Managerial Economics

MANAGERIAL ECONOMICS
PROF. B. S. PATIL
ECONOMICS
A social science, not a natural science the study of how a given society allocates scarce resources to meet the unlimited wants and needs of its members concerned with the efficient use of scarce resources to achieve the maximum satisfaction of wants seeks to understand how individuals interact with the social structure to address production and exchange of goods and services
Why study it?

Study of economics deals with production, allocation and distribution of resources Economics is a great field and entry to lots of interesting and important jobs Allows us to think abstractly and ask what if Useful for policy-making in business, government or non-profit pursuits
What I hope you get out of this course

Develop basic understanding of decision-making from an economic perspective Understand economic interactions, economic organizations & functions of the Indian economy Enhance your critical thinking, communication and problem solving skills
What this course is about

An analysis of firms and markets An analysis of things that influence economic behavior and decision-making Individual (micro) and aggregate (macro) effects How is economic information used? How do societies use and allocate scarce resources? How should societies be allocated?
MANAGERIAL ECONOMICS
Economics contributes to a great deal towards the performance of managerial duties and responsibilities. Like : Biology - Medical profession Physics - Engineering Economics contributes to managerial profession. Managers with working knowledge of economics can perform their functions more efficiently than those without it. The emphasis here is on the maximization of the objective and limitedness of the resources. The task of management is to optimize the use of resources.
INTRODUCTION
Economics though variously defined is essentially the study of logic, tools and techniques of making optimum use of the available resources to achieve the given ends Economics thus provides analytical tools and techniques that managers need to achieve the goals of the organisation they manage. Therefore, working knowledge of economics is essential for the managers. Managers are essentially practicing economists.
MANAGERIAL ECONOMICS - DEFINITIONS
Managerial economics in general defined as the study of economic theories, logic and methodology which are generally applied to seek solutions to the practical problems of business. McNair & Marian: Business economics consists of the use of economic models of thought to analyze business situations
MANAGERIAL ECONOMICS - DEFINITIONS
We may therefore, define managerial economics as the discipline which deals with the application of economic theory to business management Managerial economics thus lies on the broad line between economics and business management and serves as a bridge between the two disciplines
MANAGERIAL ECONOMICS DEFINITIONS

Mansfield: M.E. is concerned with application of economic concepts and economic analysis to the problems of formulating rational managerial decision Spencer & Siegelman: M.E. is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management
MANAGERIAL ECONOMICS MANAGEMENT DECISION PROBLEM

ECONOMIC THEORY -MICRO
-MACRO MANAGERIAL ECONOMICS -Application of economic theory & Decision
BUSINESS MANAGEMENT - DECISION PROBLEMS
Science tools to solve managerial decision problem OPTIMAL SOLUTION TO MANAGERIAL DECISION PROBLEMS
M. E refers to the application of economic theory and decision science tools to find the optimal solution to business decision problems
SCOPE OF MANAGERIAL ECONOMICS

The subject matter of business economics has been divided into two parts 1. Micro - Economics 2. Macro - Economics Micro Economics:
In micro economics we make a microscopic study of the economy. It should be remembered that micro economics does not study the economy in its totality. Micro economics consists of looking at the economy through a microscope, as it were, to see how the millions of the consumers and the individuals or firms as producers play their part in the working of the whole economic organisation. For instance, Demand : we study the demand of an individual consumer for a good and from there go on to derive the market demand for the good.

The whole content of micro economic theory may be presented as follows Micro Economic Theory
Product Pricing
Factor Pricing (Theory of Distribution)
Theory of Welfare Economics
Theory Of Demand
Theory Of Production & Costs
Wages
Rent
Interest
Profits
Macro Economics:
Macro economics analyses the behaviour of the whole economic system in totality. It studies the bahaviour of the large aggregates such as total employment, the national product or income, the general price level in the economy. Therefore, macro economics is also known as aggregative economics.

It should be noted that micro economics also deal with some aggregates but not of the type with which macro economics is concerned. Ex: Industry behaviour. Macro economics concerned with aggregates which relates to the whole economy. Ex: total production of consumer goods (total consumption) and the total production of capital goods (total investment) are two important subaggregates dealt within macro economics.
The contents of the macro economic theory

MACRO ECONOMIC THEORY
Theory of Income and Employment
Theory of General Price level & Inflation
The Theory of Economic Growth
Entrepreneurship and Profits

Unlike other factors of production, profit is not determined by the supply of and demand for entrepreneurship Profits are considered a residual from Total Revenue after the payment of rent, interest, and wages One could argue that since all other factors are determined by supply and demand, profits are indirectly determined by these forces Your author estimates profit to be about 18.5% of the Nations National Income
Theories of Profit
Economic profit is the reward for recognizing a profit opportunity and taking advantage of it Theories overlap, but see the entrepreneur as one who sees an advantage and grabs it Theories

The The The The
entrepreneur entrepreneur entrepreneur entrepreneur
as as as as
a risk taker an innovator a monopolist an exploiter of labor
The Entrepreneur as a Risk Taker

The only way to get someone to risk money is to offer a high reward (economic profit) as an incentive Economic profit is associated with uncertainty; nothing ventured, nothing gained Entrepreneurs are willing to take the risk in return for the opportunity of a large reward Profit is the reward for risk bearing
The Entrepreneur as an Innovator

An invention is not the same as an innovation Innovation includes invention but also carries the business process from production to marketing to profit generation; that is, it is the commercialization of the invention It is the effort to carry an invention through to its logical conclusion the generation of a profit Joseph Schumpeter, noted Harvard economist, even stated that innovation and financial risk are two separate components Financial risk is interest
The Entrepreneur as a Monopolist

The entrepreneur takes advantage of the idea of exclusivity to monopolize a product or service Natural scarcity to do it first and thereby lock out potential competitors Contrived scarcity to corner a market on a vital resource or gain economic power to limit competition and generate profit by reducing production and raising prices

DeBeers (diamonds) Early Railroads National Football League
The Entrepreneur as an Exploiter of Labor

Karl Marx The Capitalist exploits the value of Labor If the worker could produce enough value to sustain life by working six hours/day, but is forced by the capitalist to work 12 hours a day for six hours of value, the capitalist expropriates 6 hours of labors value for himself The capitalist uses the value of those six hours to purchase even more capital to exploit even more labor The surplus value of labor is the capitalists profit
Supply and Demand
DEMAND ANALYSIS
Micro232 2004 - jafgac
Demand
Demand means the Desire backed up by ability pay and willingness buy. Demand = Desire + Ability to pay + Willingness to buy Prices are the tools by which the market coordinates individual desires.
Micro232 2004 JAFGAC
The Law of Demand

Law of demand there is an inverse relationship between price and quantity demanded.
Quantity demanded rises as price falls, other things constant. Quantity demanded falls as prices rise, other things constant.
The Law of Demand

What accounts for the law of demand?
People tend to substitute for goods whose price has gone up.
The Demand Curve

The demand curve is the graphic representation of the law of demand. The demand curve slopes downward and to the right. As the price goes up, the quantity demanded goes down.
A Sample Demand Curve

Price (per unit)
PA
D 0 QA
Quantity demanded (per unit of time)
Other Things Constant

Other things constant places a limitation on the application of the law of demand.
All other factors that affect quantity demanded are assumed to remain constant, whether they actually remain constant or not.
Other Things Constant

Other things constant places a limitation on the application of the law of demand.
These factors may include changing tastes, prices of other goods, income, even the weather.
Shifts in Demand Versus Movements Along a Demand Curve

Demand refers to a schedule of quantities of a good that will be bought per unit of time at various prices, other things constant. Graphically, it refers to the entire demand curve.

Quantity demanded refers to a specific amount that will be demand per unit of time at a specific price. Graphically, it refers to a specific point on the demand curve.

A movement along a demand curve is the graphical representation of the effect of a change in price on the quantity demanded.

A shift in demand is the graphical representation of the effect of anything other than price on demand.
Change in Quantity Demanded

Price (per unit) 2 B Change (Contraction) in quantity demanded (a movement along the curve) 1 A
D1 0 100 200 Quantity demanded (per unit of time)
Shift in Demand
Price (per unit) 2 Change (decrease) in demand (a shift of the curve)
A D0 D1
250 100 200 Quantity demanded (per unit of time)

Shift Factors of Demand

Shift factors of demand are factors that cause shifts in the demand curve:
Income. (individual and society) The prices of other goods. Tastes and preferences. Expectations. Taxes and subsidies to consumers.
Income
An increase in income will increase demand for normal goods. An increase in income will decrease demand for inferior goods.
Price of Other Goods

When the price of a substitute good falls, demand falls for the good whose price has not changed. When the price of a complement good falls, demand rises for the good whose price has not changed.
Tastes and preferences

A change in taste will change demand with no change in price causing shift in demand curve.
Expectations
If you expect your income to rise, you may consume more now. If you expect prices to fall in the future, you may put off (postpone) purchases today.
Taxes and Subsidies

Taxes levied on consumers increase the cost of goods to consumers, thereby reducing demand. Subsidies have an opposite effect.
The Demand Table

The demand table assumes all the following:
As price rises, quantity demanded declines. Quantity demanded has a specific time dimension to it. All the products involved are identical in shape, size, quality, etc.
The Demand Table

The demand table assumes all the following:
The schedule assumes that everything else is held constant.
From a Demand Table to a Demand Curve

You plot each point in the demand table on a graph and connect the points to derive the demand curve.

The demand curve graphically conveys the same information that is on the demand table.

The curve represents the maximum price that you will pay for various quantities of a good you will happily pay less.

A Demand Table
Price per DVDs (in dollars) Price per DVD rentals cassette demanded per week (Rs) (Rs) 6.00 5.00 4.00 3.50 3.00 2.00 1.00 .50 0 E D G C F B A 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of DVDs demanded (per week) Demand for DVDs
A Demand Curve
A B C D E
0.50 1.00 2.00 3.00 4.00
9 8 6 4 2
Individual and Market Demand Curves

A market demand curve is the horizontal sum of all individual demand curves.
This is determined by adding the individual demand curves of all the demanders.
Individual and Market Demand Curves

Sellers estimate total market demand for their product which becomes smooth and downward sloping curve.
From Individual Demands to a Market Demand Curve

(1) (2) (3) Price per Alices Bruces cassette demand demand (2) Cathys demand (3) Market demand
4.00 3.50 3.00

Price per cassette (Rs)
G F E D C B A
Cathy Bruce Alice Market demand
A Rs.0.50 B 1.00 C 1.50 D 2.00 E 2.50 F 3.00 G 3.50 H 4.00
9 8 7 6 5 4 3 2
6 5 4 3 2 1 0 0
1 1 0 0 0 0 0 0
16 14 11 9 7 5 3 2
2.50 2.00 1.50 1.00 0.50 0
8 10 12 14 16
Quantity of cassettes demanded per week
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Law of Demand

The demand curve is downward sloping for the following reasons:
At lower prices, existing demanders buy more. At lower prices, new demanders enter the market.
Supply
Individuals control the factors of production inputs, or resources, necessary to produce goods. Individuals supply factors of production to intermediaries or firms.
Supply
The analysis of the supply of produced goods has two parts:
An analysis of the supply of the factors of production to households and firms. An analysis of why firms transform those factors of production into usable goods and services.
The Law of Supply

There is a direct relationship between price and quantity supplied.
Quantity supplied rises as price rises, other things constant. Quantity supplied falls as price falls, other things constant.
The Law of Supply

The law of supply is accounted for by two factors:
When prices rise, firms substitute production of one good for another. Assuming firms costs are constant, a higher price means higher profits.
The Supply Curve

The supply curve is the graphic representation of the law of supply. The supply curve slopes upward to the right. The slope tells us that the quantity supplied varies directly in the same direction with the price.
A Sample Supply Curve

Price (per unit) S
PA
QA Quantity supplied (per unit of time)
Shifts in Supply Versus Movements Along a Supply Curve

Supply refers to a schedule of quantities a seller is willing to sell per unit of time at various prices, other things constant.

Quantity supplied refers to a specific quantity that will be supplied at a specific price.

Changes in price causes changes in quantity supplied represented by a movement along a supply curve.

A movement along a supply curve the graphic representation of the effect of a change in price on the quantity supplied.

If the amount supplied is affected by anything other than a change in price, there will be a shift in supply.

Shift in supply the graphic representation of the effect of a change in a factor other than price on supply.
Shift in Supply
S0 S1 Price (per unit)
15
B A to B Shift (Increase) in Supply (a shift of the curve)
1,250 1,500 Quantity supplied (per unit of time)

Change in Quantity Supplied

S0 Price (per unit) B A to B Change (expansion) in quantity supplied (a movement along the curve)
15
1,250 1,500 Quantity supplied (per unit of time)

Shift Factors of Supply

Other factors besides price affect how much will be supplied:
Prices of inputs used in the production of a good. Technology. Suppliers expectations. Taxes and subsidies.
Price of Inputs
When costs go up, profits go down, so that the incentive to supply also goes down. If costs go up substantially, the firm may even shut down.
Technology
Advances in technology reduce the number of inputs needed to produce a given supply of goods. Costs go down, profits go up, leading to increased supply.
Expectations
If suppliers expect prices to rise in the future, they may store today's supply to reap higher profits later.
Taxes and Subsidies

When taxes go up, costs go up, and profits go down, leading suppliers to reduce output. When government subsidies go up, costs go down, and profits go up, leading suppliers to increase output.
The Supply Table

Each supplier follows the law of supply. When price rises, each supplies more, or at least as much as each did at a lower price.
From a Supply Table to a Supply Curve

To derive a supply curve from a supply table, you plot each point in the supply table on a graph and connect the points.

The supply curve represents the set of minimum prices an individual seller will accept for various quantities of a good.

Competing suppliers entry into the market places a limit on the price any supplier can charge.
Individual and Market Supply Curves

The market supply curve is derived by horizontally adding the individual supply curves of each supplier.
From Individual Supplies to a Market Supply (Price in Rs)

(1) (2) (4) (5) (3) Quantities Price Ann's Barry's Charlie's Market Supplied (per DVD) Supply Supply Supply Supply A B C D E F G H I 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 0 1 2 3 4 5 6 7 8 0 0 1 2 3 4 5 5 5 0 0 0 0 0 0 0 2 2 0 1 3 5 7 9 11 14 15
From Individual Supplies to a Market Supply

4.00 3.50
Price per DVD
Charlie
Barry
Ann
Market Supply H G F
3.00 2.50 2.00 1.50 1.00 0.50 0 A B C CA D E
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Quantity of DVDs supplied (per week)
The Interaction of Supply and Demand

Equilibrium: Equilibrium is a concept in which opposing dynamic forces cancel each other out. In a free market, the forces of supply and demand interact to determine equilibrium quantity and equilibrium price.
Equilibrium
Equilibrium price the price toward which the invisible hand drives the market. Equilibrium quantity the amount bought and sold at the equilibrium price.
What Equilibrium Isnt

Equilibrium isnt a state of the world, it is a characteristic of a model. Equilibrium isnt inherently good or bad, it is simply a state in which dynamic pressures offset each other.
What Equilibrium Isnt

When the market is not in equilibrium, you get either excess supply or excess demand, and a tendency for price to change.
Excess Supply
Excess supply a surplus, the quantity supplied is greater than quantity demanded Prices tend to fall.
Excess Demand
Excess demand a shortage, the quantity demanded is greater than quantity supplied Prices tend to rise.
Price Adjusts
The greater the difference between quantity supplied and quantity demanded, the more pressure there is for prices to rise or fall.
Price Adjusts
When quantity demanded equals quantity supplied, prices have no tendency to change.
The Graphical Interaction of Supply and Demand

Price (per DVD) (Rs) 1.50 2.50 3.50
Quantity Supplied 7 5 3
Quantity Surplus (+) Demanded Shortage (-) 3 5 7 +4 0 -4

5.00 4.00 Price per DVD 3.50 3.00 2.50 2.00 1.50 1.00 1 Excess demand E C A Excess supply
2 3 4 5 6 7 8 9 10 11 12 Quantity of DVDs supplied and demanded

When price is Rs 3.50 each, quantity supplied equals 7 and quantity demanded equals 3. The excess supply of 4 pushes price down.

When price is Rs1.50 each, quantity supplied equals 3 and quantity demanded equals 7. The excess demand of 4 pushes price up.

When price is Rs 2.50 each (at point E) quantity supplied equals 5 and quantity demanded equals 5. There is no excess supply or excess demand, so price will not rise or fall. Therefore point E is equilibrium situation
Political and Social Forces and Equilibrium

Political and social forces can push price away from a supply/demand equilibrium. These forces create an equilibrium where quantity supplied wont equal quantity demanded.
Shifts in Supply and Demand

Shifts in either supply or demand change equilibrium price and quantity.
Increase in Demand
An increase in demand creates excess demand at the original equilibrium price. The excess demand pushes price upward until a new higher price and quantity are reached.
Increase in Demand
Price (per DVDs)
S0 B 2.50 2.25 D0 0 A B1 D1
S1
Excess demand
8 9 10 Quantity of DVDs (per week)
Decrease in Supply
A decrease in supply creates excess demand at the original equilibrium price. The excess demand pushes price upward until a new higher price and lower quantity are reached.
Decrease in Supply
Price (per DVDs)
S1 C 2.50 2.25 B S0 Excess demand A D0 0 8 9 10 Quantity of DVDs (per week)
The Limitations Of Supply And Demand Analysis

Sometimes supply and demand are interconnected. Other things don't remain constant.

All actions have a multitude of ripple and possible feedback effects. The ripple effect is smaller when the goods are a small percentage of the entire economy.

