1. Managerial Economics Professor Geoffrey Heal 616 Uris Hall
Phone: (212)
(note - gmh “one” not “L”)

2. Course Outline: (I) Analyzing the structure of a market
Part A: Demand & Supply
Part B: Costs
(II) Pricing (most important part of course)
(III) e-con.com (application and review)
(IV) Foundations of Strategy

3. Analyzing the Structure of a Market
Aim: to understand key aspects of markets:
nature of demands for the products
closeness or otherwise of competitors
structure of costs
dependence of profits on the level of output

4. Material to be covered:
Analysis of demand
demand curves,
price, income & cross elasticities of demand
use of demand parameters in forecasting
Structure of costs:
fixed & variable costs
break-even analysis
opportunity costs and sunk costs
learning curves & economies of scale.

5. Pricing
How much product should you produce and what price should you charge for it?
How can you best segment your market if there are different types of buyers with different demand characteristics (e.g., business travelers vs. vacation travelers, home PC buyers vs. corporate buyers)?
What are the types of pricing schemes available (e.g., bundling, promotional offers, loyalty bonuses, volume discounts)?

6. e-con.com e-commerce business strategies.
Applications of market analysis to electronic commerce
How does the internet affect demand, pricing, and other aspects of running a business.
e-commerce business strategies.
Auctions and the internet.

7. Foundations of Strategy
Interacting with competitors
Anticipating their reactions
Forecasting the final outcome when everyone has reacted.

8. Aim of Course
To teach you to use basic economic ideas in making business decisions.
Decisions about opening and closing businesses.
Decisions about pricing and other policies.

9. Level of Course
Emphasis on understanding concepts and where and how they can be used.
Don’t aim to make you an economist, but an intelligent consumer of economics.
Evaluate and understand works of consultants, staff. Ask the right questions.
Recognize BS when you see it!

11. Consumption & Price of Copper 1880-1998

14. Compare Internet companies
eBay
AOL
Yahoo
Amazon.com

15. Demand and Supply

16. Demand Curve Shows amount purchased as a function of price Depends on:
- income
- tastes
- prices of competitive products
- prices of complementary products

17. Supply Curve Amount offered for sale as a function of price
Depends on costs of production, which in turn depend on
- costs of inputs
- technology

18. The Market Mechanism S P0 D Q0 Price ($ per unit)
The curves intersect at
equilibrium, or market-
clearing, price. At P0 the
quantity supplied is equal
to the quantity demanded
at Q0 . P0 Q0
Quantity 12

19. The Market Mechanism
Characteristics of the equilibrium or market clearing price:
QD = QS
No shortage
No excess supply
No pressure on the price to change 13

20. Demand Curve -Income Rises

21. Demand Shifts

22. Supply shifts

23. D & S shift

24. The Market Mechanism Surplus S D Q1 P1 Q2 P2 Q3 Price ($ per unit)
Quantity
Price
($ per unit) S D Q1
Assume the price is P1 , then:
1) Qs : Q1 > Qd : Q2
2) Excess supply is Q1:Q2.
3) Producers lower price.
4) Quantity supplied decreases and quantity demanded increases.
5) Equilibrium at P2Q3 P1
Surplus Q2 P2 Q3 17

25. The Market Mechanism The market price is above equilibrium A Surplus
There is excess supply
Producers lower prices
Quantity demanded increases and quantity supplied decreases
The market continues to adjust until the equilibrium price is reached. 19

26. The Market Mechanism S Shortage D Q3 P3 Q1 Q2 P2 Price ($ per unit)
Quantity
Price
($ per unit) S D
Assume the price is P2 , then:
1) Qd : Q2 > Qs : Q1
2) Shortage is Q1:Q2.
3) Producers raise price.
4) Quantity supplied increases and quantity demanded decreases.
5) Equilibrium at P3, Q3 Q3 P3 Q1 Q2 P2
Shortage 22

27. The Market Mechanism The market price is below equilibrium: Shortage
There is a shortage
Producers raise prices
Quantity demanded decreases and quantity supplied increases
The market continues to adjust until the new equilibrium price is reached. 24

28. The Market Mechanism Market Mechanism - Summary:
1) Supply and demand interact to determine the market-clearing price.
2) When not in equilibrium, the market will adjust to alleviate a shortage or surplus and return the market to equilibrium.
3) Markets must be competitive for the mechanism to be efficient. 25

31. Consumption & Price of Copper 1880-1998

32. The Long-Run Behavior of Natural Resource Prices
Observations
Consumption of copper has increased about a hundred fold from 1880 through 1998 indicating a large increase in demand.
The real price for copper has remained relatively constant. 59

33. Changes In Market Equilibrium
D1998
S1950
D1950
Quantity
Price
S1900
D1900
Long-Run Path of
Price and Consumption 63

34. Changes In Market Equilibrium
Conclusion
Decreases in the costs of production have increased the supply by more than enough to offset the increase in demand. 64

35. Changes In Market Equilibrium
Wage Inequality in the United States
Real after-tax income from 1977 to 1999:
Rose 40+% for the top 20% of the income distribution
Fell 10+% for the bottom 20% 26

36. Changes In Market Equilibrium
Question
Why did the income distribution become more unequal for 1977 to 1999? 26

37. Price elasticity of demand:
Measures responsiveness of demand to price.
Defined as E = (DQ/Q)/(DP/P) = (DQ/DP)*(P/Q)
Why is it defined in proportional terms?
- Unit free.
- Scale sensitive.
A negative number.

