Question
1. Managerial Economics serves as a “link between traditional economics and decision making
sciences.” Discuss.
2. “The main determinant of elasticity is the availability of substitutes.” Explain this statement
in the context of price elasticity of demand.
3. Find (i) the marginal and (2) the average cost functions for the following total cost function.
Calculate them at Q = 4 and Q = 6.
TC= 3Q2 + 7Q +12
4. “Oligopoly is the most prevalent form of market structure in the manufacturing sector.”
Describe this statement with the help of an example.
1.Managerial Economics serves as a “link between traditional economics and decision making
sciences.” Discuss.
TRADITIONAL ECONOMICS IS The social science that deals with the production, distribution, and consumption of goods and services and with the theory and management of economies or economic systems. The foundations of TRADITIONAL economics and all the social sciences has multiple fundamental flaws
which includes an intrinsic inconsistency in utility theory. In game theory undefined sums are used to define basic concepts, the characteristic function is ill-defined, and there are other fundamental errors.In measurement theory the models of even the most elementary variables such as length and mass are incorrect, and in decision theory even what is being measured is not understood. These errors must be removed explained and their correction outlined. Correcting these theories will lead to better decisions by individuals, organizations, affecting everyday lives of people throughout the world.
IN BUSINESS, MANAGEMENT DECISION MAKING
NEEDS Steps of Structured Decision Making:
• Problem definition. What specific decision has to be made? What are the spatial and temporal scope of the decision? Will the decision be iterated over time?
• Objectives. What are the management objectives? Ideally, these are stated in quantitative terms that relate to metrics that can be measured. Setting objectives falls in
the realm of policy, and should be informed by legal and regulatory mandates, as well as stakeholder viewpoints. A number of methods for stakeholder elicitation and conflict
resolution are appropriate for clarifying objectives. • Alternatives. What are the different management actions to choose from? This element
requires explicit articulation of the alternatives available to the decision maker. The range of permissible options is often constrained by legal or political considerations, but
structured assessment may lead to creative new alternatives. • Consequences. What are the consequences of different management actions? How much
of the objectives would each alternative achieve? In structured decision-making, we predict the consequences of the alternative actions with some type of model Depending
on the information available or the quantification desired for a structured decision process consequences may be modeled with highly scientific computer applications or with
personal judgment elicited carefully and transparently. Ideally, models are quantitative,but they need not be; the important thing is that they link actions to consequences.
• Tradeoffs. If there are multiple objectives, how do they trade off with each other? In most complex decisions, the best we can do is choose intelligently between less-than-
perfect alternatives. Numerous tools are available to help determine the relative importance or weights among conflicting objectives and to then compare alternatives
across multiple attributes to find the ‘best’ compromise solutions. • Uncertainty. Because we rarely know precisely how management actions will affect
natural systems, decisions are frequently made in the face of uncertainty. Uncertainty makes choosing among alternative far more difficult. A good decision-making process
will confront uncertainty explicitly, and evaluate the likelihood of different outcomes and their possible consequences.
• Risk Tolerance. Identifying the uncertainty that impedes decision-making, then analyzing the risk that uncertainty presents to management is an important step in making
a good decision. Understanding the level of risk a decision-maker is willing to accept, or the risk response determined by law or policy, will make the decision-making process
more objectives-driven, transparent, and defensible. • Linked decisions. Many important decisions are linked over time. The key to dealing
effectively with linked decisions is to isolate and resolve the near-term issues while sequencing the collection of information needed for future decisions
TO MAKE SUCH STRUCTURED DECISIONS WITH THE HELP OF ''TRADITIONAL ECONOMICS'' IS NOT FEASIBLE.
HENCE, HERE WE MAKE USE OF THE MANAGERIAL ECONOMICS.
Managerial economics (also called business economics), is a branch of economics that applies microeconomic analysis to specific business decisions. As such, it bridges economic theory and economics in practice. It draws heavily from quantitative techniques such as regression analysis and correlation, Lagrangian calculus (linear). If there is a unifying theme that runs through most of managerial economics it is the attempt to optimize business decisions given the firm's objectives and given constraints imposed by scarcity, for example through the use of operations research and programming.
