The document discusses key concepts in managerial economics including: - Managerial economics is the study of how managers direct scarce resources to efficiently achieve goals. - Economic and accounting profits are defined. Economic profits consider opportunity costs while accounting profits do not. - Profits signal where resources are most valued by society. Resources will flow to industries with highest profits. - Marginal analysis and the marginal principle of maximizing benefits when marginal benefits equal marginal costs.

1. +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.

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.
1-2

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.
1-3

4. + Opportunity Cost
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.
1-4

5. +
Profits as aSignal
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.
1-5

6. Control VariableExamples:
Output
 Price
 Product Quality
 Advertising
R&D
Basic Managerial Question: How much of the control variable
should be used to maximize net benefits?
Marginal (Incremental) Analysis 1-6

7. +
Net Benefits
Net Benefits = Total Benefits - Total Costs
Profits = Revenue - Costs
1-7

8. Marginal Benefit(MB)
Change in total benefits arising from a change in the control
variable,Q:
Q
MB 
B
Slope (calculus derivative) of the total benefit curve.
1-8

9. Marginal Cost (MC)
Change in total costs arising from a change in the control
variable,Q:
MC 
C
Q
Slope (calculus derivative) of the total cost curve
1-9

10. + Marginal Principle
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.
1-10

11. + The Geometry of Optimization:Total
Q
Benefit and Cost
Total Benefits
& Total Costs
Costs
Benefits
Q*
B
C
Slope = MC
Slope =MB
1-11

12. + The Geometry of Optimization: Net
Benefits
Q
Net Benefits
Q*
Maximum net benefits
Slope = MNB
1-12

13. +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.

14. Overview
I.Market Demand
Curve
The Demand Function
Determinants ofDemand
Consumer Surplus
II.Market Supply
Curve
The Supply Function
Supply Shifters
Producer Surplus
III.Market Equilibrium
IV.Price Restrictions
V. Comparative Statics
2-14

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.
D
Quantity
Price
2-15

16. Determinants of Demand
Income
Normal good
Inferior good
Prices of RelatedGoods
Prices ofsubstitutes
Prices ofcomplements
Advertising and
consumer tastes
Population
Consumer expectations
2-16

17. +
The Demand Function
A general equation representing the demand
curve
Qx
d = f(Px ,PY ,M, H,)
d Qx= 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.
2-17

18. +
Inverse Demand Function
Price as a functionof quantity
demanded.
Example:
 Demand Function
 Qx
d = 10 – 2Px
 Inverse Demand Function:
d
 2Px = 10 – Qx
 Px = 5 – 0.5Qx
d
2-18

19. Change in Quantity Demanded
Quantity
D0
4 7
6
Price
A to B:Increase in quantity demanded
B
10
A
2-19

20. Price
D1
D0
Quantity
6
7
D0 to D1:Increase in Demand
Change inDemand
13
2-20

21. Consumer Surplus:
The value consumers get
from a good but do not have
to pay for.
Consumersurplus will prove
particularly useful in
marketing and other
disciplines emphasizing
strategies like value pricing
and price discrimination.
2-21

22. I got a great deal!
That companyoffers a lot
of bang for the buck!
Dell provides good value.
Total value greatly
exceeds totalamount
paid.
Consumer surplus is
large.
2-22

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
verylast cent from me!
Total amount paidis close
to total value.
Consumer surplus is low.
2-23

24. +
Price
Quantity
10
8
6
4
2
D
1 2 3 4 5
Consumer Surplus:
The value received but not
paid for. Consumer surplus =
(8-2) + (6-2) + (4-2) = $12.
Consumer Surplus:
The Discrete Case
2-24

25. C+onsumer Surplus:
The Continuous Case
Price $
Quantity
10
8
6
4
2
D
1 2 3 4 5
Value
of 4 units = $24Consumer
Surplus =
$24 - $8 =
$16
Expenditure on 4 units = $2
x 4 = $8
2-25

26. + Market Supply Curve
The supply curve shows the amount of a good that will be
produced at alternativeprices.
Law of Supply
 The supply curve is upward sloping.
Price
Quantity
S0
2-26

27. Supply Shifters
Input prices
Technology or
government regulations
Number offirms
Entry
Exit
Substitutes in production
Taxes
Excise tax
Ad valoremtax
Producer expectations
2-27

28. +
The Supply Function
An equation representing the supply curve:
Qx
S = f(Px ,PR ,W,H,)
 Qx
S = 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.
2-28

29. +
Inverse Supply Function
Price as a functionof quantity
supplied.
Example:
 Supply Function
 Qx
s = 10 + 2Px
 Inverse Supply Function:
 2Px = 10 + Qx
s
s
 Px = 5 + 0.5Qx
2-29

30. +
Change in Quantity Supplied
Price
Quantity
S0
B
20
A
10
5 10
A to B:Increase in quantity supplied
2-30

31. +
Price
Quantity75
S0 to S1:Increase in supply
Change inSupply
S0
S1
8
6
2-31

32. + Producer Surplus
The amount producers receive in excess of the
amount necessary to induce them to produce the
good.
Price
QuantityQ*
S0
P*
2-32

33. Market Equilibrium
The Price (P) that
Balances supply and
demand
S d
 Qx= Qx
No shortage or surplus
Steady-state
2-33

34. Price
Quantity
S
D
6 12
Shortage
12 - 6 = 6
If price is too low…
7
6
5
2-34

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

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.
2-36

37. Price
Quantity
S
D
P*
Q*
PCeiling
Q s
PF
Impact of a PriceCeiling
Shortage
Q d
2-37

38. +
Impact of a PriceFloor
Quantity
S
D
P*
Q*
SurplusPrice
PF
Qd QS
2-38

39. +
Comparative StaticAnalysis
How do the equilibrium price and quantity change when a
determinant of supply and/or demand change?
2-39

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.
2-40

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.
2-41

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).
2-42

43. Price
of
PCs
Quantity of PC’s
S
D
S*
P0
P*
Q0 Q*
Big Picture: Impact of decline in
component prices on PC market
2-43

44. + Big Picture Analysis: PC Market
Equilibrium price of PCs will fall,and equilibrium quantity of
computers soldwill increase.
Use this to organize an action plan
 contracts/suppliers?
inventories?
 human resources?
 marketing?
 do I need quantitative estimates?
2-44

45. + Scenario2: Software Maker
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?
2-45

46. Price
of Software
Quantity of
Software
S
D
D*
Q0 Q1
Big Picture:Impact of lower PC prices on
the software market
P1
P0
2-46

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.
2-47

48. +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.

