationship between the number of units sold and the price... Q=f(P) Number of units sold is the dependent variable and price is the independent variable o How the number of units depends on price... Q=200-5P
Marginal Analysis -
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Marginal value: the change in the dependent variable associated with a one-unit change in a particular
independent variable Marginal profit: the change in the total profit associated with a one-unit change in output E.g. if output increases from 0 to 1 unit, total profit increases from $0 to $100, a $100 increase. Therefore, the marginal profit equals $100 if the output is one unit Central point about a marginal relationship of this sort the dependent variable, in this case total profit, is maximized when its marginal value shifts from positive to negative This is therefore useful to managers o Average profit: the total profit divided by output o if managers want to maximize profit, they should not choose the output level with the highest average profit... want to pick the one where marginal profit shifts from positive to negative it is important to understand the relationship between average and marginal values o marginal value represents the change in the total average value must increase if the marginal value is greater than the average value o average value must decrease if the marginal value is less than the average value o
Relationships among Total, Marginal and Average Values -
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the relationship between average profit and output is relatively simple to derive Take any output level. At this output level, the average profit equals the slope of the straight line o from this origin to the point Deriving the relationship between marginal profit and outpu t is also relatively simple Take and output level. At this output level, the marginal profit equals the slope if the tangent to o the total profit curve Marginal profit is defined as the extra profit resulting from a very small increase in output If we’re tr ying to find the marginal profit, we are finding the slop between two points. If these o points are extremely close together, the slope of the tangent is a good estimate of the slop between these two close points Sometimes you are given the average profit curve but not that total profit curve
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Total profit equals average profit times output Pg. 603 paragraph 2 If the slope of the total profit curve increases as we move away from the origin, the marginal profit increases as the output level rises o Because marginal profit equals the slope of this tangent, it must increase as the output level rises from 0 If the slope of the total profit curve decreases as th e input level increases, the marginal profit decreases and the output level rises The average profit curve must be rising if it is below the marginal profit curve, and it must be falling if it is above the marginal profit curve o
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The Concept of a Derivative -
If Y is the dependent variable and X is the independent variable... Y=f(X) The marginal value of Y can be estimated by
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The relationship between Y and X can be represented in a straight line
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The value of
o
is related to the steepness or flatness of a curve
If the curve is steep small change in X results in a large change in Y
is relatively large If the curve is flat large change in X results in a small change in Y is relatively small The derivative of Y with respect to X is defined as the limit of as delta X approaches zero
o
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Graphically, the derivative of Y with respect to X equals the slope of the curve showing Y (on the vertical axis) as a function of X (on the horizontal axis)
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Clearly, in the limit, as ∆X approaches zero, the ratio
is equal to the slope of the line
How to Find a Derivative Derivatives of Constants - Always zero Derivatives of Powers Derivatives of Sums and Differences Derivatives of Products - The derivative of the product of two terms is equal to the sum of the first term multiplied by the
derivative of the second plus the second term times the derivative of the first Derivatives of Quotients
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The derivative of the quotient of two terms equals the denominator times the derivative o f the numerator minus the numerator times the derivative of the denominator
( )()
Derivatives of a Function of a Function (the Chain Rule) - Suppose Y=f(W) and W=g(X)... the derivative of Y with respect to X is...
Using Derivatives to Solve Maximization and Minimization -
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the central point is that a maximum or minimum point can only occur onl y if the slope of the curve showing Y on the vertical axis and X on the horizontal axis equals zero... slope of the tangent on this point equals 0 to find the value of X that maximizes or minimizes Y, we must find the value of X where this derivative equals zero the second derivative measures the slope of the curve showing the relationship between dY/dX second derivative is important because: always negative at a point of maximization o always positive at a point of minimization o
Marginal Cost Equals Marginal Revenue and the Calculus of Optimization -
for profit maximization, set marginal cost equal to marginal revenue as long as the slope of the total revenue curve (which equals marginal revenue) exceeds the slope of total cost curve (which equals marginal cost), profit will continue to rise as output increases when these slopes become equal (when marginal revenue equals marginal cost) profit will no o longer rise but be at a maximum
Partial Differentiation and the Maximization of Multivariable Functions -
in many cases, a variable depends on a number of other variables
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to find the value of each independent variables that maximizes the dependent variable, we need to know the marginal effect of each independent variable on the dependent variable, holding constant the effect of all other independent variables here we need to know the marginal effect of Q1 on when Q2 is held constant and we need to know the marginal effect of Q2 on when Q1 is held constant we obtain the partial derivative of with respect to Q1 and the partial derivative of with respect to Q2 set the partial derivatives equal to 0 o
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Constrained Optimization -
maximize/minimize with constraints, such as Q1+Q2 cannot equal less than 30
Lagrangian Multipliers -
do we need to know this?
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Comparing Incremental Costs with Incremental Revenues -
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if a firm is considering adding a new product line, they should compare the incremental cost of adding it (the extra cost resulting from its addition) with the incremental revenue (the extra revenue resulting from its addition) if the incremental revenue exceeds the incremental cost, the new product line will add to the o firm’s profits marginal costs is the extra cost from a very small increase in output incremental output: the extra cost from an output increase that may be substantial incremental revenue: the extra revenue from an output increase that may be substantial
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Production Theory -
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managers must choose an optimal method to produce efficiency requires an understanding of the production process a production process explains how scarce resources (inputs) are sued to produce a good or service (output) production function precisely specifies the relationship between input and o utputs o understanding the production process is fundamental to gaining insight into cost analysis o control of costs along with understanding of demand, is required for managers to optimize profit
The Production Function with One Variable Input -
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Production function table, graph or equation showing the maximum product output achieved from any specific set of inputs Production is dynamic o Methods, designs and factor costs change Say a process uses two inputs. If X1 is the level of the first input and X2 is the level of the second input, the production function is
Where Q is the firm’s output rate Simplest case: o One input with fixed quantitiy One input whose quantity is variable o time needed to change an asset is the beginning of what is called the long term fixed inputs often require capital (buildings, machinery, land) variable inputs can be changed in the short run, e.g. labour in the long run, all inputs are variable E.g. an entrepreneur own 5 machines and wants to know the effect on annual output if he were to hire various number of machinists He produces more parts by hiring more machinists o Numbers in the table are produced by a production function (equation) o o he is interested in knowing how output changes as the number of machinists varies one common measure used by many managers is output per worker average product (AP): common measuring device for estimating the units of output, on average o per input unit when varying machinists, output per worker is
( )
tells us how many units of output, on average, each machinist is responsible for if he wants better metric to estimate efficiency, marginal product (MP): metric for estimating the efficiency of each input in which the input’s o MP is equal to the incremental change in output created by a small change in the input:
) (
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he wants to know how much his output will change as input changes by one machinist Q(L) total output with L units of labour per year Q(L)/Laverage product marginal product of labour MP, when between L and (L-1) units of labour per year is Q(L)-Q(L-1)
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Quant option: o The marginal product of an input is the derivative on output with regard to the quantity of the input. That is, if Q is the output and x is the quantity of the input, the marginal product of the input equals dQ/dx is the quantities of all other inputs a re fixed Marginal profit equals the average product when the latter reaches a maximum Marginal product exceeds average product when average product is increasing Marginal product is less than the average product when average product is decreasing
The Law of Diminishing Marginal Returns -
The law of diminishing returns: a well-known occurrence where managers add equal increments of an
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input while holding other input levels constant, the incremental gains to output actually get smaller if pushed to the extreme, can be counterproductive o e.g. if he hires 8 machinists he will counterproductive because he only had 5 machines. As more people are hired, they will have to ration machines or new hires will be assigned to less important tasks choosing the optimal input is difficult because managers cann ot hold all but one input constant
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The Production Function with Two Variable Inputs -
with a longer time horizon, the formerly fixed input of 5 machines becomes variable the production surface shows the amount of total output that can be obtained from various combinations of machine tools and labour o we measure output for any input bundles as height on the surface dropping a perpendicular down from a point on the surface to the ―floor‖ defined the o corresponding input bundle
Isoquants -
isoquant: a curve showing all possible (efficient) input bundles capable of producing a given output
level the surface is not meant to represent the numerical values in Table 4.3 but is a general representation of how a production surface of this sort is likely to appear an isoquant is composed of all the points having the same height in the production surface an isoquant shows all the combinations of X1 and X2 such that f(X1, X2) equals a certain output the farther the isoquant from the origin, the greater the output it represents because we assume continuous production functions, we can draw an isoquant for any input bundle each isoquant represents and infinite number of possible input combinations Isoquants are always down-sloping and convex to the origin o
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The Marginal Rate of Technical Substitution
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Generally a particular output can be produced with a number of input bundles As we move along the isoquant, the marginal rate of technical substitution (MRTS): shows the rate at which one input is substituted for another (with output remaining constant) If the output produced is the function of two inputs, Q=f(X1,X2),
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Given that Q, output, is held constant The marginal rate of technical substitution is -1 times the slope of the isoquant, which makes sense
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because
measures the slope, which is downward or negative
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Useful for managers to think of MRTS as the ratio of marginal products, MP1/MP2 for inputs 1 and 2 The marginal product metric shows the incremental effect on output of the last unit of input Managers want to increase the use of inputs with relatively high marginal products, though they mu st also consider the cost of inputs Rate of substitutability between inputs varies: One type of labour is easily substituted for another o Specialized inputs are required o No substitution among input is possible; to produce a unit of output, a fixed amount of each input o is required and inputs must be used in fixed proportions (extreme cases) Graph is right angles With perfect substitutability of inputs, isoquant are straight lines connecting the two axes Figure 4.6: Two isoquant slopes are positive o Increases in both capital and labour are required to maintain a specified output rate Marginal product of one or the other input is negative Above 0U, the marginal product of capital is negative so output increases is less capital is used while the level of labour is held constant Below 0V, the marginal product of labour is negative so output increases if less labour is used while the amount of capital is held constant 0U and 0V are ridge lines: the lines that profit-maximizing firms operate within, because outside of them, marginal products of inputs are negative If managers want to maximize profit, they cannot use input bundles outside the ridge lines No-profit managers will operate at a point outside the ridge lines because they can produce the same output with less input
The Optimal Combination of Inputs -
Managers must consider costs because inputs are scarce A manager who wants to maximize profit will try to minimize the cost of producing a given output or maximize the output derived from a given level of cost Example: what combination of capital and labour should the manager choose to maximize the output derived from the given level of cost: o Inputs: capital and labour Price of labour: Pl o Price of capital: Pk o o
Represented by a straight line Isocost curve: curve showing all the input bundles that can be purchased at a specific cost o If we superimpose the isocost curve on the isoquant map we see the input bundle that maximizes output for a given cost (curve and line touch) Pick the point on the isocost curve that is tangent to the highest-valued isoquant o Choose the curve that MPl/Pl=MPk/Pk o To determine the input the maximizes production costs: Moving along the isoquant of the specified output level, we find the point that lies on the lowest o iscost curve Ones below the isoquant are cheaper but don’t produce desired output o