The other-things-constant assumption is likely not to hold when the goods represent a large percentage of the entire economy.
The Fallacy of Composition

The fallacy of composition is the false assumption that what is true for a part will also be true for the whole.
The Fallacy of Composition

The fallacy of composition is of central relevance to macroeconomics.
In macroeconomics, the other-thingsconstant assumption, central to microeconomic supply/demand analysis, cannot hold.
End of Supply and Demand
Micro232 2004 - jafgac
This is a PowerPoint presentation on the fundamentals of the concept of elasticity as used in principles of economics. A left mouse click or the enter key will add an element to a slide or move you to the next slide. The backspace key will take you back one element or slide. The escape key will get you out of the presentation.
Principles of Microeconomics
R. Larry Reynolds
Elasticity
Elasticity is a concept borrowed from physics Elasticity is a measure of how responsive a dependent variable is to a small change in an independent variable(s) Elasticity is defined as a ratio of the percentage change in the dependent variable to the percentage change in the independent variable Elasticity can be computed for any two related variables
Fall '97
Economics 205Principles of Microeconomics
Slide 2
Elasticity [cont. . . ]
Elasticity can be computed to show the effects of:
a change in price on the quantity demanded [ a change in
quantity demanded is a movement on a demand function]
a change in income on the demand function for a good a change in the price of a related good on the demand function for a good a change in the price on the quantity supplied a change of any independent variable on a dependent variable
Fall '97
Slide 3
Own Price Elasticity

Sometimes called price elasticity can be computed at a point on a demand function or as an average [arc] between two points on a demand function price elasticity Price elasticity [ep] is related to revenue How will a change in price effect the total revenue? is an important question.
Fall '97 Economics 205Principles of Microeconomics
ep, , are common symbols used to represent
Slide 4
Elasticity as a measure of responsiveness

The law of demand tells us that as the price of a good increases the quantity that will be bought decreases but does not tell us by how much. ep [ownprice elasticity] is a measure of that information] If you change price by 5%, by what percent will the quantity purchased change?
Fall '97 Economics 205Principles of Microeconomics Slide 5
% change in quantity demanded % change in price

ep
%Q %P
At a point on a demand function this can be calculated by:
or,
ep =
Q22 - Q1 = Q Q - Q1 Q1 P2 P2 P1 P1 P - - = P1
Q Q1 P P1
Fall '97
Slide 6
+2 Q
ep =
3 Q1 P -2 P1 7
[2/3 = .66667]
% Q = 67% % P = -28.5%
-2.3
[rounded]
[-2/7=-.28571]
Price decreases from Rs.7 to Rs.5
The own price elasticity of demand at a price of Rs.7 is -2.3
Px
Rs
P1 = 7 P2 = 5
A
P = -2
This is point price elasticity. It is calculated at a point on a demand function. It is not influenced by the direction or magnitude of the price change.
P2- P1 = 5 - 7 = P = -2
Q2 - Q1 = 5 - 3 = Q = +2
Q = +2
There is a problem! If the price changes from Rs.5 to Rs.7 the coefficient of elasticity is different!
Q1 = 3
Q2 = 5
Qx/ut
Slide 7
Fall '97
ep =
Q -2 Q 5 1
[-2/5 = -.4]
+2 P P5 1
% Q = -40%
% P = 40%
= -1
[this is called unitary elasticity]
When the price increases from Rs.5 to Rs.7, the ep = -1 [unitary]

In the previous slide, when the price decreased from Rs 7 to Rs 5, ep
[+2/5 = .4]
= -2.3
The point price elasticity is different at every point!
Px
P2 = 7 P1 = 5 A P = +2
ep = -2.3
B
There is an easier way!
ep = -1
Q = -2
D
Qx/ut
Slide 8
Q 2= 3
Fall '97
Q1= 5
An easier way!
By rearranging terms =
Q
ep =
Q Q1 Q1 P
Q1
P1 P
P1
P1 Q1
this is a point on the demand function
Given that when: Q1 = 3 P1 = 7, P2 = 5, Q 2= 5

P2- P1 = 5 - 7 = P = -2
this is the slope of the demand function
ep
= -1
P P1 = 7,
* Q1 3
Q1 = 3
7 P1
= -2.33
Q2 - Q1 = 5 - 3 = Q = +2
Then,
This is the slope of the demand Q = f(P)

+2 -2
= -1
On linear demand functions the slope remains constant so you just put in P and Q
The following information was given
Px
7 5
Q = f (P) A B
Px must decrease by 5. 3
What is the Q intercept?
P1 = 7, P2 = 5,
Q2 - Q1 = 5 - 3 = Q = +2 P2- P1 = 5 - 7 = P = -2
Q
Q1 = 3 Q 2= 5
The slope of the demand function
[Q = f(P)] is
+2 -2
Q increases by 5
= -1
The equation for the demand function we have been using is Q = 10 - 1P. A table can be constructed.
The slope [-1] indicates that for every 1 unit increase in Q, Px will decrease by 1. Since Px must decrease by 5, Q must increase by 5
Q = 10 Qx ut
The slope-intercept form m Q = a10+ - 1 P

Slide 10
Q = 10 when Px = 0
Fall '97
The slope is -1
Price (Rs) 0 1 2 3 4 5 6 7 8 9 10 quantity 10 9 8 7 6 5 4 3 2 1 0
The intercept is 10
ep
Total Revenue
using our formula,

P * Q1 the slope is -1, price is 7 P7 1 Q ep = (-1) * Q1 = -2.3 3 P at a price of 7, Q = 3
Calculate ep at P = 9 Q=1 ep = (-1) 9
For a simple demand function: Q = 10 - 1P
ep =
P1
0 -.11 -.25 -.43 -.67 -1. -1.5 -2.3 -4. -9 undefined
= -9
Calculate ep for all other price and quantity combinations.

Slide 11
Fall '97
For a simple demand function: Q = 10 - 1P

price $0 $1 $2 $3 $4 $5 $6 $7 $8 $9 $10 quantity 10 9 8 7 6 5 4 3 2 1 0
ep
Total Revenue
Notice that at higher prices the absolute value of the price elasticity of demand, ep, is greater. Total revenue is price times quantity; TR = PQ. Where the total revenue [TR] is a maximum, ep is equal to 1
0 -.11 -.25 -.43 -.67 -1. -1.5 -2.3 -4. -9 undefined
0 9 16 21 24 25 24 21 16 9 0
In the range where ep < 1, [less than 1 or inelastic], TR increases as price increases, TR decreases as P decreases. In the range where ep > 1, [greater than 1 or elastic], TR decreases as price increases, TR increases as P decreases.
Slide 12
Fall '97
To solve the problem of a point elasticity that is different for every price quantity combination on a demand function, an arc price elasticity can be used. This arc price elasticity is an average or midpoint elasticity between any two prices. Typically, the two points selected would be representative of the usual range of prices in the time frame under consideration. P1 + P2 = 12
P1 = $7, P2 = $5,
Q1 = 3 Q2= 5
The formula to calculate the average or arc price elasticity is: Q P1 + P2 ep = *
Q2 - Q1 = 5 - 3 = Q = +2 P2- P1 = 5 - 7 = P = -2
Q1 + Q2 = 8
Px
The average or arc ep between $5 and $7 is calculated,
Q1 + Q2
$7 $5
Slope of demand
= - 1
ep =
The average
Fall '97
-1 P
ep between $5 and $7 is -1.5
P1 12 P2 +
Q1 8 Q2 +
= - 1.5
3 5
D
Qx/ut
Slide 13
Given: Q = 120 - 4 P
Price $ 10 $ 20 $ 25
$ 28
Quantity
Calculate the point ep at each price on the table. Calculate the TR at each price on the table. Calculate arc ep at between $10 and $20. Calculate arc ep at between $25 and $28.
TR
Calculate arc ep at between $20 and $28. Graph the demand function [labeling all axis and functions], identify which ranges on the demand function are price elastic and which are price inelastic.
Given: Q = 120 - 4 P
Price $ 10 $ 20 $ 25
$ 28
Quantity
ep
-.5 -2 -5 -14
Calculate the point ep at each price on the table. Calculate the TR at each price on the table. TR = PQ Calculate arc ep at between $10 and $20. ep = -1 Calculate arc ep at between $25 and $28. ep = -7.6
TR
$800 $800 $500 $224
80 40 20 8
ep = -4 Calculate arc ep at between $20 and $28. Graph the demand function [labeling all axis and functions], identify which ranges on the demand function are price elastic and which are price inelastic. At what price will TR by maximized? P = $15
Graphing Q = 120 - 4 P,
Price
When ep is -1 TR is a maximum. When | ep | > 1 [elastic], TR and P move in opposite directions. (P has a negative slope, TR a positive slope.) 30 When | ep | < 1 [inelastic], TR and P move in the same direction. (P and TR 15 both have a negative slope.) Arc or average ep is the average elasticity between two point [or prices] point
TR is a maximum where ep is -1 or TRs slope = 0 The top half of the demand function is elastic.
| ep | > 1 [elastic]
TR
ep = -1 | ep | < 1
inelastic
60 120 Q/ut
ep is the elasticity at a point or price.
Price elasticity of demand describes how responsive buyers are to change in the price of the good. The more elastic, the more responsive to P.
The bottom half of the demand function is inelastic.
Fall '97
Slide 16
Use of Price Elasticity

Ruffin and Gregory [Principles of Economics, AddisonWesley, 1997, p 101] report that: short run
|ep| of gasoline is = .15 (inelastic) long run |ep| of gasoline is = .78 (inelastic) short run |ep| of electricity is = . 13 (inelastic) long run |ep| of electricity is = 1.89 (elastic)
Why is the long run elasticity greater than short run? What are the determinants of elasticity?
Determinants of Price Elasticity

Availability of substitutes [greater availability of substitutes makes a good relatively more elastic] Portion of the expenditures on the good to the total budget [lower portion tends to increase relative elasticity] Time to adjust to the price changes [longer time period means there are more adjustment possible and increases relative elasticity Price elasticity for brands is tends to be more elastic than for the category of goods
An application of price elasticity.
The price elasticity of demand for milk is estimated between -.35 and -.5. Using -.5 as a reasonable figure, there are several important observations that can be made.
What effect does a 10% increase in the Pmilk have on the quantity that individuals are willing to buy?
Since
ep = -.5 e
ep
%Q %P
To solve for % Q
Multiply both sides by +10%
A 10% increase in the price of milk would reduce the quantity demanded by about 5%.
-5% = p ) % (+10%)x (-.5 = Q Pmilk P2 P1
%Q
% +10% P
x (+10%)
If price were decreased by 5%, what would be the effect on quantity A 10% increase demanded?
Fall '97
+10% -5% Q2 Q1
Dmilk
Slide 19 milk
in P reduces Q by 5%
ep
%Q %P
The price elasticity of demand is a measure of the % Q that will be caused by a % P.
If the price elasticity of demand for air travel was estimated at -2.5, what effect would a 5% decrease in price have on quantity demanded ?
-2.5 =
%Q
% 5%P -
= +12.5% change in quantity demanded
If the price elasticity of demand for wine was estimated at -.8, what effect would a 6% increase in price have on quantity demanded ?
-.8 =
%Q
% P +6%
= -4.8% decrease in quantity demanded
Fall '97
Slide 20
If the price elasticity of demand for milk were -.5, the effects of a price change on total revenue [TR] can also be estimated.
ep
When
Since , %Q %P
When |ep| < 1, demand is inelastic. This means that the % Q < % P. Since the % price decrease is greater than the % increase in Q, TR [TR = PQ] will decrease.
a price increase will increase TR, Price and TR move in the same direction. [inelastic demand
with respect to price]
|ep| < 1, a price decrease will decrease TR;
When the % price decrease is less than the % increase in Q, TR [TR = PQ] will increase. When
When |ep| > 1, demand is elastic. This means that the % Q > % P.
a price increase will decrease TR, price and TR move in opposite directions. [elastic demand
wrt price]
Fall '97
|ep| > 1, a price decrease will increase TR;
Slide 21
Graphically this can be shown

TR = PQ, so the maximum TR is the rectangle 0Q1 EP1
TR
Price and TR move in opposite directions
TR is a maximum
As price rises into the elastic range the TR will decrease. Notice that in this range the slope of demand P is negative, the slope of TR is positive
(P2 Q2) is less
TR elastic
+TR
at the midpoint, ep = -1
price rises
P2
P1
E than in Loss
(P1 Q1) TR when P
D
Q/ut
Slide 22
0
Fall '97
Q2
Q1
When price elasticity of demand is inelastic
TR
TR is a maximum
A price decrease will result in a decrease in TR [PQ]. notice that both TR and Demand have a negative slope in the inelastic range of the demand function. Price and TR move in the same P direction.
TR
A price decrease will reduce TR; a price increase will increase TR. Note that this information is useful but does not provide information about profits!
Fall '97
P1 P0 0
E TR = P1 Q1
[TR]
at the midpoint,
ep = -1
inelastic
[Maximum] results in a smaller PQ
D
Q0
Slide 23
Q1
Q/ut
Own Price Elasticity of Demand

ep
is a measure of the responsiveness of buyers to changes in the price of the good.
ep will be negative because the demand function is

negatively sloped. A linear demand function will have unitary elasticity at its midpoint. AT THIS POINT TR IS A MAXIMUM! A linear demand function will be more elastic at higher prices and tends to be more inelastic in the lower price ranges
Fall '97
Slide 24
Elastic ep
When |ep| > 1 [greater than 1], the demand is elastic

|%Q| > |%P|, this shows buyers are responsive to changes in price An increase in the price of the good results in a decrease in total revenue [TR], a decrease in the price increases TR. Price and TR move in opposite directions.
The demand for a good tends to become more elastic

as the number of substitutes increases luxury good more elastic than necessities % of price [or expenditure on the good] of the budget as the amount of time for adjustments increases elasticity
Fall '97
Slide 25
Inelastic ep
When |ep| < 1 [less than 1] the demand is inelastic The |%Q| < |%P|, buyers are not very responsive to changes in price. An increase in the price of the good results in an increase in total revenue [TR], a decrease in the price decreases TR. Price and TR move in the same direction
D1 is a perfectly elastic
demand function.
For an infinitesimally small change in price, Q changes by infinity. Buyers are very responsive to price changes. An infinitely small change in price changes Q by infinity.
D2
perfectly inelastic
ep = 0
perfectly elastic |ep| = undefined
ep
0 % Q
%P
= undefined = 0
As the dem and functio n becomes horizontal, more [buyers are more respo to price ch nsive anges],|ep| approaches infinity.
D1
De
Q/ut
much the price changes the same amount is bought. Buyers are not responsive to price changes! |ep| = 0, perfectly inelastic.
.
D2 is a perfectly inelastic demand function, no matter how
Fall '97
Slide 27
Examples
Goods that are relatively price elastic
lamb, restaurant meals, china/glassware, jewelry, air travel [LR], new cars, Fords in the long run, |ep| tends to be greater
Goods that are relatively price inelastic

electricity, gasoline, eggs, medical care, shoes, milk in the short run, |ep| tends to be less
Fall '97
Slide 28
Income Elasticity
[normal goods]
ey
[Where Y = income]
% Qx % Y
Income elasticity is a measure of the change in demand [a shift of the demand function] that is caused by a change in income.
The increase in income, Y, increases demand to D2. The increase in demand results in a larger quantity being purchased at the same Price [P1]..
At a price of P1 , the quantity demanded P given the demand D is Q1 . D is the demand function when the income is Y1 . For a normal good an increase in income to Y2 will shift the demand to the right. This is an increase in demand to D2. % Y > 0; % Q> 0; therefore,
Due to increase in income,

demand increases
P1
D2 D
Q1 Q2 Q/ut
Slide 29
ey >0
.
[it is positive]
Fall '97
Income Elasticity [continued. . .]

[normal goods]
At income Y1, the demand D1 represents the relationship between P and Q. At a price [P1] the quantity [Q1] is demanded. % Y < 0 [negative]; so, ep > 0 [ positive]
ey % Qx %Y
A decrease in income is associated with a decrease in the demand for a normal good. For a decrease in income [- Y], the demand decreases; i.e. shifts to the left, at the price [P1 ], a smaller Q2 will be purchased.
% Q < 0 [negative];
A decrease in income, P1
decreases demand
For either an increase or decrease in income the ep is positive. A positive relationship [positive correlation] between Y and Q is evidence of a normal good.
Fall '97
D2
Q2 Q1
D1
Q/ut
Slide 30
When income elasticity is positive, the good is considered a normal good. An increase in income is correlated with an increase in the demand function. A decrease in income is associated with a decrease in the demand function. For both increases The greater the value of y, the more responsive buyers + are to a change in their incomes. When the value of
ey ey
% %Q +- QxxQx % %Y +- %% Y Y
and decreases in income, ey is positive
ey is greater than 1, it is called a superior good.

