+ Managerial Economics & Business Strategy Chapter 1 The Fundamentals of Managerial Economics...

+Managerial Economics & Business Strategy

Chapter 1The Fundamentals of Managerial Economics

+Managerial Economics

Manager A person who directs resources to achieve a stated goal.

Economics The science of making decisions in the presence of scare

resources.

Managerial Economics The study of how to direct scarce resources in the way that

most efficiently achieves a managerial goal.

+Economic vs. Accounting Profits

Accounting Profits Total revenue (sales) minus dollar cost of producing goods or services. Reported on the firm’s income statement.

Economic Profits Total revenue minus total opportunity cost.

+ Opportunity Cost

Accounting Costs The explicit costs of the resources needed to produce produce goods or

services. Reported on the firm’s income statement.

Opportunity Cost The cost of the explicit and implicit resources that are foregone when a

decision is made.

Economic Profits Total revenue minus total opportunity cost.

+Profits as a Signal

Profits signal to resource holders where resources are most highly valued by society. Resources will flow into industries that are most highly

valued by society.

Control Variable Examples: Output Price Product Quality Advertising R&D

Basic Managerial Question: How much of the control variable should be used to maximize net benefits?

Marginal (Incremental) Analysis 1-6

+Net Benefits

Net Benefits = Total Benefits - Total Costs

Profits = Revenue - Costs

Marginal Benefit (MB)

Change in total benefits arising from a change in the control variable, Q:

Slope (calculus derivative) of the total benefit curve.Q

Marginal Cost (MC)

Change in total costs arising from a change in the control variable, Q:

Slope (calculus derivative) of the total cost curve

+ Marginal Principle

To maximize net benefits, the managerial control variable should be increased up to the point where MB = MC.

MB > MC means the last unit of the control variable increased benefits more than it increased costs.

MB < MC means the last unit of the control variable increased costs more than it increased benefits.

+ The Geometry of Optimization: Total Benefit and Cost

Total Benefits & Total Costs

Benefits

CSlope = MC

Slope =MB

+ The Geometry of Optimization: Net Benefits

Net Benefits

Maximum net benefits

Slope = MNB

Chapter 2 Market Forces: Demand and Supply

Overview

I. Market Demand Curve The Demand Function Determinants of Demand Consumer Surplus

II. Market Supply Curve The Supply Function Supply Shifters Producer Surplus

III. Market Equilibrium

IV. Price Restrictions

V. Comparative Statics

+Market Demand Curve

Shows the amount of a good that will be purchased at alternative prices, holding other factors constant.

Law of Demand The demand curve is downward sloping.

Quantity

Determinants of Demand

Income Normal good Inferior good

Prices of Related Goods Prices of substitutes Prices of complements

Advertising and consumer tastes

PopulationConsumer

expectations

+The Demand Function

A general equation representing the demand curve

Qxd = f(Px , PY , M, H,)

Qxd = quantity demand of good X.

Px = price of good X. PY = price of a related good Y.

Substitute good. Complement good.

M = income. Normal good. Inferior good.

H = any other variable affecting demand.

+Inverse Demand Function

Price as a function of quantity demanded.

Example: Demand Function

Qxd = 10 – 2Px

Inverse Demand Function: 2Px = 10 – Qx

Px = 5 – 0.5Qxd

Change in Quantity Demanded

Quantity

A to B: Increase in quantity demanded

Quantity

D0 to D1: Increase in Demand

Change in Demand

Consumer Surplus:

The value consumers get from a good but do not have to pay for.

Consumer surplus will prove particularly useful in marketing and other disciplines emphasizing strategies like value pricing and price discrimination.

I got a great deal!

That company offers a lot of bang for the buck!

Dell provides good value.

Total value greatly exceeds total amount paid.

Consumer surplus is large.

I got a lousy deal!

That car dealer drives a hard bargain!

I almost decided not to buy it!

They tried to squeeze the very last cent from me!

Total amount paid is close to total value.

Consumer surplus is low.

Quantity

1 2 3 4 5

Consumer Surplus:The value received but notpaid for. Consumer surplus =(8-2) + (6-2) + (4-2) = $12.

Consumer Surplus: The Discrete Case

+Consumer Surplus:The Continuous Case

Price $

Quantity

1 2 3 4 5

Valueof 4 units = $24Consumer

Surplus = $24 - $8 = $16

Expenditure on 4 units = $2 x 4 = $8

+ Market Supply Curve

The supply curve shows the amount of a good that will be produced at alternative prices.

Law of Supply The supply curve is upward sloping.

Quantity

Supply Shifters

Input prices

Technology or government regulations

Number of firms Entry Exit

Substitutes in production

Taxes Excise tax Ad valorem tax

Producer expectations

+The Supply Function

An equation representing the supply curve:

QxS = f(Px , PR ,W, H,)

QxS = quantity supplied of good X.

Px = price of good X.

PR = price of a production substitute.

W = price of inputs (e.g., wages). H = other variable affecting supply.

+Inverse Supply Function

Price as a function of quantity supplied.

Example: Supply Function

Qxs = 10 + 2Px

Inverse Supply Function: 2Px = 10 + Qx

Px = 5 + 0.5Qxs

+Change in Quantity Supplied

Quantity

A to B: Increase in quantity supplied

Quantity

S0 to S1: Increase in supply

Change in Supply

+ Producer Surplus

The amount producers receive in excess of the amount necessary to induce them to produce the good.

Quantity

Market Equilibrium

The Price (P) that Balances supply and demand Qx

S = Qxd

No shortage or surplus

Steady-state

Quantity

Shortage12 - 6 = 6

If price is too low…

Quantity

Surplus14 - 6 = 8

If price is too high…

+ Price Restrictions

Price Ceilings

The maximum legal price that can be charged.

Examples: Gasoline prices in the 1970s. Housing in New York City. Proposed restrictions on ATM fees.

Price Floors

The minimum legal price that can be charged.

Examples: Minimum wage. Agricultural price supports.

Quantity

P Ceiling

Impact of a Price Ceiling

Shortage

+Impact of a Price Floor

Quantity

Surplus

+Comparative Static Analysis

How do the equilibrium price and quantity change when a determinant of supply and/or demand change?

+Applications of Demand and Supply Analysis

Event: The WSJ reports that the prices of PC components are expected to fall by 5-8 percent over the next six months.

Scenario 1: You manage a small firm that manufactures PCs.

Scenario 2: You manage a small software company.

+ Use Comparative Static Analysis to see the Big Picture!

Comparative static analysis shows how the equilibrium price and quantity will change when a determinant of supply or demand changes.

+Scenario 1: Implications for a Small PC Maker

Step 1: Look for the “Big Picture.”

Step 2: Organize an action plan (worry about details).

PriceofPCs

Quantity of PC’s

Big Picture: Impact of decline in component prices on PC market

+ Big Picture Analysis: PC Market

Equilibrium price of PCs will fall, and equilibrium quantity of computers sold will increase.

