Managerial Economics
Lecture One:
Why economics matters to managers,
marketers and accountants
Neoclassical theory of profit maximisation
Admin
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• Check subject outline
• Assessment: 3 parts
– Group presentation in tutorials 20%
– Essay on group presentation topic 40%
– Exam 40%
• My details
– Steve Keen
• 4620-3016
– 0425 248 089 in emergency
• S.keen@uws.edu.au
• Thursdays 1-3pm
Economics as the context of business
• Management, marketing & accounting focus on specifics
– How to manage a company…
– How to market a product…
– How to quantify & compare corporate performance…
• Focus is your personal input to business
• Economics is the context of business
– “Men make their own history, but they do not make it as
they please; they do not make it under self-selected
circumstances, but under circumstances existing already,
given and transmitted from the past”
• Focus on constraints on and circumstances of your input
– Both opportunities & dilemmas
– Quick quiz: who made the above statement?
Economics as the context of business
•Often the best wisdom in economics
isn’t found in standard textbooks!
•This subject takes a deeper look at
economics you’ve already done (micro,
macro); and
•considers theories & data you
haven’t seen before that are more
relevant to business
Economics as the context of business
• A hierarchical view: starting from the bottom & working up
– The firm
– The market/industry
– The economy
– Finance
– International business
• A critical view
– Conventional theories of above
• Profit maximising behaviour, types of competition, Game
theory, IS-LM, Efficient Markets, Comparative
advantage
– Different perspectives
• Empirical data
• Critiques of conventional theories
• Alternative theories
Economics as the context of business
• What matters most to your firm’s success may lie outside it:
– “For companies, a central message … is that many of a
company’s competitive advantages lie outside the firm…”
(Porter 1998: xxiii)
• Understanding “what lies outside” may therefore be the most
important thing you can do to be a successful executive
– Economics as the study of “what lies outside”
• Relationships with other firms
• Interaction with the market
• Market interaction with the macroeconomy
• Macroeconomy’s interaction with global economy; AND…
• Theories about the economy! Because:
Economics as the context of business
• Sometimes (not often enough!) theories explain how the real
world works
• Frequently (too often!) theories affect how people behave in
the economy
– Government follows economic advice
– Firms/unions think about economy in terms of economic
models
– Government bodies (e.g. ACCC Australian Competition &
Consumer Commission) apply economic theory in policies
(e.g. competition policy, deregulation of telecommunications,
etc.)
• So you have to understand economic theory even if it’s wrong!
– Which it frequently is…
Economics as the context of business
• Emphasis in this course is on realism
– Theories presented; but also
– Empirical data examined to see whether theories actually
work
– Frequent conclusion: they don’t (but sometimes they do…)
• One consequence: can’t rely upon textbooks for this
course!
• Textbooks normally
– present theory uncritically
– only include “case studies” that confirm accepted
theory
• frequently based on invented rather than real
data
– Normally don’t go beyond microeconomics
Economics as the context of business
• This course
– Starts with micro (theory of firm…)
– Progresses through theory of the market, economy, finance
to international trade
– Based heavily on readings volume
• You must have a copy
• Tutorials and assessments based on contents
“The firm”: real world vs economic theory
• The real world: an incredible diversity
– Size: from corner store to Microsoft
– Operations: from one outlet to almost all countries
– Diversity:
• from single product (wheat farm) to many (Sony)
• From one industry to many
– Ownership: from sole proprietor to multinational listed
company
– Structure:
• from one person operations to multi-department
• From sole operations (production to sale) to
specialisation in manufacturing, wholesale, retail,
marketing, consulting…
Economics of the firm: statistics
• Firms in the Australian economy
– Range in size from sole proprietor/employee to multiemployee institutions
– From single product to diversified conglomerates
– Over 610 thousand “entities” in 2000 (ABS 8140.0)
• 3229 “large” entities employing 200 or more workers
• 607,663 “other” employing less
• “Average” employment 10.1 persons per firm
– “Average” large firm employed 750 workers
– “Average” other firm employed 6.5 workers
• Legal multitude of businesses masks much smaller
