Introduction

Economics Branches: Micro- and Macro-Economics, from micro- to managerial economics or economics of firm. Key Concepts: Demand and Supply sides of economic units and aggregates optimization. Laws of Demand and Supply, exception of Law of Demand; equilibrium price and quantity.

Show demand and supply curves and the equilibrium

Issues and Importance of Study of Managerial Economics

Managerial Economics is the application of economics to the real business activities so as to get desired business results in a fiercely competitive environment where thousands of rivals plan strategies to get control of the market. Important Issues: Production, cost and organization of firms in market place. Topics studied: Law of demand and elasticity of demand Demand forecasting Production theory returns to scale, technology, cost, revenue and profit Objectives of firms Determination of prices methods, cartels, groups, leadership Tools to judge economic efficiency break-even analysis, linear programming, game theory etc Micro planning project, capital budgeting, cost benefit analysis, public investment criteria regarding turnkey projects Business environment and social welfare.

Where do Principles of Micro-economics fit in managerial decision making?

The primary activities of decision making are: Finding occasions for making decisions Identifying possible courses of action Evaluating the revenues and costs associated with each course of action Choosing the course that best meets the goals and objective of the firm, which is maximizing the wealth of a firm PV of net cash flows or PV () and PV () = 1/(1+r) + 2/(1+r)2 + 3/(1+r)3 + .+ n/(1+r)n Where, n is the profit in year n in current prices and r is an appropriate discount rate for converting future value into present value.

Constraints to Decision Making

Constraints in managerial decision making involve: Legal - including environmental laws, laws relating to womens/child rights, provisions inconsistent with generally accepted standards of behavior Contractual bind the firm because of some prir agreements Financial maximize production subject to the budgeted amount Technological considerations set physical limit on capacity/volume of production

Circular Flow of Economic Activities

Payment for goods/service Payment for Goods/Services Product Market

Goods and Services Households Economic Resources

Factor Market

Goods and Services Firms Economic Resources

Income

Factor Payments

Demand Analysis
Individual and Market demand: Definition/explanation.
Illustration: Max, a graduating senior has accumulated an impressive file of tests during his college career. He plans to sell the collection to three prospective buyers, whose demand equations are: Q1 = 30 3P, Q2 = 22.5 0.75P, and Q3 = 37.5 1.25P, where, Q1, Q2 and Q3 are quantity demanded by the three buyers. Calculate (a) the demand equation for Maxs tests (b) how many more tests he can sell for each one-dollar decrease in price, (c) the charge to sell his entire collection if he has a file of 60 tests and (d) the quantity demanded by each of the three buyers at this price (a) Market demand Qm = Q1+ Q2 + Q3 =30 3P + 22.5 0.75P + 37.5 1.25P = 90 3P (b) The equation shows that an 1 dollar decrease in price will increase the quantity demanded by 3 tests (c) To sell the entire set of collections, i.e., Qm = 60, Qm = 90 3P or, 60 = 90 - 3p, which makes P = 10 and (d) at price P = 10, Q1 = 30 10 = 20 tests; Q2 = 22.5 0.75 x10 = 15 tests and Q3 = 37.5 1.25 x 10 = 25 tests

Demand, Supply and Equilibrium

Demand Function Qd = a + bP, where b<0 and Qs = c + dP, where d >0 At equilibrium, Qd = Qs => a + bP = c + dP Which implies Pe = c a/b d and Qe= a + b (c a/b d) Specific case: Qd = 14 2P and Qs = 2 + 4P At equilibrium, Qd = Qs => 14 2P = 2 + 4P Solving the equations, we get Pe = 2 and Qe=10 units

Theory of Costs
Involves three important/basic areas of managerial economics: Resource allocation decisions; Decisions on expanding product line; Decisions on capital investment; there are other areas Explicit cost actual payments to other parties, also called accounting cost Implicit cost value of foregone opportunities but do not involve an actual cash payment Sunk cost Expenditures made in the past or to be made in future against contractual arrangement. Example: cost of inventory, future rental payments on a warehouse (as part of long-term lease) Marginal cost cost associated with a one-unit change in the output Incremental cost total additional cost of implementing a managerial decision; Example cost of adding a new product line, acquiring a major competitor, developing an in-house legal staff etc. Opportunity cost value of next best alternative foregone

