Managerial Economics (Reviewer) Think about the organizational design.

Once
Chapter 1 you identify a bad decision, avoid the temptation
to solve the problem by simply reversing the
decision. Instead, think about why the bad
Rational-actor paradigm- people act rationally, decision was made, and how to make sure that
optimally, and self-interestedly. In other words, similar mistakes won’t be made in the future.
they respond to incentives. What is the trade-off? Every solution has costs as
well as benefits. Avoid the temptation to think
-To change behavior, you have to change self- only about the benefits, as it will make your
interest; and you do that by changing incentives. analysis seem as if it were done to justify a
foregone conclusion. Use the three questions to
-Incentives are created by rewarding good spot problems with a proposed solution; that is, in
performance. whatever solution you propose, make sure
decision makers have enough information to make
good decisions and the incentive to do so.
-The performance evaluation metric (sales,
profit, or similar outcome) is separate from the Don’t define the problem as the lack of your
reward structure (commission, bonus, raise, solution. This kind of thinking may cause you to
promotion, or other reward), but they work miss the best solution. For example, if you define a
together to create an incentive to behave a certain problem as “the lack of centralized purchasing,”
way. then the solution will be “centralized purchasing”
regardless of whether that is the best option.
Under the rational actor paradigm, bad Instead, define the problem as “high acquisition
decisions happen for one of two reasons: Either cost,” and then examine “centralized purchasing”
decision makers do not have enough versus “decentralized purchasing” (or some other
information to make good decisions, or they lack alternative) as potential solutions to the problem.
incentive to do so. Avoid jargon because most people misuse it.
Force yourself to spell out what you mean in
Problem solving requires two steps: First, figure simple language. It will help your thinking and
out why mistakes are being made; and then communication.
figure out how to make them stop. Deontologists- actions are good or ethical if they
Three Questions: conform to a set of principles Ex. The Golden Rule
1. Who is making the bad decision?
2. Does the decision maker have enough -Professor Holt -objects on principle to the
information to make a good decision? practice of raising prices in times of shortage.
3. Does the decision maker have the
incentive to make a good decision? -Spider Man principle: With great power comes
Answer to the questions: great responsibility. The laws of capitalism allow
1. letting someone else—someone with corporations to amass significant power; in turn,
better information or better incentives— society should demand a high level of
make the decision, responsibility from corporations.
2. giving more information to the current
decision maker, or Consequentialist- actions are judged based on
3. changing the current decision makers’ whether they lead to a good consequence.
incentives.
Economics= Consequentialist
Practical tips that will help you develop
problem-solving skills:
Think about the problem from the
organization’s point of view. Avoid the
temptation to think about the problem from the
employee’s point of view because you will miss
the fundamental problem of goal alignment: how
does the organization give employees enough
information to make good decisions and the
incentive to do so?
Chapter 2 The absence of property rights contributes to
poverty. The reasons are simple: Without private
property and contract enforcement, wealth-
- Wealth is created when assets move from
lower- to higher-valued uses. creating transactions are less likely to occur,8 and
this stunts development. Ironically, many poor
- An individual’s value for a good or
countries survive largely on the wealth created in
service is measured as the amount of
the so-called underground, or black market,
money he or she is willing to pay for it.
economy, where transactions are hidden from the
- To “value” a good means that you want it government.
and can pay for it.
- Buyer’s “value” for an item is how much -Secure property rights are also associated with
he will pay for it, his “top dollar.” measures of environmental quality and human
- Likewise, a seller won’t accept less than well-being.
her value, “cost,” or “bottom line.”
- The biggest advantage of capitalism is -If you give people ownership to their property,
that it creates wealth by letting a person they take care of it, invest in it, and keep it clean.
follow his or her self-interest.
- A buyer willingly buys if the price is -Efficiency- one of the most useful ideas in
below his value, and a seller sells for the economics.
same selfish reason—because the price is
above her value. Both buyer and seller
-An economy is efficient if all assets are employed
gain; otherwise, they would not transact.
in their highest-valued uses.
- Voluntary transactions create wealth.
-A good policy facilitates the movement of assets
Seller surplus- difference between the agreed-on to higher-valued uses; and a bad policy prevents
price and the seller’s value assets from moving or, worse, moves assets to
lower-valued uses.
Buyer surplus- is the buyer’s value minus the
price. -Henry Hazlitt: The art of economics consists in
looking not merely at the immediate but at the
The total surplus or gains from trade created by longer effects of any act or policy; it consists of
the transaction is the sum of buyer and seller tracing the consequences of that policy not
surplus, the difference between the buyer’s top merely for one group but for all groups.
dollar and the seller’s bottom line.
-The one lesson of business: The art of business
“zero sum fallacy” - if one person makes money, consists of identifying assets in low- valued uses
someone else must be losing it. and devising ways to profitably move them to
higher-valued ones.
-Policy makers often invoke this fallacy to justify
limits on pay, profitability, or prices, or even trade -In other words, each underemployed asset
itself. represents a potential wealth-creating trans-
action.
-The voluntary nature of trade ensures that
both parties gain. -If the movement of assets to higher valued
uses creates wealth, then anything that impedes
DOES THE GOVERNMENT CREATE WEALTH? asset movement destr;oys wealth.

