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Managerial Economics

Professor Geoffrey Heal 616 Uris Hall Phone: (212) 854-6459 e-mail: gmh1@columbia.edu (note - gmh “one” not “L”). Managerial Economics. Course Outline:. (I) Analyzing the structure of a market Part A: Demand & Supply Part B: Costs (II) Pricing (most important part of course)

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Managerial Economics

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  1. Professor Geoffrey Heal 616 Uris Hall Phone: (212) 854-6459 e-mail: gmh1@columbia.edu (note - gmh “one” not “L”) Managerial Economics

  2. Course Outline: (I) Analyzing the structure of a market Part A: Demand & Supply Part B: Costs (II) Pricing (most important part of course) (III) e-con.com (application and review) (IV) Foundations of Strategy

  3. Aim: to understand key aspects of markets: nature of demands for the products closeness or otherwise of competitors structure of costs dependence of profits on the level of output Analyzing the Structure of a Market

  4. Material to be covered: • Analysis of demand • demand curves, • price, income & cross elasticities of demand • use of demand parameters in forecasting • Structure of costs: • fixed & variable costs • break-even analysis • opportunity costs and sunk costs • learning curves & economies of scale.

  5. How much product should you produce and what price should you charge for it? How can you best segment your market if there are different types of buyers with different demand characteristics (e.g., business travelers vs. vacation travelers, home PC buyers vs. corporate buyers)? What are the types of pricing schemes available (e.g., bundling, promotional offers, loyalty bonuses, volume discounts)? Pricing

  6. Applications of market analysis to electronic commerce How does the internet affect demand, pricing, and other aspects of running a business. e-commerce business strategies. Auctions and the internet. e-con.com

  7. Interacting with competitors Anticipating their reactions Forecasting the final outcome when everyone has reacted. Foundations of Strategy

  8. Aim of Course • To teach you to use basic economic ideas in making business decisions. • Decisions about opening and closing businesses. • Decisions about pricing and other policies.

  9. Level of Course • Emphasis on understanding concepts and where and how they can be used. • Don’t aim to make you an economist, but an intelligent consumer of economics. • Evaluate and understand works of consultants, staff. Ask the right questions. • Recognize BS when you see it!

  10. Consumption & Price of Copper 1880-1998

  11. Compare Internet companies • eBay • AOL • Yahoo • Amazon.com

  12. Demand and Supply

  13. Demand Curve Shows amount purchased as a function of price Depends on: - income - tastes - prices of competitive products - prices of complementary products

  14. Supply Curve Amount offered for sale as a function of price Depends on costs of production, which in turn depend on - costs of inputs - technology

  15. S The curves intersect at equilibrium, or market- clearing, price. At P0the quantity supplied is equal to the quantity demanded at Q0 . P0 D Q0 The Market Mechanism Price ($ per unit) Quantity

  16. The Market Mechanism • Characteristics of the equilibrium or market clearing price: • QD = QS • No shortage • No excess supply • No pressure on the price to change

  17. Demand Curve -Income Rises

  18. Demand Shifts

  19. Supply shifts

  20. D & S shift

  21. Price ($ per unit) S Surplus P1 Assume the price is P1 , then: 1) Qs : Q1 > Qd : Q2 2) Excess supply is Q1:Q2. 3) Producers lower price. 4) Quantity supplied decreases and quantity demanded increases. 5) Equilibrium at P2Q3 P2 D Quantity Q1 Q3 Q2 The Market Mechanism

  22. The Market Mechanism A Surplus • The market price is above equilibrium • There is excess supply • Producers lower prices • Quantity demanded increases and quantity supplied decreases • The market continues to adjust until the equilibrium price is reached.

  23. Price ($ per unit) S Assume the price is P2 , then: 1) Qd : Q2 > Qs : Q1 2) Shortage is Q1:Q2. 3) Producers raise price. 4) Quantity supplied increases and quantity demanded decreases. 5) Equilibrium at P3, Q3 P3 P2 Shortage D Quantity Q1 Q3 Q2 The Market Mechanism

  24. The Market Mechanism Shortage • The market price is below equilibrium: • There is a shortage • Producers raise prices • Quantity demanded decreases and quantity supplied increases • The market continues to adjust until the new equilibrium price is reached.

