Managrial Economics 1: Intro

Giulio Zichella, Ph.D

Assistant Professor, Department of Operations Management
Chapter 1: an overview to ME1
• Theory of the firm
• Value maximization (an intro)
• Constraints & Limitations
• Profit measurement
• Definitions
• Drivers of Profit

17
Theory of the firm
The primary goal of the firm is long term
expected value maximization: in other words
to serve customers efficiently.

18
Firm Value
𝑛𝑛
𝑇𝑇𝑇𝑇𝑡𝑡 − 𝑇𝑇𝑇𝑇𝑡𝑡
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 = � 𝑡𝑡
(1 + 𝑖𝑖)
𝑡𝑡=1
TR  Sales and promotion; TC  production; i  finance

See you at
chapter 17 

19
Theory of the firm: limits
• Optimize (the best) vs satisfice (the good
enough)  it is about balance!
• Particularly under intense competition,
creativity is needed!

20
10 min break!
Chapter 2: Optimization
• Why important?
• Total and Marginal Revenue
• Definitions
• TR and MR curves
• Total, Marginal and Average Cost
• Definitions, Short and Long run
• TC, MC and AC curves
• Profit optimization

22
Optimization: why important?

An optimal decision is the choice alternative that

produces a result most consistent with
managerial objectives

Bottom line: serving the customers efficiently

• Max Value
• Max Profit
• Optimal Input
• Optimal Output
23
What is Total Revenue?

𝑇𝑇𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑅𝑅𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 = 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 ∗ 𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑡𝑡𝑡𝑡

Direct demand function (linear):

𝑄𝑄 = −𝑃𝑃 + 10
Inverse demand function (linear):
𝑃𝑃 = −𝑄𝑄 + 10
Total Revenue is a (non-linear) function of Q
𝑇𝑇𝑇𝑇 = 𝑃𝑃 ∗ 𝑄𝑄 = −𝑄𝑄2 + 10𝑄𝑄
24
How does TR look like?
Total Revenue
30

TR = -Q2 + 10Q
25
Total Revenue

20

15
TR
Poly. (TR)

10

0
0 1 2 3 4 5 6

Quantity 25
TR and inverse demand

𝐏𝐏 = −𝐐𝐐 + 𝟏𝟏𝟏𝟏

𝐓𝐓𝐓𝐓 = −𝐐𝐐𝟐𝟐 + 𝟏𝟏𝟏𝟏𝟏𝟏

26
What is Marginal Revenue?

Is the rate of change in total revenue that

results from a change in quantity

MR is the derivative of TR: For example:

𝑃𝑃 = −𝑄𝑄 + 10 → 𝑇𝑇𝑇𝑇 = −𝑄𝑄2 + 10𝑄𝑄
𝜕𝜕𝜕𝜕𝜕𝜕
𝑀𝑀𝑀𝑀 = = −2 ∗ 𝑄𝑄2−1 + 10 ∗ 1
𝜕𝜕𝜕𝜕
𝑴𝑴𝑴𝑴 = −𝟐𝟐𝟐𝟐 + 𝟏𝟏𝟏𝟏
TR is maximized when MR = 0 27
How to calculate (some)
derivatives

28
MR: how does it look?
Let’s draw the functions on Excel!
P, TR, MR functions
30

25

20
Dkk

15 TR
P
MR
10

0
0 1 2 3 4 5 6 7 8 9 10 11
Quantity
29
Week 36 (Sept. 4th)
Chapter 2: Optimization
• Why important?
• Total and Marginal Revenue
• Definitions
• TR and MR curves
• Total, Marginal and Average Cost
• Definitions, Short and Long run
• TC, MC and AC curves
• Profit optimization

30
Types of costs?

Costs can be distinguished between

Fixed costs (FC): Expenses that do not vary
with quantity (e.g. rented office space)
Variable costs (VC): Expenses that fluctuates
with quantity (e.g. ingredients in a pizzeria
Total Costs = FC + VC
In the long run, all costs are variable
In the short run, there are fixed and variable
costs 31
Types of costs? (2)

From Total Costs (TC) we can obtain

Marginal costs: change in TC due to change in

quantity
Average costs: Total costs divided by quantity

In the long run, a firm has to cover AC

In the short run, a firm has to cover MC
32
Costs: an example

Total Cost = Fixed Costs + Variable Costs

For example:
𝑇𝑇𝑇𝑇 = 8 + 4𝑄𝑄 + 0,5𝑄𝑄2
Fixed costs = 8
Variable Costs = 4𝑄𝑄 + 0,5𝑄𝑄 2
Marginal Costs = 4 + 𝑄𝑄
8
Average Costs = + 4 + 0,5𝑄𝑄
𝑄𝑄

33
Let’s visualize it!

34
Today
Optimization
• Why important?
• Total and Marginal Revenue
• Definitions
• TR and MR curves
• Total, Marginal and Average Cost
• Definitions, Short and Long run
• TC, MC and AC curves
• Profit optimization

35
Total Profit

Difference between Total Revenue and Total Cost

Marginal Profit: Change of profit due to changes in

quantity

36
Profit Optimization

If π = 0, 𝑤𝑤𝑤𝑤 𝑎𝑎𝑎𝑎𝑎𝑎 𝑎𝑎𝑎𝑎 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 − 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝

37
Profit Optimization (2)

38
See you on thursday!

• Chapter 3: Supply and Demand

• On Friday: Workshop Excel!
• Check regularly:
– Canvas.cbs.dk  for Exercises (do them
in advance, possibly in groups!)
– Calendar.cbs.dk  changes in
rooms/schedule
Chapter 3: Supply & Demand
• What is Demand?  Demand Curve
• What is Supply?  Supply Curve
• Market Equilibrium

40
Chapter 3: Supply & Demand
• What is Demand?  Demand Curve
• What is Supply?  Supply Curve
• Market Equilibrium

41
What is demand?

Total quantity of a good (service) that consumers

are willing to purchase

42
See also Managerial Application 3.1, page 83
Demand and Utility

Demand is important because we get a value (or

utility, or happiness) by consuming.

43
Demand and Utility (2)
Companies adapt as sales of Organic Food in
Denmark are increasing

44
Law of Demand
Negative relationship (downward slope) between
quantity demanded and price

45
Law of Demand (2)
Negative relationship (downward slope) between
quantity demanded and price

46
Determinants of demand

Several variables influence demand

• Income
• Price of complement goods (e.g. printer and
cartridges)
• Price of substitutes (e.g. tea and coffee)
• Tastes/preferences of consumers (e.g.
Økologisk)
• Expectations
47
Shifts in Demand
Price changes  movements along the curve
Example: Demand for cars (from book, pg 86)
OBS!
Q = 23𝑚𝑚𝑚𝑚𝑚𝑚 − 500𝑃𝑃
500𝑃𝑃 = 23𝑚𝑚𝑚𝑚𝑚𝑚 − 𝑄𝑄
𝑃𝑃 = 46000 − 0,002𝑄𝑄

Direct Demand
Inverse Demand

48
Shifts in Demand (2)
Non-Price changes  shifts of the curve
Example: An increase in interest rates decreases
demand for cars (downward shift)

49
Week 36
Chapter 3: Supply & Demand
• What is Demand?  Demand Curve
• What is Supply?  Supply Curve
• Market Equilibrium

50
What is supply?
Total quantity offered for sale: objective is Profit!
Several variables influence supply

• Innovation and technology

• Sellers in the market
• Changes in taxation/subsidies
• Related products
• Expectations

51
Law of Supply
Positive relationship (upward slope) between
quantity supplied and price

52
Shifts in Supply
Price changes  movements along the curve

53
Shifts in Supply (2)
Non-Price changes  shifts of the curve
Example: An increase in interest rates decreases
supply for cars (upward shift)

54
Week 36
Chapter 3: Supply & Demand
• What is Demand?  Demand Curve
• What is Supply?  Supply Curve
• Market Equilibrium

55
Market Equilibrium
Perfect balance in demand and supply
At equilibrium there is no shortage (excess demand)
or surplus (excess supply)

56
Market Equilibrium (2)
Perfect balance in demand and supply
Example: Market for cars (from book, pg 95)

57
Market Equilibrium (2)
At equilibrium, supply=demand
Example (from the book):
• Demand P = – 0,002Q + 46000
• Supply P = 0,0005Q + 26000
• Equilibrium P(Supply) = P(Demand)
 0,0005Q + 26000 = -0,002Q + 46000
 0,0005Q + 0,002Q = 46000 – 26000
 0,0025Q = 20000
 Q = 20000/0,0025 = 8 millions vehicles;
 P = -0,002*8mil + 46000 = 30000 $ 58
Production theory
Giulio Zichella, Ph.D
Assistant Professor, Department of Operations Management
Today
Production theory
• Why important?
• Production function (1 factor)
• Total, Marginal, and Average product
• Law of diminishing returns
• Input combination choice (2 factors)
• Optimal input combination
• Marginal Revenue Product
• Productivity (returns to scale)

2
Today
Production theory
• Why important?
• Production function (1 factor)
• Total, Marginal, and Average product
• Law of diminishing returns
• Input combination choice (2 factors)
• Optimal input combination
• Marginal Revenue Product
• Productivity (returns to scale)

3
Optimization: why important?

An optimal decision is the choice alternative that

produces a result most consistent with
managerial objectives

Bottom line: serving the customers efficiently

• Max Value
• Max Profit
Lecture focus: Firms’
• Optimal Input
production
• Optimal Output
4
Today
Production theory
• Why important?
• Production function (1 factor)
• Total, Marginal, and Average product
• Law of diminishing returns
• Input combination choice (2 factors)
• Optimal input combination
• Marginal Revenue Product
• Productivity (returns to scale)

5
Production Function
Maximum output that can be produced for a given
amount of input
Output: quantity of a good/service
Input: what we need to produce such good/service
Example: if “output” is 10 haircuts, what are inputs?
– The hairdressers (labour)
– The owner of the salon(entrepreneur)
– The salon (land)
– Curler, hair dryer, special chairs (capital)
6
Figure 7.1?
Output: Haircuts
Input Y: Capital
Input X: Labour
Returns to Scale:
↑ Output
↑ Input Y and X

Returns to Factor X:
↑ Output
↑ Input X
7
 Definitions

Total Product: Whole output (Q) from a production

system (multiple inputs)  pyramids columns

Marginal Product (MPx, MPy): Change in output

associated with a change in a single input.

• Partial derivative of TP with respect to X or Y

• ”How does it change TP if we change only X?”

8
Definitions (2)

Average Product (APx, APy): Total product

divided by units of input employed (holding the
other input constant)

9
Figure 7.2
Input Y = capital is fixed
E.g. Seats in a showroom

When is TP at the max?

• At X = 7 (7 hairdressers)
• Note that MP is almost zero
(discrete function)
e.g. Labour/Hairdressers

When is MP at the max?

• At X = 3 (3 hairdressers)
• Every further hairdresser will
increase total haircuts, but not as
much as before

10
e.g. Labour/Hairdressers
Figure 7.3 (page 248)
TP is at its max at X3
• After this point TP decreases
• Note that MP is zero
• Boarder point between
diminishing and negative returns

MP is at its max at X1
• After this point TP increases
at a decreasing rate
• Note the S shape of TP
• Boarder point between
increasing and diminishing
returns

11
 The graph in numbers
𝑇𝑇𝑃𝑃 = 𝑄𝑄 = 30𝑋𝑋 + 11𝑋𝑋 2 − 1.1𝑋𝑋 3
then
𝜕𝜕𝜕𝜕𝜕𝜕
𝑀𝑀𝑀𝑀𝑥𝑥 = = 30 + 22𝑋𝑋 − 3.3𝑋𝑋 2
𝜕𝜕𝜕𝜕
𝑇𝑇𝑇𝑇
𝐴𝐴𝐴𝐴𝑥𝑥 = = 30 + 11𝑋𝑋 − 1.1𝑋𝑋 2
𝑋𝑋
Point X1 (between increasing and diminishing returns)
𝜕𝜕𝑀𝑀𝑀𝑀𝑥𝑥
𝑀𝑀𝑀𝑀𝑀𝑀 𝑀𝑀𝑀𝑀𝑥𝑥 = = 0 → 22 − 6.6𝑋𝑋 = 0 → 𝑋𝑋𝑋 = 3.3
𝜕𝜕𝜕𝜕
Calculate point X3 (diminishing-negative returns) home
12
The law of diminishing returns

As the quantity of a variable input increases,

the resulting rate of output increase eventually
diminishes
Bottom line: TP increases at a diminishing
rate (until eventually may decrease!)

13
 Diminishing returns
Output: Haircuts
Y = 1 capital (e.g. seat)
X: n hairdressers

Diminishing Returns
to Factor X:
• Output ↑ as Input ↑
until X = 5
• Observe the
diminishing rate of
increase in TP
14
Today
Production theory
• Why important?
• Production function (1 factor)
• Total, Marginal, and Average product
• Law of diminishing returns
• Input combination choice (2 factors)
• Optimal input combination
• Marginal Revenue Product
• Productivity (returns to scale)

15
Input combination choice

Question: Given capital and labour, how may I

produce a given output?
Answer: In many ways!

16
The math behind the solutions
to the production optimization
problem…
…is the same as the math used
in consumer theory! 