49. + Overview
I.The ElasticityConcept
 Own Price Elasticity
 Elasticity andTotal Revenue
 Cross-Price Elasticity
 Income Elasticity
II.Linear Demand Functions
3-49

50. +
The ElasticityConcept
How responsive is variable “G” to a change in variable
“S”
%S
E 
%G
G,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.
3-50

51. +
The Elasticity ConceptUsing
Calculus
An alternative way to measure the elasticity of a function G =
f(S) is
dS G
E 
dG S
G,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

52. +
Own Price Elasticity of Demand
Negative according to the “law of demand.”
X
d
E
%P
%QX
QX ,PX
QX ,PX
QX ,PX
1
1
1QX ,PX
Elastic: E
Inelastic: E
Unitary: E
3-52

53. + Perfectly Elastic &
Inelastic Demand
 )QX ,PX
Perfectly Elastic (E Perfectly Inelastic (EQ ,P
 0)
X X
D
Price
Quantity
D
Price
Quantity
3-53

54. +
Own-Price Elasticity
and TotalRevenue
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.
3-54

55. + Elasticity,Total Revenue and Linear
Demand
QQ
P
TR
100
00 10 20 30 40 50
3-55

56. + Elasticity,Total Revenue and Linear
Demand
QQ
P
TR
100
0 10 20 30 40 50
80
800
0 10 20 30 40 50
3-56

57. + Elasticity,Total Revenue and Linear
Demand
QQ
P
TR
100
80
800
60 1200
0 10 20 30 40 500 10 20 30 40 50
3-57

58. + Elasticity,Total Revenue and Linear
Demand
QQ
P
TR
100
80
800
60 1200
40
0 10 20 30 40 500 10 20 30 40 50
3-58

59. + Elasticity,Total Revenue and Linear
Demand
QQ
P
TR
100
80
800
60 1200
40
20
0 10 20 30 40 500 10 20 30 40 50
3-59

60. + Elasticity,Total Revenue and Linear
Demand
QQ
P
TR
100
80
800
60 1200
40
20
Elastic
Elastic
0 10 20 30 40 500 10 20 30 40 50
3-60

61. + Elasticity,Total Revenue and Linear
Demand
QQ
P
TR
100
80
800
60 1200
40
20
Inelastic
Elastic
Inelastic
0 10 20
Elastic
30 40 500 10 20 30 40 50
3-61

62. + Elasticity,Total Revenue and Linear
Demand
QQ
P TR
100
80
800
60 1200
40
20
Inelastic
Elastic
Inelastic
0 10 20
Elastic
30 40 500 10 20 30 40 50
Unit elastic
Unit elastic
3-62

63. +
Demand, Marginal Revenue (MR)
and Elasticity
For a linear
inverse demand
function, MR(Q) =
a + 2bQ, where b
< 0.
When
MR > 0,demand is
elastic;
MR = 0,demand is unit
elastic;
MR < 0,demand is
inelastic.
Q
P
100
80
60
40
20
Inelastic
Elastic
0 10 20 40 50
Unit elastic
MR
3-63

64. + Factors Affecting
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 theirincomes.
3-64

65. +
Cross Price Elasticity of Demand
If EQX,PY
> 0, then X and Y are substitutes.
If EQX,PY
< 0, then X and Y are complements.
Y
d
E
%P
%QX
QX ,PY
3-65

66. +
Income Elasticity
If EQX,M > 0, then X is a normal good.
If EQX,M < 0, then X is a inferior good.
E
d
%M
%QX
QX ,M
3-66

67. +
Uses ofElasticities
Pricing.
Managing cashflows.
Impact of changes in competitors’ prices.
Impact of economic booms and recessions.
Impact of advertising campaigns.
And lotsmore!
3-67

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?
3-68

69. +
Answer: Lowerprice!
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.
3-69

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?
3-70

71. + Answer
3%
d
X
• Calls would increase by 25.92 percent!
d
d
3%8.64 %QX
%Q d
 25.92%
X
 8.64 
%QX
%P
E  8.64 
%QX
QX ,PX
3-71

72. + Example3: 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?
3-72

73. + Answer
• AT&T’s demand would fall by 36.24 percent!
4%
d
Y
d
d
 4%9.06  %QX
%Q d
 36.24%
X
9.06 
%QX
%P
E  9.06 
%QX
QX ,PY
3-73

74. +
Interpreting Demand Functions
Mathematical representations of demandcurves.
Example:
Q d
 10  2P 3P2M
X X Y
 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).
3-74

75. +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.

76. + Overview
I.Consumer Behavior
 Indifference Curve Analysis
 Consumer Preference Ordering
II.Constraints
 The Budget Constraint
 Changes inIncome
 Changes inPrices
III.Consumer Equilibrium
IV.Indifference CurveAnalysis & Demand
Curves
 Individual Demand
 Market Demand
4-76

77. + Consumer Behavior
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.
4-77

78. Indifference Curve Analysis
Indifference Curve
A curve that defines the
combinations of 2 or more
goods that give a consumer the
same level ofsatisfaction.
Marginal Rate ofSubstitution
The rate at which a consumer is
willing to substitute one good
for another and maintain the
same satisfactionlevel.
I.
II.
III.
GoodY
Good X
4-78

79. +
Consumer PreferenceOrdering
Properties
Completeness
More is Better
Diminishing MarginalRate of Substitution
Transitivity
4-79

80. Complete Preferences
Completeness Property
Consumer is capable of
expressing preferences (or
indifference) between all
possible bundles. (“I don’t
know” is NOT an option!)
If the only bundles available
to a consumer are A, B,and C,
then the consumer
 is indifferent between A and C
(they are on the same
indifference curve).
 will prefer Bto A.
will prefer B to C.
I.
II.
III.
GoodY
Good X
A
C
B
4-80

81. More Is Better!
More IsBetter Property
 Bundles that have at least as much
of every good and more of some
good are preferred to other
bundles.
 Bundle B is preferred to A since B
contains at least as much of good
Y and strictly more of good X.
 Bundle B is also preferred to C
since B contains at least as much
of good X and strictly more of
goodY.
 More generally, all bundles on
ICIII are preferred to bundles on
ICII or ICI.And all bundles on ICII
are preferred toICI.
I.
II.
III.
GoodY
Good X
A
C
B
1
33.33
100
3
4-81

82. Diminishing MarginalRate of
Substitution
Marginal Rate ofSubstitution
 The amount of good Y the consumer is
willing to give up to maintain the same
satisfaction level decreases as more of
good X is acquired.
 The rate at which a consumer is willing to
substitute one good for another and
maintain the same satisfaction level.
To go from consumption bundle A to
B the consumer must give up 50
units ofY to get one additional unit
of X.
 To go from consumption bundle B to
C the consumer must give up 16.67
units ofY to get one additional unit
of X.
 To go from consumption bundle C
to D the consumer must give up
only 8.33 units ofY to get one
additional unit ofX.
I.
II.
III.
GoodY
Good X1 2 3 4
100
50
33.33
25
A
B
C
D
4-82

83. Consistent Bundle Orderings
Transitivity Property
For the three bundles A, B,and
C, the transitivity property
implies that if C ≻B and B ≻A,
then C ≻A.
Transitive preferences along
with the more-is-betterproperty
imply that
indifference curves willnot
intersect.
the consumer will not get
caught in a perpetual cycle of
indecision.
I.
II.
III.
GoodY
1 2 5 7 Good X
100
75
50
A
B
C
4-83

84. The Budget Constraint
Opportunity Set
 The set of consumption bundles that are
affordable.
PxX + PyY  M.
Budget Line
The bundles of goods that exhaust
a consumers income.
PxX + PyY = M.
Market Rate of Substitution
 The slope of the budget line
-Px / Py
Y
X
The Opportunity Set
Budget Line
Y = M/PY – (PX/PY)XM/PY
M/PX
4-84

85. Changes in the Budget Line
Changes inIncome
Increases lead to a parallel,
outward shift in the budget
line (M1 > M0).
 Decreases lead to a parallel,
downward shift (M2 < M0).
Changes inPrice
A decreases in the price of
good X rotates the budget
line counter-clockwise (PX0
>
PX ).
1
 An increasesrotates the
budget line clockwise (not
shown).
X
X
Y
M0/PY
M /P2 Y
M2/PX
Y
M1/PY
M0/PX M1/PX
New Budget Line for
a price decrease.M0/PY
M0/PX0
M0/PX1
4-85

