Chapter 1
Managers, Profits, & Markets
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1-1
Learning Objectives
 Understand why managerial economics relies on microeconomics
and industrial organization to analyze business practices and
design business strategies.
 Explain the difference between economic and accounting profit and
relate economic profit to the value of the firm.
 Describe how separation of ownership and management can lead
to a principal-agent problem when goals of owners and managers
are not aligned and monitoring managers is costly or impossible for
owners.
 Explain the difference between price-taking and price-setting firms
and discuss the characteristics of the four market structures.
 Discuss the primary opportunities and threats presented by the
globalization of markets in business.
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1-2
Managerial Economics & Theory
 Managerial economics applies microeconomic
theory to business problems
~ How to use economic analysis to make decisions to
achieve firm’s goal of profit maximization
 Economic theory helps managers understand
real-world business problems
~ Uses simplifying assumptions to turn complexity into
relative simplicity
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1-3
Microeconomics
 Microeconomics
~ Study of behavior of individual consumers, business
firms, and markets
 Business practices or tactics
~ Routine business decisions managers must make to
earn the greatest profit under prevailing market
conditions
~ Using marginal analysis, microeconomics provides
the foundation for understanding everyday business
decisions
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1-4
Microeconomics
 Industrial organization
~ Specialized branch of microeconomics
focusing on behavior and structure of firms
and industries
~ Provides foundation for understanding
strategic decisions through application of
game theory
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1-5
Strategic Decisions
 Business actions taken to alter market
conditions and behavior of rivals
~ Increase/protect strategic firm’s profit
 While common business practices are
necessary for the goal of profitmaximization, strategic decisions are
generally optimal actions managers can
take as circumstances permit
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1-6
Economic Forces that Promote
Long-Run Profitability (Figure 1.1)
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1-7
Economic Cost of Resources
 Opportunity cost is:
~ What firm owners must give up to use
resources to produce goods and services
 Market-supplied resources
~ Owned by others and hired, rented, or leased
 Owner-supplied resources
~ Owned and used by the firm
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1-8
Total Economic Cost
 Total Economic Cost
~ Sum of opportunity costs of both marketsupplied resources and owner-supplied
resources
 Explicit Costs
~ Monetary opportunity costs of using marketsupplied resources
 Implicit Costs
~ Nonmonetary opportunity costs of using
owner-supplied resources
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1-9
Types of Implicit Costs
 Opportunity cost of cash provided by
owners
~ Equity capital (money provided to businesses
by the owners)
 Opportunity cost of using land or capital
owned by the firm
 Opportunity cost of owner’s time spent
managing or working for the firm
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1-10
Economic Cost of Using Resources
(Figure 1.2)
Explicit Costs
of
Market-Supplied Resources
The monetary payments to
resource owners
+
Implicit Costs
of
Owner-Supplied Resources
The returns forgone by not taking
the owners’ resources to market
=
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
1-11
Economic Profit vs. Accounting
Profit
Economic profit = Total revenue – Total economic cost
= Total revenue – Explicit costs – Implicit costs
Accounting profit = Total revenue – Explicit costs
 Accounting profit does not subtract implicit
costs from total revenue
 Firm owners must cover all costs of all
resources used by the firm
~ Objective is to maximize profit
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1-12
Maximizing the Value of a Firm
 Value of a firm
~ Price for which it can be sold
~ Equal to the present value of expected future
profits
 Risk premium
~ An increase in the discount rate to
compensate investors for uncertainty about
future profits
~ The larger the risk, the higher the risk
premium, and the lower the firm’s value
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1-13
Maximizing the Value of a Firm
 Maximize firm’s value by maximizing profit
in each time period
~ Cost & revenue conditions must be
independent across time periods
 Value of a firm =
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1-14
Some Common Mistakes
Managers Make
 Never increase output simply to reduce
average costs
 Pursuit of market share usually reduces
profit
 Focusing on profit margin won’t maximize
total profit
 Maximizing total revenue reduces profit
 Cost-plus pricing formulas don’t produce
profit-maximizing prices
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1-15
Principal-Agent Relationship
 Relationship formed when a business
owner (the principal) enters an agreement
with an executive manager (the agent)
whose job is to formulate and implement
tactical and strategic business decisions
that will further the objectives of the
business owner (the principal).
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
1-16
Separation of Ownership & Control
 Principal-agent problem
~ A manager takes an action or makes a
decision that advances the interests of the
manager but reduces the value of the firm.
 Complete contract
~ An employment contract that protects owners
from every possible deviation by managers
from value-maximizing decisions.
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1-17
Separation of Ownership & Control
 Hidden actions
~ Actions or decisions taken by managers that
cannot be observed by owners for any
feasible amount of monitoring effort.
 Moral Hazard
~ A situation in which managers take hidden
actions that harm the owners of the firm but
further the interests of the managers.
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
1-18
Corporate Control Mechanisms
 Internal control mechanisms
~ Require managers to hold stipulated amount
of firm’s equity
~ Increase percentage of outsiders serving on
board of directors
~ Finance corporate investments with debt
instead of equity
 External mechanism
~ Corporate takeovers
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
1-19
Price-Takers vs. Price-Setters
 Price-taking firm
~ Cannot set price of its product
~ Price is determined strictly by market forces of
demand & supply
 Price-setting firm
~ Can set price of its product
~ Has a degree of market power, which is the
ability to raise price without losing all sales
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1-20
What is a Market?
 A market is any arrangement through
which buyers & sellers exchange anything
of value
 Markets reduce transaction costs
~ Costs of making a transaction happen, other
than the price of the good or service itself
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1-21
Market Structures
 Market characteristics that determine the
economic environment in which a firm
operates
~ Number and size of firms in market
~ Degree of product differentiation among
competing firms
~ Likelihood of new firms entering market when
incumbent firms are earning economic profits
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1-22
Perfect Competition
 Large number of relatively small firms
 Undifferentiated product
 Price takers with no market power
 No barriers to entry
~ Any economic profit earned will vanish as new
firms enter
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1-23
Monopoly
 Single firm
 Produces product with no close
substitutes
 Protected by a barrier to entry
~ Allows the monopolist to raise its price without
concern that economic profits will attract new
firms
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1-24
Monopolistic Competition
 Large number of relatively small firms
 Differentiated products
~ Gives the monopolistic competitor some
degree of market power
 Price setters
 No barriers to entry
~ Ensures any economic profits will be bid away
by new entrants
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1-25
Oligopoly
 Few firms produce all or most of market
output
 Profits are interdependent
~ Actions by any one firm will affect sales and
profits of the other firms
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1-26
Globalization of Markets
 Economic integration of markets located
in nations around the world
~ Provides opportunity to sell more goods &
services to foreign buyers
~ Presents threat of increased competition from
foreign producers
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1-27
Summary
 Managerial economics applies concepts/theories from
microeconomics and industrial organization
~ Marginal analysis provides the foundation for everyday business
practices or tactics
 Opportunity cost of using any resource is what the firm owners
must give up to use the resource
~ Unlike economic profit, accounting profit does not subtract
implicit (opportunity) costs from total revenue
 With the separation of ownership and management, a principalagent problem can arise because owners cannot be certain that
managers are making decisions to maximize the value of the firm
 For price-taking firms, price is determined solely by market forces
of supply and demand, while price-setters have some degree of
market power to set price
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1-28
Chapter 2
Demand, Supply, & Market
Equilibrium
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
1-1
Learning Objectives
 Identify demand functions and distinguish between a
change in demand and a change in quantity demanded
 Identify supply functions and distinguish between a
change in supply and a change in quantity supplied
 Explain why market equilibrium occurs at the price for
which quantity demanded equals quantity supplied
 Measure gains from market exchange using consumer
surplus, producer surplus, and social surplus
 Predict the impact on equilibrium price and quantity of
shifts in demand or supply
 Examine the impact of government imposed price
ceilings and price floors
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2-2
Demand
 Quantity demanded (Qd)
~ Amount of a good or service consumers are
willing & able to purchase during a given
period of time
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2-3
General Demand Function
 Six variables that influence Qd
~ Price of good or service (P)
~ Incomes of consumers (M)
~ Prices of related goods & services (PR)
~ Taste patterns of consumers (T)
~ Expected future price of product (PE)
~ Number of consumers in market (N)
 General demand function
Qd = f(P, M, PR, T, PE , N)
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2-4
General Demand Function
Qd = a + bP + cM + dPR + eT + fPE + gN
 b, c, d, e, f, & g are slope parameters
~ Measure effect on Qd of changing one of
the variables while holding the others
constant
 Sign of parameter shows how variable
is related to Qd
~ Positive sign indicates direct relationship
~ Negative sign indicates inverse relationship
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2-5
General Demand Function
 Normal good
~ A good or service for which an increase
(decrease) in income causes consumers to
demand more (less) of the good, holding all
other variables in the general demand function
constant
 Inferior good
~ A good or service for which an increase
(decrease) in income causes consumers to
demand less (more) of the good, all other
factors held constant
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2-6
General Demand Function
 Substitutes
~ Two goods are substitutes if an increase
(decrease) in the price of one good causes
consumers to demand more (less) of the other
good, holding all other factors constant
 Complements
~ Two goods are complements if an increase
(decrease) in the price of one good causes
consumers to demand less (more) of the other
good, all other things held constant
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-7
General Demand Function
Variable
P
M
PR
Relation to Qd
Inverse
Sign of Slope Parameter
b = Qd/P is negative
c = Qd/M is positive
Inverse for inferior goods c = Qd/M is negative
d = Qd/PR is positive
Direct for substitutes
Inverse for complements d = Qd/PR is negative
Direct for normal goods
T
Direct
e = Qd/T is positive
PE
Direct
f = Qd/PE is positive
N
Direct
g = Qd/N is positive
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2-8
Direct Demand Function
 The direct demand function, or simply
demand, shows how quantity demanded,
Qd , is related to product price, P, when all
other variables are held constant
~ Qd = f(P)
 Law of Demand
~ Qd increases when P falls, all else constant
~ Qd decreases when P rises, all else constant
~ Qd/P must be negative
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2-9
Inverse Demand Function
 Traditionally, price (P) is plotted on the
vertical axis & quantity demanded (Qd) is
plotted on the horizontal axis
~ The equation plotted is the inverse demand
function, P = f(Qd)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-10
Graphing Demand Curves
 A point on a direct demand curve shows
either:
~ Maximum amount of a good that will be
purchased for a given price
~ Maximum price consumers will pay for a
specific amount of the good (demand price)
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2-11
A Demand Curve
(Figure 2.1)
Qd = 1,400 – 10P
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2-12
Graphing Demand Curves
 Change in quantity demanded
~ Occurs when price changes
~ Movement along demand curve
 Change in demand
~ Occurs when one of the other variables, or
determinants of demand, changes
~ Demand curve shifts rightward or leftward
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2-13
Shifts in Demand
(Figure 2.2)
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2-14
Supply
 Quantity supplied (Qs)
~ Amount of a good or service offered for
sale during a given period of time
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2-15
Supply
 Six variables that influence Qs
~ Price of good or service (P)
~ Input prices (PI )
~ Prices of goods related in production (Pr)
~ Technological advances (T)
~ Expected future price of product (Pe)
~ Number of firms producing product (F)
 General supply function
Qs = f(P, PI, Pr, T, Pe, F)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-16
General Supply Function
Qs = h + kP + lPI + mPr + nT + rPe + sF
 k, l, m, n, r, & s are slope parameters
~ Measure effect on Qs of changing one of the
variables while holding the others constant
 Sign of parameter shows how variable is
related to Qs
~ Positive sign indicates direct relationship
~ Negative sign indicates inverse relationship
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-17
General Supply Function
 Substitutes in production
~ Goods for which an increase in the price of one
good relative to the price of another good
causes producers to increase production of the
now higher-priced good and decrease
production of the other good
 Complements in production
~ Goods for which an increase in the price of one
good, relative to the price of another good,
causes producers to increase production of
both goods
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-18
General Supply Function
Variable
Relation to Qs
Sign of Slope Parameter
P
Direct
k = Qs/P is positive
PI
Inverse
l = Qs/PI is negative
Pr
Inverse for substitutes
Direct for complements
T
Direct
n = Qs/T is positive
Pe
Inverse
r = Qs/Pe is negative
F
Direct
s = Qs/F is positive
m = Qs/Pr is negative
m = Qs/Pr is positive
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2-19
Direct Supply Function
 The direct supply function, or simply
supply, shows how quantity supplied, Qs ,
is related to product price, P, when all
other variables are held constant
~
Qs = f(P)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-20
Inverse Supply Function
 Traditionally, price (P) is plotted on the
vertical axis & quantity supplied (Qs) is
plotted on the horizontal axis
~ The equation plotted is the inverse supply
function, P = f(Qs)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-21
Graphing Supply Curves
 A point on a direct supply curve shows
either:
~ Maximum amount of a good that will be
offered for sale at a given price
~ Minimum price necessary to induce producers
to voluntarily offer a given quantity for sale
(supply price)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-22
A Supply Curve
(Figure 2.3)
Qs = -400 + 20P
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2-23
Graphing Supply Curves
 Change in quantity supplied
~ Occurs when price changes
~ Movement along supply curve
 Change in supply
~ Occurs when one of the other variables, or
determinants of supply, changes
~ Supply curve shifts rightward or leftward
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2-24
Shifts in Supply
(Figure 2.4)
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2-25
Market Equilibrium
 Equilibrium price & quantity are
determined by the intersection of
demand & supply curves
~ At the point of intersection, Qd = Qs
~ Consumers can purchase all they want &
producers can sell all they want at the
“market-clearing” or “equilibrium” price
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2-26
Market Equilibrium
(Figure 2.5)
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2-27
Market Equilibrium
 Excess supply (surplus)
~ Exists when quantity supplied exceeds
quantity demanded
 Excess demand (shortage)
~ Exists when quantity demanded exceeds
quantity supplied
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2-28
Value of Market Exchange
 Typically, consumers value the goods
they purchase by an amount that
exceeds the purchase price of the
goods
 Economic value
~ Maximum amount any buyer in the market
is willing to pay for the unit, which is
measured by the demand price for the unit
of the good
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2-29
Measuring the Value of
Market Exchange
 Consumer surplus
~ Difference between the economic value of a
good (its demand price) & the market price the
consumer must pay
 Producer surplus
~ For each unit supplied, difference between
market price & the minimum price producers
would accept to supply the unit (its supply
price)
 Social surplus
~ Sum of consumer & producer surplus
~ Area below demand & above supply over the
relevant range of output
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2-30
Measuring the Value of
Market Exchange (Figure 2.6)
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2-31
Changes in Market Equilibrium
 Qualitative forecast
~ Predicts only the direction in which an
economic variable will move
 Quantitative forecast
~ Predicts both the direction and the
magnitude of the change in an economic
variable
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2-32
Demand Shifts (Supply Constant)
(Figure 2.7)
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2-33
Supply Shifts (Demand Constant)
(Figure 2.8)
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2-34
Simultaneous Shifts
 When demand & supply shift
simultaneously
~ Can predict either the direction in which
price changes or the direction in which
quantity changes, but not both
~ The change in equilibrium price or quantity
is said to be indeterminate when the
direction of change depends on the relative
magnitudes by which demand & supply
shift
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2-35
Simultaneous Shifts: (D, S)
P
S
S′
S′′
B
P′
P
•
A
•
•
P′′
C
D′
D
Q
Q′
Q′′
Q
Price may rise or fall; Quantity rises
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-36
Simultaneous Shifts: (D, S)
P
S
S′
S′
A
•
P
P′
P′′
•
B
•
C
D
D′
Q′ Q Q′′
Q
Price falls; Quantity may rise or fall
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-37
Simultaneous Shifts: (D, S)
P
S′′
S′
P′′
•
C
•
P′
S
B
A
•
P
D′
D
Q′′
Q Q′
Q
Price rises; Quantity may rise or fall
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-38
Simultaneous Shifts: (D, S)
P
S′′
S′
P′′
P
P′
•
C
S
A
•
B
•
D
D′
Q′′
Q′
Q
Q
Price may rise or fall; Quantity falls
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-39
Ceiling & Floor Prices
 Ceiling price
~ Maximum price government permits sellers
to charge for a good
~ When ceiling price is below equilibrium, a
shortage occurs
 Floor price
~ Minimum price government permits sellers
to charge for a good
~ When floor price is above equilibrium, a
surplus occurs
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2-40
Ceiling & Floor Prices (Figure 2.12)
Px
Price (dollars)
Px
Sx
2
Sx
3
2
1
Dx
22
50 62
Quantity
Panel A – Ceiling price
Dx
Qx
32 50
84
Qx
Quantity
Panel B – Floor price
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2-41
Summary
 6 variables influence demand: good’s price, income,
prices of related goods, consumers’ tastes, expected
future price, and number of consumers
~ Law of demand states that quantity demanded increases
(decreases) when price falls (rises), all else constant
 6 variables influence supply: good’s price, input
prices, prices of goods related in production,
producers’ expectation of future price, number of firms
 Equilibrium price and quantity determined by
intersection of supply and demand curves
 Consumer surplus arises because the equilibrium
price consumers pay is less than the value they place
on the units they purchase.
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2-42
Summary
 Consumer surplus arises because the equilibrium
price consumers pay is less than the value they place
on units they purchase
~ Producer surplus arises because equilibrium price is greater
than the minimum price producers would be willing to accept
to produce.
~ Social surplus: sum of consumer surplus and producer surplus
 When both supply and demand shift simultaneously,
one can predict either the direction of change in price
or the direction of change in quantity, but not both
 A ceiling price (below equilibrium) results in a
shortage; a floor price (above equilibrium) results in a
surplus
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2-43
Chapter 3
Marginal Analysis for
Optimal Decisions
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
1-1
Learning Objectives
 Define several key concepts and terminology related to
marginal analysis
 Use marginal analysis to find optimal activity levels in
unconstrained maximization problems and explain why
sunk costs, fixed costs, and average costs are irrelevant
for decision making
 Employ marginal analysis to find the optimal levels of
two or more activities in constrained maximization and
minimization problems
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3-2
Optimization
 An optimization problem involves the
specification of three things:
~ Objective function to be maximized or
minimized
~ Activities or choice variables that determine
the value of the objective function
~ Any constraints that may restrict the values of
the choice variables
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3-3
Optimization
 Maximization problem
~ An optimization problem that involves
maximizing the objective function
 Minimization problem
~ An optimization problem that involves
minimizing the objective function
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3-4
Optimization
 Unconstrained optimization
~ An optimization problem in which the decision
maker can choose the level of activity from an
unrestricted set of values
 Constrained optimization
~ An optimization problem in which the decision
maker chooses values for the choice
variables from a restricted set of values
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3-5
Choice Variables
 Activities or choice variables determine
the value of the objective function
 Discrete choice variables
~ Can only take specific integer values
 Continuous choice variables
~ Can take any value between two end points
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
3-6
Marginal Analysis
 Analytical techniques for solving
optimization problems that involves
changing values of choice variables by
small amounts to see if the objective
function can be further improved
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
3-7
Net Benefit
 Net Benefit (NB)
~ Difference between total benefit (TB) and total
cost (TC) for the activity
~ NB = TB – TC
 Optimal level of the activity (A*) is the
level that maximizes net benefit
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
3-8
Optimal Level of Activity
(Figure 3.1)
Total benefit and total cost (dollars)
TC
4,000
D
•
• D’
3,000
B
•
2,310
F
•
•
G
TB
2,000
NB* = $1,225
C
•
1,085
1,000
• B’
•C’
0
200
A
350 = A*
600
700
1,000
Level of activity
Net benefit (dollars)
Panel A – Total benefit and total cost curves
M
1,225
1,000
•c’’
•
•
600
0
d’’
200
350 = A*
•
600
A
f’’
1,000
Level of activity
NB
Panel B – Net benefit curve
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
3-9
Marginal Benefit & Marginal Cost
 Marginal benefit (MB)
~ Change in total benefit (TB) caused by an
incremental change in the level of the activity
 Marginal cost (MC)
~ Change in total cost (TC) caused by an
incremental change in the level of the activity
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3-10
Marginal Benefit & Marginal Cost
Change in total benefit TB
MB 