Fixed Cost, Variable Cost and Marginal Cost

Capital Labor Output Input Rate TFC AFC TVC AVC Total Cost Marginal Cost

10

1000

1000

10 10 10 10 10 10 10 10

2 3.67 5.1 6.77 8.77 11.27 14.60 24.60

1 2 3 4 5 6 7 8

1000 1000 200 1000 500 367 1000 333 510 1000 250 677 1000 200 877 1000 167 1127 1000 143 1460 1000 125 2460

200 184 170 169 175 188 208 307

1200 1367 1510 1677 1877 2127 2460 3460

200 167 143 167 200 250 333 1000

Draw curves for TFC, TVC, TC, MC, AC, AVC by using the above data; MC, AC and AVC first decline, reach a minimum and then shift upwards; short-run cost curves are U-shaped, long-run cost curves are flatter.

Total cost (TC), fixed cost (FC), variable cost (VC), average cost (c/q), marginal cost (c/q; m in y = mx + c) accounting cost, explicit cost, implicit cost, economic cost (explicit + implicit cost),opportunity cost; revenue and break-even analysis
Calculation of Economic Profit Sales $90,000 Less: Cost of goods sold $40,000 Gross profit $50,000 Less: Advertising $10,000 Depreciation $10,000 Utilities $3,000 Property Tax $2,000 Misc. expenses $5,000 $30,000 Net Accounting Profit $20,000 Less: Implicit Costs Return on own capital invested $10,000 Opportunity cost ($5000 x 12) $60,000 $70,000 Net Economic Profit [Net accounting profit implicit costs] $50,000 Econ. Profit = Revues minus all relevant costs, both explicit and implicit

Costs and the Concept of Profit-1

Costs and the Concept of Profit-2

Suppose that you are a good dressmaker. You have 4 yards of a material purchased for Tk 200 per yard a few years ago. You gave the options for (a) selling it now @Tk 1200 per yard and (b) using it in making dress that may sell for Tk 7200. The making of the dress would require 4 hours of your labor, which you can sell elsewhere for Tk 800 per hour. Decide whether you should make the dress or sell the material. Soln: Revenue from sale of the material Tk 7200 Less: cost of the material 4 x 1200 = 4800 4 hors of labor 4 x 800 = 3200 8000 Economic Profit Tk. 800 Alternatively, if economic cost is not considered Revenue = Tk 7200 and, considering the historical value only, Material cost = 4 x 400 = Tk 1600 Profit = 7200 1600 = Tk 5600

Cost, Revenue, Profit and Firms Equilibrium-1

Total cost function C = 1000 + 10q 0.9q2 + 0.04q3 MC = dc/dq = 10 1.8q + 0.12q2 Total variable cost = Total cost fixed cost = 10q 0.9q2 + 0.04q3 AVC = TVC/q = 10 0.9q + 0.04q2 Profit = Revenue Cost = pq (FC + q.AVC) Or, + FC = q(p AVC) => q = (FC + )/(p AVC) This gives the rate of output necessary to generate a certain amount of profit At break-even the = 0 and therefore, the break-even volume of output is qBE = FC/(p AVC)

Cost, Revenue, Profit and Firms Equilibrium-2

Example: FC of a firm is $10000, price per unit of its product is $20 and AVC (MC) of the forms product is $15. The firm has a target for a profit of $20000. The volume of output required to achieve the target is:

q = (FC + )/(p AVC) = (10000 + 20000)/(20 15) = 6000 units

Reminder: The break-even output can be obtained from the equation by taking = 0 i.e., the break-even volume of output for the above firm would be FC / = 10000 /(20 15) = 2000 units (p AVC)
Show the graphs for FC, VC, TC, TR and the BE value

Optimization of a Firms Output

Following are the cost and revenue functions for a firm: TC = 50 + 4q and TR = 20q q2; Calculate
the volume of output for which profit would be maximum.

Profit = (20q q2) (50 + 4q) = 16q q2 50 d/ = 16 2q d/ = 0 => 16 2q => q = 8 (i) and dq dq d/ (d/ )= 2 < 0 ...(ii) dq dq Conditions (i) and (ii) indicate that the firm will have maximum profit if the output is 8 units and the profit at output 8 is: 8 = 16q q2 50 = 16x8 82 50 = 30 units Alternatively, MC = dc/dq = 4 and MR = d/dq = 20 2q and For max MC = MR => 4 = 20 2q i.e., q = 8 implying that profit is maximum when q = 8 units.