17
Solutions to the production
optimization problem.

18
Marginal Revenue Product
(MRP)
Problem: How many people (labour) shall we hire?
MRP of labour  revenue from last unit of labour

𝜕𝜕𝑇𝑇𝑇𝑇 𝜕𝜕𝑄𝑄 𝜕𝜕𝑇𝑇𝑇𝑇

𝑀𝑀𝑀𝑀𝑀𝑀𝐿𝐿 = = ∗ = 𝑀𝑀𝑀𝑀𝐿𝐿 ∗ 𝑀𝑀𝑅𝑅𝑄𝑄
𝜕𝜕𝜕𝜕 𝜕𝜕𝐿𝐿 𝜕𝜕𝑄𝑄
• MPx  how much does quantity produce change if
the labour changes? (so it is in Q)
• MRp  how much revenue changes when Q changes?
(in perfect competition, it is price P) 19
Marginal Revenue Product
(MRP)
Problem: How many people (labour) shall we hire?

Page 260: When MRP is equal to the marginal cost

of the labour unit  Let’s try in Excel!
Price per unit (Q) = 25
Labour Q Q (predicted) Marginal Product of labour Marginal Revenue Product Price of labour
1 5 5 4.5 112.5 60
2 9 9 3.5 87.5 60
3 12 12 2.5 62.5 60
4 14 14 1.5 37.5 60
5 15 15 0.5 12.5 60

20
Today
Production theory
• Why important?
• Production function (1 factor)
• Total, Marginal, and Average product
• Law of diminishing returns
• Input combination choice (2 factors)
• Isoquant, Marginal Rate of Technical Substitution
• Marginal Revenue Product
• Productivity (returns to scale)

21
Returns to Scale

Describe how output responds to a proportionate

increase in all inputs
% 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑖𝑖𝑖𝑖 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 (𝑄𝑄)
• Output elasticity:
% 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑖𝑖𝑖𝑖 𝐴𝐴𝐴𝐴𝐴𝐴 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 (𝑋𝑋 𝑎𝑎𝑎𝑎𝑎𝑎 𝑌𝑌)

If output elasticity
• 𝜀𝜀𝑞𝑞 > 1, Increasing returns to scale
• 𝜀𝜀𝑞𝑞 = 1, Constant returns to scale
• 𝜀𝜀𝑞𝑞 < 1, decreasing returns to scale
22
Thank you!
Cost theory
Giulio Zichella, Ph.D
Assistant Professor, Department of Operations Management
Today
Cost theory
• Why important?
• Short run curves
• Long run curves
• Economies of scale
• Minimum efficient scale
• Multiplant economies
• Cost-Volume-Profit Analysis

2
Today
Cost theory
• Why important?
• Short run curves
• Long run curves
• Economies of scale
• Minimum efficient scale
• Multiplant economies
• Cost-Volume-Profit Analysis

3
Cost theory: why important?
The automotive industry crisis of 2008-2010

4
Cost theory: why important?
• Low fuel efficiency (SUV)
• Over production/capacity
• Price just above variable cost
• ”Binge selling” (discounts)
• Loss of value + quality issues
• Financial default

• Stop over-production
• Price based on value
• Technological synergies
• Lowest average costs
• International markets
5
Today
Cost theory
• Why important?
• Short run curves
• Long run curves
• Economies of scale
• Minimum efficient scale
• Multiplant economies
• Cost-Volume-Profit Analysis

6
Costs functions in Short Run: FC + VC
For example:
𝑇𝐶 = 𝑄 3 − 5𝑄 2 + 14𝑄 + 10
Fixed costs = 10
Variable Costs = 𝑄 3 − 5𝑄 2 + 14𝑄
Marginal Costs = 3𝑄 2 −10𝑄 + 14
2 10
Average Total Costs =𝑄 − 5𝑄 + 14 +
𝑄

Average Variable Costs =𝑄 2 − 5𝑄 + 14

10
Average Fixed Costs =
𝑄 7
In Excel

8
Short run: cost curves (p. 295)
At Q1:
MC at minimum
Increasing  Decreasing
Fixed costs shift short run
cost curve upwards

At Q2 & Q3:
Min ATC/ AVC when = MC
Why?

9
Today
Cost theory
• Why important?
• Short run curves
• Long run curves
• Economies of scale
• Minimum efficient scale
• Multiplant economies
• Cost-Volume-Profit Analysis

10
Returns to Scale (p. 297)

Scale as output: Total costs

increase less than total
output. Then the opposite.

Scale as input: Total output

increase more than total
input. Then the opposite.
11
Long Run Plant Scale
Is it a good idea to produce with the same plant?

For a quantity 0 to Q1  Plant A

For a quantity Q1 to Q2  Plant B (larger than A)
Q*  Lowest Average Cost
12
 Long Run Plant Scale (2)
Is it a good idea to produce whatever output with the
same scale of plant?

Nope!

The optimal scale for a plant is found at the point

of minimum long run average costs (Min LRAC) 13
Minimum efficient scale (p. 300)
Minimum LRAC  Optimal plant scale

14
Today
Cost theory
• Why important?
• Short run curves
• Long run curves
• Economies of scale
• Minimum efficient scale
• Multiplant economies
• Cost-Volume-Profit Analysis

15
 Multiplants vs Single plant

In the long run:

• we aim at minimizing average costs
• we can do so by producing in several plants at min AC
– Constant, increasing or decreasing returns to scale

16
 Multiplants and Scale

In the long run:

• we aim at minimizing average costs
• we can do so by producing in several plants at min AC
Constant increasing decreasing returns to scale

17
Multiplants exercise (p.303)
Single plant (short run)  Orange Equilibrium
Multi plant (long run)  Red Equilibrium

18
Learning curves
Average cost reduction due to production experience
Bottom line: AC shifts downwards overtime

19
Economies of scale & scope

20
Today
Cost theory
• Why important?
• Short run curves
• Long run curves
• Economies of scale
• Minimum efficient scale
• Multiplant economies
• Cost-Volume-Profit Analysis

21
CVP Analysis
The Cost-Volume-Profit Analysis is an analytical
technique used to study relations among costs,
revenues, and profit
Breakeven Point:
activity level where TR = TC (Profit = 0)

Degree of operating leverage (elasticity profit to

output):
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑜𝑓𝑖𝑡
𝐷𝑂𝐿 =
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠 (𝑄)
22
CVP Analysis (2)

23
24
Thank you!
Demand Analysis
Giulio Zichella, Ph.D
Department of Operations Management
Today
Demand analysis
• Why important?
• The good news
• Utility function
• Total & Marginal utility
• Law of diminishing marginal utility
• Indifference curves & budget constraint
• Utility maximization (goods, services)
• Demand sensitivity analysis
• Elasticity types

2
Today
Demand analysis
• Why important?
• The good news
• Utility function
• Total & Marginal utility
• Law of diminishing marginal utility
• Indifference curves & budget constraint
• Utility maximization (goods, services)
• Demand sensitivity analysis
• Elasticity types

3
Demand analysis: why important?

20 Dkk

• If the canteen increases price of a Coca Cola can

to 21 Dkk, how much are sales going to
decrease?

Answer: It depends on consumers’ behavior

(preferences & choices)
4
Today
Demand analysis
• Why important? We have seen
most of these
• The good news concepts in
Production 
• Utility function
• Total & Marginal utility
• Law of diminishing marginal utility
• Indifference curves & budget constraint
• Utility maximization (goods, services)
• Demand sensitivity analysis
• Elasticity types

5
Figure 4.1?
Utility: Happiness
Y: Services (e.g. Netflix)
X: Goods (e.g. Food)
Utility function:
↑ Utility
↑ Goods & Service

Law of marginal
utility of goods:
↑ Utility as ↑ Goods
…up until a given
point 6
 What is the shape of a utility
curve?

…just like in Production

• It’s a Cobb-Douglas
• Economic meaning
• Max Utility
• With X (goods) and
Y (services)
• 𝑈 𝑋; 𝑌 = 𝑋 𝑎 ∗ 𝑌 𝑏
• Slope: Marginal Rate
7
of Substitution
 Budget Line

…just like in Production

• It’s a line (isocost)
• Economic meaning
• Units of X (goods)
and Y (services)
• I can buy (budget)
• 𝑃𝑥 ∗ 𝑋 + 𝑃𝑦 ∗ 𝑌 = 𝐵
𝑃𝑥
• Slope: Price ratio (− )
𝑃𝑦 8
 Utility Maximization

…just like in Production

• Tangency point (A)
∗ 𝑎 𝐵
• 𝑋 = ∗
𝑎+𝑏 𝑃𝑥
𝑏 𝐵
• 𝑌∗ = ∗
𝑎+𝑏 𝑃𝑦
• Economic meaning
• Max utility
• I can afford to get 9
• Point B (not max utility); Point D (too expensive)
 Utility maximization & inverse
demand
As price of service decreases
Budget line shifts to the right
Note: utility is maximized at
• Point A (Price $50)
• Pont B (Price $25)
• Point C (Price $12,5)

• Inverse demand is
determined as the solutions
to the utility maximization
problem (Points D, E, F)
10
 Utility maximization & inverse
demand shifts
As income (budget) increases
Budget line shifts to the right
Note: utility is maximized at
• Point G (Quantity 100)
• Pont H (Quantity 250)
• Point I (Quantity 400)

• Inverse demand shifts to

the right: for the same price
($25) individuals will
demand more services
(Points J, K, L) 11
Change in income: Normal vs
Inferior good

12
Change in income: Engel
Curve

13
Today
Demand analysis
• Why important?
• The good news
• Utility function
• Total & Marginal utility
• Law of diminishing marginal utility
• Indifference curves & budget constraint
• Utility maximization (goods, services)
• Demand sensitivity analysis
• Elasticity types

14
Elasticity: a definition (and its
economic importance)
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑋
𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 =
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑌

% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
𝑃𝑟𝑖𝑐𝑒 𝑃𝑜𝑖𝑛𝑡 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 =
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒

Economic Problem: If the canteen increases price of a

Coca Cola can to 21 Dkk, how
much are my sales going to
decrease?
15
 Price point elasticity: calculation

𝑃𝑛𝑒𝑤 = 21 𝐷𝑘𝑘 𝑃𝑛𝑒𝑤 − 𝑃𝑜𝑙𝑑 = 21 − 20 = +5%

𝑃𝑜𝑙𝑑 = 20 𝐷𝑘𝑘 𝑃𝑜𝑙𝑑 20

𝑄𝑛𝑒𝑤 = 270 𝑢𝑛𝑖𝑡𝑠 270 − 300

= −10%
𝑄𝑜𝑙𝑑 = 300 𝑢𝑛𝑖𝑡𝑠 300

% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 −10%
𝑃𝑟𝑖𝑐𝑒 𝑃𝑜𝑖𝑛𝑡 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 = = = −2
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 +5%
If Price Point Elasticity is:
• Lower than -1  Elastic Demand (Coca cola)
• Between -1 and zero  Inelastic Demand (Insuline)
16
 Elasticity Characteristics
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 ∆𝑄 𝑃
𝜀𝑝 = = ∗
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 ∆𝑃 𝑄
Price point (one Convenent formulas:
good, one price) • 𝜀 = 𝑃 = 𝑄−𝑄𝑚𝑎𝑥
𝑝 𝑃−𝑃 𝑄
𝑚𝑎𝑥

Arc Price (one % 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 ∆𝑄 𝑃1 + 𝑃2

𝜖𝑝 = = ∗
good, 2 prices) % 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 ∆𝑃 𝑄1 + 𝑄2
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝐴 ∆𝑄𝐴 𝑃𝐵
Cross Price 𝐸𝑥 = = ∗
(Price of two % 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 𝐵 ∆𝑃𝐵 𝑄𝐴
If 𝐸𝑥 > 0 the two goods are substitutes
different goods)
If 𝐸𝑥 < 0 the two goods are complements
If 𝐸𝑥 = 0 the two goods are not correlated
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 ∆𝑄 𝑌
𝐸𝑦 = = ∗
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐼𝑛𝑐𝑜𝑚𝑒 (𝑌) ∆𝑌 𝑄
Income If 𝐸𝑦 > 1 superior good
If 𝐸𝑦 < 0 inferior good 17
If 1 > 𝐸𝑦 > 0 normal good
Thank you!
Competitive
Markets
Kai Storm
Assistant Professor
Department of Operations Management
Today (1/2)
Competitive Markets - why should
sociologists care?
Ø Porter’s Five Forces
Ø Competitive Advantage

2
Why should we care?

Caroline

???
3
Competitive Markets

What is Market Structure?

uMarket structure describes the
competitive environment in
terms of:
Number of buyers and sellers
Potential entrants
Barriers to entry and exit
How similar the products are
Available information, …

Michael Porter
• Competitive analysis
• ”Porter’s 5 Forces” (1979)
• Competitive advantage
• Cost
• Differentiation 4
Porter’s Five Forces
Tool for analyzing competitive environment

5
Threat of New Entrants
How credible it is that new firms will enter the
market? à Barriers to entry

6
Threat of New Entrants
How credible it is that new firms will enter the
market? à Barriers to entry
Proprietary product differences
Brand Identity
Customer’s switching cost
Government policy
Capital Requirements
Economies of Scale

