Managerial economics - University of London

[Pages:171]Managerial economics

D.J. Reyniers and M. Selvaggi

MN3028

2016

Undergraduate study in Economics, Management, Finance and the Social Sciences

This is an extract from a subject guide for an undergraduate course offered as part of the University of London International Programmes in Economics, Management, Finance and the Social Sciences. Materials for these programmes are developed by academics at the London School of Economics and Political Science (LSE). For more information, see: londoninternational.ac.uk

This guide was prepared for the University of London International Programmes by: Professor Diane Reyniers, Professor of Managerial Economics and Strategy, Department of Management, London School of Economics and Political Science and Dr Mariano Selvaggi, Independent Academic Adviser; previously of the London School of Economics and Political Science. This is one of a series of subject guides published by the University. We regret that due to pressure of work the authors are unable to enter into any correspondence relating to, or arising from, the guide. If you have any comments on this subject guide, favourable or unfavourable, please use the form at the back of this guide.

University of London International Programmes Publications Office Stewart House 32 Russell Square London WC1B 5DN United Kingdom londoninternational.ac.uk Published by: University of London ? University of London 2016 The University of London asserts copyright over all material in this subject guide except where otherwise indicated. All rights reserved. No part of this work may be reproduced in any form, or by any means, without permission in writing from the publisher. We make every effort to respect copyright. If you think we have inadvertently used your copyright material, please let us know.

Contents

Contents

Chapter 1: Introduction........................................................................................... 1 1.1 Road map to the guide............................................................................................. 1 1.2 Introduction to the subject area................................................................................ 1 1.3 Syllabus.................................................................................................................... 2 1.4 Aims of the course.................................................................................................... 2 1.5 Learning outcomes for the course............................................................................. 3 1.6 Overview of learning resources................................................................................. 3 1.7 Examination advice.................................................................................................. 6

Chapter 2: Decision analysis.................................................................................... 9 2.1 Introduction............................................................................................................. 9 2.2 Decision trees......................................................................................................... 11 2.3 Attitude towards risk.............................................................................................. 13 2.4 Some applications.................................................................................................. 16 2.5 The expected value of perfect information............................................................... 18 2.6 Overview of the chapter.......................................................................................... 21 2.7 Reminder of learning outcomes.............................................................................. 21 2.8 Test your knowledge and understanding................................................................. 21

Chapter 3: Game theory........................................................................................ 25 3.1 Introduction........................................................................................................... 25 3.2 Extensive form games............................................................................................. 27 3.3 Normal form games................................................................................................ 29 3.4 Nash equilibrium.................................................................................................... 31 3.5 Prisoners' dilemma................................................................................................. 35 3.6 Subgame-perfect equilibrium.................................................................................. 37 3.7 Perfect Bayesian equilibrium................................................................................... 39 3.8 Overview of the chapter.......................................................................................... 41 3.9 Reminder of learning outcomes.............................................................................. 41 3.10 Test your knowledge and understanding............................................................... 41

Chapter 4: Bargaining............................................................................................ 45 4.1 Introduction........................................................................................................... 45 4.2 The Nash bargaining solution.................................................................................. 47 4.3 The alternating-offers bargaining game................................................................... 49 4.4 Incomplete information bargaining......................................................................... 52 4.5 Overview of the chapter.......................................................................................... 53 4.6 Reminder of learning outcomes.............................................................................. 53 4.7 Test your knowledge and understanding................................................................. 53

Chapter 5: Auctions and bidding strategies.......................................................... 55 5.1 Introduction........................................................................................................... 55 5.2 Private and common-value auctions........................................................................ 57 5.3 Private-value auctions and their `optimal' bidding strategies.................................... 59 5.4 Auction revenue..................................................................................................... 64 5.5 Common value auctions......................................................................................... 64 5.6 Complications and concluding remarks................................................................... 66 5.7 Conclusion............................................................................................................. 70