Use this to organize an action plan contracts/suppliers? inventories? human resources? marketing? do I need quantitative estimates?

+ Scenario 2: Software Maker

More complicated chain of reasoning to arrive at the “Big Picture.”

Step 1: Use analysis like that in Scenario 1 to deduce that lower component prices will lead to a lower equilibrium price for computers. a greater number of computers sold.

Step 2: How will these changes affect the “Big Picture” in the software market?

Priceof Software

Quantity ofSoftware

Big Picture: Impact of lower PC prices on the software market

+ Big Picture Analysis: Software Market

Software prices are likely to rise, and more software will be sold.

Use this to organize an action plan.

Chapter 3Quantitative Demand Analysis

+ Overview

I. The Elasticity Concept Own Price Elasticity Elasticity and Total Revenue Cross-Price Elasticity Income Elasticity

II. Linear Demand Functions

+The Elasticity Concept

How responsive is variable “G ” to a change in variable “S”

If EG,S > 0, then S and G are directly related.If EG,S < 0, then S and G are inversely related.

If EG,S = 0, then S and G are unrelated.

+The Elasticity Concept Using Calculus

An alternative way to measure the elasticity of a function G = f(S) is

dGE SG ,

If EG,S > 0, then S and G are directly related.

If EG,S < 0, then S and G are inversely related.

If EG,S = 0, then S and G are unrelated.

+Own Price Elasticity of Demand

Negative according to the “law of demand.”

Elastic:

Inelastic:

Unitary:

1, XX PQE

+Perfectly Elastic & Inelastic Demand

)( ElasticPerfectly , XX PQE )0,

XX PQE( Inelastic Perfectly

Quantity

+Own-Price Elasticity and Total Revenue

Elastic Increase (a decrease) in price leads to a decrease (an

increase) in total revenue.

Inelastic Increase (a decrease) in price leads to an increase (a

decrease) in total revenue.

Unitary Total revenue is maximized at the point where demand is

unitary elastic.

+Elasticity, Total Revenue and Linear Demand

0 010 20 30 40 50

0 10 20 30 40 50

60 1200

0 10 20 30 40 500 10 20 30 40 50

60 1200

0 10 20 30 40 500 10 20 30 40 50

60 1200

0 10 20 30 40 500 10 20 30 40 50

60 1200

Elastic

0 10 20 30 40 500 10 20 30 40 50

60 1200

Inelastic

Elastic

Elastic Inelastic

0 10 20 30 40 500 10 20 30 40 50

P TR100

60 1200

Inelastic

Elastic

Elastic Inelastic

0 10 20 30 40 500 10 20 30 40 50

Unit elastic

+Demand, Marginal Revenue (MR) and Elasticity

For a linear inverse demand function, MR(Q) = a + 2bQ, where b < 0.

When MR > 0, demand is

elastic; MR = 0, demand is

unit elastic; MR < 0, demand is

inelastic.

Inelastic

Elastic

0 10 20 40 50

Unit elastic

+ Factors Affecting Own Price Elasticity

Available Substitutes The more substitutes available for the good, the more elastic

the demand. Time

Demand tends to be more inelastic in the short term than in the long term.

Time allows consumers to seek out available substitutes. Expenditure Share

Goods that comprise a small share of consumer’s budgets tend to be more inelastic than goods for which consumers spend a large portion of their incomes.

+Cross Price Elasticity of Demand

If EQX,PY > 0, then X and Y are substitutes.

If EQX,PY < 0, then X and Y are complements.

+Income Elasticity

If EQX,M > 0, then X is a normal good.

If EQX,M < 0, then X is a inferior good.

+Uses of Elasticities

Pricing.

Managing cash flows.

Impact of changes in competitors’ prices.

Impact of economic booms and recessions.

Impact of advertising campaigns.

And lots more!

+Example 1: Pricing and Cash Flows

According to an FTC Report by Michael Ward, AT&T’s own price elasticity of demand for long distance services is -8.64.

AT&T needs to boost revenues in order to meet it’s marketing goals.

To accomplish this goal, should AT&T raise or lower it’s price?

+Answer: Lower price!

Since demand is elastic, a reduction in price will increase quantity demanded by a greater percentage than the price decline, resulting in more revenues for AT&T.

+ Example 2: Quantifying the Change

If AT&T lowered price by 3 percent, what would happen to the volume of long distance telephone calls routed through AT&T?

+ Answer

• Calls would increase by 25.92 percent!

%92.25%

%64.8%3

%64.8,

+ Example 3: Impact of a change in a competitor’s price

According to an FTC Report by Michael Ward, AT&T’s cross price elasticity of demand for long distance services is 9.06.

If competitors reduced their prices by 4 percent, what would happen to the demand for AT&T services?

+ Answer

• AT&T’s demand would fall by 36.24 percent!

%24.36%

%06.9%4

%06.9,

+ Interpreting Demand Functions

Mathematical representations of demand curves.

Example:

Law of demand holds (coefficient of PX is negative).

X and Y are substitutes (coefficient of PY is positive).

X is an inferior good (coefficient of M is negative).

MPPQ YXd

X 23210

Chapter 4The Theory of Individual Behavior

+ Overview

I. Consumer Behavior Indifference Curve Analysis Consumer Preference Ordering

II. Constraints The Budget Constraint Changes in Income Changes in Prices

III. Consumer Equilibrium

IV. Indifference Curve Analysis & Demand Curves Individual Demand Market Demand

+ Consumer Behavior Consumer Opportunities

The possible goods and services consumer can afford to consume.

Consumer Preferences The goods and services consumers actually consume.

Given the choice between 2 bundles of goods a consumer either Prefers bundle A to bundle B: A B. Prefers bundle B to bundle A: A B. Is indifferent between the two: A B.

Indifference Curve Analysis

Indifference Curve A curve that defines the

combinations of 2 or more goods that give a consumer the same level of satisfaction.

Marginal Rate of Substitution The rate at which a

consumer is willing to substitute one good for another and maintain the same satisfaction level.

Good Y

Good X

+Consumer Preference Ordering Properties Completeness

More is Better

Diminishing Marginal Rate of Substitution

Transitivity

Complete Preferences

Completeness Property Consumer is capable of

expressing preferences (or indifference) between all possible bundles. (“I don’t know” is NOT an option!) If the only bundles

available to a consumer are A, B, and C, then the consumer is indifferent between A and

C (they are on the same indifference curve).

will prefer B to A. will prefer B to C.

Good Y

Good X

More Is Better!

More Is Better Property Bundles that have at least as

much of every good and more of some good are preferred to other bundles. Bundle B is preferred to A since

B contains at least as much of good Y and strictly more of good X.

Bundle B is also preferred to C since B contains at least as much of good X and strictly more of good Y.

More generally, all bundles on ICIII are preferred to bundles on ICII or ICI. And all bundles on ICII are preferred to ICI.

