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Managerial Economics
Lecture One:
Why economics matters to managers,marketers and accountants
Neoclassical theory of profit maximisation
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• Check subject outline• Assessment: 3 parts
– Group presentation in tutorials 20%
– Essay on group presentation topic 40%
– Exam 40%• My details
– Steve Keen
• 4620-3016
– 0425 248 089 in emergency • [email protected]
• Thursdays 1-3pm
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Economics as the context of business
• Management, marketing & accounting focus on specifics
– How to manage a company…– How to market a product…
– How to quantify & compare corporate performance…
• Focus is your personal input to business
• Economics is the context of business– “Men make their own history, but they do not make it asthey please; they do not make it under self-selectedcircumstances, but under circumstances existing already,given and transmitted from the past”
• Focus on constraints on and circumstances of your input– Both opportunities & dilemmas
– Quick quiz: who made the above statement?
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Economics as the context of business
•Often the best wisdom in economicsisn’t found in standard textbooks!
•This subject takes a deeper look ateconomics you’ve already done (micro,macro); and
•considers theories & data youhaven’t seen before that are morerelevant to business
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Economics as the context of business
• A hierarchical view: starting from the bottom & working up– The firm– The market/industry– The economy– Finance– International business
• A critical view– Conventional theories of above
• Profit maximising behaviour, types of competition, Gametheory, IS-LM, Efficient Markets, Comparativeadvantage
– Different perspectives• Empirical data• Critiques of conventional theories• Alternative theories
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Economics as the context of business
• What matters most to your firm’s success may lie outside it:
– “For companies, a central message … is that many of acompany’s competitive advantages lie outside the firm…”(Porter 1998: xxiii)
• Understanding “what lies outside” may therefore be the mostimportant thing you can do to be a successful executive
– Economics as the study of “what lies outside”• Relationships with other firms
• Interaction with the market
• Market interaction with the macroeconomy
• Macroeconomy’s interaction with global economy; AND…• Theories about the economy! Because:
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Economics as the context of business
• Sometimes (not often enough!) theories explain how the realworld works
• Frequently (too often!) theories affect how people behave inthe economy
– Government follows economic advice
– Firms/unions think about economy in terms of economic
models– Government bodies (e.g. ACCC Australian Competition &
Consumer Commission ) apply economic theory in policies (e.g.competition policy, deregulation of telecommunications,
etc.)• So you have to understand economic theory even if it’s wrong !
– Which it frequently is…
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Economics as the context of business
• Emphasis in this course is on realism
– Theories presented; but also– Empirical data examined to see whether theories actuallywork
– Frequent conclusion: they don’t (but sometimes they do…)
• One consequence: can’t rely upon textbooks for thiscourse!
• Textbooks normally
– present theory uncritically
– only include “case studies” that confirm accepted
theory• frequently based on invented rather than real
data
– Normally don’t go beyond microeconomics
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Economics as the context of business
• This course
– Starts with micro (theory of firm…)– Progresses through theory of the market, economy, financeto international trade
– Based heavily on readings volume
• You must have a copy
• Tutorials and assessments based on contents
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“The firm”: real world vs economic theory
• The real world: an incredible diversity
– Size: from corner store to Microsoft– Operations: from one outlet to almost all countries
– Diversity:
• from single product (wheat farm) to many (Sony)
• From one industry to many– Ownership: from sole proprietor to multinational listedcompany
– Structure:
• from one person operations to multi-department
• From sole operations (production to sale) tospecialisation in manufacturing, wholesale, retail,marketing, consulting…
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Economics of the firm: statistics
• Firms in the Australian economy
– Range in size from sole proprietor/employee to multi-employee institutions
– From single product to diversified conglomerates
– Over 610 thousand “entities” in 2000 (ABS 8140.0)
• 3229 “large” entities employing 200 or more workers
• 607,663 “other” employing less
• “Average” employment 10.1 persons per firm
– “Average” large firm employed 750 workers
– “Average” other firm employed 6.5 workers
• Legal multitude of businesses masks much smaller numberof operating units: 15,870 units with 700,024 legalentities in 1998/99
