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# Mngrl Dec.Glbl Eco ECO 685

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This 22 page Study Guide was uploaded by Mae Koelpin on Thursday September 17, 2015. The Study Guide belongs to ECO 685 at University of Miami taught by Staff in Fall. Since its upload, it has received 56 views. For similar materials see /class/205757/eco-685-university-of-miami in Economcs at University of Miami.

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Date Created: 09/17/15

Study Guide Key concepts Economics 691 Managerial Economics Notes David L Kelly Department of Economics University of Miami Box 248126 Coral Gables7 FL 33134 dkelly miamiedu Spring7 2004 INTRODUCTION I What is Managerial Economics 0 All resources are scarce o All decisions can be boiled down to how to allocate resources to best meet some ob jective II Managerial Economics advice for decision making A The Steps 0 Managerial economics is proscriptive It provides a scienti c method for making busi ness decisions 0 The method requires four general steps 1 Formulate the problem list the objective and the possible decisions 2 Gather data on the objective and the decisions 3 Using statistics7 estimate the relationship between the objective and the decisions7 known as the objective function 4 Using calculus or game theory7 choose the decision that maximizes the objective func tion B Example C Alternative Methods of Making Decisions 0 Alternative of relying on experience or guesswork is often almost as good 0 Both methods require common sense III Decisions Studied in Managerial Economics 1 How much to produce 2 What inputs to use 3 What price to charge IV Theory of the Firm A Objective of the rm 0 The objective of the rm is to maximize pro ts or the present value of the rm 0 Pro ts are economic pro ts 0 Individual managers may have other objectives B Economic Pro ts 0 Economic pro ts are accounting pro ts less opportunity costs 0 Economic pro ts are useful for decision making7 since they take into account other options Accounting pro ts are good for detecting fraud7 keeping records7 etc 0 Positive economic pro ts attract competitors7 negative economic pro ts cause rms to exit the industry to pursue other opportunities Thus economic pro ts tend to zero C Other objectives 1 Objectives of rms and managers 0 Most other stated goals of the rm are intermediate goals toward maximizing pro ts 0 Individual managers are motivated by incentives such as performance objectives and stock options 2 Pro t maximization ethics and welfare Maximizing pro ts improves the welfare of society in two ways 1 The rm provides products and services that consumers want as evidenced by their willingness to pay for the products and thus add to rm pro ts 2 The rm stays in business thus providing income to workers and stockholders Under speci c conditions maximizing pro ts maximizes welfare of society PRODUCTION THEORY I The Production Function Uses of the production function 1 Set inputs to produce a speci ed quantity of outputs N3 Determine the number of inputs needed to meet objective of maximizing production 03 Determine the number of inputs needed to meet objective of maximizing productivity 4 Determine the number of inputs needed to meet objective of maximizing pro ts 5quot Evaluate potential mergers spin o s outsourcing and determine the optimal factory size and number of factories Properties of the production function 1 Zero inputs implies zero output 2 Diminishing marginal product 3 Positive marginal product II Application 1 Maximizing Production A maximum occurs when the slope of the objective is zero or when the derivative of the objective with respect to each decision is zero III Application 2 maximizing productivity Skipped IV Application 3 Maximizing Pro ts A Example B Marginal Revenue Product 0 Pro ts are maximized when marginal revenue product equals marginal expenditure o If an input generates more revenue for the rm than the input costs7 then the manager can increase pro ts by purchasing the input V Multiple Inputs A Marginal Product and Price Ratios 1 Pro t maximization requires inputs to be used e iciently E icient use of inputs occurs when the ratio of marginal products equals the price ratio 2 If we reduce the rst input by one unit7 and spend the cost savings on the second input7 the second input increases by the price ratio 3 If we reduce the rst input by one unit7 the marginal product ratio gives the number of additional units of the other input required to keep production constant 4 Thus7 if b is greater than c7 we can increase pro ts by reducing the rst input by one unit7 and either 1 adding enough of the second input to keep production constant and pocket the cost savings or 2 adding an amount of the second input equal to the price ratio to keep costs constant but increase production B Example Multiple Inputs VI Mergers and Spinoffs Skipped VII How Do We Find the Production Function A Obtain inputoutput data Sources of data H Time Series Data easy to come by dif cult to compare output across years N3 Cross Section Data somewhat easy to come by sometimes dif cult to compare across factories 03 Use technical information supplied by engineers accurate but dif cult to come by especially in service industries He Conduct a randomized study accurate but very expensive and dif cult to come by 5quot Benchmarking Provides unique information but is dif cult to come by B Choosing a production function C Regression Information provided by a regression 1 Coef cients Which make the production function closest to the real world data 2 T stat does the input have any e ect on output 3 R2 What percentage of the variation in output is explained by the production func tion COST THEORY I What costs matter A Opportunity Costs The relevant cost for managerial decisions is the opportunity cost7 or the value of the next best alternative B Fixed costs variable costs and sunk costs Sunk costs are irrelevant for managerial decisions Types of sunk costs 1 Costs incurred in the past 2 Fixed