Good Y

Good X

Diminishing Marginal Rate of Substitution Marginal Rate of

Substitution The amount of good Y the consumer is

willing to give up to maintain the same satisfaction level decreases as more of good X is acquired.

The rate at which a consumer is willing to substitute one good for another and maintain the same satisfaction level.

To go from consumption bundle A to B the consumer must give up 50 units of Y to get one additional unit of X.

To go from consumption bundle B to C the consumer must give up 16.67 units of Y to get one additional unit of X.

To go from consumption bundle C to D the consumer must give up only 8.33 units of Y to get one additional unit of X.

Good Y

Good X1 3 42

33.33 25

Consistent Bundle Orderings

Transitivity Property For the three bundles A, B,

and C, the transitivity property implies that if C B and B A, then C A.

Transitive preferences along with the more-is-better property imply that indifference curves will not

intersect. the consumer will not get

caught in a perpetual cycle of indecision.

Good Y

Good X21

The Budget Constraint Opportunity Set

The set of consumption bundles that are affordable.

PxX + PyY M.

Budget Line The bundles of goods that

exhaust a consumers income. PxX + PyY = M.

Market Rate of Substitution The slope of the budget line

-Px / Py

The Opportunity Set

Budget Line

Y = M/PY – (PX/PY)XM/PY

Changes in the Budget Line

Changes in Income Increases lead to a parallel,

outward shift in the budget line (M1 > M0).

Decreases lead to a parallel, downward shift (M2 < M0).

Changes in Price A decreases in the price of

good X rotates the budget line counter-clockwise (PX0

). An increases rotates the

budget line clockwise (not shown).

YNew Budget Line for a price decrease.

M0/PX0M0/PX1

Consumer Equilibrium

The equilibrium consumption bundle is the affordable bundle that yields the highest level of satisfaction. Consumer equilibrium

occurs at a point whereMRS = PX / PY.

Equivalently, the slope of the indifference curve equals the budget line.

Consumer Equilibrium

+Price Changes and Consumer Equilibrium Substitute Goods

An increase (decrease) in the price of good X leads to an increase (decrease) in the consumption of good Y. Examples:

Coke and Pepsi. Verizon Wireless or AT&T.

Complementary Goods An increase (decrease) in the price of good X leads to a

decrease (increase) in the consumption of good Y. Examples:

DVD and DVD players. Computer CPUs and monitors.

+Complementary Goods

When the price of good X falls and the consumption of Y rises, then X and Y are complementary goods. (PX1

> PX2)

Pretzels (Y)

Beer (X)

M/PX1M/PX2

+ Income Changes and Consumer Equilibrium Normal Goods

Good X is a normal good if an increase (decrease) in income leads to an increase (decrease) in its consumption.

Inferior Goods Good X is an inferior good if an increase (decrease) in income

leads to a decrease (increase) in its consumption.

+Normal Goods

An increase in income increases the consumption of normal goods.

(M0 < M1).

M1/XX0

+Decomposing the Income and Substitution Effects

Initially, bundle A is consumed. A decrease in the price of good X expands the consumer’s opportunity set.

The substitution effect (SE) causes the consumer to move from bundle A to B.

A higher “real income” allows the consumer to achieve a higher indifference curve.

The movement from bundle B to C represents the income effect (IE). The new equilibrium is achieved at point C.

Other goods (Y)

Pizza (X)

0.5 1 2

A buy-one, get-one free pizza deal.

A Classic Marketing Application

Individual Demand Curve

An individual’s demand curve is derived from each new equilibrium point found on the indifference curve as the price of good X is varied.

Market Demand

The market demand curve is the horizontal summation of individual demand curves.

It indicates the total quantity all consumers would purchase at each price point.

Individual Demand Curves

Market Demand Curve

1 2 1 2 3

+Conclusion

Indifference curve properties reveal information about consumers’ preferences between bundles of goods. Completeness. More is better. Diminishing marginal rate of substitution. Transitivity.

Indifference curves along with price changes determine individuals’ demand curves.

Market demand is the horizontal summation of individuals’ demands.

Chapter 5The Production Process and Costs

+Overview

I. Production Analysis Total Product, Marginal Product, Average Product Isoquants Isocosts Cost Minimization

II. Cost Analysis Total Cost, Variable Cost, Fixed Costs Cubic Cost Function Cost Relations

+Production Analysis

Production Function Q = F(K,L)

Q is quantity of output produced. K is capital input. L is labor input. F is a functional form relating the inputs to output.

The maximum amount of output that can be produced with K units of capital and L units of labor.

Short-Run vs. Long-Run Decisions

Fixed vs. Variable Inputs

Production Function Algebraic FormsLinear production function: inputs are perfect

substitutes.

Leontief production function: inputs are used in fixed proportions.

Cobb-Douglas production function: inputs have a degree of substitutability.

ba LKLKFQ ,

bLaKLKFQ ,

cLbKLKFQ ,min,

+Productivity Measures: Total Product

Total Product (TP): maximum output produced with given amounts of inputs.

Example: Cobb-Douglas Production Function:

Q = F(K,L) = K.5 L.5

K is fixed at 16 units. Short run Cobb-Douglass production function:

Q = (16).5 L.5 = 4 L.5

Total Product when 100 units of labor are used?

Q = 4 (100).5 = 4(10) = 40 units

+Productivity Measures: Average Product of an Input Average Product of an Input: measure

of output produced per unit of input. Average Product of Labor: APL = Q/L.

Measures the output of an “average” worker. Example: Q = F(K,L) = K.5 L.5

If the inputs are K = 16 and L = 16, then the average product of labor is APL = [(16) 0.5(16)0.5]/16 = 1.

Average Product of Capital: APK = Q/K. Measures the output of an “average” unit of capital. Example: Q = F(K,L) = K.5 L.5

If the inputs are K = 16 and L = 16, then the average product of capital is APK = [(16)0.5(16)0.5]/16 = 1.

+ Productivity Measures: Marginal Product of an InputMarginal Product on an Input: change in

total output attributable to the last unit of an input. Marginal Product of Labor: MPL = Q/L

Measures the output produced by the last worker. Slope of the short-run production function (with respect

to labor). Marginal Product of Capital: MPK = Q/K

Measures the output produced by the last unit of capital. When capital is allowed to vary in the short run, MPK is

the slope of the production function (with respect to capital).

Q=F(K,L)

Increasing

MarginalReturns

DiminishingMarginalReturns

NegativeMarginalReturns

Increasing, Diminishing and Negative Marginal Returns

+Guiding the Production Process Producing on the production function

Aligning incentives to induce maximum worker effort.

Employing the right level of inputs When labor or capital vary in the short run, to maximize

profit a manager will hire labor until the value of marginal product of labor equals

the wage: VMPL = w, where VMPL = P x MPL. capital until the value of marginal product of capital

equals the rental rate: VMPK = r, where VMPK = P x MPK .

Isoquant

Illustrates the long-run combinations of inputs (K, L) that yield the producer the same level of output.

