CyryxCollege, Maldvies

Managerial Economics
Syllabus Lecture 1 Notes Lecture 2 Notes Lecture 3 Notes Lecture 4 Notes Lecture 5 Notes Lecture 6 Notes Lecture 7 Notes Lecture 8 Notes Lecture 9 Notes Lecture 10 Notes Problem Set 4 Problem Set 4 Key Lecture 11 Notes Lecture 12 Notes Lecture 13 Notes Problem Set 5 Problem Set 5 Key Lecture 14 Notes Lecture 15 Notes Problem Set 6 Problem Set 6 Key Lecture 16 Notes Test 1 Review Outline Lecture 17 Notes Problem Set 7 Problem 7 Key Lecture 18 Notes Problem Set 3 Problem Set 3 Key Problem Set 1 Problem Set 1Key Problem Set 2 Problem Set 2 Key

Lecture 19 Notes Problem Set 8 Problem 8 Key Lecture 20 Notes Lecture 21 Notes Problem Set 9 Problem 9 Key Lecture 22 Notes Problem Set 10 Problem 10 Key Lecture 23 Notes Problem Set 11 Problem 11 Key Lecture 24 Notes Lecture 25 Notes Lecture 26 Notes Lecture 27 Notes Problem 12 Lecture 28 Notes Lecture 29 Notes Lecture 30 Notes Problem 13 NEW Problem 13 Key Test 2 Review Outline Lecture 31 Notes Lecture 32 Notes Lecture 33 Notes Problem 14 Problem 14 Key Lecture 34 Notes Lecture 35 Notes Lecture 36 Problem 15 Problem 15 Key (CORRECTED) Lecture 37 Lecture 38 Review Outline for Final Examination

Review Outline for Final Examination I. Chapter 1. The Fundamentals of Managerial Economics A. Definition of Topic. 1. Economics 2. Managerial Decisions B. Components of Effective Decision Making 1. Identify Goals and Constraints: 2. Recognize the Nature and Importance of Profits: Economic profits differ from Accounting profits. . Good decision-making involves the maximization of economic profits. 3. Understanding Incentives. .Compensation and the structure of organizations affects importantly organizations. a. Organizational Incentives b. Incentives for Motivating Individuals 4. Understand Markets. Market forces represent a series of rivalries. In any problem, you must appreciate your position relative to other agents. 5. Recognize the Time Value of Money 6. Appreciate Marginal Analysis. Marginal decisions are an easy way to optimize totals. Calculus is just a formal expression of marginal analysis. a. Discrete Decisions. b. Continuous Decisions and the calculus c. Incremental Analysis 1. Pay attention to incremental costs and incremental benefits. 2. Ignore sunk costs. . II. Chapter Market Forces: Demand and Supply A. Introduction and Overview. 1. Overview 2. The structure of the supply and demand model. B. The Demand Side. 1. Motivation: Diminishing marginal utility: 2. Definition of Demand Curve 3. Determinants of Demand. 4. Changes in demand vs. changes in qty demanded. 5. The Notion of Consumer Surplus 6. An Analytical Example C. The Supply Side. 1. Driving Force. The Law of Diminishing Returns 2. Definition of Supply Curve 3. Determinants of supply:

4. Changes in supply vs. changes in quantity supplied. 5. Producer Surplus. 6. An Analytical Example. D. Equilibrium. Putting Supply and Demand Together 1. Definition. 2. Binding the market. Price floors Price Ceilings E. Comparative Statics. 1. Supply or Demand Shifts 2. Supply and Demand Shifts III. Quantitative Demand Analysis A. Price Elasticity of Demand 1. Motivation 2. Calculations a. Arc price elasticity of demand b. Point price elasticity of demand c. Percentage Changes 3. A Graphical Interpretation of Price Elasticity. 4. Some Observations about Price Elasticity of Demand a. Most Demand curves have elastic and inelastic segments b. Exceptions c. Elasticity and the Slope of Demand Curves 5. Price Elasticity, MR and TR. 6. Determinants of price elasticity of demand B. Other Demand Elasticities 1. Cross Price Elasticities 2. Income Elasticities 3.Other Elasticites. C. Elasticities and demand functions 1. Linear Demand functions. 2. Logrithmic Demand. D. Estimating Demand: Regression Analysis. 1. Interpreting the significance of individual parameter estimates 2. Forecasting

IV. Chapter 5. The Production Process and Costs A. Introduction B. The Production Function 1. Short Run Production. a. Diminishing Marginal Productivity and Marginal Product b. Relationships between Productivity Measures. c. Optimal Use of a single input. 2. Long Run Production (Optimal use of multiple inputs) 3. Returns to scale: Given a production function of the form F(K,L) = KL The function exhibits increasing returns to scale if >.5 constant returns to scale if =.5 decreasing returns to scale if <.5 C. Costs. 1. The relationship of production functions to cost functions. 2. Short run costs. a. Cost curves b. Sunk vs. Variable Costs c. Algebraic forms of cost curves 3. Long-Run Costs a. Long Run Average Costs b. Economics of Scale 4. Multiple Output Cost functions a. Economies of Scope b. Cost complementarities V. Chapter 6. The Organization of the Firm. A. Overview and Motivation. B. Optimal Methods of Obtaining Inputs 1. Options a. Spot b. Contract c. Internal Production 2. Factors affecting choice of the optimal method a. Costly Bargaining b. Underinvestment c. The Hold-up Problem.

C. Managerial Compensation and the Principal-Agent Problem. 1. The Principal-Agent Problem. 2. Structuring Contracts for Managers (review). 3. The Manager/Worker Problem. a. Profit Sharing. b. Revenue Sharing. c. Piece Rates. d. Time clocks and time checks VI. Chapter 8. Managing in Competitive, Monopolistic and Monopolistically Competitive Markets. A. Introductory Comments on Chapter 7. B. Competition. 1. Assumptions 2. Optimal short run decisions a. Graphically b. Analytically (set P = MR = MC) 3. Long run decisions. C. Monopoly 1. Assumptions, Sources of monopoly power. 2. Characterization: a. Graphically b. Analytically Q* is where MR = MC P* is the demand curve at Q* Profits are TR - TC 3. Observations: Social Costs of Monopoly . D. Monopolistic Competition 1. Assumptions 2. Characterization: 3. Optimizing decisions. 4. Observations.

VII. Chapter 11. Pricing Strategies. A. Basic Pricing Strategies for Firms with Market Power 1. Optimal Pricing for a monopolist or monopolistic competitor a. Basic Case b. Imperfect Demand Information P = MC/[1+1/].

B. Strategies that yield higher profits 1. Price Discrimination a. Perfect (1st degree) price discrimination i. Calculating gains ii. Necessary conditions b. Price List (2nd degree) price discrimination c. Group Division (3rd degree) price discrimination. 2. Two part pricing. 3. Commodity Bundling 4. Peak Load Pricing

I. Chapter 1. The Fundamentals of Managerial Economics A. Definition of Topic. 1. Economics 2. Managerial Decisions B. Components of Effective Decision Making 1. Identify Goals and Constraints: 2. Recognize the Nature and Importance of Profits: Economic profits differ from Accounting profits. . Good decision-making involves the maximization of economic profits. 3. Understanding Incentives. .Compensation and the structure of organizations affects importantly organizations. a. Organizational Incentives b. Incentives for Motivating Individuals 4. Understand Markets. Market forces represent a series of rivalries. In any problem, you must appreciate your position relative to other agents. 5. Recognize the Time Value of Money 6. Appreciate Marginal Analysis. Marginal decisions are an easy way to optimize totals. Calculus is just a formal expression of marginal analysis. a. Discrete Decisions. b. Continuous Decisions and the calculus c. Incremental Analysis

1. Pay attention to incremental costs and incremental benefits. 2. Ignore sunk costs. . II. Chapter Market Forces: Demand and Supply A. Introduction and Overview. 1. Overview 2. The structure of the supply and demand model. B. The Demand Side. 1. Motivation: Diminishing marginal utility: 2. Definition of Demand Curve 3. Determinants of Demand. 4. Changes in demand vs. changes in qty demanded. 5. The Notion of Consumer Surplus 6. An Analytical Example C. The Supply Side. 1. Driving Force. The Law of Diminishing Returns 2. Definition of Supply Curve 3. Determinants of supply: 4. Changes in supply vs. changes in quantity supplied. 5. Producer Surplus. 6. An Analytical Example. D. Equilibrium. Putting Supply and Demand Together 1. Definition. 2. Binding the market. Price floors Price Ceilings E. Comparative Statics. 1. Supply or Demand Shifts 2. Supply and Demand Shifts III. Quantitative Demand Analysis A. Price Elasticity of Demand 1. Motivation 2. Calculations a. Arc price elasticity of demand b. Point price elasticity of demand c. Percentage Changes 3. A Graphical Interpretation of Price Elasticity. 4. Some Observations about Price Elasticity of Demand a. Most Demand curves have elastic and inelastic segments b. Exceptions

c. Elasticity and the Slope of Demand Curves 5. Price Elasticity, MR and TR. 6. Determinants of price elasticity of demand B. Other Demand Elasticities 1. Cross Price Elasticities 2. Income Elasticities 3.Other Elasticites. C. Elasticities and demand functions 1. Linear Demand functions. 2. Logrithmic Demand. D. Estimating Demand: Regression Analysis. 1. Interpreting the significance of individual parameter estimates 2. Forecasting

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IV. Chapter 5. The Production Process and Costs A. Introduction B. The Production Function 1. Short Run Production. a. Diminishing Marginal Productivity and Marginal Product b. Relationships between Productivity Measures. c. Optimal Use of a single input. 2. Long Run Production (Optimal use of multiple inputs) 3. Returns to scale: Given a production function of the form F(K,L) = KL The function exhibits increasing returns to scale if >.5 constant returns to scale if =.5 decreasing returns to scale if <.5 C. Costs. 1. The relationship of production functions to cost functions. 2. Short run costs. a. Cost curves b. Sunk vs. Variable Costs c. Algebraic forms of cost curves 3. Long-Run Costs a. Long Run Average Costs b. Economics of Scale 4. Multiple Output Cost functions a. Economies of Scope b. Cost complementarities V. Chapter 6. The Organization of the Firm. A. Overview and Motivation. B. Optimal Methods of Obtaining Inputs 1. Options a. Spot b. Contract c. Internal Production 2. Factors affecting choice of the optimal method a. Costly Bargaining b. Underinvestment c. The Hold-up Problem.

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C. Managerial Compensation and the Principal-Agent Problem. 1. The Principal-Agent Problem. 2. Structuring Contracts for Managers (review). 3. The Manager/Worker Problem. a. Profit Sharing. b. Revenue Sharing. c. Piece Rates. d. Time clocks and time checks VI. Chapter 8. Managing in Competitive, Monopolistic and Monopolistically Competitive Markets. A. Introductory Comments on Chapter 7. B. Competition. 1. Assumptions 2. Optimal short run decisions a. Graphically b. Analytically (set P = MR = MC) 3. Long run decisions. C. Monopoly 1. Assumptions, Sources of monopoly power. 2. Characterization: a. Graphically b. Analytically Q* is where MR = MC P* is the demand curve at Q* Profits are TR - TC 3. Observations: Social Costs of Monopoly . D. Monopolistic Competition 1. Assumptions 2. Characterization: 3. Optimizing decisions. 4. Observations.

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VII. Chapter 11. Pricing Strategies. A. Basic Pricing Strategies for Firms with Market Power 1. Optimal Pricing for a monopolist or monopolistic competitor a. Basic Case b. Imperfect Demand Information P = MC/[1+1/].

B. Strategies that yield higher profits 1. Price Discrimination a. Perfect (1st degree) price discrimination i. Calculating gains ii. Necessary conditions b. Price List (2nd degree) price discrimination c. Group Division (3rd degree) price discrimination. 2. Two part pricing. 3. Commodity Bundling 4. Peak Load Pricing Lecture 1 I. Chapter 1. The Fundamentals of Managerial Economics Preview: A. Definition of Topic. 1. Economics 2. Managerial Decisions B. Components of Effective Decision Making 1. Identify Goals and Constraints: 2. Recognize the Nature and Importance of Profits: Economic profits differ from Accounting profits. . Good decision-making involves the maximization of economic profits. Lecture_______________________________________________ A. Definition of Topic. A first topic involves defining the scope of the course: 1. Economics: The study of how societies and individuals allocate scarce resources among competing ends.

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Observation: This is a study of allocation decisions. It applies widely to an immense variety of topics. It is not, for example, particularly focused on the decisions of businesses. It applies to profit as well as to non profit institutions. 2. The Manager. A person who directs resources to achieve a stated goal. Observation: Again, this is a very broad definition. Clearly, you manage your own lives. In business or organizational contexts, managers control resources other than their own time and energy such as a. The efforts of others b. Input acquisition and use c. Output/Pricing decisions 3. Managerial Economics: The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal. Observation: The difference between this course and, say microeconomics is that it is policy oriented. That is, we focus on giving you tools to make decisions, rather than describing how a market or an economy as a whole works. B. Effective Management from an Economic Perspective. Economic tools are guides to good allocative decision-making. Elements of good decision-making can be divided into six categories 1. Identify Goals and Constraints: This is critical for defining the dimension of the problem. Objectives are simply what you would like to accomplish. Constraints are the natural (and perhaps unfortunate) consequence of scarcity. a. Having a well-defined objective in mind when making an allocative decision is critical. (Very concretely, imagine how one might decide to allocate time to this course if it were uncertain whether your intention was to get a good grade or to merely pass) b. Also, it is necessary to evaluate the constraints available in the decision process. (For example, time is typically the constraint in making personal allocative decisions. Most of our applications will focus on the decisions of a profit-maximizing firm. Here the objective is typically profits. Constraints arise in the form of pricing limitations, and production considerations.) 2. Recognize the Nature and Importance of Profits: When discussing the firm, profits take on a special role. However, when making allocative decisions you must have the correct definition of profits in mind. a. Accounting Profits A = TR TCA

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b. Economic Profits E = TR (TCA +TCI)

The difference in the definitions is implicit costs. Implicit costs are measured in terms of foregone alternatives. Economic costs are the sum of implicit and implicit costs. Economic costs can be measured in terms of choices foregone, or opportunity costs.

Observations a) The function of economic profits. Accounting profits are not an incorrect definition of profits, just inappropriate for the purpose of making allocative decisions. Example: Suppose you consider opening a T.J. Cinnamon Franchise in a storefront you own in the VA Center Commons, North of Richmond. Suppose the franchise fee is $20,000 per year, and you must pay $80,000 per year for materials and help. How much must you earn to realize an accounting profit? Suppose that you must work in the store (and quit your job paying $25,000 per year). Also you could rent the store slot for $1000 per month. If you expected revenues of $120,000 per year, would this be a good allocation of resources? b) The difficulty of collecting implicit cost information. In fact, it is relatively difficult get good information pertaining to opportunity costs. A legitimate (and important) function of the manager is to do as good a job as possible in collecting this information.

Lecture 2 I. Chapter 1. The Fundamentals of Managerial Economics A. Definition of Topic. 1. Economics 2. Managerial Decisions B. Components of Effective Decision Making 1. Identify Goals and Constraints: 2. Recognize the Nature and Social Role of Profits: a. Defining Economic Profits Economic profits differ from Accounting profits. . Good decision-making involves the maximization of economic profits. Preview__________________________________________________________

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b. Understanding the Social Role of Profits. 3. Understanding Incentives. .Compensation and the structure of organizations affects importantly organizations. a. Organizational Incentives b. Incentives for Motivating Individuals 4. Understand Markets. Market forces represent a series of rivalries. In any problem, you must appreciate your position relative to other agents. 5. Recognize the Time Value of Money 6. Appreciate Marginal Analysis Marginal decisions are an easy way to optimize totals. Calculus is just a formal expression of marginal analysis. Lecture_____________________________________________________________ b) The social role of profits. The 1980s are popularly called the decade of greed. A popular depiction of attitudes in the 80s was the film Wall Street where Michael Douglas gives a lecture to shareholders extolling the virtues of selfishness. This is passe, of course, but, even at its height, it was a caricature of the role of profits in society. Profits serve a valuable social function if certain assumptions regarding competitive performance are satisfied. These assumptions include: -many buyers and sellers. This is referred to as the structural assumption. Violations cause problems of monopoly or oligopoly. -perfect information about both product quality and price. This an informational assumption: Violations are of the form of lemons markets problems, as well as Diamond Paradox -pure privacy in consumption and production. The privacy assumption. Violations cause free-riding and externalities. If these assumptions are met, then the signals sent by profits channel resources into their most efficient use. To quote Smith (1776) It is not out of the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. Profits send signals about entry, exit, expansion and innovation. Example: The computer industry in the 1980s was very dynamic. The number of firms increased substantially. As a consequence, prices fell, and also the quality of computers increased. More recently, computers have become a more commodity-like product. The number of firms has decreased, and production runs have increased.

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If competitive assumptions are satisfied, economic profits are a temporary phenomenon, attributable to a new idea, product develop or change in consumer tastes. Entry will dissipate these profits. On the other hand, if competitive assumptions are not satisfied (because, a firm has a patent, or unique license) then they are permanent, and not socially beneficial. 3. Understanding Incentives. If profits restrict the behavior of firms via incentives, in the market, it is also important to understand the effects of incentives within the firm. a. Institutional organization affects performance. The way an institution is organized often puts incredible limitations on the power of personalities to exert influence. Sometimes this is healthy (e.g., in the U.S. government, laws severely restrict the power of the presidency.) In other environments institutional restrictions are an important handicap. For example, the recent scandals at Enron and WorldCom are not a consequence of bad guys. Rather the institutional structure of these firms, and the oversight process for these firms, not only allowed, but encouraged illegal behavior. Reorganizing the structure of an institution, as well as the laws regulating the oversight process, can make firms more reliable and more efficient. b. The way people are rewarded can influence their incentive to work Example: Suppose you pay someone $75,000 to manage your restaurant. Would this person do better than someone paid $50,000? There is no particular reason to suppose that the answer should be in the affirmative. A compensation package that more nearly aligns the interests of the owner and the manager would be one that provided incentives to the manager that paralleled the interests of the owner. (e.g., a profit-sharing arrangement.) This type of problem is called a principle-agent problem. It is a common problem in many firms. Particularly in publicly-held firms, where the stockholders have only limited control over the decisions of the CEO. 4. Understand Markets. Markets are the regulating force for firms, and the source of incentives for their activities. These incentives arise via transactions, and are the consequence of competing interests. For every transaction, there are two parties. a. Consumer-Producer Rivalry: Consumers and producers are simultaneously trying to take advantage of each other. They are limited by reputation and bargaining skills. As a consequence of bargaining, each gets less than they want, but not more than it is worth, or less than it costs. b. Consumer-Consumer Rivalry: Consumers compete with each other for products. In the process, the purchasing consumer pays more than (s)he wants, but not more than it is worth to him or her. (Example: This is most clearly seen in auctions for specialized consumer goods, such as antiques. Bidding by rival potential purchasers drives up the price.) c. Producer-Producer Rivalry: Producers compete with each other, and as a consequence, offer better quality, and higher quantities at a lower price than they would like. (Again, this is most directly seen in a procurement auction)

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d. The Role of Government: Provided that the conditions that I mentioned above are satisfied, there is no need for the government to intervene. However, when one or more of these assumptions fails, the Government frequently intervenes to restore the balance. 5. Recognize the Time Value of Money. It is important to realize that money earned in the future is not valued the same as money earned today. Allocative decisions should be adjusted accordingly. a. Present Value Analysis. Suppose that the interest rate is 10%. Then it would take $1.10 next year to equal $1 today. In general PV(1+i) = FV

Similarly, for two years hence PV(1+i)2 and in general PV = FV (1+i)n = FV

Often times we are interested in a stream of earnings. PV = FVt (1+i)t

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In valuing a stream of earnings relative to a cost. (As is typical for any investment decision) It is important to consider the net present value NPV = FVt (1+i)t Co

Example: Suppose you are given the opportunity to purchase a new high-speed lathe that will reduce the costs of producing cedar wooden eggs by $2 per egg. At current prices, you sell 10,000 per year for each of the next 4 years. If the interest rate is 10%, and the machine costs $65,000 is it a good purchase? 20,000/(1.1) + 20,000/(1.1)2 + 20,000/(1.1)3 + 2 0,000/(1.1)4 = 18,182 + 16258 + 15026+ 13660 = 63,397

No. The NPV is -$1,603.

Lecture 3 Problems: Collect Problem Set 1 REVIEW___________________________________________________: I. Chapter 1. The Fundamentals of Managerial Economics B. Components of Effective Decision Making b. Incentives for Motivating Individuals. Example: What is the best way to motivate Meg Whitman, CEO of Ebay? 5. Recognize the Time Value of Money. a. Discounting the Future. b. Calculating Net Present Value of a Project Example: Suppose that a firm expects to net an extra $10,000 in yearly earnings from the production of a machine for each of the next 3 years. Suppose that the interest rate is 8%. If the machine costs $20,000 is it a good purchase? Preview__________________________________________________________ c. The present value of a firm/ Discounting over an infinite horizon 6. Appreciate Marginal Analysis Marginal decisions are an easy way to optimize totals. Calculus is just a formal expression of marginal analysis. LECTURE______________________________________________ c. The present value of a firm. The discounting equation used last lecture can be generalized to value the profitability of a firm, simply by substituting for FV

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PV

t (1+i)t

Accounting for indefinite life. There is, however, one important complication. Unlike a piece of equipment, firms are not expected to be finitely lived. In this case, the summation in the present value formula becomes infinite, e.g., PV = 0 + 1 + 1 (1+i) 2 + 2 (1+i) 3 + (1+i)3

We can still come up with a finite present value if we assume that the stream of revenues each period is fixed. That is, consider a perpetuity e.g,. a constant cash flow (CF) that, starting one year from today, will be paid to you the first day of each year, forever. The present value of that flow is PV = CF + 1 (1+i) CF + 2 (1+i) CF + (1+i)3

Notice, that as long as i > 0, terms get smaller as we get further into the future. It is well known that the present value of such a perpetuity can be expressed simply as PV = CF/i

Similarly, for a firm generating a constant profit PV = /i

Notice that the above PV formula excludes a payment received now (e.g., at time 0).The PV of a stream of returns starting today is PV = /i + = [(1+i) ]/i

You must always be careful to stipulate the timing of the first payment when doing PV calculations. Note: Your text discusses extensions of this model. In this class you will be responsible only for the material covered above. 6. Using Marginal Analysis. A final principle in intelligent decision-making pertains to the unit of analysis used. One can often cut through a very difficult optimization process by confining attention to incremental changes. a. Discrete Decisions. Example. Suppose you were faced with the problem of trying to allocate study time between two courses for a test on the same day. If you had a total of 6 hours to study, you might have the following possibilities.

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Econ Hours score 0 0 1 30 2 55 3 75 4 93 5 98 6 100

Math Hours 0 1 2 3 4 5 6

score 0 40 65 77 86 94 100

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One way to approach this problem would be to consider all combinations of all totals that were available:

Scores Econ
0 1 2 3 4 5 6 Math 6 5 4 3 2 1 0

Total
Math 100 94 86 77 65 40 0 100 124 141 152 158 138 100

Econ
0 30 55 75 93 98 100

An equivalent solution, however, is obtained by considering just the marginal changes A marginal change is the change in the total associated with studying an extra hour. Econ Math Hour score marginal hour score marginal increase increase 0 0 0 0 1 30 30 1 40 40 2 55 25 2 65 25 3 75 20 3 77 12 4 93 18 4 86 9 5 98 5 5 94 8 6 100 2 6 100 6 Note: This process has the advantage that it requires less information.

Lecture 4 REVIEW

Problems: Return Problem Set 1, Problem Set 2 due Monday.

I. Chapter 1. The Fundamentals of Managerial Economics B. Components of Effective Decision Making 5. Recognize the Time Value of Money. a. Discounting the Future. b. Calculating Net Present Value of a Project Comment: Recall problem 1. A student asked if in deciding whether to undertake a project, it made a difference if the net present value if a project was less than the cost the project. I ERRED IN MY RESPONSE. The correct answer is: ANY PROJECT WITH A POSITIVE NPV SHOULD BE UNDERTAKEN. 22

To see this, suppose you are given the chance to invest $100,000 in a project that will yield $60,000 for each of the next two years. If i=.10, then the PV of the returns is 60,000/1.1 + 60,000/1.12 =54,540 + 49,587 =104,132. The Net Present value is 104,132-100,000 = 4,132. (That is, you end up with 4,132 MORE than 100,000 in present value terms.) Suppose, alternatively, that you took the 100,000 and put it in the bank for two years. If i = .10, you would have 110,000 after one year, and $121, 000 after two years. The present value of that money is (by definition) $121,000/(1.1)2 = 100,000 c. The present value of a firm/ Discounting over an infinite horizon. With the first payment coming in one year, PV = /i If the first payment is tomorrow, PV = /i + = [(1+i) ]/i

Example: Suppose you can purchase a share of a firm that will pay a dividend of $10 each year, starting one year from today. If the discount rate is . 05, what is the present value of this stock? 10/.05 = $200. How would your answer change if the first payment came tomorrow? 10/.05 + 10 = $210. 5. Appreciate Marginal Analysis. Marginal decisions are an easy way to optimize totals that require less information in the decision-making process. a. Discrete Decisions - Allocating time for a test Preview__________________________________________________________ 5. Marginal Analysis Continued - Comparing TR to TC b. Continuous Decisions LECTURE______________________________________________

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5. Using Marginal Analysis. A final principle in intelligent decision-making pertains to the unit of analysis used. One can often cut through a very difficult optimization process by confining attention to incremental changes. a. Discrete Decisions. Example. Suppose you were faced with the problem of trying to allocate study time between two courses for a test on the same day. If you had a total of 6 hours to study, you might have the following possibilities. Econ Hours score 0 0 1 30 2 55 3 75 4 93 5 98 6 100 Math Hours 0 1 2 3 4 5 6 score 0 40 65 77 86 94 100

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One way to approach this problem would be to consider all combinations of all totals that were available:

Scores Econ
0 1 2 3 4 5 6 Math 6 5 4 3 2 1 0

Total
Math 100 94 86 77 65 40 0 100 124 141 152 158 138 100

Econ
0 30 55 75 93 98 100

An equivalent solution, however, is obtained by considering just the marginal changes A marginal change is the change in the total associated with studying an extra hour. Econ Math Hour score marginal hour score marginal increase increase 0 0 0 0 1 30 30 1 40 40 2 55 25 2 65 25 3 75 20 3 77 12 4 93 18 4 86 9 5 98 5 5 94 8 6 100 2 6 100 6 Note: This process has the advantage that it requires less information. More generally, we might consider a situation in which there were both costs and benefit (for example the case of profit maximization, where = TR TC Control Variable TB 0 0 1 90 2 170 3 240 4 300 5 350 6 390 7 420 8 440 9 450

TC
0 10 30 60 100 150 210 280 360 450

NB
0 80 140 180 200 200 180 140 80 0

MB
90 80 70 60 50 40 30 20 10 25

MC
10 20 30 40 50 60 70 80 90

MNB
80 60 40 20 0 -20 -40 -60 -80

10

450

550

-100

100

-100

Definition: The Marginal Principle: To maximize net benefits, the manager should increase the managerial control variable to the point where marginal benefit equals marginal costs. Graphically, this can be illustrated both by graphs of totals and of marginal changes: Total changes
600 500 400 TC TB 300 200 100 0 0 1 2 3 4 5 6 7 8 9 10 Output

100 80 MB, MC 60 40 20 0 0 1 2 3 4 5 6 7 8 9 10 Output

Observe the role of marginals and totals. (Notice that the totals and marginal lines should not line up exactly. There are two points of total maximization. This is due to the discreteness of decisions here. )

Lecture 5

Problems: Problem Set 2 due Monday.

