managerial economics - mba ue 27mexecutive.mba.ue.wroc.pl/en/wp-content/uploads/... · profit...
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1. Managerial decisions
6 steps in decision making, goals, examples of decisions
2. Demand analysis
demand function, demand curve, elasticities
3. Optimal price
optimal pricing, profitability analysis, price discrimination
Topics
optimal pricing, profitability analysis, price discrimination
4. Markets
market power, asymmetry of information, oligopoly, game theory
5. Decisions under risk and uncertainty
expected value, decision trees, value of information
• by firms
production level, technology, price strategy, investment, R&D,
market entry/exit, competition strategy
• by consumers
consumption level (standard commodities, consumption over
time, work vs leisure)
Economic decisions
time, work vs leisure)
• by public institutions
public goods, taxes, market organization
optimization under constraints
cost/benefit analysis
considering the opportunity cost
Economic decision making
marginal analysis
• Firm introduces a new product to the market.
• A supermarket changes its strategy to a quality oriented.
• Investment in nuclear power plants in Poland.
• Wrocław applies for a European Green Capital.
Examples of decisions
• Consumer decides about her pension program.
• Undertaking criminal activities.
1. Define the problem
2. Determine the objective
3. Explore the alternatives
4. Predict the consequences
6 steps to decision making
5. Make the choice
6. Perform sensitivity analysis
• What is the problem, that the manager faces?
• Who is the decision maker?
• What is the decision setting or context, and how does it
influence managerial objectives or options?
1. Define the problem
• What is the decision maker’s goal?
• How should the decision maker value outcomes with respect
to this goal?
• What if he or she is pursuing multiple, conflicting objectives?
2. Determine the objective
• Profit maximization as the goal of the firm.
• Maximization of the market value /enterprise value / firm
value as the goal of the firm.
• Valuation methods: asset-based, income-based, comparative
• Other objectives: maximization of market shares (revenues),
What is the objective of the firm?
• Other objectives: maximization of market shares (revenues),
reaching a „satisficing” outcome.
[Froeb, McCann]: in order to find a source of the problem one
has to answer 3 questions:
1. Who made the decision?
2. Did he/she have enough information?
3. Was he/she properly motivated to make the right decision?
Reasons for bad decisions
3. Was he/she properly motivated to make the right decision?
Decision maker’s objective might differ from owner’s objective.
• What are the alternative courses of action?
• What are the variables under the decision maker’s control?
• What constraints limit the choice of options?
3. Explore the alternatives
• What are the consequences of each alternative action?
• Should conditions change, how would this affect outcomes?
• If outcomes are uncertain, what is the likelihood of each?
• Can better information be acquired to predict outcomes?
4. Predict the consequences
• After all the analysis is done, what is the preferred course of
action?
5. Make the choice
• What features of the problem determine the optimal choice
of action?
• How does the optimal decision change if conditions in the
problem are altered?
• Is the choice sensitive to key economic variables about which
6. Perform sensitivity analysis
• Is the choice sensitive to key economic variables about which
the decision maker is uncertain?
• Demand function: a mathematical relationship between the
demanded quantity and parameters that affect it.
• Main determinants: price, incomes, prices of other
commodities, and many others.
• The demanded quantity is determined for the given market,
Demand function
• The demanded quantity is determined for the given market,
and time horizon.
( )YPPfQ C ,,=
• In order to determine the shape of the linear demand
function, two pieces of data are enough, but…
• With more data we determine the regression line.
• Formally: the Least Squares Method.
• Example:
Demand function: example (linear function)
• Example:
• with: Q in mlns of units annually, P in Euro/unit, Y in th. of
euro annually, PC
in Euro/unit.
CPYPQ 1.002.04.060 ++−=
• Cobb-Douglas function:
• Example…
Demand function: example (Cobb-Douglas)
γβαCPYPaQ ⋅⋅⋅=
• Negative relationship between the price and the demanded
quantity (law of the demand).
Demand curve
P
Q
• Price elasticity of demand: measures the sensitivity of
demand to changes in price.
Price elasticity of demand
P
EP ∆
∆
=
• Elastic demand vs inelastic demand.
• The relationship between the elasticity and the slope of the
demand curve.
PP
EP ∆=
1) The effect of price change on the value of total revenue
reached.
2) The effect of tax (cost) increase on the market price.
3) The relationship between the value of the price elasticity
and the optimal price.
Applications of price elasticity of demand
and the optimal price.
• When demand is inelastic, then:
increasing the price increases the total revenue
decreasing the price decreases the total revenue
• When demand is elastic, then:
increasing the price decreases the total revenue
Price elasticity of demand and total revenue
increasing the price decreases the total revenue
decreasing the price increases the total revenue
• The total revenue is maximal in case of the unit-elastic
demand.