The shape of an isoquant reflects the ease with which a producer can substitute among inputs while maintaining the same level of output.

Marginal Rate of Technical Substitution (MRTS) The rate at which two inputs are substituted while

maintaining the same output level.

LKL MP

MPMRTS

Linear Isoquants

Capital and labor are perfect substitutes Q = aK + bL MRTSKL = b/a Linear isoquants imply

that inputs are substituted at a constant rate, independent of the input levels employed.

Q3Q2Q1

Increasing Output

Leontief Isoquants

Capital and labor are perfect complements.

Capital and labor are used in fixed-proportions.

Q = min {bK, cL}

Since capital and labor are consumed in fixed proportions there is no input substitution along isoquants (hence, no MRTSKL).

Increasing Output

Cobb-Douglas Isoquants

Inputs are not perfectly substitutable.

Diminishing marginal rate of technical substitution. As less of one input is used in

the production process, increasingly more of the other input must be employed to produce the same output level.

Q = KaLb

MRTSKL = MPL/MPK

Increasing Output

Isocost The combinations of inputs

that produce a given level of output at the same cost:

wL + rK = C

Rearranging,

K= (1/r)C - (w/r)L

For given input prices, isocosts farther from the origin are associated with higher costs.

Changes in input prices change the slope of the isocost line.

KNew Isocost Line for a decrease in the wage (price of labor: w0 > w1).

C1/wC0C0/w

C/w0 C/w1

New Isocost Line associated with higher costs (C0 < C1).

+Cost Minimization

Marginal product per dollar spent should be equal for all inputs:

But, this is just r

wMRTSKL

+Cost Minimization

Point of Cost Minimization

Slope of Isocost =

Slope of Isoquant

+Optimal Input Substitution

A firm initially produces Q0 by employing the combination of inputs represented by point A at a cost of C0.

Suppose w0 falls to w1. The isocost curve rotates

counterclockwise; which represents the same cost level prior to the wage change.

To produce the same level of output, Q0, the firm will produce on a lower isocost line (C1) at a point B.

The slope of the new isocost line represents the lower wage relative to the rental rate of capital.

C0/w1C0/w0 C1/w1L0 L1

Cost Analysis

Types of Costs Short-Run

Fixed costs (FC) Sunk costs Short-run variable

costs (VC) Short-run total costs

(TC) Long-Run

All costs are variable No fixed costs

Total and Variable Costs

C(Q): Minimum total cost of producing alternative levels of output:

C(Q) = VC(Q) + FC

VC(Q): Costs that vary with output.

FC: Costs that do not vary with output.

C(Q) = VC + FC

Fixed and Sunk Costs

FC: Costs that do not change as output changes.

Sunk Cost: A cost that is forever lost after it has been paid.

Decision makers should ignore sunk costs to maximize profit or minimize losses

C(Q) = VC + FC

Some Definitions

Average Total CostATC = AVC + AFCATC = C(Q)/Q

Average Variable CostAVC = VC(Q)/Q

Average Fixed CostAFC = FC/Q

Marginal CostMC = C/Q

ATCAVC

Fixed Cost

AFC Fixed Cost

Q0(ATC-AVC)

= Q0 AFC

= Q0(FC/ Q0)

Variable Cost

AVCVariable Cost

= Q0[VC(Q0)/ Q0]

= VC(Q0)

Minimum of AVC

Total Cost

= Q0[C(Q0)/ Q0]

= C(Q0)

Total Cost

Minimum of ATC

+Cubic Cost Function

C(Q) = f + a Q + b Q2 + cQ3

Marginal Cost? Memorize:

MC(Q) = a + 2bQ + 3cQ2

Calculus:

dC/dQ = a + 2bQ + 3cQ2

+ An Example

Total Cost: C(Q) = 10 + Q + Q2

Variable cost function:

VC(Q) = Q + Q2

Variable cost of producing 2 units:

VC(2) = 2 + (2)2 = 6 Fixed costs:

FC = 10 Marginal cost function:

MC(Q) = 1 + 2Q Marginal cost of producing 2 units:

MC(2) = 1 + 2(2) = 5

Long-Run Average Costs

Economiesof Scale

Diseconomiesof Scale

+Economies of Scope

C(Q1, 0) + C(0, Q2) > C(Q1, Q2). It is cheaper to produce the two outputs jointly instead of

separately.

Example: It is cheaper for Time-Warner to produce Internet

connections and Instant Messaging services jointly than separately.

+Cost Complementarity

The marginal cost of producing good 1 declines as more of good two is produced:

MC1Q1,Q2) /Q2 < 0.

Example: Cow hides and steaks.

+ Conclusion

To maximize profits (minimize costs) managers must use inputs such that the value of marginal of each input reflects price the firm must pay to employ the input.

The optimal mix of inputs is achieved when the MRTSKL = (w/r).

Cost functions are the foundation for helping to determine profit-maximizing behavior in future chapters.

Chapter 8Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets

+ Overview

I. Perfect Competition Characteristics and profit outlook. Effect of new entrants.

II. Monopolies Sources of monopoly power. Maximizing monopoly profits. Pros and cons.

III. Monopolistic Competition Profit maximization. Long run equilibrium.

Perfect Competition Environment Many buyers and sellers.

Homogeneous (identical) product.

Perfect information on both sides of market.

No transaction costs.

Free entry and exit.

Key Implications

Firms are “price takers” (P = MR).

In the short-run, firms may earn profits or losses.

Entry and exit forces long-run profits to zero.

+Unrealistic? Why Learn?

Many small businesses are “price-takers,” and decision rules for such firms are similar to those of perfectly competitive firms.

It is a useful benchmark.

Explains why governments oppose monopolies.

Illuminates the “danger” to managers of competitive environments. Importance of product differentiation. Sustainable advantage.

Managing a Perfectly Competitive Firm (or Price-Taking Business)

Setting Price

FirmQf

MarketQM

Profit-Maximizing Output Decision MR = MC.

Since, MR = P,

Set P = MC to maximize profits.

Graphically: Representative Firm’s Output Decision

Pe = Df = MR

Profit = (Pe - ATC) Qf*

+ A Numerical Example Given

P=$10 C(Q) = 5 + Q2

Optimal Price? P=$10

Optimal Output? MR = P = $10 and MC = 2Q 10 = 2Q Q = 5 units

Maximum Profits? PQ - C(Q) = (10)(5) - (5 + 25) = $20

Pe = Df = MR

Profit = (Pe - ATC) Qf* < 0

Should this Firm Sustain Short Run Losses or Shut Down?

+ Shutdown Decision Rule

A profit-maximizing firm should continue to operate (sustain short-run losses) if its operating loss is less than its fixed costs. Operating results in a smaller loss than ceasing operations.

Decision rule: A firm should shutdown when P < min AVC. Continue operating as long as P ≥ min AVC.

P min AVC

Firm’s Short-Run Supply Curve: MC Above Min AVC

+ Short-Run Market Supply Curve

The market supply curve is the summation of each individual firm’s supply at each price.