39. Elasticity = (DQ/Q)/(DP/P) = (DQ/DP)*(P/Q) = -2*(P/Q)
Q = 8 - 2P or P = Q
Elasticity = (DQ/Q)/(DP/P) = (DQ/DP)*(P/Q) = -2*(P/Q)

40. Elasticity and Pricing
If elasticity is between 0 and -1 then raising price will raise profits - it will raise revenues and lower costs.
If elasticity is lower than -1 then raising price will lower revenues and also costs, so the effect on profits is not clear.
Moral - never operate where the elasticity is between 0 and -1.

41. Relationship between demand, quantity and revenue:
Q = 8 - 2P or
P = Q
so as revenue R is price times quantity
R = 4Q - 0.5Q2

42. Revenue rises as price rises
Revenue falls
as price rises
PED = -1
PED = 0

43. This is a quadratic pointing up.
The slope is: DR DQ
which is zero at Q = 4.
Slope is positive for Q<4 and vice versa.
Maximum revenue comes when Q = 4, therefore P = 2, and max revenue is 8
= 4 - Q

44. PED when revenue is maximum
Revenue is max when Q = 4, P = 2.
E = (DQ/Q)/(DP/P) = (DQ/DP)*(P/Q)
So E = (DQ/DP)*(1/2) and
DQ/DP = -2 so E = -2 * 1/2 = -1 when R is at a maximum.

45. Cross price elasticity of demand:
The responsiveness of demand for good A to change in price of good B:
DQA/QA = DQA * PB
DPB/PB DPB PA
Example:
responsiveness of demand for Dell computers to prices of Gateway computers

46. Goods are Complements:
Cross PED is negative (autos and gasoline)
Goods are substitutes-competitors:
Cross PED is positive (Dell vs. Gateway)

47. Demand elasticities in the home PC market.
Jerome Foncel and Marc Ivaldi, Ecole des Hautes Etudes en Science Sociales, Toulouse.

48. Supply Elasticity The responsiveness of supply to price changes.
(DS/S)/(DP/P), proportional change in supply divided by proportional change in price.
Usually positive.

49. Elasticities of Supply and Demand
The Market for Wheat
1981 Supply Curve for Wheat
QS = 1, P
1981 Demand Curve for Wheat
QD = 3, P

50. Elasticities of Supply and Demand
The Market for Wheat
Equilibrium: Q S = Q D

51. Elasticities of Supply and Demand
The Market for Wheat
ED=(P/Q) (DQD/DP) = (3.46/2630)(-266)= -0.35
ES=(P/Q) (DQS/DP) = (3.46/2630)(+240)= 0.32

52. Changes in the Market: 1981-1998
The Market for Wheat
Supply (Qs) Demand (QD) Equilibrium Price (Qs = QD)
P P P = P P = P1981 = $3.46/bushel
1998 1, P 3, P 1, P = 3, P P1998 = $2.65/bushel 66

53. Marginal Revenue Increase in revenue from one extra sale
Rate of change of revenue with respect to sales
Typically less than price as demand curve slopes down
Depends on PED

54. Relationship between demand, quantity and revenue:
Q = 8 - 2P or
P = Q
so as revenue R is price times quantity
R = 4Q - 0.5Q2

55. This is a quadratic pointing up. Slope is MR, which is DR/DQ
This is a quadratic pointing up. Slope is MR, which is DR/DQ. As R = 4Q Q2, slope is Q, which is zero at Q = 4.
Slope is positive for Q < 4 and vice versa. So MR is > 0 for Q < 4 and MR < 0 for Q > 4.
Maximum revenue comes when Q = 4, therefore P = 2, and max revenue is 8

56. PED when revenue is maximum
Revenue is max when Q = 4, P = 2.
E = (DQ/Q)/(DP/P) = (DQ/DP)*(P/Q)
So E = (DQ/DP)*(1/2) and
DQ/DP = -2 so E = -2 * 1/2 = -1 when R is at a maximum.