The effect of tax increase on the market price (1)
pS
S1
ptax Conclusion:tax
q
D
pE
qtax qE
ptax Conclusion:
half of the tax paid by
consumers and half
by firms
tax
taxfirm
taxcons
pS
The effect of tax increase on the market price (2)
pS
S1
Conclusion:tax
q
D
pE
qtax qE
ptax
Conclusion:
in case of elastic
demand bigger part
of the tax is paid by
the firms
tax
taxfirm
taxcons
pS
The effect of tax increase on the market price (3)
p
S
S1
ptax tax
q
D
pE
qtax qE
ptax
Conclusion:
in case of inelastic
demand bigger part of
the tax is paid by
consumers
taxfirm
taxcons
tax
pS
The effect of tax increase on the market price - conclusions
• Increase of the tax (or any other cost factor for suppliers)
results with the price increase.
• But the price always increases by less than the tax/cost.
• The less elastic the demand, the bigger is the price increase,
i.e. the bigger is the part of the tax/cost shifted onto thei.e. the bigger is the part of the tax/cost shifted onto the
buyers.
• Another consequence of the tax is the deadweight loss, i.e. a
loss in total surplus, resulting from the lower number of
transactions.
Price elasticity and optimal pricing
• When demand is inelastic, then:
increasing the price increases the total revenue
increasing the price decreases the total cost
increasing the price increases the profit!
• When demand is elastic, then:• When demand is elastic, then:
decreasing the price increases the total revenue
but decreasing the price increases the total cost as well
the effect on the profit is unsure
the effect on profit depends on the values of costs and
revenues (formally: marginal cost and marginal revenue)
there is a formula for the optimal price
Other elasticities
• Income elasticity of demand:
measures the impact of income change on the demanded
quantity
3 types of commodities: necessary, luxury, inferior
• Cross elasticity of demand:• Cross elasticity of demand:
measures the effect of change in price of some other
commodity
3 types of relationships: substitutes, complementary,
neutral
• Price elasticity of supply
Profit maximization - optimal price and production level
• „Optimal” means the best, so „optimal price”, or „optimal
production level” are the best levels, i.e. the ones that
maximize the profit.
• Usually profit maximization ≠ revenue maximization.
• Typically:• Typically:
TRTP PP >Price that maximizes the total
profit (TP) is bigger than the price
that maximizes total revenue (TR)
TRTP QQ <Production that maximizes the
total profit is smaller than
production that maximizes total
revenue
Costs in economics
• Total cost (TC) is divided into the variable cost (VC) and fixed
cost (FC).
• Fixed costs are paid anyhow, and are usually sunk, so their
level does not affect the optimal price or production.
• Variable costs depend on the production level, so their level
is crucial in profit maximization.is crucial in profit maximization.
• Distinction between fixed and variable costs depends on the
time horizon of the analysis (short run vs long run).
• Marginal cost (MC) measures how fast the costs change,
when production increases.
• By analogy, marginal revenue (MR) does the same for
revenues.
Marginal analysis
• Marginal analysis determines the direction in which
production should be changed, by comparing MC and MR.
• MR > MC → increase Q.
• MR < MC → decrease Q
• MR = MC → optimal Q• MR = MC → optimal Q
Changes in price and production due to external factors
• When variable cost increases:
optimal price increases
optimal production decreases
profit decreases
• When fixed cost increases:
optimal price and production do not change
profit decreases
• When demand increases:
optimal price increases
optimal production increases
profit increases
Optimal price formula
• In case of the elastic demand:
P
Popt
E
EMCP
+⋅=1
• Conclusions / interpretation:
optimal price is the unit cost (MC) plus the profit margin
optimal price is proportional to the MC
the profit margin depends on elasticity
the more elastic the demand, the lower the final price
Profitability analysis
• Break-even quantity:
• Break-even price = minimum of ATC (average cost)
• Shut-down price = minimum of AVC (av. variable cost)
• Stay-even analysis
Price discrimination
• Price discrimination is introduced in order to increase firm’s
profit.
• The efficient introduction of price discrimination is possible
only when certain conditions are met.
• Types:
third degree price discrimination: charging different
groups of consumers with different prices.
second degree price discrimination: price depends on
the quantity bought (bulk discounts).
first degree price discrimination (perfect): each
consumer is charged a different price (the maximal
possible).
Optimal price – special cases
1) Franchising
conflict of interest between franchisor and the franchisee
2) Firm producing two interdependent products
in case of substitutes prices should be increased
in case of complements prices should be decreasedin case of complements prices should be decreased
3) Transfer pricing
optimal transfer price should equal its MC.
Market
• Markets are defined by: market participants (demand,
supply), the product, the geographical boundries, the
institutions (formal and informal).