86. Consumer Equilibrium
The equilibrium
consumption bundle
is the affordable
bundle that yields
the highest level of
satisfaction.
Consumer equilibrium
occursat a point where
MRS = PX /PY.
Equivalently, the slope of
the indifference curve
equals the budgetline. I.
III.
II.
X
Y
Consumer
Equilibrium
M/PY
M/PX
4-86

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 andPepsi.
 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.
4-87

88. +
Complementary Goods
When the price of
good X falls and the
consumption of Y
rises, then X and Y
are complementary
)
goods. (PX1
> PX2
Pretzels (Y)
Beer (X)
II
I
0
Y2
Y1 A
B
X1 M/PX1
X2 M/PX2
M/PY1
4-88

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.
4-89

90. +
Normal Goods
An increase in
income increases
the consumption of
normal goods.
(M0 < M1).
Y
II
I
0
A
B
XM0/X
M1/Y
M1/XX0
Y0
X1
Y1
M0/Y
4-90

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

92. +
Other
goods
(Y)
II
I
A
C
B F
D
E
Pizza
(X)
0 0.5 1 2
A buy-one,
get-one free
pizza deal.
A Classic Marketing Application
4-92

93. Individual Demand Curve
An individual’s
demand curve is
derived fromeach
new equilibrium
point found onthe
indifference curve
as the price of good
X is varied.
X
Y
$
X
D
II
I
P0
P1
X0 X1
4-93

94. Market Demand
The market demand curve is the horizontal
summation of individual demand curves.
It indicates the total quantity all consumers
would purchase at each price point.
$ $
Q
D2D1
Individual Demand
Curves
50
40
Market Demand Curve
1 2 1 2 3
DM
Q
4-94

95. +
Conclusion
Indifference curve properties reveal
information about consumers’ preferences
between bundles ofgoods.
Completeness.
More is better.
 Diminishing marginalrate of substitution.
Transitivity.
Indifference curves along with price changes
determine individuals’demand curves.
Market demand is the horizontal summation of
individuals’ demands.
4-95

96. +Managerial Economics &Business Strategy
Chapter 5
The Production Process and Costs
McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.

97. +
Overview
I.ProductionAnalysis
 Total Product,Marginal Product,Average Product
 Isoquants
 Isocosts
 Cost Minimization
II.Cost Analysis
 Total Cost,Variable Cost, Fixed Costs
 Cubic CostFunction
 Cost Relations
5-97

98. +
Production Analysis
Production Function
 Q = F(K,L)
Q is quantity of output produced.
Kis 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 labor.
Short-Run vs. Long-Run Decisions
Fixed vs.Variable Inputs
5-98

99. 5-99
Production FunctionAlgebraic
Forms
Linear production function: inputs are perfect
substitutes.
Q  FK,L aK bL
Leontief production function: inputs are used in
fixed proportions.
QFK,LminbK,cL
Cobb-Douglas production function: inputs have a
degree ofsubstitutability.
Q  FK, L Ka
Lb

100. +
Productivity Measures:
Total Product
Total Product (TP): maximum output produced
with given amountsof inputs.
Example: Cobb-Douglas Production Function:
Q = F(K,L) = K.5 L.5
 K is fixed at 16 units.
 Short run Cobb-Douglass production function:
Q = (16).5 L.5 = 4 L.5
 Total Product when 100 units of labor are used?
Q = 4 (100).5 = 4(10) = 40 units
5-10
0

101. +
Productivity Measures:Average
Product of an Input
Average Product of an Input: measure of
output produced per unit of input.
Average Product of Labor: APL = Q/L.
Measures the output of an “average” worker.
Example: Q = F(K,L) = K.5 L.5
 If the inputs are K = 16 and L = 16, then the average product
of labor is APL = [(16) 0.5(16)0.5]/16 = 1.
Average Product of Capital:APK = Q/K.
Measures the output of an “average” unit of capital.
Example: Q = F(K,L) = K.5 L.5
 If the inputs are K = 16 and L = 16, then the average product
of capital is APK = [(16)0.5(16)0.5]/16 = 1.
5-10
1

102. + Productivity Measures:Marginal
Product of an Input
Marginal Product on an Input: change in total
output attributable to the last unit of an input.
Marginal Product of Labor: MPL = Q/L
Measures the output produced by the last worker.
Slope of the short-run production function (with respect to
labor).
Marginal Product of Capital: MPK = Q/K
Measures the output produced by the last unit of capital.
When capital is allowed to vary in the short run, MPK is the
slope of the production function (with respect to capital).
5-10
2

103. Q
L
Q=F(K,L)
Increasin
g
Marginal
Returns
Returns
DiminishingNegative
Marginal Marginal
Returns
MP
AP
Increasing, Diminishing and
Negative Marginal Returns
5-10
3

104. +
Guiding the ProductionProcess
Producing on the production function
 Aligning incentives to induce maximum worker effort.
Employing the right level of inputs
 When labor or capital vary in the short run, to maximize profit a
manager willhire
 labor until the value of marginal product of labor equals the
wage: VMPL = w,where VMPL = P x MPL.
 capital until the value of marginal product of capital equals the
rental rate: VMPK = r, where VMPK = P x MPK .
5-10
4

105. 5-10
5
Isoquant
Illustrates the long-run combinations of inputs (K, L) that yield
the producer the same level of output.
The shape of an isoquant reflects the ease with which a
producer can substitute among inputs while maintaining the
same levelof output.

106. K
KL
MP
MRTS
MP
 L
5-10
6
Marginal Rate of Technical
Substitution (MRTS)
The rate at which two inputs are substituted while maintaining
the same outputlevel.

107. Capital and labor
are perfect
substitutes
Q = aK + bL
MRTSKL = b/a
Linear isoquants implythat
inputs are substituted at a
constant rate,independent
of the input levels
employed. Q1 Q2 Q3
Increasing
Output
L
K
5-10
7
Linear Isoquants

108. complements.
Capital and labor are used in
fixed-proportions.
Q = min {bK, cL}
Since capital and labor are
consumed in fixed
proportions there is no input
substitution along isoquants
(hence, noMRTSKL).
Q3
Q2
Q1
Capital and labor are perfectK
Increasing
Output
L
5-10
8
Leontief Isoquants

109. Inputs are notperfectly
substitutable.
Diminishing marginal rate
of technical substitution.
 As less of one input is used in
the production process,
increasingly more of the other
input must be employed to
produce the same output level.
Q = KaLb
MRTSKL = MPL/MPK
Q1
Q2
Q3
K
L
Increasing
Output
5-10
9
Cobb-Douglas Isoquants

110. Isocost
The combinations of inputs that
produce a given level of output
at the same cost:
wL + rK = C
Rearranging,
K= (1/r)C - (w/r)L
For given input prices, isocosts
farther from the origin are
associated with higher costs.
Changes in input prices
change the slope of the isocost
line.
L
L
K
New Isocost
Line for a
decrease in the
wage (price of
labor: w0 >
w1).
C C
0 1C /0
wC1
/w
K
C1/r
C0/r
C/w0 C/w1
C/r
New Isocost Line
associated with
higher costs (C0
1< C ).
5-11
0

111. +
Cost Minimization
Marginal product per dollar spent should be equal for all
inputs:
But,this is just w r MPK r
MPL

MPK

MPL

w
r
KLMRTS 
w
5-111

112. +
Cost Minimization
Q
L
K
Point of
Cost
Minimizatio
n
Slope of Isocost
=
Slope of Isoquant
5-11
2