Consumer Behavior
Consumers equilibrium (maximization of satisfaction) Utility (total and marginal, and Marginal Utility Theory to explain consumers equilibrium: TU and MU Schedule; MU diminishes, TU is maximum when MU is zero, and consumer is in equilibrium when MU = 0. Indifference Curve Theory: indifference, indifference schedule and curve, properties of indifference curve, budget line, consumers equilibrium on the indifference curve, shifts in consumers equilibrium based on changes in price and income (PCC and ICC)

Elasticity of Demand
Elasticity = measure for response in demand to change in price and income; price, income, cross and substitution elasticity Price elasticity of demand

ep =(proportionate change in quantity demanded of a product X)

(proportionate change in price of the product x)

ep = (q/q) (p/p ) = (dq/dp). p/q

The price of a product changes from tk 10 per unit to Tk 12 and because of this, the quantity demanded changes from 10 units to 7 units. The ep stands at 1.5, this means that the increase in price by 1% would cause a reduction in demand by 1.5%. Let the demand equation is Qd = 100 4p i.e., the demand at price $10 is 100 4x10 = 60 units and the

ep = (dq/dp). p/q or, 4. 10/60 = 0.67

Price Elasticity of Demand

Determinants of ep Availability of substitutes products having good substitutes have high ep Proportion of income spent demand tends to be inelastic for goods and services that account for only a small proportion of total expenditure (demand for salt) Time period demands are usually elastic in the long term than in the short run; people have preference in maintaining the standards in consumption once achieved and consumers adjust expenditures in the long run. ep<1, the demand is elastic (luxury goods), if price increases, consumers spend less, revenues of sellers decrease ep = 1, unitary elastic, revenues of sellers remain unchanged 1< ep<0, demand is inelastic (everyday necessities), revenues of sellers increase, even with increase in price

Income Elasticity of Demand

Income elasticity of demand

ei =(proportionate change in quantity demanded of a product X)

(proportionate change in income of the consumer buying it) ei = (q/q) (I/I ) = (dq/dI). I/q Let the demand equation is Qd = 50,000 + 5I. If someones income (I) is Tk 10,500, Qd = 50,000 + 5x10,500 = 102,500; and
ei = (dq/dI). I/q = 5. 10,500/50,000 = 0.512

This means that the an 1% increase in income causes 0.512% increase in the quantity of a product (for which the ei = 0.512) consumed. Income elasticity is usually positive. But take the case of hot dogs (in the US) it is a food for low income group of people. But if the income of this group of people increases, they usually give up hot dogs and switch to other types of meat. Therefore, income elasticity of hot dogs may be negative. Use of the concept of elasticity: pricing, targeting of products for different market segments

Income elasticity: Engels Law

Percentage of income spent on food decreases as income increases Ernst Engel, Germany Implication: Farmers may not prosper as much as people in other occupations during the periods of economic prosperity; Food expenditures do not keep pace with increases in GDP; Farm incomes may not increase as rapidly as incomes in general

Cross Elasticity of Demand

The responsiveness of quantity demanded of a product X to change in the price of another (usually, a substitute or complementary) product Y ec =(proportionate change in quantity demanded of a product X) (proportionate change in price of another product Y)

ec = (qx/qx) (py/py ) = (dqx/dpy) (py/qx )

A fall in price of a product Y increases demand for its complementary product X Reduction in price of a product Y decreases demand for its substitute product X; however, cross elasticity is not reciprocal i.e., ec for coffee is not the same as ec for tea, tastes of consumers, their incomes, price of some other products matter. Exercise: the demand for X in terms of the price for y is given by qx = 100 + 0.5 py; calculate ec Soln: ec = (dqx/dpy) (py/qx ) = (150 125)/(100 - 50) (50 + 100)/(125 + 150) = 0.27; Note: (py/qx ) should be calculated as the ratio of ranges

Elasticity: Problem
The demand for (Qx) for books of a publishing company is determined as Qx = 12000 5000Px + 5I + 500Pc, where Px = price charged for the companys books I = per capita income of the buyers Pc= price of the books of competing publishers Determine the effect of a. increase in price of the companys books on its revenues b. rising incomes of the buyers on the sale of the companys books c. rise in prices of the books of the competing publishers on the demand for the companys books Assume that the initial values of Px, I, and Pc are $5, $10,000 and $6 respectively

