Basics of Managerial Economics and Linear Programming Essay Choose any topic discussed in the managerial economics class and write a 3 – 5 page essay with the following specifications.
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The paper should consist of the following:
A discussion on your selected topic covering the main points.
At least one news article related to the chosen topic, showing the application of the concept in the real world. You can easily find such news articles on internet.
Write in your own words what you’ve understood from the article(s) and how this relates to what you have learned in the Econ 140 class.
The articles should be at the end of the paper, and these should not be included in the page count.
Other Requirements:
Title of the paper and Your Name (Top corner of the first page)
References (These should be on the last page of the assignment) Notes for Linear Pr0gramming
(An Introduction)
What is Linear Programming?
• Definition: A solution method for maximization or minimization
decision problems subject to underlying constraints.
• LP is a method of formulating and solving decision problems that
involve explicit resource constraints.
Examples
• Analysts use the LP method to solve problems such as• How should a firm allocate its advertising expenditure among
various media?
• What quantities of two jointly manufactured goods should a
firm produce with a fixed amount of labor and inputs?
• How should a federal agency allocate its limited budget
between two competing safety programs?
What do all these problems have in common?
•
•
•
•
All seek to find the best values of certain variables –
•
•
•
The right advertising mix
The most profitable product quantities
The appropriate budget allocation.
Each decision has an explicit objective – maximum profit, minimum cost etc.
Constraints limit the possible values of the decision variables (values the decision
makers control). For example – limited labor supply may constrain the quantity of
output.
The problem is finding values for the decision variables that best meet the given
objective while satisfying various constraints.
Basic Assumptions
• Inequality Constraints (Notes)
• Linearity (Notes)
Example
• Example on maximization (Class Notes)
Basics of Managerial
Economics*
*Introduction + Ch.1 with emphasis on section1.1
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What is Managerial Economics?
Managerial
Economics provides
valuable economics
tools for managers so
that they can take
optimal decisions:
What should be
the pricing and
output policy?
What should be
the input mix?
What product
quality to
choose?
How many
employees to
hire?
How to ensure
quality work
from employees?
How to take into
account the
action of rival
firms?
The Manager!
Who is a
manager?
A person
responsible for
• His/her own
actions
• Actions of
other
resources
such as
individuals,
machines
etc.
Directs
efforts of
others,
buys
inputs
and/or
makes
pricing or
quality
decisions.
Managerial Economics
When the resources are scarce, managers can make
cost-effective decisions by applying the discipline of
managerial economics.
Managerial Economics studies how managers can
direct scarce resources in the most efficient ways and
achieve their goals.
Example
Think about the managerial decisions in a coffee shop:
What varieties of coffee to provide for customers? (think about
all the variety of coffee that you get in a coffee shop)
How to price different glass/cup sizes? (how much do you pay
for a small, medium or tall?)
How many workers to employ? (How many workers do you
typically see in a coffee shop?)
How to ensure quality work from the workers?
How to maintain product quality?
Next month, another coffee shop is opening in the same
shopping complex. How to not lose business to the rival firm?
What new decisions need to be made?
Managerial Decision Making –
Different Managers
➢
There are many decisions made by different managers
➢
A production manager’s objective is normally to achieve a
production target at the lowest possible cost. Of course, the
manager has to use the existing factory and resources.
➢
Human resource managers design compensation systems to
encourage employees to work hard. Of course, the manager has
limited resources available in the firm.
➢
A marketing manager must allocate an advertising budget to
promote the product most effectively. Of course, the manager has a
limited marketing budget.
Managerial Decision Making – The
CEO
➢
The job of the chief executive officer (CEO), is to focus on
maximizing profit.
➢
➢
The CEO is also concerned with how a firm is positioned in a
market relative to its rivals.
Maximizing profit requires coordination!
➢
The CEO orders the production manager to minimize the cost
of producing the particular good or service.
➢
The CEO asks the market research manager to determine how
many units can be sold at any given price, and so forth.
➢
It would be a major coordination failure if the marketing
department set up a system of pricing and advertising based
on selling 8,000 units a year, while the production department
managed to produce only 2,000.
Managerial Decision Making – Trade
Offs
➢
In an environment of scarcity, managers must focus on the tradeoffs that directly or indirectly affect profits.