“Managerial economics is .. the application of economic principles and methodologies to the decision-making process within the firm or organization.”
“Managerial economics applies economic theory and methods to business and administrative decision-making.”
“Managerial economics refers to the application of economic theory and the tools of analysis of decision science to examine how an organisation can achieve its objectives most effectively.”
“It is the application of economic analysis to business problems; it has its origin in theoretical microeconomics.”
MANAGERIAL MODEL M BUILDING
The steps:the hypothetical-deductive approach make assumptions about behaviour work out the consequences of those assumptions make predictions
test the predictions against the evidence PREDICTIONS SUPPORTED? The model is accepted as a good explanation (for the moment) PREDICTIONS REFUTED? Go back and re-work the whole process
Should Assumptions be Realistic?
The assumption of profit-maximising may be unrealistic or inaccurate However, what matters is the explanatory or predictive power of a theory (or model), not the descriptive realism of its assumptions. A model built on unrealistic assumptions may give good predictions.
Assumptions are a necessary simplifying device Example: Overtaking
What Is A “Good” Model? It allows us to make predictions and set hypotheses The predictions can be tested against the empirical evidence
The predictions are supported by the empirical evidence
MANAGERIAL ECONOMICS
Economics in general takes a ‘positive’ and predictive approach not prescriptive or ‘normative’ trying to explain “what is” not what “should be” the main objective is to understand how a market economy works Not very concerned about the descriptive realism of assumptions: “I assume X” does not mean “I believe X to be true” Some real tension if the models are used for prescription assume “perfect knowledge”: OK for model-building cannot say to a manager: “behave AS IF you had perfect knowledge”
Comparative Statics begin with an initial equilibrium position - the starting point change something identify the new equilibrium, e.g:in neo-classical model of the firm
When demand increases? When costs rise? When a fixed cost increases? This is the main purpose of the model -what it was designed to do Normative prescriptions
it will cost me $30 per unit to supply something which will give me $20 per unit in revenue- should I do it? I must pay $20 billion to set up in my industry. Should I charge higher prices to get that money back? Positive and Normative are linked by “if?” IF the aim of the firm is to maximise profit what will it do/what should it do?
What is the purpose of MANAGEERIAL economic analysis? Why do we want to apply MANAGERIAL economic analysis to business problems? For the businessperson: “to assist decision-making”, to provide decision-rules which can be applied The “normative” approach to theory: What should be? These purposes are different, they can lead to misunderstanding, and economists are not always honest about the limitations of their approach for practical purposes.
What are these limitations?
If the aim is prediction, unrealistic assumptions are acceptable and may be needed;
for instance, the firm may be assumed to behave “as if” its managers had perfect knowledge of its environment
If the aim is to produce decision-rules which can be applied by practising managers, unrealistic assumptions will produce decision-rules which are not operational
for instance, set output and price by MC=MR
How Can Managerial Economics Assist Decision-Making?
1. Adopt a general perspective, not a sample of one
2. Simple models provide stepping stone to more complexity and realism
3. Thinking logically has value itself and can expose sloppy thinking
Why Managerial Economics?
A powerful “analytical engine”.
A broader perspective on the firm.
what is a firm?
what are the firm’s overall objectives?
what pressures drive the firm towards profit and away from profit
The basis for some of the more rigourous analysis of issues in Marketing and Strategic Management.
The Structure-Conduct-Performance Paradigm:
Basic Conditions: factors which shape the market of the industry, e.g. demand, supply, political factors
Structure: attributes which give definition to the supply-side of the market, e.g. economies of scale, barriers to entry, industry concentration, product differentiation, vertical integration.
Conduct: the behavior of firms in the market, e.g. pricing behavior advertising, innovation.
Performance: a judgement about the results of market behaviour, e.g. efficiency, profitability, fairness/income distribution, economic growth.
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2. “The main determinant of elasticity is the availability of substitutes.” Explain this statementin the context of price elasticity of demand
The degree to which a demand or supply curve reacts to a change in price is the curve's ELASTICITY. Elasticity varies among products because some products may be more essential to the consumer. Products that are necessities are more insensitive to price changes because consumers would continue buying these products despite price increases. Conversely, a price increase of a good or service that is considered less of a necessity will deter more consumers because the opportunity cost of buying the product will become too high.
