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Managerial Economics

Managerial Economics. Lecture One: Why economics matters to managers, marketers and accountants Neoclassical theory of profit maximisation. Admin. Purchase Reader Check subject outline Assessment: 3 parts Group presentation in tutorials 20% Essay on group presentation topic 40% Exam 40%

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Managerial Economics

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  1. Managerial Economics Lecture One: Why economics matters to managers, marketers and accountants Neoclassical theory of profit maximisation

  2. Admin • Purchase Reader • 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 • S.keen@uws.edu.au • Thursdays 1-3pm

  3. 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 as they please; they do not make it under self-selected circumstances, 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?

  4. Economics as the context of business in... The Eighteenth Brumaire of Louis Napoleon Karl Marx • Often the best wisdom in economics isn’t found in standard textbooks! • This subject takes a deeper look at economics you’ve already done (micro, macro); and • considers theories & data you haven’t seen before that are more relevant to business

  5. 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, Game theory, IS-LM, Efficient Markets, Comparative advantage • Different perspectives • Empirical data • Critiques of conventional theories • Alternative theories

  6. 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 a company’s competitive advantages lie outside the firm…” (Porter 1998: xxiii) • Understanding “what lies outside” may therefore be the most important 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:

  7. Economics as the context of business • Sometimes (not often enough!) theories explain how the real world works • Frequently (too often!) theories affect how people behave in the 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…

  8. Economics as the context of business • Emphasis in this course is on realism • Theories presented; but also • Empirical data examined to see whether theories actually work • Frequent conclusion: they don’t (but sometimes they do…) • One consequence: can’t rely upon textbooks for this course! • 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

  9. Economics as the context of business • This course • Starts with micro (theory of firm…) • Progresses through theory of the market, economy, finance to international trade • Based heavily on readings volume • You must have a copy • Tutorials and assessments based on contents

  10. “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 listed company • Structure: • from one person operations to multi-department • From sole operations (production to sale) to specialisation in manufacturing, wholesale, retail, marketing, consulting…

  11. 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 number of operating units: 15,870 units with 700,024 legal entities in 1998/99

  12. 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 between buyer/seller; “arms length” transactions

  13. “The firm”: economic theory • The economic simplification: diversity ignored to focus on alleged 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 manufacturing to sales • Some generalisations allowed later (e.g., agency theory) • But basic theory abstracts from these details • Core model: profit maximising behaviour under conditions of diminishing marginal productivity

  14. 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 is lowered • Mathematically: a negative relationship between price and quantity • To quantity sold must  price • Simple example: linear demand curve P(Q) = a –b Q

  15. Economic theory of the firm • Key consequence of “law of demand”: • Total revenue is price times quantity • Total revenue rises for a while as increase in Q more than outweighs decline in P • But ultimately fall in P overwhelms increase in Q: total revenue peaks and then falls… • Graphing price as a function of quantity:

  16. Economic theory of the firm • If firm produces 20,000 units, market price is 80 • Total revenue = 80 * 20,000 = $1.6 million Slope=0 Slope=40 20,000x80 • 40,000 units sold, price 60 • Total revenue = 60 * 40,000 = $2.4 million • Change in total revenue $0.8 m 40,000x60 60,000x40 • Change in unit revenue=$0.8 m/20,000=$40 • 60,000 units sold, price 40 • Total revenue $2.4 million • Change in revenue per unit zero

  17. 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 revenue curve at same point (o) • Other side of profit equation is costs: • Fixed: costs incurred regardless of how many units produced (research, development, factory construction, rent, etc.) • Variable: costs that depend on level of output: wages, raw materials, intermediate goods, etc.)…

  18. Economic theory of the firm • Theory argues per unit costs rise as quantity offered for sale rises: • Slope of total cost curve is marginal cost: • Rises as output rises because of diminishing marginal productivity • After some point, each new worker hired (variable input) adds less to production than previous worker • With constant wage and diminishing output per worker, unit cost of output rises • “Please explain”…

  19. 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” must be 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…

  20. Economic theory of the firm • There is some ideal worker:machine ratio (e.g., one worker per jackhammer) • In short run, firm has fixed number of jackhammers ? If this sounds weird to you, good! You’re on to something… • To dig holes, firm has to hire workers • 1st worker operates all six jackhammers at once: pretty inefficient! • Additional workers might show increasing productivity per worker for a while (two workers operating 3 jackhammers each less messy than one operating 6, ditto three workers operating two each…)

  21. Economic theory of the firm • Eventually ideal ratio reached (6 workers for 6 jackhammers) • Then to dig more holes, have to have more than one worker per jackhammer: ? ? • More holes can be dug with 2 workers per jackhammer than with one… • But productivity of two workers per jackhammer less than one worker per jackhammer… ? ?

