managerial economics by dominick salvatore.pdf

April 2, 2018 | Author: Ratnadip Bhowmik | Category: Monopoly, Perfect Competition, Oligopoly, Demand, Economic Equilibrium
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Managerial Economics in a Global Economy, 5th Edition by Dominick Salvatore Chapter 1 The Nature and Scope of Managerial Economics PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Managerial Economics Defined • The application of economic theory and the tools of decision science to examine how an organization can achieve its aims or objectives most efficiently. PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Managerial Decision Problems Economic theory Microeconomics Macroeconomics Decision Sciences Mathematical Economics Econometrics MANAGERIAL ECONOMICS Application of economic theory and decision science tools to solve managerial decision problems OPTIMAL SOLUTIONS TO MANAGERIAL DECISION PROBLEMS PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Theory of the Firm • Combines and organizes resources for the purpose of producing goods and/or services for sale. • Internalizes transactions, reducing transactions costs. • Primary goal is to maximize the wealth or value of the firm. PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Value of the Firm The present value of all expected future profits PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Ph. Brooker. a division of Thomson Learning. Copyright ©2004 by South-Western.Alternative Theories • Sales maximization – Adequate rate of profit • Management utility maximization – Principle-agent problem • Satisficing behavior PowerPoint Slides Prepared by Robert F. . All rights reserved.D. Definitions of Profit • Business Profit: Total revenue minus the explicit or accounting costs of production. PowerPoint Slides Prepared by Robert F. • Opportunity Cost: Implicit value of a resource in its best alternative use. • Economic Profit: Total revenue minus the explicit and implicit costs of production. a division of Thomson Learning. Copyright ©2004 by South-Western. Ph. Brooker. All rights reserved. .D. . Ph.Theories of Profit • • • • • Risk-Bearing Theories of Profit Frictional Theory of Profit Monopoly Theory of Profit Innovation Theory of Profit Managerial Efficiency Theory of Profit PowerPoint Slides Prepared by Robert F. All rights reserved. a division of Thomson Learning. Brooker.D. Copyright ©2004 by South-Western. PowerPoint Slides Prepared by Robert F. . • Low (or negative) profits in an industry are a signal that buyers want less of what the industry produces. Ph. • High profits in an industry are a signal that buyers want more of what the industry produces.D.Function of Profit • Profit is a signal that guides the allocation of society’s resources. a division of Thomson Learning. Copyright ©2004 by South-Western. Brooker. All rights reserved. • Source of guidance that goes beyond enforceable laws. PowerPoint Slides Prepared by Robert F. Brooker. .Business Ethics • Identifies types of behavior that businesses and their employees should not engage in.D. Ph. a division of Thomson Learning. All rights reserved. Copyright ©2004 by South-Western. All rights reserved. a division of Thomson Learning. .The Changing Environment of Managerial Economics • Globalization of Economic Activity – Goods and Services – Capital – Technology – Skilled Labor • Technological Change – Telecommunications Advances – The Internet and the World Wide Web PowerPoint Slides Prepared by Robert F. Brooker. Copyright ©2004 by South-Western.D. Ph. D. a division of Thomson Learning. Copyright ©2004 by South-Western. Slide 1 .Managerial Economics in a Global Economy. All rights reserved. 5th Edition by Dominick Salvatore Chapter 2 Optimization Techniques and New Management Tools Prepared by Robert F. Ph. Brooker. Ph. Copyright ©2004 by South-Western. Brooker. a division of Thomson Learning.Expressing Economic Relationships Equations: Tables: TR = 100Q . Slide 2 . All rights reserved.10Q2 Q TR 0 0 1 90 2 3 4 5 6 160 210 240 250 240 TR 300 250 Graphs: 200 150 100 50 0 0 1 2 3 4 5 6 7 Q Prepared by Robert F.D. Ph. All rights reserved. Brooker. and Marginal Cost AC = TC/Q MC = TC/Q Prepared by Robert F. a division of Thomson Learning. Slide 3 . Average.D. Q 0 1 2 3 4 5 TC AC MC 20 140 140 120 160 80 20 180 60 20 240 60 60 480 96 240 Copyright ©2004 by South-Western.Total. Brooker. and Marginal Cost T C ($ ) 240 180 120 60 0 0 1 2 3 4 Q MC A C . Average. All rights reserved. a division of Thomson Learning.D. Ph.Total. Slide 4 . 1 2 3 4 Q Copyright ©2004 by South-Western. M C ($ ) AC 120 60 0 0 Prepared by Robert F. Brooker. All rights reserved. Slide 5 .Profit Maximization Q 0 1 2 3 4 5 Prepared by Robert F. Ph. a division of Thomson Learning. TR 0 90 160 210 240 250 TC Profit 20 -20 140 -50 160 0 180 30 240 0 480 -230 Copyright ©2004 by South-Western.D. a division of Thomson Learning.D. Copyright ©2004 by South-Western. Ph. Brooker. Slide 6 . All rights reserved.Profit Maximization ($) 300 TC 240 TR 180 MC 120 60 MR 0 60 Q 0 1 2 3 4 5 30 0 -30 Profit -60 Prepared by Robert F. Ph. Prepared by Robert F. Brooker.D. Copyright ©2004 by South-Western.Concept of the Derivative The derivative of Y with respect to X is equal to the limit of the ratio Y/X as X approaches zero. Slide 7 . All rights reserved. a division of Thomson Learning. Brooker. a division of Thomson Learning.Rules of Differentiation Constant Function Rule: The derivative of a constant. Slide 8 .D. All rights reserved. is zero for all values of a (the constant). Y = f(X) = a. Copyright ©2004 by South-Western. Ph. Y  f (X )  a dY 0 dX Prepared by Robert F. where a and b are constants. Ph. Copyright ©2004 by South-Western. All rights reserved. a division of Thomson Learning.D. Brooker. is defined as follows. Y  f (X )  aX b dY  b  a X b1 dX Prepared by Robert F. Slide 9 .Rules of Differentiation Power Function Rule: The derivative of a power function. U  g( X ) V  h( X ) Y  U V dY dU dV   dX dX dX Prepared by Robert F.D. Slide 10 . Copyright ©2004 by South-Western. a division of Thomson Learning.Rules of Differentiation Sum-and-Differences Rule: The derivative of the sum or difference of two functions U and V. All rights reserved. Brooker. is defined as follows. Ph. D. is defined as follows. Brooker. Copyright ©2004 by South-Western. Ph.Rules of Differentiation Product Rule: The derivative of the product of two functions U and V. U  g( X ) V  h( X ) Y  U V dY dV dU U V dX dX dX Prepared by Robert F. Slide 11 . All rights reserved. a division of Thomson Learning. Brooker. a division of Thomson Learning.D. All rights reserved. U  g( X ) dY  dX Prepared by Robert F. Ph. Slide 12 . is defined as follows.Rules of Differentiation Quotient Rule: The derivative of the ratio of two functions U and V. V  h( X )  V dU dX    U dV V U Y V dX  2 Copyright ©2004 by South-Western. Ph. Brooker. All rights reserved. Slide 13 .Rules of Differentiation Chain Rule: The derivative of a function that is a function of X is defined as follows. Y  f (U ) U  g( X ) dY dY dU   dX dU dX Prepared by Robert F. a division of Thomson Learning. Copyright ©2004 by South-Western.D. Prepared by Robert F.D. Copyright ©2004 by South-Western. a division of Thomson Learning. then X is a minimum. Ph. Brooker. All rights reserved. If d2Y/dX2 < 0.Optimization With Calculus Find X such that dY/dX = 0 Second derivative rules: If d2Y/dX2 > 0. then X is a maximum. Slide 14 . Slide 15 . Brooker.New Management Tools • • • • Benchmarking Total Quality Management Reengineering The Learning Organization Prepared by Robert F. Ph.D. a division of Thomson Learning. Copyright ©2004 by South-Western. All rights reserved. a division of Thomson Learning. Broadbanding Direct Business Model Networking Pricing Power Small-World Model Virtual Integration Virtual Management Copyright ©2004 by South-Western. Ph.Other Management Tools • • • • • • • Prepared by Robert F. All rights reserved. Slide 16 .D. Brooker. Slide 1 .D. Ph. All rights reserved. a division of Thomson Learning. 5th Edition by Dominick Salvatore Chapter 3 Demand Theory Prepared by Robert F. Copyright ©2004 by South-Western.Managerial Economics in a Global Economy. Brooker. D. • Substitution Effect • Income Effect Prepared by Robert F. Copyright ©2004 by South-Western.Law of Demand • There is an inverse relationship between the price of a good and the quantity of the good demanded per time period. Brooker. Ph. Slide 2 . All rights reserved. a division of Thomson Learning. PY. T) QdX = quantity demanded of commodity X by an individual per time period PX = price per unit of commodity X I = consumer’s income PY = price of related (substitute or complementary) commodity T = tastes of the consumer Prepared by Robert F. a division of Thomson Learning.D. All rights reserved. Slide 3 . Ph.Individual Consumer’s Demand QdX = f(PX. Copyright ©2004 by South-Western. Brooker. I. PY.D. Slide 4 . I.QdX = f(PX. a division of Thomson Learning. Copyright ©2004 by South-Western. Ph. Brooker. All rights reserved. T) QdX/PX < 0 QdX/I > 0 if a good is normal QdX/I < 0 if a good is inferior QdX/PY > 0 if X and Y are substitutes QdX/PY < 0 if X and Y are complements Prepared by Robert F. All rights reserved.D.Market Demand Curve • Horizontal summation of demand curves of individual consumers • Bandwagon Effect • Snob Effect Prepared by Robert F. Copyright ©2004 by South-Western. Ph. Brooker. Slide 5 . a division of Thomson Learning. Copyright ©2004 by South-Western. All rights reserved. Ph.D. a division of Thomson Learning.Horizontal Summation: From Individual to Market Demand Prepared by Robert F. Brooker. Slide 6 . Market Demand Function QDX = f(PX. Ph. I. Slide 7 . a division of Thomson Learning. PY.D. N. All rights reserved. T) QDX = quantity demanded of commodity X PX = price per unit of commodity X N = number of consumers on the market I = consumer income PY = price of related (substitute or complementary) commodity T = consumer tastes Prepared by Robert F. Brooker. Copyright ©2004 by South-Western. D. Copyright ©2004 by South-Western. a division of Thomson Learning. Slide 8 . Brooker. All rights reserved.Demand Faced by a Firm • Market Structure – Monopoly – Oligopoly – Monopolistic Competition – Perfect Competition • Type of Good – Durable Goods – Nondurable Goods – Producers’ Goods .Derived Demand Prepared by Robert F. Ph. Linear Demand Function QX = a0 + a1PX + a2N + a3I + a4PY + a5T PX Intercept: a0 + a2N + a3I + a4PY + a5T Slope: QX/PX = a1 QX Prepared by Robert F. a division of Thomson Learning. Slide 9 . Brooker.D. All rights reserved. Copyright ©2004 by South-Western. Ph. Price Elasticity of Demand Point Definition Q / Q Q P EP    P / P P Q Linear Function P EP  a1  Q Prepared by Robert F. Ph. Slide 10 . Copyright ©2004 by South-Western.D. Brooker. All rights reserved. a division of Thomson Learning. Price Elasticity of Demand Arc Definition Prepared by Robert F. a division of Thomson Learning. Brooker. Ph.D. All rights reserved. Slide 11 . Q2  Q1 P2  P1 EP   P2  P1 Q2  Q1 Copyright ©2004 by South-Western. Ph. Brooker. Slide 12 .D.Marginal Revenue and Price Elasticity of Demand  1  MR  P 1    EP  Prepared by Robert F. Copyright ©2004 by South-Western. All rights reserved. a division of Thomson Learning. Ph.D. Brooker. All rights reserved.Marginal Revenue and Price Elasticity of Demand PX EP  1 EP  1 EP  1 QX MRX Prepared by Robert F. Copyright ©2004 by South-Western. Slide 13 . a division of Thomson Learning. Total Revenue. a division of Thomson Learning. MR<0 EP  1 QX Copyright ©2004 by South-Western. Ph. Brooker.D. Slide 14 .Marginal Revenue. and Price Elasticity TR MR>0 EP  1 EP  1 MR=0 Prepared by Robert F. All rights reserved. Copyright ©2004 by South-Western.Determinants of Price Elasticity of Demand Demand for a commodity will be more elastic if: • It has many close substitutes • It is narrowly defined • More time is available to adjust to a price change Prepared by Robert F. All rights reserved. Ph. a division of Thomson Learning.D. Slide 15 . Brooker. Copyright ©2004 by South-Western.D. Slide 16 . Ph. a division of Thomson Learning. All rights reserved. Brooker.Determinants of Price Elasticity of Demand Demand for a commodity will be less elastic if: • It has few substitutes • It is broadly defined • Less time is available to adjust to a price change Prepared by Robert F. a division of Thomson Learning.D. Slide 17 . Ph. All rights reserved. Brooker.Income Elasticity of Demand Point Definition Q / Q Q I EI    I / I I Q Linear Function I EI  a3  Q Prepared by Robert F. Copyright ©2004 