What is managerial economics?

● Application of economic theory and methods to business decision making

● The term "business" should be applied in a broader context covering decisions that require
evaluation in terms of total benefits and costs of a transaction (both monetary and non-
monetary benefits and costs).
Covers decisions made by:
● Profit oriented enterprises
● Government institutions
● International organizations
● Non-profit organizations (NGOs)

How is Managerial economics related to other disciplines

-Microeconomic Theory is closely related to Managerial Economics
● Theory of firm
● Market structure and competition theory
● Theory of consumer behavior
● Production and cost Theory

Approach:
● Neoclassical framework
● Individuals are rational agents that maximize utilities subject to constraints
● Firms are rational agents that maximize profits subjects to constraints

Microeconomics Vs Managerial economics

Microeconomics Managerial economics

Descriptive Prescriptive

Positive (what is) Normative (what ought to be)

Without value judgment Involves value judgment

Managerial Economics in relation to Decision Sciences

● Numerical and algebraic analysis
● Statistical information and forecasting
● Analysis of risk and uncertainties
● Optimization
● Discounting and time value of money technique
●
MANAGERIAL ECONOMICS AND THE BUSINESS FUNCTION
Managerial decisions involve Quantitative analysis
● Production and operations (schedule and level of input)
● Human resources (hiring and compensation packages)
● Marketing (pricing and advertising expenses
● Finance and accounting (does finances allow expand operations or new product line

How the various theories are connected

Government Policy
1. Theory of firm
2. Pricing Theory
● Demand Theory • Consumer Theory
● Cost Theory •Production Theory
3. Competition theory

Economic Theories and Econometrics

● A scientific theory describes the relationship between important variables affecting the
organization
● Theories or hypotheses are testable, verified or refuted.
● The validation of the theory or hypothesis can be done through:
 - experimental method (controlled set up)
- observation method (it is difficult to control the other variables affecting the relationship
between a particular set of variables. To isolate the effect of X variable on the Y variable, we do
econometrics

Characteristics of a good Theory

● It makes accurate forecast
● Explains or describes the existing observations
● It can be applied to many situations, not only to a limited number of scenarios or cases
● Variables involved are measurable
● It has minimum assumptions

Steps involved in decisions making

1. Problem Perception
2. Definition of objectives
3. Identification of constraints
4. Identification of alternatives and strategies
5. Predicting the consequences of the decision
6. Decision and sensitivity analysis

Examples of Managerial Decisions

Which of the following is the cause of the decline in sales of the company?
● It is due to the reduction in advertising budget
● It is due to the problem in the quality control in production
● It is due to the new government policy

What helps the Manager make decisions ?

● Economic models/theories
● Graphs
● Tables
● Quantitative Techniques

Basic Economic Tools: A Review We will have the detailed discussions later
Demand
● shows the behavior of the consumers
● refers to the quantity demanded by the consumers given the prices holding other factors
constant
● Consumers buy more at lower prices, ceteris paribus, thus, price and quantity of a good has a
negative relationship
Supply
shows the behavior of the companies or the sellers
Refers to the quantity supplied by the sellers given the prices holding other factors constant
Sellers will sell more if the price improves, ceteris paribus, thus, price and quantity of a good has a
positive relationship

MAIN POINTS
1 Managerial economics is the application of economic principles to analyze and government
decisions.
2. In the manager has to use the following to make decisions consistent with the goals of the company
experience, judgement, common sense, intuition, rules of thumb and very important sound
analysis
3. The primary objective of many organizations, preferably the private firms, is to maximize the
value of the firm by maximizing profits. However, there are other management goals such
as making decisions in the interest of other stakeholders such as addressing the welfare
of the workers, consumers and the society at large.
The primary objective of public managers and government regulators is to maximize social
welfare, Government projects should only be undertaken if the total benefits exceed the total costs.

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PESTLE Analysis
PESTLE stands for:
Political
Economic
Social
Technological
Legal
Environmental

P - Political Factors
▸ Government policy
▸ Political stability/instability
▸ Foreign trade policy
▸ Tax policy
▸ Labor laws
▸ Environmental laws
P - Political Factors
▸ Government policy
▸ Political
stability/instability
▸ Foreign trade policy
▸ Tax policy
▸ Labor laws
▸ Environmental laws
E- Economic Factors
Macroeconomic factors:
❑ economic growth
❑ interest rates
❑ exchange rates
❑ Inflation
❑ Unemployment rate
Microeconomic factors:
❑ Income of the consumers
❑ Minimum wages
❑ Working hours
❑ Credit availability
S - Social Factors
❑ Cultural norms and
expectations
❑ Health consciousness
❑ Population growth rate
❑ Age distribution
❑ Career attitudes
❑ Factors that help us understand
the psyche
of the consumers

T -Technological Factors L - Legal Factors E - Environmental Factors

New ways of distributing goods
New ways of producing goods
New ways of communicating
with the markets
❑ Consumer rights and laws
❑ Product labeling and safety
❑ Health and safety
❑ Equal opportunities
(particularly for the
marginal sectors like women
and minority)
❑ Advertising standards
❑ Waste disposal laws
❑ Zoning laws
❑ Energy consumption
regulations
❑ Air pollution regulations
❑ Environmental protection laws
❑ Global warming issue

