PowerPoint Presentation Lecuture 78 Managerial Economics

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Weeks 7 8 Competition, market structures and
business decisions
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Examination structure
1.      Exam duration 120 minutes writing
time   2.      Reading time 10
minutes   3.      Total number of
questions 6   4.      Students must attempt all
four questions from section 1 and 1 (one)
question from section 2.   5.      Use of
calculators is permitted   6.     
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Examination structure
    Section 1. No questions just on
definitions. All the questions are problem
solving You must include the most relevant
definitions as well diagrams where
appropriate. Brief verbal explanation should
complement you numeric solution. Section 2.
Discuss advantages and disadvantages of low
interest rates for manufacturing in Australia
Or Apply this question to a country of your
choice.
4
Production and Costs
Solutions
Problem 4. Incremental cost.
Current situation. Selling to other
manufacturers. Unit profit before tax Selling
price 250 Costs Direct
material 40 Direct labour
60 Variable overhead 30 Variable
selling expenses 25 Fixed selling expenses
20 (per unit)
-175 Unit profit
before tax 75
Proposed direct sale. Additional costs per
unit Selling price 300
Costs Direct labour 30 Variable
overhead 5 Variable selling expenses
2 Fixed selling expenses (per year)
20,000
Calculate the incremental profit
5
Production and Costs
Solutions
Problem. 8.4. Incremental cost.
Current situation. Selling to other
manufacturers. Unit profit before tax Selling
price 250 Costs Direct
material 40 Direct labour
60 Variable overhead 30 Variable
selling expenses 25 Fixed selling expenses
20 (per unit)
-175 Unit profit
before tax 75
Proposed direct sale. Additional costs per
unit Selling price 300
Costs Direct labour 30 Variable
overhead 5 Variable selling expenses
2 Fixed selling expenses (per year)
20,000
Calculate the incremental profit
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Production and Costs
Solutions
Problem 8.5. Accounting and Economic Costs
Running a frozen yogurt stand. Alternative
employment 6,000.00 Fixed cost (rent)
8,000.00 Insurance
1,000.00 Variable costs per unit 0.40
Price per unit 1,00
A. What is the accounting cost function for this
business?
TCTFCTVC Total accounting cost
TFCTVC TCA8,0001,000 0.40Q 9,000
0.40Q
B. What is the economic cost function for this
business?
Total economic cost TFCTVC implicit
cost TCE8,0001,000 3x6,0000.40Q
27,000 0.40Q
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Production and Costs
Solutions
Problem 8.5. Accounting and Economic Costs
Running a frozen yogurt stand. Alternative
employment 6,000.00 Fixed cost (rent)
8,000.00 Insurance
1,000.00 Variable costs per unit 0.40
Price per unit 1,00
C. What is the economic breakeven point for this
operation.
TCETR TFCQBExAVC QBExP QBETFC/(P-AVC) 27,0
00 0.40QBE QBEx1.00 QBE
27,000/(1-.040)45,000 units
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Production and Costs
Solutions
Problem 8.5. Accounting and Economic Costs
TCETR 27,000 0.40QBE QBExP QBE
27,000/(1-.040)45,000 units
9
Production and Costs
Solutions
Problem 8.8 Multi-plant Operation
Alternative 2 Three plants Q1120,000 TFC1-120,0
00 Q2100,000 TFC2110,000 Q380,000 TFC395,000
AVC3,00 (lower distribution cost)
Alternative 1 Single Plant Monthly Q300,000
units Monthly TFC262500 VC3.25 per unit
A. Breakeven quantities for each alternative
(p5)
QBETFC/(P-AVC)
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Production and Costs
Solutions
Problem 8.8 Multi-plant Operation
Alternative 2 Three plants Q1120,000 TFC1-120,0
00 Q2100,000 TFC2110,000 Q380,000 TFC395,000
AVC3,00 (lower distribution cost)
Alternative 1 Single Plant Monthly Q300,000
units Monthly TFC262500 VC3.25 per unit
B. Which alternative is more profitable at the
projected level of sales
Alternative 1 Monthly Q200,000 units
Alternative 2 Three plants Q180,000 Q270,000 Q3
50,000
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Production and Costs
Solutions
Problem 8.8 Multi-plant Operation
Alternative 2 Three plants Q1120,000 TFC1-120,0
00 Q2100,000 TFC2110,000 Q380,000 TFC395,000
AVC3,00 (lower distribution cost)
Alternative 1 Single Plant Monthly Q300,000
units Monthly TFC262500 VC3.25 per unit
B. Which alternative is more profitable at full
capacity
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Structure
Weeks 7-8 Competition, market structures and
business decisions
Week 9 Pricing strategies and practices
Week 10 Business and Government.
Weeks 5 - 6 Production and Costs
Managerial Economics
Week 11 Capital budgeting
Weeks 3-4 Demand analysis and estimation
Week. 12 Research question Business and current
economic situation.
Week 2 Basic economics principles demand and
supply.
Week1 Introduction. The nature of managerial
economic decision making
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Competition, market structures and business
decisions
Learning objectives
What is the market Structure
How does competition affect business decisions in
different market structures?
Perfect competition monopoly oligopoly
monopolistic competition
Competitive strategies.
Measurement of market structures
Market strategies in different market structures.

