SESSION 1

Managerial Economics

• The use of Economic Analysis to make business decisions

involving the best use (allocation) of scarce resources.
• Applied Microeconomics
• Economic Theory helps managers to collect the relevant
information and process it in order to arrive at the optimal decision
• Given the goals of a firm, a decision is OPTIMAL if it brings the firm
closest to its goals
 Management Decision Problems

• Product Price and Output

• Production Technique
• Stock Levels
• Advertising Media and intensity
• Labor hiring and firing
• Investment and Financing
 Economic Conditions

• Market Structure
• Supply and Demand conditions
• State of Technology
• Govt. Regulations
• International Dimensions
• Future Macroeconomic factors
 Tools and Techniques of Analysis

• Marginal Analysis
• Linear Programming
• Game Theory
• Optimization
• Forecasting
 Demand Analysis
• Demand Schedule – A list / table showing
quantity demanded of a good at different prices,
all other things being held constant

• Demand Function –
QXD = f ( px, p1,…..pn, Y, T, Ep, EY,A, P)

• Demand Curve – Represents the relation

between price and quantity demanded of a
good, all other things being held constant
 Determinants of Demand : Demand
Function
• Own Price
• Prices of related goods → Substitutes and
Complements
• Income
• Tastes & Preferences
• Expectations
• Population
• Other exogenous factors
 Demand Curve

• Law of Demand: Other factors remaining

constant, an increase in the price of a product
leads to a fall in its demand
P P

Q
Q
Linear Demand Curve Non – Linear Demand Curve
Difference between change in Quantity
demanded and change in demand
• Change in Quantity Demanded → A movement
along the demand curve in response to a
change in price – Expansion / Contraction of
Demand

• Change in Demand → A movement of the entire

demand curve in response to a change in one of
the other determinants of demand – Shift in
Demand
 Effect of a Price Change

• 2 effects of a price change:

 Income Effect – A price change causes Real
Income to change and therefore consumption of
both goods changes
 Substitution Effect – Price change of one good
causes the relative price of the two goods to
change and consumers substitute the relatively
cheaper good for the more expensive one
 Elasticity of Demand

• Price Elasticity of Demand refers to the

responsiveness of quantity demanded to price
changes.
• Ed = dQ/Q ∕ dP/P
• Defined as the percentage change in quantity
demanded divided by the percentage change in
price
• EPd is negative due to the inverse relationship
between quantity and price, but we consider the
absolute value for interpretation
 Price Elasticity of Demand

• Determinants of Price Elasticity of Demand:

 Number and availability of Substitutes
 Expenditure on the commodity in relation to the
consumer’s budget
 Durability of the product
 Length of time period under consideration
 Consumers’ Preferences
 P P

Q Q

Perfectly Inelastic Demand Perfectly Elastic Demand

eDP = 0 eDP = ∞
 P P

Q
Q
Less than Perfectly inelastic demand Less than perfectly elastic demand
0 < eDp < 1 1 < eDp < ∞
P

Q
Unitary Elastic Demand Curve
eDp = 1
 Price elasticity and Decision Making
• Information about price elasticities can be
extremely useful to managers as they
contemplate price decisions.
• If demand is inelastic at the current price, a price
decrease will result in a decrease in total
revenue.
• Alternatively, reducing the price of a product with
elastic demand would cause revenue to
increase.
* Remember TR = P*Q
 Income Elasticity of Demand
• Measures the responsiveness of quantity
demanded of a good to changes in Income.
• Classification of Goods:
 Normal Goods – Demand Increases as Income
increases (eY >0)
 Inferior Goods – Demand decreases as
consumer Income increases (eY < 0)
 Basic Necessities – Commodities like salt, food
grains etc for which demand is relatively inelastic
and does not vary with income after a point
 Exceptions to the Law of Demand –
Upward Sloping Demand Curve
• Giffen Goods – a subclass of Inferior goods for
which the income effect outweighs the
substitution effect
• Veblen Products / Snob effect – Goods that
have a snob value attached to them for which
demand actually increases as price goes up
• Speculative Effect – In periods of rising prices,
anticipation of future increases may cause
consumers to demand more
• Bandwagon Effect – Occurs when people
demand a commodity only because others are
demanding it and in order to be fashionable
• Emergencies like war, famine etc.
 Demand Forecasting

• Estimation of future demand

• Need for Forecasting
• Short Run – Demand forecasts help in preparing
suitable sales policy and proper scheduling of
output
• Long Run – Forecasts are helpful in future
Capital Planning, planning for capacity
expansion, new plants etc.
 Qualitative Methods of Forecasting