by South-Western. Slide 18 .D. a division of Thomson Learning. All rights reserved. Ph. Brooker.Income Elasticity of Demand Arc Definition Q2  Q1 I 2  I1 EI   I 2  I1 Q2  Q1 Normal Good Inferior Good EI  0 EI  0 Prepared by Robert F. Copyright ©2004 by South-Western. D. E XY QX / QX QX PY    PY / PY PY QX E XY PY  a4  QX Copyright ©2004 by South-Western. All rights reserved. Ph. Slide 19 . Brooker. a division of Thomson Learning.Cross-Price Elasticity of Demand Point Definition Linear Function Prepared by Robert F. Ph.Cross-Price Elasticity of Demand Arc Definition Substitutes E XY  0 Prepared by Robert F. All rights reserved. Brooker. Slide 20 . a division of Thomson Learning.D. E XY QX 2  QX 1 PY 2  PY 1   PY 2  PY 1 QX 2  QX 1 Complements E XY  0 Copyright ©2004 by South-Western. All rights reserved. Ph.D.Other Factors Related to Demand Theory • International Convergence of Tastes – Globalization of Markets – Influence of International Preferences on Market Demand • Growth of Electronic Commerce – Cost of Sales – Supply Chains and Logistics – Customer Relationship Management Prepared by Robert F. Slide 21 . Brooker. a division of Thomson Learning. Copyright ©2004 by South-Western. Copyright ©2004 by South-Western.Managerial Economics in a Global Economy. All rights reserved. a division of Thomson Learning. Slide 1 . Brooker.D. Ph. 5th Edition by Dominick Salvatore Chapter 4 Demand Estimation Prepared by Robert F. All rights reserved. Slide 2 .The Identification Problem Prepared by Robert F.D. Brooker. Copyright ©2004 by South-Western. Ph. a division of Thomson Learning. All rights reserved. Brooker.D.Demand Estimation: Marketing Research Approaches • • • • • • Consumer Surveys Observational Research Consumer Clinics Market Experiments Virtual Shopping Virtual Management Prepared by Robert F. Ph. Copyright ©2004 by South-Western. Slide 3 . a division of Thomson Learning. Scatter Diagram Copyright ©2004 by South-Western. All rights reserved. a division of Thomson Learning. Brooker. Slide 4 .D. Ph.Regression Analysis Year X Y 1 10 44 2 9 40 3 11 42 4 12 46 5 11 48 6 12 52 7 13 54 8 13 58 9 14 56 10 15 60 Prepared by Robert F. All rights reserved.D. a division of Thomson Learning. Slide 5 .Regression Analysis • Regression Line: Line of Best Fit • Regression Line: Minimizes the sum of the squared vertical deviations (et) of each point from the regression line. • Ordinary Least Squares (OLS) Method Prepared by Robert F. Brooker. Copyright ©2004 by South-Western. Ph. Slide 6 .Regression Analysis Prepared by Robert F.D. Ph. All rights reserved. Brooker. Copyright ©2004 by South-Western. a division of Thomson Learning. Ordinary Least Squares (OLS) Model: Yt  a  bX t  et ˆ Yˆt  aˆ  bX t et  Yt  Yˆt Prepared by Robert F. All rights reserved. Slide 7 . Copyright ©2004 by South-Western. Brooker. Ph.D. a division of Thomson Learning. n n n t 1 t 1 t 1 2 2 ˆ )2 ˆ ˆ e  ( Y  Y )  ( Y  a  bX t  t t  t t Prepared by Robert F. All rights reserved. a division of Thomson Learning. Brooker. Copyright ©2004 by South-Western. Ph. Slide 8 .D.Ordinary Least Squares (OLS) Objective: Determine the slope and intercept that minimize the sum of the squared errors. All rights reserved. Brooker.Ordinary Least Squares (OLS) Estimation Procedure n bˆ  (X t 1 t  X )(Yt  Y ) n (X t 1 Prepared by Robert F. t  X) ˆ aˆ  Y  bX 2 Copyright ©2004 by South-Western. Ph. a division of Thomson Learning.D. Slide 9 . Ordinary Least Squares (OLS) Estimation Example Time Xt 1 2 3 4 5 6 7 8 9 10 10 9 11 12 11 12 13 13 14 15 120 n  10 Yt 44 40 42 46 48 52 54 58 56 60 500 n n  X t  120  Yt  500 t 1 n X  t 1 X t 120   12 n 10 t 1 n Yt 500   50 10 t 1 n Y  Prepared by Robert F. Xt  X Yt  Y -2 -3 -1 0 -1 0 1 1 2 3 -6 -10 -8 -4 -2 2 4 8 6 10 n (X t 1 t 1 ( X t  X )2 12 30 8 0 2 0 4 8 12 30 106 4 9 1 0 1 0 1 1 4 9 30 t  X ) 2  30 106 bˆ   3.60 n (X ( X t  X )(Yt  Y ) Copyright ©2004 by South-Western. All rights reserved.533 30 t  X )(Yt  Y )  106 aˆ  50  (3.533)(12)  7.D. a division of Thomson Learning. Slide 10 . Ph. Brooker. All rights reserved.533)(12)  7. Brooker.60 t 1 t  500 Yt 500   50 10 t 1 n Y   120 2 n (X n t n (X t 1 X t 120   12 n 10 Prepared by Robert F.533 30 t  X )(Yt  Y )  106 aˆ  50  (3. Ph. Slide 11 .D. a division of Thomson Learning. Copyright ©2004 by South-Western.Ordinary Least Squares (OLS) Estimation Example n X  n  10 n X t 1 t 1 t 1 Y n t  X )  30 106 ˆ b  3. a division of Thomson Learning. 2  2 e t (n  k ) ( X t  X ) 2 Copyright ©2004 by South-Western. All rights reserved. Brooker. Ph.D. Slide 12 .Tests of Significance Standard Error of the Slope Estimate sbˆ  2 ˆ ( Y  Y )  t (n  k ) ( X t  X ) Prepared by Robert F. Ph.02 1. Brooker.6816 0 5 11 48 46.04 4.4830 t 1 2 t t 1 Prepared by Robert F.96 15.0404 4 10 15 60 60.49 4.6249 1 4 12 46 49. Slide 13 .57 2.4830 30 Time Xt Yt 1 10 2 n n  e   (Yt  Yˆt )2  65.55 -0.3969 9 3 11 42 46.Tests of Significance Example Calculation Yˆt et  Yt  Yˆt et2  (Yt  Yˆt )2 ( X t  X )2 44 42.51 0.43 -4.55 0.10 1.43 19.1616 0 7 13 54 53.3401 1 9 14 56 57.02 -1. (X t 1  (Y  Yˆ ) ( n  k ) ( X  X ) 2 n  X )  30 2 t sbˆ  t t 2  65.96 -3.37 0.3025 9 65. All rights reserved.63 0.2601 1 8 13 58 53.43 1.49 0.90 1.4649 1 6 12 52 49.96 2.51 20.52 (10  2)(30) Copyright ©2004 by South-Western.2100 4 9 40 39.4830  0. a division of Thomson Learning.D. Ph. Slide 14 . Brooker.Tests of Significance Example Calculation n n t 1 t 1 2 2 ˆ e  ( Y  Y )  t  t t  65.4830 sbˆ    0. All rights reserved. a division of Thomson Learning.4830 n 2 ( X  X )  30  t t 1 2 ˆ  (Yt  Y ) 65.52 2 ( n  k ) ( X t  X ) (10  2)(30) Prepared by Robert F.D. Copyright ©2004 by South-Western. Ph.52 Degrees of Freedom = (n-k) = (10-2) = 8 Critical Value at 5% level =2.Tests of Significance Calculation of the t Statistic bˆ 3.53 t   6.79 sbˆ 0. Copyright ©2004 by South-Western. All rights reserved.D. a division of Thomson Learning. Slide 15 .306 Prepared by Robert F. Brooker. D. Brooker. a division of Thomson Learning. Ph. Copyright ©2004 by South-Western.Tests of Significance Decomposition of Sum of Squares Total Variation = Explained Variation + Unexplained Variation 2 2 ˆ ˆ  (Yt  Y )   (Y  Y )   (Yt  Yt ) 2 Prepared by Robert F. Slide 16 . All rights reserved. Brooker. Copyright ©2004 by South-Western. a division of Thomson Learning.D. All rights reserved. Slide 17 . Ph.Tests of Significance Decomposition of Sum of Squares Prepared by Robert F. Brooker. Slide 18 . Ph.85 440. a division of Thomson Learning.D.Tests of Significance Coefficient of Determination R2  2 ˆ ( Y  Y )  Explained Variation  2 TotalVariation ( Y  Y )  t 373.00 2 Prepared by Robert F. Copyright ©2004 by South-Western. All rights reserved.84 R   0. Ph. Slide 19 .92 Prepared by Robert F.Tests of Significance Coefficient of Correlation r  R2 withthe signof bˆ 1  r  1 r  0. All rights reserved.85  0.D. Brooker. Copyright ©2004 by South-Western. a division of Thomson Learning. All rights reserved. Ph. Brooker. Y  a  b1 X 1  b2 X 2   bk ' X k ' Copyright ©2004 by South-Western. a division of Thomson Learning. Slide 20 .D.Multiple Regression Analysis Model: Prepared by Robert F. All rights reserved.D.Multiple Regression Analysis Adjusted Coefficient of Determination R 2  1  (1  R 2 ) Prepared by Robert F. Slide 21 . Brooker. Ph. (n  1) (n  k ) Copyright ©2004 by South-Western. a division of Thomson Learning. Brooker. Copyright ©2004 by South-Western. Slide 22 .Multiple Regression Analysis Analysis of Variance and F Statistic Explained Variation /(k  1) F Unexplained Variation /(n  k ) R 2 /( k  1) F (1  R 2 ) /( n  k ) Prepared by Robert F. Ph. All rights reserved.D. a division of Thomson Learning. Problems in Regression Analysis • Multicollinearity: Two or more explanatory variables are highly correlated. Slide 23 . • Heteroskedasticity: Variance of error term is not independent of the Y variable. Ph. Brooker.D. a division of Thomson Learning. Prepared by Robert F. Copyright ©2004 by South-Western. All rights reserved. • Autocorrelation: Consecutive error terms are correlated. D. Slide 24 . a division of Thomson Learning. autocorrelation is absent. Ph. All rights reserved.Durbin-Watson Statistic Test for Autocorrelation n d 2 ( e  e )  t t 1 t 2 n 2 e t t 1 If d=2. Copyright ©2004 by South-Western. Brooker. Prepared by Robert F. D. a division of Thomson Learning. Copyright ©2004 by South-Western. All rights reserved. Ph. Slide 25 . Brooker.Steps in Demand Estimation • • • • • Model Specification: Identify Variables Collect Data Specify Functional Form Estimate Function Test the Results Prepared by Robert F. D. Brooker.Functional Form Specifications Linear Function: QX  a0  a1 PX  a2 I  a3 N  a4 PY  Power Function: QX  a ( PXb1 )( PYb2 ) Prepared by Robert F. All rights reserved. e Estimation Format: ln QX  ln a  b1 ln PX  b2 ln PY Copyright ©2004 by South-Western. a division of Thomson Learning. Ph. Slide 26 . 5th Edition by Dominick Salvatore Chapter 5 Demand Forecasting Prepared by Robert F. a division of Thomson Learning. Slide 1 . Copyright ©2004 by South-Western.Managerial Economics in a Global Economy. All rights reserved. Brooker.D. Ph. Ph.D. Slide 2 . a division of Thomson Learning. Copyright ©2004 by South-Western. All rights reserved.Qualitative Forecasts • Survey Techniques – Planned Plant and Equipment Spending – Expected Sales and Inventory Changes – Consumers’ Expenditure Plans • Opinion Polls – Business Executives – Sales Force – Consumer Intentions Prepared by Robert F. Brooker. D. Ph. All rights reserved. Brooker. Slide 3 .Time-Series Analysis • Secular Trend – Long-Run Increase or Decrease in Data • Cyclical Fluctuations – Long-Run Cycles of Expansion and Contraction • Seasonal Variation – Regularly Occurring Fluctuations • Irregular or Random Influences Prepared by Robert F. Copyright ©2004 by South-Western. a division of Thomson Learning. a division of Thomson Learning.D. All rights reserved. Copyright ©2004 by South-Western. Slide 4 . Brooker. Ph.Prepared by Robert F. D. Slide 5 . a division of Thomson Learning. Copyright ©2004 by South-Western. All rights reserved.Trend Projection • Linear Trend: St = S 0 + b t b = Growth per time period • Constant Growth Rate St = S0 (1 + g)t g = Growth rate • Estimation of Growth Rate lnSt = lnS0 + t ln(1 + g) Prepared by Robert F. Ph. Brooker. Seasonal Variation Ratio to Trend Method Actual Ratio = Trend Forecast Seasonal Average of Ratios for = Adjustment Each Seasonal Period Adjusted Forecast Prepared by Robert F. Slide 6 . Ph. All rights reserved. Brooker. Trend = Forecast Seasonal Adjustment Copyright ©2004 by South-Western. a division of Thomson Learning.D. 00 15.8869 Copyright ©2004 by South-Western.87 12.1 1994.1 = (18.00 13.8869) = 16.60 Seasonally Adjusted Forecast for 1996.1 1993.9061 0.8813 0.29 11.1 = 11. a division of Thomson Learning.1 Prepared by Robert F.45 14.1 1995.8652 0. Brooker. Ph.Seasonal Variation Ratio to Trend Method: Example Calculation for Quarter 1 Trend Forecast for 1996.90 + (0.00 Seasonal Adjustment = Ratio 0.D.60)(0. Trend Forecast Actual 12. All rights reserved.02 15.00 17.394)(17) = 18.8950 0.50 Year 1992. Slide 7 . At i w Copyright ©2004 by South-Western.D.Moving Average Forecasts Forecast is the average of data from w periods prior to the forecast data point. Brooker. Ph. All rights reserved. w Ft   i 1 Prepared by Robert F. a division of Thomson Learning. Slide 8 . Exponential Smoothing Forecasts Forecast is the weighted average of of the forecast and the actual value from the prior period.D. Ft 1  wAt  (1  w) Ft 0  w 1 Prepared by Robert F. Slide 9 . a division of Thomson Learning. Copyright ©2004 by South-Western. Brooker. All rights reserved. Ph. Ph.D. (A  F ) t 2 t n Copyright ©2004 by South-Western. a division of Thomson Learning. All rights reserved. Brooker.Root Mean Square Error Measures the Accuracy of a Forecasting Method RMSE  Prepared by Robert F. Slide 10 . Brooker. a division of Thomson Learning.D. Ph. Slide 11 . Copyright ©2004 by South-Western. All rights reserved.Barometric Methods • • • • • • • National Bureau of Economic Research Department of Commerce Leading Indicators Lagging Indicators Coincident Indicators Composite Index Diffusion Index Prepared by Robert F. All rights reserved. Copyright ©2004 by South-Western.Econometric Models Single Equation Model of the Demand For Cereal (Good X) QX = a0 + a1PX + a2Y + a3N + a4PS + a5PC + a6A + e QX = Quantity of X PS = Price of Muffins PX = Price of Good X PC = Price of Milk Y = Consumer Income A = Advertising N = Size of Population e = Random Error Prepared by Robert F. Ph. a division of Thomson Learning. Brooker. Slide 