Cost estimation – this topic parallels the topic of demand estimation in many ways, in terms of examining the nature of the process involved in cost estimation. Different types of cost scenario are described, explaining the differences between short-run, long-run and learning curve situations. The implications for appropriate model specification are explained, along with the interpretation of different mathematical forms. Cost elasticities and their relationship to returns to scale are discussed. For different scenarios the nature of empirical studies is described, the method of estimation using regression analysis is explained, and the problems of estimation and the implications in terms of managerial decision making are discussed. As with other topics, case studies are important in illustrating the application of principles to real-life situations. Three case studies are presented, all involving recent data from major industries where digital applications are important: banking, airlines and electricity generation.

Managerial economics provides a toolbox for solving problems that managers frequently face. It addresses issues relating to any aspect of decision making that ultimately affects the profit of a firm. Although the general methodology of managerial economics has not changed over the decades, there have been rapid and significant changes in the business environment in the last ten years or so, and three new themes have become increasingly important: digitization; behavioural aspects; and globalization. The first of these developments involves aspects of big data and advanced data analytics, the human-machine interface and the interconnectedness of electronic devices. The second relates to psychological aspects of decision making that cause both consumers and managers to engage in behaviour normally referred to as ‘irrational’. The third development is that improvements in technology relating to digitization have made the business world more interconnected. The text makes heavy use of recent case studies involving these three themes, for example on tech firms, Covid-19 and climate change, so students can see how the tools of managerial economics can be applied in real-life situations.

This chapter examines two fundamental issues regarding the nature of firms. First, why are they necessary in the business environment? Second, what are their objectives? Addressing these issues involves various aspects of theory which are not always associated with economics: transaction cost theory, property rights theory, motivation theory, information theory and agency theory. Regarding the first issue, the necessity for the existence of firms may appear to be self-evident, but on closer examination we can see that many transactions can be performed between individuals without firms existing at all. The problem is that with complex activities the transaction cost of engagement as individuals can be high, whereas internalizing transactions within firms can reduce this cost. The second issue regarding objectives begins with the concept of profit maximization, and then examines the various assumptions underlying it. Various problem areas related to these assumptions are identified, in particular: the existence of agency problems, the measurement of profit, risk and uncertainty, and multi-product firms. The impact of these problems on firms’ objectives is discussed.

This topic examines the nature of game theory, why it is relevant for managerial decision making, and how it determines decisions. The starting point is an explanation of the nature of game theory in terms of the inter-dependence of decision making, and its wide range of applications in real life. Different types of game and their elements are described. The prisoner’s dilemma illustrates some of the counterintuitive aspects of game theory. Static and dynamic games are analysed, and the different types of equilibrium: dominant strategy equilibrium, iterated dominant strategy equilibrium, Nash equilibrium, subgame perfect Nash equilibrium and mixed strategy equilibrium. Cournot, Bertrand and Stackelberg types of oligopoly and their strategy implications are analysed, and comparisons are drawn between them and with perfect competition and monopoly. Games with uncertain outcomes and repeated games are discussed, along with commitment strategies and credibility. Limitations of standard game theory are discussed, such as the existence of bounded rationality and social preferences. Aspects of behavioural game theory are introduced to account for these factors.

This topic examines the nature of factors that affect what people buy and how much. These factors can be categorised into controllable and uncontrollable by managers. The first category relates to internal factors to the firm and involves the marketing mix. The second category relates to external factors in the business environment. A mathematical framework of analysis is required to quantify the effects of the different variables. This involves the use of demand functions or equations, which are often in a linear or power form. The linear form entails the coefficients of explanatory variables representing the marginal effects of those variables. The power form entails the coefficients or powers of the variables representing elasticities. There is a discussion of the factors determining various elasticities and their interpretation. The importance of elasticities in economic analysis is explained, in terms of managerial decision making and forecasting. The focus is on the application of concepts in demand theory to real-life situations, and the performance of the necessary calculations to make decisions and forecasts. Many solved problems are presented as an aid to this process.

This topic examines the nature of market structure, its characteristics and implications for managerial strategy and industrial structure, conduct and performance. The starting point is a discussion of markets and the characteristics that are relevant in terms of determining structure and strategy, in particular pricing. These characteristics relate to number of sellers, type of product, barriers to entry, pricing power and the importance of non-price competition. The four main types of structure, perfect competition, monopoly, monopolistic competition and oligopoly, are described in terms of these characteristics, and in each case both a graphical and algebraic analysis of the equilibrium is presented for both short-run and long-run situations. The different types of structure are compared in terms of price, output, profit, efficiency and welfare. The relationships between structure, conduct and performance are discussed in the light of recent empirical studies, along with some implications for government policy which are examined further in Chapter 14. Case studies illustrate the application of theoretical concepts in practice, particularly in the presence of Covid-19.