REVIEW___________________________________________________: I. Chapter 1. The Fundamentals of Managerial Economics 26

B. Components of Effective Decision Making 5. Appreciate Marginal Analysis. a. Discrete Decisions - Allocating time for a test. (Recall the point, making the best incremental decisions at each step in a sequence will drive you to the maximum total. - Comparing TR and TC On a graph, the point where is maximized is where the difference between TR and TC is maximized. This is also the point where MR =MC. The DISTANCE between TR and TC equals the AREA above MC and below MR (We will use this to show that equilibrium is efficient in Chapter 2.) Note, however, in your homework that your marginals never quite line up. This is a problem with discrete analysis. Your rule in such a case is to take (produce) the last unit such that MR>MC. Example: Q 0 1 2 3 4 5 6 TR 0 19 36 51 64 75 84 TC 1 3 9 19 33 51 73 TNB -1 16 27 32 31 24 11 MR 19 17 15 13 11 9 MC 2 6 10 14 18 22 MNB 17 11 5 -1 -7 -13

If you plot this you will see that MR and MC never equal, given we are restricted to discrete changes. In a continuous world, we could find an exact answer.. Preview__________________________________________________________ 5. Marginal Analysis Continued b. Continuous Decisions c. Incremental Decisions LECTURE______________________________________________ b. Continuous Decisions. Notice that in some circumstances, it is possible to make adjustments more continuously Notice in my graphical analysis that my graphs are always a bit off. This is a problem of discreteness.

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More generally, we might consider a situation in which there were both costs and benefit (for example the case of profit maximization, where = TR TC Now, suppose that I tell you that in the problem in the introduction that TR = 20Q Q2 and that TC = 1 + 2Q2 I could come closer to finding the optimum if I used a finer grid. For example, suppose I reduce Q steps to .5 Q 0 0.5 1 1.5 2 2.5 3 3.5 4 TR 0 9.75 19 27.75 36 43.75 51 57.75 64 TC 1 1.5 3 5.5 9 13.5 19 25.5 33 TNB -1 8.25 16 22.25 27 30.25 32 32.25 31 MR 9.75 9.25 8.75 8.25 7.75 7.25 6.75 6.25 MC 0.5 1.5 2.5 3.5 4.5 5.5 6.5 7.5 MNB 9.25 7.75 6.25 4.75 3.25 1.75 0.25 -1.25

What if I wanted to find the exact maximum? I could do this by taking a infinitesimal changes. Lets do this in parts. Start with the Total Revenue relationship. TR = 20Q -Q2 Consider the slope of the line tangent to the curve at Q=4. Q 0 1 2 3 4 Graphically, TR 0 19 36 51 64

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120 100 80 60 40 20 0 0 2 4 6 8

Consider the slope of the line tangent to the curve at Q =4. We could estimate this by calculating the average slope over progressively narrower ranges, e.g., (64 - 0 )/(4 - 0) = 64/4 = 16 (64 - 19 )/(4 - 1) = 45/3 = 15 (64 -36 )/(4 - 2) = 28/2 = 14 (64 -51)/(4 - 3) = 13/1 = 13 If we really wanted the slope of the line tangent to the curve, we must take an infinitesimally small change -h. Then 64 - [20(4-h) - (4-h)2] 4 -(4-h) = 64 - 80 + 20h +16 8h + h2 h = _Q2 +12h h and as h 0 this becomes 12. This is the idea of a derivative. The only difference between taking limits, and the rules of derivation that you learned is that the rules are just a shorthand, for example, TR = 20Q -Q2 TR' = MR =20 - 2Q At Q = 4, TR'= 12.

29

You could do the same thing for costs TC = 1+2Q2 TC = MC = 4Q This is the slope of the line tangent to the TC curve To maximize profits, set MR = MC TR = 20 2Q Q = = 4Q 20/6 = 3.33 = TC

Comments a) I assume that you all have been exposed to simple differential calculus. The above development was done only to complete a little intuition pertaining to calculus. In the event that your calculus is a bit rusty, I can assure you that with only a few exceptions, our derivatives will be restricted to the following functional forms. Derivative of a constant f(x) = a; f(x) = 0 Derivative of a linear equation f(x)= ax; f(x) = a Derivative of an exponential function f(x) = xn; f(x) nxn-1 You may also find it useful to recall the following: f(x) = g(x) + h(x); f(x) = g(x) + h(x) f(x) = g(x)h(x); f(x) = g(x)h(x) + h(x) g(x) f(x) = g(h(x)) = g(h(x))h(x) b) Finally, in your homework, I would like for you to report your marginal revenue and marginal costs as derivates, rather than as incremental changes.

Lecture 6

Problems: Collect Problem Set 2. (Other review problem, 2, 3, 5, 8, 10) REVIEW___________________________________________________: I. Chapter 1. The Fundamentals of Managerial Economics B. Components of Effective Decision Making

30

5. Appreciate Marginal Analysis. a. Discrete Decisions b. Continuous Decisions TR = 10Q Q2 and that TC = .25Q2 (In problem 2). I can see the relationship of marginals to the totals on the marginals graph, as well as on a totals graph. But we also learned the idea of a derivative, which is just a slope over an infinitesimally small range. Derivative of a constant f(x) = a; f(x) = 0 Derivative of a linear equation f(x)= ax; f(x) = a Derivative of an exponential function f(x) = xn; f(x) nxn-1 You may also find it useful to recall the following: f(x) = g(x) + h(x); f(x) = g(x) + h(x) f(x) = g(x)h(x); f(x) = g(x)h(x) + h(x) g(x) f(x) = g(h(x)) = g(h(x))h(x)

Preview__________________________________________________________ c. Incremental Decisions Some review problems. LECTURE______________________________________________ Incremental analysis: For many (if not most) decisions, the manager must make a binary (yes or no) choice. In that case, the tools described above are appropriate. However, rather than considering the entire set of possibilities, consider only the changes from the status quo, and determine whether the incremental change is desirable. The trick to this incremental analysis is to attend only to the things that actually change with the decision, and ignore the rest. One practical way express this is the following: a) In making a decision pay attention to marginal costs and marginal benefits b) In making a decision, pay attention only to marginal costs and marginal benefits (That is, ignore sunk costs) Example, suppose you wait in a line in a grocery store. Another line opens up. What value should you place on the time youve spent waiting in your present line (none)

31

Example; Suppose you have a 12 month lease on an apartment. You must pay $700 per month. If you get a new job in May that forces you to leave town in May and if your lease runs through August, how much, at a minimum must you get to sublease the apartment? (Answer, you must cover any variable costs, and nothing more!) Example: A more involved example. Suppose you manufacture umbrellas, and you are deciding whether or not to purchase a new game day golf umbrella, which is big enough to keep the entire family dry in a halftime downpour. The new machine costs $40,000. For simplicity, we assume that the machine lasts one year, and is then useless. You can put the machine in a slot where a now defunct standard machine sits. Old machine removal and recycling costs are $5,000, and must be borne independent of whether or not you buy the new machine. Installation costs for the new machine are $4,000. Variable costs for the new umbrellas are $8 per umbrella for materials and energy and $4 per umbrella for labor. Suppose that you can reasonably expect to sell 2000 of these umbrellas next year, at $35 each. Is the machine a good investment? Incremental revenues are ($35)(2000) = $70,000 Incremental Costs are $40,000 $4,000 $24,000 $68,000 new machine installation variable expenses ($12)(2000)

Result: Yes, purchase the machine. Notice, however, that the $5,000 removal expenses should not be considered in this analysis.

Lecture 7 REVIEW___________________________________________________: c. Incremental Decisions In attempting to optimize, two rules: - Attend to marginal benefits, attend to marginal benefits and marginal costs. -Attend only to marginal benefits and marginal costs. (Ignore sunk costs) Preview__________________________________________________________ II. Chapter Market Forces: Demand and Supply A. Introduction and Overview. 1. Overview 2. The structure of the supply and demand model.

32

B. The Demand Side. 1. Motivation: Diminishing marginal utility: 2. Definition of Demand Curve 3. Determinants of Demand. 4. Changes in demand vs. changes in qty demanded. LECTURE______________________________________________ A. Introduction and Overview. 1. Overview. The purpose of this chapter. Economics proceeds via models. A model is an abstraction from reality, done for the purpose of explanation, or prediction. It is important to emphasize that these models are necessarily unrealistic. A model that captured all the complexity of reality wouldnt be useful at all. Rather the oversimplification of a model is useful if it serves effectively an explanatory or predictive function. For example, the first model presented in this class was the present value characterization of the firm, introduced in chapter 1. This model, of course misses many elements, including the uncertainty of returns over time, as well as the possibility that interest rates may change. Nevertheless, it is useful in that it provides some insight into the issues relevant to considering the inter-temporal value of a firm. This chapter presents a second model, the theory of price and quantity determination. This model should be a review for most of you. Nevertheless, it is of prominent importance. The purpose of this model is both explanatory and predictive. It is the primary tool that you can use to infer the effects of market impacts on prices and outputs. You are expected to master the mechanics of this model. A second function of this review is to present this model in simple algebraic terms. This presentation should help acclimatize you to the type of analysis we will do in this course. 2. The structure of the supply and demand model. a. Overview. In this model, we divide people into two groups i. Households: Who attempt to maximize utility, they face diminishing marginal utility, and are subject to a budget constraint. ii Firms: Attempt to maximize profits. Firms fact cost constraints, and are subject to a law of diminishing returns in production. We will look at Demand (household behavior) Supply (firm behavior) and equilibrium, the interaction of these parts that generates price and output predictions B. The Demand Side. 1. Motivation: Consider an example of consuming a good. Suppose that its 100 degrees F outside, and you play 3 sets of tennis and then run 10 miles. Then you put on a coat,

33

jump in the car, turn the heater up to full blast, and drive 3 hours in the sun. At the end of all this, you 1/2 dozen chili peppers. Now stop at a gas station and purchase cans of Sprite, one by one. Consider how much you would pay, for the first can, for the second, the third, and etc. The fact that you are gradually getting full is the notion of diminishing marginal utility. Diminishing marginal utility: In a given time frame, consumption of additional units of a good yields decreasing increments to total well being due to relative satiation (fullness). 2. Definition (for output market): The Demand Curve: A curve indicating varying quantities of a good or service that consumers are ready, willing and able to purchase at varying prices, per unit of time, other things constant. Demand is down-sloping due to the diminishing marginal utility of consumption. There are a number of important components in this decision a. Price/Quantity relationship: Price is the most important determinant of Quantity b. Ready, willing and able: Defines the market. Ready - in the market. Willing - desires the good. Able - has the wherewithal. c. Per unit of time: Time must be specified, as it affects diminishing marginal utility. d. Other things constant. A number of things aside from the price affect qty purchased (including substitutes, complements, and advertising, and etc.) e. Down-sloping due to diminishing marginal utility (Fullness). This is the reason that there is an inverse relationship between price and quantity. 3. Determinants of Demand. Things that affect the Marginal Utility of purchasers in the market. In addition to price, determinants include: Ps -Price of substitutes Pc Price of complements I Income (Normal goods or Inferior goods) E Expectations (regarding relative future prices B Number of buyers (population) 4. Changes in demand vs. changes in qty demanded. When one of the non-price determinants of demand changes, it is necessary to draw a new demand schedule. This is known as a change in demand (schedule). When there is a change in price, other things held constant, this is called a change in quantity demand (a movement along a schedule)

34

Example, consider Qd = f(P, Ps, Pc, I) This is a demand function. It is a relationship between quantity demanded, and the entire collection of elements that determine sales quantity. The demand curve is a relationship between price and quantity alone, holding all other elements constant. Suppose income increases. Then it would be necessary to shift the demand schedule. Note: The one thing that CANNOT change demand (curve) is a change in the price of the good! Lecture 8 REVIEW___________________________________________________: II. Chapter Market Forces: Demand and Supply A. Introduction and Overview. 1. Overview 2. The structure of the supply and demand model. B. The Demand Side. 1. Motivation: Diminishing marginal utility: 2. Definition of Demand Curve 3. Determinants of Demand. 4. Changes in demand vs. changes in qty demanded. Preview__________________________________________________________ 5. The Notion of Consumer Surplus 6. An Analytical Example LECTURE______________________________________________ 4. Changes in demand vs. changes in qty demanded. When one of the non-price determinants of demand changes, it is necessary to draw a new demand schedule. This is known as a change in demand (schedule). When there is a change in price, other things held constant, this is called a change in quantity demand (a movement along a schedule) Example, consider Qd = f(P, Ps, Pc, I)

35

This is a demand function. It is a relationship between quantity demanded, and the entire collection of elements that determine sales quantity. The demand curve is a relationship between price and quantity alone, holding all other elements constant. Suppose income increases. Then it would be necessary to shift the demand schedule. Note: The one thing that CANNOT change demand (curve) is a change in the price of the good! 5. The Notion of Consumer Surplus In markets where all consumers pay a uniform price for a good, most of the consumers who purchase the good place a higher value on the product than the purchase price. This difference between purchase price and value is termed consumer surplus. P $8 Consumer Surplus for unit Q1 $5 D Q1 10 QD For example, a consumer who values unit Q1 at $8 and pays $5 for the unit enjoys a consumer surplus of $3. Notice that the entire consumer surplus for the market is the area between the demand curve and the price. Notice that in some contexts, it is possible for a seller to collect some of the consumer surplus realized in a single-price market. In particular, the seller may sell packages of units at a higher price than single quantities of the same unit, to achieve a given sales total. (We will discuss this later in the semester. 6. An analytical example Consider the following, simple demand function. Qd = 10 - 2P + .33I. Suppose I=30, then the demand curve can be written as Qd = 20 - 2P Or inverse demand: P = 10 - Q/2 This is shown as D on the figure below

36

16 14 12 10 8 6

D'
4 2 0 0 5 10 15 20 25

If I increases to 60 then Qd = 10 - 2P+ .333(60) Qd = 30-2P So inverse demand is P= 15-Q/2, illustrated as D in the above figure. Suppose that the price is $5. How much consumer surplus to consumers receive at that price? When 15-Q/2 = 5, Q = 20. So the area of the C.S. triangle is (.5)(15-5)(20) = 100 This is the triangle illustrated below

37

16 14 12

15-5

10 8 6 4 2 0 0 5 10 15 20

D'

20

25

Lecture 9 REVIEW___________________________________________________: II. Chapter Market Forces: Demand and Supply B. The Demand Side. 5. The Notion of Consumer Surplus 6. An Analytical Example Preview__________________________________________________________ C. The Supply Side. 1. Driving Force. The Law of Diminishing Returns 2. Definition of Supply Curve 3. Determinants of supply: 4. Changes in supply vs. changes in quantity supplied. 5. Producer Surplus. LECTURE______________________________________________ C. The Supply Side. In output market, this defines the behavior of sellers, 1. Initial assumption. Firms are motivated by the profit incentive, but constrained by increasing marginal costs (or, better yet, the law of diminishing returns (crowding).

38

Example, consider conditions under which you would produce for sale quartz lamps from your uncle's shack in Southern Montana. As the amount of variable inputs (quartz, and workers) increases, the room should become crowded, and unit costs should increase as more variable inputs (labor) becomes imbed in each unit of output. This, we would expect, there would be a direct relationship 2. Definition The supply curve: A schedule of intentions indicating varying quantities of a good or service that sellers are ready, willing and able to place on the market at varying prices, per unit of time, other things constant. The supply curve is upsloping due to the law of diminishing returns (crowding) Important elements a. Schedule of intentions: An estimate b. Price/Quantity relationship: Price is the most important determinant of quantity. c. Ready, willing and able: Defines the market of relevant suppliers. Ready: Has access to market. Willing: Is a reasonable use of resources, Able: Has productive means d. Per unit of time: Time must be specified, as it affects LDR. e. other things constant. f. Upsloping due to the law of diminishing returns (crowdedness) 3. Determinants of supply: Things other than the price that affect how r.w. and a. sellers are to offer goods to the market. As a class, these are things that affect production costs Technology Factor prices. NUMBER OF SELLERS. Price expectations (e.g. hold grain in silo if price is expected to increase next year). Taxes (excise or ad valorem) 4. Changes in supply vs. changes in quantity supplied. Definition. (As with demand): A change in quantity supplied occurs in response to a change in the price of a good, all other things held constant. A change in supply occurs in response to a change in something other than price. Again, price is, by definition, the one thing that cannot change supply. 5. Producer Surplus.

39

a. Definition Symmetric to the notion of consumer surplus, in a market where a single price is charged for all transactions, producers typically receive more from a sale than is necessary to induce them to offer a unit to the market. P S $5 Producer Surplus for unit Q1 $3 D Q1 10 D Q The producer surplus for unit Q1 is $5 - $3 = $2. The producer surplus for the market is the triangle bounded by the vertical axis, the production cost, and the price. b. Observations -Producer surplus is not the same as profit. We will talk about this more later, when we discuss the theory of the firm. -There are ways for a savvy purchaser to extract producer surplus in making purchasing decisions. Similar to demand, this is typically accomplished via bulk purchases.

Lecture 10 REVIEW___________________________________________________: II. Chapter Market Forces: Demand and Supply C. The Supply Side. 1. Driving Force. The Law of Diminishing Returns 2. Definition of Supply Curve 3. Determinants of supply: 4. Changes in supply vs. changes in quantity supplied. 5. Producer Surplus. Preview__________________________________________________________ 6. An Analytical Example. D. Equilibrium. Putting Supply and Demand Together 1. Definition. 40

2. Binding the market. Price floors Price ceilings LECTURE______________________________________________ C. The Supply Side. 6. An analytical example. Consider the market supply schedule for small laser-light paper erasers. The supply function is given by Qs = -44 + 20P - 4W - 2M, where P = the price of the erasers W = the average hourly wage for labor M = an index measuring materials costs. If W = 10 and M = 8, what is the market supply curve? Qs = -44 + 20P - 4(10) -2(8) = -100 + 20P, thus Inverse supply becomes = 5 + .05Q

Plotting in a table Q
5 10 15 20 25

P
5.25 5.5 5.75 6 6.25

Now, suppose that M increases to 18, then what happens to supply, or to quantity supplied? Qs = = -44 + 20P - 4(10) -2(18) -120 + 20P, thus

There is a change in supply P = 6 + .05Q Q

5 10 15 20

P
6.25 6.5 6.75 7

41

25

7.25

Alternatively, suppose that P increases from 6.5 to 17what happens to Q? There is a change of quantity supplied from 10 to 20.
8.5 8 7.5 7 6.5 6 5.5 5 0 10 20 30 40 50 S1 S2

Graphically Q P1 0 10 2 9 4 8 6 7 8 6

P2 15 14 13 12 11

D. Equilibrium. Putting Supply and Demand Together 1. Definition. Equilibrium: A price quantity combination where Qs = Qd, and where Ps = Pd. Analytically. Suppose Qd = 100 - 4P +10I, and Qs = 10 + 6P -3W If W = 30, I =10, what are equilibrium values? Qd = 100 - 4P +10(10), and Qs = 10 + 6P -3(30) Qd = 200-4P Qs = 80+6P

42

Setting Qd = Qs implies that

P 15 14 13 12 11 10 9 Qd 140 144 148 152 156 160 164 Qs 170 164 158 152 146 140 134

Observe at a price of 15 dollars, there is a surplus, Qs = 170 > Qd = 140. Conversely, at a price of $9, there is a shortage, Qd = 164 > Qs = 134. 2. The stability and desirability of equilibrium. Absent a tendency for markets to equilibrate (or given regulations which prevent such convergence), the surplus or shortages just discussed would be permanent. However, markets do equilibrate. Given excess supply the sellers have an incentive to reduce prices. This price reduction prompts changes in quantity supplied and quantity demanded. Similarly, given an excess demand, buyers have an incentive to bid prices up, again causing a change in quantity supplied and quantity demanded. Importantly, if the assumption of pure privacy is satisfied, the equilibrium outcome is also socially desirable. Given an absence of externalities, the TC curve equals TSC and the TB curve equals TSB. Thus, D=MSB and S=MSC. At the equilibrium, where S=D, the net difference between TSB and TSC are maximized. 3. Binding the market. Permanent shortages and surpluses can be caused by regulation. A price floor: A regulated minimum price, below which the market price cannot fall. If the floor is below the equilibrium, the regulation exerts no effect. If the floor is above the equilibrium, there is a permanent shortage that the market cannot eliminate. a. Example. A price floor: Suppose the government refuses to let cheese be sold for less than $3.00 per pound. Result: A permanent surplus, and one that cannot be resolved by the market A price ceiling: A regulated maximum price, above which the market price cannot rise. If the floor is above the equilibrium, the regulation exerts not effect. If the floor is below the equilibrium, there is a permanent shortage that the market cannot eliminate. b. Example: A Rent control. Result: A shortage of housing, and one that cannot be resolved by the market.

43

Complications: One solution by sellers is to force multiple purchases (e.g., Impose a price ceiling on rents, but then make people agree to unusual lease terms, or to purchase other high cost items along with the lease). In fact, it is possible that given rent controls, the non-monetary components associated with increasing the price of a good may generate a full price for each consumer that equals the total market consumer surplus. Notice that when a ceiling binds the market, the full economic price is the sum of the pecuniary plus the non-pecuniary price (e.g., the price of waiting, purchasing undesired packages of goods, etc.) In general, with a price ceiling, buyers who purchase a good will pay the demand price, at the restricted quantity. For example P S Pf

Pc

Qc Q Given a Price ceiling Pc, Qc units will be sold. The full economic price paid by buyers will equal Pf. There are parallel examples in input markets (where the government acts more aggressively). Usury laws (a market for loanable funds) Minimum wage legislation. The point: Equilibrium is a socially desirable outcome. We interfere with the workings of a competitive market at our peril!

Lecture 11 REVIEW___________________________________________________: II. Chapter Market Forces: Demand and Supply D. Equilibrium. Putting Supply and Demand Together 1. Definition. 2. The Stability and desirability of equilibrium 3. Binding the market. Price floors 44

Price ceilings Point: Binding the market imposes high social costs Preview__________________________________________________________ E. Comparative Statics. 1. Single market changes. 2. Multiple Market Changes III. Quantitative Demand Analysis A. Price Elasticity of Demand 1. Motivation LECTURE______________________________________________ E. Comparative Statics. Given the tendency of markets to converge to competitive predictions in an unfettered and competitive market, we can use this model to predict the effects of changes in the world. 1. Single market changes. Strategy: To find the new equilibrium, consider the old equilibrium price, and the new equilibrium supply and demand curves. Then shortages or surpluses will motivate an adjustment. a. Change in demand, supply stable. Example, suppose the price of coffee falls by half. What should this do to the market for pastries? Example: What should the current economic recession do to the price and quantity of automobiles sold? b. Change in supply, demand stable Example: Suppose a new process for manufacturing computers is developed that cuts production costs by 50%. What is the predicted effect on the number of computers sold, and the price of computers? c. Change in supply and demand (and ambiguous effects). Example: Suppose software costs fall, and that at the same time a new Pentium X chip is developed that can be installed to do twice as much at 1/2 the price. What is the net effect of these changes on the price and quantity of personal computers sold? Example: Consider the market for cheese produced by U.S. farmers. Suppose that due to the flooding in Northern Europe, Farmers in the Netherlands lose half of

45

their dairy herd. Suppose also that new environmental deregulation cuts production costs in half. What are the net effects of these changes on the market for cheese produced by U.S. Farmers? A more complicated story variant: Consider the above problem, but suppose that at the outset the U.S. government imposed a price floor for cheese that at the initial equilibrium. How does the price ceiling affect results?

Lecture 12 REVIEW___________________________________________________: II. Chapter Market Forces: Demand and Supply D. Equilibrium. Putting Supply and Demand Together Equilibrium is 1. Stable 2. Socially desirable E. Comparative Statics. 1. Single market changes. 2. Multiple Market Changes Preview__________________________________________________________ III. Quantitative Demand Analysis A. Price Elasticity of Demand 1. Motivation 2. Calculation a. Arc price elasticity of demand: b. Point price elasticity of demand c. Percentage Changes Lecture ______________________________________________________ III. Chapter 3. Quantitative Demand Analysis Introduction: In the preceding chapter we reviewed the basic supply and demand model used to predict price and quantity outcomes. This model is an extremely useful device for making qualitative predictions. An important limitation of the model as it has been presented, however, is that it does not allow quantitative predictions. For quantitative predictions, it is necessary to more fully characterize the arguments in the demand and supply functions. We start with demand in this chapter. The presentation is divided into two parts. The first will deal with the quantitative conclusions that may be fairly limited elasticity

46

information. In the second part, we turn more comprehensive analysis of demand estimation via the use of regression. A. Price Elasticity of Demand 1. Motivation: Elasticity this is a tool for estimating responsiveness of some dependent variable to a change in a dependent variable, based on very little information. Definition: Elasticity: The percentage change in an independent variable brought about by a 1% change in an independent variable. Intuitively, elasticity may be regarded as a measure of sensitivity. If people are sensitive, we will say that they are elastic. If they are insensitive, we will regard them as inelastic. For concreteness, we will focus initially on price elasticity of demand (change definition accordingly) Price Elasticity of Demand: The percentage change in Quantity Demanded brought about by a 1% change in the price of a good, or = %Qd/%P = Q/Q P/P = QP PQ

2. Calculating Elasticity of Demand. There are three ways to calculate price elasticity of demand: arc price elasticity, point price elasticity, and direct percentage changes. The method that is appropriate in any particular context depends on the information provided. a. Arc Price Elasticity. Applies to a discrete change. For example, consider the demand curve implied by the following table: P 4 5 P 5 Q 40 10

4 D 10 40 Q

47

Notice Q may be calculated as Q1-Q0, and P = P1-P0. Then = (Q1-Q0)P/(P1-P0)Q But it makes a big difference if you use (P0,Q0) as your divisor, or (P1,Q1). For example: (40-10) (4) (4-5) (40) (40-10) (5) (4-5) (10) = = 30(4) -1(40) 30(5) -1(10) = -3.00 = -15.00

Neither of these points is inherently more correct. As a convention, we calculate the arc price elasticity of demand using the average of the distance between the 2 points: = (Q1-Q0)(P1+P0)/2 (P1-P0)(Q1+Q0)/2. In this case = (40-10) (4+5)/2 (4-5) (40+10)/2 = 30(4.5) -1(25) = -5.4

Arc Price elasticity is interpreted as follows: Over the range of prices between $4 and $5 on average, a 1% reduction in price increases quantity demanded by 5.4 %. b. Point price elasticity: When you are given a slope, and a point. Insight = (dQ/dP)(P/Q) Example: Suppose a demand curve is Q = 30 - 10P Then, if P = 2, then Q=10 and elasticity is -10 ( 2/10) = -2. Uses: Mostly when given a demand function. Point Price elasticity is interpreted as follows: At a price of $2 a 1% reduction in price increases quantity demanded by 2 %.