% Qx ey %Y
The |% Qx| is greater than the |% Y|. Buyers are very responsive to changes in income. Sometimes superior goods are called luxury goods.
Fall '97
Slide 31
Income Elasticity
[inferior goods] There is another classification of goods where changes in income shift the demand function in the opposite direction. An increase in income [+Y] reduces demand. An increase in income reduces the amount that individuals are willing to buy at each price of the good. Income elasticity is negative: P
ey = -ey
decreases demand
-%Q %Q
%Y +Y
x x
- ey
The greater the absolute value of - ey, the more responsive buyers are to changes in income
.
P1
- %Q
Q2
D2
D1
Q/ut
Q1
Fall '97
Slide 32
Income Elasticity
[inferior goods] Decreases in income increase the demand for inferior goods. A decrease in income [-Y] increases demand. A decrease in income [- Y] results in an increase in demand, the income elasticity of demand is negative
For both increases and decreases in income the income elasticity is negative for inferior goods. The greater the
+ Qx %%Qx - eey y %Y -Y
D2
P1
absolute value of ey, the more responsive buyers are to changes in income
. .
+%Q
Q1
D1
x
Q2 Q/ut
Slide 33
Income Elasticity
Income elasticity [ey] is a measure of the effect of an income change on demand. [Can be calculated as
point or arc.]
ey > 0,
0<
[positive] is a normal or superior good an increase in income increases demand, a decrease in income decreases demand.
ey < 1 is a normal good 1 < ey is a superior good

Economics 205Principles of Microeconomics Slide 34
ey < 0, [negative] is an inferior good

Fall '97
Examples of
normal goods, [0 <
ey
ey < 1 ], (between 0 and 1) ey > 1], (greater than 1)

(negative)
coffee, beef, Coca-Cola, food, Physicians services, hamburgers, . . .
Superior goods, [
movie tickets, foreign travel, wine, new cars, . . .
Inferior goods, [ey < 0],
flour, lard, beans, rolled oats, . . .
Fall '97
Slide 35
Cross-Price Elasticity
Cross-price elasticity [exy] is a measure of how responsive the demand for a good is to changes in the prices of related goods. Given a change in the price of good Y [Py ], what is the effect on the demand for good X [Qy ]?
exy is defined as:
e
Fall '97
xy
Q % P
x y
Slide 36
Cross-price elasticity of demand , [exy]

[substitutes]
When the price of pork increases, it will tend to increase the demand for beef. People will substitute beef, which is relatively cheaper, for pork, which is relatively more expensive.
[price of beef]
When pork is $1.50, Qp pork is purchased. price of pork increases The quantity demanded of pork decreases. When beef is $2, Qb beef Pb is purchased. at Pb = $2 more increase beef will be bought demand to substitute for the smaller 2 quantity of for an increase pork. in Ppork, demand for Db Db Dp beef increases
[price of pork]
Pp
2
1.50 -Qp
Q p Q p
.
Fall '97
pork/ut
Qb
Qb
beef/ut
Slide 37
Cross-price elasticity
In the case of beef and pork the ebp is not the same as epb ebp is the % change in the demand for beef with
respect to a % change in the price of pork respect to a % change in the price of beef beef may not be a good substitute for pork pork may not be a good substitute for beef
epb is the % change in the demand for pork with
Slide 38

[substitutes]
The cross elasticity of the demand for beef with respect to the price of pork,
ebeef-pork or ebp can be calculated:
+ebpbp = e
positive
+ of % QQb beef
%P of Pp + pork
cross elasticity is positive
An increase in the price of pork, causes an increase in the demand for beef. A decrease in the price of pork, causes a decrease in the demand for beef.
+eebp = bp
positive
% - Qb Q of beef %P of pork - Pp
If goods are substitutes, exy will be positive. The greater the coefficient, the more likely they are good substitutes.

[compliments]
as more crayons are purchased, the demand for colour books increases. At the same price a larger quantity will be bought
Pc P1 Po
a decrease in the price of crayons,
Pc
$3
increase demand
-Pc
Q1 Q2
Dp
Dc Dc
2000
increases the quantity demanded of crayons negative
crayons
+ Qb
2500
colour books
- ebcbc = e
+ of % Q Qbb %P of c
Pc
for compliments, the cross elasticity is negative for price increase or decrease.
Fall '97
Slide 40
Cross-Price Elasticity
exy > 0 exy < 0
suggests substitutes, the higher the coefficient the better the substitute
[positive],
suggests the goods are compliments, the greater the absolute value the more complimentary the goods are
[negative],
exy = 0, suggests the goods are not related exy can be used to define markets in legal
proceedings
Elasticity of Supply
Elasticity of supply is a measure of how responsive sellers are to changes in the price of the good. Elasticity of supply [ep] is defined:
e
Fall '97
% Quantity Supplied = % price

Economics 205Principles of Microeconomics Slide 42
Elasticity of supply
es =
P
%Qsupplied %P
Given a supply function, at a price [P1], Q1 is produced and offered for sale. a larger At a higher [P y quantity, Q2,pricebe 2], l will produced pp u s and offered for sale.
P2 P1
+P
The increase in price [ P ], induces a larger quantity goods [ Q]for sale. The more responsive sellers are to
+Q Q1
Fall '97
P, the greater the absolute value of
es.
Q2
Q /ut
[The supply function is flatteror more elastic]

Slide 43
The supply function is a model of sellers behavior.
Sellers behavior is influenced by: 1. technology 2. prices of inputs 3. time for adjustment
market period short run long run very long run
proache s supply ap a nity oaches infi appr
Si a perfectly inelastic supply, es = 0 l es s horizonta Se

a perfectly elastic supply [es is undefined.]
4. expectations 5. anything that influences costs of production

taxes regulations, . . .
Q /ut
Fall '97
Slide 44
Elasticity
Price elasticity of demand [measures a move on a demand
function caused by change in price/arc or point]
elastic, inelastic or unitary elasticity
income elasticity [measures a shift of a demand function

associated with a change in income]
superior, normal, and inferior
cross elasticity
measure the shift of a demand function for a good associated with the change in the price of a related good
[compliment/substitute]
price elasticity of supply [measures move on a supply curve]

Forecasting
Forecasting is the art and science of predicting future events
-Institute of business forecasting
(www.ibforecast.com)
Why Forecast?
Lead times require that decisions be made in advance of uncertain events. Forecasting is an important for all strategic and planning decisions in a supply chain. Forecasts of product demand, materials, labor, financing are an important inputs to scheduling, acquiring resources, and determining resource requirements.
Demand Management
Demand management is the interface between production planning & control and the marketplace. Activities include: Forecasting. Order Processing. Making delivery promises.
Demand Management
Resource Planning Marketplace Demand Mgt. Master Production Planning Production Planning
Forecasting Horizons.
Short Term (0 to 3 months): for inventory management and scheduling. Medium Term (3 months to 2 years): for production planning, purchasing, and distribution. Long Term (2 years and more): for capacity planning, facility location, and strategic planning.
Principles of Forecasting
Forecasts are almost always wrong. Every forecast should include an estimate of the forecast error. The greater the degree of aggregation, the more accurate the forecast. Long-term forecasts are usually less accurate than short-term forecasts.
Forecasting Methods
Qualitative methods are subjective in nature since they rely on human judgment and opinion. Quantitative methods use mathematical or simulation models based on historical demand or relationships between variables.
Some Qualitative Methods

Jury of Executive Opinion (opinions of a small group of high-level managers is pooled). Sales Force Composite (aggregation of salespersons estimate of sales in their territory). Market Research Method (solicit input from customers or potential customers regarding future purchasing plans). Delphi Method (a forecasting group uses a staff to prepare, distribute, collect, and summarize a series of questionnaires and survey results from geographically dispersed respondents, whose judgements are valued).
Quantitative Forecast Methods

Time Series Methods use historical data extrapolated into the future. They are best suited for stable environments. Moving averages, exponential smoothing methods, time series decomposition, and Box-Jenkins Methods. Causal Methods assume demand is highly correlated with certain environmental factors (indicators). Correlation methods, regression models, and econometric models. Simulation Methods imitate the consumer choices that give rise to demand to arrive at a forecast.
Time Series Demand Model

Observed Demand = Systematic Component + Random Component. Systematic Component measures the expected value of demand and consists of: Level: the current deseasonalized demand. Trend: the rate of growth or decline in demand. Seasonality: the regular periodic oscillation in demand. Random Component is that part of demand that follows no discernable or predictable pattern.The random component is estimated by the forecast error (forecast actual demand).
Basic Forecasting Approach

Understand the forecasting objective. What decisions will be made from the forecasts? What parties in the supply chain will be affected by the decision. Integrate demand planning and forecasting. All planning activities within the supply chain that will use the forecast or influence demand should be linked. Identify factors that influence the demand forecast. Is demand growing or declining? Is there are relationship (complementary or substitution) between products?
Forecasting Approach (cont.)

Understand and Identify customer segments. Customer demand can be separately forecast for different segments based on service requirements, volume, order frequency, volatility, etc. Determine the appropriate forecasting technique. Typically, using a combination of the different techniques is of the the most effective approach. Establish performance and error measures. Forecasts need to be monitored for their accuracy and timeliness.
Time Series Forecasting

Static
Assume estimates of level, trend, and seasonality do not vary as new data is observed.
Adaptive
Update forecast as new data becomes available
Time Series Forecasting

Static Adaptive
Moving average Single exponential smoothing Trend-adjusted exponential smoothing (Holts) Trend & Seasonal adjusted exponential smoothing (Winters)
Static Forecasting (steps)

1. 2. 3.
Determine periodicity (even or odd?) Deseasonalize data Find the equation of the trend line
a. b. c.
Simple linear regression Independent variable (period) Dependent variable (deseasonalized data) Per period Index (Averages)
4.
Estimate seasonalized factors

a. b.
5.
Forecast
Find the equation of the line

Use simple regression
Excel: (Tools/Data Analysis/Regression) Dependent variable (y) is deseasonalized demand Independent variable (x) is period t y= intercept + slope * x = demand Other Excel Analysis Functions
Costs and Production
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Expectations Long run vs. Short run in Economic terms Production: Total product & marginal product graphs Law of diminishing marginal returns Effects of a productivity enhancement What is the difference between average and marginal cost
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The Long Run Versus the Short Run In the short run, costs are fixed and variable In the long run, all costs are variable
PRODUCTION TABLE
Labor input (workers per day) 0 1 2 3 4 5
Total product (output per day) 0 1,000 2,200 3,500 4,700 5,800
Marginal product (output per day) 1,000 1,200 1,300 1,200 1,100
NOTE: ON THIS TABLE WE HAVE INFORMATION ON INPUTS AND OUTPUT ONLYNOT COST OF PRODUCTION
Total product curve
Marginal product curve
Total product
Marginal product
TP
Increasing marginal returns
Diminishing marginal returns
5800 4700 3500 1300 1200 1100 1000 2200
MP
1000
Labor input
Labor input
Law of diminishing marginal returns At some point, the marginal product falls as additional units are added More inputs yield additional output at a smaller rate than before Too many cooks in the kitchen
Effects of a Productivity Enhancement

Increase in total product curve
TP1 TP0
Marginal product Total product
Increase in marginal product curve
MP1
MP0
Labor input
Labor input
Now, lets talk about costs of production

Total cost Average total cost Marginal cost
COST-OUTPUT RELATIONSHIP
Units of TFC Output 1 2 TVC 3 TC 4 AFC AVC (2/1) (3/1) 5 6 ATC (4/1 or 5+6) 7
0 1 2 3 4 5 6 7 8
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50 50 50 50 50 50 50 50 50
0 20 35 60 100 145 190 237 284
50 70 85 110 150 195 240 287 334
0 50.0 25.0 16.7 12.5 10.0 8.3 7.1 6.3
0.0 20.0 17.5 20.0 25.0 29.0 31.7 33.9 35.5
0 70 42.5 36.7 37.5 39.0 40.0 41.0 41.8
Total variable cost and total fixed cost gives us total cost
Average variable cost plus average fixed cost gives us the average total cost
Average total cost
Total cost
Total Cost
Total variable cost
Costs
Average variable cost
50
Total fixed cost
Marginal cost
Output per day
The change in total cost when one more unit is produced is the marginal cost
What is the difference between average total cost and marginal cost?
Average total cost is the total cost per unit of output
Marginal cost is the change in total cost when one more additional unit of output is produced
Profit = Total revenue costs

Accountants count explicit costs (Rs) (all paid-out costs as wages, rent, interests, material costs etc) Economists count explicit and implicit costs (Implicit cost is opportunity cost)
Is bigger production better?

Pros Mass production and standardization can meet large demand (e.g. Ford) Economies of scale Capture gains quickly Cons Cant meet specialized tastes of consumers (e.g. microbrews)
Economies of Scale
Economies of Scale
The advantages of large scale production that result in lower unit (average) costs (cost per unit) AC = TC / Q Economies of scale spreads total costs over a greater range of output
Economies of Scale
Internal advantages that arise as a result of the growth of the firm
Technical Commercial Financial Managerial Risk Bearing
Economies of Scale
External economies of scale the advantages firms can gain as a result of the growth of the industry normally associated with a particular area Supply of skilled labour Reputation Local knowledge and skills Infrastructure Training facilities
Economies of Scale
Capital Scale A Scale B 5 10 Land 3 6 Labour 4 8 Output 100 300
Assume each unit of capital = Rs.50, Land = Rs.80 and Labour = Rs.20 Calculate TC and then AC for the two different scales (sizes) of production facility What happens and why?
Economies of Scale
Capital Scale A Scale B 5 10 Land 3 6 Labour 4 8 Output 100 300 TC 570 1140 AC 5.7 3.8
Doubling the scale of production (a rise of 100%) has led to an increase in output of 200% - therefore cost of production PER UNIT has fallen Dont get confused between Total Cost and Average Cost Overall costs will rise but unit costs can fall Why?
Economies of Scale
Internal: Technical
Specialisation large organisations can employ specialised labour Indivisibility of plant machines cant be broken down to do smaller jobs! Increased dimensions bigger containers can reduce average cost
Economies of Scale
Indivisibility of Plant/Machines: Some machineries available in large and lumpy size-cannot be broken and used in small production
Economies of Scale
Commercial Large firms can negotiate favourable prices as a result of buying in bulk Large firms may have advantages in keeping prices higher because of their market power
Economies of Scale
Financial Large firms able to negotiate cheaper finance deals Large firms able to be more flexible about finance share options, etc. Large firms able to utilise skills of merchant banks to arrange finance
Economies of Scale
Managerial
Use of specialists accountants, marketing, lawyers, production, human resources, etc.
Economies of Scale
Risk Bearing
Diversification Markets across regions/countries Product ranges R&D
ECONOMIES OF SCALE
Y AC
E>D AC E=D
E<D
X Large Scale Production
Diseconomies of Scale
The disadvantages of large scale production that can lead to increasing average costs
Problems of management Maintaining effective communication Co-ordinating activities often across the globe! De-motivation and alienation of staff Divorce of ownership and control
Break-Even Analysis
Defined:
Break-even analysis examines the cost tradeoffs associated with demand volume.
Break-Even Analysis
Benefits Defining Page Getting Started Break-even Analysis Break-even point Comparing variables Algebraic Approach Graphical Approach
Overview:
Benefits and Uses:

The evaluation to determine necessary levels of service or production to avoid loss. Comparing different variables to determine best case scenario.
Defining Page:
USP UVC FC Q = Unit Selling Price = Unit Variable costs = Fixed Costs = Quantity of output units sold (and manufactured)
Cont.
OI TR TC USP
Defining Page:
= Operating Income = Total Revenue = Total Cost = Unit Selling Price
Getting Started:
Determination of which equation method to use: Basic equation Contribution margin equation Graphical display
Break-even point
Break-even analysis:
Mr. Raj sells a product for Rs.10 and it cost Rs.5 to produce (UVC) and has fixed cost (FC) of Rs.25,000 per year How much will he need to sell to break-even? How much will he need to sell to make Rs.1000?
Basic equation
Algebraic approach:
Revenues Variable cost Fixed cost = OI (USP x Q) (UVC x Q) FC = OI Rs10Q Rs5Q Rs25,000 =Rs 0.00 Rs.5Q = Rs.25,000 Q = 5,000 What quantity demand will earn Rs.1,000? Rs.10Q Rs.5Q Rs.25,000 = Rs.1,000 Rs.5Q = Rs.26,000 Q = 5,200 (Because: Revenue = Rs10x200 = Rs.2000 minus Rs 5 x200=1000 UVC)
Contribution Margin equation

(USP UVC) x Q = FC + OI Q = FC + OI UMC Q = 25,000 + 0 5 Q = 5,000
Algebraic approach:
What quantity needs sold to make 1,000?
Q = 25,000 + 1,000 5 Q = 5,200
Graphical analysis:
Rs 70,000 Total Cost 60,000 Line 50,000 40,000 30,000 20,000 Total Revenue Break-even point 10,000 Line 0 1000 2000 3000 4000 5000 6000 Quantity
Cont.
Graphical analysis:
Dollars 70,000 Profit zone Total Cost 60,000 B Line 50,000 40,000 30,000 Loss zone 20,000 Total Revenue Break-even point 10,000 Line 0 1000 2000 3000 4000 5000 6000 Quantity
Break-even Analysis Simplified

When total revenue is equal to total cost the process is at the break-even point. TC = TR
Scenario 1:
Summary:
Break-even analysis can be an effective tool in determining the cost effectiveness of a product. Required quantities to avoid loss. Use as a comparison tool for making a decision.
END OF BREAK-EVEN ANALYSIS (FOR SCDL-PCP)
Break-even Analysis:
Comparing different variables
Company XYZ has to choose between two machines to purchase. The selling price is Rs10 per unit. Machine A: annual cost of Rs 3000 with per unit cost (VC) of Rs 5. Machine B: annual cost of Rs 8000 with per unit cost (VC) of Rs 2.
Comparative analysis Part 1

Determine break-even point for Machine A and Machine B. Where: V = FC SP - VC
Part 1, Cont.
Machine A:
Machine B:
v = $3,000 $10 - $5 = 600 units v = $8,000 $10 - $2 = 1000 units
Part 1: Comparison
Compare the two results to determine minimum quantity sold. Part 1 shows: 600 units are the minimum. Demand of 600 you would choose Machine A.
Part 2: Comparison
Finding point of indifference between Machine A and Machine B will give the quantity demand required to select Machine B over Machine A. Machine A FC + VC $3,000 + $5 Q $3Q Q = = = = = Machine B FC + VC $8,000 + $2Q $5,000 1667
Cont.
Part 2: Comparison
Knowing the point of indifference we will choose: Machine A when quantity demanded is between 600 and 1667. Machine B when quantity demanded exceeds 1667.
Graphically displayed
Part 2: Comparison
Dollars 21,000 18,000 Machine A 15,000 12,000 9,000 Machine B 6,000 3,000 0 500 1000 1500 2000 2500 3000 Quantity
Graphically displayed Cont.