  22. Economic theory of the firm • So productivity per worker might rise for a while; • But ultimately falls as more output can only be produced by adding more variable inputs (labour) to fixed input (capital) past ideal labour:capital ratio • Addition to output from each additional worker falls (but doesn’t become negative) • “Diminishing marginal productivity” (DMP) • DMP leads to rising marginal cost • Example: “Cobb-Douglas production function” Relative labor/capitalproduct coefficient Quantity produced No. workers Technology coefficient Amount of capital

  23. Economic theory of the firm • Cobb-Douglas production function allegedly fits aggregate economic data well (but see Shaikh, A. M., (1974). “Laws of Algebra and Laws of Production: The Humbug Production Function”, Review of Economics and Statistics, 61: 115-20) • Example with a=10, K=100, b=.4, L between 0 and 250: With 250 workers,output is 1,443 With 100 workers,output is 1,000 Change in ouputfrom next 250 is 443 Change in ouputfrom 1st 100 is 1000

  24. Economic theory of the firm • Each additional worker adds to output, but adds less than previous worker: diminishing marginal productivity • As usual, this is slope of total product curve: (maths unimportant, but here it is!): • Differentiate with respect to Labour… • Graphing marginal product:

  25. Economic theory of the firm • Output with 49 workers = 752 • Output with 50 workers = 758 • Marginal product of 50th worker  6 • Using formula, it’s exactly 6.063 • Output with 99 workers = 996 • Output with 100 workers = 1000 • Marginal product of 100th worker  4.012 • Using formula, it’s exactly 4 • Diminishing marginal product leads to rising marginal cost…

  26. 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 output desired; • 100 workers needed • To get total (variable) cost, multiply Y axis by wage rate (say $12 an hour)…

  27. Economic theory of the firm • Rate of change of variable cost is marginal cost • Rising because of diminishing marginal productivity… • So firm trying to maximise profits is (according to economic theory) faced with • Falling price • Rising cost… • How to maximise profit? • Find biggest gap between revenue and cost • Production level of 1000 units has variable costs of $1200 • Marginal cost of 1000th units is about $3

  28. Economic theory of the firm • Graphically, it’s easy: (using earlier example) • But economists prefer to make it complicated by working in average & marginal revenue & cost • Converting diagrams to averages by dividing by quantity gives us:

  29. Economic theory of the firm • What it means: “maximise profit by finding the biggest gap between revenue and cost” • Gap between curves is biggest when tangents (marginal revenue & marginal cost) are parallel: • As economists like to show it: “maximise profit by equating marginal revenue and marginal cost”

  30. 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 which marginal cost equals price”:

  31. Price Price Quantity quantity Economic theory of the firm • “Perfect competition” Downward sloping market demand curve Horizontal demand curve for single firm Marginal Cost Supply Pe Pe Demand Qe qe

  32. 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:

  33. Economic theory of the firm • It’s a breeze for competitive industries (p. 450): • A bit more complicated for monopoly (p. 500): • And a real pain for oligopoly (p. 560)…

  34. Economic theory of the firm • What to do? So many choices… Reality check time! • How does theory stack up against reality?

  35. 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 in price: • Value of E can be low (less than 1) for an industry, but in limit is infinity 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”

  36. 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 Price • Economic problems caused by government, union, monopoly behavior that makes some prices (e.g. wages) more rigid than others Supply Pe Demand Quantity Qe

  37. 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.

  38. 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 price stickiness

  39. Economic facts of the firm • Blinder’s procedure • Survey random sample of GDP so that results statistically applicable 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) by Economics 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

  40. 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

  41. Economic facts of the firm • Distribution of sample differs from GDP with respect to firm size: • 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 58 per 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 target population—a large fraction by any standard.” (68)

  42. 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 guide to functioning of economy & to how managers should manage • If survey results inconsistent with theory, relevance of economic theory seriously jeopardised: could be irrelevant to functioning of economy (& how managers should manage) What do you think the results were? And the correct answer is... Write your answer down • 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 • Fixed costs more important than variable costs

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