48

c. Percentage changes. For rough policy purposes. Insight = (%Q)/(%P) Example. Suppose that beer sales at Joe's Inn increased 20% in response to a half price (50% off night). What is the implied elasticity of demand? -20/ 50 = -.4 Example: Suppose that Joe sells 400 beers per day. What would be the effect of a 10% increase in beer prices on his sales? -.4 = %Q/10 implies 4 % decrease, or a decrease of .04(400) = 16 beers per day.

Lecture 13 REVIEW___________________________________________________: II. Chapter Market Forces: Demand and Supply A. Price Elasticity of Demand 1. Motivation 2. Calculation a. Arc price elasticity of demand: Example: If Rick Redfern reduces the price of potato chips from $2 per bag to $1 per bag, and if daily sales increase from 10 to 15, what is the arc price elasticity of demand?

(10-15)(2+1) = -5(3) (2-1) (10+15) 1(25) b. Point price elasticity of demand

-3/5

Example: If demand is given by Q = 100 10P and P = 6, what is price elasticity of demand?

-10 (6)/40 = -1.5 (Notice: If P = 4, elasticity becomes

-10 (4)/60 = -.67

A preview: Price elasticity changes with position on the demand curve. c. Percentage Changes

49

Example: If Ford Taurus sales increase by 20% in response to a 10% off sale, what is the implied price elasticity of demand?

-20/10

-2

Preview__________________________________________________________ III. Quantitative Demand Analysis 3. A Graphical Interpretation of Price Elasticity. 4. Some Observations about Price Elasticity of Demand a. Most Demand curves have elastic and inelastic segments b. Exceptions c. Elasticity and the Slope of Demand Curves 5. Elasticity TR and MR Lecture ______________________________________________________ 3. A Graphical Interpretation of Price Elasticity. a. Intuition: One way to consider the problem of sensitivity is to ask the following question: What happens to total revenue (TR) when price is changed? Consider a price increase. If TR increases, then we will say that people are "insensitive" to the change (meaning that more revenues were gained from people staying in the market and paying the higher price, than were lost from people who left the market. On the other hand, if TR falls, then people are "sensitive" in the sense that more revenues are lost from people leaving the market in response to a price decrease, than were gained from the higher prices. b. Illustration. This can be graphically illustrated as follows. Consider the problem of calculating price elasticity for a standard linear demand curve. P

Po Price box P1 Quantity Box Q0 Q1 Associated with a price change are competing effects, PQ a "price" box. D Q

50

QP a "quantity" box. Elasticity is the ratio of the qty box to the price box. Lets explain this in words. Suppose we talk about a price reduction. The price box is the loss in revenues on units that would have sold at the higher price The quantity box is the increase in revenues due to new units that are sold as a result of the price reduction. Elasticity is the ratio of the qty box to the price box. When inelastic, the coefficient is small (close to zero) When elastic, the coefficient is large (far from zero). 4. Some observations about price elasticity of demand (): a. In general is between 0 and infinity <0 by definition (though it is often treated as a positive number). - Most curves have elastic, inelastic and unitary components.

Inelastic (Price box is larger than Quantity box) b. Exceptions:

Unitary (Price box equals Quantity box)

Elastic (Price box is smaller than Quantity box)

Perfectly Inelastic

CES

Perfectly Elastic

51

(Only Price box) c. Tendencies E U I E U I Relatively Inelastic Relatively Elastic

(Only Qty. Box)

d. Summary. Coefficient values are related to the above graph as follows. Inelastic Unitary Elastic TR moves with P TR is Unchanged TR moves with Q Price box > Qty box. Price box = Qty. box Price box < Qty. box <1 =1 >1

Lecture 14 REVIEW___________________________________________________: II. Chapter Market Forces: Demand and Supply A. Price Elasticity of Demand 3. A Graphical Interpretation of Price Elasticity. 4. Some Observations about Price Elasticity of Demand a. Most Demand curves have elastic and inelastic segments b. Exceptions c. Elasticity and the Slope of Demand Curves Preview__________________________________________________________ 5. Elasticity TR and MR 6. Determinants of Price elasticity B. Other Demand Elasticities 1. Cross Price Elasticities

52

Lecture ______________________________________________________ 5. Price Elasticity, MR and TR a. Motivation: What can we say about the optimality of prices, given limited information. (Say, only information about the demand schedule, and perhaps MC information). Some important inferences can be drawn only from information about elasticity. Definition of Marginal Revenue (MR). Recall that on most demand curves, there are elastic, unitary and inelastic segments. (Motivate from comparison of quantity box to price box). Price elasticity is the ratio of the quantity box to the price box. Marginal revenue is the difference between the quantity box and the price box. P E

MR TR

D Q MR (at max)

TR E I Q b. Relation between MR, TR and || >1, MR >0 || <1, MR <0 || =1, MR =0 Thus: TR is maximized when MR = 0. - A monopolist with no marginal costs would price where MR = 0.

53

-A price-setter could never increase revenues by cutting price when || <1. (ex. Never cut prices to sold out concerts, generally don't raise price for bus service). d. Some examples: Example Suppose you are a monopolist, who owns a bridge. Access doesn't deteriorate the bridge. What price should you set? (Suppose you have no marginal costs) Answer: The price where ||=1 Example: The elasticity of demand at Jones Co. is -.5. They are considering a sale. What can you say about the rationality of a price cut? Answer: No firm can maximize profit on the inelastic portion of their demand curve. They should raise price. Example: Suppose (inverse) demand is P = 10 - 2Q. If P =2, what can you say about the optimality of pricing policy? Answer: MR = 10 - 4Q. When P = 2, Q = 4. Thus, they are on inelastic part of demand curve (and the firm could increase profits by raising price. 6. Determinants of price elasticity of demand. Your text (p.81) lists elasticities of demand for selected products in the U.S. ranging from Motorcycles and Bicycles (-2.30) to Transportation (-.6). It is important for you to be able to interpret these numbers. Some assistance may be developed by considering factors that tend to make demand curves have more or fewer elastic points. a. Determinants of price elasticity of demand i.) Availability of close substitutes: Demand is more elastic, the more substitutes that are available. ii) Price relative to income: Demand is more inelastic, the smaller price is relative to income. iii) Time: Demand is more elastic, the longer the time frame (because there are more available substitutes). b. Applications. You should be able to make comparative statements about the elasticity of demand for various products:

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i) What is more elastic: the demand for automobiles in general, or the demand for VW Polos? ii) What is more elastic: Demand for salt, or the demand for an automobile? iii) What is more elastic: Your demand for pain pills at 3 a.m. at the 7-11, or your demand for pain pills in general for your medicine cabinet. You should also be able to combine elasticity calculations with determinants information. iv) Suppose that auto-seller Jim Ford at Ford city lowers the price of the popular Focus by $2000 in honor of Spring. Suppose that in response, weekly sales at increase from 4 per week to 8. If the normal price of a new Focus is $10,000 what is the arc price elasticity of demand? = = (8-4)(18,000)/[-2,000(12)] -3.

- Over the current price range, is Marginal Revenue positive or negative? - Could Jim Ford expect to increase revenues by further lowering price? Would such a move be profitable? - What would you expect to be the response of customers to a similar percentage mark-down on all cars in the Ford city lot?. v) Suppose all U.S. domestic auto sales increase over last year by 5% in response to a 10% price decrease. What is the implied price elasticity? = -5/10 = -.5 vi) You can say a lot about the optimality of pricing from elasticity. Consider a firm selling plastic 3-sided rulers (inches, centimeters, and thumbs). Suppose that price elasticity was -.2. What can you say about the optimality of the firms' pricing decision? B. Other Demand Elasticities. Elasticity is a sensitivity measure that may be of interest with respect to any independent variable. Some other important elasticities can be readily calculated from a demand function. Here at the end of the lecture, we introduce one: Cross price elasticity 1. Cross Price Elasticity. The purpose of a cross price elasticity estimate is to capture some sense of the responsiveness of sales for one good to a change in the price of some related good.

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a. Definition. The cross price elasticity of good x with respect to a change in the price of a related good y is: XY %Qx/%Py or, decomposing, XY = (Qx/Py)(Py/Qx)

Using our point price elasticity formula, this could be calculated as: XY = Qx Py Py Qx For example, with a demand function Qx = 98 10Px + 4Py 5 = 98 10(5) + 4(3) = 60

Let Px = And Py = 3 Thus, Q

The cross price elasticity of Qx w.r.t. a change in the price of Py would be 4(3)/62 = .2 Notice that cross price elasticity information can be used to distinguish substitutes from complements. In this case, the coefficient is postitive, indicating that the products are substitutes.

Lecture 15 REVIEW___________________________________________________: III. Quantitative Demand Analysis A. Price Elasticity of Demand 5. Elasticity TR and MR. A firm maximizes profits on the elastic portion of the demand curve 6. Determinants of Price elasticity Availability of close substitutes Price as a Percentage of Income Time

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B. Other Demand Elasticities (introduction) 1. Cross Price Elasticities Review HW#5 Preview__________________________________________________________ B. Other Demand Elasticities 1. Cross Price Elasticity (continued) 2. Income Elasticity Lecture ______________________________________________________ B. Other Demand Elasticities. Elasticity is a sensitivity measure that may be of interest with respect to any independent variable. Some other important elasticities can be readily calculated from a demand function. 1. Cross Price Elasticity. The purpose of a cross price elasticity estimate is to capture some sense of the responsiveness of sales for one good to a change in the price of some related good. a. Definition. The cross price elasticity of good x with respect to a change in the price of a related good y is: XY %Qx/%Py or, decomposing, XY = (Qx/Py)(Py/Qx)

Using our arc price elasticity formula, this could be calculated as: XY = [(Qx1-Qx0)/(Py1- Py0)][(Py1 + Py0)/(Qx1+ Qx0) Percentage and point price changes are similarly calculated in a way that parallels the calculation of own price elasticity.. b. Interpretation: The percentage change in sales of good x brought about by a 1% change in the price of good y. c. Uses: i. To assess responses of competitor's actions. XY > 0 good are substitutes. XY < 0 goods are compliments. XY = 0 goods are unrelated

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Lecture 16 REVIEW___________________________________________________: II. Quantitative Demand Analysis B. Other Demand Elasticities 1. Cross Price Elasticity Preview__________________________________________________________ 1. Cross Price Elasticity (continued) 2. Income Elasticity 3. Advertising Elasticity C. Point price elasticities and demand functions 1. Linear Demand functions 2. Logarithmic Demand Lecture ______________________________________________________ B. Other Demand Elasticities. Elasticity is a sensitivity measure that may be of interest with respect to any independent variable. Some other important elasticities can be readily calculated from a demand function. 1 Cross Price Elasticity of Demand (continued) c. Uses: i. To assess responses of competitor's actions. XY > 0 good are substitutes. XY < 0 goods are compliments. XY = 0 goods are unrelated ii. Forecasting. Suppose you sell fish dinners. A close rival also sells the same, and lowers his price 20%. If the cross price elasticity of demand is 2, how much will you lose in terms of sales? 2 = (%Qx)/-20. thus, - 40% is the answer.

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iii. More complicated interactions. Continuing with the above example, Suppose your own price elasticity is -3. How much of a price increase would restore your sales? -3 = 40/%P. Implies 13.33% price decrease. 2. Income elasticity: a. Definition: The percentage change in demand brought about by a 1% change in income on aggregate demand. I = (Q/I)(I/Q)

via the arc price estimate, this is calculated as: = [(Q1-Q0)/(I1-I0)][(I1 +I0)/(Q1+Q0)]

Point and percentage change calculations are also parallel to those for price elasticity. b. Use: To assess effects of changes in underlying economic conditions - If 0 < I < 1, the good is noncyclical. Ex: Foods, shoes, gasoline. - If I > 1 We will say the good is cyclical. Ex: Autos, housing, luxury goods. - If -1< I < 0 the good is inferior - If I < -1 the good is countercyclical (Note: We dont talk much about countercyclical goods. There are few) c. Applications: i) Assessing susceptibility to economic conditions. With normal goods, firms with a big income elasticity of demand will grow quickly. Example, Income elasticity of demand for autos is 3. Such goods are also sensitive to decreases in aggregate income. ii) Forecasting: Suppose income elasticity for cigarettes is .6. A 5% increase in personal income could be expected to increase demand by : .6 x .05 = .03 or 3%.

3. Other Demand Elasticities. Elasticity is a sensitivity measure that may be of interest with respect to any independent variable. Some other important elasticities can be readily calculated from a demand function. To illustrate, we introduce one final elasticity measure, Advertising Elasticity a. Definition. The percentage change in Quantity induced by a one percent change in advertising expenditures.

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(Q/A)(A/Q)

- Using the arc elasticity formula = [(Q1-Q0)/(A1-A0)][(A1 +A0)/(Q1+Q0) A point advertising elasticity parallels the statement of the other elasticities. b. Uses: It is one of the variables the firm can control, and can use to respond to changes in the things it cannot control (such as the price of related goods, income etc.) Notice that advertising elasticity should be positive. If not, it is an advertising campaign that is detracting from sales. c. Examples. -Suppose that the income elasticity of demand is .5, and the advertising elasticity of demand is .2. If income falls by 2%, how much would a firm have to increase advertising to make up for the difference? (%Q)/(%I) = .5

If %I = -2, then %Q = -1. If A= .2, then 1/(%A) = .2, or %A = 5. -Suppose a competitor lowers the price of a good by 20% and that A = 1, XY = 2 and = -3. How much must you lower price in order to keep sales constant? How much must the firm increase advertising in order to keep sales constant? C. Point Price Elasticities and Demand Functions. Given the underlying demand function, we are able to make more precise elasticity calculations. We will consider first how to draw inferences from linear demand specifications. This will be followed by inferences from a second popular demand specification, a logarithmic specification. 1. Elasticity and Linear Demand Estimates. Consider the following demand function (say Q = mugs of beer in local restaurants), Pf = the price of meals, A = Advertising expenditures) Q = -50P + 20I -5Pf + .1A Where I is measured in 000's of dollars. and where I = $10,000, Pf = $10, A = $500, and, say, P = $2. Then Q = 200 - 50(2) = 100 60

- Point price elasticity is dQ/dP = -50 = -50(2)/100 = -1. - Point income elasticity is dQ/dI = 20 I = 20(10)/100 = 2 - Cross price elasticity is dQ/dPf = -5 bf = -5(10)/100 = -.5 - Advertising elasticity is dQ/dA = 0.1 A = 0.1(500)/100 = .5 And you can do exactly the same exercises as before. i) Suppose that GNP increases by 5%. How much could restaurants raise price and keep sales constant? 2 = x/5 implies a 10% increase in sales. To offset the sales increase, a 10% increase in price would suffice. ii) Suppose that food prices increase by 10%. What change in advertising expenditures would keep sales constant? Answer: Food price increases by 10% imply that beer sales decrease by 5% (due to the cross price elasticity of -.5) A 10% increase in advertising expenditures would offset the change. 2. Logarithmic demand. A problem with trying to do exercises with interrelated elasticities in this context is that the elasticity coefficients change with alterations in the value of the independent variables. It is for this reason that an alternative specification is used frequently. This alternative specification, called a constant elasticity demand curve, has the property that elasticities remain constant. Q = aPb1Ib2 If a = 200, b1 = -.3 and b2 =2, then

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Q = 200P-.3I2 Although this looks obtuse, it is in fact pretty useful. Most importantly, it is readily estimated, by taking logarithms: log Q = log 200 + -.3 log P + 2 log I.

More importantly, the parameters in this case are directly the elasticities. It is for this reason that this is called a constant elasticity demand function. It is a useful approximation when you wish to assume that elasticity of demand is constant. (Q/P)(P/Q) = = ab1Pb1-1 Ib2(P/Q) b1

With this information we can examine firm responses to own and other effects. 3.. Some Practice Exercises with Demand Functions. i. Example: Joe Doe, CEO of Doppler Inc. observes the sales of his weather radar printers fall 10% in response to a 5% increase in the price of weather tracking software. a. What is the implied cross price elasticity of demand? How are radar printers and weather tracking software related? What would be another example of such goods? b. Suppose that own price elasticity is -.5. Approximately, how much, and in what direction could John adjust the price in order to restore sales quantity to its original level? Would such a response be a profitable? ii. Example Suppose that the income elasticity for Calaphon aluminum cookware is 1.5, and that the advertising elasticity is 2. Approximately how much, and in what direction could Calaphon adjust its advertising revenues to counteract the effects of a projected 5% decrease in GNP in the coming year? iii. Example Suppose that the demand function for Sorby Floppy disks is of the form Qx = 600 - 40Px + .2Py + 2I Where Qx = Hundreds of packages of Sorby Floppy disks sold in the U.S. per week, Px = the price of a package of the disks. Py = the price of upgrade Hard Disk Drives for Personal Computers. I = per capita income (in thousands of dollars). Suppose that at present Px = 10

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Py = 300 I = 10,000. a. Calculate the point price elasticity of demand, the point cross price elasticity of demand for computer disks with respect to hard disk drives, and the point income elasticity of demand. Qx = 600 - 40(10) + .2(300) + 2(10) = 600 - 400 + 60 + 20 = 280 = -40(10)/280 = -1.43

Thus

b. Given the above demand relationship, what can you say about the relationship between hard-disk drives and floppy disks? Why? Answer: The sign on the intercept for hard disk and floppy disks is positive, indicating that an increase in hard-disks will increase floppy disk sales. The products are substitutes. c. Given the above demand relationships, are computer disks a normal or inferior good? Why? Answer: The positive sign on the income coefficient indicates that the floppy disks are normal goods. Incidentally, the income elasticity is = 2(10)/280 = -0.07.

Thus, the goods are noncyclical normal goods. d. Could the makers of computer disks increase profits by raising prices? Why or why not? Answer: You cant tell. The firm is on the elastic portion of the demand curve. An increase in prices will decrease both revenues and costs. A definitive answer could be given in this case only with information about the cost function. iv. Example You can do problems with non-linear equations. Suppose, for example, that the demand function is given by logQx = 5 - 1.7log Px + .3log S - 3 log Ay Then what is price elasticity of demand? Answer = -1.7

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Lecture 17 REVIEW___________________________________________________: III. Quantitative Demand Analysis C. Point price elasticities and demand functions 1. Linear Demand functions 2. Logarithmic Demand Preview__________________________________________________________ D. Estimating Demand: Regression Analysis. 1. The Bivariate Case 2. The Multivariate Case LECTURE_________________________________________________________ D. Estimating Demand: Regression Analysis. Our intention in this section is to learn from where the parameters of a demand function might come. That is, given the relationship Y = A + B1X + B2P + B3I + B4Pr Where Y X P Pr = qty. demanded = advertising and promotional expenses = price of a good = price of a related (competing) good.

We would like to know how to get values for the parameters A, B1, B2, B3, and B4. Regression analysis is simply a statistical tool that allows us to estimate the magnitude of these parameters. Estimates may be made from the price and quantity data generated in the sales process. a. Advantages i. Inexpensive ii. Non-invasive c. Disadvantages Estimates may be unreliable or imprecise. (But we can learn to qualify appropriately results) 1. The Bivariate Case. Suppose in some simple world, sales are only affected by advertising expenditures. Assume also that the factors are linearly related. Then we have Y = A + B1X.

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Suppose further, however, that this specification is a model - by assumption a simplification from the natural world. Suppose that there is some random error e in our estimate. That is, for each observation i, Yi = A + B1Xi + ei ei has a mean of 0. Graphically Q B

}A A This is called a population regression line. (or the true underlying relationship). Of course, we don't see the underlying population regression line. Rather, we must try to estimate it from available data. The general expression for this sample estimate is ^ i = a + bXi. That is, given Xi, we pick a and b to estimate i . For example, an estimate might be: ^ i = 2.533 + 1.504Xi Sales ^ * Y * * * 1.504 * * * * * } 2.533 X = Advertising The method of least squares is simply a way to pick the intercept and slope of a line that gives a best fit of the points. The idea is simply to minimize the sum of squared differences ^ between Yi and i. We will call this sum S, or 65

S S

= =

^ (Yi - i )2 (Yi -a - bXi )2

To optimize this equation, simply take the derivatives and solve: (but we will skip this derivation!) 2. Multivariate Regression. The intuition that we have motivated with a single variable readily extends to multiple variables. Although the calculations quickly become very messy, they are easy to do with a computer. a. The Problem. Consider our original problem, but now include P; Yi = A + B1Xi + B2Pi + ei

(assume that X and P are independent, and that the average ei is 0) via a regression, we can compute and estimate: ^ = a + b1Xi + b2Pi i Via such an analysis you would generate a demand function estimate of the type Yi = 100 + 4X 2.5Pi

We could, with this linear relationship, do precisely the sorts of elasticity calculations and estimates that we discussed just prior to the first exam.

Lecture 18 REVIEW___________________________________________________: III. Quantitative Demand Analysis . Estimating Demand: Regression Analysis. 1. The Bivariate Case 2. The Multivariate Case (Recall, regression analysis is just an analytical way of picking the intercept and the slope of a line to best fit the data, where by the term best fit we mean a line that minimizes the sum of squared deviations between observations and the estimated line. Squaring deviations has the advantages of (a) keeping positive and negative deviations from canceling each other out, and (b) paying particular attention to outliers. Preview__________________________________________________________ 3. Doing regressions. Examples and an analysis of regression output.

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4. Interpreting the Significance of Individual Parameter Estimates. 5. Forecasting. LECTURE_________________________________________________________ 3. Doing regressions. Examples and an analysis of regression output. Regressions are quite easy to do with a spreadsheet. a. Lets start with a bivariate case. Suppose we are interested in estimating the relationship between sales of a good (Yi) and advertising expenditures (Xi). We have the following data. Sales Yi 4 6 8 14 12 10 16 16 12 Adv Xi 1 2 4 8 6 5 8 9 7

We can use a spreadsheet to do many the appropriate calculations. In class, we will replicate these columns on EXCEL, and use the regression package to yield the following result (I interpret regression output more fully below, but here are your parameters) ^
i

2.533 +

1.504 Xi

b. A Multi case. Adding independent variables is straightforward. Consider our original problem, but now include price. P; That is, we estimate Yi = A + B1Xi + B2Pi + ei as ^ = a + b1Xi + b2Pi i Using a spreadsheet, suppose we extend our original as follows: Sales (mill U) 4 6 8 14 Adv Exp 1 2 4 8 Price 1 0.5 5 8

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12 10 16 16 12

6 5 8 9 7

4 3 2 7 6

Regressing the first column on the second and third generates a = 2.61, b1=1.75 and b2=-0.36

(Observe that the b1 coefficient changes from before (now it is 1.76 vs 1.5 before. The reason is that the new equation holds constant the effect of price changes. Notice that we can do the same exercises that we did with other elasticity estimates. Suppose, for example, that p = 20 and Sales Exp. = 6. Then what is the price elasticity of demand? Q = 2.61+ 1.765(6) - 0.36(20) = 6 Thus, = -0.36(20)/ 6 = -1.2.

c. Regression Output. A more detailed overview.. In this section, we review regression results. In this course, we will focus on just three aspects of regression results. (a) The goodness of fit or R2, (b) the standard error of the regression estimate, and (c) the standard errors of the coefficient estimates. Suppose that you conduct a linear regression of the equation: Q = o + 1 P + 2 P y + 3 A where P is the price of the good, Py is the price of a substitute good, and X are advertising expenditures. Your data look like the following
Q 50 40 60 50 35 40 61 46 52 26 33 P 5.8 6.2 5.1 5.5 4.8 5 3.8 4.5 4.3 7 5.6 Py 10 9 15 11 9 10 17 8 11 7 9 A 10 20 10 13 7 11 22 13 15 6 8

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47 51 29 42 19 72 30 41 32 47 65

4 4.5 7 4.8 12 5 6.8 5.2 6 5 3.7

11 15 8 12 6 18 6 9 12 10 17

12 15 12 22 10 18 10 20 11 21 10

Notice that you have a total of 22 observations. Now, if you input this data into EXCEL and run a regression, you will get output in three blocks of rows. At the top, you get

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Regression Statistics Multiple R 0.904081 R Square 0.817362 Adjusted R 0.7869 Square Standard 6.158553 Error Obs 22

Here, you should pay attention to two things. First note R2 . R2 is a descriptive measure indicating how well the estimate fits the regression line. A number closer to 1 indicates a better fit. Second look at the Standard Error (here 6.15) we will use this later when we talk about forecasting A second block of information is the following:
Coefficient s Intercept
X Variable 2 X Variable 3 X Variable 4

Standard Error 10.08245 0.971137 0.488371 0.291057

t Stat 2.400875 -2.13058 5.365095 0.675724

P-value 0.027378 0.04717 4.24E-05 0.507805

Lower 95% Upper 95% 3.024246 -4.10937 1.594126 -0.41481 45.38916 -0.0288 3.646185 0.808163

Lower 95.0% 3.024246 -4.10937 1.594126 -0.41481

Upper 95.0% 45.38916 -0.0288 3.646185 0.808163

24.2067 -2.06908 2.620155 0.196674

This information summarizes the descriptive power of individual coefficients. Observe first that the variables are simply summarized as X Variable 1, X Variable 2 and etc. You should replace these with your variable titles, for example:
(1) (2) Coefficients 24.2067 -2.06908 2.620155 0.196674 (3) Standard Error 10.08245 0.971137 0.488371 0.291057 (4) t Stat 2.400875 -2.13058 5.365095 0.675724 (5) P-value 0.027378 0.04717 4.24E-05 0.507805 (6) (7) Lower 95% Upper 95% 3.024246 -4.10937 1.594126 -0.41481 45.38916 -0.0288 3.646185 0.808163 Lower 95.0% 3.024246 -4.10937 1.594126 -0.41481 Upper 95.0% 45.38916 -0.0288 3.646185 0.808163

Intercept Price Price of X Advertising

Now, the second column provides an estimate of the parameter values, for example, our estimated equation is Q = 24.207 2.069 P + 2.62 Px + 0.197 Adv. Column 3 provides some particularly interesting information, in that this is a measure of the precision of the estimate. It is called the standard error of the parameter estimate i , or . For those of you who remember some statistics, you may recall from the central limit

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theorem, that about 95% of standard errors fall within the range i 2 Columns (6) and (7) provide a more precise statement of the bounds of 95% confidence bands about particular parameter estimates. If these bounds exclude 0, then you may conclude at a 95% level of confidence that the parameter explains some of the movement in the dependent variable. 4. Interpreting Significance of Parameter Estimates Column (4) lists the t test statistic for each parameter estimate. This test statistic is simply the parameter estimate divided by its standard error. The test statistic is just an alternative way to assess whether or not estimates fall within the i 2 bound. Suppose, for example, that the lower bound of the 95% confidence range for an estimate is i -2 =0 implies that (i)/ = 2 or that the bounds of the confidence band just equals zero. If the lower bound was greater than zero, for example, i -2 =1, then i / = 1/ +2, a number larger than 2. Oftentimes, you will see the information from your regression output summarized in a write up as follows Q = 24.207 2.069 P + 2.62 Px + 0.197 Adv. R2 = .82 , n=22 (10.1) (0.97) (0.49) (0.29) Where the standard errors are written in parentheses below the coefficient estimates. I would like you to be able to interpret the following from this information: a) The variability of individual parameter estimates. There is (roughly) a 95% chance that the true value of any coefficient estimate is within 2 of the estimate. For example, the price coefficient is in the interval 2.069 2(0.97) and 2.069 +2(0.97), or -4.09 to -.129. Thus the price coefficient is, significantly less than 1 with a 95% probability (alternatively, you might observe that -2.069/.97 = -2.13 Lecture 19 71

REVIEW___________________________________________________: III. Quantitative Demand Analysis . Estimating Demand: Regression Analysis. 3. Doing regressions. Examples and an analysis of regression output. Preview__________________________________________________________ 4. Interpreting the Significance of Individual Parameter Estimates. 5. Forecasting. IV. Chapter 5. The Production Process and Costs A. Introduction: B. The Production Function. LECTURE_________________________________________________________ 4. Interpreting the significance of individual parameter estimates. Example #1. If I give you the estimated equation Q = 24.207 2.069 P + 2.62 Px + 0.197 Adv. (10.1) (0.97) (0.49) (0.29)

R2 = .82 , n=22 SER = 2.2

I might ask whether or not price was a significant explainer of sales. You could evaluate this by adding and subtracting 2 times the std. error of the regression to the parameter estimate. If the interval doesnt include zero then at a 95% level of confidence, an inverse relationship exists between price and quantity. -2.069 + 2(.97) = -.129 - 2.069 2(.97) = -4.009 Result: Yes, price is inversely related to quantity. On the other hand, consider advertising .197+ 2(.29) = .1125 .197 2(.29) =-.383 This interval includes zero, so we cannot conclude that there is a direct relationship between advertising and quantity at a 95% level of confidence. Comments on Multivariate Regression. Obviously, when constructing a demand relationship, you have some choice as to which variables to include. Increasing the number of independent variables always improves your estimate in the sense

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that you get a better "fit." (Intuitively, by adding terms you gain extra latitude in trying to minimize the squared differences between observed and predicted data.) Nevertheless, it is generally not a good idea to add variables to "maximize the fit," for you can easily add in too many things, disguising possible significant relationships. Question: In the above, if Advertising does not significantly affect sales, should we delete it from the analysis? No, because advertising may still be important, and deleting imwe might introduce bias. In general, the appropriate approach is to include all variables for which you have a straightforward reason for including. 5. Forecasting. One can also get a feel for the precision of a forecast by using the SER Given independent variable values one can construct an approximate 95% forecast interval by adding and subtracting 2* the MSE of the regression to the point estimate. For example, example 1 above, suppose P = 2, Px = 1 and Adv =10. Then Q = 24.207 2.069(2) + 2.62 (1) + 0.197 (10) = 24.659 An approximate 95% confidence interval about the estimate would be 24.659 + 2(2.2) = 29.059 24.659 - 2(2.2) = 20.259 Your estimates get worse the further away you get from the mean of the sample. Thus, observations out of the range of the sample are very speculative. (Example: Can you forecast future sales, given price and advertising expenses? It depends on the relationship between your proposed price and advertising expenditures, and those you've observed in the past.) Also, your forecasts will be worse, to the extent that there is any expectation that the future may be different from the past (For example, a forecast of cigarette sales would be very considerably more variable than a 95% confidence interval would suggest were there some substantial possibility that cigarette sales would be outlawed next year.

