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Managerial
Economics

Now in its sixth edition, Ivan Png’s Managerial Economics has been extensively
revised with

• an introductory chapter emphasizing decision-making and behavioral biases,

• intensive application to current business and economic issues including tech-
nology, globalization, and pandemics,
• a closing chapter highlighting business responses to climate change,
• a streamlined presentation focusing on the economics that managers need
to know.

As always, the text presents the key concepts of microeconomics intuitively,

without sophisticated mathematics. Throughout, it emphasizes actual management
applications.
The new sixth edition is updated with fresh up-to-date vignettes and discussion
questions from all over the world and enhanced with detailed instructor supplements.
It is an ideal text for any course focusing on the practical application of microeco-
nomic principles to management.
The book provides truly useful economics for managers. In the words of one pro-
fessor, “I can use your book for serious conversation with adult students.”

Ivan Png is a Distinguished Professor in the School of Business and Department of

Economics at the National University of Singapore. Previously, Dr. Png was a faculty
member at the Anderson School, University of California, Los Angeles (1985–1996)
and the Hong Kong University of Science and Technology (1993–1996), and Visiting
Professor at the Cornell Dyson School (2016). His book, Managerial Economics,
has been published in multiple editions and adapted into Chinese (traditional and
simplified characters). He is the Principal Investigator of a S$4.75 million project,
SPIRE (Service Productivity and Innovation Research), funded by the Social Sciences
Research Council, Singapore, 2017–2022.
 “This book is full of engaging real-​world examples that will help bring economic
concepts to life for business students. Each chapter starts with an interesting motiv-
ating case, and additional entertaining examples are presented throughout. As a text-
book, it provides a comprehensive coverage of relevant microeconomics topics with
explanations that are intuitive, clear and concise.”
Jaimie Lien, Assistant Professor, Chinese University of Hong Kong

“Ivan Png’s book has an engaging selection of international business case studies
combined with fundamental microeconomics tools. Concepts are presented in an
intuitive way, the exercises explore them in depth, and the supplementary materials
provide a richer learning experience. Any student of business with an interest in eco-
nomics should start from this book.”
Isleide Zissimos, University of Warwick

“I have been using Ivan Png’s book for 14 years for MBA teaching in Hong Kong and
Shanghai. Light in mathematics and calculation, it is very user-​friendly, a rare feature
among numerous textbooks in the market on managerial economics. The many up-​
to-​date examples from the Asia Pacific region make it particularly relevant for MBA
students from the region.”
Wen Zhou, Associate Professor, University of Hong Kong

ii
Managerial
Economics
Sixth edition

Ivan Png
 Cover image: © OfirPeretz / Getty Images

Sixth edition published 2022

by Routledge
4 Park Square, Milton Park, Abingdon, Oxon OX14 4RN

and by Routledge
605 Third Avenue, New York, NY 10158

Routledge is an imprint of the Taylor & Francis Group, an informa business

© 2022 Ivan Png

The right of Ivan Png to be identified as author of this work has been
asserted in accordance with sections 77 and 78 of the Copyright, Designs
and Patents Act 1988.

All rights reserved. No part of this book may be reprinted or reproduced or utilized
in any form or by any electronic, mechanical, or other means, now known or
hereafter invented, including photocopying and recording, or in any information
storage or retrieval system, without permission in writing from the publishers.

First edition published by Wiley Blackwell, 1996

Fifth edition published by Routledge, 2015

Trademark notice: Product or corporate names may be trademarks or registered trademarks,

and are used only for identification and explanation without intent to infringe.

British Library Cataloguing-​in-​Publication Data

A catalogue record for this book is available from the British Library

Library of Congress Cataloging-​in-​Publication Data

Names: Png, Ivan, 1957–
Title: Managerial economics / Ivan Png.
Description: 6th Edition. | New York, NY : Routledge, 2022. |
Revised edition of the author’s Managerial economics, 2016. |
Includes bibliographical references and index. |
Identifiers: LCCN 2021043635 (print) | LCCN 2021043636 (ebook) |
ISBN 9781032145426 (hardback) | ISBN 9781032145402 (paperback) |
ISBN 9781003239857 (ebook) | ISBN 9781032209319 (ebook other)
Subjects: LCSH: Managerial economics.
Classification: LCC HD30.22 .P62 2022 (print) |
LCC HD30.22 (ebook) | DDC 338.5024/658–dc23
LC record available at https://lccn.loc.gov/2021043635
LC ebook record available at https://lccn.loc.gov/2021043636

ISBN: 9781032145426 (hbk)

ISBN: 9781032145402 (pbk)
ISBN: 9781003239857 (ebk)
ISBN: 9781032209319 (ebk+​)

DOI: 10.4324/​9781003239857

Typeset in Minion Pro

by Newgen Publishing UK

Access the companion website: www.routledge.com/​cw/​png

iv
For my parents and three Cs –​CW, CY, CH
vi
Contents

Preface ix
Acknowledgments xiii
About the author xv

1 Introduction to managerial economics 1

PART I: COMPETITIVE MARKETS 19

2 Demand 21

3 Elasticity 45

4 Supply 67

5 Market equilibrium 95

PART II: MARKET POWER 121

6 Costs 123

7 Monopoly 147

8 Pricing 173

9 Strategic thinking 197

Contents

PART III: IMPERFECT MARKETS 223

10 Externalities 225

11 Asymmetric information 247

12 Incentives and organization 269

13 Regulation 293

Index 317

viii
Preface

Managerial economics is the science of directing scarce resources in the management

of a business or other organization. This book presents tools and concepts from man-
agerial economics that practicing managers can and do use. It

• emphasizes simple, practical ideas,

• focuses on application to business decision-​making,
• integrates current business and economic issues and practice from all over
the world,
• provides conceptual rigor without mathematical complexity.

This book is aimed at business students as well as practitioners. Accordingly, it is

deliberately written in a simple and accessible style. It presents a minimum of technical
jargon, complicated figures, and highbrow mathematics. It starts with the very basics
and does not presume any prior knowledge of economics. While the mathematics is
minimal, the economics is rigorous. The application of economic concepts to business
practice will challenge even readers with some background in economics.
Besides the managerial focus, two features are worth emphasizing. First, the same
principles of managerial economics apply globally. Reflecting this unity, the book
includes applications throughout the world. Second, the book uses illustrations from
both consumer and industrial markets. The reasons are simple: a customer is as likely
to be another business as a human being, and likewise for suppliers.
For most readers, this may be their only formal book on economics. Accordingly,
the book eschews sophisticated theories and models, such as indifference curves and
production functions, which are more useful in advanced economics courses. Further,
the book recognizes that many topics traditionally covered by managerial economics
textbooks are now the domain of other basic management courses. Accordingly, the
book omits linear programming and capital budgeting.
Preface

Regarding language, this book refers to businesses rather than firms. Realistically,
many firms are involved in a wide range of businesses. In economics, the usual
unit of analysis is a business, industry, or market rather than a firm. Also, the book
refers to buyers and sellers rather than consumers and firms, since in most markets,
demand and supply do not neatly divide among households and businesses. To cite
just two examples, in the market for telecommunications, the demand side consists
of businesses and households, while in the market for human resources the supply
side comprises households and businesses. Outsourcing has reinforced this diversity
of suppliers.
Managerial economics is a practical science. Just as no one learns cooking or tennis
simply by watching a professional, so no one can learn managerial economics merely
by reading this book. Every chapter of this book includes progress checks, and review
and discussion questions. The progress checks and review questions are to help the
reader check and reinforce the chapter material. Readers should practice their new-​
found skills on these checks and questions. The discussion questions are intended to
challenge, provoke, and stretch. They will be useful for class and group discussions.