-Governments play a critical role in the wealth- Three Impediments:

creating process by enforcing property rights
and contracts—legal mechanisms that Taxes -The government collects taxes out of the
facilitate voluntary transactions. total surplus created by a transaction. If the tax is
larger than the surplus, the transaction will not Accordingly, we define the “opportunity cost” of
take place. one alternative as the forgone opportunity to earn
profit from the other. With this definition, costs
Subsidies -The opposite of a tax is a subsidy. By imply decision- making rules, and vice versa.
encouraging low-value consumers to buy or high-
value sellers to sell, subsidies destroy wealth by -The opportunity cost of an alternative is what
moving assets from higher- to lower- valued you give up to pursue it.
uses—in exactly the wrong direction.
-Costs and decisions are inherently linked to one
Price control- is a regulation that allows trade another.
only at certain prices.
General rule for making decisions: When
Two types: making decisions, you should consider all costs
and benefits that vary with the consequence of a
Price ceilings- outlaw trade at prices above the decision and only costs and benefits that vary
ceiling with the consequence of the decision. These are
the relevant costs and relevant benefits of a
decision.
Price floors- outlaw trade at prices below the
floor.
Two types of mistakes in implementing the rule:
Companies- collections of transactions.
1. You can consider irrelevant costs
Chapter 3 2. you can ignore relevant ones.

-The capital cost is a fixed cost, as opposed to the The sunk-cost fallacy means that you consider
labor or ingredients, which vary with input. Costs costs and benefits that do not vary with the
that change with output level are called variable consequences of your decision. In other words,
costs. you make decisions using irrelevant costs and
benefits.
-Fixed costs do not vary with the amount of
output. Variable costs change as output changes. -One of the most frequent causes of the sunk-
cost fallacy in business is the “overhead”
allocated to various activities within a company.
Accounting costs

-Costs paid to its suppliers for product ingredients -Depreciation5 is another common cause of the
-General operating expenses, like salaries to sunk-cost fallacy.
factory managers and marketing expenses
-Accounting profit does not necessarily
-Depreciation expenses related to investments in correspond to economic profit.
buildings and equipment
-Interest payments on borrowed funds -Accounting costs do not necessarily correspond
to the relevant costs of a decision.
Economists are interested in all the relevant
costs of decision making, including the implicit -The hidden-cost fallacy occurs when you ignore
costs that do not show up in the accounting relevant costs—those costs that do vary with the
statements. consequences of your decision.

Example of implicit cost: -If you begin with the costs, you will always get
confused; but if you begin with the decision, you
Interest is the cost that creditors charge for use of will never get confused.
their capital.
Chapter 4: Marginal cost (MC) is the additional cost incurred
by producing and selling one more unit.
Summary of Main Points they use breakeven
analysis because it is eas- Marginal revenue (MR) is the additional revenue
gained from selling one more unit.
All investment decisions involve a trade-off
between current sacrifice and future gain. Before -Sell more if MR > MC; sell less if MR < MC. If MR =
investing, you need to know is whether the future MC, you are selling the right amount
gains are bigger than the current sacrifice. (maximizing profit).
Discounting is a tool that allows you to figure this
out. -Marginal analysis points you in the right
direction, but it cannot tell you how far to go.
Companies, like individuals, have different
discount rates, determined by their cost of capital. -To increase profit, increase spending on
They invest only in projects that earn a return whichever medium has a higher marginal effect,
higher than the cost of capital. and pay for the increase by reducing spending on
the other.
The NPV rule states that if the present value of the
net cash flows of a project is larger than zero, the -It is common to confuse marginal cost with
project earns economic profit (i.e., the investment average cost. Average cost is total cost divided by
earns more than the cost of capital). the number of units produced.

