Chapter 1 – Basic Microeconomic Principles

Prof. Jepsen ECO 610 Lecture 1

December 3, 2012

copyright John Wiley and Sons

Outline

• Course outline

• Economics review (Chapter 1)

– Costs

– Demand

– Profit maximization

– Game theory

About the Course

• Goal of course (from syllabus): – “We will apply economic theory to managerial

decision making. We will employ many of the traditional tools of microeconomics and see how they can be used to analyze practical business problems…”

• Grading: – 30% group projects

– 30% midterm exam (Monday, December 10)

– 40% final exam (Saturday, December 29)

Topics Covered in Course

• Today – Intro and Economies of Scale/Scope

• Tuesday – Make or Buy

• Wednesday – Incentives in Firms

• Thursday – Competitors and Competition

• Friday – Strategic Commitment

• Monday – midterm exam (6pm to 8:30pm)

• Tuesday – Dynamics of Pricing Rivalries

• Wednesday – Entry and Exit

• Thursday – Industry Analysis

Economics Review – Costs

• Managers are most familiar with two ways to present costs

– Income statement

– Statement of costs of goods

• Managers should be interested in “total costs”

– Useful for understanding effects of price change on profits

Total Costs

Q (Output)

Tota

l C

ost

TC(Q)

Fixed and Variable Costs

• Fixed costs do not vary with the amount produced

– Example: price of land for factory

• Variable costs do vary with the amount produced

– Example: raw materials

• Some costs are “semi-fixed”

Average Cost Function

Q (Output)

Ave

rage

Cost

AC(Q) = TC(Q)/Q

Marginal Cost

• Marginal cost (MC) = increase in cost from producing “marginally more” of the output

– Often easier to think of producing one more unit of output: MC(Q) = TC(Q+1) – TC(Q)

• MC often depends on the total volume of output

Relationship between Marginal Cost and Average Cost

Q

Marginal cost

Average cost Cost

Q*

MC < AC MC > AC

Long Run versus Short Run

• Short run

– Firm cannot change production level

• Long run

– Firm can choose level of production

– Long-run cost curve is “lower envelope” of short-run cost curves (for different production levels)

Sunk versus Avoidable Costs

• Sunk costs

– Costs that cannot be avoided

– Example: inventory that has already been purchased (and cannot be returned)

• Avoidable costs

– Costs that can be avoided

– Example: future inventory purchases

Economic Costs and Profits

• Managers should consider economic costs, not accounting costs

• Main difference is that economic costs consider the opportunity costs – Opportunity cost: What is the next best use of the

money / resources?

– Accounting cost: dollar amount spent

• Economic profit = sales revenue – economic cost

Demand Curves

• Relates quantity sold to price (or other attribute)

• Slopes down – As price

increases, quantity demanded decreases Quantity

Price Elasticity of Demand

• Elasticity = % change in quantity

-------------------------

% change in price

• Elastic = elasticity > 1

• Inelastic = elasticity < 1

• Firm-level elasticity is usually greater than industry-level elasticity

Total Revenue and Marginal Revenue

• Total revenue = Price * Quantity

– TR(Q) = P(Q) * Q

• Marginal revenue (MR) = increase in revenue from producing “marginally more” of the output

– Often easier to think of producing one more unit of output: MR(Q) = TR(Q+1) – TR(Q)

– Analogous to marginal cost discussed earlier

Marginal Revenue and Demand

Quantity

Price,

Marg

inal R

evenue

Demand

Marginal

Revenue

Pricing and Output Decisions

• To maximize profits, firm should produce quantity (Q) where marginal revenue (MR) is equal to marginal cost (MC)

– MR = MC

• If MR > MC, firm can increase profit by lowering its price (and selling more)

• If MR < MC, firm can increase profit by raising its (and selling less)

Optimal Output and Price

Quantity

Price,

Marg

inal R

evenue

Demand

Marginal

Revenue

Marginal

Cost

Q*

Perfect Competition

• Many producers with identical products

• Free entry and exit of firms

• In long-run, economic profits are zero

• No markets are “perfectly” competitive, but many are close

– Book examples: aluminum smelting, copper mining

Perfect Competition (Cont’d)

• P = MR in perfect competition

– In other words, each firm’s demand curve is flat

Demand

Marginal Cost

Quantity

Price,

Marg

inal C

ost

Game Theory

• An important point of managerial economics is to develop optimal response to rivals, as well as to predict how rivals will respond to your actions

• Game theory provides a framework for predicting responses

• Easiest way to explain is through an example:

Game Theory Example

• Airbus and Boeing are both considering expanding their capacity. Their profits depend on whether they expand, as well as whether their rival expands.

• Thus, there are four possible scenarios

Game Theory Example (Cont’d)

• Suppose the profits from the four scenarios are (in millions of euros):

– Airbus expands and Boeing does not: 20 for Airbus, 15 for Boeing

– Airbus and Boeing expand: 16 for each

– Airbus does not expand and Boeing does: 15 for Airbus, 20 for Boeing

– Airbus and Boeing do not expand: 18 for each

Game Theory Example (Cont’d)

• For each firm, the largest payoff is if they expand and their rival does not

• The smallest payoff is if they do not expand and their rival does

• What should each firm do?

• To answer this question, consider Airbus’ optimal strategy for each possible outcome (expand or not) for Boeing

Game Theory Example (Cont’d)

• Suppose Boeing expands:

– If Airbus expands, their profits are 16

– If Airbus does not expand, their profits are 15

– Therefore, their “dominant strategy” is to expand regardless of whether or not Boeing expands.

• Using similar logic, Boeing’s dominant strategy is also to expand

• Therefore, the equilibrium is that both firms expand

Game Theory Example (Cont’d)

• Another way to see this is by constructing a game matrix:

Boeing

Do Not Expand Expand

Do Not Expand 18, 18 15, 20

Expand 20, 15 16, 16

• First number is for Airbus; 2nd is for Boeing

Sequential Game

• Previous example assumed that both firms made their expansion decisions at the same time

• Suppose instead that the expansion decisions were sequential – Airbus decides first, then Boeing reacts

• Also suppose that there are three choices: no expansion, small expansion, large expansion

Sequential Game (Continued)

Airbus Small

Do not expand (20, 15)

Do not expand (18, 18)

Do not expand (18, 9)

Small (15, 20)

Large (9, 18)

Small (16, 16)

Small (12, 8)

Large (8, 12)

Large (0, 0) Boeing

Boeing

Boeing

Sequential Game (Continued)

• To find equilibrium, consider Boeing’s response:

– If Airbus does not expand, Boeing’s optimal choice is small expansion

– If Airbus chooses small expansion, Boeing’s optimal choice is small expansion

– If Airbus chooses large expansion, Boeing’s optimal choice is to not expand

Sequential Game (Continued)

• Because Airbus knows Boeing’s optimal response, it can choose the optimal expansion decision:

– If Airbus does not expand, Boeing will choose “small” and Airbus profits are 15

– If Airbus chooses “small”, Boeing will choose “small” and Airbus profits are 16

– If Airbus chooses “large”, Boeing will choose not to expand and Airbus profits are 18

Sequential Game (Continued)

• In this case, Airbus will choose large expansion because it has the largest profits for them (18)

• This equilibrium is called “subgame perfect”

• Note that the first mover – Airbus in this case – has a distinct advantage

Sequential Game (Continued)

Airbus Small

Do not expand (20, 15)

Do not expand (18, 18)

Do not expand (18, 9)

Small (15, 20)

Large (9, 18)

Small (16, 16)

Small (12, 8)

Large (8, 12)

Large (0, 0) Boeing

Boeing

Boeing