➢
➢
Evaluating trade-offs often involves marginal reasoning:
considering the effect of a small change.
How to Produce
➢
To produce a given level of output, a firm must use more of
one input if it uses less of another input. Example: Metal and
plastic substitute each other in the production of cars. Small
increments and reductions of them affect the car’s weight,
safety, and cost.
Managerial Decision Making – Trade
Offs
➢
What Prices to Charge
➢
➢
Consumers buy fewer units of a product when its price
rises given their limited budgets. Example: When a
manager sets the price of a product, the manager must
consider whether raising the price offsets the loss from
selling fewer units.
Whether to Innovate
➢
There are short run and long run profits. Example:
Investments in innovation such as designing new
products and better production methods may raise the
long run profit, but these typically lower the short run
profit.
Managerial Decision Making
➢
Other Decision Makers
➢
Consumers purchase products subject to their limited
budgets
➢
Workers decide on which jobs to take and how much to work
given their scarce time and limits on their abilities.
➢
Rivals may introduce new, superior products or cut the
prices of existing products.
➢
Governments around the world may tax, subsidize, or
regulate products.
Managerial Decision Making Strategy
➢
A strategy is a battle plan that specifies the actions or
moves that the manager will make to maximize the firm’s
profit when interacting with a small number of rival firms.
➢
One tool that is helpful in understanding and developing
such strategies is game theory, which we use in several
chapters.
Managerial Decision-Making Example: Pepsi’s
price-cutting strategy in the 1930s
In 1931, the Pepsi-Cola company was in a desperate condition. The company had entered
bankruptcy for the second time in 12 years.
The president of Pepsi, Charles G. Guth tried to sell Pepsi to its rival Coca-Cola, but Coke
wanted no part of it.
During this period, Pepsi and Coke sold cola in 6-ounce bottles.
To reduce costs, Guth purchased a large supply of recycled 12-ounce beer bottles. Pepsi
priced the 12-ounce bottles at 10 cents, twice the price of 6-ounce Cokes. But this
strategy failed to boost sales!
Then Guth had an idea: to sell 12-ounce Pepsi bottles for the same price as 6-ounce
Cokes. This worked for Pepsi! Pepsi’s sales shot up.
By 1934, Pepsi was out of bankruptcy. Its profits rose to $2.1 million by 1936, and to
$4.2 million by 1938.
Ref: Tedlow, Richard, New and Improved: The Story of Mass Marketing in
America, New York, Basic Books, 1990
Pepsi’s success in the 1930s can be understood
using economics
In 1931, Pepsi’s main objective was to increase profits. But the
president could not just order his subordinates to increase Pepsi’s
profits. The management cannot directly control its profits or market
share. However, the management can control marketing, production
and the administrative decisions that determine profitability.
Pepsi put in use the basic principle of the law of demand. By selling at a
lower price, it could increase the quantity sold.
Will that translate into higher sales revenues? This depends on price
elasticity of demand.
Economic Analysis continued..
As long as Coke didn’t respond to Pepsi’s price cut with its own, we would
expect that the demand for Pepsi would have been relatively sensitive to
price, in other words, price-elastic. (Coke had a large share of the market, it
was more profitable to keep its price high than to respond with a price cut
of its own).
And price-elastic demand implies that price cut leads to higher sales
revenue.
Will higher sales revenue lead to higher profits?
This will depend on the economic relationship between the additional sales
revenue that the price cut generated and the additional cost of producing
more quantity.
That profits increased after the price-cut suggests that the additional sales
revenue far exceeded the additional costs of production.
Firm
Organization
and Market
Structure*
* (Based on Ch. 7 – Emphasis on sections 7.2,
parts of 7.3 and 7.4)
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or distributed.)
Profit
Maximization
In general, the overall goal of
private-sector firms is to
maximize profits.
To maximize profits, any firm
must answer 2 questions.
1. OUTPUT DECISION: What
is the output level, q, that
maximizes profit or
minimizes losses?
2. SHUTDOWN DECISION: The
firm might make losses even
at the best possible positive
output. Should the firm
shutdown if its profit is
negative?
Optimal
Output Marginal
Analysis
Managers need to make optimal decisions
about the levels of various business
activities. They need to analyze benefits
and costs to make the best possible
decision under a given set of circumstances.
Finding the best solution involves applying
analytical principles which economists refer
to as “marginal analysis”.