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Economics of the firm: statistics
• Concentration obvious (ABS 8140.0.55.001)
– Top 20 units responsible for 13.9% of sales– 15,850 others responsible for remaining 86.1% of sales
• Economic theory abstracts from this concentration & diversity
– Claims firms share several essential common properties
• Profit maximising behaviour• Under conditions of diminishing marginal productivity
• Selling on “spot” market (no stocks) to anonymous buyers
– Only interest buyers have is in getting lowest price
– No interest in continuing relationship betweenbuyer/seller; “arms length” transactions
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“The firm”: economic theory
• The economic simplification: diversity ignored to focus onalleged essence of profit maximising behavior:
– Basic model
• single industry & product
• one location
• privately owned, sole proprietor
– No internal structure considered
– No specialisation: firm does everything from manufacturingto sales
• Some generalisations allowed later (e.g., agency theory)
– But basic theory abstracts from these details
– Core model: profit maximising behaviour under conditionsof diminishing marginal productivity
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Economic theory of the firm
• Profit maximising behavior:
– Seeking highest possible profit given constraints of• Falling price as quantity offered for sale rises
• Rising costs as quantity offered for sale rises
– Falling price as quantity offered for sale rises:
• “Law of demand”: can only sell additional units if price islowered
• Mathematically: a negative relationship between priceand quantity
– To ↑quantity sold must ↓price
– Simple example: linear demand curve P(Q) = a –b Q
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Economic theory of the firm
• Graphing price as a function of quantity: • Key consequence of“law of demand”:
• Total revenue is pricetimes quantity
• Total revenue risesfor a while asincrease in Q morethan outweighsdecline in P
• But ultimately fall inP overwhelmsincrease in Q: totalrevenue peaks and
then falls…
a 100:= b 12000
:= P Q( ) a b Q⋅−:=
0 5 .104
1 .105
1.5 .105
2 .105
0
20
40
60
80
100
Price as function of quantity
P Q( )
Q
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TR Q( ) P Q( ) Q⋅:=
0 2 .104
4 .104
6 .104
8 .104
1 .105
0
20
40
60
80
100
0
5 .105
1 .106
1.5 .106
2 .106
2.5 .106
Price (LH Scale)
Revenue=Price x Quantity (RHS)
P Q( ) TR Q( )
Q
Economic theory of the firm• If firm produces
20,000 units, market
price is 80– Total revenue =80 * 20,000 =$1.6 million
2 0
, 0 0 0 x 8 0
• 40,000 units sold,price 60
– Total revenue =60 * 40,000 =$2.4 million
– Change in total revenue $0.8 m
4 0 , 0 0 0 x 6 0
– Change in unit revenue=$0.8m/20,000=$40
60,000x40
• 60,000 units sold, price 40
– Total revenue $2.4 million
– Change in revenue per unit zero
S l o
p e = 4 0
S l o
p e = 4 0
Slope=0Slope=0
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Economic theory of the firm
• Change in revenue called “marginal revenue”
• “In the limit”, marginal revenue equals slope of total revenue curve:
• Value of marginal revenue (x)equals slope of total revenuecurve at same point (o)
• Other side of profit equation is
costs:– Fixed: costs incurred
regardless of how many unitsproduced (research,development, factory
construction, rent, etc.)– Variable: costs that depend
on level of output: wages, rawmaterials, intermediategoods, etc.)…
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Economic theory of the firm
• Theory argues per unit costs rise as quantity offered for sale rises:
• Slope of total cost curveis marginal cost:
• Rises as output risesbecause of diminishing marginal productivity
– After some point, eachnew worker hired(variable input) addsless to production thanprevious worker
– With constant wageand diminishing outputper worker, unit costof output rises
• “Please explain”…
k 1000000:= c 30:= d1
100000:= f
1
400000000:=
FC Q( ) k:= VC Q( ) c Q⋅ d Q2
⋅+ f Q3
⋅+:= TC Q( ) FC Q( ) VC Q( )+:=
0 5 .104
1 .105
1.5 .105
2 .105
0
5 .106
1.10
7
1.5 .107
2 .107
2.5 .107
3 .107
Total Cost
Fixed Cost
Variable Cost
TC Q( )
FC Q( )
VC Q( )
Q
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Economic theory of the firm
• Rising marginal cost: the argument…– Production occurs in “the short run”– “Short run”: period in which at least one crucial input to production can’t be varied (normally machinery)
– Therefore to increase output, more “variable factors” mustbe added to the fixed factors
• Economic models normally consider just two factors:– Labour– “Capital”: grab-bag for all non-human inputs to
production• Factory buildings
• Machine tools• Electrical circuitry, computers• Raw materials and intermediate inputs (e.g., car
stereo units for cars)
– As you add more & more variable factors to fixed factors…
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Economic theory of the firm
• There is some ideal worker:machineratio (e.g., one worker per jackhammer)
• In short run, firm has fixednumber of jackhammers
• To dig holes, firm has to hire workers• 1st worker operates all six jackhammers at once : pretty inefficient!