A
Change in activity
Change in total benefit TC
MC 

A
Change in activity
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3-11
Relating Marginals to Totals
 Marginal variables measure rates of
change in corresponding total variables
~ Marginal benefit (marginal cost) of a unit of
activity can be measured by the slope of the
line tangent to the total benefit (total cost)
curve at that point of activity
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3-12
Relating Marginals to Totals
(Figure 3.2)
Total benefit and total cost (dollars)
TC
4,000
100
320
3,000
100
520
100
•B
•C
B’
•
1,000
C’
•
F
•
D’ •
•
G
TB
D
820
100
2,000
640
•
520
100
340
A
100
0
200
350 = A*
600
800
1,000
Level of activity
Marginal benefit and marginal
cost (dollars)
Panel A – Measuring slopes along TB and TC
MC (= slope of TC)
8
6
5.20
4
•
•
c (200, $6.40)
• d’ (600, $8.20)
b
•
c’ (200, $3.40)
•
d (600, $3.20)
2
MB (= slope of TB)
g
0
200
350 = A*
600
800
•
1,000
A
Level of activity
Panel B – Marginals give slopes of totals
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3-13
Using Marginal Analysis to Find
Optimal Activity Levels
 If marginal benefit > marginal cost
~ Activity should be increased to reach highest
net benefit
 If marginal cost > marginal benefit
~ Activity should be decreased to reach highest
net benefit
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3-14
Using Marginal Analysis to Find
Optimal Activity Levels
 Optimal level of activity
~ When no further increases in net benefit are
possible
~ Occurs when MB = MC
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
3-15
Using Marginal Analysis to Find A*
(Figure 3.3)
Net benefit (dollars)
MB = MC
MB > MC
100
300
•c’’
MB < MC
M
•
100
•
d’’
500
A
0
200
350 = A*
600
800
1,000
NB
Level of activity
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3-16
Unconstrained Maximization with
Discrete Choice Variables
 Increase activity if MB > MC
 Decrease activity if MB < MC
 Optimal level of activity
~ Last level for which MB exceeds MC
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
3-17
Irrelevance of Sunk, Fixed, and
Average Costs
 Sunk costs
~ Previously paid & cannot be recovered
 Fixed costs
~ Constant & must be paid no matter the level
of activity
 Average (or unit) costs
~ Computed by dividing total cost by the
number of units of activity
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
3-18
Irrelevance of Sunk, Fixed, and
Average Costs
 Decision makers wishing to maximize the
net benefit of an activity should ignore
these costs, because none of these costs
affect the marginal cost of the activity and
so are irrelevant for optimal decisions
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
3-19
Constrained Optimization
 The ratio MB/P represents the
additional benefit per additional dollar
spent on the activity
 Ratios of marginal benefits to prices of
various activities are used to allocate a
fixed number of dollars among activities
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
3-20
Constrained Optimization
 To maximize or minimize an objective
function subject to a constraint
~ Ratios of the marginal benefit to price
must be equal for all activities
~ Constraint must be met
MBA MBB MBC
MBZ
... 