Others use the acronym STEEPLE rather than PESTLE

Ethical Factors
❑ Fair trade
❑ Laws on slavery
❑ Child labor
❑ Corporate Social Responsibility (CSR)
❑ Charities

Use of PESTLE or STEEPLE Analysis

❑ Marketing planning
❑ Product development
❑ Workforce planning
❑ Organizational change
❑ Strategic business planning

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The Economics of Production, Cost and Profit Maximization of the Firm: Part 1

At the end of this lecture, you should be able to:

❑ Discuss the role of profit in the optimal allocation of resources
❑ Discuss and differentiate the various theories of profits.
❑ Explain the role of the demand analysis in the determination of the optimal total revenue for the firm
❑ derive the inverse demand equation and draw the inverse demand curve

“Government and business leaders should pursue the path to new programs and policies the way a
climber ascends a formidable mountain or the way a soldier makes his way through a mine field with
small and careful steps” ~Anonymous

Profits as a signal for optimal resource allocation

❑ In an economy that is driven by market forces, the profit serves as a mechanism in achieving an optimal
allocation of the scarce or limited resources
❑ Resources will move towards profitable uses.
❑ Resources will move away from uses which are incurring losses.
❑ The allocation of the resources is optimal if the economy is maximizing profits and/or minimizing losses.

What about the organizations which are not profit oriented?

The tools of economics can also be applied to non-profit organizations. It may not be profit
maximization. You may call it attaining efficient use of resources.

Non-profit organizations also consider the opportunity cost of their valuable resources.

Non-profit organizations also use marginal analysis.

The Five Theories of Profits

❑ Frictional theory of profit – profits or losses are the result of disequilibrium conditions or
shocks or adjustments.
❑ Monopoly theory of profit – profits are the result of the monopoly power of the firm to charge
higher prices than under competitive conditions.
❑ Innovation theory of profit – profits are a reward for successful innovation. Innovations that
reduce the cost of production, or those that increase the demand for the product( new product line,
new designs, new markets.
❑ Risk and uncertainty bearing theory of profit –profits are a reward for the entrepreneur for
assuming risks and uncertainties
❑ Managerial efficiency theory of profits – entrepreneurs who are more efficient in the use of
resources will get more profits

Accounting Profit versus Economic Profit

❑ Accounting Profit = Total Revenue - Explicit Cost

❑ Economic Profit = Total Revenue - Explicit Cost - Implicit Cost
❑ Explicit Cost = involves cash payment
❑ Implicit Cost = costs incurred for using your own resources, no cash payment is made
❑ Accounting profit is greater than economic profit

A Simple Model of the Firm

❑ single good or service for a single market
❑ find combination of output and price that maximize profits.
❑ revenues and costs are assumed predictable (We discuss risks and uncertainty later)
❑ If revenues and costs of one product does not affect the revenues and costs of other products, the firm can
maximize the total profits by maximizing the profits per product. Multi-product companies like Procter and
Gamble assign product managers to specific consumer products.

Total Revenue, Total Costs and Profits

❑Total Revenue = (Price)(Quantity)
❑ Total Costs = (Per unit cost) (Quantity)
❑ Profits = Total Revenue – Total Costs
❑ The law of demand influences the Total Revenue. Other things equal, the higher the price, the fewer
is the quantity demanded by the consumers, thus the lower the quantity sold by the firm.
❑ The pricing strategy of other firms will have an impact on the quantity of a product that you can sell.

Simple Analysis
❑ If firm A reduces the price of its good, the law of demand says that firm A will be able to sell a higher
quantity of the product.
❑ There are three sources of additional quantity sold by firm A
1. Existing consumers of firm A who decide to buy more
2. Consumers from competitors of firm A, say firms B, and C who now decide to buy from A
(depends on market structure).
3. New consumers of the product

Why is the demand curve important?

❑ Helps the firm predict the consequences of its output and pricing decisions. Offering a discount or
reducing the price is not always advantageous to the producer (consider the market
structure or the number of competitors in the market).
❑ Examples of how the knowledge about the demand curve is used:
a) Predict the impact on profit of offering selective fare discounts by airlines.
b) Predict the impact of government day care subsidies on working mothers.
c) Predict the impact of reducing the price of necessities on profits

Sample Demand Equation: Q = 8.5 - 0.05P

❑ 8.5 lot is the intercept which states that if the price is 0, the consumers would want to have 8.5
lot of a product (1 lot =100 microchips). The intercept captures the effects of other factors not
considered in the equation.
❑ 0.05 is the slope of the demand curve which states that as price increases by 1 unit (1 unit
=$1,000), the quantity demanded decreases by 0.05 unit or lot.
❑ Take note of the unit of the price and quantity when you interpret the equation.

Inverse Demand:
Demand: Q = 8.5 – 0.05 P
To get the Inverse demand, we invert the equation:
Q = 8.5 – 0.05P
0.05P = 8.5 – Q
P = 8.5 – Q thus P = 170 – 20Q: Inverse Demand
0.05
Demand equation: unknown is Q
Inverse demand equation: unknown is P
Reminder: all other factors are assumed constant (we will study the factors affecting demand in a
separate lecture)

Why do we invert the demand?