This topic examines not just what goods and services consumers buy, but why they buy them. The standard neoclassical model, based on expected utility theory and indifference curve analysis, examines the ‘what’ question, but is too narrow in focus and involves numerous anomalies. To gain a better understanding of what people buy it is necessary to understand the psychology of consumers and examine the ‘why’ question. This approach reveals several important biases which cause the anomalies: biases in expectations, biases in estimating and maximizing utilities and biases in discounting. These biases are often a result of bounded rationality, social preferences and emotional or visceral influences. The field of behavioural economics has developed a body of theory, based on the concepts of prospect theory and mental accounting, which accounts for these biases and anomalies. The fundamental concepts here are the use of reference points and loss aversion. These and other behavioural factors are in turn based on evolutionary psychology. The process of natural selection has caused our brains to evolve not as utility maximising machines but as biological fitness maximising machines.

This topic examines relationships between inputs and outputs in the production process. The starting point is the explanation of various concepts that are fundamental in production and costs: factors of production, fixed and variable factors, short and long run, scale, productivity and efficiency. The increasing importance of intangible factors is discussed, along with their main features of scalability, sunkenness, spillover effects and synergy. Production functions can take various mathematical forms. The significance of average and marginal product is explained. The concepts of the law of diminishing returns, isoquants, economies of scale, diseconomies of scale and returns to scale are introduced and interpreted. The determination of the optimal use of factors of production is explained, using mathematical analysis. Case studies play an important role in this topic in terms of demonstrating the application of theoretical concepts to real-life situations, particularly in a digital age where intangible assets and network effects are important. The leading case study relates to the so-called ‘productivity puzzle’, and various explanations of the puzzle are presented.

This second chapter on business strategy examines marketing mix decisions. In particular, it focuses on more complex aspects of pricing not covered in the context of Chapter 9 on market structure and pricing. This starts with a discussion of price discrimination, and its various degrees and types. It then moves on to examine multi-product pricing, transfer pricing and dynamic aspects of pricing over the product life cycle (PLC). A detailed discussion of psychological pricing is included, and this covers behavioural aspects not normally considered within the scope of managerial economics, but highly prominent in real-life applications. Advertising decisions are also discussed in the context of the marketing mix, examining the different strategy variables in terms of content and choice of media. Recent trends in strategy related to digital and social media are discussed. There is also a discussion on the controversial topic of the effects of advertising on welfare. Finally, there is an advanced section at the end of the chapter related to optimising the marketing mix, which is mathematical in nature and involves some counterintuitive conclusions.

This topic examines the various concepts related to the costs of a firm, and in particular relationships between costs and output, and why these relationships are important for managerial decision making. The starting point is a discussion of the types of cost that are relevant, and irrelevant, for decision making. Distinctions are drawn between explicit and implicit costs, historical and current costs, sunk and incremental costs, and private and social costs. Cost relationships with output, and various types of unit cost, are explained, and the reasons for these relationships based on production theory. Distinctions between short-run cost relationships and long-run cost relationships are explained, and factors that can cause costs to change, aided by graphical presentation. Economies and diseconomies of scale, and returns to scale, are explained in cost terms, along with economies of scope. Cost-volume-profit (CVP) analysis is discussed, and its implications for managerial decision making. There is an extensive problem-solving section with many different types of example. More complex CVP problems are presented in case studies, for example battery charging for electric vehicles.

This topic examines how demand relationships can be estimated from empirical data. The whole process of performing an empirical study is explained, starting from model specification, through the collection of data, statistical analysis and interpretation of results. The focus is on statistical analysis and the application of regression analysis using OLS. Different mathematical forms of the regression model are explained, along with the relevant transformations and interpretations. The concept of goodness of fit, and the coefficient of determination, are explained, along with their application in selecting the best model. The advantages of using multiple regression are discussed, and its implementation and interpretation. Analysis of variance (ANOVA) is explained, and how this relates to goodness of fit. The implications of empirical studies are also discussed, and the light they shed on economic theory. More advanced aspects, related to inferential statistics and hypothesis testing, are covered in an appendix, along with the assumptions involved in the classical linear regression model (CLRM) and consequences of the violation of these assumptions.

This chapter is the first of two chapters relating to business strategy and covers the most fundamental aspects in terms of strategic planning and positioning. The starting point is a discussion of the concept of competitive advantage, and how this relates to value creation. Different types of competitive advantage, based on costs and benefits, are discussed, and these are related to market positioning, targeting and segmentation. The relevance of price elasticity is explained in the context of positioning and competitive advantage. Various forms of integration are discussed, in terms of vertical, horizontal and diversification aspects. The nature, costs and benefits of each of these forms is explained. Recent trends in diversification are discussed, along with empirical studies. As with other chapters, case studies are vital in order to illustrate the management principles; in this case, three prominent tech firms are discussed in terms of their strategy development since their origins: Apple, Netflix and Tesla. Although all of them are high-cap tech firms of global reach, they each have quite different prospects.