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And
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o
To minimize the cost of producing a given output or to maximize the output from a given cost outlay, the firm must make MPl/Pl=MPk=Pk
Corner Solutions -
Corner solutions optimal input bundles with just one input deplo yed In the two-input case, just one input is used to produce the product in the least expensive way o For cases where just capital is used, MPk/Pk>MPl/Pl For cases where just labour is used, MPk/Pk
Returns to Scale -
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Suppose we want to consider a situation where all inputs are variable and managers increase the level of inputs by the same proportion 3 possibilities for what will happen to the output: o Increasing returns to scale: Output may increase by a larger proportion than inputs, e.g. doubling inputs may more than double outputs Decreasing returns to scale: Output may increase by a smaller proportion than inputs o o Constant returns to scale: Outputs may increase by exactly the same proportion as inputs Bigger is not always better, managers can experience decreasing returns to scale A big problem is the difficulty in coordinating a large organization o
The Output Elasticity -
Output elasticity: the percentage of change in output resulting from a 1% increase in all inputs
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>1, means increasing returns to scale o =1, means constant returns to scale <1, means decreasing returns to scale o Cobb-Douglas production function for the Lone Star Company: o
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Q is the number of parts per year, L is the number of workers hires and K is the amount of capital used When you multiply both inputs (L and K) by 1.01, the new value of Q (that is Q’) equals... 1.011055484Q Therefore, if the manager increases the use of both inputs by 1%, output increases by slightly more than 1.1%... the output elasticity is approximately 1.1 It is exactly 1.1 for a minute change in input use (of both inputs) Because a 1% change us larger than minute, the increase in output is slightly larger than 1.1
Estimations of Production -
Managers need to estimate a production function Commonly choose the Cobb Douglas form. With only two inputs:
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Advantage of this form is that the marginal productivity of ea ch depends on the level of all inputs employed, which is often realistic Consider the marginal product of labour, which equals
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Logarithms can be taken of both sides of the first equation
()
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logQ=loga+blogL+clogK managers can easily estimate returns to scale using this if the sum of exponents (b+c) exceeds 1, increasing returns to scales are indicated if the sum of exponents equals 1, constant returns to scale prevail if the sum of exponents is less than 1, decreasing returns to scale are indicated this is true because if the Cobbs-Douglas production function prevails, the output elasticity equals the sum of exponents o
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The Analysis of Costs Opportunity costs -
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producing a particular product as the revenue a manager could have received if she had used her resources to produce the next best alternative product or services opportunity costs: the revenues forgone if resources (inputs) are not optimally used managers need to reduce opportunity costs o opportunity cost doctrine: the inputs’ values (when used in their most productive way) together with the production costs (the accounting costs of producing a product) determine the economic cost of production opportunity costs of an input may not equal its historical cost: the money that managers actually paid for an input managers concerned with two types of costs: explicit costs: the ordinary items accountants include as the firm’s expenses o o implicit costs: the forgone value of resources that managers did not put to their best use Ex: the cost per year of attending Wharton is $90,000. Many students work beforehand and make $70,000. According to an accountant, the average yearly cost of attending Wharton is $90,000, whereas an economist would say $160,000. sunk costs: resources that are spent and cannot be recovered the difference between what a resource costs and what it is sold for in the future o Ex: if a company builds a plant for $12 million and disposes of it for $4 million, it incurs sunk o costs of $8 million
Short-run costs functions -
cost function: function showing various relationships between input costs and output rate
short-run so short that a manager cannot alter the quantity of some inputs as the length of time increases, more inputs become variable short run: the time span between where the quantity of no input is variable and one where the quantities of all inputs are variable in the short run we say that it is so brief that managers cannot alter the quantities of plant and equipment fixed inputs: when the quantities of plant and equipment cannot be altered they determine the firm’s scale of plant: this scale is determined by fixed inputs o variable inputs: inputs that a manager can vary in quantity in the short run short run cost concepts: o fixed total fixed cost (TFC): the total cost per period of the time incurred for fixed inputs variable o total variable cost (TVC): the total cost incurred by managers for variable inputs increase as output rises because greater output requires more inputs and higher variable costs up to a particular output rate, total variable costs rise at a decreasing rate; beyond that output level, they increase at an increasing rate... follows law of diminishing returns total o total cost (TC): the sum of total fixed and total variable costs total fixed cost + total variable cost
Average and Marginal Costs
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three average cost functions corresponding to the three total cost functions: average fixed cost (AFC): the total fixed cost divided by output o declines with increases in output rectangular hyperbola total fixed cost (TFC): the total cost per period of the time incurred for fixed inputs average variable cost (AVC): the total variable cost divided by output o the variable cost, on average, of each unit of output initially, increasing output results in decreases in AVC, however, as output increases, at some point of increased production, AVC rises, this increasing the average variable cost per unit total variable cost divided by number of units produced, where U is the number of input units used and W is the cost per unit of input
inverse of average product times the cost per unit of input because of their inverse relationship, AVC mirrors the behaviour of AP when AP increase, AVC decreases; when AP decreases, AVC increases we expect AVC to initially decrease, hit a minimum, and then increase Average total cost (ATC): the total cost divided by output AFC + AVC takes a similar shape to AVC but higher at all output levels due to fixed costs ATC reaches its minimum at output levels relatively higher than AVC be cause increases in average variable cost are for a time more than offset by decreases in average fixed cost (which must decrease as output increases) Marginal Cost (MC): the incremental cost of producing an additional unit of output at low output levels, MC may decrease with increases in output, but after reaching a minimum, it increases (like AVC) with additional output
o
o
but
consequently,
and
hence we can define MC as
the behaviour of MP is inverse to that of MC as MP increases, MC decreases; when MP decreases, MC increases
is zero because fixed costs can’t vary, therefore
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we saw that the behaviour of marginal product is to increase, attain a maximum, and then decline with increases in output; marginal cost normally decreases, attains a minimum, and then increases marginal cost always equals average variable cost when the average variable cost is at a minimum (because MP=AP when AP is maximized)
Long Run Cost Functions -
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in the long run, all inputs are variable and there are no fixed costs because no inputs are variable long-run average cost function (LAC): function showing the minimum cost per unit of all output levels when any desired size plant is built Any point on the long run average cost function is also a point on the short-run average cost function... it is a point on the lowest-cost short-run cost function for the given output level when given the freedom, managers want to choose the plant scale that minimizes average cost Fig 5.4 pg. 141 o the minimum average cost of producing all outputs is given by the long-run AC function each point is also a point on a short-run AC function o at that output level, it is a point on the lowest-cost short-run AC function; it is the best and o efficient manager can do o the two functions are tangent at that point long run total cost of production= long run average cost x output long-run total cost function: the relationship between long-run total cost and output long-run marginal cost function: function representing how varying output affects the cost of producing the last unit if the manager has chosen the most efficient input bundle shows behaviour similar to average costs long-run marginal cost < LAC, when LAC is decreasing long-run marginal cost = LAC, when LAC is at a minimum long-run marginal cost > LAC when LAC is increasing
Managerial Use of Scale Economies -
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economies of scale: when the firm’s average unit cost decreases as output increases
managers use many sources of scale economies to create competitive advantages e.g. UPS use them in their distribution network to decrease costs o e.g. larger cruise ships have lower cost per passenger o however, increasing size eventually causes diseconomies of scale: when the average costs per unit of output increase (usually because of the complexity of managing and coordinating all of the necessary activities
Managerial Use of Scope Economies -
economies of scope: exist when the cost of jointly producing two (or more) products is less than the cost
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of producing one this is a cost efficiency strategy for managers simple way for managers to estimate the extent of their scope economies is to use:
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S is the degrees of economies of scope, C(Q1) is the cost of producing Q1 units of the first product alone, C(Q2) is the cost of producing Q2 units of the second product alone and C(Q1+Q2) is the cost of producing Q1 units of the first product in combination with Q2 units of the second product
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if there are economies of scope, S is greater than zero because the cost of producing both products together, C(Q1+Q2), is less than the cost of producing each alone, C(Q1) + C(Q2) the larger the value of S, the greater are the scope economies managers use scope economies to create cost advantages by producing multiple products rather than just one... often these cost savings arise because the products share either processes (like distribution) or resources (such as components) also diseconomies of scope
Managerial Use of Break-Even Analysis -
managers use it to estimate how possible pricing chang es affect firm performance break-even point: the output level that must be reached if managers are to avoid losses intersection of the cost and revenue functions o can be modelled with both linear and curvilinear
Profit Contribution Analysis -
profit contribution analysis: break-even analysis to understand the relationship between price and
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profit profit contribution is the difference between total revenue and total variable cost; on a per unit basis, it is equal to price minus average variable cost
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Perfect Competition -
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a dominant constraint in pricing decisions is the structure of the market market structure is important because it largely determines the potential pricing power of managers classify markets based on degree of pricing power... perfectly competitive market (managers have no market power)monopoly market (managers face no competition and possess plenty of market power) managers are price takers: they accept the decisions of the aggregate market managers with no market power have no control over price o still face supply side challenges of efficient production and cost c ontrol from the demand side, managers must choose the profit-maximizing output when the price is given... in all other markets, managers can vary both output and price in perfectly competitive markets, managers cannot overrule the price set by the interaction of the aggregate market demand and supply curves ex: farmers who do not control price but control quantity... prices may change as conditions o influencing demand (taste, income) and supply (weather, crop disease) change
Market Structure -
the situation of the price-taking producer is one of the four general categories of market structure we investigate: perfect competition: when there are many firms that are small relative to the entire market and o produce similar products no control over price firms produce identical products barriers to entry (barriers that determine how easily firms can enter an industry, depending on the market structure) are low no nonprice competition monopolistic competition: when there are many firms and consumers, just as in perfect o competition; however, each firm produces a product that is slightly different from the products produced by the other firms less control over price than monopolist and more control over price than a manager in a perfectly competitive market firms produce somewhat different products low barriers to entry considerable emphasis placed on managers using nonprice competition much of the nonprice competition centers around the ability of managers to differentiate their products; this differentiation gives managers the power to overrule the market price monopoly: markets with a single seller o barriers to entry are blocked (once entry occurs, monopoly no longer exists) nonprice competition in advertising oligopoly: markets with a few sellers o most prevalent category in present-day business less control over price than monopolist and more control over price than a manager in a perfectly competitive market firms sometimes produce identical products e.g. in steel/aluminum they do but in cars they do not considerable barriers to entry
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managers of oligopoly that produce differentiated products also tend to rely heavily on nonprice competition, whereas managers from oligopolies that produce nondifferenitated products do not
see table 6.1
Market Price in Perfect Competition -
in a perfectly competitive industry, market price is determined b y the intersection of market demand and supply curves individuals managers cannot always affect price sometimes, even with great increases in output, price chan ge is miniscule o o this means that managers in this market essentially face a horizon tal demand curve...no matter how many units one manager sells, the market price remains the same
Shifts in Supply and Demand Curves -
shifts in the supply and demand curves result in price changes two of the major factors causing shifts in supply curves: o technological advancements — shift curve to the right o changes in input prices — shift curve to the left
The Output Decision of a Perfectly Competitive Firm -