1. In math, the independent variable (X) is written on the horizontal axis, the dependent variable (Y)
is written on the vertical axis.
2. If we do this, we should see the price on the horizontal axis (independent variable, consumers
do not control the price) and put the quantity demanded on the vertical axis (consumers can
decide on how many units they would like to buy).
3. In all economics books, the price is on the vertical axis, quantity demanded is on the horizontal
axis.
4. Price and Quantity demanded are reversed because they are based on the inverse demand curve.
5. This helps us add various demand curve horizontally.
______________________________________________________________________

The Economics of Production, Cost and Profit Maximization of the Firm: Part 2

At the end of this lecture, you should be able to:

❑ derive the total revenue equation given the inverse demand curve
❑ discuss the difference in the implications of a quadratic total revenue function from a linear function
❑ compute the fixed cost, variable cost and the marginal cost and discuss their relationship
❑ compute the optimal level of output using the Total Revenue Total Cost approach

Total Revenue
❑ Recall Demand: Q= 8.5 – 0.05P
❑ Computed Inverse demand: P = 170 – 20Q
❑ Total Revenue: Price times Quantity substituting the P equation
Total Revenue = (170 – 20Q)Q = 170Q - 20Q2
❑ It is a quadratic function, or a parabola. As the quantity sold increases, Total Revenue increases, reaches the
peak then decreases.

What is the lesson of this table and graph? Increasing the quantity sold does not always
increase the Total Revenue if the higher quantity sold happens by reducing the price. Remember
Total Revenue depends on P and Qd.
Another case: Total Revenue increases as the Qd increases
❑ This happens when the seller is able to sell more output without lowering the price.
❑ Snip info: Market Structure when your output is too small relative to the size of the market, there is no need
to reduce the price of your product to be able to sell all.

COST OF PRODUCTION
Going back to our example, to produce the microchips, the firm needs to have plant, equipment and
labor. Whether the firm produces the microchips or not, it has to spend 100 unit (1unit = $1000)
per week to run the plant. To produce a lot (1 lot=100 microchips), it has to spend 38 units (1 unit =
$1,000 in materials, labor, etc.

100 units (1 unit = $1000) is the fixed cost,

38 units (1 unit=$1000) is the variable cost
Cost function: C = 100 + 38Q

What is the cost of producing 2 lots (1 lot= 100 microchips)?

C = 100 + 38(2) = 100 + 76 = 176 meaning $176,000

Relationship of the Fixed Cost, Variable Cost and Marginal Cost

Total Cost = Fixed Cost + Variable Cost
= 100 + 38Q

Marginal Cost is also = change in Variable Cost/ change in the Q

Cost Schedule And Graph

Total Revenue Total Cost Approach to Profit Maximization

1. Total Revenue Total Cost Approach or TR TC Approach
Hint: find the output where the difference between TR and TC is the highest
2. However make sure that the TR > TC.
3. This means that at the optimal level of output, after paying all the costs, the extra left with you is
the highest (profits).

How to derive the Profit function?

❑ Profit = Total Revenue – Total Costs
❑ Recall that the Total Revenue equation is TR= 170Q - 20Q²
(see earlier computation)
❑ Recall that the Total Cost equation is TC = 100 + 38 Q
❑ Profit = Total Revenue – Total Cost
Profit = (170Q - 20Q2) - (100 + 38Q)
= 170Q - 20Q2 - 100 - 38Q
= - 20Q²+ 170Q - 38Q - 100
= - 20Q² + 170Q - 38Q - 100
= - 20Q² + 132Q - 100
= -100 + 132Q - 20Q²
Example, the profit when Q = 1 is: -100 + 132(1) -20(1)(1)
= - 100 + 132 – 20 = -120 + 132 = 12

TR TC Approach to Profit Maximization Profit is Maximized at Q = 3.4 lots (1 lot=100

microchips)

How to do the profit maximization using the Total Revenue Total Cost approach?
1. Invert the demand equation
2. Find the Total Revenue equation
3. The Total Cost equation is given
4. Compute the Total Revenue at the given level of output
5. Compute the Total Cost at the given level of output
6. Compute the Total Profits = Total Revenue - Total Cost
7. Choose the output where the total profit is maximum

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FACTORS AFFECTING DEMAND AND THE ELASTICITY OF DEMAND:PART 1

At the end of this lecture, the students must be able to:

❑ Understand the law of demand and the concepts associated with the negative relationship between price and
quantity demanded
❑ Explain the concept of own price elasticity, cross price elasticity and income elasticity and explain the
factors affecting them
❑ Identify and explain the various determinants of demand

KEY TERMS
▶ demand
▶ law of demand
▶ marginal utility
▶ law of diminishing marginal utility
▶ demand curve
▶ quantity demanded
▶ individual demand
▶ market demand

Demand
▶ Demand indicates how much of a product consumers are both willing and able
to buy at each possible price during a given period, other things remaining
constant.