Non-price competition.
Multinational companies. Vertical and horizontal
coordination.
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Competition, market structures and business
decisions
Reading
Mansfield, Chapters 11 12
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What is the market structure?
Competition, market structures and business
decisions
Market structures

• The competitive environment in the market for any
  product is the market structure faced by the firm
• Is measured in terms of
• the number of the actual buyers and sellers plus
  potential entrants
• Barriers to entry and exit
• Capital requirements
• Price vs Non-price competition
• Etc
• Potential entrants pose a sufficiently credible
  threat of entry to affect price/output decisions
  of incumbents

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Competition, market structures and business
decisions
Market structures
What is the market structure?
The firm in competitive markets
Non-perfect competition
Perfect competition
Monopoly
Oligopoly
Monopolistic competition
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Competition, market structures and business
decisions
Market structures
Perfect competition

• Profit maximiser
• Identical product
• Very small share of the market
• Price-taker
• Produces a homogeneous product
• Perfect information
• No barriers to entry (legal, technological, or
  resource)
• No technical progress
• No investment lag - Immediate implementation of
  production decisions)
• Homogeneous goals of the owners and managerial
  staff

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The Firm Supply Curve
Competition, market structures and business
decisions
Market structures
Perfect competition

• The short-run supply curve corresponds with the
  portion of the marginal cost curve that lies
  above the average cost curve.
• In a perfectly competitive market, Where PltAC
  losses can be reduced by expanding production so
  long as added revenues exceed added costs

Cost and revenue
per unit ()
LRMC
LRAC
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The Industry Supply Curve
Competition, market structures and business
decisions
Market structures
Perfect competition

• The sum of quantities that individual firms
  supply at each price
• The sum of marginal cost curves of individual
  firms above their average variable cost curves

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Market price determination
Competition, market structures and business
decisions
Market structures
Perfect competition

• Negatively sloped demand curve
• Positively sloped supply curve

Quantity per time period (millions)
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Demand Curve for a single firm
Competition, market structures and business
decisions
Market structures
Perfect competition

• Horizontal
• Competitive firm price taker

Price per unit ()
10
8
Demand
6
4
2
0
50
100
150
Quantity per time period (000)
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Optimal price/output decision in the short run
Competition, market structures and business
decisions
Market structures
Perfect competition
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Optimal price/output decision in the long run
Competition, market structures and business
decisions
Market structures
Perfect competition
Cost and revenue
per unit ()
LRMC
LRAC
P AR MR
P
Q

Output per time period
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Breakeven point
Competition, market structures and business
decisions
Market structures
Perfect competition
Price, cost
per unit ()
MC
ATC
AVC
D
2.00
B
1.40
1.25
1.00
A
100
0
Output per time period
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Basic Assumptions
Competition, market structures and business
decisions
Market structures
Monopoly

• One firm in industry
• Profit-maximiser
• Faces market supply curve
• One product
• No close substitutes
• Price-maker
• No restrictions on resources

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Price-makers demand curve
Competition, market structures and business
decisions
Market structures
Monopoly
Price per unit ()
12
10
8
Demand
6
4
2
200
150
100
50
0
Quantity per time period
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Competition, market structures and business
decisions
Market structures
Monopoly
P, Cost
MC

• Produces the quantity maximising profit (PgtAC)
• Operates at a price above marginal revenue
• Makes economic profit
• Restricts information
• Imposes barriers to entry (controlling markets,
  inputs and/or lobbing the government)