12 .D. Econometric Models Multiple Equation Model of GNP Ct  a1  b1GNPt  u1t I t  a2  b2 t 1  u2t GNPt  Ct  I t  Gt Reduced Form Equation Gt a1  a2 b2 t 1 GNPt  Prepared by Robert F. Brooker, Ph.D. 1  b1  1  b1  1  b1 Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 13 Input-Output Forecasting Three-Sector Input-Output Flow Table Producing Industry Supplying Industry A B C Value Added Total Prepared by Robert F. Brooker, Ph.D. A 20 80 40 60 200 B 60 90 30 120 300 C 30 20 10 40 100 Final Demand 90 110 20 Total 200 300 100 220 220 Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 14 Input-Output Forecasting Direct Requirements Matrix Direct Requirements = Input Requirements Column Total Producing Industry Supplying Industry A B C Prepared by Robert F. Brooker, Ph.D. A 0.1 0.4 0.2 B 0.2 0.3 0.1 C 0.3 0.2 0.1 Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 15 Input-Output Forecasting Total Requirements Matrix Producing Industry Supplying Industry A B C Prepared by Robert F. Brooker, Ph.D. A 1.47 0.96 0.43 B 0.51 1.81 0.31 C 0.60 0.72 1.33 Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 16 Input-Output Forecasting Total Requirements Matrix 1.47 0.96 0.43 Prepared by Robert F. Brooker, Ph.D. 0.51 1.81 0.31 0.60 0.72 1.33 Final Total Demand Demand Vector Vector 90 110 20 = 200 300 100 Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 17 Input-Output Forecasting Revised Input-Output Flow Table Producing Industry Supplying Industry A B C Prepared by Robert F. Brooker, Ph.D. A 22 88 43 B 62 93 31 C 31 21 10 Final Demand 100 110 20 Total 215 310 104 Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 18 5th Edition by Dominick Salvatore Chapter 6 Production Theory and Estimation Prepared by Robert F. Ph. All rights reserved.D. a division of Thomson Learning.Managerial Economics in a Global Economy. Brooker. Copyright ©2004 by South-Western. Slide 1 . Copyright ©2004 by South-Western. Land • Fixed Inputs • Variable Inputs • Short Run – At least one input is fixed • Long Run – All inputs are variable Prepared by Robert F. a division of Thomson Learning. Capital. Slide 2 . Brooker. All rights reserved.The Organization of Production • Inputs – Labor.D. Ph. Slide 3 . K) K 6 5 4 3 2 1 Q 10 12 12 10 7 3 1 24 28 28 23 18 8 2 31 36 36 33 28 12 3 36 40 40 36 30 14 4 40 42 40 36 30 14 5 39 40 36 33 28 12 6 L Prepared by Robert F. a division of Thomson Learning. Copyright ©2004 by South-Western. All rights reserved.Production Function With Two Inputs Q = f(L. Brooker.D. Ph. Brooker. Copyright ©2004 by South-Western.D. All rights reserved.Production Function With Two Inputs Discrete Production Surface Prepared by Robert F. Ph. Slide 4 . a division of Thomson Learning. All rights reserved. Ph. Brooker.D. a division of Thomson Learning.Production Function With Two Inputs Continuous Production Surface Prepared by Robert F. Slide 5 . Copyright ©2004 by South-Western. Slide 6 . Ph. Brooker. Copyright ©2004 by South-Western. a division of Thomson Learning.Production Function With One Variable Input Total Product Marginal Product Average Product Production or Output Elasticity TP = Q = f(L) TP MPL = L TP APL = L MPL EL = AP L Prepared by Robert F.D. All rights reserved. Ph. Brooker. a division of Thomson Learning. Marginal. Copyright ©2004 by South-Western. and Average Product of Labor.8 2 EL 1 1. All rights reserved.57 0 -1 Prepared by Robert F.25 1 0.D.Production Function With One Variable Input Total. and Output Elasticity L 0 1 2 3 4 5 6 Q 0 3 8 12 14 14 12 MPL 3 5 4 2 0 -2 APL 3 4 4 3. Slide 7 .5 2. Copyright ©2004 by South-Western.Production Function With One Variable Input Prepared by Robert F.D. All rights reserved. Ph. a division of Thomson Learning. Slide 8 . Brooker. Slide 9 . Copyright ©2004 by South-Western.Production Function With One Variable Input Prepared by Robert F. a division of Thomson Learning.D. All rights reserved. Ph. Brooker. D. Ph. a division of Thomson Learning.Optimal Use of the Variable Input Marginal Revenue Product of Labor MRPL = (MPL)(MR) Marginal Resource Cost of Labor TC MRCL = L Optimal Use of Labor MRPL = MRCL Prepared by Robert F. Slide 10 . Copyright ©2004 by South-Western. All rights reserved. Brooker. 50 4.50 MPL 4 3 2 1 0 MR = P $10 10 10 10 10 MRPL $40 30 20 10 0 MRCL $20 20 20 20 20 Prepared by Robert F.00 4.D.Optimal Use of the Variable Input Use of Labor is Optimal When L = 3.50 L 2. Ph.50 3. a division of Thomson Learning. Copyright ©2004 by South-Western. Slide 11 . All rights reserved. Brooker.00 3. All rights reserved. a division of Thomson Learning.D. Copyright ©2004 by South-Western. Ph. Brooker.Optimal Use of the Variable Input Prepared by Robert F. Slide 12 . All rights reserved. which is defined by the portion of each isoquant that is negatively sloped. a division of Thomson Learning.Production With Two Variable Inputs Isoquants show combinations of two inputs that can produce the same level of output. Copyright ©2004 by South-Western. Brooker.D. Firms will only use combinations of two inputs that are in the economic region of production. Slide 13 . Prepared by Robert F. Ph. All rights reserved.Production With Two Variable Inputs Isoquants Prepared by Robert F. Brooker. Copyright ©2004 by South-Western. Slide 14 . Ph.D. a division of Thomson Learning. Ph. Brooker. All rights reserved. Slide 15 . a division of Thomson Learning. Copyright ©2004 by South-Western.D.Production With Two Variable Inputs Economic Region of Production Prepared by Robert F. a division of Thomson Learning.Production With Two Variable Inputs Marginal Rate of Technical Substitution MRTS = -K/L = MPL/MPK Prepared by Robert F. Ph. Slide 16 .D. Brooker. All rights reserved. Copyright ©2004 by South-Western. Brooker. Ph. a division of Thomson Learning.5 Prepared by Robert F.D. Slide 17 .5/1) = 2. All rights reserved. Copyright ©2004 by South-Western.Production With Two Variable Inputs MRTS = -(-2. All rights reserved. Copyright ©2004 by South-Western.Production With Two Variable Inputs Perfect Substitutes Perfect Complements Prepared by Robert F. Ph. Brooker. a division of Thomson Learning.D. Slide 18 . Slide 19 . Brooker. All rights reserved. C  wL  rK C  Total Cost w  Wage Rate of Labor ( L) C w K  L r r r  Cost of Capital ( K ) Prepared by Robert F. Copyright ©2004 by South-Western. a division of Thomson Learning. Ph.D.Optimal Combination of Inputs Isocost lines represent all combinations of two inputs that a firm can purchase with the same total cost. Copyright ©2004 by South-Western. Slide 20 .Optimal Combination of Inputs Isocost Lines AB C = $100. Ph. w = $5. r = $10 Prepared by Robert F.D. w = r = $10 A’B’ C = $140. w = r = $10 AB* C = $100. a division of Thomson Learning. All rights reserved. Brooker. w = r = $10 A’’B’’ C = $80. a division of Thomson Learning. Brooker. Copyright ©2004 by South-Western. Slide 21 .Optimal Combination of Inputs MRTS = w/r Prepared by Robert F. All rights reserved.D. Ph. Brooker. Slide 22 .Optimal Combination of Inputs Effect of a Change in Input Prices Prepared by Robert F.D. a division of Thomson Learning. Copyright ©2004 by South-Western. All rights reserved. Ph. K) Q = f(hL. hK) If  = h.D. If  < h. then f has constant returns to scale. All rights reserved.Returns to Scale Production Function Q = f(L. If  > h. Copyright ©2004 by South-Western. Ph. a division of Thomson Learning. Slide 23 . the f has decreasing returns to scale. Prepared by Robert F. Brooker. then f has increasing returns to scale. Brooker. Copyright ©2004 by South-Western. a division of Thomson Learning. Ph. Slide 24 . All rights reserved.Returns to Scale Constant Returns to Scale Increasing Returns to Scale Decreasing Returns to Scale Prepared by Robert F.D. Empirical Production Functions Cobb-Douglas Production Function Q = AKaLb Estimated using Natural Logarithms ln Q = ln A + a ln K + b ln L Prepared by Robert F. Slide 25 . All rights reserved. a division of Thomson Learning. Copyright ©2004 by South-Western. Brooker. Ph.D. a division of Thomson Learning.Innovations and Global Competitiveness • • • • • • • Product Innovation Process Innovation Product Cycle Model Just-In-Time Production System Competitive Benchmarking Computer-Aided Design (CAD) Computer-Aided Manufacturing (CAM) Prepared by Robert F. All rights reserved. Copyright ©2004 by South-Western. Slide 26 . Brooker.D. Ph. All rights reserved.Managerial Economics in a Global Economy. 5th Edition by Dominick Salvatore Chapter 7 Cost Theory and Estimation Prepared by Robert F. Copyright ©2004 by South-Western. Brooker. Slide 1 . a division of Thomson Learning. Ph.D. Slide 2 . Ph. Brooker. Copyright ©2004 by South-Western. a division of Thomson Learning.D.The Nature of Costs • Explicit Costs – Accounting Costs • Economic Costs – Implicit Costs – Alternative or Opportunity Costs • Relevant Costs – Incremental Costs – Sunk Costs are Irrelevant Prepared by Robert F. All rights reserved. Brooker.D.Short-Run Cost Functions Total Cost = TC = f(Q) Total Fixed Cost = TFC Total Variable Cost = TVC TC = TFC + TVC Prepared by Robert F. All rights reserved. Ph. Copyright ©2004 by South-Western. a division of Thomson Learning. Slide 3 . All rights reserved. Copyright ©2004 by South-Western. Brooker.Short-Run Cost Functions Average Total Cost = ATC = TC/Q Average Fixed Cost = AFC = TFC/Q Average Variable Cost = AVC = TVC/Q ATC = AFC + AVC Marginal Cost = TC/Q = TVC/Q Prepared by Robert F. Slide 4 . Ph.D. a division of Thomson Learning. MC $20 10 15 35 55 Slide 5 .D. Brooker.Short-Run Cost Functions Q 0 1 2 3 4 5 TFC $60 60 60 60 60 60 TVC $0 20 30 45 80 135 TC $60 80 90 105 140 195 AFC $60 30 20 15 12 AVC $20 15 15 20 27 ATC $80 45 35 35 39 Prepared by Robert F. Copyright ©2004 by South-Western. Ph. All rights reserved. a division of Thomson Learning. Ph. Brooker. a division of Thomson Learning.D. Slide 6 .Prepared by Robert F. Copyright ©2004 by South-Western. All rights reserved. Slide 7 . Brooker. a division of Thomson Learning. Ph.D. Copyright ©2004 by South-Western.Short-Run Cost Functions Average Variable Cost AVC = TVC/Q = w/APL Marginal Cost TC/Q = TVC/Q = w/MPL Prepared by Robert F. All rights reserved. Long-Run Cost Curves Long-Run Total Cost = LTC = f(Q) Long-Run Average Cost = LAC = LTC/Q Long-Run Marginal Cost = LMC = LTC/Q Prepared by Robert F. a division of Thomson Learning. Brooker.D. All rights reserved. Ph. Copyright ©2004 by South-Western. Slide 8 . Ph.Derivation of Long-Run Cost Curves Prepared by Robert F. Copyright ©2004 by South-Western.D. All rights reserved. Brooker. a division of Thomson Learning. Slide 9 . Ph. Brooker. All rights reserved.Relationship Between Long-Run and Short-Run Average Cost Curves Prepared by Robert F. Slide 10 .D. Copyright ©2004 by South-Western. a division of Thomson Learning. D. Copyright ©2004 by South-Western. All rights reserved. a division of Thomson Learning. Slide 11 . Brooker. Ph.Possible Shapes of the LAC Curve Prepared by Robert F. Slide 12 .Learning Curves Average Cost of Unit Q = C = aQb Estimation Form: log C = log a + b Log Q Prepared by Robert F. a division of Thomson Learning. Copyright ©2004 by South-Western.D. All rights reserved. Ph. Brooker. Slide 13 . a division of Thomson Learning. Ph.Minimizing Costs Internationally • • • • Foreign Sourcing of Inputs New International Economies of Scale Immigration of Skilled Labor Brain Drain Prepared by Robert F.D. Brooker. All rights reserved. Copyright ©2004 by South-Western. a division of Thomson Learning.D. Copyright ©2004 by South-Western. Slide 14 . Brooker.Logistics or Supply Chain Management • Merges and integrates functions – Purchasing – Transportation – Warehousing – Distribution – Customer Services • Source of competitive advantage Prepared by Robert F. Ph. All rights reserved. Copyright ©2004 by South-Western. Brooker.Logistics or Supply Chain Management • Reasons for the growth of logistics – Advances in computer technology • Decreased cost of logistical problem solving – Growth of just-in-time inventory management • Increased need to monitor and manage input and output flows – Globalization of production and distribution • Increased complexity of input and output flows Prepared by Robert F. Slide 15 . a division of Thomson Learning. All rights reserved. Ph.D. All rights reserved.D.AVC) Prepared by Robert F. a division of Thomson Learning. Ph. Brooker. Copyright ©2004 by South-Western. Slide 16 .Cost-Volume-Profit Analysis Total Revenue = TR = (P)(Q) Total Cost = TC = TFC + (AVC)(Q) Breakeven Volume TR = TC (P)(Q) = TFC + (AVC)(Q) QBE = TFC/(P . Cost-Volume-Profit Analysis P = 40 TFC = 200 