TU-91.

2010
Managerial Economics

Helsinki University of Technology

Spring 2007

by
Hannele Wallenius
 Grades will be based on

 performance in the final exam 70 %

 homework 10 %
 computer exercises 20 %
 Table of Contents
Lecture 1 Introduction: What is Managerial Economics?
The Goals of a Firm: Economic and Non-economic Goals
and Optimal Decision Making

Lecture 2 Demand Estimation: From Theory to Practice

- Market Studies and Experiments
- Regression Analysis

Lecture 3 The Theory of Production: Production Functions

Lecture 4 The Theory of Production :Optimal Combination of Inputs

and Returns to Scale

Lecture 5 Cost: Relationship between Production and Cost;

Economies of Scale and Scope

Lecture 6 The Estimation of Production and Cost Functions

Lecture 7 Linear Programming: A Mechanism for Resource
Allocation
Lecture 8 Using Simplex Algorithm and Excel for Solving LP-
Problems
Lecture 9 Market Structure and Output and Pricing Decisions
Lecture 10 Special Pricing Practices
E-products in Information Economy and Electronic Market
Places
 Course Objectives

 To present the core of

microeconomic theory

 To show how the theoretical

concepts can actually be
implemented

 To demonstrate the relation of

managerial economics to the other
courses in business
Ch 1 INTRODUCTION

How does managerial economics

differ from “regular” economics?
There is no difference in the
theory; standard economic theory
provides the basis for managerial
economics.
The difference is in the way the
economic theory is applied.
What is managerial
economics?
 Managerial economics is the
use of economic analysis to
make business decisions
involving the best use
(allocation) of an organization’s
scarce resources

 Managerial economics is
(mostly) applied
microeconomics (normative
microeconomics)
Managerial economics deals
with
“How decisions should be made
by managers to achieve the
firm’s goals - in particular, how
to maximize profit.”

(Also government agencies and

nonprofit institutions benefit
from knowledge of economics,
i.e. efficient recourse allocation
is important for them too...)
 Relationship between
Managerial Economics and
Related Disciplines

Management
Decision Problems

Economic Decision Sciences

Concepts
Managerial
Economics

Optimal Solutions to Managerial

Decision Problems
 Management
Decision Problems

Economic Concepts Decision Sciences

Managerial
Economics

Optimal Solutions to Managerial

Decision Problems

 Management Decision
Problems
 Product Price and Output
 Make or Buy
 Production Technique
 Stock Levels
 Advertising Media and Intensity
 Labor Hiring and Training
 Investment and Financing
 Management
Decision Problems

Economic Concepts Decision Sciences

Managerial
Economics

Optimal Solutions to Managerial

Decision Problems
 Decision Sciences
Tools and Techniques of Analysis
 Numerical Analysis
 Statistical Estimation
 Forecasting
 Game Theory
 Optimization
 Simulation
 Management
Decision Problems

Economic Concepts Decision Sciences

Managerial
Economics

Optimal Solutions to Managerial

Decision Problems

 Economic Concepts
Framework for Decisions
 Theory of Consumer Behaviour

 Theory of the Firm

 Theory of Market Structure and

Pricing
 Management
Decision Problems

Economic Concepts Decision Sciences

Managerial
Economics

Optimal Solutions to Managerial

Decision Problems

 Managerial Economics
 Use of Economic Concepts and
Decision Science Methodology to
Solve Managerial Decision
Problems
Ch 2 THE GOALS OF A FIRM

Economic Goals:
Maximizing or Satisficing
1. Profit
2. Market share
3. Revenue growth
4. Return on investment
5. Technology
6. Customer satisfaction
7. Shareholder value
THE GOALS OF A FIRM continued

Non-economic Objectives:
1. “A good place for our employees
to work”
2. “Provide good products/services
to our customers”
3. “Act as a good citizen in our
society”
Optimal Decision:

Given the goal(s) that the firm

is pursuing, the optimal decision
in managerial economics is one
that brings the firm closest to
this goal.
 Roles ofdecisions
Making Managers:and processing
information are the two primary
tasks of managers.
Examples:
• Whether or not to close down a
branch of the firm?
• Whether or not a store or
restaurant should stay open more
hours a day?
• How a hospital can treat more
patients without a decrease in
patient care?
Role of Managers continued

 How a government agency can

be reorganized to be more
efficient?

 Whether to install an in-house

computer rather than pay for
outside computing services?
All these, as well as many other
managerial decisions require the
use of basic economics.

Economic theory helps decision

makers to know what information
is necessary in order to make the
decision and how to process and
use that information.
 Questions that managers must
answer:
♦ Should our firm be in this business?
♦ If so, what price and output levels
achieve our goals?
♦ How can we maintain a competitive
advantage over our competitors?
 Cost-leader?
 Product Differentiation?
 Market Niche?
 Outsourcing, alliances, mergers,
acquisitions?
 International Dimensions?
Questions that managers must
answer:
♦ What are the economic conditions
in a particular market?
 Market Structure?
 Supply and Demand Conditions?
 Technology?
 Government Regulations?
 International Dimensions?
 Future Conditions?
 Macroeconomic Factors?
DMs Optimize

We should emphasize that

practically in all managerial
decisions the task of the
manager is the same!