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Some additional examples: Example #2: Suppose you conduct a regression with n=9 data points, and generate the following results: Qi= 10 - .5Pi + .1 Ai (5) (.03) (.2)

n = 9, R2 = .83 SER = .5 - Interpret R2, - Does price explain movement in sales? IF p=4 and A=10, make a 95% confidence interval for sales

Example #2. Consider a regression with the log of data. lnQi= 50 - .2 ln Pi + .12ln Ai (20) (.3) (.08) n = 12, R2 = .68, - Interpret R2 -. Does price alone explain movement in sales, Qi? Notice finally, that we can make one further interesting insight with a log linear regression. Observe that =-.2 Notice that two standard deviations about -.2 are not necessarily greater than zero. However, this interval does not include -1. Thus, we can conclude that we are on the inelastic portion of the demand curve. Lecture 20 REVIEW___________________________________________________: III. Quantitative Demand Analysis . Estimating Demand: Regression Analysis. 4. Interpreting the Significance of Individual Parameter Estimates. 5. Forecasting. Preview__________________________________________________________ IV. Chapter 5. The Production Process and Costs

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A. Introduction: 1. Overview. 2. The Role of the Manager in the Production Process. B. The Production Function. 1. Short Run Production. b. Relationships between Productivity Measures. Lecture _______________________________________________________________ A. Introduction: 1. Overview. The purpose of this chapter is to provide tools allowing a manager to make better decisions about choosing which inputs to use in a production process, and what level of output to produce. To a large extent, this chapter is a much more detailed development of the material motivating the supply decisions of the firm that we used to develop the supply and demand model of chapter 2. The discussion falls into 2 parts. A first part deals with production theory or the right combinations of inputs to employ. The second part costs addresses the appropriate level of output. We start with production

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2. The Role of the Manager in the Production Process. In turn production (input acquisition and use) has two dimensions: (i) Planning (or deciding what types of fixed productive assets to acquire), and (ii) Operating. In the operating horizon, the manager must attend to two issues. These are much easier to articulate than to do a. Produce on the Production Function. A production function illustrates the maximum amount of output feasible given a particular set of inputs. If the workers do not work to maximum capacity, less will be produced. One very important managerial function is to motivate workers to work efficiently. Observation: The same sorts of principle-agent problems that we mentioned in chapter 1 could be a problem for managers here as they try to develop compensation schemes for their employees.. Clothes sales-people are paid sales commissions and waiters tips as a means of improving service. We will talk more about these problems in chapter 6. b. Use the Right Level of Inputs. The manager must decide the optimal amount of variable inputs to use. (The right number of sales people, or waiters, etc.) To analyze this question, we must characterize the productivity of inputs. That is our next project. B. The Production Function. We start by characterizing the way that inputs are converted in to units of output. The process is represented by a production function, which illustrates the maximum amount of output available for a given combination of inputs. Although the production function that is appropriate for a particular circumstance is particular to that firm, the general issues underlying production analysis are illustrated by considering a generic production function Q Where = F (K, L) Q K L = units of output = units of capital input (typically machines of some sort) = units of labor input.

Notice that although this function is generic, it is not a poor general description of the production process. Most typically, production requires some combination of machines and labor. Time Horizon: Economists often find it convenient to divide input allocation decisions into two parts. The parts are distinguished by time frame. In a short run some factors of production (usually capital) are fixed. In the long run, all factors are variable. Thus, the short run is an operating horizon, where the optimal amount of

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variable inputs are chosen. In distinction, the long run is a planning horizon, where all inputs are variable. Observation: The amount of time necessary to define the short run varies across industry. The short run in steel production, for example, is a much longer period of time than the short run for a pizza maker. Nevertheless, in either environment, within the short run the same sort of issues are relevant. 1. Short run decisions. As just mentioned, in the short run some factors are fixed. Let us assume that K, capital is fixed at level K*, or Q = F(K*,L)

Then, the relevant problem is to determine the optimal amount of variable input L. To answer this question, consider the following production relationship K* L 1 1 1 1 1 1 1 1 Q = TP / = 4 6 8 6 4 2 0 -2 Q/L = APL 4 5 6 6 5.6 5 4.2857 1 3.5

2 2 2 2 2 2 2 2 2

0 1 2 3 4 5 6 7 8

0 4 10 18 24 28 30 30 28

Notice in the above relationship that K is fixed at 2 units. If PK= $100 per day, then fixed costs = $100*2 = $200. a. Measures of Productivity. Now lets consider the variable input. First, we must define some terms. Total Product: (TP) is simply the maximum total output available from a given combination of inputs. Average Product (AP) is the average output for all units of a given input. In the above table the average product of the variable input labor APL = Q/L

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Marginal Product (MP) is the change in output associated with the use of an additional input unit. The above table the marginal product of labor, is MPL = Q/L Observation: Diminishing Marginal Productivity : As is the case in much of economic analysis, marginal decisions play a pivotal role in production analysis. In the table, notice that MP first increases, then decreases. This is a very typical pattern, and reflects basic economic assumptions. As a few resources are hired, there are gains from specializing the use of these inputs (for example, by dividing tasks and creating an assembly line). After a while, however, factors begin to experience some crowding (e.g., workers on the line start getting in each others way.) Thus, declining marginal productivity is a consequence of the law of diminishing returns. Eventually, crowding becomes so severe that marginal productivity is negative. In this case, total output actually falls as extra units of input are hired. No rational manager would use resources to the point of negative marginal productivity. But notice also, that diminishing marginal productivity is not a consequence of worse or lazy workers. Rather it is a consequence of crowding. b. Relationships between Productivity Measures. The productivity measures are related systematically. These interrelationships can be seen by plotting the curves suggested in the above table. These charts appear below.
35 30 25 20 15 10 5 0 0 1 2 3 4 5 6 7 8 9 MP TP

10 8 6 4 2 0 0 -2 -4 1 2 3 4 5 6 7 8 9 MP AP

Increasing

Decreasing

Negative

78 AP MP

Marginal Returns

Marginal Returns

Marginal Returns

i. TP, MP and AP. In the upper table: The marginal productivity is illustrated as the slope of the line tangent to the total product curve. Notice that the curve first increases at an increasing rate (reflecting gains from specialization), then increases at a decreasing rate (the law of diminishing returns) finally peaks out and decreases (indicating negative marginal productivity). In the lower table the marginal schedule also reflects the combination of first increasing marginal returns, then decreasing marginal returns, and finally negative marginal returns. Observation: The above curves do not line up exactly. (Ive stretched out the lower cuve a bit) This is because we use discrete rather continuous changes. If I had used an actual function and taken derivatives for the marginals this sort of adjustment would not have been necessary. Observation: An optimizing firm will always produce in the range of decreasing marginal returns to labor. Reason: A firm would never stop where there are increasing marginal returns, because if it is profitable to hire a worker who makes 6 units per hour, it should be profitable to hire a worker who makes more than 6. Similarly, a firm would never stop when there are negative marginal returns, because output could be increased by laying off workers and cutting production expenses. ii. The relationship between marginal and average. Note the relationship between the MP and the AP curves. The marginal curve drives the average curve. This is a general relationship and we will see it often. Motivation: Consider the grades of a representative student. Semester 0 1 2 3 4 5 6 MGP 3 3 2 1 2 4 Overall GPA 3/1 6/2 (3+3+2)/3 = 2.67 (3+3+2+1)/4 = 2.25 (3+3+2+1+2)/5 =2 (3+3+2+1+2+4)/6= 2.5

Intuition: The average conveys the same information as the marginal, but it is a less volatile measure. The average carries the weight of all previous semesters grades. Rule: When the marginal is below the average, it pulls the average down, when the marginal is above the average, it brings the average up.

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Lecture 21 REVIEW___________________________________________________: IV. Chapter 5. The Production Process and Costs A. Introduction: 1. Overview. 2. The Role of the Manager in the Production Process. B. The Production Function. 1. Short Run Production. a. Relationships between Productivity Measures. b. The relationships between Marginals and averages. c. Optimal Use of a Single Input. i. Rule ii. Comparative Statics 3. Long Run Production a. Optimal Use of Multiple inputs Preview__________________________________________________________ c. Optimal Use of a Single Input . i. VMP. To decide the appropriate level of a variable input to use, simply convert productivity into value. Do this by multiplying marginal productivity in units, by the value of the units. For labor. VMPL = PQ(MPL). (Similarly, for capital VMPK = PQ(MPK). The optimal hiring decision for labor can be seen by modifying the production function above. Suppose that output sells for $3 per unit, and that labor costs $400 per week. Then the following relationship applies.

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L 0 1 2 3 4 5 6 7 8 Graphically
1000 800 600 400 200 0 0 -200 -400

L 1 1 1 1 1 1 1 1

Q = TP 0 4 10 18 24 28 30 30 28

Q/L = MPL 4 6 8 6 4 2 0 -2

PQ

VMPL

PL

100 100 100 100 100 100 100 100

400 600 800 600 400 200 0 -200

300 300 300 300 300 300 300 300

PL

8 VMPL

Rule: Profit Maximizing Input Usage: To maximize profits a manager should use an input L up to the point where VMPL is as close to w as possible without w exceeding VMPL. ii. Comparative Statics. Notice that you can use the above graph to anticipate the response of a firm to changes in underlying conditions. For example, what would be the effects of a change in the PL? What would be the effects of a change in the price of inputs?

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Examples. Starting from an initial equilibrium, consider the effects of an increase in the price of labor on the amount of labor employed $

w w VMP = MP*PQ L* L L

As seenSuppose now chart, the optimal amount more popular, and consequently, PQ in the above that the product becomes of labor will fall. increases. $

VMP* w

VMP = MP*PQ L* L L

This outward shift of the VMP schedule will increase the amount of labor employed. A labor enhancing improvement in the production function will have a similar effect.

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2. Long Run Production. Now, let us suppose that a firm can vary all its factors of production. Starting from the relationship VMPL = MPLPQ = PL Observe that we might rewrite MPL/ PL = 1/PQ If the firm had multiple inputs, this relationship should hold for all inputs. That is, for inputs i, j MPi /Pi = MPj Pj

This is called the least cost combination of inputs. It is an important and general principle of hiring multiple inputs: A firm should hire resources until the marginal value per dollar spent is equal for all inputs.

Example: Jones & Printing Co. is presently paying $10 per hour for labor, and $5 per hour for Printing Machines. - If the Marginal Productivity of labor is 100 pages per day, and the marginal productivity of machines is 150 per day is it using a least cost combination of inputs? - If not which machines should be used relatively more? Example: Suppose that Randolph Tire Co. Currently uses Labor and Rubber Banding Machines to finish tires. Suppose that labor is negotiating its contract, and asks for a 33% increase in salary. Management argues that the consequence of such a wage increase will be a sharp reduction in the number of employees. Employees dont believe management. They firmly believe that management will continue to employ the same number of workers even after a substantial wage increase. Lecture 22 REVIEW___________________________________________________: IV. Chapter 5. The Production Process and Costs B. The Production Function. 1. Short Run Production. Optimal Allocation of a single resource: Hire until VMPL = PL 2. Long Run Production Optimal Allocation of multiple inputs: Hire until MPL/PL= MPK/PK

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Preview__________________________________________________________ C. Costs. 1. The relationship of production functions to cost functions. 2. Short run costs. a. Cost curves b. Sunk vs. Variable Costs Lecture____________________________________________________________ C. Costs and the Theory of the Firm 1. The Relationship of Production Functions to Cost Functions. To provide some context for this discussion, consider the problem of producing blueberry tarts in my house. We may have the following relationship. (a) Inputs: (Number of Workers) 0 1 2 3 4 5 6 (b) Output (Number of Blueberry Pies) 0 5 15 23 29 33 35 (c) Marginal Pies 5 10 8 6 4 2 (d) Marginal Costs Per pie (Assume that labor costs $20 per unit, and that ingredients are free) $20/5 =$4 $20/10=$2 $20/8 = $2.5 $20/6 = 3.33 $20/5 =$5 $20/2 = $10

In the lecture on short run production, we focused on the relationship between the number of workers (column a) and the marginal productivity of those workers (column c). A closely related question pertains to the relationship between the number of pies made (column b) and the marginal costs of making pies (column d). Observations - After exhausting gains from specialization the relationship between units of labor and marginal productivity is inverse. This motivates the labor demand curve we developed last time in class.

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Marginal Number of Pies (Column c)

12 10 8 6 4 2 0 0 2 4 6 8 Units of Labor (Column a)

- Conversely, the marginal cost curve first falls, and then, upon exhausting gains from specialization, increases.
$12 $10 $8 $6 $4 $2 $0 0 10 20 30 40 Units of Output (pies column b)

- Intuitively, marginal costs increase as Marginal productive decreases, because the marginal productivity increases imply that more labor is imbedded in each unit of output. In this section we focus on this latter view of the relationship between inputs and outputs. We start with the single output case, first in the short run, and then in the long run. Then we consider some aspects of costs in a multi-product environment. 2. Short Run Costs. Recall that the short run is defined as a timeframe where there are unavoidable input commitments, as well as variable inputs. The short run cost function may be used to describe this relation. a. Cost function components.

Marginal Costs Extra Pies (Column d)

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Fixed costs: Costs associated with fixed input commitments. These costs do not change with the level of output Variable costs: Costs associated with the variable components. These costs vary with the level of output. b. Total cost relationships. One way to represent these costs is in terms of total expenditures. Lets shift to a new problem expressed exclusively in terms of Q. Consider, for example, the first three columns of the following table.
Q 0 1 2 3 4 5 6 7 8 TFC 10 10 10 10 10 10 10 10 10 TVC 0 6 10 12 16 23 35 53 78 TC 10 16 20 22 26 33 45 63 88 MC 6 4 2 4 7 12 18 25 AFC 10 5 3.333333 2.5 2 1.666667 1.428571 1.25 AVC 6 5 4 4 4.6 5.833333 7.571429 9.75 ATC 16 10 7.333333 6.5 6.6 7.5 9 11

Graphically, these relationships appear as follows:

100 80 60 40 20 0 0 2 4 6 8 10 MC

TC

TC

TVC

MC

TVC
TFC

Observations

FC

-Notice that the TVC and the TC curves both take on the shape of a recliner: that is, first increasing at a decreasing rate, and then increasing at an increasing rate. The difference between the two curves is TFC, which is a fixed amount. -Notice also that the slope of the line tangent to either TVC or TC is the marginal cost. Marginal costs first decrease and then increase due to the law of diminishing returns. (This is the same logic as diminishing marginal productivity: At the outset, gains from division of labor increase. Thus marginal productivity

86

increases, and marginal costs increase, reflecting gains from specialization. Later, as the law of diminishing returns sets in, marginal productivity falls, as marginal costs increase. Intuitively, more labor is imbedded in each unit of output.) c. Average Cost Relationships. The same relationships can be generated by dividing costs by quantity, to get per unit costs. In this case: AFC AVC ATC MC = = = = TFC/Q TVC/Q TC/Q TC/Q (Average Fixed Costs) (Average Variable Costs) (Average Total Costs

These are illustrated in the rightmost columns of the above table. Graphically, these curves are represented as
30 25 20 15 10 5 0 0 2 4 6 8 10 ATC AVC MC

Observations - ATC and AVC approach each other as quantity expands. This is because the difference between the two curves is AFC. AFC is a fixed quantity allocated over an increasing number of units. - MC intersects ATC and AVC at their minimum points. This follows for the same reason that MP intersects AP at its peak: The marginal drives the average. The averages reflect the same information as the marginal. The marginal is more volatile, however, because it is not weighed down by the effects of any output other than the current increment. Lecture 23 REVIEW___________________________________________________: IV. Chapter 5. The Production Process and Costs C. Costs. 1. The relationship of production functions to cost functions. 2. Short run costs. 87

a. Cost curves 1. TC, TVC and TFC 2. MC, AVC and ATC a. Relationship between MC and AVC/ATC b. Relationship between AVC and ATC Preview__________________________________________________________ b. Sunk vs. Variable Costs c. The supply curve for the firm d. Algebraic Forms of the Cost Function. e. Sunk costs vs. Variable Costs 3. Long Run Costs a. Long run average costs b. Economies of Scale c. Lecture____________________________________________________________ C. Costs and the Theory of the Firm 2. Short Run Costs: Observations (continued) c. The Supply Curve for the Firm: The price a firm might receive for producing units is often dictated by factors beyond the firms control. However, suppose that price is fixed. Observe that a firm will shutdown if unit revenues do not exceed AVC. The firm will breakeven when P = ATC. o Why would a firm produce at a loss in the short run? A firm can minimize losses by producing at a loss. For example, suppose you were a plumber and you had fixed cost obligations of $500 per month for licenses and tool payments. Suppose you there was a job that would cost you $1000 in variable cost to complete. How much must you earn to break even? How much must you earn to take the job? o What does breakeven mean? The breakeven point implies that all factors of production (including the entrepreneur) are earning enough to be indifferent between staying in the industry and doing something else. Firms earn normal profits at the breakeven point. d. Algebraic Forms of the Cost Function. The appropriate specification of the cost function depends on the underlying cost relationships. However, a cubic cost function is often used, because it is sufficiently general to allow any relationship. If C(Q) f + aQ + bQ2 + cQ3

Notice that fixed costs are f.

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Marginal costs are the derivative of C(Q), or C(Q) = a + 2bQ + 3cQ2

Notice that other cost relations are easily derived. For instance, average variable costs are AVC = a + bQ = + 200 cQ2 + 2Q2

Example: Suppose C(Q)

What are marginal costs, average fixed costs, average variable costs and average total costs when Q=10? When are average total costs minimized? (To be worked in class). C(10) = 200 +2(10)2 this is total cost ATC = 400/10 = 40 ATC = 200/Q + 4Q ATC min =100 -2Q2 100/3 = Q2 The firm earns 0 profits at the ATC min, or when MC=ATC At what price would the firm earn 0 profits? At what price would the firm shut down? e. Sunk vs. Variable Costs. A final distinction (and one weve made before). Fixed costs may be divided into two components: Sunk costs and recoverable costs. Sunk costs are costs forever lost after they are paid. This is an important distinction, for the opportunity costs of recoverable assets and sunk cost assets is remarkably different. Example: Suppose you are choosing between the purchase of a Toyota Corolla (for $12,500) and a GEO Probe (for $11,000). After a year the book value on the cars will be $11,000 and $7,000. What are the sunk cost components associated with the purchase of each car? How does this difference affect your decision to undertake a 5 year loan to pay for the cars?

3. Long-Run Costs. In the Long run, all costs are variable. As I indicated at the outset of this chapter, the long run may be viewed as the planning horizon, since the project for the firm is to pick the optimal plant size. Information about the Long-Run Average Cost curve is very useful for determining the structure of an industry.

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a. Long Run Average Costs. The long run average cost curve (LRAC) is the envelope of all short run costs curves. That is, the LRAC is the tangency of all efficient production points on for each plant size. ATC0 ATC1 ATC3 ATC2

Economics of Diseconomies of Scale Scale Efficient Plant Size Q In the above chart, the bold line is the LRAC. Note that the efficient scale of operation is not at the point of minimum marginal costs unless the firm is at an optimal plant size. b. Economics of Scale Economies of scale arise when LRAC falls as the plant expands. Diseconomies of scale arise when LRAC increases as the plant expands. Minimum Efficient Scale (MES): The first point where LRAC is at a minimum If a range exists where costs neither increase nor decrease, there exist constant returns to scale. Application: The shape of the LRAC can determine how many firms can survive in an industry. - Suppose that MES is 10,000 units, and that market demand, at a competitive price is 40,000 units. How many efficient firms can survive in the industry? - Suppose that MES is 10,000 units, but that diseconomies of scale set in very soon after achieving the optimal plant size. Can a single firm efficiently service the industry? - Suppose an industry is characterized by continuous diminishing returns to scale. What is the optimal industry structure? Lecturer 24 REVIEW___________________________________________________: IV. Chapter 5. The Production Process and Costs C. Costs. 90

1. The relationship of production functions to cost functions. 2. Short run costs. a. Cost curves 1. TC, TVC and TFC 2. MC, AVC and ATC a. Relationship between MC and AVC/ATC b. Relationship between AVC and ATC Preview__________________________________________________________ b. The supply curve for the firm c. Algebraic Forms of the Cost Function. Lecture____________________________________________________________ C. Costs and the Theory of the Firm Lecture: Discussion of the supply curve for the firm In the short run, a firm will produce the quantity Q* where MR = MC (or, in a world of discrete changes , the last level of output here MR exceeds MC). To determine profits and losses, compare AR to ATC. If it is the case that at Q* AR=ATC, the firm earns zero economic profits. This is known as the breakeven point. The breakeven point occurs where MC=ATC If it is the case that at Q* AR<AVC, the firm will shutdown. The point where AR=AVC at Q* is the shutdown point, that is, the lowest price such that the firm will produce at a loss in the short run. The shutdown point occurs where MC=AVC The supply curve for the firm is the MC curve above the shutdown point (e.g., where MC=AVC) d. Algebraic Forms of the Cost Function. The appropriate specification of the cost function depends on the underlying cost relationships. However, a cubic cost function is often used, because it is sufficiently general to allow any relationship. If C(Q) f + aQ + bQ2 + cQ3

Notice that fixed costs are f. Marginal costs are the derivative of C(Q), or C(Q) = a + 2bQ + 3cQ2

Notice that other cost relations are easily derived. For instance, average variable costs are AVC = a + bQ + cQ2

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Lecture 25 REVIEW___________________________________________________: IV. Chapter 5. The Production Process and Costs C. Costs 1. Short Run Costs. b. The supply curve for the firm c. Algebraic Forms of the Cost Function. Preview__________________________________________________________ c. Algebraic Forms of the cost function (continued) d. Sunk costs vs. Variable Costs Lecture____________________________________________________________ C. Costs and the Theory of the Firm 2. Short Run Costs: Observations (continued) Example: Suppose C(Q) = 200 + 2Q2

What are marginal costs, average fixed costs, average variable costs and average total costs when Q=10? When are average total costs minimized? (To be worked in class). C(10) = 200 +2(10)2 this is total cost ATC = 400/10 = 40 ATC = 200/Q + 4Q ATC min =100 -2Q2 100/3 = Q2 The firm earns 0 profits at the ATC min, or when MC=ATC At what price would the firm earn 0 profits? At what price would the firm shut down? e. Sunk vs. Variable Costs. A final distinction (and one weve made before). Fixed costs may be divided into two components: Sunk costs and recoverable costs. Sunk costs are costs forever lost after they are paid. This is an important distinction, for the opportunity costs of recoverable assets and sunk cost assets is remarkably different. Example: Suppose you are choosing between the purchase of a Toyota Corolla (for $12,500) and a GEO Probe (for $11,000). After a year the book value on the cars will be

92

$11,000 and $7,000. What are the sunk cost components associated with the purchase of each car? How does this difference affect your decision to undertake a 5 year loan to pay for the cars? Example: Suppose you are the Ford Motor Company, and you purchase vast quantities of titanium dioxide for use in catalytic converters. You purchase so much that the price of the metal skyrockets to $50 per ounce. Then a new catalytic converter technology is developed that no longer uses titanium dioxide. The market price of the compound falls to $2 per ounce. You have 100,000 tons of titanium dioxide. What should you do with it? Notice a firm whose fixed costs are sunk will behave differently that one whose fixed costs are resalable. Consider, for example the decision to stay in the airline industry when you can resell your fleet of planes, and when you cannot. You would stay in business longer when you cannot resell your fleet, because those costs are sunk.

Lecture 26 REVIEW___________________________________________________: IV. Chapter 5. The Production Process and Costs C. Costs 2. Short Run Costs. c. Algebraic Forms of the Cost Function. d. Sunk costs vs. Variable Costs Preview__________________________________________________________ 3. Long Run Costs a. Long run average costs b. Economies of Scale, Diseconomies of Scale and Long Run Survivability 4. Multi-Output Cost Functions Lecture____________________________________________________________ C. Costs and the Theory of the Firm 3. Long-Run Costs. In the Long run, all costs are variable. As I indicated at the outset of this chapter, the long run may be viewed as the planning horizon, since the project for the firm is to pick the optimal plant size. Information about the Long-Run Average Cost curve is very useful for determining the structure of an industry.