AVC = 5 QBE = 40 Prepared by Robert F. Brooker. All rights reserved.D. Copyright ©2004 by South-Western. Ph. a division of Thomson Learning. Slide 17 . Copyright ©2004 by South-Western. All rights reserved.Operating Leverage Operating Leverage = TFC/TVC Degree of Operating Leverage = DOL % Q( P  AVC ) DOL   %Q Q( P  AVC )  TFC Prepared by Robert F. Brooker. a division of Thomson Learning.D. Slide 18 . Ph. Copyright ©2004 by South-Western.Operating Leverage TC’ has a higher DOL than TC and therefore a higher QBE Prepared by Robert F. Slide 19 . All rights reserved. Ph.D. Brooker. a division of Thomson Learning. Copyright ©2004 by South-Western. a division of Thomson Learning. Slide 20 . All rights reserved.D. Brooker.Empirical Estimation Data Collection Issues • Opportunity Costs Must be Extracted from Accounting Cost Data • Costs Must be Apportioned Among Products • Costs Must be Matched to Output Over Time • Costs Must be Corrected for Inflation Prepared by Robert F. Ph. Ph. All rights reserved. Copyright ©2004 by South-Western. Brooker.Empirical Estimation Functional Form for Short-Run Cost Functions Theoretical Form Linear Approximation TVC  aQ  bQ 2  cQ3 TVC  a  bQ TVC 2 AVC   a  bQ  cQ Q a AVC   b Q MC  a  2bQ  3cQ 2 MC  b Prepared by Robert F. Slide 21 .D. a division of Thomson Learning. a division of Thomson Learning. Brooker.D. Copyright ©2004 by South-Western.Empirical Estimation Theoretical Form Linear Approximation Prepared by Robert F. Slide 22 . All rights reserved. Ph. Copyright ©2004 by South-Western. a division of Thomson Learning. Ph. All rights reserved.Empirical Estimation Long-Run Cost Curves • Cross-Sectional Regression Analysis • Engineering Method • Survival Technique Prepared by Robert F.D. Brooker. Slide 23 . D. All rights reserved. Ph. a division of Thomson Learning. Brooker. Copyright ©2004 by South-Western. Slide 24 .Empirical Estimation Actual LAC versus empirically estimated LAC’ Prepared by Robert F. Slide 1 . Ph. All rights reserved. Monopoly and Monopolistic Competition Prepared by Robert F. Brooker.D.Managerial Economics in a Global Economy. 5th Edition by Dominick Salvatore Chapter 8 Market Structure: Perfect Competition. Copyright ©2004 by South-Western. a division of Thomson Learning. a division of Thomson Learning. Slide 2 . Brooker.D. Ph.Prepared by Robert F. Perfect Competition Monopolistic Competition Oligopoly Monopoly Less Competitive More Competitive Market Structure Copyright ©2004 by South-Western. All rights reserved. Copyright ©2004 by South-Western.Perfect Competition • • • • • Many buyers and sellers Buyers and sellers are price takers Product is homogeneous Perfect mobility of resources Economic agents have perfect knowledge • Example: Stock Market Prepared by Robert F. Ph.D. Slide 3 . All rights reserved. Brooker. a division of Thomson Learning. Ph. Copyright ©2004 by South-Western.D. a division of Thomson Learning.Monopolistic Competition • • • • Many sellers and buyers Differentiated product Perfect mobility of resources Example: Fast-food outlets Prepared by Robert F. Slide 4 . All rights reserved. Brooker. Slide 5 . All rights reserved. Brooker. Copyright ©2004 by South-Western.Oligopoly • Few sellers and many buyers • Product may be homogeneous or differentiated • Barriers to resource mobility • Example: Automobile manufacturers Prepared by Robert F.D. Ph. a division of Thomson Learning. Monopoly • Single seller and many buyers • No close substitutes for product • Significant barriers to resource mobility – Control of an essential input – Patents or copyrights – Economies of scale: Natural monopoly – Government franchise: Post office Prepared by Robert F.D. Brooker. All rights reserved. a division of Thomson Learning. Copyright ©2004 by South-Western. Slide 6 . Ph. Brooker.D.Perfect Competition: Price Determination Prepared by Robert F. Slide 7 . All rights reserved. Copyright ©2004 by South-Western. Ph. a division of Thomson Learning. Perfect Competition: Price Determination QD  625  5P QD  QS QS  175  5P 625  5P  175  5P 450  10P P  $45 QD  625  5P  625  5(45)  400 QS  175  5P  175  5(45)  400 Prepared by Robert F. a division of Thomson Learning. Brooker. Slide 8 . All rights reserved.D. Copyright ©2004 by South-Western. Ph. All rights reserved. a division of Thomson Learning. Ph. Slide 9 . Copyright ©2004 by South-Western.D.Perfect Competition: Short-Run Equilibrium Firm’s Demand Curve = Market Price = Marginal Revenue Firm’s Supply Curve = Marginal Cost where Marginal Cost > Average Variable Cost Prepared by Robert F. Brooker. a division of Thomson Learning. Ph. Copyright ©2004 by South-Western. Brooker.D.Perfect Competition: Short-Run Equilibrium Prepared by Robert F. Slide 10 . All rights reserved. All rights reserved. Slide 11 . a division of Thomson Learning. long-run: Price = Marginal Cost = Average Cost Economic Profit = 0 Prepared by Robert F.Perfect Competition: Long-Run Equilibrium Quantity is set by the firm so that short-run: Price = Marginal Cost = Average Total Cost At the same quantity.D. Copyright ©2004 by South-Western. Ph. Brooker. Perfect Competition: Long-Run Equilibrium Prepared by Robert F. Slide 12 . All rights reserved. Ph. Brooker.D. a division of Thomson Learning. Copyright ©2004 by South-Western. All rights reserved. Copyright ©2004 by South-Western. Ph. Brooker.Competition in the Global Economy Domestic Supply World Supply Domestic Demand Prepared by Robert F. a division of Thomson Learning.D. Slide 13 . D. Copyright ©2004 by South-Western. a division of Thomson Learning. Brooker. All rights reserved.Competition in the Global Economy • Foreign Exchange Rate – Price of a foreign currency in terms of the domestic currency • Depreciation of the Domestic Currency – Increase in the price of a foreign currency relative to the domestic currency • Appreciation of the Domestic Currency – Decrease in the price of a foreign currency relative to the domestic currency Prepared by Robert F. Ph. Slide 14 . All rights reserved. Copyright ©2004 by South-Western.Competition in the Global Economy /€ R = Exchange Rate = Dollar Price of Euros € € Supply of Euros Demand for Euros € Prepared by Robert F. Brooker.D. Slide 15 . Ph. a division of Thomson Learning. Slide 16 . Ph. All rights reserved. Copyright ©2004 by South-Western. a division of Thomson Learning. Brooker.Monopoly • Single seller that produces a product with no close substitutes • Sources of Monopoly – Control of an essential input to a product – Patents or copyrights – Economies of scale: Natural monopoly – Government franchise: Post office Prepared by Robert F.D. Slide 17 .D. Ph. Copyright ©2004 by South-Western. All rights reserved. Brooker. a division of Thomson Learning.Monopoly Short-Run Equilibrium • Demand curve for the firm is the market demand curve • Firm produces a quantity (Q*) where marginal revenue (MR) is equal to marginal cost (MR) • Exception: Q* = 0 if average variable cost (AVC) is above the demand curve at all levels of output Prepared by Robert F. All rights reserved.Monopoly Short-Run Equilibrium Q* = 500 P* = $11 Prepared by Robert F.D. Slide 18 . Copyright ©2004 by South-Western. Brooker. Ph. a division of Thomson Learning. a division of Thomson Learning.Monopoly Long-Run Equilibrium Q* = 700 P* = $9 Prepared by Robert F. Brooker. Copyright ©2004 by South-Western. Slide 19 . All rights reserved. Ph.D. a division of Thomson Learning. Copyright ©2004 by South-Western.Social Cost of Monopoly Prepared by Robert F. Ph. Brooker. Slide 20 . All rights reserved.D. a division of Thomson Learning.D. Ph. All rights reserved. Brooker. Copyright ©2004 by South-Western.Monopolistic Competition • Many sellers of differentiated (similar but not identical) products • Limited monopoly power • Downward-sloping demand curve • Increase in market share by competitors causes decrease in demand for the firm’s product Prepared by Robert F. Slide 21 . All rights reserved.Monopolistic Competition Short-Run Equilibrium Prepared by Robert F. Copyright ©2004 by South-Western. Slide 22 . Ph. Brooker.D. a division of Thomson Learning. Slide 23 . Copyright ©2004 by South-Western. Ph.Monopolistic Competition Long-Run Equilibrium Profit = 0 Prepared by Robert F. All rights reserved.D. Brooker. a division of Thomson Learning. Slide 24 . Brooker. Copyright ©2004 by South-Western.Monopolistic Competition Long-Run Equilibrium Cost with selling expenses Cost without selling expenses Prepared by Robert F. All rights reserved. Ph.D. a division of Thomson Learning. All rights reserved.Managerial Economics in a Global Economy. 5th Edition by Dominick Salvatore Chapter 9 Oligopoly and Firm Architecture Prepared by Robert F. Copyright ©2004 by South-Western.D. a division of Thomson Learning. Ph. Slide 1 . Brooker. Slide 2 . All rights reserved. a division of Thomson Learning. Copyright ©2004 by South-Western. Ph.Oligopoly • • • • • • Few sellers of a product Nonprice competition Barriers to entry Duopoly . Brooker.D.Differentiated product Prepared by Robert F.Two sellers Pure oligopoly .Homogeneous product Differentiated oligopoly . All rights reserved. Brooker.Sources of Oligopoly • • • • • • • Economies of scale Large capital investment required Patented production processes Brand loyalty Control of a raw material or resource Government franchise Limit pricing Prepared by Robert F. Slide 3 . Copyright ©2004 by South-Western. Ph.D. a division of Thomson Learning. a division of Thomson Learning.Measures of Oligopoly • Concentration Ratios – 4. or 12 largest firms in an industry • Herfindahl Index (H) – H = Sum of the squared market shares of all firms in an industry • Theory of Contestable Markets – If entry is absolutely free and exit is entirely costless then firms will operate as if they are perfectly competitive Prepared by Robert F.D. Brooker. All rights reserved. Slide 4 . 8. Ph. Copyright ©2004 by South-Western. Prepared by Robert F. Copyright ©2004 by South-Western. a division of Thomson Learning.Cournot Model • Proposed by Augustin Cournot • Behavioral assumption – Firms maximize profits under the assumption that market rivals will not change their rates of production.D. Slide 5 . Ph. Brooker. • Bertrand Model – Firms assume that their market rivals will not change their prices. All rights reserved. Brooker.Cournot Model • Example – Two firms (duopoly) – Identical products – Marginal cost is zero – Initially Firm A has a monopoly and then Firm B enters the market Prepared by Robert F.D. a division of Thomson Learning. All rights reserved. Copyright ©2004 by South-Western. Ph. Slide 6 . Brooker. Ph. which reduces demand for Firm A’s product – Firm A then reduces output further – This continues until equilibrium is attained Prepared by Robert F. Copyright ©2004 by South-Western.Cournot Model • Adjustment process – Entry by Firm B reduces the demand for Firm A’s product – Firm A reacts by reducing output. All rights reserved. a division of Thomson Learning. which increases demand for Firm B’s product – Firm B reacts by increasing output. Slide 7 .D. Ph.Cournot Model Prepared by Robert F.D. All rights reserved. Brooker. Slide 8 . a division of Thomson Learning. Copyright ©2004 by South-Western. Cournot Model • Equilibrium – Firms are maximizing profits simultaneously – The market is shared equally among the firms – Price is above the competitive equilibrium and below the monopoly equilibrium Prepared by Robert F. Brooker.D. Ph. Copyright ©2004 by South-Western. All rights reserved. Slide 9 . a division of Thomson Learning. Kinked Demand Curve Model • Proposed by Paul Sweezy • If an oligopolist raises price. and oligopolists will not change price when marginal cost changes Prepared by Robert F. other firms will follow. Copyright ©2004 by South-Western. other firms will not follow. Ph. so demand will be elastic • If an oligopolist lowers price. Slide 10 . a division of Thomson Learning. Brooker. MR will have a discontinuity. All rights reserved. so demand will be inelastic • Implication is that demand curve will be kinked.D. Copyright ©2004 by South-Western. All rights reserved. Slide 11 .D. Ph.Kinked Demand Curve Model Prepared by Robert F. a division of Thomson Learning. Brooker. Ph.Cartels • Collusion – Cooperation among firms to restrict competition in order to increase profits • Market-Sharing Cartel – Collusion to divide up markets • Centralized Cartel – Formal agreement among member firms to set a monopoly price and restrict output – Incentive to cheat Prepared by Robert F.D. All rights reserved. a division of Thomson Learning. Slide 12 . Copyright ©2004 by South-Western. Brooker. Ph. a