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• #  Fundamental Economics Concepts and Optimisation Techniques

LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
Apply marginal analysis concepts in making managerial decisions;
2.
Apply mathematics, in particular, differential calculus to find optimal
solutions to economics and management problems at the firm level;
3.
Compute present values of future cash flows; and
4.
Identify risks and uncertainties associated with business decisions.
• ###  INTRODUCTION

An economic problem involves tradeoffs and opportunity costs. An economic problem can be illustrated in the pricing decisions by Malaysia Airlines on whether to offer discounts for unsold business class seats, when it is unsure whether the seats will ever be sold. This topic provides selected basic tools often used in managerial economics. These include concepts of marginal analysis, net present value and the tradeoff between risk and returns.

In this topic, we will focus on learning the mathematical tools to find the best value. The tools are called optimisation techniques. Depending on the problem, the highest value or lowest value is the optimum. In golf, for instance, the lowest

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number is the best but in bowling, the highest number is the best. Finding the least cost input combinations to produce a given output, the most profitable output, or the maximum net present value for a given investment; are all optimisation problems.

2.1

### MARGINAL ANALYSIS

Marginal analysis is the most useful concept in economic decision-making. Since resources are scarce and we cannot have everything that we want, choices must be made. The concept of opportunity cost reminds us that every time we make a choice, something else must be given up. Economics provides us with a set of tools that can help us make better choices. Most of the time, the best decision is made by weighing the marginal benefits against the marginal costs. We will carry out the decision as long as the marginal benefit is greater than the marginal cost. The best is when marginal benefit equals marginal cost.

• ### 2.1.1 What is Marginal Return or Revenue?

Marginal return (or marginal benefit or marginal revenue) is the change in total benefits derived from doing an activity and is also known as the additional benefits received when one more unit of the activity is produced. Benefits can be expressed in terms of units of utility or satisfaction, or they can be expressed in monetary values (for example, Ringgit Malaysia).

In microeconomics, Marginal Revenue (MR) is the extra revenue that an additional unit of product will bring to the firm. It can also be described as the change in total revenue/change in number of units sold.

More formally, marginal revenue is equal to the change in total revenue over the change in quantity when the change in quantity is equal to one unit (or the change in output in the bracket where the change in revenue has occurred).

• ### 2.1.2 What is Marginal Cost?

In economics and finance, marginal cost is the change in total cost that arises when the quantity produced changes by one unit. Mathematically, the marginal cost (MC) function is expressed as the derivative of the total cost (TC) function with respect to quantity (Q). Note that the marginal cost may change with volume and so at each level of production, the marginal cost is the cost of the next unit produced.

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MC

dTC

dQ

or

MC

  /

TC

Q

In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit. If producing additional vehicles requires, for example, building a new factory, the marginal cost of those extra vehicles includes the cost of the new factory. In practice, the analysis is segregated into short and long-run cases, and over the longest run, all costs are marginal. At each level of production and time period being considered, marginal costs include all costs which vary with the level of production and other costs are considered fixed costs (http://www.wikipedia.org).

In a nutshell, marginal cost is the change in total cost of doing an activity and is also known as the additional costs incurred when one more unit of the activity is produced.

SELF-CHECK 2.1
1.
When do you use „marginal analysis?‰
2.
Your firm is operating a long-distance express bus service from
Kuala Lumpur to Kota Bharu. During the festive season, you
obtain licences to offer additional trips. Using the concepts of
marginal benefits and marginal costs, how would you decide on
the optimal number of additional trips to offer?
2.2

### RELATIONSHIPS AMONG TOTAL PROFIT, AVERAGE PROFIT AND MARGINAL PROFIT

The relationships among total profit, average profit and marginal profit are discussed below:

Total Profit, π(Q), is Total Revenue (TR) minus Total Cost (TC). Total profits are maximised at the output level (Q) where marginal revenue equals marginal cost. Another way to state the rule is that marginal revenue minus marginal cost must be zero for total profit to be a maximum.