?
If this soundsweird to you,good! You’re onto something…
• Additional workers might show increasing productivity per workerfor a while (two workers operating 3 jackhammers each less messythan one operating 6, ditto three workers operating two each…)
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Economic theory of the firm
• Eventually ideal ratio reached(6 workers for 6 jackhammers)
? ?
• Then to dig more holes, have tohave more than one worker per jackhammer:
??
• More holes can be dug with
2 workers per jackhammerthan with one…
• But productivity of twoworkers per jackhammerless than one worker per
jackhammer…
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Economic theory of the firm
• So productivity per worker might rise for a while;
• But ultimately falls as more output can only be produced byadding more variable inputs (labour) to fixed input (capital) pastideal labour:capital ratio
– Addition to output from each additional worker falls (butdoesn’t become negative)
• “Diminishing marginal productivity” (DMP)• DMP leads to rising marginal cost
• Example: “Cobb-Douglas production function”
1
Q L K
β β
α
−
= × ×Quantity producedQuantity produced
Technology coefficientTechnology coefficient
No. workersNo. workers
Amount of capitalAmount of capital
Relative labor/capitalRelative labor/capital
product coefficientproduct coefficient
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α 10:= K 100:= β .4:= L 0 0.1, 250..:= Θ K L, α, β,( ) α Lβ
⋅ K1 β−
⋅:=
0 50 100 150 200 2500
500
1000
1500 Cobb-Douglas Production Function
Number of workers
O u t p u t
Θ K L, α, β,( )
L
Economic theory of the firm
• Cobb-Douglas production
function allegedly fitsaggregate economic datawell (but see Shaikh, A.M., (1974). “Laws ofAlgebra and Laws ofProduction: The HumbugProduction Function”,Review of Economics and Statistics , 61: 115-20)
• Example with α =10,K=100, β =.4, L between0 and 250:
With 100 workers,output is 1,000
With 250 workers,output is 1,443
Chan
geinouput
from
1
st
100
is1000
Cha
ngeinou
put
from
next250
is44
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Economic theory of the firm
• Each additional worker adds to output, but adds less thanprevious worker: diminishing marginal productivity
– As usual, this is slope of total product curve: (mathsunimportant, but here it is!):
1Q L K β β α −= × ×
1 1dQ L K dL
β β α β − −= × × ×
• Differentiate with respect to Labour…
• Graphing marginal product:
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MP L( ) α β⋅ Lβ 1−
⋅ K1 β−
⋅:=
0 50 100 150 200 2500
100
200
300
400
500
600
700800
900
1000
1100
1200
1300
14001500
01
2
3
4
5
6
78
9
10
11
12
13
1415
Total Product (Q) LHS
Marginal Product RHS
Cobb-Douglas Production Function
Workers
O u t p u t
M a r g i n a l P
r o d u c t
Θ K L, α, β,( ) MP L( )
L
Economic theory of the firm
• Output with 49workers = 752
• Output with 50workers = 758
• Marginal product of50th worker ≈ 6– Using formula, it’s
exactly 6.063
• Diminishing marginal product
leads to rising marginal cost…
• Output with 99workers = 996
• Output with 100
workers = 1000• Marginal product of100th worker ≈ 4.012– Using formula, it’s
exactly 4
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Q 0 1500..:=L Q( )
Q
α K1 β−
⋅
1
β
:=
0 500 1000 15000
50
100
150
200
250
300
Workers needed given desired output
Output
W
o r k e r s n e e d e d
L Q( )
Q
Economic theory of the firm
• First step is to “flip the axes”: graph labour input (on Y axis) needed to produce output(on X axis):
• Just reads in reverse:
– 1,000 units of outputdesired;
– 100 workers needed
• To get total (variable)cost, multiply Y axis bywage rate (say $12 anhour)…
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Economic theory of the firm
• Rate of change ofvariable cost is marginalcost
• Rising because ofdiminishing marginalproductivity…
• So firm trying tomaximise profits is(according to economictheory) faced with
– Falling price
– Rising cost…
• How to maximise profit?
