Managerial Economics

Managerial Economics Dr. Timothy Simin 2011 Tim.Simin@mccombs.utexas.edu

OutlineDay 1 Introductions Who am I? Syllabus Who are you? Helicopter Tour of Economics Overview of Micro Overview of Macro Other economics we won’t have time for Micro Economics This morning This afternoon – CASES! Tomorrow Tim.Simin@mccombs.utexas.edu 2

IntroductionWho am I? Tim Simin Born in Detroit BUT raised in Dallas, TX 1992: Graduated Summa Cum Laude from UTD with BS in Economics and Finance 1992 – 1994 : Division of Monetary Affairs at the Federal Reserve Board of Governors in Washington, D.C. 1995 – 2000: Ph.D. in Finance from the University of Washington 2000 – Today: Assoc. professor of Finance, Smeal College of Business, Penn State Course taught Research Tim.Simin@mccombs.utexas.edu 3

IntroductionsSyllabus Download it (for now) at http://timsimin.net/UT/ Schedule Please contact me via email about scheduling, homework, or other problems Tim.Simin@mccombs.utexas.edu 4

IntroductionsWho are you? Write down on regular sized piece of paper: Name Current Job, i.e. company and position Be specific please Expertise Economic background Senior Economist Some undergrad economics Took home economics in high school I abhor economics Anything else you want me to know about you Nickname, etc. Tim.Simin@mccombs.utexas.edu 5

Helicopter TourWhat is economics? Wikipedia: Economics is the social science that analyzes the production, distribution, and consumption of goods and services Most economics based on the idea that agents are rational Most economics can be summed up by saying, “People respond to incentives” - Landsberg A “positive” rather than “normative” science Not a science of what is right or wrong, only what the outcome will be given some action May be morally offensive Tim.Simin@mccombs.utexas.edu 6

Helicopter TourWhat Microeconomics? Microeconomics covers: Price determination via quantities supplied and demanded Laws of demand Opportunity costs and sunk costs Theory of the firm Monopolies, Oligopolies, and perfect competition Cost benefit analysis/profit maximization Theory of the consumer Utility functions, budget constraints, utility maximization Specialization, efficiency, comparative advantage Examples Tim.Simin@mccombs.utexas.edu 7

Helicopter TourWhat is Macroeconomics? Macroeconomics covers: Fiscal policy http://www.wtfnoway.com/ and http://www.usdebtclock.org/ Monetary policy National Income Accounting GNP, GDP Interest rate determination Exchange rate determination Business Cycles Inflation Tim.Simin@mccombs.utexas.edu 8

Helicopter TourWhat Else is in economics? Game theory Models of strategic interaction between agents Prisoner’s dilemma Finance The economics of how companies choose and finance projects The economics of how financial asset prices are determined Law and Economics Coase theorems Behavioral Economics People are NOT rational but behave according to documented psychological biases Tim.Simin@mccombs.utexas.edu 9

Game TheoryThe game of dilemmas Consider a non-cooperative duopoly trying to figure out what price to charge for a homogeneous good. Both firms can pick between just two prices, a high price, $10 or a low price, $6 If firm 1 charges the high price and firm 2 also charges a high price their profits will be $1000. If firm 1 charges a high price and firm 2 charges a low price then firm two will get more business and the profits of firm 1 will be $0 and firm 2 will make $1500. Now if both firms charge the low price then each firm will only make $300. Let’s look at a picture of these assumptions. Tim.Simin@mccombs.utexas.edu 10

What price will the each firm end up paying? Is that rational? Is it efficient? Game TheoryThe game of dilemmas Tim.Simin@mccombs.utexas.edu 11

IntroductionSome definitions Models A filter for reality Don’t attack assumptions only how well it fits reality Opportunity cost: Value of the next best alternative Sum of explicit and implicit costs Positive vs. Normative analysis: Positive analysis = scientific or objective Normative analysis = moral or value judgment Tim.Simin@mccombs.utexas.edu 12

IntroductionSome definitions Rationality: What is rational behavior? “Most of economics can be summarized in four words: ‘People respond to incentives.’ The rest is commentary.” - Landsberg This assumption brings up many questions of seemingly “irrational” behavior Why do people vote? Why do people buy insurance when they rent a car even though their car insurance or credit card already provides them coverage? Why do people buy actively managed mutual funds? Tim.Simin@mccombs.utexas.edu 13

