+ Managerial Economics & Business Strategy

Chapter 1
The Fundamentals of Managerial
Economics

McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
 1-2
+
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.
 1-3
+
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 1-4

 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.
 1-5
+
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.
Marginal (Incremental) Analysis 1-6

 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?
 1-7
+
Net Benefits

 Net Benefits = Total Benefits - Total Costs

 Profits = Revenue - Costs

 1-8

Marginal Benefit (MB)

 Change in total benefits arising from a change in the control

variable, Q:

B
MB 
Q
 Slope (calculus derivative) of the total benefit curve.
 1-9

Marginal Cost (MC)

 Change in total costs arising from a change in the control

variable, Q:

C
MC 
Q
 Slope (calculus derivative) of the total cost curve
 Marginal Principle
1-10
+

 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
1-11
+
Benefit and Cost
Total Benefits Costs
& Total Costs
Benefits
Slope =MB

B
Slope = MC
C

Q* Q
 The Geometry of Optimization: Net
1-12
+
Benefits
Net Benefits

Maximum net benefits

Slope = MNB

Q* Q
+ Managerial Economics & Business Strategy

Chapter 2
Market Forces: Demand and
Supply

McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
 2-14

Overview

I. Market Demand Curve III. Market Equilibrium

 The Demand Function
 Determinants of Demand IV. Price Restrictions
 Consumer Surplus
V. Comparative Statics

II. Market Supply Curve

 The Supply Function
 Supply Shifters
 Producer Surplus
 2-15
+
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.

Price

D
Quantity
 2-16

Determinants of Demand

 Income
 Normal good
 Inferior good

 Prices of Related Goods

 Prices of substitutes
 Prices of complements

 Advertisingand
consumer tastes
 Population

 Consumer expectations
 2-17
+
The Demand Function
Ageneral 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.
 2-18
+
Inverse Demand Function

Price as a function of quantity demanded.

Example:
 Demand Function
 Qxd = 10 – 2Px
 Inverse Demand Function:
 2Px = 10 – Qxd
 Px = 5 – 0.5Qxd
 2-19
Change in Quantity Demanded
Price
A to B: Increase in quantity demanded

A
10

B
6

D0

4 7 Quantity
 2-20

Change in Demand
Price D0 to D1: Increase in Demand

6
D1

D0
7 13 Quantity
 2-21

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.
 2-22

I got a great deal!

 Thatcompany offers a lot

of bang for the buck!
 Dell provides good value.
 Totalvalue greatly
exceeds total amount
paid.
 Consumer surplus is
large.
 2-23

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.
+ Consumer Surplus: 2-24

The Discrete Case

Price
Consumer Surplus:
10 The value received but not
8 paid for. Consumer surplus =
(8-2) + (6-2) + (4-2) = $12.
6

2
D
1 2 3 4 5 Quantity
+ Consumer Surplus: 2-25

The Continuous Case

Price $

10
Value
Consumer 8 of 4 units = $24
Surplus =
$24 - $8 =
$16
6

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

2
D
1 2 3 4 5 Quantity
 2-26
+ 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.

Price
S0

Quantity
 2-27

Supply Shifters
 Input prices
 Technology or
government regulations
 Number of firms
 Entry
 Exit

 Substitutes in production
 Taxes
 Excise tax
 Ad valorem tax

 Producer expectations
 2-28
+
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.
 2-29
+
Inverse Supply Function

Price as a function of quantity supplied.

Example:
 Supply Function
 Qxs = 10 + 2Px
 Inverse Supply Function:
 2Px = 10 + Qxs
 Px = 5 + 0.5Qxs
 2-30
+
Change in Quantity Supplied

Price A to B: Increase in quantity supplied

S0
B
20

A
10

5 10 Quantity
 2-31
+ Change in Supply
S0 to S1: Increase in supply
Price

S0

S1

5 7 Quantity
 2-32
+ Producer Surplus
 The
amount producers receive in excess of the
amount necessary to induce them to produce the
good.
Price

S0
P*

Q* Quantity
 2-33

Market Equilibrium

 ThePrice (P) that

Balances supply and
demand
 QxS = Qxd
 No shortage or surplus

 Steady-state
 2-34

If price is too low…

Price S

7
6

Shortage D
12 - 6 = 6
6 12 Quantity
 2-35
If price is too high…
Surplus
Price 14 - 6 = 8
S
9
8
7

6 8 14 Quantity
 2-36
+ 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.
 2-37
Impact of a Price Ceiling

Price S

PF

P*

P Ceiling

Shortage D

Qs Qd Quantity
Q*
 2-38
+
Impact of a Price Floor

Price Surplus S
PF

P*

Qd Q* QS Quantity
 2-39
+
Comparative Static Analysis
 How do the equilibrium price and quantity change when a
determinant of supply and/or demand change?
 2-40
+
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.

