The Economics of Effective Management
• Identify Goals and Constraints
• Recognize the Role of Profits
• Five Forces Model
• Understand Incentives
• Understand Markets
• Recognize the Time Value of Money
• Use Marginal Analysis
– A person who directs resources to achieve a stated
– The science of making decisions in the presence of
• Managerial Economics
– The study of how to direct scarce resources in the
way that most efficiently achieves a managerial
• Make sure you include all costs and benefits
when making decisions (opportunity cost).
• When decisions span time, make sure you are
comparing apples to apples (PV analysis).
• Optimal economic decisions are made at the
margin (marginal analysis).
Supply & Demand
I. Market Demand Curve
– The Demand Function
– Determinants of Demand
– Consumer Surplus
II. Market Supply Curve
– The Supply Function
– Supply Shifters
– Producer Surplus
III. Market Equilibrium
IV. Price Restrictions
V. Comparative Statics
Market Demand Curve
• Shows the amount of a good that will be
purchased at alternative prices, holding other
• Law of Demand
– The demand curve is downward sloping.
Determinants of Demand
– Normal good
– Inferior good
• Prices of Related Goods
– Prices of substitutes
– Prices of complements
• Advertising and
• Consumer expectations
Supply & Demand Conclusion
• Use supply and demand analysis to
– clarify the “big picture” (the general impact of
a current event on equilibrium prices and
– organize an action plan (needed changes in
production, inventories, raw materials, human
resources, marketing plans, etc.).
I. The Elasticity Concept
– Own Price Elasticity
– Elasticity and Total Revenue
– Cross-Price Elasticity
– Income Elasticity
II. Demand Functions
III. Regression Analysis
Elasticity, Total Revenue
and Linear Demand
0 10 20 30 40 500 10 20 30 40 50
Quantitative Demand Function
• Elasticities are tools you can use to quantify the
impact of changes in prices, income, and
advertising on sales and revenues.
• Given market or survey data, regression analysis
can be used to estimate:
– Demand functions.
– A host of other things, including cost functions.
• Managers can quantify the impact of changes in
prices, income, advertising, etc.
I. Consumer Behavior
– Indifference Curve Analysis.
– Consumer Preference Ordering.
– The Budget Constraint.
– Changes in Income.
– Changes in Prices.
III. Consumer Equilibrium
IV. Indifference Curve Analysis & Demand Curves
– Individual Demand.
– Market Demand.
Indifference Curve Analysis
– A curve that defines the
combinations of 2 or more goods
that give a consumer the same
level of satisfaction.
Marginal Rate of
– The rate at which a consumer is
willing to substitute one good for
another and maintain the same
Individual Demand and Behavior
• Indifference curve properties reveal information
about consumers’ preferences between bundles of
– More is better.
– Diminishing marginal rate of substitution.
• Indifference curves along with price changes
determine individuals’ demand curves.
• Market demand is the horizontal summation of
I. Production Analysis
– Total Product, Marginal Product, Average Product.
– Cost Minimization
II. Cost Analysis
– Total Cost, Variable Cost, Fixed Costs.
– Cubic Cost Function.
– Cost Relations.
III. Multi-Product Cost Functions
• Production Function
– Q = F(K,L)
• Q is quantity of output produced.
• K is capital input.
• L is labor input.
• F is a functional form relating the inputs to output.
– The maximum amount of output that can be
produced with K units of capital and L units of
• Short-Run vs. Long-Run Decisions
• Fixed vs. Variable Inputs
• To maximize profits (minimize costs) managers
must use inputs such that the value of marginal of
each input reflects price the firm must pay to
employ the input.
• The optimal mix of inputs is achieved when the
MRTSKL = (w/r).
• Cost functions are the foundation for helping to
determine profit-maximizing behavior in future
I. Methods of Procuring Inputs
– Spot Exchange
– Vertical Integration
II. Transaction Costs
– Specialized Investments
III. Optimal Procurement Input
IV. Principal-Agent Problem
Production and Agency Issues
• The optimal method for acquiring inputs depends
on the nature of the transactions costs and
specialized nature of the inputs being procured.
• To overcome the principal-agent problem,
principals must devise plans to align the agents’
interests with the principals.
Nature of Industry
I. Market Structure
– Measures of Industry Concentration
– Pricing Behavior
– Integration and Merger Activity
– Dansby-Willig Index
– Structure-Conduct-Performance Paradigm
IV. Preview of Coming Attractions
Relating the Five Forces to the SCP Paradigm
and the Feedback Critique
•Supplier Switching Costs
•Price/Value of Substitute
Products or Services
•Customer Switching Costs
•Speed of Adjustment
•Economies of Scale
Substitutes & Complements
•Price/Value of Surrogate
Products or Services
•Price/Value of Complementary
Products or Services
•Timing of Decisions
•Price, Quantity, Quality,
or Service Competition
•Degree of Differentiation
Of Industry Profits
• Modern approach to studying industries involves
examining the interrelationship between
structure, conduct, and performance.
