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# 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 (π) and PV (π) = π1/(1+r) + π2/(1+r)2 + π3/(1+r)3 + …….+ πn/(1+r)n Where, πn 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. 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 . laws relating to women’s/child rights.

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 .

Qm = 60. which makes P = 10 and (d) at price P = 10. Q1. where. Q2 = 22. He plans to sell the collection to three prospective buyers. whose demand equations are: Q1 = 30 – 3P.25 x 10 = 25 tests . a graduating senior has accumulated an impressive file of tests during his college career.5 – 1.5 – 1..5 – 0.5 – 1. (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.75P + 37. 60 = 90 . Q2 and Q3 are quantity demanded by the three buyers. Q2 = 22. and Q3 = 37. i.e.25P.Demand Analysis Individual and Market demand: Definition/explanation.5 – 0. Illustration: Max.3p.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. Qm = 90 – 3P or.75 x10 = 15 tests and Q3 = 37. Calculate (a) the demand equation for Max’s tests (b) how many more tests he can sell for each one-dollar decrease in price. Q1 = 30 – 10 = 20 tests.

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. where b<0 and Qs = c + dP. where d >0 At equilibrium. Supply and Equilibrium Qd = a + bP. Qd = Qs => 14 – 2P = 2 + 4P Solving the equations.Demand. we get Pe = 2 and Qe=10 units Demand Function .

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. • Decisions on expanding product line.Theory of Costs Involves three important/basic areas of managerial economics: • Resource allocation decisions. there are other areas Explicit cost – actual payments to other parties. Example – cost of adding a new product line. Opportunity cost – value of next best alternative foregone . 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 inventory. developing an in-house legal staff etc. acquiring a major competitor. • Decisions on capital investment.

. AVC by using the above data. Variable Cost and Marginal Cost Capital Labor Output Input Rate TFC AFC TVC AVC Total Cost Marginal Cost 10 10 10 10 10 10 10 10 10 0 2 3.67 5. AC and AVC first decline. short-run cost curves are U-shaped.1 6.60 24. TC.27 14.77 11. AC.Fixed Cost.60 0 1 2 3 4 5 6 7 8 1000 ─ 0 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 1000 1200 1367 1510 1677 1877 2127 2460 3460 ─ 200 167 143 167 200 250 333 1000 Draw curves for TFC. reach a minimum and then shift upwards.77 8. MC. long-run cost curves are flatter. MC. TVC.

both explicit and implicit Costs and the Concept of Profit-1 . marginal cost (Δc/Δq. economic cost (explicit + implicit cost). revenue and break-even analysis Calculation of Economic Profit Sales $90.000 Net Economic Profit [Net accounting profit – implicit costs] ─$50.000 Depreciation $10. m in y = mx + c) accounting cost. variable cost (VC).000 Utilities $3.Total cost (TC).000 $30. expenses $5.opportunity cost. fixed cost (FC).000 $70.000 Less: Implicit Costs Return on own capital invested $10.000 Less: Cost of goods sold $40.000 Property Tax $2.000 Econ.000 Gross profit $50. explicit cost. Profit = Revues minus all relevant costs. average cost (c/q).000 Net Accounting Profit $20.000 Less: Advertising $10.000 Misc. implicit cost.000 Opportunity cost ($5000 x 12) $60.

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. Decide whether you should make the dress or sell the material. considering the historical value only. Soln: Revenue from sale of the dress Tk 7200 Less: cost of the material 4 x 1200 = 4800 4 hors of labor 4 x 800 = 3200 8000 Economic Profit Tk. You have 4 yards of a material purchased for Tk 200 per yard a few years ago. if economic cost is not considered Revenue = Tk 4800 and.Costs and the Concept of Profit-2 Suppose that you are a good dressmaker.– 800 Alternatively. Material cost = 4 x 200 = Tk 800 Profit = 4800 – 800 = Tk 4000 . The making of the dress would require 4 hours of your labor. which you can sell elsewhere for Tk 800 per hour.

the break-even volume of output is qBE = FC/(p – AVC) . π + FC = q(p – AVC) => q = (FC + π)/(p – AVC) This gives the rate of output necessary to generate a certain amount of profit π At break-even the π = 0 and therefore. Profit and Firm’s Equilibrium-1 Total cost function C = 1000 + 10q – 0.Cost.04q2 Profit π = Revenue – Cost = pq – (FC + q.04q3 MC = dc/dq = 10 – 1. Revenue.9q2 + 0.12q2 Total variable cost = Total cost – fixed cost = 10q – 0.9q + 0.04q3 AVC = TVC/q = 10 – 0.8q + 0.AVC) Or.9q2 + 0.

