Combined

RUTGERS UNIVERSITY
Managerial Economic Analysis

22:223:581:61
Livingston – Beck 251
Professor Sharon Gifford Office hours: Tue. 5:30 – 6:30

Voice: 973-353-1646 (Newark) Levin 217c or by appointment
E-mail: sgifford@andromeda.rutgers.edu
Course Description:
This course is designed to give you a working knowledge of the basic principles of
microeconomic theory, with an emphasis on the applications of economics to management
decision making. No prior economic training is assumed. Those with recent undergraduate
degrees in economics are strongly encouraged to consider substituting an economics elective for
this course.
Course Materials:
Textbook: Managerial Economics and Business Strategy, Fifth Edition, by Michael R. Baye
(ISBN 0-07-298389-2), Irwin. The text and Study Guide may be available at the New Jersey and
Rutgers Bookstore. However, I strongly recommend that you try to obtain the textbook and
Study Guide online before class starts. The bookstores often run out if the book in the first week.
Class Notes: Blackboard https://blackboard.newark.rutgers.edu/ . You will need your Rutgers

NetID to logon. If you want to have your email forwarded from your Rutgers address, go to
http://business.rutgers.edu/students/return.htm. If Blackboard is not accessible go to
http://andromeda.rutgers.edu/~sgifford/manecon/. The Powerpoint slides are in the directory
"slides". All other material for your class is in the directory "Night class".
Prerequisite Topics
Calculus: differentiation of linear and power functions, graphing a function, maximizing an
objective function.
Statistics: regression analysis, t-statistics, R2 .
Course Requirements
Your grade for the course will be based on two 1-hour in-class exams (20% each), two projects
(15% each) and a final exam (20%). The final 10% is based on class participation. Participation
credit is earned by being active in class (asking questions, answering questions, telling good
jokes, etc.) You can also get participation credit by being active in the Discussion Board on Bb.
The projects will be done in groups of up to 4 students. The first project is based on
question 10 in chapter 3 of the textbook. Each group will use a different data set, available on
the disk that accompanies the text, to run a regression and answer the questions in the text. Each
group will hand in one report. The second project will be an industry analysis based on the
industry of your choice. Each group will hand in one report.
1
Outline
See Calendar on Bb for dates
Week 1 Managerial Economics and Market Forces Ch. 1 and 2

Week 2 Demand Ch. 3
Week 3 Individual Behavior Ch. 4
Week 4 Production and Costs Ch. 5
Week 5 1 hour exam. Chapters 1-5 Ch. 6
Organization of the Firm (project 1 due)
Week 6 Nature of Industry Ch. 7
Week 7 Managing Markets Ch. 8
Week 8 Rivalry Ch. 9
Week 9 1 hour exam. Chapters 6-9 Ch. 10
Game Theory
Week 10 Pricing Strategy Ch. 11
Week 11 Economics of Information Ch. 12
Week 12 Government in the Marketplace (project 2 due) Ch. 14
Week 13 Review
Final Exam Chapters 10, 11, 12 and 14
To prepare for class and the exams, read the assigned chapter(s) before class. Download and
print the transparencies and class summaries. Go through the study guide either before or soon
after class to test your understanding of the material. Start working on the projects as soon as the
material is assigned.
2
Managerial Economics Prof. Sharon Gifford
Lecture 1
Managerial Economics and Market Forces
The objective of this course is to teach students how to use microeconomic models as a
tool for making good business decisions. A manager of a firm must understand how to
allocate the firm’s scarce resources in order to achieve the firm’s goal. In general, a
firm’s goal is to maximize the value of the firm. The firm’s value depends on the profits
that are generated over time. The appropriate way to measure the value of the firm is to
calculate the present value of the stream of profits that the firm will receive in the future.
If the firm’s profits grow at a constant rate over time, then maximizing the value of the
firm is equivalent to maximizing current profits. Clearly, the assumption of a constant
growth rate in profits is extreme.
To maximize current profits, the manager must understand marginal analysis.
This mathematical tool considers how profits are affected by the choice of the quantity of
the product produced. To calculate the effect of an increase in the quantity produced,
marginal analysis reveals that this is measured by the difference between marginal
revenue and marginal cost. Increasing output by one unit generates an addition to
revenue, called marginal revenue, and an addition to costs, called marginal costs. If
marginal revenue is greater than marginal cost, then profit increases with the additional
output. Profit is maximized only when the additional revenue just offsets the additional
costs.
Demand and supply represent market forces. Demand is the willingness of
consumers to pay for a product. Supply is the willingness of firms to produce a product.
The law of demand states that more will be purchased only if the price is decreased.
Equivalently, if the price falls, a greater quantity will be demanded. When the price of
the product changes, this is a movement along a stationary demand curve. The demand
can be shifted by changes in factors other than the price. For example, if a good is
normal, then an increase in consumer income increases demand for the good. For an
inferior good, an increase in income reduces demand. Both of these effects shift the
demand curve. Other factors that shift demand are prices of complementary and
substitute goods and advertising and other sources of product information. If some
consumers pay less than the maximum they are willing to pay, then the difference
represents a surplus of value over price. The sum of all these surplus values is called
consumer surplus.
The supply of a product is determined by a firm’s costs. The law of supply states
that an increase in the price of the product will result in an increase in the quantity
supplied. Equivalently, to generate a greater quantity supplied, a higher price must be
offered. Changes in price and the quantity supplied are movements along a stationary
supply curve. Changes in other determinants of supply will shift the supply curve. For
example, an increase in input prices increases costs and so increases the minimum price
required by firms to supply a given quantity of the product. This is a decrease in supply.
At the same price, firms will supply less. Other factors that affect supply are technology,
the number of firms and taxes. If some units are sold at a price higher than the minimum
required by the firm, then this difference represents a surplus for the firm. The sum of all
surpluses in a market is called producer surplus.
1
An equilibrium is a situation in which no one has an incentive to change his or her

decision given the decisions of others. A market equilibrium is a price at which the
quantity demanded is equal to the quantity supplied. Those consumers who are willing to
pay this price can buy as much of the good as they want. Those unwilling to pay this
price will not buy any. Firms willing to sell at this price will sell all they want to at this
price. Those unwilling to sell at this price will sell nothing.
Some government policies prevent the market equilibrium price from being
achieved. A price ceiling, such as rent control, is less than the market equilibrium price
and results in a shortage. The quantity demanded is greater than the quantity supplied.
Some customers who are willing to pay the price ceiling are unable to buy as much as
they want. The product is restricted to those with the lowest search costs. The costs of
search for an available unit of the good will pay two prices: the monetary price and a
nonpecuniary price that is equal to the opportunity cost of their time spent searching. The
total surplus, consumer and producer, is less than at the market equilibrium price.
A price floor, such as a minimum wage, is above the market equilibrium price and
results in a surplus of the product. The quantity of labor supplied is greater than the
quantity demanded. Some workers willing to sell at the price floor will not be able to
sell. Again, the total consumer and producer surplus is less than at the market
equilibrium price.
Comparative statics is the analysis of the effect shifts in supply and/or demand on
the equilibrium price and quantity. Understanding these effects allows managers to
predict changes in market prices. An increase in demand results in a higher price and
quantity. A decrease in supply results in a higher price and lower quantity. However, if
both supply and demand change simultaneously, the effect on price and quantity may be
indeterminate.
2
Chapter 1: Fundamentals of Managerial How are managers like economists?

Economics
Goals and Constraints • Hiring?
Goal: maximize profits • Purchase?
Market Rivalry • Advertising?
Time Value of Money
Maximizing Profits
2/26/2008 Managerial Economic Analysis Prof. Sharon Gifford Rutgers University 1 2/26/2008 Managerial Economic Analysis Prof. Sharon Gifford Rutgers University 2
How are managers like

How are managers like entrepreneurs?
central planners?
• product characteristics
• assign tasks
• pricing policy
• motivate effort • performance
• planning
• reward performance
Goals and Constraints What is the Invisible Hand
• What is the manager’s goal?

over time
• How does greed serve consumers?
under uncertainty
risk considerations • What are opportunity costs?
• What constrains managers?
financial constraints
• How does self interest contribute to the
market constraints
general welfare?
management constraints
1
Rivalry and Benefits of Trade Time Value of Money

• Why do you care if you have to wait for
• What determines “the price”? revenues?
• Who benefits from trade, buyer or seller? • What is the opportunity cost of waiting?
• Is all trade voluntary? • If you invest $100 today at 10% interest,
• How do sellers get customers to buy? how much money do you have in one
• How do consumers get sellers to offer year.
goods and services? • Receiving this in one year is equivalent to
receiving $100 today.
Present Value (PV) and Future A sequence of incomes

Values (FV)
Three payments over three years has a
• If PV is received now, then in one year, present value of
FV = PV + iPV = (1+i)PV
PV = FV1/(1+i) + FV2/(1+i)2 + FV3/(1+i)3
or PV = FV/(1+i)
• Higher interest rates reduce PV. • In general,
• In 5 years
PV = t FVt/(1+i)t
FV = PV(1+i)5 or PV = FV/(1+i)5
A NAÏVE way to estimate the value of

Uses of Net Present Value the firm.
• Net present value of a project with initial Assume that the growth of profits is constant,
costs C0 then
NPV = PV − C0.
πt+1 = (1+g)π
πt for t = 0,…,∞
∞, and
• The value of a firm is the present value
PVfirm = πt/(1+i)t = π0(1+g)t/(1+i)t
of future profits πt t t
= π0 [(1+i)/(i−
−g)].
PVfirm = t πt/(1+i)
Maximizing the value of the firm is the same as
• How do we measure these future profits? maximizing current profits.
2
Simple Profit Maximization Marginal This and That

• What do you get if you sell one more
• What is the simplest way to define
unit?
profits?
MR(Q+1) = TR(Q+1) − TR(Q) = ∆TR
• What do profits depend on?
• What does it cost to produce one more
• What if quantity (Q) produced and sold?
unit?
π(Q) = TR(Q) − TC(Q).
MC(Q+1) = TC(Q+1) − TC(Q) = ∆TC
Marginal Profit Calculus

• ∆π(Q+1)
∆π = π(Q+1) – π(Q) = ∆TR − ∆TC = dπ dTR dTC
= − = MR Q − MC Q
dQ dQ dQ
MR(Q+1) − MC(Q+1).
• > 0 if MR(Q) > MC(Q)
• Should you produce more or less?
• < 0 if MR(Q) < MC(Q)
• If MR(Q+1) > MC(Q+1) then ∆π(Q+1)
∆π > 0. • = 0 if MR(Q) = MC(Q)
• How do we know if profits are
• If MR(Q+1) < MC(Q+1) then ∆π(Q+1)
∆π < 0. maximized?
What is a derivative? How do you take a derivative?

f(x) = m⋅xn
$ Slope = dπ/dQ = 0
df(x)/dx = m⋅n⋅xn-1
f(x) = 5x – 10x2
π(Q) df(x)/dx = 5 − 20x
Q*
3
Example: TR(Q) = 10Q − 2Q2 TC(Q) = 2 + Q2 Next