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a. Long Run Average Costs. The long run average cost curve (LRAC) is the envelope of all short run costs curves. That is, the LRAC is the tangency of all efficient production points on for each plant size. ATC0 ATC1 ATC3 ATC2

Economics of Diseconomies of Scale Scale Efficient Plant Size Q In the above chart, the bold line is the LRAC. Note that the efficient scale of operation is not at the point of minimum marginal costs unless the firm is at an optimal plant size. b. Economies of Scale Economies of Scale arise when LRAC falls as the plant expands. Reasons for Economies of Scale: - Physical Relationships (double a pipe diameter, and flow through expands quadratically) - Gains from specialization and division of labor Diseconomies of scale arise when LRAC increases as the plant expands. Reasons for Diseconomies of Scale Transportation Costs Crowding with respect to managerial efficiency Minimum Efficient Scale (MES): The first point where LRAC is at a minimum If a range exists where costs neither increase nor decrease, there exist constant returns to scale. Application: The shape of the LRAC can determine how many firms can survive in an industry. - Suppose that MES is 10,000 units, and that market demand, at a competitive price is 40,000 units. How many efficient firms can survive in the industry? - Suppose that MES is 10,000 units, but that diseconomies of scale set in very soon after achieving the optimal plant size. Can a single firm efficiently service the industry? - Suppose an industry is characterized by continuous diminishing returns to scale. What is the optimal industry structure?

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c. Measuring Returns to Scale. The notion of scale economies and diseconomies is related to production, and can be measured with a production function. A firm is said to enjoy increasing returns to scale if a constant increase in all inputs causes a more than proportionate increase in output. A firm that enjoys economies of scale does because it realizes increasing returns to scale The firm enjoys constant returns to scale if a constant increase in all inputs causes a constant increase in outputs. A firm with a range of plant choices at MES will enjoy constant returns to scale over this entire range. The firm has decreasing returns to scale if a constant increase in outputs causes a decreasing increment to outputs. Firms with diseconomies of scale may suffer decreasing returns to scale. Increasing, constant or decreasing returns to scale can be determined analytically. Here we introduce this by focusing on a specific form of production function Q = F(K,L) = (KL)a

Consider a production function consisting of both Capital and Labor, Q = F(K,L) = K x L. When one unit of each input is used Q = 1. Doubling both inputs increases outputs to 2x2 = 4. This firm has increasing returns to scale. A firm with the production function Q = F(K,L) = (KL).5 has constant returns to scale. To see this, observe that when K = 1, and L = 1, Q =1. When K=2, L = 2, Q =2, etc. A firm with the production function Q = (K,L).25 has decreasing returns to scale When K=1 and L=1, Q =1. When K=2, L=4, Q = 4.25 =1.41 RULE: For any production function of the form Q = F(K,L) = (KL)a The firm exhibits increasing returns to scale if a>.5 The firm exhibits decreasing returns to scale if a<.5 The firm exhibits constant returns to scale if a=.5 Example: Suppose that the production function for Greckos Smoothies is F(K, L) = (KL).25 Grecko currently produces with K=4 and L=4. - What is output?

95

- Would Grecko enjoy increasing, decreasing or constant returns to scale if it doubled output to K = 8, L = 8? - How would your answer change if Grekos production function wast F(K, L) = (KL)1 4. Multiple Output Cost Functions. All of the insights pertaining to single product output apply to a multi-product firm. There are, however some interesting additional cost issues that arise. In finishing this chapter, consider two points: The notion of economies of scope, and economies of scale. To illustrate, we will consider cost conditions for a firm that produces just two products: Q1 and Q2. Denote the cost function for this firm as C(Q1, Q2). a. Economies of Scope: Exist when the joint production of two goods is less expensive that the production of both goods separately. Mathematically, if C(Q1, 0) + C(0, Q2) > C(Q1, Q2) Economies of scope are an important reason why firms produce multiple products. For example, it may be more efficient to produce both cars and light trucks in a single plant than to produce both good separately, the two products may share many parts of the same assembly (such as the chassis) and producing the products separately would require considerable duplicative construction. b. Cost complementarities: These exist in the marginal cost of producing one good increases when the output of another product is increased. Mathematically, when: MC1(Q1, Q2)< 0 Q2 This often arises when one product is a by-product of another. For example there are cost complementarities in the production of in the production of Flouride and Aluminum Ingot from Alumina. Cost complementarities are an important reason for economies of scope. These notions are conveniently expressed algebraically with at quadratic cost function: C(Q1, Q2) Then MC1 = = f + aQ1Q2 + Q12 + Q22

aQ2 + 2Q1

96

Cost complementarities exist whenever a < 0. Economies of scope exist whenever C(Q1, 0) + C(0, Q2) > C(Q1, Q2) C(Q1, 0) C(0, Q 2) = = f f + Q12 + Q22

Thus, economics of scope exist if 2f+ + Q12+ Q22 > f+ aQ1Q2 +Q12+Q22 Or if f - aQ1Q2 > 0.

Comparing the two conditions, it is seen that cost complementarities are a stronger condition than economies of scope. Given a<0, cost complementarities always exist. However, economics of scope may also even without cost complementarities, if the costs of paying fixed set-up costs twice are sufficiently high. Example: Suppose C = 100 - .5Q1Q2 + Q12 + Q22

Do cost complementarities exist? Do economies of scope exist? What about the case where C = 100 + .5Q1Q2 + Q12 + Q22 ?

Notice the existence of economies of scope and cost complementarities have a lot to do with the effectiveness of mergers and the sales of subsidiaries. Sales of an unprofitable subsidiary may not reduce losses much, due to cost complementarities. Similarly, due to economies of scope, it may be the case that multi-product mergers are efficient.

Lecture 27 REVIEW___________________________________________________: IV. Chapter 5. The Production Process and Costs

97

C. Costs 3. Long Run Costs a. Long run average costs b. Economies of Scale, Diseconomies of Scale and Long Run Survivability c. Measuring returns to scale Preview__________________________________________________________ 4. Multi-Output Cost Functions V. Chapter 6. The Organization of the Firm. Ch. (6.) A. Overview and Motivation B. Optimal methods of obtaining inputs Lecture____________________________________________________________ 4. Multiple Output Cost Functions. We end this chapter by considering briefly cost conditions for firms that produce multiple outputs. In general, all of the insights pertaining to single product output apply to a multi-product firm. There are, however some interesting additional cost issues that arise. In finishing this chapter, consider two points: The notion of economies of scope, and economies of scale. To illustrate, we will consider cost conditions for a firm that produces just two products: Q1 and Q2. Denote the cost function for this firm as C(Q1, Q2). a. Economies of Scope: Exist when the joint production of two goods is less expensive that the production of both goods separately. Mathematically, if C(Q1, 0) + C(0, Q2) > C(Q1, Q2) Economies of scope are an important reason why firms produce multiple products. For example, it may be more efficient to produce both cars and light trucks in a single plant than to produce both good separately, the two products may share many parts of the same assembly (such as the chassis) and producing the products separately would require considerable duplicative construction. b. Cost complementarities: These exist in the marginal cost of producing one good increases when the output of another product is increased. Mathematically, when: MC1(Q1, Q2)< 0 Q2 This often arises when one product is a by-product of another. For example there are cost complementarities in the production of in the production of Flouride and Aluminum Ingot from Alumina.

98

Cost complementarities are an important reason for economies of scope. These notions are conveniently expressed algebraically with at quadratic cost function: C(Q1, Q2) Then MC1 = = f + aQ1Q2 + Q12 + Q22

aQ2 + 2Q1

Cost complementarities exist whenever a < 0. Economies of scope exist whenever C(Q1, 0) + C(0, Q2) > C(Q1, Q2) C(Q1, 0) C(0, Q 2) = = f f + Q12 + Q22

Thus, economics of scope exist if 2f+ + Q12+ Q22 > f+ aQ1Q2 +Q12+Q22 Or if f - aQ1Q2 > 0.

Comparing the two conditions, it is seen that cost complementarities are a stronger condition than economies of scope. Given a<0, cost complementarities always exist. However, economics of scope may also even without cost complementarities, if the costs of paying fixed set-up costs twice are sufficiently high. Example: Suppose C = 100 - .5Q1Q2 + Q12 + Q22

Do cost complementarities exist? Do economies of scope exist? What about the case where C = 100 + .5Q1Q2 + Q12 + Q22 ?

Notice the existence of economies of scope and cost complementarities have a lot to do with the effectiveness of mergers and the sales of subsidiaries. Sales of an unprofitable subsidiary may not reduce losses much, due to cost complementarities. Similarly, due to economies of scope, it may be the case that multi-product mergers are efficient.

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Lecture 28 REVIEW___________________________________________________: IV. Chapter 5. The Production Process and Costs C. Costs 4. Multi-Output Cost Functions Economies of Scope and Cost Complementarities. Preview__________________________________________________________ V. Chapter 6. The Organization of the Firm. Ch. (6.) B. Overview and Motivation B. Optimal methods of obtaining inputs Lecture____________________________________________________________ V. The Organization of the Firm: Optimal Contracting, and Motivating Resources to Work Efficiently (Chapter 6) A. Overview and Motivation. In the preceding chapter we discussed the decision rule for the optimal combination of inputs. That is, firms should hire resources until MPL w = MPK r

assuming that the inputs are working on their production function. This rule suggests two important issues that are the subject of this chapter: (a) Is the firm obtaining resources at the minimum necessary price? Clearly, the firm will suffer inordinately high costs if this condition is not met. (b) Are inputs working efficiently? As mentioned in Chapter 1, in many instances the incentives of individuals and firms do not naturally overlap. Compensation schemes may in many instances be altered to make incentives more compatible. Consider these questions in turn. A. Methods of Procuring Inputs: 1. There are three generic ways to acquire inputs: a. Spot purchases. This is purchasing on an as needed basis at the then prevailing market price. Spot exchanges allow firms to avoid vertical integration, and to concentrate on their primary specialty. Homogenous inputs that are available at a competitive price are often purchased on a spot basis. b. Contract purchases. This is an agreement to purchase inputs under some continuing arrangement that specifies the terms of exchange. In many instances, particularly when the arrangement is fairly complicated, terms of the exchange are not

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entirely spelled out. These areas are a problem of incomplete contracts and are a basis for negotiation. c. Internal production. Occurs when firms decide to go into the production of the needed input. Internal production can come at the cost of administrative overhead, and requires development of a specialization in production of the input. Example. Suppose I sell ice cream cakes. I need ice cream as an input. - If I go to a food wholesaler and make purchases as needed, I make a spot purchase. -If I strike a one-year deal with Breyers, to use only their products, I have made a contractual arrangement. -If I decide to make ice cream myself, I have gone into internal production. 2. Specialized Investments and Transactions Costs. If spot purchases are the easiest, allow the most efficient specialization, why arent all inputs acquired on a spot basis? The reason is that not all inputs are available on an essentially competitive basis. Rather, firms frequently must make specialized investments either to use or to produce particular inputs. Contracting could surmount this problem. However, in some instances the contract negotiation costs are too high, and internal production is necessary. Consider these terms in more detail a. Specialized investment: An expenditure that must be made to all two parties to exchange that has little or no value in any alternative use. i) Example: Suppose you produce applications software (e.g., wordprocessing programs). A specialized investment would be the production of code that enabled the program to work in a Windows XP environment. This extra code would be useless if you wanted to sell your software to the makers of Apple Computers. ii) Types of Specialized Assets -Site Specificity: Locating your plant close to a particular input. (Example: Locating an electricity plant close to a coal mine since it is less expensive to ship electricity than coal. The arrangement would make little sense if coal from the mine was not purchased by the electricity plant) - Physical-Asset Specificity: The production or acquisition of specialized physical capital in order to use an input. For example, for a bicycle maker, a special machine needed to make wheel rims that work with a particular tire would be a specialized physical asset. - Human capital: Workers learning specific skills to use a particular product. (Example, learning how to use products on the MS office suite) iii. A relationship-specific exchange. This occurs when the parties to a transaction have made specialized investments. Notice that specialized investments make

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impossible the satisfaction of the many-buyers/ many-sellers assumption underlying competitive market theory. (One buyer or seller will always be better suited than others to buy or sell the input). Thus the presence specialized investment can create a need for contracting. b. Transactions Costs. The costs of contracting are importantly affected by specialized investment, for three reasons i.) Costly Bargaining. As mentioned above, specialized investment means that there are only a few parties that may efficiently engage in a buyer/seller relationship. Consequently, there is no market price. In fact, there is often a lot of difference between the minimum price necessary to induce supply, and the maximum acceptable purchase price, creating considerable room for bargaining. ii) Underinvestment. Either the buyer or the seller may under-invest in the specialized inputs. (Who would spend a lot of time learning how to use UNIX, for example, if the university might shift exclusively to networked computers?) iii) Opportunism. Once a firm has engaged in a specialized investment, the firm on the other side of the bargain has an incentive to take advantage of the sunk cost expenditure. (Suppose you spend $300 for three nights in an isolated resort hotel, meals not included. How much do you think they will charge for meals?) A comment on opportunism: When one side of a bargain tries to take advantage of the specific investment made by another, a hold-up problem is created. Avoiding hold-up problems is often a reason for more formal arrangements, such as contracts or even internal production. B. Optimal Input Procurement. Now we consider factors affecting the optimal input method. In general, more formal arrangements are called for as the relationship-specific capital is increased. 1. Spot Exchange. This is the most straightforward purchasing method. Given many buyers and sellers, a homogenous input, and no relationship-specific capital, input prices are determined by the intersection of market supply and market demand schedules. However, reasons often exist that would induce a manager to bear the expense of drafting a contract: Specialized investments are insidious. For example, suppose you retail fresh fish in a cafe/restaurant store, and you need 500 pounds of fresh fish at 8:00 a.m. each day. Even though fish are homogenous, the size of the input need creates hold-up opportunities for both the buyer and the seller. -The fish seller, with a truck full of fish may refuse to unload the product unless a premium is paid. - The fish buyer (the restaurant owner), may call several trucks to deliver fish at once, and then bargain with the one offering the lowest price.

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2. Contracts. When hold-up opportunities become high relative to the costs of negotiating a contract, contracting becomes optimal. Despite the costs of contract negotiation, formalizing a relationship into a contract can resolve numerous problems. A good contract, for example, eliminates the incentives to skimp on specific investments in capital and labor. (e.g., You will spend more on training workers that will be around for three or four years). a. Optimal contract length. Once the decision has been made to negotiate a contract, the question of optimal contract length becomes a question. Optimal length is determined by the marginal cost of writing the contract, and the marginal benefit of extending contract terms. i. Marginal costs increase with time. As the timeframe expands, more contingencies must be considered, increasing the negotiation costs. ii. Marginal benefits include avoided transactions costs or bargaining and opportunism. These may be temporally related, but for the present, assume that they are constant. Then a graphical representation of the optimal contract term problem is illustrated as follows: $ MC

MB L* Time

b. Some comparative statics effects. i. Optimal contract length will increase if the level of specialized investment increases. (As could be seen by an upward shift of the MB schedule). ii. Changes in the costs of writing contracts would also affect the optimal length. For example, an increasingly uncertain environment would shift MC up. On the other hand, an increasingly standardized product and a more established market for the final product would shift MC down, extending the optimal contract. 3. Vertical Integration. When specialized investments generate transactions costs, and when the economic environment is plagued by uncertainty, vertical integration becomes necessary. The advantage of vertical integration is that the middleman is avoided, reducing the latitude for opportunism. The cost is that the firm must develop expertise in development of a more primitive stage of the production process for its product. This often involves building a costly production facility, and often requires that the firm engage in some process that has little to do with their primary area of expertise.

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4. The Economic Trade-Off. A summary of the relevant decision calculus is illustrated below. Spot Exchange No Large specialized investments relative to contracting Yes cost? Complex contracting environment relative to cost of vertical integration? No Contract Yes Vertically Integrate.

Spot exchange is optimal when there are few hold-up opportunities, or where the costs of those opportunities are small relative to contracting costs. When specialized investments become large, contracting or vertical integration is desirable. The choice among these latter alternatives depends on the complexity of the economic environment relative to the costs of integration. Final comments. When a contract is called for, a formal contract is not always necessary., Despite considerable specific investment, it is not always necessary to resort to written contracts. Buyers, for example often can punish opportunistic behavior by not purchasing from a seller again, and by spreading the word that they were treated badly. These reputational considerations can play a large role in unwritten, but highly efficient contracts. Review Problem: Suppose you manufacture inboard motor-boats, and you agree to purchase 100,000 motors from Johnson Motor Company for $1000 per motor, in two years time. Feeling that you are protected from opportunism, you customize your boat design to accommodate the Johnson motors. In the mean time, Johnson finds itself on the verge of bankruptcy, and says that it will go broke if the company doesnt receive $1500 per motor. a) Was the decision to contract a bad one? b) What should you do? c) Should this situation have been avoided?

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B. Getting the Most Out of Human Factors The second portion of this chapter deals with the issue of the optimal compensation structure for labor. Standard production theory assumes that all employees work efficiently, all the time. Of course this is not true. Workers in factories shirk. Managers try to maximize things other than the PDV of the firm. Sports players attempt to do something other than win. Of course, no human factor is efficient all of the time. However, one can improve the motivation of employees by constructing contracts that align the interests of employees and management. Importantly, this task is non-trivial. Example: How do you structure the contract of a basketball player? Flat salary, points scored? Assists? Winning? In general there are a number of dangers to attend to . a) Stock. Useful for a CEO, of limited use when employees cannot themselves affect materially the profitability of the firm. b) Flat salary: Does motivate stellar effort, but can provide needed security. c) Time clocks and monitoring: Generally, people do not respond well to sticks: Time clocks can be important when an entire group must be present to initiate a task. If monitoring is to be done, it must be random d) Piece rate compensation: A good scheme when quality is not an issue. (great for catching chickens. Terrible for paintings or poems. e) Sales commissions. Great unless costs are a problem. Also sales workers may undermine each others efforts. Conclusion: Motivating employees is a nontrivial task. But notice also, that most people really want to do a good job. Be careful to not undermine good intentions. Lecture 29 REVIEW___________________________________________________: V. Chapter 6. The Organization of the Firm. Ch. (6.) C. Overview and Motivation D. Optimal methods of obtaining inputs a. Spot, Contract and Vertical Integration b. Specialized investments and hold up problems c. Optimal plan: Purchase on the spot market unless you have unusual needs. Then contract. Vertically integrate only if contract terms become too complex. Preview__________________________________________________________ E. Getting the Most out of Human Factors.

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Lecture____________________________________________________________ V. The Organization of the Firm: Optimal Contracting, and Motivating Resources to Work Efficiently (Chapter 6) C. Getting the Most Out of Human Factors The second portion of this chapter deals with the issue of the optimal compensation structure for labor. Standard production theory assumes that all employees work efficiently, all the time. Of course this is not true. Workers in factories shirk. Managers try to maximize things other than the PDV of the firm. Sports players attempt to do something other than win. Of course, no human factor is efficient all of the time. However, one can improve the motivation of employees by constructing contracts that align the interests of employees and management. Importantly, this task is non-trivial. Example: How do you structure the contract of a basketball player? Flat salary, points scored? Assists? Winning? In general there are a number of dangers to attend to . f) Stock. Useful for a CEO, of limited use when employees cannot themselves affect materially the profitability of the firm. g) Flat salary: Does motivate stellar effort, but can provide needed security. h) Time clocks and monitoring: Generally, people do not respond well to sticks: Time clocks can be important when an entire group must be present to initiate a task. If monitoring is to be done, it must be random i) Piece rate compensation: A good scheme when quality is not an issue. (great for catching chickens. Terrible for paintings or poems. j) Sales commissions. Great unless costs are a problem. Also sales workers may undermine each others efforts. Conclusion: Motivating employees is a nontrivial task. But notice also, that most people really want to do a good job. Be careful to not undermine good intentions. Lecture 30 REVIEW___________________________________________________: V. The Structure of the Firm C . Getting the Most out of Human Factors. Preview__________________________________________________________ VI. Chapter 7. The Nature of Industry (Introduction) A. Market Structure a. Definition b. Types of Structures i. Competition

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ii. Monopoly iii. Monopolistic Competition iv. Oligopoly B. A Paradigm for Analyzing Markets VII. Chapter 8. Managing in Competitive, Monopolistic and Monopolistically Competitive Markets. A. Competition. 1. Assumptions 2. Optimal short run decisions: 3. Long run decisions. B. Monopoly 1. Assumptions, Sources of monopoly power. 2. Characterization: Lecture____________________________________________________________ VI. Chapter 7. The Nature of Industry. To date, we have considered in some detail demand considerations for a firm, and then a variety of cost considerations for a firm. Our next project is to use these tools to talk about the optimal behavior of firms in the market. These decisions are affected importantly by the structure of the industry in which a firm competes. Chaper 7 overviews some of the candidate structures. A. Some terminology 1. Market Structure Refers to the number of competitors in an industry, the relative size of the firms, as well as demand conditions and entry and exit requirements. When a market has very few players, it is said to be concentrated. a. Market definition. When attempting to characterize the structure of a particular industry, it is critically important to pay attention to the appropriate market definition. A market is defined as a collection of products/geographic areas where cross-elasticities of demand and supply are sufficiently high so that unilateral price changes by one producer causes enough of a response to make the action unprofitable. i. Some industries that are not concentrated at the national level, involve very concentrated markets. Example: Public Utilities. ii. Other industries that are quite concentrated at the national level involve relatively unconcentrated markets, due to international competition. Example: The automobile industry. B. Market structures. i. Competitive. A market is competitive when (a) There are many buyers and many sellers; (b) The product is homogenous; (c) There is perfect information and (d) Entry and exit is easy. Example: Agriculture. 107

Observation: Competitive markets are commodity markets. Managers in such markets waste very little money on advertising (0ther than product advertising in general). Most efforts involve minimizing costs. ii. Monopolistic Competition. A market structure where (a) There are many buyers and many sellers; (b) Products are differentiated; (c) There is perfect information and (d) Entry and exit is easy. Examples: Gasoline, Fast Food, Restaurants. Observation: As we will see in the coming lectures, monopolistically competitive producers are able to post prices above costs because they face a downsloping demand curve for their product. Managers in these industries spend considerable resources on advertising, as well as on introducing new product variants, in an effort to decrease demand elasticity. iii) Monopoly A market structure characterized by a single producer, whose position is protected by significant barriers to entry and/or exit. Examples: Electric utilities, a movie theatre in small town. Observation: Monopolists have both pricing and output discretion. When regulated (as is often the case) price and output determination is done in conjunction with regulatory authorities. iv) Oligopoly. A market structure characterized by few sellers, who are strategically aware of the actions of their rivals, and some difficulty in entry and/or exit. Notice that in oligopolies, products can be homogenous or differentiated products, and information can be perfect or imperfect. Examples: Brewing, automobile production, breakfast cereals, soft drinks. Observation: Oligopoly is one of the most pervasive industrial structures in the United States, and in modern capitalistic economies in general. The strategic nature of decisions makes the analysis of decisions in an oligopolistic environment considerably more complicated than the other structures, and often more interesting. We will devote some attention to decision-making in an oligopoloistc environment if time permits. 2. Conduct. A general term used to describe the actions of firms. Behavior classified as firm conduct involves most of the decisions made by management, including pricing, advertising, research and development expenditures and output. 3. Performance. This term encompasses all elements pertaining to the social desirability of outcomes for an industry. Profitability, the degree of innovation, the amount of consumer and producer surplus extracted are all performance measures. C. A Model for Industrial Performance. Analyzing Industrial performance is an area of economics called industrial organization. The first generic model of industrial performance was articulated by Joseph Bain and his colleagues at Harvard University in

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the 1940s. The Paradigm was simple, if somewhat deterministic: Structure gives rise to certain types of conduct. Conduct, in terms generates observed performance. In this Structure-Conduct-Performance paradigm, the structure of the industry was the primary determining element. It is widely recognized in the new industrial economics that the interrelationships between three components are involved. Conduct, for example can lead to new basic developments which confer market power on firms. Similarly, the adaptation of existing technology can eliminate the power of a large incumbent. Nevertheless, despite the fact that underlying elements of an industry may change, it remains true that many of the problems faced by managers are colored by the type of industry in which the firm competes. Lecture 30 REVIEW___________________________________________________: VI. Chapter 7. The Nature of Industry (Introduction) C. Market Structure a. Definition b. Types of Structures i. Competition ii. Monopoly iii. Monopolistic Competition iv. Oligopoly D. A Paradigm for Analyzing Markets Preview__________________________________________________________ VII. Chapter 8. Managing in Competitive, Monopolistic and Monopolistically Competitive Markets. A. Competition. 1. Assumptions 2. Optimal short run decisions: 3. Long run decisions. Lecture____________________________________________________________ VI. Chapter 8. Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets. A. Introduction. This chapter considers the nature of optimal decisions in the three market structures that do not involve strategic considerations. Although we will discuss the role of the manager in each of these contexts, our primary task in this chapter is characterizing 109

optimal decisions in each case. Both graphical and algebraic tools will be used to develop solutions in each case. In overview, three considerations are relevant in each of the structural situations. a) The optimal quantity b) The optimal price c) The determination of profits and losses. The answer to each question involves the same calculation in each case. a) To determine the optimal quantity compare Marginal Revenue (MR) with Marginal Costs (MC) b) To determine the optimal price, find the Average Revenue (AR) at the optimal quantity. c) To identify profits or losses, find the difference between P and ATC at the optimal quantity, then multiply this difference by the quantity. We consider each structure separately, since implications differ somewhat, due to changes in the industrial structure. B. Perfect Competition. Recall that in this case, there are many producers of a homogenous good. The price that any individual firm may charge is tightly constrained by the identical products of rivals. For this reason, the demand curve facing an individual competitor is determined by the intersection of market supply and market demand curves. P S Df D Q Market Firm Q P

1. Short Run Decisions. Weve already discussed this at some length. To review, optimal short run decisions are made by comparing the above firm demand curve with costs for the firm. Consider a representative case. P ............. . . PROFITS . . . . . MC Df = AR = MR = P ATC AVC

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Q Q* In the case of the competitive firm, Df = AR = MR = P i) Optimal quantity: Q* is determined by the point where MR = MC. That is the dashed vertical line extending down from the origin. ii) The optimal price: Since AR = MR = P, the price is, trivially, P iii) Determination of profits or losses. At Q*, profit per unit is P-ATC. Thus, total profits are = (P-ATC)Q*.