DemandTypes of demand Demand (Qd) Amount of a good consumers are willing to buy at a given price and over a given period of time Not how much a consumer wants or desires a good Two types of demand functions Generalized demand Many different things affect quantity demanded Ordinary demand Only price affects Qd. Price is the most important factor Tim.Simin@mccombs.utexas.edu 14

DemandDeterminants of demand Qd = f(P, M, Pr, T, Pe, N) P = own price: (inverse relation to Qd) M = income Normal goods: Qd up as Income up and visa versa Inferior goods: Qd down as Income up and visa versa Pr = price of related goods: Substitutes have a direct price/quantity relation Complements have an inverse relation T = tastes (direct) Pe = expectation of future price (direct) N = changes in population - the plague (direct) Other factors affecting demand Availability of credit (direct) Level of advertising: production costs (direct) Disposable income: after tax and benefits (direct) Tim.Simin@mccombs.utexas.edu 15

DemandGeneralized vs. Ordinary Linear generalized demand Qd = a + bP + cM + dPr + eT + fPe + gN Linear ordinary demand Q = a - bP In both cases: a is the intercept - the reservation price b is the partial derivative with respect to P - measures how Q changes with a one unit change in P, etc Tim.Simin@mccombs.utexas.edu 16

DemandLinear generalized demand function Suppose we know all the parameters and variable values except price, then the generalized demand collapses into the ordinary demand function. Q = 1 - 10P + 2M - 1Pr + 3T + 0Pe + 2N Q = 1 - 10P + 2(2) - 1(5) + 3(3) + 2(1) Q = 1 - 10P + 4 - 5 + 9 + 2 Q = 11 - 10P Q = f(p) [holding everything but price constant] Changes in P cause movement along the line; all others shift the line Tim.Simin@mccombs.utexas.edu 17

DemandThe First Law of Demand First Law of Demand: The price of a good is inversely related to the quantity demanded ceteris paribus. Normally, as the price of a good increases the quantity demanded decreases. Difference between “demand” and “quantity demanded” Demand refers to the whole curve. Quantity demanded refers to points (movements) along the curve. Incentives - a justification for the First Law of Demand Example: Do seat belt and helmet laws reduce the number of injuries that occur while driving? Tim.Simin@mccombs.utexas.edu 18

SupplyDeterminants of supply Qs = g(P, Pi, Pr, T, Pe, F) P = own price (direct relation to Qs) Pi = price of inputs (inverse) Pr = prices of goods related in production (inverse for substitutes and direct for complements) T = level of technology (direct) Pe = expectations of producers as to future price (inverse) F= the number of firms producing the good (direct) Tim.Simin@mccombs.utexas.edu 19

Market EquilibriumEquilibrium, excess supply, excess demand Market equilibrium: consumers can buy and suppliers can sell all they want Qs = Qd When a price is set above the equilibrium price then there is an excess supply (surplus). Qs > Qd  Qs - Qd > 0 When a price is set below the equilibrium price then there is an excess demand (shortage). Qs < Qd  Qs - Qd < 0 Tim.Simin@mccombs.utexas.edu 20

Market EquilibriumEquilibrium, excess supply, excess demand Can either of these situations last? What happens in each case? Tim.Simin@mccombs.utexas.edu 21

SurplusConsumer and Supplier Tim.Simin@mccombs.utexas.edu 22

SurplusConsumer and Supplier Tim.Simin@mccombs.utexas.edu 23

Elasticity, TR, and MRElasticity Elasticity: How much quantity demanded changes when price changes. Three kinds of elasticity Price elasticity (Ed): response of Qd to changes in “own price”. Ed = (% change in Qd) / (% change in P) Cross-price elasticity of demand (CPE): Response in Qd of A when price of B changes CPE = % change in QA / % change in PB Income elasticity of demand (IE): Response Qd to income changes IE = % change in Qd / % change in M Tim.Simin@mccombs.utexas.edu 24

Elasticity, TR, and MRPrice elasticity Price elasticity: response of quantity demanded of a product to changes in its “own price”. Always negative for downward sloping demand and always quoted in absolute value Smaller absolute values of Ed = less consumer response to a price change Use “coefficient of elasticity” to predict effects of price changes. Tim.Simin@mccombs.utexas.edu 25