PA
PB
PC
PZ
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
3-21
Summary
 Marginal analysis is an analytical technique for solving
optimization problems by changing the value of a choice
variable by a small amount to see if the objective
function can be further improved
 The optimal level of the activity (A*) is that which
maximizes net benefit, and occurs where marginal
benefit equals marginal cost (MB = MC)
~ Sunk costs have previously been paid and cannot be recovered;
Fixed costs are constant and must be paid no matter the level of
activity; Average (or unit) cost is the cost per unit of activity;
these 3 types of costs are irrelevant for optimal decision making
 The ratio MB/P denotes the additional benefit of that
activity per additional dollar spent (“bang per buck”)
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3-22
Chapter 4
Basic Estimation Techniques
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
1-1
Learning Objectives
 Set up and interpret simple linear regression equations
 Estimate intercept and slope parameters of a regression
line using the method of least-squares
 Determine statistical significance using either t-tests or
p-values associated with parameter estimates
 Evaluate the “fit” of a regression equation to the data
using the R2 statistic and test for statistical significance
of the whole regression equation using an F-test
 Set up and interpret multiple regression models
 Use linear regression techniques to estimate the
parameters of two common nonlinear models: quadratic
and log-linear regression models
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
4-2
Basic Estimation
 Parameters
~ The coefficients in an equation that determine
the exact mathematical relation among the
variables
 Parameter estimation
~ The process of finding estimates of the
numerical values of the parameters of an
equation
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
4-3
Regression Analysis
 Regression analysis
~ A statistical technique for estimating the
parameters of an equation and testing for
statistical significance
 Dependent variable
~ Variable whose variation is to be explained
 Explanatory variables
~ Variables that are thought to cause the
dependent variable to take on different values
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
4-4
Simple Linear Regression
 True regression line relates dependent
variable Y to one explanatory (or
independent) variable X
Y  a  bX
~ Intercept parameter (a) gives value of Y where
regression line crosses Y-axis (value of Y when X
is zero)
~ Slope parameter (b) gives the change in Y
associated with a one-unit change in X:
b  Y X
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
4-5
Simple Linear Regression
 Regression line shows the average or
expected value of Y for each level of X
 True (or actual) underlying relation
between Y and X is unknown to the
researcher but is to be discovered by
analyzing the sample data
 Random error term
~ Unobservable term added to a regression model to
capture the effects of all the minor, unpredictable
factors that affect Y but cannot reasonably by
included as explanatory variables
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
4-6
Fitting a Regression Line
 Time series
~ A data set in which the data for the
dependent and explanatory variables are
collected over time for a single firm
 Cross-sectional
~ A data set in which the data for the
dependent and explanatory variables are
collected from many different firms or
industries at a given point in time
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
4-7
Fitting a Regression Line
 Method of least squares
~ A method of estimating the parameters of a
linear regression equation by finding the line
that minimizes the sum of the squared
distances from each sample data point to
the sample regression line
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
4-8
Fitting a Regression Line
 Parameter estimates are obtained by
choosing values of a & b that minimize
the sum of squared residuals
~ The residual is the difference between the
actual and fitted values of Y: Yi – Ŷi
~ Equivalent to fitting a line through a scatter
diagram of the sample data points
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4-9
Fitting a Regression Line
 The sample regression line is an
estimate of the true (or population)
regression line
ˆ
Yˆ  aˆ  bX
~Where â and b̂ are least squares estimates
of the true (population) parameters a and b
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
4-10
Sample Regression Line
(Figure 4.2)
S
S
60,000
Sii =
 60,000
Sales (dollars)
70,000
60,000
ei
50,000
20,000
10,000
•
•
40,000
30,000
•
Sample regression line
Ŝi = 11,573 + 4.9719A
•
= 46,376
Ŝi Ŝ
i 46,376
•
•
•
A
0
2,000
4,000
6,000
8,000
10,000
Advertising expenditures (dollars)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
4-11
Unbiased Estimators
 The estimates â & b̂ do not generally
equal the true values of a & b
~
â & b̂ are random variables computed using
data from a random sample
 The distribution of values the estimates
might take is centered around the true
value of the parameter
 An estimator is unbiased if its average
value (or expected value) is equal to the
true value of the parameter
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
4-12
Relative Frequency Distribution*
(Figure 4.3)
Relative Frequency Distribution*
for bˆ when b  5
Relative frequency of b̂
1
0
1
2
3
4
5
6
7
8
9
10
ˆ
Least-squares estimate of b (b)
*Also called a probability density function (pdf)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
4-13
Statistical Significance
 Statistical significance
~ There is sufficient evidence from the
sample to indicate that the true value of the
coefficient is not zero
 Hypothesis testing
~ A statistical technique for making a
probabilistic statement about the true value
of a parameter
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
4-14
Statistical Significance
 Must determine if there is sufficient
statistical evidence to indicate that Y is
truly related to X (i.e., b  0)
 Even if b = 0, it is possible that the
sample will produce an estimate b̂ that
is different from zero
 Test for statistical significance using
t-tests or p-values
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
4-15
Statistical Significance
 First determine the level of significance
~ Probability of finding a parameter estimate to
be statistically different from zero when, in
fact, it is zero
~ Probability of a Type I Error
 1 – level of significance = level of
confidence
~ Level of confidence is the probability of
correctly failing to reject the true hypothesis
that b = 0
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4-16
Performing a t-Test
b̂
 t-ratio is computed as t 
Sb̂
where Sb̂ is the standard error of the estimate bˆ
 Use t-table to choose critical t-value with
n – k degrees of freedom for the chosen
level of significance
n = number of observations
~ k = number of parameters estimated
~
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4-17
Performing a t-Test
 t-statistic
~ Numerical value of the t-ratio
 If the absolute value of t-statistic is
greater than the critical t, the parameter
estimate is statistically significant at the
given level of significance
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4-18
Using p-Values
 Treat as statistically significant only those
parameter estimates with p-values
smaller than the maximum acceptable
significance level
 p-value gives exact level of significance
~ Also the probability of finding significance
when none exists
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4-19
Coefficient of Determination
 R2 measures the fraction of total variation
in the dependent variable (Y) that is
explained by the variation in X
~ Ranges from 0 to 1
~ High R2 indicates Y and X are highly
correlated, and does not prove that Y and X
are causally related
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4-20
F-Test
 Used to test for significance of overall
regression equation
 Compare F-statistic to critical F-value
from F-table
~ Two degrees of freedom, n – k & k – 1
~ Level of significance
 If F-statistic exceeds the critical F, the
regression equation overall is statistically
significant at the specified level of
significance
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4-21
Multiple Regression
 Uses more than one explanatory variable
 Coefficient for each explanatory variable
measures the change in the dependent
variable associated with a one-unit
change in that explanatory variable, all
else constant
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4-22
Quadratic Regression Models
 Use when curve fitting scatter plot is
U-shaped or ∩-shaped
 Y = a + bX + cX2
~ For linear transformation compute new
variable Z = X2
~ Estimate Y = a + bX + cZ
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4-23
Log-Linear Regression Models
 Use when relation takes the form: Y = aXbZc
Percentage change in Y
b=
Percentage change in X
Percentage change in Y
c=
Percentage change in Z
 Transform by taking natural logarithms:
lnY  ln a  b ln X  c ln Z
~ b and c are elasticities
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4-24
Summary
 A simple linear regression model relates a dependent
variable Y to a single explanatory variable X
~ The regression equation is correctly interpreted as providing the
average value (expected value) of Y for a given value of X
 Parameter estimates are obtained by choosing values of
a and b that create the best-fitting line that passes
through the scatter diagram of the sample data points
 If the absolute value of the t-ratio is greater (less) than the
critical t-value, then is (is not) statistically significant
~ Exact level of significance associated with a t-statistic is its p-value
 A high R2 indicates Y and X are highly correlated and the
data tightly fit the sample regression line
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4-25
Summary
 If the F-statistic exceeds the critical F-value, the
regression equation is statistically significant
 In multiple regression, the coefficients measure the
change in Y associated with a one-unit change in that
explanatory variable
 Quadratic regression models are appropriate when the
curve fitting the scatter plot is U-shaped or ∩-shaped
(Y = a + bX + cX2)
 Log-linear regression models are appropriate when the
relation is in multiplicative exponential form (Y = aXbZc)
~ The equation is transformed by taking natural logarithms
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4-26
Chapter 5
Theory of Consumer Behavior
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1-1
Learning Objectives
 Explain the concept of utility and basic assumptions
underlying consumer preferences
 Define the concept of indifference curves and explain
the properties of indifference curves and maps
 Construct a consumer’s budget line and explain how to
rotate or shift the line when prices or income change
 Derive/interpret equilibrium conditions for a consumer to
be maximizing utility subject to a budget constraint
 Use indifference curves to derive a demand curve for an
individual consumer and construct a market demand
curve by horizontally summing individual demands
 Define a corner solution and explain the condition that
creates a corner solution
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5-2
The Consumer’s
Optimization Problem
 Individual consumption decisions are
made with the goal of maximizing total
satisfaction from consuming various
goods and services
~ Subject to the constraint that spending on
goods exactly equals the individual’s money
income
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5-3
Consumer Theory
 Assumes buyers are completely informed
about:
~ Range of products available
~ Prices of all products
~ Capacity of products to satisfy their incomes
 Requires that consumers can rank all
consumption bundles based on the level of
satisfaction they would receive from
consuming the various bundles
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5-4
Typical Consumption Bundles for
Two Goods, X & Y (Figure 5.1)
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5-5
Properties of Consumer
Preferences
 Completeness
~ For every pair of consumption bundles, A and B,
the consumer can say one of the following:
 A is preferred to B
 B is preferred to A
 The consumer is indifferent between A and B
 Transitivity
~ If A is preferred to B, and B is preferred to C,
then A must be preferred to C
 Nonsatiation
~ More of a good is always preferred to less
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5-6
Utility
 Benefits consumers obtain from goods &
services they consume is utility
 A utility function shows an individual’s
perception of the utility level attained from
consuming each conceivable bundle of
goods
U = f(X, Y)
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5-7
Indifference Curves
 Set of points representing different
bundles of goods & services, each of
which yields the same level of total utility
 Downward-sloping & convex
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5-8
Typical Indifference Curve
(Figure 5.2)
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5-9
Marginal Rate of Substitution
 MRS measures the number of units of Y
that must be given up per unit of X added
so as to keep utility constant
~ Negative of the slope of the indifference curve
~ Diminishes along the indifference curve as X
increases & Y decreases
~ Ratio of the marginal utilities of the goods
Y MU X

MRS  
X MUY
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5-10
Slope of an Indifference Curve &
the MRS (Figure 5.3)
Quantity of good Y
600
A
T
C (360,320)
320
I
T’
B
0
360
800
Quantity of good X
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5-11
Indifference Maps
 An indifference map consists of several
indifference curves
 The higher (or further to the right) an
indifference curve, the greater the level
of utility associated with the curve
 Combinations of goods on higher
indifference curves are preferred to
combinations on lower curves
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5-12
(Figure 5.4)
Quantity of Y
Indifference Map
IV
III
II
I
Quantity of X
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5-13
Marginal Utility
 Addition to total utility attributable to the
addition of one unit of a good to the
current rate of consumption, holding
constant the amounts of all other goods
consumed
MU  U X
Y MU X

MRS  
X MUY
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5-14
Consumer’s Budget Line
 Shows all possible bundles of goods that
can be purchased at given prices if the
entire income is spent
M  PX X  PY Y
or
M PX
Y

X
PY PY
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5-15
Consumer’s Budget Constraint
(Figure 5.5)
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5-16
Typical Budget Line
Quantity of Y
M
PY
(Figure 5.6)
•A
Y
M PX

X
PY PY
•
Quantity of X
B
M
PX
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5-17
Shifting Budget Lines (Figure 5.7)
100
80
R
A
Quantity of Y
Quantity of Y
120
F
Z
B
N
160
200
240
Quantity of X
Panel A – Changes in money income
100
A
C
125
D
B
200
250
Quantity of X
Panel B – Changes in price of X
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5-18
Utility Maximization
 Utility maximization subject to a limited
income occurs at the combination of
goods for which the indifference curve is
just tangent to the budget line
PX
Y

 MRS 
X
PY
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5-19
Utility Maximization
 Consumer allocates income so that the
marginal utility per dollar spent on each
good is the same for all commodities
purchased
MU X PX
MRS 

MUY
PY
MU X MUY

PX
PY
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5-20
Constrained Utility Maximization
(Figure 5.8)
50
Quantity of pizzas
45
•A
40
•B
•D
•
R
30
E
IV
III
20
•
15
10
0
10
20
30
40
50
60
70
C
II
T
I
80
90
100
Quantity of burgers
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5-21
Utility Maximization, N Goods
 The utility maximization principle is
easily extended to cover any number of
goods
Pj
X i

 MRS 
Pi
X j
MU1 MU 2 MU 3
MU N


 ... 
P1
P2
P3
PN
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5-22
Individual Consumer Demand
 An individual’s demand curve for a
specific commodity relates utilitymaximizing quantities purchased to
market prices
~ Income & prices held constant
~ Slope of demand curve illustrates law of
demand—quantity demanded varies
inversely with price
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5-23
Deriving a Demand Curve
(Figure 5.9)
Quantity of Y
100
Px=$10
Px=$8
Px=$5
Price of X ($)
0
50 65
90 100
125
200
Quantity of X
10
8
5
Demand for X
0
50 65
90
Quantity of X
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5-24
Market Demand & Marginal Benefit
 List of prices & quantities consumers are
willing & able to purchase at each price, all
else constant
 Derived by horizontally summing demand
curves for all individuals in market
 Because prices along market demand
measure the economic value of each unit of
the good, it can be interpreted as the
marginal benefit curve for a good
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5-25
Derivation of Market Demand
(Table 5.1)
Quantity demanded
Price
Consumer 1
Consumer 2
Consumer 3
Market
demand
$6
3
0
0
3
5
5
1
0
6
4
8
3
1
12
3
10
5
4
19
2
12
7
6
25
1
13
10
8
31
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5-26
Derivation of Market Demand
Figure (5.10)
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5-27
Corner Solution
 In many cases consumers spend their
entire budget and choose to purchase
none of some specific good
 A corner solution exists when the utility
maximizing bundle lies at one of the
endpoints of the budget line and the
consumer chooses to consume zero
units of a good
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5-28
Corner Solution: X* = 0
Figure (5.11)
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5-29
Corner Solution
 For goods X and Y, a corner solution, in which
the consumer purchases none of good X, results
when
MU X MUY

PX
PY
 In general, a corner solution, in which the
consumer purchases none of good X, results
when
MU j
MU X MU i

 ... 
PX
Pi
Pj
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5-30
Summary
 Basic premise for analyzing consumer behavior
~ Individuals make consumption decisions with the goal of
maximizing their total satisfaction from consuming various
goods and services, subject to the constraint that their spending
on goods exactly equals their incomes
 The benefit consumers obtain from the goods and
services they consume is called utility
~ The utility function shows an individual's perception of the level
of utility from consuming each conceivable bundle of goods
~ Marginal utility is the addition to total utility attributable to adding
one unit of a good, holding constant the amounts of all other
goods consumed
~ The marginal rate of substitution (MRS) shows the rate at which
one good can be substituted for another while keeping utility
constant
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5-31
Summary
 An indifference curve is a set of points representing
different bundles of goods and services, each of which
yields the same level of total utility
 The consumer’s budget line shows the set of all
consumption bundles that can be purchased at given
prices and income if the entire income is spent
 A consumer maximizes utility subject to a limited
income at the combination of goods for which the
indifference curve is just tangent to the budget line
~ At this combination, the MRS is equal to the price ratio
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5-32
Summary
 An individual consumer’s demand curve relates utilitymaximizing quantities to market prices, holding
constant income and prices of all other goods
~ The slope of the demand curve illustrates the law of demand:
quantity demanded varies inversely with price
 Market demand is derived by horizontally summing the
demand curves for all individuals in the market
 When a consumer spends the entire budget and
chooses to purchase none of a specific good, this
outcome is called a corner solution
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5-33
Chapter 6
Elasticity & Demand
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1-1
Learning Objectives
 Define price elasticity of demand and use it to predict
changes in quantity demanded and price of a good
 Explain the role price elasticity plays in determining how
a change in price affects total revenue
 Explain factors that affect price elasticity of demand
 Calculate price elasticity over an interval and at a point
on a demand curve
 Relate marginal revenue to total revenue and demand
elasticity and write the marginal revenue equation for
linear inverse demand functions
 Define/compute income elasticity of demand and
cross-price elasticity of demand
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6-2
Price Elasticity of Demand (E)
 Measures responsiveness or sensitivity
of consumers to changes in the price of
a good
 Q
E
 P
 P & Q are inversely related by the law of
demand so E is always negative
~ The larger the absolute value of E, the more
sensitive buyers are to a change in price
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6-3
Price Elasticity of Demand (E)
Table 6.1
Elasticity
Responsiveness
E
Elastic
%∆Q> %∆P E> 1
Unitary Elastic
%∆Q= %∆P E= 1
Inelastic
%∆Q< %∆P E< 1
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6-4
Price Elasticity of Demand (E)
 Percentage change in quantity demanded
can be predicted for a given percentage
change in price as:
%Qd = %P x E
 Percentage change in price required for a
given change in quantity demanded can be
predicted as:
%P = %Qd ÷ E
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6-5
Price Elasticity & Total Revenue
 Total revenue
~ Total amount paid to producers for a good or
service (TR = P x Q)
 Price effect
~ The effect on total revenue of changing price,
holding output constant
 Quantity effect
~ The effect on total revenue of changing
output, holding price constant
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6-6
Price Elasticity & Total Revenue
Table 6.2
Elastic
Unitary elastic
Inelastic
%∆Q> %∆P %∆Q= %∆P%∆Q< %∆P
Quantity effect
dominates
No dominant
effect
Price effect
dominates
Price
rises
TR falls
No change in TR
TR rises
Price
falls
TR rises
No change in TR
TR falls
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6-7
Factors Affecting
Price Elasticity of Demand
 Availability of substitutes
~ The better & more numerous the substitutes for a
good, the more elastic is demand
 Percentage of consumer’s budget
~ The greater the percentage of the consumer’s
budget spent on the good, the more elastic is
demand
 Time period of adjustment
~ The longer the time period consumers have to
adjust to price changes, the more elastic is
demand
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6-8
Calculating
Price Elasticity of Demand
 Price elasticity can be calculated by
multiplying the slope of demand (Q/P)
times the ratio of price to quantity (P/Q)
Q
100
Q P
Q
 Q