Dollars 21,000 18,000 Machine A 15,000 12,000 9,000 Machine B 6,000 Point of indifference 3,000 0 500 1000 1500 2000 2500 3000 Quantity
Part 2: Comparison
Exercise 1:
Company ABC sell widgets for $30 a unit. Their fixed cost is$100,000 Their variable cost is $10 per unit. What is the break-even point using the basic algebraic approach?
Answer
Exercise 1:
Revenues Variable cost - Fixed cost = OI
(USP x Q) (UVC x Q) FC $30Q - $10Q $100,00 $20Q Q
= OI = $ 0.00 = $100,000 = 5,000
Exercise 2:
Company DEF has a choice of two machines to purchase. They both make the same product which sells for $10. Machine A has FC of $5,000 and a per unit cost of $5. Machine B has FC of $15,000 and a per unit cost of $1. Under what conditions would you select Machine A?
Answer
Exercise 2:
Step 1: Break-even analysis on both options. Machine A: v = $5,000 $10 - $5 = 1000 units Machine B: v = $15,000 $10 - $1 = 1667 units
Answer Cont.
Machine A FC + VC $5,000 + $5 Q $4Q Q
Exercise 2:
= Machine B = FC + VC = $15,000 + $1Q = $10,000 = 2500
Machine A should be purchased if expected demand is between 1000 and 2500 units per year.
Lecture 5 Perfect competition ECN101 Professor Grob
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Expectations for Chapter 5

Describe how a perfectly competitive firm maximizes profits or minimizes losses. Explain how a perfectly competitive firm achieves economic efficiency in the long run. Identify factors that contribute to monopoly. Develop a model that illustrates profit maximization and loss minimzation for a monopoly. Assess the advantages and disadvantages of a 1,400,000 2,800,000 perfectly competitive firm and a 2,800,000 monopoly. 0 1,400,000
Quantity of fish (lbs.) Quantity of fish (lbs.) 15 15 14 14 13 13 12 12 11 11 10 10 9 89 78 67 56 45 34 23 12 01 0 0
Continuum of market structures

#producers or sellers
1 2
30+
Many
Duopoly Monopoly Oligopoly Monopolistic competition
Perfect Competition
Chapter 5 deals with the extremes

#producers or sellers
Many
Monopoly
Perfect Competition
Market equilibrium facing a competitive firm

Price 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0 0 1,400,000 Quantity of fish (lbs.)
Market supply
Market demand
2,800,000 Quantity
Some characteristics of market structures

Perfect Competition No barriers to entry Many sellers Many buyers Standardized product Perfect information about the market (buying, producing, selling) Monopoly High barriers to entry One seller Many buyers Brand loyalty Control of production and distribution processes
Demand and revenue for a competitive firm

$ 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0 0
Demand and Marginal Revenue for one company
Total revenue
$ 70 63 56 49
Total revenue
Demand = P = MR
42 35 28 21 14 7 0 2 4 6 8 10 12 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of fish (lbs.) Quantity of fish (lbs.) 1 7
Profit Maximization and Loss Minimization Marginal revenue (MR)= marginal Cost (MC) In the case of the perfectly competitive firm, marginal revenue = price Price=MR=MC is the point where profits are maximized If price falls below average total cost, then what? Operate as long as total revenue exceeds total cost.
Short-run economic profit/loss for a competitive firm

Profit maximization
Rs 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 0 500 1000 1500 2000 2500 3000 3500 Quantity of fish (lbs.) 2.00 1.00 0.00 0 700 1600 Quantity of fish (lbs.) 3000
Loss minimization
Rs 8.00 7.00 6.00 5.33 5.00 4.00 3.00
MC A Demand = P = MR ATC
Total loss = Rs.2,128
MC ATC AVC Demand = P = MR
Total profit = Rs.2,500
Long-run adjustments for a competitive firm: effects of market entry

Price and cost Price
Market
S0
7
Individual firm
7
S1
6
Demand0 = Price0
LRATC A 5 5 Demand1 = Price1
D0
4 0 Quantity of fish (lbs.) 4 0 500 Quantity of fish (lbs.)
Perfect Competition Long-run adjustments for a competitive firm: effects of market exit
Price and cost Price
Market
S1
6
Individual firm
6 LRATC A 5 Demand1 = Price1
S2
5
Demand2 = Price2
D0
3 0 Quantity of fish (lbs.) 3 0 500 Quantity of fish (lbs.)
Monopoly
Monopoly
While a competitive firm is a price taker, a monopoly firm is a price maker.
Harcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Monopoly
A firm is considered a monopoly if . . . it is the sole seller of its product. its product does not have close substitutes.
Why Monopolies Arise The fundamental cause of monopoly is barriers to entry.
Why Monopolies Arise

Barriers to entry have three sources:
Ownership of a key resource.
This tends to be rare. De Beers is an example
The government gives a single firm the exclusive right to produce some good.
Patents, Copyrights and Government Licensing.
Costs of production make a single producer more efficient than a large number of producers.
Natural Monopolies
Economies of Scale as a Cause of Monopoly...

Cost
Average total cost 0

Quantity of Output
Monopoly versus Competition

Monopoly Is the sole producer Has a downwardsloping demand curve Is a price maker Reduces price to increase sales Competitive Firm Is one of many producers Has a horizontal demand curve Is a price taker Sells as much or as little at same price
Demand Curves for Competitive and Monopoly Firms...

(a) A Competitive Firms Demand Curve Price (b) A Monopolists Demand Curve
Price
Demand
Demand
0 Quantity of Output 0 Quantity of Output
A Monopolys Revenue
Total Revenue
P x Q = TR
Average Revenue
TR/Q = AR = P
Marginal Revenue
TR/Q = MR
A Monopolys Marginal Revenue A monopolists marginal revenue is always less than the price of its good.
The demand curve is downward sloping. When a monopoly drops the price to sell one more unit, the revenue received from previously sold units also decreases.
A Monopolys Total, Average, and Marginal Revenue

(Rs)
Quantity (Q) 0 1 2 3 4 5 6 7 8 Price (P) 11.00 10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00 Total Revenue (TR=P x Q) 0.00 10.00 18.00 24.00 28.00 30.00 30.00 28.00 24.00 Average Revenue (AR=TR/Q) 10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00 Marginal Revenue (MR= TR / Q ) 10.00 8.00 6.00 4.00 2.00 0.00 -2.00 -4.00
A Monopolys Marginal Revenue When a monopoly increases the amount it sells, it has two effects on total revenue (P x Q).
The output effectmore output is sold, so Q is higher. The price effectprice falls, so P is lower.
Demand and Marginal Revenue Curves for a Monopoly...

Price $11 10 9 8 7 6 5 4 3 2 1 0 -1 -2 -3 -4
Marginal revenue
1 2 3 4 5 6 7 8
Demand (average revenue)

Quantity of Water
Profit-Maximization for a Monopoly...

Costs and Revenue 2. ...and then the demand curve shows the price consistent with this quantity. B 1. The intersection of the marginal-revenue curve and the marginalcost curve determines the profit-maximizing quantity... Average total cost A Demand
Monopoly price
Marginal cost
Marginal revenue 0
QMAX
Quantity
Comparing Monopoly and Competition

For a competitive firm, price equals marginal cost.
P = MR = MC
For a monopoly firm, price exceeds marginal cost.
P > MR = MC
A Monopolys Profit Profit equals total revenue minus total costs.
Profit = TR - TC Profit = (TR/Q - TC/Q) x Q Profit = (P - ATC) x Q
The Monopolists Profit...

Costs and Revenue Marginal cost Monopoly E price B
y ol op it on f M pro
C
Average total cost
Average total cost D
Demand
Marginal revenue 0
QMAX
Quantity
The Monopolists Profit

The monopolist will receive economic profits as long as price is greater than average total cost.
Public Policy Toward Monopolies

Government responds to the problem of monopoly in one of four ways.
Making monopolized industries more competitive. Regulating the behavior of monopolies. Turning some private monopolies into public enterprises.
Price Discrimination
Price discrimination is the practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same. In order to do this, the firm must have market power.
Price Discrimination
Two important effects of price discrimination:

It can increase the monopolists profits. It can reduce deadweight loss.
But in order to price discriminate, the firm must
Be able to separate the customers on the basis of willingness to pay. Prevent the customers from reselling the product.
Monopolistic Competition
The Four Types of Market Structure

Number of Firms?
Many firms One firm Few firms
Type of Products?
Differentiated products
Identical products
Perfect Competition
Monopoly
Oligopoly
Tap water Cable TV
Tennis balls Crude oil
Novels Movies
Wheat Milk
Types of Imperfectly Competitive Markets

Many firms selling products that are similar but not identical.
Oligopoly
Only a few sellers, each offering a similar or identical product to the others.
Markets that have some features of competition and some features of monopoly.
Attributes of Monopolistic Competition

Large number of firms Product differentiation Free entry and exit Downward-sloping demand curve
Many Sellers
There are many firms competing for the same group of customers.
Product examples include books, CDs, movies, computer games, restaurants, piano lessons, furniture, bath soaps etc.
Product Differentiation
Each firm produces a product that is at least slightly different from those of other firms. Rather than being a price taker, each firm faces a downward-sloping demand curve.
Free Entry or Exit

Firms can enter or exit the market without restriction. The number of firms in the market adjusts until economic profits are zero.
Monopolistic Competitors in the Short Run...

(a) Firm Makes a Profit
Price
MC
ATC
Price Average total cost
Profit
Demand
MR
0 Profitmaximizing quantity Quantity

(b) Firm Makes Losses
Price Losses Average total cost Price Demand
MC
ATC
MR
0 Lossminimizing quantity Quantity
Monopolistic Competition in the Short Run

Short-run economic profits encourage new firms to enter the market. This:
Increases the number of products offered. Reduces demand faced by firms already in the market. Incumbent firms demand curves shift to the left. Demand for the incumbent firms products fall, and their profits decline.
Monopolistic Competition in the Short Run

Short-run economic losses encourage firms to exit the market. This:
Decreases the number of products offered. Increases demand faced by the remaining firms. Shifts the remaining firms demand curves to the right. Increases the remaining firms profits.
The Long-Run Equilibrium

Firms will enter and exit until the firms are making exactly zero economic profits.
A Monopolistic Competitor in the Long Run...

Price
MC ATC
P=ATC
MR
0 Profit-maximizing quantity
Demand Quantity
Two Characteristics of LongRun Equilibrium

As in a monopoly, price exceeds marginal cost.
Profit maximization requires marginal revenue to equal marginal cost. The downward-sloping demand curve makes marginal revenue less than price.
Two Characteristics of LongRun Equilibrium

As in a competitive market, price equals average total cost.
Free entry and exit drive economic profit to zero.
Monopolistic versus Perfect Competition

There are two noteworthy differences between monopolistic and perfect competitionexcess capacity and markup.
Excess Capacity
There is no excess capacity in perfect competition in the long run. Free entry results in competitive firms producing at the point where average total cost is minimized, which is the efficient scale of the firm.
Excess Capacity
There is excess capacity in monopolistic competition in the long run. In monopolistic competition, output is less than the efficient scale of perfect competition.
Excess Capacity...
(a) Monopolistically Competitive Firm Price MC ATC (b) Perfectly Competitive Firm MC Price ATC
P Excess capacity Demand
P = MC
P = MR (demand curve)
Quantity Quantity Efficient produced scale

Quantity Quantity= Efficient produced scale
Markup Over Marginal Cost

For a competitive firm, price equals marginal cost. For a monopolistically competitive firm, price exceeds marginal cost.
Markup Over Marginal Cost

Because price exceeds marginal cost, an extra unit sold at the posted price means more profit for the monopolistically competitive firm.
Markup Over Marginal Cost...

(a) Monopolistically Competitive Firm Price Markup (b) Perfectly Competitive Firm Price
MC
ATC
MC
ATC
P
Marginal cost
P = MC
P = MR
(demand curve)
MR
Demand Quantity Quantity Quantity produced
Quantity produced
Monopolistic versus Perfect Competition...

MC
P
ATC P = MC
MC ATC P = MR
Marginal cost
(demand curve)
MR
Quantity produced Efficient scale
Demand Quantity
Quantity produced = Quantity Efficient scale
Excess capacity
Monopolistic Competition and the Welfare of Society

Monopolistic competition does not have all the desirable properties of perfect competition.

There is the normal deadweight loss of monopoly pricing in monopolistic competition caused by the markup of price over marginal cost. However, the administrative burden of regulating the pricing of all firms that produce differentiated products would be overwhelming.

Another way in which monopolistic competition may be socially inefficient is that the number of firms in the market may not be the ideal one. There may be too much or too little entry.

The product-variety externality:
Because consumers get some consumer surplus from the introduction of a new product, entry of a new firm conveys a positive externality on consumers.

The business-stealing externality: Because other firms lose customers and profits from the entry of a new competitor, entry of a new firm imposes a negative externality on existing firms.
Advertising
When firms sell differentiated products and charge prices above marginal cost, each firm has an incentive to advertise in order to attract more buyers to its particular product.
Advertising
Firms that sell highly differentiated consumer goods typically spend between 10 and 20 percent of revenue on advertising. Overall, about 2 percent of total revenue, or over $100 billion a year, is spent on advertising.
Advertising
Critics of advertising argue that firms advertise in order to manipulate peoples tastes. They also argue that it impedes competition by implying that products are more different than they truly are.
Advertising
Defenders argue that advertising provides information to consumers They also argue that advertising increases competition by offering a greater variety of products and prices. The willingness of a firm to spend advertising dollars can be a signal to consumers about the quality of the product being offered.
Brand Names
Critics argue that brand names cause consumers to perceive differences that do not really exist.
Brand Names
Economists have argued that brand names may be a useful way for consumers to ensure that the goods they are buying are of high quality.
providing information about quality. giving firms incentive to maintain high quality.
Summary
A monopolistically competitive market is characterized by three attributes: many firms, differentiated products, and free entry. The equilibrium in a monopolistically competitive market differs from perfect competition in that each firm has excess capacity and each firm charges a price above marginal cost.
Summary
Monopolistic competition does not have all of the desirable properties of perfect competition. There is a standard deadweight loss of monopoly caused by the markup of price over marginal cost. The number of firms can be too large or too small.
Summary
The product differentiation inherent in monopolistic competition leads to the use of advertising and brand names.
Critics of advertising and brand names argue that firms use them to take advantage of consumer irrationality and to reduce competition.
Summary
Defenders argue that firms use advertising and brand names to inform consumers and to compete more vigorously on price and product quality.
Graphical Review

(a) Firm Makes a Profit
Price
MC
ATC
Price Average total cost
Profit
Demand
MR
0 Profitmaximizing quantity Quantity

(b) Firm Makes Losses
Price Losses Average total cost Price Demand
MC
ATC
MR
0 Lossminimizing quantity Quantity
A Monopolistic Competitor in the Long Run...

Price
MC ATC
P=ATC
MR
0 Profit-maximizing quantity
Demand Quantity
Excess Capacity...
(a) Monopolistically Competitive Firm Price MC ATC (b) Perfectly Competitive Firm MC Price ATC
P Excess capacity Demand
P = MC
P = MR (demand curve)
Quantity Quantity Efficient produced scale

Quantity Quantity= Efficient produced scale
Markup Over Marginal Cost...

MC
ATC
MC
ATC
P
Marginal cost
P = MC
P = MR
(demand curve)
MR
Demand Quantity Quantity Quantity produced
Quantity produced
Monopolistic versus Perfect Competition...