7
Porter’s Five Forces
Tool for analyzing competitive environment

8
Threat of Substitutes
How credible it is that customers will switch?

9
Threat of Substitutes
How credible it is that customers will switch?

Relative price-performance
Buyer’s propensity to substitute
Customer’s switching cost

10
Porter’s Five Forces
Tool for analyzing competitive environment

11
Bargaining power of buyers
Buyers: how much price sensitive?

Brand identity and

perceived quality
Buyer volume/concentration
Versus firm concentration
Buyer information
Product differences

12
Porter’s Five Forces
Tool for analyzing competitive environment

13
Suppliers’ bargaining power
Suppliers: how powerful?

Differentiation and presence of

substitute inputs
Supplier volume/concentration
versus buyer concentration
Switching costs
Importance of volume to
suppliers

14
Porter’s Five Forces
Tool for analyzing competitive environment

15
Rivalry determinants
How is intense rivalry in a given market?

Industry Growth
Product Differences
Switching costs
Exit barriers
Availability of information
16
Competitive Advantage
How can we outperform competitors?
Two Main Strategies

Differentiation

Cost Focus

17
 What does that mean for Caroline?
This is a competitive market with High: Hardly any
high rivalry! barriers to entry, low
switching costs

Low: many suppliers, little

influence on price

Low: Many
buyers, little
influence on price

High: No barriers
to exit, no
‘product’ 18
differences
Today (2/2)

• Types of competition
• Perfect competition (PC)
Ø Supply curve under PC
Ø Cost curves (short run and long run)
Ø Equilibrium & profit maximization

19
Different types of competition

Degree of
Market
# preferences Share
suppliers Top 4
Non Low High

1 100%

2 100%
80-90%
Few
70-80%
Many > 0%

20
Degree of preferences
• How possible is it to differentiate products?

Ø Low degree: Homogeneous products

(commodities, e.g. raw materials)

Ø Mid degree: e.g. breakfast cereals,

simple services

Ø High degree: Heterogeneous products

(unique, e.g. car, complex services) 21
Different types of competition

Degree of
Market
# preferences Share
suppliers Top 4
Non Low High
Monopoly 100%
1 Partly monopoly

2 Duopoly
Diff. duopoly 100%
Partly duopoly
Diff. oligopoly 80-90%
Few Oligopoly
Partly oligopoly Monopolistic 70-80%
competition
Many PC > 0%

22
Today: Perfect competition (PC)

Degree of
Market
# preferences Share
suppliers Top 4
Non Low High
Monopoly 100%
1 Partly monopoly

2 Duopoly
Diff. duopoly 100%
Partly duopoly
Diff. oligopoly 80-90%
Few Oligopoly
Partly oligopoly Monopolistic 70-80%
competition
Many PC > 0%

23
Perfect competition

Ø Supply curve(s)
Ø Cost curves (short run and long run)
Ø Equilibrium & profit maximization

24
PC supply curve: 1 firm
40

Supply 1 firm
35 75; 35

30 62,5; 30

25 50; 25
Price

20 37,5; 20
(25 − 10)
𝑃 = 𝑀𝐶 = 5 + 𝑄
15 25; 15 (50 − 12,5)

10 12,5; 10
𝑀𝐶 = 5 + 0,4𝑄
5 0; 5

0
0 12,5 25 37,5 50 62,5 75 87,5
Quantity (1 Firm)

25
PC supply curve: 1 firm
45

40

35

30

25
Price

20

15

10

0
0 12,5 25 37,5 50 62,5 75 87,5 100
Quantity

1 firm

26
PC supply curve: 2 firms
45

40

35

30

25
Price

20

15

10

0
0 12,5 25 37,5 50 62,5 75 87,5 100
Quantity

1 firm 2 firms

27
PC supply: 1000 identical firms
40

35 75000; 35

30 62500; 30

25 50000; 25
Price

20 37500; 20
(25 − 10)
𝑀𝐶 = 5 + 𝑄
15 25000; 15
(50000 − 12500)
or
10
0,4
12500; 10
𝑀𝐶 = 5 + 𝑄
1000
5 0; 5

0
0 12500 25000 37500 50000 62500 75000 87500
Quantity (1000 Firms)

28
Profit maxmization

29
Profit maximization with marginal
analysis
We know (also from previous classes) that there are 2 breakeven
points at: TR = TC

So – where to produce???

Finding optimal points of production is easiest with marginal

analysis = we look at the marginal instead of the total.
(Read: ”We use the derivative of different functions rather than the original
function itself”)

2 conditions for profit maximization:

1) MR = MC
(Read: ”The additional revenue from selling 1 more unit needs to be equal
to the additional cost for producing that one unit for profit maximization”)
2) Profits must always be decreasing beyond the point where MR
= MC 30
Profit maxmization in competitive
markets

31
Profit maximization in competitive
markets

ATC
P

++

32
Profit maxization in competitive
markets

Important: Note that we

assume the following:

Assumptions SR:
Profits!
Firms cannot
*immediately* exit (or
enter) the market
AT
++
Assumptions LR:
Firms can freely enter or
AVC exit the market.

33
PC Equilibrium: Short Run
Equilibrium in the short run (SR):MR=P=MC. P>AVC

Market à Price maker Firm à Price taker

Market Firm
$ Supply = Σmc $ Supply = MC
AVC
P* P*
Contribution Firm
AVC*
Demand
Market
Demand
Q* Q q* q 34
PC Equilibrium: Short Run
Equilibrium in the short run (SR):MR=P=MC. P<AVC

Note that P needs to be > AVC! In PC in Firm à Price taker

the SR, MC=MR=firm’s supply curve AS
LONG AS P>AVC. Firm
Otherwise it should stop producing.
$ Supply = MC
Some call this the shutdown rule. Let’s
see what happens if P is below AVC, at AVC
Pnew: According to the rule, the company
should STOP production immediately. X
Why? Firm
Because each unit it produces will create
losses (VC). In this case, it is better to
Demand
Pnew X
take only the FC as a loss and not
increase the damage by producing units
(meaning adding more VC) on top of that.
qnew q 35
PC Equilibrium: Long Run
In the LR, MR=P=MC=minLAC

Market à Price maker Firm à Price taker

LMC
$ S1 $
Positive profit
attracts more
LAC
firms S2
P1*
P2*
This continues
until there is no
more profit to get

Q1* Q2* Q q2* q1* q

36
Key takeaways
Competetive markets mean ruthless competition!

Firms are price-takers.

1) Total profit is max. when:
Marginal profit= MR – MC =0
2) Profit maximizing level in perfect
competition: P = MC = MR =AR

3) In the short run, more than

“normal” rates of return are MR. MC AR P
feasible –> economic profits
4) In the long run, economic profits
attract competitors to enter and
economic profits will dissipate

37
Thank you!
Competitive
Markets
Kai Storm
Assistant Professor
Department of Operations Management
Today (1/2)
Competitive Markets - why should
sociologists care?
Ø Porter’s Five Forces
Ø Competitive Advantage

2
Why should we care?

Caroline

???
3
Competitive Markets

What is Market Structure?

uMarket structure describes the
competitive environment in
terms of:
Number of buyers and sellers
Potential entrants
Barriers to entry and exit
How similar the products are
Available information, …

Michael Porter
• Competitive analysis
• ”Porter’s 5 Forces” (1979)
• Competitive advantage
• Cost
• Differentiation 4
Porter’s Five Forces
Tool for analyzing competitive environment

5
Threat of New Entrants
How credible it is that new firms will enter the
market? à Barriers to entry

6
Threat of New Entrants
How credible it is that new firms will enter the
market? à Barriers to entry
Proprietary product differences
Brand Identity
Customer’s switching cost
Government policy
Capital Requirements
Economies of Scale

7
Porter’s Five Forces
Tool for analyzing competitive environment

8
Threat of Substitutes
How credible it is that customers will switch?

9
Threat of Substitutes
How credible it is that customers will switch?

Relative price-performance
Buyer’s propensity to substitute
Customer’s switching cost

10
Porter’s Five Forces
Tool for analyzing competitive environment

11
Bargaining power of buyers
Buyers: how much price sensitive?

Brand identity and

perceived quality
Buyer volume/concentration
Versus firm concentration
Buyer information
Product differences

12
Porter’s Five Forces
Tool for analyzing competitive environment

13
Suppliers’ bargaining power
Suppliers: how powerful?

Differentiation and presence of

substitute inputs
Supplier volume/concentration
versus buyer concentration
Switching costs
Importance of volume to
suppliers

14
Porter’s Five Forces
Tool for analyzing competitive environment

15
Rivalry determinants
How is intense rivalry in a given market?

Industry Growth
Product Differences
Switching costs
Exit barriers
Availability of information
16
Competitive Advantage
How can we outperform competitors?
Two Main Strategies

Differentiation

Cost Focus

17
 What does that mean for Caroline?
This is a competitive market with High: Hardly any
high rivalry! barriers to entry, low
switching costs

Low: many suppliers, little

influence on price

Low: Many
buyers, little
influence on price

High: No barriers
to exit, no
‘product’ 18
differences
Today (2/2)

• Types of competition
• Perfect competition (PC)
Ø Supply curve under PC
Ø Cost curves (short run and long run)
Ø Equilibrium & profit maximization

19
Different types of competition

Degree of
Market
# preferences Share
suppliers Top 4
Non Low High

1 100%

2 100%
80-90%
Few
70-80%
Many > 0%

20
Degree of preferences
• How possible is it to differentiate products?

Ø Low degree: Homogeneous products

(commodities, e.g. raw materials)

Ø Mid degree: e.g. breakfast cereals,

simple services

Ø High degree: Heterogeneous products

(unique, e.g. car, complex services) 21
Different types of competition

Degree of
Market
# preferences Share
suppliers Top 4
Non Low High
Monopoly 100%
1 Partly monopoly

2 Duopoly
Diff. duopoly 100%
Partly duopoly
Diff. oligopoly 80-90%
Few Oligopoly
Partly oligopoly Monopolistic 70-80%
competition
Many PC > 0%

22
Today: Perfect competition (PC)

Degree of
Market
# preferences Share
suppliers Top 4
Non Low High
Monopoly 100%
1 Partly monopoly

2 Duopoly
Diff. duopoly 100%
Partly duopoly
Diff. oligopoly 80-90%
Few Oligopoly
Partly oligopoly Monopolistic 70-80%
competition
Many PC > 0%

23
Perfect competition

Ø Supply curve(s)
Ø Cost curves (short run and long run)
Ø Equilibrium & profit maximization

24
PC supply curve: 1 firm
40

Supply 1 firm
35 75; 35

30 62,5; 30

25 50; 25
Price

20 37,5; 20
(25 − 10)
𝑃 = 𝑀𝐶 = 5 + 𝑄
15 25; 15 (50 − 12,5)

10 12,5; 10
𝑀𝐶 = 5 + 0,4𝑄
5 0; 5

0
0 12,5 25 37,5 50 62,5 75 87,5
Quantity (1 Firm)

25
PC supply curve: 1 firm
45

40

35

30

25
Price

20

15

10

0
0 12,5 25 37,5 50 62,5 75 87,5 100
Quantity

1 firm

26
PC supply curve: 2 firms
45

40

35

30

25
Price

20

15

10

0
0 12,5 25 37,5 50 62,5 75 87,5 100
Quantity

1 firm 2 firms

27
PC supply: 1000 identical firms
40

35 75000; 35

30 62500; 30

25 50000; 25
Price

20 37500; 20
(25 − 10)
𝑀𝐶 = 5 + 𝑄
15 25000; 15
(50000 − 12500)
or
10
0,4
12500; 10
𝑀𝐶 = 5 + 𝑄
1000
5 0; 5

0
0 12500 25000 37500 50000 62500 75000 87500
Quantity (1000 Firms)

28
Profit maxmization

29
Profit maximization with marginal
analysis
We know (also from previous classes) that there are 2 breakeven
points at: TR = TC

So – where to produce???

Finding optimal points of production is easiest with marginal

analysis = we look at the marginal instead of the total.
(Read: ”We use the derivative of different functions rather than the original
function itself”)

2 conditions for profit maximization:

1) MR = MC
(Read: ”The additional revenue from selling 1 more unit needs to be equal
to the additional cost for producing that one unit for profit maximization”)
2) Profits must always be decreasing beyond the point where MR
= MC 30
Profit maxmization in competitive
markets

31
Profit maximization in competitive
markets

ATC
P

++

32
Profit maxization in competitive
markets

Important: Note that we

assume the following:

Assumptions SR:
Profits!
Firms cannot
*immediately* exit (or
enter) the market
AT
++
Assumptions LR:
Firms can freely enter or
AVC exit the market.