  25. The Market Mechanism • Market Mechanism - Summary: 1) Supply and demand interact to determine the market-clearing price. 2) When not in equilibrium, the market will adjust to alleviate a shortage or surplus and return the market to equilibrium. 3) Markets must be competitive for the mechanism to be efficient.

  26. Consumption & Price of Copper 1880-1998

  27. The Long-Run Behaviorof Natural Resource Prices • Observations • Consumption of copper has increased about a hundred fold from 1880 through 1998 indicating a large increase in demand. • The real price for copper has remained relatively constant.

  28. Price S1900 S1950 S1998 Long-Run Path of Price and Consumption D1900 D1950 D1998 Quantity Changes In Market Equilibrium

  29. Changes In Market Equilibrium • Conclusion • Decreases in the costs of production have increased the supply by more than enough to offset the increase in demand.

  30. Changes In Market Equilibrium • Wage Inequality in the United States • Real after-tax income from 1977 to 1999: • Rose 40+% for the top 20% of the income distribution • Fell 10+% for the bottom 20%

  31. Changes In Market Equilibrium • Question • Why did the income distribution become more unequal for 1977 to 1999?

  32. Measures responsiveness of demand to price. Defined as E = (DQ/Q)/(DP/P) = (DQ/DP)*(P/Q) Why is it defined in proportional terms? - Unit free. - Scale sensitive. A negative number. Price elasticity of demand:

  33. Elasticity = (DQ/Q)/(DP/P) = (DQ/DP)*(P/Q) = -2*(P/Q) Q = 8 - 2P or P = 4 - 0.5Q

  34. Elasticity and Pricing If elasticity is between 0 and -1 then raising price will raise profits - it will raise revenues and lower costs. If elasticity is lower than -1 then raising price will lower revenues and also costs, so the effect on profits is not clear. Moral - never operate where the elasticity is between 0 and -1.

  35. Relationship between demand, quantity and revenue: Q = 8 - 2P or P = 4 - 0.5Q so as revenue R is price times quantity R = 4Q - 0.5Q2

  36. Revenue rises as price rises Revenue falls as price rises PED = -1 PED = 0

  37. This is a quadratic pointing up. The slope is: DR DQ which is zero at Q = 4. Slope is positive for Q<4 and vice versa. Maximum revenue comes when Q = 4, therefore P = 2, and max revenue is 8 = 4 - Q

  38. PED when revenue is maximum • Revenue is max when Q = 4, P = 2. • E = (DQ/Q)/(DP/P) = (DQ/DP)*(P/Q) • So E = (DQ/DP)*(1/2) and • DQ/DP = -2 so E = -2 * 1/2 = -1 when R is at a maximum.

  39. The responsiveness of demand for good A to change in price of good B: DQA/QA = DQA* PB DPB/PB DPB PA Example: responsiveness of demand for Dell computers to prices of Gateway computers Cross price elasticity of demand:

  40. Supply Elasticity • The responsiveness of supply to price changes. • (DS/S)/(DP/P), proportional change in supply divided by proportional change in price. • Usually positive.

  41. Elasticities of Supply and Demand The Market for Wheat • 1981 Supply Curve for Wheat • QS = 1,800 + 240P • 1981 Demand Curve for Wheat • QD = 3,550 - 266P

  42. Elasticities of Supply and Demand The Market for Wheat • Equilibrium: Q S = Q D

  43. Elasticities of Supply and Demand The Market for Wheat • ED=(P/Q) (DQD/DP) = (3.46/2630)(-266)= -0.35 • ES=(P/Q) (DQS/DP) = (3.46/2630)(+240)= 0.32

  44. Changes in the Market: 1981-1998 The Market for Wheat Supply (Qs) Demand (QD) Equilibrium Price (Qs = QD) 1981 1800 + 240P 3550 - 266P 1800+240P = 3550-266P 506P = 1750 P1981 = $3.46/bushel 1998 1,944 + 207P 3,244 - 283P 1,944+207P = 3,244-283P P1998= $2.65/bushel

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