π(Q) = TR(Q) −TC(Q) • What are demand and supply?
= 10Q − 2Q2 − 2 − Q2
• What is the difference between demand and
= 10Q − 3Q2 − 2
quantity demanded?
Set dπ/dQ = 10 − 6Q = 0 • What is the difference between supply and
quantity supplied?
Solve for Q: 10 = 6Q
Q = 10/6 = 5/3 • What makes demand or supply change?
• Whar makes the quantity demanded or
At Q = 5/3, profits are maximized. supplied change?
4
Lecture 2
Demand Analysis, Estimation and Individual Behavior
Demand analysis uses an estimated demand equation to answer many questions about
how the quantity demanded of a good depends on a variety of factors. In general,
consumer demand depends on the price of the good, consumer income, the prices of
related goods and the information available to the consumer about the good. The reasons
for these relationships are explored further below when we consider individual behavior.
The problem of estimating the demand equation will also be considered below. But first,
we will analyze the information available from a demand equation.
Managers are very concerned with accurate predictions of future demand for their
product. Managers must often plan production ahead of time, before they know what
actual demand is. However, managers may have some information about how they
expect of the aspects of their markets to behave. For example, economists may predict
increasing consumer income because of a booming economy. Or managers may know
that a competitor is advertising a reduction in price. To determine the effect of these
predicted changes, managers need to know how sensitive the demand for their product is
to these changes. This sensitivity is called elasticity.
Elasticity indicates the percentage change in the quantity demanded for a percentage
change in some other variable, such as income or prices. Own-price elasticity measures
the percentage change in the quantity demanded for a percentage change in the price of
the good’s own price. This price elasticity determines whether demand is elastic or
inelastic. If demand is elastic, then the percentage change in quantity is greater than the
percentage change in price, implying that a decrease in the price will increase the
quantity so much that revenues increase. If demand is inelastic, then lowering the price
will reduce revenues because the increase in quantity is not sufficient to compensate for
the lower price. Demand tends to be more elastic if there are available substitutes and if
the time horizon is longer.
Cross-price elasticity measures the effect on the quantity demanded of a change in
the price of some other price. If cross-price elasticity is positive, then the two goods are
substitutes: a decrease in the price of a substitute decreases the quantity demanded of the
good in question. If the cross-price elasticity is negative, then the two goods are
complements. Notice that the sign of the cross-price elasticity is important.
Income elasticity measures the percentage change in the quantity demanded for a
percentage change in consumer income. If income elasticity is positive, then the good is
said to be normal: and increase in income increases the quantity demanded. If the income
elasticity is negative, then the good is said to be inferior. This means that people buy less
of this good when their income increases. If the income elasticity is zero, then the good
is a necessity.
To estimate the demand or product, regression analysis is used along with data on
the relevant variables. Regression techniques essentially fit a line to the data. This line
may be straight (linear) or not (nonlinear). The goal of regression techniques is to
minimize the unexplained errors, the difference between the actual observations and the
forecasted quantities from the fitted equation. The computer printout of regression
results contain information about how well the equation fits the data and whether or not
the independent variables have explanatory power.
1
The measure of the explanatory power of an independent variable is the number

of standard deviations that the estimated coefficient on that variable is from zero. The t-
statistic measures this. We know from statistical theory that the probability that the
estimated coefficient is more than two standard deviations from zero when the true
coefficient is zero is less than 5%. Therefore, if the absolute value of the t-statistic is
greater than 2, then we can be 95% confident that the true coefficient is not zero,
implying that the independent variable has explanatory power.
Although the t-statistic gives information about the explanatory power of
individual variables, we are also concerned with the explanatory power of the equation as
a whole. This is measured by the coefficient of determination, R2. This measures the
percentage of he total deviation in the data that is explained by the equation. If R2 is
close to one, then most of the deviation in the data is explained. However, this can be the
case for only if the data is closely packed along the estimated line. If the data is widely
spread out, then not line will fit the data closely. Therefore, there is no particular value of
R2 for which we can say we have a good fit. However, R2 can be used to compare the
goodness of fit of two different specifications of the equation, as long as the equations
contain the same number of independent variables. If one equation has more variables
than the other does, then the adjusted R2 must be used.
The relationships between the quantity demanded and the other variables are
made clearer by the theory of consumer behavior. Consumers are assumed to have
rational preferences over goods. This means that consumers can compare all bundles of
goods, prefer more to less, and are consistent in these comparisons. In addition,
consumers are assumed to have a decreasing willingness to trade away a good as they
have less of it. These assumptions are described by a diagram of indifference curves. An
indifference curve connects all bundles of goods that the consumer considers to be
equivalent. Consumers want to be on the highest indifference curve possible, but their
choice is limited by the budget constraint. This constrain says that consumers cannot
spend more money than they have.
The bundle of goods that is on the highest indifference curve without violating the
budget constraint is the consumer’s equilibrium bundle. At this bundle, the consumer if
just willing to trade one good for some of another at the terms of trade prescribed by the
prices of the good. This implies that observing the prices at which consumers are just
willing to trade reveals information about consumer preferences. By observing changes in
quantities purchased at different prices, we can collect data on the demand for the good.
Since a demand equation is estimated from the observations of prices and quantities, the
estimated demand measures the willingness of consumers to trade for the good.
Therefore, preferences themselves are revealed by the demand equation.
2
Demand
Chapter 2 Demand and Supply • Why does demand depend on tastes?
• Demand reflects customers’ willingness to pay for
• Why does demand depend on product
a product.
• Supply reflects firms’ willingness to sell a qualities?
product. • Why does demand depend on available
• Together, these determine the equilibrium price substitute and complementary goods?
and quantity sold.
• Changes in demand and supply result in changes • Why does demand depend on income?
in price and quantity. • Why does demand depend on information?
Demand Curve Law of Demand

• At what price will any quantity will sell,
• What happens if the price decreases?
holding all else constant?
• What quantity can be sold at any price, • This is a movement along a stationary
holding all else constant? demand curve.
P • What if any other factor changes?
10 P = 10 – 0.5 Q
• This shifts the demand curve.
5 D
10 20 Q
A decrease in price increases the quantity Change in Demand

demanded.
• Increase in income increases demand for a
normal good.
P
P0
P1
D'
Q0 Q1 D
Q
1
Complements and Substitutes Estimating a Demand Function
• Considers all of these effects:
• What happens if the price of a substitute Q = α0 + α1 Px + α2 Py + α3 M + α4 A
increases?
• What happens if the price of a complement • Px price of the good x
increases? • Py price of another good y
• If advertising increases, this may increase • M measure of consumer income
demand.
• A advertising expenditures
• Are these are all shifts in demand or
• Where do I get one of these?
changes in the quantity demanded?
Get curve from equation:

Q = α0 + α1 Px + α2 Py + α3 M + α4 A
Why do we expect that Qdx = 12,000 − 3 Px + 4 Py − 1 M + 2 A
α1 < 0 law of demand
< 0 for complements If Py = 15, M = 10,000, A = 2,000 then the
α2 equation for the demand curve is
> 0 for substitutes
Qdx = 6,060 −3 Px
< 0 for inferior goods or
α3 Px = 2,020 − 1/3 Qdx.
> 0 for normal goods
Consumer Surplus If a consumer is willing to pay 4 for a first

unit, 3 for a second and 2 for a third:
• Not every customer pays the most they are
willing to pay. P
4
• Consumer surplus is the difference between 3
what the consumer is willing to pay and the
2
actual price.
1 2 3 Q
2
Calculating Consumer Surplus Supply
• If P = 2, consumer surplus is • What does supply depend on?
(4 + 3 + 2) − (2 + 2 + 2) = 3. • Supply curve: minimum price at which any
quantity will be supplied, holding all else
• At P = 2, the firm’s revenue is $6.
constant.
• Consumer is willing to pay $9 for all • Law of supply: if price increases more will
three. be supplied.
• The firm could increase its revenue by • Is this is a movement along a stationary
selling a bundle of 3 for $9. supply curve or a shift in supply?
Changes in Supply • A decrease in price decreases the quantity

supplied.
• If input prices increase, supply shifts up
(back). This is a decrease in supply. S0
S1
P S0
P0
P1
Q1 Q0
Q
Supply Function Equation for supply curve:

Qxs = β0 + βx Px + β2 Pr If
Qxs = 200 + 3 Px − 6 Pr
Px price of the good x
Pr price of input good r and Pr = 100, then the equation for the
supply curve is
We expect:
βx > 0 Qxs = 3 Px − 400
βr < 0. or
Px = 1/3 Qxs + 400/3 .
3
Producer Surplus Graph of Producer Surplus
P S
• Not every unit is sold “at cost”. 400
PS
• Producer surplus is the difference between
the actual price and the minimum price at 400/3
which the good would be supplied.
800 Q
PS = [400 − 400/3]800/2 = (266.67)400 = 106,668.
Gains from trade are CS + PS.

Market Equilibrium P surplus S

• An equilibrium is a situation in which no PH
Pe
one has an incentive to do something
PL D
different, given the actions of others. shortage
Q
• A market equilibrium is a price Pe at which
supply equals demand: At PH > Pe, QSx > QDx. This is a surplus.
QS = QD = Qe. At PL < Pe, QSx < QDx. This is a shortage.
Calculating the Equilibrium Price Comparative Statics

If demand is
QD = 10 − 2P • Changes in supply and/or demand result in
and supply is changes in the equilibrium P and Q.
QS = 2 + 2P
then set • Changes in supply or demand are caused by
changes in things other than price.
QD = 10 − 2P = QS = 2 + 2P
and solve for Pe = 2 and Qe = 2 + 2Pe = 6.

4
An increase in income for a normal good An increase in materials costs
S P S1 S0
P
P1 P1
P0 D1 P0
D0 D
Q0 Q1 Q Q1 Q0 Q
For a normal good, increased income An increase in costs decreases supply, resulting
increases demand, which results in a higher in a higher price and lower quantity.
price and larger quantity.
Excel Worksheets Price Ceilings

• Click here to A price ceiling is a government policy that
Practice calculating demand and supply on sets price P C < P e.
S
“Demand” and “Supply” sheets
P(QS)
Shift demand and supply curves
Pe
Determine market equilibrium on “market” sheet
Calculate CS and PS on “Surplus” sheet. PC
D
QS Qe QD
Only QS is traded, buyers willing to pay

P(QS). Example: rent control.
Example: Rent Control Price Floors

• The shortage implies that goods are
allocated to those with lowest “waiting-in- • A price floor is a minimum price which can
line” costs. be charged or paid.
• P(QS) > Pe includes cost-of-waiting and is S
full economic price paid. PF
• Those with a low opportunity cost of Pe

waiting benefit from the price ceiling.
• At QS there is less consumer and producer D
surplus than at Qe. QD Qe QS
5
Example: minimum wage Conclusion
• If both supply and demand shift, the results
• Only QD is traded and there is a surplus of may be ambiguous.
job seekers. • The key to this analysis is whether a change
in a firm’s environment affects demand or
• The surplus implies that workers are supply or both.
allocated to those firms with the lowest • For next week: Demand analysis and
“search” costs. estimation.
• At QD there is less consumer and producer • Be sure to study Chapter 3 for next week.
surplus than at Qe. • Introduce yourself on the Discussion Board
6
Lecture 3
Individual Behavior
The relationships between the quantity demanded and the other variables are made
clearer by the theory of consumer behavior. Consumers are assumed to have rational
preferences over goods. This means that consumers can compare all bundles of goods,
prefer more to less, and are consistent in these comparisons. In addition, consumers are
assumed to have a decreasing willingness to trade away a good as they have less of it.
These assumptions are described by a diagram of indifference curves. An indifference
curve connects all bundles of goods that the consumer considers to be equivalent.
Consumers want to be on the highest indifference curve possible, but their choice is
limited by the budget constraint. This constrain says that consumers cannot spend more
money than they have.
The bundle of goods that is on the highest indifference curve without violating the
budget constraint is the consumer’s equilibrium bundle. At this bundle, the consumer if
just willing to trade one good for some of another at the terms of trade prescribed by the
prices of the good. This implies that observing the prices at which consumers are just
willing to trade reveals information about consumer preferences. By observing changes in
quantities purchased at different prices, we can collect data on the demand for the good.
Since a demand equation is estimated from the observations of prices and quantities, the
estimated demand measures the willingness of consumers to trade for the good.
Therefore, preferences themselves are revealed by the demand equation.
1
Regression Analysis
• Regression analysis estimates the demand
Chapter 3: equation.
• Used to forecast effects of anticipated