E
P
 P
P Q
100
P
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6-9
Calculating
Price Elasticity of Demand
 Price elasticity can be measured at an
interval (or arc) along demand, or at a
specific point on the demand curve
~ If the price change is relatively small, a point
calculation is suitable
~ If the price change spans a sizable arc along
the demand curve, the interval calculation
provides a better measure
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6-10
Computation of Elasticity
Over an Interval
 When calculating price elasticity of
demand over an interval of demand, use
the interval or arc elasticity formula
Q Average P
E

P Average Q
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6-11
Computation of Elasticity at a Point
 When calculating price elasticity at a point
on demand, multiply the slope of demand
(Q/P), computed at the point of
measure, times the ratio P/Q, using the
values of P and Q at the point of measure
 Method of measuring point elasticity
depends on whether demand is linear or
curvilinear
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6-12
Point Elasticity When
Demand is Linear
 Given Q = a + bP + cM + dPR, let income
& price of the related good take specific
values M and PR , respectively
 Then express demand as Q = a′ + bP,
where a′ = a + cM + dPR and the slope
parameter is b = ∆Q ∕ ∆P
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6-13
Point Elasticity When
Demand is Linear
 Compute elasticity using either of the two
formulas below which give the same value for E
P
P
Eb
or E 
Q
PA
Where P and Q are values of price and quantity
demanded at the point of measure along demand, and
A ( = –a′ ∕ b) is the price-intercept of demand
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6-14
Point Elasticity When
Demand is Curvilinear
 Compute elasticity using either of two
equivalent formulas below
Q P
P
 
E
P Q P  A
Where ∆Q ∕ ∆P is the slope of the curved demand at
the point of measure, P and Q are values of price and
quantity demanded at the point of measure, and A is
the price-intercept of the tangent line extended to cross
the price axis
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6-15
Elasticity (Generally) Varies Along
a Demand Curve
 For linear demand, price and Evary
directly
~ The higher the price, the more elastic is demand
~ The lower the price, the less elastic is demand
 For curvilinear demand, no general rule
about the relation between price and
quantity
~ Special case of Q = aPb which has a constant
price elasticity (equal to b) for all prices
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6-16
Constant Elasticity of Demand
(Figure 6.3)
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6-17
Marginal Revenue
 Marginal revenue (MR) is the change in total
revenue per unit change in output
 Since MR measures the rate of change in total
revenue as quantity changes, MR is the slope
of the total revenue (TR) curve
TR
MR 
Q
 Inframarginal units
~ Units of output that could have been sold at a higher
price had a firm not lowered its price to sell the
marginal unit
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6-18
Demand & Marginal Revenue
(Table 6.3)
TR = P  Q
MR = TR/Q
Unit sales (Q)
Price
0
$ 4.50
$ 0.00
1
4.00
4.00
$ 4.00
2
3.50
$7.00
$3.00
3
3.10
$9.30
$2.30
4
2.80
$11.20
1.90
5
2.40
$12.00
$ 0.80
6
2.00
$12.00
0.00
7
1.50
$ 10.50
$ -1.50
--
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6-19
Demand, MR, & TR
Panel A
(Figure 6.4)
Panel B
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6-20
Demand & Marginal Revenue
 When inverse demand is linear,
P = A + BQ (A > 0, B < 0)
~ Marginal revenue is also linear, intersects
the vertical (price) axis at the same point as
demand, & is twice as steep as demand
MR = A + 2BQ
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6-21
Linear Demand, MR, & Elasticity
(Figure 6.5)
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6-22
MR, TR, & Price Elasticity
(Table 6.4)
Total revenue
Price elasticity
of demand
TR increases as
Q increases
(P decreases)
Elastic
(│E│> 1)
MR = 0
TR is maximized
Unit Elastic
(│E│= 1)
MR < 0
TR decreases as
Q increases
(P decreases)
Inelastic
(│E│< 1)
Marginal
revenue
MR > 0
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6-23
Marginal Revenue & Price Elasticity
 For all demand & marginal revenue
curves, the relation between marginal
revenue, price, & elasticity can be
expressed as
1

MR  P  1  
E

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6-24
Income Elasticity
 Income elasticity (EM) measures the
responsiveness of quantity demanded to
changes in income, holding the price of the
good & all other demand determinants
constant
~ Positive for a normal good
~ Negative for an inferior good
 Qd Qd M
EM 


 M M Qd
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6-25
Cross-Price Elasticity
 Cross-price elasticity (EXR) measures the
responsiveness of quantity demanded of good
X to changes in the price of related good R,
holding the price of good X & all other demand
determinants for good X constant
~ Positive when the two goods are substitutes
~ Negative when the two goods are complements
E XR
 QX QX PR



 PR
PR Q X
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6-26
Interval Elasticity Measures
 To calculate interval measures of income &
cross-price elasticities, the following
formulas can be employed
Q Average M
EM 

M Average Q
E XR
Q Average PR


PR Average Q
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6-27
Point Elasticity Measures
 For the linear demand function
Q = a + bP + cM + dPR, point measures of
income & cross-price elasticities can be
calculated as
M
EM  c
Q
E XR
PR
d
Q
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6-28
Summary
 Price elasticity of demand, E, measures responsiveness
or sensitivity of consumers to changes in the price of a
good : E = %ΔQd / %ΔP
~ The larger the absolute value of E, the more sensitive buyers will
be to a change in price
 The effect of changing price on total revenue is
determined by the price elasticity of demand. When
demand is elastic (inelastic), the quantity (price) effect
dominates
 Several factors affect the elasticity of demand:
~ availability of substitutes for a good
~ percentage of the consumers’ budgets spent on the good
~ length of time consumers have to adjust to price changes
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6-29
Summary
 When demand is linear, the point elasticity can be
computed as: E = b(P/Q) or E = P / (P– A)
 When MR is positive (negative), total revenue increases
(decreases) as quantity increases, and demand is
elastic (inelastic). When MR is 0, the price elasticity of
demand is unitary and total revenue is maximized
~ For any demand curve, when demand is elastic (inelastic), MR is
positive (negative). When demand is unitary elastic, MR is 0
 Income elasticity, EM, measures the responsiveness of
quantity demanded to income changes all else constant
 Cross-price elasticity, EXY , measures the
responsiveness of quantity demanded of good X to
changes in the price of good Y, all else constant
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6-30
Chapter 7
Demand Estimation &
Forecasting
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7-1
Learning Objectives
 Explain strengths and weaknesses of direct methods
of demand estimation
 Specify an empirical demand function
 Employ linear regression methodology to estimate
the demand function for a single price-setting firm
 Forecast sales and prices using time-series
regression analysis
 Use dummy variables in time-series demand analysis
to account for cyclical or seasonal variation in sales
 Discuss and explain several important problems that
arise when using statistical methods to forecast
demand
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7-2
Direct Methods of Demand Estimation
 Consumer interviews
~ Range from stopping shoppers to speak
with them to administering detailed
questionnaires
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7-3
Direct Methods of Demand Estimation
 Potential problems with consumer
interviews
~ Selection of a representative sample, which is a
sample (usually random) having characteristics
that accurately reflect the population as a whole
~ Response bias, which is the difference between
responses given by an individual to a
hypothetical question and the action the
individual takes when the situation actually
occurs
~ Inability of the respondent to answer accurately
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7-4
Direct Methods of Demand Estimation
 Market studies & experiments
~ Market studies attempt to hold everything
constant during the study except the price of
the good
~ Lab experiments use volunteers to simulate
actual buying conditions
~ Field experiments observe actual behavior of
consumers
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7-5
Empirical Demand Functions
 Demand equations derived from actual
market data
 Useful in making pricing & production
decisions
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7-6
Empirical Demand Functions
 In linear form, an empirical demand function
can be specified as
Q  a  bP  cM  dPR  eN
where Q is quantity demanded, P is the price of the
good or service, M is consumer income, PR is the
price of some related good R, and N is the number
of buyers
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7-7
Empirical Demand Functions
Q  a  bP  cM  dPR  eN
 In linear form
~ b = Q/P
~ c = Q/M
~ d = Q/PR
 Expected signs of coefficients
~ b is expected to be negative
~ c is positive for normal goods; negative for inferior
goods
~ d is positive for substitutes; negative for complements
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7-8
Empirical Demand Functions
Q  a  bP  cM  dPR  eN
 Estimated elasticities of demand are
computed as
P
ˆ
ˆ
Eb
Q
M
ˆ
ˆ
EM  c
Q
PR
ˆ
ˆ
E XR  d
Q
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7-9
Nonlinear Empirical Demand
Specification
 When demand is specified in log-linear
form, the demand function can be written
b
c d
e
as
Q  aP M P N
R
 To estimate a log-linear demand function,
covert to logarithms
ln Q  ln a  b ln P  c ln M  d ln PR  e ln N
 In this form, elasticities are constant
Eˆ  bˆ
Eˆ M  cˆ
Eˆ XR  dˆ
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7-10
Demand for a Price-Setter
 To estimate demand function for a pricesetting firm:
~ Step 1: Specify price-setting firm’s demand
function
~ Step 2: Collect data for the variables in the
firm’s demand function
~ Step 3: Estimate firm’s demand
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7-11
Time-Series Forecasts
 A time-series model shows how a timeordered sequence of observations on a
variable is generated
 Simplest form is linear trend forecasting
~ Sales in each time period (Qt ) are assumed
to be linearly related to time (t)
Qt  a  bt
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7-12
Linear Trend Forecasting
 Use regression analysis to estimate
values of a and b
ˆ
Qˆ t  aˆ  bt
~ If b > 0, sales are increasing over time
~ If b < 0, sales are decreasing over time
~ If b = 0, sales are constant over time
 Statistical significance of a trend is
determined by testing b̂ or by examining
the p-value for b̂
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7-13
A Linear Trend Forecast
(Figure 7.1)
Q
Estimated trend line

Q̂ 2009
12
2018
Q̂ 2004
20137
Sales
 


2018
2013
2012
2011
2010
2009
2008
2007
2006
2005
  
2004
2003

 

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t
7-14
Forecasting Sales for Terminator
Pest Control (Figure 7.2)
2013
2013
2013
2013
2013
2013
2013
2013
2013
2013
2013
2013
2014
2014
2014
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
7-15
Seasonal (or Cyclical) Variation
 Can bias the estimation of parameters in
linear trend forecasting
 To account for such variation, dummy
variables are added to the trend equation
~ Shift trend line up or down depending on the
particular seasonal pattern
~ Significance of seasonal behavior determined
by using t-test or p-value for the estimated
coefficient on the dummy variable
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7-16
Sales with Seasonal Variation
(Figure 7.3)




2010

 
2011


 

2012
 

2013
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7-17
Dummy Variables
 To account for N seasonal time periods
~ N – 1 dummy variables are added
 Each dummy variable accounts for one
seasonal time period
~ Takes value of one (1) for observations that
occur during the season assigned to that
dummy variable
~ Takes value of zero (0) otherwise
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7-18
Effect of Seasonal Variation
(Figure 7.4)
Qt
Qt = a′ + bt
Sales
Qt = a + bt
a′
c
a
t
Time
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7-19
Some Final Warnings
 The further into the future a forecast is
made, the wider is the confidence interval
or region of uncertainty
 Model misspecification, either by
excluding an important variable or by
using an inappropriate functional form,
reduces reliability of the forecast
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
7-20
Some Final Warnings
 Forecasts are incapable of predicting
sharp changes that occur because of
structural changes in the market
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7-21
Summary
 Consumer interviews and market studies are two
direct methods of demand estimation
~ Problems can include: (1) selection of a representative
sample; (2) response bias; and (3) inability of the respondent
to answer accurately
 Empirical demand functions are demand equations
derived from actual market data and are extremely
useful in making pricing and production decisions
 The first step to estimating a single price-setting
firm’s demand is to specify the demand function; the
second step is to collect data; the third step is to
estimate the parameters using the linear regression
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7-22
Summary
 A time-series model shows how a time-ordered
sequence of observations on a variable is generated
~ The simplest form of time-series forecasting is linear trend
forecasting
 Seasonal or cyclical variation can bias results in
linear trend models; to account for this, dummy
variables are added to the trend equation
~ Dummy variables take a value of 1 for those observations
that occur during the season assigned to that dummy
variable, and a value of 0 otherwise
 When making forecasts, analysts must recognize the
limitations that are inherent in forecasting
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7-23
Chapter 8
Production & Cost in the
Short Run
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7-1
Learning Objectives
 Explain general concepts of production and cost
analysis
 Examine the structure of short-run production based on
the relation among total, average, and marginal
products
 Examine the structure of short-run costs using graphs of
the total cost curves, average cost curves, and the
short-run marginal cost curve
 Relate short-run costs to the production function using
the relations between (i) average variable cost and
average product, and (ii) short-run marginal cost and
marginal product
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8-2
Basic Concepts of
Production Theory
 Production function
~ A schedule showing the maximum amount of
output that can be produced from any specified
set of inputs, given existing technology
 Variable proportions production
~ Production in which a given level of output can be
produced with more than one combination of
inputs
 Fixed proportions production
~ Production in which one, and only one, ratio of
inputs can be used to produce a good
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8-3
Basic Concepts of
Production Theory
 Technical efficiency
~ Achieved when maximum amount of output is
produced with a given combination of inputs
and technology
 Economic efficiency
~ Achieved when firm is producing a given
output at the lowest possible total cost
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8-4
Basic Concepts of
Production Theory
 Inputs are considered variable or fixed depending
on how readily their usage can be changed
 Variable input
~ An input for which the level of usage may be varied to
increase or decrease output
 Fixed input
~ An input for which the level of usage cannot be changed
and which must be paid even if no output is produced
 Quasi-fixed input
~ A “lumpy” or indivisible input for which a fixed amount must
be used for any positive level of output
~ None is purchased when output is zero
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8-5
Basic Concepts of
Production Theory
 Short run
~ Current time span during which at least one
input is a fixed input
 Long run
~ Time period far enough in the future to allow
all fixed inputs to become variable inputs
 Planning horizon
~ Set of all possible short-run situations the firm
can face in the future
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8-6
Sunk Costs
 Sunk cost
~ Payment for an input that, once made, cannot
be recovered should the firm no longer wish
to employ that input
~ Irrelevant for all future time periods; not part
of the economic cost of production in future
time periods
~ Should be ignored for decision making
purposes
~ Fixed costs are sunk costs
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8-7
Avoidable Costs
 Avoidable costs
~ Input costs the firm can recover or avoid
paying should it no longer wish to employ that
input
~ Matter in decision making and should not be
ignored
~ Variable costs and quasi-fixed costs are
avoidable costs
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8-8
Inputs in Production
(Table 8.1)
Input Type
Payment
Relation
to Output
Avoidable
or Sunk?
Employed in
SR or LR?
Variable
Variable cost
Direct
Avoidable
SR & LR
Fixed
Fixed costs
Constant
Sunk
SR only
Quasi-fixed
Quasi-fixed costs
Constant
Avoidable
If required:
SR & LR
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8-9
Short Run Production
 In the short run, capital is fixed
~ Only changes in the variable labor input can
change the level of output
 Short run production function
Q = f (L, K) = f (L)
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8-10
Average & Marginal Products
 Average product of labor
~ AP = Q/L
 Marginal product of labor
~ MP = Q/L
 When AP is rising, MP is greater than AP
 When AP is falling, MP is less than AP
 When AP reaches it maximum, AP = MP
 Law of diminishing marginal product
~ As usage of a variable input increases, a point is
reached beyond which its marginal product decreases
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8-11
Total, Average, & Marginal Products
of Labor, K = 2 (Table 8.3)
Number of
workers (L)
Total product (Q) Average product
(AP=Q/L)
Marginal product
(MP=Q/L)
0
0
--
--
1
52
52
52
2
112
56
60
3
170
56.7
58
4
220
55
50
5
258
51.6
38
6
286
47.7
28
7
304
43.4
18
8
314
39.3
10
9
318
35.3
4
10
314
31.4
-4
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8-12
Total, Average, & Marginal Products
K = 2 (Figure 8.1)
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8-13
Short Run Production Costs
 Total fixed cost (TFC)
~ Total amount paid for fixed inputs
~ Does not vary with output
 Total variable cost (TVC)
~ Total amount paid for variable inputs
~ Increases as output increases
 Total cost (TC)
TC = TFC + TVC
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8-14
Short-Run Total Cost Schedules
(Table 8.5)
Output (Q)
Total fixed cost
(TFC)
Total variable cost
(TVC)
Total Cost
(TC=TFC+TVC)
0
$ 6,000
6,000
4,000
10,000
200
6,000
6,000
12,000
300
6,000
9,000
15,000
400
6,000
14,000
20,000
500
6,000
22,000
28,000
600
6,000
34,000
40,000
0
$6,000
100
$
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8-15
Total Cost Curves
(Figure 8.3)
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8-16
Average Costs
 Average fixed cost (AFC)
TFC
AVC 
Q
 Average variable cost (AVC)
TVC
AFC 
Q
 Average total cost (ATC)
TC
ATC 
 AFC  AVC
Q
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8-17
Short Run Marginal Cost
 Short run marginal cost (SMC) measures
rate of change in total cost (TC) as output
varies
TVC TC
SMC 