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managers cannot affect market price of product must sell output within their capabilities at the market price o relationship between total revenue, cost and output o distance between total revenue and total cost curves is the profit at the corresponding output total revenue curve is a straight line through the origin with a slope equal to the fixed price o slope of total revenue is always the market price o and it follows that
is the firm’s marginal revenue... the firm’s total revenue is PQ, therefore, marginal revenue is so the firm’s marginal revenue is the product’s price in the case of a price taker, the price of a condition reads P=MR, therefore, P=MC... this is why managers want to avoid these markets: the nature of competition is to grind the price down to marginal cost... competitive pressure is relentless there is no above normal economic profit (except in the short run) managers should never produce output where MC is greater than MR because the manager takes the price as given, it is constant for all output levels marginal revenue curve is also the firm’s demand curve, which is horizontal o central pointmanagers maximize profit at the output where price (or marginal revenue equals the marginal cost
Setting the Marginal Cost Equal to the Price -
if managers want to maximize firm value, they should set price equal to marginal cost when marginal cost is increasing
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managers in perfectly competitive markets often accrue n egative profits (figure 6.5 pg. 181) o if the price is at a certain level, short-run average total costs may exceed the price at all possible outputs because the short run is too short to permit the manager to alter the scale of a plant, all she can so o is product at a loss or discontinue the product for any output where price exceeds average variable costs, managers should produce, even o thought the price does not cover average total costs if there is no output rate where the manager is able to exceed the average variable costs, the o manager is better off shutting the plant however, the fixed costs still stand so if the loss of producing is smaller than the fixed costs, the manager would be more profitable without shutting down the plant o managers want TR to exceed VC by as much as possible, thus maximizing controllable cash flow if VC exceeds TR do not produce because controllable cash flow is negative P = MC and P > AVC o shutdown point: when the price equals the minimum average variable cost o price is equal to marginal cost because it intersects with average variable cost at this point at this price, the manager loses money equal to fixed cost if he produces or he loses that money if he shuts down... any price below this, the manager shuts down the marginal cost curve (above the average variable cost) is the supply curve for the firm
Another Way of viewing the price equals marginal cost profit-maximizing rule -
marginal revenue product (MRP): the amount an additional unit of the variable input adds to the firm’s total revenue Marginal expenditure (ME) is the amount of additional unit of labour adds to the firm’s total cost
to maximize profit, managers should use labour (a variable input) where its marginal revenue product equals its marginal expenditure... MRP = ME to maximize profit... MR=MC in the case of perfect competition, MR = P rule becomes... P x MPL = MEL = PL managers should continue to hire more labour as long as P x MPL > PL and should not hire labour if P x MPL < PL the stopping rule to maximizing is P x MP L = PL... dividing both sides by MPPL gives P = PL /MPL and as was shown in Chapter 5, MC = PL /MPL therefore to maximize profit in a perfectly competitive market, P = MC o
Producer Surplus in the Short Run -
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producer surplus: the difference between the market price and the price the producer is willing to receive for a good or service (the producer’s reservation price) to arrive at producer’s surplus, managers subtract the only available cost from total revenue, hence the
variable-cost profit is larger than the profit is larger than profit (by the level of fixed cost), and producer surplus and variable-cost profit are the same because the perfectly competitive firm’s marginal cost represents its supply curve, we can view producer surplus, we can view producer surplus as the difference between the supply curve and the price received for the good market supply is the horizontal su mmation of individual firms’ supply curves dor the product refer to figure 6.7 pg 188 the market equilibrium price of P* yields a consumer surplus of A and a producer surplus of B
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the sum of A and V, the total surplus, is the economist’s measure of social welfare at the price P* and the quantity Q* for consumers, the total amount they are willing to pay for goods are areas A, B and C or the area below the demand curve and to the left of the equilibrium quantity for producers, the total variable cost of supplying quantity Q* is the area beneath the supply curve and to the lest of the equilibrium quantity or area C in the market consumers pay and producers receive P*, yet P* is less than the total benefit and greater than the variable cost of the goods the market exchange generates value for participants, represented by consumer, producer and total surplus in this case, the difference between what the demanders are willing to spend (A, B and C) and what the suppliers are willing to receive (C) is the measure of social welfare... A + B a more gently sloped demand curve reduces consumer surplus and a more gently sloped supply curve reduces producer surplus
Long-run equilibrium of the firm -
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the long-run equilibrium of the firm is at the point where its lon g-run average total cost curve equals the price if price exceeds the average total cost, economic profit is earned and new firms enter the industry this increases supply, thereby driving down price and hence profit o if the price is less than the average total costs for any firm, the firm will exit the industry o as firms exit, supply falls, causing price and profit to rise when economic profit is zero (long-run average cost equals price), a firm is in long-run o equilibrium economic profit is above what the owners could obtain elsewhere from the resources they invest in the firm long-run equilibrium occurs when owners receive no more and no less than they could obtain o elsewhere from these resources the price must be the lowest value of the long-run average total cost if managers maximize their profit, they must operate where price equals lon g-run marginal cost o also must operate where price equals long-run average cost o o therefore, long-run average cost must equal long-run marginal cost... this is at a point where long-run average cost is a minimum
The Long-run Adjustment process: A constant-cost Industry -
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assume that this industry is a constant-cost industry, meaning that ex pansion of the industry does not increase input prices assume the industry is in long-run equilibrium with the result that the price equals the minimum value of the long-run and short-run average cost a constant-cost industry has a horizontal long-run supply curve if the demand curve shifts to the right with the number or firms fixed... o the product price rises each firm expands its output o each firm makes economic profit because the new price exceeds the short-run average costs of o the firm when the output increases firms enter the industry, the supply curve shifts to the right o in a constant-cost industry, entrance of new firms does not influence the cost of existing firms
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the inputs used by this industry are used b y other industries as well and new firms in this industry do not bid up the price of inputs and hence raise the costs of existing firms neither does entry of new firms reduce existing firms’ costs a constant cost industry has a horizontal long run supply curve as long as the industry remains in a state of constant costs, its output can be increased indefinitely industry output can be raised or lowered, in accord with demand conditions, without changing this longrun equilibrium price
The long-run adjustment process: an increasing-cost industry -
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increasing cost industry — industry expansion increases input prices the original position (of the equilibrium) is one of the long-run equilibrium because price equals the minimum value of long run and short-run average cost if the demand curve shifts to the right, the product price goes up and the firms earn economic profit, attracting new entrants o more inputs are needed by the industry and in an increasing-cost industry, the prices of th e inputs rise with the amount used by the industry the cost of inputs increases for established firms as well as entrants and the average cost curves o are pushed up if each firm’s marginal cost curve is shifted to the left b y the increase in input prices, the industry supply curve tends to shift to the left this tendency is more than counterbalanced by the increase in the number of firms, which shifts o industry supply curve to the right without offsetting, there would be no expansion in total industry output o this process of adjustment must go on until a new point of long-run equilibrium is reached o an increasing-cost industry has positively sloped long-run supply curve after long-run equilibrium is achieved, increases in output require increases in the price of the product in constant-cost industries, new firms enter in response to an increase in demand until the price returns to original level in increasing-cost industries, new firms enter until the minimum point on the long -run average cost curve has increased to the point where it equals the new higher price also decreasing-cost industries, where their long-run supply curves are negatively slopes
How a Perfectly Competitive Economy Allocates Resources -
important for managers to understand how a competitive economy allocates resources simple case: consumers become more favourably disposed toward corn and less favourably disposed toward rice than n the past rising demand for corn increases its price and results in some increase in th e output of corn o o corn output cannot be increased substantially because the capacity of the industry cannot be expanded in the short-run falling demand of rice reduces its price and results in some reduction in the output of rice o o output of rice cannot be limited greatly because firms continue to produce as long as they can cover their variable costs because of the increased price of corn and the decreased price of rice, corn producers earn o economic profit and rice producers show economic loss o producers reallocate resources to correct this imbalance when short-run equilibrium is achieved in both the corn and rice industries, the reallocation of o resources is not yet complete because there has not been enough time for producers to build new capacity or liquidate old capacity
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o o
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o o o
o o
neither industry operates at minimum average cost corn producers may operate at greater than the output level where average cost is a minimum and the rice producers may operate at less than the output level where average cost is a minimum long-run: shift in consumer demand curve from rice to corn results in greater adjustments in output and smaller adjustments in price than in the short run existing firms can leave rice production and new firms can enter corn production as firms leave rice production, the supply curve shifts to the left, causing the price to rise above its short-run level the transfer of resources out of rice production ceases when the price has increased and costs have decreased to the point where loss no longer occurs whereas rice production loses resources, corn production gains them the short-run profit in corn production stimulates the entry of new firms the increased demand for inputs raises input prices and cost curves in corn production and the price of corn is depressed but he movement to the right of the supply curve because of new entry of new firms entry stops when economic profit is more is no longer being earned at that point, when long-run equilibrium is achieved, more firms and more resources are used in the corn industry than in the short run
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Monopoly and Monopolistic Competition -
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equilibrium price sent by the intersection of the supp ly and demand curves is rarely seen do not have to consider actions of market rivals because there are none monopolies have no intramarket competition and firm demand is equal to market demand downward sloping demand curve firms decide price an quantity (no longer passive price takers) higher economic profit although monopolies may have no ―direct‖ substitutes, cross elasticities can tell us what goods, locations and time are substitutes for a ―monopoly‖ product must consider product, spatial and temporal competition o the higher the profit, the more others will test your market de fences and try to enter your market if companies are doing too good a job, authorities may try to regulate actions still produce where marginal revenue equals marginal cost monopolistic competitive markets: o market managers still have market power but they must deal with intramarket rivals lack of entry barriers allows others into the market o
Price and Output Decisions in Monopoly
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monopolist maximizes profit by choosing the price and output where the difference between total revenue and total cost is the largest maximize profit if they set output at the point where marginal cost equals marginal revenue note that with a linear demand curve, the marginal revenue curve has twice the slope of the demand curve unlike firms in a perfectly competitive market, the firm’s marginal revenue is no longer constant, nor is it equal to price recall
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where MR is marginal revenue, P is price and isthe price elasticity of demand because < 0, the marginal revenue equals price minus
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marginal revenue is price minus something positive, so price must exceed marginal revenue o no rational manager produces where marginal revenue is negative (producing another unit decreases total revenue) if managers are to produce where marginal revenue equals marginal cost, a negative marginal revenue implies a negative marginal cost total costs increase (not decrease) when managers increase production if marginal revenue is positive, then < -1 (that is > 1), which implies an elastic demand o a monopolist will not produce in the inelastic range of the demand curve if maximizing profit also true that price must exceed average variable cost if managers are to maximize profit if not, the monopolist is not covering variable cost and should shut the operation to reduce losses o to only fixed cost o
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figure 7.4 (pg 206) produce output Q where: o marginal cost curve intersects that of marginal revenue demand curve slopes downward to the right (not like the horizontal demand curve of perfectly o competitive market) o profit per unit of P-ATC (multiplied by Q to get shaded area) P>AVC o relative to managers in perfectly competitive markets, monopolists choose a higher price and o lower output... allows them to charge a higher price than marginal cost and hence generate economic profit output is limited under monopoly, price is increased, an d profit is increased (compared to o perfectly competitive markets) to see that monopolist’s price exceeds marginal costs,
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because