Key features
• Simple, practical ideas for business decision-​making.
• Easy to read, with minimal technical jargon, figures, and mathematics.
• Up-​to-​date vignettes and illustrations from around the world –​ behavioral
biases, technology, climate change, pandemics, globalization.
• Every chapter is reinforced with progress checks, review questions, and dis-
cussion questions.
• Complete instructor’s supplements –​transparency masters, answers to discus-
sion questions, casebank, and testbank.

Organization
This book is organized into three parts. Following the Introduction, Part I presents the
framework of perfectly competitive markets. Chapters 2–​5 are the basis of managerial
economics. These are presented at a very gradual pace, accessible to readers with no
prior background in economics.
The book gathers pace in Parts II and III. These are relatively self-​contained, so
the reader may skip Part II and go directly to Part III. Part II broadens the perspec-
tive to situations of market power, while Part III focuses on the issues of management
in imperfect markets. Chapter 13 on regulation is the only chapter in Part III that
depends on understanding Part II.
A complete course in managerial economics would cover the entire book. For
shorter courses, there are three alternatives. One is a course focusing on the economics

x
 Preface

of strategy, which would comprise Chapters 1–​9. Another alternative focuses on the
economics of organization, comprising Chapters 1–​5 and 10–​12. The third alternative
focuses on strategy and organization, and would comprise Chapters 1 and 6–​12.

Website
Online support for this book can be found at www.routledge.com/​cw/​png. The site
contains additional cases and applications, as well as updates and corrections to the
book. The site also contains a link to resources for instructors, including transparen-
cies, answers to discussion questions, a testbank, and a casebank.
xii
Acknowledgments

I thank generations of students at NUS, HKUST, and UCLA for their enthusiastic
support and encouragement.
xiv
newgenprepdf

About the author

Ivan Png is a Distinguished Professor in the School of Business and Department

of Economics at the National University of Singapore. Previously, he was a faculty
member at the Anderson School, University of California, Los Angeles (1985–​1996)
and the Hong Kong University of Science and Technology (1993–​1996).
Dr. Png attended the Anglo-​Chinese School, Singapore, graduated with first-​class
honors in economics from the University of Cambridge (1978), and received a PhD
from the Stanford Graduate School of Business (1985).
His book, Managerial Economics, has been published in multiple editions and
adapted into Chinese (traditional and simplified characters). He is the Principal
Investigator of a S$4.75 million project, SPIRE (Service Productivity and Innovation
Research), funded by the Social Sciences Research Council, Singapore, 2017–​2022.
Dr. Png speaks English and Chinese (Mandarin). He is married to Ms. Joy Cheng.
They have two sons, Max and Lucas.
xvi
CHAPTER 1

Introduction to
managerial economics

LEARNING OBJECTIVES

• Appreciate the objective of managerial economics.

• Understand value added and economic profit.
• Apply total benefit and total cost to decide participation.
• Apply marginal benefit and marginal cost to decide extent.
• Appreciate the effect of bounded rationality on decision-​making.
• Understand the vertical and horizontal boundaries of an organization.
• Distinguish competitive markets, market power, and imperfect markets.

1.1 What is managerial economics?

Amazon.com is a multinational company which offers retailing, cloud computing, and online advertising ser-
vices. One of its major consumer services is Amazon Prime, a bundle that includes free shipping on consumer
purchases, discounts on groceries, as well as video, music, games, and books. In March 2014, Amazon raised
the price of Prime from US$79 to US$99 per year, then, in April 2018, raised the price again to US$119. What
if Amazon were to increase the price again? How would that affect sales, revenue, and profit? How does “free
shipping” help Amazon in competing against other retailers?
Amazon operates a worldwide network of warehouses as well as a fleet of cargo jets to support its retail
businesses. What services should it perform in-​house, and what should it buy from others? In 2019, Amazon and
non-​governmental organization Global Optimism launched the Climate Pledge, by which businesses commit to
net zero carbon emissions by the year 2040. Why should a for-​profit business indulge in climate policy?

DOI: 10.4324/9781003239857-1
Introduction to managerial economics

All of these are questions of managerial economics. Managerial economics is

Managerial
the science of cost-​effective management of scarce resources. Wherever resources are
economics: The
science of cost-​
scarce, managers can make more cost-​effective decisions by applying the discipline of
effective management managerial economics. The decisions may concern customers, suppliers, competitors,
of scarce resources. or the internal workings of the organization. All organizations, whether profit-​
oriented businesses, non-​profit organizations, or households would gain from better
use of scarce resources.
Amazon has limited financial, human, and physical resources. Amazon man-
agers seek to maximize the financial return from these limited resources. They must
organize the business, manage demand and costs, set prices, compete against online
and traditional competitors, and plan for the future. By applying the principles of
managerial economics, Amazon managers would make better decisions and conceive
more effective long-​term strategy.
Managerial economics consists of three branches: competitive markets, market
power, and imperfect markets. Accordingly, this book is organized into three parts.
Before introducing the three branches of managerial economics, let us first develop
some background –​ the meaning of value added, how to make decisions, and organ-
izational boundaries.

1.2 Value added

For the most part, this book takes the viewpoint of a profit-​oriented business, while
also considering the management of non-​profit organizations and households. The
primary goal of a profit-​oriented business is to maximize profit. Indeed, the aim of
business strategy is to deliver sustained profit above the competitive level.
Accordingly, an essential concept for managerial decision-​making is economic
profit. To appreciate the concept of economic profit, consider the basic equation of
managerial economics:

Valueadded = Buyer benefit − Seller cost

= Buyer surplus + Seller economic profit. (1.1)

Value added: Buyer This equation states that value added is the difference between buyer benefit
benefit less seller and seller cost. It is only to the extent that businesses deliver benefit to buyers that
cost. Comprises exceeds the cost of production that they create value. Equation (1.1) is basic to all
buyer surplus and organizations –​ whether profit-​oriented, non-​profits, or households. To create value,
economic profit. an organization must deliver benefit that exceeds cost. If the delivered benefit is less
than the cost of production, then value is destroyed. In that case, society would be
better off without production of the good or service.
Referring to Figure 1.1, value added is shared by buyer and seller. The buyer gets
some part of the value added in buyer surplus, which is the difference between the
buyer’s benefit and their expenditure. The seller gets the other part of the value added

2
 Introduction to managerial economics

Buyer
surplus
Value added
Seller
Buyer benefit economic
profit
Buyer’s expenditure =
Seller’s revenue
Seller
cost

Figure 1.1 Value added

in economic profit, which is the difference between the revenue that the seller receives
(equal to the buyer’s expenditure) and the cost of production.
The larger is the value added, the larger is the amount to be shared by buyer and
seller. For profit-​oriented businesses, that means the potential for economic profit is
greater!
The concept of value added applies to governments and non-​profits as well. Suppose
that the government provides free healthcare. Since the healthcare is free, the govern-
ment receives no revenue. While the government incurs an economic loss on the ser-
vice, that does not mean that it is making a mistake. The healthcare provides a benefit.
Referring to Figure 1.1, the value added is the buyer benefit minus the cost of pro-
vision. So long as the benefit exceeds the cost, the service adds value. The question
of value added is distinct from that of how the service should be provided –​ whether
commercially or non-​commercially.

Progress check 1A. Explain the relation among the following: buyer benefit,
seller cost, value added, buyer surplus, and economic profit.

National Health Ser vice

In England, the National Health Service (NHS) provides subsidized
healthcare to a population of 56.3 million. The NHS employs over
1.5 million people to deliver service at hospitals and clinics across the
country.
The NHS charges a fixed fee for prescriptions, and also charges for
dental treatment and eye tests. It does not charge for consultations or med-
ical treatment. In the financial year 2019–​2020, the NHS earned operating
income of £2.2 billion, while incurring expenses of £125.4 billion and an
economic loss of £123.2 billion.
Introduction to managerial economics

The government covered most of the loss through a subsidy of £122.8

billion. The NHS carried forward the remaining loss of £400 million to the
following year.
While the NHS incurs an economic loss, it still creates value so long as
buyer surplus exceeds economic loss. However, buyer surplus is not readily
quantifiable.