Although NPV is the correct way to analyze -Average costs are not what you need to make
investments, not all companies use it. Instead, extent decisions. Using average cost can lead to
they use breakeven analysis because it is poor decisions. To compute marginal cost, look
easier and more intuitive. only at the additional cost of producing one
more unit.
Breakeven quantity is equal to fixed cost divided
by the contribution margin. If you expect to sell
more than the breakeven quantity, then your -Costs are defined by the decision you are trying
investment will be profitable. Avoidable costs can to make.
be recovered by shutting down. If the benefits of
shutting down (you recover your avoidable costs) -Marginal analysis can be used to design incen-
are larger than the costs (you forgo revenue), then tives to encourage hard work.
shut down. The breakeven price is average
avoidable cost. -To induce higher effort, use incentives that
If you incur sunk costs, you are vulnerable to post- reduce marginal costs or increase marginal
investment hold-up. Anticipate hold-up and benefits. Fixed costs or benefits do not change
choose contracts or organizational forms that give effort.6
each party both the incentive to make sunk-cost
investments and to trade after these investments --
Incentive schemes are most effective when
are made.
“effort matters, there is little intrinsic desire to
do the job, and money boosts the recipient’s social
-Average cost (AC) is irrelevant to an extent status.”8
decision.
-Marginal cost is the extra cost required to make --
and sell one additional unit of output. Incentive pay almost certainly leads to
differences among workers: If you reward
Marginal Analysis- To analyze extent decisions, productivity, more productive workers, or those
we break down the decision into small steps and who work harder than others, will get paid more.
then compute the costs and benefits of taking Moreover, incentive pay schemes typically expose
another step. If the benefits of taking another step workers to risk beyond their control.
are greater than the costs, then take another step.
-. If you adopt incentive pay, you get higher -The breakeven quantity (Q) is
productivity but at the expense of some inequality.

Chapter 5: where F is annual fixed cost, P is price, and MC is

marginal cost.
-All investment decisions involve a trade-off
between current sacrifice and future gain. -The breakeven quantity is the quantity that will
lead to zero profit.4 The logic behind the
-compounding, (future value, one period in the calculation is simple. Each unit sold earns the
future) = (present value) x (1 + r) where r is the contribution margin (P – MC), so named because
rate of return. this is the amount that one sale earns. You have to
sell at least the breakeven quantity to earn enough
to cover fixed costs. If you sell more than the
-A good rule of thumb to know when thinking
breakeven quantity, you have earned more than
about compounding is the “rule of 72”.1 If you enough to cover your fixed costs, or to earn a
invest at a rate of return r, divide 72 by r to get the profit.
number of years it takes to double your money.
-Common business mistake: Do not invoke
-Determine whether an investment is breakeven analysis to justify higher prices or
profitable. The rule is simple: discount the greater output.
future benefits of an investment, and compare
them to the current cost of the investment. If
-pricing and production are extent decisions that
the difference is positive (called the “net present
require marginal analysis, not breakeven analysis.
value”), then the investment earns more than
the cost of capital. This intuition can be
formalized into a general decision rule, called the -To study shutdown decisions, we work with
NPV rule. breakeven prices rather than quantities. If you
shut down, you lose your revenue, but you get
back your avoidable cost. If revenue is less than
-If the net present value of discounted cash flow
avoidable cost, or equivalently, if price is less than
is larger than zero, then the project earns more
than the cost of capital. average avoidable cost,8 then shut down.