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extra profit earned by monopoly managers is generates by their ability to choose price greater than marginal cost, whereas the perfect competitor merely charg es the marginal cost o price is always higher than average variable cost
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>1, it follows that
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<1, which means that P must exceed MC
Cost-Plus Pricing -
cost-plus pricing: simplistic strategy that guarantees that price is higher than the estimated average cost
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price is set as a function of cost managers first allocate unit costs conditional on a given o utput level, then they add profit margin o this margin is generally a percentage of costs and is added to the estimated average costs the markup is meant to cover costs that are difficult to allocate to specific products and as a o return on firm investment percentage markup of this strategy:
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where (price-cost) is the profit margin: the price of a product minus its costs ex: if the price of a book is $6 and the cost is $4
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so there is 50% markup managers may also choose target return: what managers hope to earn and what determines the markup with a price function, sub target rate of return into it to find the price
Cost-Plus Pricing at Therma-Stent -
Therma-Stent is a producer of graft stents managers set price by estimating the average production costs (including indirect ones) then they add a 40% markup to set the product’s market price
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factory cost/unit= $2,300 (at production of 20,000) o 40% markup= $920 US list price= $3,220 o price is set without considering prices of rival products pricing scheme works better when products are differentiated... Therma -Stent is unique in form and structure o
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Cost-Plus Pricing at Internet Companies and Government-Regulates Industries -
many online companies seem to have adopted a cost-plus pricing scheme some companies have structured a pricing policy called ―At Cost‖ where they sell products based at the wholesale price plus a fixed transaction fee (the markup) many automobile dealers also use a cost-plus pricing scheme , though they tend to make it difficult for consumers to accurately determine cost government regulators also use cost-plus pricing in industries they regulate or control o dangers of such pricing scheme in a government controlled industry is that, when profit is guaranteed, firm managers may lose the incentive to be cost efficient this tends to create a larger government regulatory bu reaucracy to monitor costs o
Can Cost-Plus Pricing Maximize Profit? -
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we question how good a heuristic cost-plus pricing is for managers to use it seems unlikely that cost-plus pricing will often maximize profit this pricing technique seems simple-minded in that it does not explicitly consider the extent of o demand or the product’s price elasticity, including the pricing behaviour of rivals the possibility that cost-plus pricing is sometimes a good heuristic revolves around what factors managers consider in determining the size of the percentage markup or the target rate of return in choosing markup to maximize profit, managers must understand how marginal cost and price o elasticity of demand are associated note the negative association between elasticity and markup as the price elasticity of demand decreases (in absolute value), the optimal markup increases o if the quantity demanded is not very sensitive to price, obviously a high price should be set if you want to make the most amount of money possible
The Multiple-Product Firm: Demand Interrelationships -
more complex decisions for managers producing multiple p roducts change in the price or quantity sold of one product may influence the demand for other products TR=TRX+TRY marginal revenue from product X is
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marginal revenue from product Y is
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the last term in each of these equations represents the demand interrelationship between the two products in the first one, the last term shows the effect of an increase in the quantity sold of product X on the total revenue from product Y
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if X and Y are complements, this effect is positive because an increase in the quantity sold of one product increases the total revenue from the other product if X and Y are substitutes, this effect is negative because an increase in the quantity sold of one product reduces the total revenue of the other product
Pricing of Joint Products: Fixed Proportions -
in addition to being interrelated on the demand side, some products also have interrelated characteristics ex: a bundle might be one hide and two sides of beef in the case of cattle because they are produced from each animal with such jointly produced products. there is no economically correct way to allocate the cost of producing each bundle to the individual products to determine the optimal price and output of such bundled product, managers need to compare the marginal revenue generated by the bundle to its marginal cost of production if the marginal revenue (sum of the marginal revenues obtained from each product package) is greater than its marginal cost, managers should expand output total marginal revenue curve: the vertical summation of the two marginal revenue curves for individual products Figure 7.5 page 217 o 2 joint products, each with a demand curve marginal cost for bundled product in the fixed proportion in which it is produced (produced in o the same place, therefore same cost) o profit maximizing output is Q (total marginal revenue equals marginal cost) optimal price output for A is Pa and the optimal price output for B is Pb o total marginal revenue curve coincides with the marginal revenue curve for product A ar all o outputs beyond Qo managers should never sell product B at a level where its marginal revenue is negative (negative marginal revenue means managers can increase revenue by selling fewer units) if total output exceeds Qo, managers shouls sell only part of product B produced... they want to sell the amount corresponding to an output of Qo product bundles if output Qo, total marginal revenue equals the marginal revenue of product A alone What if marginal cost curve intersects the total marginal revenue curve to the right of Qo? o profit-maximizing output is Q1 where marginal cost and total marginal revenue curves intersect all of product A produced is sold, but not all of product B is sold... amount sold is limited to the amount of output Qo, so that the price of product B is Pb the ―surplus‖ amount of product B (Q1-Qo) must be kept off the market to avoid depressing its price
Output of Joint Products: Variable Proportions -
more realistic if the manager is considering a fairly long period a firm produces 2 products each with an isocost curve: curve showing the amounts of goods produced at the same total cost isorevenue lines: lines showing the combinations of outputs of products that yield the same total revenue want to know how much of A and B to produce if an output combination is at a point where an isorevenue line is not tangent to an isocost curve, o it cannot be the optimal output combination
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if an output combination is at a point where an isorevenue line is not tangent to an isocost curve, it is possible to increase revenue without ch anging cost by moving to a point on the same isocost curve where an isorevenue line is tangent to the isocost curve we find the optimal output combination by comparing the profit level at each tangency point and choosing the point where the profit level is the highest
Monopsony -
monopsony: markets that consist of a single buyer
controls price consider The Company in company town... when it wishes to hire another workers, because it employs such a large proportion of the labour force, it will influence the wage demand for labour is labour’s marginal revenue p roduct... marginal revenue multiplied by the marginal product of labour downward sloping... marginal revenue falls as output increases and because labour’s marginal o product falls as more labour is employed labour supply curve: P=c+eQ upward sloping...to hire another worker, The Company must increase the wage to entice a o worker either into the workforce or away from another job The Company’s total expenditure on labour (total cost) is: C=PQ=(C+eQ)Q=cQ+eQ2 to maximize profit, managers will equate the marginal b enefit of hiring another work with the marginal expenditure (marginal cost) of hiring another worker: o
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Figure 7.8 page 223 note that the monopsonist restricts the amount of labour hires and pays a lower wage than it would if the labour market were perfectly competitive
Monopolistic Competition -
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central characteristic of monopolistic competition is product differentiation sell similar yet not identical products due to differences among their products, managers have some control over their product price, though price differentials are relatively small because products of other firms are so similar product group: group of firms that produce similar products process by which we combine firms intro product groups is somewhat arbitrary; there is no way o to decide how close a pair of substitute products must be to belong to the same product group in addition to product differentiation, other conditions must be met for an industry to qualify as one of monopolistic competition: there must be many firms in the product group — the product must be produces by perhaps 50 to o 100 or more firms, with each firm’s product a fairly close substitute for the product of the other firms in the product group the number of firms in the product group must be large enough that each firm expects its actions o to go unheeded by its rivals and unimpeded by possible retaliatory moves on their part — when formulating their own price and output policies, they do not explicitly concern themselves with their rivals’ responses... if there are m any firms, this condition is normally met entry into the product group must be relatively easy, and there must be no collusion, such as o price fixing or market sharing, among managers in the product group — generally difficult, if not impossible, for a great many firms to collude
Price Output Decision under Monopolistic Competition - demand curves slope downward to the right
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if the firm raises its price slightly, it will lose some of its customers to other firms and if it lowers its price slightly, it will gain some of its competitors’ customers in the short-run, marginal cost equals marginal revenue to maximize profit economic profit is earned because price exceeds average total cost price must exceed average variable cost for profit to be maximized one condition for long-run equilibrium in these markets is that each firm make no economic profit or loss because entry or exit of firms will occur otherwise and entry and exit are incompatible with longrun equilibrium another condition for long-run equilibrium is that each firm max imizes profit zero economic profit condition is met at this combination of price and output because the firm’s average cost at this output equals the price profit maximizing condition is met because the marginal revenue curve intersects the marginal cost curve
Advertising Expenditures: A Simple Rule -
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quantity a firm sells of its product is assumed to be a function of its price and the level of its advertising expenditures we assume diminishing marginal returns to advertising expenditures, meaning that ev entually successive advertising outlays yield smaller increases in sales if we assume that neither price nor marginal cost is altered by small changes in advertising expenditure, managers realize an increase in gross profit of (P-MC) from each additional unit of product why is the gross profit of selling an additional unit of output? it takes no account of whatever additional advertising expenditures are required to sell this ex tra o unit of output o to obtain the net profit, managers must deduct these additional advertising outlays from the gross profit to maximize net profit, a manager must set advertising expenditures at the level where an extra dollar of advertising results in extra gross profit equal to the extra d ollar of advertising cost unless this is the case, a manager can increase the firm’s total net profit by changing advertising outlays if an extra dollar of ad results in more than a dollar of increase in gross profit, the ex tra dollar should be spent on advertising if the extra dollar (as well as the last dollar) of advertising results in less than a dollar’s increase in growth profit, advertising outlays should be cut if ∆Q id the number of extra units of output sold as a result of an extra dollar of advertising, the manager should set advertising expenditures so that ∆Q(P-MC)=1 because the right side equals the extra dollar or advertising cost and the left side equals the extra gross profit resulting from this advertising dollar if we multiply both sides by P/(P-MC), we obtain P∆Q=P/(P-MC) because maximizing profit, substitute MR for MC in this equation: P∆Q=P/(P-MR) right side of this equation equals the absolute of th e price elasticity of demand for the firm’s product left side of equation is the marginal revenue from an extra dollar of advertising (P time the extra number or units sold as a result of extra ad) to maximize profit, the managers should set advertising expenditure so that
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Using Graphs to Help Determine Advertising Expenditure -
managers should think of price elasticity as a proxy for the effectiveness of their differentiation strategies advertising is a strategic variable managers use to conve y their differentiating message
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with no advertising, differentiation is slight between rival products, hence the price elasticity of demand is high (in absolute value) increases in advertising spending reduce the produ ct’s price elasticity (in absolute value) considerably (by decreasing the product’s perceived substitutability with other goods)
Advertising, Price Elasticity, and Brand Equity: Evidence on Managerial Behaviour -
promotions appeal to the price-sensitive, whereas ads b uild brand loyalty promotions use a price-oriented message to test the limits of brand lo yalty; advertising illuminates brand worth and does not mention price both strategies persuade purchasers by influencing the price sensitivities of consumers promotions increase price elasticity and, in the long run, limit the price consumers are willing to pay for brand quality
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Managerial Use of Price Discrimination -
managers try to identify submarkets on the basis of individual’s price elasticity of demand
Motivation for Price Discrimination -