1.3 Decision-​m aking

The two fundamental decisions in business can be stated simply as participation
(“which”) and extent (“how much”). Which market to enter? How much to invest?
Which products to sell? How much to produce? Which R&D strategy to follow? How
much to spend on R&D? Which job to take? How many hours to work?
The decision on participation resolves into analyzing the total benefits and costs.
The decision on extent resolves into analyzing the marginal benefits and costs.
To explain, consider the following example. Angela works as an analyst at a fixed after-​
tax salary of $70,000 per year. On average, she works 50 hours a week. Another firm has
offered her an analyst job for $40 after-​tax per hour. Should she switch to the new firm?
In deciding whether to continue with her current job or switch, Angela should con-
sider the total earnings and total costs of each alternative. Yet, Angela’s total earnings
and total costs at the new job depend on how many hours she would work.
So she must first decide, if she takes the new job, how much to work. In this deci-
sion, Angela should consider the marginal earnings and marginal cost of each add-
itional hour. The marginal value of a variable with respect to some factor is the
Marginal value: change in the variable associated with a unit increase in the factor.
The change in the If she takes the new job, Angela should work up to the point that her marginal
variable associated earnings per hour equal her marginal cost per hour. To understand why, suppose that
with a unit increase her marginal earnings exceed her marginal cost. Then she should work more. The add-
in a factor. itional earnings would exceed the additional cost. By contrast, if her marginal earnings
are less than her marginal cost, then she should work less. The reduction in earnings
would be less than the reduction in cost.
In the new job, Angela’s marginal earnings would be $40 per hour. Suppose that she
would work 40 hours a week. On the basis of 50 weeks a year, she would earn $40 ×
40 × 50 =​$80,000. This would exceed her current earnings.
However, the higher earnings do not mean that she should take the new job. Angela
must also consider the total costs of the two jobs, for instance, the commuting time
and expenses. In deciding which job to take, she should compare the total surplus
Average value: The (total earnings minus total cost).
total value of the Closely related to the total is the concept of average. Generally, the average value
variable divided by of a variable with respect to some factor is the total value of the variable divided by the
the total quantity of total quantity of the factor. Angela could also choose the job according to the average
the factor.
surplus.

4
 Introduction to managerial economics

Generally, the marginal value of a variable may be less than, equal to, or greater
than the average value. The relation between the marginal and average values with
respect to some factor depends on whether the average value is decreasing, constant,
or increasing with respect to the factor.

Progress check 1B. Suppose that the offer from the new firm is $25 per hour.
Should Angela reject?

Amazon Prime: free shipping

Amazon’s Prime service provides subscribers with free shipping on selected
consumer purchases. For Prime members, the marginal cost of goods that
qualify for free shipping is just the price of the item. This would be less than
the cost of the similar item at another online retailer that does not offer free
shipping. Essentially, by persuading consumers to pay upfront for Prime
membership, Amazon has given itself a pricing advantage in competing
against other retailers.

1.4 Bounded rationality

Managers are human and as such are subject to bounded rationality. Typically, man-
agerial economics theories assume that individuals make decisions rationally, in the
sense that they always choose the alternative that maximizes the difference between
benefit and cost.
However, people do not always behave rationally, and indeed, they make system-
atic errors in decisions. Human beings behave with bounded rationality (less than full
rationality) because they have limited cognitive abilities and cannot fully exercise self-​
control. The boundedly rational decisions lead to systematic mistakes in the scenarios
that follow.
To the extent that individuals are subject to bounded rationality, the role for
managerial economics is even larger than when individuals are fully rational. The
techniques of managerial economics help to correct systematic biases in individual
decision-​making as well as show how to make better overall decisions.

Sunk-​c ost fallacy

A sunk cost is a cost that has already been incurred and cannot be recovered.
Sunk costs do not affect forward-​looking benefits or costs, and should not affect
rational decisions. Yet, the sunk-​cost fallacy is the tendency to consider sunk costs
in decision-​making.
Introduction to managerial economics

Psychologists Hal Arkes and Catherine Blumer gave discounts at random to people
buying season subscriptions at the Ohio University Theater. The researchers then
monitored the attendance of the subscribers. Consumers who paid the regular price
attended more plays than those who received the unanticipated discounts.
Rationally, the marginal benefit and marginal cost of attending another play should
not depend on the price that the subscriber paid. At the point of deciding whether to
attend a play, the subscription price was a sunk cost. Yet, the experiment showed that
consumers who had incurred a larger sunk cost tended to consume more.

Status quo bias

Status quo bias is a preference for the current situation. The individual takes reference
from the current situation, and perceives any change from the current situation as
a loss.
Behavioral economists Jack Knetsch and Jack Sinden randomly gave students
either A$2 cash or a lottery ticket. The students who received A$2 cash could buy
lottery tickets for A$2, and half did so. The students who received lottery tickets could
sell the tickets for A$2 in cash, but only a quarter did so.
Rationally, the benefit and cost of the lottery ticket should not depend on whether
the student received cash or the lottery ticket. Then, the proportions of students buying
vis-​à-​vis keeping the tickets should be the same. However, the experiment revealed
that the proportions differed. Individuals tended (perhaps out of sheer inertia) to
prefer the status quo.

Anchoring
Anchoring is the tendency to over-​rely on pre-​existing or early information in making
decisions. The decision-​maker gives insufficient consideration to later information.
Behavioral economists Amos Tversky and Daniel Kahneman posed the multipli-
cation problem

8 × 7 × 6 × 5 × 4 × 3 × 2 ×1 = ?

to one group of students and the problem

1× 2 × 3 × 4 × 5 × 6 × 7 × 8 = ?

to another group. The researchers did not give the students enough time to complete
the calculation.
Mathematically, the answers to the two problems are identical, 40,320. However, in
reality, the median estimates were 2,250 in the former group of students and 512 in the
latter. Pressed for time, the students anchored on the first few numbers that they could
calculate. Hence, those who saw larger numbers first guessed the answer to be larger
than those who saw smaller numbers first.

6
 Introduction to managerial economics

Progress check 1C. What is bounded rationality and what problems does
it cause?

Driving in Singapore
The Singapore government aims to encourage commuters to travel by public
transport rather than in private cars. It discourages driving by limiting the
registration of new cars and auctioning the licenses, and also by charging
for road use during peak hours.
Licenses, which allow the owner to operate a car for ten years, fluctuate
in price with demand conditions and the quota of licenses. At the time of
writing, the auction prices of licenses were S$48,002 and S$60,001 for
smaller and larger cars respectively.
For the buyer of a new car, the auction price of a license is a sunk
cost. In particular, the auction price does not affect the marginal cost of
driving.
Management scholars Teck Ho, Ivan Png, and Sadat Reza studied the
effect of fluctuations in license prices on owner behavior. Those who bought
cars when licenses were more expensive drove more. Empirically, govern-
ment policy between 2009 and 2013 which increased the cost of buying
cars resulted in car buyers driving 5.6% more. Apparently, car buyers were
prone to the sunk-​cost fallacy.