Law of Demand
▶ The law of demand says that quantity demanded varies inversely with price,
other things constant. Thus, the higher the price, the smaller the quantity
demanded

When the price of the good increases, the quantity demanded for the good decreases because of two
effects:
a) Substitution effect
b) Income effect

Demand, wants, and needs

▶ Substitution effect
When the price of good “x” increases, the relative price of good “x” increases relative to the price of a
substitute “y”, thus, the consumers shift to the cheaper substitute “y”
▶ If all prices changed by same margin, there would be no substitution
effect
▶ Income effect
When the price of good “x” increases, the purchasing power of the peso decreases, thus the consumers
can buy less of good “x”.

▶ Diminishing marginal utility

▶ Marginal utility – additional satisfaction you derive from each item
▶ Law of marginal utility states that as the unit of a commodity consumed increases, the
additional utility decreases or total utility increases at a decreasing rate) (example: pizza slices)

Demand vs. Quantity demanded

▶ Quantity demanded - affected by the price of the good itself
▶ Demand – affected by factors other than the price of the goods, for example the income, price of
substitutes, price of complementary, number of consumers, taste and preference, income and price
expectations
▶Demand curve- graphical representation of demand
▶ Demand schedule – tabular representation of demand
▶ Demand equation- mathematical representation of demand

Demand Schedule
Price Quantity Demanded Per Pizza per Week (millions)
a. $15 8
b. 1214
c. 9 20
d. 6 26
e. 3 32

Demand Equation for PizzaPrice in US$, Qd in M

Qdx = 38 – 2Px
Qdx = 38 – 2(0) = 38
Qdx = 38 – 2(3) = 32
Qdx = 38 – 2(6) = 26
Qdx = 38 – 2(9) = 20
Qdx = 38 – 2(12) = 14
Qdx = 38 – 2(15) = 8

More Complicated Demand Equation or Function

Qdx = f( Px, Py, Pz, I, N)
Where Qdx is the quantity demanded for x
Px is the price of x
Py is the price of substitutes,
Pz is the price of complementary good
I is the income
N is the target population

DETERMINANTS OF DEMAND
▶ Own price (-)
▶ Consumer Income
+ for normal goods
- for inferior goods
▶ The prices of related goods
-for complementary goods
+ for substitute goods
▶ The number and composition of consumers(+)
▶ Consumer expectations
income expectation (+)
price expectation (+)
▶ Consumer tastes and preferences (+)

Changes in Consumer Income

▶ If income ↑, consumers willing and able to buy more which ↑ demand
▶ Demand curve shifts to the right
▶ Two categories of goods:
▶ Normal goods(+) – demand increases as money income increases
▶ Inferior goods (-) – demand decreases as money income increases.

Changes in the Prices of Related Goods

▶ Substitutes (+)
▶ An increase in price of pizza will increase the demand for a taco (if they are
substitutes)
▶ Example: Tacos and Pizza
▶ Complements (-)
▶ Certain goods used together
▶ Example: airline tickets and car rentals
▶ An increase in the price of one also reduces the demand for the other

Changes in the population and its composition

▶ An increase in the target population will increase the demand for the good.
Change in the composition also changes the demand pattern
▶ Consumer expectations- an expectation that the income will increase in the
immediate future will increase the demand today. An expectation that the price
of the good will increase tomorrow will increase the demand for the good today
▶ Changes in consumer tastes
▶ Tastes are your likes and dislikes as a consumer

Movement along the demand

▶ A change in price, causes a movement along the demand curve, and changes the
quantity demand

Demand shifts
▶ A change in one of the determinants of demand other than its own price causes
a shift of a demand curve

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Factors Affecting Demand and the Elasticity of Demand: Part 2

At the end of this lecture, the students must be able to:

❑ Understand the law of demand and the concepts associated with the negative relationship between price and
quantity demanded
❑ Explain the concept of own price elasticity, cross price elasticity and income elasticity and explain the
factors affecting them
❑ Identify and explain the various determinants of demand

Elasticity of Demand
▶ Compute the elasticity of demand and explain its relevance.
▶ Discuss factors that influence elasticity of demand.

Computing the Elasticity of Demand

▶ Own Price Elasticity of demand measures the percentage change in quantity
demanded divided by percentage change in price.

Own Price Elasticity of demand = Percentage change in quantity demanded

Percentage change in price

Example
Problem 1
If the price of plane fare increases by 10 %, and the quantity demanded decreases by 25 %, what is the
own price elasticity of demand for air travel?
Answer = - 25%/10% = -2.5, price elastic

Problem 2
If the price of rice increases by 10 %, and the quantity demanded decreases by 5 %, what is the own
price elasticity of demand for rice?
Answer = - 5%/10 % = - 0.5 price inelastic

Problem 3
If the price of pork increases by 10%, and the quantity demand decreases by 10 %, what is the own
price elasticity of demand for pork?
Answer = -10%/10 % = -1 unitary elastic

Type of Own Price Elasticity of Demand

▶ sign is negative because of the law of demand
▶ > - 1 it is price elastic (e.g. – 3.4) A percentage change in price will result in larger percentage
change in the quantity demanded
▶ = -1 it is unitary price elastic A percentage change in the price will result in the same
percentage change in quantity demanded
▶ < -1 it is price inelastic (e.g. -0.5) A percentage change in the price will result in a lower
percentage change in quantity demanded
▶ Demand is usually more elastic at higher prices and less elastic with lower
prices