Figure 8.1 pg 243: by charging price Pm, monopolist sells Qm units o aside from customers whose reservation price was Pm, all other pu rchasing customer in area AB o of the demand curve (above Pm) value the good at a price higher than Pm, but they are only asked to pay Pm for it they therefore gain a considerable amount of consumer surplus o consumers in BC (below Pm) are unwilling to spend Pm for the good but have reservation prices o that exceed the marginal cost of producing the good and hence represent potential profitable sales profitable sales could continue up to Qc o o the amount of profit represented by those potential sales is X + Z o the single price monopolist settles for: a variable-cost profit of W + Y revenue is PmQm= W + Y + U variable cost is the area under U if the manager raises the price into the area V, area X + Z becomes greater o if the manager lowers the price below Pm to capture some of the potential profit in area X + Z, o area V becomes bigger o managers cannot increase the price by deviating from Pm because it is the profit maximizing price from the single-price monopolist cannot enter these areas with a single-priced strategy o managers can capture surplus from area V and profit from areas X + Z only with a strategy that involves two or more prices if the benefit of capturing that profit exceeds the cost of doing so, then the manager should do so o
Price Discrimination -
price discrimination: when the same product is sold at more than one price
even if the products are not precisely the same, price discrimination is said to occur if similar products are sold at prices that are in different ratios to their marginal costs
First-Degree Price Discrimination - auto dealer is an exampleattempts to extract the reservation price of each buyer - (Fig. 8.1) consumers in segment AB of the demand curve are willing to pay more than the single
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monopoly price of Pm consumers in segment BC of the demand curve are willing to pay more for the good than it costs the producer to produce it —that is, the firm’s marginal cost simple monopolist makes a variable-cost profit of W + Y and leaves the consumer surplus of V with the consumers of segment AB if managers could be perfectly price discriminate, they would charge the consumers in segment AB their reservation prices, capturing all the consumer surplus and turning it into producer surplus
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when managers can be perfectly price discriminate in segment AB, the firm ’s variable-cost profit increases to V+W+Y not constrained by a single price so they can serve consumers in segment BC this increases the variable cost profit by X + Z because the reservation price of the consumers in o segment BC exceeds the additional cost of producing the units involved: Qc-Qm o by perfectly discriminating in both the AB and BC segments, managers increase the firm’s variable-cost profit (and hence its profit) by V+X+Z if managers capture all of V+X+Z, we say they are practicing price discrimination of the first degree first degree price discrimination allows the manager to charge each consumer their reservation price managers sell to a consumer as long as the reservation price exceeds the marginal cost of o production o essentially, in perfect discrimination, the firm’s demand curve becomes the firm;s marginal revenue curve cannot sell more than Qc o the perfectly-discriminating manager maximizes profit by producing until marginal revenue (represented by the demand curve) is equal to the output’s marginal cost interesting outcome of the first-degree price discrimination is that it produces the same ou tput as if the monopolist were in a perfectly competitive market — that is Qc the difference between the 2 scenarios is in the distribution of consumer and producer surplus in figure 8.1, under perfectly competitive pricing, consumer surplus is V + W + X and producer surplus is Y + Z because total welfare is the sum of consumer and producer surplus, social welfare is V through Z under first degree discrimination, consumer surplus is zero (it has all been captured) and producer surplus is V through Z therefore, the welfare is the same under both pricing me chanisms, V through Z, but the o consumers benefit under perfect competition and producers get all the benefit of first-degree price discrimination because the output is the same in each pricing scheme, social welfare is identical o managers usually must have a relatively small number of buyers and must be able to estimate the maximum prices they are willing to accept two-part tariff method of pricing (discussed later) is a simpler way to operationalize first-degree price discrimination
Second-Degree Price Discrimination - most common in utility pricing - plays important role in the schedule of rates charged by many public utilities — gas, water, electricity and
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others Fig. 8.2 page 249 company charges a high price of Po if the consumer purchases fewer than X units of gas per o month o for an amount beyond X units per month, the company charges a medium price of P1 for an amount beyond Y, the company charges an even lower price of P2 o o the company’s total revenues from each consumer are equal to the shaded area because the consumer purchases X units at a price of Po, (Y-X) units at a price of P1 and (Z-Y) units at a pric of P2 by charging different prices for various amounts of the commodity, reven ue and profits increase o o if the manager charged only a single price and wanted to sell Z units, she would charge a price of P2, thus the firm’s total revenue would equal the rectangle 0P2EZ, which is less than when the other shaded parts are included unlike first-degree price discrimination, managers leave a surplus of A + B + C
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because the 2nd (and 3rd) degree discrimination occurs at the group level an d not that of the individual, consumers retain some surplus
Third-Degree Price Discrimination - most common form - 3 conditions must be true
demand must be heterogeneous managers must be able to identify and segregate different segments o o markets must be successfully sealed Differences in consumer price elasticity of demand ma y be due to difference among classes in income levels, tastes or the availability of substitutes because managers cannot always appeal to each consumer, they try and group individuals with similar traits segmenting and sealing the market means that managers must segregate groups based on considerably different price elasticities of demand and make sure than they are unable to transfer the product easily from one class to another or else people can make money by buying the product from the low-price classes and selling it to the high-price classes using a third-degree strategy, managers must decide ho w much output to allocate to each class of buyer and at what price if there are 2 classes of buyers, managers will choose a total output across the 2 markets managers will maximize profit by allocating the total output so that the marginal revenue in one c lass is equal to the marginal revenue in the other managers want to allocate so the marginal revenue of both classes is equal when this is true, the ratio of the price in the first class to that in the second equals o o
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if = than P1=P2 therefore, segments with a lower (in absolute value) p rice elasticity are charged at a higher price turning to the more realistic case in which managers choose total output, it is obvious they must look at costs as well as demand in 2 classes manager will optimize profit when the marginal cost of the entire output is equal to the common value of the marginal revenue in the two classes the firm’s profit is
the total cost is a function of the total amount of the good produced and sold and is allocated Q1 to class 1 and Q2 to class 2 the monopolist has 2 output choices so profit is maximized when and note that and because revenues in class 2 are independent of sales in class 1 and because revenues in class 1 are independent of sales in class 2 two relationships are rewritten as
⁄ ⁄ ⁄ ⁄ ⁄ ⁄ ⁄ ⁄ ⁄ ⁄ ⁄⁄ both and equal MC (not MC1 and MC2) because the manager knows that producing another unit incurs additional costs Figure 8.3: curve representing the horizontal summation of the two marginal revenu e curves is G o
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shows that for each level of marginal revenue, the total output needed if marginal revenue in each class is to be maintained at this level optimal output is shown by the point where the G curve intersects the marginal cost curve because marginal cost must be equal to the common value of the marginal revenue in each class if this were not true, profit could be increased b y expanding output (if marginal cost were less than marginal revenue) or contracting output (if marginal cost were greater then marginal revenue managers produce an output of Q units and sell Q1 units in the class 1 market and Q2 units in the class 2 market the price is P1 in the class 1 market and P2 in the class 2 market results in a higher profit than if the firm quoted the same price in both markets
Managerial Use of Third-Degree Price Discrimination -
exampleairline tickets o charge lower fare for essentially the same ticket is it is purchased in ad vance, etc. price elasticity for business travel is much less elastic than for vacation travel and tickets are o priced accordingly o Internet firms such as Expedia scour airline databases continuously looking for che ap fares... diminishing airlines’ ability to practice third degree price discrimination because the airlines release the sale of certain seats to the sites, they are still falling into a managerial pricing plan (the plan would be different however if the sites were not present) Priceline uses a more first-degree strategy as consumers name their target price, X, and if the o cost of the seat to Priceless was Y, managers have created a surplus of Y-X
Using Coupons and Rebates for Price Discrimination -
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coupons and rebates price discriminate because only a certain segment of consumers regularly use them in buying goods and services more price sensitive and on the more price elastic part of the demand curve o managers price discriminate as other customers are willing to pay more (bu y a good without a o coupon) by estimating price elasticity of demand, managers can figure out how coupons should be priced managers choose a posted price P but then issue a coupon for $X example: affluent group (R) with price elasticity of -2 o less affluent group (S) with price elasticity of -5 o every buyer pays the nominal price of P per unit, but an $X credit appears for those who tender a coupon Although all buyers pay the same price P, in reality buyers without coupons pay P while coupon tenders pay P-X... what should P-X be? to maximize profit, the marginal revenue in each market should be equal and they in turn should equal the marginal cost
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given the price elasticities, solve for P and then solve for X one group pays P and the other pays P-X o so by issuing coupons (or rebates) managers can price discriminate and increase profit
Peak Loading Price -
different times, seasons, etc, influences people’s price elasticities for demand
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managers facing these demand conditions should charge different prices in the peak Pp and in the trough Pt MR=MC still marginal revenue curves differ because the service demand curves change between peak and trough MC is usually high in the peak because the supplier is operating at or near capacity and it is usually lower in the trough because much excess capacity exists both the third degree price discrimination and peak trough situations have separate marginal revenue s for each demand class, but in third degree price discrimination, the demand classes share the same supplier capacity at the same time marginal cost in third-degree price discrimination is a function of Q1 + Q2... two demands are interdependent in how they influence marginal cost optimal solution for third degree price discrimination is MR1(Q1)=MR2(Q2)=MC(Q1+Q2) optimal solution for peak trough pricing MR1(Q1)=MC1(Q1) and MR2(Q2)=MC2(Q2) parentheses indicate ―a function of‖
Two-Part Tariffs -
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two-part tariff: when managers set prices so that consumers pay an entry fee and then use a fee for
each unit of the product they consumer o often managers will implement a first-degree price discrimination strategy through a two-part tariff ex: wireless phone users pay an initial fee and then are charged monthly fees o upfront fee is designed to extract the consumer surplus so managers use it for first degree price discrimination example of this pricing principle: o assume all demanders for a service are clones and have the same demand curve for the service (i.e. same preferences) assume managers face a constant marginal cost of production o the profit-maximizing optimal two-part tariff requires managers to price the use fee equal to the o marginal cost and to price the entry fee equal to the consumer surplus managers must choose use fee before they determine their entry fee o (Figure 8.5) use fee P* equals MC o o the use of fee, the demander wishes to consume Q* units resulting consumer surplus is A* and that is the optimal entry fee o the use fee covers the manager’s variable cost of serving the consumer (because MC=AVC and o (AVC)Q*=VC) and the variable cost profit of the firm for serving this consumer is A*+P*Q* (AVC)Q*=A* (because AVC=P*) multiplying A* by the number of clones and subtracting the firm’s fixed cost gives managers o their profit a two-part tariff lets managers act as first-degree price discriminators managers capture the entire consumer surplus through the entry fee and convert it into producer surplus (variable-cost profit) managers produce until price equals marginal cost two-part tariff is simpler for managers to implement than first-degree price discrimination because they need not charge individuals different prices for each unit of the good consumers two-part tariff advantages: o entry fee is collected up front at the beginning of the demand period (whereas for first-degree price discrimination price from the consumer is collected at the time of e ach individual consumption of the product or service)
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although managers understand that there are some units for which consumers will pay a high price and some units for which consumers will pay a low price, at a given time managers are not certain of consumer reservation prices all a manager must know is that sometime over the demand period, consumers will show variance in their reservation prices... by using a tw o-part tariff strategy, managers need not worry about this variance in behaviour... they have already collected their surplus with the entry fee two-part tariffs can be used to get customers to reveal th eir preferences o ex: in the wireless phone industry, managers offer customers different plans that vary in monthly charges and use fees... customers choose the plans they believe are optimal for them; hence they reveal their preferences o
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A Two-Part Tariff with a Rising Marginal Cost -
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if the marginal costs are upward-sloping rather than constant, the optimal rule for managers remains the same: charge a use fee equal to marginal cost and an entry fee equal to the resulting consumer surplus the difference is that managers realize additional profit from the use fee (figure 88.6 pg 272 area o X*) as well as their entry fee charging a use fee of P* results in selling Q* to the consumer yields revenues of P*Q*=X*+Y* from the use fee the variable cost of selling Q* units to the customer is the area under the marginal cost curve Y* the revenue from the use fee more than covers the variable-costs of serving the customer, and managers earn a variable-cost profit from serving the customer of X* from the use fee the entry fee is the consumer surplus that results from charging the use fee of P* (that is, A*) hence the variable-cost profit of serving this customer is A*+X*
A Two-Part Tariff with Different Demand Curves -