Elasticity, TR, and MRPrice elasticity Demand is: elastic when |Ed| > 1 inelastic when |Ed| <1 unitary elastic when |Ed| = 1 As price goes from $1 to $0.90, 10% decrease price, Qd goes up 100% increase. As price goes from $0.20 to $0.10 50% decrease in price Qd goes up 11.11% increase. Tim.Simin@mccombs.utexas.edu 26

Elasticity, TR, and MRPrice elasticity Who Cares? Managers! elasticity shows effect of price change on Total Revenue. TR = P * Q Raise price TR will go up due to a price effect, but falls due to a quantity effect. Tim.Simin@mccombs.utexas.edu 27

Elasticity, TR, and MRMarginal revenue MR = addition to TR from selling one more unit of output (the change in total revenue) / (the change in quantity) Let’s derive MR Demand P = a – bQ Total Revenue TR = P * Q = (a - bQ) * Q = aQ - bQ2 Marginal Revenue MR = MR is just a line. It is the same line as demand with twice the slope! Tim.Simin@mccombs.utexas.edu 28

Elasticity, TR, and MRMarginal revenue Example: Let demand be P = 5 - (1/10)Q First: Find TR = P * Q = (5 - (1/10)Q) * Q = 5Q - (1/10)Q2 Next: find MR = 5 - 2*(1/10)Q Tim.Simin@mccombs.utexas.edu 29

Elasticity, TR, and MRRelating all three How are TR, MR, and elasticity related? Tim.Simin@mccombs.utexas.edu 30

OptimizationConcepts and terms Objective function: function to maximize or minimize. Managers maximize profits or sales or minimize costs Consumers maximize utility or satisfaction Choice variables: variables that when changed affect value of objective If objective is profit, then a choice variable is quantity. If objective is cost, then a choice variable is expenditures. If objective is utility, then a choice variable is amount of a good Unconstrained and constrained maximization Why is marginal analysis so important? Tim.Simin@mccombs.utexas.edu 31

OptimizationExample I Cost/benefit analysis Tim.Simin@mccombs.utexas.edu 32

OptimizationExample II Economists define profit as total revenue less total costs p = TR - TC Define TR as we did above TR = P * Q; where P = a – bQ so TR = P * Q = (a - bQ) * Q = aQ - bQ2 Define costs as something simple like an input TC = w*Q Then our profit function becomes p = TR – TC = aQ - bQ2 - wQ Tim.Simin@mccombs.utexas.edu 33

OptimizationExample II (cont) We want Q that to produce to get maximum profit To do this take the derivative of the profit function with respect to Q and set the first derivative equal to zero. NOTE: MR = MC a - 2bQ = w Now just solve out for Q Q* = (a - w)/2b = profit maximizing level of output. THIS IS ALWAYS THE CASE: MB = MC IS OPTIMUM CHOICE!!! Tim.Simin@mccombs.utexas.edu 34

Consumer behaviorSome definitions Rational behavior: Consistent with behavior postulates and preference axioms Behavior Postulates: Statement without proof – usually obvious or well known Preference axioms: How people deal with ranking preferences Utility: Ranking of preferences or a measure of happiness. More preferred goods or bundles of goods have a higher utility Utility Maximization: Trying to get most preferred bundle of goods they can afford Tim.Simin@mccombs.utexas.edu 35

Consumer behaviorIndifference Curves (IC’s) Lets define some variables. x1 = some number of hamburger’s x2 = some number of CD’s p1 = the price of a hamburger p2 = the price of a CD M = income (x1,x2) = A consumption bundle Graph consumption bundles A=(5,2), five burgers and two CDs B=(2,1), two burgers and one CD Tim.Simin@mccombs.utexas.edu 36

Consumer behaviorIndifference Curves (cont) Indifference Curves (I.C.’s): lines connecting bundles that we prefer by the same amount Properties of Indifference Curves: Visual representation of utility Higher the IC, higher the level of utility I.C.’s almost always convex to the origin I.C.’s never intersect I.C.’s are infinite in number Tim.Simin@mccombs.utexas.edu 37

Consumer behaviorIndifference Curves (cont) Why do I.C.’s usually have that shape? Tim.Simin@mccombs.utexas.edu 38

Consumer behaviorIndifference Curves (cont) What about perfect substitutes/compliments? Tim.Simin@mccombs.utexas.edu 39