I am sure you are already applying marginal
analysis in your everyday life, without even
knowing about it!
What is
Marginal
Analysis?
In general, when a manager needs to adjust a
business activity (either more or less), the
manager needs to estimate how changing the
activity will affect the benefits the firm
receives from engaging in the activity, and
the costs the firm incurs from engaging in the
activity.
If changing the activity level causes benefits
to rise by more than costs rise, then the net
benefit the firm receives from the activity
will rise.
The manager should continue adjusting the
activity level until no further net gains are
possible, which means the activity has
reached its optimal level.
Optimal output – Graph and analysis (Class
Notes).
Two
observations
about Q*
Notice the following in your
graphs showing the optimal
level of output (Q*).
The optimal level of output
does not generally result in
maximization of total revenue.
You can see that TR is still rising
at Q*.
Also, at Q* , the TC is not
minimized.
Managers should be aware of
this difference!
If at the optimal output, a firm incurs losses, it
will continue to operate in the short run, if the
revenue is high enough to cover the variable costs
and some fixed costs.
Example (Text):
Shutdown?
If for a firm, TR = $2000, TVC = $1000 and TFC
= $3000.
Profit = TR – TVC – TFC = $2000 – $1000 – $3000
= -$2000
If the firm shuts down, the loss will be equal to
the unavoidable fixed costs, that is, $3000.
But if the firm continues to operate, the loss is
lower, that is, $2000.
Thus the firm will continue to operate.
In the long run, it pays to shut down if the firm
faces any loss at all.
Profit Over
Time – Finding
The Present
Value
➢
Firms maximize profit not
only for the current period.
They are normally interested
in maximizing profit over
many periods.
➢
Because money in the future
is worth less than today, a
stream of profits is
calculated using the present
value of future profits.
➢
Class Notes.
Net Present
Value Example
Suppose you can buy a new Toyota Corolla for
$20,000 and sell it for $12,000 after three
years. Alternatively, you can lease the car for
$300 per month for three years and return it
at the end of the three years. For
simplification, assume that the lease
payments are made yearly instead of monthly
– that is $3600 paid at the beginning of each,
for three years. If the interest rate is 4%, is it
better to lease or buy the car?
PrincipalAgent Problem
Principal: Individual who employs one or
more agents to achieve an objective.
Agent: Individual employed by a principal to
achieve the principal’s objective.
An agency relationship exists whenever there
is an arrangement in which one person’s
welfare depends on what another person
does.
Principal-agent problem: Problem arising
when agents (example, a firm’s managers)
pursue their own goals rather than the goals
of principals (example, the firm’s owners).
➢
Consistent
Objectives:
Contingent
Rewards
To make the owner and
manager objectives more
closely aligned, many firms
use contingent rewards:
higher pay if the firm does
well.
✓A
year-end bonus based
on the performance of
the firm or a group of
workers within the firm
✓A
stock option or the right
to buy a certain number
of the firm’s shares at a
pre-specified exercise
price within a specified
time
Consistent Objectives: Profit Sharing
The agency problem can be
avoided by paying the
manager a share of the firm’s
profit. For example, their
earnings can be based on the
company’s stock price which
rises as the firm’s profit
increases.
The manager (agent) earns
1/3 of the joint profit,
shareholders (principals) get
2/3. The output level, q*,
maximizes both shares. No
conflict!!
Conflicting Objectives: Revenue Objectives
➢
Sometimes profit can be
manipulated by owners
or managers. So profit
sharing is not possible.
➢
Revenue sharing:
executive compensation
is primarily determined
by the firm’s revenue.
But managers prefer to
maximize revenue rather
than profit.
Conflicting Objectives: Revenue Objectives
Given the conflict, many
corporations mix revenue
incentive with other
incentives; a typical CEO’s
compensation is a weighted
average of a measure of
revenue, profit,
shareholders’ returns, and
other measures.
Sometimes managers are
given revenue incentive to
get more loyal customers,
and thus have higher longrun profit.
Aligning the
Objectives Example
Three months ago, the owner of a car
dealership significantly changed his sales
manager’s compensation plan. Under the old
plan, the manager was paid a salary of $6000
per month, under the new plan, she receives 2%
of the sales price of each car sold. During the
past 3 months, the number of cars sold
increased by 40%, but the dealership’s profits
significantly declined. According to the sales
manager – “Consumers are driving harder
bargains and I have had to authorize
significantly lower prices to remain
competitive.” What advice would you give the
owner of the dealership? (BP, 2014)
Make or Buy Organizational
Design
What economic factors
determine the size and
breadth of firms?