Average profit is total profit divided by quantity: A π (Q) = π(Q)/Q. Marginal profit is the profit attributable to the last unit of output:

M π (Q) = Δπ(Q)/ΔQ.

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Tables, graphs and/or algebraic expressions are usually used to show the relationships among total profit, average profit and marginal profit. The relationships are shown in Table 2.1 and Figure 2.1.

Table 2.1: Quantity (Q), profit (), average profit and marginal profit.

 TR TC (Q) M  (Q) A  (Q) 0 20 0 20 - - 34 1 26 8 28 8 2 34 66 32 24 16 3 44 96 52 20 17.33 4 56 124 68 16 17 150 5 70 80 12 16 174 6 86 88 8 14.67 7 104 196 92 4 13.14 8 124 216 92 0 11.5 9 146 234 88 4 9.78 10 250 170 80 8 8

In Table 2.1, total profit rises up to a maximum. Marginal profit is the slope of the total profit curve. The slope of total profit is zero at its maximum, because the slope of the horizontal line is zero. Hence, marginal profit is zero at maximum profit. The decision rule for maximising profits is to expand output until marginal profit is zero.

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Figure 2.1: Total profit, average profit and marginal profit. Source: McGuigan, J. R., Moyer, R. C., & Harris, F. H. (2005) Managerial economics:

Applications, strategy and tactics (10th ed.). Mason, Ohio: South-Western.

In algebra, profit (called the dependent variable) depends on the level of output (the independent variable). The highest profits occur where ∆π(Q) = 0. You see that a quick method to find maximum profits uses calculus: marginal profit is the derivative of total profit. Therefore, local maximum profits occur at the quantity where the derivative of total profits with respect to output equals zero.

SELF-CHECK 2.2
Discuss and show the relationships among total profit, average profit
and marginal profit. Make sure you understand the use of symbols
representing all the terms.

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2.3

### TYPES OF OPTIMISATION TECHNIQUES

There are two types of optimisation techniques:

Unconstrained Optimisation is a relatively simple calculus problem that can be solved using differentiation, such as finding the quantity that maximises profit in the function π (Q) = 16Q - Q². [The answer is Q = 8.]

Constrained Optimisation involves one or more constraints. This happens when there are inequalities, for instance, when you must spend less than or equal to your budget allocation. Lagrangian multipliers are used to solve these problems.

• ### 2.3.1 Calculus in Managerial Economics

We study differentiation and the rules for differentiating functions because these methods can be used to find optimal solutions to the various kinds of maximising and minimising problems in managerial economics.

The rules for differentiating functions are summarised below:

 Name Function Derivative Example Constant Y = c dY/dX = 0 Y = 5 Functions dY/dX = 0 A Line Y = cX dY/dX = c Y = 5X dY/dX = 5 Power Y = cX b dY/dX = bcX b-1 Y = 5X 2 Functions dY/dX = 10X Sum of Y = G(X) + H(X) dY/dX = dG/dX + dH/dX Y = 5X + 5X 2 Functions dY/dX = 5 + 10X Product of Y = G(X) x H(X) dY/dX = (dG/dX)H + (dH/dX)G Y = (5X)(5X 2 ) Two Functions dY/dX = 5(5X 2 ) + (10X)(5X) = 75X 2

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• ### 2.3.2 Optimisation in One Variable Case

MAXIMISATION PROBLEM: Profit maximisation assumes that there is some output level that is the most profitable. A profit function might look like an arch, rising to a peak and then declining at even larger outputs. A firm might sell huge amounts at very low prices but discover that profits are low or negative.

MINIMISATION PROBLEM: Cost minimisation assumes that there is a least cost point to produce. An average cost curve might have a U-shape. At the least cost point, the slope of the cost function is zero.

The first order condition for an optimum is that the derivative at that point is zero. To determine whether that optimum is either maximum or minimum, you must find the second derivative, which is the derivative of the first derivative.