Demand Analysis
changes in prices, income, advertising, etc.
on demand.
Elasticities Price Elasticity

• effect of an independent variable X on
Linear demand:
quantity Q: for any explanatory variable x
QX = 22,000 − 2.5PX + 4PY − 1M + 1.5A
% ∆Q ∆Q / Q Own price elasticity depends on Px/QX:
E QX = =
% ∆X ∆X / X
%∆Q = EQX × %∆X ∂Q X PX P

E Q X PX = ⋅ = −2.5 X < 0
∂PX Q X QX
dQ / Q dQ X
E QX = = ⋅
dX / X dX Q
Price Elasticity and MR Cross-price Elasticity

> 1 elastic : ∆TR/∆Q = MR > 0 QX = 22,000 − 2.5PX + 4PY − 1M + 1.5A
EQXPX < 1inelastic : ∆TR/∆Q = MR < 0
∂Q X PY P
= 1 unitary elastic : ∆TR/∆Q = MR = 0 E Q X PY = ⋅ =4 Y
∂PY Q X QX
P elastic
unitary elastic > 0 substitute s
inelastic
D
E Q XPY < 0 complement s
MR Q = 0 independen t
1
Income elasticity Nonlinear Demand
∂Q X M M
E QX M = ⋅ = −1 <0 Q X = cPXβ X PYβ Y M β M A β A
∂M Q X QX
Taking natural logarithms:
> 0 normal
lnQX = lnc +β X ln PX +βY ln PY +βM ln M +β A ln A
E Q X M < 0 inferior
= 0 necessity Elasticities are the coefficients:
• Advertising elasticity: E Q X A = 1 5 A Q X EQX = βX E QY = βY E QM = βM EQA = βA
Regression Analysis • Or nonlinear
• Finds the equation that best fits the data. P

• May be linear • •
P •
•
• • P’ • •
• •
P’ • •
•
•
Q’ Q(P’) Q
Q’ Q(P’) Q
Sum of Squared Errors (SSE) Interpretation of Results

• The deviations of observed Q’ from • t-statistics: number of standard deviations σb that
predicted Q(P’) are residual errors. the estimated coefficient is from zero (H0).
• Squaring and summing these errors gives
the (SSE).
b−0
• Least Squares Regression chooses the tb =
coefficients β0 and βX for the equation σb
which minimize the SSE.
QX = β0 + βXPX 2σ σ σ 2σ
0 b
2
Goodness of Fit P
•
• R2 measures how much of the deviation in TSS − SSE •
•
the data is explained by the equation. R2 = •
TSS
• The total deviation is measured by the total •
error
sum of squared errors TSS: deviations of
observed values Q’ from the mean Q. Q’ Q Q
• The coefficient of determination is the • Note that 0 ≤ ≤ 1. The closer
R2 is to 1, R2
proportion of the total deviation explained the more explanatory power the equation
by the regression. has.
• R2 may be low because the TSS is large.
Using R2 Estimating Nonlinear Equations

• R2 can be used to compare the results of two • The data must be converted by taking the
natural log of each variable.
different specifications of the equation, if
• A linear regression techniques can then be
the have the same independent variables. used on the logged data.
• If the two equations have a different number lnQX = ln c +β X ln PX +βY ln PY +β M ln M +β A ln A
of independent variables, then the adjusted
R2 is used.
Forcasting Auction of Airwaves

• To forecast with a nonlinear specification, • Data to access data go, to the CD or Bb.
the value of the independent variables must • Click Tools, Data Analysis, Regression.
be entered in their logged form. • Enter data for dependent variables lnP in
Input Y.
• The result is a value for lnQ. To get Q, take
• Enter data for independent data lnQ and
the antilog: lnPop in Input X.
Q = elnQ • Hit Enter.
If lnQ = 6.215, then Q = e6.215 = 500.
3
Regression Results Insert values for Pop and Q
SUMMARY OUTPUT Forecasting Auction Prices:
Regression Statistics
Multiple R 0.92
R Square
Adjusted R Square
0.85
0.81
lnP = 2.23 + 1.25*lnPop - 1.2*lnQ
Standard Error 0.32
Observations 10.00
ANOVA
Pop lnPop Q lnQ
Regression
df
2.00
SS
4.02
MS
2.01
F
19.95
Significance F
0.00
32.00 3.47 6.00 1.79
lnP = 2.23 + 1.25 * 3.47 -1.2 * 1.79 = 4.41
Residual 7.00 0.71 0.10
Total 9.00 4.73
lnP 4.41
Intercept
Coefficients Standard Error
2.23 0.43
t Stat P-value
5.24 0.00
Lower 95% Upper 95% Lower 95.0% Upper 95.0%
1.23 3.24 1.23 3.24 P = e = e = 82.44
ln Pop 1.25 0.20 6.11 0.00 0.77 1.73 0.77 1.73
ln Q -1.20 0.20 -6.10 0.00 -1.66 -0.73 -1.66 -0.73
Link
Table 3-8 Data Table 3-8 Regression Results

Data Quantity Price
180 475 Multiple R 0.87
• Open Excel 590 400
R Square
Adjusted R Square
0.75
0.72
430 450 Standard Error 112.22
• Run the regression 250 550
Observations 10.00
• Check your results 275 575 Analysis of Variance

df SS MS F Significance F
720 375 Regression 1.00 301470.89 301470.89 23.94 0.0012
660 375 Residual 8.00 100751.61 12593.95
Total 9.00 402222.50
490 450
700 400 Coefficients Standard Error t Statastic P-value Lower 95% Upper 95%
210 500 Intercept 1631.47 243.97 6.69 0.0002 1068.87 2194.07
Price -2.60 0.53 -4.89 0.0012 -3.82 -1.37
Table 3-9 Data Table 3-9 Results

Quantity Price Advertising Distance
• Data
28.00 250.00 11.00 12.00 Multiple R 0.89
• Regression 69.00 400.00 24.00 6.00

R Square
Adjusted R Square
0.79
0.69
43.00 450.00 15.00 5.00 Standard Error 9.18
Observations 10.00
32.00 550.00 31.00 7.00
42.00 575.00 34.00 4.00 Analysis of Variance
df SS MS F Significance F
72.00 375.00 22.00 2.00 Regression 3.00 1920.99 640.33 7.59 0.0182
66.00 375.00 12.00 5.00 Residual 6.00 505.91 84.32
Total 9.00 2426.90
49.00 450.00 24.00 7.00
70.00 400.00 22.00 4.00 Coefficients Standard Error t Stat P-value Lower 95% Upper 95%
60.00 375.00 10.00 5.00
Intercept 135.15 20.65 6.54 0.0006 84.61 185.68
Price -0.14 0.06 -2.41 0.0527 -0.29 0.00
Advertising 0.54 0.64 0.85 0.4296 -1.02 2.09
Distance -5.78 1.26 -4.61 0.0037 -8.86 -2.71
4
Project 1 Instructions
• Groups of up to four members • Send me an email with the names in your
• Read directions carefully group
• Excel guide in EXCELREG.doc • I will set up a group on Bb with an assigned
• Use assigned data to analyze regressions data set
• Write 2-3 page business report that • Your group can then communicate and
addresses the questions in the assignment exchange documents through the group
page.
• Provide calculations and regression results
in appendix and regressions on disk
5
Lecture 4
Production and Costs
Before a firm can determine the quantity to produce that maximizes its profits, it needs to
know the cost of producing any particular quantity. Production technology and costs are
closely connected. Understanding the nature of the production function helps to
understand the nature of costs. Production depends on the technology available and the
inputs used. A production function gives the maximum output that can be generated with
the technology and amounts of inputs. Inputs can be either fixed or variable. Fixed
inputs are those which, for the current planning horizon, cannot be increased and cannot
be put to any other use. Variable inputs can be increased or decreased. Planning
horizons can vary in length. The short-run is any length of time over which some input is
fixed. In the long run all inputs are variable.
There are two concepts of productivity that are crucial to understanding the
relationship between production and costs. These are marginal productivity, which is a
short-run concept, and economies of scale, which is a long-run concept. Marginal
productivity is the measure of the additional output generated from increasing one input
while holding all others fixed. Marginal product may be initially increasing, but is
eventually decreasing, due to the existence of other fixed inputs. The marginal product
and the price of the output determine the firm’s demand for the input in the short-run.
In the long run, all inputs are variable and may be substitutable. If the rate of
substitution between inputs is the same, no matter what combinations are used, then these
inputs are perfect substitutes. If inputs cannot be substituted at all, then they are perfect
complements. If the substitutability of inputs varies, then this substitutability is equal to
the ratio of the marginal products. This substitutability is called the marginal rate of
substitution.
The goal of the firm’s production problem is to produce whatever quantity the
firm thinks is optimal at the least cost. An isoquant is all combinations of inputs that
generate a given level of output. An isocost line is all combinations of inputs that
generate the same expenditure. The optimal combination of inputs is the one that is on
the isoquant for the desired quantity and on the lowest isocost line. At this point, the two
curves are tangent and the ability of the firm to substitute between inputs is equal to the
rate at which they can be traded at their market prices.
A cost function is the cost of these optimal input combinations for any quantity of
output the firm wants to produce. The costs of fixed inputs are fixed costs and the costs
of variable inputs are variable costs. The shape of total costs in the short-run depends on
the shape of the production function. If there is initially increasing marginal productivity
but eventual decreasing marginal productivity, then the total cost curve is increasing at a
decreasing rate initially and then increasing at a decreasing rate. This implies that
marginal cost, the slope of total cost, is U-shaped.
There are several important relationships among the different types of costs. If
marginal cost is below average cost (either total or variable), then average cost is falling.
If marginal cost is above average cost then average cost is rising. Marginal cost equals
average cost at the minimum of average cost.
In the long run, we are concerned with whether or not production exhibits
economies of scale. Production can be scaled up only if all inputs are variable.
1
Increasing returns to scale result in declining average costs. If average costs are constant,
then the firm has constant returns to scale. Decreasing returns to scale occur if average
costs are rising. This cost structures will be very important in determining the structure
of industry.
Up to now we have considered a single product firm. However, many firms
produce multiple products. There are two reasons for this. One is indivisible inputs that
are not used to capacity by one input. This results in economies of scope. It is cheaper to
produce two products with the same indivisible input than for two firms to duplicate this
input and produce the two products separately.
Another reason for multi-product production is that producing a second input may
lower the marginal costs of producing one product. This occurs when the second product
generates byproduct that is an input for the first product. The cost of this byproduct is
essentially zero. This is called cost complementarity.
2
De gustibus non disputandum est
• Preferences are taken as given, except for four
assumptions of rationality:
Chapter 4
1. Completeness: A B or B A or A ~ B.
Individual Behavior
2. Nonsatiability: more less
Theory of consumer choice explains
how consumption depends on prices, 3. Transitivity: If A B and B C, then A C.
income and preferences.
Diminishing marginal rate of Indifference Curves

substitution (MRS) • All bundles that are considered equivalent
• Completeness implies ICs fill the plane.
• You are less willing to trade for something
you have more of. • More less implies negative slope.
• The first unit goes to highest valued use. C B A
Y
• The next unit goes to next highest valued
use. C•
• The first unit is of greater value than the B•
second. A•
X
• Transitivity implies they do not cross. 4. Diminishing MRS implies that the slope of
an IC is decreasing (in absolute value).
• A ~ C and B ~ C so A ~ B.
• But A B, more of X and Y. Y
A
MRSA
Y B
•A MRSB
B •
∆X=1 ∆X=1 X
C•
The MRS at a point is the slope of the
indifference curve.
X
Willingness to trade Y for X
1
Constraints Budget Constraint
M PX
Y= − X
With given income M and prices PX and PY, the Y PY PY
consumer cannot spend more than income.
PX X + PY Y ≤ M
M/PY
slope = - PX/PY
To graph the constraint, solve for Y:
M PX
Y= − X M/PX X
PY PY
Changes in income M Increase in PY

if M’ > M
Y
Y
M/PY
M’/PY
M/PY’ slope = −PX/PY
M/PY
slope = −PX/PY’
M/PX M’/PX X
M/PX X
Consumer Equilibrium Equilibrium prices Reflect

Preferences
Most preferred bundle that satisfies budget constraint.
Y slope = -PX/PY
Y At A, MRS > PX/PY.
slope = MRS Willing to trade more Y
for X than prices require.
A • At B, MRS < PX/PY.