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MN3028 Managerial economics

5.8 Overview of the chapter.......................................................................................... 71 5.9 Reminder of learning outcomes.............................................................................. 71 5.10 Test your knowledge and understanding............................................................... 71 Chapter 6: Asymmetric information I.................................................................... 73 6.1 Introduction........................................................................................................... 73 6.2 Adverse selection.................................................................................................... 74 6.3 Moral hazard.......................................................................................................... 78 6.4 Overview of the chapter.......................................................................................... 80 6.5 Reminder of learning outcomes.............................................................................. 80 6.6 Test your knowledge and understanding................................................................. 81 Chapter 7: Asymmetric information II................................................................... 83 7.1 Introduction........................................................................................................... 83 7.2 Signalling and screening......................................................................................... 84 7.3 Principal-agent problems........................................................................................ 88 7.4 Overview of the chapter.......................................................................................... 92 7.5 Reminder of learning outcomes.............................................................................. 92 7.6 Test your knowledge and understanding................................................................. 92 Chapter 8: Demand theory.................................................................................... 95 8.1 Introduction........................................................................................................... 95 8.2 Reviewing consumer choice.................................................................................... 96 8.3 Consumer welfare effects of a price change.......................................................... 101 8.4 Elasticity............................................................................................................... 103 8.5 Overview of the chapter........................................................................................ 105 8.6 Reminder of learning outcomes............................................................................ 105 8.7 Test your knowledge and understanding............................................................... 105 Chapter 9: Other topics in consumer theory....................................................... 107 9.1 Introduction......................................................................................................... 107 9.2 State-contingent commodities model.................................................................... 108 9.3 Intertemporal choice............................................................................................. 111 9.4 Labour supply....................................................................................................... 114 9.5 Risk and return..................................................................................................... 118 9.6 Overview of the chapter........................................................................................ 121 9.7 Reminder of learning outcomes............................................................................ 122 9.8 Test your knowledge and understanding............................................................... 122 Chapter 10: Production and input demands....................................................... 125 10.1 Introduction....................................................................................................... 125 10.2 Production functions and isoquants.................................................................... 126 10.3 Firm demand for inputs...................................................................................... 129 10.4 Industry demand for inputs................................................................................. 136 10.5 Overview of the chapter...................................................................................... 138 10.6 Reminder of learning outcomes.......................................................................... 138 10.7 Test your knowledge and understanding............................................................. 139 Chapter 11: Cost concepts................................................................................... 141 11.1 Introduction....................................................................................................... 141 11.2 Types of economic costs...................................................................................... 143 11.3 From production function to cost function........................................................... 145 11.4 Division of output among plants......................................................................... 146 11.5 Estimation of cost functions................................................................................ 148

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11.6 Overview of the chapter...................................................................................... 149 11.7 Reminder of learning outcomes.......................................................................... 149 11.8 Test your knowledge and understanding............................................................. 149 Chapter 12: Topics in labour economics.............................................................. 151 12.1 Introduction....................................................................................................... 151 12.2 Efficiency wages................................................................................................. 152 12.3 Firm demand for labour...................................................................................... 156 12.4 Internal labour markets....................................................................................... 159 12.5 Overview of the chapter...................................................................................... 163 12.6 Reminder of learning outcomes.......................................................................... 163 12.7 Test your knowledge and understanding............................................................. 163 Chapter 13: Market structure and performance................................................. 165 13.1 Introduction....................................................................................................... 165 13.2 Determinants of market structure........................................................................ 166 13.3 Measures of market structure.............................................................................. 171 13.4 Perfect competition............................................................................................. 172 13.5 Overview of the chapter...................................................................................... 175 13.6 Reminder of learning outcomes.......................................................................... 175 13.7 Test your knowledge and understanding............................................................. 175 Chapter 14: Monopoly and monopolistic competition....................................... 177 14.1 Introduction....................................................................................................... 177 14.2 Monopoly........................................................................................................... 179 14.3 Monopolistic competition................................................................................... 182 14.4 Overview of the chapter...................................................................................... 185 14.5 Reminder of learning outcomes.......................................................................... 185 14.6 Test your knowledge and understanding............................................................. 185 Chapter 15: Price discrimination......................................................................... 187 15.1 Introduction....................................................................................................... 187 15.2 Price discrimination............................................................................................ 188 15.3 Overview of the chapter...................................................................................... 198 15.4 Reminder of learning outcomes.......................................................................... 198 15.5 Test your knowledge and understanding............................................................. 198 Chapter 16: Other monopolistic pricing practices.............................................. 201 16.1 Introduction....................................................................................................... 201 16.2 Skimming or intertemporal price discrimination................................................... 202 16.3 Commodity bundling.......................................................................................... 207 16.4 Multiproduct firms.............................................................................................. 211 16.5 Transfer pricing................................................................................................... 214 16.6 Overview of the chapter...................................................................................... 221 16.7 Reminder of learning outcomes.......................................................................... 221 16.8 Test your knowledge and understanding............................................................. 221 Chapter 17: Oligopoly theory.............................................................................. 223 17.1 Introduction....................................................................................................... 223 17.2 Symmetric oligopoly models................................................................................ 226 17.3 Strategic asymmetry........................................................................................... 231 17.4 Overview of the chapter...................................................................................... 234 17.5 Reminder of learning outcomes.......................................................................... 234 17.6 Test your knowledge and understanding............................................................. 235

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MN3028 Managerial economics

Chapter 18: Cartels and (implicit) collusion........................................................ 237 18.1 Introduction....................................................................................................... 237 18.2 Profit maximisation by a cartel............................................................................ 238 18.3 Tacit (or implicit) collusion................................................................................... 242 18.4 Overview of the chapter...................................................................................... 244 18.5 Reminder of learning outcomes.......................................................................... 244 18.6 Test your knowledge and understanding............................................................. 244

Chapter 19: Introduction to corporate governance............................................ 247 19.1 Introduction....................................................................................................... 247 19.2 Directors and their duties.................................................................................... 249 19.3 International corporate governance codes........................................................... 251 19.4 The UK Stewardship Code................................................................................... 255 19.5 Overview of the chapter...................................................................................... 256 19.6 Reminder of learning outcomes.......................................................................... 256 19.7 Test your knowledge and understanding............................................................. 256