 2-41
+ 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.
 2-42
+
Scenario 1: Implications for a Small
PC Maker
 Step 1: Look for the “Big Picture.”

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

Big Picture: Impact of decline in 2-43

component prices on PC market

Price S
of
PCs S*

P0
P*

Q* Quantity of PC’s
Q0
 2-44
+ 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
2-45
+

 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?
Big Picture: Impact of lower PC prices on
2-46

the software market

Price S
of Software

P1
P0

D*

Q0 Q1 Quantity of
Software
 2-47
+
Big Picture Analysis: Software
Market
 Software prices are likely to rise, and more software will be
sold.

 Use this to organize an action plan.

+ Managerial Economics & Business Strategy

Chapter 3
Quantitative Demand Analysis

McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
 3-49
+ Overview

I. The Elasticity Concept

 Own Price Elasticity
 Elasticity and Total Revenue
 Cross-Price Elasticity
 Income Elasticity

II. Linear Demand Functions

 3-50
+
The Elasticity Concept

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

% G
EG , S 
% 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.
 3-51
+
The Elasticity Concept Using Calculus

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

dG S
EG , S 
dS G
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.
 3-52
+
Own Price Elasticity of Demand

%QX
d
EQX , PX 
%PX
 Negative according to the “law of demand.”

Elastic: EQ X , PX  1
Inelastic: EQ X , PX  1
Unitary: EQ X , PX  1
 3-53
+
Perfectly Elastic &
Inelastic Demand

Price Price
D

Quantity Quantity

Perfectly Elastic ( EQX ,PX  ) Perfectly Inelastic ( EQX , PX  0)

 3-54
+
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.
 3-55
+
Elasticity, Total Revenue and Linear Demand

P
TR
100

0 10 20 30 40 50 Q 0 Q
 3-56
+
Elasticity, Total Revenue and Linear Demand

P
TR
100

80

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-57
+
Elasticity, Total Revenue and Linear Demand

P
TR
100

80

60 1200

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-58
+
Elasticity, Total Revenue and Linear Demand

P
TR
100

80

60 1200

40

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-59
+
Elasticity, Total Revenue and Linear Demand

P
TR
100

80

60 1200

40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-60
+
Elasticity, Total Revenue and Linear Demand

P
TR
100
Elastic
80

60 1200

40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic
 3-61
+
Elasticity, Total Revenue and Linear Demand

P
TR
100
Elastic
80

60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic Inelastic
 3-62
+
Elasticity, Total Revenue and Linear Demand

P TR
100
Elastic Unit elastic
80 Unit elastic

60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic Inelastic
 3-63
+
Demand, Marginal Revenue (MR) and Elasticity

P  Fora linear
100 inverse demand
Elastic
Unit elastic
function, MR(Q) =
80
a + 2bQ, where b
60 < 0.
Inelastic
40  When
 MR > 0, demand is
20
elastic;
 MR = 0, demand is unit
elastic;
0 10 20 40 50 Q
 MR < 0, demand is
MR inelastic.
+ Factors Affecting 3-64

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.
 3-65
+
Cross Price Elasticity of Demand

%QX
d
EQX , PY 
%PY

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

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

 3-66
+
Income Elasticity

%QX
d
EQX , M 
%M

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

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

 3-67
+
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!

 3-68
+
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?
 3-69
+
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.
 3-70
+ 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
3-71
+

• Calls would increase by 25.92 percent!

% QX
d
EQX , PX  8.64 
%PX
% Q X
d
 8.64 
 3%
 3%   8.64   %QX
d

%QX  25.92%
d
 3-72
+ 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
3-73
+

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

%QX
d
EQX , PY  9.06 
%PY
%QX
d
9.06 
 4%
 4%  9.06  %QX
d

%QX  36.24%
d
 3-74
+
Interpreting Demand Functions
 Mathematical representations of demand curves.

 Example:

QX  10  2 PX  3PY  2M
d

 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).
+ Managerial Economics & Business Strategy

Chapter 4
The Theory of Individual Behavior

McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
+ Overview 4-76

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
4-77
+
 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.
 4-78

Indifference Curve Analysis

Indifference Curve Good Y

 A curve that defines the
III.
combinations of 2 or more
goods that give a consumer the II.
same level of satisfaction. I.
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 X
 4-79
+
Consumer Preference Ordering
Properties
 Completeness

 More is Better

 Diminishing Marginal Rate of Substitution

 Transitivity
 4-80

Complete Preferences
 Completeness Property
 Consumer is capable of Good Y
expressing preferences (or III.
indifference) between all
possible bundles. (“I don’t II.
know” is NOT an option!) I.
 If the only bundles available A B
to a consumer are A, B, and C,
then the consumer
 is indifferent between A and C
(they are on the same C

indifference curve).
 will prefer B to A.
 will prefer B to C. Good X
 4-81

More Is Better!