Q
Q
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8-18
Average & Marginal Cost Schedules
(Table 8.6)
Output
(Q)
Average
Average
fixed cost
variable cost
(AFC=TFC/Q) (AVC=TVC/Q)
Average total
cost
(ATC=TC/Q=
AFC+AVC)
--
Short-run
marginal cost
(SMC=TC/Q)
0
--
--
100
$60
$40
$100
$40
200
30
30
60
20
300
20
30
50
30
400
15
35
50
50
500
12
44
56
80
600
10
56.7
66.7
--
120
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8-19
Average & Marginal Cost Curves
(Figure 8.4)
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8-20
Short Run Average & Marginal
Cost Curves (Figure 8.5)
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8-21
Short Run Cost Curve Relations
 AFC decreases continuously as output
increases
~ Equal to vertical distance between ATC &
AVC
 AVC is U-shaped
~ Equals SMC at AVC’s minimum
 ATC is U-shaped
~ Equals SMC at ATC’s minimum
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8-22
Short Run Cost Curve Relations
 SMC is U-shaped
~ Intersects AVC & ATC at their minimum
points
~ Lies below AVC & ATC when AVC & ATC
are falling
~ Lies above AVC & ATC when AVC & ATC
are rising
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8-23
Relations Between Short-Run
Costs & Production
 In the case of a single variable input,
short-run costs are related to the
production function by two relations
w
w
and SMC 
AVC 
AP
MP
Where w is the price of the variable input
TC = wL + rK
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8-24
Short-Run Production & Cost
Relations (Figure 8.6)
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8-25
Relations Between Short-Run
Costs & Production
 When marginal product (average
product) is increasing, marginal cost
(average cost) is decreasing
 When marginal product (average
product) is decreasing, marginal cost
(average variable cost) is increasing
 When marginal product = average
product at maximum AP, marginal cost =
average variable cost at minimum AVC
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8-26
Summary
 Technical efficiency occurs when a firm produces
maximum output for a given input combination and
technology; economic efficiency is achieved when the
firm produces a given output at the lowest total cost
~ Production inputs can be variable, fixed, or quasi-fixed inputs
 Short run refers to the current time span during which
one or more inputs are fixed; Long run refers to the
period far enough in the future that all fixed inputs
become variable inputs
 Sunk costs are irrelevant for future decisions and are
not part of economic cost of production in future time
periods; avoidable costs are payments a firm can
recover or avoid, thus they do matter in decisions
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8-27
Summary
 The total product curve gives the economically efficient
amount of labor for any output level when capital is
fixed in the short run
 Average product of labor is the total product divided by
the number of workers: AP = Q/L
 Marginal product of labor is the additional output
attributable to using one additional worker with the use
of capital fixed: MP = ∆Q/∆L
 The law of diminishing marginal product states that as
the number of units of the variable input increases,
other inputs held constant, a point will be reached
beyond which the marginal product of the variable input
declines
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8-28
Summary
 Short-run total cost, TC, is the sum of total variable
cost, TVC, and total fixed cost, TFC: TC = TVC + TFC
 Average fixed cost, AFC, is TFC divided by output:
AFC = TFC/Q; average variable cost, AVC, is TVC
divided by output: AVC = TVC/Q; average total cost
(ATC) is TC divided by output: ATC = TC/Q
 Short-run marginal cost, SMC, is the change in either
TVC or TC per unit change in output Q
 The link between product curves and cost curves in the
short run when one input is variable is reflected in the
relations , AVC = w/AP and SMC = w/MP, where w is
the price of the variable input
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8-29
Chapter 9
Production & Cost in the
Long Run
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9-1
Learning Objectives
 Graph a typical production isoquant and discuss the
properties of isoquants
 Construct isocost curves
 Use optimization theory to find optimal input
combination
 Construct the firm’s expansion path and show how it
relates to the firm’s long-run cost structure
 Calculate long-run total, average, and marginal costs
 Explain how a variety of forces affect long-run costs:
scale, scope, learning, and purchasing economies.
 Show the relation between long-run and short-run cost
curves using long-run and short-run expansion paths
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9-2
Production Isoquants
 In the long run, all inputs are variable &
isoquants are used to study production
decisions
~ An isoquant is a curve showing all possible
input combinations physically capable of
producing a given level of output
~ Isoquants are downward sloping; if greater
amounts of labor are used, less capital is
required to produce a given output
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9-3
A Typical Isoquant Map
(Figure 9.1)
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9-4
Marginal Rate of
Technical Substitution
 The MRTS is the slope of an isoquant &
measures the rate at which the two inputs
can be substituted for one another along an
isoquant while maintaining a constant level
of output
K
MRTS  
L
The minus sign is added to make MRTS a positive
number since ∆K/∆L, the slope of the isoquant, is
negative
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9-5
Marginal Rate of
Technical Substitution
 The MRTS can also be expressed as the
ratio of two marginal products:
MPL
MRTS 
MPK
As labor is substituted for capital, MPL declines &
MPK rises causing MRTS to diminish
K MPL
MRTS  

L MPK
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9-6
Isocost Curves
 Show various combinations of inputs that may
be purchased for given level of expenditure
(C) at given input prices (w, r)
C  wL rK
C w
K  L
r r
 Slope of an isocost curve is the negative of
the input price ratio (-w/r)
 K-intercept is C/r
~ Represents amount of capital that may be
purchased if zero labor is purchased
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9-7
Isocost Curves
(Figure 9.3)
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9-8
Optimal Combination of Inputs
 Minimize total cost of producing a given
Q by choosing the input combination on
the isoquant for which Q is just tangent to
an isocost curve
~ Two slopes are equal in equilibrium
~ Implies marginal product per dollar spent on last
unit of each input is the same
MPL w
MPL MPK
MRTS 