Solution to Elasticity: Problem

a. Effect of increase in price of the companys books on its revenues The effect of increase in price can be assessed by computing price elasticity of demand. Substituting the initial values of I and Pc in the demand equation,

Qx = 12000 5000Px + 5(10000)I + 500(6) = 65000 5000Px

The value of dq/dp for the given demand equation is:
dQx/dPx = d/dPx (65000 5000Px)= 5000; and p/q = Px/Qx

where Px = $5 and Qx= 65000 5000Px = 65000 5000(6) = 40000

Now, ep = (dq/dp). p/q and for the given demand equation

ep = 5000 . 5/40000 = 0.625

[dq/dp= dQx/dPx = 5000, and p/q = Px/Qx where Px = $5 and

Qx= 40000]. The value of ep = 0.625 i.e., 1 < ep < 0 implies that the companys books are price inelastic and raising the price of its books will increase the total revenue

Solution to Elasticity: Problem

b. Income elasticity ei = dQx/dI . I/Q
The demand function is: Qx = 12000 5000Px + 5I + 500Pc dQx/dI = 5, and at income I = 10,000 quantity demanded Qx = 40,000 , which means that the income elasticity ei = dQx/dI . I/Q= 5. 10000/40000 = 1.25 We find that income elasticity ei > 1. this implies that the companys books belong to luxury goods. Since with increase in income buyers tend to buy more of luxury goods, during the period of rising incomes, the sale of the companys books will increase.

Solution to Elasticity: Problem

c. The demand function is: Qx = 12000 5000Px + 5I + 500Pc And the cross elasticity ec = dQx/dPy . Py/Qx The Pc in the demand curve is equivalent to Py of the cross elasticity and ec = dQx/dPy.Py/Qx = 500. 6/4000 = 0.075 [since dQx/dPy = dQx/dPc = 500] This implies that a 1% increase in the price of the books of competing publishers would result in a 0.075% increase in the demand for the companys books.

Regression Equation
Simple regression relationship between two variables Y = a + bX, where Y may be production cost and X output. Y = dependent variable, X = independent variable, a = intercept on y- axis and in the given case, fixed cost b = slope of the cost function, variable cost per unit or marginal cost; the function may be compared with the equation y = mx + c PRODUCTION TOTAL TOTAL
Problem: Formulate the regression equation and predict the cost of producing 20 units of the product Show freehand plotting of the cost At the different levels of output and Draw the straight line cruising Through the points.
PERIOD 1 2 3 4 5 COST ($Y) 100 150 160 240 230 OUTPUT (X) 0 5 8 10 15

6
7

370
410

23
25

Regression Equation: Soln of the Problem

Cost (Yt)
100 150 160 240

Output (Xt) Yt Yav Xt Xav

0 5 8 10 137.14 87.14 77.14 2.86 12.29 7.29 4.29 2.29

(Xt Xav )2
151.04 53.14 18.40 5.24

(Xt Xav)(Yt Yav )

1685.45 635.25 330.93 6.55

230 370
410

15 23
25

7.14 132.86
172.86

2.71 10.71
12.71

7.34 114.70
161.54

19.35 1422.93
2197.05

Yav =237.14

Xav = 12.29

(Xt Xav )2 (Xt Xav)(Yt Yav )

= 511.40 = 6245.71

The regression equation is: Y = a + bX, where, b = (Xt Xav)(Yt Yav ) (Xt Xav )2 = 6245.71 511.40 = 12.21; a = Yav bXav = 237.14 (12.21)(12.29) = 87.08 The equation therefore, is Y = 87.08 + 12.21X

Add: talk about R2 the coefficient of determination (proportion of the dependent variable explained by the regression , value of it varies between 0 and 1; when the value of R2 is higher it means that the regression fits the data very well.

Production function relates output to inputs; general equation is: Q = f(K,L), where K is capital and L is labor; one of the specific is the Cobb-Douglas production function Q = AKL where A, and are constants. Prices of inputs and the price of the output must be used with production to determine which of the possible input combinations is the best give the firms objective. Marginal product: addition to total product for one extra unit of an input and Marginal product of capital MPk = dQ /dK = AK 1L and Marginal product of labor MPL = dQ /dL = AKL 1 Law of diminishing marginal return: when increasing amounts of a variable input are continued with a fixed level of another input, a point will be reached when marginal product of the variable input will decrease.