33
PC Equilibrium: Short Run
Equilibrium in the short run (SR):MR=P=MC. P>AVC

Market à Price maker Firm à Price taker

Market Firm
$ Supply = Σmc $ Supply = MC
AVC
P* P*
Contribution Firm
AVC*
Demand
Market
Demand
Q* Q q* q 34
PC Equilibrium: Short Run
Equilibrium in the short run (SR):MR=P=MC. P<AVC

Note that P needs to be > AVC! In PC in Firm à Price taker

the SR, MC=MR=firm’s supply curve AS
LONG AS P>AVC. Firm
Otherwise it should stop producing.
$ Supply = MC
Some call this the shutdown rule. Let’s
see what happens if P is below AVC, at AVC
Pnew: According to the rule, the company
should STOP production immediately. X
Why? Firm
Because each unit it produces will create
losses (VC). In this case, it is better to
Demand
Pnew X
take only the FC as a loss and not
increase the damage by producing units
(meaning adding more VC) on top of that.
qnew q 35
PC Equilibrium: Long Run
In the LR, MR=P=MC=minLAC

Market à Price maker Firm à Price taker

LMC
$ S1 $
Positive profit
attracts more
LAC
firms S2
P1*
P2*
This continues
until there is no
more profit to get

Q1* Q2* Q q2* q1* q

36
Key takeaways
Competetive markets mean ruthless competition!

Firms are price-takers.

1) Total profit is max. when:
Marginal profit= MR – MC =0
2) Profit maximizing level in perfect
competition: P = MC = MR =AR

3) In the short run, more than

“normal” rates of return are MR. MC AR P
feasible –> economic profits
4) In the long run, economic profits
attract competitors to enter and
economic profits will dissipate

37
Thank you!
Fall 2021

Monopoly
Kai Storm
Assistant Professor
Department of Operations Management
Today
• Monopoly!
Ø Basic characteristics & examples
Ø Profit maximization
Ø Social cost
§ Underproduction, higher prices
§ Deadweight Loss
§ Wealth Transfer Problem

Ø Natural Monopoly

• Monopoly Regulation
Ø Price Ceilings
Ø Antitrust

2
Today
• Monopoly
Ø Basic characteristics & examples
Ø Profit maximization
Ø Social cost
§ Underproduction, higher prices
§ Deadweight Loss
§ Wealth Transfer Problem

Ø Natural Monopoly

• Monopoly Regulation
Ø Price Ceilings
Ø Antitrust

3
Today: Monopoly

Single seller of a highly differentiated product

Degree of
Market
# preferences Share
suppliers Top 4
Non Low High
Monopoly 100%
1 Partly monopoly

2 Duopoly
100%
Diff. duopoly
Partly duopoly
Diff. oligopoly 80-90%
Few Oligopoly
Partly oligopoly Monopolistic 70-80%
competition
Many PC > 0%
4
 Porter’s Five Forces: Monopoly
Low: High barriers to entry, high switching costs

Low: many buyers,

High: 1 supplier, no influence on price
influence on price (monopoly)

Low Rivalry:
Low: High product • Imperfect information
differentiation, • Profit in long run
imperfect substitutes 5
Examples of Monopolies

6
7
Today
• Monopoly
Ø Basic characteristics & examples
Ø Profit maximization
Ø Social cost
§ Underproduction, higher prices
§ Deadweight Loss
§ Wealth Transfer Problem

Ø Natural Monopoly

• Monopoly Regulation
Ø Price Ceilings
Ø Antitrust

8
Monopoly: Short Run
Firm = Market = Price maker
€
MC AVC

P*
Contribution
AVC*
Demand

MR
Q* Q 9
PC vs Monopoly: ↓Q, ↑P
PC firm sets MR=MC! (P=MR)
P This gives the quantity QPC and the price PPC

Monopolist also sets MR=MC!

This gives the price PM and quantity QM
MC
PM

PPC MRPC

MRM
Demand

Q
QM QPC 10
Today
• Monopoly
Ø Basic characteristics & examples
Ø Profit maximization
Ø Social cost
§ Underproduction, higher prices
§ Deadweight Loss
§ Wealth Transfer Problem

Ø Natural Monopoly

• Monopoly Regulation
Ø Price Ceilings
Ø Antitrust
Ø Market Niches
11
PC vs Monopoly: PC
equilibrium
P
Consumer Surplus (CS) is the area between
the demand function and the price!

Social surplus is the sum of CS and PS!

MC
CSPC

PPC Producer Surplus (PS)

is the area between the
PSPC price and the MC curve!

Demand

Q
QPC
12
PC vs Monopoly:
Underproduction
P
Consumer Surplus (CS) is the area between
the demand function and the price!

Social surplus is the sum of CS and PS!

CSM
MC
PM

PSM Producer Surplus (PS)

is the area between the
price and the MC curve!

Demand
MR
Q
QM
13
PC vs Monopoly: DWL
P
Deadweight loss (DWL) is the difference in
social surplus of PC and monopoly!

MC
PM

PPC

MR
Demand

Q
QM QPC
14
Let’s look at an example

15
PC vs Monopoly: DWL Exercise

100 small companies have identical marginal

cost functions: mc = 2 + Q
Market demand is: P = 23 – 0.01Q

What is the perfect competitive price?

What if someone bought all the small
companies and acted like a monopolist?
What is CS, PS and DWL in the two cases?
Getting to the market supply
We have a market supply of MC = 2 + 0,01Q
But why?

Well, we know that 100 small companies have identical marginal cost
functions of MC = 2 + Q. We also know that we need the market supply to
find the equilibrium…

So, we take all MC curves together to get the market supply :)

This gives us MC = 2 + 0,01Q. This procedure is in more detail explained
in the competitive market slides and in the book!

17
PC vs Monopoly: Perfect
Competition
!"
23 − 12,5 ∗ (1050)
P 𝐶𝑆 = = 5512,5
2
Pmax = 23 !"
12,5 − 2 ∗ (1050)
𝑃𝑆 = = 5512,5
2

Supply: MC = 2 + 0,01Q
CSPC

PPC = 12,5

PSPC

Demand: 23 – 0,01Q
2
Q
QPC = 1050 18
PC vs Monopoly: Monopoly

#
23 − 16 ∗ (700)
P 𝐶𝑆 = = 2450
2
Pmax = 23 #
700 ∗ 9 − 2
𝑃𝑆 = 16 − 9 ∗ 700 + = 7350
2

CSM Supply: MC = 2 + 0,01Q

PM= 16

PSM

9
Demand: 23 – 0,01Q
MR = 23 – 0,02Q
2
Q
QM = 700 19
PC vs Monopoly: DWL

P
#
(1050 − 700) ∗ 16 − 9
𝐷𝑊𝐿 = = 1225
Pmax = 23 2

CSM Supply: MC = 2 + 0,01Q

PM= 16

PSM DWLM

9
Demand: 23 – 0,01Q

2
Q
QM = 700 QPC = 1050 20
The wealth transfer problem
The book defines the wealth transfer problem as ”an unwarranted transfer of wealth
measured by the transformation of consumer surplus into producer surplus” (p.457)

• What does that mean? Monopolists control market price and market output! They
can limit production, hence creating deadweight loss of what would otherwise have
been mutually beneficial trade (dark blue triangle in Figure 12.2 on p. 456).
• But monopolists also seek to “eat up” as much of the remaining consumer surplus
as possible. Why? If a consumer would have been willing and able to pay more for
the good, that revenue is ”lost” to the monopolist if they charge a lower price.
• By controlling price and quantity in the market, our monopolist can transform some
of the consumer surplus into producer surplus (and in monopolies there is only one
producer). This is the light blue rectangle on p. 456. And this is what we mean by
wealth transfer problem J It is a problem because monopolists use their market
power to realize economic profits – to the detriment of consumers who loose ‘twice’
(first from the DWL and then from a reduced consumer surplus).
21
Today
• Monopoly
Ø Basic characteristics & examples
Ø Profit maximization
Ø Social cost
§ Underproduction, higher prices
§ Deadweight Loss
§ Wealth Transfer Problem

Ø Natural Monopoly

• Monopoly Regulation
Ø Price Ceilings
Ø Antitrust
Ø Market Niches
22
Social Benefits of Monopoly:
Natural Monopoly
Due to extremely high fixed costs,
only one firm can exploit economies of scale

23
Natural Monopoly: Long Run
One firm makes a profit in Natural monopoly
€
LMC LAC

P*
Profit
LAC*
Demand

MR
Q* Q 24
Natural Monopoly: Long Run
Two firms would make a loss
€
LMC LAC
LAC’
Loss
P*

Demand

MR

½Q* Q* Q 25
Social Benefits of Monopoly: Natural Monopoly

• In a natural monopoly we find a positive profit – but only if

one firm supplies the whole market.
• There is “no room” for more firms than this one firm (the
monopolist).

• The long run average costs (LAC) are higher than the price
if there is more than one firm producing and selling on the
market.

• Keyword: Economies of scale

26
Today
• Monopoly
Ø Basic characteristics & examples
Ø Profit maximization
Ø Social cost
§ Underproduction, higher prices
§ Deadweight Loss
§ Wealth Transfer Problem

Ø Natural Monopoly

• Monopoly Regulation
Ø Price Ceilings
Ø Antitrust

27
Monopoly Regulation: Price ceiling
P1 original price, P2 price ceiling

Profit no ceiling
Profit with ceiling

28
Monopoly Regulation: European
Antitrust
• High market power (remember 5-forces?)
Ø High prices, lower output
Ø Anticompetitive conduct
Ø Monopolies, oligopolies etc.

29
Thank you
Monopolistic Competition
Giulio Zichella, Ph.D
Department of Operations Management
Today
• A quick recap of inverse demand shifts
• Monopolistic Competition
 Basic characteristics & examples
 Profit maximization
 Short Run
 Long Run
 Excel Exercise

2
Today
• A quick recap of inverse demand shifts
• Monopolistic Competition
 Basic characteristics & examples
 Profit maximization
 Short Run
 Long Run
 In-class exercise

3
Why are we interested in monopolistic
competition?

• Many markets are under

monopolistic competition
• (Imperfect) Competition is key
But what does competition do to
demand? Let’s review it 
4
 Inverse Demand Function

Price (€)

P = 80 - 0,10 *Q
80 Maximum price
P-max

Maximum quantity
800 Q
Q-max 5
Demand Function
Only the maximum price and the maximum quantity
determines the location of a linear demand function

Intuition:
P-max expresses the general willingness to pay –
when this increase P-max will increase without Q-
max being affected.
Q-max expresses the size of the market in terms of
how many units will be demanded if the firm starts
giving their product away (or sells it extremely
cheap) 6
Demand Shifts: Increased
Competition
€

Price of substitute decreases

This is often described as
”increased competition”
This causes the inverse demand
Curve to become flatter
 (P-max moves down)

Q
7
 Demand Shifts: Increased
Competition (2)
€

Price of substitute decreases

Pmax1 Size of the market decreases

This causes the inverse demand

Curve to shift downwards
Pmax2
 (Both P-max and Q-max
move down)

Qmax2 Qmax1 Q
8
Why bothering?
Demand shifts in the long run are
an essential element of Monopolistic Competition

9
Today
• A quick recap of inverse demand shifts
• Monopolistic Competition
 Basic characteristics & examples
 Profit maximization
 Short Run
 Long Run
 In-class exercise

10
Monopolistic Competition

Many sellers of differentiated products

Degree of
Market
# preferences Share
suppliers Top 4
Non Low High
Monopoly 100%
1 Partly monopoly

2 Duopoly
Diff. duopoly 100%
Partly duopoly
Diff. oligopoly 80-90%
Few Oligopoly
Partly oligopoly
Monopolistic
70-80%
Many competition
PC > 0%
11
 Porter’s Five Forces: Monopolistic
Competition
High: Low barriers to entry

Low: many suppliers, Low: many buyers, no

no influence on price influence on price

Medium Rivalry:
Low: High product • Perfect information
differentiation, • Profit in Long Run
imperfect substitutes 12
These conditions are more realistic
than PC and Monopoly.