or

MPK
r
w
r
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9-9
Optimal Input Combination to Minimize
Cost for Given Output (Figure 9.4)
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9-10
Output Maximization for Given Cost
(Figure 9.5)
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9-11
Optimization & Cost
 Expansion path gives the efficient (leastcost) input combinations for every level of
output
~ Derived for a specific set of input prices
~ Along expansion path, input-price ratio is
constant & equal to the marginal rate of
technical substitution
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9-12
Expansion Path
(Figure 9.6)
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9-13
Long-Run Costs
 Long-run total cost (LTC) for a given level
of output is given by:
LTC = wL* + rK*
Where w & r are prices of labor & capital, respectively,
& (L*, K*) is the input combination on the expansion
path that minimizes the total cost of producing that
output
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9-14
Long-Run Costs
 Long-run average cost (LAC) measures the
cost per unit of output when production can be
adjusted so that the optimal amount of each
input is employed
~ LAC is U-shaped
~ Falling LAC indicates economies of scale
~ Rising LAC indicates diseconomies of scale
LTC
LAC 
Q
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9-15
Long-Run Costs
 Long-run marginal cost (LMC) measures the
rate of change in long-run total cost as output
changes along expansion path
~ LMC is U-shaped
~ LMC lies below LAC when LAC is falling
~ LMC lies above LAC when LAC is rising
~ LMC = LAC at the minimum value of LAC
LTC
LMC 
Q
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9-16
Derivation of a Long-Run Cost
Schedule (Table 9.1)
Least-cost
combination of
Output
Labor
(units)
Capital
(units)
Total cost
(w = $5, r = $10)
LAC
LMC
LMC
100
10
7
$120
$1.20
$1.20
200
12
8
140
0.70
0.20
300
20
10
200
0.67
0.60
400
30
15
300
0.75
1.00
500
40
22
420
0.84
1.20
600
52
30
560
0.93
1.40
700
60
42
720
1.03
1.60
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9-17
Long-Run Total, Average, &
Marginal Cost (Figure 9.8)
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9-18
Long-Run Average & Marginal
Cost Curves (Figure 9.9)
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9-19
Economies of Scale
 Larger-scale firms are able to take greater
advantage of opportunities for
specialization & division of labor
 Scale economies also arise when quasifixed costs are spread over more units of
output causing LAC to fall
 Variety of technological factors can also
contribute to falling LAC
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
9-20
Economies & Diseconomies
of Scale (Figure 9.10)
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9-21
Constant Long-Run Costs
 Absence of economies and diseconomies
of scale
~ Firm experiences constant costs in the long
run
~ LAC curve is flat & equal to LMC at all output
levels
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
9-22
Constant Long-Run Costs
(Figure 9.11)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
9-23
Minimum Efficient Scale (MES)
 The minimum efficient scale of operation
(MES) is the lowest level of output
needed to reach the minimum value of
long-run average cost
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9-24
Minimum Efficient Scale (MES)
(Figure 9.12)
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9-25
MES with Various Shapes of LAC
(Figure 9.13)
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9-26
Economies of Scope
 Exist for a multi-product firm when the joint cost
of producing two or more goods is less than the
sum of the separate costs for specialized,
single-product firms to produce the two goods:
LTC(X, Y) < LTC(X,0) + LTC(0,Y)
 Firms already producing good X can add
production of good Y at a lower cost than a
single-product firm can produce Y:
LTC(X, Y) – LTC(X,0) < LTC(0,Y)
 Arise when firms produce joint products or
employ common inputs in production
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9-27
Purchasing Economies of Scale
 Purchasing economies of scale arise
when large-scale purchasing of raw
materials enables large buyers to obtain
lower input prices through quantity
discounts
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9-28
Purchasing Economies of Scale
(Figure 9.14)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
9-29
Learning or Experience Economies
 “Learning by doing” or “Learning through
experience”
 As total cumulative output increases,
learning or experience economies cause
long-run average cost to fall at every
output level
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
9-30
Learning or Experience Economies
(Figure 9.15)
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9-31
Relations Between Short-Run &
Long-Run Costs
 LMC intersects LAC when the latter is at its
minimum point
 At each output where a particular ATC is
tangent to LAC, the relevant SMC = LMC
 For all ATC curves, point of tangency with LAC
is at an output less (greater) than the output of
minimum ATC if the tangency is at an output
less (greater) than that associated with
minimum LAC
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9-32
Long-Run Average Cost as the
Planning Horizon (Figure 9.16)
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9-33
Restructuring Short-Run Costs
 Because managers have greatest flexibility
to choose inputs in the long run, costs are
lower in the long run than in the short run for
all output levels except that for which the
fixed input is at its optimal level
~ Short-run costs can be reduced by adjusting fixed
inputs to their optimal long-run levels when the
opportunity arises
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9-34
Restructuring Short-Run Costs
(Figure 9.14)
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9-35
Summary
 In the long run, all fixed inputs become variable inputs
~ An isoquant is a curve showing all possible input combinations
capable of producing a given level of output
~ The marginal rate of technical substitution, MRTS, is the slope
of an isoquant and measures the rate at which the two inputs
can be substituted for one another while maintaining a constant
level of output
 Isocost curves show the various combinations of inputs
that may be purchased for a given level of expenditure
at given input prices
~ The isocost curve’s slope is the negative of the input price ratio
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9-36
Summary
 Minimize total cost of producing a given quantity of
output by choosing the input combination on the
isoquant that is just tangent to an isocost curve
~ The two slopes are equal in equilibrium
~ Maximizing output for a given level of expenditure requires
choosing an input combination satisfying the exact same
conditions as for minimizing costs
 The expansion path shows the optimal (or efficient)
input combination for every level of output; long-run
cost curves are derived from the expansion path
 LMC lies below (above) LAC when LAC is falling
(rising); LMC equals LAC at LAC’s minimum value
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9-37
Summary
 When LAC is decreasing, economies of scale are
present, and when LAC is increasing, diseconomies of
scale are present; Economies of scope arise when
firms produce joint products or when firms employ
common inputs in production
 Because managers possess the greatest flexibility in
choosing inputs in the long run, long-run costs are
lower than short-run costs for all output levels except
the output level for which the short-run fixed input is at
its optimal level
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9-38
Chapter 10
Production & Cost Estimation
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1-1
Learning Objectives
 Specify and explain the properties of a short-run cubic
production function
 Employ regression analysis to estimate a short-run
production function
 Discuss two important problems concerning the proper
measurement of cost: correcting for inflation and
measuring economic (opportunity) costs
 Specify and estimate a short-run cost function using a
cubic specification
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10-2
Empirical Production Function
 An empirical production function is the
mathematical form of the production
function to be estimated
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10-3
Empirical Production Function
 Long-run production function
~ A production function in which all inputs are
variable
 Short-run production function
~ A production function in which at least one
input is fixed
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10-4
Empirical Production Function
 Cubic empirical specification for a shortrun production function is derived from a
long-run cubic production function
 Cubic form of the long-run production
function is expressed as
Q  aK L  bK L
3 3
2
2
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10-5
Properties of a Short-Run Cubic
Production Function
Q  AL  BL
3
2
 Holding capital constant, short-run
cubic production function is derived as
follows:
Q  aK L  bK L
3
2
 AL  BL
3 3
2
2
where A  aK and B  bK
3
2
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10-6
Properties of a Short-Run Cubic
Production Function
Q  AL  BL
3
2
 The average & marginal products of
labor are, respectively:
AP  Q L  AL  BL
2
MP  Q L  3 AL  2 BL
2
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10-7
Properties of a Short-Run Cubic
Production Function
Q  AL  BL
3
2
 Marginal product of labor begins to
diminish beyond Lm units of labor
 Average product of labor begins to
diminish beyond La units of labor
B
B
and La  
Lm  
3A
2A
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10-8
MP & AP Curves for the Short-Run
Cubic Production Function
(Figure 10.1)
Q = AL3 + BL2
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10-9
Properties of a Short-Run Cubic
Production Function
3
2
Q  AL  BL
 To have necessary properties of a
production function, parameters must
satisfy the following restrictions:
A < 0 and B > 0
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10-10
Estimation of a Short-Run
Production Function
 To use linear regression analysis, the
cubic equation must be transformed into
linear form
~ Q = AX + BW
~ Where X = L3 and W = L2
 Estimated regression line must pass
through the origin
~ Specify in computer routine
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10-11
Estimation of a Short-Run
Production Function
 Estimate using data for which the level
of usage of one or more inputs is fixed
~ Usually time series data are used
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10-12
Estimation of a Short-Run
Production Function
 Data collection may be complicated by
the fact that accounting data do not
include firm’s opportunity costs
~ Capital costs should reflect not only
acquisition cost but any foregone rental
income, depreciation, & capital gains/losses
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10-13
Estimation of a Short-Run
Production Function
 Nominal cost data
~ Data that have not been corrected for the
effects of inflation
 Must eliminate effects of inflation
~ Correct for the influence of inflation by
dividing nominal cost data by an
appropriate price index (or implicit price
deflator)
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10-14
Properties of a Short-Run
Cubic Cost Function
TVC  aQ  bQ  cQ
2
3
 Average variable cost & marginal cost
functions are, respectively:
AVC  a  bQ  cQ
2
SMC  a  2bQ  3cQ 2
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10-15
Properties of a Short-Run
Cubic Cost Function
TVC  aQ  bQ  cQ
2
3
 Average variable cost reaches its
minimum value at:
Qm   b 2c
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10-16
Properties of a Short-Run
Cubic Cost Function
TVC  aQ  bQ  cQ
2
3
 To conform to theoretical properties,
parameters must satisfy the following
restrictions:
a > 0, b < 0, and c > 0
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10-17
Properties of a Short-Run
Cubic Cost Function
 Cubic specification produces S-shaped
TVC curve & U-shaped AVC & SMC
curves
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10-18
Properties of a Short-Run
Cubic Cost Function
 All three cost curves employ the same
parameters
~ Only necessary to estimate one of these
functions to obtain estimates of all three
 In the short-run cubic specification,
input prices are assumed constant
~ Not explicitly included in cost equation
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10-19
Summary of Short-Run Empirical
Production Functions
Short-run cubic
production equations
Total product
Q  AL3  BL2
Average product of labor
AP  AL  BL
Marginal product of labor
MP  3 AL2  2 BL
Diminishing marginal
returns
Restrictions on parameters
B
begin at Lm  
3A
A < 0 and B > 0
2
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10-20
Summary of Short-Run Empirical
Cost Functions
Short-run cubic
cost equations
Total variable cost
Average variable cost
Marginal cost
Average variable cost
reaches minimum at
Restrictions on parameters
TVC  aQ  bQ 2  cQ 3
AVC  a  bQ  cQ 2
SMC  a  2bQ  3cQ 2
b
Qm  
2c
a > 0, b < 0, and c > 0
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10-21
Summary
 The first step in estimating a production function is to
specify the empirical production function, which is the
exact mathematical form of the equation to be estimated
 To estimate a cubic short-run production function using
linear regression, transform the cubic equation into linear
form; the estimated regression line must pass through
the origin
 A manager typically uses time-series observations on
cost, output, and input prices to estimate the short-run
cost function. The effects of inflation must be eliminated
 Because all 3 cost curves (TVC, AVC, and SMC) employ
the same parameters, one can estimate any one of them
to obtain estimates of all 3 curves
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10-22
Chapter 11
Managerial Decisions in
Competitive Markets
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1-1
Learning Objectives
 Discuss 3 characteristics of perfectly competitive markets
 Explain why the demand curve facing a perfectly
competitive firm is perfectly elastic and serves as the
firm’s marginal revenue curve
 Find short-run profit-maximizing output, derive firm and
industry supply curves, and identify producer surplus
 Explain characteristics of long-run competitive
equilibrium for a firm, derive long-run industry supply,
and identify economic rent and producer surplus
 Find the profit-maximizing level of a variable input
 Employ empirically estimated values of market price,
average variable cost, and marginal cost to calculate
profit-maximizing output and profit
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11-2
Perfect Competition
 Firms are price-takers
~ Each produces only a very small portion of
total market or industry output
 All firms produce a homogeneous product
 Entry into & exit from the market is
unrestricted
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11-3
Demand for a Competitive
Price-Taker
 Demand curve is horizontal at price determined
by intersection of market demand & supply
~ Perfectly elastic
 Marginal revenue equals price
~ Demand curve is also marginal revenue curve
(D = MR)
 Can sell all they want at the market price
~ Each additional unit of sales adds to total revenue an
amount equal to price
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11-4
Demand for a Competitive
Price-Taking Firm (Figure 11.2)
Price (dollars)
Price (dollars)
S
P0
P0
D = MR
D
0
Q0
Quantity
Panel A –
Market
0
Quantity
Panel B – Demand curve
facing a price-taker
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11-5
Profit-Maximization in the
Short Run
 In the short run, managers must make two
decisions:
1. Produce or shut down?
~ If shut down, produce no output and hires no variable
inputs
~ If shut down, firm loses amount equal to TFC
2. If produce, what is the optimal output level?
~ If firm does produce, then how much?
~ Produce amount that maximizes economic profit
Profit = π = TR - TC
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11-6
Profit-Maximization in the
Short Run
 In the short run, the firm incurs costs that
are:
~ Unavoidable and must be paid even if output
is zero
~ Variable costs that are avoidable if the firm
chooses to shut down
 In making the decision to produce or shut
down, the firm considers only the
(avoidable) variable costs & ignores fixed
costs
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11-7
Profit Margin (or Average Profit)
 Level of output that maximizes total profit
occurs at a higher level than the output that
maximizes profit margin (& average profit)
~ Managers should ignore profit margin (average
profit) when making optimal decisions
 ( P  ATC )Q
Average profit  
Q
Q
 P  ATC  Profit margin
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11-8
Short-Run Output Decision
 Firm will produce output where P = SMC
as long as:
~ Total revenue ≥ total avoidable cost or total
variable cost (TR  TVC)
 Equivalently, the firm should produce if
P  AVC
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11-9
Short-Run Output Decision
 The firm will shut down if:
~ Total revenue cannot cover total avoidable
cost (TR < TVC) or, equivalently, P  AVC
~ Produce zero output
~ Lose only total fixed costs
~ Shutdown price is minimum AVC
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11-10
Fixed, Sunk,& Average Costs
 Fixed, sunk, & average costs are
irrelevant in the production decision
~ Fixed costs have no effect on marginal cost or
minimum average variable cost—thus optimal
level of output is unaffected
~ Sunk costs are forever unrecoverable and
cannot affect current or future decisions
~ Only marginal costs, not average costs,
matter for the optimal level of output
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11-11
Profit Maximization: P = $36
(Figure 11.3)
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11-12
Profit Maximization: P = $36
(Figure 11.3)
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11-13
Profit Maximization: P = $36
(Figure 11.4)
Break-even point
Panel A: Total revenue
& total cost
Break-even point
Panel B: Profit curve when
P = $36
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11-14
Short-Run Loss Minimization:
P = $10.50 (Figure 11.5)
Profit
$3,150
- $5,100
Total =cost
= $17
x 300
= -$1,950
= $5,100
Total revenue = $10.50 x 300
= $3,150
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11-15
Summary of Short-Run
Output Decision
 AVC tells whether to produce
~ Shut down if price falls below minimum
AVC
 SMC tells how much to produce
~ If P  minimum AVC, produce output at
which P = SMC
 ATC tells how much profit/loss if
produce
π = (P – ATC)Q
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11-16
Short-Run Supply Curves
 For an individual price-taking firm
~ Portion of firm’s marginal cost curve above
minimum AVC
~ For prices below minimum AVC, quantity
supplied is zero
 For a competitive industry
~ Horizontal sum of supply curves of all
individual firms; always upward sloping
~ Supply prices give marginal costs of
production for every firm
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11-17
Short-Run Producer Surplus
 Short-run producer surplus is the amount
by which TR exceeds TVC
~ The area above the short-run supply curve
that is below market price over the range of
output supplied
~ Exceeds economic profit by the amount of
TFC
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
11-18
Computing Short-Run
Producer Surplus (Figure 11.6)
Producer surplus  TR  TVC
 $9 110  $5.55 110
 $990  $610
 $380
Or, equivalently,
Producer surplus = Area of trapezoid edba in Figure 11.6
= Height  Average base
 80  110 
 ($9  $5)  

2


 $380
$380 multiplied by 100 firms  ($380 100)  $38, 000
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11-19
Short-Run Firm & Industry Supply
(Figure 11.6)
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11-20
Long-Run Profit-Maximizing
Equilibrium (Figure 11.7)
Profit = ($17 - $12) x
240 = $1,200
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11-21
Long-Run Competitive Equilibrium
 All firms are in profit-maximizing
equilibrium (P = LMC)
 Occurs because of entry/exit of firms
in/out of industry
~ Market adjusts so P = LMC = LAC
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11-22
Long-Run Competitive Equilibrium
(Figure 11.8)
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11-23
Long-Run Industry Supply
 Long-run industry supply curve can be flat
(perfectly elastic) or upward sloping
~ Depends on whether constant cost industry or
increasing cost industry
 Economic profit is zero for all points on
the long-run industry supply curve for both
types of industries
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11-24
Long-Run Industry Supply
 Constant cost industry
~ As industry output expands, input prices remain
constant, & minimum LAC is unchanged
~ P = minimum LAC, so curve is horizontal
(perfectly elastic)
 Increasing cost industry
~ As industry output expands, input prices rise, &
minimum LAC rises
~ Long-run supply price rises & curve is upward
sloping
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11-25
Long-Run Industry Supply for a
Constant Cost Industry (Figure 11.9)
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11-26
Long-Run Industry Supply for an
Increasing Cost Industry (Figure 11.10)
Firm’s output
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11-27
Economic Rent
 Payment to the owner of a scarce, superior
resource in excess of the resource’s
opportunity cost
 In long-run competitive equilibrium firms that
employ such resources earn zero economic
profit
~ Potential economic profit is paid to the resource
as economic rent
~ In increasing cost industries, all long-run producer
surplus is paid to resource suppliers as economic
rent
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11-28
Economic Rent in Long-Run
Competitive Equilibrium (Figure 11.11)
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11-29
Profit-Maximizing Input Usage
 Profit-maximizing level of input usage
produces exactly that level of output
that maximizes profit
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11-30
Profit-Maximizing Input Usage
 Marginal revenue product (MRP)
~ MRP of an additional unit of a variable input is the
additional revenue from hiring one more unit of the
input
TR
MRP 
 P  MP
L
 If choose to produce:
~ If the MRP of an additional unit of input is greater
than the price of input, that unit should be hired
~ Employ amount of input where MRP = input price
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11-31
Profit-Maximizing Input Usage
 Average revenue product (ARP)
~ Average revenue per worker
TR
ARP 
 P  AP
L
 Shut down in short run if ARP < MRP
~ When ARP < MRP, TR < TVC
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11-32
Profit-Maximizing Labor Usage
(Figure 11.12)
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11-33
Implementing the
Profit-Maximizing Output Decision
 Step 1: Forecast product price
~ Use statistical techniques from Chapter 7
 Step 2: Estimate AVC & SMC
~ AVC = a + bQ + cQ2
~ SMC = a + 2bQ + 3cQ2
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11-34
Implementing the
Profit-Maximizing Output Decision
 Step 3: Check shutdown rule
~ If P  AVCmin then produce
~ If P < AVCmin then shut down
~ To find AVCmin substitute Qmin into AVC
equation
Qmin
b