division of Thomson Learning. Brooker.D.Centralized Cartel Prepared by Robert F. Slide 13 . All rights reserved. Copyright ©2004 by South-Western. or lowest cost firm in the industry – Demand curve is defined as the market demand curve less supply by the followers • Followers – Take market price as given and behave as perfect competitors Prepared by Robert F.D. Brooker. Ph. Copyright ©2004 by South-Western. dominant. a division of Thomson Learning.Price Leadership • Implicit Collusion • Price Leader (Barometric Firm) – Largest. All rights reserved. Slide 14 . Copyright ©2004 by South-Western. All rights reserved. Brooker.Price Leadership Prepared by Robert F.D. a division of Thomson Learning. Ph. Slide 15 . too much may be spent on advertising and model changes Prepared by Robert F. Copyright ©2004 by South-Western. Brooker. All rights reserved.D. a division of Thomson Learning. Ph. Slide 16 .Efficiency of Oligopoly • Price is usually greater then long-run average cost (LAC) • Quantity produced usually does correspond to minimum LAC • Price is usually greater than long-run marginal cost (LMC) • When a differentiated product is produced. Ph.D. a division of Thomson Learning.Sales Maximization Model • Proposed by William Baumol • Managers seek to maximize sales. rather than to maximize profits • Sales (or total revenue. All rights reserved. Slide 17 . TR) will be at a maximum when the firm produces a quantity that sets marginal revenue equal to zero (MR = 0) Prepared by Robert F. Brooker. after ensuring that an adequate rate of return has been earned. Copyright ©2004 by South-Western. Brooker. Slide 18 . a division of Thomson Learning. Copyright ©2004 by South-Western.D. Ph. All rights reserved.Sales Maximization Model MR = 0 where Q = 50 MR = MC where Q = 40 Prepared by Robert F. D. Slide 19 . All rights reserved. Ph. a division of Thomson Learning. Brooker.Global Oligopolists • Impetus toward globalization – Advances in telecommunications and transportation – Globalization of tastes – Reduction of barriers to international trade Prepared by Robert F. Copyright ©2004 by South-Western. D. All rights reserved. Slide 20 . Copyright ©2004 by South-Western.Architecture of the Ideal Firm • • • • • • Core Competencies Outsourcing of Non-Core Tasks Learning Organization Efficient and Flexibile Integrates Physical and Virtual Real-Time Enterprise Prepared by Robert F. Brooker. a division of Thomson Learning. Ph. D. Ph. Copyright ©2004 by South-Western. Brooker. All rights reserved.Extending the Firm • Virtual Corporation – Temporary network of independent companies working together to exploit a business opportunity • Relationship Enterprise – Strategic alliances – Complementary capabilities and resources – Stable longer-term relationships Prepared by Robert F. Slide 21 . a division of Thomson Learning. 5th Edition by Dominick Salvatore Chapter 10 Game Theory and Strategic Behavior Prepared by Robert F. Brooker. Ph. Copyright ©2004 by South-Western. Slide 1 . All rights reserved.D. a division of Thomson Learning.Managerial Economics in a Global Economy. D.Strategic Behavior • Decisions that take into account the predicted reactions of rival firms – Interdependence of outcomes • Game Theory – Players – Strategies – Payoff matrix Prepared by Robert F. Slide 2 . All rights reserved. Brooker. Ph. a division of Thomson Learning. Copyright ©2004 by South-Western. a division of Thomson Learning.D. Slide 3 . Brooker. All rights reserved. Copyright ©2004 by South-Western.Strategic Behavior • Types of Games – Zero-sum games – Nonzero-sum games • Nash Equilibrium – Each player chooses a strategy that is optimal given the strategy of the other player – A strategy is dominant if it is optimal regardless of what the other player does Prepared by Robert F. Ph. All rights reserved. Firm B Advertise Don't Advertise (4. a division of Thomson Learning. 3) (5. 2) Copyright ©2004 by South-Western.D. Slide 4 .Advertising Example 1 Firm A Advertise Don't Advertise Prepared by Robert F. Ph. 1) (2. Brooker. 5) (3. 3) (5. 2) Copyright ©2004 by South-Western. Brooker.Advertising Example 1 What is the optimal strategy for Firm A if Firm B chooses to advertise? Firm A Advertise Don't Advertise Prepared by Robert F. 5) (3. All rights reserved. 1) (2. Slide 5 .D. Ph. Firm B Advertise Don't Advertise (4. a division of Thomson Learning. Advertising Example 1 What is the optimal strategy for Firm A if Firm B chooses to advertise? If Firm A chooses to advertise. The optimal strategy is to advertise. Firm B Advertise Don't Advertise (4. Ph. Slide 6 . All rights reserved. Brooker. Firm A Advertise Don't Advertise Prepared by Robert F. Otherwise.D. the payoff is 4. a division of Thomson Learning. 2) Copyright ©2004 by South-Western. 3) (5. 5) (3. 1) (2. the payoff is 2. Advertising Example 1 What is the optimal strategy for Firm A if Firm B chooses not to advertise? Firm A Advertise Don't Advertise Prepared by Robert F. Brooker. 3) (5.D. All rights reserved. 2) Copyright ©2004 by South-Western. Slide 7 . a division of Thomson Learning. Firm B Advertise Don't Advertise (4. 1) (2. 5) (3. Ph. a division of Thomson Learning.Advertising Example 1 What is the optimal strategy for Firm A if Firm B chooses not to advertise? If Firm A chooses to advertise. Again. the optimal strategy is to advertise. the payoff is 5. Firm B Advertise Don't Advertise (4. All rights reserved. Ph. Slide 8 . 1) (2. 3) (5. Brooker. Otherwise. Firm A Advertise Don't Advertise Prepared by Robert F. 2) Copyright ©2004 by South-Western.D. 5) (3. the payoff is 3. the optimal strategy for Firm A is to advertise. Slide 9 . a division of Thomson Learning. Firm A Advertise Don't Advertise Prepared by Robert F. 1) (2.D. Ph. 2) Copyright ©2004 by South-Western. 5) (3. Firm B Advertise Don't Advertise (4. Brooker. The dominant strategy for Firm A is to advertise.Advertising Example 1 Regardless of what Firm B decides to do. All rights reserved. 3) (5. 1) (2. 3) (5.Advertising Example 1 What is the optimal strategy for Firm B if Firm A chooses to advertise? Firm A Advertise Don't Advertise Prepared by Robert F.D. All rights reserved. 5) (3. Firm B Advertise Don't Advertise (4. Slide 10 . Brooker. 2) Copyright ©2004 by South-Western. Ph. a division of Thomson Learning. Slide 11 . Ph. 5) (3. the payoff is 1. Firm B Advertise Don't Advertise (4. All rights reserved. Firm A Advertise Don't Advertise Prepared by Robert F. 1) (2.Advertising Example 1 What is the optimal strategy for Firm B if Firm A chooses to advertise? If Firm B chooses to advertise. 3) (5. Otherwise. Brooker.D. 2) Copyright ©2004 by South-Western. The optimal strategy is to advertise. a division of Thomson Learning. the payoff is 3. Slide 12 . 2) Copyright ©2004 by South-Western. All rights reserved. 3) (5.Advertising Example 1 What is the optimal strategy for Firm B if Firm A chooses not to advertise? Firm A Advertise Don't Advertise Prepared by Robert F. Ph. Brooker. Firm B Advertise Don't Advertise (4. a division of Thomson Learning.D. 5) (3. 1) (2. the payoff is 2.Advertising Example 1 What is the optimal strategy for Firm B if Firm A chooses not to advertise? If Firm B chooses to advertise. All rights reserved. the optimal strategy is to advertise. 3) (5. a division of Thomson Learning. the payoff is 5. Firm B Advertise Don't Advertise (4. Otherwise. Ph.D. 1) (2. Firm A Advertise Don't Advertise Prepared by Robert F. Brooker. 2) Copyright ©2004 by South-Western. Again. Slide 13 . 5) (3. 5) (3. 3) (5. Firm B Advertise Don't Advertise (4. Brooker. 2) Copyright ©2004 by South-Western. Ph. 1) (2. a division of Thomson Learning.Advertising Example 1 Regardless of what Firm A decides to do. Slide 14 . the optimal strategy for Firm B is to advertise. The dominant strategy for Firm B is to advertise. All rights reserved.D. Firm A Advertise Don't Advertise Prepared by Robert F. 2) Copyright ©2004 by South-Western. Ph. Brooker. 5) (3. Slide 15 .D. The Nash equilibrium is for both firms to advertise. Firm B Advertise Don't Advertise (4. All rights reserved. 3) (5. a division of Thomson Learning.Advertising Example 1 The dominant strategy for Firm A is to advertise and the dominant strategy for Firm B is to advertise. Firm A Advertise Don't Advertise Prepared by Robert F. 1) (2. a division of Thomson Learning. 2) Copyright ©2004 by South-Western. Firm B Advertise Don't Advertise (4.D.Advertising Example 2 Firm A Advertise Don't Advertise Prepared by Robert F. Brooker. 5) (6. Slide 16 . 3) (5. Ph. All rights reserved. 1) (2. D.Advertising Example 2 What is the optimal strategy for Firm A if Firm B chooses to advertise? Firm A Advertise Don't Advertise Prepared by Robert F. Firm B Advertise Don't Advertise (4. Slide 17 . 2) Copyright ©2004 by South-Western. All rights reserved. a division of Thomson Learning. Ph. 3) (5. Brooker. 1) (2. 5) (6. 5) (6. Ph. the payoff is 4. a division of Thomson Learning. 2) Copyright ©2004 by South-Western.D. Firm A Advertise Don't Advertise Prepared by Robert F. Brooker. Firm B Advertise Don't Advertise (4. All rights reserved.Advertising Example 2 What is the optimal strategy for Firm A if Firm B chooses to advertise? If Firm A chooses to advertise. the payoff is 2. Slide 18 . The optimal strategy is to advertise. 3) (5. 1) (2. Otherwise. 2) Copyright ©2004 by South-Western. Firm B Advertise Don't Advertise (4.D. 3) (5. All rights reserved.Advertising Example 2 What is the optimal strategy for Firm A if Firm B chooses not to advertise? Firm A Advertise Don't Advertise Prepared by Robert F. 5) (6. 1) (2. Brooker. a division of Thomson Learning. Slide 19 . Ph. Slide 20 . 1) (2. Brooker. All rights reserved. the optimal strategy is not to advertise. the payoff is 5. Firm B Advertise Don't Advertise (4.Advertising Example 2 What is the optimal strategy for Firm A if Firm B chooses not to advertise? If Firm A chooses to advertise. a division of Thomson Learning. the payoff is 6. Firm A Advertise Don't Advertise Prepared by Robert F. 5) (6.D. 3) (5. 2) Copyright ©2004 by South-Western. Otherwise. Ph. In this case. a division of Thomson Learning. 1) (2. Slide 21 . Firm B Advertise Don't Advertise (4. Brooker.Advertising Example 2 The optimal strategy for Firm A depends on which strategy is chosen by Firms B. Ph. 3) (5.D. 2) Copyright ©2004 by South-Western. Firm A does not have a dominant strategy. 5) (6. Firm A Advertise Don't Advertise Prepared by Robert F. All rights reserved. All rights reserved. 2) Copyright ©2004 by South-Western.Advertising Example 2 What is the optimal strategy for Firm B if Firm A chooses to advertise? Firm A Advertise Don't Advertise Prepared by Robert F. 5) (6. 1) (2. a division of Thomson Learning. 3) (5. Ph. Firm B Advertise Don't Advertise (4. Brooker. Slide 22 .D. 3) (5. the payoff is 1. 5) (6. Ph.D.Advertising Example 2 What is the optimal strategy for Firm B if Firm A chooses to advertise? If Firm B chooses to advertise. Slide 23 . All rights reserved. Firm B Advertise Don't Advertise (4. The optimal strategy is to advertise. 2) Copyright ©2004 by South-Western. a division of Thomson Learning. Brooker. the payoff is 3. 1) (2. Firm A Advertise Don't Advertise Prepared by Robert F. Otherwise. 3) (5. 1) (2. Brooker. a division of Thomson Learning. Ph.Advertising Example 2 What is the optimal strategy for Firm B if Firm A chooses not to advertise? Firm A Advertise Don't Advertise Prepared by Robert F. Firm B Advertise Don't Advertise (4.D. 2) Copyright ©2004 by South-Western. 5) (6. All rights reserved. Slide 24 . Ph. the payoff is 5. Again. a division of Thomson Learning. 3) (5. Firm B Advertise Don't Advertise (4. Brooker. All rights reserved. the payoff is 2. 5) (6.D. Otherwise. 1) (2. the optimal strategy is to advertise. 2) Copyright ©2004 by South-Western. Firm A Advertise Don't Advertise Prepared by Robert F. Slide 25 .Advertising Example 2 What is the optimal strategy for Firm B if Firm A chooses not to advertise? If Firm B chooses to advertise. Brooker. Firm B Advertise Don't Advertise (4. The dominant strategy for Firm B is to advertise. the optimal strategy for Firm B is to advertise. 3) (5. a division of Thomson Learning. 5) (6.D. Slide 26 . Firm A Advertise Don't Advertise Prepared by Robert F. 1) (2. 2) Copyright ©2004 by South-Western. Ph. All rights reserved.Advertising Example 2 Regardless of what Firm A decides to do. a division of Thomson Learning.Advertising Example 2 The dominant strategy for Firm B is to advertise. 3) (5. Slide 27 . 5) (3.D. Firm B Advertise Don't Advertise (4. The Nash equilibrium is for both firms to advertise. Brooker. If Firm B chooses to advertise. 