A •
Prefer to trade X for Y.
Y* • C Y* • C
• B • B At C, MRS = PX/PY.
No incentive to trade.
X* X X* X
2
Excel Workbook Deriving Consumer Demand
• Y is a composite good
• Use this workbook to practice calculating
• Holding PY constant, at price PX, X(PX) is chosen.
the slope and axis of the budget line.
• If PX increases to PX’, then X(PX’) is chosen.
Consumer Budget Y Consumer Budget
PXX + PYY ≤ M 30 Y
25
M P
Y = − X X 20
PY PY
15 Y
PX PY M
10
5 2 50
5
PX/PY M/PX M/PY
0
2.5 10 25
0 10 20 30 X
Y= 25 -2.5 X(PX’) X(PX) X
Consumer Demand Law of Demand?

These two points generate two points on
consumer’s demand for X. • If X is a normal good, then demand is
At each point on D, PX/PY = MRS or
marginal value of X. negatively sloped.
• If X is an inferior good, demand is

PX’
PX
negatively sloped as long as PXX is not too
D great a proportion of M.
X(PX’) X(PX)
Overtime or Wage Increase?

Income
• B
C •
A •
LCLBLA 24 leisure
2/26/2008 Managerial Economic Analysis Prof. Sharon Gifford Rutgers University 17
3
Lecture 5
Organization of the Firm
Firms exist because they can generate goods more cheaply than if each person produced
for their own needs. The last chapter described three reasons for this: economies of scale,
economies of scope and cost complementarity. But to porduce the product, firms must
acquire resources. Many resources are bought outright, while others, such as labor, are
hired temporarily. Labor presents some special consideration, because the providers of
labor services still retain some freedom to choose they actions. The problem for the firm
is to determine the best way to hire and motivate labor services.
Typically, labor services are hired in one of three ways: spot exchange, contracts
and internally. Each of these practices has advantages and disadvantages and each is best
in different situations. Spot exchange occurs in markets where a payment is made at the
time of service at an easily determined and enforeable price and quality of service.
Contracts allow the buyer and seller to make specific arrangements for cusomized
delivery of services and payments. Internal labor services occur when a person is hired at
a wage or salary and the employee’s task are only vaguely set out at the time of hiring.
Which of these types of purchase techniques is used depends on the existence of
transaction costs. Transaction costs are caused by the costs of time spent searching for
the service, negotiating the terms of trade and enforcing the agreement. Search costs
arise when the service required is not readilly available on spot markets. Negotiation
costs include the time spent explaining the desired characteristics of the service and
negotiating terms which motivate the supply of those services. Enforcement costs arise
when there are specific investments by one or more parties. Specific invests are
expenditures which cannot be recouped by trading with any other partner. When these
exist, each party to the transaction has an incentive to renegotiate the terms after the
specific investments have been made. Specific investments can be in specialized
equipment, choice of location, of acquisition of human capital. Because of the possibility
of this “hold-up” problem, parties are reluctant to engage in specific investments.
Spot exchanges have the benefit of economizing on time. If the desired service is
widely produced and easily obtainable at given prices, spot exchange requires little time
or attention. If the quality of the service is easily observed, then there is no need for
contracting. If there are no specific investments, then there is no opportunity for hold-up.
However, the need for customized services, then contracting is useful for
specifying the desired services. This imposes contracting costs but provides the buyer
with the desired service. If there are no specific investments, then neither trade need
worry about enforcement. Specific investments require stronger contracts to assure that
each party lives up to the agreement.
If the service required is complex or vague enough, then it cannot be specified in
a contract. In this case, the seller agrees to a wage or salary, depending on time served,
and accepts direction of the buyer. The buyer (employer) can now specify exactly what
service is desired at different times but bears the cost of spending time giving directions
to the seller (employee). Thus, internalizing the trade within the firm requires more
attention from the buyer but customizes the service.
The internal transaction does not eleiminate the problem of motivating the
activities of the seller. If the actions desired by the employer cannot be perfectly
1
monitored and are costly to the employee, then, if given a fixed wage or salary, the
employee has an incentive to shirk. If the employer makes the compensation dependent
on some measure of the employees performance, then this is called an incentive contract.
However, if the employee cannot control the measure of performance, then the employee
is subject to risk. The optimal incentive is usually a combination of a base salary, to
minimize risk, and a performance component, such as a bonus, which motivate high
performance.
This is an example of the more general principal-agent problem. The principal
hires the agent to perform tasks which benefit the principal. However, these task are
costly to the agent and are not perfectly monitored by the principal. The relationship
between stockholders and managers of a company is another example of the principal-
agent problem. Incentives are used by stockholders to motivate managers’ effort to
maximize the value of the stock. However, if managers are rewarded according to
current stock prices, they will concentrate on short-run profits, perhaps to the detrimant
of the future value of the firm. Stock options have the advantage of providing managers
with incentives to maximize the long-term value of the firm.
However, managers cannot pefectly control the stock value of the firm, as this
will be dependent on many outside influences. To minimize the risk that managers face,
they are also paid a base salary aling with bonuses and stock options. If managers
perform well and the value of the stock increase dramatically, then managers can receive
extremely high incomes.
This same approsch is used to motivate employees of the firm other than top
management. Employees often participate in profit-sharing programs. An extreme
version is compensation by piece rate. This method ties an employees income to the
number of units the employee produces. Commissions are a form of piece rate. if the
employee can closely control the number of units produced, then this method generates
little risk for the employee while providing powerful incentives.
2
Production function
Chapter 5
• Output is produced from inputs, given a
Production and Costs particular technology
• 2 inputs: labor L and capital K
Productivity determines the Q = F(K,L)
relationship between inputs and • Efficient production: generates any output
outputs and the various measures of level at the least cost.
costs. • Short-run: some input is fixed.
• Long-run: all inputs are variable.
Some Definitions Total and Marginal Product

• TP is increasing with additional L if the
• Total product (TP) is the most that can be MPL > 0.
produced with given inputs. • Diminishing marginal returns occur when
MPL > 0 but decreasing.
• Average product of labor (APL) is TP/L. Q TP
MPL ↑
• Marginal product of labor (MPL) is ∆TP/∆L. MPL ↓
L0 L
Marginal Productivity Excel Workbook

• This is a short-run concept: only one input • Compare TP with AP and MP click here
changes.
2 3
Total, Marginal and Average Product TP = aQ + bQ - cQ
a b c
50 25 1 Total Product
• As long as marginal product is positive L TP MP AP Q
0 0 0 0 3500
output is increasing. 1
2
74
192
74
118
74
96
3000
3 348 156 116 2500
• If marginal product is decreasing, then 4
5
536
750
188
214
134
150
2000
TP
1500
output increases at a decreasing rate. 6
7
984
1232
234
248
164
176 1000
8 1488 256 186 500
• In general, firms will produce where there 9 1746 258 194
0
10 2000 254 200 L
are diminishing marginal returns. 11
12
2244
2472
244
228
204
206
0 5 10 15 20
13 2678 206 206
Marginal and Average Product
1
Value of Marginal Product Optimal Employment
• The value of marginal product of labor • Firm’s optimal purchase of L is where
VMPL is the additional revenue generated w = VMPL and VMPL is decreasing.
by the additional input.
• This implies diminishing MPL.
• If P is the price of the product, then $
VMPL = P⋅MPL
• If w is paid for L and w < VMPL, then the
firm should buy more L. w
• If w > VMPL, then firm should buy less of VMPL
L. L*
Short-Run vs. Long-run Perfect Substitutes

Q = 4K + L
• In the SR some inputs are fixed. • If L is decreased by 1, Q decreases by 1.
• In the LR all inputs are variable. • If K is increased by 1, Q increases by 4.
• In the LR the firm is able to substitute some • Rate of substitution is ∆K/∆L = − 1/4.
K
of one input for some of another and keep
output the same (on same isoquant). 5.5
5
Q = 22
• This is called the marginal rate of technical
substitution (MRTS).
2 22 L
Perfect Complements No Substitution

Q = min {K/4, L}
Q = min {K/4, L} • If K = 4 and L = 1, can produce Q(4,1) = 1.
• K > 4 when L = 1 does not increase Q.
K
• If K/4 > L, then can only produce L.
• Must have 1 unit of L for every 4 of K
4 Q=1
• No substitution: fixed proportions
1 L
2
Variable Substitution Graph of Isoquant
Q = K0.5 L0.5 Q = K0.5 L0.5
• The ability to substitute is K
MRTSKL = MPL/MPK
10
• MPL = 0.5K0.5L0.5-1 = K0.5/2L0.5 Q = 10
• MPL depends on level of K and L.
10 L
Costs Iso-Cost Line

• Economic costs are the opportunity cost of • All bundles of K and L that cost the same.
production. • Solve iso-cost equation for K to graph it:
• With efficient production each level of Q is K C w
produced at lowest costs. K= − L
r r
• To minimize the cost of producing any Q,
find lowest expenditure C/r
slo pe = - w /r
C = rK + wL
on K and L which produces Q.
C/w L
Optimal Inputs for Q “Bang-per-buck”

• Use K and L on isoquant for Q and on • At cost minimizing K* and L*, slopes are
lowest isocost. equal
K
MRTSKL = MPL/MPK = w/r
C’/r
or “bang-per-buck” is the same.
C/r
MPL MPK
K* Q =
L* C/w C’/w L w r
3
Cost Definitions An Example
• If TC(Q) = 200 + 2Q2
• TC(Q) = FC + VC(Q)
• FC = 200
• MC(Q) = dTC(Q)/dQ = dVC(Q)/dQ • VC(Q) = 2Q2
• MC(Q) = 4Q
• AVC(Q) = VC(Q)/Q
• AVC(Q) = 2Q2/Q = 2Q
• AFC(Q) = FC/Q
• AFC(Q) = 200/Q
• ATC(Q) = TC(Q)/Q = AFC(Q) + AVC(Q) • ATC(Q) = 200/Q + 2Q
Graph of Example Productivity and Costs