Observation: Optimal profits may also easily be illustrated on a TR, TC chart. Of course, as weve seen previously, demand may cross the average cost curves at any point. This gives rise to a number of possible outcomes, detailed below: P MC ATC AVC Loss Q* Production at a loss. P MC ATC AVC Df = AR = MR = P Q No Production. i) Observations. Df = AR = MR = P Q

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- The competitive firm will produce at a loss in the short run. This is due to the existence of fixed costs. As long as the firm can cover variable costs and make some contribution of fixed costs, then production is optimal. 2. Intermediate-Run Decisions for the Competitive Firm. An important feature of competitive firms is that they are driven to the point of zero economic profits. Recall that in a competitive market entry and exit is costless. Recall also that the market supply schedule is the horizontal sum of individual supply schedules. Thus the entry of additional competitors will shift the market supply schedule out, and the exit of some incumbent competitors will shift the market supply schedule in. These changes will drive the price (or the individual demand curve faced by each firm) down or up. P exit entry D Q Market Firm Q S2 S0 S1 Df P

Thus, in the long run, for a competitive industry, price will be driven to MC, or the minimum point on the AC curve

MC AC Df = AR = MR = P Q

Example: (Continuing from above). Again assuming TC = 100 + 5Q + .5Q2 What price do you think this firm will be forced to charge in the intermediate run? 3. Long Run (planning horizon) decisions for competitive firms. One additional characteristic of competitive firms is that they are driven to the efficient scale of operation: Suppose, for example, that there are economies of scale. Every firm has an incentive to exploit the economies to earn higher profits. But all survivors must also 112

expand, for any plant that doesnt exploit all economies of scale will have higher costs than larger, efficient rivals who do exploit the economies. P S2 S0 S1 Df D Q Market Firm Q P MC ATC1

The Carrot of increased profits from expansion. Later, when the market price falls, this is the stick of losses from firms that fail to expand. Thus, firms have an incentive to exploit all available economies of scale. Similarly, firms are motivated to contract when they realize diseconomies of scale. P S
2

P S0

MC ATC1 Df

S1 D Q Market Firm Q

The thing that is different about the case of contraction is that when firms contract other, smaller firms enter the industry to drive prices down. This is what happened in the 1990s with the move to downsize many firms.

Lecture 31 REVIEW___________________________________________________: VII. Chapter 8. Managing in Competitive, Monopolistic and Monopolistically Competitive Markets. A. Competition.

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1. Assumptions 2. Optimal short run decisions: 3. Long run decisions. Preview__________________________________________________________ REVIEW Lecture____________________________________________________________ Lecture 33 REVIEW___________________________________________________: VII. Chapter 8. Managing in Competitive, Monopolistic and Monopolistically Competitive Markets. A. Competition. 1. Assumptions 2. Optimal short run decisions: 3. Long run decisions. Preview__________________________________________________________ B. Monopoly 1. Assumptions, Sources of monopoly power. 2. Characterization: 3. Optimizing decisions. a. Optimizing with Demand Curve 4. Observations: Social Costs of Monopoly . C. Monopolistic Competition 1. Assumptions 2. Characterization: 3. Optimizing decisions. 4. Observations. a. Social cost of product differentiation b. Optimal Advertising decisions.

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Lecture____________________________________________________________ Now we turn our attention to the case exactly opposite to the competitor: The monopolist. The insight critical to understanding monopoly is that for one reason or another (reasons that we will discuss momentarily) the monopolist is the market. Cost conditions, on the other hand do not necessarily differ) Thus, to analyze optimizing decisions for the monopolist, we must combine the market demand curve with the firms supply curves. . P S MC ATC

Pc

P* c =0

Market

D Q

Firm Q*

1. Reasons for monopoly: A single firm may come to dominate a market for a variety of reasons. a) Economies of scale. If it is the case that production is characterized by economies of scale over range under the market demand curve, then only a single firm can efficiently exist in an industry. These types of cases are typically regulated monopolies, such as electric utilities and water and sewer service. b) Patents. Many monopolies are the consequence of government activity. If an inventor develops a cost saving technology, or a unique product, and secures a defensible patent for the invention, the inventor has a legal monopoly for 17 years following the patent. This monopoly power is provided as an incentive for creative activity. In the absence of patents, new developments would be copied by firms that did not incur the product development costs, undercutting the incentive for new product development. c) Economies of Scope and Cost Complementarities. If firms enjoy economies of scope, and particularly cost complementarities, they can produce a product more cheaply than any rival, because costs are defrayed by the production of the complementary product.

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2. Characterizing the problem for a monopolist. a. Demand. Critically, when a firm faces a downsloping demand curve, P=AR no longer equals MR. This is true as long as the monopolist cannot price discriminate, or charge different prices to different consumers. In this case, the Marginal Revenue is different from P = AR. The reason is that in order to sell additional units, the firm must lower the price, causing the firm to lose sales on units that would have sold at the higher price.

Po P1

MR for the range Po - P1 D = AR= P Qo Q1 MR

In terms of the above graph, the marginal revenue from lowering the price from Po to P1 is the change in total revenues over that range. Essentially, it is the quantity box less the price box. b. Costs and Monopoly Supply: As we will demonstrate formally in a moment, for any linear demand curve, the MR curve has exactly twice the slope of the demand curve. There is no well-defined supply curve for the monopolist. Unlike the competitor, the monopolist does not produce goods until P = MC. Thus, the MC curve is not a supply curve. Rather, willingness-to-produce is the combination of MC and the demand curve. 2. Optimization for the Monopolist. a. A Homogeneous Product Monopolist, with a down-sloping demand curve. Placing the market demand curve over the cost curves for the firm generates, the optimizing decisions for the monopolist follow the same rules as for a competitor. (For simplicity, AVC is again suppressed.) P MC ....... . Profits . . ........ ATC D = AR = P Q Q* MR

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i) The optimal quantity Q* is determined by the intersection of MR and MC curves. ii) The optimal price is the intersection of the demand curve and the vertical line extending up from AR. iii) Profits are the difference between the price, and ATC, multiplied by Q* An algebraic example. Suppose you are a monopolist of a firm. Your total cost and inverse demand curves are, respectively TC = 50 + .5Q2 P = 200 - 2Q a. What is the marginal revenue curve for the monopolist? MR = 200 4Q b. What is the optimal quantity for the monopolist? MR = MC 200 4Q = Q Q = 40 P = 200 2(40) = 120 c. Determine monopoly profits. = = = = TR 120(40) 4800 3950 TC [50 + .5(40)2] 850

Lecture 34 REVIEW___________________________________________________: VII. Chapter 8. Managing in Competitive, Monopolistic and Monopolistically Competitive Markets. B. Monopoly 1. Assumptions, Sources of monopoly power. 2. Characterization: 3. Optimizing decisions. a. Graphically b. Analytically Preview__________________________________________________________ 4. Observations: Social Costs of Monopoly C. Monopolistic Competition . 1. Assumptions 2. Characterization:

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3. Optimizing decisions. 4. Observations. Lecture____________________________________________________________ 4. The Social Costs of Monopoly: The social costs of monopoly. There is no entry and exit, so monopoly profits can be permanent. a) Monopoly pricing is inefficient. The graph below allows a comparison between the monopolist, and a competitor with similar cost curves. (Recall that a competitor would be forced to produce where MC = ATC.) P Monopoly Profits Pm Pc . D = AR = P MR Qc Q MC ATC

Qm

Continuing with the above example, what would a competitor be forced to charge? MC = ATC Calculate profits, price and ATC. b) Results: Compared to a competitor, a monopolist i) charges a higher price, ii) produces a lower quantity iv) Earns persistent economic profits. A numerical example. Suppose P = 90 Q and TC = 400 +10Q + Q2 MR = 90 2Q, MC = 10 + 2Q Thus, 80 = 4Q and Q = 20 P = 70 Profits are 70(20) [400 +10(20) + 202] 1400 - 1000 400 Compare outcomes to the competitor in a LR equilibrium. The competitor will produce where MC = ATC. ATC = 400/Q + 10 + Q, or 10 + 2Q = 400/Q +10 + Q 118

Q = 20 P = 50 Profits equal 0 Notice, with market demand of 90-Q, Q must equal 40 for P to equal 50. Thus, a second firm must exist in the market in a competitive equilibrium. Note: It is possible to conjure up numbers where quantity is not lower for the monopolist than for the competitor (we are comparing a single firm to multiple firms in the market, so using a single cost curve is not the best example). However, price will definitely be higher. Lecture 35 REVIEW___________________________________________________: VII. Chapter 8. Managing in Competitive, Monopolistic and Monopolistically Competitive Markets. B. Monopoly 3. Optimizing decisions. a. Graphically b. Analytically 4. Observations: Social Costs of Monopoly The monopolist posts a higher price, produces a smaller quantity and earning economic profits. Example: P = 124 2Q and TC = 625 + 4Q + Q2 = TR TC = (124 2Q)Q (625 + 4Q + Q2) MR = 124 4Q MC = 4 + 2Q Optimum: 120 = 6Q Q = 20 P = 84 = 84(20) [625 + 4(20) + 202] = 1680 1115 = 565 Compare to a Competitor, who will produce where MC=ATC 4+2Q = 625/Q + 4 + Q 2 625 = Q 25 = Q P = 4 + 2(25) = 54

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But notice that at this price, the market would produce 124-2(25) = 76 units, or roughly 3 firms would compete. Preview__________________________________________________________ C. Monopolistic Competition . 1. Assumptions 2. Characterization: 3. Optimizing decisions. 4. Observations. Lecture____________________________________________________________ C. Monopolistic Competition. The third structural model we consider combines important components of the preceding two models. 1. Assumptions (c) Products are differentiated. As indicated at the beginning of class, examples of monopolistic competition include restaurants and beer, soft drinks, and many food products. 2. Characterization. Due to product differentiation monopolistic competitors face downsloping demand curves. Thus in the optimum, monopolistically competitive firms will not produce at the point where ATC = MC, as in the competitive case. However, due to entry and exit, all profits will be driven to zero. a. Short Run Decisions. In the short run, the decision-calculus is exactly as the monopolist. P

MC ....... . Profits . . ........ AC D = AR = P Q Q* MR Optimal quantity Q* is determined by the intersection of Marginal Revenue and Marginal cost curves. The optimal price is the intersection of the vertical extending from Q* and the demand curve. Profits are the difference between AR and ATC multiplied by the number of units produced.

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b. Long Run Decisions. Due to free entry and exit, however, profits in a monopolistically competitive firm are driven to zero. The dynamic motivating this outcome involves shifts in the firms demand curve. As new competitors enter the market, the monopolistic competitor still has his or her following, however, some consumers will switch to one of the entrants, shift the demand curve for the firm inward. Inward shifts of this nature will persist until the demand curve is just tangent to the ATC curve at the optimum. P

MC . .. .. AC D = AR = P Q Q* MR

3. Implications of Product Differentiation. a. Product Differentiation and Social Welfare. Notice that although monopolistically competitive firms earn zero economic profits, MC does not equal ATC in the long run. Some would argue that this is a social cost associated with this industry structure. Others, however, would (I think quite reasonably) contend that the welfare loss is the cost of product differentiation. Consumers value differentiation, and if they did not, homogenous product competitive industries would prevail. b. The nature of Managerial Decisions and the Industry Structure. Note the difference in managerial decisions in each industry structure. In the competitive industry, the primary focus of managerial decisions will be on reducing costs. Monopolists, on the other hand, are frequently regulated. Even if not, they are concerned with pricing as well as output level decisions. Finally, the monopolistic competitor will typically engage in considerable advertising, and new product development in order to make demand more inelastic, and to capture short term profits. Lecture 37 REVIEW___________________________________________________: VIII. Chapter 11. Pricing Strategies. A. Basic Pricing Strategies for Firms with Market Power 1. Optimal Pricing for a monopolist or monopolistic competitor

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a. Basic Case b. Imperfect Demand Information P = MC/[1+1/].

Preview__________________________________________________________ B. Strategies that yield higher profits 1. Price Discrimination a. Perfect (1st degree) price discrimination i. Calculating gains ii. Necessary conditions b. Price List (2nd degree) price discrimination c. Group Division (3rd degree price discrimination. 2. Two part pricing. . Lecture____________________________________________________________ A. Basic Pricing Strategies for Firms with Market Power. 1. Optimal Pricing for a monopolist or monopolistic competitor. Generally speaking, firms with downsloping demand can raise prices above the competitive level. This applies both to monopolistic competitors as well as to monopolists. a. Basic Case. With perfect demand information, the firm can maximize profits by setting MR equal to MC to find the optimal quantity. Then the firm inserts Q into the price function to find the optimal price. We just reviewed this above. One important problem with this approach is that firms rarely have complete demand information. b.. Optimization without a demand curve. As we noted earlier in the semester, often times we dont have a good estimate of the demand curve. Rather, we must rely elasticity information to draw inference about optimal outcomes. Fortunately, this is not too difficult. Recall, a monopolist optimizes where MR = MC. MC should be known. Lets consider MR. TR = P(Q)Q. Taking the derivative w.r.t. Q yields MR = dP Q+P dQ

Pull out P from the RHS and we have 1 1+ MR = P[ + 1] = P[ ] Now in an optimum MR = MC, thus MC = P(1/ + 1) Or 122

MC/(1+1/)

This is a useful expression, since it allows us to determine the optimal markup with only information regarding price elasticity of demand. B. Strategies that Yield Greater Profits. However, if firms with downsloping demand are not constrained to charge the same price to all consumers, even higher profits are available. We start with price discrimination, 1. Price Discrimination: The practice of charging different prices to consumers for the same good. The below figures illustrate maximum profits available from posting a uniform price: P MC

D Qm MR Now, if the firm is restricted to posting a single price, then the Qm will be produced, and the maximum profits than can be realized is the area in the shaded box. However, more surplus is available: Consumers take home the triangle above the shaded box at the top of the figure. Also, due to the inefficiently high price, fewer units are sold than would have been sold at the competitive price, causing an additional welfare loss. a. First-degree price discrimination: The practice of charging different prices to consumers for the same good. Suppose that the firm could successfully size up every consumer that came into their shop, size them up, and charge them their limit price for the good. The, the efficient quantity would be produced, and the firm would enjoy the entire surplus. P MC Q

123

Qe MR

Perfect price discrimination requires satisfaction of two conditions a. The firm must be able to assess accurately the maximum willingness to pay of each consumer b. The firm must be able to prevent arbitrage, or the resale of units from low value consumers to high value consumers. In practice, the first of these conditios is difficult to satisfy with any precision However, first degree price discrimination is often attempted in markets where the resale is impossible, and where the item exchanged is very costly (e.g. real estate or automobiles) or where the consumer knows little about the cost of the service (automobile repairs) Lecture 37 REVIEW___________________________________________________: VIII. Chapter 11. Pricing Strategies. A. Basic Pricing Strategies for Firms with Market Power 1. Optimal Pricing for a monopolist or monopolistic competitor a. Basic Case b. Imperfect Demand Information P = MC/[1+1/].

Preview__________________________________________________________ B. Strategies that yield higher profits 1. Price Discrimination a. Perfect (1st degree) price discrimination i. Calculating gains ii. Necessary conditions b. Price List (2nd degree) price discrimination c. Group Division (3rd degree price discrimination. 2. Two part pricing. 3. Lecture____________________________________________________________ B. Strategies that Yield Greater Profits. The second of these conditions can be problematic, but ini practice, the first is typically a condemning problem. However, it is fairly conventional in a number of markets, including mechanical repairs, automobiles, and real estate to make an effort at first degree price discrimination. Other methods of price discrimination are more typical.

124

2. Second Degree Price Discrimination: One standard alternative is to offer all consumers a schedule that decreases with quantities purchased. This is second degree price discrimination: The practice of posting a discrete schedule of declining prices for different ranges of quantities. Example: Suppose Best Buy sells a first CD for $15, and then additional CDs for $10. Suppose that the MC of selling the CDs was $5 each. Suppose that your demand is such that you would pay up to $15 for a first CD and $10 for a second CD. If they charged $10 each they would earn $10, and if they charged $15 each they would earn $10. P $15 $10 $5 Qe MR c. Third Degree Price Discrimination: The practice of identifying different types of consumers, and charging different prices to each group. This is a very standard practice in entertainment goods (such as food, movies and sporting events): Senior citizens discounts, Students discounts, etc. appear to be a way for the firm to help out particular groups of people. In fact, it is also a way to increase profits. By separating low-value buyers from the high value buyers, and charging different prices, the firm makes sales it would otherwise forego. Successful third degree price discrimination requires two things 1. High and low value groups must be separable. (This is often pretty easy. Senior citizens can be required to show a drivers license, etc.) 2. There must be a way to prevent one group from reselling to the other. (If this is not prohibited, then arbitrage will eliminate sales in the high-value market). Optimal pricing under third degree price discrimination is easily motivated graphically. Just identify the demand curves for the separate groups, and optimize with respect to each group. P P Q MC

125

MC D Q MR1 D

MC Q MR2

Manipulating the elasticity formula presented earlier for the case of a monopolist, this can be algebraically expressed as MC = = MR1 = P1[(1+1)/1] = MR2 P2[(2+1)/2]

Solving for prices P1 P2 = = MC/[1+1/1] MC/[1+1/2] = 1P

Example: Suppose you are selling popcorn in a movie theatre. Theatre-goers are prohibited from bringing in food from home, so you have some market power. Suppose that the price elasticity of demand for students is -2, while the price elasticity of demand for the general public is -1.5. If popcorn costs $.25 per box to prepare, box and sell, what price should be charged to each group? Answer: Let group 1 be the general public, and let group 2 be students. Then P1 P2 = = = .25/[1+1/-2] MC/[1+1/-1.5] .50 = = .50 .75

2. Two Part Pricing: The practice of charging a per unit cost that equals marginal cost, plus a fixed fee equal to the consumer surplus each consumer receives at the MC price. This is a second scheme that allows firms with some market power to increase profits. It is typically employed by athletic clubs and discount centers (buying clubs),where an initiation fee is charged, along with some (possible zero) usage fee. The profitability of two part pricing is easily seen in an illustration P P

MC 126

MC

D Q MR1 Single Price Monopolist

D Q MR2 Two part pricing

If a firm charges P=MC in the second case, but an initiation fee equal to the entire consumer surplus triangle, profits are higher than they would be as a single price monopolist. Example: What would be the optimal initiation fee in the above example if the demand curve was 10 - P, and the marginal cost of a visit was $1? Answer: The optimal quantity is 10 - 1 = 9. Thus the consumer surplus realized from marginal cost pricing is (1/2)[10-1]9 = $40.50.

Lecture 38 REVIEW___________________________________________________: VIII. Chapter 11. Pricing Strategies. B. Strategies that yield higher profits 1. Price Discrimination a. Perfect (1st degree) price discrimination i. Calculating gains ii. Necessary conditions b. Price List (2nd degree) price discrimination c. Group Division (3rd degree price discrimination. 2. Two part pricing. Review Homework Preview__________________________________________________________ 3. Commodity Bundling 4. Peak Load Pricing Lecture____________________________________________________________ 3. Commodity Bundling The practice of bundling several different products together and selling them at a single bundle price. This is final scheme for increasing profits that we will discuss. The potential profitability of bundling can be seen in the following example. Suppose a firm sells computers and monitors, but that different consumers value the different products differently. Consumer 1 2 Valuation of computer 2000 1500 Valuation of Monitor 200 300

127

Suppose, for simplicity that MC equals zero. If demand consisted of only these two consumers, then the best the firm could do with single product, nondiscriminatory price is 1500 for the computers, and 200 for the monitors. However, if the firm charged $1800 for the computer/monitor combination, it could earn 100 more per sale. Observe that effective first-degree price discrimination would be more profitable. However, when it is impossible to distinguish consumers before the fact, this is a profitimproving option relative to single-product pricing. Commodity pricing is a very standard feature of big-ticket items, such as automobiles and new houses.

TEST
Test 1 Review I. Chapter 1. The Fundamentals of Managerial Economics A. Definition of Topic. 1. Economics 2. Managerial Decisions B. Components of Effective Decision Making 1. Identify Goals and Constraints: 2. Recognize the Nature and Importance of Profits: Economic profits differ from Accounting profits. . Good decision-making involves the maximization of economic profits. Acct = TR TCExplicit

Econ

TR

(TCExplicit + TCImplicit)

3. Understanding Incentives. .Compensation and the structure of organizations affects importantly organizations. a. Organizational Incentives b. Incentives for Motivating Individuals 4. Understand Markets. Market forces represent a series of rivalries. In any problem, you must appreciate your position relative to other agents. 5. Recognize the Time Value of Money PV NPV = =

FVt (1+i)t FVt

128 Co

(1+i)t 6. Appreciate Marginal Analysis. Marginal decisions are an easy way to optimize totals. Calculus is just a formal expression of marginal analysis. a. Discrete Decisions. b. Continuous Decisions and the calculus Note: You should be able to graphically illustrate why the point where Marginal Benefits equals Marginal Costs maximizes the difference between Total Benefits and Total Costs. c. Incremental Analysis 1. Pay attention to incremental costs and incremental benefits. 2. Ignore sunk costs. .

129

II. Chapter Market Forces: Demand and Supply A. Introduction and Overview. 1. Overview 2. The structure of the supply and demand model. B. The Demand Side. 1. Motivation: Diminishing marginal utility: 2. Definition of Demand Curve 3. Determinants of Demand. 4. Changes in demand vs. changes in qty demanded. 5. The Notion of Consumer Surplus 6. An Analytical Example C. The Supply Side. 1. Driving Force. The Law of Diminishing Returns 2. Definition of Supply Curve 3. Determinants of supply: 4. Changes in supply vs. changes in quantity supplied. 5. Producer Surplus. 6. An Analytical Example. Note: You should be able to look at a linear demand or supply function, and, with appropriate information about the nonprice parameters, be able to generate demand and supply curves. Given a price you should be able to calculate consumer and producer surplus. D. Equilibrium. Putting Supply and Demand Together 1. Definition. 2. Binding the market. Price floors Price Ceilings E. Comparative Statics. 1. Supply or Demand Shifts 2. Supply and Demand Shifts

130

III. Quantitative Demand Analysis A. Price Elasticity of Demand 1. Motivation 2. Calculations a. Arc price elasticity of demand

= (Q1-Q0)(P1+P0) (P1-P0)(Q1+Q0).
b. Point price elasticity of demand = (dQ/dP)(P/Q) c. Percentage Changes

= % Qd/% P
3. A Graphical Interpretation of Price Elasticity. 4. Some Observations about Price Elasticity of Demand a. Most Demand curves have elastic and inelastic segments b. Exceptions c. Elasticity and the Slope of Demand Curves 5. Price Elasticity, MR and TR. TR is maximized at the point where || = 1 No firm maximizes profits on the inelastic portion of their demand curve. 6. Determinants of price elasticity of demand a. Availability of substitutes b. Price Relative to Income c. Time B. Other Demand Elasticities 1. Cross Price Elasticities xy = % Qx/% Py xy> 0 implies substitutes xy< 0 implies complements xy = 0 implies unrelated goods. 2. Income Elasticities I = % Q/% I I > 1 normal, cyclical good 1> I > 0 normal, noncyclical good I< 0 inferior good.

131

3.Other Elasticites. Advertising elasticity A = % Q/% A For any successful advertising campaign, A >0 C. Elasticities and demand functions 1. Linear Demand functions. Given Qx = a + bP + cI + dPy

= b(Q/P)

I = c(Q/I)

xy =d(Qx/Py)

2. Logrithmic Demand. Given Qx = aPbIcPyd

=b

I = c

xy =d

Note: An equivalent expression for this function is ln Qx = lna + blnP+ clnI + dlnPy

Review Outline. E303 Second Examination Spring 2006 III. Quantitative Demand Analysis (Continued) D. Estimating Demand: Regression Analysis. 1. Interpreting the significance of individual parameter estimates 2. Forecasting IV. Chapter 5. The Production Process and Costs A. Introduction: B. The Production Function 1. Short Run Production. a. Diminishing Marginal Productivity and Marginal Product b. Relationships between Productivity Measures. c. Optimal Use of a single input. i. VMP and PL ii. Shifts in the VMP schedule. 2. Long Run Production (Optimal use of multiple inputs) C. Costs.