-The NPV rule illustrates the link between the idea -The breakeven price is the average avoidable
of “economic profit” introduced in Chapter 3 and cost per unit.
investment decisions.
--
Economics is often called the “dismal science,”
-Positive NPV create economic profit because partly because of its dark view of human nature.
they earn a return higher than the company’s cost
of capital. -Sunk costs are unavoidable, even in the long
run, so if you make sunk-cost investments, you are
-Projects with negative NPV may create vulnerable to post-investment hold-up.
accounting profit but not economic profit. In
making investment decisions, choose only -Hold-up can occur only if costs are sunk,
projects with a positive NPV.
Anticipate Hold-up
-NPV analysis is the “correct” way to evaluate
investment decisions.
-In general, there are many investments that are
vulnerable to hold-up. Anytime that one party
Breakeven analysis
makes a specific investment—one that is sunk or
lacks value outside a trading rela- tionship—the
-If you can sell more than the breakeven quantity, party can be held up by its trading partner.
then entry is profitable; otherwise, entry is
unprofitable.
 -Consumers are using marginal analysis to
maximize consumer surplus (make all
purchases so that marginal value exceeds price),
Chapter 6: while sellers use it to maximize profit.

Profit = (P – C) x Q,
-You cannot sell more without decreasing
price.
-“simple pricing,” the case of a single firm, selling
a single product, at a single price.
-Marginal analysis, not average analysis, tells you
where to price or, equivalently, how many to sell.
-First Law of Demand: Consumers demand
(purchase) more as price falls
-You don’t need the entire demand curve to know
how to price—all you need is information on MR
-How much to buy is an extent decision,;thinking
and MC. If MR > MC, reduce price; if MR < MC,
in marginal terms is critical.
increase price.

-To describe how consumers will respond to price,

-estimate marginal revenue- measuring
economists use demand curves, which tell you
quantity responses to past price changes,
how much a single consumer or a group of
“experimenting” with price changes, or surveying
consumers will consume as a function of price.
potential consumers to see how quantity would
change in response to a price change.
-Demand curves describe buyer behavior and
tell you how much consumers will buy at a given -If you do get any useful information about
price. demand away from the current price, it’s likely to
come in the form of information about price
-To describe the buying behavior of a group of elasticity of demand, which we denote by e.
consumers, we add up all the individual demand
curves to get an aggregate demand curve. -Price elasticity of demand (e) = (% change in
quantity demanded)/(% change in price)
-aggregate or market demand curve is the
relationship between the price and the number of -Price elasticity measures the sensitivity of
purchases made by this group of consumers.
quantity to price. A demand curve for which
quantity changes more than price is said to be
-As price decreases, “quantity demanded” elastic, or sensitive to price; and a demand curve
increases. If something other than price causes an for which quantity changes less than price is said
increase in demand, we instead say that the to be inelastic, or insensitive to price.
“demand shifts” to the right, or “demand
increases,” such that consumers purchase more at
if |e| > 1, demand is elastic; if |e| < 1, demand is
the same prices.
inelastic.

-We use demand curves to change the pricing Since price and quantity move in opposite
decision (“what price should I charge”) into a directions—as price goes up, quantity goes down,
quantity decision. and vice versa—price elasticity is negative; that
is, e <
-If marginal revenue (MR) is greater than marginal
cost (MC),4 sell more, and you do this by reducing
price.
-For elastic demand, if you reduce price, revenue
Reduce price (sell more) if MR > MC. Increase goes up.
price (sell less) if MR < MC.
-Elasticity is important because it tells you how
revenue changes as you change price, as the
following approximation shows: 1. Products with close substitutes have more
elastic demand.

-Consumers respond to a price increase by

switching to their next-best alternative.
%Δ means “percentage change in.”
2. Demand for an individual brand is more
elastic than industry aggregate demand.

-As a rough rule of thumb, we can say that brand

price elasticity is approximately equal to industry
price elasticity divided by the brand share.

3. Products with many complements have less

elastic demand.

-Products that are consumed as part of a larger

bundle of complementary goods—say, shoe- laces
and shoes—have less elastic demand.

-When demand is elastic, quantity changes by a 4. In the long run, demand curves become
greater percentage than price, so revenue will rise more elastic.
following a price decrease and fall following a
price increase. On the other hand, if you increase
price when demand is elastic, revenue will go -As time passes, information about a new price
down. becomes more widely known, so more consumers
react to the change.
-The exact numerical relationship between
marginal revenue (change in revenue) and 5. As price increases, demand becomes more
elasticity is MR = P(l – 1/|e|). elastic.

