Managerial Economics
Professor Geoffrey Heal
616 Uris Hall
Phone: (212) 854-6459
e-mail: gmh1@columbia.edu
(note - gmh “one” not “L”)
Course Outline:
(I) Analyzing the structure of a market
Part A: Demand & Supply
Part B: Costs
(II) Pricing (most important part of course)
(III) e-con.com (application and review)
(IV) Foundations of Strategy
Analyzing the Structure of a Market

Aim: to understand key aspects of markets:

nature of demands for the products

closeness or otherwise of competitors

structure of costs

dependence of profits on the level of output
Material to be covered:

Analysis of demand
– demand curves,
– price, income & cross elasticities of demand
– use of demand parameters in forecasting

Structure of costs:
– fixed & variable costs
– break-even analysis
– opportunity costs and sunk costs
– learning curves & economies of scale.
Pricing

How much product should you produce and what
price should you charge for it?

How can you best segment your market if there are
different types of buyers with different demand
characteristics (e.g., business travelers vs. vacation
travelers, home PC buyers vs. corporate buyers)?

What are the types of pricing schemes available
(e.g., bundling, promotional offers, loyalty bonuses,
volume discounts)?
e-con.com

Applications of market analysis to electronic
commerce
How does the internet affect demand,
pricing, and other aspects of running a
business.

e-commerce business strategies.

Auctions and the internet.

Foundations of Strategy



Interacting with competitors
Anticipating their reactions
Forecasting the final outcome when
everyone has reacted.
Aim of Course



To teach you to use basic economic ideas in
making business decisions.
Decisions about opening and closing
businesses.
Decisions about pricing and other policies.
Level of Course




Emphasis on understanding concepts and
where and how they can be used.
Don’t aim to make you an economist, but an
intelligent consumer of economics.
Evaluate and understand works of
consultants, staff. Ask the right questions.
Recognize BS when you see it!
Consumption & Price of Copper
1880-1998
Profit margin
1999/2001
Operating margin
1999/2001
MSFT
40.0%/30.5%
49.5%/46.3%
INTC
25%/17.7%
34.2%/20.7%
CPQ
1.5%/0.8%
2.4%/1.2%
DELL
7%/6.7%
9.9%/8%
Compare Internet companies




eBay
AOL
Yahoo
Amazon.com
Demand and Supply
Demand Curve
Shows amount purchased as a function of price
Depends on:
- income
- tastes
- prices of competitive products
- prices of complementary products
Supply Curve
Amount offered for sale as a function of price
Depends on costs of production, which in turn
depend on
- costs of inputs
- technology
The Market Mechanism
Price
($ per unit)
S
The curves intersect at
equilibrium, or marketclearing, price. At P0 the
quantity supplied is equal
to the quantity demanded
at Q0 .
P0
D
Q0
Quantity
The Market Mechanism

Characteristics of the equilibrium or market
clearing price:




QD = QS
No shortage
No excess supply
No pressure on the price to change
Demand Curve -Income Rises
Demand Shifts
Supply shifts
D & S shift
The Market Mechanism
Price
($ per unit)
S
Surplus
P1
Assume the price is P1 , then:
1) Qs : Q1 > Qd : Q2
2) Excess supply is Q1:Q2.
3) Producers lower price.
4) Quantity supplied decreases
and quantity demanded
increases.
5) Equilibrium at P2Q3
P2
D
Q1
Q3
Q2 Quantity
The Market Mechanism
A Surplus

The market price is above equilibrium
There is excess supply
 Producers lower prices
 Quantity demanded increases and quantity
supplied decreases
 The market continues to adjust until the
equilibrium price is reached.

The Market Mechanism
Price
($ per unit)
S
Assume the price is P2 , then:
1) Qd : Q2 > Qs : Q1
2) Shortage is Q1:Q2.
3) Producers raise price.
4) Quantity supplied increases
and quantity demanded
decreases.
5) Equilibrium at P3, Q3
P3
P2
Shortage
Q1
Q3
D
Q2 Quantity
The Market Mechanism
Shortage

The market price is below equilibrium:
There is a shortage
 Producers raise prices
 Quantity demanded decreases and quantity
supplied increases
 The market continues to adjust until the new
equilibrium price is reached.