costs Which cannot be recovered eg a signing bonus 3 Costs Which must be incurred but are unrelated to the number of units produced II Short run costs Properties of Cost functions in the short run 1 Total costs increase With total output N Average xed costs decline With total output as the xed costs are spread over a larger number of units 03 Marginal costs and average variable costs initially fall workers become more specialized and e icient and then rise With production With capital xed7 diminishing returns to labor makes it di cult to raise production by just adding workers Hgt Thus average total costs initially fall and then rise because of 2 and III Examples of using Short run cost curves Uses of cost functions 1 Choose a level of output to minimize costs and maximize pro ts short run costs N Conduct a break even analysis short run costs 03 Minimize average costs 4 Make decisions regarding mergers7 spin o fs7 expansion7 and contraction of the size of the rm long run costs IV Long Run Costs In the long run7 no costs are xed Long run average costs initially decline but may eventually decrease or increase Types of industries and long run costs 1 lndustries characterized by large xed costs cruise ships7 telecommunications7 etc are characterized by decreasing long run average costs 2 Heavily taxed industries or countries Which heavily tax large rms often have increasing long run average costs street vendors in Peru 3 Large rms face information problems about local markets and employees lack mean ingful incentives lf long run average costs are decreasing7 industry consolidation reduces costs If long run average costs are increasing7 spin o s and outsourcing are in order Study Guide Key Concepts Second Quiz Economics 685 Managerial Economics Notes David L Kelly Department of Economics University of Miami Box 248126 Coral Gables7 FL 33134 dkelly miamiedu Spring7 2005 COST THEORY IV Long Run Costs lf long run average costs are decreasing7 industry consolidation reduces costs If long run average costs are increasing7 spin o s and outsourcing are in order V Application Banking mergers VI Measuring Cost Functions Skipped PRICING I Market Demand Function Factors that a ect quantity demanded 1 Price of the product inversely related to demand 2 Income of consumers positively or negatively related to demand 3 Price of competitors positively related to demand 4 Advertising positively related to demand 5 Price of complementary goods inversely related to demand II Price Elasticity and the Optimal Pricing Policy A Price Elasticity of Demand 0 Elasticity measures the degree of pricing power a rm has or the degree of competition in the industry o If the elasticity is between 0 and 17 the rm can increase prices and lose relatively few customers7 thus increasing pro ts Table 1 Elasticity jargon B Examples C Examples and Determinants of Elasticity Determinants of elasticity 1 Level of competition decreases elasticity 2 Degree of product di erentiation increases elasticity 3 Level of income decreases elasticity 4 Length of time decreases elasticity D Example Set the price to maximize pro ts E Optimal pricing policy 0 Optimal Pricing Policy is a xed markup over marginal costs 0 Optimal markup is determined by the elasticity 0 Thus marginal costs increases price and the degree of competition decreases price are the two factors that determine the price III Other Elasticities IV Estimating Demand Skipped Table 2 Income Elasticity Meanings V Evaluating Pricing Strategies Cost plus pricing 0 Uses Wholesale costs equal to cost of goods rather than marginal costs 0 Typically fails to account for labor and transportation costs 0 Typically fails to account for degree of competition 0 Can be close to optimal price When Wholesale costs are close to marginal costs VI Evaluating Pricing Strategies Price Discrimination A Degrees of discrimination 1 First degree discriminate against every customer 2 Second degree discriminate based on quantity purchased 3 Third degree discriminate against a group B Pitfalls of discrimination 1 Discrimination requires a lack of competition 2 There are costs to acquiring information about customers 3 A target group is not always easy to identify 4 Arbitrage can sometimes result 5 Price discrimination can be illegal VII Evaluating Pricing Strategies 99 cent pricing 0 Raises queue time andor labor costs 0 Helps to prevent theft 0 No evidence that consumers believe 199 is really 1 VIII Evaluating Pricing Strategies Flat rate pricing and price confusion 0 Customers like at rate pricing 0 Flat rate pricing usually generates shortages on the most popular products Consumers thus pay by having to buy earlier than desired or risk that the product is sold out o A complicated pricing scheme discriminates against customers With no time to gure out the best price 0 Other methods of price discrimination generally do not annoy customers as much IX Evaluating Pricing Strategies The popcorn problem Charging very di erent markups for goods usually bought together may be a way of price discriminating BUSINESS STRATEGY X Framework Two Person Games A Payoff matrix B Dominant Strategy Compute the optimal strategy for each of the possible strategies of the opponent The strategy is dominant if the optimal strategy is the same for all possible strategies of the opponent C Nash Equilibrium 1 Predict a strategy for any player Compute the optimal strategy of the other player7 given the prediction N Compute the optimal strategy of the rst player7 given the optimal strategy of the 03 other player If the strategy is identical to the predicted strategy7 then the strategies constitute a Nash Equilibrium XI Some Simple Games A AntiCoordination Games to compete or not B Coordination Games C Mixed Coordination and AntiCoordination Advantages of coordinating competiting or not coordinating not competiting 1 Coordinate by locating near competitors to draW shoppers to the area 2 Coordinate by locating near competitors if even With two competitors demand in the area is better than other areas 3 Coordinate if di