Managerial Economics: Chapter 1 Introduction to Managerial Economics

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Managerial Economics Chapter 1Introduction to
Managerial Economics
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Chapter Objectives

• Motivation Two cases
• Boeing corporation
• Walt Disney corporation
• What is managerial economics?
• Managerial decision-making process
• Theory of the firm
• Introduction to demand and supply analysis
• Equilibrium price and quantity
• Shifts in demand and supply curves
• Reading material
• Mansfield et al., Chapter 1, pp 3 -31.

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Case study Boeing vs Airbus

• Boeing is the largest producer of commercial
  aircraft carriers.
• In 1996 it acquired McDonnell Douglas, the
  leading military contractor in the U.S.
• Problem International competition from Airbus,
  the European producer of commercial carriers.
• It has been argued by Boeing that Airbus is
  subsidized by European governments.
• Airbus has claimed that Boeing has been
  subsidized by the U.S. government indirectly
  though defense spending.
• How do companies formulate competitive
  strategies?
• How do we deal with threats by other companies?
• Is the fact that the market has only two firms
  important?

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Case study The Ups and Downs of the Walt Disney
Company

• Walt Disney company was founded in 1929.
• Products produced Theme park services and
  movies.
• Problem In the early 1980s attendance fell
• 11.5 million visitors in 1980 9.9 million
  visitors in 1984
• To what extend the decline in attendance had to
  do with demographics? What could be done about
  it?
• Should prices at the theme parks be raised?
• Solution
• The company chose Michael Eisner to be the CEO.
• Disney engaged in advertising to increase the
  demand for its services and park attendance.
• Eisner team used simple and sophisticated pricing
  techniques to improve profits.

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Case study The Ups and Downs of the Walt Disney
Company

• Result
• Profits rose from 100 million in 1984 to 1.9
  billion in 1997
• Revenues increased tenfold to over 25 billion in
  2002.
• Disney is one of the 100 largest global firms and
  the second largest media company (behind
  Time-Warner).
• Disney holdings include the following ABC
  television and radio networks many radio and
  television stations several film and television
  studios theme parks in the US, Japan, France and
  Hong Kong etc.
• Disney uses sophisticated pricing techniques
  based on managerial principles
• Price discrimination to increase sales.
• Bundling techniques.

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Managerial Economics and Related Disciplines

• Managerial economics develops the tools for
  better decision making by business executives.
• It utilizes economic, mathematical, and
  statistical principles especially those used in
  microeconomics.
• Managerial economics provides an integrating
  framework for executives by analyzing
• How various functional areas of the firm must be
  combined to achieve the firms objectives.
• How the external market environment affects the
  firms objectives and strategy.
• In this class we will use cases to understand the
  principles that govern the behavior of firms and
  the evolution of markets.

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The Theory of the Firm

• To apply managerial economics to business
  decisions we need a theory of the firm.
• A theory indicates how a firm behaves and what
  its goals are.
• Economists are working with models.
• A model is an analytical framework (formal or
  informal) which takes into account only the
  important (relevant) factors.
• Models are used to illustrate the basic
  principles of managerial economics.
• The basic theory of the firm (business
  enterprise) assumes that the firm maximizes
  profits, or more generally it maximizes its
  wealth or value.

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Value of the Firm

• The present value of the firms expected future
  cash flows
• The numerator is profits per year and the
  denominator is the discount factor (one plus the
  relevant interest rate)

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Present Value of Expected Future Profits

• TRt the firms total revenue in year t
• TCt the firms total cost in year t
• i the interest rate
• and t goes from 1 (next year) to n (the last year
  in the planning horizon)

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What are Profits?

• There is a difference between accounting and
  economic profits
• When reporting profits the accountant is
  interested in various legal definitions and tax
  laws.
• The economists calculates profits after taking
  out the labor and capital provided by the owners.
• The accountant is concerned with controlling the
  firms day-to-day operations, whereas the
  economist is concerned primarily with decision
  making processes.

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Why Do Profits Exist?

• There are three important reasons for why
  economic profits exist.
• Innovations
• Process innovations result in producing a good
  or a service cheaper (e.g., quality circles,
  assembly line)
• Product innovation is the introduction of new
  products or services (e.g., fax machine,
  internet, windows).
• Risk in the presence of uncertainty
• A good example is the stock marker.
• Innovation is also associated with risk.
• Monopoly power.
• If markets are not perfectly competitive, prices
  exceed average costs (e.g., the market for
  commercial carriers)

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Introduction to Demand and Supply

• A market is an institution that allows a group of
  sellers and buyers to engage in economic
  transactions
• An economic transaction consists of an exchange
  of two different objects.
• A participant in a market can be in contact with
  a subset of other market participants.
• Sellers or buyers can be individuals, firms, or
  institutions.

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Introduction to Demand and Supply

• The market does not have to be a physical place.
• Market structure refers to the number of
  participants (Monopoly, oligopoly, perfect
  competition, etc)
• The demand side of the market summarizes the
  behavior of buyers.
• The supply side of the market summarizes the
  behavior of sellers.

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Market demand curve

• Shows the maximum amount of a commodity that
  buyers would like to purchase at various prices
• The following figure shows the shape of a demand
  curve.

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A Hypothetical Demand Curve for Coca Cola in the
US
Price (Cents per can)

• Price is expressed in cents per can.
• Quantity is measured in millions of Coca Cola
  cans per day.