2c
AVC min  a  bQmin  cQ
2
min
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11-35
Implementing the
Profit-Maximizing Output Decision
 Step 4: If P  AVCmin, find output where
P = SMC
~ Set forecasted price equal to estimated
marginal cost & solve for Q*
P = a + 2bQ* + 3cQ*2
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11-36
Implementing the
Profit-Maximizing Output Decision
 Step 5: Compute profit or loss
~ Profit = TR – TC
= P x Q* - AVC x Q* - TFC
= (P – AVC)Q* - TFC
~ If P < AVCmin, firm shuts down & profit
is -TFC
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11-37
Profit & Loss at Beau Apparel
(Figure 11.13)
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11-38
Profit & Loss at Beau Apparel
(Figure 11.13)
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11-39
Summary
 Perfect competitors are price-takers, produce
homogenous output, and have no barriers to entry
 The demand curve for a perfectly competitive firm is
perfectly elastic (or horizontal) at the market
determined equilibrium price, and marginal revenue
equals price
 Managers make two decisions in the short run: (1)
produce or shut down, and (2) if produce, how much to
produce
~ When positive profit is possible, profit is maximized at the output
where P = SMC
~ When market price falls below minimum AVC the firm shuts
down and produces nothing, losing only TFC
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11-40
Summary
 In long-run competitive equilibrium, all firms are in
profit-maximizing equilibrium (P = LMC)
~ No incentive for firms to enter or exit the industry because
economic profit is zero (P = LAC)
 Choosing either output or input usage leads to the
same optimal output decision and profit level
 Five steps to find the profit-maximizing rate of
production and the level of profit for a competitive firm:
1) Forecast the price of the product
2) Estimate average variable cost and marginal cost
3) Check the shutdown rule
4) If P ≥ min AVC find the output level where P = SMC
5) Compute profit or loss
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11-41
Chapter 12
Managerial Decisions for
Firms with Market Power
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
1-1
Learning Objectives
 Define market power and describe measurement of
market power
 Explain why entry barriers are necessary for long run
market power and discuss major types of entry barriers
 Find the profit-maximizing output, price, and input
usage for a monopolist and monopolistic competitor
 Employ empirically estimated or forecasted demand,
average variable cost, and marginal cost to calculate
profit-maximizing output and price for monopolistic or
monopolistically competitive firms
 Select production levels at multiple plants to minimize
the total cost of producing a given total output for a firm
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12-2
Market Power
 Ability of a firm to raise price without
losing all its sales
~ Any firm that faces downward sloping demand
has market power
 Gives firm ability to raise price above
average cost & earn economic profit (if
demand & cost conditions permit)
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12-3
Monopoly
 Single firm
 Produces & sells a good or service for
which there are no good substitutes
 New firms are prevented from entering
market because of a barrier to entry
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12-4
Measurement of Market Power
 Degree of market power inversely related to
price elasticity of demand
~ The less elastic the firm’s demand, the greater its
degree of market power
~ The fewer close substitutes for a firm’s product,
the smaller the elasticity of demand (in absolute
value) & the greater the firm’s market power
~ When demand is perfectly elastic (demand is
horizontal), the firm has no market power
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12-5
Measurement of Market Power
 Lerner index measures proportionate amount
by which price exceeds marginal cost:
P  MC
Lerner index 
P
~ Equals zero under perfect competition
~ Increases as market power increases
~ Also equals –1/E, which shows that the index (&
market power), vary inversely with elasticity
~ The lower the elasticity of demand (absolute value),
the greater the index & the degree of market power
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12-6
Measurement of Market Power
 If consumers view two goods as
substitutes, cross-price elasticity of
demand (EXY) is positive
~ The higher the positive cross-price elasticity,
the greater the substitutability between two
goods, & the smaller the degree of market
power for the two firms
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12-7
Barriers to Entry
 Entry of new firms into a market erodes
market power of existing firms by
increasing the number of substitutes
 A firm can possess a high degree of
market power only when strong barriers to
entry exist
~ Conditions that make it difficult for new firms
to enter a market in which economic profits
are being earned
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12-8
Common Entry Barriers
 Economies of scale
~ When long-run average cost declines over a
wide range of output relative to demand for
the product, there may not be room for
another large producer to enter market
 Barriers created by government
~ Licenses, exclusive franchises
 Essential input barriers
~ One firm controls a crucial input in the
production process
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12-9
Common Entry Barriers
 Brand loyalties
~ Strong customer allegiance to existing firms
may keep new firms from finding enough
buyers to make entry worthwhile
 Consumer lock-in
~ Potential entrants can be deterred if they
believe high switching costs will keep them
from inducing many consumers to change
brands
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12-10
Common Entry Barriers
 Network externalities
~ Occur when benefit or utility of a product
increases as more consumers buy & use it
~ Make it difficult for new firms to enter markets
where firms have established a large base or
network of buyers
 Sunk costs
~ Entry costs (which are sunk costs) can serve
as a barrier if they are so high that the
manager cannot expect to earn enough future
profit to make entry worthwhile
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12-11
Demand & Marginal Revenue
for a Monopolist
 Market demand curve is the firm’s demand
curve
 Monopolist must lower price to sell
additional units of output
~ Marginal revenue is less than price for all
but the first unit sold
 When MR is positive (negative), demand
is elastic (inelastic)
 For linear demand, MR is also linear, has
the same vertical intercept as demand,
and is twice as steep
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12-12
Demand & Marginal Revenue
for a Monopolist (Figure 12.1)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-13
Short-Run Profit Maximization
for Monopoly
 Monopolist will produce where MR = SMC as
long as TR at least covers the firm’s total
avoidable cost (TR ≥ TVC)
~ Price for this output is given by the demand curve
 If TR < TVC (or, equivalently, P < AVC) the firm
shuts down & loses only fixed costs
 If P > ATC, firm makes economic profit
 If ATC > P > AVC, firm incurs a loss, but
continues to produce in short run
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12-14
Short-Run Profit Maximization
for Monopoly (Figure 12.3)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-15
Short-Run Loss Minimization
for Monopoly (Figure 12.4)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-16
Long-Run Profit Maximization
for Monopoly
 Monopolist maximizes profit by choosing
to produce output where MR = LMC, as
long as P  LAC
 Will exit industry if P < LAC
 Monopolist will adjust plant size to the
optimal level
~ Optimal plant is where the short-run average
cost curve is tangent to the long-run average
cost at the profit-maximizing output level
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12-17
Long-Run Profit Maximization
for Monopoly (Figure 12.5)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-18
Profit-Maximizing Input Usage
 Profit-maximizing level of input usage
produces exactly that level of output
that maximizes profit
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-19
Profit-Maximizing Input Usage
 Marginal revenue product (MRP)
~ MRP is the additional revenue attributable to hiring
one more unit of the input
TR
MRP 
 MR  MP
L
 When producing with a single variable input:
~ Employ amount of input for which MRP = input price
~ Relevant range of MRP curve is downward sloping,
positive portion, for which ARP > MRP
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12-20
Monopoly Firm’s Demand for Labor
(Figure 12.6)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-21
Profit-Maximizing Input Usage
 For a firm with market power, profitmaximizing conditions MRP = w and
MR = MC are equivalent
~ Whether Q or L is chosen to maximize
profit, resulting levels of input usage,
output, price, & profit are the same
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-22
Monopolistic Competition
 Large number of firms sell a
differentiated product
~ Products are close (not perfect) substitutes
 Market is monopolistic
~ Product differentiation creates a degree of
market power
 Market is competitive
~ Large number of firms, easy entry
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12-23
Monopolistic Competition
 Short-run equilibrium is identical to
monopoly
 Unrestricted entry/exit leads to long-run
equilibrium
~ Attained when demand curve for each
producer is tangent to LAC
~ At equilibrium output, P = LAC and
MR = LMC
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-24
Short-Run Profit Maximization for
Monopolistic Competition (Figure 12.7)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-25
Long-Run Profit Maximization for
Monopolistic Competition (Figure 12.8)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-26
Implementing the Profit-Maximizing
Output & Pricing Decision
 Step 1: Estimate demand equation
~ Use statistical techniques from Chapter 7
~ Substitute forecasts of demand-shifting
variables into estimated demand equation
to get
Q = a′ + bP
ˆ  dPˆ
Where a'  a  cM
R
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-27
Implementing the Profit-Maximizing
Output & Pricing Decision
 Step 2: Find inverse demand equation
~ Solve for P
 a' 1
P
 Q  A  BQ
b
b
 a'
1
ˆ
ˆ
Where a'  a  cM  dPR , A 
, and B 
b
b
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-28
Implementing the Profit-Maximizing
Output & Pricing Decision
 Step 3: Solve for marginal revenue
~ When demand is expressed as P = A + BQ,
marginal revenue is
 a' 2
MR  A  2 BQ 
 Q
b
b
 Step 4: Estimate AVC & SMC
~ Use statistical techniques from Chapter 10
AVC = a + bQ + cQ2
SMC = a + 2bQ + 3cQ2
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-29
Implementing the Profit-Maximizing
Output & Pricing Decision
 Step 5: Find output where MR = SMC
~ Set equations equal & solve for Q*
~ The larger of the two solutions is the profitmaximizing output level
 Step 6: Find profit-maximizing price
~ Substitute Q* into inverse demand
P* = A + BQ*
Q* & P* are only optimal if P  AVC
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-30
Implementing the Profit-Maximizing
Output & Pricing Decision
 Step 7: Check shutdown rule
~ Substitute Q* into estimated AVC function
AVC* = a + bQ* + cQ*2
~ If P*  AVC*, produce Q* units of output &
sell each unit for P*
~ If P* < AVC*, shut down in short run
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-31
Implementing the Profit-Maximizing
Output & Pricing Decision
 Step 8: Compute profit or loss
~ Profit = TR – TC
= P x Q* - AVC x Q* - TFC
= (P – AVC)Q* - TFC
~ If P < AVC, firm shuts down & profit
is -TFC
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-32
Maximizing Profit at Aztec
Electronics: An Example
 Aztec possesses market power via
patents
 Sells advanced wireless stereo
headphones
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-33
Maximizing Profit at Aztec
Electronics: An Example
 Estimation of demand & marginal
revenue
Q  41, 000  500 P  0.6M  22.5 PR
 41, 000  500 P  0.6(45, 000)  22.5(800)
 50, 000  500P
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-34
Maximizing Profit at Aztec
Electronics: An Example
 Solve for inverse demand
Q  50 , 000  500 P
Q  50 , 000 500 P

500
500
Q
50 , 000

P
500
500
1
P  100 
Q
500
 100  0.002Q
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-35
Maximizing Profit at Aztec
Electronics: An Example
 Determine marginal revenue function
P = 100 – 0.002Q
MR = 100 – 0.004Q
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-36
Demand & Marginal Revenue for
Aztec Electronics (Figure 12.9)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-37
Maximizing Profit at Aztec
Electronics: An Example
 Estimation of average variable cost and
marginal cost
~ Given the estimated AVC equation:
AVC = 28 – 0.005Q + 0.000001Q2
~ Then,
SMC = 28 – (2 x 0.005)Q + (3 x 0.000001)Q2
= 28 – 0.01Q + 0.000003Q2
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-38
Maximizing Profit at Aztec
Electronics: An Example
 Output decision
~ Set MR = MC and solve for Q*
100 – 0.004Q = 28 – 0.01Q + 0.000003Q2
0 = (28 – 100) + (-0.01 + 0.004)Q + 0.000003Q2
= -72 – 0.006Q + 0.000003Q2
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-39
Maximizing Profit at Aztec
Electronics: An Example
 Output decision
~ Solve for Q* using the quadratic formula
2

(

0
.
006
)