AC
D
MR
Q
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Competition, market structures and business
decisions
Solutions
Problem. Perfectly competitive firm supply
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Competition, market structures and business
decisions
Solutions
Problem. 1. Perfectly competitive firm supply
A. Construct the table showing the firms
marginal cost of production
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Competition, market structures and business
decisions
Solutions
Problem 2. Perfectly competitive firm supply
B. What is the minimum price for Mankato to
supply one ton of newsprint?
The minimum marginal cost of newsprint is 50.
So this also represents the minimum price
necessary to justify supplying a single unit of
output.
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Competition, market structures and business
decisions
Solutions
Problem 2. Perfectly competitive firm supply
C. How much newsprint would Mankato supply at
industry price of 75 and 100?
In a perfectly competitive market, PMR.
Therefore, Mankato will supply output so long as
price at least covers the marginal cost of
production. At P75, Q3 units of output can
be justified since P75gtMC75. However
production of a fourth unit cant be warranted
since P75ltMC80 A P100, Q6 units of output
can be justified since P100MC
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Competition, market structures and business
decisions
Solutions
Problem 3 Perfectly competitive industry supply
TC250000200Q0.02Q2 MC2000.04Q
A. Calculate the industry price necessary for the
firm to supply 5000, 10000 and 15000 of product
The marginal cost curve constitute the supply
curve for firms in perfectly competitive
industries. Since PMR, the price necessary to
induce supply of a given amount is found by
setting PMC Here PMC2000.04Q Q5000
P2000.04x5000400 Q10000 P2000.04x1000060
0 Q15000 P2000.04x15000800
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Competition, market structures and business
decisions
Solutions
Problem 3. Perfectly competitive industry
supply
TC250000200Q0.02Q2 MC2000.04Q
B. Calculate the quantity supplied at industry
prices of 200, 500, and 1000 per ton.
PMC2000.04Q 0.04Q-200P Therefore, the
firms supply curve is Q-500025P P200
Q-500025x2000 P500 Q-500025x5007,500 P
1,000 Q-500025x1,00020,000
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Competition, market structures and business
decisions
Solutions
Problem 4. Monopoly versus Perfectly
competitive equilibrium
TR15Q-0.000005Q2 MR15-0.00001Q MC5, All
other costs are zero
A. Calculate output, price and profit at the
profit maximising activity level.
MRMC 15-0.00001Q5 0.00001Q10 Q1,000,000 PTR/
Q(15Q-0.000005Q2)/Q15-0.000005QQ-0.000005x1,000
,00010 ?TR-TC PxQ-MCxQ10x1,000,000 -
5x1,000,0005,000,000
B. Profit at perfect competition
PMCAC ?TR-TC0
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Competition, market structures and business
decisions
Market structures
In the real life
A real competitive firm (compare to the ideal
one)

• A typical firm, if it is not a small one, is not
  owner-managed
• Separation of ownership, long-term strategic and
  short-run current control (shareholders, board of
  directors, brunch managers) implies the
  segregation of objectives
• Natural, economic and legal barriers
• Diversification (non-homogenous product, more
  than one kind of activity)
• Technical progress
• Different criteria for different time horizons
  (short-run operation vs long-run planning.
• Price-making
• Price/marketing strategies
• Imperfect information
• Investment lag

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Competition, market structures and business
decisions
Market structures
?ligopoly
Element of the theory relevant to this subject

• An olygopolistic industry is composed of a few
  firms selling identical or similar products in
  the same market
• Each firm carefully watches decisions of
  competitors and often plans anti-strategies they
• either ignore each other
• or form cartels
• or a price leader appears, causing monopolistic
  price formation
• Elements of non-profit maximisation appear. A
  sales- revenue producers more than a profit
  maximiser and charges a lower price.

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Neoclassical view
Competition, market structures and business
decisions
Market structures
?onopolistic competition

• The market consists of n mono-product firms
• The products are viewed by the buyers as close
  though not perfect substitutes for one another
• Therefore, each of the sellers is a monopolist of
  its particular product variant with a limited
  degree of monopoly power.
• Such a monopolist is enjoying a monopoly power
  and making economic profit during only a short
  period of time
• from the introduction of an unique product or
  technology
• until such a technology becomes available to
  rivals, or
• until a new more innovative product is
  introduced by a rival.