113. +
Optimal Input Substitution
A firm initially produces Q0
by employing the
combination of inputs
represented by point A at a
cost ofC0.
Suppose w0 falls tow1.
 The isocost curverotates
counterclockwise; which
represents the same cost level
prior to the wage change.
To produce the same level of
output,Q0, the firm will
produce on a lower isocost line
(C1)at a point B.
 The slope of the new isocost
line represents the lower wage
relative to the rental rate of
capital.
Q0
A
K
C0/w1LC1/w10 L0 L1C0/w0
K0
K1
B
5-11
3

114. 5-11
4
Cost Analysis
Types ofCosts
Short-Run
Fixed costs(FC)
Sunk costs
Short-run variable costs
(VC)
Short-run totalcosts
(TC)
Long-Run
All costs arevariable
No fixedcosts

115. Total and Variable Costs
C(Q): Minimum total cost
of producing alternative
levels of output:
C(Q) = VC(Q) + FC
VC(Q): Costs that vary
with output.
FC: Costs that do not vary
with output.
$
Q
C(Q) = VC +
FC
VC(
Q)
F
C
0
5-11
5

116. Sunk Cost:A cost that is
forever lost after it has been
paid.
Decision makers should
ignore sunk costs to
maximize profit or minimize
losses
FC: Costs that do not change $
as output changes.
Q
F
C
C(Q) = VC +
FC
VC(
Q)
5-11
6
Fixed and Sunk Costs

117. Some Definitions
Average Total Cost
ATC = AVC +AFC
ATC = C(Q)/Q
Average Variable Cost
AVC = VC(Q)/Q
Average Fixed Cost
AFC = FC/Q
Marginal Cost
MC = C/Q
$
Q
AF
C
MC ATC
AVC
MR
5-11
7

118. $
Q
ATC
AVC
MC
ATC
AVC
Q0
AFC Fixed Cost
Fixed Cost
Q0(ATC-AVC)
= Q0AFC
= Q0(FC/ Q0)
= FC
5-11
8

119. Variable Cost
$
Q
ATC
AVC
MC
AVC
Variable Cost
Q0
Q0AVC
= Q0[VC(Q0)/ Q0]
= VC(Q0)
Minimum ofAVC
5-11
9

120. $
Q
ATC
AVC
MC
ATC
Total Cost
Q0
= Q0[C(Q0)/ Q0]
= C(Q0)
Total Cost
Q0ATC
Minimum ofATC
5-12
0

121. +
Cubic CostFunction
C(Q) = f + a Q + b Q2 + cQ3
Marginal Cost?
 Memorize:
MC(Q) = a + 2bQ + 3cQ2
 Calculus:
dC/dQ = a + 2bQ + 3cQ2
5-12
1

122. + An Example
 Total Cost: C(Q) = 10 + Q + Q2
 Variable cost function:
VC(Q) = Q +
Q2
 Variable cost of producing 2 units:
VC(2) = 2 + (2)2 = 6
 Fixed costs:
FC = 10
 Marginal cost function:
MC(Q) = 1 + 2Q
 Marginal cost of producing 2 units:
MC(2) = 1 + 2(2) = 5
5-12
2

123. Q
Economies
of Scale
Diseconomies
of Scale
Q*
5-12
3
Long-Run Average Costs
$
LRAC

124. +
Economies ofScope
C(Q1, 0) + C(0, Q2) > C(Q1, Q2).
 It is cheaper to produce the two outputs jointly instead of
separately.
Example:
 It is cheaper for Time-Warner to produce Internet connections
and Instant Messaging services jointly than separately.
5-12
4

125. +
Cost Complementarity
The marginal cost of producing good 1 declines as more of
good two isproduced:
MC1Q1,Q2)/Q2< 0.
Example:
 Cow hides and steaks.
5-12
5

126. + Conclusion
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 chapters.
5-12
6

127. +Managerial Economics &Business Strategy
Chapter 8
Managing in Competitive,
Monopolistic, and Monopolistically
Competitive Markets
McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.

128. + Overview
I. PerfectCompetition
 Characteristics andprofit outlook.
 Effect of new entrants.
II.Monopolies
 Sources of monopoly power.
 Maximizing monopoly profits.
 Pros and cons.
III.Monopolistic Competition
 Profit maximization.
 Long run equilibrium.
8-12
8

129. Many buyers and sellers.
Homogeneous (identical) product.
Perfect information on both sides of market.
No transactioncosts.
Free entry andexit.
8-12
9
Perfect Competition Environment

130. Firms are “price takers” (P = MR).
In the short-run, firms may earn profits or losses.
Entry and exit forces long-run profits to zero.
8-13
0
Key Implications

131. +
Unrealistic? Why Learn?
Many small businesses are “price-takers,” and
decision rules for such firms are similar to those of
perfectly competitive firms.
It is a usefulbenchmark.
Explains why governments oppose monopolies.
Illuminates the “danger” to managers of
competitive environments.
 Importance of productdifferentiation.
 Sustainable advantage.
8-13
1

132. Managing a Perfectly Competitive
Firm
(or Price-Taking Business)
8-13
2

133. Firm
Qf
$
Df
Market
QM
$
D
S
Pe
8-13
3
Setting Price

134. 8-13
4
Profit-Maximizing Output Decision
MR = MC.
Since, MR = P,
Set P = M C to maximize profits.

135. Graphically: Representative
Firm’s Output Decision
$
Qf
MC
ATC
AVC
Pe = Df = MR
Qf*
ATC
Pe
Profit = (Pe - ATC)  Qf*
8-13
5

136. + A Numerical Example
Given
P=$10
 C(Q) = 5 + Q2
Optimal Price?
P=$10
Optimal Output?
 MR = P = $10 and M C = 2Q
 10 = 2Q
 Q = 5 units
Maximum Profits?
 PQ - C(Q) = (10)(5) - (5 + 25) = $20
8-13
6

137. $
Qf
ATC
AVC
MC
Pe = Df = MR
Qf*
ATC
Pe
Profit = (Pe - ATC)  Qf* < 0
+ Should this Firm Sustain Short Run Losses
orShut Down?
Loss
8-13
7

138. + Shutdown Decision Rule
A profit-maximizing firm should continue to operate (sustain
short-run losses) if its operating loss is less than its fixed costs.
 Operating results in a smaller loss than ceasing operations.
Decision rule:
 A firm should shutdown when P < min AVC.
 Continue operating as long as P ≥ min AVC.
8-13
8

139. +
$
Qf
ATC
AVC
MC
Qf*
P minAVC
Firm’s Short-Run Supply Curve:
M C Above Min AVC
8-13
9

140. + Short-Run Market Supply Curve
The market supply curve is the summation of
each individual firm’s supply at each price.
Firm 1 Firm 2
5
10 20 30
Market
Q Q
P
P P
15
18 25 43Q
S1 S2
SM
8-14
0

141. +
Long RunAdjustments?
If firms are price takers but there are barriers to entry,profits
will persist.
If the industry is perfectly competitive, firms are not only
price takers but there is free entry.
 Other “greedy capitalists” enter the market.
8-14
1

142. +
Effect of Entry onPrice?
Firm
Qf
$
Market
QM
$
D
S*
Pe
Pe*
Df
Df*
S
Entry
8-14
2

143. Effect of Entry on the Firm’s
Output and Profits?
$
Q
AC
MC
Pe Df
Pe* Df*
QL Qf*
8-14
3

144. +
Summary ofLogic
Short run profits leads to entry.
Entry increases market supply, drives down the market price,
increases the marketquantity.
Demand for individual firm’s product shifts down.
Firm reduces output to maximize profit.
Long run profits are zero.
8-14
4

145. +
Features of LongRun Competitive
Equilibrium
P = M C
 Socially efficient output.
P = minimum AC
 Efficient plant size.
 Zero profits
 Firms are earning just enough to offset their opportunity cost.
8-14
5

146. 8-14
6
Monopoly Environment
Single firm serves the “relevant market.”
Most monopolies are “local” monopolies.
The demand for the firm’s product is the market demand
curve.
Firm has control over price.
 But the price charged affects the quantity demanded of the
monopolist’s product.