The Market Mechanism

Market Mechanism - Summary:
1) Supply and demand interact to
determine the market-clearing price.
2) When not in equilibrium, the market
will adjust to alleviate a shortage or
surplus and return the market to equilibrium.
3) Markets must be competitive for the
mechanism to be efficient.
Consumption & Price of Copper
1880-1998
The Long-Run Behavior
of Natural Resource Prices

Observations
Consumption of copper has increased about a
hundred fold from 1880 through 1998 indicating
a large increase in demand.
 The real price for copper has remained
relatively constant.

Changes In Market Equilibrium
S1998
Price
S1900
S1950
D1998
D1950
D1900
Quantity
Changes In Market Equilibrium

Conclusion

Decreases in the costs of production have
increased the supply by more than enough to
offset the increase in demand.
Changes In Market Equilibrium

Wage Inequality in the United States

Real after-tax income from 1977 to 1999:
– Rose 40+% for the top 20% of the income
distribution
– Fell 10+% for the bottom 20%
Changes In Market Equilibrium

Question

Why did the income distribution become more
unequal for 1977 to 1999?
Price elasticity of demand:
Measures responsiveness of demand to price.
Defined as E = (DQ/Q)/(DP/P) = (DQ/DP)*(P/Q)
Why is it defined in proportional terms?
- Unit free.
- Scale sensitive.
A negative number.
Q = 8 - 2P or P = 4 - 0.5Q
Elasticity = (DQ/Q)/(DP/P) = (DQ/DP)*(P/Q) = -2*(P/Q)
Elasticity and Pricing



If elasticity is between 0 and -1 then raising
price will raise profits - it will raise revenues
and lower costs.
If elasticity is lower than -1 then raising
price will lower revenues and also costs, so
the effect on profits is not clear.
Moral - never operate where the elasticity is
between 0 and -1.
Relationship between demand,
quantity and revenue:
Q = 8 - 2P
or
P = 4 - 0.5Q
so as revenue R is price times quantity
R = 4Q - 0.5Q2
Revenue rises as price rises
Revenue falls
as price rises
PED = -1
PED = 0
This is a quadratic pointing up.
The slope is:
DR
=4-Q
DQ
which is zero at Q = 4.
Slope is positive for Q<4 and vice versa.
Maximum revenue comes when Q = 4, therefore
P = 2, and max revenue is 8
PED when revenue is maximum




Revenue is max when Q = 4, P = 2.
E = (DQ/Q)/(DP/P) = (DQ/DP)*(P/Q)
So E = (DQ/DP)*(1/2) and
DQ/DP = -2 so E = -2 * 1/2 = -1 when R is
at a maximum.
Cross price elasticity of demand:
The responsiveness of demand for good A to
change in price of good B:
DQA/QA = DQA * PB
DPB/PB
DPB PA
Example:
responsiveness of demand for Dell computers to
prices of Gateway computers
Supply Elasticity



The responsiveness of supply to price
changes.
(DS/S)/(DP/P), proportional change in
supply divided by proportional change in
price.
Usually positive.
Elasticities of Supply and Demand
The Market for Wheat

1981 Supply Curve for Wheat


QS = 1,800 + 240P
1981 Demand Curve for Wheat

QD = 3,550 - 266P
Elasticities of Supply and Demand
The Market for Wheat

Equilibrium: Q S = Q D
1,800  240 P  3,550  266 P
506 P  1,750
P  3.46 / bushel
Q  1,800  (240)(3.46)  2,630 million bushels
Elasticities of Supply and
Demand
The Market for Wheat