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in most markets people do not have the same demand curves consider a market with strong demanders, who are willing to purchase more units than the weak at any given price managers should consider at least three two-part tariff pricing options o if the strong demander is willing to buy significantly more units at an y price, then it is more profitable to charge a use fee equal to marginal cost and an entry fee equal to the resulting surplus of the strong demander this strategy excludes the weak demander from the market... the weak demanders consumer surplus is smaller than that of the strong demander so the weak demander is not willing to pay the entry fee in a single-price scenario, no consumer whose reservation price is below the market price participates in that market other two pricing possibilities are used when the strong demand is not that much stronger than the weak demand o managers should set the use fee at or above marginal cost and set the entry fee equal to the resulting consumer surplus of the weak demander cannot use first degree price discrimination against the strong demander and this demander will realize some consumer surplus o if managers want to exclude the weak demander, they should set the use fee equal to marginal cost (=AVC) and the entry fee equal to the resulting consumer surplus of the strong demander revenue from the use fee equals the variable cost incurred serving the strong demander o o the variable cost profit is the entry fee (areas A* through F)
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if managers want to include the weak demander, they must choose P*, which maximizes the area 2A*+2C+D+E once P* is chosen, it determines the consumer surplus A* o because both managers are willing to pay A*, managers realize 2A* in revenues o o revenues from the use fee more than cover the variable cost of serving the consumers at a use fee of P*, the weak demander wants Qw units of the good and the strong demander o wants Qs area C represents the variable-cost profit managers realize from the use fee revenues from the o weak demander, and are C+D+E represents the variable-cost profit realized from the use fee revenues from the strong demander the total variable cost-profit is 2A*+2C+D+E from serving both demander types o o if the use fee is set equal to marginal cost, the resulting consumer surplus of the weak demand er is A*+C+D... both demanders will pay it no profit from use fee because it equals marginal cost (=average cost) o the profit managers earn is 2A*+2C+2D o whichever is the largest of 2A*+2C+D+E and 2A*+2C+D+E and A*+B+C+D+E+F will determine the optimal two-part tariff if demand curves intersect, things get more complicated o
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Bundling and Intrafirm Pricing -
simple bundling: when managers offer several products or services as one package so consumers do not
have an option to purchase package components separately mixed bundling: allows consumers to purchase package components either as a single unit or separately bundling price generally less than price of components bundling best used when there is wide variance in consumers’ price sensitivity of demand and when market conditions make it difficult to price discriminate managers increase profit by leveraging the different v aluations (reservation prices) consumers have for a product managers prefer to form bundles so as to create negative correlations across consumers o negative correlation: when some customers have higher reservation prices for one item in the bundle but lower reservation prices for another item in the bundle, whereas another group of customers has the reverse preferences
The Mechanics of Bundling -
can increase seller’s profit if customers have varied tastes it is a way to emulate perfect price discrimination when perfect price discrimination is not possible we need not know the reservation prices of each customer for each good, but rather the distribution of all consumers; reservation prices over the goods
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we assume the goods are independent o if goods are complementary, the goods as a bundle of higher value than the goods separately, i.e. hardware and software the cost of the bundle is the sum of the individual costs od the two goods if managers cannot price discriminate but must charge a single price for each good, we’ll assume that price is the simple monopoly profit-maximizing one 3 possible pricing scenarios: price separately (fig 9.1 page 291) o managers choose the optimal simple monopoly prices for good 1 and 2 (the ones that max profit) whether consumers purchase goods separately depends on their reservation price for the good relative to the prices charged by the seller e.g. consumers in the upper right cell buy both goods given their high reservation prices for the goods pure bundling (fig 9.2 page 291) o managers choose the optimal pure bundle price whether consumers purchase the bundle depends on the sum of their reservation prices for the goods relative to the bundled price charged by the seller line buy the bundled product... (r1+r2)> Consumers located to the right of the mixed bundling (fig 9.3 page 292) o Managers choose the optimal pure bundle price, the optimal separate price for good 1 and the optimal separate price for good 2... all set to maximize profit Whether the consumer purchases the goods separately or as a bundle depends on the consumer surplus. Consumers choose the goods or bundles that maximize their consumer surplus
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the optimal solution is the greatest profit of the profit-maximizing solutions yielded by separate p ricing, pure bundling and mixed bundling calculating the best mixed bundle prices solution is derived either by educated trial and error or via a computer program p rogram that searches all o separate prices and pure bundle prices and chooses the combination yielding the highest hi ghest profit credibility of the bundle: when managers correctly anticipate which customers will purchase the bundle or the goods separately extraction: when the manager extracts the entire consumer surplus for each customer manager can also practice exclusion: when the manager does not sell a good to a customer who values the good at less than the cost of producing it manager may want to practice inclusion: when a manager sells a good to a consumer who values the good at greater than the seller’s cost of producing p roducing the good perfect price discrimination extracts all available consumer surplus, does not sell to anyone for less than cost and sells to everyone who values the good more than cost perfect price discrimination satisfies price separately, pure bundling and mixed bund ling o o these strategies can be compared to perfect price p rice discrimination on the 3 dimensions of extraction, exclusion and inclusion pricing separately should always entail exclusion and will not fully complete extraction or inclusion pure bundling can allow complete extraction, but when the sum of all demanders o can also fail inclusion and exclusion the best price strategy changes when the cost of producing the goods changes o reservation prices for goods does not lie on a line with the slop of -1 (less than perfect correlation of reservation prices), extraction is less than complete mixed bundling falls somewhere between price separately and pure bun dling in general, optimal pricing solutions among these 3 methods entail a trade-off among the concepts of extraction, exclusion and inclusion mixed bundling weakly dominates pure bundling mixed bundling weakly dominates pricing separately technically mixed bundling should be a part part of any bundling strategy because the profit is always always better than or equal to that of pricing p ricing separately or pure bundling negative correlation of reservation prices enables a ma nager to fully extract all consumer surplus with a pure bundle when the cost of production is low o if we increase the production cost while keeping the t he reservation prices with perfectly negative correlation, initially mixed bundling is the profit maximizing action; if production costs keep increasing, eventually separate pricing will maximize profit negative correlation is not required to make bundling the best choice (fig 9.5-9.7) suppose customers are uniformly distributed over reservation prices for good 1 from $0 to $100 o and for good 2 $0 to $100zero correlation of reservation prices even without negative correlation, bundling can increase profit over simple monopoly pricing o (pricing separately) o optimal separate prices in the case of uniformly distributed d istributed consumer reservation prices the optimal separate prices when the uniform distribution of consumer reservation prices is between $0 and $100 for both goods are $50 for each good... profits are $500,000 o optimal pure bundle price in the case of uniformly distributed consumer reservation prices the optimal pure bundle price when the uniform distribution of consumer reservation prices is between $0 and $100 for both goods is $81.65... profits are $544,331.10 o optimal mixed bundle pricing in the case of uniformly distributed consumer reservation prices the optimal mixed bundle pricing when the uniform distribution of consumer reservation prices is between $0 d $100 for both goods is P1=66.67, P2=66.67 and Pbundle=86.19... profit is $549,201.
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here, best pricing policy is mixed bundling we must consider quantity discounting as a form of o f mixed bundling su m consider only customers’ reservation prices as candidates for optimal separate prices and only the sum of customers’ reservation prices as candidates for pure bundling in mixed bundling, the optimal op timal prices need not be any customer’s reservation price (or sum o f reservation prices)... consumer selects the good or bundle that leaves her with the greatest consumer surplus complexity of solving for the optimal bundle is that managers have no marginal profit=0 formula to help derive the optimal pricing scheme but rather the procedure is more trial and error than derivation d erivation a manager can maximize profit even if the prices of the individual goods or the bundle are different than th an reservation prices of consumers o cannot be true when considering just separate pricing p ricing or pure bundling whether we deal with prices different than reservation prices or their sums depends on trade-offs o from the customers’ view of consumer surplus and from the producers’ view of producer surplus if you do not charge the th e reservation prices of the customers, you cannot maximize profit using a separate pricing strategy... same is true for pure bundling o
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When to Unbundle
the concept of bundling entails a null case of pricing the bundled goods separately just because bundling is the optimal pricing strategy at time t, does not mean it is the optimal pricing strategy at time t+1 o managers must reassess their markets periodically to see if changed cond itions warrant new prices, including an unbundling of commodities anal yzing the ―crow’s feet‖ (the large blue lines) in figure 9.8 page - The bundling problem is solved by analyzing 310 the ―crow’s feet‖ method is extended when the reservation price of consumer B for good Y o increases from 10 to 11 - although some form of bundling (pure or mixed) will many times increase a firm’s profit, unbundling can also increase profit all depends on reservation prices and the costs of production o -
Bundling as a Pre-emptive Strategy -
bundling is used to deter entry by b y potential arrivals example: Alpha company has developed a bundle of product W and product S, which they plan to sell for o $X the Beta company is developing product produ ct C that is a close substitute to W o o the Gamma company is developing product p roduct N that is a close substitute to S o only Alpha has financial ability to bring both products to the market Alpha’s entry cost to the market is 30 o o costs Beta 17 to enter the market o costs Gamma 17 to enter the marker if Alpha were to produce each product separately, it would cost them 15 to enter the market o entry costs are independent of units sold o Alpha’s entry costs are 15 for each product regardless of whether the product is sold separately o or is included in a bundle consumers also regard making their own bundle o f C and N as comparable to Alpha’s bundle of o W and S
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it costs each producer 2 to distribute each product (4 for Alpha to produce its i ts bundle) o if Alpha were the only participant in this market, the pure bundling strategy yields all consumers purchasing and a net revenue exclusive of entry costs of (30 x 3 – (4 x 3)=78)... Alpha’s entry costs are 30, yielding a profit of 48 exceeds the best separate price strategy of Pw=Ps=15, which yields a profit of (15x4)(2x4)-(15x2)=22, or the mixed bundling strategy of the bundle priced at 30 and Pw=Pn=20, which yields a profit of ((30-4) x 1)+((20-2)x2)-(15x2)=32 if Alpha faces the entry threat from Beta and Gamma, G amma, it cannot price the bundle at 30 o Beta and Gamma could enter and sell their products for 23/3 and make money if both Beta and Gamma priced at 23/3, all three consumers would purchase from Beta and o Gamma, who would be earning a normal profit (and zero excess profit) o if Alpha prices at slightly less than 46.3, then neither Beta or Gamma can enter the market because neither can cover the 23/3 cost profit would be reduced but it leaves Alpha as the sole producer threat of entry can significantly reduce monopoly monopol y profit at the same time, the use of bundling can preclude entry and keep a profitable market for the bundler simple guidelines that help managers construct more effective bundling po licies: if goods’ reservation prices are positively correlated, pure bundling can do no better than o separate pricing (but mixed bundles might) o if the marginal cost of producing a good exceeds its reservation price, in general you should think carefully about selling it if goods’ reservation prices are correlated perfectly negatively and the marginal cost of o production of the goods is zero, pure bundling b undling is best if goods’ reservation prices are negatively correlated, as the marginal cost of production o increases, mixed bundling is likely to be better than pure bundling; and as it increases further, separate prices are likely to be better o
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Tying at IBM, Xerox and Microsoft -
tying: a pricing technique in which managers sell a product that needs a complementary product
successful implementation of a tying strategy generally requires the exercise of market power IBM< Xerox and Microsoftmarket shares over 85% o why do firms engage in tying: way of practicing price discrimination — by by setting the price of the complementary product well o above its cost, managers can get a much higher price from those who use it more often o maintain their monopoly position (Microsoft ties Internet browser with Windows operating system) ensure that a firm’s product works properly and its brand name is protected, e.g. McDonald’s o franchises must buy their materials and food from McDonald’s so that the hamburgers hambu rgers are uniform and the company’s brand name is not tarnished
Transfer Pricing o
Wikipedia: Transfer pricing refers to the pricing of contributions (assets, tangible and intangible, services, and funds) transferred within an organization. For example, goods from the production division may be sold to the marketing division, or goods from a parent company may ma y be sold to a foreign subsidiary. Since the prices are set within an organisation (i.e. controlled), the typical market mechanisms that establish prices for such transactions between third parties may not apply. The choice of the transfer t ransfer price will affect the allocation of the total profit among the parts of the company