2) Copyright ©2004 by South-Western. 1) (2. then the optimal strategy for Firm A is to advertise. All rights reserved. Firm A Advertise Don't Advertise Prepared by Robert F. Ph. However. All rights reserved. Ph. the evidence is not sufficient to convict them of more than the crime of possessing stolen goods. Brooker. Slide 28 . Prepared by Robert F. The suspects are told the following: If you confess and your accomplice does not. you will get 10 years in prison. Copyright ©2004 by South-Western. They are immediately separated. you will both get 5 years in prison. If convicted.Prisoners’ Dilemma Two suspects are arrested for armed robbery.D. which carries a sentence of only 1 year. If you both confess. you will go free. If you do not confess and your accomplice does. a division of Thomson Learning. they will get a term of 10 years in prison. 5) (0.D. Brooker. a division of Thomson Learning. All rights reserved.Prisoners’ Dilemma Payoff Matrix (negative values) Confess Individual A Don't Confess Prepared by Robert F. 10) (10. Ph. 0) (1. Individual B Confess Don't Confess (5. Slide 29 . 1) Copyright ©2004 by South-Western. 0) (1. Ph. Individual B Confess Don't Confess (5.D. a division of Thomson Learning. 10) (10. All rights reserved.Prisoners’ Dilemma Dominant Strategy Both Individuals Confess (Nash Equilibrium) Confess Individual A Don't Confess Prepared by Robert F. Slide 30 . Brooker. 5) (0. 1) Copyright ©2004 by South-Western. 1) (1. Slide 31 .Prisoners’ Dilemma Application: Price Competition Firm A Low Price High Price Prepared by Robert F.D. Ph. Brooker. All rights reserved. a division of Thomson Learning. 2) (5. Firm B Low Price High Price (2. 5) (3. 3) Copyright ©2004 by South-Western. Firm B Low Price High Price (2.D. 5) (3.Prisoners’ Dilemma Application: Price Competition Dominant Strategy: Low Price Firm A Low Price High Price Prepared by Robert F. 3) Copyright ©2004 by South-Western. 1) (1. Brooker. Ph. 2) (5. a division of Thomson Learning. Slide 32 . All rights reserved. Ph. All rights reserved. Slide 33 . 1) (1. a division of Thomson Learning.Prisoners’ Dilemma Application: Nonprice Competition Firm A Advertise Don't Advertise Prepared by Robert F. 2) (5.D. 3) Copyright ©2004 by South-Western. 5) (3. Firm B Advertise Don't Advertise (2. Brooker. a division of Thomson Learning. Brooker. 3) Copyright ©2004 by South-Western. Ph. 5) (3.D. Slide 34 . All rights reserved. 2) (5.Prisoners’ Dilemma Application: Nonprice Competition Dominant Strategy: Advertise Firm A Advertise Don't Advertise Prepared by Robert F. Firm B Advertise Don't Advertise (2. 1) (1. a division of Thomson Learning. 2) (5. Slide 35 .D.Prisoners’ Dilemma Application: Cartel Cheating Firm A Cheat Don't Cheat Prepared by Robert F. 1) (1. All rights reserved. 3) Copyright ©2004 by South-Western. 5) (3. Firm B Cheat Don't Cheat (2. Brooker. Ph. Slide 36 . a division of Thomson Learning. Brooker. Firm B Cheat Don't Cheat (2. All rights reserved. 5) (3.D. 2) (5. 3) Copyright ©2004 by South-Western. Ph.Prisoners’ Dilemma Application: Cartel Cheating Dominant Strategy: Cheat Firm A Cheat Don't Cheat Prepared by Robert F. 1) (1. All rights reserved. Slide 37 . Copyright ©2004 by South-Western.Extensions of Game Theory • Repeated Games – Many consecutive moves and countermoves by each player • Tit-For-Tat Strategy – Do to your opponent what your opponent has just done to you Prepared by Robert F. Brooker. Ph. a division of Thomson Learning.D. D. All rights reserved. Brooker. Copyright ©2004 by South-Western. Ph.Extensions of Game Theory • Tit-For-Tat Strategy – Stable set of players – Small number of players – Easy detection of cheating – Stable demand and cost conditions – Game repeated a large and uncertain number of times Prepared by Robert F. Slide 38 . a division of Thomson Learning. Extensions of Game Theory • Threat Strategies – Credibility – Reputation – Commitment – Example: Entry deterrence Prepared by Robert F. Brooker. Copyright ©2004 by South-Western. a division of Thomson Learning.D. All rights reserved. Ph. Slide 39 . Slide 40 . -2) (6. a division of Thomson Learning. Brooker. 2) (8. 0) Copyright ©2004 by South-Western. 0) (7. 0) Firm B Enter Do Not Enter (4. Firm B Enter Do Not Enter (4. Ph. All rights reserved.D. -2) (6.Entry Deterrence No Credible Entry Deterrence Firm A Low Price High Price Credible Entry Deterrence Firm A Low Price High Price Prepared by Robert F. 0) (3. 2) (10. 2) (10. Slide 41 . Ph. 0) Firm B Enter Do Not Enter (4. -2) (6. -2) (6.D. a division of Thomson Learning. Firm B Enter Do Not Enter (4. 2) (8. 0) (7. Brooker. All rights reserved.Entry Deterrence No Credible Entry Deterrence Firm A Low Price High Price Credible Entry Deterrence Firm A Low Price High Price Prepared by Robert F. 0) (3. 0) Copyright ©2004 by South-Western. 100) (0.International Competition Boeing Versus Airbus Industrie Boeing Produce Don't Produce Prepared by Robert F. Ph. 0) (0. 0) Copyright ©2004 by South-Western. Airbus Produce Don't Product (-10. All rights reserved. Slide 42 . -10) (100. Brooker. a division of Thomson Learning.D. Sequential Games • Sequence of moves by rivals • Payoffs depend on entire sequence • Decision trees – Decision nodes – Branches (alternatives) • Solution by reverse induction – From final decision to first decision Prepared by Robert F. Copyright ©2004 by South-Western. All rights reserved. Brooker. Ph. Slide 43 . a division of Thomson Learning.D. High-price. All rights reserved. Ph.D. Copyright ©2004 by South-Western. Low-price Strategy Game gh i H c P ri e Firm A Firm B rice P h Hig $100 $100 Low P $130 $50 $180 $80 $150 $120 B rice A Lo w Pri ric P h g Hi ce e B Low P rice Prepared by Robert F. Slide 44 . a division of Thomson Learning. Brooker. All rights reserved. Brooker. Slide 45 . Firm A Firm B $100 $100 $130 $50 $180 $80 $150 $120 Copyright ©2004 by South-Western.D. a division of Thomson Learning.High-price. Ph. Low-price Strategy Game rice P h Hig gh i H c P ri e B rice A Lo w X X Low P Pri ric P h g Hi ce B Low P e rice Prepared by Robert F. Slide 46 .High-price. Copyright ©2004 by South-Western. a division of Thomson Learning. All rights reserved.D. Brooker. Ph. Low-price Strategy Game rice P h Hig A e B X igh H c P ri Lo w Pri X X Low P rice ric P h g Hi ce B Low P e rice Prepared by Robert F. Firm A Firm B $100 $100 $130 $50 $180 $80 $150 $120 Solution: Both firms choose low price. Brooker. Slide 47 .Airbus and Boeing Airbus J Jet o b um Boeing $50 $50 c Cr uiser $120 $100 et $0 $150 $0 $200 B 80 3 A Soni No A3 8 oJ b m Ju A 0 B Soni c Cr uiser Prepared by Robert F.D. Ph. Copyright ©2004 by South-Western. All rights reserved. a division of Thomson Learning. All rights reserved.Airbus and Boeing Airbus J B Jet o b um X Boeing $50 $50 c Cr uiser $120 $100 et $0 $150 $0 $200 80 3 A Soni No A3 8 oJ b m Ju A 0 X B Soni c Cr uiser Prepared by Robert F. a division of Thomson Learning. Ph. Copyright ©2004 by South-Western. Slide 48 .D. Brooker. $50 c Cr uiser oJ b m Ju B $50 Boeing Solution: Airbus builds A380 and Boeing builds Sonic Cruiser. Copyright ©2004 by South-Western. a division of Thomson Learning.D. All rights reserved. Slide 49 . Brooker.Airbus and Boeing Airbus J B X Soni 80 3 A A Jet o b um X No A3 8 0 $120 $100 et $0 $150 $0 $200 X Soni c Cr uiser Prepared by Robert F. Ph. D.Integrating Case Study gh Hi c Pri Firm A Firm B tise r e v Ad 60 70 Not Adv er 100 50 40 60 75 70 70 50 90 40 80 50 60 30 e A tise B se Pri gh P ric e Lo w ce erti Adv A Hi Not A dver ti se A w Lo tise r e v Ad ic Pr e gh Hi c Pri e A Not A dver tise B Lo w Pri ce e ertis v d A A Not Prepared by Robert F. Adv er tise Copyright ©2004 by South-Western. Slide 50 . Ph. a division of Thomson Learning. All rights reserved. Brooker. Ph. Slide 1 . 5th Edition by Dominick Salvatore Chapter 11 Pricing Practices Prepared by Robert F. All rights reserved.D. Brooker. Copyright ©2004 by South-Western.Managerial Economics in a Global Economy. a division of Thomson Learning. Pricing of Multiple Products • Products with Interrelated Demands • Plant Capacity Utilization and Optimal Product Pricing • Optimal Pricing of Joint Products – Fixed Proportions – Variable Proportions Prepared by Robert F. a division of Thomson Learning. Ph.D. Copyright ©2004 by South-Western. All rights reserved. Slide 2 . Brooker. Brooker.D. a division of Thomson Learning. Slide 3 . All rights reserved.Pricing of Multiple Products Products with Interrelated Demands For a two-product (A and B) firm. the marginal revenue functions of the firm are: TRA TRB MRA   Q A Q A TRB TRA MRB   QB QB Prepared by Robert F. Ph. Copyright ©2004 by South-Western. Brooker. a division of Thomson Learning.D. Ph.Pricing of Multiple Products Plant Capacity Utilization A multi-product firm using a single plant should produce quantities where the marginal revenue (MR i) from each of its k products is equal to the marginal cost (MC) of production. Slide 4 . All rights reserved.  MRk  MC Copyright ©2004 by South-Western. MR1  MR2  Prepared by Robert F. Pricing of Multiple Products Plant Capacity Utilization Prepared by Robert F. All rights reserved. Slide 5 . a division of Thomson Learning. Ph. Brooker.D. Copyright ©2004 by South-Western. Brooker. a division of Thomson Learning.Pricing of Multiple Products Joint Products in Fixed Proportions Prepared by Robert F. Slide 6 .D. Copyright ©2004 by South-Western. All rights reserved. Ph. Copyright ©2004 by South-Western. a division of Thomson Learning. Ph.Pricing of Multiple Products Joint Products in Variable Proportions Prepared by Robert F. Brooker. All rights reserved.D. Slide 7 . Ph.D. All rights reserved. a division of Thomson Learning. Objective of the firm is to attain higher profits than would be available otherwise. Copyright ©2004 by South-Western.Price Discrimination Charging different prices for a product when the price differences are not justified by cost differences. Slide 8 . Brooker. Prepared by Robert F. Firm must be able to segment the market and prevent resale of units across market segments Prepared by Robert F. Ph.Firm must be an imperfect competitor (a price maker) 2.Price elasticity must differ for units of the product sold at different prices 3. Brooker. Slide 9 . All rights reserved. a division of Thomson Learning.Price Discrimination 1. Copyright ©2004 by South-Western.D. First-Degree Price Discrimination • Each unit is sold at the highest possible price • Firm extracts all of the consumers’ surplus • Firm maximizes total revenue and profit from any quantity sold Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 10 Second-Degree Price Discrimination • Charging a uniform price per unit for a specific quantity, a lower price per unit for an additional quantity, and so on • Firm extracts part, but not all, of the consumers’ surplus Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 11 First- and Second-Degree Price Discrimination In the absence of price discrimination, a firm that charges $2 and sells 40 units will have total revenue equal to $80. Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 12 First- and Second-Degree Price Discrimination In the absence of price discrimination, a firm that charges $2 and sells 40 units will have total revenue equal to $80. Consumers will have consumers’ surplus equal to $80. Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 13 First- and Second-Degree Price Discrimination If a firm that practices first-degree price discrimination charges $2 and sells 40 units, then total revenue will be equal to $160 and consumers’ surplus will be zero. Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 14 First- and Second-Degree Price Discrimination If a firm that practices second-degree price discrimination charges $4 per unit for the first 20 units and $2 per unit for the next 20 units, then total revenue will be equal to $120 and consumers’ surplus will be $40. Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 15 Copyright ©2004 by South-Western. All rights reserved. Brooker.D. Ph.Third-Degree Price Discrimination • Charging different prices for the same product sold in different markets • Firm maximizes profits by selling a quantity on each market such that the marginal revenue on each market is equal to the marginal cost of production Prepared by Robert F. Slide 16 . a division of Thomson Learning. 