Managerial Economics

1
Managerial Economics

• Lecture One
• Why economics matters to managers, marketers and
  accountants
• Neoclassical theory of profit maximisation

2
Admin

• Purchase Reader
• Check subject outline
• Assessment 3 parts
• Group presentation in tutorials 20
• Essay on group presentation topic 40
• Exam 40
• My details
• Steve Keen
• 4620-3016
• 0425 248 089 in emergency
• S.keen_at_uws.edu.au
• Thursdays 1-3pm

3
Economics as the context of business

• Management, marketing accounting focus on
  specifics
• How to manage a company
• How to market a product
• How to quantify compare corporate performance
• Focus is your personal input to business
• Economics is the context of business
• Men make their own history, but they do not make
  it as they please they do not make it under
  self-selected circumstances, but under
  circumstances existing already, given and
  transmitted from the past
• Focus on constraints on and circumstances of your
  input
• Both opportunities dilemmas
• Quick quiz who made the above statement?

4
Economics as the context of business
in...
The Eighteenth Brumaire of Louis Napoleon
Karl Marx

• Often the best wisdom in economics isnt found in
  standard textbooks!
• This subject takes a deeper look at economics
  youve already done (micro, macro) and
• considers theories data you havent seen before
  that are more relevant to business

5
Economics as the context of business

• A hierarchical view starting from the bottom
  working up
• The firm
• The market/industry
• The economy
• Finance
• International business
• A critical view
• Conventional theories of above
• Profit maximising behaviour, types of
  competition, Game theory, IS-LM, Efficient
  Markets, Comparative advantage
• Different perspectives
• Empirical data
• Critiques of conventional theories
• Alternative theories

6
Economics as the context of business

• What matters most to your firms success may lie
  outside it
• For companies, a central message is that many
  of a companys competitive advantages lie outside
  the firm (Porter 1998 xxiii)
• Understanding what lies outside may therefore
  be the most important thing you can do to be a
  successful executive
• Economics as the study of what lies outside
• Relationships with other firms
• Interaction with the market
• Market interaction with the macroeconomy
• Macroeconomys interaction with global economy
  AND
• Theories about the economy! Because

7
Economics as the context of business

• Sometimes (not often enough!) theories explain
  how the real world works
• Frequently (too often!) theories affect how
  people behave in the economy
• Government follows economic advice
• Firms/unions think about economy in terms of
  economic models
• Government bodies (e.g. ACCC Australian
  Competition Consumer Commission) apply economic
  theory in policies (e.g. competition policy,
  deregulation of telecommunications, etc.)
• So you have to understand economic theory even if
  its wrong!
• Which it frequently is

8
Economics as the context of business

• Emphasis in this course is on realism
• Theories presented but also
• Empirical data examined to see whether theories
  actually work
• Frequent conclusion they dont (but sometimes
  they do)
• One consequence cant rely upon textbooks for
  this course!
• Textbooks normally
• present theory uncritically
• only include case studies that confirm accepted
  theory
• frequently based on invented rather than real
  data
• Normally dont go beyond microeconomics

9
Economics as the context of business

• This course
• Starts with micro (theory of firm)
• Progresses through theory of the market, economy,
  finance to international trade
• Based heavily on readings volume
• You must have a copy
• Tutorials and assessments based on contents

10
The firm real world vs economic theory

• The real world an incredible diversity
• Size from corner store to Microsoft
• Operations from one outlet to almost all
  countries
• Diversity
• from single product (wheat farm) to many (Sony)
• From one industry to many
• Ownership from sole proprietor to multinational
  listed company
• Structure
• from one person operations to multi-department
• From sole operations (production to sale) to
  specialisation in manufacturing, wholesale,
  retail, marketing, consulting

11
Economics of the firm statistics

• Firms in the Australian economy
• Range in size from sole proprietor/employee to
  multi-employee institutions
• From single product to diversified conglomerates
• Over 610 thousand entities in 2000 (ABS 8140.0)
• 3229 large entities employing 200 or more
  workers
• 607,663 other employing less
• Average employment 10.1 persons per firm
• Average large firm employed 750 workers
• Average other firm employed 6.5 workers
• Legal multitude of businesses masks much smaller
  number of operating units 15,870 units with
  700,024 legal entities in 1998/99