The second order condition states that:

  If the second derivative is negative, then itÊs a maximum  If the second derivative is positive, then itÊs a minimum

Examples:

• 1. π = 100Q - Q 2

First derivative: d π /dQ = 100 -2Q To find the optimum point, set the first derivative as equals 0.

dπ /dQ = 100 -2Q = 0

Therefore Q = 50 To determine whether Q = 50 is a maximum or minimum, find the second derivative. The second derivative is -2, thus implying that Q =50 is a MAXIMUM.

• 2. π = 50 + 5X 2 dπ/dX = 10X = 0 Therefore X = 0 The second derivative is 0, implying X = 0 is a MINIMUM.

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### 2.3.3 Optimisation in More-than-One Variable Case

Economic relationships usually involve several independent variables. For example: the production of shoes requires materials, machine and labour; while the demand for shoes depends on price and income. In this case, we use Partial Differentiation. A partial derivative is like a controlled experiment – it holds the „other‰ variables constant. Assume quantity, Q = f (P, I). If price is increased, holding the disposable income constant then the partial derivative of Q with respect to price is Q/P, holding income constant. Similarly, the partial derivative of Q with respect to income is Q/I, holding price constant.

Example:

Assume Sales is a function of advertising in newspapers and magazines (X, Y) and it is given in the following relationship:

Max S = 200X 100Y 10X 2 20Y 2 + 20XY

To find the optimum, differentiate the above with respect to X and Y and set them equal to zero:

S/X = 200 – 2 – 0X + 20Y= 0 S/Y = 100 – 40Y + 20X = 0

Then, solve for X & Y and Sales:

• 200 – 20X + 20Y= 0

• 100 – 40Y + 20X = 0

Adding them, the 20X and +20X cancel, so we get 300 - 20Y = 0, or Y =15

Plug into one of them: 200 20X + 300 = 0,

hence X = 25

To find Sales, plug into the equation: S = 200X + 100Y 10X2 20Y2 + 20XY =

3,250

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SELF-CHECK 2.3
1.
Find the derivatives of the following:
(i)
TC = 50 + 100Q  6Q 2 + .5Q 3
(ii) ATC = 50/Q + 100  6Q + .5Q 2
(iii)
(iv)
MC = 100  12Q + 1.5Q 2
Q = 50  .75P
(v)
Q = .4X 1.5
2.
Given Y = -2X 2 + 20X  20,
(i)
Find the optimal value of X.
(ii) Is this a maximum or a minimum?
3.
Suppose Q = 2000 + 15Y  5.5P, find the optimal values of Y, P
and Q.
2.4

### CONCEPT OF NET PRESENT VALUE

To find managerial decision rules that maximise shareholdersÊ wealth over a long period of time, you must consider the present value of the benefits as well as the present value of the costs. The net present value is the difference between the present values of all the benefits and costs. When the net present value is positive, then the decision improves shareholdersÊ wealth.

Present value recognises that a dollar received in the future is worth less than a dollar in hand today, because a dollar today could be invested to earn a return. To compare monies in the future with today, the future dollars must be discounted by a present value interest factor, PVIF = l/(l+i), where it is the interest compensation for postponing receiving cash by one period. For dollars received in n periods, the discount factor is PVIF n = [l/(l+i)] n

.

What will be the present value of \$500 to be received 10 years from today if the discount rate is 6%?

 PV = \$500 {1/(1+.06) 10 } = \$500 (1/1.791) = \$500 (.558) = \$279

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  Net Present Value, NPV = Present value of future returns minus initial outlay. This is for the simple example of a single cost today yielding a benefit or stream of benefits in the future. For the more general case, NPV = Present value of all cash flows (both positive and negative ones). Example: A project with an initial cash outlay of \$40,000 with the following cash flows for five years. The firm has a 12% required rate of return. Year In-flows Out-flows Net Cash flows (NCF) Initial outlay 40,000 -40,000 1 50,000 36,000 14,000 2 51,000 38,000 13,000 3 51,000 38,000 13,000 4 52,000 40,000 12,000 5 52,000 41,000 11,000 The present value of the NCFÊs is \$47,678. Subtracting the initial cash outlay of \$40,000 leaves an NPV of \$7,678. NPV>0, therefore we accept.  NPV Rule: Carry out all projects that have a positive net present value. By doing this, the manager will maximise shareholder wealth.