A good or service is considered to be highly elastic if a slight change in price leads to a sharp change in the quantity demanded or supplied. Usually these kinds of products are readily available in the market and a person may not necessarily need them in his or her daily life. On the other hand, an inelastic good or service is one in which changes in price witness only modest changes in the quantity demanded or supplied, if any at all. These goods tend to be things that are more of a necessity to the consumer in his or her daily life.
To determine the elasticity of the SUPPLY OR DEMAND curves, we can use this simple equation:
Elasticity = (% change in quantity / % change in price)
If elasticity is greater than or equal to one, the curve is considered to be elastic. If it is less than one, the curve is said to be inelastic.
As we mentioned previously, the demand curve is a negative slope, and if there is a large decrease in the quantity demanded with a small increase in price, the demand curve looks flatter, or more horizontal. This flatter curve means that the good or service in question is elastic.
Meanwhile, inelastic demand is represented with a much more upright curve as quantity changes little with a large movement in price.
Elasticity of supply works similarly. If a change in price results in a big change in the amount supplied, the supply curve appears flatter and is considered elastic. Elasticity in this case would be greater than or equal to one.
On the other hand, if a big change in price only results in a minor change in the quantity supplied, the supply curve is steeper and its elasticity would be less than one.
Factors Affecting Demand Elasticity
There are three main factors that influence a demand's price elasticity:
1. The availability of substitutes - This is probably the most important factor influencing the elasticity of a good or service. In general, the more substitutes, the more elastic the demand will be. For example, if the price of a cup of coffee went up by $0.25, consumers could replace their morning caffeine with a cup of tea. This means that coffee is an elastic good because a raise in price will cause a large decrease in demand as consumers start buying more tea instead of coffee.
However, if the price of caffeine were to go up as a whole, we would probably see little change in the consumption of coffee or tea because there are few substitutes for caffeine. Most people are not willing to give up their morning cup of caffeine no matter what the price. We would say, therefore, that caffeine is an inelastic product because of its lack of substitutes. Thus, while a product within an industry is elastic due to the availability of substitutes, the industry itself tends to be inelastic. Usually, unique goods such as diamonds are inelastic because they have few if any substitutes.
2. Amount of income available to spend on the good - This factor affecting demand elasticity refers to the total a person can spend on a particular good or service. Thus, if the price of a can of Coke goes up from $0.50 to $1 and income stays the same, the income that is available to spend on coke, which is $2, is now enough for only two rather than four cans of Coke. In other words, the consumer is forced to reduce his or her demand of Coke. Thus if there is an increase in price and no change in the amount of income available to spend on the good, there will be an elastic reaction in demand; demand will be sensitive to a change in price if there is no change in income.
3. Time - The third influential factor is time. If the price of cigarettes goes up $2 per pack, a smoker with very few available substitutes will most likely continue buying his or her daily cigarettes. This means that tobacco is inelastic because the change in price will not have a significant influence on the quantity demanded. However, if that smoker finds that he or she cannot afford to spend the extra $2 per day and begins to kick the habit over a period of time, the price elasticity of cigarettes for that consumer becomes elastic in the long run.
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Price elasticity of demand is defined as the measure of responsiveness in the quantity demanded for a commodity as a result of change in price of the same commodity. In other words, it is percentage change in quantity demanded as per the percentage change in price of the same commodity. In economics and business studies, the price elasticity of demand (PED) is a measure of the sensitivity of quantity demanded to changes in price. It is measured as elasticity, that is it measures the relationship as the ratio of percentage changes between quantity demanded of a good and changes in its price. Drinking water is a good example of a good that has inelastic characteristics in that people will pay anything for it (high or low prices with relatively equivalent quantity demanded), so it is not elastic. On the other hand, demand for sugar is very elastic because as the price of sugar increases, there are many substitutions which consumers may switch to.
A price drop usually results in an increase in the quantity demanded by consumers (see Giffen good for an exception). The demand for a good is relatively inelastic when the change in quantity demanded is less than change in price. Goods and services for which no substitutes exist are generally inelastic. Demand for an antibiotic, for example, becomes highly inelastic when it alone can kill an infection resistant to all other antibiotics. Rather than die of an infection, patients will generally be willing to pay whatever is necessary to acquire enough of the antibiotic to kill the infection.