Income Elasticity of Demand

▶ Formula = percentage change in Qd
percentage change in income
▶ Income elastic – those goods which are sensitive to a change in income. Example: luxuries
▶ Income inelastic – those goods whose consumption is relatively unchanged despite the change
in income. Example: necessities

Examples of Income Elasticity of Demand

Problem 1
if your income goes up by 12%, and your demand for movies goes up by 16%, what is the income
elasticity for movies?
Answer = 16% / 12% = 1.33 income elastic and movies are a normal good

Problem 2
If your income increases by 12 % and your demand for instant noodles decreases by 9 %, what is the
income elasticity for instant noodles?
Answer = - 9% / 12% = - 0.75, income inelastic and instant noodles are an inferior good

Determinants of Demand Elasticity

Availability of substitutes
▶ The greater the availability of substitutes for a good, the greater the own
price elasticity of demand
Share of consumer’s budget spent on the good
▶ If the price of the good takes a large portion of the income, the good is more
price elastic.
A matter of time
▶ The longer the adjustment period, the greater the consumer’s ability to
substitute, so the higher is the price elasticity of demand.
______________________________________________________________________

PRICE DISCRIMINATION AND PRICING STRATEGIES

At the end of this lecture, the students should be able to:

❑ Understand what is a Lerner index and its relationship to mark up pricing
❑ differentiate first degree from second degree and third degree price discrimination in optimizing profits
❑ discuss what is meant by two-part pricing, block pricing, peak load pricing, customized pricing, and bundle
pricing

Price Mark ups as Pricing Strategy

❑ The usual pricing strategy adopted by businesses is the price mark up, where they the sellers
determine the marginal cost of the product and add a mark up to determine the price
❑ Price elasticity of demand plays a role in determining how much is the mark up. Products
which are unique and which cannot be easily duplicated have higher mark ups because they have
fewer substitutes. Products which are easily substituted have lower mark ups

Lerner Index, L = (P – MC)

P
Where P is the price and MC is the marginal cost

The Lerner index measures the difference between the price and the marginal cost as a percentage of
the price of the product. It measures how much the firms in an industry mark up their prices over
their marginal cost. The higher the Lerner index, the higher is the mark up.

Lerner Index and Mark up Factor:

An Example
A firm in an airline industry has a marginal cost of Php 10,000 and charges a price of Php15,000.
(a) compute the Lerner index,
(b) compute the mark up factor.

Answer: (a) (15,000 – 10,000)/15,000 = 5,000/15,000 = 1/3 = 0.33

(b) 1/(1 - 1/3) = 1/ (2/3) = 1/0.67 = 1.49

Price Mark ups as Pricing Strategy

● The greater the number of substitutes, the more price elastic is the demand for the good, and
the lower is the mark up price
● Recall from microeconomics that the demand curve is horizontal in a purely competitive
market which means that the price is constant or the same with the other sellers. This is
because there are many sellers thus there are many substitutes.

Thinking Aloud
Between a seller of vegetables in the market and oil companies like Petron, Shell and Caltex, (a) which
has a higher Lerner index, (b) Which has a higher mark up? Discuss why? (c) Is the price mark up
dependent on the market structure?

First-degree Price Discrimination

● The firm charges different prices to maximize
profits
First degree price discrimination – the firm
charges price based on the willingness of the buyer.
This way the maximum consumer surplus is extracted
● It is difficult to implement because it is difficult
to find the maximum price that each consumer
is willing to pay for alternative quantities of a
product.
● Those who charge first degree price
discrimination include car dealers,
mechanics, doctors, lawyers

Second-degree Price Discrimination

● Second-degree price discrimination – the firm charges a set of declining prices for
different range of quantities
Example: electric utility companies charge a higher price for the first 100 kwh than
on subsequent units of consumption.
● The advantage of the second-degree price discrimination is that the firm does not rely on the
disclosure of the customers on their maximum willingness to pay.Consumers then sort
themselves on which consumption level is appropriate for them. Bigger users are charged
lower price per unit

Third-degree Price Discrimination

 ● Third-degree price discrimination – charging different prices depending on the price
elasticity of demand of consumers. Different markets have different price elasticity of
demand.
● Consumers who are more sensitive to the price (own price elasticity of demand is higher are
charged lower price, while consumers who are less sensitive to the price are charged higher
price.
● Naturally those who have limited sources of income are more sensitive to price such as senior
citizens, students, tourists compared to business related travels
● For the third-degree price discrimination to work, the discount is not transferable. Thus, there
a member of the family of a senior citizen cannot use the senior discount card for purchasing
from Jollibee, or Mercury Drug stores for themselves rather than for the card holder

Thinking Aloud
Trivia: What do you think is the reason why the drugstores do not allow discounts for purchasing
vitamins but there are discounts for prescription drugs

Optimal price depending on the given own price elasticity of demand. If the demand is more price
elastic in market 1 compared to market 2, which markets should be charged higher?