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in some cases, transactions occur where markets do not exist... many times they involve intrafirm pricing say there are 2 divisions of a firm, where a product required as an input is produced exclusively in an upstream plant for use in a product of a downstream plant transfer pricing results from creating an internal market that stimulates an external one and allows optimal profit-maximizing decisions by managers in both divisions of the firm transfer price: payment that simulates a market where no formal market exists in considering transfer pricing policies managers need to ensure that the profit-maximizing output of the downstream and the upstream output is produced they must ensure that the upstream managers have the right incentive to produce the profit-maximizing amount of the upstream product in the most efficient way demand curve for the downstream product: parentheses mean ―function of‖ production function of the downstream operation: o Qd can be produced with labor and capital given the critical upstream input Qu this production yields a downstream cost function of , which is the total cost od the downstream division exclusive of the cost of the upstream operations total cost of the upstream division is a function of Qu... profit for the multidivisional firm is
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to max profit we must have
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Qu is the variable that controls what the firm does without the critical input produced by the upstream division, nothing can be produced in the downstream division whatever is produced upstream equals the amount produced downstream when the transfer pricing is done correctly... Qu=Qd cannot have a total revenue equation for upstream division in equation TRu=PuQu as is would be exactly offset for a cost item for the downstream division o
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if managers produce another unit in the upstream product, they incur an additional cost MCu producing that additional upstream product enables the firm to produce MPu more downstream o units each additional downstream units produced causes managers to incur additional cost in the o downstream plant (MCd) but also enables them to earn additional revenue (MRd) o if the additional net revenue earned, (MRd-MCd)MPu, which is produced as a result of incurring additional cost upstream, MCu, exceeds that additional u pstream cost, then managers want to produce the additional unit upstream (because profit increases) if it does not, managers do not want to produce an additional unit upstream (because profit decreases) o managers maximize profit when the additional net revenue earned downstream as a result of producing an additional unit upstream just equals the additional cost incurred in producing that unit upstream MPu=1 because every time one more unit is produced upstream, one more unit can be produced downstream in situations where it would appear that the upstream firm has to produces multiple units to enable one additional unit to be produced downstream, such as 4 tires being required to produce one car) we treat this by requiring one bundle (of 4 tires) to be produced upstream in order to produce one car MRd-MCd=MCu o o MRd=MCd+MCu marginal revenue of the product must equal the marginal cost of producing it o
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the marginal cost of producing the downstream product is the marginal cost of the downstream operation (excludes the cost of the upstream operation) plus the marginal cost of the upstream product from the point of view of the conglomerate, profit is the same the profit of each division differs o if the conglomerate’s managers determine the optimal Q, and order both divisions to produce it, then the conglomerate maximized prices regardless of transfer price if the managers are trying to maximize firm profit, it is critical that the correct Pu be chose if too high, the upstream division will produce too much of the product o o managers in the downstream division will see their marginal cost of produc ing another unit as too high and therefore will produce too little downstream output if Pu is set too low, managers of the downstream division will set their marginal cost of procuring another unit as too low and will therefore want to produce more than optimal output
Transfer Pricing: A Perfectly Competitive Market for the Upstream Prod uct -
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in many cases, there is a market outside the form for the product transferred from one division to the others here, output levels of the downstream and upstream divisions no longer have to be equal o o can buy/sell extra product from external sellers/buyers assuming the market for upstream product is perfectly competitive, we can readily determine how managers should set the transfer price Fig. 9.10 o perfectly competitive market for upstream, therefore horizontal demand curve to max profit, managers at upstream division should produce the output where the marginal cost o of the upstream division equals the externally determined market price o in this sense, upstream division acts like a perfectly competitive firm to max the firm’s overall pr ofit, the transfer price should equal the price of the upstream division o in the perfectly competitive market outside the firm because managers at the upstream division can sell as much product as they want to external o customers at Pu, they have no incentive to sell below Pu to the downstream division because managers at the downstream division can but as much of the upstream product as they o want from external suppliers at Pu, they have no incentive to buy it from the upstream division at a price above Pu managers at the downstream division have a marginal cost of MCt, which is the sum of the o downstream division’s marginal cost MCd and the market determined price of the upstream product Pu to max their own profit, managers at the downstream division must choose the output level o where their marginal cost MCt (=MCd+Pu) equals their marginal revenue MRd in this case, the optimal solution calls for the conglomerate’s upstream division to sell part of its o output (Qu-Qd) to outside consumers (since Qu>Qd)
The Global Use of Transfer Pricing -
for domestic interdivisional transfers, the most common methods were the use of market p rices, actual or standard full production costs, full production costs plus a markup, and negotiated prices for international transfers, market-based transfer prices and full production costs plus a markup were the most commonly reported methods since 1977, the shift has been to market-based prices in both the domestic and international markets managers use transfer pricing to shift profits between divisions to minimize tax liability
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in many countries, managers use transfer prices to decrease profit in high-tax countries, transferring profit to low-tax countries tax rate in a downstream country is and the tax rate in an upstream country is ... suppose the case is one of no external market for the upstream product the after-tax profit in the downstream country is o o the after-tax profit in the upstream country is supposing that all profits are expressed in the same currency, the overall conglomerate’s after -tax profit is o
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because , the conglomerate’s after -tax profit is higher if Pu is greater, but the optimal before-tax profit-maximizing Pu is what it is (and it could be low) suppose the firm, having determines the optimal Q*d=Q*u=Q*, now creates a subterfuge (trick) Pu= for tax purposes and sets it such that
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all corporate profit is taxed at the lowest rate we see the motivation of high tax rate countries to look at the transfer price policies of multinational firms why transfer prices have become so important on the international level: o increased globalization different levels of taxation in various countries o greater scrutiny by tax authorities o o inconsistent rules and laws in the various tax jurisdictions transfer price policies that seem to cause the fewest legal problems in the international scenario are comparable uncontrolled price, in which the prices are the same or similar to arms-length o transaction prices o cost- plus prices, in which markup used in arm’s length transaction is added to the seller’s cost of the good or service resale price, in which the resale price is used as a base for determining an arm’s length margin o for the functions performed by the selling company
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, the profit in the downstream country becomes 0 and the after-tax profit is
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Oligopoly -
oligopoly: a market with a small number of firms
oligopolies can rule markets because: o high entry barriers that managers create using their cooperative market power o government fiat economies of scale — because costs decrease as output expands, only a few firms can survive in o the market o behavioural strategy — more varied in oligopolies as a opposed to monopolies...variance in choice due to tight interdependence between market rivals
Cooperative Behaviour -
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encourages cooperation among rival managers increase profit, decrease uncertainty, and raise barriers to discourage others from entering the o market cartel: when a collusive arrangement is make openly and formally legal in some countries but not usually in the US o if a cartel is established to set a uniform price for a particular product, they must estimate the marginal cost curve from the cartel as a whole if input prices do not increase as the cartel expands, the marginal cost curve is the horizontal summation of the marginal cost curve of individual firms to maximize profit, the cartel will use the monopoly price (max cartel, not individual firms) cartel managers also determine the distribution of sales across all members makes cartels unstable o should allocate sales to cartels so that the marginal co st of all members is equal (to max profits) o otherwise, managers can increase corporate profit by reallocating ou tput amounts among members to reduce the cost of producing the cartel’s overall output if the MC at firm A is higher than that of firm B, cartel mangers can increase profit by o transferring some production from firm A to firm B this allocation unlikely to take place because allocation decisions are the result of negotiation between members with varying interests and capabilities those with most influence and best negotiators are likely to receive largest sales quotas even though total cartel costs are raised managers at high cost firms likely to receive bigger sales quotas than cost minimization requires because they are unwilling to accept the small quotas required by cost minimization
The Breakdown of Collusive Agreements -
not stable Figure 10.2 page 337 if manager chooses to leave cartel, they would face the demand curve DD’ as long as the other o firms in the cartel maintained a price of Po extremely elastic prices even if firms were unable to leave cartel, they’d face same demand curve if they granted secret o price concessions o max profit of manager leaving cartel or secretly lowering price is where MC=MR higher profits realized as long as other managers don’t d o the same... cartel would dimish
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Price Leadership -
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price leadership: in oligopolistic industries, managers at one firm have significant market power a nd
can set their price o ex: steel, nonferrous alloys, agricultural implements assume market composed of one dominant firm (price leader) and number of small firms dominant firm sets price and allows small firms to sell as much as the y want at that price o whatever amount the small firms to not supply at that price is provided by the dominant firm o because managers at the small firms are price takers, the y act as if they are in a competitive market...choose output where price equals marginal cost supply curve for all small firms is estimated by horizontally summing their marginal cost curves demand curve at large firm=total amount demanded-amount supplied by small firms optimal output for the dominant firm is the output Q1, where its marginal cost equals its marginal revenue
Possible Behaviour in Markets with Few Rivals -
duopolies — behaviour using two firms (for example purposes... applicable to oligopolistic markets) when rival managers make decisions without knowing the decisions of others, we say decision making is simultaneous sequential move strategies — managers know the decisions of others before making their decisions first movers/market leaders — take action before others o accelerate before others: see what others don’t see because of business insight or luck
When Rivals Are Few: Price Competition - often price competition results in a downward spiral of price cuts, stopped only (sometimes) by the
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constraint of marginal cost consider two firms with identical total cost functions, same market demand curve and marginal cost if managers at both firms want to compete on price, the competition will drive price down to the level of their marginal cost (never produce below marginal co st) consider a good demanded that has a reservation price of $99 and a production cost of $5 firm A will charge $99, which will be countered by a price of $98 by firm B and then a price of o $97 by firm A, etc, until the price bids down to $5 we can expect that price equal to marginal cost is the ultimate resolution of this pricing contest when developing output function for firm A, it is in terms of firm B (and vice versa)... sub o ne into the next and find to equal outputs, prices, marginal costs, revenues, profits
When Rivals Are Few: Collusion - instead of price wars, managers can engage in a cartel (here it is legal) - market demand curve is the cartel’s demand curve, and the cartel’s marginal cost curve is the horizontal summation of each firm’s marginal cost curve - cartel behaves as a monopolist and sets its marginal revenue equal to its marginal cost - since each firm has the same marginal cost equation, each should produce the same amount sot that both have the same marginal cost, which equals the cartel’s marginal revenue (2 firms split total revenue) - this revenue is much higher than when firms competed on price - cooperative behaviour significantly restricts output and significantly increases profit (what monopolists
do) When Rivals Are Few: Quantity (Capacity) Competition - competing on price is lose-lose, but cartels are often illegal