-This expression has an intuitive interpretation. Forecasting Demand Using Elasticity

The left side of the expression is the current
margin of price over marginal cost, (P – MC)/P, -We can also use elasticity as a forecasting tool.
whereas the right side is the desired margin, With an elasticity and a percentage change in
which is the inverse elasticity, 1/|e|. If the current price, you can predict the corresponding change in
margin is greater than the desired margin, reduce quantity:
price because MR > MC, and vice versa.

-the more elastic demand becomes (1/|e|

becomes smaller), the less you can raise price over
marginal cost because you lose too many
For example, if the price elasticity of demand is –2,
customers.
and price goes up by 10%, then quan- tity is
forecast to decrease by 20%.
-Given the importance of elasticity (price elasticity
of demand) to pricing—the more elastic demand -Price is only one of many factors that affect
is, the lower the profit-maximizing price is. demand. Income, prices of substitutes and
complements, advertising, and tastes all affect
-five factors that affect demand elasticity and demand. To measure the ef- fects of these other
optimal pricing. variables on demand, we define a factor elasticity
of demand: -Our expressions for optimal pricing, MR = MC or
(P – MC)/P = 1/|e|, take into account both a firm’s
cost structure and its consumers’ demand to
obtain the optimal price.

-For example, demand for bottled water, iced tea, -cost-plus pricing arrives at a price by adding a
and carbonated soft drinks is strongly influenced
fixed dollar margin to the cost of each product,
by temperature. If the temperature elasticity of
while mark-up pricing multiples the cost by a fixed
demand for beverages is 0.25, then a 1% increase
number greater than 1.
in temperature will lead to a 0.25% increase in
quantity demanded.
Chapter 7:
-Income elasticity of demand measures the
change in demand arising from changes in in- -law of diminishing marginal returns states that
come. Positive income elasticity means that the as you try to expand output, your marginal
good is normal; that is, as income increases, productivity (the extra output associated with
demand increases. Negative income elasticity extra inputs) eventually declines.
means that the good is inferior; that is, as in-
come increases, demand declines -Diminishing marginal returns occur for a variety
of reasons, among them the difficulty of
-Cross-price elasticity of demand for Good A monitoring and motivating larger workforces, the
with respect to the price of Good B measures the increasing complexity of larger systems, or the
change in demand of A owing to a change in the “fixity” of some factor. these are known as
price of B. “bottlenecks.”

-Positive cross-price elasticity means that Good -bottlenecks arise when more workers, or any
B is a substitute for Good A. As the price of a variable input, must share a fixed amount of a
substitute increases, demand increases. complementary input. When productivity falls
from bottlenecks, costs increase.
-Negative cross-price elasticity means that Good
B is a complement to Good A: As the price of a -Diminishing marginal productivity implies
complement increases, demand decreases. increasing marginal cost.

-Stay-even analysis is a simple but powerful tool -Increasing marginal costs eventually lead to
that allows you to do marginal analysis of pricing. increasing average costs.
In particular, it is used to determine the volume
required to offset a change in price. -The law of diminishing marginal returns is
primarily a short-run phenomenon arising from
-For example, you know from the First Law of the fixity of at least one factor of production,
Demand that raising price will result in selling like capital or plant size. In the long run, however,
fewer units. Stay-even analysis tells you how you can increase the size of the plant, hire more
many unit sales you can lose before a price workers, buy more machines, and remove
increase becomes unprofitable. When combined production bottlenecks. In other words, your
with information about elasticity of de-mand, the “fixed” costs become “variable” in the long run.
analysis will give you a quick answer to the
question of whether changing price makes sense. - -If long-run average costs are constant with
-If the predicted quantity decrease is bigger respect to output, then you have constant
than the stay-even quantity decrease, then the returns to scale.
price increase is not profitable, and vice versa. -If long-run average costs rise with output, you
have decreasing returns to scale or dis-
Cost-based Pricing economies of scale.
-If long-run average costs fall with output, you sellers must compete with one another in order to
have increasing returns to scale or economies sell to buyers.
of scale.
-Do not use demand and supply analysis to
-The same factors (i.e., the fixity of some input) describe changes facing an individual firm.
that cause diminishing marginal returns in the
short run can also cause decreasing returns to -Demand and supply analysis is especially
scale in the long run. important if your firm’s success or profitability is
closely linked to the profitability of your primary
-Knowing whether your long-run costs exhibit industry.
constant, decreasing, or increasing returns to scale
can help you make better long-run decisions. If -changes in price lead to changes in quantity
your long-run costs exhibit increasing returns to demanded; movement along the demand curve.
scale, securing big orders allows you to reduce
average costs.
-A controllable factor is something that affects
demand that a company can control. Ex. Price,
LEARNING CURVES advertising, warranties, product quality,
distribution speed, service quality, and prices of
-Learning curves are characteristic of many substitute or complementary products
processes. That is, when you produce more, you
learn from the experience; then, in the future, -An uncontrollable factor is something that
you are able to produce at a lower cost. affects demand that a company cannot control. Ex.
income, weather, interest rates, and prices of
-Learning curves mean that current production substitute and complementary products owned by
lowers future costs, which has important other companies
strategic consequences.
-Expectations of future changes can also affect
-Maxim: “Look ahead and reason back” current demand.