A certain pizzeria gives a discount to students provided they show proof that they are enrolled
students. What document/proof should be required from them to quality for the discount? Support
your answer.

OTHER PRICING STRATEGIES

Two-part pricing – charging a per unit price equal to marginal cost plus fixed fee equal to the
consumer surplus each receives at his per unit price. Examples include charging a fixed membership
fee in athletic clubs and charging marginal cost per use of the facility.
Block pricing - Bigger bottles of hair shampoos, conditioners, dishwashing soaps, bleaching
solutions and bigger packaging of powder soap, bleach solutions and other grocery items are priced
lower per unit.
Bundle pricing – Fastfoods like McDo or Jollibee offer value meals where the customers get a
discount by buying items in bundle.
Peak-load pricing – Savory restaurant offers discount prices during weekdays (off peak period) but
not on week-end (peak period).
Customized pricing – Software companies for example Stata software for doing regressions have
customized their products according to the needs of the customers. Student version is the cheapest but
also has limits on what it can do. Versions with better features are priced higher.
Inducing brand loyalty – loyalty cards are issued to customers either for free or for a minimum
charge and customers earn points which they can exchange for a product of the store, or for a free
product
● Examples: Ramen Kuroda enables you to earn points so you can avail of extra noodles worth
Php 40. You have to earn 30 points (30 visits), after that you will be issued a loyalty card
which you can present every time you visit the store and get an extra noodle. A regular noodle
soup is priced Php 180 per order.

Thinking Aloud
Questions:
1. Vikings buffet restaurants offer meals for approximately Php 1,000. You can try as many dishes as
you want including Chinese, Japanese, German, American, French, Pinoy. There is a promo where
clients can dine for free during their birthdays provided they bring one paying customer. What pricing
strategy is this? Discuss.
2. SM stores allow you to earn a peso point for every purchase worth Php 200. If the customer has to
pay Php 100 for the issuance of the card, would you get one? Why or why not?
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DEMAND ESTIMATIONS AND READING REGRESSION RESULTS

At the end of this lecture, the students should be able to:

● learn how to use the tools of regression analysis in evaluating the demands for the products
● interpret the results of regressions using the example for demand parameters
● identify which are the important parts of a regression table
 ● make optimal decisions for the firm based on the results
● provided by the regression analysis

Demand Estimation And Regression Analysis

Economists use econometrics which is the application of regressions to help summarize and analyze
the relationship of important economic variables.

Simple regression: Y = a+bX

Where Y is the dependent variable (e.g. Quantity demanded) X is the independent variable (e.g. Price)

Simple versus multiple regression - In simple linear regression we only have one independent variable
and one dependent variable. In multiple linear regression, we have one dependent variable and two or
more independent variables.

Simple regression: Qdx = a + bPx

Multiple regression: Qdx = a + bPx + cPy+dPz+eB + fN+ ()

We estimate the parameters a, b, up to f. The is the error term

Demand Estimation And Regression Analysis

Example of a problem Suppose firm A wants to determine what are the determinants of demand for
product x. The manager selected the following variables to be tested. Qdx is the quantity sold for
product x, Px is the price of product x. Py is the price of product y (a substitute good), Pz is the price of
product z (a complementary product), B is the income of the consumers, N is the population of the
target market

Demand Estimation and Regression Analysis

The following are the hypotheses for the demand equation. We use two-tailed tests, thus, the
alternative value uses a sign.

Testing the statistical significance of the intercept Hol: a = 0 versus Hal:a #0

Testing the statistical significance of the coefficient of Px Ho2: b = 0 versus Ha2: b #0
Testing the statistical significance of the coefficient of Py Ho3: c = 0 versus Ha3: c #0
Testing the statistical significance of the coefficient of Pz Ho4: d = 0 versus Ha4: d #0
Testing the statistical significance of the coefficient of budget or incomeHo5: e = 0 versus Ha5:e#0
Testing the statistical significance of the coefficient of the population Ho6: f=0 versus Ha6: f#0
Testing the overall significance of the model
Ho7: the model fit of the regression is the same with that of the model that contains only the intercept
Ha7: the model fit of the regression is better than the regression that contains only the intercept

Regression Table

Intercept - shows the value of the dependent variable (Qd) when the value of the independent
variable (P) is zero. It is represented by the "a" in the example regression. It shows the average effects
of the variables which have not been included in the regression (income of the consumers, number of
target consumers, price of substitutes, price of complementary products among others

Slope - the value that shows the change in the dependent variable with respect to a particular
independent variable. It is represented by "b" in the binary or simple regression. If there are 5
explanatory variables, then there will be 5 slopes in the regression such as "b", "c." "d", "e", "f" in the
multiple regression (see slide 3).

Standard error of the estimates -Since the coefficients of the regression model refer to the
estimates of the parameters of the population, the results vary depending on the sample and the
variation is captured by the standard error. The lower the standard error, the more precise are the
estimates.