• The relevant market:
product market:
• substitution on the demand side (e.g. SSNIP),
• substitution on the supply side,
geographic market.
Market properties
1) Market structure.
2) Product differentiation.
3) Transparency.
4) Entry and exit barriers.
1. Market structure
• The number of economic agents on both sides of the market
(one, few, many).
• Examplary market structures: monopoly, oligopoly, polipoly,
monopsony, oligopsony, bilateral oligopoly.
• Market structure affects the market power.• Market structure affects the market power.
• Market structure affects the dominating mechanism of
transaction making (posted prices, auctions, bargaining).
Concentration ratios: CR-n
• CR-n: the market share (measured by sales value) of n
biggest firms in the market:
• monopoly: CR-1 bigger than 90%,
• oligopoly: CR-4 bigger than 60%,
• monopolistic competition: CR-4 between 40% and 60%,• monopolistic competition: CR-4 between 40% and 60%,
• effective competition: CR-4 lower than 40%.
Concentration ratios: HHI
• Hefindahl-Hirschman index (HHI):
• values between 0 for polypoly to 1 (or 10000) for monopoly,
∑∞
=
=1
2
i
isHHI
• values between 0 for polypoly to 1 (or 10000) for monopoly,
• effective no. of firms in the market = 1/HHI,
• used when assessing the concentration level, and in case of
mergers and acquistitions.
2. Product differentiation
• Homogeneous market
lack of preferences on the buyers’ side,
price is the main criterion,
competition: prices (cost),
examples: unprocessed materials, currencies markets.
• Heterogeneous market
strong preferences,
price and quality differentiation,
all forms of competition possible
3. Transparency: transparent markets
• transparency of the market depends on the amount of
information available to market participants,
• perfectly transparent market: everyone knows everything
about everyone,
• the closer to this ideal, the more transparent is the market,
• factors positively affecting the transparency level:• factors positively affecting the transparency level:
simplicity of the product,
limited no. of suppliers,
publishing the information,
regularity of purchases,
• examples: expert markets,
• consequences: market efficiency, rationality of choices
3. Transparency: nontransparent markets
• examples: real-estate markets, financial markets,
• consequences: potential inefficiency (e.g. the same products
traded at different prices), irrationality of choices,
• there are high costs of acquiring the information,
• information on the quality of the product:
before purchase,before purchase,
after the purchase,
never,
• consequences of asymmetry of information: adverse
selection
4. Entry and exit barriers
• entry barriers: all impediments to enter the market,
• examples: entry costs, licenses, patents, education,
• exit barriers: all impediments to exit the market (less
important),
• examples: shut-down costs,• examples: shut-down costs,
• with no entry / exit barriers between two markets, profits
reached on both of them are the same
Competition level
Competition in the market is the more intense::
• the less concentrated is the market,
• the more homogeneous is the market,
• the more transparent is the market,
• the less enty / exit barriers there are in the market.
Model of the market with the most intense competition:
perfectly competitive market (polipoly, homogeneous, perfectly
transparent, no enty and exit barriers).
Oligopolistic markets, applying game theory
• competition or cooperation: Cournot oligopoly, cartel
agreements,
• Prisoner’s Dilemma game
• price competition: Bertrand oligopoly and price wars,
• price competition: kinked-demand model and price
stickinessstickiness
• market entry games
• heterogeneous oligopoly: Hotelling model
Decisions under risk
• Risk:
neutral concept: both a threat and an opportunity
negative concept: only a threat
• Difference between risk and uncertainty:
risk: known probabilitiesrisk: known probabilities
uncertainty: unknown probabilities
• Risk measures:
volatility measures (e.g. standard deviation)
sensitivity measures (e.g. beta, Greeks)
threat measures (e.g. Value at Risk)
Decisions under risk: example (demand)
Firm enters a new market with its product and has to determine
the price. Potential profits depend on whether the demand is
elastic or inelastic, and are presented below (in mlns PLN):
Elastic demand Inelastic demand
Low price 20 6
High price – 5 25
Firm estimates that the probability that the demand is elastic
equals 0.4, and the probability that it is inelastic equals 0.6.
Expected value
• The expected value can be interpreted as the average
( ) nn pxpxpxXE ⋅++⋅+⋅= ...2211
• The expected value can be interpreted as the average
outcome.
• By the law of the large numbers: the bigger the sample, the
closer the average to the expected value.
• Expected value is a decision-making criterion for economic
agents that are risk neutral.
• But most decision-makers are not risk neutral.
