Managerial

Economics:
Chapter 1: Foundations.
MSc Class of 2024
Fall Semester 2022

Dr. Anna Ressi | Assistant Professor

for Economics, Management and
Organization
Managerial Economics: Chapter 1

Outline of Chapter 1: Foundations.

1 Basic Microeconomics
1.1 Firms & Consumers
1.2 Perfect Competition and
Monopoly
2 Basic Game Theory
1.1 Nash-Equilibrium
1.2 Subgame-perfect Nash-
Equilibrium
Managerial Economics: Chapter 1

Chapter 1. Learning Objectives

by getting acquainted with useful concepts.

by clarifying main assumptions underlying analytical frameworks.

how are they represented?

how are they assumed to behave?
how do we measure their well-being?

Delineate the scope of market interaction

2 extremes: perfect competition and monopoly

Get acquainted with basic game theory.

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Managerial Economics: Chapter 1

Outline of Chapter 1: Foundations.

1 Basic Microeconomics
1.1 Firms & Consumers
1.2 Perfect Competition and
Monopoly
2 Basic Game Theory
1.1 Nash-Equilibrium
1.2 Subgame-perfect Nash-
Equilibrium
Managerial Economics: Chapter 1

Representation of Market Participants: Consumers

Consumers as Decision-makers
Consumers are assumed to be rational
Able to assign a monetary value to every transaction reservation price
They choose what they like best
Maximize their consumer surplus = reservation price product price
New theories with systematic biases or behavioural patterns

RPIWTPIJPGZP.ie:4?po
behavioural IO (not covered in this course)

They are risk-neutral and forward-looking

They form expectations about the future
Expected utility maximizers

Many buyers non-strategic

Consumers may act as strategic players (e.g. adoption of network
goods)

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Managerial Economics: Chapter 1

Representation of Market Participants: Consumers

Utility and Demand
Demand curves
Summarize how demand of a single individual, or a collection of them,
changes with the price paid
9
Example: choke price is 50
Inverse demand curve: P
From individual to (downward sloping) aggregate demand
Either any consumer is representative of all others
:
Use incremental RPs
Or account for taste differences among consumers

%
Order list of buyers by decreasing RP
"
Elasticity of demand "
no dress
approach

6 %EE-G.tn# ÄÄDen =L
Managerial Economics: Chapter 1

Representation of Market Participants: Firms

Costs
Technological characteristics can be summarized by a total cost function
Economic costs refer to opportunity costs
Cost function:
Minimal cost to produce output q given the input
prices and the production technology
Fixed cost:
Average cost:
Expenditure per unit of production
Marginal cost:
Increase in cost from producing an additional unit of output
we will often take it as constant
Sunk costs

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Managerial Economics: Chapter 1

Representation of Market Participants: Firms

↑ ¥-93
"
Firms
•
:-X
Seen as a program of profit maximization
Profit = Revenues Costs ( )
Revenues depend on consumers preferences and on type of market
interaction
PCATC
Costs depend on technology
Profit-maximization implies that P > AVC produeeinthe
Short run
)
oiqa FOC
0
-

P > ATC produceinthe

MR MC :O long -

run
Mc haomuchtoproducl
-

MR > Mc given 0
q >

Sc howtoentrmarket
in the first place
8
Managerial Economics: Chapter 1

Representation of Market Participants: Firms

Costs and Market Structure
Economies of scale: average costs are decreasing 4¥
Economies of scope: it is less costly to produce a set of goods in one firm than it
is to produce this set in two or more firms
Learning-by-doing and experience curves: costs decrease with cumulative
output
Sunk costs
(Network externalities)
Favour a concentrated industry

Ac
S -
-

¥
S > 1 econ . d- Scale
disecon ofscale
5<1
.

:
5=1 min .

effscale
µ,
9
Managerial Economics: Chapter 1

Welfare Analysis of Market Outcomes

Partial Equilibrium Approach
Focus on one (or a small number of) market(s) at a time
Abstract away cross-market effects

Social Surplus
Definition: Social surplus equals the sum of all consumers willingness to pay
minus the total cost of supplying the consumers with the products.
Social surplus: Sum of producer surplus and consumer surplus
Producer surplus (PS): Gross profit (before fixed costs)
Consumer surplus (CS): Difference between willingness to pay and price
actually paid

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Managerial Economics: Chapter 1

Outline of Chapter 1: Foundations.