38
Competition, market structures and business
decisions
Market structures
?onopolistic competition
Price Costs
MC
AC
Pmc
Demand
MR
Q
Qmc
Quantity
Short-run quantity, price and economic profit
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Competition, market structures and business
decisions
Market structures
?onopolistic competition
Price Costs
MC
AC
D1
D2
Quantity
MR1
MR2
Long-run equilibrium same costs, lower demand and
excess capacity low output high price decision
40
Competition, market structures and business
decisions
Market structures
?onopolistic competition
Price Costs
Price Costs
MC
AC
MC
AC
Pmc
D1
D
D2
MR
Quantity
MR1
Quantity
Qmc
MR2
Long-run equilibrium same costs, lower demand and
excess capacity low output high price decision
41
Competition, market structures and business
decisions
Market structures
?onopolistic competition contemporary view

• Cost functions are identical across firms
  
• Non-zero marginal costs
• Perfect availability of the technology used in
  the production of all product variants

• the firms are characterised by different cost
  functions
• Relatively low marginal costs
• Each portion of cutting-edge technological
  information does not spill over immediately

42
Competition, market structures and business
decisions
Market structures
?onopolistic competition contemporary view

• Cutting-edge technology does not spill over
  immediately
• For the time, each firm possesses some unique
  product-attributable elements of otherwise common
  technology
• These unique elements make the product variants
  different
• The differences are viewed by the buyers as
  differences in quality characteristics
• We assume the simplest case
• all the quality characteristics of each
  product can be aggregated into a scalar quality
  characteristic
• Increase quality generates increase in consumer
  demand.
• Increase in quality can be achieved by a firm
  only through increase in the cost of the first
  copy
• Each firm is characterised by its cost elasticity
  of quality

43
Competition, market structures and business
decisions
Market structures
?onopolistic competition contemporary view

• Aiming at increase in profit, High Tech firm
  struggles for consumer demand investing in the
  quality of its product.
• Increase in quality is associated with increase
  in costs.
• The firm sets the price to cover the costs and
  earn profit, depending on anticipated demand
• Increase in quality causes increase in quantity
  demanded
• Increase in price causes decrease in quantity
  demanded

44
Competition, market structures and business
decisions
Market structures
?onopolistic competition contemporary view

• To ensure economic profit, relative increase in
  demand, associated with increase in quality per
  unit of relative increase in cost should not be
  offset by relative decrease in demand per unit of
  relative increase in price and
• Otherwise, the firm is not competitive.

45
Competition, market structures and business
decisions
Competitive strategies in Imperfectly competitive
markets

• Not all industries offer the same potential for
  sustained profitability
• Not all firms are equally capable of exploring
  the profit potential that is available.
• An effective competitive strategy in imperfectly
  competitive markets must be founded on the firms
  competitive advantage.

46
Competition, market structures and business
decisions
Competitive strategies in Imperfectly competitive
markets

• A competitive advantage is a unique or rare
  ability to create, distribute or service valued
  by customers.
• It is a business-world analogue to what
  economists call comparative advantage or when
  one nation or region of the country is better
  suited to the production of one product than to
  the production of some other product
• Above-normal rate of return require a competitive
  advantage that cannot easily be copied
• In production
• In distribution or
• In marketing

47
Competition, market structures and business
decisions
Non-price competition.
Product differentiation
Product differentiation refers to the increase
in time of the number of product categories
suppled and the number of items in each category
48
Competition, market structures and business
decisions
Non-price competition.
Product differentiation
A simple model of the reason for product
differentiation
Price

• Based on the comparative theory of perfect and
  monopolistic competition
• Considers constant quantity as well as
  non-changing AC and MC corresponding to this
  quantity
• Producing a little bit different product a firm
  might hope to charge a higher price

P
P
Quantity
Q
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Competition, market structures and business
decisions
Non-price competition.
Barriers to entry
Price
Absolute cost advantages Ability of established
firms to produce any given level of output at
lower unit costs than potential entrants
LAC
P
LAC
P
Quantity
Q
50
Competition, market structures and business
decisions
Non-price competition.
Barriers to entry
Price
Economies of scale Ability of established firms
to produce any given level of output greater
than a certain level Q at lower unit costs and
to restrict potential entrants who are not able
to invest in that level of production
LAC
P
D
Quantity
Q
51
Competition, market structures and business
decisions
Non-price competition.
Barriers to entry
Price
Product differentiation advantages Variety of
demand curves and common LAC. Some firms have
advantage of technology or specialisation and
are facing demand curves to the right of the
critical one.
LAC
P
D1
D2
D2
Quantity
Q
52
Competition, market structures and business
decisions
Non-profit-maximising competition.