Firm 1 Firm 2

10 20 30

Market

18 25 43

+Long Run Adjustments?

If firms are price takers but there are barriers to entry, profits will persist.

If the industry is perfectly competitive, firms are not only price takers but there is free entry. Other “greedy capitalists” enter the market.

+Effect of Entry on Price?

FirmQf

MarketQM

Pe* Df*

Effect of Entry on the Firm’s Output and Profits?

Pe* Df*

+Summary of Logic

Short run profits leads to entry.

Entry increases market supply, drives down the market price, increases the market quantity.

Demand for individual firm’s product shifts down.

Firm reduces output to maximize profit.

Long run profits are zero.

+Features of Long Run Competitive Equilibrium

P = MC Socially efficient output.

P = minimum AC Efficient plant size. Zero profits

Firms are earning just enough to offset their opportunity cost.

Monopoly Environment

Single firm serves the “relevant market.”

Most monopolies are “local” monopolies.

The demand for the firm’s product is the market demand curve.

Firm has control over price. But the price charged affects the quantity demanded of the

monopolist’s product.

+“Natural” Sources of Monopoly Power

Economies of scale

Economies of scope

Cost complementarities

“Created” Sources of Monopoly Power

Patents and other legal barriers (like licenses)

Tying contracts

Exclusive contracts

CollusionContract...

Managing a Monopoly

Market power permits you to price above MC

Is the sky the limit?

No. How much you sell depends on the price you set!

A Monopolist’s Marginal Revenue

0 010 20 30 40 50 10 20 30 40 50

60 1200

Inelastic

Elastic

Elastic Inelastic

Unit elastic

Monopoly Profit Maximization

Profit

Produce where MR = MC.Charge the price on the demand curve that corresponds to that quantity.

+Alternative Profit Computation

Cost Total

Cost Total - Revenue Total

Useful Formulae

What’s the MR if a firm faces a linear demand curve for its product?

Alternatively,

.0,2 bwherebQaMR

+ A Numerical Example Given estimates of

P = 10 - Q C(Q) = 6 + 2Q

Optimal output? MR = 10 - 2Q MC = 2 10 - 2Q = 2 Q = 4 units

Optimal price? P = 10 - (4) = $6

Maximum profits? PQ - C(Q) = (6)(4) - (6 + 8) = $10

Long Run Adjustments?

None, unless the source of monopoly power is eliminated.

Why Government Dislikes Monopoly?

P > MC Too little output, at too high a

price.

Deadweight loss of monopoly.

Deadweight Loss of Monopoly

Deadweight Loss of Monopoly8-

+Arguments for Monopoly

The beneficial effects of economies of scale, economies of scope, and cost complementarities on price and output may outweigh the negative effects of market power.

Encourages innovation.

Monopolistic Competition: Environment and Implications Numerous buyers and sellers

Differentiated products Implication: Since products are differentiated, each firm faces

a downward sloping demand curve. Consumers view differentiated products as close substitutes:

there exists some willingness to substitute.

Free entry and exit Implication: Firms will earn zero profits in the long run.

Managing a Monopolistically Competitive Firm

Like a monopoly, monopolistically competitive firms have market power that permits pricing above marginal

cost. level of sales depends on the price it sets.

But … The presence of other brands in the market makes the

demand for your brand more elastic than if you were a monopolist.

Free entry and exit impacts profitability.

Therefore, monopolistically competitive firms have limited market power.

Marginal Revenue Like a Monopolist

0 010 20 30 40 50 10 20 30 40 50

60 1200

Inelastic

Elastic

Elastic Inelastic

Unit elastic

+Monopolistic Competition: Profit Maximization

Maximize profits like a monopolist Produce output where MR = MC. Charge the price on the demand curve that corresponds to

that quantity.

Short-Run Monopolistic Competition

Profit

Quantity of Brand X

+Long Run Adjustments?

If the industry is truly monopolistically competitive, there is free entry. In this case other “greedy capitalists” enter, and their new

brands steal market share. This reduces the demand for your product until profits are

ultimately zero.

Quantity of Brand XMR1

Long Run Equilibrium(P = AC, so zero profits)

Long-Run Monopolistic Competition

Monopolistic Competition

The Good (To Consumers) Product Variety

The Bad (To Society) P > MC Excess capacity

Unexploited economies of scale

The Ugly (To Managers) P = ATC > minimum of

average costs. Zero Profits (in the long run)!

+ Maximizing Profits: A Synthesizing Example

C(Q) = 125 + 4Q2

Determine the profit-maximizing output and price, and discuss its implications, if You are a price taker and other firms charge $40 per unit; You are a monopolist and the inverse demand for your product is P

= 100 - Q; You are a monopolistically competitive firm and the inverse

demand for your brand is P = 100 – Q.

+Marginal Cost

C(Q) = 125 + 4Q2,

So MC = 8Q.

This is independent of market structure.

+ Price Taker

MR = P = $40.

Set MR = MC. 40 = 8Q. Q = 5 units.

Cost of producing 5 units. C(Q) = 125 + 4Q2 = 125 + 100 = $225.

Revenues: PQ = (40)(5) = $200.

Maximum profits of -$25.

Implications: Expect exit in the long-run.

+Monopoly/Monopolistic Competition

MR = 100 - 2Q (since P = 100 - Q).

Set MR = MC, or 100 - 2Q = 8Q. Optimal output: Q = 10. Optimal price: P = 100 - (10) = $90. Maximal profits:

PQ - C(Q) = (90)(10) -(125 + 4(100)) = $375.

Implications Monopolist will not face entry (unless patent or other entry

barriers are eliminated). Monopolistically competitive firm should expect other firms to

clone, so profits will decline over time.

+ Conclusion

Firms operating in a perfectly competitive market take the market price as given. Produce output where P = MC. Firms may earn profits or losses in the short run. … but, in the long run, entry or exit forces profits to zero.

A monopoly firm, in contrast, can earn persistent profits provided that source of monopoly power is not eliminated.

A monopolistically competitive firm can earn profits in the short run, but entry by competing brands will erode these profits over time.

Chapter 9Basic Oligopoly Models

+ Overview

I. Conditions for Oligopoly?

II. Role of Strategic Interdependence

III. Profit Maximization in Four Oligopoly Settings Sweezy (Kinked-Demand) Model Cournot Model Stackelberg Model Bertrand Model

+Oligopoly Environment

Relatively few firms, usually less than 10. Duopoly - two firms Triopoly - three firms

The products firms offer can be either differentiated or homogeneous.

Firms’ decisions impact one another.

Many different strategic variables are modeled: No single oligopoly model.

Role of Strategic Interaction

Your actions affect the profits of your rivals.

Your rivals’ actions affect your profits.

How will rivals respond to your actions?

+An Example

You and another firm sell differentiated products.

How does the quantity demanded for your product change when you change your price?