erentiating your product and being wrong about customer preferences yields more losses than the gains from being right about customer preferences 4 Coordinate only if incumbant rms Will not react forcefully to your entry D Prisoners Dilemmas o A prisoner7s dilemma is one in Which the optimal outcome for both rms is to cooperate and not compete7 but incentives result in rms cheating7 leading to the worst possible outcome for both rms 1 Cartels and Cheating The incentive to cheat in cartels is very strong 2 Price Matching Offers By o ering to match prices7 rms decrease the incentive for other rms to cheat on a cartel agreement Study Guide De nitions Economics 685 Managerial Economics David L Kelly Department of Economics University of Miami Box 248126 Coral Gables7 FL 33134 dkelly miamiedu Spring7 2004 H N 03 Hgt 5quot G 5 00 9 H 03 H 4 Introduction Managerial Economics is the application of economic theory to decisions made by managers and rms Economics is the study of the allocation of scarce resources The value of a rm is the present value of the rms cash ows Economic Pro ts are pro ts after taking into account capital and labor provided by owners Production Theory The Production Function is a graph7 table7 or equation showing the maximum output rate that can be achieved by any speci ed set of inputs Law of diminishing marginal returns if all other inputs are held constant7 then the additional output from increasing one input eventually falls The Marginal Product is the additional output from an additional unit of an input Marginal Revenue Product is the amount of additional revenue from an additional unit of an input The Marginal Expenditure is the amount of additional costs from an additional unit of input Cost Theory Explicit Costs Accounting Costs7 or costs that would appear as costs in an account ing statement Implicit Costs Other costs7 such as the cost of the owners capital and labor7 andor the cost of alternative uses of each input Opportunity Costs The value of all inputs to a rm7s production in their most valuable alternative use H G H 00 H N3 O Total Variable Cost The total cost of all inputs that change With the amount pro duced all variable inputs Total xed costs The total cost of all inputs that do not vary With the amount produced all xed inputs Sunk costs Are costs that have been incurred and cannot be reversed Average Costs Costs divided by output Marginal Costs The cost of one additional unit of an input Long Run Average Costs The minimum cost per unit of producing a given output level When any sized plant can be built Study Guide Key Concepts Second Quiz Economics 685 Managerial Economics Notes David L Kelly Department of Economics University of Miami Box 248126 Coral Gables7 FL 33134 dkelly miamiedu Spring7 2005 BUSINESS STRATEGY I Framework Two Person Games A Payoff matrix B Dominant Strategy Compute the optimal strategy for each of the possible strategies of the opponent The strategy is dominant if the optimal strategy is the same for all possible strategies of the opponent C Nash Equilibrium 1 Predict a strategy for any player 2 Compute the optimal strategy of the other player7 given the prediction 3 Compute the optimal strategy of the rst player7 given the optimal strategy of the other player If the strategy is identical to the predicted strategy7 then the strategies constitute a Nash Equilibrium II Some Simple Games A AntiCoordination Games to compete or not B Coordination Games C Mixed Coordination and AntiCoordination Advantages of coordinating competiting or not coordinating not competiting 1 Coordinate by locating near competitors to draW shoppers to the area 2 Coordinate by locating near competitors if even With two competitors demand in the area is better than other areas 3 Coordinate if di erentiating your product and being wrong about customer preferences yields more losses than the gains from being right about customer preferences 4 Coordinate only if incumbant rms Will not react forcefully to your entry D Prisoners Dilemmas A prisoner7s dilemma is one in Which the optimal outcome for both rms is to cooperate and not compete7 but incentives result in rms cheating7 leading to the worst possible outcome for both rms 1 Cartels and Cheating The incentive to cheat in cartels is very strong 2 Price Matching Offers By o ering to match prices7 rms decrease the incentive for other rms to cheat on a cartel agreement III Mixed Strategies 0 When each player has an interest in disguising their actions7 it is often optimal to choose a random or mixed strategy 0 To compute a mixed strategy7 assume a player plays each possible strategy With a random probability Then compute the probability that makes the opponent indi erent between hisher possible strategies A Using Mixed Strategies to Prevent Opponents From Reacting Sellers randomize When sales occur so that customers cannot react by shopping only When sales occur 03 Using Mixed Strategies to Avoid Coordination o A mixed strategy usually exists in games where each player wants to avoid coordinating with the other players 0 Mixed strategies here give on average a worse outcome since players sometimes acci dently coordinate IV Dynamic Games A Finite Repeated Games Skipped B In nitely Repeated Games Skipped C Sequential Games 1 Extensive Form To nd the sub game perfect equilibrium7 start at the last move and nd the optimal strategy at each node Then work backward to the beginning7 nding the optimal strategy at each node The sub game perfect equilibrium is the outcome where the optimal strategy is chosen at each node D Entry and Exit 0 Threats to retaliate are generally credible only if it is optimal to carry out the threat lf not7 the opposing player can act with impunity7 knowing that it is not in the opposing player7s best interest to retaliate o Pre emptive actions are much more e ective that retaliation By taking an action earlier in the game7 players can avoid the credibility problem 0 Adding capacity to deter entry is a common pre emptive action

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