• The shape of the TP curve determines the
$ MC ATC
AVC MC(Q) = 4Q shape of VC and TC.
AVC(Q) = 2Q • If L is variable input, K is fixed input:
AFC(Q) = 200/Q
• VC = w⋅L
ATC(Q) = 200/Q + 2Q
• FC = r⋅K
• TC = VC + FC
Q
• MC is slope of TC
• Multiply L by the wage and flip the graph. Graph of MC

• Vertical axis measures costs. • Initial ↑ MPL implies initial ↓ MC
• ↑ slope of TP implies ↓ slope of VC. • Eventual ↓ MPL implies eventual ↑ MC
Q w⋅L
TC • MC is U-shaped
TP
VC
$ MC
↑ MPL ↓ MPL
FC
L Q
Q
4
MC and AVC Example
• If MC < AVC, then AVC is falling.
• If MC > AVC, then AVC is rising. • TC(Q) = 100 + 10Q − 18Q2 + 2Q3
• If MC = AVC, AVC is minimized. • MC(Q) = 10 − 36Q + 6Q2
$ MC • dMC/dQ = − 36 + 12 Q
ATC
AVC • MC is declining for Q < 3
min ATC
• and increasing for Q > 3.
min AVC
Q
Excel Worksheet ATC and AFC

• Compare TC, AC and MC click here • AFC = FC/Q is declining.
Productivity and Costs TC(Q) = w*L(Q)
w
• ATC = AVC + AFC
$ Total Costs
10
Q TC AC MC L
200 MC
0 0 0 ATC
150
74 10 0.135 0.135 1 AFC
TC AVC
192 20 0.104 0.085 2 100
348 30 0.086 0.064 3
536 40 0.075 0.053 4 50
750 50 0.067 0.047 5 AFC AFC
0
984 60 0.061 0.043 6
1232 70 0.057 0.040 7 0 2000 4000Q Q
LR Costs One technology may exhibit all

three properties
• In the long-run FC = 0.
• Economies of scale is a long-run concept: $
LAC
increasing if LAC is falling

decreasing if LAC is rising
↑ rts constant ↓ rts
constant if LAC is constant rts
5
Next Week Multi-Product Production
• Organization of the Firm.
• Project 1 is due next week. • Economies of scope: lower costs to produce
• Midterm Exam in 2 weeks two products together.
C(Q1,0) + C(0,Q2) > C(Q1,Q2)
• Due to shared resources (indivisible inputs).
• Hub-and-spoke airline operations.
• Cost complementarity: production of a

second product lowers MC of the first.
MC1(Q1,0) > MC1(Q1,Q2)
• One product uses byproduct of production
of the other product.
• Lumber mills generate sawdust and
shavings as byproduct of sawing and
shaving lumber.
• MC of byproduct is zero.
6
Lecture 6: Nature of Industry
There are two measures of the degree of concentration in an industry. The concentration
ration gives the percentage of sales in some number of firms (four-firm concentration:
sales of top four firms) and measures the degree of market dominance by a small number
of firms.
The Herfindahl-Hirschman Index is the sum of the squared market shares of all
firms in the relevant market, which therefore reflects unequal shares and all the of the
firms (more firms, lower index). There is evidence that increased concentration leads to
increased prices and profits. Concentration is not necessarily bad for consumers.
Concentration may be due to the greater efficiency of a few firms which come to
dominate the industry. A large number of smaller may be less efficient, and so charge
even higher prices. The main limitation of the use these measures is that one must be
able to define the relevant market.
The rest of this chapter is concerned with why industry structure matters. This is
primarily a concern about whether firms have market power to exploit and whether the
threat of potential entrants will spur better industry performance. Structure is easier to
observe than performance, so we are at a disadvantage. This is why there is so much
argument among economists and lawyers about the break-up of firms and the
deregulation of industry.
We will see that competition promotes the most "social welfare". But sometimes,
the lack of a monopoly means the lack of a market altogether. The threat of entry can
keep firms from charging high prices, even if they have no current competition. the
threat of entry can also promote more technological innovation. But it can also prevent
firms from undertaking large investments unless they can protect the market for their
product.
Describing the structure of a market may not be too hard, but we have to
remember that what we are most concerned with is the incentives for firm behavior. Be
sure to read the paper on the California electricity market under "External Links" on the
course site.
1
Organizing Transactions
• Labor services can be hired in many ways.
• Labor input must be motivated to perform
Chapter 6 to achieve firm’s objectives.
• Three types of transactions
Spot exchange
Organization of the Firm Contract
Internal organization
Transaction Costs Spot Exchange

• One time trade and immediate exchange of
• Most effective organization depends on TC service
• Three sources of transaction costs known service quality (commodity)
Searching verifiable delivery at payment
Negotiating
• Service must be easily “found”
Specialized investments
• No search costs.
• Service provider bears no transaction-
specific costs.
• May be repeated over time.
Spot Exchange, cont’d. Using Spot Transactions

• Getting required quality of service does not • Manager of Pizza-Shack pays drivers to
deliver pizzas.
require direction of seller’s effort by the
• Pays fee per delivery.
buyer.
• Are drivers easily found when needed?
• Prices are sufficient information. • If paid ahead, can driver just take the pizza?
• If paid after, can manager stiff the driver?
• Price system economizes on time and
• What if the driver has to buy a uniform and
attention. decals for the car?
1
Contracts Using a Contract
• Contract is required if service provider incurs • Manager writes contract specifying terms
transaction specific costs (uniform). (delivery, payments, penalties).
• Service provider retains control over how it meets
• Penalties for nonperformance must be
requirements of contract (not closely monitored).
enforced by courts (small claims court).
• Contract must specify quality and motivations
(timeliness, distance). • Costly to write a contract for each delivery.
• Enforcement is required (penalty for • Who pays for uniform and decals?
nonperformance, legal enforcement).
• Contracts require attention to write.
Transaction Costs Specific investments

• Provider buys specialized equipment,
• Required fixed costs in addition to price location, human capital.
incurred to purchase an input or service. • Bargaining problems arise because there is
• Search, negotiate, investments. a single buyer and seller.
• Must revenues to seller (price x quantity) • Once specific investments are made, they
cover production costs (VC) and transaction are sunk costs.
costs (FC)? • This leads to opportunism: renegotiation of
terms: “hold-up problem”.
• Seller may under-invest in specific assets.
Specific investments prevent spot Internalize

exchange • Purchaser acquires “control” over how
• Seller cannot recoup cost of investment. service is provided.
• Buyer will not make investment for seller. • Services required are not explicitly
specified in contract.
• If these specific investments are high
enough internalization is best • Service provider accepts direction of efforts
from buyer.
• Then the buyer makes the investment.
• Service is fitted to needs of buyer.
• Provider requires direction (attention) from
buyer.
2
Hiring the Driver The Principal-agent Problem
• Manager pays for and controls driver’s time • Employee motivation and compensation
(monthly salary).
• Time and distance for each delivery are not • Example: stockholders and management
specified (driver is on standby). • Performance of stock depends on manager’s
• Driver makes whatever deliveries required effort and other factors.
by the manager.
• Manager still must spend time giving the • Manager’s effort is costly to manager.
driver instructions. • Owner cannot perfectly monitor manager.
Piece Rates Flat Salary

• An extreme version of incentives is piece • Manager’s pay does not depend on
performance.
rate: the manager is paid by the number of • In extreme case, manager has no incentive
units produced. to work at all.
• If the manager can control production • However, if long-term performance can be
observed, manager may be fired if
measure, then risk is minimal. performance is low.
• Must be able to measure output • If pay is higher than opportunity cost,
individually. manager wants to keep job.
Using Stock Performance Long-term Compensation

• With fixed salary, independent of stock • Stock options reward effort which generates
performance, manager may shirk. improved future performance.
• Incentive contract, based solely on stock • Stock options for other employees provide
performance, puts manager’s income at risk. incentives if employees feel their behavior
• Compensation based on stock price along strongly affects stock price.
with base salary reduces risk and rewards
high effort. • Managers cannot sell stocks in large
• But manager may focus an short-term quantities without disclosure.
performance only. • How did Enron managers get around this?
3
Market Incentives • Project 1 due today.
• Midterm exam is next week.
• Reputation as good manager increases value
on employment market. • Test yourself with the Study Guide.
• Bad performance may eliminate future • Sample exam with answers is on Bb.
employment. • You may bring one 8(1/2) x 11sheet of
• Some managers become entrenched because paper with notes but no magnifying glass.
of influence with board members. • Write out your notes yourself.
• Firms with poor management are subject to • You may want a calculator.
takeovers which replace management.
• Why didn’t these controls work for Enron? • The exam will be for 2 hours.
4
Lecture 7: Perfect Competition, Monopoly, and Monopolistic Competition
This chapter covers the three main industry models: perfect competition, monopoly, and
monopolistic competition. Oligopoly models are described in the next chapter (next
week).
The fundamental assumptions of perfect competition are:
a) Both buyers and sellers (the firms in the market) are price takers.
b) All firms produce the same product at the same costs.
c) There is perfect information about product and price.
d) There are no transaction costs.
e) There is free entry into the market.
"Price taking" means taking the price as given and believing that you cannot change it
through your actions. In the context of a firm in a PC market this means that they take
the market price as given and believe that no matter their output the price will remain
fixed. This is like facing a perfectly horizontal demand curve at the given price.
Marginal revenue is therefore simply the given price. "Free entry" simply means that
there are no barriers to entry and any firm can enter the market and begin producing the
given product if they choose to.
In the short run, the number of firms in the industry is fixed (no entry or exit
occurs) and the firms face their short run cost curves. An individual firm follows two
rules in determining its short run action: a) If P < AVC (short run) they shut down (Q =
0). b) If they produce they do so at the Q which satisfies MC(Q) = P. It follows that a
firm's short run supply curve is its short run marginal cost curve in the region where short
run marginal cost exceeds short run average variable cost. Firms would rather shut down
than sell at a price below average variable cost.
The overall market short run supply curve is therefore the horizontal sum of all
the individual firm's short run supply curves. By summing the quantities supplied by
each firm at the given price, you derive the quantity supplied by the market at that price.
Doing this for every price results in the market supply as a function of price. The short
run competitive equilibrium is at the intersection of the market supply and market
demand curves. This determines the price that the firms take as given in choosing their
quantities and the amount of output the industry as a whole produces. The amount an
individual firm produces is where the equilibrium price crosses the individual firm's
supply curve.
In the long run firms enter the market if there are positive profits and exit the
market if there are negative profits. Therefore, the long run equilibrium price is equal to
average cost, making profits zero. Since this must also maximize profits, price equals
marginal cost as well. Therefore, the long-run equilibrium price is equal to the minimum
of average costs, where average cost equals marginal cost.
A monopoly is an industry that is served by a single firm. Because it is the only
firm in the market, the demand curve facing a monopolist is the market demand curve.
Any firm is said to have market power when they face a downward sloping firm demand
curve. Entry into a market governed by a monopoly is assumed to be completely blocked.
In other words there are barriers to entry. These barriers allow a monopolist who makes
profits to persist. There are many different types of barriers to entry that can be broadly
classified as legal (government protected monopoly, copyrights, patents, etc.),
1
technological (the potential entrant can't access key resources, is at a cost disadvantage
(scale economies), lacks specific knowledge, etc.) and strategic (these are barriers that
could fall into the other two categories, but are barriers that the monopolist has erected,
like establishing a brand name (product differentiation), brand proliferation, limit pricing,
etc.).
The fundamental assumptions governing an economic model of monopoly are:
a) Sellers are price makers (i.e. they dictate the market price through their action).
b) Entry into the industry is completely blocked.
c) Buyers are price takers.
The monopoly quantity will be where marginal cost equals marginal revenue. Since the
marginal revenue is less than the price, this implies that the monopolist’s price will be
greater than marginal cost. This implies that there are buyers who are willing to pay
prices higher than the marginal cost but are unable to purchase the product. This implies
a dead weight loss from monopoly due to reduced trade. Less output is produced and
sold by a monopolist than the amount that would maximize the gains from trade.
A monopolist with multiple plants for producing its product faces a similar but more
complicated problem than a competitive firm with multiple plants. In both cases, the
total cost of producing the output is minimized if the production is distributed between
the plants so that the marginal cost of an additional unit of output is the same at both
plants. The competitive firm only has to choose output where the marginal cost in each
plant is equal to marginal revenue, which is the price of the product. The monopolist will
also choose output at each plant where marginal cost is equal to marginal revenue, but for
the monopolist, marginal revenue depends on the total amount produced.
A monopolistic competitive market is one in which
a) there are many buyers and sellers (like perfect competition)
b) free entry and exit in the long-run (like perfect competition)
c) but each firm produces differentiated product(s).
This last assumption implies that firms face negatively sloping firm demands for their
products. Therefore, they price like monopolists, since they have market power.
However, free entry and exit implies that positive profits cannot be sustained in the long-
run. If a firm is making positive profits, other firms are free to enter this market. This
results in a decreased demand for the firm’s product, reducing profits as well. Entry
continues until profits fall to zero.
The firm will still be pricing above marginal cost and have average costs above
the minimum in the long-run equilibrium. This implies that this market results in a dead
weight loss similar to monopoly. The only way to remove this dead weight loss is for all
the firms to produce the same product and behave as perfect competitors. This eliminates
the dead weight loss but also the variety of products. The value of this variety is difficult
to measure.
2
Market Structure
• Optimal firm decisions depend on the firm’s
Chapter 7 market environment.
number of firms
their relative sizes
The Nature of Industry costs
demand conditions
ease of entry and exit
Number and Size of Firms Concentration Ratios