(

0
.
006
)
 4(  72)(0.000003)
*
Q 
2(0.000003)
0.036

 6 , 000
0.000006
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-40
Maximizing Profit at Aztec
Electronics: An Example
 Pricing decision
~ Substitute Q* into inverse demand
P* = 100 – 0.002(6,000)
= $88
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-41
Maximizing Profit at Aztec
Electronics: An Example
 Shutdown decision
~ Compute AVC at 6,000 units:
AVC* = 28 - 0.005(6,000) + 0.000001(6,000)2
= $34
~ Because P = $88 > $34 = ATC, Aztec should
produce rather than shut down
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-42
Maximizing Profit at Aztec
Electronics: An Example
 Computation of total profit
π = TR – TVC – TFC
= (P* x Q*) – (AVC* x Q*) – TFC
= ($88 x 6,000) – ($34 x 6,000) - $270,000
= $528,000 - $204,000 - $270,000
= $54,000
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-43
Profit Maximization at
Aztec Electronics (Figure 12.10)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12-44
Multiple Plants
 If a firm produces in 2 plants, A & B
~ Allocate production so MCA = MCB
~ Optimal total output is that for which MR =
MCT
 For profit-maximization, allocate total
output so that
MR = MCT = MCA = MCB
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12-45
A Multiplant Firm
(Figure 12.11)
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12-46
Summary
 Price-setting firms possess market power
~ A monopoly exists when a single firm produces and sells a
particular good or service for which there are no good substitutes
and new firms are prevented from entering the market
~ Monopolistic competition arises when the market consists of a
large number of relatively small firms that produce similar, but
slightly differentiated, products and have some market power
 A firm can possess a high degree of market power only
when strong barriers to the entry of new firms exist
 In the short run, the manager of a monopoly firm will
choose to produce where MR = SMC, rather than shut
down, as long as total revenue at least covers the
firm’s total variable cost (TR ≥ TVC)
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12-47
Summary
 In the long run, the monopolist maximizes profit by
choosing to produce where MR = LMC, unless price is
less than long-run average cost (P < LAC), in which
case the firm exits the industry
 For firms with market power, marginal revenue product
(MRP) is equal to marginal revenue times marginal
product: MRP = MR × MP
 Whether the manager chooses Q or L to maximize
profit, the resulting levels of input usage, output, price,
and profit are the same
 Short-run equilibrium under monopolistic competition is
exactly the same as for monopoly
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12-48
Summary
 Long-run equilibrium in a monopolistically competitive
market is attained when the demand curve for each
producer is tangent to the long-run average cost curve
~ Unrestricted entry and exit lead to this equilibrium
 8 steps can be employed for profit-maximization for a
monopoly or monopolistically competitive firm:
(1) estimate demand equation, (2) find inverse demand
equation, (3) solve for marginal revenue, (4) estimate
average variable cost and marginal cost, (5) find output
level where MR = SMC, (6) find profit-maximizing price,
(7) check the shutdown rule, and (8) compute profit/loss
 A firm producing in two plants, A and B, should allocate
production between the two plants so that MCA = MCB
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12-49
Chapter 13
Strategic Decision Making in
Oligopoly Markets
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1-1
Learning Objectives
 Employ concepts of dominant strategies, dominated
strategies, Nash equilibrium, and best-response curves
to make simultaneous decisions
 Employ the roll-back method to make sequential
decisions, determine existence of first- or second-mover
advantages, and employ credible commitments
 Understand and explain why cooperation can
sometimes be achieved when decisions are repeated
over time and discuss four types of facilitating practices
for reaching cooperative outcomes
 Explain why it is difficult, but not impossible, to create
strategic barriers to entry by either limit pricing or
capacity expansion
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13-2
Oligopoly Markets
 Interdependence of firms’ profits
~ Distinguishing feature of oligopoly
~ Arises when number of firms in market is
small enough that every firms’ price & output
decisions affect demand & marginal revenue
conditions of every other firm in market
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13-3
Strategic Decisions
 Strategic behavior
~ Actions taken by firms to plan for & react to
competition from rival firms
 Game theory
~ Useful guidelines on behavior for strategic
situations involving interdependence
 Simultaneous Decisions
~ Occur when managers must make individual
decisions without knowing their rivals’
decisions
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13-4
Dominant Strategies
 Always provide best outcome no matter what
decisions rivals make
 When one exists, the rational decision maker
always follows its dominant strategy
 Predict rivals will follow their dominant
strategies, if they exist
 Dominant strategy equilibrium
~ Exists when all decision makers have dominant
strategies
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13-5
Prisoners’ Dilemma
 All rivals have dominant strategies
 In dominant strategy equilibrium, all are
worse off than if they had cooperated in
making their decisions
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13-6
Prisoners’ Dilemma
(Table 13.1)
Bill
Don’t confess
Jan
e
Don’t
confess
A
Confess
B
2 years, 2 years
C
Confess
B
12 years, 1 year
J D
1 year, 12 years
JB
6 years, 6 years
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13-7
Dominated Strategies
 Never the best strategy, so never would
be chosen & should be eliminated
 Successive elimination of dominated
strategies should continue until none
remain
 Search for dominant strategies first, then
dominated strategies
~ When neither form of strategic dominance
exists, employ a different concept for making
simultaneous decisions
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13-8
Successive Elimination of
Dominated Strategies (Table 13.3)
Palace’s price
High ($10)
High
($10)
Castle’s
price
A
$1,000, $1,000
D
Medium
$1,100, $400
($8)
Low
($6)
G
C
$1,200, $300
Medium ($8)
Low ($6)
B
C
$900, $1,100
C P
C
$500, $1,200
E
F
P
$800, $800
H
$500, $350
$450, $500
I
P
$400, $400
Payoffs in dollars of profit per
week
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13-9
Successive Elimination of
Dominated Strategies (Table 13.3)
Unique
Palace’s price Solution
Reduced Payoff
Table
Medium ($8)
Castle’s
price
High
($10)
Low
($6)
B
$900, $1,100
H
$500, $350
Low ($6)
C
C
CP
$500, $1,200
P
I
$400, $400
Payoffs in dollars of profit per week
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13-10
Making Mutually Best Decisions
 For all firms in an oligopoly to be
predicting correctly each others’
decisions:
~ All firms must be choosing individually best
actions given the predicted actions of their
rivals, which they can then believe are
correctly predicted
~ Strategically astute managers look for
mutually best decisions
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13-11
Nash Equilibrium
 Set of actions or decisions for which all
managers are choosing their best
actions given the actions they expect
their rivals to choose
 Strategic stability
~ No single firm can unilaterally make a
different decision & do better
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13-12
Super Bowl Advertising: A Unique
Nash Equilibrium (Table 13.4)
Pepsi’s budget
Low
C
A
D
Medium
P
C
C
$45, $35
F
$65, $30
H
$45, $10
High
P
$57.5, $50
E
$50, $35
G
High
B
$60, $45
Low
Coke’s
budget
Medium
$30, $25
I
$60, $20
C P
$50, $40
Payoffs in millions of dollars of semiannual profit
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13-13
Nash Equilibrium
 When a unique Nash equilibrium set of
decisions exists
~ Rivals can be expected to make the decisions
leading to the Nash equilibrium
~ With multiple Nash equilibria, no way to predict
the likely outcome
 All dominant strategy equilibria are also
Nash equilibria
~ Nash equilibria can occur without dominant or
dominated strategies
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13-14
Best-Response Curves
 Analyze & explain simultaneous decisions
when choices are continuous (not
discrete)
 Indicate the best decision based on the
decision the firm expects its rival will make
~ Usually the profit-maximizing decision
 Nash equilibrium occurs where firms’ bestresponse curves intersect
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13-15
Bravo Airway’s quantity
Arrow Airline’s
price
Panel A :
Arrow believes PB = $100
Arrow Airline’s price
and marginal revenue
Deriving Best-Response Curve for
Arrow Airlines (Figure 13.1)
Panel B: Two points on
Arrow’s best-response
curve
Bravo Airway’s price
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13-16
Arrow Airline’s
price
Best-Response Curves & Nash
Equilibrium (Figure 13.2)
Bravo Airway’s price
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13-17
Sequential Decisions
 One firm makes its decision first, then a
rival firm, knowing the action of the first
firm, makes its decision
~ The best decision a manager makes today
depends on how rivals respond tomorrow
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13-18
Game Tree
 Shows firms decisions as nodes with
branches extending from the nodes
~ One branch for each action that can be taken at
the node
~ Sequence of decisions proceeds from left to right
until final payoffs are reached
 Roll-back method (or backward induction)
~ Method of finding Nash solution by looking ahead
to future decisions to reason back to the current
best decision
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13-19
Sequential Pizza Pricing
(Figure 13.3)
Panel
A – Gamesolution
tree
Panel
B – Roll-back
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13-20
First-Mover & Second-Mover
Advantages
 First-mover advantage
~ If letting rivals know what you are doing by going
first in a sequential decision increases your payoff
 Second-mover advantage
~ If reacting to a decision already made by a rival
increases your payoff
 Determine whether the order of decision
making can be confer an advantage
~ Apply roll-back method to game trees for each
possible sequence of decisions
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13-21
First-Mover Advantage in
Technology Choice (Figure 13.4)
Motorola’s technology
Analog
SM B
A
Sony’s
technolog
y
$10, $13.75
Analog
C
Digital
Digital
$9.50, $11
$8, $9
SM
D
$11.875, $11.25
Panel A – Simultaneous technology decision
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13-22
First-Mover Advantage in
Technology Choice (Figure 13.4)
Panel B – Motorola secures a first-mover advantage
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13-23
Strategic Moves & Commitments
 Actions used to put rivals at a disadvantage
 Three types
~ Commitments
~ Threats
~ Promises
 Only credible strategic moves matter
 Managers announce or demonstrate to rivals
that they will bind themselves to take a
particular action or make a specific decision
~ No matter what action is taken by rivals
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13-24
Threats & Promises
 Conditional statements
 Threats
~ Explicit or tacit
~ “If you take action A, I will take action B, which
is undesirable or costly to you.”
 Promises
~ “If you take action A, I will take action B, which
is desirable or rewarding to you.”
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13-25
Cooperation in Repeated
Strategic Decisions
 Cooperation occurs when oligopoly
firms make individual decisions that
make every firm better off than they
would be in a (noncooperative) Nash
equilibrium
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13-26
Cheating
 Making noncooperative decisions
~ Does not imply that firms have made any
agreement to cooperate
 One-time prisoners’ dilemmas
~ Cooperation is not strategically stable
~ No future consequences from cheating, so
both firms expect the other to cheat
~ Cheating is best response for each
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13-27
Pricing Dilemma for AMD & Intel
(Table 13.5)
AMD’s price
High
Low
A: Cooperatio
High
$5,n$2.5
Intel’s
price
B:
AMD
cheats
$2, $3
A
C: Intel cheats
Low
$6, $0.5
D: Noncooperati
$3,on
$1
I
IA
Payoffs in millions of dollars of profit per week
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13-28
Punishment for Cheating
 With repeated decisions, cheaters can
be punished
 When credible threats of punishment in
later rounds of decision making exist
~ Strategically astute managers can
sometimes achieve cooperation in
prisoners’ dilemmas
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13-29
Deciding to Cooperate
 Cooperate
~ When present value of costs of cheating
exceeds present value of benefits of
cheating
~ Achieved in an oligopoly market when all
firms decide not to cheat
 Cheat
~ When present value of benefits of cheating
exceeds present value of costs of cheating
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13-30
Deciding to Cooperate
PVBenefits of cheating
B1
B2
BN


 ... 
1
2
(1  r ) (1  r )
( 1  r )N
Where Bi = πCheat – πCooperate for i = 1,…, N
PVCosts of cheating
C1
C2
CP


 ... 
N 1
N 2
(1  r )
(1  r )
( 1  r )N  P
Where Cj = πCooperate – πNash for j = 1,…, P
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13-31
A Firm’s Benefits & Costs of
Cheating (Figure 13.5)
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13-32
Trigger Strategies
 A rival’s cheating “triggers” punishment
phase
 Tit-for-tat strategy
~ Punishes after an episode of cheating &
returns to cooperation if cheating ends
 Grim strategy
~ Punishment continues forever, even if
cheaters return to cooperation
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13-33
Facilitating Practices
 Legal tactics designed to make
cooperation more likely
 Four tactics
~ Price matching
~ Sale-price guarantees
~ Public pricing
~ Price leadership
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13-34
Price Matching
 Firm publicly announces that it will
match any lower prices by rivals
~ Usually in advertisements
 Discourages noncooperative pricecutting
~ Eliminates benefit to other firms from
cutting prices
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13-35
Sale-Price Guarantees
 Firm promises customers who buy an
item today that they are entitled to
receive any sale price the firm might
offer in some stipulated future period
~ Primary purpose is to make it costly for
firms to cut prices
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13-36
Public Pricing
 Public prices facilitate quick detection of
noncooperative price cuts
~ Timely & authentic
 Early detection
~ Reduces PV of benefits of cheating
~ Increases PV of costs of cheating
~ Reduces likelihood of noncooperative price
cuts
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13-37
Price Leadership
 Price leader sets its price at a level it
believes will maximize total industry
profit
~ Rest of firms cooperate by setting same
price
 Does not require explicit agreement
~ Generally lawful means of facilitating
cooperative pricing
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13-38
Cartels
 Most extreme form of cooperative
oligopoly
 Explicit collusive agreement to drive up
prices by restricting total market output
 Illegal in U.S., Canada, Mexico,
Germany, & European Union
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13-39
Cartels
 Pricing schemes usually strategically
unstable & difficult to maintain
~ Strong incentive to cheat by lowering price
 When undetected, price cuts occur along
very elastic single-firm demand curve
~ Lure of much greater revenues for any one firm
that cuts price
~ Cartel members secretly cut prices causing
price to fall sharply along a much steeper
demand curve
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13-40
Intel’s Incentive to Cheat
(Figure 13.6)
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13-41
Tacit Collusion
 Far less extreme form of cooperation
among oligopoly firms
 Cooperation occurs without any explicit
agreement or any other facilitating
practices
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13-42
Strategic Entry Deterrence
 Established firm(s) makes strategic
moves designed to discourage or
prevent entry of new firm(s) into a
market
 Two types of strategic moves
~ Limit pricing
~ Capacity expansion
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13-43
Limit Pricing
 Established firm(s) commits to setting
price below profit-maximizing level to
prevent entry
~ Under certain circumstances, an oligopolist
(or monopolist), may make a credible
commitment to charge a lower price forever
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13-44
Limit Pricing: Entry Deterred
(Figure 13.7)
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13-45
Limit Pricing: Entry Occurs
(Figure 13.8)
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13-46
Capacity Expansion
 Established firm(s) can make the threat of
a price cut credible by irreversibly
increasing plant capacity
 When increasing capacity results in lower
marginal costs of production, the
established firm’s best response to entry
of a new firm may be to increase its own
level of production
~ Requires established firm to cut its price to sell
extra output
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13-47
Excess Capacity Barrier to Entry
(Figure 13.9)
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13-48
Excess Capacity Barrier to Entry
(Figure 13.9)
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13-49
Summary
 Simultaneous decision games occur when managers
must make their decisions without knowing the
decisions of their rivals
~ A dominant strategy is a strategy that always provides the best
outcome no matter what decisions rivals make
~ A prisoners’ dilemma arises when all rivals possess dominant
strategies, and in dominant strategy equilibrium, they are all
worse off than if they cooperated in making their decisions
~ In Nash equilibrium, no single firm can unilaterally make a
different decision and do better
~ Best-response curves are used to analyze simultaneous
decisions when choices are continuous rather than discrete
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13-50
Summary
 Sequential decisions occur when one firm makes its
decision first, and then a rival firm makes its decision
~ Three types of strategic moves: commitments, threats, promises
 When decisions are repeated over and over, managers
get a chance to punish cheaters, and, through credible
threat of punishment, rivals may be able to achieve the
cooperative outcome in prisoners’ dilemma situations
 Strategic entry deterrence occurs when an established
firm makes a strategic move designed to discourage or
prevent the entry of a new firm(s)
~ Two types of strategic moves designed to manipulate the beliefs
of potential entrants about the profitability of entering are limit
pricing and capacity expansion
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