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Managerial Economics

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Jorge Sánchez

on 1 February 2014

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Transcript of Managerial Economics

Chapter 8: Production and Cost in the short run
A manager must produce with some inputs that are fixed in quantity. The manager has a fixed amount of plant and equipment with wich to produce the firms's output.
Chapter 9: Production and Cost in the long run
Chapter 11: Managerial Decisions in competitive markets
How do managers make price and output decisions to maximize the profit of the firm?
- Taking into account:
Chapter 12: Managerial Decisions for firms with market power
Managerial Economics
Foundations of business
analysis and strategy

Christopher Thomas, S. Charles Maurice 11th edition
Presented by: JORGE SÁNCHEZ
February 01st, 2014

Chapter 13: Strategic Decision Making in Oligopoly Markets
Successful managers must learn how to anticipate the actions and reactions of other firms in the market.
General concepts
Inputs in production:

* Production periods:
- Short run:
- Long run:
Kinds of production
*
Variable proportions production:
production in wich a given level of output can be produced with more than one combination of inputs.
*
Fixed proportions production:
production in which one, and only one ratio of inputs can be used to produce a good.
Production
Creation of goods and services from inputs or resources.
Production function
Schedule showing the maximum amount of output that can be produced from any specified set of inputs, given the existing technology.
Inputs
-
Variable input:
level of usage may be varied to increase or decrease output.
-
Fixed input:
level of usage can not be changed and it must be paid even if no output is produced.
-
Quasi-fixed input:
lumpy or indivisible input for which a fixed amount must be used for any positive level of output, and none is purchased when output is zero.
Efficiency
Economic efficiency
Producing a given level of output at the lowest-possible total cost.
Technical efficiency
Producing the maximum output for any given combination of inputs and existing technology.
Costs
Avoidable cost
Payment for an input that a firm can recover or avoid paying should the firm no longer wish to use that input. Variable costs and quasi-fixed costs are avoidable costs.
Sunk cost
Payment for an input that, once made, cannot be recovered should the firm no longer wish to employ that input. Fixed costs are sunk costs.
Operating and planning periods
2014
2015
2019
Short run Production Period
(Operating horizon)
Current time span during which at least one input is a fixed input and must be paid whether or not any output is produced.
Long run production period
(Planning horizon)
Time period for enough in the future to allow all fixed inputs to become variable inputs. Thus, the set of all possible short-run situations the firm can face in the future.
Production in the short run
Average and Marginal Products
Average product of labor (AP):
Short-run costs of production
Total Cost
Total fixed cost (TFC):
Total amount paid for fixed inputs. It does not vary with output.
Total variable cost (TVC):
Total amount paid for variable inputs. It increases with increases in output.
Total cost (TC):
TC = TVC + TFC
Average and Marginal Costs
Production function
Once level of capital (K) is fixed, the only way the firm can change its output is by changing the amount of labor (L) it employs.
Marginal product of labor (MP):
When:
AP rises, MP > AP
AP falls, MP < AP
AP reaches its maximum, AP = MP
As the number of units of the variable input increases, other inputs held constant, a point will be reached beyond which its marginal product decreases.
Law of diminishing marginal product
Changes in Fixed Inputs
Average fixed cost (AFC):
Average variable cost (AVC):
Average total cost (ATC):
Short-run marginal cost (SMC):
Relations:
(1) AFC declines continuously, approaching both axes asymptotically.
(2) AVC first declines, reaches a minimum at Q2, and rises thereafter. When AVC is at its minimum, SMC equals AVC.
(3) ATC first declines, reaches a minimum at Q3, and rises thereafter. When ATC is at its minimum, SMC equals ATC.
(4) SMC first declines, reaches a minimum at Q1, and rises thereafter. SMC equals both AVC and ATC when these curves are at their minimum values.
* SMC lies below both AVC and ATC over the range for which these curves decline.
* SMC lies above them when they are rising.
Relations
Total Variable Cost (TVC):

Total Fixed Cost (TFC):

Total Cost (TC):

Average Variable Cost(AVC):