number of operating units: 15,870 units with 700,024
legal entities in 1998/99
Economics of the firm: statistics
• Concentration obvious (ABS 8140.0.55.001)
– Top 20 units responsible for 13.9% of sales
– 15,850 others responsible for remaining 86.1% of sales
• Economic theory abstracts from this concentration & diversity
– Claims firms share several essential common properties
• Profit maximising behaviour
• Under conditions of diminishing marginal productivity
• Selling on “spot” market (no stocks) to anonymous buyers
– Only interest buyers have is in getting lowest price
– No interest in continuing relationship between
buyer/seller; “arms length” transactions
“The firm”: economic theory
• The economic simplification: diversity ignored to focus on
alleged essence of profit maximising behavior:
– Basic model
• single industry & product
• one location
• privately owned, sole proprietor
– No internal structure considered
– No specialisation: firm does everything from manufacturing
to sales
• Some generalisations allowed later (e.g., agency theory)
– But basic theory abstracts from these details
– Core model: profit maximising behaviour under conditions
of diminishing marginal productivity
Economic theory of the firm
• Profit maximising behavior:
– Seeking highest possible profit given constraints of
• Falling price as quantity offered for sale rises
• Rising costs as quantity offered for sale rises
– Falling price as quantity offered for sale rises:
• “Law of demand”: can only sell additional units if price is
lowered
• Mathematically: a negative relationship between price
and quantity
– To quantity sold must  price
– Simple example: linear demand curve P(Q) = a –b Q
Economic theory of the firm
• Key consequence of
“law of demand”:
• Total revenue is price
times quantity
• Total revenue rises
for a while as
increase in Q more
than outweighs
decline in P
• But ultimately fall in
P overwhelms
increase in Q: total
revenue peaks and
then falls…
• Graphing price as a function of quantity:
a  100
b 
1
P ( Q)  a  b  Q
2000
100
80
60
P ( Q)
40
20
Price as function of quantity
0
0
4
5  10
5
1  10
Q
5
1.5  10
5
2  10
Economic theory of the firm
• If firm produces
20,000 units, market
6
Slope=0
price is 80
2.5  10
– Total revenue =
6
80 * 20,000 =
2  10
$1.6 million
• 40,000 units sold,
6
1.5  10
price 60
TR ( Q )
– Total revenue =
6

1 10
60 * 40,000 =
$2.4 million
5
5  10
60,000x40
– Change in total
revenue $0.8 m
0
– Change in unit
4
4
4
4
5
2  10
4  10
6  10
8  10
1  10
revenue=$0.8
Q
m/20,000=$40
Price (LH Scale)
• 60,000 units sold, price 40
Revenue=Price x Quantity (RHS)
– Total revenue $2.4 million
– Change in revenue per unit zero
TR ( Q)  P ( Q)  Q
100
80
40,000x60
20,000x80
60
P ( Q)
40
20
0
0
Economic theory of the firm
• Change in revenue called “marginal revenue”
• “In the limit”, marginal revenue equals slope of total revenue curve:
• Value of marginal revenue (x)
equals slope of total revenue
curve at same point (o)
• Other side of profit equation is
costs:
– Fixed: costs incurred
regardless of how many units
produced (research,
development, factory
construction, rent, etc.)
– Variable: costs that depend
on level of output: wages, raw
materials, intermediate
goods, etc.)…
Economic theory of the firm
• Theory argues per unit costs rise as quantity offered for sale rises:
k  1000000
c  30
d 
2
FC ( Q)  k
1
100000
3
VC ( Q)  c  Q  d  Q  f  Q
7
3  10
Total Cost
Fixed Cost
7
2.5  10
Variable Cost
7
2  10
TC ( Q )
FC ( Q ) 1.5  107
VC ( Q )
7
1  10
6
5  10
0
0
4
5  10
5
1  10
Q
• Slope of total cost curve
is marginal cost:
TC ( Q)  FC ( Q)  VC ( Q)
• Rises as output rises
because of diminishing
marginal productivity
– After some point, each
new worker hired
(variable input) adds
less to production than
previous worker
– With constant wage
and diminishing output
per worker, unit cost
of output rises
5
5
• “Please explain”…
1.5  10
2  10
f 
1
400000000
Economic theory of the firm
• Rising marginal cost: the argument…
– Production occurs in “the short run”
– “Short run”: period in which at least one crucial input to
production can’t be varied (normally machinery)
– Therefore to increase output, more “variable factors” must
be added to the fixed factors
• Economic models normally consider just two factors:
– Labour
– “Capital”: grab-bag for all non-human inputs to
production
• Factory buildings
• Machine tools
• Electrical circuitry, computers
• Raw materials and intermediate inputs (e.g., car
stereo units for cars)
– As you add more & more variable factors to fixed factors…
Economic theory of the firm
• There is some ideal worker:machine
ratio (e.g., one worker per jackhammer)
• In short run, firm has fixed
number of jackhammers
?