58. Marginal Revenue & PED MR = P{1 + 1/PED}
Remember PED < 0 so MR < P.
The larger PED as a number the nearer MR is to P
If PED = - 1, then MR = 0. (Top of revenue curve)
…………………………………………
Derivation - dR/dQ = d{P(Q).Q}/dQ
= P + Q*dP/dQ
= P{1 + (Q/P)*dP/dQ}

59. Income Elasticity of Demand:
Responsiveness of demand to changes in income
IED = (DQ/Q)/DI/I) = (DQ/DI)*(I/Q)
Use to define necessities and luxuries

60. Necessities - IED < 1
Luxuries - IED > 1
Cyclical vs. defensive sectors
Cyclical - high IED - foreign travel, consumer durables
Defensive - low IED - food, utilities

63. Short-run vs. long-run elasticities
Critical in understanding oil market, energy markets, metal markets
Responding to a price movement takes time - possibly many years
Long-run elasticity measures total response
Short-run elasticity measures immediate response

64. Short-run
demand P1 Po
Long-run
demand
Short-run drop
in demand
Long-run drop
in demand

65. Short-Run Versus Long-Run Elasticities
The Demand for Gasoline
Years Following Price or Income Change
Elasticity
Price
Income 93

66. Short-Run Versus Long-Run Elasticities
The Demand for Automobiles
Years Following Price or Income Change
Elasticity
Price
Income 93

67. Short-Run Versus Long-Run Elasticities
The Demand for
Gasoline and Automobiles
Data Explains:
1) Why the price of oil did not continue to rise above $30/barrel even though it rose very rapidly in the early 1970s.
2) Why automobile sales are so sensitive to the business cycle. 95

68. The World Oil Market In 1995: P* = $18/barrel
World demand and total supply = 23 bb/yr (= 63 mbd)
OPEC supply = 10 bb/yr (= 27 mbd)
Non-OPEC supply = 13 bb/yr (= 35 mbd)
US consumption about 17 mbd = 5.5 bb/yr
129

69. Price of Crude Oil

71. Price Elasticity Estimates
Short-Run Long-Run
World Demand:
Competitive Supply
(non-OPEC)
130

72. Upheaval in the World Oil Market
Short-Run Impact of a stoppage of Saudi Production equal to 3 bb/yr (= 8 mbd).
Short-run Demand
D = P
Short-run Competitive Supply
SC = P
131

73. Upheaval in the World Oil Market
Short-Run Impact of a stoppage of Saudi Production equal to 3 bb/yr.
Short-run Total Supply--before supply reduction (includes OPEC, 10bb/yr)
ST = P
Short-run Total Supply--after supply reduction
ST = P
132

74. Upheaval in the World Oil Market
New Price After Reduction
Demand = Supply
P = P
P = 41.08
133

75. Impact of Saudi Production Cut18 ST
S’T SC D
Price
($ per
barrel) 45
Short-Run
Effect 40 35 30 25 20 15 10 5
Quantity
(billions barrels/yr) 5 10 15 20 23 25 30 35
134

76. Upheaval in the World Oil Market
Long-Run Impact of a stoppage Saudi Production equal to 3 bb/yr..
Long-run Demand
D = P
Long-run Total Supply
S = P
136

77. Upheaval in the World Oil Market
New Price is found setting long-run supply equal to long-run demand:
P = P
P = 21.75
137

78. Impact of Saudi Production CutSC ST
Due to the elasticity
of the long-run
supply and demand
curves, the long-run
effect of a cut
in production is
much less.
S’T
Long-run Effect
Price
($ per
barrel) 45 D 40 35 30 25 20 18 15 10 5
Quantity
(billions barrels/yr) 5 10 15 20 23 25 30 35
139

79. - market research and pricing policy - forecasting
Uses of elasticities
- market research and pricing policy
- forecasting

80. Examples: 1. Spring 1990 - sales of BMWs in the US fell sharply
Possible explanations:
(a) rising D mark pushed US prices up “too high”
(b) entry of Lexus and Infiniti at lower prices had drawn away sales
(c ) recession lowered incomes of target market

81. (a) depends on own price elasticity of demand
(b) depends on cross PED between BMW and Lexus-Infiniti
(c ) depends on IED for BMW

82. The price of oil in 2020
Project user income growth by 2020: call this G%
Multiply G by IED for oil: G*IED gives growth in demand for oil by 2020 at constant prices
Estimate possible % growth in supply by 2020 (at constant prices). Call this S. Suppose S < G*IED

83. Then if prices were to stay constant demand would rise more than supply. So price must rise to keep the two equal
How much? Enough to reduce demand by (G*IED-S)%. Call this R:
R = (G*IED - S)
A 1% rise in price reduces demand by PED%: hence to reduce demand by R = (G*IED - S)% we need a price rise of R/PED

84. Example:
Let growth of user incomes to 2020 be 3% p.a. = 1.03 = 86% in total
Let IED be 1.1
The demand growth by 2020 = G*IED = 86*1.1 = 95%

85. Let supply growth S be 30%
Then demand growth exceeds supply growth by = 65%
Assume PED in the long run is Then price growth must be 50%
This may raise S: rework with a bigger S

86. Lessons on Demand and Supply
Formalism of demand and supply curves provides tools for analyzing how various shocks (input costs, customers’ income, competitors’ prices, etc.) affect own sales and prices.

87. Elasticities provide useful summary numbers that feed into these analyses
Short Run  Long Run. Use numbers appropriate to the time scale of the decision

88. AMAX Case

91. Marginal Costs