147. +
“Natural” Sources of
Monopoly Power
Economies ofscale
Economies ofscope
Cost complementarities
8-14
7

148. Collusion
Contract...
I.
II.
III.
8-14
8
“Created” Sources of
Monopoly Power
Patents and other legal barriers (like licenses)
Tying contracts
Exclusive contracts

149. Market power permits you to price
above M C
Is the sky the limit?
No. How much you sell depends on
the price youset!
8-14
9
Managing aMonopoly

150. QQ
P
TR
100
0 10 20 30 40 50 0 10 20 30 40 50
800
60 1200
40
20
Inelastic
Elastic Inelastic
Elastic
Unit elastic
Unit elastic
MR
8-15
0
A Monopolist’s Marginal Revenue

151. Monopoly Profit Maximization
$
Q
ATC
MC
MRQM
Profit
PM
ATC
D
Produce where MR = MC.
Charge the price on the demand curve that corresponds to that quantity.
8-15
1

152. +
Alternative ProfitComputation
Q
  P ATCQ
  P  ATC
  Total Revenue-Total Cost
  PQ Total Cost
 
PQ Total Cost
Q Q
  P 
TotalCost
Q Q
8-15
2

153. Alternatively,
What’s the MR if a firm faces a linear
demand curve for its product?
P  a bQ
MR  a  2bQ,where b  0.

 
 E
MR  P1E
8-15
3
Useful Formulae

154. + A Numerical Example
Given estimatesof
 P = 10 - Q
 C(Q) = 6 + 2Q
Optimal output?
 MR = 10 - 2Q
 M C = 2
 10 - 2Q = 2
 Q = 4 units
Optimal price?
 P = 10 - (4) = $6
Maximum profits?
 PQ - C(Q) = (6)(4) - (6 + 8) = $10
8-15
4

155. None, unless the source of
monopoly power is
eliminated.
8-15
5
Long RunAdjustments?

156. 8-15
6
Why Government Dislikes
Monopoly?
P > M C
Too little output,at too high a price.
Deadweight loss of
monopoly.

157. +
$
Q
ATC
MC
MRQM
PM
D
MC
Deadweight Loss
of Monopoly
Deadweight Loss of Monopoly
8-15
7

158. +
Arguments forMonopoly
The beneficial effects of economies of scale, economies of
scope, and cost complementarities on price and output may
outweigh the negative effects of market power.
Encourages innovation.
8-15
8

159. 8-15
9
Monopolistic Competition:
Environment and Implications
Numerous buyers and sellers
Differentiated products
 Implication: Since products are differentiated, each firm faces a
downward sloping demand curve.
 Consumers view differentiated products as close substitutes: there
exists some willingnessto substitute.
Free entry andexit
 Implication: Firms will earn zero profits in the long run.

160. Managing aMonopolistically
Competitive Firm
Like a monopoly, monopolistically
competitive firms
have market power that permits pricing above marginal cost.
level of sales depends on the price it sets.
But …
The presence of other brands in the market makes the
demand for your brand more elastic than if you were a
monopolist.
Free entry and exit impacts profitability.
Therefore, monopolisticallycompetitive
firms have limited market power.
8-16
0

161. QQ
P
TR
100
0 10 20 30 40 50 0 10 20 30 40 50
800
60 1200
40
20
Inelastic
Elastic Inelastic
Elastic
Unit elastic
Unit elastic
MR
8-16
1
Marginal Revenue Like a Monopolist

162. +
Monopolistic Competition:
Profit Maximization
Maximize profits like a monopolist
 Produce output where MR = MC.
 Charge the price on the demand curve that corresponds to that
quantity.
8-16
2

163. Short-Run Monopolistic
Competition
$
ATC
MC
D
MRQM
Profit
PM
ATC
Quantity of Brand X
8-16
3

164. +
Long RunAdjustments?
If the industry is truly monopolistically competitive,there is
free entry.
 In this case other “greedy capitalists” enter,and their new
brandssteal market share.
 This reduces the demand for your product until profits are
ultimately zero.
8-16
4

165. +
$
AC
MC
D
MR
Q* Quantity of Brand
XMR1
D1
Entry
P*
P1
Q1
Long Run Equilibrium
(P = AC, so zeroprofits)
Long-Run Monopolistic Competition
8-16
5

166. 8-16
6
Monopolistic Competition
The Good (ToConsumers)
Product Variety
The Bad (To Society)
P > M C
Excess capacity
 Unexploited economiesof scale
The Ugly (To Managers)
P = ATC > minimum of
average costs.
Zero Profits (in the long run)!

167. + Maximizing Profits:A Synthesizing
Example
C(Q) = 125 + 4Q2
Determine the profit-maximizing output and price, and discuss its
implications,if
 You are a price taker and other firms charge $40 per unit;
 You are a monopolist and the inverse demand for your product is P = 100
- Q;
 You are a monopolistically competitive firm and the inverse demand for
your brand is P = 100 – Q.
8-16
7

168. +
Marginal Cost
C(Q) = 125 + 4Q2,
So M C = 8Q.
This is independent of market structure.
8-16
8

169. + Price Taker
MR = P = $40.
Set MR = MC.
 40 = 8Q.
 Q = 5 units.
Cost of producing 5 units.
 C(Q) = 125 + 4Q2 = 125 + 100 = $225.
Revenues:
 PQ = (40)(5) = $200.
Maximum profitsof -$25.
Implications: Expect exit in the long-run.
8-16
9

170. M+onopoly/Monopolistic Competition
MR = 100 - 2Q (since P = 100 - Q).
Set MR = MC, or 100 - 2Q = 8Q.
 Optimal output: Q = 10.
 Optimal price: P = 100 - (10) = $90.
 Maximal profits:
 PQ - C(Q) = (90)(10) -(125 + 4(100)) = $375.
Implications
 Monopolist will not face entry (unless patent or other entry barriers are
eliminated).
 Monopolistically competitive firm should expect other firms to clone, so
profits will decline over time.
8-17
0

171. + Conclusion
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 noteliminated.
A monopolistically competitive firm can earn
profits in the short run, but entry by competing
brands will erode these profits over time.
8-17
1

172. +Managerial Economics &Business Strategy
Chapter 9
Basic Oligopoly Models
McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.