Short-run Marginal Cost (SMC):
w
: price of a unit of labor services
r
: price of a unit of capital services
• When marginal product (average product) is increasing, marginal cost (AVC) is decreasing.
• When marginal product (average product) is decreasing, marginal cost (AVC) is increasing.
• When marginal product equals average product at maximum AP, marginal cost equals minimum AVC.
Production Isoquants
All inputs are variable in the long run.
A curve showing all possible combinations of inputs physically capable of producing a given fixed level of output.
It shows how one input can be substituted for another while keeping the level of output constant.
Marginal rate of technical substitution (MRTS)
Slope of an isoquant that measures the rate at which one input is substituted for another along an isoquant.
The minus sign is added to make MRTS a positive number, since ∆K / ∆L, the slope of the isoquant, is negative.
Isocost curves
Line that shows the various combinations of inputs that may be purchased for a given level of expenditure (
C
) at given input prices (
w
,
r
).
Optimal combination of inputs
To producing a given level of output at the lowest possible cost when two inputs (
L
and
K
) are variable and the prices of the inputs are, respectively,
w
and
r
, a manager chooses the combination of inputs for which:
which implies that:
Production of a given output at minimum cost
In the case of two variable inputs, labor and capital, the manager of the firm maximizes output for a given level of cost by using the amounts of labor and capital such that the marginal rate of technical substitution (MRTS) equals the input prices ratio (
w
/
r
).
which implies that:
Production of maximum output with a given level of cost
Optimization and cost
The expansion path is the curve along which a firm expands (or contracts) output when input prices remain constant. Each point on the expansion path represents an efficient (least-cost) input combination. Along the expansion path, the marginal rate of technical substitution equals the constant input price ratio. Also, it indicates how input usage changes when output or cost changes.
Long-run costs
Long-run total cost:

Long-run average cost:

Long-run marginal cost:
w & r: prices of labor & capital, respectively; (L*, K*): input combination on the expansion path that minimizes LTC of producing that output.
Forces affecting long-run cost
Economies and diseconomies of scale
Economies of scale:
occurs when long-run average cost (LAC) falls as output increases.
Diseconomies of scale:
occurs when long-run average cost (LAC) rises as output increases.
Reasons
1. Larger-scale firms have greater opportunities for specialization and division of labor.
2. Scale economies also arise when quasi-fixed costs are spread over more units of output causing LAC to fall.
3. A variety of technological factors can also contribute to falling LAC.
Constant Costs
Neither economies or diseconomies of scale occur, thus LAC is flat and equal to LMC at all output levels.
Minimum efficient scale
Lowest level of output needed to reach minimum long-run average cost.
Economies of Scope
Exist for a multi-product firm when the joint cost of producing two or more goods is less than the sum of the separate costs of producing the goods:
Firms that already produce good
X
can add production of good
Y
at lower cost than a specialized, single-product firm can produce
Y
:
Joint products
When production of good X causes one or more other goods to be produced as byproducts at little or no additional cost.
Reasons that give rise to economies of scope
Common or
shared inputs
Inputs that contribute to the production of two or more goods or services.
Purchasing Economies of Scale
Large buyers of inputs receive lower input prices through quantity discounts, causing LAC to shift downward at the point of discount.
Learning of Experience Economies
“Learning by doing” or “Learning through experience”
As total cumulative output increases, learning or experience economies cause long-run average cost to fall at every output level.
Relations between short-run and long-run costs
*
LMC
intersects
LAC
when the latter is at its minimum point.
* At each output where a particular
ATC
is tangent to
LAC
, the relevant
SMC
=
LMC
.
* For all
ATC
curves, point of tangency with
LAC
is at an output less (greater) than the output of minimum
ATC
if the tangency is at an output less (greater) than that associated with minimum
LAC
.
Long-run Average Cost (LAC) as the Planning Horizon
Restructuring Short-run Costs
It can be achieved by adjusting plant size to the level that is optimal for the new output level, as soon as the next opportunity for a long-run adjustment arises. It can be easy to understand with a short-run expansion path.
Short-run expansion path:
Horizontal line showing the cost-minimizing input combinations for various output levels when capital is fixed in the short run.
Perfect competition
A market structure that exists when:
(1) Firms are price-takers.
(2) All firms produce a homogeneous product.
(3) Entry and exit are unrestricted.
Demand facing a price-taking firm
Demand curve facing a competitive price-taking firm is horizontal or perfectly elastic at the price determined by the intersection of the
market
demand and supply curves. Since marginal revenue equals price for a competitive firm, the demand curve is also simultaneously th marginal revenue (
D
=
MR
). Price-taking firms can sell they want at the market price. Each additional unit of sales adds to total revenue an amount equal to price.
Profit maximization in the short run
A manager must take two decisions during the period:
Produce
Shut down
Zero output in the short run but must still pay for fixed inputs.
What is the optimal level of output?
- There are two output decisions:
Managers can not maximize both profit and profit margin at the same level of output. For this reason, profit margin (or average profit), should be ignored when making profit-maximizing decisions. When a firm can make positive profit in the short run, profit is maximized at the output level where
MR
(=
P
) =
SMC
.
Earning positive economic profit (π)
Operating at a Loss or Shutting down
The manager of the firm will choose to produce the output where
P
=
SMC
, rather than shut down, as long as total revenue is greater than or equal to the firm's total avoidable cost or total variable cost (
TR
>=
TVC
). Or, equivalently, a firm should produce as long as price is greater than or equal to average variable cost (
P
>=
AVC
). If total revenue can not cover total avoidable cost, that is, if total revenue is less than total variable cost (or, equivalently,
P
<
AVC
), the manager will shut down and produce nothing, losing an amount equal to total fixed cost.
Short-run supply for the firm and industry
The short-run supply curve for an individual price-taking firm is the portion of the firm's marginal cost curve above minimum average variable cost. For market prices less than minimum average variable cost, quantity supplied is zero. The short-run supply curve for a competitive industry can be obtained by horizontally summing the supply curves of all the individual firms in the industry. Short-run industry supply is always upward-sloping, and supply prices along the industry supply curve give the marginal costs of production for every firm contributing to industry supply.
Producer Surplus and Profit in Short-run competitive equilibrium
Short-run producer surplus is the amount by which total revenue exceeds total variable cost and equals the area above the short-run supply curve below market price over the range of output supplied. Short-run producer surplus exceeds economic profit by the amount of total fixed costs.
Profit maximization in the long run
Profit-maximizing equilibrium for the firm
In long-run competitive equilibrium, all firms are maximizing profit (
P
=
LMC
), and there is no incentive for firms to enter or exit the industry because economic profit is zero (
P
=
LAC
). Occurs because of the entry of new firms into the industry or the exit of existing firms from the industry. The market adjusts so that
P
=
LMC
=
LAC
, which is at the minimum point on
LAC
.
Long-run supply for a perfectly competitive industry
In an constant-cost industry