Under Monopolistic Competition,

suppliers compete based on how
much demand becomes “flatter”
overtime
13
Examples of Markets Monopolistic
Competition

14
Today
• A quick recap of inverse demand shifts
• Monopolistic Competition
 Basic characteristics & examples
 Profit maximization
 Short Run
 Long Run
 In-class exercise

15
Monopolistic Competition: Short Run

SR equilibrium, P>MC>AC

€ MC AC

P1*
Profit1
LAC1*
Demand1

MR1
16
Q 1* Q
Monopolistic Competition: Long Run
LR equilibrium, P=AC, 𝜋𝜋 = 0
1) Profit attracts
firms in the
€ LMC LAC market,
which will
supply
P1* substitutes

2) This pushes the curves

P2=C2* downwards
(both inverse demand and MR)
LAC1*
3) This process continues
until there is on average no
more profit

17
Q 2* Q 1* Q
Monopolistic Competition: Long Run

LR Scenario 1: High Price, Low Output, P=AC, 𝜋𝜋 = 0

€ LMC LAC

𝑃𝑃𝐻𝐻𝐻𝐻

Demand2

MR2
18
𝑄𝑄𝐿𝐿𝐿𝐿𝐿𝐿 Q
Monopolistic Competition: Long Run

LR Scenario 2: Low Price, High Output P=AC, 𝜋𝜋 = 0

€ LMC LAC

𝑃𝑃𝐿𝐿𝐿𝐿𝐿𝐿

Demand2

MR2
19
𝑄𝑄𝐻𝐻𝐻𝐻 Q
Monopolistic Competition: Recap

A mixture of monopoly and perfect competition –

which is the reason for the mixed name
Firm optimizes as if it was a MONOPOLIST

The market mechanisms are as under

COMPETITION
In principle same assumptions as under PC
with just the one exception, that we are dealing
with heterogeneous products (differentiated
products) 20
Monopolistic Competition: Recap (2)

Firms compete by differentiating themselves,

and by this build consumer preferences
towards their products
In theory there is no profit on average on
markets in monopolistic competition – but
the firms who focus on differentiation can
earn profit even in the long run

21
Today
• A quick recap of inverse demand shifts
• Monopolistic Competition
 Basic characteristics & examples
 Profit maximization
 Short Run
 Long Run
 In-class exercise

22
Monopolistic Competition: Exercise (from book)

𝑇𝑇𝑇𝑇 = 20000𝑄𝑄 − 15,6𝑄𝑄2

𝑃𝑃 = 20000 − 15,6𝑄𝑄
𝑀𝑀𝑅𝑅 = 20000 − 31,2𝑄𝑄
𝑇𝑇𝑇𝑇 = 400000 + 4640𝑄𝑄 + 10𝑄𝑄 2
400000
𝐴𝐴𝐴𝐴𝐴𝐴 = + 4640 + 10𝑄𝑄
𝑄𝑄
𝑀𝑀𝑀𝑀 = 4640 + 20𝑄𝑄
Monopolistic Competition: Short Run

𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 1: 𝑀𝑀𝑀𝑀 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀

𝑀𝑀𝑅𝑅 = 𝑀𝑀𝑀𝑀
𝑀𝑀𝑀𝑀 = 4640 + 20𝑄𝑄
𝑀𝑀𝑀𝑀 = 20000 − 31,2𝑄𝑄
4640 + 20𝑄𝑄 = 20000 − 31,2𝑄𝑄
𝑄𝑄 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 300
𝑃𝑃𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 20000 − 15,6 300 = $15320

24
 Monopolistic Competition: Short Run

Monopolistic Competition: Short Run Equilibrium

25000

20000

𝑃𝑃𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = $15320
15000

Demand SR
$

MR
10000
MC

5000

0
0 100 200 300 400 500 600 700
𝑄𝑄𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 300 Quantity (Q)

25
Long Run: High price, Low Q
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 2: 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑎𝑎𝑎𝑎 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑!
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂: 𝐻𝐻𝐻𝐻𝐻𝐻𝐻 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃, 𝐿𝐿𝐿𝐿𝐿𝐿 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 = 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐴𝐴𝐴𝐴
400000
−15,6 = 10 −
𝑄𝑄 2
𝑄𝑄 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 125
400000
𝑃𝑃𝑀𝑀𝑀𝑀𝑙𝑙𝑟𝑟 = 𝐴𝐴𝐴𝐴 = + 4640 + 10 ∗ 125
125
𝑃𝑃𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = $9090 26
 Long Run: High price, Low Q

LR Demand (P) shifts until it is tangent to ATC: Zero profit

25000

20000

15000

Demand SR
$

ATC
10000 125 Demand LR
𝑷𝑷𝑴𝑴𝑴𝑴𝒍𝒍𝒓𝒓 = $𝟗𝟗𝟗𝟗𝟗𝟗𝟗𝟗
200
300
5000 400
500
572,7178029

0
0 100 200 300 400 500 600 700
Quantity
𝑸𝑸𝑴𝑴𝑴𝑴𝒍𝒍𝒓𝒓 = 𝟏𝟏𝟏𝟏𝟏𝟏

27
 Long Run vs Short Run
Monopolistic Competition: LR vs SR Equilibrium
25000

20000

𝑷𝑷𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴 = $𝟏𝟏𝟏𝟏𝟏𝟏𝟏𝟏𝟏𝟏
15000
Demand SR
ATC
$

MR
10000
MC
𝑷𝑷𝑴𝑴𝑴𝑴𝒍𝒍𝒓𝒓 = $𝟗𝟗𝟗𝟗𝟗𝟗𝟗𝟗
Demand LR

5000

0
0 100 200 300 400 500 600 700

𝑸𝑸𝑴𝑴𝑴𝑴𝒍𝒍𝒓𝒓 = 𝟏𝟏𝟏𝟏𝟏𝟏 𝑸𝑸𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴 = 𝟑𝟑𝟑𝟑𝟑𝟑

28
Long Run: Low price, High Q
The exercise on the book makes the following
assumptions:
• Slope of Demand do not change SR to LR
• Cost structure do not change
• Outcome: LR high price, low output
…however, it is more realistic that demand
would simply become more flat as
competitors enter the market
• Outcome: LR low price, high output 29
Long Run: Low price, High Q
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝑅𝑅𝑅𝑅𝑅𝑅: 𝑃𝑃 = 𝑀𝑀𝑀𝑀 = 𝑀𝑀𝑀𝑀 = 𝐴𝐴𝐴𝐴!
𝑀𝑀𝑀𝑀 = (𝑚𝑚𝑚𝑚𝑚𝑚)𝐴𝐴𝐴𝐴
400000
4640 + 20𝑄𝑄 = + 4640 + 10𝑄𝑄
𝑄𝑄
𝑄𝑄𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 200

𝑀𝑀𝑀𝑀𝑙𝑙𝑟𝑟
400000
𝑃𝑃 = 𝐴𝐴𝐴𝐴 = + 4640 + 10 ∗ 200
200
𝑃𝑃𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = $8640
30
 Long Run: Low price, High Q
Monopolistic Competition: LR Equilibrium (low price, high Q)
25000

20000

15000
Demand SR
ATC
€

MR
10000
MC
𝑷𝑷𝑴𝑴𝑴𝑴𝒍𝒍𝒓𝒓 = $𝟖𝟖𝟖𝟖𝟖𝟖𝟖𝟖
P=MR=MC=AC

5000

0
0 100 200 300 400 500 600 700

𝐐𝐐𝐌𝐌𝐌𝐌𝐥𝐥𝐫𝐫 = 𝟐𝟐𝟐𝟐𝟐𝟐 Quantity

31
Recap of Monopolisitic Competition

D1  Short Run – D2, D3  Long Run

D2  High price, low Q
D3  low price, high Q

32
Thank you 
ME1: Oligopoly
Giulio Zichella, Ph.D
Assistant Professor, Department of Operations Management
 Before we start
• Spare class: Consolidation (after game
theory)
• Feel free to suggest topics!
• Office hours
Today
• Oligopoly
 Basic characteristics & examples
 Equilibria
 Sweezy Model
 Kinked Demand
 In-class Exercise
 Cartels and Collusion
• Market concentration index
 Herfindahl Index

3
Today
• Oligopoly
 Basic characteristics & examples
 Equilibria
 Sweezy Model
 Kinked Demand
 In-class Exercise
 Cartels and Collusion
• Market concentration index
 Herfindahl Index

4
Oligopoly

Few (powerful) sellers of homogeneous and

heterogeneous products
Degree of
Market
# preferences Share
suppliers Top 4
Non Low High
Monopoly 100%
1 Partly monopoly

2 Duopoly
Diff. duopoly 100%
Partly duopoly
Diff. oligopoly 80-90%
Few Oligopoly
Partly oligopoly 70-80%
Monopolistic
Many PC competition > 0%
5
Examples of Oligopolies

6
 Porter’s Five Forces: Oligopoly
Low: High barriers to entry (e.g. capital intensive)

Low: many suppliers, Low: many buyers, no

no influence on price influence on price

Low Rivalry:
High: low product • Imperfect information
differentiation, • Profit in Long Run
imperfect substitutes 7
Today
• Oligopoly
 Basic characteristics & examples
 Equilibria
 Sweezy Model
 Kinked Demand
 In-class Exercise
 Cartels and Collusion
• Market concentration index
 Herfindahl Index

8
Oligopoly equilibria

Several models describe oligopoly outcomes

‒Kinked demand (Sweezy)

‒Cartels
‒Cournot
‒Stackelberg
Not included in the syllabus!
‒Bertrand
‒Price leadership

9
Today
• Oligopoly
 Basic characteristics & examples
 Equilibria
 Sweezy Model
 Kinked Demand
 In-class Exercise
 Cartels and Collusion
• Market concentration index
 Herfindahl Index

10
Kinked Demand
Under uncertainty, prices tend to be stable

• Theory developed by Paul Sweezy

• GENERAL OLIGOPOLY: If one firm changes its
price, the outcome of such move is unknown.
Other companies can choose to follow or not – or
maybe even move opposite…
• The kinked demand arises when the competitors
mimic a price decrease but not a price increase.
• Implication is a kinked demand function and a
discontinuous MR function
11
Kinked Demand
Before Kink (Q)  elastic demand, after kink  inelastic

12
Kinked Demand: example

10
P = 7 - 0,025Q, for 0<Q≤40
MR = 7 - 0,05Q, for 0<Q≤40

7 MC2 = 4 + 0,02Q
6 MC1 = 3 + 0,02Q
5
4 MC3 = 1 + 0,02Q
3
P = 10 - 0,1Q, for 40<Q
2 MR = 10 - 0,2Q, for 40<Q
1

Q
40 50 100 13
10 min break!
Today
• Oligopoly
 Basic characteristics & examples
 Profit maximization
 Sweezy Model
 Kinked Demand
 In-class Exercise
 Cartels and Collusion
• Market concentration indexes
 Herfindahl Index

15
Kinked Demand: exercise
• Current price is 160, at which the firm serves 40
customers (Q=40)
• If the firm increases its price by $1 it looses one
customer
• If the firm decreases its price by $2 it gains one
more customer

• Find the demand function and the MR-function

• For which MCs will the current price of $160 be
optimal?
• Why is there a kink?
16
Kinked Demand: exercise (2)
• If the firm increases its price by $1 it looses one
customer
∆𝑃 +1
= = −1
∆𝑄 −1
160 = 𝑃𝑚𝑎𝑥 − 40

𝑃𝑚𝑎𝑥 = 200

P = 200 − 𝑄

𝑀𝑅 = 200 − 2𝑄
𝑎𝑡 𝑡ℎ𝑒 𝑘𝑖𝑛𝑘, 𝑀𝑅 = 200 − 2 ∗ 40 = 120 17
Kinked Demand: exercise (3)

• If the firm decreases its price by $2 it gains one

more customer
∆𝑃 −2
= = −2
∆𝑄 +1

160 = 𝑃𝑚𝑎𝑥 − 2 ∗ 40

𝑃𝑚𝑎𝑥 = 240

P = 240 − 2𝑄

𝑀𝑅 = 240 − 4𝑄
𝑎𝑡 𝑡ℎ𝑒 𝑘𝑖𝑛𝑘, 𝑀𝑅 = 240 − 4 ∗ 40 = 80 18
Kinked Demand: exercise (4)

19
Kinked Demand: conclusion
Leads to a tactical static situation
 observes very few price changes in this
type of markets

= kinked demand

Often locked for longer periods of time.

No firms gain from raising (or lowering) their prices

before costs have changed substantially

The most cost efficient can in the end gain market

shares, when the less cost efficient eventually raises
their price.
20
Today
• Oligopoly
 Basic characteristics & examples
 Profit maximization
 Sweezy Model
 Kinked Demand
 In-class Exercise
 Cartels and Collusion
• Market concentration indexes
 Herfindahl Index
 NAICS system
21
 Cartels and collusion

Oligopoly firms (in)formally collaborate to charge

monopoly prices/quantities and share monopoly
profits

• Overt and Covert Agreements

 Overt agreements create cartels that operate like
monopoly.

 Collusion exists when firms reach secret, covert

agreements.

22
Cartels and collusion (2)

• Enforcement Problem
 Cartels are typically short-lived because
coordination problems often lead to cheating.

 Cartel subversion can be extremely profitable.

 Detecting the source of secret price

concessions can be extremely difficult.

23
 Cartels and collusion (3)
2016
NHH, a construction company,
settled in court a case of bid rigging
(acting as a cartel, to control prices
in bids for public/private contracts)

2012
Mayor real estate agents
VS
(controlling boligsiden.dk)
colluded to boycott boliga.dk
Sources: Danish Competition and Consumer authority 24
https://www.en.kfst.dk/nyheder/kfst/english/news/2016/20161206-construction-cartel-ends-in-withdrawal-of-charges/
https://www.en.kfst.dk/nyheder/kfst/english/decisions/20120125-anticompetitive-boycott-agreements-in-the-real-estate-business/
Cartels and collusion (4)

Centralized Cartel

• The “competing” companies act like if they were

ONE big company.

• The cartel MC curve is the horizontal aggregation

of all the cartel members’ MC curves (just like the
market supply under PC)

• The cartel sets aggregated MC = MR of the market

demand, just like if they acted under a monopoly

25
Cartels and collusion (5)

Centralized Cartel

26
Cartels and collusion (4)

Market Sharing Cartel

• The “competing” firms share the market

geographically between them. This way each firm
gets its own little local monopoly.

• Each firm is sole supplier to its local market.

• With no close substitutes within the limited

geographical area the local monopolist can earn an
abnormal profit.
27
Today
• Oligopoly
 Basic characteristics & examples
 Profit maximization
 Sweezy Model
 Kinked Demand
 In-class Exercise
 Cartels and Collusion
• Market concentration indexes
 Herfindahl Index

28
Market concentration
Herfindahl Index: Method to measure the concentration in an
industry. Measured as the sum of squared market shares

Degree of
Herfin- Market
# preferences dahl Share
suppliers Index Top 4
Non Low High
Monopoly 10.000 100%
1 Partly monopoly

2 Duopoly
Diff. duopoly 5.000 100%
Partly duopoly
Diff. oligopoly ”3.000” 80-90%
Few Oligopoly
Partly oligopoly Monopolistic ”2.000” 70-80%
competition
Many PC 0 > 0%
29
Market concentration (2)

Herfindahl Index: (firms’ market shares squared)

For example:
• 1 big supplier with 60% market share,
• 2 smaller with each 10%
• 4 suppliers with each 5%
• Herfindahl index = 3600+100+100+25+25+25+25
= 3900.