D1 (Rival holds itsprice constant)

D2 (Rival matches your price change)

Q0 QL2 QL1QH1 QH2

(Rival holds itsprice constant)

Demand if Rivals Match Price Reductions but not Price Increases

+Key Insight

The effect of a price reduction on the quantity demanded of your product depends upon whether your rivals respond by cutting their prices too!

The effect of a price increase on the quantity demanded of your product depends upon whether your rivals respond by raising their prices too!

Strategic interdependence: You aren’t in complete control of your own destiny!

+Sweezy (Kinked-Demand) Model Environment

Few firms in the market serving many consumers.

Firms produce differentiated products.

Barriers to entry.

Each firm believes rivals will match (or follow) price reductions, but won’t match (or follow) price increases.

Key feature of Sweezy Model Price-Rigidity.

+ Sweezy Demand and Marginal Revenue

D1(Rival holds itsprice constant)

DS: Sweezy Demand

MRS: Sweezy MR

+ Sweezy Profit-Maximizing Decision

DS: Sweezy DemandMRS

D1 (Rival holds price constant)

+Sweezy Oligopoly Summary

Firms believe rivals match price cuts, but not price increases.

Firms operating in a Sweezy oligopoly maximize profit by producing where

MRS = MC. The kinked-shaped marginal revenue curve implies that there

exists a range over which changes in MC will not impact the profit-maximizing level of output.

Therefore, the firm may have no incentive to change price provided that marginal cost remains in a given range.

+ Cournot Model Environment

A few firms produce goods that are either perfect substitutes (homogeneous) or imperfect substitutes (differentiated).

Firms’ control variable is output in contrast to price.

Each firm believes their rivals will hold output constant if it changes its own output (The output of rivals is viewed as given or “fixed”).

Barriers to entry exist.

Inverse Demand in a Cournot DuopolyMarket demand in a homogeneous-

product Cournot duopoly is

Thus, each firm’s marginal revenue depends on the output produced by the other firm. More formally,

212 2bQbQaMR

121 2bQbQaMR

21 QQbaP

+ Best-Response Function

Since a firm’s marginal revenue in a homogeneous Cournot oligopoly depends on both its output and its rivals, each firm needs a way to “respond” to rival’s output decisions.

Firm 1’s best-response (or reaction) function is a schedule summarizing the amount of Q1 firm 1 should produce in order to maximize its profits for each quantity of Q2 produced by firm 2.

Since the products are substitutes, an increase in firm 2’s output leads to a decrease in the profit-maximizing amount of firm 1’s product.

Best-Response Function for a Cournot DuopolyTo find a firm’s best-response function, equate

its marginal revenue to marginal cost and solve for its output as a function of its rival’s output.

Firm 1’s best-response function is (c1 is firm 1’s MC)

Firm 2’s best-response function is (c2 is firm 2’s MC)

+ Graph of Firm 1’s Best-Response Function

(Firm 1’s Reaction Function)

(a-c1)/b Q1 = r1(Q2) = (a-c1)/2b - 0.5Q2

+ Cournot Equilibrium

Situation where each firm produces the output that maximizes its profits, given the the output of rival firms.

No firm can gain by unilaterally changing its own output to improve its profit. A point where the two firm’s best-response functions

intersect.

+ Graph of Cournot Equilibrium

Cournot Equilibrium

(a-c1)/b

(a-c2)/b

+Summary of Cournot Equilibrium

The output Q1* maximizes firm 1’s profits, given that firm

2 produces Q2*.

The output Q2* maximizes firm 2’s profits, given that firm

1 produces Q1*.

Neither firm has an incentive to change its output, given the output of the rival.

Beliefs are consistent: In equilibrium, each firm “thinks” rivals will stick to their

current output – and they do!

+ Stackelberg Model EnvironmentFew firms serving many consumers.

Firms produce differentiated or homogeneous products.

Barriers to entry.

Firm one is the leader. The leader commits to an output before all other firms.

Remaining firms are followers. They choose their outputs so as to maximize profits, given

the leader’s output.

The Algebra of the Stackelberg ModelSince the follower reacts to the leader’s

output, the follower’s output is determined by its reaction function

The Stackelberg leader uses this reaction function to determine its profit maximizing output level, which simplifies to

122 5.02

+ Stackelberg Summary

Stackelberg model illustrates how commitment can enhance profits in strategic environments.

Leader produces more than the Cournot equilibrium output. Larger market share, higher profits. First-mover advantage.

Follower produces less than the Cournot equilibrium output. Smaller market share, lower profits.

+Bertrand Model Environment

Few firms that sell to many consumers.Firms produce identical products at

constant marginal cost.Each firm independently sets its price in

order to maximize profits (price is each firms’ control variable).

Barriers to entry exist.Consumers enjoy

Perfect information. Zero transaction costs.

+ Bertrand Equilibrium

Firms set P1 = P2 = MC! Why?

Suppose MC < P1 < P2.

Firm 1 earns (P1 - MC) on each unit sold, while firm 2 earns nothing.

Firm 2 has an incentive to slightly undercut firm 1’s price to capture the entire market.

Firm 1 then has an incentive to undercut firm 2’s price. This undercutting continues...

Equilibrium: Each firm charges P1 = P2 = MC.

+ Conclusion

Different oligopoly scenarios give rise to different optimal strategies and different outcomes.

Your optimal price and output depends on … Beliefs about the reactions of rivals. Your choice variable (P or Q) and the nature of the product

market (differentiated or homogeneous products). Your ability to credibly commit prior to your rivals.

Chapter 10Game Theory: Inside Oligopoly

+Game Environments

Players’ planned decisions are called strategies.

Payoffs to players are the profits or losses resulting from strategies.

Order of play is important: Simultaneous-move game: each player makes decisions

with knowledge of other players’ decisions. Sequential-move game: one player observes its rival’s

move prior to selecting a strategy.

Frequency of rival interaction One-shot game: game is played once. Repeated game: game is played more than once; either

a finite or infinite number of interactions.

10-199

+ Simultaneous-Move, One-Shot Games: Normal Form GameA Normal Form Game consists of:

Set of players i ∈ {1, 2, … n} where n is a finite number. Each players strategy set or feasible actions consist of a finite

number of strategies.

Player 1’s strategies are S1 = {a, b, c, …}. Player 2’s strategies are S2 = {A, B, C, …}.

Payoffs.

Player 1’s payoff: π1(a,B) = 11. Player 2’s payoff: π2(b,C) = 12.

10-200

+Real World Examples of Collusion

Garbage Collection Industry

NASDAQ

Airlines

10-201

+Pricing to Prevent Entry: An Application of Game Theory

Two firms: an incumbent and potential entrant.

Potential entrant’s strategies: Enter. Stay Out.

Incumbent’s strategies: {if enter, play hard}. {if enter, play soft}. {if stay out, play hard}. {if stay out, play soft}.

Move Sequence: Entrant moves first. Incumbent observes entrant’s action

and selects an action.