Input prices remain constant as all firms in the industry expand output.
In an increasing-cost industry
Input prices rise as all firms in the industry expand output.
Economic rent and producer surplus in long-run equilibrium
Firms that employ exceptionally productive resources earn zero economic profit in long-run competitive equilibrium because the potential economic profit form employing a superior resource is paid to the resource owner as economic rent. In increasing-cost industries, all long-run producer surplus is paid to resource suppliers as economic rent.
Profit-maximizing input usage
Profit-maximizing level of input usage produces exactly that level of output that maximizes profit.
Marginal revenue product
Additional revenue earned when the firm hires one more unit of the input.
If the
MRP
of an additional unit of a variable input is grater than the price of that input, that unit should be hired. If the
MRP
of an additional unit adds less than its price, that unit should not be hired. If the usage of the variable input varies continuously, the manager should employ the amount of the input at which
MRP
= Input price.
Average revenue product
Average revenue per worker
If the price of a single variable input employed by a competitive firm rises above the point of maximum
ARP
(=
P
*
AP
), then the firm minimizes its loss by shutting down and hiring none of the variable input.
Implementing the profit-maximizing output decision
General rules of implementation
Then:
So:
Ability possessed by all price-setting firms to raise price without losing all its sales, which causes the price-setting firm's demand to be downward-sloping.
Monopoly
A firm that produces a good for which there are no close substitutes in a market that other firms are prevented from entering because of a barrier to entry.
Monopolistic competition
A market consisting of a large number of firms selling a differentiated product with low barriers to entry.
Measurement of the market power
Identifies producers and products that compete for consumers in a particular geographic area.
Elasticity of Demand
Cross-price Elasticity of Demand
Lerner Index
A ratio that measures the proportionate amount by which price exceeds marginal cost.
E
: price elasticity of demand
Barriers to entry
Condition that makes it difficult for new firms to enter a market in which economic profits are being earned. The most structural entry barriers are:
- Economies of Scale
- Barriers created by Government
- Essential Input Barriers
- Brand Loyalties
- Consumer Lock-In
- Network Externalities (Network effects)
- Sunk Costs as a General Barrier to Entry
Profit maximization under monopoly
A monopolist chooses the point on the market demand curve that maximizes profit. If marginal revenue exceeds marginal cost, a profit-maximizing monopolist increases output. If marginal revenue is less than marginal cost, the monopolist does not produce these additional units.
Demand and Marginal Revenue for a Monopolist
The market demand curve is the demand curve for the monopolist. Because the monopolist must lower price in order to sell additional units of output, marginal revenue is less than price for all but the first unit sold of output sold. When MR is positive (negative), demand is elastic (inelastic). For a linear market demand, the monopolist's MR is also linear, with the same vertical intercept as demand, and is twice as steep.
Short-run Equilibrium: Profit Maximization or Loss Minimization
The manager of a monopoly firm will choose to produce the output where MR = SMC, rather than shut down, as long as TR at least covers the firm’s total avoidable cost which is the firm's total variable cost (TR ≥ TVC). The price for that output is given by the demand curve. If TR can not cover total avoidable cost, that is, TR < TVC (or, equivalently, P < AVC) the manager will shut down and produce nothing , losing an amount equal to total fixed cost. If P > ATC, firm makes economic profit. If ATC > P > AVC, firm incurs a loss, but continues to produce in short run.
Long-run Equilibrium
Monopolist maximizes profit in the long-run by choosing to produce the level of output where MR = LMC, unless P < LAC, in which case the firm exits the industry. Monopolist will adjust plant size to the optimal level; that is, the optimal plant is the one with the short-run average cost curve tangent to the long-run average cost at the profit-maximizing output level.
Profit-maximizing input usage
Profit-maximizing level of input usage produces exactly that level of output that maximizes profit.
Marginal revenue product
Additional revenue attributable to hiring one additional unit of the input, which is also equal to:
* When producing with a single variable input:
- Employ amount of input for which
MRP
= input price.
- Relevant range of
MRP
curve is downward sloping, positive portion, for which
ARP
>
MRP
.
* For a firm with market power, profit-maximizing conditions
MRP
=
w
and
MR
=
MC
are equivalent.
- Whether
Q
or
L
is chosen to maximize profit, resulting levels of input usage, output, price and profit are the same.
Monopolistic competition
Large number of relatively small firms.
Products that are similar to, but somewhat different from, one another.
Unrestricted entry and exit of firms into and out of the market.
Short-run Equilibrium
With a given demand, marginal revenue and cost curves, a monopolistic competition maximizes profit or minimizes loss by
MR
=
MC
.
Long-run Equilibrium
Attained when demand curve for each producer is tangent to
LAC
curve. Unrestricted entry / and exit lead to this equilibrium. At the equilibrium output,
P
=
LAC
and
MR
=
LMC.
Implementing the profit-maximizing output and pricing decision
General rules of implementation
Then:
Multiplant firms
* For a firm that produces using two plants, A and B, with marginal costs
MCA
and
MCB
, respectively, the total cost of producing any given level of total output
QT
(=
QA
+
QB
) is minimized when the manager allocates production between the two plants so that the marginal costs are equal:
MCA
=
MCB
.