MC
P
ATC P = MC
MC ATC P = MR
Marginal cost
(demand curve)
MR
Quantity produced Efficient scale
Demand Quantity
Quantity produced = Efficient scale
Quantity
Excess capacity
Oligopoly
Imperfect Competition
Imperfect competition includes industries in which firms have competitors but do not face so much competition that they are price takers.
Types of Imperfectly Competitive Markets

Oligopoly
Only a few sellers, each offering a similar or identical product to the others.
Many firms selling products that are similar but not identical.
The Four Types of Market Structure

Number of Firms?
Many firms One firm Few firms
Type of Products?
Differentiated products
Identical products
Perfect Competition
Monopoly
Oligopoly
Tap water Cable TV
Cell Phone Crude oil
Novels Movies
Wheat Milk
Characteristics of an Oligopoly Market

Few sellers offering similar or identical products Interdependent firms Best off cooperating and acting like a monopolist by producing a small quantity of output and charging a price above marginal cost There is a tension between cooperation and self-interest.
Competition, Monopolies, and Cartels

The Oligopolists may agree on a monopoly outcome.
Collusion
The two firms may agree on the quantity to produce and the price to charge.
Cartel
The two firms may join together and act in unison.
However, both outcomes are illegal in India due to MRTP Act.
Profit-maximising cartel Profit-maximising cartel

Industry MC
P1
Industry MR
O
Industry D AR
Q
Q1
Oligopoly
Tacit collusion
price leadership: dominant firm price leadership: Low Cost firm
Collusion and the law The breakdown of collusion
Oligopoly
Non-collusive oligopoly: the kinked demand curve theory
assumptions of the model
Rs
Kinked demand for a firm under oligopoly Kinked demand for a firm under oligopoly
P1
Q1
Oligopoly
assumptions of the model the shape of the demand curve
The MR curve The MR curve

P1 MR
D = AR
Q1
Stable price under conditions of a Stable price under conditions of a kinked demand curve kinked demand curve
MC2 P1 MC1
a b
O
D = AR
Q1
Q
MR
Oligopoly
assumptions of the model the shape of the demand curve stable prices
Oligopoly
Oligopoly and the consumer
disadvantages
worse if there is extensive collusion
advantages
countervailing power supernormal profits may allow higher R&D greater choice for consumers
difficulties in drawing general conclusions
Summary of Equilibrium for an Oligopoly

Possible outcome if oligopoly firms pursue their own self-interests:
Joint output is greater than the monopoly quantity but less than the competitive industry quantity. Market prices are lower than monopoly price but greater than competitive price. Total profits are less than the monopoly profit.
How the Size of an Oligopoly Affects the Market Outcome

How increasing the number of sellers affects the price and quantity:
The output effect: Because price is above marginal cost, selling more at the going price raises profits. The price effect: Raising production lowers the price and the profit per unit on all units sold.
Pricing Methods and Policies Context and concepts Learning outcomes Explore the meaning of price to marketers understand the nature of the internal and external factors that influence pricing decisions explain pricing methods and their uses Understand the two generic pricing strategies and their application
Importance of price to marketers

Price is a key element in the marketing mix because: Directly -Price relates directly to the generation of total revenue -Price is also the only marketing mix element that generates revenue, others are costs Indirectly -Price can be a major determinant of the quantity of goods sold -Price also influences total costs through its impact on quantity sold Symbolically -Price has a psychological impact on customers -By raising price the quality of the product can be emphasised -By lowering price marketers can emphasis a bargain
Price and Competition

Price competition Is a policy whereby marketers emphasises price as an issue and matches or beats the prices of competitors Non-price competition Is a policy in which a seller elects not to focus on price but to emphasis other factors instead.
Non-Price Competition
Non price competition is done in the following ways: - Reinforcing the quality image of the product (Sony) - Reinforcing the desirability of the product benefits - Using extended warranty to help customers think they are getting more for their money - Emphasise the longer term cost saving derived from using this product with the cheaper competition - Customer loyalty cards - Incentives for purchasing off-peak, or out of season - Internet shopping - Home delivery systems
Some pricing context

In service markets the influences on prices are related to service characteristics - perishability (service cannot be stored) - intangibility (difficult to measure quality) In non-profit markets the pricing of the product/service is for different objectives in organisational markets prices are affected by the relationship between price & cost, value management
Internal influences on pricing

Organisational objectives - the role pricing can play in achieving long and short-term corporate objectives Marketing objectives - long & short term marketing objectives; price & product positioning Costs - the relationship between price and cost; balancing the need to cover costs against the price the market will bear
External influences on pricing

Customers and consumers: demand & elasticity; price sensitivity Channels of distribution: need to cover costs, value added to products; desired margins Competitors: pricing under different market structures Legal and regulatory: freedom to set prices, unfair pricing practices: sales taxes, VAT and their impact on prices
Internal & External Influences on Pricing

Internal factors - Marketing strategies .Targeting .positioning and .marketing mix strategy -Financial strategies .the cost base of fixed & variable costs .the financial objectives of the organisation External factors -Types of customers .customer perception of value of the product .elasticity of demand -the competitiveness of the market place
.perfect competition .monopolistic .oligopolistic .pure monopoly
Pricing Methods
Break-even analysis Cost-based pricing Target Rate of return Return on investment Payback period Going rate Seal bid Competitive reaction Identifying customer value Matching sellers/buyers Perceived values Demand differentiation
Competition-based pricing
Market-based pricing
Pricing Methods
Cost-based pricing - prices set mainly on the basis of cost (fixed & variable overheads) Competition-based pricing - pricing a product or service at a price comparable with that charged by the competition (this could be slightly higher or lower than the competition) Customer-based pricing - relies on the perceived value and how much customers are prepared to pay for the product or service
Two generic pricing strategies for new products

Skimming Policy Price skimming involves charging a relatively high price for a short time where a new, innovative, or much-improved product is launched onto a market A major disadvantage is that it encourages new entrants Penetration Policy
Penetration pricing involves the setting of lower, rather than higher prices in order to achieve a large, if not dominant market share. This strategy is most often used in businesses wishing to enter a new market or build on a relatively small market share. A successful penetration pricing strategy may lead to large sales volumes/market shares and therefore lower costs per unit.
New product launch strategy High
Promotion
Low
High
Rapid skimming
Slow skimming
Price
Rapid penetration Low Slow penetration
New product launch pricing strategies

Rapid Skimming strategy - tends to combine high price and high promotion expenditure. High prices is used to create high revenue, while high promotion used for product awareness & knowledge Slow skimming strategy - tends to combine high prices with low level of promotion expenditure - High prices means high revenue but promotion is left to mainly word-ofmouth
Rapid penetration strategy - tends to combine low prices with high promotional expenditure - aims to gain market share rapidly
Slow penetration strategy - tends to combine low prices with low promotional expenditure - mainly used by Own-label brands
Conditions for charging high & low prices

Conditions for charging high prices -product provides high value -customers have high ability to pay -lack of competition -high pressure to buy Conditions for charging low prices -lack of differential advantage -market presence or dominance -economies of scale -objective to make money later -make money by using loss leader to attract customers -using low price as a barrier to entry
Trial prices for new product

Pricing a new product low for a limited period of time in order to lower the risk to customers - the idea is to win customers acceptance first and make profits later Trial pricing also works for services. Health clubs & other service providers may offer trial membership or special introductory prices. The hope is that the customer tries the service at a low price and is converted to a regular price customer
Characteristics of high price market segments
Products provide high value Customers have high ability to pay Customer and bill payer are different lack of competition High pressure to buy
Steps in Price Planning

The process involves: -Developing a pricing objective (s) - Estimating demand -Determining costs -Evaluating the pricing environment -Choosing a pricing strategy -Selecting the final price
Conclusion
Pricing decisions should be made on the basis of cost, competition, demand but in the context of the overall marketing objectives and strategy. Pricing decision must also take account of the other elements of the marketing mix and must be consistent with them
Chapter 12 Cost/Benefit Analysis: Four Four Different Approaches
Copyright: Vail Training Associates
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Cost/Benefit Analysis
A systematic comparison of the expected costs and benefits of a course of action.
Dictionary of Accounting, Ralph Estes Second Edition, MIT Press, 1995

56
When benefits and costs are measured on the same scale, such as dollars, the benefits should exceed the costs for a given course of action.
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When benefits can not be measured readily in dollars, cost-benefit analysis generally requires the comparison of two or more alternatives.
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When the alternatives are estimated to provide the same benefit (such as the same level of national defense), the alternative with the lowest cost should be selected.
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4.1.2.1 Project Selection Methods

(PMBOK Third Edition)
Two Broad Categories

Benefit Measurement Methods Mathematical Models
56

PMBOK Third Edition
Mathematical Models
Also known as Algorithms
(Constrained Optimization Methods, PMBOK 2000 Edition)
Linear Programming Non Linear Programming Dynamic Programming Integer Programming Multi-objective Programming
56

PMBOK Third Edition
Mathematical Models
56

PMBOK Third Edition
Mathematical Models
Linear Programming
A mathematical approach to obtaining the best or optimal solution to a complex problem with:
(a) A specified objective (such as maximization of profits) (b) Quantifiable constraints or limitations.
56
Mathematical Models
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10

PMBOK Third Edition
Benefit Measurement Methods

Comparative Approaches Scoring Models Benefit Contribution Economic Models
56
11

PMBOK Third Edition

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12

PMBOK Third Edition

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13

PMBOK Third Edition

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14

PMBOK Third Edition

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15
Economic Models
The process of identifying the financial (economic) benefits is called Capital Budgeting. It is the decision-making process by which some organizations evaluate and select projects.
Kerzner, Seventh Edition
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16
Economic Models
Sophisticated capital budgeting techniques take into consideration depreciation schedules, tax information, inflation and other economic considerations.
Fortunately: These are beyond the scope of this presentation.
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17
Economic Models Since we are discussing only the principles of capital budgeting we will restrict our discussion to:
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18
Economic Models
Benefit/Cost Ratio Payback Period Discounted Cash Flow

Net Present Value
Internal Rate of Return (IRR)

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19
Economic Models
Benefit/Cost Ratio Payback Period Discounted Cash Flow Net Present Value Internal Rate of Return (IRR)
56 20
Economic Models
Benefit/Cost Ratio Simply put it is the financial value of the benefit divided by the financial cost. $Benefit $Cost
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21
Economic Models
Benefit/Cost Ratio
Project Benefit = Project Cost = Rs. 7,000 Rs. 5,000
Benefit/Cost Ratio = 1.4
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22
Economic Models
Benefit/Cost Ratio (Criteria)

An organization could establish any criteria that they wanted for the purposes of evaluating a project. Company A might have a Benefit/Cost Ratio requirement of 1.5 or greater. Company B might simply make the decision to do the project if it had a Benefit/Cost Ratio of 1.0.
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23
Economic Models

Net Present Value

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24
Economic Models
Payback Period Payback period is the length of time, usually expressed in years or fractions there of, needed for a firm to recover its initial investment on a project.
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25
Economic Models
Payback Period
Initial Project Expense = Rs.5,000
Payback Year 1 Year 2 Year 3 Year 4 Rs 1,000 2,000 2,000 2,000
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Rs (4,000) (2,000) 0 2,000

26
Economic Models
Payback Period (Criteria)

An organization that uses Payback Period would also have to define what the payback period criteria would be. Some organizations would be very happy with a payback period of three years. Others would no doubt use a much shorter payback period criteria.
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27
Economic Models
Benefit/Cost Ratio & Payback Period

These two approaches have a common problem. They do not take into consideration the TIME VALUE OF MONEY. As a result they are typically used on only relatively short term projects.
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28
Economic Models
Future Value And Present Value Concepts

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29
Economic Models
Future Value
FV = PV (1+interest rate) raised to the (number of years) power.

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30
Economic Models
Future Value
Lets say we have Rs.1,000 invested at 6% for three years. FV = Rs.1,000 (1+.06) to the third power. FV = Rs.1,000 * (1.1910) FV = Rs.1,191
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31
Economic Models
Future Value Table

Years 1 2 3 4 5 2%
1.0200 1.0404 1.0612 1.0824 1.1040
3%
1.0300 1.0609 1.0927 1.1255 1.1592
6%
1.0600 1.1236 1.1910 1.2624 1.3382 56
10%
1.1000 1.2100 1.3310 1.4641 1.6105 32
Economic Models
Present Value
PV = FV * 1 / ((1+interest rate) to the (number of years) power).
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33
Economic Models
Present Value
The result of discounting one or more amounts to be received or paid in the future by a discount rate.
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34
Economic Models
Present Value
For example:
Rs.100 invested at 6% will amount to Rs.106 at the end of one year (this is a future value). Therefore:
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35
Economic Models
Present Value The present value of Rs.106 due at the end of one year at 6% is Rs.100.
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36
Economic Models
Present Value
Lets say we have Rs.1,000 being sent to us 3years from now and the inflation rate is at 3%. PV = Rs.1,000 * 1/((1+.03) to the third power). PV = Rs.1,000 * (.9151) FV = Rs.915.10
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37
Economic Models
Present Value Table

Years 1 2 3 4 5 2%
.9803 .9611 .9422 .9238 .9057
3%
.9708 .9425 .9151 .8884 .8626
6%
.9433 .8899 .8396 .7921 .7472 56
10%
.9090 .8264 .7513 .6830 .6209 38
Economic Models
Present Value Analysis

Any method of evaluating alternatives with the time value of money incorporated to more effectively determine the long term financial effects on investment dollars. (It is the recognition that any amount due in the future is worth less than that same amount if it were due today.)
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39
Economic Models

Net Present Value

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40
Economic Models
Discounted Cash Flow

1. A method of evaluating a long term project that explicitly takes into account the time value of money. 2. The present value of all expected net cash receipts from a project, discounted by an appropriate discount rate.
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41
Economic Models
Discounted Cash Flow Initial Project Expense = Rs.5,000
(Payback) Discounted
Future Value
Cash Flow at 6%.

Present Value
Year 1 Year 2 Year 3 Year 4
Rs.1,000 Rs.2,000 Rs.2,000 Rs.2,000
Rs.943 Rs.1,780 Rs.1,697 Rs.1,584

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(Rs.4,057) (Rs.2,277) (Rs. 580) Rs.1,004

42
Economic Models
Initial Project Expense = Rs.5,000

Payback Year 1 Year 2 Year 3 Year 4 Rs.1,000 Rs.2,000 Rs.2,000 Rs.2,000 (Rs.4,000) (Rs.2,000) Rs 0 Rs.2,000
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43
Economic Models

Net Present Value
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44
Economic Models
Net Present Value

The algebraic sum of the present values of all outlays and inflows associated with a given project or investment. Calculation of net present value usually involves subtracting the initial outlay cost of an investment from the present value of all future cash flows.
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45
Economic Models
Net Present Value Discounted Cash Flow at 6%. Year 1 Rs.1,000 Rs. 943 Year 2 Rs.2,000 Rs.1,780 Year 3 Rs.2,000 Rs.1,697 Year 4 Rs.2,000 Rs.1,584 Total Rs.6,004 accrued benefit Less Investment - 5,000 Net Present Value Rs.1,004
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46
Economic Models

Net Present Value
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47
Economic Models
The effective annual Return on Investment (ROI) over the life of a project.
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48
Economic Models
IF we invested Rs.5,000 in a project, and we got a Rs.6,004 discounted return on the investment, WHAT interest rate would we have had to have received on an investment of Rs.5,000 to get that Rs.6,004?
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49
Economic Models
Rs.6,004 / Rs.5000 = 1.2008 (a factor)

Years 1 2 3 2%
1.0200 1.0404 1.0612
3%
1.0300 1.0609 1.0927
6%
1.0600 1.1236 1.1910
10%
1.1000 1.2100 1.3310
4
5
1.0824
1.1040
1.1255
1.1592 56
1.2624
1.3382
1.4641
1.6105 50
Economic Models
We are looking for a factor of 1.2008

Is it 5% ? No, 5% for 4 years = 1.2155 Is it 4.5% ? No, 4.5% for 4 years = 1.1925 Is it 4.7% ? Very close, 4.7% = 1.2016
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Economic Models
Internal Rate of Return (Criteria)
Hurdle Rate
The minimum acceptable
return on investment.
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52
Economic Models
Internal Rate of Return (Criteria)
Hurdle Rates
High Tech Companies tend to very high hurdle rates. Less competitive organizations tend to have much lower hurdle rates.
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53
Economic Models

Net Present Value

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54
End of Cost-Benefit Analysis
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CHAPTER 12a. COST BENEFIT ANALYSIS
Principles of Macroeconomics: Ch. 20
Second Canadian Edition
Cost-Benefit Analysis - 1
In cost-benefit analysis, we compare the costs and benefits of one or more projects to determine which are worthwhile, and which should be prioritized when there are multiple projects. The computations are similar to those in cost effectiveness analysis; we simply are applying economic evaluation techniques to two entities: costs and benefits. The minimum requirement for a project to be judged worthwhile is that its benefit-cost ratio be at least 1.0. This means that the benefits equal or exceed the costs of the project. When comparing multiple worthwhile projects, priority would be given to the project with the highest benefit-cost ratio. Cost-benefit analysis can be much more complex that we will present here. Real work problems frequently have benefits to multiple groups, i.e. the recipients of the service and society at large. For example, a person cured of substance abuse could show his or her wages as a personal benefit. Society would also gain because this individual now pays taxes, does not steal to pay for the drug habit, etc.
Principles of Macroeconomics: Ch. 20 Cost Benefit Analysis, Slide 2 Second Canadian Edition
Cost-Benefit Analysis - 2
In many cases, benefits to one group may be costs to another group. For example, welfare reform may save the government money, but reduce the income of merchants who own the stores where welfare recipients shop. Another complexity which we will not pursue is the probability or likelihood of the occurrence of different events or outcomes. Future events and costs are based on the assumption of their likelihood of occurrence. We can calculate scenarios with different probabilities for future events to see what impact that would make for choosing among the available alternatives.
Principles of Macroeconomics: Ch. 20 Cost Benefit Analysis, Slide 3
Example 1: East Stockton Urban Renewal Project - 1

This problem is similar to the problem in Quantitative Methods for Public Decision Making by Christopher K. McKenna, page 157-159. The objective and social benefits of urban renewal are (1) superior pattern of resource allocation, (2) social benefits of the removal of blight, and (3) improved local financial position. Although there may be a number of alternative uses for land being redeveloped, we are here considering the more aggregate alternatives, either urban renewal or no urban renewal in a particular section of the city. This is the level of evaluation appropriate for cost-benefit analysis. The alternatives would then be the particular urban renewal projects that should or should not be undertaken. Among the constraints active on urban renewal is the legal requirement that a redevelopment agency must provide former residents of an urban renewal area with decent, safe, and sanitary housing that is conveniently located and within the means of the residents. Note that it is not implicitly assumed that relocation results in housing facility improvement for the residents,

The costs include those for relocation, survey and planning, administration, public improvements, demolition, and the value of improvements demolished. Benefits include those specifically associated with the stated objectives as well as non-economic negative effects of relocation and possible land value writedown. In urban renewal there are, of course, tangible and intangible benefits; in this exercise, our goal is to determine what level of intangible benefits would decision makers have to substantiate in order to justify the project from a costbenefit perspective. The East Stockton, California, Urban Renewal Project was officially approved by the federal government in July 1959. The workbook, Urban Renewal.xls, which can be downloaded from the course download web page, displays the various costs associated with the renewal project and the time at which they occurred. Most of the costs were actually incurred over an interval of time; in such cases the center of the interval is used as the date of the cost.

The cost of the land is not included in the list of costs since land purchases were later resold. In the East Stockton renewal project, the land was purchased for $669,129 over a period roughly centered at June 30, 1960. After clearing and renewal, the land was subsequently sold for $1,200,000 over a period roughly centered at June 30, 1965. Employing a discount rate of 6 percent, the selling price was discounted to June 30, 1960, yielding a present value of $896,760; hence, the redevelopment agency had a profit of $227,631 on the project area land. This amount is included in the list of tangible benefits in the UrbanRenewal workbook. Other tangible benefits were not quite so easily estimated. The increase in the property value in the project area was the result of three factors: inflation, growth in real income and population, and urban renewal. To isolate the increase due to urban renewal, a comparison was made between increases in the project area and increases near the project area. The comparison led to an estimate of $415,500 as the increase in the value of the neighborhood properties. Public improvements such as schools and parts were estimated at a value equal to their cost.