• Consumer Interviews or Surveys

_ to estimate demand for new products
_ to test consumer reactions to price changes
or advertising
 Opinion Polls
 Market Studies and experiments
_ to test new or improved products in
controlled settings
 Experts’ Opinion
_ Delphi Technique: Opinions of different
experts are taken and compiled. If there are
discrepancies between the different viewpoints,
successive rounds of iterations are undertaken
taking into account the opinions of other experts,
until near consensus emerges
 Statistical Forecasts
Time Series Analysis : Forecasts on the basis of an
analysis of historical time series data
 Trend Projection Method
_ Based on the assumption that there is an identifiable
trend in the variable to be forecast which will continue
in the future
_ Time Series data is used to fit a trend line on the
variable under forecast either graphically or by
statistical techniques
Y = a + bt; t → time
_ Forecasting is done by extrapolating the trend line
into the future.
 Components of Time Series
 Trend – Persistent overall upward or downward pattern
 Cyclical – Repeating up & down movements
 Seasonal – Regular fluctuations in economic activity during
each year due to weather, customs etc.
 Random – Erratic, unsystematic fluctuations due to unforeseen
events.
 Any observed value of time series is the result of all the above
factors operating together
 These are examined separately using Smoothing Techniques
 Smoothing Techniques
 Moving Averages – The forecast for the next period
represents a simple arithmetic average or a weighted
average of the last few observations.
 Exponential Smoothing – Similar to Moving Average
method, but with more weightage given to more recent
data
_ Weights decline exponentially
_ If there are n observations in a time series, the
forecast for the next period is a weighted average of
the observed value of the time series in period n and
the forecasted value for the same period
_ Forecasts are updated with new data
 Barometric Methods of Forecasting

• Use Indicator Series – correlated with the variable to

be forecast
• Three types of Indicators
 Leading Economic Indicators
_ Tend to anticipate turning points in economic activity
_ Must be accurate and provide sufficient lead time
 Coincident Indicators
 Lagging Indicators
 Regression Method
• A Statistical technique using estimating equations
• Development of a theoretical model
_ Identify variables that influence demand for the variable under
forecast
_ Based on Economic theory, expressed in mathematical terms
• Data Collection
_ Use either time series or cross-section data on all relevant
variables
• Choice of a functional form
_ Linear Qd = a + bP
_ Multiplicative Qd = aPb
• Estimation and Interpretation of results
 Simultaneous Equation Method

• In many econometric contexts, single equation

methods may produce estimates with poor
statistical properties.
• Simultaneous Equation Models have been
developed as one means of addressing these
problems.
• Multiple Equation Models are used to predict the
values of endogenous variables (to be
determined) as a function of exogenous variables
(determined outside the system
 Input Output Forecasting
• Input – Output model is a specific formulation of the inter-
industry flows within an economy
• Depicts how industries are dependent on each other as
_ Supplier of Inputs
_ Consumer of output
• An Input – Output Matrix is drawn up, which specifies, for each
industry, its sales (to other industries as well as for final
consumption) as also its consumption of other industries’ output
• This method can be used to forecast sectoral impacts of
changes in Final Demand
• Also used to forecast employment implications
 Production & Supply Analysis
• Production involves the transformation of inputs such as
Capital, Labor and Land into output
• Production Function is a technical relation which
connects factor inputs and output
X = f ( L, K, R, S, V)
• In the process of production, the manager is concerned
with efficiency in the use of inputs
Technical Efficiency – Occurs when it is not possible to
increase output without increasing inputs
Economic Efficiency – Occurs when a given output is being
produced at the lowest possible cost
 Short Run Analysis
• Short Run – Some inputs are fixed and some
are variable
• We usually assume Capital (K) to be fixed and
analyze how output varies with changes in Labor
(L)
• X = f (L) given K, R, S, V
• Marginal Product of Labor (MPL) – The change in
output resulting from a very small change in
Labor
• MPL = ∂X ∕ ∂L
Production Function

TPL

L
 Law of Diminishing Marginal returns
• As additional units of a variable input are
combined with a fixed input, at some point the
additional output (i.e., marginal product) starts to
diminish

• Also known as the Law of Variable Proportions

since it refers to the Short Run when all factors
are kept fixed except one ( therefore the
proportion in which factors are being employed
keeps changing)
 Three Stages of Production