If this sounds
weird to you,
good! You’re on
to something…
• To dig holes, firm has to hire workers
• 1st worker operates all six jackhammers at once: pretty inefficient!
• Additional workers might show increasing productivity per worker
for a while (two workers operating 3 jackhammers each less messy
than one operating 6, ditto three workers operating two each…)
Economic theory of the firm
• Eventually ideal ratio reached
(6 workers for 6 jackhammers)
• Then to dig more holes, have to
have more than one worker
per jackhammer:
• More holes can be dug with
2 workers per jackhammer
than with one…
• But productivity of two
workers per jackhammer
less than one worker per
jackhammer…
Economic theory of the firm
• So productivity per worker might rise for a while;
• But ultimately falls as more output can only be produced by
adding more variable inputs (labour) to fixed input (capital)
past ideal labour:capital ratio
– Addition to output from each additional worker falls (but
doesn’t become negative)
• “Diminishing marginal productivity” (DMP)
• DMP leads to rising marginal cost
• Example: “Cobb-Douglas production function”
Q    L K

Quantity produced
1 
Relative labor/capital
product coefficient
No. workers
Technology coefficient
Amount of capital
Economic theory of the firm
K  100
  .4
L  0  0.1  250

 ( K  L     )    L  K
1 
Cobb-Douglas Production Function
With 250 workers,
output is 1,443
With 100 workers,
output is 1,000
Change in ouput
from 1st 100 is 1000
1000
 (K  L     )
500
0
0
50
100
150
L
Number of workers
Change in ouput
from next 250 is 443
1500
Output
• Cobb-Douglas production
function allegedly fits
aggregate economic data
well (but see Shaikh, A.
M., (1974). “Laws of
Algebra and Laws of
Production: The Humbug
Production Function”,
Review of Economics and
Statistics, 61: 115-20)
• Example with =10,
K=100, =.4, L between 0
and 250:
  10
200
250
Economic theory of the firm
• Each additional worker adds to output, but adds less than
previous worker: diminishing marginal productivity
– As usual, this is slope of total product curve: (maths
unimportant, but here it is!):
• Differentiate with respect to Labour…
Q    L K
dQ
 1
1 
• Graphing marginal product:
     L K
dL

1 
Economic theory of the firm
Output
• Output with 99
workers = 996
• Output with 100
workers = 1000
• Marginal product of
100th worker  4.012
– Using formula, it’s
exactly 4
K
1 
Cobb-Douglas Production Function
1500
15
1400
Total Product (Q) LHS
14
1300
Marginal Product RHS
13
1200
12
1100
11
1000
10
900
9
800
8
700
7
600
6
500
5
400
4
300
3
200
2
100
1
 (K  L     )
0
0
50
150
100
200
L
Workers
• Diminishing marginal product
leads to rising marginal cost…
0
250
MP ( L)
Marginal Product
• Output with 49
workers = 752
• Output with 50
workers = 758
• Marginal product of
50th worker  6
– Using formula, it’s
exactly 6.063
 1
MP ( L)      L
Economic theory of the firm
• First step is to “flip the axes”: graph labour input (on Y axis)
needed to produce output (on X axis):
1
• Just reads in reverse:

Q  0  1500
 Q 
L ( Q) 
   K1 
– 1,000 units of output


desired;
Workers needed given desired output
300
– 100 workers needed
250
Workers needed
• To get total (variable)
cost, multiply Y axis by
wage rate (say $12 an
hour)…
200
L ( Q ) 150
100
50
0
0
500
1000
Q
Output
1500
Economic theory of the firm
VC ( Q)  w  L ( Q)
MC ( Q) 
d
dQ
VC ( Q)
Variable cost of desired output
Production level of 1000
units has variable costs
of $1200
Marginal cost of 1000th
units is about $3
6
5
4
3 MC ( Q )
2
1
500
1000
Q
Output
0
1500
Marginal cost
Total variable cost
• Rate of change of
w  12
variable cost is marginal
cost
3500
•
• Rising because of
3000
diminishing marginal
productivity…
2500
•
• So firm trying to
2000
maximise profits is
VC ( Q )
1500
(according to economic
theory) faced with
1000
– Falling price
500
– Rising cost…
0
0
• How to maximise profit?