• Find biggest gapbetween revenue and
cost
w 12:= VC Q( ) w L Q( )⋅:= MC Q( )Q
VC Q( )d
d:=
0 500 1000 15000
500
1000
1500
2000
2500
3000
3500
0
1
2
3
4
5
6
Variable cost of desired output
Output
T o t a l v a r i a b l e
c o s t
M a r g i n a l c o s t
VC Q( ) MC Q( )
Q
• Production level of 1000Production level of 1000units has variable costsunits has variable costsof $1200of $1200
• Marginal cost of 1000Marginal cost of 1000thth
units is about $3units is about $3
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Profit Q( ) TR Q( ) TC Q( )−:=
0 5 .104
1 .105
1.5 .105
2 .105
0
5 .106
1 .107
1.5 .107
2 .107
2.5 .107
3 .107
Total Revenue
Total Cost
Profit
TR Q( )
TC Q( )
Profit Q( )
Q
Economic theory of the firm
• Graphically, it’s easy: (using earlier example)• But economists
prefer to make itcomplicated byworking in average &marginal revenue &cost
• Converting diagramsto averages bydividing by quantitygives us:
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Economic theory of the firm
• As economists like to show it:“maximise profit by equating
marginal revenue and marginalcost”
MC Q( )Q
VC Q( )d
d:= AC Q( ) TC Q( ) Q÷:=
0 5 .104
1 .105
1.5 .105
2 .105
0
50
100
150
200
Marginal Cost
Average Cost
Price
Marginal RevenueMC Q( )
AC Q( )
P Q( )
MR Q( )
Q
• What it means: “maximise profitby finding the biggest gap between
revenue and cost”• Gap between curves is biggestwhen tangents (marginal revenue &marginal cost) are parallel:
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Economic theory of the firm
• So it’s “really easy” to manage a firm:
– Objective is to maximise profits
– Procedure is
• (1) Work out marginal cost
• (2) Work out marginal revenue
• (3) Choose output level that equates the two• For competitive firms, it’s even easier…
– Competitive firms are “price takers”
• Too small to affect market price/take price as “given”
• Marginal revenue therefore equals price– (MR less than price for less competitive industries)
– Profit maximisation rule is “produce output level at whichmarginal cost equals price”:
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Economic theory of the firm
• “Perfect competition”
Demand
Supply
Qe
Pe
Marginal Cost
quantity
Price
qe
Pe
Downward sloping market
demand curve
Horizontal demand curve for
single firm
< <0,dP MR P dQ = =0,dP MR P dq
Quantity
Price
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Economic theory of the firm
• So the economic theory rules are:
– If you’re a monopoly or oligopoly
• Work out your marginal cost and marginal revenue
• Produce the output level at which they are equal
– If you’re in a competitive industry
• Work out your marginal cost
• Produce output level at which marginal cost equals price
– If you’re in an industry with a small number of large firms
• More complicated: game theory…
– More on this later– As a typical text (Thomas & Maurice 2003, Managerial Economics , McGraw-Hill, Boston) summarises it:
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Economic theory of the firm
• It’s a breeze forcompetitive
industries (p.450):
• A bit morecomplicated formonopoly (p. 500):
• And a real pain foroligopoly (p. 560)…
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Economic theory of the firm
• What to do? So many choices…
• How does theory stack up against
reality?
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Economic facts of the firm
• Theory makes many predictions; e.g.