Why do some economic
transactions take place within
firms, whereas others are
transacted via markets?
What can economic analysis
say about the likely ways in
which firms are organized?
Background The Nature of
the Firm
About a century ago, the typical firm in the
industrial world was a very small concern,
managed by its owners and employing a small
number of workers.
Only the railroads, steel producers and some
other manufacturers were the large firms.
Today, the firms are bigger – for example, the
firm size can be (amongst others) 50
employees, 250,000 employees or even more
than 2 million.
Although firms range in size from the single
proprietor to the largest Fortune500 companies,
the vast majority of managers work for firms
with 50 or more employees.
According to Coase, “ Firms will be organized to
minimize the total cost of production including
transaction costs.” (R. Coase, “ The Nature of
the Firm,” Econometrica (1939): 386-405
The ownermanaged
firm..
This firm was the norm in the nineteenth
century and still represented today.
Consider a small clothing producer, run by a
sole proprietor who was both owner and
manager.
The proprietor got the necessary equipment,
hired workers, and made all important
decisions.
As sole owner, the proprietor claimed all profits
(and paid all losses) from the business.
He/she had a strong incentive to take optimal
actions because ultimate profit depended on it.
The large-scale
firm
Contrast this with the large-scale
firm today.
Due to the economies of scale,
average costs decline at higher
levels of output. This explains
(partially) the large firm size.
But the big scale makes the
business of transforming inputs
into outputs much more
complicated.
It is not possible for a single
owner-manager to take on all
management responsibilities.
“The modern firm distributes
information and management
responsibilities among a wide
group of inside managers. Today’s
firm is an organization based on a
set of agreements and
contracts..”
Organization Structure
On the one hand, a large
scale firm has the
advantage of declining
average costs, on the
other hand, the division
of management
responsibilities raises
many problems.
The design of the
organization structure
involves many aspects
such as determining the
vertical boundaries of the
firm, having mechanisms
for monitoring and
rewarding managers and
other firm employees etc.
Vertical
Boundaries of
the Firm
Vertical boundaries of a firm define the
activities that the firm itself performs as
opposed to purchases from independent firms in
the market.
The production of any good or service, from
music recordings to medical treatments, usually
require many activities.
The process that begins with the acquisition of
raw materials and ends with the distribution
and sale of finished goods and services is known
as the vertical chain.
Vertical Chain
A central issue in business is
how to organize the vertical
chain.
Is it better to organize all of the
activities in a single firm, or is
it better to rely on independent
firms in the market?
How to organize the vertical chain?
A firm’s decision to perform an activity itself or
purchase it from an independent firm is called a
make-or-buy decision.
Make means the firm performs the activity itself.
Make Vs. Buy
Examples: Italian fashion icon Benetton dyes
fabrics, designs and assembles clothing, and
operates retail stores.
Kimberly Clark’s Scott Paper division owns
forest land, mills timber, and produces
consumer paper products.
Buy means it relies on an independent firm to
perform the activity.
Two types of ‘Buy’ considered here : Spot
Exchange and Contracts.
Question: Spot
Exchange
(Buy),
Contracts
(Buy) or
Vertical
Integration
(Make)?
A major oil company refines gasoline from crude
oil produced by oil wells that it owns.
Transcontinental, an interstate natural-gas
pipeline, has a legal obligation to purchase a
specific amount of gas per week from a well
owned by Fred Smith in Enid, Oklahoma
A cabinetmaker purchases a dozen wood screws
from the local hardware store.
Question: Spot Exchange (Buy), Contracts (Buy) or Vertical
Integration (Make)?
Clone 1 PC is legally obligated to purchase 300 computer chips each year for the
next three years from AMI. The price paid in the first year is $200 per chip, and
the price rises during the second and third years by the same percentage by which
the wholesale price index rises during those years.
Clone 2 PC purchased 300 computer chips from a firm that ran an advertisement in
the back of a computer magazine.
Clone 3 PC manufactures its own motherboards and computer chips for its
personal computers.
Spot Excha…
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