1 (50) = $7 P2 = 6 .1 Q2 MR1 = MC = 2 MR2 = MC = 2 MR1 = 12 . Ph. All rights reserved.0.0.Third-Degree Price Discrimination Q1 = 120 .0.0. a division of Thomson Learning.1 Q1 and MR1 = 12 .2 Q1 Q2 = 120 .10 P1 or P1 = 12 . Copyright ©2004 by South-Western. Slide 17 .0.1 Q2 = 2 Q1 = 50 Q2 = 40 P1 = 12 .0.05 (40) = $4 Prepared by Robert F.D.2 Q1 = 2 MR2 = 6 .05 Q2 and MR2 = 6 .20 P2 or P2 = 6 .0.0. Brooker. Third-Degree Price Discrimination Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 18 International Price Discrimination • Persistent Dumping • Predatory Dumping – Temporary sale at or below cost – Designed to bankrupt competitors – Trade restrictions apply • Sporadic Dumping – Occasional sale of surplus output Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 19 Transfer Pricing • Pricing of intermediate products sold by one division of a firm and purchased by another division of the same firm • Made necessary by decentralization and the creation of semiautonomous profit centers within firms Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 20 Transfer Pricing No External Market Transfer Price = Pt MC of Intermediate Good = MCp Pt = MCp Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 21 Transfer Pricing Competitive External Market Transfer Price = Pt MC of Intermediate Good = MC’p Pt = MC’p Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 22 Transfer Pricing Imperfectly Competitive External Market Transfer Price = Pt = $4 Prepared by Robert F. Brooker, Ph.D. External Market Price = Pe = $6 Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 23 Slide 24 .C)/C • Price = P = C (1 + m) Prepared by Robert F.Pricing in Practice Cost-Plus Pricing • Markup or Full-Cost Pricing • Fully Allocated Average Cost (C) – Average variable cost at normal output – Allocated overhead • Markup on Cost (m) = (P . Copyright ©2004 by South-Western. a division of Thomson Learning.D. Ph. Brooker. All rights reserved. a division of Thomson Learning.D. All rights reserved. Ph. Brooker.Pricing in Practice Optimal Markup  1  MR  P 1    EP   EP  P  MR   E  1   p  MR  C  EP  P C  E  1   p  Prepared by Robert F. Copyright ©2004 by South-Western. Slide 25 . a division of Thomson Learning. All rights reserved. Slide 26 . Copyright ©2004 by South-Western. Brooker. Ph.Pricing in Practice Optimal Markup  EP  P C  E  1   p  P  C (1  m)  EP  C (1  m)  C   E  1   p  EP m 1 EP  1 Prepared by Robert F.D. D. All rights reserved. Copyright ©2004 by South-Western. a division of Thomson Learning. Brooker. Slide 27 . Ph. Prepared by Robert F.Pricing in Practice Incremental Analysis A firm should take an action if the incremental increase in revenue from the action exceeds the incremental increase in cost from the action. Two-Part Tariff Tying Bundling Prestige Pricing Price Lining Skimming Value Pricing Copyright ©2004 by South-Western. Ph. Brooker. a division of Thomson Learning. All rights reserved.Pricing in Practice • • • • • • • Prepared by Robert F.D. Slide 28 . Ph. Copyright ©2004 by South-Western.D. All rights reserved. 5th Edition by Dominick Salvatore Chapter 12 Regulation and Antitrust: The Role of Government in the Economy Prepared by Robert F.Managerial Economics in a Global Economy. a division of Thomson Learning. Brooker. Slide 1 . All rights reserved.Government Regulation Restriction of Competition • Licensing – Ensure a minimum degree of competence – Restriction on entry • Patent – Exclusive use of an invention for 17 years – Limited monopoly • Robinson-Patman Act (1936) – Restrictions on price competition Prepared by Robert F. Copyright ©2004 by South-Western. Slide 2 .D. Brooker. a division of Thomson Learning. Ph. Copyright ©2004 by South-Western. Ph.Government Regulation Consumer Protection Food and Drug Act of 1906 – Forbids adulteration and mislabeling of foods and drugs sold in interstate commerce – Recently expanded to include cosmetics Prepared by Robert F. All rights reserved. Slide 3 .D. Brooker. a division of Thomson Learning. a division of Thomson Learning. Brooker. Copyright ©2004 by South-Western. All rights reserved.D.Government Regulation Consumer Protection Federal Trade Commission Act of 1914 – Protects firms against unfair methods of competition based on misrepresentation – Price of products – Country of origin – Usefulness of product – Quality of product – Wheeler-Lea Act of 1938 prohibits false or deceptive advertising Prepared by Robert F. Slide 4 . Ph. Slide 5 .Government Regulation Consumer Protection 1990 Nutrition Labeling Act – Food and Drug Administration (FDA) – Labeling requirements on all foods sold in the United States Prepared by Robert F.D. All rights reserved. Ph. a division of Thomson Learning. Brooker. Copyright ©2004 by South-Western. All rights reserved.Government Regulation Consumer Protection • Consumer Credit Protection Act of 1968 – Requires lenders to disclose credit terms to borrowers • Consumer Product Safety Commission – Protect consumers from dangerous products – Provide product information to consumers – Set safety standards Prepared by Robert F. Ph.D. Copyright ©2004 by South-Western. Slide 6 . a division of Thomson Learning. Brooker. Copyright ©2004 by South-Western. Brooker.Government Regulation Consumer Protection • Fair Credit Reporting Act of 1971 – Right to examine credit file – Bans credit discrimination • Warranty Act of 1975 – Requires clear explanations of warranties • National Highway Traffic Safety Administration (NHTSA) – Imposes safety standards on traffic Prepared by Robert F. Ph. a division of Thomson Learning. All rights reserved. Slide 7 .D. Brooker. All rights reserved. Ph.D. a division of Thomson Learning.Government Regulation Worker Protection • Occupational Safety and Health Administration (OSHA) – Safety standards in the work place • Equal Employment Opportunity Commission (EEOC) – Hiring and firing standards • Minimum Wage Laws Prepared by Robert F. Slide 8 . Copyright ©2004 by South-Western. Government Regulation Protection of the Environment • Environmental Protection Agency (EPA) – Regulates environmental usage – Enforces environmental legislation • Clean Air Act of 1990 – Requires reduction in overall pollution – Established a market for pollution permits Prepared by Robert F. Copyright ©2004 by South-Western. Slide 9 . Brooker. All rights reserved. a division of Thomson Learning. Ph.D. Brooker. Slide 10 . All rights reserved. a division of Thomson Learning. Copyright ©2004 by South-Western. Ph.Externalities • Externalities are harmful or beneficial side effects of the production or consumption of some products • Public Interest Theory of Regulation – Regulation is justified when it is undertaken to overcome market failures – Externalities can cause market failures Prepared by Robert F.D. D.Externalities • External Diseconomies of Production or Consumption – Uncompensated costs • External Economies of Production or Consumption – Uncompensated benefits Prepared by Robert F. Brooker. a division of Thomson Learning. Slide 11 . All rights reserved. Copyright ©2004 by South-Western. Ph. MSB = Marginal Social Benefit Activity of A causes external benefit for B. Slide 12 . Prepared by Robert F. Socially optimal output is 3. All rights reserved. Socially optimal output is 10. Copyright ©2004 by South-Western. Brooker. a division of Thomson Learning.D.Externalities MSC = Marginal Social Cost Activity of A imposes external cost on B. Ph. Slide 13 . Ph. Socially optimal output is 10. Copyright ©2004 by South-Western.D. All rights reserved. a division of Thomson Learning.Externalities Activity of A imposes external cost on B. Socially optimal output is 3. Brooker. Tax yields this result Prepared by Robert F. Activity of A causes external benefit for B. Subsidy yields this result. Ph. a division of Thomson Learning.D. Copyright ©2004 by South-Western. Slide 14 . Brooker. All rights reserved.Public Utility Regulation • Natural Monopolies • Long-Run Average Cost (LAC) has a negative slope • Long-Run Marginal Cost (LMC) is below LAC • Regulators Set Price = LAC Prepared by Robert F. Slide 15 . Brooker. All rights reserved.Public Utility Regulation Regulators set price = $2 Socially optimal price = $1 Prepared by Robert F. Ph. a division of Thomson Learning.D. Copyright ©2004 by South-Western. Public Utility Regulation • Rate regulation is difficult in practice • Guaranteed return gives little incentive to control costs • Averch-Johnson Effect – Rates that are set too high or too low can lead to over. Slide 16 . All rights reserved. a division of Thomson Learning.or under-investment by in plant and equipment by utility • Regulatory Lag or 9-12 Months Prepared by Robert F.D. Ph. Copyright ©2004 by South-Western. Brooker. Antitrust Sherman Act (1890) • Made any contract. in restraint of trade illegal • Made monopolization or conspiracies to monopolize markets illegal Prepared by Robert F. a division of Thomson Learning. Ph. Slide 17 . All rights reserved. Brooker. or conspiracy.D. combination in the form of a trust or otherwise. Copyright ©2004 by South-Western. Brooker. Slide 18 . Ph. a division of Thomson Learning.D.Antitrust Clayton Act (1914) • Made it illegal to engage in any of the following if the effect was to lessen competition or create a monopoly – Price discrimination – Exclusive or tying contracts – Acquisition of competitors stocks – Interlocking directorates among competitors Prepared by Robert F. All rights reserved. Copyright ©2004 by South-Western. Antitrust Clayton Act (1914) • Federal Trade Commission Act (1914) – Prohibited “unfair methods of competition” • Robinson-Patman Act (1936) – Prohibited “unreasonable low prices” • Wheeler-Lea Act (1938) – Prohibited false or deceptive advertising to protect consumers • Celler-Kefauver Antimerger Act (195) Prepared by Robert F. All rights reserved.D. Brooker. Copyright ©2004 by South-Western. Ph. Slide 19 . a division of Thomson Learning. a division of Thomson Learning.D. All rights reserved. Brooker. Copyright ©2004 by South-Western. Slide 20 .Antitrust Enforcement • Remedies – Dissolution and divestiture – Injunction – Consent decree – Fines and jail sentences • Anticompetitive Conduct – Conscious parallelism – Predatory pricing Prepared by Robert F. Ph. Slide 21 .Regulation International Competition • Tariff – Tax on imports • Import Quota – Restricts quantity of imports • Voluntary Export Restraint – Exporter restricts quantity of exports • Antidumping Complaints Prepared by Robert F. a division of Thomson Learning. Ph. Brooker. All rights reserved. Copyright ©2004 by South-Western.D. Regulation International Competition Tariff raises price from $3 to $4 and reduces imports from 400 to 200. Ph. Prepared by Robert F. a division of Thomson Learning. Brooker. All rights reserved. Slide 22 .D. Copyright ©2004 by South-Western. 5th Edition by Dominick Salvatore Chapter 13 Risk Analysis Prepared by Robert F. All rights reserved. a division of Thomson Learning.D. Brooker.Managerial Economics in a Global Economy. Ph. Slide 1 . Copyright ©2004 by South-Western. a division of Thomson Learning. All rights reserved. Slide 2 . Ph. Brooker. Copyright ©2004 by South-Western.D.Risk and Uncertainty • Risk – Situation where there is more than one possible outcome to a decision and the probability of each outcome is known • Uncertainty – Situation where there is more than one possible outcome to a decision and the probability of each outcome is unknown Prepared by Robert F. Ph. Copyright ©2004 by South-Western. All rights reserved. Slide 3 .Measuring Risk Probability Distributions • Probability – Chance that an event will occur • Probability Distribution – List of all possible events and the probability that each will occur • Expected Value or Expected Profit n E ( )      i  Pi i 1 Prepared by Robert F. Brooker. a division of Thomson Learning.D. 25 $600 $150 Normal 0.50 500 250 Recession 0.25 400 100 $500 Expected profit from Project A Boom 0.Measuring Risk Probability Distributions Calculation of Expected Profit Project A B State of Probability Outcome Expected () Economy (P) Value Boom 0. Slide 4 .50 500 250 Recession 0. Ph. Copyright ©2004 by South-Western. Brooker.25 200 50 $500 Expected profit from Project B Prepared by Robert F. All rights reserved. a division of Thomson Learning.25 $800 $200 Normal 0.D. Measuring Risk Probability Distributions • Discrete Probability Distribution – List of individual events and their probabilities – Represented by a bar chart or histogram • Continuous Probability Distribution – Continuous range of events and their probabilities – Represented by a smooth curve Prepared by Robert F. Brooker.D. Slide 5 . All rights reserved. Copyright ©2004 by South-Western. Ph. a division of Thomson Learning. Brooker. Project B: E() = 500. Ph. High Risk Copyright ©2004 by South-Western. E() = 500. All rights reserved. a division of Thomson Learning.D. Slide 6 .Measuring Risk Probability Distributions Discrete Probability Distributions Project A. Low Risk Prepared by Robert F. Low Risk Prepared by Robert F. a division of Thomson Learning. Slide 7 . High Risk Copyright ©2004 by South-Western. All rights reserved. Project B: E() = 500.Measuring Risk Probability Distributions Continuous Probability Distributions Project A: E() = 500.D. Ph. Brooker. Ph. Brooker. Slide 8 .D. a division of Thomson Learning. Copyright ©2004 by South-Western. All rights reserved.Measuring Risk Probability Distributions An Absolute Measure of Risk: The Standard Deviation  n 2 ( X  X )  Pi  i i 1 Prepared by Robert F. Ph.D. a division of Thomson Learning. 