 More Is Better Property

 Bundles that have at least as much Good Y
of every good and more of some III.
good are preferred to other
bundles. II.
 Bundle B is preferred to A since B
contains at least as much of good
I.
Y and strictly more of good X.
 Bundle B is also preferred to C 100
A B
since B contains at least as much
of good X and strictly more of
good Y. C
 More generally, all bundles on 33.33
ICIII are preferred to bundles on
ICII or ICI. And all bundles on ICII
are preferred to ICI. 1 3
Good X
 4-82

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 Good Y
satisfaction level decreases as more of
good X is acquired.
 The rate at which a consumer is willing to III.
substitute one good for another and
maintain the same satisfaction level.
II.
 To go from consumption bundle A
to B the consumer must give up 50 I.
units of Y to get one additional unit
of X. 100 A

 To go from consumption bundle B to

C the consumer must give up 16.67
units of Y to get one additional unit 50
B
of X.
C
33.33 D
 To go from consumption bundle C 25
to D the consumer must give up
only 8.33 units of Y to get one
additional unit of X.
1 2 3 4 Good X
 4-83

Consistent Bundle Orderings

 Transitivity Property
 For the three bundles A, B, and Good Y
C, the transitivity property III.
implies that if C  B and B  A,
then C  A. II.
 Transitive preferences along I.
with the more-is-better property 100 A
imply that C
75
 indifference curves will not B
50
intersect.
 the consumer will not get
caught in a perpetual cycle of
indecision.
1 2 5 7 Good X
 4-84

The Budget Constraint

 Opportunity Set The Opportunity Set
Y
 The set of consumption bundles that are
affordable.
Budget Line
 PxX + PyY  M.
M/PY
Y = M/PY – (PX/PY)X
 Budget Line
 The bundles of goods that exhaust
a consumers income.
 PxX + PyY = M.

 Market Rate of Substitution M/PX

 The slope of the budget line X

 -Px / Py
 4-85

Changes in the Budget Line

Y

 Changes in Income
M1/PY

 Increases lead to a parallel,

outward shift in the budget M0/PY

line (M1 > M0).

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

 Changes in Price X
M2/PX M0/PX M1/PX
 A decreases in the price of Y
good X rotates the budget New Budget Line for
line counter-clockwise (PX0 > M0/PY a price decrease.
PX1).
 An increases rotates the
budget line clockwise (not
shown).

M0/PX0 M0/PX1
X
 4-86

Consumer Equilibrium

 The equilibrium Y

consumption bundle is the Consumer

affordable bundle that
M/PY
Equilibrium
yields the highest level of
satisfaction.
 Consumer equilibrium occurs at a
point where
MRS = PX / PY. III.
 Equivalently, the slope of the II.
indifference curve equals the budget
I.
line.
M/PX
X
 4-87
+
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.
 4-88
+
Complementary Goods

When the price of

Pretzels (Y)
good X falls and the
consumption of Y
rises, then X and Y M/PY
1
are complementary
goods. (PX1 > PX2)

B
Y2

Y1 A II

I
0 X1 M/PX1 X2 M/PX2 Beer (X)
 4-89
+
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.
 4-90
+
Normal Goods

Y
An increase in
income increases
the consumption of M1/Y

normal goods.

(M0 < M1).

B
Y1
M0/Y
II
A
Y0
I
X0 M0/X X1 M1/X X
0
 4-91
+
Decomposing the Income and
Substitution Effects
Initially, bundle A is consumed. Y
A decrease in the price of good
X expands the consumer’s
opportunity set.
The substitution effect (SE) C
causes the consumer to move
from bundle A to B. A II
A higher “real income” allows B
the consumer to achieve a
higher indifference curve. I
The movement from bundle B to
C represents the income effect IE X
0
(IE). The new equilibrium is SE
achieved at point C.
 4-92
+
A Classic Marketing Application

Other
goods
(Y)

A
A buy-one,
C E
get-one free
D
pizza deal. II
I

0 0.5 1 2 B F Pizza
(X)
 4-93
Individual Demand Curve
Y

 An individual’s
demand curve is
derived from each II

new equilibrium I

point found on the $ X

indifference curve
as the price of good P0
X is varied. P1 D

X0 X1 X
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Market Demand
 Themarket 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 $ Market Demand Curve

Curves
50

40

D1 D2 DM
1 2 Q 1 2 3 Q
 4-95
+
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.