• Find biggest gap
between revenue and
cost
Economic theory of the firm
• Graphically, it’s easy: (using earlier example)
Profit( Q)  TR ( Q)  TC ( Q)
7
3  10
Total Revenue
Total Cost
7
2.5  10
Profit
7
2  10
TR ( Q )
TC ( Q )
7
1.5  10
Profit ( Q )
7
1  10
6
5  10
0
0
4
5  10
5
1  10
Q
5
1.5  10
5
2  10
• But economists
prefer to make it
complicated by
working in average &
marginal revenue &
cost
• Converting diagrams
to averages by
dividing by quantity
gives us:
Economic theory of the firm
• As economists like to show it: • What it means: “maximise profit
by finding the biggest gap
“maximise profit by equating
between revenue and cost”
marginal revenue and marginal
cost”
• Gap between curves is biggest
when tangents (marginal revenue &
d
marginal cost) are parallel:
MC ( Q) 
VC ( Q)
AC ( Q)  TC ( Q)  Q
dQ
200
Marginal Cost
Average Cost
Price
150
Marginal Revenue
MC ( Q )
AC ( Q )
P ( Q)
100
MR ( Q )
50
0
0
4
5  10
5
1  10
Q
5
1.5  10
5
2  10
Economic theory of the firm
• So it’s “really easy” to manage a firm:
– Objective is to maximise profits
– Procedure is
• (1) Work out marginal cost
• (2) Work out marginal revenue
• (3) Choose output level that equates the two
• For competitive firms, it’s even easier…
– Competitive firms are “price takers”
• Too small to affect market price/take price as “given”
• Marginal revenue therefore equals price
– (MR less than price for less competitive industries)
– Profit maximisation rule is “produce output level at which
marginal cost equals price”:
Economic theory of the firm
Downward sloping market demand
curve
Supply
Pe
Horizontal demand curve for single
firm
Price
Price
• “Perfect competition”
dP
 0, MR  P
dQ
Marginal Cost
dP
 0, MR  P
dq
Pe
Demand
Qe
qe
Quantity
quantity
Economic theory of the firm
• So the economic theory rules are:
– If you’re a monopoly or oligopoly
• Work out your marginal cost and marginal revenue
• Produce the output level at which they are equal
– If you’re in a competitive industry
• Work out your marginal cost
• Produce output level at which marginal cost equals price
– If you’re in an industry with a small number of large firms
• More complicated: game theory…
– More on this later
– As a typical text (Thomas & Maurice 2003, Managerial
Economics, McGraw-Hill, Boston) summarises it:
Economic theory of the firm
• It’s a breeze for
competitive
industries (p.
450):
• A bit more
complicated for
monopoly (p. 500):
• And a real pain
for oligopoly (p.
560)…
Economic theory of the firm
• What to do? So many choices…
• How does theory stack up against
reality?
Economic facts of the firm
• Theory makes many predictions; e.g.