• S1,…,S4 are the sales of the four largest
• Some industries are dominated by a few firms.
large firms. • ST is total sales of all firms.
• Concentration ratios measure how much
S1 + S 2 + S 3 + S 4
output is produced by the largest firms. C4 =
ST
• Concentration ratios are a rough measure of
the size distribution of firms in an industry.
Using Market Shares Herfindahl-Hirshman Index

• Equivalently, with w1,…,w4 the shares of • The Herfindahl-Hirshman index uses
the four largest firms, squared market shares wi of all firms and
eliminates decimal places.
C4 = w1+w2+w3+w4. • Larger weights on larger firms.
• For highly concentrated industries, C4 is HHI = 10 000 N

i =1 w 2i
close to 1.
1
Shortcomings Using Price Elasticities
• Both indices depend on definition of the • A firm’s elasticity of demand is greater than
market. the market elasticity if there are substitutes.
• Products with large positive cross-price • market elasticity ET< EF firm
elasticities are in the same market. elasticity
• Exclude foreign firms. • The Rothschild index: 0 < ET/EF < 1
• Ignores difference between national and • If Rothschild index is close to one, the firm
local markets. has monopoly power.
• Both indices are trying to measure market • In some markets price is easily observed
power.
while in others it is difficult.
Using Price Mark-up Ease of Entry

• Lerner index measures price markup over • Measures of concentration and market
marginal cost. elasticity are for a fixed number of firms.
• Firms in a competitive market will have L • Ease of entry of new firms in the long run
close to zero.
depends on barriers to entry:
• A better measure, but requires more
information. capital requirements,
licenses,
P − MC patents,
L=
P market size.
Consolidation Other Consolidations

• In the long run, firms may merge as well.
• Vertical integration unites a firm with a • Conglomerate mergers combine different
supplier or customer. products.
• This can reduce transaction costs. • This can spread risk and improve cash
• Horizontal mergers are between firms flows.
producing a similar product.
• Hostile takeovers remove inefficient
• This can reduce costs due to economies of
management.
scale or increase market power.
2
Market Performance Industry Analysis
• Firm performance is measured by profits • Industry analysis models firm conduct and
and by contributions to social welfare.
performance for different market structures.
• The Dansby-Willig performance index
• Structure-Conduct-Performance Paradigm
measures how much consumer and producer
surplus would increase if a market assumes that concentration causes
expanded to the socially efficient output. monopoly pricing which causes high profits
and poor social performance.
Two extreme cases

• Feedback view recognizes that high profits
affect structure by encouraging new firms to • 1. Perfect competition
many firms
enter the market, affecting conduct and
similar products
future performance. similar technologies and costs
easy entry
• In addition, low prices and good social • 2. Monopoly
performance can occur with few firms. one firm
no entry
Many Intermediate Cases Project 2

• Groups can have up 4 members.
• 1. Monopolistic competition
• Choose an industry that you are interested
many firms
in.
product differentiation
• Be sure to carefully review each member' s
easy entry
contribution to the report.
• 2. Oligopoly: few firms, similar products, • Project is due on class before Final Exam.
no entry. Includes Sweezy, Cournot,
Bertrand, Dominant Firm, and others.
3
Lecture 8: Basic Oligopoly Models
Oligopoly refers to market structures in which there are more than one firm but
there are few enough that each has a material effect on the market price. Unlike perfect
competition and monopoly, there is no single theory of oligopoly. Oligopoly can refer to
any situation that occurs between the two theoretical extremes of perfect competition and
monopoly. However, we can list the basic assumptions:
a) Sellers are price makers

b) Sellers behave strategically
c) There are barriers to entry in most models
d) Buyers are price takers
The Sweezy Model (Kinked Demand) explains stable prices even as costs
fluctuate. There is a kink in the firm demand curve at the current price because the firm
believes that if it lowers its price, the other firms will match this price reduction. If the
firm raises its price, it assumes the other firms will not match the price increase. This
implies that the demand curve is more elastic above the current price than below it. The
result is a discontinuity in the MR curve, with MC passing through the gap. Small shifts
in MC do not result in any price changes.
In the Cournot Model (Quantity Competition) all firms produce the same
standardized product. The total quantity produced and demand determine the price.
Each firm chooses its quantity taking the other firms' quantities as given. In duopoly,
each firm takes the other firm's quantity as given and uses a reaction function to choose
quantity to maximize profits. A Cournot duopoly produces a total market quantity which
is 2/3 of the competitive quantity, which is more than the monopoly quantity of 1/2 the
competitive quantity. If there are more firms in the market the quantity produced
increases and approaches the competitive quantity as the number of firms increases.
Collusion (Cartel) is a formal or informal effort to prevent quantity competition
from lowering the market price below the monopoly price. Both firms are better off if
they maintain the monopoly price.
In the Stackelberg Model (Price Leadership) the optimal production decision of a
one firm must take into account how the follower firm will react. The leader determines
its residual demand by subtracting the followers' supply from the market demand. Using
this residual demand, the price leader chooses the quantity to maximize its profits. The
follower’s supply the rest of the market taking the leader’s quantity as given.
In the Bertrand Model (Price Competition) firms choose prices and the firm with
the lower price gets the entire market. This leads to a price war, which drives the price
down to marginal cost. The price, market quantity and profits are the same as in a
perfectly competitive market.
In Contestable Markets, there is free entry and exit, so the number of firms is not
given, as in the other oligopoly models. If current firms make positive profits, then
additional firms enter the market and the price falls. This continues until price falls to
average costs. If there are negative profits, then some current firms exit the market. This
continues until price rises to equal average costs. The market is in long-run equilibrium
when there is no incentive for firms to enter or exit the market. Therefore, the condition
1
for long-run equilibrium is zero profits. The quantity, price and profits are the same as
the competitive long-run equilibrium, even though there may be few firms.
2
Perfect Competition
• 1. many buyers and sellers (all price takers)
• 2. Firms produce the same product
Chapter 8 • 3. perfect information
• 4. no transaction costs
Competition, Monopoly and
Monopolistic Competition • 5. free entry and exit of firms
• Examples: agriculture, stock and
commodity markets.
Implications Market Determines Price

• Market equilibrium Pe is where supply
• Market price is the market equilibrium equals demand
price. Firms are price takers.
• Firm demand is horizontal line: price-taker.
• Firm can sell all it wants at the market
Market Firm
price. Each firm is small.
P S P
• Firm demand is horizontal line at market
price. P= MR. Pe DF
• Each additional unit of output can be sold at D

this price.
QM QF
MR = P Maximizing Profits
• Marginal revenue is equal to the market price • Profits: total revenue minus total costs
because the price does not depend on the firm’s π(Q) = P⋅Q – TC(Q)
production level. • Setting dπ(Q)/dQ = 0 gives

P − MC(Q) = 0
• TR(Q) = P⋅Q
• or P = MC(Q).
• MR(Q) = dTR(Q)/dQ = P
1
Firm Supply Firm Profits
The firm supplies the quantity Q* at which the
• If P > ATC(QF), then
MC(Q*) = P.
π = [P − ATC(QF)]QF > 0
MC
$ • If P = ATC(QF), then π = 0.
P AVC
• This occurs at the min ATC.
• If P= min ATC, then π = 0.
Q* Q • min ATC is where ATC = MC.

• Firm may produce at a loss in the short run. Losses in the short-run
• Pe < ATC so π < 0: profits are negative.
• Firm’s choice is to produce QF or Q = 0
• But Pe > AVC. Revenues cover variables
costs. • Better to produce QF > 0 if
π(QF) = P⋅QF − VC(QF) − FC > π(0) = − FC
$ MC P⋅QF − VC(QF) > 0
ATC
AVC QF[P − AVC(QF)] > 0
Pe
P > AVC(QF)
• If P < min AVC, then it is better to shut
QF Q
down in the short run.
Firm Supply Market Supply

• The firm’s short-run supply curve is the MC • Market supply is the horizontal sum of all
curve above min AVC. firm supplies in the industry.
• min AVC can be found by setting AVC =
MC. $ MC P SF SM
AVC
min
AVC
Q
Q
2
Algebraic Example Entry and Exit
• In the long-run, firms choose to enter or exit
If TC(Q) = 100 + 10Q2 then MC(Q) = 20Q the market.
and firm supply is • If π > 0 at P0, additional firms will enter.
P = 20Q = MC and QF = P/20. • Market supply shifts out and the
If there are 100 firms then market quantity is equilibrium price falls to P1 where π = 0.
QM = 100QF = 100P/20 = 5P P S0
S1
and market supply is P0
P1
P = QM/5.
D
Q
• If π < 0 at P0, additional firms will exit. Long-run Equilibrium

• Market supply shifts back and the • A long-run equilibrium is P = min LAC.
equilibrium price rises to P1 where π = 0.
• No firms want to enter or exit.
S1
P S0
$
LAC
P1
P0
min LAC
D
Q
Q
Long-run Efficiency An Example

• Profits are maximize (P = LMC) and profits If LRC = 100Q + 100Q2 − 5Q3
are zero (P = LAC). Set LAC = LMC and solve for Q:
• Economic profits take into account the 100 + 100Q − 5Q2 =100 + 200Q −15Q2
opportunity cost of the owner(s) of the firm.
100Q − 5Q2 = 200Q − 15Q2
• The long-run equilibrium Pe can be found
15Q − 5Q = 10Q = 200 − 100 = 100
by setting LAC = LMC
Q = 10 and LAC(10) = 600 = Pe in the LR.
3
Practice Calculations Gains from Trade
• Because MC = MB, gains from trade are
Excel Sheet: Make small changes in a,b,c or f to maximized in a perfectly competitive market.
check your calculations of minATC and minAVC
Total, Marginal and Average Costs
a b c f
TC = f + aQ + bQ^2 - cQ^
P S = MC
Total Costs
500 40 2 1000 Q
Q TC MC ATC AVC 15000
1 1462 426 1462 462 10000 CS