ECONOMIES OF SCOPE -Supply curves describe the behavior of a group

of sellers and tell you how much will be sold at a
-If the cost of producing two products jointly is given price.
less than the cost of producing those two products
separately—that is, -Supply curves slope upward; that is, the higher
the price, the higher the quantity supplied.
Cost(Q1, Q2) < Cost(Q1) + Cost(Q2)
-Market equilibrium is the price at which
—then there are economies of scope between quantity supplied equals quantity demanded.
the two products.
-In market equilibrium, there are no
DISECONOMIES OF SCOPE unconsummated wealth-creating transactions.

-If the cost of producing two products together is CHAPTER 9

higher than the cost of producing them separately.
two fatal errors:
Chapter 8
1. fundamental error of attribution-
-“monopoly” - involves only a single firm. “confusing correlation with causality.”
2. to ignore the long-run forces that tend
to erode profit.
-“perfect competition” - many sellers and many
buyers come together in a “market” setting. ;
COMPETITIVE INDUSTRIES THE INDIFFERENCE PRINCIPLE

-Firms produce a product or service with very -Entry and exit, or asset mobility- the major
close substitutes so that they have very elastic competitive force driving profit to zero
demand. (remember that economic profit includes a cost of
-Firms have many rivals and no cost capital, so economic profit is normally zero).
advantages.
-The industry has no barriers to entry or exit. -The ability of assets to move from lower- to
higher-valued uses is the force that moves an
-A competitive firm cannot affect price, so there industry toward long-run equilibrium.
is little a competitive firm can do except react to
industry price. If price is above MC, it sells more; -indifference principle: If an asset is mobile,
if price is below MC, it sells less. In sum, a then in long-run equilibrium, the asset will be
competitive firm’s fortunes are closely tied to indifferent about where it is used; that is, it will
those of the industry in which it competes. make the same profit no matter where it goes.

-At the higher price, firms in the industry enjoy -Labor and capital are generally highly mobile
above-average profit—but only for a while. assets.
This “for a while” is the period that economists
call the “short run.” Above- average profit lasts -Wages also adjust to restore equilibrium. The
only for a while because profit attracts capital to indifference principle tells us that in long- run
the industry; existing firms expand capacity, or equilibrium, all professions should be equally
new entrants come into the industry. This attractive, provided labor is mobile
increases industry supply, which leads to a
decrease in price. -Once equilibrium is reached, differences in
wages, called compensating wage differentials,
-Long-run equilibrium- capital flow into the reflect differences in the inherent
industry stops attractiveness of various professions.

-In the long run, no competitive industry earns

more than an average rate of return. If it does,
firms will enter the industry or expand, increasing
supply until the profit rate returns to average.

-A competitive firm can earn positive or negative

profit in the short run but only until entry or exit
occurs. In the long run, competitive firms earn
only an average rate of return.

-When firms are in long-run equilibrium,

economic profit is zero (including the
opportunity cost of capital), firms break even, and
price equals average cost.

-if Price equals Average Cost, and cost includes a

capital charge for the opportunity cost of capital,
there’s no reason for capital to move because it
cannot earn a higher rate of return elsewhere.

-profit exhibits mean reversion where the mean

is zero economic profit.