12
Economics of the firm statistics

• Concentration obvious (ABS 8140.0.55.001)
• Top 20 units responsible for 13.9 of sales
• 15,850 others responsible for remaining 86.1 of
  sales
• Economic theory abstracts from this concentration
  diversity
• Claims firms share several essential common
  properties
• Profit maximising behaviour
• Under conditions of diminishing marginal
  productivity
• Selling on spot market (no stocks) to anonymous
  buyers
• Only interest buyers have is in getting lowest
  price
• No interest in continuing relationship between
  buyer/seller arms length transactions

13
The firm economic theory

• The economic simplification diversity ignored to
  focus on alleged essence of profit maximising
  behavior
• Basic model
• single industry product
• one location
• privately owned, sole proprietor
• No internal structure considered
• No specialisation firm does everything from
  manufacturing to sales
• Some generalisations allowed later (e.g., agency
  theory)
• But basic theory abstracts from these details
• Core model profit maximising behaviour under
  conditions of diminishing marginal productivity

14
Economic theory of the firm

• Profit maximising behavior
• Seeking highest possible profit given constraints
  of
• Falling price as quantity offered for sale rises
• Rising costs as quantity offered for sale rises
• Falling price as quantity offered for sale rises
• Law of demand can only sell additional units
  if price is lowered
• Mathematically a negative relationship between
  price and quantity
• To ?quantity sold must ? price
• Simple example linear demand curve P(Q) a b Q

15
Economic theory of the firm

• Key consequence of law of demand
• Total revenue is price times quantity
• Total revenue rises for a while as increase in Q
  more than outweighs decline in P
• But ultimately fall in P overwhelms increase in
  Q total revenue peaks and then falls

• Graphing price as a function of quantity

16
Economic theory of the firm

• If firm produces 20,000 units, market price is 80
• Total revenue 80 20,000 1.6 million

Slope0
Slope40
20,000x80

• 40,000 units sold, price 60
• Total revenue 60 40,000 2.4 million
• Change in total revenue 0.8 m

40,000x60
60,000x40

• Change in unit revenue0.8 m/20,00040

• 60,000 units sold, price 40
• Total revenue 2.4 million
• Change in revenue per unit zero

17
Economic theory of the firm

• Change in revenue called marginal revenue
• In the limit, marginal revenue equals slope of
  total revenue curve

• Value of marginal revenue (x) equals slope of
  total revenue curve at same point (o)
• Other side of profit equation is costs
• Fixed costs incurred regardless of how many
  units produced (research, development, factory
  construction, rent, etc.)
• Variable costs that depend on level of output
  wages, raw materials, intermediate goods, etc.)

18
Economic theory of the firm

• Theory argues per unit costs rise as quantity
  offered for sale rises

• Slope of total cost curve is marginal cost
• Rises as output rises because of diminishing
  marginal productivity
• After some point, each new worker hired (variable
  input) adds less to production than previous
  worker
• With constant wage and diminishing output per
  worker, unit cost of output rises
• Please explain

19
Economic theory of the firm

• Rising marginal cost the argument
• Production occurs in the short run
• Short run period in which at least one crucial
  input to production cant be varied (normally
  machinery)
• Therefore to increase output, more variable
  factors must be added to the fixed factors
• Economic models normally consider just two
  factors
• Labour
• Capital grab-bag for all non-human inputs to
  production
• Factory buildings
• Machine tools
• Electrical circuitry, computers
• Raw materials and intermediate inputs (e.g., car
  stereo units for cars)
• As you add more more variable factors to fixed
  factors

20
Economic theory of the firm

• There is some ideal workermachine ratio (e.g.,
  one worker per jackhammer)

• In short run, firm has fixed number of jackhammers

?
If this sounds weird to you, good! Youre on to
something

• To dig holes, firm has to hire workers
• 1st worker operates all six jackhammers at once
  pretty inefficient!

• Additional workers might show increasing
  productivity per worker for a while (two workers
  operating 3 jackhammers each less messy than one
  operating 6, ditto three workers operating two
  each)

21
Economic theory of the firm

• Eventually ideal ratio reached (6 workers for 6
  jackhammers)

• Then to dig more holes, have to have more than
  one worker per jackhammer

?
?