000  $70.Measuring Risk Probability Distributions Calculation of the Standard Deviation Project A   (600  500)2 (0. Copyright ©2004 by South-Western.25)   5.50)  (400  500)2 (0. All rights reserved.71 Prepared by Robert F. Slide 9 .25)  (500  500)2 (0. Brooker. 000  $212. Brooker.25)  (500  500)2 (0. Slide 10 .25)   45. a division of Thomson Learning.D. Ph. Copyright ©2004 by South-Western.13 Prepared by Robert F.Measuring Risk Probability Distributions Calculation of the Standard Deviation Project B   (800  500)2 (0. All rights reserved.50)  (200  500) 2 (0. D. Brooker. Copyright ©2004 by South-Western.Measuring Risk Probability Distributions The Normal Distribution i  Z  Prepared by Robert F. Ph. a division of Thomson Learning. All rights reserved. Slide 11 . All rights reserved. Slide 12 .14 500 Prepared by Robert F.13 vB   0. Brooker.D. Ph.42 500 Copyright ©2004 by South-Western. 212.Measuring Risk Probability Distributions A Relative Measure of Risk: The Coefficient of Variation  v  Project A Project B 70.71 vA   0. a division of Thomson Learning. Copyright ©2004 by South-Western. Brooker.D. All rights reserved.Utility Theory • Risk Averse – Must be compensated for taking on risk – Diminishing marginal utility of money • Risk Neutral – Are indifferent to risk – Constant marginal utility of money • Risk Seeking – Prefer to take on risk – Increasing marginal utility of money Prepared by Robert F. a division of Thomson Learning. Slide 13 . Ph. D. Brooker. Slide 14 . All rights reserved. Ph.Utility Theory Prepared by Robert F. a division of Thomson Learning. Copyright ©2004 by South-Western. Brooker. Ph. a division of Thomson Learning. All rights reserved. Slide 15 .D. Copyright ©2004 by South-Western.Utility Theory Utility Function of a Risk Averse Manager Prepared by Robert F. Brooker. a division of Thomson Learning.Adjusting Value for Risk • Value of the Firm = Net Present Value n t NPV   t 1 (1  r ) t • Risk-Adjusted Discount Rate k  r  Risk Premium n NPV   t 1 Prepared by Robert F. All rights reserved. t (1  k ) Copyright ©2004 by South-Western.D. t Slide 16 . Ph. Adjusting Value for Risk Prepared by Robert F. All rights reserved. a division of Thomson Learning. Copyright ©2004 by South-Western.D. Ph. Slide 17 . Brooker. a division of Thomson Learning. Copyright ©2004 by South-Western. Slide 18 . Brooker. All rights reserved. Ph.D.Adjusting Value for Risk • Certainty Equivalent Approach n  Rt NPV   t 1 (1  r ) t • Certainty Equivalent Coefficient equivalent certain sum Rt*   expected risky sum Rt Prepared by Robert F. a division of Thomson Learning.Other Techniques • Decision Trees – Sequence of possible managerial decisions and their expected outcomes – Conditional probabilities • Simulation – Sensitivity analysis Prepared by Robert F.D. Copyright ©2004 by South-Western. Slide 19 . Brooker. All rights reserved. Ph. Copyright ©2004 by South-Western.Prepared by Robert F. Slide 20 . Ph.D. All rights reserved. Brooker. a division of Thomson Learning. Uncertainty • Maximin Criterion – Determine worst possible outcome for each strategy – Select the strategy that yields the best of the worst outcomes Prepared by Robert F. a division of Thomson Learning. Brooker.D. Ph. All rights reserved. Copyright ©2004 by South-Western. Slide 21 . State of Nature Success Failure 20. Slide 22 .D.Uncertainty: Maximin The payoff matrix below shows the payoffs from two states of nature and two strategies.000 0 0 Maximin -10. All rights reserved.000 -10.000 0 Copyright ©2004 by South-Western. Ph. Strategy Invest Do Not Invest Prepared by Robert F. Brooker. a division of Thomson Learning. Slide 23 .Do Not Invest. The maximin strategy is the best of the two worst outcomes .000 0 Copyright ©2004 by South-Western.D.000 0 0 Maximin -10.Uncertainty: Maximin The payoff matrix below shows the payoffs from two states of nature and two strategies. Brooker. Ph. For the strategy “Do Not Invest” the worst outcome is 0. For the strategy “Invest” the worst outcome is a loss of 10. All rights reserved. a division of Thomson Learning.000.000 -10. Strategy Invest Do Not Invest Prepared by Robert F. State of Nature Success Failure 20. Brooker.Uncertainty: Minimax Regret The payoff matrix below shows the payoffs from two states of nature and two strategies.000 -10. Slide 24 . Ph.D. State of Nature Success Failure 20.000 0 0 Copyright ©2004 by South-Western. All rights reserved. a division of Thomson Learning. Strategy Invest Do Not Invest Prepared by Robert F. All rights reserved.000 20.000 0 Copyright ©2004 by South-Western. Ph. Brooker.D.000 0 0 Regret Matrix Success Failure 0 10. State of Nature Success Failure 20.Uncertainty: Minimax Regret The regret matrix represents the difference between the a given strategy and the payoff of the best strategy under the same state of nature. Slide 25 . a division of Thomson Learning. Strategy Invest Do Not Invest Prepared by Robert F.000 -10. Brooker. All rights reserved.000 Slide 26 .Uncertainty: Minimax Regret For each strategy. Ph.000 20. The minimax regret strategy is the one that results in the minimum value of the maximum regret. Maximum Regret 10.D. a division of Thomson Learning.000 0 Copyright ©2004 by South-Western. Regret Matrix Success Failure 0 10.000 0 0 Prepared by Robert F. Strategy Invest Do Not Invest State of Nature Success Failure 20.000 -10. the maximum regret is identified.000 20. D.Uncertainty: Informal Methods • • • • Gather Additional Information Request the Opinion of an Authority Control the Business Environment Diversification Prepared by Robert F. All rights reserved. Copyright ©2004 by South-Western. Brooker. a division of Thomson Learning. Ph. Slide 27 . Brooker. All rights reserved.Foreign-Exchange Risk • Foreign-Exchange Rate – Price of a unit of a foreign currency in terms of domestic currency • Hedging – Covering foreign exchange risk – Typically uses forward currency contracts Prepared by Robert F. a division of Thomson Learning. Copyright ©2004 by South-Western. Ph.D. Slide 28 . Brooker. • Futures Contract – Standardized.Foreign-Exchange Risk • Forward Contract – Agreement to purchase or sell a specific amount of a foreign currency at a rate specified today for delivery at a specified future date. Slide 29 .D. All rights reserved. type of forward contract for predetermined quantities of the currency and selected calendar dates. Copyright ©2004 by South-Western. Prepared by Robert F. Ph. and more liquid. a division of Thomson Learning. Brooker.D. Copyright ©2004 by South-Western.Information and Risk • Asymmetric Information – Situation in which one party to a transaction has less information than the other with regard to the quality of a good • Adverse Selection – Problem that arises from asymmetric information – Low-quality goods drive high-quality goods out of the market Prepared by Robert F. Ph. Slide 30 . a division of Thomson Learning. All rights reserved. Copyright ©2004 by South-Western. All rights reserved. Slide 31 . Brooker. Ph.D.Information and Risk • Moral Hazard – Tendency for the probability of loss to increase when the loss is insured • Methods of Reducing Moral Hazard – Specifying precautions as a condition for obtaining insurance – Coinsurance Prepared by Robert F. a division of Thomson Learning. Brooker. 5th Edition by Dominick Salvatore Chapter 14 Long-Run Investment Decisions: Capital Budgeting Prepared by Robert F. Copyright ©2004 by South-Western. Ph.Managerial Economics in a Global Economy.D. Slide 1 . a division of Thomson Learning. All rights reserved. Capital Budgeting Defined Process of planning expenditures that give rise to revenues or returns over a number of years Prepared by Robert F. Ph.D. Copyright ©2004 by South-Western. a division of Thomson Learning. Slide 2 . All rights reserved. Brooker. a division of Thomson Learning. Copyright ©2004 by South-Western. Brooker. Slide 3 . All rights reserved. Ph.D.Categories of Investment • Replacement • Cost Reduction • Output Expansion to Accommodate Demand Increases • Output Expansion for New Products • Government Regulation Prepared by Robert F. D. a division of Thomson Learning. Copyright ©2004 by South-Western. Slide 4 . Brooker. All rights reserved.Capital Budgeting Process • Demand for Capital – Schedule of investment projects – Ordered from highest to lowest return • Supply of Capital – Marginal cost of capital – Increasing marginal cost • Optimal Capital Budget – Undertake all projects where return is greater than marginal cost Prepared by Robert F. Ph. Slide 5 . All rights reserved. Ph. B. Copyright ©2004 by South-Western. a division of Thomson Learning. Brooker. and C Prepared by Robert F.Capital Budgeting Process Firm will undertake projects A.D. Ph. Slide 6 .D. a division of Thomson Learning. Brooker. Copyright ©2004 by South-Western.Capital Budgeting Process Projecting Net Cash Flows – Incremental basis – After-tax basis – Depreciation is a non-cash expense that affects cash flows through its effect on taxes Prepared by Robert F. All rights reserved. a division of Thomson Learning.000 Fixed costs 150. All rights reserved.000 Net cash flow $290.000 Less: Income tax 60. Copyright ©2004 by South-Western.D.000 Prepared by Robert F.000 Plus: Depreciation 200. Brooker.000 Less: Variable costs 500.000 Profit after taxes $90.000 Depreciation 200. Slide 7 .Capital Budgeting Process Example: Calculation of Net Cash Flow Sales $1.000.000 Profit before taxes $150. Ph. Capital Budgeting Process Net Present Value (NPV) n Rt NPV    C0 t t 1 (1  k ) Rt = Return (net cash flow) k = Risk-adjusted discount rate C0 = Initial cost of project Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 8 Capital Budgeting Process Internal Rate of Return (IRR) n Rt  C0  t t 1 (1  k *) Rt = Return (net cash flow) k* = IRR C0 = Initial cost of project Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 9 Capital Rationing Profitability Index (PI) n Rt  t (1  k ) PI  t 1 C0 Rt = Return (net cash flow) k = Risk-adjusted discount rate C0 = Initial cost of project Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 10 The Cost of Capital Cost of Debt (kd) kd = r(1-t) r = Interest rate t = Marginal tax rate kd = After-tax cost of debt Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 11 The Cost of Capital Cost of Equity Capital (ke): Risk-Free Rate Plus Premium ke = rf + rp ke = rf + p1 + p2 rf = Risk free rate of return rp = Risk premium p1 = Additional risk of firm’s debt p2 = Additional risk of firm’s equities Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 12 The Cost of Capital Cost of Equity Capital (ke): Dividend Valuation Model ¥ D P  t (1  k ) t 1 e D ke D ke  P P = Price of a share of stock D = Constant dividend per share ke = Required rate of return Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 13 D. a division of Thomson Learning. Ph. All rights reserved.The Cost of Capital Cost of Equity Capital (ke): Dividend Valuation Model D P Ke  g P= D= ke = g= D ke   g P Price of a share of stock Dividend per share Required rate of return Growth rate of dividends Prepared by Robert F. Copyright ©2004 by South-Western. Brooker. Slide 14 . Copyright ©2004 by South-Western. Brooker.The Cost of Capital Cost of Equity Capital (ke): Capital Asset Pricing Model (CAPM) ke  rf  b ( k m  rf ) rf = Risk-free rate of return b = Beta coefficient km = Average rate of return on all shares of common stock Prepared by Robert F.D. Ph. Slide 15 . a division of Thomson Learning. All rights reserved. D. Proportion of debt Cost of debt Proportion of equity Cost of equity Copyright ©2004 by South-Western. All rights reserved. Brooker. a division of Thomson Learning. Slide 16 .The Cost of Capital Weighted Cost of Capital: Composite Cost of Capital (kc) kc  wd kd  we ke wd = kd = we = ke = Prepared by Robert F. Ph.
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