30
Market concentration (3)

Herfindahl Index: (firms’ market shares squared)

• Monopoly: 10.000
• Partly monopoly: Close to 10.000 (appr. 8.000 –
10.000)
• Duopoly: 5.000  appr. 8.000 (if one firm get too
small  partly monopoly)
• Symmetrical Duopoly (2 equally big suppliers):
5.000
• Oligopoly: approx. 2.000
• Monopolistic Competition: 100  1,800/2,000
• Perfect competition: 0  100 (in principle 0)
31
Market concentration (4)

Herfindahl Index: (firms’ market shares squared)

Perfect Competition

Monopolistisk
Competition

Monopoly
Oligopoly

Duopoly
100 1.800-2.000 5.000 10.000

Appr. 80% of all companies Appr. 20% of all

measured in no. of CVR-numbers, companies measured in
but only 20% of turnover, no. of no. of CVR-numbers,
employees and aggregated profits. but 80% of turnover etc. 32
 Market concentration (5)
Herfindahl Index: Beer Industry Consolidation

33
Source: Danish Business Insider on Goldman Sachs study
https://www.businessinsider.com.au/global-beer-industry-consolidation-2014-2
Market concentration (5)
HHI ‘09 (3250)  Oligopoly; HHI ’14 (6025)  Duopoly

34
Thank you!

• Check Canvas for exercises!

ME1: Game theory
Giulio Zichella, Ph.D
Assistant Professor, Department of Operations Management
 Before we start

• Next week:
– Workshop Game Theory
– Consolidation
Today
• Game theory
 Why important?
 Simultaneus games
 Prisoner’s dilemma
 Nash Equilibrium/Equilibria
 Finite vs infinite games
 Sequential games
 First mover advantage
 Backward induction method
 Example: Kinked demand

3
Today
• Game theory
 Why important?
 Simultaneus games
 Prisoner’s dilemma
 Nash Equilibrium/Equilibria
 Finite vs infinite games
 Sequential games
 First mover advantage
 Backward induction method
 Example: Kinked demand

4
Game theory is about strategic
behavior
• What should we do?
• What will others do as a counterstrike?

• Oligopoly: Kinked demand

• Cartels, Mergers, Salary bargaining 5
Collaborate or not?

Own interest versus group interest

https://www.youtube.com/watch?v=7FbkwrhW_0I

https://ncase.me/trust/

6
 Game theory: why important?

“By pursuing his own interest, The best for the group
an individual frequently comes when everyone in the
promotes that of the society group does what's best for
more effectually than when he himself and the group.
really intends to promote it.”
John Nash 7
Adam Smith
Today
• Game theory
 Why important?
 Simultaneus games
 Prisoner’s dilemma
 Nash Equilibrium/Equilibria
 Finite vs infinite games
 Sequential games
 First mover advantage
 Backward induction method
 Example: Kinked demand

8
 Prisoner’s dilemma
Two suspects are arrested for armed robbery. They
are immediately separated. If convicted, they will get
a term of 10 years in prison. However, the evidence
is not sufficient to convict them of more than the
crime of possessing stolen goods, which carries a
sentence of only 1 year.
The suspects are told the following: If you confess
and your accomplice does not, you will go free. If
you do not confess and your accomplice does, you
will get 10 years in prison. If you both confess, you
will both get 5 years in prison.
Prisoner’s dilemma (PD) matrix
Individual B

Confess Do not Confess

Confess (5 years; 5 years) (0 year; 10 years)

Individual A
Do not Confess (10 years; 0 year) (1 year; 1 year)

• Player: participant in the game (e.g. “Individual A”)

• Strategy: a possible action (e.g. “confess”)
• Strategy set: all possible strategies
• Payoff: result given all players’ actions (e.g. “5 years”)
• Payoff matrix: all possible payoffs given all strategies
• PD is a simultaneous game (vs sequential)
10
Prisoner’s dilemma matrix (2)
Individual B

Confess Do not Confess

Confess (5 years; 5 years) (0 year; 10 years)

Individual A
Do not Confess (10 years; 0 year) (1 year; 1 year)

• Should Individual A confess or not?

• “A” considers what is best doing for each strategy
• If Individual B confesses, A is better off confessing
• If Individual B do not confess, A is still better off
confessing
• A’s dominant and secure strategy is “confess” 11
Prisoner’s dilemma matrix (3)
Individual B

Confess Do not Confess

Confess (5 years; 5 years) (0 years; 10 years)

Individual A
Do not Confess (10 years; 0 year) (1 year; 1 year)

• Should Individual B confess or not?

• “B” considers what is best doing for each strategy
• If Individual A confesses, B is better off confessing
• If Individual A do not confess, B is still better off
confessing
• B’s dominant and secure strategy is “confess” 12
Prisoner’s dilemma matrix (4)
Individual B

Confess Do not Confess

Confess (5 years; 5 years) (0 years; 10 years)

Individual A
Do not Confess (10 years; 0 year) (1 year; 1 year)

A and B’s dominant strategy is to “Confess”

• A dominant strategy is an action that is optimal no
matter what the opponent does
“Confess, Confess” is a Nash Equilibrium (NE)
• In a NE no player wishes to change its strategy
unilatelally 13
Prisoner’s dilemma matrix (5)
Individual B

Confess Do not Confess

Confess (5 years; 5 years) (0 years; 10 years)

Individual A
Do not Confess (10 years; 0 year) (1 year;, 1 year)

However, “do not confess; do not confess” is a Pareto

optimal equilibrium
• Individual A & B cannot get a better payoff without
making the other worse off

14
A PD application: Discounting
Coca Cola vs Pepsi: price discounting

• Let’s assume the two are substitutes, as they are

perceived very similar in taste
• Price becomes a key factor to determine profits!
• Shall the companies discount or keep their
current prices?

15
PD application: discounting
Pepsi

Discount Regular Price

Discount ($4 billion; $2 billion) ($8 billion; $1 billion)

Coca Cola
Regular Price ($2 billion; $5 billion) ($6 billion;, $4 billion)

Pepsi and Coca Cola will decide both to “discount”

• That is a Nash Equilibrium (players cannot improve by
changing strategy unilaterally)
• but they could improve if they would keep regular price
• “The best for the group comes when everyone in the
group does what's best for himself and the group.” 16
Multiple Nash Equilibria
Coca Cola vs Pepsi: advertising

• Let’s assume the two companies are thinking

about advertising cherry flavoured drinks
• If only one company advertises, costs > benefits
• If both advertises, benefits > costs

17
PD application: advertising
Pepsi

Advertising Not Advertising

Advertising ($6 billion; $6 billion) ($2 billion; $5 billion)

Coca Cola
Not advertising ($5 billion; $2 billion) ($4 billion; $4 billion)

• There are two Nash equilibria

• …overall they would be better off advertising
• Non-zero sum game: game with potential for mutual
loss or gain
• Note that there is no secure strategy (or maximin,
guarantees the best outcome under worst conditions)
Three Nash Equilibria, non-
zero sum game

19
10 min break!
What happens if…

• Prisoners’ dilemma is played once?

• Prisoners’ dilemma is played a finite
number (e.g. 10) of times?
• Prisoners’ dilemma is played infinitely

21
Evidence from the lab

• Prisoners’ dilemma is played once?

• People tend to ”confess-confess” (NE)

• Prisoners’ dilemma is played a known,

finite number (e.g. 10) of times?
• People often collaborate (Pareto optimal)
until the last (e.g. 9th) game round
• This is known as the ”end-of-game” problem
• E.g. end of work career

• Prisoners’ dilemma is played infinitely

• People usually collaborate
22
Today
• Game theory
 Why important?
 Simultaneus games
 Prisoner’s dilemma
 Nash Equilibrium/Equilibria
 Finite vs infinite games
 Sequential games
 First mover advantage
 Backward induction method
 Example: Kinked demand

23
Sequential games

Players may play sequentially (vs

simultaneously)
• Instead of a matrix, we can illustrate a game
as a tree
• First player is at the left side of the tree
• Last player at the right side of the tree

24
Prisoner’s dilemma: sequential
P1 moves first, then P2: Nash equilibrium is ”confess-
confess”
P2: not confess
(1 year; 1 year)

P2: confess (10 years; free)

P1: Do not confess

P1: Confess

P2: not confess (free; 10 years)

(5 years; 5 years)
P2: confess
25
Sequential games: backward
induction
Draw the game tree or decision tree
Solve backwards:
1. Find best response for B in the last round for
all possible strategies of A. Remove the ones
that B will never play.
2. Of all the strategies that B will potentially pick,
find the one that gives the highest payoff to A.
3. A will choose this strategy!
26
Sequential Game: kinked
demand example
Price

300 P = 200 - Q    for Q £ 50

Firm specific Demand:
P = 300 - 3Q  for 50 < Q

𝑀𝑅 = 200 − 2𝑄 𝑓𝑜𝑟 𝑄 ≤ 50
200 𝑀𝑅 = 300 − 6𝑄 𝑓𝑜𝑟 50 < 𝑄
𝑀𝐶 𝑐𝑜𝑢𝑙𝑑 𝑏𝑒 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 100 𝑎𝑛𝑑 𝑧𝑒𝑟𝑜
150
𝑎𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 𝑤𝑜𝑢𝑙𝑑 𝑛𝑜𝑡 𝑐ℎ𝑎𝑛𝑔𝑒.
100

MC = 60

0 Q 27
50 100 300
Let’s suppose there are three
firms in the oligopoly

Firm 1 could increase price (P1):

(P1 , P2 , P3) (150 , 150 , 150) (180 , 150 , 150) (180 , 180 , 150) (180 , 180 , 180)
( avr P = 150 ) ( avr P = 160 ) ( avr P = 170 ) ( avr P = 180 )

(Q1 , Q2 , Q3) (50 , 50 , 50) (20 , 60 , 60) (30 , 30 , 70) (40 , 40 , 40)
( Σ = 150 ) ( Σ = 140 ) ( Σ = 130 ) ( Σ = 120 )
(Π1 , Π2 , Π3) (45 , 45 , 45) (24 , 54 , 54) (36 , 36 , 63) (48 , 48 , 48)
x 100 ( Σ = 135 ) ( Σ = 132 ) ( Σ = 135 ) ( Σ = 144 )

…or decrease its price:

(P1 , P2 , P3) (150 , 150 , 150) (120 , 150 , 150) (120 , 120 , 150) (120 , 120 , 120)
( avr P = 150 ) ( avr P = 140 ) ( avr P = 130 ) ( avr P = 120 )

(Q1 , Q2 , Q3) (50 , 50 , 50) (80 , 40 , 40) (70 , 70 , 30) (60 , 60 , 60)
( Σ = 150 ) ( Σ = 160 ) ( Σ = 170 ) ( Σ = 180 )
(Π1 , Π2 , Π3) (45 , 45 , 45) (48 , 36 , 36) (42 , 42 , 27) (36 , 36 , 36)
x 100 ( Σ = 135 ) ( Σ = 120 ) ( Σ = 111 ) ( Σ = 108 ) 28
Sequential game: kinked demand

(48 , 48 , 48)
P3 
P2  P3  (36 , 36 , 63)

P2  P3  (36 , 63 , 36)
P1  P3 
(24 , 54 , 54)

P1  P2  P3  (45 , 45 , 45)

(48 , 36 , 36)
P1  P3 
P2  P3  (42 , 27 , 42)

P2  P3  (42 , 42 , 27)
P3 
(36 , 36 , 36)
29
Kinked Demand as
a sequential P3  P3 

normal form
P2 
game ( 48 , 48 , 48 ) ( 36 , 36 , 63 )

P2  ( 36 , 63 , 36 ) ( 24 , 54 , 54 )
P1 

P1  P2  P3  (45 , 45 , 45)

P1 
P3  P3 

Don’t P2  ( 48 , 36 , 36 ) ( 42 , 27 , 42 )

change
P2  (42 , 42 , 27 ) ( 36 , 36 , 36 )
the price
Thank you!
ME1: Pricing Practices
Giulio Zichella, Ph.D
Assistant Professor, Department of Operations Management
Today
• Pricing Practices
Ø Why important?
Ø Price Discrimination
Ø Definition, types
Ø Two markets, one price
Ø Two markets, two prices
Ø Two part pricing
Ø Extract all Consumer surplus
Ø Examples and bundle pricing

2
Today
• Pricing Practices
Ø Why important?
Ø Price Discrimination
Ø Definition, types
Ø Two markets, one price
Ø Two markets, two prices
Ø Two part pricing
Ø Extract all Consumer surplus
Ø Examples and bundle pricing

3
Pricing: why important?

Pricing is a pervasive topic in several fields

How do we price a good or service?

