BUS7500
Managerial Economics
Week 3
Dr. Jenne Meyer
Background: consumer surplus and demand
curves
 First Law of Demand - consumers demand (purchase) more as price falls,
assuming other factors are held constant.
 Consumers make consumption decisions using marginal analysis, consume
more if marginal value > price
 But, the marginal value of consuming each subsequent unit diminishes the
more you consume.
 Consumer surplus = value to consumer - price paid
 Definition: Demand curves are functions that relate the price of a product
to the quantity demanded by consumers
Background: consumer surplus and demand
curves (cont.)
 Hot dog consumer
 Values first dog at $5, next at $4 . . . fifth at $1
 Note that if hot dogs price is $3, consumer will purchase 3 hot dogs
Background: aggregate demand
 Aggregate Demand: the buying
behavior of a group of consumers;
a total of all the individual demand
curves.
 To construct demand, sort by value.
Price
$7.00
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
Quantity
1
2
3
4
5
6
7
Marginal
Revenue Revenue
$7.00
$7.00
$12.00
$5.00
$15.00
$3.00
$16.00
$1.00
$15.00
-$1.00
$12.00
-$3.00
$7.00
-$5.00
$8.00
 Role of heterogeneity?
 How to estimate?
$6.00
Price
 Discussion: Why do aggregate
demand curves slope downward?
$4.00
$2.00
$0.00
$0.00
$2
Pricing trade-off
 Pricing is an extent decision
 Profit= Revenue - Cost
 Demand curves turn pricing decisions into quantity decisions: “what price
should I charge?” is equivalent to “how much should I sell?”
 Fundamental tradeoff:
 Lower price sell more, but earn less on each unit sold
 Higher price sell less, but earn more on each unit sold
 Tradeoff created by downward sloping demand
Marginal analysis of pricing
 Marginal analysis finds the profit increasing solution to the pricing tradeoff.
 It tells you only whether to raise or lower price, not .
 Definition: marginal revenue (MR) is change in total revenue from selling
extra unit.
 If MR>0, then total revenue will increase if you sell one more.
 If MR>MC, then total profits will increase if you sell one more.
 Proposition: Profits are maximized when MR = MC
Example: finding the optimal price
 Start from the top
 If MR > MC, reduce price (sell one more unit)
Find the optimum price
5760
10800
15840
25200
Total Quantity
Quantity per version
Total Cost
5,760
1,920 ea. Of 3
$
5,161.17
10,800
3,600 ea. Of 3
$
6,675.30
15,840
5,280 ea. Of 3
$
8,230.69
25,200
8,400 ea. Of 3
$
11,204.36
Makeready*
Printing Costs
$
$
1,546.89
3,614.28
$
$
1,546.89
5,128.41
$
$
1,546.89
6,683.80
$
$
1,546.89
9,657.47
Packaging/Inserting
sticker cost per
packaging cost
sticker + packaging
cost per sheet
On tab #3
$
0.63
$
2,077.08
$
5,691.36
$
0.99
$
$
$
$
0.47
3,469.90
8,598.31
0.80
$
$
$
$
0.42
4,848.15
11,531.95
0.73
$
$
$
$
0.38
7,377.77
17,035.25
0.68
Additional expenses:
• Web - $140/year
• Printed envelopes - $0.08/each for 10K
• Other expenses?
Estimating elasticities
 Definition: Arc (price) elasticity=
 [(q1-q2)/(q1+q2)]  [(p1-p2)/(p1+p2)].
 Discussion: Why, when price changes from $10 to $8, does
quantity changes from 1 to 2?
 Example: On a promotion week for Vlasic, the price of Vlasic
pickles dropped by 25% and quantity increased by 300%.
 Is the price elasticity of demand -12?
HINT: could something other than price be changing?
Estimating elasticities (cont.)
 3-Liter Coke Promotion (Instituted to meet Wal-Mart promotion)
Product
3 Liter
Q 3-liter
P of 3-liter
2 Liter
Q 2-liter
P of 3-liter
Total Liters Q liters
P liters
Initial
210
$1.79
Final % Change
420
66.67%
$1.50
-17.63%
Elasticity
-3.78
120
$1.79
48
$1.50
-85.71%
-17.63%
4.86
870
$0.60
1356
$0.51
43.67%
-16.23%
-2.69
Intuition: MR and price elasticity
 Revenue and price elasticity are related.
 %Rev ≈ %P + %Q
 Elasticity tells you the size of |%P| relative to |%Q|
 If demand is elastic
 If P↑ then Rev↓
 If P↓ then Rev↑
 If demand is inelastic
 If P↑ then Rev↑