A number of factors determine the elasticity:
Substitutes: The more substitutes, the higher the elasticity, as people can easily switch from one good to another if a minor price change is made
• Percentage of income: The higher the percentage that the product's price is of the consumers income, the higher the elasticity, as people will be careful with purchasing the good because of its cost
• Necessity: The more necessary a good is, the lower the elasticity, as people will attempt to buy it no matter the price, such as the case of insulin for those that need it.
• Duration: The longer a price change holds, the higher the elasticity, as more and more people will stop demanding the goods (i.e. if you go to the supermarket and find that blueberries have doubled in price, you'll buy it because you need it this time, but next time you won't, unless the price drops back down again)
• Breadth of definition: The broader the definition, the lower the elasticity. For example, Company X's fried dumplings will have a relatively high elasticity, where as food in general will have an extremely low elasticity (see Substitutes, Necessity above)
Substitute good
In economics, one kind of good (or service) is said to be a substitute good for another kind in so far as the two kinds of goods can be consumed or used in place of one another in at least some of their possible uses.
Examples
Classic examples of substitute goods include margarine and butter, or petroleum and natural gas (used for heating or electricity). The fact that one good is substitutable for another has immediate economic consequences: insofar as one good can be substituted for another, the demand for the two kinds of good will be bound together by the fact that customers can trade off one good for the other if it becomes advantageous to do so.
Increase in price
Thus, an increase in price for one kind of good (ceteris paribus) will result in an increase in demand for its substitute goods.
Decrease in price
A decrease in price (ceteris paribus, again) will result in a decrease in demand for its substitutes. Thus, economists can predict that a spike in the cost of wood will likely mean increased business for bricklayers, or that falling cellular phone rates will mean a fall-off in business for public pay phones.
Different types
It is important to note that when speaking about substitute goods we are speaking about two different kinds of goods; so the "substitutability" of one good for another is always a matter of degree. One good is a perfect substitute for another only if it can be used in exactly the same way. In that case the utility of a combination is an increasing function of the sum of the two amounts, and theoretically, in the case of a price difference, there would be no demand for the more expensive good.
Perfect and Imperfect substitues
Perfect substitutes may alternately be characterized as goods having a constant marginal rate of substitution. Alternate types of soft drinks are commonly used as an example of perfect substitutes. As the price of Coca Cola rises, consumers would be expected to substitute Pepsi in equal quantities, i.e., total cola consumption would hold constant. Also, blank media such as a writable Compact Discs from alternate manufacturers would be perfect substitutes. If one manufacturer raises the price of its CDs, consumers would be expected to switch to a lower cost manufacturer.
Imperfect substitutes exhibit variable marginal rates of substitution along the consumer indifference curve.
Perfect Competition
One of the requirements for perfect competition is that the products of competing firms should be perfect substitutes. When this condition is not satisfied, the market is characterized by product differentiation.
Good Substitution
Substitute goods exhibit no complementarities, as in a complementary good.
In other words, good substitution is an economic concept where two goods are of comparable value. Car brands are an example. While someone could argue that Ford trucks are considerably different from Toyota trucks, if the price of Ford trucks goes up enough, some people will buy Toyota trucks instead.
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3“Oligopoly is the most prevalent form of market structure in the manufacturing sector.”
Describe this statement with the help of an example.
OLIGOPLY
A market structure characterized by a small number of large firms that dominate the market, selling either identical or differentiated products, with significant barriers to entry into the industry. This is one of four basic market structures. The other three are perfect competition, monopoly, and monopolistic competition. Oligopoly dominates the modern economic landscape, accounting for about half of all output produced in the economy. Oligopolistic industries are as diverse as they are widespread, ranging from breakfast cereal to cars, from computers to aircraft, from television broadcasting to pharmaceuticals, from petroleum to detergent.
Oligopoly is a market structure characterized by a small number of relatively large firms that dominate an industry. The market can be dominated by as few as two firms or as many as twenty, and still be considered oligopoly. With fewer than two firms, the industry is monopoly. As the number of firms increase (but with no exact number) oligopoly becomes monopolistic competition.