ED=(P/Q) (DQD/DP) = (3.46/2630)(-266)= 0.35
ES=(P/Q) (DQS/DP) = (3.46/2630)(+240)= 0.32
Changes in the Market: 1981-1998
The Market for Wheat
Supply (Qs) Demand (QD)
Equilibrium Price (Qs = QD)
1981
1800 + 240P
3550 - 266P
1800+240P = 3550-266P
506P = 1750
P1981 = $3.46/bushel
1998
1,944 + 207P
3,244 - 283P
1,944+207P = 3,244-283P
P1998 = $2.65/bushel
Marginal Revenue




Increase in revenue from one extra sale
Rate of change of revenue with respect to
sales
Typically less than price as demand curve
slopes down
Depends on PED
Marginal Revenue & PED








MR
= P{1 + 1/PED}
Remember PED < 0 so MR < P.
The larger PED as a number the nearer MR is to P
If PED = - 1, then MR = 0. (Top of revenue curve)
…………………………………………
Derivation - dR/dQ = d{P(Q).Q}/dQ
= P + Q*dP/dQ
= P{1 + (Q/P)*dP/dQ}
Income Elasticity of Demand:
Responsiveness of demand to changes in
income
IED = (DQ/Q)/DI/I) = (DQ/DI)*(I/Q)
Use to define necessities and luxuries
Necessities - IED < 1
Luxuries - IED > 1
Cyclical vs. defensive sectors
Cyclical - high IED - foreign travel, consumer
durables
Defensive - low IED - food, utilities
Short-run vs. long-run elasticities
Critical in understanding oil market, energy
markets, metal markets
Responding to a price movement takes time possibly many years
Long-run elasticity measures total response
Short-run elasticity measures immediate
response
Short-run
demand
P1
Po
Long-run drop
in demand
Long-run
demand
Short-run drop
in demand
Short-Run Versus
Long-Run Elasticities
The Demand for Gasoline
Years Following Price or Income Change
Elasticity
1
2
3
4
5
6
Price
-0.11 -0.22 -0.32 -0.49 -0.82 -1.17
Income
0.07
0.13
0.20
0.32
0.54
0.78
Short-Run Versus
Long-Run Elasticities
The Demand for Automobiles
Years Following Price or Income Change
Elasticity
Price
Income
1
2
3
4
5
6
-1.20 -0.93 -0.75 -0.55 -0.42 -0.40
3.00
2.33
1.88
1.38
1.02
1.00
Short-Run Versus
Long-Run Elasticities
The Demand for
Gasoline and Automobiles

Data Explains:
1) Why the price of oil did not continue to
rise above $30/barrel even though it
rose very rapidly in the early 1970s.
2) Why automobile sales are so sensitive to
the business cycle.
The World Oil Market

In 1995:
P* = $18/barrel
 World demand and total supply = 23 bb/yr (= 63
mbd)
 OPEC supply = 10 bb/yr (= 27 mbd)
 Non-OPEC supply = 13 bb/yr (= 35 mbd)
 US consumption about 17 mbd = 5.5 bb/yr

Price of Crude Oil
Impact of Saudi Production Cut
SC
D S’T ST
Price 45
($ per
barrel) 40
Short-Run
Effect
35
30
25
20
18
15
10
5
0
5
10
15
20 23 25
30
Quantity
35 (billions barrels/yr)
Impact of Saudi Production Cut
SC
Price 45
D
($ per
barrel) 40
S’T ST
Long-run Effect
Due to the elasticity
of the long-run
supply and demand
curves, the long-run
effect of a cut
in production is
much less.
35
30
25
20
18
15
10
5
0
5
10
15
20 23 25
30
35
Quantity
(billions barrels/yr)
AMAX Case
Price (1980 $)
10
9
8
7
6
5
Price (1980 $)
4
3
2
1
0
1975
1976
1977
1978
Year
1979
1980
Moly Consumption & Production
250
200
150
Consumption
Production
100
50
0
1975
1976
1977
Year
1978
1979
Output
350
325
300
275
250
225
200
175
150
125
100
75
50
25
0
Marginal Cost
Marginal Costs
MC
14
12
10
8
6
MC
4
2
0