173. + Overview
I.Conditions for Oligopoly?
II.Role of StrategicInterdependence
III. Profit Maximization in Four Oligopoly Settings
 Sweezy (Kinked-Demand) Model
 Cournot Model
 Stackelberg Model
 Bertrand Model
9-17
3

174. +
Oligopoly Environment
Relatively few firms, usually less than 10.
Duopoly - twofirms
Triopoly - threefirms
The products firms offer can be either
differentiated or homogeneous.
Firms’ decisions impact one another.
Many different strategic variables are
modeled:
 No single oligopoly model.
9-17
4

175. Your actions affect theprofits
of your rivals.
Your rivals’actions affect
your profits.
How will rivals respond to
your actions?
9-17
5
Role of StrategicInteraction

176. +
An Example
You and another firm sell differentiated products.
How does the quantity demanded for your product change
when you change your price?
9-17
6

177. +
P
Q
D2 (Rival matches your price change)
PH
P0
PL
D1 (Rival holds its
price constant)
QL1QH1 QH2Q0QL2
9-17
7

178. +
P
Q
D1
Q0
D2 (Rival matches your price change)
(Rival holds its
price constant)
D
Demand if Rivals Match Price
Reductions but not Price Increases
P0
9-17
8

179. +
Key Insight
The effect of a price reduction on the quantity
demanded of your product depends upon whether
your rivals respond by cutting their prices too!
The effect of a price increase on the quantity
demanded of your product depends upon whether
your rivals respond by raising their prices too!
Strategic interdependence:You aren’t in complete
control of your owndestiny!
9-17
9

180. + Sweezy (Kinked-Demand) Model
Environment
Few firms in the market serving many
consumers.
Firms produce differentiated products.
Barriers toentry.
Each firm believes rivals will match (or follow)
price reductions, but won’t match (or follow)
price increases.
Key feature of SweezyModel
 Price-Rigidity.
9-18
0

181. + Sweezy Demand and Marginal
Revenue
P
QQ0
D1
(Rival holds its
price constant)
MR1
MR2
D2 (Rival matches your price change)
DS: Sweezy Demand
P0
MRS: Sweezy MR
9-18
1

182. + Sweezy Profit-Maximizing Decision
Q
P0
Q0
DS: Sweezy Demand
MRS
MC1
MC2
MC3
P
D2 (Rival matches your price change)
D1 (Rival holds price
constant)
9-18
2

183. +
Sweezy Oligopoly Summary
Firms believe rivals match price cuts,but not price increases.
Firms operating in a Sweezy oligopoly maximize profit by
producing where
MRS = MC.
 The kinked-shaped marginal revenue curve implies that there exists a
range over which changes in M C will not impact the profit-maximizing
level ofoutput.
 Therefore, the firm may have no incentive to change price provided that
marginal cost remains in a given range.
9-18
3

184. + Cournot Model Environment
A few firms produce goods that are either
perfect substitutes (homogeneous) or
imperfect substitutes (differentiated).
Firms’ control variable is output in contrast
to price.
Each firm believes their rivals will hold
output constant if it changes its own output
(The output of rivals is viewed as given or
“fixed”).
Barriers to entry exist.
9-18
4

185. Thus, each firm’s marginal revenue depends
on the output produced by the other firm.
More formally,MR1  a bQ2 2bQ1
MR2  a bQ1 2bQ2
9-18
5
Inverse Demand in a Cournot
Duopoly
Market demand in a homogeneous-product
Cournot duopoly is
P  a bQ1 Q2 

186. + Best-Response Function
Since a firm’s marginal revenue in a
homogeneous Cournot oligopoly depends on both
its output and its rivals, each firm needs a way to
“respond”to rival’s output decisions.
Firm 1’s best-response (or reaction) function is a
schedule summarizing the amount of Q1 firm 1
should produce in order to maximize its profits for
each quantity of Q2 produced by firm 2.
Since the products are substitutes, an increase in
firm 2’s output leads to a decrease in the profit-
maximizing amount of firm 1’s product.
9-18
6

187. M C )
Firm 2’s best-response function is (c2 is firm 2’s
M C )
2b 2
 Q2
a  c1 1
Q1  r1Q2
12 2 1
Q
2b 2
 
a c2

1
Q  r Q
9-18
7
Best-Response Function fora
Cournot Duopoly
To find a firm’s best-response function, equate
its marginal revenue to marginal cost and solve
for its output as a function of its rival’s output.
Firm 1’s best-response function is (c1 is firm 1’s

188. + Graph of Firm 1’s Best-Response
Function
Q1
M
Q1Q1
Q2
r1 (Firm 1’s Reaction Function)
Q2
(a-c1)/b Q1 = r1(Q2) = (a-c1)/2b - 0.5Q2
9-18
8

189. + Cournot Equilibrium
Situation where each firm produces the
output that maximizes its profits, given the
the output of rival firms.
Nofirm can gain by unilaterally changing
its own output to improve its profit.
 A point where the two firm’s best-response functions intersect.
9-18
9

190. + Graph of Cournot Equilibrium
*
Q2
Q1
*
Q1
Q1
M
r2
Q2
M
Q2
(a-c1)/b
r1
Cournot Equilibrium
(a-c2)/b
9-19
0

191. +Summary of Cournot Equilibrium
The output Q1
* maximizes firm 1’s profits,given that firm 2
*produces Q2 .
The output Q2
* maximizes firm 2’s profits,given that firm 1
*produces Q1 .
Neither firm has an incentive to change its output,given the
output of therival.
Beliefs are consistent:
 In equilibrium, each firm “thinks” rivals will stick to their current
output – and they do!
9-19
1

192. +
Stackelberg Model Environment
Fewfirms serving many consumers.
Firms produce differentiated or
homogeneous products.
Barriers to entry.
Firm one is theleader.
 The leader commits to an output before all other firms.
Remaining firms are followers.
 They choose their outputs so as to maximize profits, given the
leader’s output.
9-19
2

193. The Algebra of the Stackelberg
Model
Since the follower reacts to the leader’s
output, the follower’s output is determined by
its reaction function
The Stackelberg leader uses this reaction
function to determineits profit maximizing
2b
0.5Q1
a c2
Q2  r2Q1
2b
output level, which saimcp2lif2ice1s to
Q1 
9-19
3

194. + Stackelberg Summary
Stackelberg model illustrates how commitment can enhance
profits in strategicenvironments.
Leader produces more than the Cournot equilibrium output.
 Larger market share,higher profits.
 First-mover advantage.
Follower produces less than the Cournot equilibrium output.
 Smaller market share,lower profits.
9-19
4

195. +
Bertrand Model Environment
Few firms that sell to many consumers.
Firms produce identical products at constant
marginal cost.
Each firm independently sets its price in order
to maximize profits (price is each firms’
control variable).
Barriers to entry exist.
Consumers enjoy
Perfect information.
Zero transactioncosts.
9-19
5

196. + Bertrand Equilibrium
Firms set P1 = P2 = MC! Why?
Suppose M C < P1 < P2.
Firm 1 earns (P1 - MC) on each unit sold, while
firm 2 earns nothing.
Firm 2 has an incentive to slightly undercut
firm 1’s price to capture the entire market.
Firm 1 then has an incentive to undercut firm
2’s price. This undercutting continues...
Equilibrium: Each firm charges P1 = P2 = MC.
9-19
6

197. + Conclusion
Different oligopoly scenarios give rise to
different optimal strategies and different
outcomes.
Youroptimal 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 products).
 Your ability to credibly commit prior to your rivals.
9-19
7

198. +Managerial Economics &Business Strategy
Chapter 10
Game Theory:Inside
Oligopoly
McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.

