MANAGERIAL ECONOMICS MSc Programme Prof.Howard Davies

Why Managerial Economics? n A powerful ‘analytical engine’ n A broader perspective on the firm what is a firm? what are the firm’s overall objectives? what pressures drive the firm towards profit and away from profit n The basis for some of the more rigourous analysis of Marketing issues

What Topics Will We Cover? n The Economic Approach to the Firm n Basic Models n Transactions Cost Analysis: What Is A Firm? n Ownership and Control, Diversification and Mergers n The Behaviour of Costs n Demand Theory and Forecasting n Market Structures n Game Theory n Pricing in Theory and Practice n Non-price Marketing decisions n The Economics of the Information Sector n Economics and the Analysis of Business Strategy

Classroom Work and Assessment n CLASSROOM –6:45 -8:00 Lecture –8:00-8:15 Break –8:15 - 9:45 In-class activities n ASSESSMENT –In-class activities:20% –Mid-term quiz 25% –PBL Problem Solutions: 20% –Peer Appraisal: 10% –End of term Quiz: 25%

Reading Materials n H.Davies and P-L Lam, Managerial Economics: An Analysis of Business Issues, FT Prentice Hall 2001 n Copies of academic journal articles

Managerial Economics n The application of economic analysis to business problems n Related to, but not the same as –industrial economics –management science

Managerial Economics n The economics ‘method’ –‘illicit relationships with beautiful models’ n The steps:the hypothetico-deductive approach –make assumptions about behaviour –work out the consequences of those assumptions –make predictions –test the predictions against the evidence –PREDICTIONS SUPPORTED? The model is accepted as a good explanation (for the moment) –PREDICTIONS REFUTED? Go back and re-work the whole process

Managerial Economics n A ‘positive’ approach, not prescriptive or ‘normative’ –trying to explain ‘what is’ not what ‘should be’ –main objective to understand how a market economy works n Not very concerned about the descriptive realism of assumptions: ‘I assume X’ does not mean ‘I believe X to be true’ n Some real tension if the models are used for prescription –assume ‘perfect knowledge’: OK for model-building –cannot say to a manager: ‘behave AS IF you had perfect knowledge

The Basic Model of the Firm n The neo-classical model n The firm aims to maximize profit by choosing the level of output which gives the biggest difference between revenue and costs. n STEP BY STEP TO THE MODEL Demand: Average Revenue $ Quantity Produced P1 P2 Q1Q2

The Basic Model of the Firm n The neo-classical model n The firm aims to maximize profit by choosing the level of output which gives the biggest difference between revenue and costs. n STEP BY STEP TO THE MODEL Demand: Average Revenue Marginal Revenue $ Quantity Produced

The Basic Model of the Firm n The neo-classical model n The firm aims to maximize profit by choosing the level of output which gives the biggest difference between revenue and costs. n WHAT IS THE EQUILIBRIUM? Demand: Average Revenue Marginal Revenue Marginal Cost $ Quantity Produced ProfitMaxing Output Profit Maxing Price

The Basic Model of the Firm n The neo-classical model n The firm aims to maximize profit by choosing the level of output which gives the biggest difference between revenue and costs. n MORE DETAIL ON THE EQUILIBRIUM Demand: Average Revenue Marginal Revenue Marginal Cost $ Quantity Produced ProfitMaxing Output Profit Maxing Price Average Cost

What Can We Do With This Model? n Comparative Statics –begin with an initial equilibrium position - the starting point –change something –identify the new equilibrium, e.g: When demand increases? When costs rise? When a fixed cost increases? –This is the main purpose of the model -what it was designed to do n Normative prescriptions –it will cost me $30 per unit to supply something which will give me $20 per unit in revenue- should I do it? –I must pay $20 billion to set up in my industry. Should I charge higher prices to get that money back? n Positive and Normative are linked by “if?” IF the aim of the firm is to maximise profit what will it do/what should it do?

What Is A “Good” Model? n It allows us to make predictions and set hypotheses n The predictions can be tested against the empirical evidence n The predictions are supported by the empirical evidence n gravity - pulleys, weights and strings

Typical Exam/Quiz Questions for this Topic n Economists are often accused of using models which are based upon unrealistic assumptions and therefore cannot be useful. Write a defence of the economists’ approach and explain your own judgment on this issue. n Discuss the relative merits and disadvantages of auctioning mobile phone licenses versus allocating them through a ‘beauty contest’.

Look at the Discussion Topics for This Week n What assumption is being made about competition in the model described this week? n How will different kinds of competitive situation change the basic model of the firm? n Will auctioning licences for 3G mobile phones increase the price of calls?

See You Next Week n Do some preparation for the in-class work!!