Risk attitudes
• Risk neutrality:
only the expected value matters
might be a strategy for long-term investors
• Risk aversion:
decisions based on expected value (+) and risk (-)decisions based on expected value (+) and risk (-)
demonstrated by most people
• Risk seeking:
decisions based on expected value (+) and risk (+)
rational if one wants to reach very high profits
• Behavioral economics: most people have loss aversion
Decisions under risk: example (procurement auction)
Firm B. takes part in a procurement
auction concerning the delivery of
stationery, which was started by the
City Council. The winner will be
determined using a (reversed) first-
price sealed-bid auction. B. has
calculated that the delivery of the
Price Probability
16400 0.71
17000 0.62
17700 0.52calculated that the delivery of the
specified stationery would cost it
15600 PLN. The table shows
estimations of the probabilities of
winning for various price levels,
based on the results of the previous
auctions.
18500 0.4
19200 0.32
20100 0.2
Decisions under risk: example (procurement, continued)
Price Probability Potential
profit
Expected
profit
Standard
deviation
16400 0.71 800 568 363
17000 0.62 1400 868 679.5
17700 0.52 2100 1092 1049.2
18500 0.4 2900 1160 1420.7
19200 0.32 3600 1152 1679.3
20100 0.2 4500 900 1800
Decision tree: example (introduction of a new product)
Firm decides whether to introduce a new product to the
market. If it decides not to, then it keeps the current level of
profit (150 th. zł). If it decides to do it, then the product will
either be accepted (p=0.3) or rejected (p=0.7) by the
consumers. If the product is accepted, then the profit equals
400 th. zł. If the product is rejected, then the firm can either
withdraw it from the market (which would result with a finalwithdraw it from the market (which would result with a final
profit of 90 th. zł), or try to change consumers’ minds with an
advertising campaign. If the campaign succeeds (p=0.6), then
the profit equals 140 th. zł. If it fails, then firm can either finally
withdraw the product from the market, which results with a loss
of 80 th. zł, or lower deep the price. The price cut would either
work (p=0.5) and result with a profit of 10 th. zł, or not work
(p=0.5), and then the final loss is 240 th. zł.
Decision tree: example (introduction of a new product, cont.)
success
advertising
failure
p = 0,7
success
p = 0.3
withdrawal
not introduceintroduce
150 th. zł
400 th. zł
90 th. zł
low sales
p = 0.5p = 0.5
high sales
price cutwithdrawal
p = 0,4
failure
p = 0.6
success
140 th. zł
– 80 th. zł
10 th. zł– 240 th. zł
Value of the information
• information is true by definition, and so acquiring the
additional information will never be harmful to the decision
maker,
• acquiring a new information is profitable, if the expected value
of information (EVI) is higher than its cost,
• value of information has to be calculated ex ante,
• EVI = E(profit with information) – E(profit with no information)
• calculation of EVI usually demands calculation of conditional
probabilities (Bayes rule)
Value of the information: example (elasticities, continued)
• Let’s say, that a market research would reveal all information,
Elastic demand Inelastic demand
Low price 20 6
High price – 5 25
• Let’s say, that a market research would reveal all information,
i.e. it would either reveal that demand is elastic (p = 0.4) or
inelastic (p = 0.6).
• Expected profit without market research was 13 mln.
• Expected profit with market research is 23 mln.
• Value of information (market research) = 10 mln.
Value of the information: example (yachts, part 1)
(Samuelson, Marks):
The demand for yachts changes dynamically: it grows fast in case
of economic boom, and drops rapidly in case of recession. The
demand in case of boom is P=20-0.05Q, and in case of recession
is P=20-0.1Q (Q in units, P in th. USD), with the forecasts showing
a 40% recession risk.a 40% recession risk.
The yachts are produced by the external producer, and have to
be ordered by the dealer in advance. The seller pays 10 000 USD
for each yacht ordered, and additionally has 150 000 USD of fixed
costs per year.
Find the optimal number yachts that should be ordered by the
yacht dealer.
Value of the information: example (yachts, part 2)
(Samuelson, Marks):
Historical data demonstrate that recessions can be to a certain
extent predicted by observations from the stock exchange, as
recessions are often preceded by drops in stock prices. The table
shows data for 40 periods under study
Boom Recession
Increases on stock exchange 26 0
Decreases on stock exchange 6 8
What is the value of information from the stock exchange?
Decisions under uncertainty
• In case of uncertainty the decision maker is unable to
estimate the probabilities of the unknown events.
• The most popular criteria for decision making:
Laplace criterion,
pessimist criterion (Wald’s maximin model),
optimist criterion (maximax model),optimist criterion (maximax model),
regret criterion.
Decisions under uncertainty: example
Firm B. manufactures wooden blocks. The wood needed to
produce a single block costs 3 PLN. Above that B. has some fixed
costs (amortization, cost of rent, salaries) that add up to 22 th.
PLN monthly.
B. is not sure about the demand function, believing it’s one of
the three possibilities:the three possibilities:
Find the optimal price using different criteria.
32000
−⋅= PQ
47000
−⋅= PQ5
24000−⋅= PQ