Some investments may increase NPV, but at the same time, they may increase risk. Whether the extra risk is acceptable depends on what is the acceptable rate of return for that risk.

SELF-CHECK 2.4
1.
What is Net Present Value (NPV)?
2.
What is the rule when you use NPV?
2.5
RISK
• ### 2.5.1 What is Risk?

Uncertainty about a situation can often indicate risk, which is the possibility of loss, damage or any other undesirable event. Most people desire low risk, which would translate to a high probability of success, profit or some form of gain.

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Risk

event.

is the possibility of loss, damage or any other undesirable

For example, if sale for next month is above a certain level (a desirable event), then these orders will reduce inventory and if there is a delay in shipping orders (an undesirable event) which means losing orders, then that possibility of delay is a risk to the firm.

An investment decision is risk-free when the expected dollar returns and initial investment are certain. But most managerial decisions involve uncertainties. There is always a possibility that cash flows will fall below the expected level and sometimes there is also the possibility that the cash flows will be negative (a loss).

• ### 2.5.2 How to Measure Risk?

Variability in the outcomes of an investment is a measure of risk. The bigger the variability of the possible outcomes, the higher is the risk of the investment. Variability can be described using probability distributions.

n

In any distributions, the sum of the probabilities, p j , must equal one p j = 1.

j=1

This assures that all possible outcomes, r j , have been exhausted and each outcome is discrete. Probabilities can be thought of as the percentage likelihood that each outcome, or state of nature, occuring:

• (a) Expected Value is the weighted average of the possible outcomes:

 ^ n r j=1 ____________ σ = √ Σ (r j -

= p j r j = 1.

j=1

• (b) Standard Deviation, σ measures the dispersion of outcomes around its expected value.

r^) 2 p j

The expected values and standard deviations of two projects, with differing cash flows and differing probability distributions, can be compared. If two projects have the same expected value, you may wish to select the one with the lower standard deviation. Or if two projects have the same standard deviations, you may wish to select the one with the higher expected value. If one project has a higher expected value and a higher standard deviation, then the choice depends on a tradeoff between risk and return.

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• ### 2.5.3 Risk and Return

We face risk every day. Driving a car or riding a motorcycle, crossing a busy street, even eating your favourite meals, involves some form of risk. With investment decisions, balancing risk and return can be very tricky. Investors want to maximize their return, while at the same time want to minimize risk. Unfortunately, for most investments, the higher the return, the higher is the risk associated with it.

Some investments are certainly more "risky" than others but no investment is risk-free. Avoiding risk by not investing at all can be the riskiest move of all. Try to keep your money under your pillow! You will not earn anything from it; you will definitely lose due to inflation or worse, somebody might steal it from you. Trying to avoid risk is like standing at the curb, never setting your foot into the street to get to the other side. You will neve r be able to get to your destination if you do not accept some risk. In investing, just like crossing that street, you carefully consider the situation, accept a comfortable level of risk and proceed to where you are going. Risk can never be eliminated but it can be managed.

In an investment decision, we can divide the required return into two parts, the risk- free return and a risk premium.

Required Return = Risk-free Return + Risk Premium

The greater the risk, the greater must be the risk premium as a reward for accepting that risk.

Two mutually exclusive projects with different risks can be compared using the NPV rule. You can discount the riskier project with a higher required return (because of its higher risk premium). The different discount rates adjust for risk. The project with a higher risk-adjusted NPV should be selected.

SELF-CHECK 2.5
1.
In your own words, define „risk‰.
2.
How do you measure risk?
3.
How do you select projects based on the expected values and
standard deviations?
4.
What is the relationship between risk and return?

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ACTIVITY 2.1