 If P↓ then Rev↓
 Discussion: In 1980, Marion Barry, mayor of the District of Columbia, raised
the sales tax on gasoline sold in the District by 6%. What happened to gas
sales and availability of gas? Why?
What makes demand more elastic?
 Products with close substitutes have elastic demand.
 Demand for an individual brand is more elastic than industry aggregate
demand.
 Products with many complements have less elastic demand.
Describing demand with price elasticity
 First law of demand: e < 0 ( as price goes up, quantity
goes down).
 Discussion: Do all demand curves slope downward?
 Second law of demand: in the long run, |e| increases.
 Discussion: Give an example of the second law of
demand.
Describing demand (cont.)
 Third law of demand: as
price increases, demand
curves become more
price elastic, |e|
increases.
HFCS
Price
Sugar Price
HFCS Demand
HFCS Quantity
Other elasticities
 Definition: income elasticity measures the change in demand arising from a
change in income
 (%change in quantity demanded)  (%change in income)
Inferior (neg.) vs. normal (pos).
 Definition: cross-price elasticity of good one with respect to the price of
good two
 (%change in quantity of good one)  (%change in price of good two)
Substitute (pos.) vs. complement (neg.).
 Definition: advertising elasticity; a change in demand arising form a change
in advertising
 (%change in quantity)  (%change in advertising) .
 Discussion: The income elasticity of demand for WSJ is 0.50. Real income
grew by 3.5% in the United States.
 Estimate WSJ demand
Stay-even analysis
 Stay-even analysis tells you how many sales you need when changing price
to maintain the same profit level
 Q1 = Q0*(P0-VC0)/(P1-VC0)
 When combined with information about the elasticity of demand, the
analysis gives a quick answer to the question of whether or not changing
price makes sense.
 To see the effect of a variety of potential price changes, we can draw a stayeven curve that shows the required quantities at a variety of price levels.
Extra: quick and dirty estimators
 Linear Demand Curve Formula, e= p / (pmax-p)
 Discussion: How high would the price of the brand have to go before you
would switch to another brand of running shoes?
 Discussion: How high would the price of all running shoes have to go before
you should switch to a different type of shoe?
Elasticity
 Class exercises
 http://hspm.sph.sc.edu/COURSES/ECON/Elast/Elast.html
Chapter 7
Anecdote: Rayovac Company
 Founded in 1906, three entrepreneurs started a battery production
company that grew to rival Energizer and Duracell.
 In 1996, The Thomas H. Lee Company acquired Rayovac – taking advantage
of easy credit availability the company then bought many other battery
production companies as well. A move the company said they made to take
advantage or efficiencies and economies of scale.
 They expected that as they produced more of the same good, average costs would fall.
 The company also bought many unrelated companies at the same time as
the battery binge – the reasoning being that because of synergies, if they
centralized the production of many different goods the costs of production
would be lower.
 By February 2009 the new conglomerate was bankrupt
 Moral of the story? In business investments if you hear the words efficiency
or synergy, keep your money.
Increasing marginal costs
 Definition: The law of diminishing marginal returns: as you try to expand
output marginal productivity eventually declines.
 Diminishing marginal returns  marginal productivity declines
 Diminishing marginal productivity  increasing marginal costs
 Increasing marginal costs eventually lead to increasing average costs
 Some causes of diminishing marginal returns
 Difficulty of monitoring and
motivating a large work force
 Increasing complexity of a large
system
 The “fixity” of some factor, like
testing capacity
Graph 2: marginal vs. average cost

