Managerial Econ FROM SLIDES Flashcards
Changes in DEMAND
a shift of the entire demand curve, caused by:
- income
- consumer taste
- price related goods
Changes in Supply
a shift of the supply curve cause by
- cost of production (labour, capital, raw material)
- weather pattern (for agricultural products
Price Elasticity of Demand
measures the % change in quantity demanded, from a 1% change in price
Formula:
p change Q
_ * ________
Q. change P
When Ep > 1, the good is price elastic
When Ep < 1, the good is price in elastic
Cross- price elasticity of Demand
measures the % change in quantity demanded of good A that resulted from a 1% change in price of good B
- compliments
- substitutes
Regression Analysis
= estimation of relationship between different variables using available data
can use ordinary least square (OLS) regression to find linear function that best describes observations
Production Decisions
- should firm use labour- intensive or capital- intensive productive technology?
- how many workers should be employed?
How to adjust production when eg. wage increase?
Formal approach: describes a firms production function, consider only labour (L) and capital (K)
Cobb-Douglas function
q(L,K) = c * L^a * K^B
Estimating the Production Function
- Need production data (inputs, outputs)
- Consider Cobb-Douglas function
- Take (natural) logs to linearize the production function, and add the error term E –> ln(q) = ln(c) + aln(L) + …..
- write production function in terms of q
Efficiency Measures
= measures how much, on average, each worker/ unit of capital can produce
Marginal product of labour/ capital
= measures additional output when labour/capital increases by one unit
Optimal Input Choice: short run
= labour is variable, but capital is fixed
Optimal Input Choice: Long run
= firms can adjust both capital & labour input
- isoquants and isocost
Isoquants
firms can produce the same output level with different combinations of capital & labour (long run)
Slope of a isoquant
= measures how one input can be substituted for the other without changing output
input combinations leading to the same output
- positive slope = marginal rate of tech. substitution
Isocost line
= shows all combinations of capital (K) and labour (L) leading to the same cost of production
input combinations leading to the same cost
- to get the isocost line, solve the cost function for K
Cost Minimizing Input Choice
- choose the output level (q) we want to produce
2. Combine isoquant & isocost line to identity the efficient input combination
Knowing Cost of Production ?
knowing production costs is important for
- production
- investment decisions
- optimal pricing
- mergers & acquisitions
- government regulations
Total Cost of a FirmL
formula = cost of capital/labour + other costs
other costs
- costs of other inputs
- R&D / advirtisment expenses
- Management / exec compensations
- licensing / legal fees
Opportunity costs
= costs associated with opportunities that are foregone when a firms resources are not put to their highest - value use
- often hidden but should be included in cost calculations
Sunk Costs
= expenditures that have been made in the past & cannot be recovered
- this should NOT affect economic decision making
Total Cost of a Firm: Components
Total Cost = FC + VC
FC - does not vary w/ output (costs that need to be paid by firm regardless of the level of output
VC - costs that vary w/ output
economic profit vs. accounting profit
economic profit < accounting profit (includes opportunity costs)
ATC
is the slope of the line from organ to total cost curve (TC)
MC
is the slope of a post on total cost curve (TC) or VC
Cost estimation - procedure
- Linear cost function (constant)
- Quadratic cost function (linear MC)
- Cubic Cost function (quadratic MC)
Identifying the appropriate cost function
- Eliminate all cost functions where higher-power coefficient is significant (5% level)
- Amount the remaining cost functions, choose the one with the highest adjusted R2
Demand Estimation
= knowing characteristics of demand is important for managerial/economic decision making
firms - optimal pricing, forcasting
government - enforcing antitrust law
Data sources
= commercial data providers (product/consumer level)
Linear Demand Function
= general linear demand function for product x
Demand estimation - accounting for trends
panel data - observations for different points in time (day/moth/year)
Consumer preference
usually changes over time
- need to account for changes of demand over time
Estimation of Linear Demand function
add:
- time coefficient bt to account for trends
- time error term E
Non - linear Demand Estimation
= often actual demand can be better described by a non-linear demand function
- use the constant elasticity demand function to describe a non-linear relationship between price & quantity demanded
adjusted R2
Rule - choose the model with the higher adjusted R2
Demand Forecasting
= use demand estimation to forecast demand
- important for input procurement/adjustment of production capacity
Industry Analysis
= Whether a firm has market power depends on how we define its market (e.g. monopoly)
Market Definition
= product market - what products to include?
Industry Concentration
= Use HHI (Herfinahl - Hirschnian Index)
HHI (Herfinahl - Hirschnian Index) rules
- HHI < 1500 (market is competitive)
- 2,500 < HHI < 2,500 (market is moderately concentrated)
- HHI > 2,500 (market is highly concentrated)
Barrier to entry:
- scale economies
- patents
- technology
- name recognition
- strategic action
Firms compete in:
- Prices (when output can be easily adj.)