1 Basic Microeconomics
1.1 Firms & Consumers
1.2 Perfect Competition and
Monopoly
2 Basic Game Theory
1.1 Nash-Equilibrium
1.2 Subgame-perfect Nash-
Equilibrium
Managerial Economics: Chapter 1

The Basic Market Forms

Market Forms Sellers

Sellers
One Few Many

Buyers Many Monopoly Oligopoly Perfect

Competition

Few Oligopsony

One Bilateral Monopsony

bargaining

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Managerial Economics: Chapter 1

Perfect Competition Paradigm

Assumptions:

Single market with a homogenous product

Firms are identical and produce at cost
Consumers have quasi-linear preferences
Firms and consumers take the market price as given

Firms Consumers

FOC: FOC:

price = marginal costs price = marginal utility

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Managerial Economics: Chapter 1

Perfect Competition Paradigm

GRAPHICAL REPRESENTATION

The Firm The Industry

Di
"

$/unit $/unit

MC
→
IMU
D1 S1 =
Mc
AC I
P
'
•
P
'

\ ↓ s
'

↑ , -
'

PC b-
PC • •
_

i
-

'
qc % Quantity QC =
n ☒ ok Quantity
14
Managerial Economics: Chapter 1

Perfect Competition Paradigm

price ""
Competitive Equilibrium and Efficiency
µ „ MC
Equilibrium:
Marginal utility = marginal cost
CS
Graphical representation
Inverse Demand = marginal utility (WTP)
p*
% PS*
Jt
-4g
hoss
Supply = marginal cost
-
- -
-

Equilibrium is found where demand and supply '

!
intersect
Social welfare = PS + CS ! !

j÷
*Gross profits (before fixed cost) q* quantity

Lesson

A perfectly competitive firm produces at marginal cost equal to the market price.
Social welfare is maximal. Hence, the market is efficient.

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Managerial Economics: Chapter 1

Strategies in a Constant Environment

Monopoly Trade-off

Output decisions affect market clearing price

Price "" "
reserve
1
additional
P1
⑤
*g- renren.es

FEE
a-
Demand

Q1 Quantity
Qz

16
Managerial Economics: Chapter 1

Strategies in a Constant Environment

GRAPHICAL REPRESENTATION: Price Setting and Social Welfare

Price

50-91-2-9
PCQJ-5i-YQR-PCQJQMR-R-a-P.IQ )
/

GMP.SK/YR=-gOQ-A2Q2MR--5O-Qp:#*i-; =
"

Marc :b !
PS :* Demand

am @ ¥50 Leo Quantity

17
Managerial Economics: Chapter 1
.
Strategies in a Constant Environment
b g/Y=fCg)hYg)+f'
G) hcg )
(fis) -

Monopoly Pricing Formula (G) -1092 GPG# FG ) # PG )

G) MC
'
(

µ
=
Monopoly problem: maxq (q) qP(q) C(q)
FOC gives:PG ) Mata Pka ) :-O PG) Mc
qp G)
- - '
= -

Inverse price elasticity of demand:

-9%9
Divide both sides of (1) by P(q) yields the

Inverse
Markup or elasticity of
Lerner index demand

Lesson market power abilitytocbarge P> Mc!

A profit-maximizing monopolist increases its markup as demand becomes less
price elastic.

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Managerial Economics: Chapter 1

Empirical Application: Mark-Up

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Managerial Economics: Chapter 1

Empirical Application: Mark-Up

Herfindahl Indices in the US Manufacturing Sector

Herfindahl Index: , where

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Managerial Economics: Chapter 1

Outline of Chapter 1: Foundations.

1 Basic Microeconomics
1.1 Firms & Consumers
1.2 Perfect Competition and
Monopoly
2 Basic Game Theory
1.1 Nash-Equilibrium
1.2 Subgame-perfect Nash-
Equilibrium
Managerial Economics: Chapter 1

Game Theory
Foundations
In the majority of markets firms interact with few competitors
(Coca Cola vs. Pepsi Cola)
Oligopoly market: Middle group between monopoly and perfect competition

This kind of interaction is analyzed using game theory

-making

Distinguish cooperative and non-cooperative games

-
Focus on non-cooperative games
Finite games vs. continuous games
Also consider timing
Simultaneous versus sequential games
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Managerial Economics: Chapter 1

Game Theory
Foundations
Games consist of players, feasible actions, and a payoff function
Players (firms?) choose strategies, one for each player
Combination of strategies determines outcome
Outcome determines pay-offs (profits?)

Concept of equilibrium
Equilibrium first formalized by Nash:

No firm wants to change its current strategy given that no other firm
changes its current strategy.
Nash-equilibrium

A Nash-equilibrium is a situation in which all players choose mutual best

responses.

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Managerial Economics: Chapter 1

Game Theory
Foundations

Firms might do better by coordinating but such coordination may not be

possible (or legal)

Dominated strategies
Some strategies can be eliminated on occasions
They are never good strategies, no matter what the rivals do
never employed and so can be eliminated
Elimination of a dominated strategy may result in another being
dominated: it also can be eliminated

Dominant strategies
One strategy might always be the best, no matter what the rivals do
always chosen

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Managerial Economics: Chapter 1

Game Theory: Simultaneous-move Games

gptrakgic
Nash-Equilibrium
Example 1: Two airlines
Prices are fixed, so firms compete in departure times
variable
70% of consumers prefer evening departure, 30% prefer morning
departure
If the airlines choose the same departure times they share the market
equally
Pay-offs to the airlines are determined by market shares maxmarhet
Represent the pay-offs in a pay-off matrix (normal form)
Share
good
What is the outcome in this game?
column
American
→
player
player
row -

Morning Evening
↑ Morning 15,15 30170
Delta
25
Evening 70,30 35,3520
Managerial Economics: Chapter 1

Game Theory: Simultaneous-move Games

Nash-Equilibrium
Example 2: Two airlines
Still 70% of consumers prefer evening departure, 30% prefer morning
departure
Now suppose that Delta has a frequent flier program
When both airline choose the same departure times Delta gets 60% of
the travelers
This changes the pay-off matrix

What is the outcome in this game?