• Appear as the result of
• Ability to affect prices and
• Separation of ownership and managerial control

• Managers aim is stability and increase of
  salaries
• Stability may be achieved through the increase
  of activity
• The increase of sale (not of profit) affects
  managers salaries
• Banks and retailers would prefer to deal with
  firms increasing sales

53
Competition, market structures and business
decisions
Non-profit-maximising competition.
P, Cost
MC
AC
D
MR
Q
Profit maximising decision
54
Competition, market structures and business
decisions
Non-profit-maximising competition.
P, Cost

• Increasing sales, the firm is moving left
  downward the demand curve and, therefore,
  decreases price,
• The limitation is AC curve. Some profit should be
  obtained anyway

D
MR
Q
Profit maximising decision
Sales maximising decision
55
Competition, market structures and business
decisions
Non-profit-maximising competition.
P, Cost
MC
AC
D
MR
Q
Profit maximising decision
56
Competition, market structures and business
decisions
Non-profit-maximising competition.
P, Cost
MC
Old sales maximising decision is, at a new level
of average cost, a profit maximising decision
AC
D
MR
Q
Old profit maximising decision
New profit maximising decision
57
Competition, market structures and business
decisions
Measurement of market structures
Seller concentration
Seller concentration refers to the degree to
which production for a particular market or or in
a particular industry is concentrated in the
hand of few large firms
Measurement of concentration

• number of firms in the market
• size distribution of firms in the market

58
Competition, market structures and business
decisions
Measurement of market structures
Seller concentration
Measurement of concentration
59
Competition, market structures and business
decisions
Measurement of market structures
Seller concentration
Measurement of concentration
Diagrammatic approach
100
The curve of real (not equal distribution
The curve of equal distribution of shares of the
market among firms
Cumulative of output
This distance measures concentration
N
No of firms cumulated from the largest
60
Competition, market structures and business
decisions
Multinational companies. Vertical and horizontal
coordination.
Diversification
Vertical coordination
Multinational company
61
Competition, market structures and business
decisions
Multinational companies. Vertical and horizontal
coordination.
Diversification
Invest in production facilities to produce a
product D
Buys shares of a firm Y producing a good B
A firm X producing a good A
Invents a new product C
62
Competition, market structures and business
decisions
Multinational companies. Vertical and horizontal
coordination.
Vertical coordination
A firm X producing a good A
63
Competition, market structures and business
decisions
Multinational companies. Vertical and horizontal
coordination.
Vertical coordination
A firm X producing a good A
Invest in production facilities or buys
shares of or coordinate activities with a firm
producing an input D
64
Competition, market structures and business
decisions
Multinational companies. Vertical and horizontal
coordination.
Vertical coordination
A firm X producing a good A
Invest in facilities or buys shares of or
coordinate activities with a firm providing
professional training for employees
Invest in production facilities or buys
shares of or coordinate activities with a firm
producing an input D
65
Competition, market structures and business
decisions
Multinational companies. Vertical and horizontal
coordination.
Vertical coordination
Invest in production facilities or buys
shares of or coordinate activities with a firm
using A as an input
A firm X producing a good A
Invest in facilities or buys shares of or
coordinate activities with a firm providing
professional training for employees
Invest in production facilities or buys
shares of or coordinate activities with a firm
producing an input D
66
Competition, market structures and business
decisions
Multinational companies. Vertical and horizontal
coordination.
Vertical coordination
Invest in production facilities or buys
shares of or coordinate activities with a firm
using A as an input
Invest in or buys shares of or coordinate
activities with a firm specialising in the
selling of product A
A firm X producing a good A
Invest in facilities or buys shares of or
coordinate activities with a firm providing
professional training for employees
Invest in production facilities or buys
shares of or coordinate activities with a firm
producing an input D
67
Competition, market structures and business
decisions
Multinational companies. Vertical and horizontal
coordination.
Multinational company
Undertake vertical coordination measures abroad
Establishes branches in other countries
A firm producing a good A in a home country
Buys share of analogous firms in other countries
Conduct diversification practices abroad