132

1. The relationship of production functions to cost functions. 2. Short run costs. a. Cost curves b. Sunk vs. Variable Costs c. Algebraic forms of cost curves 3. Long-Run Costs a. Long Run Average Costs b. Economics of Scale c. Returns to Scaels: Measuring Scale Economies 4. Multiple Output Cost functions a. Economies of Scope b. Cost complementarities V. The Organization of the Firm. Ch. (6.) A. Overview and Motivation. The optimal structure of the firm is narrow and focused. All inputs would be purchased, and all outputs would be sold on spot markets. B. Optimal Methods of Obtaining Inputs 1. Options a. Spot b. Contract c. Internal Production 2. Factors affecting choice of the optimal method a. Costly Bargaining b. Underinvestment c. The Hold-up Problem. 3. Decision Rule a. Spot is optimal unless the costs of opportunism are too high. b. The choice between contractual arrangements and internal production are determined by the contracting costs, particularly the relative uncertainty of the contracting environment. C.Getting the Most out of Human Factors. 1. The Principal-Agent Problem. 2. Structuring Contracts for Managers (review). 3. The Manager/Worker Problem. a. Profit Sharing. b. Revenue Sharing. c. Piece Rates. d. Time clocks and time checks

133

VI. Chapter 7. The Nature of Industry (Introduction) E. Market Structure a. Definition b. Types of Structures i. Competition ii. Monopoly iii. Monopolistic Competition iv. Oligopoly F. A Paradigm for Analyzing Markets VII. Chapter 8. Managing in Competitive, Monopolistic and Monopolistically Competitive Markets. A. Introduction a. Rule for determining optimal quantity (Compare MR to MC) b. Rule fro determining profits and losses (Compare AR to ATC) B. Competition a. Assumptions b. Optimal Short Run Decisions c. The Intermediate run (entry but no expansion) d. The Long run (expansion but no entry) C. Monopoly a. Assumptions Optimal Decisions

Problem Set #1

KEY

1. To attract Walt Snore to the job of CEO of Good Sleep Inc. Walt is given the following (a) a signing bonus of $750,000. (b) In addition to his salary Walt will be paid a bonus of $750,000 in any year that company return on assets exceeds 7%. Also (c) Walt receives 500 shares per annum of the stock, which he may not sell for 5 years. Comment on the likely effectiveness of each of these components of as a means to mitigate the principle-agent problem. Most Likely: Stock Least Likely: Signing Bonus Reason: The signing bonus doesnt induce effort. The earnings bonus helps some, but is imperfect, the restricted sale stock does promote attention to the long term value of the firm. 2. Good Sleep anticipates the following earnings for the next 5 years. Years in the Future Anticipated Profit

134

1 2 3 4 5

22 24 26 28 30

If the discount rate is 10% and the machine costs $90 (000), what is the net present value of the machine? Is it a good purchase? PV = NPV = = 22/(1.1) + 24/(1.1)2+ 26/(1.1)3 + 28/(1.1)4+ 30/(1.1)5= $97.120 $97,120 90,000 $7,120

Good purchase YES

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3. Joe Holiday has the opportunity to operate a business renting beach umbrellas next summer. He will operate the concession for 3 months. Looking at weather patterns, Joe observes that rain is frequent along this stretch of beach, and on average, there are only 60 rentable days in a summer. In each of these days, Joe believes he can rent 40 umbrellas per day at $7 per rental. Joe will run the concession by himself day, and must pay Beachcomber Enterprises $9,000 for the concession (the use of the umbrellas and for the beachfront rental location). Suppose Joe could earn $4500 working construction. a. What are Joes Accounting Profits for undertaking the business? What are his Economic Profits

= = = = = = =

TR 60(40 $7) $16,800 $7,800 TR $16,800 $3,300

TCEX $9,000 $9,000 TCEX $9,000 TCIM $4,500

b. Can Joe expect economic profits from the venture? If so, to what are these profits attributable? Yes, he can expect positive economic profits. This is a return to his risk-taking (it might, after all, rain all summer!) or to locational rents (he may have the only stand on the beach)

Problem Set #1 4. To attract Walt Snore to the job of CEO of Good Sleep Inc. Walt is given the following (a) a signing bonus of $750,000. (b) a bonus of $750,000 in any year that company return on revenues exceeds 7%, and (c) receives 500 shares per annum of the stock, which he may not sell for 5 years. Which of these components best mitigates the principle-agent problem? Which is does the least? Why? Most Likely:_____________ Least Likely:____________ Reason: _________________________________________________________________

136

_______________________________________________________________________ _ 5. Good Sleep Inc. is considering the purchase of a new mattress assembler that allows the construction of multiple firmness levels in the same mattress. Good Sleep anticipates the following 5-year earnings stream from the sale of this mattress. Years in the Future 1 2 3 4 5 Anticipated Profit (000s) 22 24 26 28 30

If the discount rate is 10% and the machine costs $90 (000), payable at once, what is the net present value of the machine? Is it a good purchase? (Write out the net earnings stream to generate your answer ) Net Present Value__________________________________________________ Good purchase?:______

137

6. Joe Holiday has the opportunity to operate a business renting beach umbrellas next summer. He will operate the concession for 3 months. Looking at weather patterns, Joe observes that rain is frequent along this stretch of beach, and on average, there are 60 rentable days in a summer. In each of these days, Joe believes he can rent 40 umbrellas per day at $7 per rental. Joe will run the concession by himself day, and must pay Beachcomber Enterprises $9,000 for the concession (the use of the umbrellas and for the beachfront rental location). Suppose Joe could earn $4500 working construction. a. What are Joes Accounting Profits for undertaking the business? What are his Economic Profits Accounting profits (A):___________________________________________________ Economic profits (E):___________________________________________________ b. Can Joe expect economic profits from the venture? If so, to what are these profits attributable? Positive economic profits? ( Y / N ) Justification: _________________________________________________________

Problem Set #2 (Note: On this problem, you may use EXCEL to generate numbers, but please fill in your answers 1. Consider the total profit function

=
=

TR - TC (10 Q)Q .25Q2

a. Create a table that shows Total Revenue, Total Cost and Total Profit, (in your table, let quantity run from 0 to 8 in increments of 1.) Indicate in your table where total profits are maximized Q TR TC T Profit 0 0 0 0 1 9 0.25 8.75 2 16 1 15 3 21 2.25 18.75 4 24 4 20 138

5 6 7 8

25 24 21 16

6.25 9 12.25 16

18.75 15 8.75 0

b. Next illustrate the relationship between TR, TC and total profit in the coordinate axes below 30 25 20 15 10 5 0 0 5 MC 10 MR Profit Max TR TC

On your graph, -highlight the point where total revenues are maximized. -show how profits may be seen. -highlight the point where total profits are maximized c. Next, create a table showing marginal revenues, marginal costs and marginal profits. Indicate in this table where TOTAL profits are maximized Q MR MC M PRO 0 10 0 10 1 8 0.5 7.5 2 6 1 5 3 4 1.5 2.5 4 2 2 0 5 0 2.5 -2.5 6 -2 3 -5 7 -4 3.5 -7.5 8 -6 4 -10

d. Finally, in the coordinate axes below create a graph that illustrates the relationships between marginal revenue and marginal cost. 139

- show the point where TOTAL profits are maximized - show the point where marginal profits are zero. . 12 10 8 6 4 2 0 -2 0 -4 -6 -8 M PR0 = 0

MC MR MR 5 MR 10

140

2.Take the derivatives of the following functions. Do not simplify. a. f(x) = b. f(x) = c. f(x) = d. f(x) = 10 20x2 30x 20x + 30x3 f(x) f(x) f(x) = = = f(x) ___0___________________________ ___40x_________________________ ____30_________________________ =___20+90x2_____________________

e. f(x) = (10 + 15x2)(3x 4x3) f(x) =_30x(3x 4x3)+ (3-12x2)(10 + 15x2)_____________________________ f. f(x) = 10/x2 f(x) =___-20/x3________________

Problem Set #2 (Note: On this problem, you may use EXCEL to generate numbers, but please fill in your answers in the table below.) 1. Consider the total profit function

=
=

TR - TC (10 Q)Q .25Q2

a. Create a table that shows Total Revenue, Total Cost and Total Profit, (in your table, let quantity run from 0 to 8 in increments of 1.) Indicate in your table where total profits are maximized Q 0 1 2 3 4 5 6 7 141 TR TC T Profit

8 b. Next illustrate the relationship between TR, TC and total profit in the coordinate axes below

Qty On your graph, -highlight the point where total revenues are maximized. -show how profits may be seen. -highlight the point where total profits are maximized c. Next, create a table showing marginal revenues, marginal costs and marginal profits. Indicate in this table where TOTAL profits are maximized Q 0 1 2 3 4 5 6 7 8 d. Finally, in the coordinate axes below create a graph that illustrates the relationships between marginal revenue and marginal cost. - show the point where TOTAL profits are maximized - show the point where marginal profits are zero. . 142 MR MC M Profit

MR, MC

Qty

143

2.Take the derivatives of the following functions. Do not simplify. a. f(x) = b. f(x) = c. f(x) = d. f(x) = e. f(x) = f. f(x) = 10 20x2 30x 20x + 30x3 f(x) f(x) f(x) = = = f(x) _______________________________ _______________________________ _______________________________ =_______________________________ =_______________________________ =_______________________________

(10 + 15x2)(3x 4x3) f(x) 10/x2 f(x)

Problem Set #3 1. The American Bagel Co. is considering opening a Bagel bakery and coffee shop near Campus. In an effort to predict the profitability of this venture, their in-house consulting team estimated that the daily demand for Bagels in the area to be the following Q = -5P + 20Pp - 30Pc +5I Where P = the price of bagels, Pp = the price of pastries (each), Pc = the price of coffee (per cup), and I = Income (average annual per capita, for local residents in thousands of dollars) a. Comment on this estimated demand function. Are the parameters reasonable? Why or why not? (Restrict your commentary to the signs of the parameters) Reasonable Sign? (Y/N) Reason P _________________________________________________ Pp _________________________________________________ Pc _________________________________________________ I __________________________________________________

144

b. Suppose that the price of pastries = $1, coffee costs $.50 per cup, and average per capita income in the fan area is $12,000. Calculate the inverse demand curve (e.g., express price as a function of quantity). Demand: __________________________________

Inverse demand _________________________________ c. What happens to the predicted number of bagels sold per day if the price of bagels is increased from $1.00 to $2.00? Is this a change in demand or a change in quantity demanded? Initial Quantity: __________________________________

Terminal Quantity _________________________________ Change in Demand or Change in Quantity Demanded (Circle One)

145

d. Holding the price of bagels again at $1.00, what happens to the predicted number of bagels sold per day if the price of coffee increases from $.50 to $1.00 per cup. Is this a change in demand or a change in quantity demanded? Initial Quantity: __________________________________ Terminal Quantity _________________________________ Change in Demand or Change in Quantity Demanded (Circle One) e. In the coordinate axes below, illustrate the changes that occurred above in parts c and d above. (Note, your graph need not be precise) P

Q e. Suppose that the price of Bagels is set at $1. How much consumer surplus do consumers receive at that price? Consumer Surplus: __________________________________ Problem Set #3 1. The American Bagel Co. is considering opening a Bagel bakery and coffee shop near Campus. In an effort to predict the profitability of this venture, their in-house consulting team estimated that the daily demand for Bagels in the area to be the following Q = -5P + 20Pp - 30Pc +5I

146

Where P = the price of bagels, Pp = the price of pastries (each), Pc = the price of coffee (per cup), and I = Income (average annual per capita, for local residents in thousands of dollars) a. Comment on this estimated demand function. Are the parameters reasonable? Why or why not? (Restrict your commentary to the signs of the parameters) Reasonable Sign? (Y/N) Reason P _______Y__________________________Downsloping Demand Curve (d.m.u.) Pp ______Y_________________________Pastries and Bagels are Substitutes Pc ______Y_________________________Coffee is a complement__________ I _______Y________________________Food consumed at a caf s probably a normal good b. Suppose that the price of pastries = $1, coffee costs $.50 per cup, and average per capita income in the fan area is $12,000. Calculate the inverse demand curve (e.g., express price as a function of quantity). Demand: Q = -5P + 20(1)- 30(.5)+ 5(12) = -5P +65 = 13 - Q/5______________________

Inverse demand _______P

c. What happens to the predicted number of bagels sold per day if the price of bagels is increased from $1.00 to $2.00? Is this a change in demand or a change in quantity demanded? (Note: The appropriate was corrected via an email broadcast) Quantity Changes from: 65-5(1)= 60 to 65 5(2) = 55

Change in Demand or Change in Quantity Demanded (Circle One) d. Holding the price of bagels again at $1.00, what happens to the predicted number of bagels sold per day if the price of coffee increases from $.50 to $1.00 per cup. Is this a change in demand or a change in quantity demanded? For these problems you need a new demand curve Q = -5P + 20(1)- 30(1)+ 5(12) = -5P +50

147

Demand:

= =

-5P + 20(1)- 30(1)+ 5(12) 50 5P

Inverse demand _P = 10 Q/5________________ Before, at Pc = .50, Q = 60 Now, at P = 1, Q = 50 Change in Demand or Change in Quantity Demanded (Circle One) e. In the coordinate axes below, illustrate the changes that occurred above in parts c and d above. (Note, your graph need not be precise) P

(c)

(d) Q e. Suppose that the price of Bagels is set at $1. How much consumer surplus do consumers receive at that price? The demand curve is _P = 13 - Q/5. When P=1, Q = 60. When P = 13, Q = 0. Thus, we need to find the area of a triangle with a length of 60 and a height of 12 Consumer Surplus: _.5(12)(60) = 360_________________________

Problem Set #4. Equilibrium Analysis. 1. Consider the market for popcorn crisps a new product that you prepare fresh (like popcorn) but that has the look and feel of a potato chip.

148

a. What relationship should characterize the relationship between the price of popcorn crisps and the number of packages sold per month? Why? Relationship: __ ___________________________ Reason: __ ______________

b. What relationship should characterize the relationship between the price of popcorn crisps and the number of packages produced per month? Why? Relationship: _ ____________________________ Reason: __ _____________ c. Suppose that Crisp-Makers of America, Local #458, a trade union that manufactures the crisps, successfully negotiates a wage increase. Will this affect the supply of or the demand for the crisps. How would the curve be affected? Supply / Demand (circle one). Direction of adjustment: ________________ d. Relative to the initial equilibrium, identify the price and/or quantity adjustment. What process causes the adjustment to the new equilibrium? Equlibrium Price Change: Equilibrium Quantity Change Increase /Decrease /No Change (Circle One) Increase /Decrease /No Change (Circle One)

Adjustment Process: _______________________________________________________ _______________________________________________________________________

149

3.

Suppose that the free market equilibrium price of bourbon is $6.00 a bottle, and that the government sets a price ceiling of $4.50 a bottle on bourbon. The most likely result of this action is that: a. b. c. d. there will now be an excess demand for bourbon the market price of bourbon will remain at $6.00 a bottle. there will be a large reduction in the quantity of bourbon demanded. there will now be an excess supply of bourbon.

4. The winds of the recent hurricanes in Florida are bringing soothing financial gain to California citrus growers. Due to the extensive damage to the Florida citrus corp, California citrus products are commanding their highest prices ever. Which of the following statements best explains the economics of the quotation? a b. c. d. The supply of Florida oranges has increased, causing their price to increase and the demand for the substitute California oranges to also increase. The supply of Florida oranges has decreased, causing the demand for California oranges to increase and their prices to rise. The demand for Florida oranges has been reduced by the hurricanes, causing a greater demand for the California oranges and an increase in their price. The demand for Florida oranges has been reduced causing their prices to fall and therefore increasing the demand for the substitute California oranges.

5.

Suppose that a new, influential research study proves conclusively that cigarette smoking causes cancer in a way that causes people to start to pay more attention to the warning that "cigarette smoking is injurious to health." At the same time, suppose that new restrictions on the use of fertilizer dramatically raise tobacco production costs. Using conventional supply and demand analysis, one would expect the combined effect of these changes on the cigarette market to be: a. b. c. d. an increase in equilibrium price, with the change in equilibrium quantity uncertain a decrease in equilibrium price, with the change in equilibrium quantity uncertain. an increase in equilibrium quantity, with the change in equilibrium price uncertain. a decrease in equilibrium quantity, with the change in equilibrium price uncertain.

150

/ Problem Set #4. Equilibrium Analysis. 1. Consider the market for popcorn crisps a new product that you prepare fresh (like popcorn) but that has the look and feel of a potato chip. a. What relationship should characterize the relationship between the price of popcorn crisps and the number of packages sold per month? Why? Relationship: _Inverse___________________________ Reason: __Diminishing Marginal Utility ______________

b. What relationship should characterize the relationship between the price of popcorn crisps and the number of packages produced per month? Why? Relationship: _ Direct____________________________ Reason: __Law of Diminishing Returns (Crowding) _____________ c. Suppose that Crisp-Makers of America, Local #458, a trade union that manufactures the crisps, successfully negotiates a wage increase. Will this affect the supply of or the demand for the crisps. How would the curve be affected? Supply / Demand (circle one). Direction of adjustment: __Supply will shift up and in __ d. Relative to the initial equilibrium, identify the price and/or quantity adjustment. What process causes the adjustment to the new equilibrium? Equlibrium Price Change: Equilibrium Quantity Change Increase /Decrease /No Change (Circle One) Increase /Decrease /No Change (Circle One)

Adjustment Process: _At the initial price with new supply and old demand a shortage exists_______

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3.

Suppose that the free market equilibrium price of bourbon is $6.00 a bottle, and that the government sets a price ceiling of $4.50 a bottle on bourbon. The most likely result of this action is that: a. b. c. d. there will now be an excess demand for bourbon the market price of bourbon will remain at $6.00 a bottle. there will be a large reduction in the quantity of bourbon demanded. the market price of bourbon will fall because the price ceiling will create an excess supply.

4. The winds of the recent hurricanes in Florida are bringing soothing financial gain to California citrus growers. Due to the extensive damage to the Florida citrus corp, California citrus products are commanding their highest prices ever. Which of the following statements best explains the economics of the quotation? a b. c. d. The supply of Florida oranges has increased, causing their price to increase and the demand for the substitute California oranges to also increase. The supply of Florida oranges has decreased, causing the demand for California oranges to increase and their prices to rise. The demand for Florida oranges has been reduced by the hurricanes, causing a greater demand for the California oranges and an increase in their price. The demand for Florida oranges has been reduced causing their prices to fall and therefore increasing the demand for the substitute California oranges.

5.

Suppose that a new, influential research study proves conclusively that cigarette smoking causes cancer in a way that causes people to start to pay more attention to the warning that "cigarette smoking is injurious to health." At the same time, suppose that new restrictions on the use of fertilizer dramatically raise tobacco production costs. Using conventional supply and demand analysis, one would expect the combined effect of these changes on the cigarette market to be: a. b. c. d. an increase in equilibrium price, with the change in equilibrium quantity uncertain a decrease in equilibrium price, with the change in equilibrium quantity uncertain. an increase in equilibrium quantity, with the change in equilibrium price uncertain. a decrease in equilibrium quantity, with the change in equilibrium price uncertain.

152

Spring 2006 Problem Set #5 1. Chez What has recently opened a stand between the Commons and the School of Business. They sell mostly breakfast items, particularly coffee, and croissants. The operators are particularly concerned about the demand for croissants. In an effort to assess the wisdom of their pricing strategy, they asked an economist client to estimate the demand for croissants sold at Chez What. He came with the following information. Q = 102-2P - 10Pc + 15Pa Where P = the price of croissants, Pc = the price of coffee sold at Chez What, and Pa = the price of coffee sold at the nearby Alpine bagel bakery a. Suppose that the price of coffee at Chez What is $1 and that the price of coffee at the Alpine Bagel Bakery is $2 per cup. Calculate the inverse demand curve (e.g., express price as a function of quantity). Demand: __________________________________

Inverse demand _________________________________ For parts b and c assume that the price of croissants is $1. b. Calculate the point price elasticity of demand. Would Chez What increase profits by Raising the price of croissants? ___________________________________

Raise Price? ___________________________________ c. Calculate the cross price elasticity of demand for croissants with respect to the price of coffee. How is coffee related to croissants? Why? XY Relationship ___________________________________ ________________________

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2. Joe is evaluating the marketing strategy at his restaurant and inn. Suppose that in response to a $2.00 off" sales promotion for Spaghetti dinners, Joe finds that nightly dinner sales increase from 20 per night to 40. Normally, the dinners sell for $6.00. a. What is the arc price elasticity of demand? = __________________________

b. Would Joe increase revenues by further reducing the price? What about profits? Explain. Price reduction prompts revenue increase Price reduction prompts profit increase Y / N / Cant tell Y / N / Cant tell

Explanation _____________________________________________

3. Fred McCutchen a new employee at McCutchoni Frozen Foods estimates that the price elasticity of demand for McCutchoni Frozen Pizzas to be -1.5, as compared to a price elasticity of demand for frozen pizzas in general of -2.34. In light of the relative inelasticity of McCutchoni Frozen Pizza's, Fred recommends raising the price to increase sales revenues. You, a more experienced member of the firm, are suspicious of Joe's estimate, and are skeptical of his recommended plan of action? Why? (Hint: Think about the determinants of price elasticity of demand) Reason to suspect Freds estimate______________________________________________ Reason to doubt Freds plan of action _________________________________________ E303, Problem Set #5 1. Chez What has recently opened a stand between the Commons and the School of Business. They sell mostly breakfast items, particularly coffee, and croissants. The operators are particularly concerned about the demand for croissants. In an effort to assess the wisdom of their pricing strategy, they asked an economist client to estimate the demand for croissants sold at Chez What. He came with the following information. Q = 102-2P - 10Pc + 15Pa

154

Where P = the price of croissants, Pc = the price of coffee sold at Chez What, and Pa = the price of coffee sold at the nearby Alpine bagel bakery a. Suppose that the price of coffee at Chez What is $1 and that the price of coffee at the Alpine Bagel Bakery is $2 per cup. Calculate the inverse demand curve (e.g., express price as a function of quantity). Demand: Q = = = 102 2P 10(1) + 15(2) 102 2P +20 122 2P

Inverse demand ____P = 61 - .5Q________________________ For parts b and c assume that the price of croissants is $1. b. Calculate the point price elasticity of demand. Would Chez What increase profits by Raising the price of croissants? ? ____dQ/dP (P/Q)___= -2(1)/120 = -.0167__________

Raise Price? ______Yes, the firm is on the inelastic portion of demand. c. Calculate the cross price elasticity of demand for croissants with respect to the price of coffee (at Chez What). How is coffee related to croissants? Why? XY dQ/dPc (Pc/Q) = -10(1)/120_= -.0813___________

Relationship __Complements: Inverse relationship_________________

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2. Joe is evaluating the marketing strategy at his restaurant and inn. Suppose that in response to a $2.00 off" sales promotion for Spaghetti dinners, Joe finds that nightly dinner sales increase from 20 per night to 40. Normally, the dinners sell for $6.00. b. What is the arc price elasticity of demand? = _ (Q1-Q0)(P1+P0) (P1-P0)(Q1+Q0) = (20 40)(6+4) = -20(10) = (4 6)(20+40) 120 -1.67

b. Would Joe increase revenues by further reducing the price? What about profits? Explain. Price reduction prompts revenue increase Price reduction prompts profit increase Y / N / Cant tell Y / N / Cant tell

Explanation Joe is on the elastic portion of demand. A price reduction will increase revenues. However, the profitability of such an action cannot be discerned absent cost information 3. Fred McCutchen a new employee at McCutchoni Frozen Foods estimates that the price elasticity of demand for McCutchoni Frozen Pizzas to be -1.5, as compared to a price elasticity of demand for frozen pizzas in general of -2.34. In light of the relative inelasticity of McCutchoni Frozen Pizza's, Fred recommends raising the price to increase sales revenues. You, a more experienced member of the firm, are suspicious of Joe's estimate, and are skeptical of his recommended plan of action? Why? (Hint: Think about the determinants of price elasticity of demand) Reason to suspect Freds estimate: Elasticity for a group should be lower than for a particular product in that group Reason to doubt Freds plan of action: If McCutchoni is on the elastic portion of demand, a price increase will reduce revenues. E303, Problem Set #6 1. We-R-Food's, a restaurant consulting firm estimates that in the Southeastern United States a 10% reduction in the price of fried potatoes will increase sandwich sales by 20%. But they further estimate that a 10% reduction in the price of salads will decrease sandwich sales by 15%.

156

a. What is the implied cross price elasticity of sandwiches with respect to changes in the price of fried potatoes?

sandwiches ff = _________________________________________
b. What is the implied cross price elasticity of sandwiches with respect to changes in the price of. salads?

sandwiches salads = _________________________________________

c. From your cross price elasticity estimates, what can you say about the relationship between fried potatoes and sandwiches, and between salads and sandwiches at fast food restaurants in the Southeastern United States? Why? French fries and Sandwiches_______________________________ Reason ________________________________________________ Salads and Sandwiches_______________________________ Reason ________________________________________________ 2. Suppose that for Mazda Miata's, the income elasticity I = 3. a. What does the above information suggest about the kind of product a Mazda Miata is? Why? Kind of Product _______________________________ Reason ________________________________________________ b. Economists predict a strong rebound in economic performance this year, and predict that GNP will grow by 4%. What effect will this have on Miata sales? Estimated percentage change in sales _______________________________ 3. The demand for Sorby ZIP disks is given by the following equation Q = 10P-3PH1.5I2.

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Where P is the price of the ZIP disks PH is the price of Hard disk drive space, and I is income (in thousands of dollars) a. What is the price elasticity of demand?

_______________________________

b. What is the income elasticity of demand? What does the income elasticity of demand suggest about the kind of good Sorby disks are?

______________________________

Kind of Good _____________________________________________. c. Suppose that due to a recession in the market for information goods income for ZIP disk users is projected to fall by 4% next year. How will sales be affected?

____________________________________________________

Problem Set #6 1. We-R-Food's, a restaurant consulting firm estimates that in the Southeastern United States a 10% reduction in the price of fried potatoes will increase sandwich sales by 20%. But they further estimate that a 10% reduction in the price of salads will decrease sandwich sales by 15%. a. What is the implied cross price elasticity of sandwiches with respect to changes in the price of fried potatoes?

sandwiches ff = __% Qs/% Pff = -20/10 = -2______________________________________

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b. What is the implied cross price elasticity of sandwiches with respect to changes in the price of. salads?

sandwiches salads = _% Qs/% Psalads = -15/-10 = 1.5

c. From your cross price elasticity estimates, what can you say about the relationship between fried potatoes and sandwiches, and between salads and sandwiches at fast food restaurants in the Southeastern United States? Why? French fries and Sandwiches___Complements, ________________________ Reason __xy<0_________________________________________________ Salads and Sandwiches__Substitutes_____________________________ Reason __xy>0______________________________________________ 2. Suppose that for Mazda Miata's, the income elasticity I = 3. a. What does the above information suggest about the kind of product a Mazda Miata is? Why? Kind of Product __Normal Cyclical Good_________________________ Reason __I>1_____________________________________________ b. Economists predict a strong rebound in economic performance this year, and predict that GNP will grow by 4%. What effect will this have on Miata sales? Estimated percentage change in sales __ =% Q/% I thus, 3 = % Q/4 % Q = 12% 3. The demand for Sorby ZIP disks is given by the following equation Q = 10P-3PH1.5I2. Where P is the price of the ZIP disks PH is the price of Hard disk drive space, and I is income (in thousands of dollars)

a. What is the price elasticity of demand?

159

__-3_____________________________

b. What is the income elasticity of demand? What does the income elasticity of demand suggest about the kind of good Sorby disks are?

___2.___________________________

Kind of Good ____Normal, cyclical__________________. c. Suppose that due to a recession in the market for information goods income for ZIP disk users is projected to fall by 4% next year. How will sales be affected?

_% Q/% I. Thus, 2 = % Q/-4, % Q=-8

Problem Set #7 Regression Analysis Consider the following data Sales Adv Yi Xi 3 4 6 5 7 6 5 9 10 9 1 2 3 4 5 6 7 8 9 10

1. Input this data on a spreadsheet. Using the regression option, generate regression predictions. Write your results as an equation, as we did in class. In particular, (a) Write the regression equation, with estimated coefficients,

160

(b) Below the regression equation, list in parentheses the standard errors of the coefficient estimates (c) To the right of the estimated equation write R2 = ^ Equation: ____Y_=___________________________________ R2 = Std Errors ( ) ( )

2. Multivariate Regression. Now add to your above regression in a price variable, with values: 8, 7.5, 7.25, 7.25, 6, 6.75, 6, 5, 4.4, 5.2. Estimate the new regression equation. Print regression results. Write out the estimated demand function, as in 1 above. Equation: ____Y_=___________________________________ R2 = Std Errors ( )( )( )

3. Evaluating regression results: A Descriptive Statistic. With the data you generated in (2) above do the following. a. Interpret the R2. (In a sentence) _________________________________________________________________ _ b. At an approximate 95% level of confidence, can you conclude that price affects sales? Explain Price Affects Sales? Y/N (circle one) Reason: ____________________________________________________

Problem Set #7 Regression Analysis Consider the following data

161

Sales Yi 3 4 6 5 7 6 5 9 10 9

Adv Xi 1 2 3 4 5 6 7 8 9 10

1. Input this data on a spreadsheet. Using the regression option, generate regression predictions. Write your results as an equation, as we did in class. In particular, (a) Write the regression equation, with estimated coefficients, (b) Below the regression equation, list in parentheses the standard errors of the coefficient estimates (c) To the right of the estimated equation write R2 = ^ Equation: ____Y_=___2.733____+ 0.667Xi__________________ R2 = .757 Std Errors (0.827 ) ( 0.133 )

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2. Multivariate Regression. Now add to your above regression in a price variable, with values: 8, 7.5, 7.25, 7.25, 6, 6.75, 6, 5, 4.4, 5.2. Estimate the new regression equation. Print regression results. Write out the estimated demand function, as in 1 above. Equation: ____Y_=__17.68_ + 0.005 1.78 _______________________ R2 = 0.868 Std Errors ( 6.19) (0.133 ) ( 0.734)

3. Evaluating regression results: A Descriptive Statistic. With the data you generated in (2) above do the following. a. Interpret the R2. (In a sentence) 86.8% of the movement in the sales is explained by movements in price and advertising. _________________________________________________________________ _

b. At an approximate 95% level of confidence, can you conclude that price affects sales? Explain. Price Affects Sales? Y/N (circle one) Reason: The interval about price, -3.52 to -0.048 doesnt include 0.

Problem Set 8. E303 Davis, Spring, 2006. 1. Bill Smith is the new Director of Marketing at the Jonesfield Ham Company. In the interest of assessing Jonesfields pricing policy, Bill examined sales data for the last 24 months, and estimated the following relationship Q = 125 (15) R2 = Where Q P .71, 14P (2.8) + 5Ps (3.2) + 4I (3.6)

MSE = 2.75

number of sugar cured hams sold in the Richmond area per month price per pound of the hams

163

Ps I

price per point of Smithfield salt-cured country hams Per capita income (in thousands of dollars.)

