Primer

Microeconomic Principles
 Introduction

Review basic microeconomic tools for

business strategy
Critical for students with little background
in microeconomics
 Overview

Cost functions
Demand and revenue functions
Price and output decision for a profit-
maximizing firm
Perfectly competitive markets
Game theory
 Total Cost

Total Cost (TC) shows the relationship

between output and cost of producing any
given level of output
Assumes the firm produces in the most efficient
way possible given its technology
TC depends on the prices and quantities of
inputs the firm purchases to produce its
output
Total cost will rise with output
Firms must purchase more inputs to increase
output
Total Cost Function
 Fixed and Variable Cost

Total costs can be classified into fixed and

variable costs
TC = TFC + TVC
Variable costs, like labor (L) and raw
materials, rise as output increases
Fixed costs, like administrators’ salaries,
property taxes, and insurance, remain
constant as output increases
Shape of TC, TVC, and TFC

TV
C

TF
C

0
 Fixed and Variable Cost

Whether costs are fixed or variable

depends on the time period under
consideration
A 7 year-old machine with a 9-year economic life is
a fixed cost for the next 2 years. But becomes a
variable cost after 2 years as the machine must be
replaced.
 Average Cost

Average Cost (AC) is per unit cost

AC = TC/Q
AC varies with output and typically has a U
shape
Falling AC indicates economies of scale
Constant AC indicates constant returns to scale
Rising AC indicates diseconomies of scale
Minimum efficient scale shows Q at which
AC reaches its minimum
Economies of scale and minimum efficient
scale are critical in determining the size of
firms and the structure of industries
Average Cost and Minimum Efficient Scale

Economies of
scale

Constant returns to
scale

Diseconomies of
scale

Q’ = minimum efficient
scale
 Marginal Cost

Marginal cost is the incremental cost

of producing one more unit of output
MC = ΔTC/ΔQ
MC is the slope of the TC curve
MC and AC have a unique
relationship:
MC < AC when AC is falling
MC > AC when AC is rising
MC = AC when AC is constant
Marginal Cost and Average Cost
 Short-Run versus Long-Run Costs

In the short run, a firm commits to a

certain size plant, so it can vary output only
by varying the Q of other inputs (like L and
raw materials)
For each plant size, there is a short-run
average cost curve (SAC)
Long-run average cost curve (LAC) is the
lower envelope of the SACs
LAC shows the lowest possible SAC for any given
level of output
Short-Run versus Long-Run Cost
Functions
S, M, and L represent
three different plant sizes –
small, medium, and large.
For any given level of
output, the optimal plant
size is the one that has the
lowest SAC.
E.g., if output is Q1, then
the firm should chose a
small plant with its
associated SACS. Choosing
the large plant instead
(with SACL) results in
wasted capacity and
wasted resources (like L)
used to operate in a space
that is too large.
 Short-Run Average Cost

Short run average cost has two

components
Average Fixed Cost (AFC) = TFC/Q
Average Variable Cost (AVC) = TVC/Q
So SAC = AFC + AVC
SAC is U shaped
AFC falls as Q rises, so AFC tends to pull SAC down
initially
However, AVC rises as Q rises which eventually pulls
SAC up
If TC = $10M + 4Q2 then TFC = $10M and TVC = 4Q2
AFC = $10M/Q; AVC = 4Q, so SAC = $10M/Q + 4Q
 Shapes of SAC, AFC, AVC
Average
cost
curves

SAC
AV
C

AF
C
Outp
ut
 Sunk Cost

Sunk costs must be incurred no matter what

the decision is and thus cannot be avoided
It is important to ignore sunk costs when
making decisions
Avoidable costs are the opposite of sunk
costs
Fixed costs need not be sunk costs
E.g., plant and equipment are fixed in the SR but they
are not entirely sunk. The firm may recoup some of its
expenditures on plant and equipment by selling them
to another party.
 Accounting and Economic Costs

Accounting costs are costs reported in

companies’ net income statements generated by
accountants
Economic costs = accounting costs + opportunity
costs of any resources supplied by firm’s owners
Opportunity cost of any decision is the value of
the next best alternative that the decision forces
the decision maker to forgo
E.g., if Joe, a talented MBA, quits his job making $120,000
per year to play professional poker then Joe must count
his forgone salary of $120,000 as a cost of this decision!
 Accounting and Economic Profits

Economic profit = Accounting profit –

opportunity cost of any resources supplied
by the firm’s owners
You cannot make good, informed business
or life decisions without contemplating
opportunity cost
If Joe nets $100,000 in tournament winnings, an
economist would say he lost $20,000 playing poker
versus an accountant would say he earned
$100,000.
Sadly, Joe married an economist ☹!
 The Demand Curve