• Customer’s value
• Internal costs and financial objectives
• Competitors
Today
• Economics behind pricing
• Price discrimination
• Two part pricing
4
Today
• Pricing Practices
Ø Why important?
Ø Price Discrimination
Ø Definition, types
Ø Two markets, one price
Ø Two markets, two prices
Ø Two part pricing
Ø Extract all Consumer surplus
Ø Examples and bundle pricing

5
Price Discrimination: Definition

To sell the (in principle) same product, produced

under the control of a single firm

At different prices , to different customers (markets /

segments)
• NOT because of different costs
• BUT because of different demands (willingness
to pay).

6
Price Discrimination: Example

7
Price Discrimination: Conditions

1. Firm must control price (not all markets can be PC)

2. Different price elasticities (willingness to pay;
intercept with P-axis) amongst different
segments/markets
3. Possible to keep segments / markets separated
4. It must be legal and ethical.
5. Not because of differences in costs

8
Price Discrimination: Objective

How may producers capture Consumer Surplus?

P
Consumer Surplus (CS) is the area between
the demand function and the price

Supply (MC)
CSPC

PSPC

Demand
9
Q
Price Discrimination:
𝟏𝒔𝒕 𝒅𝒆𝒈𝒓𝒆𝒆
All consumers pay their willingness to pay
P ”Next to impossible”
Can occur for unique objects
e.g.: used car, art, auction, B2B with
secret price
Supply
PS

PS

Demand
10
Q
Price Discrimination:
𝟐𝒏𝒅 𝒅𝒆𝒈𝒓𝒆𝒆
Consumers pay different prices
P depending on volume purchased
E.g. 1 unit ”full price” – take 3 pay
for 2 (Supermarkets)

Supply
PS

PS

Demand
11
Q
 Price Discrimination:
𝟑𝒓𝒅 𝒅𝒆𝒈𝒓𝒆𝒆
• Different segments
pay different prices
• Very common form
of PD

To segment on age or
occupation is pretty normal but
other methods are available
The challenge is to keep the
12
segments separated!
Today
• Pricing Practices
Ø Why important?
Ø Price Discrimination
Ø Definition, types
Ø Two markets, one price
Ø Two markets, two prices
Ø Two part pricing
Ø Extract all Consumer surplus
Ø Examples and bundle pricing

13
Price Discrimination: two
markets, one price (1)

We have two markets for a service (e.g. students,

adults)
• Adults à 𝑃 = 200 − 2𝑄
• Students à 𝑃 = 100 − 0,5𝑄
1. Student demand more elastic, lower Pmax,
(willingness to pay; intercept with P-axis)
2. For 𝑃 > 100, only adults will buy.
3. For 0 < 𝑃 < 100 both adults and students will buy.
14
 Price Discrimination: two
markets, one price (2)
Step 1: Add the two demands (adults, students)
Adults Students Total market
200 200

P = 200 – 2Q P = 200 – 2Q
120
100 P = 100 – 0,5Q 100 P = 120 – 0,4Q

MR = 120 – 0,8Q
50 100 100 200 50 100 150 300

𝑃!"#$%& = 200 − 2𝑄 𝑃&%#"'(% = 100 − 0,5𝑄 𝑄%)% = 𝑄!"#$%& + 𝑄&%#"'(%&

𝑀𝑅!"#$%& = 200 − 4𝑄 𝑀𝑅&%#"'(% = 100 − 𝑄 𝑄%)% = 300 − 2,5𝑃
𝑄!"#$%& = 100 − 0,5𝑃 𝑄&%#"'(% = 200 − 2𝑃 𝑃)(' = 120 − 0,4𝑄
15
Price Discrimination: Two
markets, one price (2)
Step 2: Find optimum (MC=MR). Example, MC=0
200

P = 200 – 2Q

120

100

60 P = 120 – 0,4Q
MR = 200 – 4Q
MC = 0
50 100 150 300

Option 1 Option 2
MR = 120 – 0,8Q
Q* = 50 Q* = 150
P* = 100 P* = 60 16
TR* = 5000 TR* = 9000
 Price Discrimination: two
markets, one price (𝑴𝑪 ≠ 𝟎)
Maybe sell to both and maybe
only to the high willingness
Only selling to to pay segment – Depends
$ the segment on what gives the MC3
with the high highest profit
willingness to pay MC2

Sell to
both MC1
segments

MR

Q1max + Q2max 17
Q
 Price Discrimination: two
markets, one price (recap)
1. Direct demand functions are found on each market
2. Q-functions are then added to a TOTAL Q-function
3. Total Inverse demand (P-function) and MR is found
from the total Q-function
4. MR = MC to find the total quantity
5. The optimal price is found by inserting the total
quantity into the total P-function and/or high
segment P-function
6. From optimal price, Q on each markets are found 18
10 min break!
Today
• Pricing Practices
Ø Why important?
Ø Price Discrimination
Ø Definition, types
Ø Two markets, one price
Ø Two markets, two prices
Ø Two part pricing
Ø Extract all Consumer surplus
Ø Examples and bundle pricing

20
 Price Discrimination: two
markets, two prices
1. After finding P-total, we find MR total
2. We set MRTOT = MC to find the optimal MR
3. MR1=MR2=MRTOT from which the optimal quantity
on each market is found
4. Optimal quantity on each market is inserted in the
inverse demand functions to find the optimal prices
 Price Discrimination: two
markets, two prices (2)

Basic principle: MR1 = MR2 (= MC)

Because if it wasn’t so, it would be possible to increase revenue by re-allocating

units from low MR to high MR – without increasing costs (because same total quantity)

Segment 1 Segment 2 TOTAL market

P1max P1max

P1* P2max P2max

MC
2
P*
Demand 1 Demand 2
MR* MR* MR*
MRTOT
MR1 MR2
Q1’ Q1* Q1max Q2* Q2max Q1 ’ Q1*+Q2* ½(Q1max + Q2max)

22
Price Discrimination: Two
markets (exercise)
We have two markets with different demands
• Sophisticated à P1 = 1000 – 10Q1
• Price sensitive à P2 = 600 – 5Q2
• MC = 100 + QTOTAL

• Find optimal P, Q and contribution (TR-TVC)

– When the firm CAN keep the segments
separated
– When the firm cannot keep segments separated
23
 Price Discrimination: two
markets, one price (exercise)
1000
Sophisticated Price Sensitive Total market
1000
PTOT = 1000 - 10Q1

600 600 MC = 100 + QTOT

458 458 458

PTOT = 733 - 3,33QTOT

P1 = 1000 - 10Q1 P2 = 600 - 5Q2

40 MR = 733 – 6,67QTOT
54 100 28 120 40 83 220

𝑃&)*+,& = 1000 − 10𝑄 𝑃&'(&,% = 600 − 5𝑄 𝑄%)% = 𝑄&)*+,& + 𝑄&'(&,%

𝑀𝑅&)*+,& = 1000 − 20𝑄 𝑀𝑅&'(&,% = 600 − 10𝑄 𝑄%)% = 220 − 0,3𝑃
𝑄&)*+,& = 100 − 0,1𝑃 𝑄&'(&,% = 120 − 0,2𝑃 𝑃)(' = 733,33 − 3,33𝑄

𝑄%)% = 82,63
100 + 𝑄 = 733,33 − 6,66𝑄
𝑃%)% = 458 24
 Price Discrimination: two
markets, two prices (exercise)
Sophisticated Price Sensitive Total market
1000 1000
MRTOT = 1000 – 20QTOT

591 600 600 MC = 100 + QTOT

391
P1 = 1000 - 10Q1 P2 = 600 - 5Q2
183 183 183

MRTOT = 733 - 6,67QTOT

MR1 = 1000 - 20Q2 MR2 = 600 - 10Q2
20 41 50 100 42 60 120 20 83 110

𝑃&)*+,& = 1000 − 10𝑄 𝑃&'(&,% = 600 − 5𝑄 𝑄%)% = 𝑄&)*+,& + 𝑄&'(&,%

𝑀𝑅&)*+,& = 1000 − 20𝑄 𝑀𝑅&'(&,% = 600 − 10𝑄 𝑄%)% = 220 − 0,3𝑃
𝑄&)*+,& = 100 − 0,1𝑃 𝑄&'(&,% = 120 − 0,2𝑃 𝑃%-) = 733,33 − 3,33𝑄

𝑄%)% = 82,63 𝑀𝑅%-) = 733,33 − 6,67𝑄

100 + 𝑄 = 733,33 − 6,66𝑄
𝑀𝑅%)% = 𝑀𝑅. = 𝑀𝑅/ = 𝑀𝐶%)% = 183 25
 Two markets – Comparison
Sophisticated Price Conscious TOTAL
Q same prices 54 28 83
Q different prices 41 42 83

P same prices 458 458 458

P different prices 591 391 490 (TR/Q)

MR same prices - 84 316 183

MR different prices 183 183 183

TR same prices 24.800 13.000 37.800

TR different prices 24.200 16.300 40.500

Contribution same p N/A N/A 26.100

Contribution different HA
N/AAlmen ME 2012 2013
N/A 26 28.800
p
Today
• Pricing Practices
Ø Why important?
Ø Price Discrimination
Ø Definition, types
Ø Two markets, one price
Ø Two markets, two prices
Ø Two part pricing
Ø Extract all Consumer surplus
Ø Examples and bundle pricing

27
Two-part pricing

A price discrimination technique in which the price of

a product or service is composed of two parts -
1. a fixed fee (equal to the consumer surplus)
2. a per-unit charge (equal to the Marginal Cost).

28
Two-part pricing: example

29
From Monopoly price…

30
…to two-part pricing

31
See you tomorrow!

• Workshop: consolidation 2
• Next week: Capital Budgeting (last
topic!)
• Check Canvas for exercises!
ME1: Consolidation 2
Giulio Zichella, Ph.D
Assistant Professor, Department of Operations Management
 Today
• Consolidation
Ø Isocost + budget lines + example (Cassius)
Ø Price point elasticity (Ludovico, Eline)
Ø MonComp: High price, low output (Kamma)
Ø Kinked demand: explanation of kink (Lena)
Ø Multiplant (Matt, Kimia)

2
Maximization of Utility

3
Solution to utility maximization
problem: General solutions
𝐶𝑜𝑏𝑏 𝐷𝑜𝑢𝑔𝑙𝑎𝑠
U(X; Y) = X ! ∗ Y " = X # ∗ Y $
2 ∗ 𝑋 + 4 ∗ 𝑌 = 100

∗
𝑎 𝐵 2 100
𝑋 = ∗ = ∗ = 20
𝑎 + 𝑏 𝑃& 2 + 3 2

∗
𝑏 𝐵 3 100
𝑌 = ∗ = ∗ = 15
𝑎 + 𝑏 𝑃' 2 + 3 4

4
Solution to utility maximization
problem: General solutions
𝐼𝑛 Excel
Utility curve
U(X; Y)= X # ∗ Y $ = 20# ∗ 15$ = 1,35 𝑚𝑖𝑙
𝑋 # ∗ 𝑌 $ = 1,35 𝑚𝑖𝑙
1,35 𝑚𝑖𝑙
𝑌$ =
𝑋#
1,35 𝑚𝑖𝑙
!
𝑌=
𝑋#
1,35𝑚𝑖𝑙 (
𝑌=( )$
𝑋#
5
Solution to utility maximization
problem: General solutions
𝐼𝑛 Excel
Budget line
2 ∗ 𝑋 + 4 ∗ 𝑌 = 100
4𝑌 = 100 − 2𝑋
𝑌 = 25 − 0,5𝑋

6
Solution to utility maximization
problem: General solutions
𝐼𝑛 Excel

7
Price point elasticity
𝑃 = 100 − 2𝑄

∆𝑄 𝑃
𝜀) = ∗
∆𝑃 𝑄

∆𝑄 1
= = 0,5
∆𝑃 −2

P and Q change along the curve

8
Price point elasticity
𝐼𝑛 Excel

Q 0 10 20 25 30 40 50
Inverse demand P 100 80 60 50 40 20 0
PPE #DIV/0! -4 -1,5 -1 -0,66667 -0,25 0

−∞

−1

9
Price point elasticity
𝐼𝑛 Excel

Q 0 10 20 25 30 40 50
Inverse demand P 100 80 60 50 40 20 0
PPE #DIV/0! -4 -1,5 -1 -0,66667 -0,25 0

−∞

−1

10
MonComp: High price, low Q
𝑃 = 100 − 2𝑄
𝑀𝑅 = 100 − 4𝑄
𝑄#
𝑇𝐶 = + 250
2
𝑄 250
𝐴𝑇𝐶 = +
2 𝑄
Slope ATC=Slope Inverse demand (P)
250
0,5 − # = −2
𝑄

11
MonComp: High price, low Q
250
0,5 − # = −2
𝑄
2,5𝑄# = 250
Q# = 100
𝑄 = 10
10 250
𝑤ℎ𝑒𝑛 𝑄 = 10 → 𝐴𝑇𝐶 = + = 30
2 10
𝑃 = 𝑃𝑚𝑎𝑥 + 𝑠𝑙𝑜𝑝𝑒 ∗ 𝑄
30 = 𝑃𝑚𝑎𝑥 − 2 ∗ 10
𝑃𝑚𝑎𝑥 = 50
𝑃 = 50 − 2 ∗ 𝑄
12
MonComp: High price, low Q
𝐼𝑛 Excel

13
Kinked Demand
Before Kink (Q) à elastic demand, after kink à inelastic

14
Multiplants
Single plant (short run) à Orange Equilibrium
Multi plant (long run) à Red Equilibrium

15
MES=
Thank you J
ME1: Capital Budgeting
Giulio Zichella, Ph.D
Assistant Professor, Department of Operations Management
 Before we start

• Today: Last topic.