Namely, each goal involves an

optimization problem.
The manager attempts either
to maximize or minimize some
objective function, frequently
subject to some constraint(s).

And, for all goals that involve

an optimization problem, the
same general economic
principles apply!
REVIEW OF SUPPLY AND
DEMAND
“Economic analysis begins and
ends with demand and supply.”

The primary importance of demand

and supply is the way they
determine prices and quantities
sold in the market.

Managers are extremely interested

in forecasting future prices and
output, both for the goods and
services they sell and for the inputs
they use.
DEMAND ELASTICITY

 Elasticity measures the

sensitivity of the quantity
demanded to changes in the
determinants of demand
(supply).

Some elasticity concepts:

• price elasticity of demand
• elasticity of derived demand
• cross-elasticity of demand
• income elasticity of demand
• elasticity of supply
Determinants of Price Elasticity of
Demand

1. The number and availability of

substitutes
2. The expenditure on the
commodity in relation to the
consumer’s budget
3. The durability of the product
4. The length of the time period
under consideration
5. Consumer’s preferences
 Short-Run vs. Long-Run
Elasticity
 A long-run demand curve will generally
be more elastic than a short-run curve

P
As the time DS5 D
S4 DS3
period DS2
lengthens
f DS1
consumers e
find way to d
adjust to the c b
price change, P2
via P1 a
substitution or
shifting
consumption DL

Q3 Q2 Q1 Q
 Elasticity of Derived Demand

 The demand for components of final

products is called derived demand
The derived demand curve will be
the more inelastic:
1. The more essential is the
component in question.
2. The more inelastic is the demand
for the final product.
3. The smaller is the fraction of total
cost going to this component.
4. The more inelastic is the supply
curve of cooperating factors.
5. The shorter the time period under
consideration.
 The Relationship between Elasticity and
Total Revenue
IF DEMAND IS

P ↓ Q ↑ elastic if TR ↑ (relative ∆ Q> relative ∆ P)

P ↓ Q ↑ inelastic if TR ↓ (relative ∆ Q< relative ∆ P)
P ↑ Q ↓ elastic if TR ↓ (relative ∆ Q> relative ∆ P)
P ↑ Q ↓ inelastic if TR ↑ (relative ∆ Q< relative ∆ P)
 Demand, Total Revenue, Marginal
Revenue, and Elasticity

Price and marginal

D E>1
revenue ($) E=1
p0 E<1
D
0 q0 Quantity
M
Total Revenue

R
($)

0 q0 Quantity
The Cross-Elasticity of
Demand

Cross-price elasticity measures

the relative responsiveness of
the quantity purchased of some
good when the price of another
good changes, holding the price
of the good and money income
constant.
It is, therefore, the
percentage change in
quantity demanded in
response to a given
percentage change in the
price of another good.

%∆QA
EX =
% ∆ PB
Cross-elasticity can be either
positive or negative. In
particular, cross-elasticity is
positive for substitutes and
negative for complements.
 Categories of Income Elasticity

Q Superior

Normal

Inferior

Y
 Income elasticity > 1: superior goods
 Income elasticity > 0, and <1: normal
goods
 Income elasticity < 0: inferior goods
Applications of Supply and
Demand

 Interference with the Price

Mechanism:
• the effect of a price ceiling
• the effect of a price floor
• the effect of a subsidy
• the incidence of taxes
The Effect of a Price Ceiling on
Quantity of Supply and Demand

P
S
P2

P0

P1

D
0
Q1 Q0 Q2 Q
The Effect of a Price Floor on Supply
and Demand

W
S
W1

W0

D
0
Q1 Q0 Q2 Q
 The Use of Price Supports

Surplus (Q2-Q1) bought Production quota

Q3
P by the government introduced by the
S P government
P1
P1
P0

D
D
0 0 Q
Q1 Q2 Q Q1 Q3

a) b)
 The Incidence of Taxes
 effect of demand elasticity
 effect of supply elasticity

 Imposition of a Voluntary
Export Quota

 Shift in Demand as
Consumer Tastes Change
 Demand Elasticity and Tax Incidence
More elastic demand shifts the tax burden
more to the supplier.

S’
P P
S S

D’ D’
D
0 0
Q Q
The more
Supply elasticand
Elasticity theTax
supply, the more
Incidence
heavily consumers will bear the burden of
the tax.

P
S1’
S1
S’
P1
P2 S
P*

D
Q1 Q2 Q* Q
 Imposition of a Voluntary Export
Quota
P
S’
P’’
S1
P’
P D’’
S0
P1
D’
P0 0
Q’ Q’’ Q
b) D & S of other cars
D
0
Q1 Q0 Q
a)D & S of Japanese cars
in USA before 1981
The Downward Shift in Beef
Demand
Decrease in the demand of beef will, over
time, shift resources out of beef
production.

S1
P
S0
P0
P1
D0
D2
D1
0
Q1 Q0 Q