1.5 Organization
Throughout this book, we will take the viewpoint of an organization, which may be a
business, non-​profit, or household. Managers of all such organizations face the same
issue of how to effectively manage scarce resources. Since our analysis focuses on the
organization, we first must identify its boundaries. We briefly discuss this issue here, Vertical boundaries:
while leaving the detailed analysis to Chapters 6 and 12. Delineate activities
closer to or further
from the end user.
Organizational boundaries
The activities of an organization are subject to vertical and horizontal boundaries. The Horizontal
vertical boundaries of an organization delineate activities closer to or further from boundaries: Defined
the end user. By contrast, the horizontal boundaries of an organization are defined by the scale and
by the organization’s scale and scope of operations. Scale refers to the rate of produc- scope of the
tion or delivery of a good or service, while scope refers to the range of different items organization’s
produced or delivered. operations.
Introduction to managerial economics

In online business-​to-​consumer retailing, the value chain runs from the manufac-
turer of the goods such as books and clothing to the retailer to the delivery provider to
the end user. The end users are consumers.
Consider two online retailers. Suppose that one ships goods through its own
warehouses and delivery service, while the other ships goods through a third-​party
delivery service. With regard to vertical boundaries, the retailer that ships goods
through its own warehouses and delivery service is more vertically integrated than the
other which ships goods through a third-​party delivery service.
With regard to horizontal boundaries, on online retailer that sells 40,000 books per
month is operating on a larger scale than one which sells 400 per month. An online
retailer that sells books as well as clothing is operating with a larger scope than one that
specializes in books.
In the production of motorcars, the vertical chain runs from the production of
raw materials, to manufacturing of batteries, motors, vehicle bodies, and other
components, to assembly into vehicles, and finally, to distribution to end users. The
end users include households and businesses such as car rental agencies and taxi
operators.
With regard to vertical boundaries, a car manufacturer that produces batteries is
more vertically integrated than one that buys batteries from others. As for horizontal
boundaries, a car manufacturer that also manufactures trucks is producing with a
larger scope than one that specializes in cars.

Amazon.com: horizontal and vertical growth

Jeff Bezos founded Amazon.com in 1994 to sell books through the Internet
in the United States. Horizontally, Amazon.com expanded its retail business
in product range and geography to sell a wide range of goods and ser-
vices, including digital entertainment, pharmaceuticals, and groceries
across the world.
Online retailers like Amazon.com use geographically spread data
centers to serve customers and suppliers. Amazon.com decided to set up its
own data centers and computing services. Besides using these for its own
business, Amazon.com uses them to provide cloud computing services to
external customers.
In logistics, Amazon.com set up warehouses and acquired a fleet of
cargo jets to ship goods to consumers. Data centers, warehouses, and
cargo jets expanded Amazon.com’s vertical boundaries.

Outsourcing:
Purchase of services Outsourcing
or supplies from Outsourcing is the purchase of services or supplies from external sources. It is the
external sources.
opposite of vertical integration, and affects the vertical boundaries of the organization.

8
 Introduction to managerial economics

If an online retailer outsources the shipping of goods to a third-​party delivery service,

then it is shrinking its vertical boundaries. Similarly, if a car producer outsources the
manufacturing of batteries, it is shrinking its vertical boundaries.
The costs of transport and communications, and barriers to trade and investment
have declined over time. These trends have stimulated the growth of outsourcing across
international borders. Financial institutions in advanced economies outsource cus-
tomer service to call centers in the Philippines. Technology companies in the United
States outsource manufacturing to contractors in China and Taiwan. Chapter 12 on
incentives and organization discusses outsourcing in detail.

Progress check 1D. Explain the difference between the vertical and hori-
zontal boundaries of an organization.

1.6 Markets
One concept of managerial economics –​ the market –​ is so fundamental that it
appears in the names of each branch of the discipline. A market consists of buyers Market: Buyers
and sellers who communicate with one another for voluntary exchange. In this and sellers who
sense, a market is not limited to any physical structure or particular location. The communicate with
market extends as far as there are buyers or sellers who can communicate and trade one another for
at relatively low cost. voluntary exchange.
With the decline of the costs of transport and communications, and barriers to
trade, the markets for many goods and services have expanded to global scale. Growers
of flowers in Colombia, Ecuador, Ethiopia, and Kenya export roses, carnations, and
chrysanthemums to Europe and North America. Tutors living in Canada and the
United States offer online English lessons to students in China.
Consider, for instance, the market for cut roses. Increases in the supply in Colombia
or Ethiopia would affect the global price of cut roses. And that change in price would
reverberate to buyers and other sellers throughout the world.
In markets for consumer products, the buyers are households and sellers are
businesses. In markets for industrial products, both buyers and sellers are businesses.
Finally, in markets for human resources, the buyers are businesses and sellers are
households.
By contrast with a market, an industry consists of businesses engaged in the pro- Industry: Businesses
duction or delivery of the same or similar items. For instance, the motorcar industry engaged in
consists of all manufacturers of motorcars, and the battery industry consists of all production or
manufacturers of batteries. Members of an industry can be buyers in one market and delivery of the same
sellers in another. The motorcar industry is a buyer in the battery market and a seller or similar items.
in the motorcar market.
Introduction to managerial economics

Spotify and TikTok

Conventionally, publishers of music and videos produced their entertain-
ment on physical media such as CDs and DVDs, and distributed them to
consumers through wholesalers and retailers.
By contrast, publishers of digital entertainment can sell directly to con-
sumers through the Internet. The markets for digital entertainment services
are truly global and are limited only by the bandwidth of Internet access
and government regulation.
In the digital entertainment industry, Spotify and TikTok are notable for
their huge scale. At the time of writing, Spotify served 356 million users,
including 158 million paid subscribers, while TikTok served over 800 million
active users worldwide.

Competitive markets
The market for cut roses includes many competing producers and buyers. How should
a producer respond to an increase in the price of water, a drop in the price of roses, or
a change in labor laws? How will these changes affect buyers?
The basic starting point of managerial economics is the model of competitive
markets. This applies to markets with many buyers and many sellers. The market for
cut roses is an example of a competitive market. In a competitive market, buyers pro-
vide the demand and sellers provide the supply. Accordingly, the model is also called
the demand–​supply model.
The model describes the systematic effect of changes in prices and other economic
variables on buyers and sellers. Further, the model describes the interaction of these
changes. In the example of cut roses, the model can describe how growers should
adjust prices when the price of water increases, the price of roses drops, and labor
laws change. These changes affect all growers. The model also describes the interaction
among the adjustments of the various growers and how these affect buyers.
Part I of this book presents the model of competitive markets. Chapter 2 begins
with the demand side, considering how buyers respond to changes in prices and
income. Next, Chapter 3 develops quantitative methods that support precise estimates
of changes in economic behavior. Then, Chapter 4 looks at the supply side of the
market, considering how sellers respond to changes in the prices of products and
inputs. Chapter 5 brings demand and supply together and shows that the outcome of
market competition is efficient.

Market power
In a competitive market, an individual manager may have little freedom of action.
Key variables such as prices, scale of operations, and input mix are determined by

10
 Introduction to managerial economics

market forces. The role of a manager is simply to follow the market and survive. Not all
markets, however, have so many buyers and sellers to be competitive.
Market power is the ability of a buyer or seller to influence market conditions. Market power: The
A seller with market power will have relatively more freedom to choose suppliers, set ability of a buyer or
prices, and use advertising to influence demand. A buyer with market power will be seller to influence
able to influence the supplies of goods and services that it purchases. market conditions.
A business with market power must determine its horizontal boundaries. These
depend on how its costs vary with the scale and scope of operations. Accordingly,
businesses with market power –​ whether buyers or sellers –​ need to understand and
manage their costs.
In addition to managing costs, sellers with market power need to manage their
demand. Three key tools in managing demand are price, advertising, and policy
toward competitors. What price maximizes profit? A lower price boosts sales, while
a higher price brings in higher margins. What is the best way to compete with other
businesses?
Part II of this book addresses all of these issues. We begin by analyzing costs
(Chapter 6), then consider management in the extreme case of market power, where
there is only one seller or only one buyer (Chapter 7). Next, we discuss pricing policy
(Chapter 8), and strategic thinking (Chapter 9).