Increasing marginal costs eventually lead to increasing average costs.
Economies of scale
 Definition: short run “fixity” vs. long run “flexibility”
 i.e. factors that are fixed costs in the SR but become variable in the long run

If long-run average costs are constant with respect to output, then you have
constant returns to scale.

If long run average costs rise with output, you have decreasing returns to
scale or diseconomies of scale.

If average costs fall with output, you have increasing returns to scale or
economies of scale.
 Discussion: Category Killer stores & economies of scale
Learning curves
 Discussion: Every time an airplane manufacturer doubles production,
marginal costs decrease by 20%.
Learning curves graph
Economies of scope
 If the cost of producing two products jointly is less than the cost of
producing those two products separately then there are economies of scope
between the two products.
 Cost(Q1, Q2) < Cost(Q1) + Cost(Q2)
 Discussion: Company X is a small family-owned company that makes, sells,
and distributes a popular breakfast sausage.
 Can this firm realize economies of scope?
 Discussion: Scope economies in your company.
 Implication?
Anecdote: pet food production
 A pet food company has 2,500 products (SKU’s) with 200 different formulas
 They receive a lot of pressure from large customers like Wal-Mart to reduce
prices.
 To respond to Wal-Mart, the company shrinks it product offerings
 70 SKUs w/13 formulas
 This led to a 25% savings for the company because of reduced production costs (see graph)
Diseconomies of scope
 Production can also exhibit diseconomies of scope when the cost of
producing two products together is higher than the cost of separate
production.
 This was true for the pet food company – producing so many different products in one
factory was more expensive than producing each food in a different factory would have
been because of the cost of set-up, clean-up and transition times associated with
producing each different pet food
In class questions
 Learning curves: every time you double production, your costs decrease by
50%. The first unit costs you $64 to produce. On a project for 4 units, what
is your break-even price?
 You can win another project for 2 more units. What is your break-even price
for those units?
Answer
 The break-even price for 4 units is $33.
 The extra costs for the fifth and sixth units is only $24, so break-even is
$12/unit for those two.
 If the project were for six units total, break-even would be $26/unit for
those six.
Q
1
2
3
4
5
6
MC
$64
$32
$21
$16
$13
$11
TC
$64
$96
$117
$133
$146
$157
AC
$64
$48
$39
$33
$29
$26
Chapter 8
Anecdote: Y2K and generator sales
 From 1990-98, sales of portable generators grew 2% yearly.
 In 1999, public anticipation of Y2K power outages increased demand for
generators.
 Walters, Rosenberg and Matthews invested to increase capacity in anticipation of this
demand growth – they vertically integrated their company to increase capacity and reduce
variable costs.
 Demand grew as expected - Industry shipments increased by 87%. Prices also increased by
an average of 21%.
 Discussion: What will happen next? Why?
Which industry or market?
 Every industry or market has a time, product, and geographic dimension.
 For example: The yearly market for portable generators in the U.S.
 Time: annual
 Product: portable generators
 Geography: US
 When analyzing a problem, or investment opportunity, it helps to first
define the time, product and geographic dimensions of the market in
question.
Shifts in the demand curve
 Movement along the demand curve indicates the “quantity demanded”
increased.
 Shifts in demand curve can occur for multiple reasons
 Uncontrollable factor – affects demand and is out of a company’s control.
Income, weather, interest rates, and prices of substitute and complementary products owned by
other companies.
 Controllable factor – affects demand but can be controlled by a company
Price, advertising, warranties, product quality, distribution speed, service quality, and prices of
substitute or complementary products also owned by the company
Demand increase

At a given price, more quantity demanded
Supply curves
 Definition: Supply curves are functions that relate the price of a product to
the quantity supplied by sellers.
 Discussion: Why do supply curves slope upwards?
Market equilibrium
 Definition: Market equilibrium is the price at which quantity supplied equals
quantity demanded.
 At the equilibrium price, there is no pressure for the price to change given
the equality of quantity demanded and supplied.
Market equilibrium (cont.)
 Proposition: In a competitive equilibrium there are no
unconsummated wealth-creating transactions.
Price
$12
$11
$10
$9
$8
$7
$6
$5
$4
Demand
1
2
3
4
5
6
7
8
9
Supply
9
8
7
6
5
4
3
2
1
Using supply and demand

Supply and demand curves can be used to describe changes that occur at
the industry level
Portable generator market 1997-1998
 1997- Stable industry sales with intense competition (2% avg. sales growth)
 1997- Industry anticipates record demand will occur in 1999
 1998 – Massive capital expenses throughout industry on vertical integration
projects
Portable generator market 1999 +
 Demand shift due to fear of power grid failure caused by Y2K
 Supply shift caused by manufacturer’s eagerness to capitalize on
record demand for product
 Manufacturers fail to anticipate reduced demand in 2000
 Sales from 2000 pulled forward into 1999
Generator demand shifts graph
Using supply and demand (cont.)
 Discussion: “over the past decade, the price of computers has fallen, while
quantity has risen.” How? Why?
Prices convey information
 Prices are a primary way that market participants communicate with one
another
 Buyers signal their willingness to pay, and sellers signal their willingness to
sell with prices
 Price information especially important in financial markets
Prices convey information (cont.)
 Discussion: Gas pipeline burst between Tucson and Phoenix
 What happened to gas prices in Phoenix, in Tucson and in Los Angeles?
Alternate intro anecdote
 Video enhancement products are state-of-the-art graphics systems that
capture, analyze, enhance, and edit all major video formats without altering
underlying footage.
 In 1998, this market consisted of a small number of companies, and demand
was relatively light due to the extremely high price of the technology (prices
ranged between $45,000 and $80,000)
 In 2000, Intergraph entered the market at a price of $25,000, attempting to
quickly capture a major share of the market. Intergraph produced a product
at a substantially lower cost than the competition.
Alternate into anecdote (cont.)
 What happened??
 Entry caused an increase in supply and a strong downward pressure on price (average
pricing fell to around $40,000).
 A number of firms exited and prices rose back to around $45,000.
 Later, the events of 9/11/01 caused demand to spike.
 What happened??
 In the short run, average prices shot up.
 Higher prices eventually attracted more entrants, increasing supply. Pricing fell back down
to an average level of around $30,000.
Extra: using demand and supply
 Discussion: Is there a shortage of affordable housing?
 Discussion: Is there a shortage of kidneys?
Naked Economics
 Chapter 1: The Power of Markets
 Chapter 2: Incentives Matter
 Key learnings/take-aways?
 What did you write about?
Class Exercise
 Time permitting
 http://hspm.sph.sc.edu/COURSES/ECON/SD/SD.html
Discussion
 Key learnings?
 Next weeks assignments.