Managerial

Economics
Tirthatanmoy Das Lecture 17 June 7, 2022

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Previous class

Key concepts..
q Prisoner’s dilemma, Sequential game, Repeated Games

q Oligopoly

q Cournot model, reaction function

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Example: Cournot Equilibrium

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Setting prices

q Bertrand model

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Setting prices

q Example: make price decisions first and then produce based on

orders (e.g. catalog sales etc.)

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The Bertrand Model: Price Competition

q Bertrand model: Oligopoly model in which

q Firms produce a good

q Each firm treats the price of its competitors as fixed

q All firms decide simultaneously what price to charge

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The Bertrand Model: Price Competition

q Price Competition with Homogeneous Products: firms produce a

homogeneous good
q Suppose: P = 30 – Q
q MC1 = MC2 = $3

q Two duopolists compete by simultaneously choosing a price

instead of a quantity

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The Bertrand Model: Price Competition

q Nash equilibrium in the Bertrand model results in both firms

setting price equal to marginal cost: P1 = P2 = $3

q The industry output: 27 units

q Each firm: 13.5 units (why?), zero profit

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The Bertrand Model: Price Competition

q Price Competition with slightly differentiated Products:

q Suppose, fixed cost is 20
q Firm 1’s demand: Q1 =12 - 2P1 + P2
q Firm 2’s demand: Q2 =12 - 2P2 + P1

q Firm 1’s profit: 𝜋! = 𝑃! 𝑄! − 20 = 12𝑃! − 2𝑃!" + 𝑃! 𝑃" − 20

q Firm 1’s profit maximizing price: Dp / DP = 12 - 4P + P =0
1 1 1 2
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The Bertrand Model: Price Competition

q Price Competition with slightly differentiated Products:

q Firm 1’s reaction curve: P1 = 3 + 1 P2

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q Firm 2’s reaction curve: P2 = 3 + 1 P1

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The Bertrand Model: Price Competition

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The Bertrand Model: Price Competition

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 Markets with asymmetric information

Asymmetric information: Situation in which a buyer and a seller

possess different information about a transaction

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Why would a manager care?

Because, managers can use their informational advantage to increase

performance, and how managers at an information disadvantage can
mitigate the effect by using creative defenses

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Quality uncertainty and the market for lemons

q The lemons problem: With asymmetric information, low-quality

goods can drive high-quality goods out of the market

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The market for used cars

Akerlof’s model:

q Used cars are either gems (which is good) or lemons (which is bad)
model

q Information asymmetry means that sellers have more information

about the quality of the car they are selling than the buyer does

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The market for used cars

q The less informed buyer does not know the quality (whether
lemon or gems) of the car he/she is considering for purchase

q As a result, he/she probably is willing to pay, at most, the value of

a car of average quality

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The market for used cars

q Owners of gems are less willing to sell at the average price because
they know that gems are worth more than the average

q Owners of lemons are eager to sell at the average price because

they know that lemons are worth less than the average

q As a result, most of the used cars on the market are lemons

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The market for used cars

q This is a case of adverse selection in that the market dynamics lead

to only lemons being offered for sale on the used car market

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Why study market for used cars

q The implications go far beyond the market for used cars

q Other markets such as the following are also characterized by

asymmetric information about product quality
q Insurance
q Financial credit
q Employment

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Adverse selection

q Adverse selection: Form of market failure resulting when products

of different qualities are sold at a single price because of asymmetric
information, so that too much of the low-quality product and too
little of the high-quality product are sold

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Two additional examples

q Market for automobile insurance. How?

q Market for credit. How?

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Market signaling

Market signaling: Process by which sellers send signals to buyers

conveying information about product quality

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Market signaling: labor market example

q What characteristics can a firm examine to obtain information

about people’s productivity before it hires them?

q Can potential employees convey information about their

productivity?

q Example: Dressing well for the job interview might be a weak signal

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Market signaling: labor market example

q To be strong, a signal must be easier for high-productivity people

to give than for low-productivity people to give, so that high-
productivity people are more likely to give it

q For example, education is a strong signal in labor markets. More

productive people are more likely to attain high levels of education
in order to signal their productivity to firms and thereby obtain better-
paying jobs
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Market signaling: labor market example

q What is important is that the cost of education is greater for the low-
productivity group than for the high-productivity group
q Suppose the wage is $10,000 for low $20,000 for high
q Workers work for 10 years
q Base wage $100,000
q Suppose that for each group, the cost of attaining educational level y is
given by
q 𝐶! 𝑦 = $40,000𝑦
q 𝐶!! 𝑦 = $20,000𝑦
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Market signaling: labor market example

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Market signaling: labor market example

q Obtain the education level y* if the benefit (i.e., the increase in earnings)
is at least as large as the cost of this education

q Group I will obtain no education as long as

$100,000 < $40,000𝑦 ∗ or 𝑦 ∗ > 2.5

q Group II will obtain an education level y* as long as

$100,000 > $20,000𝑦 ∗ or 𝑦 ∗ < 5
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Market signaling: labor market example

Equilibrium:

q High-productivity people will obtain a college education to signal

their productivity

q Firms will read this signal and offer them a high wage

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Moral hazard

Moral hazard: When a party whose actions are unobserved can affect
the probability or magnitude of a payment associated with an event

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Moral hazard

q The possibility that an individual’s behavior may change because

she has insurance is an example of a problem known as moral hazard

q The concept of moral hazard applies not only to problems of

insurance, but also to problems of workers who perform below
their capabilities when employers cannot monitor their behavior
(“job shirking”)

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The Principal-Agent problem

q Principal–agent problem: Problem arising when agents (e.g., a firm’s

managers) pursue their own goals rather than the goals of
principals (e.g., the firm’s owners)

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The Principal-Agent problem

q Agent: Individual employed by a principal to achieve the

principal’s objective

q Principal: Individual who employs one or more agents to achieve

an objective

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Example: The Principal-Agent problem

q Why real CEO compensation has risen nearly 80% between 1990 to
2009?

q The answer lies in the principal–agent problem, which is at the

heart of CEO salary determination

q Directors often cannot monitor executives’ activities and therefore

cannot negotiate compensation packages that are tightly linked to
their performance
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Incentives in Principal-Agent problem

How can owners design reward systems so that managers and

workers come as close as possible to meeting owners’ goals?

Suppose cost = 10,000a; 𝑃𝑟𝑜𝑏$%%& = 0.5, 𝑃𝑟𝑜𝑏'(& = 0.5 35

Incentives in Principal-Agent problem

q Payment scheme as w(R), where R: revenue

q If 𝑅 = $10,000 𝑜𝑟 $20,000, 𝑤 = 0
q If 𝑅 = $40,000, 𝑤 = $24,000

q Under this bonus arrangement, a low effort generates no payment.

A high effort, however, generates an expected payment of $12,000,
and an expected payment less the cost of effort of $12,000 - $10,000 =
$2000 36
Incentives in Principal-Agent problem

q Under this system, the repairperson will choose to make a high

level of effort. This arrangement makes the owners better off than
before because they get an expected revenue of $30,000 and an
expected profit of $18,000

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