- Quantities (when adjusting output takes a long time)
Profit Maximization
= R(q) - C(q)
Market structure and profits
revenue depends on demand elastic
- competitive vs. monopolistic markets
- homogenous vs. heterogeneous products
costs:
- competitive firms: strong incentives to reduce costs by improving efficiency
- firms with market power: incentives to reduce costs are weaker
Perfectly Competitive Markets
- Price Taking
- each firm takes market price as given (price taken)
- each firm is small - Product homogeneity
- perfectly identical products - Force Entry & Exit
- no special costs to enter (or exit) an industry
profut maximizing occurs when
P =.MC (q)
Positive Profits
ATC < P
Negative profits
ATC > P (fixed costs are too high)
Short Run Productions - competitive
if P> min (AVC), the firm should continue to produce in
p< min (AVC), the firm should shut down (cannot even corner variable costs)
Supply curve
the competitive firm chooses output level where P=MC (q) as long as P>min (AVC)
Long Run
= zero economics profit
P* = min (AtC): price where AC is minimized
Economic profit
- difference between firms rev & direct & indirect costs
- takes into account opp. costs
Economic Rent
= the opp. cost since the owner bears the app. cost of renting the land to someone else
- although economic rent is earned, economic profit is zero
- market prices typically reflect economic rents
Characteristics of a Monopoly
- one seller - many buyers
- one product (not many substitutes)
- Barriers to entry (patents)
- Price setter (can decide what to change)
Optimal Advertising Budgets
depends on how effective advertising is
Constant elasticity demand function
log-linearize the demand function & add a time coefficient before running your regression
The Social costs of monopoly
- competitive firm will produce where P= MC
- Monopoly produces where MR = MC
results in higher prices & lower quantities
Deadweight loss from Monopoly power
monopolists restricts output & charges higher prices
- consumers are worse off
social cost of money usually exceeds the DWL. (Advertisement, lobbying, building capacity
The Case for Monopolies
- creative destruction (replacement of one monopoly by another from innovation)
- industry dynamics (1. profits attract competitors, 2. barriers to entry disappear)
Natural Monopolies
= if one firm can produce the entire output at a lower cost than serval firms
Characteristics of Monopolistic Competition
- Many firms
- Free entry and exit (low barriers)
- Differentiated but substitutable products
( sushi restaurant example)
Product differentiation
(key to market power)
- gives firms market power (demand is not perfectly elastic, firms can charge prices above MC)
Costs & Benefits of Monopolistic Competition
Social costs
- P > MC = DWL
- Advertise (to differentiate products) = insufficient use of economic resources)
Benefits
- greater product variety
- Important drive for innovation (smartphones)
Oligopoly
- Small # of firms
- Product diff. may or may not exist
- barriers to entry
- -> scale economies
- -> patents
- -> technology
- -> name recognition
Equilibrium
= Because only a few, each must consider: how its actions will affect its rivals, and how their rivals will respond
Using Nash equilibrium
= to analyze oligopolistic behaviour (each firm is doing the best it can, given what its competitors are doing)
The Cournot Model
used to analyze duopolies (market with 2 firms)
- each firm correctly assumes how much its competitors will produce
The Stackelberg model
= oligopoly model in which one firm sets its output before other firms do
firm 1 - can select its preferred point of firm 2s reaction curve
- going first allows firm 1 to produce a large quantity (always advantageous if firms chooses quantity (not price) (first mover advantages)
Price Competition (Oligopoly)
Competition in a oligopolistic industry may occur with price instead of output
Oligopoly Price Competition : Bertrand Competition
Often where output can be easily changes
Price Competition : Bertrand - Homogeneous Products
Cosumers will first observe prices, and then buy from lowest price seller
Cobb-douglas function
q = c * La * KB
Barriers to entry for Oligopoly
Technological advances scale economies patents name recognition strategic action
Double marginalization problem
arises when there are two monopolies within the same vertical supply chain. Then each monopolist exercises market power, and adds a markup to the product. this results in higher prices and therefor lower consumer surplus
One segment tariff
P=MC , T=CS
Two segment tariff
P>MC ,
Price Competition (Bertrand) Differentiated products
Assumptions
- firms face the same demand curves
- firms set price simultaneously
non-cooperative equilibrium
=Nash equilibrium
Observations of Oligopoly behaviour
- collusion will lead to greater profits
- in some oligopoly markets, collusion is feasible
- explicit or implicit - in other oligopoly markets, firms are very aggressive and collusion is not possible
- deviation is the best strategy - in some markets, dominant firms regularly announce price changes tat small firms match
- price leadership
Dominant Firms
in some industries, a single firm has overwhelming market share
ex: De Beers and the market for diamonds
dominant firms assumptions
one large firm
- many smaller, price taking firms; The “competitive fringe
- the large firm acts as a dominant firm, setting a price that maximizes its own profits
- dominant firm must determine its demand curve Dd
Dominant firms demand curve
the dominant firms demand curve is the difference between market demand D and the supply of the fringe firms
Price discrimination types
first degree
second degree
third degree
intertemporal
Capturing Consumer surplus
a firm with market power faces a downward sloping demand curve, and can therefor set its price above marginal cost
- consumer
- firm wants to capture more of the CS
- pricing strategies