Profit and Firm’s Equilibrium-2 Example: FC of a firm is $10000. The firm has a target for a profit of $20000.Cost.. TC.e. TR and the BE value . the break-even volume of output for the above firm would be FC / 10000 / = (p – AVC) (20 – 15) = 2000 units Show the graphs for FC. Revenue. VC. price per unit of its product is $20 and AVC (MC) of the form’s product is $15. The volume of output required to achieve the target is: q = (FC + π)/(p – AVC) = (10000 + 20000)/(20 – 15) = 6000 units Reminder: The break-even output can be obtained from the equation by taking π = 0 i.

e.. Calculate the volume of output for which profit would be maximum..……(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: π8 = 16q – q2 – 50 = 16x8 – 82 – 50 = 30 units Alternatively. MC = dc/dq = 4 and MR = dR/dq = 20 – 2q and For πmax MC = MR => 4 = 20 – 2q i.Optimization of a Firm’s Output Following are the cost and revenue functions for a firm: TC = 50 + 4q and TR = 20q ─ q2. .. Profit π = (20q ─ q2) − (50 + 4q) = 16q – q2 – 50 dπ/ = 16 – 2q dπ/ = 0 => 16 – 2q => q = 8 ………(i) and dq dq d/ (dπ/ )= – 2 < 0 . q = 8 implying that profit is maximum when q = 8 units.

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

e. 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 = ─(Δq/q)÷ (Δp/p ) = ─ (dq/dp).5%.67 . The ep stands at ─ 1. the demand at price $10 is 100 – 4x10 = 60 units and the ep = ─ (dq/dp). p/q or.5. this means that the increase in price by 1% would cause a reduction in demand by 1. income.Elasticity of Demand Elasticity = measure for response in demand to change in price and income.. – 4. the quantity demanded changes from 10 units to 7 units. p/q The price of a product changes from tk 10 per unit to Tk 12 and because of this. 10/60 = ─ 0. Let the demand equation is Qd = 100 – 4p i. price.

revenues of sellers decrease ep = –1. demand is inelastic (everyday necessities). even with increase in price . if price increases. revenues of sellers remain unchanged –1< ep<0. unitary elastic. the demand is elastic (luxury goods).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. ep<–1. consumers spend less. revenues of sellers increase. people have preference in maintaining the standards in consumption once achieved and consumers adjust expenditures in the long run.

500. Therefore. Use of the concept of elasticity: pricing. But take the case of hot dogs (in the US) – it is a food for low income group of people.512) consumed.512 This means that the an 1% increase in income causes 0.000 + 5x10. Qd = 50.000 + 5I. and ei = (dq/dI).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 = (Δq/q)÷ (ΔI/I ) = (dq/dI). they usually give up hot dogs and switch to other types of meat. targeting of products for different market segments . If someone’s income (I) is Tk 10.500.000 = 0. 10. But if the income of this group of people increases. I/q = 5. I/q Let the demand equation is Qd = 50.500/50.500 = 102. income elasticity of hot dogs may be negative. Income elasticity is usually positive.512% increase in the quantity of a product (for which the ei = 0.

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

tastes of consumers. their incomes. calculate ec Soln: ec = (dqx/dpy)÷ (py/qx ) = (150 – 125)/(100 . ec for coffee is not the same as ec for tea. 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 = (Δqx/qx)÷ (Δpy/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. price of some other products matter.5 py. however.Cross Elasticity of Demand The responsiveness of quantity demanded of a product X to change in the price of another (usually. Exercise: the demand for X in terms of the price for y is given by qx = 100 + 0. cross elasticity is not reciprocal i. Note: (py/qx ) should be calculated as the ratio of ranges .e..50)÷ (50 + 100)/(125 + 150) = 0.27.

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

– 1 < ep < 0 implies that the company’s books are price inelastic and raising the price of its books will increase the total revenue . The value of ep = ─ 0. and p/q = Px/Qx where Px = $5 and Qx= 65000 – 5000Px = 65000 – 5000(6) = 40000 Now.e. 5/40000 = ─ 0. ep = ─ (dq/dp).Solution to Elasticity: Problem a.625 [dq/dp= dQx/dPx = ─ 5000. 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.. p/q and for the given demand equation ep = ─ 5000 . Effect of increase in price of the company’s books on its revenues The effect of increase in price can be assessed by computing price elasticity of demand. and p/q = Px/Qx where Px = $5 and Qx= 40000].625 i.

10000/40000 = 1.000 .25 We find that income elasticity ei > 1.000 quantity demanded Qx = 40. . the sale of the company’s books will increase. which means that the income elasticity ei = dQx/dI . Income elasticity ei = dQx/dI . I/Q= 5. and at income I = 10. Since with increase in income buyers tend to buy more of luxury goods. I/Q The demand function is: Qx = 12000 – 5000Px + 5I + 500Pc dQx/dI = 5.Solution to Elasticity: Problem b. during the period of rising incomes. this implies that the company’s books belong to luxury goods.

. Py/Qx The Pc in the demand curve is equivalent to Py of the cross elasticity and ec = dQx/dPy.Solution to Elasticity: Problem c. 6/4000 = 0.Py/Qx = 500.075 [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. The demand function is: Qx = 12000 – 5000Px + 5I + 500Pc And the cross elasticity ec = dQx/dPy .075% increase in the demand for the company’s books.