– Firms should have rising marginal costs
– Competitive firms should have elastic demand curves:
• Elasticity: how much demand changes for a change in
price:
%changeQ Q Q P Q
E 
%change P

P P

Q P
– Value of E can be low (less than 1) for an industry,
but in limit is infinity for competitive firms
(horizontal demand curve…)
– Relative prices should move frequently as supply & demand
shift
• Problem: not observed in reality
– Relative prices seem stable
– Money prices tend to move up, not down…
– “Price stickiness”
Economic facts of the firm
Price
• Dispute in economics over whether prices “sticky” or
“flexible”
• Ideological division in dispute
– Neoclassicals/Free marketeers believe prices
“flexible”
• Prices adjust rapidly to changes in demand,
supply
Pe
Supply
Demand
Qe Quantity
• Economic problems caused by
government, union, monopoly
behavior that makes some prices
(e.g. wages) more rigid than others
Economic facts of the firm
•
•
•
•
•
– Keynesians/Mixed economy supporters believe “sticky”
• Prices adjust sluggishly
• Key markets (e.g. labour) can’t be “cleared”
(unemployment eliminated) simply by price movements
• Can have underemployment for substantial time;
government intervention needed for full employment
Ideological dispute continues, but statistical results imply
“sluggish” price adjustments the rule
Theory implies rapid adjustments should occur
Why the difference?
Plenty of theories as to why prices are sticky;
Alan Blinder (in Readings) decided to ask firms “Why?”
– Alan S. Blinder et al., (1998). Asking About Prices: a new
approach to understanding price stickiness, Russell Sage
Foundation, New York.
Economic facts of the firm
• Enormous volume of theoretical research in economics
• Huge amount of statistical (“econometric”) research too
• Relatively little empirical research
– Finding out what actually happens at firm/consumer level
– Also asking firms why they do what they do
• Frequency and rapidity of price changes etc.
• How behavior compares to different theories of price
stickiness
Economic facts of the firm
• Blinder’s procedure
– Survey random sample of GDP so that results statistically
applicable to whole US economy
• 200 firms surveyed
– Structured survey to ensure objectivity
• Questions tailored to test economic theory
• Key economists consulted on design of questions
– Face to face interviews of top executives (25%
President/CEO, 45% Vice President, 20% Manager) by
Economics PhD students
• Questionnaire taken seriously, informed answers
• Interviewers could help clarify questions
• Interviews took 45-70 minutes for 30 questions
• Trial surveys undertaken prior to real thing to improve
uniformity of presentation, interpretation
Economic facts of the firm
– Sample representative of private, for profit, unregulated,
non-farm industry (71% of US GDP)
• Reflects relative weight of industries in US GDP
• Excluded companies with < $10 million in sales
– Excluded group represents 25-50% of GDP
– Weight of industries in which small firms common
increased to compensate
• Farms excluded because “no-one believes farm prices to
be sticky” (60)
– Perhaps price dynamics of farm sector different to
manufacturing?
– Random sample selected, of those approached 61% took
part to yield 200 firms—high response rate
Economic facts of the firm
• Distribution of sample differs from GDP with respect to firm
size:
Size
Sample
GDP
< $10 m
0%
26.4%
$10-$25 m
22.5%
7.1%
$25-$50 m
13.5%
12.7%
64%
67%
> $50 m
• But big firms overwhelmingly important component:
– Average sales of firms surveyed $3.2 billion!
• (even though 36% of surveyed firms had sales < $ 50 m)
• 7 biggest firms had sales > $20 billion each & represented
58 per cent of total sales by sample
– Firms surveyed represent 7.6% of US GDP
– “we interviewed an astounding 10 to 15 per cent of the target
population—a large fraction by any standard.” (68)
Economic facts of the firm
• Blinder’s survey serious coverage of US economy
• Results give serious evaluation of economic theory
• If survey results consistent with theory, theory a good guide
to functioning of economy & to how managers should manage
• If survey results inconsistent with theory, relevance of
economic theory seriously jeopardised: could be irrelevant to
functioning of economy (& how managers should manage)
• Results contradict most of economic theory
– Most sales to other businesses, not end consumers
– Most sales to repeat customers, not “impersonal”
– Marginal costs fall for most firms, not rise
– Most firms face inelastic demand (E<1), not elastic
– Fixed costs more important than variable costs