• Industries dramatically vary with respect to
– The four-firm concentration ratio and Herfindahl-
Hirschman index measure industry concentration.
• The Lerner index measures the degree to which
firms can markup price above marginal cost; it is a
measure of a firm’s market power.
• Industry performance is measured by industry
profitability and social welfare.
I. Perfect Competition
– Characteristics and profit outlook.
– Effect of new entrants.
– Sources of monopoly power.
– Maximizing monopoly profits.
– Pros and cons.
III. Monopolistic Competition
– Profit maximization.
– Long run equilibrium.
• Firms operating in a perfectly competitive market
take the market price as given.
– Produce output where P = MC.
– Firms may earn profits or losses in the short run.
– … but, in the long run, entry or exit forces profits to zero.
• A monopoly firm, in contrast, can earn persistent
profits provided that source of monopoly power is
• A monopolistically competitive firm can earn profits
in the short run, but entry by competing brands will
erode these profits over time.
Role of Strategic Interaction
• Your actions affect
the profits of your
• Your rivals’ actions
affect your profits.
• How will rivals
respond to your
• Different oligopoly scenarios give rise to different
optimal strategies and different outcomes.
• Your optimal price and output depends on …
– Beliefs about the reactions of rivals.
– Your choice variable (P or Q) and the nature of the
product market (differentiated or homogeneous
– Your ability to credibly commit prior to your rivals.
I. Introduction to Game Theory
II. Simultaneous-Move, One-Shot Games
III. Infinitely Repeated Games
IV. Finitely Repeated Games
V. Multistage Games
Two-Player Nash Equilibrium
• The Nash equilibrium is a condition describing
the set of strategies in which no player can
improve her payoff by unilaterally changing her
own strategy, given the other player’s strategy.
) ≥ π1(s1,s2
) for all s1.
) ≥ π1(s1
,s2) for all s2.
• Look for dominant strategies.
• Put yourself in your rival’s shoes.
• In many games, players have competing
objectives: One firm gains at the expense of its
• However, some games result in higher profits by
each firm when they “coordinate” decisions.
Examples of Coordination Games
• Industry standards
– size of floppy disks.
– size of CDs.
• National standards
– electric current.
– traffic laws.
I. Basic Pricing Strategies
– Monopoly & Monopolistic Competition
– Cournot Oligopoly
II. Extracting Consumer Surplus
– Price Discrimination Two-Part Pricing
– Block Pricing Commodity Bundling
III. Pricing for Special Cost and Demand Structures
– Peak-Load Pricing Transfer Pricing
– Cross Subsidies
IV. Pricing in Markets with Intense Price
– Price Matching Randomized Pricing
– Brand Loyalty
Standard Pricing and Profits for Firms
with Market Power
P = 10 - 2Q
1 2 3 4 5
MR = 10 - 4Q
Profits from standard pricing
Uncertainty and Consumer Behavior
• Risk Aversion
– Risk Averse: An individual who prefers a sure amount of
$M to a risky prospect with an expected value, E[x], of
– Risk Loving: An individual who prefers a risky prospect
with an expected value, E[x], of $M to a sure amount of
– Risk Neutral: An individual who is indifferent between a
risky prospect where E[x] = $M and a sure amount of $M.
• Situation that exists when some people have
better information than others.
• Example: Insider trading
• Situation where one party to a contract takes
a hidden action that benefits him or her at the
expense of another party.
– The principal-agent problem.
– Care taken with rental cars.
– Treasury bills
– Spectrum rights
– Consumer goods (eBay and other Internet auction sites)
– Oil leases
• Major types of Auction
– First-price, sealed-bid
– Second-price, sealed-bid
• Information plays an important role in how
economic agents make decisions.
– When information is costly to acquire, consumers will continue to
search for price information as long as the observed price is greater
than the consumer’s reservation price.
– When there is uncertainty surrounding the price a firm can charge, a
firm maximizes profit at the point where the expected marginal
revenue equals marginal cost.
• Many items are sold via auctions
– English auction
– First-price, sealed bid auction
– Second-price, sealed bid auction
– Dutch auction
I. Market Failure
– Market Power
– Public Goods
– Incomplete Information
II. Rent Seeking
III. Government Policy and International Markets
• Administered by the DOJ and FTC
– To eliminate deadweight loss of monopoly and
promote social welfare.
– Make it illegal for managers to pursue strategies that
foster monopoly power.
Sherman Act (1890)
• Sections 1 and 2 prohibits price-fixing, market
sharing and other collusive practices designed
to “monopolize, or attempt to monopolize” a
Government Policies Designed to
Mitigate Incomplete Information
• Truth in lending
• Truth in advertising
• Contract enforcement
• Market power, externalities, public goods,
and incomplete information create a potential
role for government in the marketplace.
• Government’s presence creates rent-seeking
incentives, which may undermine its ability to