Imperfect markets
Businesses with market power have relatively more freedom of action than those in
competitive markets. Businesses will also have relatively more freedom of action in
markets that are subject to imperfections. A market may be imperfect in two Imperfect market:
ways: when one party directly (rather than through a market) conveys a benefit or cost One party directly
to others, or when one party has better information than others. The challenge is to conveys a benefit
resolve the market imperfection. or cost to others, or
Water resources illustrate the direct imposition of costs on others. If one farmer one party has better
draws more water, there is less for others. Farmers might compete to draw water, which information than
would degrade the resource and could even destroy it. The challenge is to resolve such others.
competition.
The market for residential mortgages illustrates differences in information.
Applicants for mortgages better know their ability and willingness to repay than
potential lenders. The challenge for lenders is resolving the informational differences
so that they can provide loans in a cost-​effective way.
Differences in information can cause a market to be imperfect. Imperfection can
arise within an organization, where some members have better information than
others and interests diverge. Accordingly, another issue is how to structure incentives
and organization.
Part III of this book addresses all of these issues. We begin by considering the
sources of market imperfections –​ where one party directly conveys a benefit or
cost to others (Chapter 10) and where one party has better information than others
(Chapter 11). Then we study the appropriate structure of incentives and organization
Introduction to managerial economics

(Chapter 12). Finally, we discuss how government regulation can resolve market
imperfections (Chapter 13).

Progress check 1E. Distinguish the three branches of managerial economics.

Key takeaways
• Managerial economics is the science of cost-​effective management of scarce
resources.
• Value added is the difference between buyer benefit and seller cost, and
comprises buyer surplus and economic profit.
• In decisions on participation, compare the total benefit and total cost.
• In decisions on extent, compare the marginal benefit and marginal cost.
• In decision-​making, take care to avoid systematic biases, including the sunk-​
cost fallacy, status quo bias, and anchoring.
• The vertical boundaries of an organization delineate activities closer to or
further from the end user.
• The horizontal boundaries of an organization are defined by the scale and
scope of operations.
• Businesses with market power must manage their costs, pricing, advertising,
and relations with competitors.
• Businesses in imperfect markets should act strategically to resolve the
imperfection.

Review questions

1. Explain the difference between value added and economic profit.

2. Consider a charity that gives free meals. Since the charity receives no rev-
enue while meals are costly, do the free meals mean that the charity is
destroying value?
3. Maggie works ten hours a day at a supermarket. The store pays $10 per
hour for a basic eight-​hour day and $15 per hour for overtime. What are
Maggie’s (a) marginal pay and (b) average pay?
4. Explain the difference between the marginal and average values.

12
 Introduction to managerial economics

5. In decisions on participation, managers should compare the total benefit

and total cost. True or false?
6. In deciding how many hours to work, why should a worker compare the
marginal earnings and marginal cost of each hour?
7. Why do individuals act with bounded rationality?
8. Describe the vertical boundaries of your local cable television provider. In
what ways could the vertical boundaries be expanded or reduced?
9. Describe the horizontal boundaries of your university. In what ways could
the horizontal boundaries be expanded or reduced?
10. In the context of manufacturing Apple iPhones, explain the concepts of
outsourcing and vertical integration.
11. Explain the difference between: (a) the market for electricity; and (b) the
electricity industry.
12. In every market, all buyers are consumers and all sellers are businesses.
True or false?
13. What is another name for the model of competitive markets?
14. What distinguishes a manufacturer with market power from one without
market power?
15. Should managers operating in an imperfect market: (a) set high prices
to make up for the imperfection; or (b) act strategically to resolve the
imperfection?

Discussion questions

1. The Hong Kong Hospital Authority provides healthcare at subsidized prices

through a network of hospitals and clinics. In the financial year 2019–​2020,
the Authority earned fees and charges of HK$4.8 billion while incurring
expenses of HK$76.9 billion. The government paid the Authority a subsidy
of HK$71.3 billion.
(a) What is the economic profit of the Hospital Authority?
(b) What is the minimum benefit that the Hospital Authority must provide
to add value?
(c) Some critics might argue that, since the Hospital Authority is losing
money, it should be shut down. Please explain why or why not.
(d) The waiting times for some specialist services are quite long. Should
the government increase the subsidy so that the Hospital Authority can
expand its staff and facilities?
2. At the time of writing, Amazon.com offered Prime, a bundle that includes
free shipping on consumer purchases, discounts on groceries, as well as
video, music, games, and books, at a price of US$119 per year. The price of
the Harry Potter paperback box set was US$50.33 with free shipping.
Introduction to managerial economics

(a) From the viewpoint of an Amazon Prime subscriber, compare the mar-
ginal cost of buying the Harry Potter box set from Amazon vis-​à-​vis a
competing retailer that charges for shipping.
(b) Suppose that Amazon Prime subscribers are subject to the sunk-​cost
fallacy. How would that affect their demand to buy products from
Amazon vis-​à-​vis competing retailers?
(c) By default, Amazon has set membership of Prime to automatically
renew. This auto renewal takes advantage of a behavioral bias. Explain
which one.
(d) Considering your answers to (a)–​(c) above, explain how the Prime ser-
vice gives Amazon an advantage over competitors.
3. The Singapore government discourages driving by limiting the registration
of new cars and auctioning the licenses. Each license allows the owner to
operate a car for ten years. The prices of licenses fluctuate with demand
conditions and the number of licenses.
(a) Classify and explain the following as decisions of participation or
extent. (i) Whether to buy a new car; (ii) How much to drive the car.
(b) How would the price of a new car license affect the decision on whether
to buy a new car?
(c) How would the price of a new car license affect the marginal cost of
driving and the decision on how much to drive the car?
(d) People who bought cars when licenses were more expensive drove
more. How would you explain such behavior?
4. Uber Technologies provides ride hail, delivery, and freight booking ser-
vices. In 2019, it served customers through the Google Cloud Platform,
Amazon Web Services, as well as its own cloud computing facilities. In late
2020, Uber sold its self-​driving car division to Aurora Innovation which
specializes in self-​driving technologies for cars and trucks.
(a) Apply the concepts of vertical integration and (dis)integration to
explain: (i) Uber’s operation of its own cloud computing facilities, and
(ii) Uber’s sale of the self-​driving car division.
(b) Apply the concept of outsourcing to explain Uber’s use of the Google
Cloud Platform and Amazon Web Services.
(c) Consider each of Uber’s decisions on (i) cloud computing and (ii)
development of self-​driving technology. Explain whether it is a deci-
sion on participation or extent.
5. Historically, fresh flowers in northern Europe were supplied by local
growers. Producers had to grow flowers in heated greenhouses to meet
demand in winter, such as on Valentine’s Day. Now, European consumers
buy roses, carnations, and chrysanthemums produced in Colombia,
Ecuador, Ethiopia, and Kenya.
(a) The liberalization of airline regulation allowed the entry of new airlines
and increased flights. How did that affect the market(s) for fresh flowers?