Consumer behaviorBudget lines Goal of consumers Spend income to obtain the greatest possible satisfaction Limited means or income Budget Constraint Income = price of burger’s * quantity of burger’s + price of CD’s * quantity of CD’s M = p1x1 + p2x2 Rearrange and graph Work out example Tim.Simin@mccombs.utexas.edu 40

Utility MaximizationPutting it all together Consumer is faced with two combinations of cds and burgers, bundle A and bundle B Which can she afford? Which will she pick? Can we do this in excel? Tim.Simin@mccombs.utexas.edu 41

Production Theory Costs and Product Production Theory: How firms deal with inputs in production and costs of inputs Notes: Short run vs. Long run Assume firm produces a product rather than a service The Producer’s Problem: Producers want to be efficient maximize output subject to costs of production OR minimize costs subject to an output level. Two kinds of efficiency technical efficiency economic efficiency Tim.Simin@mccombs.utexas.edu 42

Production Theory Costs and Product (cont) Production: Creation of goods and services from inputs or resources Production function: Schedule (table or equation) of max output produced from specified set of inputs and technology Assuming producers are technically efficient (not wasteful) Really dealing with economic efficiency Two views of the producer problem: Find optimal level of output given a cost function Solve the profit max problem Find the most efficient means of producing a given level of output Constrained minimization problem with production function being the objective function and an output the constraint Tim.Simin@mccombs.utexas.edu 43

Production Theory Total Product Total Product: fancy name for output (Q) Q = f(I1, I2, I3, ...) Land labor (L) capital (K) entrepreneurial ability There are two different types of inputs Fixed inputs These can be changed only in the long run Variable inputs Restrict ourselves to L and K for simplicity Tim.Simin@mccombs.utexas.edu 44

Production Theory Total Product (cont) The general production function will be Q = f(L,K) Specific forms of typical production functions Multiplicative: Q=LK Cubic: Q=aK3L3+bK2L2 Cobb-Douglas: Q=KL Additive: Q=wL+rK Three aspects of short run production Total product: TP = Q=f(L,K) Average product AP = Q/L Marginal product MP = Q/L Fix K to examine short-run production Tim.Simin@mccombs.utexas.edu 45

Production Theory Example Cubic production: Q=aK3L3+bK2L2 Let a = -.1 and b = 3. See excel sheet Note shapes of curves TP increases and then falls back down right around 10 people. AP is maximized at 44.8, somewhere between 7 and 8 people. MP (the additional output coming from adding one more worker), actually goes negative at the 11th worker. MP = 0 when TP is maximized. Why? Why do the curves have these shapes? Law of diminishing marginal product: As variable input increases, ceteris paribus, a point will be reached where mp falls Tim.Simin@mccombs.utexas.edu 46

Using TP, AP, MP What can we do with this stuff Assume the following production function: Q=2L.3K.7 Make a short run decision about how many people to hire to produce 20 units. Fix our capital input at 8. In the long run, we can increase our capital input to 12. How many people will we need working for us to produce 20 units? What does AP do for us? Not much really. It is just the average amount of output per worker, given a particular K. What does MP do for us? How much more output we get for one more unit of input. Back to our original scenario with k=8. What is MP? Is the Law of diminishing marginal product at work here? Tim.Simin@mccombs.utexas.edu 47

CostsA rose by any other name… Opportunity costs: The value of the next best alternative Consist of two different parts Explicit costs: Out of pocket expense or monetary expense. Implicit costs: Forgone return had the owners used their resources in the next best use. These are both real costs! Example: Consider two companies exactly the same in every way except one rents the building and the other owns the building it operates in. Are their costs different? Tim.Simin@mccombs.utexas.edu 48

CostsTotal, fixed, and variable Short Run Costs: Total costs = Fixed costs + Variable costs TC = FC + VC Fixed costs: must be paid whether we produce or not (I.E. Rent, Debt payments) Variable costs: Costs which change with level of output (I.E. Cost of inputs, Wages) Can break down these costs too. Average fixed costs = FC/Q Average variable costs = VC/Q Short Run Marginal Costs = TC/Q = the derivative of TC SMC is additional cost for next unit of output In the short run fixed costs are constant so = (VC/Q) Tim.Simin@mccombs.utexas.edu 49

Costs What do the short run cost curves look like Tim.Simin@mccombs.utexas.edu 50

Managerial Economics