Urban renewal is generally expected to reduce the cost of municipal services. The savings in the cost of fire protection was estimated by noting that prior to urban renewal the per person expenditure for East Stockton as was 2 times what it was for the rest of the city. Assuming that after renewal the residents of East Stockton would require only average protection, the reduced cost of fire protection was estimated to be $42,000 annually. Capitalizing the annual amount of $42,000 at 6 percent yields $700,000 as the present value of future fire protection cost savings. The savings in health protection and police protection costs were estimated similarly. The questions we will answer in this exercise are: what level of intangible benefits need to be identified in order for this project to satisfy the minimum cost benefit ratio of 1.0? Does a higher or lower discount rate substantially change our answer?
Tangible costs/benefits of urban renewal project
The tangible costs and benefits for the project have The tangible costs and benefits for the project have been entered in aaworkbook called UrbanRenewal.xls been entered in workbook called UrbanRenewal.xls which can be downloaded from aacourse web page. All which can be downloaded from course web page. All of this information is given in the chapter by McKenna. of this information is given in the chapter by McKenna. Note that the worksheet includes the Date of the Note that the worksheet includes the Date of the expense because not all expenses occurred at regular expense because not all expenses occurred at regular annual intervals. Excel has another worksheet function annual intervals. Excel has another worksheet function to support calculations of net present value when the to support calculations of net present value when the stream of payments occur in different time periods, the stream of payments occur in different time periods, the XNPV function. XNPV function.
The discount rate
First, we enter the discount First, we enter the discount rate stated in the problem rate stated in the problem 6% in the cell D2 of the 6% in the cell D2 of the Cost-benefit analysis Cost-benefit analysis worksheet. worksheet.
Use XNPV function to calculate value of tangible costs

First, select the cell in which we First, select the cell in which we Excel to return the present value of Excel to return the present value of the tangible costs, cell B14 on the the tangible costs, cell B14 on the Cost-benefit analysis worksheet. Cost-benefit analysis worksheet.
Second, select the Second, select the Function command Function command from the Insert menu. from the Insert menu.
Unlike the NPV function, Unlike the NPV function, the XNPV function does the XNPV function does not make the assumption not make the assumption that the series of costs that the series of costs occurs at regular, annual occurs at regular, annual intervals. XPNV permits intervals. XPNV permits us to associated dates us to associated dates with each cost item. with each cost item.
Locate the XNPV function

We will search for the XNPV We will search for the XNPV function. First, type XNPV in the function. First, type XNPV in the Search for text box, and click on Search for text box, and click on the Go button. the Go button.
The XNPV function name will appear in The XNPV function name will appear in the Select aafunction list box. Click on the the Select function list box. Click on the OK button access the dialog box where OK button access the dialog box where the function arguments are entered. the function arguments are entered.
Note: the XNPV function is part of the Note: the XNPV function is part of the Analysis Toolpak that we used for Analysis Toolpak that we used for Data Analysis. If Excel does not find Data Analysis. If Excel does not find it, check to make sure the Analysis it, check to make sure the Analysis Toolpak Add-in has been installed. Toolpak Add-in has been installed.
The arguments to the XNPV function

The first argument to The first argument to the XNPV function is the the XNPV function is the discount rate, which we discount rate, which we put in cell D2. put in cell D2.
The third argument to The third argument to the XNPV function is the the XNPV function is the cells containing the cells containing the dates the tangible costs dates the tangible costs occurred, C2:C12. occurred, C2:C12.
The second argument The second argument to the XNPV function is to the XNPV function is the cells containing the the cells containing the tangible costs, B2:B12. tangible costs, B2:B12.
With the arguments With the arguments entered, click on entered, click on the OK button. the OK button.
Net present value of tangible costs
Excel computes the Excel computes the net present value for net present value for the series of costs for the series of costs for this project. this project.
The table of tangible benefits - 1

The XPNV function discounts the stream of costs or benefits The XPNV function discounts the stream of costs or benefits back to the first date in the series. For costs, the entry for back to the first date in the series. For costs, the entry for Survey and planning was dated to occur at the start of the Survey and planning was dated to occur at the start of the project. Since this item was listed first, ititcould be used for project. Since this item was listed first, could be used for the date (12-31-58) to which all other costs were discounted. the date (12-31-58) to which all other costs were discounted.
The table of tangible benefits - 2

The table of tangible benefits was copied The table of tangible benefits was copied from the McKenna text, except for the from the McKenna text, except for the entry on row 18 which was added as aa entry on row 18 which was added as requirement of the XNPV function. requirement of the XNPV function.
In the case of benefits, there was, quite naturally, no benefit In the case of benefits, there was, quite naturally, no benefit to be realized at the start of the project. To satisfy the Excel to be realized at the start of the project. To satisfy the Excel XPNV function, I Iadded aadummy entry to the table, XPNV function, added dummy entry to the table, Immediate benefits with aavalue of $0 to be realized at the Immediate benefits with value of $0 to be realized at the start of the project on 12-31-58. Since this entry was for zero start of the project on 12-31-58. Since this entry was for zero dollars, ititwill not affect our benefit calculations. The date dollars, will not affect our benefit calculations. The date entry in cell C18 meets the requirement of the XNPV function entry in cell C18 meets the requirement of the XNPV function for an initial date to which all other benefits are discounted. for an initial date to which all other benefits are discounted.
Use XNPV to calculate value of tangible benefits

First, select the cell in which we First, select the cell in which we Excel to return the present value of Excel to return the present value of the tangible benefits cell B26 on the the tangible benefits cell B26 on the Cost-benefit analysis worksheet. Cost-benefit analysis worksheet.
Second, select the Second, select the Function command Function command from the Insert menu. from the Insert menu.
Locate the XNPV function
We will search for the XNPV We will search for the XNPV function. First, type XNPV in function. First, type XNPV in the Search for text box, and the Search for text box, and click on the Go button. click on the Go button.
The XNPV function name will appear in The XNPV function name will appear in the Select aafunction list box. Click on the the Select function list box. Click on the OK button access the dialog box where OK button access the dialog box where the function arguments are entered. the function arguments are entered.
Note: the XNPV function is part Note: the XNPV function is part of the Analysis Toolpak that we of the Analysis Toolpak that we used for Data Analysis. If Excel used for Data Analysis. If Excel does not find it, check to make does not find it, check to make sure the Analysis Toolpak Add-in sure the Analysis Toolpak Add-in has been installed. has been installed.
The arguments to the XNPV function

The first argument to The first argument to the XNPV function is the the XNPV function is the discount rate, which we discount rate, which we put in cell D2. put in cell D2.
The second argument to The second argument to the XNPV function is the the XNPV function is the cells containing the tangible cells containing the tangible benefits, B18:B24. benefits, B18:B24.
The third argument to the XNPV The third argument to the XNPV function is the cells containing function is the cells containing the dates the tangible benefits the dates the tangible benefits occurred, C18:C24. occurred, C18:C24.
Net present value of tangible benefits
Excel computes the net Excel computes the net present value for the series present value for the series of benefits for this project. of benefits for this project.
Compute the required intangible benefits
The problem statement wanted The problem statement wanted us to find the minimum level of us to find the minimum level of intangible benefits that would be intangible benefits that would be necessary to meet the minimum necessary to meet the minimum benefit-cost ratio of 1.0. benefit-cost ratio of 1.0. The Required intangible benefits The Required intangible benefits are equal to the difference are equal to the difference between tangible costs and between tangible costs and tangible benefits. tangible benefits.
In cell B28, enter the formula In cell B28, enter the formula for computing the difference for computing the difference between tangible costs in cell between tangible costs in cell B14 and tangible benefits in B14 and tangible benefits in cell B26: =B14-B26. cell B26: =B14-B26. In order to satisfy benefit-cost In order to satisfy benefit-cost criteria, the project planners criteria, the project planners would have to identify and would have to identify and document $1,062,932 in document $1,062,932 in intangible benefits. intangible benefits.
What if the discount rate were different
The problem statement also The problem statement also wanted us to determine whether wanted us to determine whether or not aahigher or lower discount or not higher or lower discount rate substantially changes our rate substantially changes our answer. answer. In order to see the results of the In order to see the results of the testing different discount rates, testing different discount rates, we split the screen at row 24 and we split the screen at row 24 and arrange the panes as shown. arrange the panes as shown.
Test a higher discount rate
Enter 7% in cell D2 Enter 7% in cell D2 to test the effect of aa to test the effect of higher discount rate. higher discount rate.
Excel has recalculated the Excel has recalculated the required intangible benefits required intangible benefits needed to be higher by needed to be higher by about $15,000 about $15,000 ($1,077,691-$1,062,932). ($1,077,691-$1,062,932). For this size of the urban For this size of the urban renewal project, I Iwould renewal project, would not consider this aa not consider this substantial difference substantial difference
Test a lower discount rate
To test aalower discount rate, To test lower discount rate, enter 5% in cell D2 to test the enter 5% in cell D2 to test the effect of aahigher discount rate. effect of higher discount rate.
Excel has recalculated the Excel has recalculated the required intangible benefits required intangible benefits needed to be lower by about needed to be lower by about $16,000 ($1,046,037$16,000 ($1,046,037$1,062,932). $1,062,932). For this size of the urban For this size of the urban renewal project, I Iwould not renewal project, would not consider this aasubstantial consider this substantial difference difference We have answered all We have answered all of the questions stated of the questions stated in the problem. in the problem.
Example 2: A Highway Expansion Project

This example was adapted from a problem presented in Public Policy Analysis: Applied Research Methods by Theodore H. Poister, pages 397-400. This case pertains to a hypothetical highway project in which two alternative expansion levels (expansion to a 4-lane highway and expansion to a 6-lane highway) are considered in comparison with the alternative of retaining the existing roadway. In this application, the alternatives are compared incrementally, so that the benefits and costs of expanding to a 4-lane highway are derived by comparing it with the existing roadway, and the costs and benefits corresponding to the 6-lane expansion are based on the incremental costs and benefits beyond the 4-lane highway expansion. Sequentially, then, the analysis addresses the issue of whether it is justifiable to expand to a 4-lane highway, as if so, whether it is further justified to expand to the 6-lane highway. For this problem, we will present in detail how the benefits and costs are derived. The sheet, column, and row labels have been entered into the workbook, HighwayProject.xls.
The benefit of travel time saved by the proposed highways
The average time spent per trip declines dramatically The average time spent per trip declines dramatically with the expansion to the 4-lane highway, and then with the expansion to the 4-lane highway, and then modestly as we move to the 6-lane highway modestly as we move to the 6-lane highway expansion. Average driving time per trip on the expansion. Average driving time per trip on the existing highway is estimated to be 30 minutes. If existing highway is estimated to be 30 minutes. If the highway is expanded to 4-lanes, the average trip the highway is expanded to 4-lanes, the average trip time drops to 18 minutes. If the highway is time drops to 18 minutes. If the highway is expanded to 6-lanes, the average trip time drops an expanded to 6-lanes, the average trip time drops an additional two minutes to 16 minutes. additional two minutes to 16 minutes.
Computing the time cost per trip

Setting the value of the drivers time at $2.00 Setting the value of the drivers time at $2.00 per hour, the time cost per trip is computed by per hour, the time cost per trip is computed by dividing the number of minutes in the average dividing the number of minutes in the average trip by 60 and then multiplying by $2.00. trip by 60 and then multiplying by $2.00.
In cell B3, enter the formula In cell B3, enter the formula =B2/60*2. In cell C3, enter the =B2/60*2. In cell C3, enter the formula =C2/60*2. In cell D3, formula =C2/60*2. In cell D3, enter the formula =D2/60*2. enter the formula =D2/60*2.
Total cost per trip

Other trip costs increase slightly at the first expansion level Other trip costs increase slightly at the first expansion level (from $1.75 to $1.90), because of higher and less efficient (from $1.75 to $1.90), because of higher and less efficient operating speeds, and then decrease slightly at the second operating speeds, and then decrease slightly at the second expansion level (from $1.90 to $1.85) because of improved expansion level (from $1.90 to $1.85) because of improved maneuverability in dispersed traffic. Enter $1.75 in cell B4, maneuverability in dispersed traffic. Enter $1.75 in cell B4, $1.90 in cell C4, and $1.85 in cell D4. $1.90 in cell C4, and $1.85 in cell D4.
Total variable cost per trip is Total variable cost per trip is computed by adding Time cost computed by adding Time cost per trip and Other costs per per trip and Other costs per trip. Enter =B3+B4 in cell B5, trip. Enter =B3+B4 in cell B5, =C3+C4 in cell C5, and =C3+C4 in cell C5, and =D3+D4 in cell D5. =D3+D4 in cell D5.
Cost savings per trip

The cost savings per trip when The cost savings per trip when expanding to the 4-lane highway expanding to the 4-lane highway is the difference between the is the difference between the total variable costs for the total variable costs for the existing highway ($2.75) and existing highway ($2.75) and the 4-lane highway ($2.50) the 4-lane highway ($2.50) which equals $.25. Enter the which equals $.25. Enter the formula =B5-C5 in cell C6. formula =B5-C5 in cell C6.
The cost savings per trip when The cost savings per trip when expanding to the 6-lane highway expanding to the 6-lane highway is the difference between the is the difference between the total variable costs for the 4total variable costs for the 4lane highway ($2.50) and the 6lane highway ($2.50) and the 6lane highway ($2.38) which lane highway ($2.38) which equals $.12. Enter the formula equals $.12. Enter the formula =C5-D5 in cell D6. =C5-D5 in cell D6.
Computing cost savings on current trips
First, we enter the same number of trips per year First, we enter the same number of trips per year for each highway condition, 11million trips per year for each highway condition, million trips per year in cells B8, C8, and D8. It is likely that the in cells B8, C8, and D8. It is likely that the number of trips would increase because of number of trips would increase because of improved travel. Estimating savings based on the improved travel. Estimating savings based on the existing number of trips is, therefore, a existing number of trips is, therefore, a conservative estimate of the probable savings. conservative estimate of the probable savings.
Second, to compute the cost Second, to compute the cost savings for all trips, we multiply savings for all trips, we multiply the cost savings per trip on row the cost savings per trip on row 66by the number of trips per by the number of trips per year on row 8. Enter =C6*C8 in year on row 8. Enter =C6*C8 in cell C9 and =D6*D8 in cell D9. cell C9 and =D6*D8 in cell D9.
Projected savings worksheet

First, copy the cost savings for each of the First, copy the cost savings for each of the expansion projects from cells C9 through D9 expansion projects from cells C9 through D9 on the Cost-benefit Analysis worksheet and on the Cost-benefit Analysis worksheet and Paste Special the Values into cells B2 through Paste Special the Values into cells B2 through C2 on the Projected Savings worksheet. C2 on the Projected Savings worksheet.
Second, fill the annual savings Second, fill the annual savings down for aatwenty-five year time down for twenty-five year time period. For this problem, the period. For this problem, the present value of the benefits present value of the benefits stream is computed by stream is computed by assuming that the same amount assuming that the same amount of benefit will accrue for each of of benefit will accrue for each of 25 years into the future. 25 years into the future. Highlight cells B2 through C26 Highlight cells B2 through C26 and select the Fill > Down and select the Fill > Down command from the Edit menu. command from the Edit menu.
Compute NPV of savings for 4 lane expansion
First, select the cell in which we First, select the cell in which we Excel to return the present value Excel to return the present value of the savings, cell C10 on the of the savings, cell C10 on the Cost-benefit Analysis worksheet. Cost-benefit Analysis worksheet. Second, select the Second, select the Function command Function command from the Insert menu. from the Insert menu.
Locate the NPV function

We will search for the NPV We will search for the NPV function. First, type NPV in function. First, type NPV in the Search for text box, and the Search for text box, and click on the Go button. click on the Go button.
The NPV function name will The NPV function name will appear in the Select aafunction appear in the Select function list box. Click on the OK button list box. Click on the OK button access the dialog box where the access the dialog box where the function arguments are entered. function arguments are entered.
The arguments to the NPV function

The first argument to the The first argument to the NPV function is the NPV function is the discount rate, which we discount rate, which we will enter directly as 8%. will enter directly as 8%.
The second argument to the NPV function is the cells The second argument to the NPV function is the cells containing the projected savings for 44lane expansion, containing the projected savings for lane expansion, 'Projected Savings'!B2:B26. 'Projected Savings'!B2:B26. Remember to enter the quote marks around the name of the Remember to enter the quote marks around the name of the worksheet Projected Savings because ititcontains aaspace. worksheet Projected Savings because contains space.
NPV for projected savings for 4 lane expansion
The NPV function returns the The NPV function returns the present value of the projected present value of the projected savings for 44lane expansion, savings for lane expansion, $2,668,694.05. $2,668,694.05.
Compute NPV of projected savings for 6 lane expansion
First, select the cell in which we First, select the cell in which we Excel to return the present value Excel to return the present value of the savings, cell D10 on the of the savings, cell D10 on the Cost-benefit Analysis worksheet. Cost-benefit Analysis worksheet. Second, select the Second, select the Function command Function command from the Insert menu. from the Insert menu.
We will search for the NPV We will search for the NPV function. First, type NPV in function. First, type NPV in the Search for text box, the Search for text box, and click on the Go button. and click on the Go button.