The quantity of a good that a firm can

sell depends on
Price of the good
Quality of the good
Prices of related goods (substitutes and
complements)
Consumer tastes
Consumer incomes
Advertising, etc.
The Demand Curve

Demand curve shows the

relationship between the price
of the good and the quantity
sold assuming all other
determinants of quantity
demanded (like prices of
substitutes or consumer
incomes) are held constant.
At the price of P’ consumers
are willing to buy Q’ units of
the good.
Demand has a negative slope.
Thus, we expect that quantity
demanded of the good rises as
its price falls.
 Price Elasticity of Demand

Elasticity measures how sensitive

consumer purchases are to a change in
price ΔQ / Q0
η=
ΔP / P0

η >1
Demand is “elastic” if
Demand is “inelastic” if η < 1
Price Elasticity of Demand

Inelastic DB is an elastic demand

demand versus DA is an inelastic
demand.
Consumers react much
Elastic demand more strongly to the price
increase (of P0 to P1)
when their demand is
represented by DB rather
than by DA.
 Price Elasticity of Demand

Demand is elastic when

Close substitutes are readily available
Good is fairly undifferentiated and consumers are
well informed of competitors’ prices (e.g., airline
services)
Expenditures on the good are a large fraction of
the consumer’s budget (e.g., major appliances)
Good is an input into the production of a final
good whose demand is sensitive to price (e.g.,
computer components)
 Price Elasticity of Demand

Demand is inelastic when

Complexity of the product makes comparison
difficult
Information about substitutes is scarce
Buyers pay only a fraction of the full price of the
good or service (e.g., doctor’s visits)
Switching to other products is costly (e.g.,
software)
Product is used jointly with other products to
which the customer is committed (e.g., HP
toner cartridges)
 Price Elasticity of Demand

Demand can be elastic at brand level even

when it may be inelastic at industry level
E.g., demand for Shell gas is elastic but demand for
gasoline is inelastic
Total Revenue and Marginal Revenue
Total Revenue (TR) = P × Q
Marginal Revenue (MR) = ΔTR/ΔQ
MR = P(1 – 1/η)
Where η is the price elasticity of demand
MR > 0 if demand is elastic (as η > 1) and MR
< 0 if demand is inelastic (as η < 1)
MR is slope of TR curve (which looks like a
hill). If MR > 0, then TR is rising. And if MR <
0, then TR is falling
Thus, if MR > 0, then demand is elastic and TR is
rising
 TR and MR curves
Revenue MR >
curves 0 MR = 0

MR <
0

T
R
0 Q’
Elastic Inelasti Outp
demand c ut
demand
Marginal Revenue versus Price

Whenever demand slopes

downward, MR < P.
Elastic Intuition: Price is Average
Revenue (AR) as AR = TR/Q
= (P x Q)/Q = P. Since AR
(or price) is falling, then
MR must be pulling the AR
Inelast
down. So MR < P.
ic Demand is elastic when MR
> 0 (and TR is rising) and
demand is inelastic when
MR < 0 (and TR is falling).
TR is maximized when MR
= 0.
Firm’s Pricing and Output Decision

Profits are maximized when MR =

MC
If MR > MC, the firm can increase
profits by increasing output
If MR < MC, the firm can increase
profits by decreasing Poutput
⎛ 1⎞
⎜ 1 − ⎟ = MC
Optimally, MR = MC or⎝ η ⎠
Optimal Price & Quantity for a Firm

The profit-maximizing
firm selects its level of
output by setting MR =
MC at Q*. The demand
curve determines the
price at which that
quantity (Q*) can be sold,
P*.
Thus, the firm chooses
one price-quantity pair on
the demand curve to
maximize its profits.
 Perfect Competition

Perfect competition is a market structure

wherein:
Industry has many small firms producing identical
products
Firms can enter and exit at will
Each firm must charge the same price
Each firm faces an infinitely elastic demand
curve
Thus, the firm’s demand is flat
So P = MR. If the firm sells one more unit at a
constant price of $8, then its TR rises by $8
Supply Curve of the Competitive Firm

The firm’s supply curve is

its MC curve.
The firm maximizes profit
by setting MR (or P)
equal to MC. So the MC
curve tells us the quantity
supplied at any given
price.
If price = P0, the firm
produces Q0 units of
output. Or if price = P2,
the firm produces Q2
units of output.
 Perfectly Competitive Industry Supply Curve

Typical Industry
Firm

The perfectly competitive industry’s SR supply curve (SS) is the horizontal

summation of the firm’s supply curves. E.g., if 1,000 identical firms produce
40 units at P = $10, then the industry supplies 40,000 units (or 40 x 1,000)
when P = $10.
 LR Industry Profits