2 1856 364 928 428
5000
3 2194 314 731.3 398
4 2488 276 622 372 0
5 2750 250 550 350
6
7
2992
3226
236
234
498.7
460.9
332
318
0 5 10
PS
8 3464 244 433 308 Q Marginal and Average Costs
9
10
3718
4000
266
300
413.1
400
302
300
800 D = MB
700
11 4322 346 392.9 302
12 4696 404 391.3 308 600
13 5134 474 394.9 318 500
14 5648 556 403.4 332 400 Q
15 6250 650 416.7 350 300
Monopoly MR < P
The change in revenue from selling one more
• A monopoly can arise from economies of unit of output is
scale, scope or cost complementarities that TR(Q0+1) − TR(Q0) = P1⋅(Q0+1) − P0⋅Q0
give one firm a cost advantage. = B − A = P1 − A < P1
• A monopoly may be licensed or own a
patent. P0 A
• A monopoly faces the market demand. P1
B
• If a monopoly firm wants to sell more of its D
product, it must lower it’s price. Q0 Q0+1 Q
• MR has the same vertical intercept and

Linear Demand twice the slope as a linear demand
• At Q = 25, MR = 0, TR is max’d, EP = -1
If demand is P = 100 − 2 Q then
P
TR(Q) = P⋅Q = (100 − 2 Q)⋅Q = 100 Q − 2Q2. 100
slope = -4
MR(Q) = dTR(Q)/dQ = 100 − 4 Q. slope = -2
D
25 MR 50 Q
4
Profit maximization There is no supply curve for a
monopolist.
Set MR(Q) = MC(Q).
If TC(Q) = 10 + 2Q, then P
100
MC(Q) = 2
5.1
Set MR(Q) = 100 − 4 Q = 2 = MC
Solve for the optimal Q = 24.5. 2 MC
D
Optimal P = 100 − 2(24.5) = 5.1 24.5 Q
MR
Implications of Monopoly Inefficiency

• If P > AC, π > 0. No entry of other firms A: lost gains from trade due to QM < QPC
due to barriers to entry.
P MC
P MC
AC
P(QM) A
AC(QM)
MR D
MR D
QM QPC Q
QM Q
Multiple Plants Demand for product: P = 70 − 0.5Q, where

Q = Q1+Q2. Then
• Same product produced by two plants,
MR(Q) = 70 − (Q1+Q2)
1 and 2.
MC1(Q1) = 3Q1 MC2(Q2) = Q2
π(Q1,Q2) = R(Q1 + Q2) − TC1(Q1) − TC2(Q2)
MC1(Q1) = 3Q1 = 70 − Q1 − Q2 = MR(Q1+Q2)
• Optimal production implies
and
MC1(Q1) = MC2(Q2)
MC2(Q2) = Q2 = 70 − Q1 − Q2 = MR(Q1+Q2)
5
Two equations with two unknowns, Q1 and Q2.
Solve the second one for Q1 as a function of Q2
MC Equal Across Plants
• MC1(10) = 3⋅10 = 30 = MC2(30)
Q1 = 70 − 2Q2
• So MC(40) = 30 = MR(Q) = 70 − Q
substitute into the first equation P MC1
MC2
Q2 = 70 − 4Q1 = 70 − 4(70 − 2Q2) MC(Q)
and solve for Q2 = 30 and

30
Q1 = 70 − 2Q2 = 10. MR D
Then Q1+Q2 = 40 and P = 70 − 0.5 Q = 50. 10 30 40 Q
Monopolistic Competition
• 1. many buyers and sellers (like PC) • Each firm faces a negatively sloping
• 2. free entry and exit (like PC) demand for its product.
• 3. firms produce differentiated products • Firms price like monopolists.
• Products are close, not perfect, substitutes
• Positive profits lead to entry of firms in the
• Common consumer products:
cereals, personal hygiene, detergents LR.
• Each variation designed to fit a niche in • Entry reduces firm’s demand.
consumer tastes.
• Entry and exit imply zero profits in the long
• Product distinctions require advertising.
run.
Positive profits in the SR Zero Profit in LR

• Entry in the long run decreases firm’s
P MC demand
AC P MC
P(QMC)
AC(QMC)
P(QMC)= AC
AC(QMC)
D
MR D MR' D’
QMC Q QMC Q
6
Implications
• In the long-run equilibrium, profits are zero
but P > MC : inefficient
• and AC > min AC : inefficient
• Alternative is a homogeneous product
produced by all firms.
• This would be a perfectly competitive
market.
• Value of variety of products is hard to
measure.
7
Lecture 9: Game theory
Chapter 10 introduces the analytical tools of game theory for modeling the strategic
interactions of firms in oligopolies. . Game theory refers to the analysis of situations in
which the outcome for each individual player depends not only on his own actions but
also on the actions of a small number of other players. The critical element is the
importance of strategic thinking. In determining your optimal action you need to
consider the actions of the other players which are also made upon considering your
action, etc.
All the players in our games are going to be maximizing their own well being (in
economic games this is generally profit). Each player also believes that each other player
acts this way. The specification of a (single play) game entails three elements: a) the
identity of the players, b) the set of strategies available to each player c) the pay-off to
each player for each possible combination of strategies.
The set of strategies (one for each player) that is the solution is called the Nash
equilibrium. In an equilibrium, neither player wants to change his or her decision, given
the other player's decision. One way of finding an equilibrium of a game is through the
concept of a dominant strategy. A dominant strategy for any player is a strategy for that
player that yields the best payoff no matter what the other player does. If any player has
a dominant strategy they would clearly play it. A way to find the solution to the game
then is to check for dominant strategies. Dominant strategies will be played.
In the pricing game (Prisoners’ Dilemma), the Nash equilibrium is for both firms
to charge a low price, even though they would both be better off if they both charged a
high price. This characteristic is also represented in the advertising and quality games.
In the coordination game (Battle of the Sexes), there are two equilibria in which both
players choose the same strategy. This game represents the problem of choosing a
common standard. Often an outside party is needed to determine which standard should
be provided. The employee monitoring game has no Nash equilibrium. If employees are
monitored, then their best response is to work hard. But if employees are working hard,
the firm can lower costs by not monitoring. A typical response to this dilemma is to have
random monitoring. In the bargaining game, the strategy of asking for nothing is a
dominated strategy. Therefore, any request by one party that generates a positive payoff
only if the other party asks for nothing can be ruled out.
Repeated games can be of three types, infinitely repeated, finitely repeated with a
known final period and finitely repeated with an uncertain final period. The infinitely
repeated game allows players to adopt trigger strategies, which result in effective
collusion. This resolves the dilemmas of the one-shot games. In the finitely repeated
games, a certain final period eliminates the use of trigger strategies. In the last period,
the optimal strategy is to cheat, since there is no future play in which to be punished.
However, the same is true of each preceding period, given that cheating is best in the next
period. An uncertain final period results in equilibrium trigger strategies just as in the
infinitely repeated games.
In multi-stage, or sequential, games, players take turns choosing their strategies,
based on the previous strategies of other players. Although a game may have multiple
Nash equilibria, some are “better” than others. A subgame perfect Nash equilibrium
requires that at each node of the equilibrium path, the player chooses the strategy that has
1
the highest payoff. This eliminates Nash equilibria in which one player makes a threat
that is not credible. In the sequential entry game, an incumbent firm cannot prevent entry
by another firm by threatening to lower its price after entry. This threat is not believable
sine the best strategy for the incumbent firm is to maintain the high price after entry. In a
sequential bargaining game, a threat to reject a low offer is not believable since it is better
to accept a low offer once it is made.
2
Several Interacting Firms
• Oligopoly refers to markets in which firms
interact strategically.
• Each firm’s decision depends upon what it
Chapter 9 believes other firms will do.
• More than one firm, but not many.
• Interdependence of decisions makes
Basic Oligopoly Models manager’s problem complex.
• Number of possible beliefs about other
firm’s behavior leads to many models of
oligopoly.
Assumptions Sweezy Model (Kinked Demand)

• Firms choose prices.
• All models assume:
• Each firm believes a price reduction will be
1. Few firms who try to predict reactions of
matched but a price increase will not be
other firms.
matched.
2. Barriers to entry even in the long run.
• Demand is more elastic to price increase
• except for contestable markets, which than to price decrease.
assumes free entry and exit.
Kink in Demand Equilibrium P* and Q*

• At current price P*, demand is more elastic At current Q*, there is a gap in MR.
for a price increase than for a price At lower Q, MR > MC. At higher Q, MR < MC.
decrease. Therefore, Q* is optimal.
P P
price is matched
P*
MC
P* price not matched
D
D
Q Q* MR Q
1
Predictions Cournot (Quantity Competition)
• MC may shift and leave the optimal Q* and • Firms choose quantities, market price
P* unchanged. depends on total quantity supplied.
• Model explains reluctance of firms to • Firms assume other firms’ quantities
change prices, even as MC changes. remain the same.
• Therefore, price can be “sticky”. • Each firm has a reaction function that
determines the best quantity for any given
level of other firms’ quantities.
A Duopoly Example Deriving MR

• The equilibrium choices are given by the
quantities that satisfy both reaction • Firm 1’s demand can be written
functions. P = (10 − Q2) − Q1
• Firm 1’s problem: choose Q1 to • Firm 2' s quantity is assumed constant and so
is part of the intercept. The slope of
max π(Q1,Q2) = P(Q1,Q2)⋅Q1 − TC1(Q1) demand is −1.
where • MR1 = (10 − Q2) − 2Q1
P(Q1,Q2) = 10 − (Q1+Q2) • Same intercept, twice the slope.
Set MR1(Q1,Q2) = MC1(Q1)
Firm 1’s Reaction Function Firm 2’s Reaction Function
• If MC1 = 0, then set • Firm 2’s problem is similar and reaction

function is
MR1 = (10 − Q2) − 2Q1 = 0 = MC
Q2*(Q1) = 5 − (1/2)Q1
• and solve for Q1 as a function of Q2: • This is due to symmetry of the example.
Q1*(Q2) = 5 − (1/2)Q2 • Solve these two equations for the two
• This is firm 1’s reaction function. unknowns, Q1* and Q2*.
• It specifies what Q1 should be for any Q2.