Production Function

Matrix of Inputs (capital and labor) and Output

CAPITAL
8 7 6 5 4 3 2 1 Labor 283 265 245 224 200 173 141 100 1 2 400 374 346 316 283 245 200 141 3 490 458 424 387 346 300 245 173 4 565 529 490 447 400 346 283 200 5 632 592 548 500 447 387 316 224 6 693 648 600 548 490 424 346 245 7 748 700 648 592 529 458 374 265 8 800 748 693 632 565 490 400 283

If 4 units of capital and 2 units of labor are used, the maximum production will be 283 units; if K = 8 and L = 2, the output Q = 400 units , and the like. There is a substitutability between the factors of production; there are varying ways to produce a particular rate of output by using different combinations of inputs 245 units can be output can be produced by using any of the combinations - K = 6 and L = 1, K = 3 and L = 2, K = 2 and L = 3 or K = 1 and L = 6 A firm can use a labor intensive or a capital intensive process (e.g., 6 units of capital and 1 unit of labor or 1 unit of capital and 6 units of labor to produce the same output.

Total, Average and Marginal Products

Ten equally skilled and diligent workers are ready to work in a factory equipped with machines and ready stock of materials. As workers add in, the output increases and figures on the number of workers, total product, average product and marginal product can be shown as under: Av. Product (AP) No of Workers Total Product Av. Product Marginal Product = average output 0 0 1 2 2 2 per unit and AP = TP/L, 2 5 2.5 3 TP = Total product 3 9 3 4 L = No of workers 4 14 3.5 5 Marginal Product (MP) 5 22 4.4 8 = change in output 6 40 6.7 18 Associated with one7 57 8.1 17 Unit change in workers 8 63 7.9 6 Q/ , MP = L 9 64 7.1 1 Q = amount of output. 10 63 6.3 1

Total Output
Total Output (Q)

Rate of labor input (L)

Average and Marginal Product

Marginal product
Average product Rate of labor input

Producers Equilibrium
Output at which a producer is most satisfied, usually, a level at which the firm has the maximum profit, which can be attained either by minimizing costs or maximizing sales. Minimizing costs: manufacturer may use two factors of production and a number of different combinations of the factors can yield the same amount of output. The curve representing these combinations is called the iso-quant/equal product curve/product indifference curve. The producer may choose any of these combinations but his decision on which combination he would pick depends on the prices of the factors and his budget that may be shown by his budget line.
Isoquant
Budget Line

Producers Equilibrium
Maximizing revenue: The manufacturer has a fixed amount of resources and he can produce different combination of two goods that may be produced by the same amount of resources. The curve drawn by plotting the points showing such combinations is called production possibility curve and the manufacturer can choose any of these combinations. But the manufacturers choice will be determined by the market prices of the goods and he will chose the combination that gives him the maximum revenue. The curve that shows the different combinations of two goods that can give the same amount of revenue is called the iso-revenue curve.
Production possibility
curve

Iso-revenue curve

Returns to Scale
Q = f(K,L), if both inputs are changed by some factor output may change to some factor h, which may be equal to , more than or less than . Now consider the case hQ = f(k, L), where = 2 i.e., both the inputs are doubled. In such case, the CobbDouglas production function Q = AKL may look like hQ = A(2K)(2L) = 2 + (AKL) = 2 + (Q) => h = 2 + The equation h = 2 + is derived from a production function that uses both factors K and L increased by 2 times and the equation shows that if both factors of production are increased by 2 times, the output increases by this increases 2 + times. If the proportion in which the output increases is the same as the proportion of increase of the inputs i.e., if h = 2 then + = 1 This is a situation when we have constant returns to scale. Similarly, if h > 2, + > 1, it is a situation, when we have increasing returns to scale and if h < 2, + < 1, it is a situation, when we have decreasing returns to scale. Thus in case of constant returns to scale, the function Q = AKL may be written as Q = AKL1

Economies of Scale
Economies of scale may be understood as the benefits obtained because of increase in the size of the firm/output. Why do increasing returns to scale occur? Use of technologies that are cost-efficient at high levels of production Specialization of labor Economies in inventories When do decreasing returns to scale occur? When firms grow so large that the management cannot effectively manage (for example, increase in costs of gathering, organizing, transportation, reviewing information etc) Economies of scope: firms often find that even without increasing the scale, per unit costs are lower when two or more products are produced (because of use of idle/temporarily surplus capacity)