Perfectly competitive industries earn zero

economic profit in the LR
SR profits attract news firms ➔ entry of firms shifts
industry supply curve out ➔ lowers market price ➔
until all profits are competed away
SR losses encourage some firms to exit ➔ shifts
industry supply curve in ➔ raises the market price
➔ until all losses are eliminated
Market is so competitive that firms can only hope
to cover their costs (L, K, raw materials, and
opportunity costs) in LR
 LR Industry Profits

The idea that free entry dissipates economic

profits is one of the most powerful insights of
economics and it is critical for strategy!
Firms that base their strategy on goods that
can easily be imitated or on skills and
resources that can easily be acquired, put
themselves at risk to the forces of
competition!
To attain competitive advantage, a firm must
secure a position that protects itself from
imitation and entry
 Perfectly Competitive Industry in SR Equilibrium

Typical Industry
Firm

P* is determined by the intersection of SR industry S and D. The typical firm

reacts to the market price of P* by setting it equal to MC and producing q*. The
firm is making profit as P* > AC at q*. Note: total profit = TR – TC or total profit
= (P x Q) – (AC x Q) or (P – AC) x Q. In other words, total profit = per unit profit x
output. This is a SR equilibrium as profits will encourage new firms to enter!
 Industry Adjustment to a LR Equilibrium

Typical Industry
Firm

S S
R R

LR LR

SR economic profits attract new firms into the industry. The entry of firms
shifts the SR industry supply curve out from SS to SS’ which lowers the
price from P* to P**. The typical firm now earns zero profit at P** (the LR
equilibrium) as P** = AC at q**.
 Game Theory
Game theory –a method of analyzing
situations in which the outcomes of your
choices depend on others’ choices, and vice
versa
Game theory is widely used to study the
strategic interactions of oligopoly firms
3 elements common to all game theory:
1. Players –decision makers whose behavior we are
trying to predict
2. Strategies –possible choices of players (e.g., P or
Q)
3. Payoffs –outcomes or consequences of strategies
chosen (e.g., profits)
 Simplest Game

Consider the simplest game:

Industry with two firms producing identical products
Two firms (Alpha and Beta), need to decide whether to
expand
Note: expansion of capacity implies a trade-off between
greater capacity to secure larger market share and
downward pressure on price
Each firm has a dominant strategy -where the firm is
better off adopting a particular strategy regardless of
the strategy adopted by the other firm
Payoff matrix shows how each combination of
choices affects Alpha and Beta’s profits
 Simplest Game
Prisoner’s Dilemma Game with a Dominant-
strategy and Nash Equilibrium
 Determination of Equilibrium

Alpha should pick “expand” no matter what Beta does

Beta should pick “expand” no matter what Alpha does
So (expand, expand) is the dominant-strategy and
Nash equilibrium for this game
Nash equilibrium –a set of strategies such that each
firm’s choice is the best one possible given the
strategy chosen by the other firms
All dominant-strategy equilibria are Nash equilibria
Not all Nash equilibria are dominant-strategy
equilibria
 Prisoner’s Dilemma

Prisoner’s dilemma game –each firm

follows its own self-interest and both firms
end up worse off than they could be if they
made different (coordinated) choices
By following their own self-interest (expand) both
Alpha and Beta are worse off than had they
colluded and picked “do not expand” instead
Wide-applicability and frequently used to
analyze oligopoly firms
 Nash Equilibrium

Consider a modified expansion game wherein the two firms chose between
three options –small, large, or no expansion. Neither firm has a dominant
strategy. The Nash equilibrium is (small, small).
 Game Tree for Sequential Game

Alpha moves before Beta does. Equilibrium is found by determining Beta’s

optimal decision for each of Alpha’s three choices. Alpha anticipates that Beta
will choose a profit-maximizing response to any move Alpha might make. Given
these expectations, Alpha’s strategy is determined.
Game Tree for Sequential Game
Alpha makes the first move and Beta responds to
maximize its profits
Optimal responses by Beta are

Alpha chooses large expansion to maximize its

profits
Subgame Perfect Nash Equilibrium (SPNE)
SPNE -each firm chooses an optimal action at each stage of
the game and believes that all other firms will behave in the
same way
Sequential versus Simultaneous Move Games

In the sequential-move game, Alpha’s

capacity choice has commitment value and
it forces Beta into a corner
By committing to a large-capacity expansion, Alpha
forces Beta into a position where Beta’s best
response (of no expansion) yields an outcome that
is most profitable for Alpha
By contrast, in the simultaneous-move
game, Beta cannot observe Alpha’s decision
before making its own decision, so the
large-capacity decision no longer has
commitment value for Alpha