14
 Introduction to managerial economics

(b) How did the development of more fuel-​efficient and larger aircraft
affect the market(s) for fresh flowers?
(c) Compare the advantage of South American and East African growers
over European growers in winter vis-​à-​vis other seasons.
6. In January 2021, the Brexit agreement for the UK to leave the European
Union (EU) came into effect. From then, the movements of goods, services,
and people between the UK and EU were subject to national and European
laws and regulations.
(a) How would Brexit affect the supply of services by London investment
bankers to EU member countries such as France and Germany?
(b) How would Brexit affect the market power of French and German
investment bankers?
(c) UK and EU member countries apply different laws and regulations on
the production and sale of goods and services. How would Brexit affect
the degree of imperfection in the markets for goods and services?
7. The Australian national electricity transmission grid links eastern and
southern states –​ Queensland, New South Wales, Australian Capital
Territory, Victoria, South Australia, and Tasmania. The national grid does
not connect with regional grids in Western Australia and the Northern
Territory. In the wholesale electricity market, producers of electric power
sell to distributors which then sell to retailers of electric power. In the retail
electricity market, retailers sell to industrial and residential users.
(a) In 2005, Basslink connected the island of Tasmania to the electricity
grid in the other eastern and southern states. How did Basslink affect
the boundaries of electricity markets in Australia?
(b) Transmitting electric power over long distances is costly. Western
Australia and the Northern Territory are far from the other states. Could
that explain why their grids are not connected with the national grid?
(c) State governments allow only one company to distribute electricity
in each geographical area. Comment on the market power of that
company.
(d) Apply the concept of vertical integration to explain the merger of a pro-
ducer of electric power with a distributor.

You are the consultant!

In your organization or personal experience, identify and explain any
decisions that have been systematically biased by: (a) the sunk-​cost fallacy,
(b) status quo bias, or (c) anchoring. Explain how the organization or you
could have achieved a better outcome by controlling the bias.
Introduction to managerial economics

Progress check answers

1A. Value added =​buyer benefit − seller cost =​buyer surplus +​seller eco-
nomic profit.
1B. Angela should compare the marginal earnings and marginal cost in the
new job, decide how much she would work in the new job, and then
compare the total earnings and total costs in the current and new jobs.
1C. Bounded rationality is the idea that there are limits to rationality
when individuals make decisions. It can result in suboptimal decision-​
making: for instance, individuals may erroneously count sunk costs,
display a tendency to stick to the status quo, or rely excessively on a
specific piece of information when making decisions.
1D. The vertical boundaries delineate activities closer to or further from the
end user. By contrast, the horizontal boundaries are defined by the
organization’s scale and scope of operations.
1E. The three branches of managerial economics are competitive markets,
market power, and imperfect markets.

Review answers

1. Value added is the difference between buyer benefit and seller cost.
Economic profit is the difference between seller revenue and seller cost.
2. Value added is the difference between buyer benefit and seller
cost (not the difference between seller revenue and seller cost). So,
even though the charity receives no revenue, it need not be destroying
value. For the free meals to create value, the buyer’s benefit must
exceed the seller’s cost. In this example, the recipients of the meals are
the “buyers,” though they buy the meals at a price of zero. The charity
is the seller.
3. (a) Maggie’s marginal pay from ten hours of work is $15 per hour,
since she is paid $15 for an additional hour worked from nine
hours to ten hours.
(b) Maggie’s average pay is her total pay divided by her total hours
worked. This can be expressed as (8 × $10 +​2 × $15)/​10 =​$110/​
10 =​$11. Therefore, her average pay is $11 per hour.
4. The average value of a variable with respect to some factor measures
the total value of the variable divided by the total quantity of the
factor, whereas the marginal value measures the change in the vari-
able associated with a unit increase in the factor. The relation between
marginal and average values with respect to some factor depends on
whether the average value is decreasing, constant, or increasing with
respect to the factor.

16
 Introduction to managerial economics

5. True.
6. The decision of how many hours to work is one of extent. By comparing
the marginal earnings (benefit) and marginal cost of each hour, the
worker maximizes her net benefit from working, i.e., total benefit minus
total cost. As long as marginal earnings exceed marginal cost, it is in
the worker’s interest to work longer hours, and vice versa.
7. People act with bounded rationality because they have limited cogni-
tive ability and lack self-​control.
8. With regard to vertical boundaries, a local cable TV provider that
produces TV programs is more vertically integrated than a local cable
TV provider that buys TV programs from others.
9. A university that merges with a hospital is expanding its horizontal
boundaries. A university that shuts some of its faculties down is shrinking
its horizontal boundaries.
10. When Apple engages a contractor in China to manufacture iPhones,
Apple is outsourcing, i.e., vertically disintegrating. If Apple were to
manufacture the iPhones, it would be vertically integrating (upstream).
11. (a) The electricity market includes buyers and sellers. (b) The electricity
industry consists of sellers only.
12. False. In business-​to-​business markets, buyers are businesses. In human
resource markets, sellers are human beings.
13. Demand and supply model.
14. A manufacturer with market power can influence conditions of demand
and/​or supply.
15. (b).

Discussion answers

1. (a) Economic profit =​HK$4.8 billion -​HK$76.9 billion, which is a loss

of HK$72.1 billion.
(b) Value added =​ buyer benefit –​ seller cost. For value added ≥ 0,
the hospital needs buyer benefit ≥ seller cost, or buyer benefit ≥
HK$76.9 billion.
(c) Not necessarily. The Hospital Authority can still be value adding,
rather than value destroying, if buyer benefit exceeds the seller cost
of HK$76.9 billion. Evidence to the contrary is needed for critics
to make a convincing case that the Hospital Authority should be
shut down.
(d) The government should only increase its subsidy if it assesses that
the marginal value added from the expansion of staff and facilities,
i.e. marginal buyer benefit minus marginal seller cost, is positive.
Introduction to managerial economics

If the marginal buyer benefit (e.g., earlier detection of conditions

and increased patient satisfaction) is higher than the marginal seller
cost (e.g., higher payroll expenditures), then the increase in subsidy
would increase value added and should be undertaken.

Sources
Amazon.com
Ali, Fareeha. “Amazon Prime reaches 200 million members worldwide.”
digitalcommerce360.com, 16 April 2021. www.digitalcommerce360.com/​article/​
amazon-​prime-​membership/​
“The Climate Pledge celebrates surpassing 100 signatories.” Amazon.com, 21 April
2021. www.aboutamazon.com/​news/​sustainability/​the-​climate-​pledge-celebrates-
surpassing-​100-​signatories
Day, Matt. “Amazon increases Prime cost to $119 a year.” Seattle Times, 26 April
2018. www.seattletimes.com/​business/​amazon/​amazon-​increases-​prime-cost-
to-119-​a-​year/​
Miller, Ron. “How AWS came to be.” TechCrunch, 2 July 2016. https://​techcrunch.com/​
2016/​07/​02/​andy-​jassys-​brief-​history-​of-​the-​genesis-​of-​aws/​
Anchoring
Tversky, Amos, and Daniel Kahneman. “Judgment under uncertainty: Heuristics and
biases.” Science 185, no. 4157 (1974): 1124–​1131.
Flowers
Fredenburgh, Jez. “The 4,000 mile flower delivery.” BBC.com. www.bbc.com/​future/​
bespoke/​made-​on-​earth/​the-​new-​roots-​of-​the-​flower-​trade/​
Hong Kong Hospital Authority
Hong Kong Hospital Authority. “Annual Report, 2019–​2020.” www.ha.org.hk/​ho/​
corpcomm/​AR201920/​PDF/​HA_​Annual_​Report_​2019-​2020.pdf
National Health Service
National Health Service. “Annual Report 2019/​20.” www.england.nhs.uk/​publications/​
annual-​report/​
Singapore driving
Ho, Teck-​Hua, Ivan P.L. Png, and Sadat Reza. “Sunk cost fallacy in driving the world’s
costliest cars.” Management Science 64, no. 4 (2018): 1761–​1778.
Status quo bias
Knetsch, Jack L., and John A. Sinden. “Willingness to pay and compensation
demanded: Experimental evidence of an unexpected disparity in measures of
value.” Quarterly Journal of Economics 99, no. 3 (1984): 507–​521.
Sunk-​cost fallacy
Arkes, Hal R., and Catherine Blumer. “The psychology of sunk cost.” Organizational
Behavior and Human Decision Processes 35, no. 1 (1985): 124–​140.