199. +
Game Environments
Players’ planned decisions are called
strategies.
Payoffs to players are the profits or losses
resulting from strategies.
Order of play is important:
 Simultaneous-move game: each player makes decisions with
knowledge of other players’ decisions.
 Sequential-move game: one player observes its rival’s move
prior to selecting a strategy.
Frequency of rivalinteraction
 One-shot game: game is played once.
 Repeated game: game is played more than once; either a finite
or infinite number of interactions.
10-1
99

200. + Simultaneous-Move, One-Shot
Games: Normal Form Game
A Normal Form Game consists of:
 Set of players i ∈{1,2,… n} where n is a finite number.
 Each players strategy set or feasible actions consist of a finite
number ofstrategies.
Player 1’s strategies are S1 = {a,b,c,…}.
Player 2’s strategies are S2 = {A, B,C, …}.
 Payoffs.
Player 1’s payoff:π1(a,B) = 11.
Player 2’s payoff:π2(b,C) = 12.
10-2
00

201. +
Real World Examples of Collusion
Garbage Collection Industry
OPEC
NASDAQ
Airlines
10-201

202. +
of Game Theory
Two firms: an incumbent and potential entrant.
Potential entrant’s strategies:
Enter.
Stay Out.
Incumbent’s strategies:
 {if enter, playhard}.
 {if enter, playsoft}.
{if stay out,play hard}.
 {if stay out,play soft}.
Move Sequence:
 Entrant moves first.Incumbent observes entrant’s action and
selects an action.
10-202
Pricing to Prevent Entry: An Application

203. +
Entrant
Enter
Incumbent
Hard
Soft
The Pricing to Prevent Entry Game in
Extensive Form
-1, 1
5, 5
Out
0, 10
10-203

204. + Identify Nash and Subgame Perfect
Equilibria
Entrant
Enter
Incumbent
Soft
-1, 1
Hard
5, 5
Out
0, 10
10-204

205. + Two Nash Equilibria
Entrant
Enter
Incumbent
Soft
-1, 1
Hard
5, 5
Out
0, 10
Nash Equilibria Strategies {player 1; player 2}:
{enter; If enter, play soft}
{stay out; If enter, play hard}
10-205

206. + One SubgamePerfect Equilibrium
Entrant
Enter
Incumbent
Soft
-1, 1
Hard
5, 5
Out
0, 10
Subgame Perfect Equilibrium Strategy:
{enter; If enter, play soft}
10-206

207. +
Insights
Establishing a reputation for being unkind to entrants can
enhance long-term profits.
It is costly to do so in the short-term,so much so that it isn’t
optimal to do so in a one-shot game.
10-207

208. +Managerial Economics & Business Strategy
Chapter 11
Pricing Strategies for Firms with Market Power
McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.

209. + Overview
I.Basic Pricing Strategies
 Monopoly & MonopolisticCompetition
Cournot Oligopoly
II.Extracting Consumer Surplus
 Price Discrimination ■ Two-PartPricing
 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 Competition
 Price Matching ■ Randomized Pricing
Brand Loyalty
11-2
09

210. + Standard Pricing and Profits for
Firms with MarketPower
Price
Quantity
P = 10 - 2Q
10
8
6
4
2
1 2
MC
3 4 5
MR = 10 - 4Q
Profits from standard pricing
= $8
11-2
10

211. +
An Algebraic Example
P = 10 - 2Q
C(Q) = 2Q
If the firm must charge a single price to all
consumers, the profit-maximizing price is
obtained by setting MR = MC.
10 - 4Q = 2,so Q* = 2.
P* = 10 - 2(2) = 6.
Profits = (6)(2) - 2(2) = $8.
11-2
11

212. + A Simple Markup Rule
Suppose the elasticity of demand for the firm’s product is
EF.
Since MR = P[1 + EF]/ EF.
Setting MR = M C and simplifying yields this simple pricing
formula:
P = [EF/(1+ EF)]  MC.
The optimal price is a simple markup over relevant costs!
 More elastic the demand, lower markup.
 Less elastic the demand, higher markup.
11-2
12

213. + An Example
Elasticity of demand for Kodak film is -2.
P = [EF/(1+ EF)]  M C
P = [-2/(1 - 2)]  M C
P = 2  M C
Price is twice marginal cost.
Fifty percent of Kodak’s price is margin above manufacturing
costs.
11-2
13

214. +Markup Rule for Cournot Oligopoly
Homogeneous product Cournotoligopoly.
N = total number of firms in the industry.
Market elasticity of demand EM .
Elasticity of individual firm’s demand is given
by EF = N x EM.
Since P = [EF/(1+ EF)]  MC,
Then, P = [NEM/(1+ NEM)]  MC.
The greater the number of firms, the lower the
profit-maximizing markup factor.
11-2
14

215. + An Example
Homogeneous product Cournot industry, 3
firms.
M C = $10.
Elasticity of market demand = - ½.
Determine the profit-maximizingprice?
EF = N EM = 3  (-1/2) = -1.5.
P = [EF/(1+ EF)]  MC.
P = [-1.5/(1- 1.5]  $10.
P = 3  $10 = $30.
11-2
15

216. +
Extracting Consumer Surplus:
Moving From Single Price Markets
Most models examined to this point involve a
“single” equilibrium price.
In reality,there are many different prices being
charged inthe market.
Price discrimination is the practice of charging
different prices to consumer for the same good
to achieve higher prices.
The three basic forms of price discrimination
are:
 First-degree (or perfect) price discrimination.
 Second-degree price discrimination.
 Third-degree price discrimiation.
11-2
16

217. + First-Degree or Perfect
Price Discrimination
Practice of charging each consumer the
maximum amount he or she will pay for each
incremental unit.
Permits a firm to extract all surplus from
consumers.
11-21
7

218. P+erfectPrice Discrimination
Price
Quantity
D
10
8
6
4
2
1 2 3 4 5
Profits*:
.5(4-0)(10 - 2)
= $16
Total Cost* = $8
MC
* Assuming no fixedcosts
11-21
8

219. +
Caveats:
In practice, transactions costs and
information constraints make this difficult to
implement perfectly (but car dealers and
someprofessionals come close).
Price discrimination won’t work if
consumers can resell the good.
11-21
9

220. Second-Degree
Price Discrimination
The practice ofposting
a discrete schedule of
declining prices for
different quantities.
Eliminates the
information constraint
present in first-degree
price discrimination.
Example: Electric
utilities
Price
MC
D
$5
$10
Quantity
$8
2 4
11-22
0

221. T+hird-Degree Price Discrimination
The practice of charging different
groupsof consumers different prices
for the same product.
Group must have observable
characteristics for third-degree price
discrimination towork.
Examples include student discounts,
senior citizen’s discounts, regional &
international pricing.
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222. + Implementing Third-DegreePrice
Discrimination
Suppose the total demand for a product is
comprised of two groups with different
elasticities, E1< E2.
Notice that group 1 is more price sensitive than
group 2.
Profit-maximizing prices?
P1 = [E1/(1+ E1)]  M C
P2 = [E2/(1+ E2)]  M C
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223. + An Example
Suppose the elasticity of demand for Kodak
film in the US is EU = -1.5,and the elasticity of
demand in Japan is EJ = -2.5.
Marginal cost of manufacturing film is $3.
PU = [EU/(1+ EU)]  M C = [-1.5/(1 - 1.5)]  $3 =
$9
PJ = [EJ/(1+ EJ)]  M C = [-2.5/(1 - 2.5)]  $3 =
$5
Kodak’s optimal third-degree pricing
strategy is to charge a higher price in the US,
where demand is less elastic.
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3

224. +
Two-Part Pricing
When it isn’t feasible to charge different
prices for different units sold, but demand
information is known, two-part pricing may
permit you to extract all surplus from
consumers.
Two-part pricing consists of a fixed fee and
a per unitcharge.
 Example: Athletic club memberships.
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4

225. 1. Set price at marginal cost.
2. Compute consumer surplus.
3. Charge a fixed-fee equal to
consumer surplus.
Quantity
D
10
8
6
4
2
1 2 3 4 5
MC
Fixed Fee = Profits* = $16
Price
Per Unit
Charge
* Assuming no fixedcosts
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5
How Two-Part Pricing Works

226. + Block Pricing
The practice of packaging multiple units of an identical
product together and selling them as one package.
Examples
Paper.
 Six-packs ofsoda.
 Different sized of cans of green beans.
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6