Chapter 20: Concluding remarks......................................................................... 257 20.1 Overview............................................................................................................ 257 20.2 Associated online material.................................................................................. 257

Appendix 1: Maths checkpoints.......................................................................... 259 1. Functions ? a few general remarks.......................................................................... 259 2. Differentiation........................................................................................................ 260 3. Logarithmic functions/properties of In and exp......................................................... 262 4. Integration............................................................................................................. 262 5. Systems of equations/manipulating equations......................................................... 263 6. Uniform distribution................................................................................................ 264 7. Probabilities.......................................................................................................... 264 8. The discount factor `'............................................................................................. 266 9. The company's profit function.................................................................................. 267 General suggestions for studying and revising............................................................. 268 Overview and definitions of some important functions................................................. 268 10. A few hints on solving questions........................................................................... 269

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Chapter 1: Introduction

Chapter 1: Introduction

1.1 Road map to the guide

Welcome to the subject guide for MN3028 Managerial economics. This course considers a variety of exciting topics that lie at the intersection of management and economics. You will learn how economics can provide a useful framework to think about managerial issues and analyse problems that businesses and societies commonly face in the real world. We hope that this knowledge and critical thinking will serve you well in your future studies and professional career.

This guide will help you to engage actively with the course and develop a robust understanding of the subject matter. It provides a framework for covering the topics in the syllabus and directions to the Essential reading. However, the guide is not a substitute for the careful study of the readings listed at the beginning of each chapter. For each topic in the syllabus it is advisable to start with the relevant chapter of the guide, then do the reading for that particular topic, then come back to the guide and attempt the sample exercises at the end of the chapter. This will help you check your understanding of the topic by applying your knowledge to solve specific problems.

The subject guide is divided into 20 chapters, consisting of an introductory chapter; five main content blocks covering the syllabus (namely, risk and information, game theory and strategic behaviour, demand and supply theory, market structure and competition, and corporate governance); and a concluding chapter. It aims to:

? provide an effective framework for the study of the subject

? introduce you to the relevant subject material

? present the material in a structured/digestible format

? guide you towards appropriate learning resources

? enable you to approach managerial decision problems using economic reasoning

? discuss business practice topics using an analytical approach, relying on equations and numerical insight

? encourage you to take an active approach to learning by reading recommended material; undertaking learning activities; and participating in discussion via the virtual learning environment (VLE).

1.2 Introduction to the subject area

This course is intended as an intermediate economics course for BSc (Management) and BSc (Economics) students. The main objective of the course is to enable you to approach managerial decision problems using economic reasoning. As such, it is less theoretical than a microeconomic principles course and more attention is given to topics that are relevant to managerial decision making. For instance, business practices such as price discrimination, transfer pricing, bundling, resale price maintenance and corporate governance are discussed. Most topics are analysed using equations and numerical examples ? that is, an analytical approach is used. The theories that are presented are not practical `recipes'; they are meant to give you insight and train your mind to think more like an

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MN3028 Managerial economics

economist. The emphasis throughout is on the application of knowledge and problem-solving rather than pure memorising and essay writing. Why should economics and management students study economics? The environment in which modern managers operate is an increasingly complex one. It cannot be navigated without a thorough understanding of how business decisions are and should be taken. Intuition and factual knowledge are not sufficient. Managers need to be able to analyse; to put their observations into perspective; and to organise their thoughts in a rigorous, logical way. The main objective of this course is to enable you to approach managerial decision problems using economic reasoning. At the end of studying this subject, you should have acquired a sufficient level of model-building skills to analyse microeconomic situations of relevance to managers. The emphasis is therefore on `learning by doing' rather than repeating memorised material. You are strongly advised to develop problem-solving skills using the exercises at the end of each chapter and past examination papers as well as ancillary material available through the VLE to complement and clarify your thinking.

1.3 Syllabus

The course covers basic topics in microeconomics such as supply and demand, consumer theory, labour supply, asymmetry of information, neo-classical view of the firm, production, costs, factor demands, perfect competition, monopoly, monopolistic competition, oligopoly, cartels and tacit collusion. We also analyse some newer material regarding alternative theories of the firm, internal organisation of the firm, market structure, efficiency wages, incentive structures, corporate governance as well as some industrial organisation theories of commonly used pricing practices. The following topics also form part of the course syllabus: ? individual (one person) decision making under uncertainty, attitudes

towards risk and the value of information ? theory of games and strategic decision making, including

its applications to oligopoly, collusion among firms, product differentiation, entry deterrence and other market practices ? the effects of asymmetric information in areas such as bargaining, bidding and auctions, situations of moral hazard and adverse selection ? corporate governance in modern organisations. Some knowledge of constrained maximisation and Lagrangian functions would be helpful for students taking this subject, although this is not a prerequisite.

1.4 Aims of the course

This course has two main objectives, which directly relate to the major themes that will be emphasised throughout this subject guide. The course aims to: ? enable students to approach managerial decision problems using

economic reasoning ? present business practice topics using an analytical approach, using

equations and numerical insight.

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