18
PART I

Competitive
markets
20
CHAPTER 2

Demand

LEARNING OBJECTIVES

• Appreciate why buyers purchase more at lower prices.

• Distinguish consumer demand for normal products and inferior products.
• Appreciate the impact on demand of changes in the prices of substitutes and
complements.
• Appreciate the effect of the output of the item being produced on business
demand for inputs.
• Appreciate the concept of buyer surplus.
• Apply package deals and two-​part pricing to extract buyer surplus.

2.1 Introduction
Based in Indonesia and Singapore respectively, Go-​Jek and Grab are the Southeast Asian counterparts of Uber
and more. Calling themselves “super apps,” Go-​Jek and Grab not only provide ride hail and delivery services, like
Uber, but have also expanded into financial services and e-​commerce.
Uber introduced its ride hail service to Singapore in 2013, followed by Grab. Uber and Grab competed
intensely on price through wide and intensive promotions and discounts. Meanwhile, between 2013 and 2017,
Singapore’s dominant taxi operator, Comfort Delgro, shrunk its fleet by one quarter from 16,600 to 13,340 taxis.
In early 2018, Uber decided to exit Singapore and other Southeast Asian markets. Uber traded its businesses
for 27.5% of Grab’s shareholding. Later the same year, Go-​Jek launched its app in Singapore. Go-​Jek president
Andre Soelistyo committed to “bringing choice back to the ride-​hailing market in Singapore.”
In 2020, Grab earned revenue of US$1.6 billion from 25 million transactions served by over 5 million drivers
and 2 million merchants. The outbreak of Covid-​19 reduced ride hail revenues by 6% from the previous year but
increased delivery revenues 350%.

DOI: 10.4324/9781003239857-3
COMPETITIVE MARKETS

How did the price war between Grab and Uber affect taxi operators like Comfort
Delgro? After Uber’s exit, how did the reduction in promotions and discounts affect
Grab? Why did the Covid-​19 pandemic reduce Grab’s revenues from ride hail but raise
its revenues from deliveries?
This chapter introduces the concept of a demand curve, which describes the quan-
tity demanded of an item as a function of its price and other factors. Next, we con-
sider how demand depends on income, the prices of complementary and substitute
products, and advertising. Businesses can use the model of demand to plan their
strategy.
The concept of demand explains why the price war between Grab and Uber caused
Comfort Delgro to shrink its fleet of taxis. The concept explains how Uber’s exit from
the Singapore market and the reduction in promotions and discounts affected Grab.
It also explains why the Covid-​19 pandemic reduced Grab’s ride hail revenues but
increased its delivery revenues.

2.2 Individual demand

To understand how a price cut will affect sales, we need to know how the cut in price
will affect the purchases of the individual buyers and, generally, how an individual’s
purchases depend on the price of the item. The individual demand curve provides this
information: it is a graph that shows the quantity that the buyer will purchase at every
possible price.

Construction
Let us construct Angela’s demand for rides. We must ask Angela a series of questions
that elicit her responses to changes in price. We first ask: “How many rides would you
take each month at a price of $20 per ride?” Suppose that Angela’s answer is: “None.”
(Strictly, we pose the question holding “other things equal,” because Angela’s decision
may depend on other factors, such as her income.)
We then pose similar questions to Angela for other possible prices for a ride: $19,
$18, …, $1, and $0. At each price, Angela says how many rides she would take a
month. Table 2.1 presents this information and represents Angela’s demand for rides.

Table 2.1 Individual demand

Price ($ per ride) Quantity (rides per month)
20 0
19 1
18 2
… …
0 20

22
 Demand

20
Demand curve
19 ------
------------------------------------------
18 -------------

-------------------------------------
Price ($ per ride)

1 ----------------------------------------------------

-------
0 1 2 19 20
Quantity (rides per month)

Figure 2.1 Individual demand curve

(Assuming that the consumer’s demand curve is a straight line, we can draw the
demand without filling all the rows of the table.)
Next we graph the information from Table 2.1 as shown in Figure 2.1. We represent
the price of rides on the vertical axis and the quantity in rides a month on the hori-
zontal axis. (Note that demand and supply curves do not follow the scientific conven-
tion of representing the independent variable, price, on the horizontal axis and the
dependent variable, quantity, on the vertical axis.)
At a price of $20, Angela says that she would not take any rides, so mark the point
with the price equal to $20 and quantity of rides equal to zero. Continuing with the
information from Table 2.1, mark every pair of price and quantity that Angela reports.
Joining these points then yields Angela’s demand curve for rides.
Knowing Angela’s demand curve, a ride hail operator can predict how Angela will
respond to changes in its price. For instance, if presently the operator charges $12
per ride, Angela will buy eight rides a month. If the operator reduces its price to $11,
it knows that Angela will increase consumption to nine rides a month. By contrast,
if the operator raises its price to $13 per ride, Angela would cut back to seven rides
a month.

Marginal benefit
The individual demand curve shows the quantity that the buyer will purchase at
every possible price. Let us now consider the individual demand curve from another
perspective.
Referring to Angela’s demand curve in Figure 2.1, we can use the curve to determine
how much Angela would be willing to pay for various quantities of rides. Specifically,
COMPETITIVE MARKETS

the curve shows that she is willing to pay $19 per ride for one ride a month. Further,
it shows that Angela is willing to pay $18 per ride for two rides a month, and so on.
Generally, if the number of rides is larger, the price that Angela is willing to pay is
lower. Equivalently, at a lower price, Angela is willing to buy a larger quantity. These
two related properties of a demand curve reflect the principle of diminishing marginal
benefit.
Any item that a consumer is willing to buy must provide some benefit. We measure
Marginal benefit: the benefit in monetary terms. The marginal benefit is the benefit provided by an
The benefit additional unit of the item. The marginal benefit of the first ride is the benefit from one
provided by an ride a month. Similarly, the marginal benefit of the second ride is the additional benefit
additional unit. from taking a second ride each month.
By the principle of diminishing marginal benefit, each additional unit of con-
sumption provides less benefit than the preceding unit. In Angela’s case, this means
Diminishing that the marginal benefit of the second ride is less than the marginal benefit of the
marginal benefit: first ride, the marginal benefit of the third ride is less than the marginal benefit of the
Each additional
second ride, and so on.
unit provides less
Accordingly, the price that an individual is willing to pay will decrease with the
benefit than the
quantity purchased. Hence, the demand curve will slope downward. This is a gen-
preceding unit.
eral property of all demand curves: the lower the price, the larger will be the quantity
demanded. The fundamental reason for the downward slope is diminishing marginal
benefit.

Progress check 2A. Suppose that the operator presently charges $11 per
ride. By how much must the operator cut the price for Angela to increase
her consumption by three rides a month?

Preferences
The procedure for constructing a demand curve relies completely on the consumer’s
individual preferences. The individual decides how much he or she wants to buy at
each possible price. The demand curve then displays information in a graphical way.
Consumers may have different preferences and hence their demand curves will
differ. One person may like to eat red meat while another is a vegetarian. Further,
demand curves will change with changes in the consumer’s preferences. As a person
grows older, her demand for rock videos and extreme sports will decline, while her
demand for healthcare and cruise ship holidays will increase.