APL
L
MPL

Stage I – Capital is Stage II – Addition to Stage III – Fixed Input capacity

Underutilized and TP due to increase in is reached and additional L
Successive units of L continues to be causes output to decline
L add greater positive but is falling
Amounts to TP With each unit
 Relation between MP and AP

• MP > AP → AP is rising
• MP < AP → AP is falling
• MP = AP → when AP is maximum
• TP is maximum when MP = 0
 Optimal Input Usage
• A profit maximizing firm will be using optimal
amount of an input at the point at which the
monetary value of the input’s marginal product is
equal to the additional cost of using that input
• Monetary value of the input’s MP = Px (MPL)
• Cost of input = w (Wage rate)
• Profit Maximization requires
w = Px * MPL
 Long Run Analysis
• All inputs are variable
• Analysis is carried out with the help of Isoquants
• Isoquant : An Isoquant shows the various combinations of inputs
(L & K) that the firm can use to produce a specific level of output,
given the state of technology.
 A higher isoquant refers to a larger output, while a lower isoquant
refers to a smaller output.
 Isoquant shape shows input substitutability
 C – shaped isoquants are common and imply imperfect
substitutability
 Substituting Inputs
There exists some degree of
substitutability between inputs.
Different degrees of substitution:

K K
K

L L L

a) Perfect substitution b) Perfect c) Imperfect substitution

complementarity
 Substituting Inputs continued
• In case the two inputs are imperfectly
substitutable, the optimal combination of inputs
depends on the degree of substitutability and
on the relative prices of the inputs
• The degree of imperfection in substitutability is
measured with marginal rate of technical
substitution (MRTS):

MRTS = ∆ L/∆ K
 Law of Diminishing Marginal
Rate of Technical Substitution:

Table 7.8 Input C ombinations

for Isoquant Q = 52
C ombination L K
A 6 2
B 4 3
C 3 4
D 2 6
E 2 8
Optimal Combination of Multiple Inputs
• Isocost : If a firm uses only L & K, the total cost or
expenditure of the firm can be represented by :
C = wL + rK
• Optimization problem : One can solve for the
combination of inputs that either :
 Minimizes total cost subject to a given constraint on
output
OR
 Maximizes output subject to a given total cost
constraint
 Isocost Curve

Assume PL =$100 and

Input combinations K =$200
for $1000 Budget
Combination L K
A 0 5
B 2 4
C 4 3
D 6 2
E 8 1
G 10 0
 Isocost Curve and Optimal
Combination of L and K
K

100L + 200K = 1000

5

“Q52”

10 L
Isocost and isoquant curve for inputs L and K
 Optimal input Combination

• Depends on the relative prices of inputs and the

degree to which they can be substituted for each
other

MPL ∕ MPK = w ∕ r

• Represented by the point of tangency between

Isocost and Isoquant
 Returns To Scale
• Shows the output effect of increasing all inputs.

• 3 types of returns to scale :

 Constant

 Increasing

 Decreasing
• If the quantity of all inputs used in the production
is increased by a given proportion, we have
• Constant Returns to Scale if output increases in
the same proportion;
• Increasing Returns to Scale if output increases
by a greater proportion; and
• Decreasing Returns to Scale if output increases
by a smaller proportion.
 Constant Returns to Scale
capital

6 B

200Q

3 A

100Q

6
labor
3
 Increasing returns to scale

capital

6 C

300Q

3 A

100Q
Labor
3 6
 Decreasing Returns to Scale

capital

6
D

150Q

3 A

100Q

labor
3 6
Measurement of Returns to
Scale continued

If original production function is

Q = f(X,Y)
and if the resulting equation after
the multiplication of inputs by k is
hQ = f(kX, kY)
where h presents the magnitude of
increase in production
Then, if
h > k, increasing returns
h = k, constant returns
h < k, decreasing returns
 Graphically, the returns to scale concept can
be illustrated with reference to the production
function using the following graphs

IRS CRS DRS

Q Q Q

L, K L, K L, K
Reasons for Increasing Returns to
Scale:
• Division of labor (specialization)
increased labor productivity

• Indivisibility of machinery or more

sophisticated machinery justified
increased
productivity

• Geometrical reasons
• Decreasing returns to scale can result
from certain managerial inefficiencies:
– problems in communication
– increased bureaucracy
 Supply Function

• Is a Price – Output relation

• S = S(P), dS/dP >0
• Market supply along with market demand
determines the market price
• The slope and shape of the supply curve
depends on production conditions and laws of
return.
• Also depends on the time perspective