• Next week
– Recap (Consolidation 3 + contemporary ME)
– Last year’s exam workshop (3hr 20 min)
– Don’t panic for exam J
• Do exercises (workshop and lectures) again!
• Study in groups, ask questions!
Today
• Capital Budgeting
Ø Why important?
Ø Value of money
Ø Future value, compounded interest
Ø Present value, discount factor
Ø Six steps in capital budgeting
1. Estimate project’s costs
2. Estimate project’s cash flows
3. Estimate cash flows’ risk
4. Estimate discount factor
5. Net Present Value / Profitability Index
6. Investment Decision 3
Today
• Capital Budgeting
Ø Why important?
Ø Value of money
Ø Future value, compounded interest
Ø Present value, discount factor
Ø Six steps in capital budgeting
1. Estimate project’s costs
2. Estimate project’s cash flows
3. Estimate cash flows’ risk
4. Estimate discount factor
5. Net Present Value / Profitability Index
6. Investment Decision 4
Capital budgeting: why important?

”Process of planning and evaluating capital

expenditures”
High relevance in several fields:
• Finance à which project shall we invest in?
• Accounting à what is our cost structure?
• Strategy à which investment decision is
best aligned with a company’s long term
strategy?

5
Capital budgeting: why important?

”Process of planning and evaluating capital

expenditures”
Many different types of projects require capital
budgeting. For example:
• Replacement of damaged equipment
• Cost reduction via new equipment
• Expansion of product lines

6
Today
• Capital Budgeting
Ø Why important?
Ø Value of money
Ø Future value, compounded interest
Ø Present value, discount factor
Ø Six steps in capital budgeting
1. Estimate project’s costs
2. Estimate project’s cash flows
3. Estimate cash flows’ risk
4. Estimate discount factor
5. Net Present Value / Profitability Index
6. Investment Decision 7
Value of money
Time is a critical factor in determining the value
of money
Compounding

• How much is 100 dkk invested today

worth in 2023?

2021 2023

• How much is 100 dkk received in 2023

worth today?

8
Discounting
Future value of money?
”How much is 100 dkk invested today worth in 2023?”
Investment:
• Year 2021: Capital 100dkk
• Time: two years
• Annual interest rate: 10% annual
”How much do I get in 2023?”
(Future value of 100dkk)
A. 120DKK A. Simple interest
B. 121DKK B. Compounded interest
Both are correct! Depends on compounding!
9
 Compounded interest?
Annual Interest =
10% Year 2021 Year 2022 Year 2023 Total

10% ∗ 100 10% ∗ 100

𝑖𝑛𝑣𝑒𝑠𝑡 100𝑑𝑘𝑘 100 + 10 + 10 = 120 𝑑𝑘𝑘
= 10 𝑑𝑘𝑘 = 10 𝑑𝑘𝑘
Simple
Interest 𝐶 + 2𝑖𝐶 =
𝑖𝑛𝑣𝑒𝑠𝑡
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 (𝐶)
𝑖∗𝐶 𝑖∗𝐶 𝐶 1 + 2𝑖 =
𝐶 1 + 𝑖𝑡

100 ∗ 10% 10% ∗ (100 + 10)

𝑖𝑛𝑣𝑒𝑠𝑡 100𝑑𝑘𝑘 100 + 10 + 11 = 121 𝑑𝑘𝑘
= 10 𝑑𝑘𝑘 = 11 𝑑𝑘𝑘

Compounded
Interest 𝐶 + 𝑖𝐶 + 𝑖𝐶 + 𝑖 1 𝐶
𝑖𝑛𝑣𝑒𝑠𝑡
= 𝐶 1 + 2𝑖 + 𝑖 1
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 (𝐶) 𝑖∗𝐶 𝑖(𝐶 + 𝑖𝐶)
= 𝐶(1 + 𝑖)1
= 𝐶(1 + 𝑖)2
10
Future Value: Compounding

Compounding tells us the future value of money

Compounded interest:
• Interest is calculated at 𝑡 = 1 and then
added to the Capital
• At 𝑡 = 2, interest is calculated on Capital
plus interest
• 𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑓𝑎𝑐𝑡𝑜𝑟: (1 + 𝑖)!
• 𝑖 is the interest rate
• 𝑡 is the time periods (e.g. 2 years)
11
Today
• Capital Budgeting
Ø Why important?
Ø Value of money
Ø Future value, compounded interest
Ø Present value, discount factor
Ø Six steps in capital budgeting
1. Estimate project’s costs
2. Estimate project’s cash flows
3. Estimate cash flows’ risk
4. Estimate discount factor
5. Net Present Value / Profitability Index
6. Investment Decision 12
Value of money
Time is a critical factor in determining the value
of money
Compounding

• How much is 100 dkk invested today

worth in 2023?

2021 2023

• How much is 100 dkk received in 2023

worth today?

13
Discounting
 Compounded interest?
”How much is 100 dkk received in 2023 worth today?”
Investment:
• Year 2023: Receive capital 100 dkk
• Time: two years
• Annual cost of capital: 10% annual
How much am I willing to pay for this investment?
(Present value of 100dkk)
A. More than 100 dkk 100
!
= 82,64 𝑑𝑘𝑘
B. Less than 100 dkk (1 + 10%)

14
Present value of money?
Discounting tells us the present value of money
Discount factor:
• Inverse of the compounding factor
"
• Discount Factor =
("$%)!
• 𝑘 is the cost of capital
• 𝑡 is the time periods (e.g. 2 years)

15
Net Present Value (NPV): a spoiler

NPV tells us the present value of an investment

$
𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠
!
(1 + 𝑘)!
!"#
Where:
• ∑-*+, 𝑖𝑠 𝑡ℎ𝑒 𝑠𝑢𝑚𝑚𝑎𝑡𝑖𝑜𝑛, 𝑓𝑟𝑜𝑚 𝑡𝑖𝑚𝑒 1 𝑡𝑜 𝑡𝑖𝑚𝑒 𝑛
• Cash flows are both positive (e.g. sales) and
negative (e.g. costs)
• 𝑘 is the discount rate
• t is time (e.g. year)
16
10 min break!
Today
• Capital Budgeting
Ø Why important?
Ø Value of money
Ø Future value, compounded interest
Ø Present value, discount factor
Ø Six steps in capital budgeting
1. Estimate project’s costs
2. Estimate project’s cash flows
3. Estimate cash flows’ risk
4. Estimate discount factor
5. Net Present Value / Profitability Index
6. Investment Decision 18
Problem: new manufacturing
facility.
STEP 1: Estimate costs à two years to build
the plant

19
Step 2: Estimate Cash flows
After year two, we start having positive cash flows

20
Steps 3 & 4: discount rate

The discount rate ”k” takes into account

• Riskiness of cash flows (step 3)
• The alternative use of money (step 4)

Note that, as ”k” increases

"
• The discount factor decreases
("$%)!
• Much smaller present values
21
As discount rate increases,
present values becomes smaller

22
Step 5: Net Present Value

23
Step 5: NPV

In Excel

24
Step 6: make a decision
• Net Present-value Analysis
• If NPV > 0, the project should be accepted.
• If NPV < 0, the project should be rejected.

• Profitability Index or Benefit/cost Ratio Analysis

• PI > 1 indicates a desirable investment.
• PI < 1 indicates an undesirable investment.

• Internal Rate of Return Analysis

• Accept when IRR > k; reject when IRR < k.

• Payback Period Analysis

• Number of years to recover investment 25
Profitability Index (PI)

Profitability index is defined as:

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐼𝑛𝑓𝑙𝑜𝑤𝑠

=
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑂𝑢𝑡𝑓𝑙𝑜𝑤𝑠

) 𝐶𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠
∑'("
(1 + 𝑘)'
=
) 𝐶𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠
∑'("
(1 + 𝑘)'

26
Internal Rate of Return (IRR)

IRR is the value of discount rate ”k” that

make the NPV=0 and PI=1:

)
𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠
𝑁𝑃𝑉 = ; =0
(1 + 𝐼𝑅𝑅)'
'("

) 𝐶𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠
∑'("
(1 + 𝐼𝑅𝑅)'
𝑃𝐼 = =1
) 𝐶𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠
∑'("
(1 + 𝐼𝑅𝑅)'
27
Payback Period Analysis

Payback period analysis looks at how many

years are needed to recover investment
(positive NPV).
We distinguish between:
• Nominal payback à based on non-discounted
cash flows
• Discounted payback à based on discounted
cash flows

28
Step 6: Payback period (nominal
vs discounted)

29
Step 6: PI, IRR and Payback

In Excel

30
Thank you!
ME1: Consolidation 3
Giulio Zichella, Ph.D
Assistant Professor, Department of Operations Management
Today
• Consolidation
Ø Deadweight loss: PC vs Monopoly
(Carmela, Astrid)
Ø Price ceilings (Astrid)
Ø TVC Exercise 2.3 (Eline, Kamma)
Ø Multiplant (Astrid, Siff)
Ø First/Second mover advantage (Sabine)
Ø Exercise 14.2 (Pricing practices)

2
Today
Ø Consolidation Part 3
Ø Before we start…
Ø Videos uploaded
Ø Evaluation J
Ø Tomorrow 2020 exam

3
PC vs Monopoly: DWL

P
(1050 − 700) ∗ 16 − 9
𝐷𝑊𝐿! = = 1225
Pmax = 23 2

CSM Supply: MC = 2 + 0,01Q

PM= 16

PSM DWLM

9
Demand: 23 – 0,01Q

2
Q
QM = 700 QPC = 1050 4
© 2019 Cengage Learning
Multiplants
Single plant (short run) à Orange Equilibrium
Multi plant (long run) à Red Equilibrium

6
MES=
TVC, point exclusions, AVC max
Monthly salary (𝑷𝑳 = 𝟑𝟎𝟎𝟎𝟎 𝒅𝒌𝒌)

L Q
0 0
1 195
2 560
3 1065
4 1680
5 2375
6 3120
7 3885
8 4640
9 5355
10 6000
11 6545
12 6960
13 7215
14 7280
15 7125
16 6720

7
8
9
 Two markets – Comparison
Sophisticated Price Conscious TOTAL
Q same prices 54 28 83
Q different prices 41 42 83

P same prices 458 458 458

P different prices 591 391 490 (TR/Q)

MR same prices - 84 316 183

MR different prices 183 183 183

TR same prices 24.800 13.000 37.800

TR different prices 24.200 16.300 40.500

Contribution same p N/A N/A 26.100

Contribution different HA
N/AAlmen ME 2012 2013
N/A 10 28.800
p
 Price Discrimination: two
markets, one price (exercise)
1000
Sophisticated Price Sensitive Total market
1000
PTOT = 1000 - 10Q1

600 600 MC = 100 + QTOT

458 458 458

PTOT = 733 - 3,33QTOT

P1 = 1000 - 10Q1 P2 = 600 - 5Q2

40 MR = 733 – 6,67QTOT
54 100 28 120 40 83 220

𝑃"#$%&" = 1000 − 10𝑄 𝑃"'("&) = 600 − 5𝑄 𝑄)#) = 𝑄"#$%&" + 𝑄"'("&)

𝑀𝑅"#$%&" = 1000 − 20𝑄 𝑀𝑅"'("&) = 600 − 10𝑄 𝑄)#) = 220 − 0,3𝑃
𝑄"#$%&" = 100 − 0,1𝑃 𝑄"'("&) = 120 − 0,2𝑃 𝑃#(' = 733,33 − 3,33𝑄

𝑄)#) = 82,63
100 + 𝑄 = 733,33 − 6,66𝑄
𝑃)#) = 458 11
 Price Discrimination: two
markets, two prices (exercise)
Sophisticated Price Sensitive Total market
1000 1000
MRTOT = 1000 – 20QTOT

591 600 600 MC = 100 + QTOT

391
P1 = 1000 - 10Q1 P2 = 600 - 5Q2
183 183 183

MRTOT = 733 - 6,67QTOT

MR1 = 1000 - 20Q2 MR2 = 600 - 10Q2
20 41 50 100 42 60 120 20 83 110

𝑃"#$%&" = 1000 − 10𝑄 𝑃"'("&) = 600 − 5𝑄 𝑄)#) = 𝑄"#$%&" + 𝑄"'("&)

𝑀𝑅"#$%&" = 1000 − 20𝑄 𝑀𝑅"'("&) = 600 − 10𝑄 𝑄)#) = 220 − 0,3𝑃
𝑄"#$%&" = 100 − 0,1𝑃 𝑄"'("&) = 120 − 0,2𝑃 𝑃)*# = 733,33 − 3,33𝑄

𝑄)#) = 82,63 𝑀𝑅)*# = 733,33 − 6,67𝑄

100 + 𝑄 = 733,33 − 6,66𝑄
𝑀𝑅)#) = 𝑀𝑅+ = 𝑀𝑅, = 𝑀𝐶)#) = 183 12
Thank you J