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 6 7 COST ($Y) 100 150 160 240 230 370 410 OUTPUT (X) 0 5 8 10 15 23 25 . a = intercept on y. fixed cost b = slope of the cost function. X = independent variable.Regression Equation Simple regression – relationship between two variables Y = a + bX. variable cost per unit or marginal cost. Y = dependent variable.axis and in the given case. where Y may be production cost and X output.

08 The equation therefore.14 – (12.93 2197.24 7.71 (Xt – Xav )2 151.86 172. is Y = 87.21)(12.71 10.14 ─ 77. where.71 ÷ 511.86 ─ 7.34 114.29 Σ(Xt – Xav )2 Σ(Xt – Xav)(Yt – Yav ) The regression equation is: Y = a + bX.14 18.40 = 12.40 5.04 53.14 Xav = 12.21. . a = Yav – bXav = 237.55 ─ 19.08 + 12.14 ─ 2.14 ─ 87.29 ─ 7.14 132.93 ─ 6.71 12. value of it varies between 0 and 1.29 ─ 2.35 1422.21X Add: talk about R2 – the coefficient of determination (proportion of the dependent variable explained by the regression .54 = 511. b = Σ(Xt – Xav)(Yt – Yav ) ÷ Σ(Xt – Xav )2 = 6245.70 161. when the value of R2 is higher it means that the regression fits the data very well.71 Yav =237.05 = 6245.86 ─ 12.25 330.29 ─ 4.29) = 87.45 635.40 (Xt – Xav)(Yt – Yav ) 1685.29 2.Regression Equation: Soln of the Problem Cost (Yt) 100 150 160 240 230 370 410 Output (Xt) Yt – Yav Xt – Xav 0 5 8 10 15 23 25 ─ 137.

L). α and β are constants.Production function relates output to inputs. where K is capital and L is labor. a point will be reached when marginal product of the variable input will decrease. Marginal product: addition to total product for one extra unit of an input and Marginal product of capital MPk = dQ /dK = αAKα –1Lβ and Marginal product of labor MPL = dQ /dL = βAKαLβ – 1 Law of diminishing marginal return: when increasing amounts of a variable input are continued with a fixed level of another input. general equation is: Q = f(K. 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 firm’s objective. one of the specific is the Cobb-Douglas production function Q = AKαLβ where A. Production Function .

and the like.K = 6 and L = 1. 6 units of capital and 1 unit of labor or 1 unit of capital and 6 units of labor to produce the same output. •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 . if K = 8 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. the output Q = 400 units .. . K = 3 and L = 2.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.

10 63 6. 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.5 5 Marginal Product (MP) 5 22 4.3 −1 .5 3 TP = Total product 3 9 3 4 L = No of workers 4 14 3. total product.Total.9 6 ΔQ MP = /ΔL.1 17 Unit change in workers 8 63 7.7 18 Associated with one7 57 8. Product Marginal Product = average output 0 0 − − 1 2 2 2 per unit and AP = TP/L. As workers add in.4 8 = change in output 6 40 6. 2 5 2. Product (AP) No of Workers Total Product Av. average product and marginal product can be shown as under: Av.1 1 Q = amount of output. 9 64 7. the output increases and figures on the number of workers.

Total Output Total Output (Q) Rate of labor input (L) .

Average and Marginal Product Marginal product Average product Rate of labor input .

The curve representing these combinations is called the iso-quant/equal product curve/product indifference curve. Isoquant Budget Line . a level at which the firm has the maximum profit.Producer’s Equilibrium Output at which a producer is most satisfied. 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. which can be attained either by minimizing costs or maximizing sales. 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. usually.

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 drawn by plotting the points showing such combinations is called production possibility curve and the manufacturer can choose any of these combinations. Production possibility curve Iso-revenue curve .Producer’s 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 that shows the different combinations of two goods that can give the same amount of revenue is called the iso-revenue curve.

the CobbDouglas production function Q = AKαLβ may look like hQ = A(2K)α(2L)β = 2α + β(AKαLβ) = 2α + β(Q) => h = 2α + β The equation h = 2α + β 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.L). α + β > 1. when we have increasing returns to scale and if h < 2. α + β < 1. Similarly. the output increases by this increases 2α + β times.Returns to Scale Q = f(K. if h = 2 then α + β = 1 This is a situation when we have constant returns to scale. the function Q = AKαLβ may be written as Q = AKαL1 – α .e. If the proportion in which the output increases is the same as the proportion of increase of the inputs i. λL). it is a situation. where λ = 2 i. it is a situation. more than λ or less than λ. when we have decreasing returns to scale. if h > 2. if both inputs are changed by some factor λ output may change to some factor h. In such case.e.. both the inputs are doubled. Thus in case of constant returns to scale. which may be equal to λ. Now consider the case hQ = f(λk..

transportation. increase in costs of gathering. per unit costs are lower when two or more products are produced (because of use of idle/temporarily ‘surplus’ capacity) . organizing. reviewing information etc) Economies of scope: firms often find that even without increasing the scale.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.