10-202

+ The Pricing to Prevent Entry Game in Extensive Form

Entrant

Incumbent

10-203

+ Identify Nash and Subgame Perfect Equilibria

Entrant

Incumbent

10-204

+ Two Nash Equilibria

Entrant

Incumbent

Nash Equilibria Strategies {player 1; player 2}:{enter; If enter, play soft}{stay out; If enter, play hard}

10-205

+ One Subgame Perfect Equilibrium

Entrant

Incumbent

Subgame Perfect Equilibrium Strategy:{enter; If enter, play soft}

10-206

+Insights

Establishing a reputation for being unkind to entrants can enhance long-term profits.

It is costly to do so in the short-term, so much so that it isn’t optimal to do so in a one-shot game.

10-207

Chapter 11Pricing Strategies for Firms with Market Power

+ Overview

I. Basic Pricing Strategies Monopoly & Monopolistic Competition Cournot Oligopoly

II. Extracting Consumer Surplus Price Discrimination Two-Part Pricing Block Pricing Commodity Bundling

III. Pricing for Special Cost and Demand Structures Peak-Load Pricing Transfer Pricing Cross Subsidies

IV. Pricing in Markets with Intense Price Competition Price Matching Randomized Pricing Brand Loyalty

11-209

+ Standard Pricing and Profits for Firms with Market Power

Quantity

P = 10 - 2Q

1 2 3 4 5

MR = 10 - 4Q

Profits from standard pricing= $8

11-210

+An Algebraic Example

P = 10 - 2Q

C(Q) = 2Q

If the firm must charge a single price to all consumers, the profit-maximizing price is obtained by setting MR = MC.

10 - 4Q = 2, so Q* = 2.

P* = 10 - 2(2) = 6.

Profits = (6)(2) - 2(2) = $8.

11-211

+ A Simple Markup Rule

Suppose the elasticity of demand for the firm’s product is EF.

Since MR = P[1 + EF]/ EF.

Setting MR = MC and simplifying yields this simple pricing formula:

P = [EF/(1+ EF)] MC.

The optimal price is a simple markup over relevant costs! More elastic the demand, lower markup. Less elastic the demand, higher markup.

11-212

+ An Example

Elasticity of demand for Kodak film is -2.

P = [EF/(1+ EF)] MC

P = [-2/(1 - 2)] MC

P = 2 MC

Price is twice marginal cost.

Fifty percent of Kodak’s price is margin above manufacturing costs.

11-213

+Markup Rule for Cournot Oligopoly

Homogeneous product Cournot oligopoly.

N = total number of firms in the industry.

Market elasticity of demand EM .

Elasticity of individual firm’s demand is given by EF = N x EM.

Since P = [EF/(1+ EF)] MC,

Then, P = [NEM/(1+ NEM)] MC.

The greater the number of firms, the lower the profit-maximizing markup factor.

11-214

+ An Example

Homogeneous product Cournot industry, 3 firms.

MC = $10.

Elasticity of market demand = - ½.

Determine the profit-maximizing price?

EF = N EM = 3 (-1/2) = -1.5.

P = [EF/(1+ EF)] MC.

P = [-1.5/(1- 1.5] $10.

P = 3 $10 = $30.

11-215

+Extracting Consumer Surplus: Moving From Single Price MarketsMost models examined to this point

involve a “single” equilibrium price. In reality, there are many different prices

being charged in the market.Price discrimination is the practice of

charging different prices to consumer for the same good to achieve higher prices.

The three basic forms of price discrimination are: First-degree (or perfect) price discrimination. Second-degree price discrimination. Third-degree price discrimiation.

11-216

+ First-Degree or Perfect Price Discrimination

Practice of charging each consumer the maximum amount he or she will pay for each incremental unit.

Permits a firm to extract all surplus from consumers.

11-217

+Perfect Price Discrimination

Quantity

1 2 3 4 5

Profits*:.5(4-0)(10 - 2)

Total Cost* = $8

* Assuming no fixed costs

11-218

+Caveats:

In practice, transactions costs and information constraints make this difficult to implement perfectly (but car dealers and some professionals come close).

Price discrimination won’t work if consumers can resell the good.

11-219

Second-Degree Price Discrimination

The practice of posting a discrete schedule of declining prices for different quantities.

Eliminates the information constraint present in first-degree price discrimination.

Example: Electric utilities

4Quantity

11-220

+Third-Degree Price Discrimination

The practice of charging different groups of consumers different prices for the same product.

Group must have observable characteristics for third-degree price discrimination to work.

Examples include student discounts, senior citizen’s discounts, regional & international pricing.

11-221

+Implementing Third-Degree Price Discrimination

Suppose the total demand for a product is comprised of two groups with different elasticities, E1 < E2.

Notice that group 1 is more price sensitive than group 2.

Profit-maximizing prices?

P1 = [E1/(1+ E1)] MC

P2 = [E2/(1+ E2)] MC

11-222

+ An Example

Suppose the elasticity of demand for Kodak film in the US is EU = -1.5, and the elasticity of demand in Japan is EJ = -2.5.

Marginal cost of manufacturing film is $3.

PU = [EU/(1+ EU)] MC = [-1.5/(1 - 1.5)] $3 = $9

PJ = [EJ/(1+ EJ)] MC = [-2.5/(1 - 2.5)] $3 = $5

Kodak’s optimal third-degree pricing strategy is to charge a higher price in the US, where demand is less elastic.

11-223

+Two-Part Pricing

When it isn’t feasible to charge different prices for different units sold, but demand information is known, two-part pricing may permit you to extract all surplus from consumers.

Two-part pricing consists of a fixed fee and a per unit charge. Example: Athletic club memberships.

11-224

How Two-Part Pricing Works

1. Set price at marginal cost.

2. Compute consumer surplus.

3. Charge a fixed-fee equal to consumer surplus.

Quantity

1 2 3 4 5

Fixed Fee = Profits* = $16

Per UnitCharge

11-225

+ Block Pricing

The practice of packaging multiple units of an identical product together and selling them as one package.

Examples Paper. Six-packs of soda. Different sized of cans of green beans.

11-226

+ An Algebraic Example

Typical consumer’s demand is P = 10 - 2Q

C(Q) = 2Q

Optimal number of units in a package?

Optimal package price?

11-227

+Optimal Quantity To Package: 4 Units

Quantity

1 2 3 4 5

MC = AC

11-228

+Optimal Price for the Package: $24

Quantity

1 2 3 4 5

MC = AC

Consumer’s valuation of 4units = .5(8)(4) + (2)(4) = $24Therefore, set P = $24!

11-229

+ Costs and Profits with Block Pricing

Quantity

1 2 3 4 5

MC = AC

Profits* = [.5(8)(4) + (2)(4)] – (2)(4)= $16

Costs = (2)(4) = $8

11-230

+Commodity Bundling

The practice of bundling two or more products together and charging one price for the bundle.

Examples Vacation packages. Computers and software. Film and developing.

