GYAAN KOSH TERM 1

Learning and Development Council, CAC

Managerial Economics
This document covers the basic concepts of Managerial Economics covered in Term 1. The document only summarizes the main concepts and is not intended to be an instructive material on the subject.

Gyaan Kosh Term 1

MGEC

Learning & Development Council, CAC

Opportunity cost: Taken into account for economic decisions. Opportunity Cost is the next best or alternative benefit from an investment Sunk costs: Never taken into account for economic decisions. Marginal Analysis: Used for profit maximization (deciding how much to produce) where TR and TC are functions of quantity. To maximize profits we take derivative=0

P r o f it M a x im iz a t io n G r a p h

For profit maximization, marginal revenue should be equal to marginal costs for EACH activity. If MR > MC increase production If MR < MC decrease production Demand Curve is the Marginal Benefit curve Consumer Surplus = Net benefit to customers = Willingness to pay total paid. (Area under the demand curve above the price line) Demand and elasticity Demand shows quantity purchased as a function of price. Managers Knowledge of demand is critical because it helps in:
Making production decisions Defining market structure Taking strategic and operational decisions

Gyaan Kosh Term 1

MGEC

Learning & Development Council, CAC

Price Elasticity of Demand is measure of responsiveness i.e. % Change in quantity demanded due to a 1% change in Price Demand is more elastic, Greater the availability of other substitutes Greater the time frame Greater the goods share of the budget Lower the switching costs Income Elasticity of Demand
Positive: Normal Good Negative: Inferior Good

Cross Price Elasticity of Demand (change in demand of one good based on change in price of another)
Positive: Substitutes Negative: Complements

Monopoly pricing strategy If a uniform pricing is set for products the firm stands to lose the consumer surplus by not capturing the full willingness to pay. So in order to capture more consumer surplus, price discrimination can be carried out. Three main types of pricing discrimination 1. First Degree 2. Second Degree (IGNORE) 3. Third Degree - Direct/Indirect Segmentation 1. First degree price discrimination Sell each buyer at his/her reservation price Knowledge about each potential buyers demand curve (need not be different) No resale Charge each customer its reservation price (or, Marginal Benefit) Example: Car Market of USA (based on auction and willingness to pay) It is quite impractical to find out the willingness to pay of each buyer. 3. Third Degree Price Discrimination Sells same basic product in different forms or with different conditions attached to discriminate among buyers groups (or segments) Direct Segmentation demographics Indirect Segmentation time (inelastic impatient consumers v. elastic patient consumers), rebates, coupons, location, memberships. Example: Discount to students, Flight tickets for different timings. Requirements
Heterogeneous Buyers No Resale

Gyaan Kosh Term 1

MGEC

Learning & Development Council, CAC

Supply The supply curve is the MC curve above the shutdown point. The shutdown point in case of unavoidable cost is given by the lowest point of average variable cost. And the shutdown point in case of avoidable costs is given by the lowest point of average total cost.

Types of market competition Number of Firms

Monopoly: One Firm Competition: Many Firms Other cases, duopoly

Gyaan Kosh Term 1

MGEC

Learning & Development Council, CAC

Barriers to Entry
Monopoly high barriers to new entry Competition free entry

Short run (SR)

Due to frictions, firm can only adjust some inputs for which it occurs variable costs Other inputs cannot be adjusted, for which it incurs fixed costs

Long run (LR)

Enough time passes for the firm to adjust all inputs All costs are variable

Economies of Scale
AC decreases as X increases Quantity discounts on purchases are one way of realizing such economies

Economies of Scope
Joint production cost of multiple products is less than cost of producing each individually

Market efficiency & distortions Pareto Efficiency: No reallocation would make one person better off without making someone else worse off. So in order to maximize net gain to society we need to maximize sum of Consumer Surplus and Producer Surplus; otherwise, there will be a Deadweight Loss (DWL) Antitrust laws: Promote a competitive economy competition benefits consumers Possible Prohibitions as a result of antitrust laws Prohibit anti-competitive contracts and agreements Exclusive contracts, tying, etc. Prohibit abuse of dominant position: Collusion/Cartelization - Explicit or Implicit Predatory pricing Bid rigging Attempt to monopolize a market through M&A activity

Note: Cognizance of all the above situations can help in finding out possible antitrust violations in case analyses.

Gyaan Kosh Term 1

MGEC

Learning & Development Council, CAC

Consumer behavior The driving assumption for consumers preferences is that we are rational. Being rational entails: Completeness: consumers can compare and rank all possible baskets. Transitivity: (A > B) and (B > C) (A >C) * Consistency More is better than less Indifference Curve: It is a graphical representation of consumers preferences and represents all combinations of market baskets that provide a person with the same level of satisfaction. The shape of IC indicates tradeoffs. Marginal Rate of Substitution: Measures the value of 1 extra unit of a good in terms of another Substitution effect: Buy more of the relatively cheaper good and less of the relatively expensive good. Income effect: Consumers enjoy an increase in purchasing power because one of the goods is now cheaper They occur simultaneously but in opposite directions Budget line: It is the amount of good that I can buy given a particular income. At some prices of goods Pa and Pb, a consumer can buy a maximum of I/Pa (all goods A) or I/Pb (all goods B). The line joining these two points is called the budget line. Any point on this line represents a combination of two goods that can be bought at the given prices and income levels. Special case: Giffen goods: Income effect is larger than substitution effect. Demand is upward sloping.