The second argument to the NPV function is the cells The second argument to the NPV function is the cells containing the projected savings for 66lane expansion, containing the projected savings for lane expansion, 'Projected Savings'!C2:C26. 'Projected Savings'!C2:C26. Remember to enter the quote marks around the name of the Remember to enter the quote marks around the name of the worksheet Projected Savings because ititcontains aaspace. worksheet Projected Savings because contains space.
NPV for projected savings for 6 lane expansion
The NPV function returns the The NPV function returns the present value of the projected present value of the projected savings for 66lane expansion, savings for lane expansion, $1,245,394.11. $1,245,394.11.
The costs of the highway projects - 1
The expansion to aa4-lane highway The expansion to 4-lane highway will cost $2,000,000 in construction will cost $2,000,000 in construction costs. Enter $2,000,000 in cell C13. costs. Enter $2,000,000 in cell C13. Similarly, the expansion to 66lanes Similarly, the expansion to lanes will cost an additional $2,000,000. will cost an additional $2,000,000. Enter $2,000,000 in cell D13. Enter $2,000,000 in cell D13.
The annual maintenance costs for both The annual maintenance costs for both the existing highway and each of the the existing highway and each of the alternatives is entered in the worksheet. alternatives is entered in the worksheet. Enter $20,000 in cell B14, $30,000 in Enter $20,000 in cell B14, $30,000 in cell C14, and $50,000 in cell D14. cell C14, and $50,000 in cell D14.

The increase in maintenance costs are The increase in maintenance costs are computed by subtracting the existing roadway computed by subtracting the existing roadway maintenance costs from the 4-lane expansion maintenance costs from the 4-lane expansion maintenance costs and subtracting the 4-lane maintenance costs and subtracting the 4-lane expansion maintenance costs from the 6-lane expansion maintenance costs from the 6-lane maintenance costs. maintenance costs.
First, enter the formula First, enter the formula =C14-B14 in cell C15 to =C14-B14 in cell C15 to compute the increase in compute the increase in maintenance costs maintenance costs associated with the associated with the expansion to 44lanes. expansion to lanes.
Second, enter the Second, enter the formula =D14-C14 in formula =D14-C14 in cell D15 to compute cell D15 to compute the increase in the increase in maintenance costs maintenance costs associated with adding associated with adding two additional lanes to two additional lanes to the 44lane highway. the lane highway.
Annual Maintenance worksheet

First, copy the increase in maintenance First, copy the increase in maintenance costs for each of the expansion projects costs for each of the expansion projects from cells C15 through D15 on the Costfrom cells C15 through D15 on the Costbenefit Analysis worksheet and Paste benefit Analysis worksheet and Paste Special the Values into cells B2 through C2 Special the Values into cells B2 through C2 on the Annual Maintenance worksheet. on the Annual Maintenance worksheet.
Second, fill the annual maintenance Second, fill the annual maintenance cost increases down for aatwenty-five cost increases down for twenty-five year time period. For this problem, year time period. For this problem, the present value of the cost stream the present value of the cost stream is computed by assuming that the is computed by assuming that the same amount of maintenance costs same amount of maintenance costs will be incurred for each of 25 years will be incurred for each of 25 years into the future. into the future. Highlight cells B2 through C26 and Highlight cells B2 through C26 and select the Fill > Down command from select the Fill > Down command from the Edit menu. the Edit menu.
Compute NPV of increased maintenance for 4 lane expansion
First, select the cell in which we First, select the cell in which we Excel to return the present value Excel to return the present value of the increased maintenance, of the increased maintenance, cell C16 on the Cost-benefit cell C16 on the Cost-benefit Analysis worksheet. Analysis worksheet. Second, select the Second, select the Function command Function command from the Insert menu. from the Insert menu.

We will search for the NPV We will search for the NPV function. First, type NPV in the function. First, type NPV in the Search for text box, and click on Search for text box, and click on the Go button. the Go button.

The second argument to the NPV function is the cells The second argument to the NPV function is the cells containing the increased maintenance for 44lane expansion, containing the increased maintenance for lane expansion, 'Projected Savings'!B2:B26. 'Projected Savings'!B2:B26. Remember to enter the quote marks around the name of the Remember to enter the quote marks around the name of the worksheet Annual Maintenance because ititcontains aaspace. worksheet Annual Maintenance because contains space.
NPV for increased maintenance for 4 lane expansion
The NPV function returns the The NPV function returns the present value of the increased present value of the increased maintenance for 44lane maintenance for lane expansion, $106,747.76. expansion, $106,747.76.
Compute NPV of maintenance for 6 lane expansion
First, select the cell in which we First, select the cell in which we Excel to return the present value Excel to return the present value of the increased maintenance, of the increased maintenance, cell D16 on the Cost-benefit cell D16 on the Cost-benefit Analysis worksheet. Analysis worksheet. Second, select the Second, select the Function command Function command from the Insert menu. from the Insert menu.

The second argument to the NPV function is the cells The second argument to the NPV function is the cells containing the increased maintenance for 66lane expansion, containing the increased maintenance for lane expansion, 'Projected Savings'!C2:C26. 'Projected Savings'!C2:C26. Remember to enter the quote marks around the name of the Remember to enter the quote marks around the name of the worksheet Annual Maintenance because ititcontains aaspace. worksheet Annual Maintenance because contains space.
NPV for increased maintenance for 6 lane expansion
The NPV function returns the The NPV function returns the present value of the increased present value of the increased maintenance for 66lane maintenance for lane expansion, $213,495.52. expansion, $213,495.52.
Total project costs

The total project costs for the The total project costs for the two expansion projects are the two expansion projects are the sum of the capital costs and sum of the capital costs and the yearly maintenance costs. the yearly maintenance costs.
Sum total project costs for the 44 Sum total project costs for the lane expansion by entering the lane expansion by entering the formula =C13+C16 in cell C17. formula =C13+C16 in cell C17. Sum total project costs for the 66 Sum total project costs for the lane expansion by entering the lane expansion by entering the formula =D13+D16 in cell D17. formula =D13+D16 in cell D17.
Compute benefit-cost ratio for the two expansion plans
First, compute the First, compute the benefit-cost ratio for benefit-cost ratio for the 4-lane expansion the 4-lane expansion by dividing the present by dividing the present value of savings (C10) value of savings (C10) by total project costs by total project costs (C17), displaying the (C17), displaying the result in cell C19. result in cell C19.
Second, compute the Second, compute the benefit-cost ratio for benefit-cost ratio for the 6-lane expansion the 6-lane expansion by dividing the present by dividing the present value of savings (D10) value of savings (D10) by total project costs by total project costs (D17), displaying the (D17), displaying the result in cell D18. result in cell D18.
Results of the benefit-cost analysis
The benefit-cost ratio for the 4-lane expansion The benefit-cost ratio for the 4-lane expansion is over 1.0. Based on this analysis, the 4-lane is over 1.0. Based on this analysis, the 4-lane expansion is justified. expansion is justified. However, the benefit-cost ratio for the However, the benefit-cost ratio for the additional 22lanes to complete aa6-lane additional lanes to complete 6-lane expansion is less than 1.0. The additional 22 expansion is less than 1.0. The additional lanes to complete the 6-lane expansion is not lanes to complete the 6-lane expansion is not justified, based on benefit-cost analysis. justified, based on benefit-cost analysis.
Example 3: Methadone Maintenance Treatment Program - 1

This problem is from Quantitative Methods for Public Decision Making by Christopher K. McKenna, page 162-163. Cost-benefit analysis has used the past 6 years' experience of a methadone maintenance treatment program (MMTP) to see if it is worth continuing for the next six years. Here decision makers are considering two basic alternatives, to continue the program or not. Although the effects of the program are expected to last longer than the 6-year length of the program, only the benefits during these years are considered. All projections are based on the assumption that future experience will follow the patterns of the past. The actual expenditures of the program include salaries for physicians, counselors, nurses, and administrators, rent, supplies, and the cost of the methadone. The analysis includes a dropout rate; if a patient drops out there no further costs or benefits for that patient. The total costs for the six years can be found on the 'Costs of the MMTP' worksheet in the 'MMTP.xls' workbook.
Example 3: Methadone Maintenance Treatment Program - 2

In methadone treatment as in most social programs there are both tangible and intangible benefits. Here the intangibles are not included in the calculations; however, the decision maker must be aware of them when interpreting the results of the analysis. The benefits of MMTP include decreases in private protection expenditures, the costs of injury to crime victims, the negative value placed on fear of attack by an addict, criminal justice expenditures, expenditures on heroin by the addict, expenditures for narcotic-related illnesses, and increases in legal earning. The last three are tangible benefits and are summarized on the worksheet 'Benefits of the MMTP' worksheet in the 'MMTP.xls' workbook. Your assignment is to determine the net present value of the MMTP, and to compute and interpret its cost-benefit ratio. HINT: since we conducting this analysis on an on-going program, any start-up costs have either been absorbed or included in the first year of the new cycle for the program, 1978. Do not discount 1978 costs or benefit with the NPV function, but rather add the full amount of 1978 costs and benefits to the discounted costs and benefits for the years 1979 to 1983, discounted back to 1978 using a 10% discount rate.
Principles of Macroeconomics: Ch. 20 Cost Benefit Analysis, Slide 55 Second Canadian Edition
Open the MMTP.xls workbook
The MMTP.xls workbook contains The MMTP.xls workbook contains three worksheets: one three worksheets: one containing the annual costs for containing the annual costs for the program, one containing the the program, one containing the annual benefits for the program, annual benefits for the program, and one for computing the and one for computing the benefit-cost ratio. benefit-cost ratio.
Costs in the first year

The first-year costs The first-year costs are not discounted. are not discounted.
First, enter aa First, enter label Costs, label Costs, year 11in cell B9. year in cell B9.
Second, enter the Second, enter the first year costs, first year costs, $2,220,000, in cell C9. $2,220,000, in cell C9.
Costs in the years two through six

The total costs for years two The total costs for years two through six are discounted to through six are discounted to the first year using aa10% rate. the first year using 10% rate.
First, enter aa First, enter label NPV, label NPV, Costs, year 2-6 Costs, year 2-6 in cell B10. in cell B10.
Second, select Second, select cell C10 and insert cell C10 and insert the NPV function. the NPV function.

The first argument to the The first argument to the NPV function is the discount NPV function is the discount rate, which we will enter rate, which we will enter directly as 10%. directly as 10%.
The second argument to the NPV function is the cells The second argument to the NPV function is the cells containing the costs of the program in years 22through 6, containing the costs of the program in years through 6, 'Costs of the MMTP'!D3:D7. 'Costs of the MMTP'!D3:D7. Remember to enter the quote marks around the name of the Remember to enter the quote marks around the name of the worksheet Costs of the MMTP because ititcontains spaces. worksheet Costs of the MMTP because contains spaces.
NPV for projected savings for MMTP
The NPV function returns the The NPV function returns the present value of the costs for present value of the costs for years 22through 6, $5,247,308. years through 6, $5,247,308.
Total Project Cost

The total project cost is The total project cost is computed by summing the first computed by summing the first year costs and the discounted year costs and the discounted costs for years two through six. costs for years two through six.
First, enter the First, enter the label Total Project label Total Project Cost in cell B11. Cost in cell B11.
Second, sum the costs by Second, sum the costs by entering the formula =C9+C10 entering the formula =C9+C10 in cell C11. The total project in cell C11. The total project cost is $7,467,308. cost is $7,467,308.
Increased earnings benefit in the first year

Like the first-year costs, Like the first-year costs, the first-year benefits the first-year benefits are not discounted. are not discounted.
First, enter First, enter aalabel Year label Year 11in cell A9. in cell A9.
Second, enter aaformula to Second, enter formula to point to the first year benefits point to the first year benefits =B2 in cell B9. By using aa =B2 in cell B9. By using formula, we can drag fill the formula, we can drag fill the other benefit columns. other benefit columns.
Increased earnings benefit in years two through six

The total benefits for years two The total benefits for years two through six are discounted to through six are discounted to the first year using the same the first year using the same 10% rate we used for costs. 10% rate we used for costs.
First, enter aa First, enter label Yr 2-6 label Yr 2-6 in cell A10. in cell A10.
Second, select Second, select cell B10 and insert cell B10 and insert the NPV function. the NPV function.

The second argument to the NPV function is the cells The second argument to the NPV function is the cells containing the increased earnings, 'Benefits of the containing the increased earnings, 'Benefits of the MMTP'!B3:B7. MMTP'!B3:B7. Remember to enter the quote marks around the name of the Remember to enter the quote marks around the name of the worksheet Benefits of the MMTP because ititcontains aaspace. worksheet Benefits of the MMTP because contains space.
NPV for increased earnings for MMTP
The NPV function returns the The NPV function returns the present value of the increased present value of the increased earnings for years 22through 6, earnings for years through 6, $6,727,065.65. $6,727,065.65.
Total Increased Earnings Benefit

The total for the increased The total for the increased earnings benefit is computed by earnings benefit is computed by summing the first year benefit summing the first year benefit and the discounted benefits for and the discounted benefits for years two through six. years two through six.
First, enter First, enter the label Total the label Total in cell A11. in cell A11.
Second, sum the costs by Second, sum the costs by entering the formula =B9+B10 entering the formula =B9+B10 in cell B11. The total project in cell B11. The total project cost is 7,141,065.65. cost is 7,141,065.65.
Drag fill the other benefit columns

The benefits attributed to criminal The benefits attributed to criminal justice savings and reduced heroin justice savings and reduced heroin consumption are computed in the consumption are computed in the same way as increased earnings. same way as increased earnings. We can complete these calculations We can complete these calculations by drag filling the columns. by drag filling the columns.
First, select cells First, select cells B9 through D11. B9 through D11.
Second, select the Second, select the Fill > Right command Fill > Right command from the Edit menu. from the Edit menu.
Total Project Benefits

The total benefits attributed to The total benefits attributed to the project are computed by the project are computed by summing the total benefits from summing the total benefits from the three tangible sources. the three tangible sources.
First, select cell B13 First, select cell B13 and enter the label and enter the label Total project benefits. Total project benefits. Second, select cell C13 Second, select cell C13 and enter the formula and enter the formula =B11+C11+D11. =B11+C11+D11. The total project benefits The total project benefits are $$39,352,844.66. are 39,352,844.66.
The Benefit-cost Ratio

To compute the benefit cost ratio To compute the benefit cost ratio for the MMTP project, we enter the for the MMTP project, we enter the total costs and total benefits on total costs and total benefits on the Benefit-cost Ratio worksheet. the Benefit-cost Ratio worksheet.
First, in cell B1, enter aa First, in cell B1, enter reference to the total project reference to the total project costs ='Costs of the MMTP'!C11. costs ='Costs of the MMTP'!C11. Second, in cell B2, enter aareference Second, in cell B2, enter reference to the total project benefits to the total project benefits ='Benefits of the MMTP'!C13. ='Benefits of the MMTP'!C13.
Third, compute the ratio Third, compute the ratio by entering the formula by entering the formula =B2/B1 in cell B4. =B2/B1 in cell B4. The ratio of 5.27 indicates that The ratio of 5.27 indicates that the benefits clearly out weigh the benefits clearly out weigh the costs. Using benefit-cost the costs. Using benefit-cost criteria, the MMTP program criteria, the MMTP program should be continued. should be continued.
Chapter 20
The Influence of Monetary and Fiscal Policy on Aggregate Demand
Overview
The theory of liquidity preference. The supply and demand for money. How fiscal policy affects aggregate demand. The economy in the long-run and short-run.
Aggregate Demand (AD)

Many factors influence AD, including desired spending by households and business firms. When desired spending changes, shifts in the AD cause short-run fluctuations in output and employment. Monetary and Fiscal policy are used to stabilize the economy during these fluctuations.
Principles of Macroeconomics: Ch. 20 Second Canadian Edition
How Monetary Policy Influences Aggregate Demand

The Aggregate Demand curve is downward sloping due to three effects:
Pigous Wealth Effect Keyness Interest-Rate Effect Real Exchange-Rate Effect
Of these three effects, the Keyness Interest-Rate Effect is most important.

Theory of Liquidity Preference:

Keyness theory: The development of interest rates
The Liquidity Preference Theory of interest rates states that ...market rates of interest adjust to balance the supply and demand for money.
Theory of Liquidity Preference:

Keyness theory: The development of interest rates
Summary: An increase in the price level causes an increase in the demand for money, which ... ... leads to higher interest rates, which ... ... leads to reduced total spending (i.e. AD).
Overview
Theory of Liquidity Preference: The Supply and Demand for Money

The Money Supply is controlled by the RBI, which alters the money supply in three ways:

Open-Market Operations Changing the Bank Rate Buying and selling Canadian dollars in the market for foreign-currency exchange
The quantity of money supplied in the economy is fixed at whatever level the RBI decides to set it.

Because the money supply is fixed by the RBI it does not depend on the interest rate. The fixed money supply is represented by a vertical supply curve.
The Money Market

Interest Rate Money Supply
QFixed
Quantity of Money

By using the Open-Market Operations the RBI can shift the vertical money supply curve left or right. If the RBI buys government bonds:
Bank reserves increase and the money supply increases. Bank reserves decrease and the money supply declines.
If the RBI sells government bonds:
The Money Market

If the RBI buys government bonds, money supply increases.
QFixed
Quantity of Money
The Money Market

If the RBI sells government bonds, money supply decreases.
QFixed
Quantity of Money

The Money Demand is determined by several factors. However, the most important is the interest rate. People choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services. (i.e. a desire of liquidity)

The primary opportunity cost of having the convenience of holding money is the interest income that one gives up when one holds cash. An increase in the interest rate raises the cost of holding money and thus reduces the quantity of money balances people wish to hold.
The Money Market

Interest Rate Money Demand
I0
Q0
Quantity of Money
The Money Market

I1
I0
Q0
Quantity of Money
The Money Market

I1
I0
Q1
Q0
Quantity of Money
Equilibrium in the Money Market

By the Theory of Liquidity Preference:
The interest rate adjusts to balance the supply and demand for money. There is one interest rate, called the equilibrium interest rate, at which the quantity of money demanded exactly equals the quantity of money supplied.