T statistic - is computed by dividing the coefficient of an explanatory variable with its standard error.
The explanatory variable is deemed statistically significant with 5 % error if the t value is 2 while it is
statistically significant with 1% error if the t value is 3 (rule of thumb). The level of significance such as
10%, 5% or 1% shows the percentage of committing a mistake in making a conclusion that there is a
significant relationship between the explanatory variable and the dependent variable, given the null
hypothesis (Ho) that the coefficient of the given explanatory variable is zero.
P value of each coefficient - indicates if the coefficient is statistically significant from zero meaning
we reject the particular null hypothesis (Ho) and accept the alternative hypothesis (Ha). It gives the
actual value of the level of significance (% of committing an error) in rejecting the Null hypothesis.
Example, a p equal to 0.04 means that we are 96% confident that the Coefficient being tested is not
zero, (4% error)

Confidence interval- shows the range of values for the unknown parameter in the regression. Using
a two tailed test, if zero is within the given interval, then we fail to reject the Ho. If zero is not
contained in the confidence interval, then Ho should be rejected

R square - shows how much percentage of the variation in the dependent variable
is explained by the model. 0≤ R square ≤1.

Adjusted R square-shows the R square after adjusting for the number of explanatory variables. This
is because as the number of explanatory variables increases, the R square automatically increases.

Multiple R - is the absolute value of the correlation coefficient

The F statistic - measures the percentage of the variation in the dependent variable explained by the
model relative to the total unexplained variation. This refers to the overall fit of the model. The greater
the F statistic, the better the overall fit of the model.

p value for F - shows the chance that the regression model fits the data by chance. A value equal to
0.03 indicates that there is 3% chance that the regression model fits the data only by chance. Another
way of saying this is that we are 97% sure that the model with the explanatory variables fits the data
better than the model with no independent variables or the model with only the intercept.

Criteria For Evaluating The Hypotheses

1) Using the p value

If the p value of the coefficient of the
regression is ≤ 0.05, we can reject the Null
hypothesis with 95% confidence or 5% error.
If the p value of the coefficient of the
regression is ≤ 0.01, we can reject the Null
hypothesis with 99% confidence or 1 % error.

2) Using the t statistic

As a rule of thumb, if the absolute value of the t statistic is at
least 2, we can reject the Null hypothesis with 95%
confidence (or with 5% error)
As a rule of thumb, if the absolute value of the t statistic is at
least 3, we can reject the Null hypothesis with 99%
confidence (or with 1% error).

3) Using the confidence interval

If zero is not in the interval (95%), we can reject the Null hypothesis with 95% confidence (or with 5%
error).
If zero is not in the interval (99%), we can reject the Null hypothesis with 99% confidence (or with 1%
error).

Questions:

1) Can you write the demand equation for the apartment? Please indicate the resulting signs of the
explanatory variables.
2) Which determinants of demand for apartments are statistically significant? How do you know?
3) What is the meaning of the R square of 0.79?
4) is the overall model statistically significant?
5) Based on the results of the regressions, would you increase your budget for advertising? Why or
why not?

The log-log function

The log-log function expresses the dependent and the independent variables in logarithmic form
Example: Quarterly demand for coffee (hypothetical) In Qdt = 1.2789 0.1647 In Pt +0.5115 In Yt +
0.1483 In Pt' where Qd is the amount of per capita consumption of coffee (half kg) P is the relative
price of coffee in pesos P' is the relative price of tea per / kg.

The coefficients of the explanatory variables show the elasticity of the dependent variable with respect
to the explanatory variables

Analysis of the log-log demand equation

1. Is the demand for coffee price elastic or price inelastic?

2. Will a 10% increase in the price of coffee cause a substantial number of consumers shifting to tea?
Why or why not? 3. What is the cross price elasticity of demand between the consumption of coffee
and the price of tea? Are the two goods substitutes or complementary? How do you know? 4. What is
the income elasticity of demand for coffee? Is coffee a normal good or an inferior good?

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MARKET STRUCTURES

At the end of this lecture, you should be able to:

❑ differentiate one market structure from the other market structures
❑ describe the characteristics of pure competitive markets, monopolistically competitive markets, oligopolistic
markets and monopolistic markets.
❑ discuss whether there are short run and long run profits under the different market structures.
❑ understand the impact of market structures on the welfare of the consumers

Characteristics of Pure Competition

❑ Product is homogeneous or undifferentiated

❑ Many small companies competing with each other
❑ No barriers to entry or exit
❑ Has no control over price or
price takers
❑ Does not advertise
❑ Market demand is downward sloping but individual
firm demand is horizontal or perfectly elastic
❑ examples include agricultural products
Characteristics of Monopolistic Competition

❑ Many sellers
❑ Products are differentiated
❑ Has a narrow control over price
❑ Has low barriers to entry and exit
❑ Considerable emphasis on advertising, brand names and trademarks
❑ Examples include shoes, clothing, grocery items

Barriers to Entry
❑ The size of the market is limited and economic profit is only possible with one firm. For example, if there are
several electric companies in a certain geographical areas, those firms may not have enough market share to
cover the fixed costs and they will end up incurring losses.
❑ A firm may have the sole control over the technology, thus, no one can duplicate its product.
❑ The capital requirement is too huge to compete with the existing monopoly. For example financing a railway.
❑ The government grants patents to encourage innovations. Since it takes time and resources to develop
medicines, they enjoy patent protection for a certain number of years.
❑ The producer may have the sole control over the resources to production.
❑ A firm may enjoy geographic monopoly. A small sari-sari store in a remote area where the next store is 50
km away is also a monopoly.