• More holes can be dug with 2 workers per
  jackhammer than with one
• But productivity of two workers per jackhammer
  less than one worker per jackhammer

?
?
22
Economic theory of the firm

• So productivity per worker might rise for a
  while
• But ultimately falls as more output can only be
  produced by adding more variable inputs (labour)
  to fixed input (capital) past ideal
  labourcapital ratio
• Addition to output from each additional worker
  falls (but doesnt become negative)
• Diminishing marginal productivity (DMP)
• DMP leads to rising marginal cost
• Example Cobb-Douglas production function

Relative labor/capitalproduct coefficient
Quantity produced
No. workers
Technology coefficient
Amount of capital
23
Economic theory of the firm

• Cobb-Douglas production function allegedly fits
  aggregate economic data well (but see Shaikh, A.
  M., (1974). Laws of Algebra and Laws of
  Production The Humbug Production Function,
  Review of Economics and Statistics, 61 115-20)
• Example with a10, K100, b.4, L between 0 and
  250

With 250 workers,output is 1,443
With 100 workers,output is 1,000
Change in ouputfrom next 250 is 443
Change in ouputfrom 1st 100 is 1000
24
Economic theory of the firm

• Each additional worker adds to output, but adds
  less than previous worker diminishing marginal
  productivity
• As usual, this is slope of total product curve
  (maths unimportant, but here it is!)

• Differentiate with respect to Labour

• Graphing marginal product

25
Economic theory of the firm

• Output with 49 workers 752
• Output with 50 workers 758
• Marginal product of 50th worker ? 6
• Using formula, its exactly 6.063

• Output with 99 workers 996
• Output with 100 workers 1000
• Marginal product of 100th worker ? 4.012
• Using formula, its exactly 4

• Diminishing marginal product leads to rising
  marginal cost

26
Economic theory of the firm

• First step is to flip the axes graph labour
  input (on Y axis) needed to produce output (on X
  axis)

• Just reads in reverse
• 1,000 units of output desired
• 100 workers needed

• To get total (variable) cost, multiply Y axis by
  wage rate (say 12 an hour)

27
Economic theory of the firm

• Rate of change of variable cost is marginal cost
• Rising because of diminishing marginal
  productivity
• So firm trying to maximise profits is (according
  to economic theory) faced with
• Falling price
• Rising cost
• How to maximise profit?
• Find biggest gap between revenue and cost

• Production level of 1000 units has variable costs
  of 1200

• Marginal cost of 1000th units is about 3

28
Economic theory of the firm

• Graphically, its easy (using earlier example)

• But economists prefer to make it complicated by
  working in average marginal revenue cost
• Converting diagrams to averages by dividing by
  quantity gives us

29
Economic theory of the firm

• What it means maximise profit by finding the
  biggest gap between revenue and cost
• Gap between curves is biggest when tangents
  (marginal revenue marginal cost) are parallel

• As economists like to show it maximise profit
  by equating marginal revenue and marginal cost

30
Economic theory of the firm

• So its really easy to manage a firm
• Objective is to maximise profits
• Procedure is
• (1) Work out marginal cost
• (2) Work out marginal revenue
• (3) Choose output level that equates the two
• For competitive firms, its even easier
• Competitive firms are price takers
• Too small to affect market price/take price as
  given
• Marginal revenue therefore equals price
• (MR less than price for less competitive
  industries)
• Profit maximisation rule is produce output level
  at which marginal cost equals price

31
Economic theory of the firm

• Perfect competition

Downward sloping market demand curve
Horizontal demand curve for single firm
Marginal Cost
Supply
Pe
Pe
Demand
Qe
qe
32
Economic theory of the firm

• So the economic theory rules are
• If youre a monopoly or oligopoly
• Work out your marginal cost and marginal revenue
• Produce the output level at which they are equal
• If youre in a competitive industry
• Work out your marginal cost
• Produce output level at which marginal cost
  equals price
• If youre in an industry with a small number of
  large firms
• More complicated game theory
• More on this later
• As a typical text (Thomas Maurice 2003,
  Managerial Economics, McGraw-Hill, Boston)
  summarises it

33
Economic theory of the firm

• Its a breeze for competitive industries (p. 450)

• A bit more complicated for monopoly (p. 500)

• And a real pain for oligopoly (p. 560)

34
Economic theory of the firm

• What to do? So many choices

Reality check time!