Money Demand QFixed

Quantity of Money

IE
Money Demand QFixed
Quantity of Money

Interest Rate
Money Supply
Money Supply and Money Demand are equal at the equilibrium interest rate.
IE
Money Demand QFixed
Quantity of Money
Theory of Liquidity Preference and the Aggregate Demand Curve

The general price level of all goods and services in the economy influences the money demand and interest rates: A higher price level raises money demand (i.e. a shift in the money demand curve.) Higher money demand leads to a higher interest rate. Higher interest rates reduces the quantity of goods and services demanded (AD).
Theory of Liquidity Preference and the Aggregate Demand Curve

As interest rates increase, the cost of borrowing and the return to saving is greater. Fewer households and firms borrow money, leading to a decrease in spending. The end result is a negative relationship between the price level and the AD.
Changes in the Money Supply

The RBI has control over shifts in the aggregate demand when it changes monetary policy. Recall:
An increase in the money supply (i.e. buying bonds) will... shift the Money Supply to the right without a change in the Money Demand the interest rate will fall, thus inducing people to hold the additional money the RBI has created.
Changes in Money Supply

Interest Rate MS0
IE0
Money Demand QFixed0
Quantity of Money

Interest Rate MS0 MS1
IE0
Quantity of Money

IE0
Quantity of Money

IE0 IE1
Money Demand QFixed0 QFixed1
Quantity of Money
Monetary Policy in the Closed Economy

A monetary injection by the RBI causes interest rates to fall, leading to a stimulative effect on residential and firm investment, and increasing output. The increase in output requires that people hold more money. This raises the demand curve for money and causes a partial reversal in the interest rate. As a result, the increase in the quantity of goods and services is smaller that it would have otherwise been.
Small Open Economy Considerations

A monetary injection by the RBI causes the Rupee to depreciate, which causes net exports to rise shifting the AD curve to the right. Output increases by more than it would in a closed economy. The RBI must allow the exchange rate to vary freely if its desire is to change the money supply.
Overview
4 4
How Fiscal Policy Influences Aggregate Demand

Fiscal policy refers to the governments choices regarding the overall level of government purchases or taxes. Fiscal policy influences saving, investment, and growth in the longrun. In the short-run, fiscal policy affects the aggregate demand.
Changes in Government Purchases

The Union government can influence the economy because
of the size of the central government in relation to the economy and other economic entities. of the deliberate use of spending and taxes to manipulate the economy toward achieving a predetermined outcome.

The Union governments control of the economy is both direct and indirect.
Its expenditures have a direct effect on aggregate spending and therefore equilibrium GDP. Taxes and tax policy indirectly affect the aggregate spending of consumers.

There are two macroeconomic effects from government purchases:
The Multiplier Effect The Crowding-Out Effect
The Multiplier Effect of Government Purchases

Each rupee spent by the government can raise the aggregate demand for goods and services by more than a rupee a multiplier effect. The total impact of the quantity of goods and services demanded can be much larger than the initial impulse from higher government spending.
The Multiplier Effect

Price Level
AD1
Quantity of Output

Price Level
An increase in government purchases initially increases AD
AD1
AD2
Quantity of Output

Price Level
The multiplier effect can amplify the shift in AD
AD3 AD1 AD2
Quantity of Output
The Multiplier Effect of Government Purchases

The formula for the multiplier is:
Multiplier = 1 (1 - MPC)
the MPC is the Marginal Propensity to Consume.
Changes in Taxes
When the government cuts taxes, it:
Increases households take-home pay, which ... results in households saving some of the additional income, but households will spend some on consumer goods, thus shifting the aggregate-demand curve to the right.
Open Economy Considerations

In a small, open economy, an expansionary fiscal policy causes the Rupee to appreciate. Since this causes net exports to fall, there is an additional effect that reduces the demand for Indian produced goods and services.
Changes in Taxes
The size of the shift in aggregate demand resulting from a tax change is also affected by the multiplier effect. The duration of the shift in the aggregate demand is also determined by the RBIs policy for the exchange rate (fixed or varied).
Using Policy to Stabilize the Economy

Many policy-makers believe it necessary to use monetary and fiscal policy to achieve any level of aggregate demand and GDP that they wish.
Active monetary and fiscal intervention is necessary to tame an inherently unstable private sector. The use of policy instruments stabilize aggregate demand and production and employment.

The use of government tax and spending policies to stabilize economic ups and downs in the shortrun are called discretionary fiscal policies. Generally, those that accept this approach to short-run economic stabilization follow the Keynesian theory of the economy.

Some economists argue that the government should avoid using monetary and fiscal policy to try to stabilize the economy. They suggest the economy should be left to deal with the short-run fluctuations on its own. Discretionary Fiscal policy affects the economy with substantial lags.
Automatic Stabilizers
Automatic Stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policy-makers having to take any deliberate action. Automatic stabilizers include:
The Tax System Government Spending Flexible Exchange Rate
Conclusion
Government macroeconomic policy should proceed carefully and with an understanding of the consequences of its policies in the short and long-run. Fiscal policies can have long-run effects on saving, investment, the trade balance and growth. Monetary policy can ultimately determine the level of prices and affect the inflation rate.
Business Cycles and Inflation
Business cycle
Why do we subject to booms and study business Capitalism is cycles? busts: profits to be made
When goods are unsold and jobs become scarce, many are hurt economically Downturns can be mild or prolonged Macroeconomic instability can be modified by good policies
What are the four phases of the business cycle?

Peak: GDP is at a temporary high Recession: decline in total output, income, employment and trade lasting at least 6 months Trough: the low point Recovery: expansion of GDP moving toward full employment
The business cycle

Real GDP Peak
Peak Real GDP Recovery Recession
Trough
0 0 Time
How do we predict a recession?

Leading economic indicators Theories of business cycles
Demand changes Supply changes
Usually caused by some disturbance (war, oil price shocks, tight monetary policy, terrorism, natural calamities etc.)
Inflation
Why do we care about inflation?

Many labor agreements are tied to an inflation measure automatic increases in income Many retirees live on fixed income and would be hurt by inflation If income does not increase, real purchasing power declines with inflation Inflation favors those in debt Inflation hurts taxpayers
Rates of inflation over time

Percent Change in CPI (1984-1986=100)
20% 15% 10% 5% 0%
19 13
19 21
19 37
19 61
19 45
19 77
19 85
-5% -10% -15%
20 01
19 29
19 53
19 69
19 93
Who wins & who loses from inflation?

Loses Savers (non interest bearing) Fixed income (retirees, workers with no or small pay raise) Wins Debtors Home owners Banks,leasing companies.
Causes of inflation
Demand pull
Demand outpaces supply Too much money chases too few goods
Cost push
Businesses raise prices Workers demand higher wages to keep up with inflation Prices of other inputs rises
Government Policy and Market Failures
McGraw-Hill/Irwin
Introduction
Economists use the invisible hand framework to determine whether the government should intervene in the market.
Invisible hand framework perfectly competitive markets lead individuals to make voluntary choices that are in societys interest.
McGraw-Hill/Irwin
Market Failures
Market failure the invisible hand pushes in such a way that individual decisions do not lead to socially desirable outcomes.
McGraw-Hill/Irwin
Market Failures
When a market failure exists, government intervention into markets to improve the outcome is justified. Government failure occurs when government intervention does not improve the situation.
McGraw-Hill/Irwin
Externalities
Externalities are the effect of a decision on a third party that is not taken into account by the decision-maker. Externalities can be either positive or negative.
McGraw-Hill/Irwin
Externalities
Negative externalities occur when the effects of a decision not taken into account by the decision-maker are detrimental to others.
McGraw-Hill/Irwin
Externalities
Positive externalities occur when the effects of a decision not taken into account by the decision-maker is beneficial to others.
McGraw-Hill/Irwin
A Negative Externality Example

When there is a negative externality, marginal social cost is greater than marginal private cost.
A steel plant benefits the owner of the plant and the buyers of steel. The plants neighbors are made worse off by the pollution caused by the plant.
McGraw-Hill/Irwin

Marginal social cost includes all the marginal costs borne by society.
It is the marginal private costs of production plus the cost of the negative externalities associated with that production.
McGraw-Hill/Irwin

When there are negative externalities, the competitive price is too low and equilibrium quantity too high to maximize social welfare.
McGraw-Hill/Irwin
A Negative Externality
Cost S1 = Marginal social cost S = Marginal private cost P1 P0 D = Marginal social benefit 0
McGraw-Hill/Irwin
Marginal cost from externality
Q1 Q0
Quantity
A Positive Externality Example

Private trades can benefit third parties not involved in the trade.
A person who is working and taking night classes benefits himself directly, and his coworkers indirectly.
McGraw-Hill/Irwin
A Positive Externality Example

Marginal social benefit equals the marginal private benefit of consuming a good plus the positive externalities resulting from consuming that good.
McGraw-Hill/Irwin
A Positive Externality
Cost P1 P0 S = Marginal private and social cost D1 = Marginal social benefit Marginal benefit of an externality
D0 = Marginal private benefit 0

McGraw-Hill/Irwin
Q0 Q1
Quantity
Alternative Methods of Dealing with Externalities

Externalities can be dealt with via:
Direct regulation. Incentive policies. Voluntary solutions.
McGraw-Hill/Irwin
Direct Regulation
Direct regulation the amount of a good people are allowed to use is directly limited by the government.
McGraw-Hill/Irwin
Direct Regulation
Direct regulation is inefficient, not efficient.
Inefficient achieving a goal in a more costly manner than necessary. Efficient achieving a goal at the lowest cost in total resources without consideration as to who pays those costs.
McGraw-Hill/Irwin
Incentive Policies
Incentive policies are more efficient than direct regulatory policies. The two types of incentive policies are either taxes or market incentives.
McGraw-Hill/Irwin
Tax Incentive Policies

A tax incentive program uses a tax to create incentives for individuals to structure their activities in a way that is consistent with the desired ends. The tax often yields the desired end more efficiently than straight regulation.
McGraw-Hill/Irwin

This solution embodies a measure of fairness about it the person who conserves the most pays the least tax.
McGraw-Hill/Irwin

A way to handle pollution is through a tax called an effluent fee. Effluent fees charges imposed by government on the level of pollution created.
McGraw-Hill/Irwin
Regulation Through Taxation

Cost Marginal social cost Marginal private cost P1 P0
Efficient tax Marginal social benefit
0
McGraw-Hill/Irwin
Q1 Q0
Quantity
Market Incentive Policies

Market incentive program market participants certify they have reduced total consumption their own and/or others by a specified amount.
McGraw-Hill/Irwin

A market incentive program is similar to the regulatory solution. The amount of the good consumed is reduced.
McGraw-Hill/Irwin

A market incentive program differs from a regulatory solution. Individuals who reduce consumption by more than the required amount receive marketable certificates that can be sold to others.
McGraw-Hill/Irwin
Voluntary Reductions
Voluntary reductions allow individuals to choose whether to follow what is socially optimal or what is privately optimal. Economists are dubious of voluntary solutions.
McGraw-Hill/Irwin
A persons willingness to do things for the good of society generally depends on the belief that others will also be helping.
McGraw-Hill/Irwin
The socially conscious will often lose their social conscience when they believe a large number of other people are not contributing.
This is example of a free rider problem individuals unwillingness to share in the cost of a public good.
McGraw-Hill/Irwin
The Optimal Policy

An optimal policy is one in which the marginal cost of undertaking the policy equals the marginal benefit of that policy.
McGraw-Hill/Irwin
The Optimal Policy

Resources are being wasted if a policy isnt optimal.
What is saved by reducing the program is worth more than what is lost from the reducing the program.
McGraw-Hill/Irwin
The Optimal Policy

Some environmentalists want to totally eliminate pollution. Economists want to reduce pollution to the point where marginal costs of reducing pollution equals the marginal benefits.
McGraw-Hill/Irwin
The Optimal Policy

Optimal level of pollution the amount of pollution at which the marginal benefit of reducing pollution equals the marginal cost.
McGraw-Hill/Irwin
Public Goods
A public good is nonexclusive and nonrival.
Nonexclusive no one can be excluded from its benefits. Nonrival consumption by one does not preclude consumption by others.
McGraw-Hill/Irwin
Public Goods
There are no pure examples of a public good.
The closest example is national defense.
Technology can change the public nature of goods.

Roads are an example.
McGraw-Hill/Irwin
Public Goods
Once a pure public good is supplied to one individual, it is simultaneously supplied to all. A private good is only supplied to the individual who bought it.
McGraw-Hill/Irwin
Public Goods
With public goods, the focus is on groups. With private goods, the focus is on the individual.
McGraw-Hill/Irwin
Public Goods
In the case of a public good, the social benefit of a public good is the sum of the individual benefits.
McGraw-Hill/Irwin
Public Goods
Adding demand curves vertically is easy to do in textbooks, but not in practice. This is because individuals do not buy public goods directly so that their demand is not revealed in their actions.
McGraw-Hill/Irwin
The Market Value of a Public Good

Price 1.00 .80 .60 .40 .20 1
McGraw-Hill/Irwin
0.50 0.10 0.60 0.50 2 0.40 DA 0.10 3 Quantity Market demand DB
Informational Problems
Perfectly competitive markets assume perfect information. Real-world markets often involve deception, cheating, and inaccurate information.
McGraw-Hill/Irwin
When there is a lack of information, buyers and sellers do not have equal information, markets may not work properly.
McGraw-Hill/Irwin
Economists call such market failures adverse selection problems. Adverse selection problems problems that occur when a buyer or a seller have different amounts of information about the good for sale.
McGraw-Hill/Irwin
Policies to Deal with Informational Problems

Regulate the market and see that individuals provide the correct information. Government licenses individuals in the market and requires them to provide full information about the good being sold.
McGraw-Hill/Irwin
A Market in Information
Information is valuable, and is an economic product in its own right. Left on their own, markets will develop to provide information that people need and are willing to pay for it.
McGraw-Hill/Irwin
A Market in Information
If the government regulates information, then markets for information will not develop.
McGraw-Hill/Irwin
Licensing of Doctors
Currently all doctors practicing medicine are required to be licensed. Licensing of doctors is justified by informational problems.
McGraw-Hill/Irwin
Some economists argue that licensure laws were established to restrict supply, not to help the consumer.
Instead of licensing doctors, the government could give the public information about which treatments work and which do not.
McGraw-Hill/Irwin
Providing information rather than licensing would give rise to consumer sovereignty.
Consumer sovereignty the right of the individual to make choices about what is consumed and produced.
McGraw-Hill/Irwin
An Informational Alternative to Licensure

In this scenario, the government would require doctors to post their:
Grades in college. Grades in medical school. Success rate for various procedures. References. Medical philosophy. Charges and fees.
McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
An Informational Alternative to Licensure

This information alternative would provide much more useful information to the public than the present licensing procedure.
McGraw-Hill/Irwin
Government Failures and Market Failures

Market failures should not automatically call for government intervention. Why? Because governments fail too.
McGraw-Hill/Irwin
Government Failures and Market Failures

Government failure occurs when the government intervention in the market to improve the market failure actually makes the situation worse.
McGraw-Hill/Irwin
Reasons for Government Failures

Governments do not have an incentive to correct the problem. Governments do not have the information to deal with the problem. Intervention in the markets is almost always more complicated than it initially looks.
McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Reasons for Government Failures

The bureaucratic nature of government intervention does not allow fine tuning. Government intervention leads to more government intervention.
McGraw-Hill/Irwin

Managerial Economics

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MANAGERIAL ECONOMICS

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MANAGERIAL ECONOMICS - DEFINITIONS

MANAGERIAL ECONOMICS - DEFINITIONS

MANAGERIAL ECONOMICS DEFINITIONS

MANAGERIAL ECONOMICS MANAGEMENT DECISION PROBLEM

BUSINESS MANAGEMENT - DECISION PROBLEMS

SCOPE OF MANAGERIAL ECONOMICS

SCOPE OF MANAGERIAL ECONOMICS

Factor Pricing (Theory of Distribution)

Theory of Welfare Economics

Theory Of Production & Costs

SCOPE OF MANAGERIAL ECONOMICS

SCOPE OF MANAGERIAL ECONOMICS

SCOPE OF MANAGERIAL ECONOMICS

The contents of the macro economic theory

Theory of Income and Employment

Theory of General Price level & Inflation

The Theory of Economic Growth

Entrepreneurship and Profits

The The The The

entrepreneur entrepreneur entrepreneur entrepreneur

a risk taker an innovator a monopolist an exploiter of labor

The Entrepreneur as a Risk Taker

The Entrepreneur as an Innovator

The Entrepreneur as a Monopolist

DeBeers (diamonds) Early Railroads National Football League

The Entrepreneur as an Exploiter of Labor

Supply and Demand

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The Law of Demand

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The Law of Demand

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The Demand Curve

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A Sample Demand Curve

Other Things Constant

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Other Things Constant

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Shifts in Demand Versus Movements Along a Demand Curve

Shifts in Demand Versus Movements Along a Demand Curve

Micro232 2004 JAFGAC

Shifts in Demand Versus Movements Along a Demand Curve

Micro232 2004 JAFGAC

Shifts in Demand Versus Movements Along a Demand Curve

Micro232 2004 JAFGAC

Change in Quantity Demanded

D1 0 100 200 Quantity demanded (per unit of time)

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250 100 200 Quantity demanded (per unit of time)

Shift Factors of Demand

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Micro232 2004 JAFGAC

Price of Other Goods

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Tastes and preferences

Micro232 2004 JAFGAC

Micro232 2004 JAFGAC

Taxes and Subsidies