Assume that at present P = $3.50; Ps = $5.00, I = $12 (000). 1. Construct an approximate 95% confidence interval about the price variable. Does this suggest that price is an important explainor of sales? Why or why not? Interval ______________ to _____________

Price an important explainor of sales? Y / N. (circle one) Explanation __________________________________________________________________. 2. Construct an approximate 95% confidence interval about the income variable. Does this suggest that income is an important explainor of sales? Why or why not? Interval ______________ to _____________

Income an important explainor of sales? Y / N. (circle one) Explanation __________________________________________________________________. 3. Assume your answer to 2 was no. Should you eliminate the income variable from your regression? Eliminate? Y / N (circle one) Explanation __________________________________________________________________.

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4. Using current values (e. g., P = $3.50; Ps = $5.00, I = $12 (000).) a) forecast sales for the next month.

Forecast ______________ b) Provide an approximate 95% confidence band about your projection.

Interval ______________

to

_____________

c) Aside from the width of the interval, what factor would tend to make you less confident of your projection? Why? Factors :_______________________

________________________ Reason that they would undermine your confidence in the forecast _______________________________________________________________________ _

Problem Set 8. E303 Davis, Spring, 2006.

KEY

1. Bill Smith is the new Director of Marketing at the Jonesfield Ham Company. In the interest of assessing Jonesfields pricing policy, Bill examined sales data for the last 24 months, and estimated the following relationship Q = 125 (15) R2 = Where Q .71, 14P (2.8) + 5Ps (3.2) + 4I (3.6)

MSE = 2.75

number of sugar cured hams sold in the Richmond area per month

165

P Ps I

price per pound of the hams price per point of Smithfield salt-cured country hams Per capita income (in thousands of dollars.)

Assume that at present P = $3.50; Ps = $5.00, I = $12 (000). 1. Construct an approximate 95% confidence interval about the price variable. Does this suggest that price is an important explainor of sales? Why or why not? 14 + 2(2.8) 19.6 to 14 2(2.8) to 8.4

Yes, price is an important explainor of sales. The interval does not include 0. 2. Construct an approximate 95% confidence interval about the income variable. Does this suggest that income is an important explainor of sales? Why or why not? 4 + 2(3.6) 11.2 to to 4 2(3.6) -3.2

No, I cannot conclude that income is an important explainor of sales. The interval includes 0. 3. Assume your answer to 2 was no. Should you eliminate the income variable from your regression? No. Eliminating relevant variables can create bias.

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4. Using current values a) forecast sales for the next month. Q = 125 - 14(3.5) + 5(5) + 4(12) = 125 49 + 25 + 48 = 149 b) Provide an approximate 95% confidence band about your projection. 149 + 2(2.75) to 154.5 to 149 2(2.75) 143.5

c) What would tend to make you less confident of your projection? Why? Factors that make the future look different from the past, such as - Independent variable values that deviate from their means - Some probability of a change in the underlying legal or social environment These factors are not included in the estimates

Fall 2005

KEY

1. Optimal Use of a Single Input. Julian Smyth is manages production at Taffy Apple Inc., a company that produces a variety of taffy/fruit candies. Over the last several months, he has varied then number of employees on his caramel apple production line, and found the following relationship. Labo r 5 6 7 8 9 10 11 12 MP TP 100 150 230 300 360 410 450 480 MRP

50 80 70 60 50 40 30

250 400 350 300 250 200 150

a. In the column labeled MP, calculate the marginal product of labor. (Note, make your first entry in row 6, as the change between 5 and 6 units of labor) See listings under MP 167

b. Suppose the apples sell for $5 per (dozen) box. Calculate the Marginal Revenue Product (MRP) See listing under MRP c. If labor costs $225 per day, how many laborers should the firm hire? Number ______10___________________________________

168

2. Optimal Use of a Single Input. A Graphical Representation. a. In the coordinate axes provided below, illustrate the general relationship between MRP and the Price of Labor. Identify the equilibrium quantity of labor to hire. (Note, your graph need not use the numbers in problem 3. Just be certain to include ranges that illustrate gains from specialization and the law of diminishing returns in your graph. $

PL MRP L* Q

b. Suppose that the candy workers union agrees to way concessions, that make the price of labor fall. In the coordinate axes below illustrate the effect on the equilibrium quantity of labor $

PL PL L* L* Q c. Finally, suppose that the price of caramel apples increases. Illustrate the effect of this change on the equilibrium quantity of labor employed. $

MRP* MRP L* L* Q

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3. Optimal use of multiple inputs. In his shop, Julian Valenti retrofits sunroofs into automobiles. The process can use a combination of skilled labor and unskilled labor. Given his current mix of employees, the marginal product of the last unit of skilled labor is 3 sunroofs per day, and the marginal product of the last unit of unskilled labor is 1 sunroof per day. Current market rates for skilled and unskilled labor is $40 and $10, respectively. Is Julian using a least cost combination of inputs? If not, which of type of labor should he use relatively more? Comparison Expression: Compare __MPS/Ps_to MPU/PU_here 3/40 vs. 1/10___ Result:_Hire relatively more unskilled labor_________________________ Problem Set #9 Spring 2006 1. Optimal Use of a Single Input. Julian Smyth is manages production at Taffy Apple Inc., a company that produces a variety of taffy/fruit candies. Over the last several months, he has varied then number of employees on his caramel apple production line, and found the following relationship. Labo r 5 6 7 8 9 10 11 12 MP TP 100 150 230 300 360 410 450 480 MRP

50 80 70 60 50 40 30

250 400 350 300 250 200 150

d. In the column labeled MP, calculate the marginal product of labor. (Note, make your first entry in row 6, as the change between 5 and 6 units of labor) e. Suppose the apples sell for $5 (per dozen) box. Calculate the Marginal Revenue Product (MRP) f. If labor costs $225 per day, how many laborers should the firm hire? Number ___________________________________________

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2. Optimal Use of a Single Input. A graphical representation. a. In the coordinate axes provided below, illustrate the general relationship between MRP and the Price of Labor. Identify the equilibrium quantity of labor to hire. (Note, your graph need not use the numbers in problem 3. Just be certain to include ranges that illustrate gains from specialization and the law of diminishing returns in your graph. $

Q b. Suppose that the candy workers union agrees to way concessions, that make the price of labor fall. In the coordinate axes below illustrate the effect on the equilibrium quantity of labor $

Q c. Finally, suppose that the price of caramel apples increases. Illustrate the effect of this change on the equilibrium quantity of labor employed. $

171

2. Optimal use of multiple inputs. In his shop, Julian Valenti retrofits sunroofs into automobiles. The process can use a combination of skilled labor and unskilled labor. Given his current mix of employees, the marginal product of the last unit of skilled labor is 3 sunroofs per day, and the marginal product of the last unit of unskilled labor is 1 sunroof per day. Current market rates for skilled and unskilled labor are $40 and $10, respectively. Is Julian using a least cost combination of inputs? If not, which of type of labor should he use relatively more? Comparison Expression:_______________________________________ Result:______________________________________________________ Problem Set #10 Costs of the Firm 1. Short run costs for the firm. Consider a firm with the following Fixed Costs and Marginal Costs
Q 0 1 2 3 4 5 6 7 8 TFC 15 3 2 1 2 5 9 14 20 TVC TC MC AFC AVC ATC

a) Total Costs a. Fill in the blanks for TVC and TC Construct a graph that illustrates the TVC, TFC, and TC curves b. On this graph, show how MC may be illustrated (at any arbitrary point) b) Unit Costs 172

a. Fill in the blanks for AVC, AFC and ATC b. Construct a graph that illustrates MC,AVC, and ATC c. What is the relationship between AVC and ATC? Why? Relationship _________________________ Reason: ____________________________. d. What is the relationship between MC and AVC? MC and ATC? Why? Relationship _______________________________ Reason: _________________________________ 2. Production for a firm in the Short Run. a. In general, how should the firm determine the optimal output level? Rule:_________________. b. Referring again to table 1, if the price is $10 per unit, how much should the firm produce? Illustrate this result in your unit cost figure. Is the firm earning economic profits at that level of output? c. What is the minimum price at which the firm would produce? Why? Shutdown point:_________________________________________

d. When does the firm breakeven? Why? Breakeven point:____________________________________________. Problem Set #10 Costs of the Firm

173

3. Short run costs for the firm. Consider a firm with the following Fixed Costs and Marginal Costs
Q 0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 TFC 15.00 15.00 15.00 15.00 15.00 15.00 15.00 15.00 15.00 TVC 0.00 3.00 5.00 6.00 8.00 13.00 22.00 36.00 56.00 TC 15.00 18.00 20.00 21.00 23.00 28.00 37.00 51.00 71.00 MC 3.00 2.00 1.00 2.00 5.00 9.00 14.00 20.00 AFC 15.00 7.50 5.00 3.75 3.00 2.50 2.14 1.88 AVC 3.00 2.50 2.00 2.00 2.60 3.67 5.14 7.00 ATC 18.00 10.00 7.00 5.75 5.60 6.17 7.29 8.88

c) Total Costs a. Fill in the blanks for TVC and TC Construct a graph that illustrates the TVC, TFC, and TC curves
80.00 70.00 60.00 50.00 40.00 30.00 20.00 10.00 0.00 0.00 TFC MC TVC TC

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

b. On this graph, show how MC may be illustrated (at any arbitrary point) At any point, MC is the slope of the line tangent to the curve d) Unit Costs a. Fill in the blanks for AVC, AFC and ATC See table above b. Construct a graph that illustrates MC,AVC, and ATC 174

25

MC

20

15 ATC 10 AVC 5

0 0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

c. What is the relationship between AVC and ATC? Why? Relationship _The curves approach each other as quantity expands. Reason: The difference between them is AFC d. What is the relationship between MC and AVC? MC and ATC? Why? Relationship MC cuts both AVC and ATC at their minimum points Reason: The Marginal Drives the average

Production for a firm in the Short Run. a. In general, how should the firm determine the optimal output level? Rule:_Compare MR (price) to MC________________. b. Referring again to table 1, if the price is $10 per unit, how much should the firm produce? Illustrate this result in your unit cost figure. Is the firm earning economic profits at that level of output? The firm should produce 6 units. The firm is earning profits because at a price of $10 AR (=P) exceeds ATC.

175

c. What is the minimum price at which the firm would produce? Why? Shutdown point:_When price is such that P=MC = AVC. Here at an output of 4, (and AVC=MC = 2 At prices below $2, the firm would not only lose its fixed costs, but it would also be paying variable costs to produce d. When does the firm breakeven? Why? Breakeven point: When price is such that P = MC = ATC. At this point the firm just covers all costs of operation.

Problem Set #11 1. Characterizing Cost Functions Analytically. Consider the Cost function TC = 100 +10Q + Q2 a. What are the fixed costs for this relationship? What are Variable Costs? Fixed Costs: ____100__________________________________ Variable Costs: _10Q + Q2 ________________________________ b. What is the marginal cost function? Marginal Cost: ___10+2Q___________________________________ c. Identify Expressions for Average Variable and Average Total Cost Average Variable Costs: __ 10+Q_________________________________ Average Total Costs: ____ 100/Q + 10 + Q________________________________ d. Finally, identify the output levels where AVC and ATC are minimized.

176

AVC min: ___0___________________________________ 100/Q + 10 + Q = 10 + 2Q 100/Q = Q ATC min: _Q = 10_________________________________ 2. Sunk Cost vs. Fixed Cost: Radio broadcaster CoolPlay Inc., paid $50,000 for an operating license last year, and the company is not meeting its advertising revenue expectations. Currently, they company is taking in $6,000 per month in revenues and has $5,000 per month in variable expenses. What difference does it make to CoolPlay if the license is transferable (e.g., resalable) or not? Under which condition would CoolPlay remain in the market longer (resalable or not resalable?) Difference ___If the license is nontransferable, it is a sunk costs. Condition Under Which CoolPlay will remain in the market longer? Saleable/ Not Resalable (Circle one)

177

3. Long Run Costs for the Firm. Consider the following long run cost curve.
25 20 15 10 LRAC

MES

Economies of Scale
0 0 2 4

a. On the figure to the left, identify the range of the LRAC where the firm enjoys economics of scale What factors might allow a firm to enjoy economies of scale?

Diseconomies of Scale
6 8 10

Reasons for scale economies: __Gains from specialization. Physical relationships b. Identify the range of the LRAC where the firm suffers diseconomies of scale. What factors would result in diseconomies of scale Reasons for diseconomies of scale: Transportation Costs, Managerial Inefficiency (Crowding) c. What is MES on the above figure? Suppose that at an average cost of $10 per unit demand is such that the industry could sell 40 units. What is the maximum number of firms that are sustainable in this market? Why? Maximum number of sustainable firms: __If MES is 4, the industry could suppose 10 firms (students might see MES at 3 units as well.) Firms must operate at MES to efficiently survive. 4. Returns to Scale. Jakes Free Runoff Bottled Water Company Produces with the Long Run Production Function Q = (KL)2/3 Currently K = 4 and L = 4. If Jakes doubles inputs to K=8 and L=8, will it realize increasing, constant or decreasing returns to scale (circle one)? As a result, does Jakes enjoy economies of scale, diseconomies of scale, or does Jakes appear t be operating at Efficient Scale? (circle one)

178

Problem Set #12 1. Multi-Product Production. Consider the following cost relationship for a firm that can produce 2 products, Q1 and Q2. C(Q1, Q2) a. = 300 + 5Q1 + 5Q2 + Q1Q2

Does the firm exhibit cost complementarities? Explain.

Cost Complementarities? (Y / N) __________________________ b. At an output level Q1 = 20 and Q2 = 20 does the firm exhibit economies of scope? Explain Economies of Scope? (Y/ N) Justification: ____________________________ 2. Input Acquisition. The Roasted Pepper Pizza Company features roasted fresh peppers and goat cheese on its Mediterranean Style Pizzas. The local company purchases 200 pounds of fresh peppers 250 pounds of goat cheese from a local Grocery wholesaler each day at the market price. a. What kind acquisition is this? (Circle One) Spot Market Purchase, Contract or Vertical Integration

b. What features of this transaction suggest that a contractual arrangement might be a good idea? What problem would a contract alleviate? _________________________________________________________ _________________________________________________________

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3. Compensation Issues. Stevens Cards produces and sells a low-volume high-end holiday cards. The company is particularly well-known for the elegant poems printed on the inside of the cards. At present the company compensates poets on a perpoem basis. On the other hand, company executives, disguised as customers monitors sales people, who are paid an hourly fee. a. How might the company alter its compensation package for the poets to improve firm performance? Why would such an alteration help? Alteration:_______________________________________________ Why the alteration may help:________________________________ ________________________________________________________ b. How might the company alter its compensation for salespeople to improve firm performance? Alteration:_______________________________________________ Why the alteration may help:________________________________ _________________________________________________________

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Homework Problem Set #13 NEW E303 Davis, Spring 2006 1. The Competitive Firm in the Intermediate Run. a. In the two coordinate axes below, illustrate the relationship between market supply and demand and optimizing decisions of a firm. Illustrate a situation where the firm is earning economic profits. P P

Market

Firm

b. What dynamic tends to drive profits to zero? Illustrate this dynamic in the same graph. Dynamic:________________________________________________________

2. Finding the Competitive Price. Consider a firm with a TC function TC = 49 + 7Q + Q2

What price would this firm charge if it was in a long run competitive equilibrium? What Profits would it earn? Why? Optimal Price _________________________________________________ Optimal Profits ________________________________________________ Reason: _______________________________________________________ _____________________________________________________________

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3. The Competitive Firm in the Long Run. In the 1990s many firms went through a period of downsizing that was induced by technological developments (in large part, the computer spreadsheet). a. In the right most panel of the two-panel graph below, illustrate the carrot and the stick that drives firms to downsize. P P

Market

Firm

b. Illustrate the market response to downsizing in the rightmost panel of the above figure. c. Explain how the market price can fall as firms reduce their scale of operation. Explanation___________________________________________________ Homework Problem Set #13 NEW E303 Davis, Spring 2006 4. The Competitive Firm in the Intermediate Run. a. In the two coordinate axes below, illustrate the relationship between market supply and demand and optimizing decisions of a firm. Illustrate a situation where the firm is earning economic profits. P S P MC

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Profits S (b) (a) D Market Q Firm Q* Q P=MR ATC

b. What dynamic tends to drive profits to zero? Illustrate this dynamic in the same graph. Dynamic:___Entry causes supply to shift out, which drives down prices and profits 5. Finding the Competitive Price. Consider a firm with a TC function TC = 49 + 7Q + Q2

What price would this firm charge if it was in a long run competitive equilibrium? What Profits would it earn? Why? ATC = 49/Q + 7 + Q = MC = 7 + 2Q Q=7 Optimal Price ________P = MC = 7 + 2(7) = 21________________ Optimal Profits = 0 _______________________________________ Reason: __In an intermediate run competitive equilibrium entry and exit drive, P = ATC.

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6. The Competitive Firm in the Long Run. In the 1990s many firms went through a period of downsizing that was induced by technological developments (in large part, the computer spreadsheet). a. In the right most panel of the two-panel graph below, illustrate the carrot and the stick that drives firms to downsize. P S1 MC2 Profit (Carrot) MC1 ATC2 ATC1 P

S1

D Market Q Firm Q

b. Illustrate the market response to downsizing in the rightmost panel of the above figure. Market supply will shift out. c. Explain how the market price can fall as firms reduce their scale of operation. Explanation__ Entry will occur _________________________________________

Homework Problem Set #14 E303 Davis, Spring 2006 7. Monopoly Pricing. A Graphical Analysis. The two panel graph below illustrates the relation between market forces and optimizing decisions for a firm in the canned peaches market, a competitive industry. a. In the rightmost panel illustrate the optimal output, price and profit levels for the competitive firm. P

184

MC

ATC

Market

D Q

Firm Q*

b. Suppose that due to concerns regarding the paucity of domestic peach producers the government gives to USAPeaches Inc. an exclusive right to domestically produce and sell canned peaches. Circle the components in the competitive chart that you would use to generate predictions for the monopolist. c. In the coordinate axis below, identify the optimal monopoly output, monopoly price and monopoly profits. Compare these predictions to the price and profit conditions for the firm as a competitor that you developed in part a.. P

Q Comparing Monopoly to Competitor. In each case, circle the one that is greater. Output: Monopolist / Competitor _______________________________________ Price:__ Monopolist / Competitor _______________________________________ Profit: __ Monopolist / Competitor _______________________________________

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8. Monopoly Pricing. An Analytical Example. Consider a firm with the demand curve P = 500 Q and a cost function TC = 2500 + 4Q2. a. What is the marginal revenue function for this firm? MR_________________________________________________________________ b. Intuitively, why is marginal revenue more steeply sloped than demand (average revenue?) Reason for Steeper MR Slope:____________________________________________ ____________________________________________________________________ c. Identify the optimal level of output, price and profits for this firm.

Qm ________________

Pm__________________

m_____________________

d. Were this firm a member of a competitive industry, what would be the quantity, price and profit level for the firm? Qc _________________ Pc___________________

c_____________________

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9. Monopolistic Competition. Schliezal Hickendorfer operates a small restaurant in the fan that specializes in German/Chinese Cuisine. The market is monopolistically competitive. The below demand and cost conditions illustrate current market conditions for Schliezal. P MC ATC

D Q a. Identify short run output, price and profit conditions for Schiezal.

b. Why doesnt the outcome in a define a long run equilibrium? What will alter these predictions? Change: __________________________________ c. Illustrate Schliezals long run competitive equilibrium output, price and profits. P

Q Problem Set #14 E303 Davis, Spring 2006

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10. Monopoly Pricing. A Graphical Analysis. The two panel graph below illustrates the relation between market forces and optimizing decisions for a firm in the canned peaches market, a competitive industry. a. In the rightmost panel illustrate the optimal output, price and profit levels for the competitive firm. P S MC ATC

Pc

P* c =0

Market

D Q

Firm Q*

b. Suppose that due to concerns regarding the paucity of domestic peach producers the government gives to USAPeaches Inc. an exclusive right to domestically produce and sell canned peaches. Circle the components in the competitive chart that you would use to generate predictions for the monopolist. c. In the coordinate axis below, identify the optimal monopoly output, monopoly price and monopoly profits. Compare these predictions to the price and profit conditions for the firm as a competitor that you developed in part a.. P Monopoly Profit
Pm

MC ATC

D MR Qm Firm Q Comparing Monopoly to Competitor. In each case, circle the one that is greater. Output: Monopolist / Competitor _______________________________________

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Price:__ Monopolist / Competitor _______________________________________ Profit: __ Monopolist / Competitor _______________________________________

11. Monopoly Pricing. An Analytical Example. Consider a firm with the demand curve P = 500 Q and a cost function TC = 2500 + 4Q2. a. What is the marginal revenue function for this firm? MR____500 2Q_________________________________________________ b. Intuitively, why is marginal revenue more steeply sloped than demand (average revenue?) Reason for Steeper MR Slope:_To sell more units the firm must reduce the price on unit that would have sold at a higher price c. Identify the optimal level of output, price and profits for this firm. MR = MC 500 2Q = 8Q 10Q = 500 Q = 50 Qm __50_________ P = 500 Q = 500 50 = 450

= TR - TC = 450(50) [2500 + 4(50)2] = 10,000

Pm___450_________ m___10,000__________

d. Were this firm a member of a competitive industry, what would be the quantity, price and profit level for the firm? MC = ATC P = MC = ATC 2 8Q =2500/Q +4 Q Q = 625 = 8(25) 4Q2 = 2500 Q = 25 = 200 Qc _=25__________ Pc___200___________

c__=0___________

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12. Monopolistic Competition. Schliezal Hickendorfer operates a small restaurant in the fan that specializes in German/Chinese Cuisine. The market is monopolistically competitive. The below demand and cost conditions illustrate current market conditions for Schliezal. P Profits MC
Pmc

ATC

D MR Qm Firm Q a. Identify short run output, price and profit conditions for Schiezal. See above b. Why doesnt the outcome in a define a long run equilibrium? What will alter these predictions? Change: Entry will shift in residual demand. c. Illustrate Schliezals long run competitive equilibrium. P Profit =0 MC ATC
Pm

D MR Qm Firm Q

Problem Set #15

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13. Joe Holiday is a monopoly provider of Fishing Reels in a remote fishing village on a barrier island off the Gulf Coast. Currently he is selling is BassMaster reels for $50 each. Joe doesnt know the precise demand function for fishing reels, but he estimates price elasticity of demand to be -2. If the reels cost Joe $30 each, is he maximizing profits? If not, what would be the profit maximizing price? Is $50 a profit maximizing price? Y/N (circle one) Profit Maximizing Price_____________________________________

14. Consider the inverse demand relationship P = 21-Q. The total cost function is TC = 50 Q. a. What is the optimal price, quantity and maximum profits available to the seller, if the seller can post only a single price to all consumers? Optimal Price_______________________ Optimal Profits ______________________ b) Illustrate in the coordinate axes provided below the maximal profits available to this seller, if the seller is forced to post a single price. P

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15. Now suppose that the seller is free to post consider post different prices to each different consumer. a) Identify the profit maximizing quantity and maximal profits for the seller under these circumstances.

Maximum Profits with Perfect Price Discrimination______________ b) Shade in the appropriate area in the figure below. P

Q c) What are the two conditions must be satisfied in order for a seller to realize maximum profits with perfect price discrimination? Why is each condition necessary? Condition 1: _____________________________ Condition 2:_____________________________

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16. Consider again the demand relationships in (2) and (3) above, but suppose that the demand relationship was for a single consumer who was considering joining a health club. Describe the membership and acess fee structure that would optimize profits. (Be explicit) Membership Price: ____________________ Access Fee: __________________________

17. Suppose that Handsome Joe Hedley needs a new summer suit. He is willing to pay up to $300 for a first linen suit, and $200 for a second. If suits cost Smith & Co. Fine Clothiers $100 each, identify the sales quantity from setting price equal to $300 and $200 what pricing structure would maximize profits? Quantity Price $300: Price $200 How might Smith use Second Degree price discrimination to increase profits? What are the maximum profits available? Pricing Strategy: ___________________________________ _________________________________________________ Maximum Profits: __________________________________ _________________________________________________ 18. Suppose that an airline can divide travelers into economy class and business class. The price elasticity of demand for the business class is -1.5, and for the economy class is -3. If the marginal cost of a seat on an flight from Richmond to New York is $20, what are the optimal prices for each group? Profits

Business Class__________________________________ Economy Class__________________________________

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Homework Problem Set #15

KEY

19. Joe Holiday is a monopoly provider of Fishing Reels in a remote fishing village on a barrier island off the Gulf Coast. Currently he is selling is BassMaster reels for $50 each. Joe doesnt know the precise demand function for fishing reels, but he estimates price elasticity of demand to be -2. If the reels cost Joe $30 each, is he maximizing profits? If not, what would be the profit maximizing price? Is $50 a profit maximizing price? Y/N (circle one) Profit Maximizing Price_______P = MC/(1+1/) = 30/(1-1/2) = 60

20. Consider the inverse demand relationship P = 21-Q. The total cost function is TC = 50 Q. a. What is the optimal price, quantity and maximum profits available to the seller, if the seller can post only a single price to all consumers? MR = 21-2Q = 1 implies that Q = 10, so P = 21-10 = 11 and profits are ($11(10) [50-$1(10)] = $55. Optimal Price______11_______________ Optimal Profits ____50________________ b) Illustrate in the coordinate axes provided below the maximal profits available to this seller, if the seller is forced to post a single price. P

$ 6 $ 1 5 Q

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21. Now suppose that the seller is free to post consider post different prices to each different consumer. a) Identify the profit maximizing quantity and maximal profits for the seller under these circumstances. The firm would charge a different price to each consumer equal to their marginal valuation. Profits would equal .5(21-1)(20) = 200 Maximum Profits with Perfect Price Discrimination_$150 (take out fixed cost) b) Shade in the appropriate area in the figure below. P 1 1

1 10 Q

c) What are the two conditions must be satisfied in order for a seller to realize maximum profits with perfect price discrimination? Why is each condition necessary? Condition 1: - No resales: Low value sellers will drive price down via resales Condition 2:- Ability to size up willingness to pay______________.

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22. Consider again the demand relationships in (2) and (3) above, but suppose that the demand relationship was for a single consumer who was considering joining a health club. Describe the membership and access fee structure that would optimize profits. (Be explicit) Membership Price: $200 (equal to consumer surplus) Access Fee: $1 per unit (marginal cost).

23. Suppose that Handsome Joe Hedley needs a new summer suit. He is willing to pay up to $300 for a first linen suit, and $200 for a second. If suits cost Smith & Co. Fine Clothiers $100 each, identify the sales quantity from setting price equal to $300 and $200 what pricing structure would maximize profits? Price $300: Price $200 Quantity 1 2 Profits $200 $200

How might Smith use Second Degree price discrimination to increase profits? What are the maximum profits available? Pricing Strategy: Charge a high price for a first suit, but then a lower price for additional suits. Maximum Profits: Charging $300 for the first suit and $200 for the second, Smith earns $300. 24. Suppose that an airline can divide travelers into economy class and business class. The price elasticity of demand for the business class is -1.5, and for the economy class is -3. If the marginal cost of a seat on an flight from Richmond to New York is $20, what are the optimal prices for each group? P1 P2 = = 20/[1+1/-1.5] 20/[1+1/-3] 60 30

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