Because an oligopolistic firm is relatively large compared to the overall market, it has a substantial degree of market control. It does not have the total control over the supply side as exhibited by monopoly, but its capital is significantly greater than that of a monopolistically competitive firm.
Relative size and extent of market control means that interdependence among firms in an industry is a key feature of oligopoly. The actions of one firm depend on and influence the actions of another. Such interdependence creates a number of interesting economic issues. One is the tendency for competing oligopolistic firms to turn into cooperating oligopolistic firms. When they do, inefficiency worsens, and they tend to come under the scrutiny of government. Alternatively, oligopolistic firms tend to be a prime source of innovations, innovations that promote technological advances and economic growth.
Like much of the imperfection that makes up the real world, there is both good and bad with oligopoly. The challenge in economics is, of course, to promote the good and limit the bad.
Characteristics
The three most important characteristics of oligopoly are: (1) an industry dominated by a small number of large firms, (2) firms sell either identical or differentiated products, and (3) the industry has significant barriers to entry.
Small Number of Large Firms: An oligopolistic industry is dominated by a small number of large firms, each of which is relatively large compared to the overall size of the market. This generates substantial market control, the extent of market control depending on the number and size of the firms.
Identical or Differentiated Products: Some oligopolistic industries produce identical products, while others produce differentiated products. Identical product oligopolies tend to process raw materials or intermediate goods that are used as inputs by other industries. Notable examples are petroleum, steel, and aluminum. Differentiated product oligopolies tend to focus on consumer goods that satisfy the wide variety of consumer wants and needs. A few examples of differentiated oligopolistic industries include automobiles, household detergents, and computers.
Barriers to Entry: Firms in a oligopolistic industry attain and retain market control through barriers to entry. The most common barriers to entry include patents, resource ownership, government franchises, start-up cost, brand name recognition, and decreasing average cost. Each of these make it extremely difficult, if not impossible, for potential firms to enter an industry.
Behavior
Although oligopolistic industries tend to be diverse, they also tend to exhibit several behavioral tendencies: (1) interdependence, (2) rigid prices, (3) nonprice competition, (4) mergers, and (5) collusion.
Interdependence: Each oligopolistic firm keeps a close eye on the activities of other firms in the industry. Decisions made by one firm invariably affect others and are invariably affected by others. Competition among interdependent oligopoly firms is comparable to a game or an athletic contest. One team's success depends not only on its own actions but on the actions of its competitor. Oligopolistic firms engage in competition among the few.
• Rigid Prices: Many oligopolistic industries (not all, but many) tend to keep prices relatively constant, preferring to compete in ways that do not involve changing the price. The prime reason for rigid prices is that competitors are likely to match price decreases, but not price increases. As such, a firm has little to gain from changing prices.
• Nonprice Competition: Because oligopolistic firms have little to gain through price competition, they generally rely on nonprice methods of competition. Three of the more common methods of nonprice competition are: (a) advertising, (b) product differentiation, and (c) barriers to entry. The goal for most oligopolistic firms is to attract buyers and increase market share, while holding the line on price.
• Mergers: Oligopolistic firms perpetually balance competition against cooperation. One way to pursue cooperation is through merger--legally combining two separate firms into a single firm. Because oligopolistic industries have a small number of firms, the incentive to merge is quite high. Doing so then gives the resulting firm greater market control.
• Collusion: Another common method of cooperation is through collusion--two or more firms that secretly agree to control prices, production, or other aspects of the market. When done right, collusion means that the firms behave as if they are one firm, a monopoly. As such they can set a monopoly price, produce a monopoly quantity, and allocate resources as inefficiently as a monopoly. A formal method of collusion, usually found among international produces is a cartel.
Oligopoly is the most prevalent form of market structure in the manufacturing sector
Manufacturing sector maintain OLIGOPOLY through barriers to entry. The most common barriers to entry include -patents, -resource ownership, -government franchises,
-start-up cost, -brand name recognition, and decreasing average cost. Each of these make it extremely difficult, if not impossible, for potential firms to enter an industry.