• How does theory stack up against reality?

35
Economic facts of the firm

• Theory makes many predictions e.g.
• Firms should have rising marginal costs
• Competitive firms should have elastic demand
  curves
• Elasticity how much demand changes for a change
  in price

• Value of E can be low (less than 1) for an
  industry, but in limit is infinity for
  competitive firms (horizontal demand curve)
• Relative prices should move frequently as supply
  demand shift
• Problem not observed in reality
• Relative prices seem stable
• Money prices tend to move up, not down
• Price stickiness

36
Economic facts of the firm

• Dispute in economics over whether prices sticky
  or flexible
• Ideological division in dispute
• Neoclassicals/Free marketeers believe prices
  flexible
• Prices adjust rapidly to changes in demand, supply

Price
Supply

• Economic problems caused by government, union,
  monopoly behavior that makes some prices (e.g.
  wages) more rigid than others

Pe
Demand
Quantity
Qe
37
Economic facts of the firm

• Keynesians/Mixed economy supporters believe
  sticky
• Prices adjust sluggishly
• Key markets (e.g. labour) cant be cleared
  (unemployment eliminated) simply by price
  movements
• Can have underemployment for substantial time
  government intervention needed for full
  employment
• Ideological dispute continues, but statistical
  results imply sluggish price adjustments the
  rule
• Theory implies rapid adjustments should occur
• Why the difference?
• Plenty of theories as to why prices are sticky
• Alan Blinder (in Readings) decided to ask firms
  Why?
• Alan S. Blinder et al., (1998). Asking About
  Prices a new approach to understanding price
  stickiness, Russell Sage Foundation, New York.

38
Economic facts of the firm

• Enormous volume of theoretical research in
  economics
• Huge amount of statistical (econometric)
  research too
• Relatively little empirical research
• Finding out what actually happens at
  firm/consumer level
• Also asking firms why they do what they do
• Frequency and rapidity of price changes etc.
• How behavior compares to different theories of
  price stickiness

39
Economic facts of the firm

• Blinders procedure
• Survey random sample of GDP so that results
  statistically applicable to whole US economy
• 200 firms surveyed
• Structured survey to ensure objectivity
• Questions tailored to test economic theory
• Key economists consulted on design of questions
• Face to face interviews of top executives (25
  President/CEO, 45 Vice President, 20 Manager)
  by Economics PhD students
• Questionnaire taken seriously, informed answers
• Interviewers could help clarify questions
• Interviews took 45-70 minutes for 30 questions
• Trial surveys undertaken prior to real thing to
  improve uniformity of presentation, interpretation

40
Economic facts of the firm

• Sample representative of private, for profit,
  unregulated, non-farm industry (71 of US GDP)
• Reflects relative weight of industries in US GDP
• Excluded companies with lt 10 million in sales
• Excluded group represents 25-50 of GDP
• Weight of industries in which small firms common
  increased to compensate
• Farms excluded because no-one believes farm
  prices to be sticky (60)
• Perhaps price dynamics of farm sector different
  to manufacturing?
• Random sample selected, of those approached 61
  took part to yield 200 firmshigh response rate

41
Economic facts of the firm

• Distribution of sample differs from GDP with
  respect to firm size

• But big firms overwhelmingly important component
• Average sales of firms surveyed 3.2 billion!
• (even though 36 of surveyed firms had sales lt
  50 m)
• 7 biggest firms had sales gt 20 billion each
  represented 58 per cent of total sales by sample
• Firms surveyed represent 7.6 of US GDP
• we interviewed an astounding 10 to 15 per cent
  of the target populationa large fraction by any
  standard. (68)

42
Economic facts of the firm

• Blinders survey serious coverage of US economy
• Results give serious evaluation of economic
  theory
• If survey results consistent with theory, theory
  a good guide to functioning of economy to how
  managers should manage
• If survey results inconsistent with theory,
  relevance of economic theory seriously
  jeopardised could be irrelevant to functioning
  of economy ( how managers should manage)

What do you think the results were?
And the correct answer is...
Write your answer down

• Results contradict most of economic theory
• Most sales to other businesses, not end consumers
• Most sales to repeat customers, not impersonal
• Marginal costs fall for most firms, not rise
• Most firms face inelastic demand (Elt1), not
  elastic
• Fixed costs more important than variable costs