227. + An Algebraic Example
Typical consumer’s demand is P = 10 - 2Q
C(Q) = 2Q
Optimal number of units in a package?
Optimal package price?
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7

228. Quantity
D
Price
10
8
6
4
2
1 2 3 4 5
MC =AC
11-22
O+ptimal Quantity To Package: 4 Units8

229. +Optimal Price for the Package: $24
Price
Quantity
D
10
8
6
4
2
1 2 3 4 5
MC =AC
Consumer’s valuation of 4
units = .5(8)(4) + (2)(4) = $24
Therefore, set P = $24!
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230. + Costs andProfits with Block
Pricing
Price
Quantity
D
10
8
6
4
2
1 2 3 4 5
MC =AC
Profits* = [.5(8)(4) + (2)(4)] – (2)(4)
= $16
Costs = (2)(4) = $8
* Assuming no fixedcosts
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231. +
Commodity Bundling
The practice of bundling two or more products together and
charging one price for the bundle.
Examples
 Vacation packages.
 Computers and software.
 Film and developing.
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232. + An Example that Illustrates
Kodak’s Moment
Total market size for film and developing is 4
million consumers.
Four types ofconsumers
 25% will use only Kodak film (F).
 25% will use only Kodak developing (D).
 25% will use only Kodak film and use only Kodak developing (FD).
 25% have no preference (N).
Zero costs (forsimplicity).
Maximum price each type of consumer will
pay is as follows:
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2

233. Type Film Developing
F $8 $3
FD $8 $4
D $4 $6
N $3 $2
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3
+Reservation Prices for Kodak Film
and Developing by Type of
Consumer

234. + Optimal Film Price?
Type Film Developing
F $8 $3
FD $8 $4
D $4 $6
N $3 $2
Optimal Price is $8; only types F and FD buy resulting in profits
of $8 x 2 million = $16 Million.
At a price of $4, only typesF, FD, and D will buy
(profits of $12 Million).
At a price of $3, all will types will buy (profits of $12 Million).
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4

235. O+ptimal Price for Developing?
Type Film Developing
F $8 $3
FD $8 $4
D $4 $6
N $3 $2
At a price of $6, only “D” type buys (profits of $6 Million).
At a price of $4, only “D” and “FD” types buy (profits of $8Million).
At a price of $2, all types buy (profits of $8 Million).
Optimal Price is $3, to earn profits of $3 x 3 million = $9 Million.
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5

236. T+otalProfits byPricing Each Item
Separately?
Type Film Developing
F $8 $3
FD $8 $4
D $4 $6
N $3 $2
Total Profit = Film Profits + Development Profits
= $16 Million + $9 Million = $25 Million
Surprisingly, the firm can earn even greater profits by bundling!
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6

237. +
Pricing a “Bundle” of Film and
Developing
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7

238. C+onsumer Valuations of a Bundle
Type Film Developing Value of Bundle
F $8 $3 $11
FD $8 $4 $12
D $4 $6 $10
N $3 $2 $5
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239. +What’s the Optimal Price for a
Bundle?
Type Film Developing Value of Bundle
F $8 $3 $11
FD $8 $4 $12
D $4 $6 $10
N $3 $2 $5
Optimal Bundle Price = $10 (for profits of $30 million)
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240. Peak-Load Pricing
When demand during
peak times is higher
than the capacity ofthe
firm, the firm should
engage in peak-load
pricing.
Charge a higher price (PH)
during peak times (DH).
Charge a lower price (PL)
during off-peak times (DL).
Quantity
Price
MC
MRL
PL
QL QH
DH
MRH
DL
PH
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241. + Cross-Subsidies
Prices charged for one product are subsidized by the sale of
another product.
May be profitable when there are significant demand
complementarities effects.
Examples
Browser and server software.
Drinks and meals at restaurants.
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242. D+ouble Marginalization
Consider a large firm with two divisions:
 the upstream division is the sole provider of a key input.
 the downstream division uses the input produced by the upstream
division to produce the final output.
Incentives to maximize divisional profits leads the
upstream manager to produce where MRU = MCU.
 Implication: PU > MCU.
Similarly, when the downstream division has market
power and has an incentive to maximize divisional
profits, the manager will produce where MRD = MCD.
 Implication: PD > MCD.
Thus, both divisions mark price up over marginal
cost resulting in in a phenomenon called double
marginalization.
 Result:less than optimal overall profits for the firm.
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2

243. +
Transfer Pricing
To overcome double marginalization, the
internal price at which an upstream division
sells inputs to a downstream division should be
set in order to maximize the overall firm profits.
To achieve this goal, the upstream division
produces such that its marginal cost, MCu,
equals the net marginal revenue to the
downstream division (NMRd):
NMRd = MRd - MCd = MCu
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3

244. + Upstream Division’s Problem
Demand for the final product P = 10 - 2Q.
C(Q) = 2Q.
Suppose the upstream manager sets MR =
M C to maximize profits.
10 - 4Q = 2,so Q* = 2.
P* = 10 - 2(2) = $6, so upstream manager
charges the downstream division $6 per unit.
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245. +
Downstream Division’s Problem
Demand for the final product P = 10 - 2Q.
Downstream division’s marginal cost is the $6
charged by the upstream division.
Downstream division setsMR = M C to maximize
profits.
10 - 4Q = 6,so Q* = 1.
P* = 10 - 2(1) = $8,so downstream division
charges $8 per unit.
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5

246. + Analysis
This pricing strategy by the upstream division
results in less than optimal profits!
The upstream division needs the price to be $6
and the quantity sold to be 2 units in order to
maximize profits. Unfortunately,
The downstream division sets price at $8, which is
too high; only 1 unit is sold at that price.
 Downstream division profits are $8  1 – 6(1) = $2.
The upstream division’s profits are $6  1 - 2(1) =
$4 instead of the monopoly profits of $6  2- 2(2)
= $8.
Overall firm profit is $4 + $2 = $6.
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6

247. + Upstream Division’s
“Monopoly Profits”
Price
Quantity
P = 10 - 2Q
10
8
6
4
2
1
MC =AC
2 3 4 5
MR = 10 - 4Q
Profit = $8
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7

248. + Upstream’s Profits when
Downstream Marks Price Up to
$8 Price
Quantity
P = 10 - 2Q
2
1
MC =AC
2 3 4 5
MR = 10 - 4Q
Profit = $4Downstream 10
Price 8
6
4
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8

249. Provide upstream manager with an incentive
to set the optimal transfer price of $2
(upstream division’s marginal cost).
Overall profit with optimal transfer price:
  $62 $22  $8
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9
Solutions for the OverallFirm?

250. + Pricing in Markets with Intense Price
Competition
Price Matching
Advertising a price and a promise to match any lower price
offered by a competitor.
No firm has an incentive to lower their prices.
Each firm charges the monopoly price and shares the market.
Induce brand loyalty
Some consumers will remain “loyal” to a firm; even in the face
of price cuts.
Advertising campaigns and “frequent-user” style programs can
help firms induce loyal among consumers.
Randomized Pricing
A strategy of constantly changing prices.
Decreases consumers’ incentive to shop around as they cannot
learn from experience which firm charges the lowest price.
Reduces the ability of rival firms to undercut a firm’s prices.
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251. + Conclusion
First degree price discrimination, block pricing,
and two part pricing permit a firm to extract all
consumer surplus.
Commodity bundling, second-degree and third
degree price discrimination permit a firm to
extract some (but not all) consumer surplus.
Simple markup rules are the easiest to implement,
but leave consumers with the most surplus and
may result indouble-marginalization.
Different strategies require differentinformation.
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