A
65
B
55
C
45
0
Quantity
30
20
25
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Properties of the Demand Curve

• The demand curve can refer to an individual,
  firm, or to a whole market.
• The demand curve refers to a particular period of
  time.
• It is downward sloping implying that a lower
  price results in more quantity demanded.
• Any demand curve is drawn based on the
  assumption that the following variables (or
  parameters) are constant
• Prices of competing goods
• Incomes of consumers
• Number of consumers in the market
• Tastes of consumers

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Moving Along the Demand Curve

• Any change in a variable (parameter) that appears
  in an axis of a graph causes a movement along the
  demand curve.
• There are two movement parameters the price
  and quantity of the product itself (as opposed
  to substitute or complement products.

Price (Cents per can)
B
55
C
45
0
Quantity
30
25
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Shifting the Demand Curve

• Any change in prices of competing goods, income,
  number of consumers or tastes causes a rightward
  or a leftward shift in the demand curve.
• The demand curve shifts if there is a change in
• the price of a substitute product
• the price of a complement product
• consumer income
• the number of consumers
• consumer tastes.

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Demand Shifts to the Right if the Price of a
Substitute Product Increases
Price (Cents per can)
New demand curve
0
Quantity

• An increase in the price of Pepsi shifts the
  demand curve to the right.

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Demand Shifts to the Right if the Price of a
Complement Product Declines
Price (Cents per can)
New demand curve
0
Quantity

• A decline in the price of Big Mac shifts the
  demand curve to the right

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The Supply Curve

• The behavior of sellers is modeled by the supply
  curve
• The market supply curve shows the maximum
  quantity sellers are willing to provide at any
  given price
• The following figure illustrates the supply curve
  of Coca Cola

Price
Supply Curve
C
65
B
55
A
45
0
Quantity
28
25
18
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Properties of the Supply Curve

• A supply curve refers to a particular period of
  time
• A day, a month, a year etc.
• The supply curve can capture the behavior of
  firms, of an individual, or of the market as a
  whole.
• The supply curve is upward-sloping.

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Properties of the Supply Curve

• The supply curves movement parameters are the
  variables in the two axes
• The own price
• The own quantity
• The supply curves shift parameters are
• Technological improvements
• Prices of intermediate goods, capital, and labor

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Any Change in Price or Quantity Causes a Movement
Along the Supply Curve

• The following graph illustrates a move along the
  supply curve caused by an increase in the market
  price or quantity.

Price
B
A
0
Quantity
25
Shifting the Supply Curve

• The supply curve shifts to the right if
• There is technological progress
• The price of labor, capital, land or raw
  materials declines.
• The supply curve shifts to the left if
• The price of labor, capital, land or raw
  materials increases.

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Shifting the Supply Curve

• The effect of an increase in the wage of labor on
  the supply curve of Coca Cola is illustrated
  below

Supply Curve
Price
Supply Curve
0
Quantity
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Putting the Demand and Supply Curves Together

• The market equilibrium price is a price that does
  not have a tendency to change.
• At the equilibrium price the quantity demanded
  equals the quantity supplied.

Price
Supply Curve
E
55
Demand Curve
0
Quantity
25
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Excess Demand and Supply

• If the market price is higher than the
  equilibrium price (excess supply), there is
  pressure for the price to decline.
• If the market price is lower than the equilibrium
  price (excess demand), there is pressure for the
  price to rise.
• Therefore the actual price, which is the price
  that prevails in the market, tends to be close to
  the equilibrium price
• Sometimes actual prices differ across firms, but
  these deviations are small and can be ignored.

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Excess Demand and Supply for Coca Cola

• If the price is 65 cents per can, there is an
  excess supply of 8 million cans per day
• If the price is 45 cents per can, there is an
  excess demand of 12 million cans per day

Price
Supply Curve
65
45
Demand Curve
0
Quantity
18
20
28
30
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If the Demand Curve Shifts Left, the Equilibrium
Price and Quantity Decline

• In the case of Walt Disney, the demand shifted to
  the left due to demographic changes reducing the
  number of visitors from 11.5 million to 9.9
  million

Price
Supply Curve
Demand Curve
0
Quantity
11.5
9.9
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If the Supply Curve Shifts Right, the price Falls
and the Quantity Increases

• The entry of Russia in the world market for
  aluminum in the 1990s reduced its price from 80
  cents to 47 cents

Price
Supply Curve
New supply curve
Demand Curve
0
Quantity
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If the Supply Curve Shifts Left, the Price Rises
and the Quantity Falls

• An increase in malpractice insurance rates
  decreases the supply of medical services provided
  by doctors.

New supply curve
Price
Supply Curve
Demand Curve
0
Quantity
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Summary

• We used two case studies to motivate the study of
  managerial economics.
• Courses in managerial economics provide the
  fundamental analytical tool to decisions made by
  executives.
• To apply managerial economics to business
  management we need a theory of a firm describing
  its behavior and goals.
• Economic profits versus accounting profits.
• Economic profits exist because of innovation,
  risk, and monopoly power.
• Managerial economists assume that firms maximize
  profits.

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Summary

• Every market has a demand side and a supply side
• The market demand summarizes the behavior of
  buyers.
• The market supply summarizes the behavior of
  producers.
• The intersection of demand and supply curves
  determines the equilibrium price and quantity.
• Both demand and supply curves shift over time as
  a result of changes in various parameters.
• Rightward shifts in the demand curve and leftward
  shifts in the supply curve tend to increase the
  equilibrium price.
• Leftward shifts in the demand curve and rightward
  shifts in the supply curve tend to reduce the
  equilibrium price.