– Firms should have rising marginal costs
– Competitive firms should have elastic demand curves:
• Elasticity: how much demand changes for a change inprice: %
% P
Q Q changeQ P Q E
change P P Q P
∆ ∆= = =
∆ ∆– Value of E can be low (less than 1) for an industry, but in limit isinfinity for competitive firms (horizontal demand curve…)
– Relative prices should move frequently as supply & demand shift
• Problem: not observed in reality
– Relative prices seem stable
– Money prices tend to move up, not down…
– “Price stickiness”
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Economic facts of the firm
• Dispute in economics over whether prices “sticky” or“flexible”
• Ideological division in dispute– Neoclassicals/Free marketeers believe prices
“flexible”
• Prices adjust rapidly to changes in demand,supply
Demand
Supply
Quantity
Price
Qe
Pe
• Economic problems caused bygovernment, union, monopolybehavior that makes some prices(e.g. wages) more rigid than others
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Economic facts of the firm
– Keynesians/Mixed economy supporters believe “sticky”
• Prices adjust sluggishly
• Key markets (e.g. labour) can’t be “cleared”(unemployment eliminated) simply by price movements
• Can have underemployment for substantial time;government intervention needed for full employment
• Ideological dispute continues, but statistical results imply“sluggish” price adjustments the rule
• Theory implies rapid adjustments should occur
• Why the difference?
• Plenty of theories as to why prices are sticky;• Alan Blinder (in Readings ) decided to ask firms “Why?”
– Alan S. Blinder et al., (1998). Asking About Prices: a new approach to understanding price stickiness, Russell Sage
Foundation , New York.
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Economic facts of the firm
• Enormous volume of theoretical research in economics
• Huge amount of statistical (“econometric ”) research too
• Relatively little empirical research
– Finding out what actually happens at firm/consumer level
– Also asking firms why they do what they do
• Frequency and rapidity of price changes etc.
• How behavior compares to different theories of pricestickiness
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Economic facts of the firm
• Blinder’s procedure
– Survey random sample of GDP so that results statisticallyapplicable to whole US economy
• 200 firms surveyed
– Structured survey to ensure objectivity
• Questions tailored to test economic theory
• Key economists consulted on design of questions
– Face to face interviews of top executives (25%President/CEO, 45% Vice President, 20% Manager) byEconomics PhD students
• Questionnaire taken seriously, informed answers• Interviewers could help clarify questions
• Interviews took 45-70 minutes for 30 questions
• Trial surveys undertaken prior to real thing to improve
uniformity of presentation, interpretation
E
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Economic facts of the firm
– Sample representative of private, for profit, unregulated,non-farm industry (71% of US GDP)
• Reflects relative weight of industries in US GDP• Excluded companies with < $10 million in sales
– Excluded group represents 25-50% of GDP
– Weight of industries in which small firms common
increased to compensate• Farms excluded because “no-one believes farm prices to
be sticky” (60)
– Perhaps price dynamics of farm sector different to
manufacturing?– Random sample selected, of those approached 61% took
part to yield 200 firms—high response rate
E f f h f
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Economic facts of the firm
• Distribution of sample differs from GDP with respect to firmsize:
Size Sample GDP< $10 m 0% 26.4%
$10-$25 m 22.5% 7.1%
$25-$50 m 13.5% 12.7%
> $50 m 64% 67%
• But big firms overwhelmingly important component:
– Average sales of firms surveyed $3.2 billion !
• (even though 36% of surveyed firms had sales < $ 50 m)
• 7 biggest firms had sales > $20 billion each & represented 58per cent of total sales by sample
– Firms surveyed represent 7.6% of US GDP
– “we interviewed an astounding 10 to 15 per cent of the targetpopulation—a large fraction by any standard.” (68)
E f f h f
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Economic facts of the firm
• Blinder’s survey serious coverage of US economy• Results give serious evaluation of economic theory
• If survey results consistent with theory, theory a good guideto functioning of economy & to how managers should manage
• If survey results inconsistent with theory, relevance ofeconomic theory seriously jeopardised: could be irrelevant tofunctioning of economy (& how managers should manage)
• Results contradict most of economic theory
– Most sales to other businesses, not end consumers– Most sales to repeat customers, not “impersonal”
– Marginal costs fall for most firms, not rise
– Most firms face inelastic demand (E<1), not elastic