Deliveroo: discount vouchers

Founded in London, Deliveroo delivers food and groceries in the United
Kingdom and Ireland, as well as ten other countries. At the time of writing,
it served 7.1 million consumers with an average of 3.3 orders per month,

24
 Demand

and derived about half of its revenues and orders from the United Kingdom
and Ireland.
In May 2021, Deliveroo offered a voucher for 20% discount on a pur-
chase of at least £15 at specific Subway restaurants. The discount voucher
targets people who had consumed to a level at which their marginal benefit
is close to the regular Subway price. Since their marginal benefit is close to
the regular price, they would not buy more. However, the discount would
reduce the price of additional items and might persuade such consumers
to buy more.
Why was the discount limited to purchases of at least £15? This is a
way to target the discount and induce additional consumption. By con-
trast, if there was no minimum purchase, then all consumers would pay
less, including those who do not increase consumption. Then Deliveroo
and Subway would simply reduce their profit from such consumers without
increasing their purchases.

2.3 Demand and income

We have discussed how Angela’s demand for rides varies with the price of rides. For
businesses, it is also useful to appreciate the effect of other factors that affect demand.
An important factor is income. If Angela gets a raise, how would that affect her demand
for rides?

Income changes
Suppose that Angela’s income is presently $50,000 a year. Table 2.1 and Figure 2.1
represent Angela’s demand for rides with an income of $50,000 a year.
We then ask Angela a series of questions. These questions probe the effect of
changes in income as well as price: “Suppose that your income is $40,000 a year. How
many rides would you buy a month at a price of $20 per ride?” We then repeat the
question with other possible prices and tabulate the information.
Suppose that Table 2.2 represents Angela’s answers. We also represent this informa-
tion in Figure 2.2. Marking the pairs of prices and quantities, and joining the points,
we have Angela’s demand curve with an income of $40,000 a year.
Angela’s demand curve for rides with $40,000 income lies to the left of her demand
curve with $50,000 income. At every price, the quantity demanded with $40,000
income is less than or equal to the quantity demanded with $50,000 income.
Referring to Figure 2.1, if the price of rides drops from $8 to $7 per ride, while
Angela’s income remains unchanged at $50,000 a year, we trace Angela’s response by
moving along her demand curve from the $8 level to the $7 level.
By contrast, referring to Figure 2.2, if her income falls from $50,000 to $40,000,
while the price remains at $8 per ride, we represent Angela’s response by shifting the
COMPETITIVE MARKETS

Table 2.2 Individual demand with lower income

Price ($ per ride) Quantity (rides per month)
20 0
19 0
… 0
10 0
9 2
8 4
… …
0 20

20
Demand curve with
$50,000 income
Price ($ per ride)

Demand curve with

$40,000 income
10
8

0 4 12 20
Quantity (rides per month)

Figure 2.2 Individual demand curve with lower income

entire demand curve to the left. The essential reason for this difference is that the
figure, having just two axes, does not explicitly represent the buyer’s income.
Let us understand the difference in graphical representation between a change in
price and a change in income in another way. On Figure 2.2, at the $8 level, mark
two quantities: a quantity of 12 rides a month when Angela’s income is $50,000, and
another quantity of four rides a month when Angela’s income is $40,000.
Can we join these points to form a demand curve? The answer is definitely “no,”
because each point corresponds to a different income and different demand curve.
A demand curve shows how a buyer’s purchases depend on changes in the price of
some item, holding income and other factors unchanged. Accordingly, for each of the
points, there is a separate demand curve.

26
 Demand

In general, we represent a change in the price of the item by a movement along the
demand curve. By contrast, we represent a change in income or any factor other than
the price of the item by a shift in the entire demand curve.

Normal and inferior products

When Angela’s income drops from $50,000 to $40,000 a year, her demand for rides
shifts to the left. As Angela’s income falls, her demand for rides also falls. By contrast,
if her income were to rise, her demand would increase.
Let us compare Angela’s demand for rides with her demand for bus travel. If
Angela’s income falls, it is quite possible that she will substitute cheaper forms of travel
for more expensive ones. In particular, the drop in her income may lead to an increase
in her demand for bus travel.
By contrast, when Angela’s income increases, we can expect her to switch away
from cheaper forms of travel and toward more expensive alternatives. So, as her
income rises, Angela’s demand for bus travel will fall.
Goods and services can be categorized according to the effect of changes in income
on demand. If the demand for an item increases as the buyer’s income increases,
while the demand falls as the buyer’s income falls, then the item is a normal product. Normal product:
Equivalently, the demand for a normal product is positively related to the buyer’s Demand is positively
income. related to buyer’s
By contrast, the demand for an inferior product is negatively related to the buyer’s income.
income. This means that the demand falls as the buyer’s income increases, while the
demand increases as the buyer’s income falls.
Inferior product:
For Angela, ride hail is a normal product, while bus travel is an inferior product.
Demand is
Generally, broad categories of products tend to be normal, while particular products
negatively related to
within the categories may be inferior. Consider, for instance, the broad category of
buyer’s income.
commuting. While commuting as a category is a normal product, bus travel may be
an inferior product.
The distinction between normal and inferior products is important for business
strategy. When the economy is growing and incomes are rising, the demand for normal
products will rise, while the demand for inferior products will fall. By contrast, when
the economy is in recession and incomes are falling, the demand for normal products
will fall, while the demand for inferior products will rise.
The distinction is also useful in international business. The demand for normal
products is relatively higher in richer countries, while the demand for inferior products
is relatively higher in poorer countries. For instance, in developed countries, relatively
more people commute to work by car than bus. The reverse is true in poorer countries.

Progress check 2B. Draw a curve to represent an individual consumer’s

demand for bus travel. (a) Explain why it slopes downward. (b) How will a
drop in the consumer’s income affect the demand curve?
COMPETITIVE MARKETS

Uber and Go-​J ek: cars and motorbikes

Uber and Go-​Jek were established in the same year, 2010, but on
opposite sides of the world. Garrett Camp and Travis Kalanick founded
Uber as a mobile app to hail cars in San Francisco. Nadiem Makarim and
Michaelangelo Moran founded Go-​Jek as a call center to book motorcycle
taxis (ojeks) in Indonesia. Five years later, they upgraded Go-​Jek into a
mobile app encompassing ride hail by motorcycle or car, delivery, as well
as e-​commerce.
The differences in income between San Francisco and Jakarta may
explain why Uber started with cars and Go-​Jek with motorbikes. American
consumers earn more than Indonesians and are willing to pay more for
travel. In Jakarta and elsewhere in Asia, motorcycle taxis offer more
economical transport than four-​wheeled taxis. Moreover, when traffic is
congested, motorbikes may be faster than cars.

2.4 Other factors in demand

Individual demand may depend on other factors besides the price of the item and the
buyer’s income. The other factors may include the prices of related products, adver-
tising, durability, season, and location. Here, we discuss the prices of related products
and advertising, as well as a particular factor in business demand, production.

Complements and substitutes

Suppose that Angela uses ride hail to meet dates. How would an increase in the price of
restaurant meals affect Angela’s demand for rides? A change in the price of restaurant
meals will affect Angela’s purchases of rides at all prices of rides. Hence, it would shift
the entire demand curve.
Suppose that presently the price of restaurant meals is $20. Figure 2.3 represents
Complements: An Angela’s demand curve for rides when the price of restaurant meals is $20.
increase in the price We next construct Angela’s demand when the price of restaurant meals is $25. To
of one causes a fall do so, we ask Angela how many rides she would take at various ride prices if the price
in the demand for of restaurant meals were $25. Figure 2.3 shows the new demand curve: when the price
the other. of restaurant meals is higher, the demand curve for rides is further to the left, implying
that demand is lower.
Generally, related products can be classified as either complements or substitutes
Substitutes: An according to the effect of an increase in the price of one product on the demand for
increase in the price
the other. Two products are complements if an increase in the price of one causes the
of one causes an
demand for the other to fall. By contrast, two products are substitutes if an increase in
increase in the
the price of one causes the demand for the other to increase.
demand for the
For Angela, restaurant meals and rides are complements. The more restaurant
other.
meals she consumes, the more rides she will want. Hence, if the price of restaurant

28
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