GAME THEORY: Simultaneous games Assumptions: Buyer is able to assign a monetary value to each transaction and product: reservation price (RP). This is the maximum price that a buyer is willing to pay for a product A buyer evaluates a transaction in terms of its consumer surplus Although game theory began as applied mathematics, it has become a dominant mode of reasoning in business and economics. Game Theory improves strategic decision-making. It makes one aware of which strategy matters in what situation, to say nothing of the strategic nuances on the part of one's competitors or opponents. It can improve one's ability to run a business or to evaluate changes in policy. Phrases such as "Competitive Advantage", "Winner's Curse", "Everyday Low Prices", "First Mover Advantage", "Market Failure", "Credibility", "Incentive Contracts", "Hostile Takeover", "Coalition Building", "Cartelization", "Mutually Assured Destruction", make a lot more sense when they are strategically explained using game theory.

Gyaan Kosh Term 1

MGEC

Learning & Development Council, CAC

Examples of application of game theory:

Prisoner's dilemma: Cigarette Advertising on TV: In 1971, when advertising for cigarettes on television was banned, the profits of the cigarette companies went up. Folk theorem: Do firms always conspire to monopolize the market? Game theory says that in a continuously repeated game, competition leads to collaboration. That is why some times the biggest competitors appear to be colluding even when they are not doing so. Stag Hunt: In early societies, people formed alliances to hunt deer. If even one person in the group did not help in the hunt, the deer would be lost. The hunters were sometimes tempted to leave the hunt by seeing rabbits, but they preferred deer to rabbit. However, only one person was needed to catch a rabbit. From a game theory perspective, the best strategy is to hunt the deer, but people may decide to hunt the rabbit because they believe others may defect from the hunt also. Countries face the same dilemma in situations involving nuclear weapons. Each country generally believes that the world would be better if no countries possessed nuclear weapons. However, the temptation to build up a nuclear arsenal arises because each country is afraid that other countries may stash nuclear warheads and undermine international security. Centipede game: Following the designation of Mr. Bush as President-Elect and the election of the new Congress, the smart money seemed to be betting that Bush would have been a one-term President and that the Democrats would have an excellent chance of retaking the Congress in '02. Centipede game explained how the Republicans were likely to respond - assuming that the corporate Republican Party would have acted as a rational, self-interested agent as those terms were understood in game theory. Hotelling law: The observation by Hotelling was that in many markets it is rational for all the producers to make their products as similar as possible. Suppose, for example, there are two newsagents in a street, both want to maximize their share of local business by locating their shop so that it is the nearest newsagent for as much of the trade visiting the street as possible. In this situation, both newsagents will position themselves in the middle of the street guaranteeing themselves half the market. It would be socially more desirable for them to separate themselves, and sit a third of the way along the street from different ends. Unfortunately, if one newsagent did this, the other could position himself so as to capture more than half the total market. Too little variety results from the process. Hotelling's law manifests itself in numerous markets - competing airline operators scheduling their airlines to run at the same time for example. Nash Equilibrium in Game Theory is a pair of strategies that forms a self-enforcing agreement i.e. when both players choose a strategy which is their best response to the opponent Neither is made better off by unilaterally switching to another strategy Mixed Strategies: Strategies in which players make random choices among possible actions based on set of chosen probabilities Repetitive game: Only a small number of sellers are sufficient to have benefits of competition. When games are indefiniteanything can happen rivals could end up charging low prices in each round, high prices in each round, or anything in between. In repeated play of PD, a strategy is no longer what price you pick in each round but rather a rule you use to select price in each round

Gyaan Kosh Term 1

MGEC

Learning & Development Council, CAC

Three examples of such rules: Choose the low price in each round (regardless) Grim trigger rule: choose a high price in the first round. In subsequent rounds choose high price if rival chose high price in previous round. If rival chose low price in previous round then choose low price in every round thereafter Tit-for-tat: choose a high price in the first round. In subsequent rounds choose the price that rival chose in previous round. Predatory pricing drive rivals out and creates a reputation for toughness to deter future entry, thus allowing the firm to raise prices.

Competition in capacity Cournot Model: This is the traditional model of competition in capacity/ quantity. The strategy consists of making simultaneous quantity choices. Both the firms have same information, and no cooperation is allowed. StackelbergModel: This model supports the concept of first mover advantage.

Differentiation Vertical: when your product is superior to your competitors product for all buyers. This superiority allows one to extract price premium. Horizontal: Different products both of which are neither superior nor inferior. For e.g. red vs. blue widgets. This allows firms to price above cost because there will be different buyers in the market willing to pay some price for their preferred widgets. Differentiation softens price competition

Information asymmetry and moral hazard Information asymmetry: Sellers know more than buyers Buyerseller information asymmetry (BSIA) is a growing problem. Application Second Hand Market Auction Flea Markets Insurance Market for Lemons: Also called ADVERSE SELECTION: Because of information asymmetry, low quality goods drive out high quality goods. That is why markets sometime break down Signaling in the Market:- Firms with better quality products can use strong signals of quality to convey their superiority. E.g. warranties.

Moral Hazard: When actions are unobserved i.e. people cant be monitored they might become careless and raise costs. E.g. Behaviour after insurance.