* A manager who has n plants that can produce output will maximize profit when the firm produces the level of total output allocates that output among the n plants so that:

MR
=
MC1
=
MC2
= ... =
MCn
Don't forget !
Strategic behavior
Actions taken by firms to plan for and react to competition from rival firms.
Oligopoly
A market consisting of a few relatively large firms, each with a substantial share of the market and all recognize their independence.
Decision making when rivals make simultaneous decisions
Strategic decision making
Game theory
An analytical guide or tool for making decisions in situations involving interdependence.
Game
Any decision-making situation in which people compete with each other for the purpose of gaining the greatest individual pay off.
Simultaneous decision games
A situation in which competing firms must make their individual decisions without knowing their rivals’s decisions.
The Prisoners's Dilemma
Arises when all rivals possess dominant strategies, and, in dominant strategy equilibrium, they are all worse off than if they had cooperated in making their decisions.
Dominant Strategy
When one exists, a rational decision maker always chooses to follow its own dominant strategy and predicts that if its rivals have dominant strategies, they also will choose to follow their dominant strategies.
Decisions with One Dominant Strategy
When a firm does not have a dominant strategy, but at least one of its rivals does have a dominant strategy, the firm's manager can predict with confidence that its rivals will follow their dominant strategies. Then, the manager can choose its own best strategy, knowing the actions that will almost certainly be taken boy those rivals possessing dominant strategies.
Dominated Strategies
Strategies that would never be chosen no matter what rivals might choose to do.
Successive elimination of dominated strategies
In a simultaneous decision having no dominant strategy equilibrium, managers can simplify their decisions by eliminating all dominated strategies that may exist. the process of elimination should be repeated until no more dominated strategies turn up.
Nash Equilibrium: Making mutually best decisions
Set of actions for which all managers are choosing their best actions given the actions chosen by their rivals.
When managers face a simultaneous decision-makingsituation possessing a unique Nash equilibrium set of decisions, rivalse can be expected to make the decisions leading to the Nash equilibrium. If there are multiple Nash equilibria, there is generally no way to preodict the likely outcome.
Best-response curves and continuous decision choices
A curve indicating the best decision (usually the profit-maximizing one) given the decision the manager believes a rival will make.
When decision choices are continuous, best-response curves give managers the profit-maximizing price to set given the price they anticipate their rival will set. A Nash equilibrium occurs at the price where the firms'best-response curves intersect.
Strategy when rivals make sequential decisions
Sequential decisions
One firm makes its decision first, then a rival firm, knowing the action of the first firm, makes its decision.
Game tree
A diagram showing the structure and payoff of a sequential decision situation.
Decision nodes
Points in a game tree, represented by boxes, where decisions are made.
Making sequential decisions
When firms make sequential decisions, managers make best decisions for themselves by working backward through the game free using the roll-back method (unique path that is also a Nash decision path: Each firms does the best for itself given the best decisions made by its rivals).
First-mover and Second-Mover Advantages
*
First-mover advantage
: a firm can increase its payoff by making its decision first.
*
Second-mover advantage
:
a firm can increase its payoff by making its decision second.
*
Roll-back method
can be applied to the game trees for each possible sequence of decisions.
Strategic Moves
Commitments
Threats
Promises
Unconditional actions taken for the purpose of increasing payoffs to the committing firms.
Conditional strategic moves that take the form: "If you do A, I will do B, which is costly to you."
Conditional strategic moves that take the form: "If you do A, I will do B, which is desirable to you".
Cooperation in Repeated Strategic Decisions
Cooperation occurs when oligopoly firms make individual decisions that make every firm better off than they would be in a (non cooperative) Nash equilibrium.
One-time Prisoner's Dilemma Decisions
There can be no future consequences from cheating, so both firms expect the other to cheat, which then makes cheating the best response for each firm.
Punishment for Cheating in repeated decisions
Making a retaliatory decision that forces rivals to return to a non cooperative Nash outcome.
Deciding to Cooperate
Cooperation (deciding not to cheat) maximizes the value of a firm when the present value of the costs of cheating is greater than the present value of the benefits from cheating. Achieved in an oligopoly market when all firms decide not to cheat.
Trigger Strategies for punishing Cheating
Punishment strategies that choose cooperative actions until an episode of cheating triggers a period of punishment.
Tit-for-tat strategy
: Punishes after an episode of cheating and returns to cooperation if cheating ends.
Grim strategy
: Punishes forever after an episode of cheating.
Facilitating Practices
Lawful methods of encouraging cooperative pricing behavior:
*
Price matching
: A commitment to match any rival's lower price.
*
Sale-price guarantee
: A firm's promise to give its buyers any sale price it might offer during a stipulated future period.
*
Public pricing
: Informing buyers about prices in a way that makes pricing information public knowledge.
*
Price leadership
: a leader firm sets the industry profit-maximizing price and the follower firms cooperate by all setting the same price.
Explicit Price-fixing agreements and Cartels
A group of firms or nations entering an explicit agreement to restrict competition for the purpose of driving up prices.
Tacit collusion
Cooperation among rival firms that does not involve any explicit agreement.
Strategic Entry Deterrence
Strategic moves taken by established firms to prevent entry of new firms.
Limit pricing: An established firm commits to setting price below the profit-maximizing level to prevent entry.



Capacity expansion as a barrier to entry: Strategy in which an established firm irreversibly expands capacity to make credible its threat to decrease price if entry occurs.
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