Characteristics of Oligopoly

❑ There are few sellers

❑ Product may be standardized or differentiated
❑ Significant barriers to entry and exit
❑ Spends on advertisement to differentiate the products
❑ Price is dictated by mutual interdependence, has a greater control on price if there is collusion
❑ Examples include gasoline stations limited to Petron, Caltex, and Shell before deregulation, automobiles,
household appliances. TV network

Dominant Fuel Companies in the Philippines

The “Big three” consists of Petron Corporation, Pilipinas Shell and Chevon (Caltex)
Philippines. Together they account for more than half of the market share (52.82%)

The deregulation of the oil industry allowed greater competition which led to the
decline in the market share of the “Big three”.

Duopoly

❑ A special case of oligopoly

❑ There are two sellers
❑ Pricing heavily interdependent
❑ Uses advertising to increase market shares
❑ PLDT and Globe Telecom are the two leading telecommunications companies in the country creating
duopoly.
❑ According to Rappler Philippines, the Philippines has the lowest average
internet connection in the Asia Pacific in 2017. More likely this is still true today.

Characteristics of Monopoly

❑ Firm can be small or large but there must be a single seller

❑ Product is unique no close substitutes
❑ Has substantial control over the price
❑ Sponsor advertisement as part of public relations
❑ High barriers to entry and exit
❑ Market demand curve is also the firm demand curve which is downward sloping
❑ Examples include public utilities like electricity, natural gas, water districts

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Short run versus Long run Profit Maximization Under Pure Competition

Short run: it is possible to have positive economic profits

Long run: since it is easy for competitors to enter the market, the existence of positive economic
profit will attract more sellers. Firms will continue to enter until economic profit becomes zero.
Long run adjustment: Positive economic profits :new firms will enter the industry. Negative
economic profits: losing firms will exit In the long run: firms enjoy normal profits but economic profit
is zero

Short run Versus Long run Profit Maximization Under Monopolistic Competition

● Since there are many sellers under monopolistic competition, each firm tries to differentiate
the products from competitors. Differentiation may be real (meaning there is a real difference
in the substance) or fancy (they may be different only in packaging, or minor features like
scents varieties.
● They try to make customers loyal to them through advertising to make it appear that the
products of the competitors are not close substitutes to their products.
● Optimal output is produced where MR = MC
● Just like any other firms, they can also incur losses.
● Short run Versus the Long run Profit

Maximization Under Monopolistic Competition

Short run: Since firms have a way to differentiate their products from competitors, they can keep
their customers loyal to them. Advertising makes the product less elastic meaning, the customers are
not attracted to shift to similar products because they believe that they are not close substitutes. In
this case, the firms can somewhat control the price of their products.
Long run: Positive economic profits attract other firms to enter the industry, and since there are low
barriers to entry, the long run economic profit becomes zero. Firms which are realizing negative
economic profits may decide to exit.

Profit Maximization Under Oligopoly

● Optimal output is produced where MR = MC

● Since there are few sellers, the output and pricing decisions of the oligopolists are
interdependent, meaning their decisions are based on what the competitors are doing.
● There is uncertainty when firm A increases its price. If the competitors do not follow the price
increase, firm A will lose a number of its customers to other oligopolists, thus, a price increase
may not be beneficial to firm A. If firm A reduces its price and all other oligopolists also
reduce their prices, this may lead to price war causing the firms to reduce their profits. Thus,
there is price rigidity because of the uncertainty in the consequences of the decisions.
● One way to reduce uncertainty on the effects of the firm decision is for firms to act together.
● A cartel is an overt way to maximize the profits together. The Organization of Petroleum
Exporting Countries (OPEC) is an example of a cartel.
● Firms can also make tacit (secret) decisions to act together to increase their profits.

Short run versus Long run Profit Maximization Under Oligopoly

Short run: firms may enjoy not only positive normal profit but also positive economic profits
because the firms have substantial control over the market.
Long run: Even though there is positive economic profit in the short run and this attracts other firms
to enter the industry, there are high barriers. Thus, it is possible that oligopolists may realize positive
economic profits in the long run.
● Does this mean that oligopolists do not incur losses? No, even though they are big firms, it is
still possible for them to incur losses. The Caltex gasoline station in Bacal III is now being
replaced by a new oil player.
Short run Versus Long run Profit Maximization under Monopoly

● Is it possible for a monopolist to incur losses? Yes. Being big or having no competitors is not a
guarantee that the firm will not incur losses.
● Since the demand for the product of the monopoly is inelastic (remember the greater the
number of competitors, the greater the elasticity of demand), it is beneficial for the
monopolist to increase the price to increase revenue and maximize economic profits.
● Profit is maximized where MR = MC
● Unlike the pure competition where the economic profit is zero in the long run, it is possible
for the monopoly to enjoy positive economic profit in both the short run and in the long run
because the entry of potential competitors is prevented.