11-231

+ An Example that Illustrates Kodak’s Moment

Total market size for film and developing is 4 million consumers.

Four types of consumers 25% will use only Kodak film (F). 25% will use only Kodak developing (D). 25% will use only Kodak film and use only Kodak developing

(FD). 25% have no preference (N).

Zero costs (for simplicity).

Maximum price each type of consumer will pay is as follows:

11-232

+Reservation Prices for Kodak Film and Developing by Type of Consumer

Type Film DevelopingF $8 $3

FD $8 $4D $4 $6N $3 $2

11-233

+ Optimal Film Price?

FD $8 $4D $4 $6N $3 $2

Optimal Price is $8; only types F and FD buy resulting in profits of $8 x 2 million = $16 Million.

At a price of $4, only types F, FD, and D will buy (profits of $12 Million).

At a price of $3, all will types will buy (profits of $12 Million).

11-234

+Optimal Price for Developing?

FD $8 $4D $4 $6N $3 $2

Optimal Price is $3, to earn profits of $3 x 3 million = $9 Million.

At a price of $6, only “D” type buys (profits of $6 Million).

At a price of $4, only “D” and “FD” types buy (profits of $8 Million).

At a price of $2, all types buy (profits of $8 Million).

11-235

+Total Profits by Pricing Each Item Separately?

FD $8 $4D $4 $6N $3 $2

Total Profit = Film Profits + Development Profits = $16 Million + $9 Million = $25 Million

Surprisingly, the firm can earn even greater profits by bundling!

11-236

Pricing a “Bundle” of Film and Developing

11-237

+Consumer Valuations of a Bundle

Type Film Developing Value of BundleF $8 $3 $11

FD $8 $4 $12D $4 $6 $10N $3 $2 $5

11-238

+What’s the Optimal Price for a Bundle?

Type Film Developing Value of BundleF $8 $3 $11

FD $8 $4 $12D $4 $6 $10N $3 $2 $5

Optimal Bundle Price = $10 (for profits of $30 million)

11-239

Peak-Load Pricing

When demand during peak times is higher than the capacity of the firm, the firm should engage in peak-load pricing.

Charge a higher price (PH) during peak times (DH).

Charge a lower price (PL)

during off-peak times (DL). Quantity

PriceMC

11-240

+ Cross-Subsidies Prices charged for one product are subsidized by the sale of

another product.

May be profitable when there are significant demand complementarities effects.

Examples Browser and server software. Drinks and meals at restaurants.

11-241

+Double Marginalization

Consider a large firm with two divisions: the upstream division is the sole provider of a key input. the downstream division uses the input produced by the

upstream division to produce the final output.

Incentives to maximize divisional profits leads the upstream manager to produce where MRU = MCU. Implication: PU > MCU.

Similarly, when the downstream division has market power and has an incentive to maximize divisional profits, the manager will produce where MRD = MCD. Implication: PD > MCD.

Thus, both divisions mark price up over marginal cost resulting in in a phenomenon called double marginalization. Result: less than optimal overall profits for the firm.

11-242

+Transfer Pricing

To overcome double marginalization, the internal price at which an upstream division sells inputs to a downstream division should be set in order to maximize the overall firm profits.

To achieve this goal, the upstream division produces such that its marginal cost, MCu, equals the net marginal revenue to the downstream division (NMRd):

NMRd = MRd - MCd = MCu

11-243

+ Upstream Division’s Problem

Demand for the final product P = 10 - 2Q.

C(Q) = 2Q.

Suppose the upstream manager sets MR = MC to maximize profits.

10 - 4Q = 2, so Q* = 2.

P* = 10 - 2(2) = $6, so upstream manager charges the downstream division $6 per unit.

11-244

+Downstream Division’s Problem

Demand for the final product P = 10 - 2Q.

Downstream division’s marginal cost is the $6 charged by the upstream division.

Downstream division sets MR = MC to maximize profits.

10 - 4Q = 6, so Q* = 1.

P* = 10 - 2(1) = $8, so downstream division charges $8 per unit.

11-245

+ AnalysisThis pricing strategy by the upstream division

results in less than optimal profits!

The upstream division needs the price to be $6 and the quantity sold to be 2 units in order to maximize profits. Unfortunately,

The downstream division sets price at $8, which is too high; only 1 unit is sold at that price. Downstream division profits are $8 1 – 6(1) = $2.

The upstream division’s profits are $6 1 - 2(1) = $4 instead of the monopoly profits of $6 2 - 2(2) = $8.

Overall firm profit is $4 + $2 = $6.

11-246

+ Upstream Division’s “Monopoly Profits”

Quantity

P = 10 - 2Q

1 2 3 4 5

MC = AC

MR = 10 - 4Q

Profit = $8

11-247

+ Upstream’s Profits when Downstream Marks Price Up to $8Price

Quantity

P = 10 - 2Q

1 2 3 4 5

MC = AC

MR = 10 - 4Q

Profit = $4DownstreamPrice

11-248

Solutions for the Overall Firm?

Provide upstream manager with an incentive to set the optimal transfer price of $2 (upstream division’s marginal cost).

Overall profit with optimal transfer price:

8$22$26$

11-249

+ Pricing in Markets with Intense Price Competition Price Matching

Advertising a price and a promise to match any lower price offered by a competitor.

No firm has an incentive to lower their prices. Each firm charges the monopoly price and shares the

market.

Induce brand loyalty Some consumers will remain “loyal” to a firm; even in the

face of price cuts. Advertising campaigns and “frequent-user” style programs

can help firms induce loyal among consumers.

Randomized Pricing A strategy of constantly changing prices. Decreases consumers’ incentive to shop around as they

cannot learn from experience which firm charges the lowest price.

Reduces the ability of rival firms to undercut a firm’s prices.

11-250

+ Conclusion

First degree price discrimination, block pricing, and two part pricing permit a firm to extract all consumer surplus.

Commodity bundling, second-degree and third degree price discrimination permit a firm to extract some (but not all) consumer surplus.

Simple markup rules are the easiest to implement, but leave consumers with the most surplus and may result in double-marginalization.

Different strategies require different information.

11-251

+ Managerial Economics & Business Strategy Chapter 1 The Fundamentals of Managerial Economics...

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Managerial Economics Baye Solutions (3-5)

Managerial Economics and Business Strategy, 8E Baye Chap. 2

Managerial Economics & Business StrategyMichael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006Two-Part Pricing • When it isn’t

Managerial Economics vtusolution · Managerial Economics ... 2005 Gupta G.S., 2. Managerial Economics, Tata Mcgraw-Hill, ... principles of micro and macro economics in managerial

Managerial Economics & Business Strategy Chapter 7 The Nature of Industry McGraw-Hill/Irwin Michael R. Baye, Managerial Economics and Business Strategy

Managerial Economics –ECO404 VU · DEFINITION OF MANAGERIAL ECONOMICS Joel Dean, author of the first managerial economics textbook, defines managerial economics as “the use of