2
Solve for Q2* Solve for Q1*
Similarly
Q2*(Q1) = 5 − (1/2)Q1
= 5 − (1/2) [5 − (1/2)Q2] Q1*(Q2) = 5 − (1/2)Q2 = 5 − (1/2)(10/3)
= 2.5 + (1/4)Q2
= 5 − 10/6 = 20/6 = 10/3.
Q2* = (4/3)(2.5) = 10/3.
Price and Profits Collusion

MRM = 10 − 2QM = 0 = MC => QM*= 5
• P(Q1*,Q2*) = 10 − Q = 10 − 20/3 = 10/3.
• If the firms had colluded on quantity, they would
• Profits for firm 1 are choose to each produce half of the monopoly
quantity QM = Q1 + Q2.
π1(Q1*,Q2*) = P⋅Q1* − TC1
or QM = 5 and P = 10 − 5 = 5.
= (10/3)(10/3) − 0 = 100/9 = 11.11 • Total profits are
• Total profits of both firms are πM = PM⋅QM − 0 = 5⋅5 = 25
π1 + π2 = 200/9 = 22.22. • Each firm gets πi = (1/2) 25 = 12.5 > 11.11.
Excel Worksheet (click) Better Off Colluding

Cournot Reaction Functions • Each firm makes a higher profit if the two
a b c Reaction Curves
P = a - bQ1- bQ2
10 1 0
20
firms collude and act like a monopolist.
MR1 = (a - bQ2) - 2bQ1 = c = MC
Solve for Q1 as a function of Q2
Q1 = 5 -0.5 * Q2
15
• This is one explanation for the desire of
Q2 = 5 -0.5 * Q1
Solve these equations Q1
firms to horizontally merge.
Q2
10
for Q1 and Q2 Q2
Q1 = Q2 = 3.33
Calculate price P =
Calculate firm'
s profit =
3.33
11.11
5
• Anti-trust regulation prohibits collusion
Calculate total profit = 22.22 5
Compare to collusion
and competition
0
0 5 10 15 20
because it produces less surplus..
Collusive Q, P and profits 5.00 5 25
Q1
Competitive Q, P and profits 10.00 0 0
• We will return to this later.
3
Stackelberg (Price Leader) Residual Demand
Sfollower
P
• One firm (follower) chooses a quantity P1
taking the other firm’s quantity as given.

Dresidual
P2
• “Price” leader chooses a quantity that Dmarket
considers the supply of follower.

Q
• The follower behaves like a Cournot firm. At P1, follower supply equals demand.
• The leader is more sophisticated. At P2, no follower supply.
At intermediate prices, leader faces residual D.
• Leader’s reaction function takes into Algebraic Example

account the followers reaction function.
• Market demand: P = 50 − (QL+QF)
• Using the residual demand, the leader
determines it’s MR and sets it equal to MC. Costs: TCL = 5 + 2QL
P
Sfollower TCF = 5 + 2QF
P1 • Follower’s reaction function: set
Dresidual
MRF = MCF
P2
Dmarket MRF = (50 − QL) − 2QF = 2 = MCF
MRresidual
Q
• Solve for QF* = 24 − (1/2)QL
The Leader’s QL* The Follower’s QF*

• Substitute the follower'
s reaction function • Substitute QL* into follower’s reaction
function
into market demand function to get the
QF* = 24 − (1/2)24 = 12.
residual demand:
• Substitute Q = QL* + QF* = 36 into market
P = 50 − [24 − (1/2)QL] − QL demand
= 26 − (1/2) QL P = 50 − 36 = 14.
• Set MRL = 26 − QL = 2 = MCL
to get QL* = 24.
4
Profits Bertrand (Price Competition)
• πL(QL*) = P⋅QL* − 5 − 2QL* • Firms choose their own prices, taking the
= 14⋅24 − 5 − 2⋅24 = 283. other prices as given.
• Firms sell perfect substitutes.
• πF(QF*) = P⋅QF* − 5 − 2QF* • Buyers choose the firm with the lowest
= 14⋅12 − 5 − 2⋅12 = 139. price.
• Firm with the lowest price captures the
market.
Firm 1’s Demand Equilibrium

• Equilibrium price equals marginal cost.
QD if P1 < P2
Q1 = (1/2)QD if P1 = P2 P
0 if P1 > P2
Given P2, firm 1 chooses P1 < P2. MC

D
Given P1, firm 2 chooses P2 < P1.
Outcome is P = MC. Q
Comparing the Models Competition vs. Monopoly

An Example • In general, QM = (1/2) Qp
• demand: P = 1,000 − Q1 − Q2 • Total surplus is also half of competition
• costs: TCi = 4Qi i = 1,2 P
• Competitive market: Q = Q1 + Q2
Ppc = MC = 4, Qpc = 996, πi = 0 MC
• Monopoly: MRM = 1,000 − 2Q = 4 = MC
MR D
QM = 498, PM = 502
QM Qpc Q
πM = (PM − 4)QM = (502 − 4)498 = 248,004
5
• Cournot produces more than Monopoly but less
Cournot: Reaction Functions than Competition.
• Surplus is also more than Monopoly but less than
Q1* = 498 − (1/2)Q2 Competition.
Q2* = 498 − (1/2)Q1 P
Q1* = Q2* = 332 = (1/3)Qpc

MC
Pc = 1,000 − 664 = 336, πi = 110,224.
• In general, if there are N Cournot firms MR D
Qi* = Qpc/(N+1) QM QC Qpc Q
Collusion and Bertrand Entry in Oligopoly

• Cournot collusion is the same as monopoly: Contestable Markets: Free entry and exit
Qi* = (1/2)QM = 249. If π > 0, entry occurs, P falls until P = AC.
Pc = PM = 502, πi = (1/2)πM = 124,002. If π < 0, exit occurs, P increases until P =AC.
• Bertrand is the same as perfect competition: LR equilibrium implies π = 0.
PB = PPC = MC, QB = Qpc, πi = 0 Same as long-run perfect competition, even if

there are few firms.
6
Lecture 10: Pricing Strategies
Firms with market power (not price takers) have the ability to affect the price of their
product. Up to now we have considered only the case in which the firm charges the same
price for each unit of the product that it sells. For this case, we have the markup rule
which relates the optimal price to the constant elasticity and constant marginal cost of the
product. Under special circumstances, a firm with market power may be able to make
higher profits with other pricing stragegies.
Price discrimination (PD) describes three pricing strategies that result in different
customers paying different prices for the same product. The firm must have some
information about customers’ willingness to pay for the product and be able to prevent
arbitrage. The differences in the three types of PD are due to the amount of information
the seller has about customers’ willingness to pay for the product. If the firm can
determine each customer’s willingness to pay for each unit purchased, then the firm can
practice first degree PD. In this case, each unit of the product is sold for the most the
buyer is willing to pay. The seller captures all the gains from trade and so wants to
maximize those gains by selling the competitive quantity.
If the firm does not have sufficient information to proctice first degree PD, it can
offer quantity discounts. This is known as second degree PD. The profits to the firm ate
not as great as with first degree PD. If the firm can only distinguish groups of customers
by their willingness to pay then the firm can discriminate among market segments and
charge different prices to each group. This is third degree PD. A market segments with a
higher elasticity of demand will pay a lower price.
If a seller cannot distinguish individual customers’ willingness to pay, it can use
another method to extract all the gains from trade. A firm can implement a two-part price
if it can prevent those who do not buy a “membership” from being able to purchase the
product. By charging a fixed fee equal to a consumer’s consumer surplus from buying
the product, the firm is able to capture all the gains from trade, and so wants to maximize
them. Therefore, the two-part priceing strategy results in the competitive quantity being
sold, but the seller captures all the gains from trade. If unable to charge a “membership” a
seller can use block pricing to extract consumer surplus. This requires the customer to
buy in minimum blocks. The firm charges the total value of the block to the consumer in
an all-or-nothing offer . By choosing the block size so that MC equals the marginal value
of the good, the firm again maximizes the gains from trade and captures them all. Firms
that sell multiple products for which consumers have different valuations can increase its
revenues by bundling the goods and selling them together for a single price rather than
selling the products individually.
Firms which have varying demand at different times can increase sales by
lowering the price when demand is low and raising price when demand is high. This is
known as peak-load pricing. In addition, cross-subsidies can increase profits. By selling
on product at a loss, the firm can increase the demand of a complemetary product. If the
increased revenues are greater than the losses generated then this will increase profits.
Cost complementarities can also make this strategy profitable. Multiproduct firms that
genarate an input in one division for the production of a product in another division want
to set transfer prices so that each division has an incentive to maximize the profits of the
firm as a whole. If the upstream division chooses a monopoly price, it will reduce the
1
profits of the firm as a whole. By setting the transfer price equal to the marginal cost of
producing the input, then the upstream division becomes a price taker and maximizes its
divisional profits and the profits of the firm as a whole.
Pricing strategies can also be used in oligopoly situations in which price wars are
a concern. To eliminate the incentive of a competitor to undercut a firm’s price, it can
promise to match any competitor’s advertised price. Then there is not benefit to the
competitor undercutting the firm’s price. This can also be achieved by accepting
competitor’s coupons. Firms can prevent customers from being attracted to competitors’
lower prices if they can instill “brand loyalty”. This may be done with advertising which
distinguishes the firm’s product or with frequent-purchase discounts, such as frequent
flyer miles. Finally, a firm can increase the costs of price competition by using random
pricing. This makes it difficult for customer to seach for the seller with the lowest price
and for competitiors to undercut the firm’s price.

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RUTGERS UNIVERSITY

Managerial Economic Analysis

Professor Sharon Gifford Office hours: Tue. 5:30 – 6:30

Class Notes: Blackboard https://blackboard.newark.rutgers.edu/ . You will need your Rutgers

Week 1 Managerial Economics and Market Forces Ch. 1 and 2

An equilibrium is a situation in which no one has an incentive to change his or her

Chapter 1: Fundamentals of Managerial How are managers like economists?

How are managers like

Goals and Constraints What is the Invisible Hand

• What is the manager’s goal?

Rivalry and Benefits of Trade Time Value of Money

Present Value (PV) and Future A sequence of incomes

A NAÏVE way to estimate the value of

Simple Profit Maximization Marginal This and That

Marginal Profit Calculus

What is a derivative? How do you take a derivative?

Example: TR(Q) = 10Q − 2Q2 TC(Q) = 2 + Q2 Next

The measure of the explanatory power of an independent variable is the number

Demand Curve Law of Demand

A decrease in price increases the quantity Change in Demand

Get curve from equation:

Consumer Surplus If a consumer is willing to pay 4 for a first

Changes in Supply • A decrease in price decreases the quantity

Supply Function Equation for supply curve:

Gains from trade are CS + PS.

Market Equilibrium P surplus S

QS = QD = Qe. At PL < Pe, QSx < QDx. This is a shortage.

Calculating the Equilibrium Price Comparative Statics

and solve for Pe = 2 and Qe = 2 + 2Pe = 6.

Excel Worksheets Price Ceilings

Only QS is traded, buyers willing to pay

Example: Rent Control Price Floors

• Those with a low opportunity cost of Pe

• Used to forecast effects of anticipated

Elasticities Price Elasticity

%∆Q = EQX × %∆X ∂Q X PX P

Price Elasticity and MR Cross-price Elasticity

• Advertising elasticity: E Q X A = 1 5 A Q X EQX = βX E QY = βY E QM = βM EQA = βA

Regression Analysis • Or nonlinear

• Finds the equation that best fits the data. P

Sum of Squared Errors (SSE) Interpretation of Results

Using R2 Estimating Nonlinear Equations

Forcasting Auction of Airwaves

Table 3-8 Data Table 3-8 Regression Results

• Check your results 275 575 Analysis of Variance

Table 3-9 Data Table 3-9 Results

• Regression 69.00 400.00 24.00 6.00

Diminishing marginal rate of Indifference Curves

Changes in income M Increase in PY

Consumer Equilibrium Equilibrium prices Reflect

A • At B, MRS < PX/PY.

Consumer Demand Law of Demand?

• If X is an inferior good, demand is

Overtime or Wage Increase?

Some Definitions Total and Marginal Product

• Marginal product of labor (MPL) is ∆TP/∆L. MPL ↓

Marginal Productivity Excel Workbook

Short-Run vs. Long-run Perfect Substitutes

Perfect Complements No Substitution

Costs Iso-Cost Line

Optimal Inputs for Q “Bang-per-buck”

Graph of Example Productivity and Costs

• Multiply L by the wage and flip the graph. Graph of MC

Excel Worksheet ATC and AFC