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must compete on some metric that affects profit and gives them a higher profit relative to competing on price one metric is quantity (sometimes called Cournot) Cournot analysis makes the following assumptions: rival managers move simultaneously, have the same view of market demand, estimate each other’s cost functions, and choose their profit-maximizing output conditional on their rival choosing the same it is thought as problematic that rival managers hold the same beliefs regarding demand, but more evident than some think o sometimes exposed to same data firms get to know each other when they’ve competed for a long time o still possible that those with the same economic data come up with different assessments o o without knowing the other firms’ cost functions, good approximations can be made because many of the expenses are similar to one’s own assumption that firm A optimizes their quantity given that firm B’s quantity is fixed Which output you actually choose to produce of all the ―what-if‖ possibilities depends on what o you think your adversary will actually so (and your adversary is going though the same ―what-if‖ process) By a process of deduction, managers can estimate the most logical output for rivals given profito maximizing behaviour... Cournot solution view Cournot solution to the preceding case in two different ways: following a series of what-if scenarios o if firm A managers think that managers at firm B will hand over the market to them, they should behave as a monopolist since the monopolist’s marginal revenue is the same as the cartel’s in the preceding situation, managers maximize profit by setting MR=MC rewrite market demand curve as Q=100-P firm A’s residual d emand curve (market demand curve less what managers assumed firm B produces) if the highest price could be $4 and the lowest marginal cost could be $4, the price could never be equal to or exceed firm A’s marginal cost at a positive level of output what-if firm B produced 50 units, firm A makes an optimizing-quantity response by doing more what-if situations, we can make a whole table of all possible firm outputs reaction function: a function that identifies for managers the profit-maximizing output to p roduce given the amount of their rivals we identify how to anticipate the profit-maximizing output of a rival by substitutions firm A’s reaction into firm B’s reaction function and solving for qA (and vice versa) the only way that managers at both firms can profit maximize is if they stay on their reaction functions profit-maximizing output is conditional on the output of their rival o must find point of intersection between these functions (Nash equilibrium) A Cournot equilibrium occurs where the two firms’ reaction functions interest. This is the only output combination where both firms’ expectations of what the other firm will produce are consistent with their own expectations of what the other firm will produce are consistent with their own expectations of their own optimal output the profits here are less than that of firms in monopolies, bu t considerably better than when firms compete on price adding just one more producer to a monopoly market significantly changes prices, output and profit
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The Cournot Scenario with More than Two Firms consider a market demand curve P=a-bQ with n identical firms, i.e. Qi=Q/n where a and b parameters -
of the demand function and Qi is the output of the ith firm
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marginal cost of each firm is MCi=c+eQi, where c and e are the parameters of the marginal cost function market demand curve can be rewritten as
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total revenue for firm i is
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The marginal revenue of the firm i is
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since all firms are the same, Qi=Qk further simplifying of marginal revenue gives MRi=a-(n+1)bQi to maximize profit, managers will set MRi=MCi or
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Solving for Q given
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as shown in figure 10.2, the more firms you add, the lesser the profits... after 3 firms are added, profit becomes negative because of high level of fixed costs even if managers of these entrants have higher costs, they still erode the market power of incumbents and generate significant downward pressure on price
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When Managers Move First: Stackelberg Behaviour - consider a situation where managers at one firm are able to implement actions prior to those of rival
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managers How should managers at firm B react to the capacity decision of A managers? o if they want to maximize profit, they have to follow the reaction function (how B should act to maximize profit, given the decision of A managers managers cannot possibly max profit if they are operating off their reaction function, so o managers at firm A can anticipate the capacity choice of B managers as a general managerial rule, if you have the market strength so market rivals yield you the power to move first, use it in the given example, firm B’s total profit is worse than under the Cournot so managers at B do pay a penalty for moving second profit situation is exactly reversed is managers at firm B moved first in the case where firms have the same costs, it is worth the same amount for each firm to go first o o in situations where the firms have different cost functions, the low-cost firm has a greater advantage than the high-cost firm in all pricing schemes discussed here, including the first mover situation managers at a low cost firm have the most to gain by moving first o they can even afford to ―purchase‖ the first-mover advantage (i.e. outbid high cost firm for the patent on the product, build a bigger plant than the high cost firm to pre-empt the output decision of the second mover consider firms with different cost functions and use the Stackelberg solution for each firm moving first o we can see how lower cost leverages the advantage of moving first each firm A and B gain profits by moving firms firm A gains the most from moving first, so if it were a question of acquiring the patent rights o from an inventor, managers at firm A could outbid managers at firm B for the patent for the first time in our analysis of firm behaviour, your optimal strategy depends o n what your adversary does... your MR depends not only on what you do but also on what your adversary does
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reciprocal decisionsmy actions depend on your actions which in turn depend on my actions such interdependence is typical of most of the economy
Duopolists and Price Competition with Differentiated Products -
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view two competitors who product differentiated but highly substitutable products for simplicity, zero marginal cost depending on the quantity equation, as managers at firm 2 price their product higher, the quantity demanded at firm 1’s product increases as bu yers switch differentiation can only mitigate price competition; it is difficult to erase it as a p urchase attribute demand for one firm’s product depends not only on what managers control (the price) but also on what the rival charges (though they can influence the choices of rivals) as in Cournot, id managers get into a price war, they will compete prices down to marginal cost (which we decided are 0 here) and this profit will be 0 lose-lose situation o Bertrand model — compete on price without committing economic suicide
A Bertrand equilibrium occurs where the two firms’ reaction functions interest this is the only price combination at which both firms’ expectations of how the other firm will o price are consistent with their own expectation of their own optimal price
The Sticky Pricing of Managers -
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the Cournot model explains why price may be ―sticky‖... managers evolve the optimum and stay there even in markets with homogeneous products, managers show little incentive to deviate especially true where cost and demand have been stable or easily anticipated and managers have o competed for several years prices can also be sticky when products are somewhat differentiated consider managers facing a limited number of competitors... should managers increase price, demand will be quite elastic some customers will buy elsewhere when price increases, but other customers have a higher o value for the product should managers drop their price, they could assume the demand become less elastic because rivals will also reduce prices to protect their sales although lowering the price, if no other firm followed suit, might increase sales, when rivals follow a price cut, margins decrease and the increase in sales may not make up the difference o managers face a kinked demand curve with demand being gently sloped above it and steeply sloped below it this pattern yields a discontinuous marginal revenue curve o therefore, the marginal revenue cost curves yield the same price Po and quantity Qo for the o profit-maximizing profit when they intersect the marginal revenue in the d iscontinuity costs can shift around quite a bit without changing the profit-maximizing price (making it sticky) o
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Game Theory Making Strategy and Game Theory -
interactive: when the consequence of a manager’s decision depends on both the manager’s own action
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and the actions of others game theorymanagers increase ability to anticipate decisions of others through its use a rule basic to formulating strategy is the direct result of interactive payoffs: the lack of an unconditional optimal strategy
Strategic Basics -
the rules (the parameters) define the game all game theoretic models are defined by a common set of five parameters: the players — entity making a decision o o the feasible strategy set — only actions given a nonzero probability of occurrence are assessed the outcomes or consequences o each strategy of a player intersects the strategies of others to form the outcome matrix an outcome is defined by the strategy choice of each player o the payoffs based on preferences (assuming rational managers, they prefer higher to lower) player identities are important as payoffs are subjective o the order of play — the order in which players reveal their chosen strategies simultaneous players commit to a strategy before learning others’ strategies of others nonsimultaneoussequential
Visual Representation -
matrix form: form that summarizes all possible outcomes
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extensive form (game trees): form that provides a road map of player decisions o o
states timing of choices among players nodes=decisions, lines=strategy set
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Solution Concepts -
much of the theory’s predictive power comes from solution concepts, which are basically rules of behaviour
Equilibria -
equilibrium: when no player has an incentive to unilaterally change his or her strategy
the present choice rewards players with the highest payoff if no other player changes behaviour rational, optimal, stable
Dominant Strategies -
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dominant strategies: a strategy whose payout in any outcome is higher relative to all other feasible
strategies although strategy choices of others affect managerial payoffs, thinking abo ut others does not change the decision always pick dominant strategy if one exists, if not dominated strategies o we don’t actually play these, we reduce the set of possible outcomes by using different degrees of rationality in matrix form, we the degree of rationality by the rounds of iterative dominance needed to reach the equilibrium... many people act rationally with a few degrees of rationality
3 degrees of rationality
The Nash Equilibrium -
anticipate behaviours without dominant strategy equilibriumNash Equilibrium choose strategy that maximizes payoff, conditional on others doing the same (dominant if followed) you would look at each option for the first company and decide how the second company would react you would look at each option for the second company and decide how the first company would react any cell that both companies choose is a Nash equilibrium
Strategic Foreseight: The Use of Backward Induction
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strategic foresight: a manager’s ability to make decisions today that are rational given what is
anticipated in the future backward induction: used in game theory, to solve games by looking to the future, determining strategy players will choose (anticipation), and then choosing an action that is rational based on those beliefs easier to use extensive forms
If IBM expands, HP will not... If IBM does not expand, HP will. Taking this into account, IBM will make $150 if it expands and $60 if it does not. Therefore, IBM should expand
Backward Induction and the Centipede Game -
centipede game: a sequential game involving a series of six decisions that shows the usefulness of
backward induction in strategic thinking
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if you are firm I, you start at the end and anticipate what firm II will do based on how much profit it will get, work backwards until you get to the present (see Figure 11.9 page 385)
The Credibility of Commitments -
credible commitment: when the costs of falsely sending one are greater than the associated benefits
when managers say its product is best, the claim is not credible because it costs nothing to say it and benefits are high, whereas giving product warranty increases commitment cost (Figure 11.10 page 387) look at an extensive diagram to see how a second firm will react to the first firm dropping or maintaining its price. Hypothetically, if the second firm claims it will drop its price when the first one maintains its price, you can see if the claim is credible based on their profits when it either drops or maintains its price the equilibrium just describes is a subgame perfect equilibrium subgame: a segment of a larger game o in repeated games, all subgame perfect equilibria are Nash equilibria, although not all Nash equilibria are subgame perfect Nash equilibria based on noncredible threats are not subgame perfect o o
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the equilibrium for any subgame is rational, conditional on equilibrium play in the future
Related Games -
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Prisoner’s dilemma (Figure 11.11 page 388) rational choice for both to price low, however firms that have been competing for years may not cooperative behaviour is easier to maintain in an infinite horizon game because the future always looms in finite horizon games, the future grows smaller as we approach the last period folk theorem: this theorem states that any type of behaviour can be supported by an equilibrium (as long as the players believe there is a high probability that future interaction will occur) in an infinite horizon game, if they both price high, they could see mutual benefits, but there is risk that one firm could undercut the other by pricing low in a finite horizon game, behaviour is predicted on the use of credible signals of future behaviour and their power diminishes as the future grows shorter managers at both firms price low o The equilibrium in a repeated version of the game identical to that of a one-shot game... managers should price low
Incomplete Information Games -
incomplete information game (IIG): A branch of game theory that loosens the restrictive assumption
that all players have the same information the introduction of incomplete information makes it possible to d erive cooperation as an equilibrium behaviour tit for tat: strategy that allows players to cooperate in the first period and in all succeeding periods the players mimic the preceding period’s strategy of the other player (follow pricing method of other firm) if the other firm is opportunistic, firm suffers only one period of low p ayoffs in IIG models, players possess asymmetric information, which is summarized in the form of pla yer types type — player characteristics that are unknown to others o knowing whether a firm is ―hard‖ or ―soft‖ will affect whether or not a new firm enters the market, but this is unknown
Coordination Games -
matching games — players prefer the same outcome
may be obstructions - battle of the sexes — want to coordinate but want different outcomes (each prefer payoff not favoured by the other) if this game is repeated, players often switch between equilibria so that both gain o - assurance games — players have similar preferences for outcomes but have an associated risk although managers at both firms both prefer to shift, there is risk that if one shifts the other does o not - first-mover games — both managers want to coordinate but each has an incentive to produce a superior product (similar to battle of the sexes) both firms want to introduce a superior product first which is determined b y who is willing to o pay the most o