American
Morning Evening
Morning 18 12 30 7dg
5-003-042
Delta
Evening 28
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Managerial Economics: Chapter 1

Game Theory: Simultaneous-move Games

Nash-Equilibrium: Sequential Elimination of Dominated Strategies
Example 3: Change the airline game to a pricing game
Three strategies: low, medium, high
Pay-off matrix

.ua#-F@
What is the outcome in this game?

American
↑
daninded
Low Medium High
Low 15,000 15,000 25,000 22,000 40,000 20,000
Delta Medium 22,000 25,000 35,000 35,000 38,000 33,000

÷:* :*
High 20,000 40,000 33,000 38,000 30,000 30,000

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÷
1) prefvenas utility

¥j
,
"

2) technology
trade oft
3) marginal reverue
-

F- a- q
?
ftp.q-aqnq
MR
29
=
a-
Managerial Economics: Chapter 1

Game Theory: Simultaneous-move Games

Nash-
Airline pricing game (Example 4):
60 potential passengers with a reservation price of $500
120 additional passengers with a reservation price of $260
Price discrimination is not possible (perhaps for regulatory reasons or

Costs are $200 per passenger no matter when the plane leaves
Airlines must choose between a price of $500 and a price of $260
If equal prices are charged the passengers are evenly shared
The low-price airline gets all the passengers

What is the outcome in this game?

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Managerial Economics: Chapter 1

Game Theory: Simultaneous-move Games

Nash-Equilibrium
Example 4:

American

Delta

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 Player
2

± .IE#-t-:-:*
:*
Managerial Economics: Chapter 1

Game Theory: Simultaneous-move Games

Nash-Equilibrium
- What if there are no dominated or dominant strategies?
- Then we need to use the Nash equilibrium concept.
- Example 5: Twist to the story
- RP of the 120 additional customers is 220
American
!" = $%% !& = ''%

Delta
!" = $%% 90-0-990-0-0 0 / 3600
3600,0

1-821800-focalpo.int
!& = ''%

30
Managerial Economics: Chapter 1

Game Theory: Sequential-move Games

Foundations
In a wide variety of markets firms compete sequentially

Second firms sees this move and responds

These are dynamic games
May create a first-mover or second-mover advantage
May also allow early mover to preempt the market
Can generate very different equilibria from simultaneous move games
Sequential-move games are best represented in their extensive form
Illustrates players, feasible actions, payoffs, and timing
Solutions concept: Subgame-perfect Nash-equilibrium (Selten 1978)
Is a Nash-equilibrium
In no stage of the game, a player can be better off when unilaterally
changing his/her strategy
Excludes implausible threats
Solution via backward induction
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Managerial Economics: Chapter 1

Game Theory: Sequential-move Games

Subgame-perfect Nash-Equilibrium
- Example 6:
- Two software firms
- Microhard is the incumbent firm, Newvel a potential entrant

Microhard
Fight Accomodate
Enter 0 0 2 2
Newvel of
off

Stay Out 1
E-
5
e-
1 5
g-

What is the outcome of this game?

32
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 Managerial Economics: Chapter 1

Game Theory: Sequential-move Games

Subgame-perfect Nash-Equilibrium
- Example 6: Newvel moves first Microhard
Fight Accomodate
Enter 0 0 2 2
Newvel
Stay Out 1 5 1 5
extensive form -

game Wee
form What is the outcome of this game?

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Managerial Economics: Chapter 1

Game Theory: Sequential-move Games

Subgame-perfect Nash-Equilibrium
- Example 6: Newvel moves first backward
90 )

Ü '
indudion

:*:
÷
AB •
•

What is the outcome of this game?

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Managerial Economics: Chapter 1

Case. A Beautiful Mind (2001)

A Beautiful Mind (2001) is a U.S.

movie based on the biography of
John Nash (played by Russell
Crowe).

John Nash (1928-2015) was an

American mathematician.
He shared the Nobel prize in
Economic Sciences with Reinhard
Selten and John Harsanyi for their
contributions in Game Theory.
In later years, he became mentally ill
(which the movie, unfortunately,
focuses on).

The movie brought in $313 million

worldwide. It received 8 Academy
Awards nominations and received 4

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Managerial Economics: Chapter 1

Review questions

Which measure do we use to judge market allocations?

Explain, in your own words, the monopoly-pricing formula.

Give the definition of the Lerner index. What is this measure used for?

What is a Nash-equilibrium and a subgame-perfect Nash-equilibrium?

Under which conditions are they applied?

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