MANAGERIAL ECONOMICS (GIMENA)

Managerial economics is the science of directing scarce resources to manage cost effectively. It consists of three
branches: competitive markets, market power, and imperfect markets. A market consists of buyers and sellers that
communicate with each other for voluntary exchange.

1. THEORY OF COST & PROFIT WITH PROBLEMS

In economics, the cost-of-production theory of value is the theory that the price of an object or condition is determined
by the sum of the cost of the resources that went into making it. The cost can comprise any of the factors of production
(including labor, capital, or land) and taxation.

In Economics, however, the term has a precise meaning. Profit may be defined as the net income of a business after all
the other costs—rent, wages and interest etc., have been deducted from the total income.

Profits are, therefore, uncertain and vary from person to person and from firm to firm. They may become zero, when
costs are equal to income, and if the costs are higher, profits may actually be converted into loss.

2. GROWTH RATE
An economic growth rate is a measure of economic growth from one period to another in percentage terms. This
measure does not adjust for inflation; it is expressed in nominal terms. In practice, it is a measure of the rate of change
that a nation's gross domestic product (GDP) goes through from one year to another, but gross national product (GNP)
can also be used if a nation's economy depends heavily on foreign earnings.

BREAKING DOWN 'Economic Growth Rate'

Causes of Economic Growth

Economic growth can be spurred by a variety of factors or occurrences. Most commonly, increases in aggregate demand
encourage a corresponding increase in overall output that brings in a new source of income. Technological
advancements and new product developments can exert positive influences on economic growth. Increases in demand,
or availability, in foreign markets that result in higher exports can also have positive influences. This can be due to the
spread of previously unavailable products into a new market or increases in the particular market’s economic standing
that raise the discretionary income of its citizens. As demand rises, associated sales levels also rise. This influx of income
causes an increase in the economic growth rate.

3. INTRODUCTION TO MANAGERIAL ECONOMICS

 Refers to the application of economic theory and tools of analysis of decision science to examine how an
organization can achieve its aims or objectives most efficiently.
 It is a science of directing scarce resources to manage cost effectively.
 Consist of 3 branches: competitive markets, market power, and imperfect markets.
 A market consist of buyers & sellers that communicate w/ each other for voluntary exchange whether a market
is local or global, the same managerial economics apply.
 Applies models that are necessarily less than completely realistic.

4. MARKET STRUCTURE
Types of market structure
Perfect competition – Many firms, freedom of entry, homogeneous product, normal profit.
There are two extreme forms of market structure: monopoly and, its opposite, perfect competition. Perfect competition
is characterized by many buyers and sellers, many products that are similar in nature and, as a result, many substitutes.
Perfect competition means there are few, if any, barriers to entry for new companies, and prices are determined by
supply and demand. Thus, producers in a perfectly competitive market are subject to the prices determined by the
market and do not have any leverage. For example, in a perfectly competitive market, should a single firm decide to
increase its selling price of a good, the consumers can just turn to the nearest competitor for a better price, causing any
firm that increases its prices to lose market share and profits.

Monopoly – One firm dominates the market, barriers to entry, possibly supernormal profit.
1. Monopoly diagram

A monopoly is a market structure in which there is only one producer/seller for a product. In other words, the single
business is the industry. Entry into such a market is restricted due to high costs or other impediments, which may be
economic, social or political. For instance, a government can create a monopoly over an industry that it wants to control,
such as electricity. Another reason for the barriers against entry into a monopolistic industry is that oftentimes, one
entity has the exclusive rights to a natural resource. For example, in Saudi Arabia the government has sole control over
the oil industry. A monopoly may also form when a company has a copyright or patent that prevents others from
entering the market. Pfizer, for instance, had a patent on Viagra.

Oligopoly – An industry dominated by a few firms, e.g. 5 firm concentration ratio of > 50%. Interdependence of firms
1. Oligopoly diagram
2. Collusive behavior – firms seek to form agreement to increase prices.

An oligopoly, there are only a few firms that make up an industry. This select group of firms has control over the price
and, like a monopoly, an oligopoly has high barriers to entry. The products that the oligopolistic firms produce are often
nearly identical and, therefore, the companies, which are competing for market share, are interdependent as a result of
market forces. Assume, for example, that an economy needs only 100 widgets. Company X produces 50 widgets and its
competitor, Company Y, produces the other 50. The prices of the two brands will be interdependent and, therefore,
similar. So, if Company X starts selling the widgets at a lower price, it will get a greater market share, thereby forcing
Company Y to lower its prices as well.

Monopolistic competition – Freedom of entry and exit, but firms have differentiated products. Likelihood of normal
profits in the long term.

Contestable markets – An industry with freedom of entry and exit, low sunk costs. The theory of contestability suggests
the number of firms is not so important, but the threat of competition.

5. DEMAND AND SUPPLY ANALYSIS

It is represented by the intersection of the demand and supply curves. The analysis of various equilibria is a fundamental
aspect of microeconomics: Market Equilibrium: A situation in a market when the price is such that the quantity
demanded by consumers is correctly balanced by the quantity that firms wish to supply.

6. PRODUCTION THEORY
Production theory explains the principles in which the business has to take decisions on how much of each commodity
it sells and how much it produces and also how much of raw material ie., fixed capital and labor it employs and how
much it will use. It defines the relationships between the prices of the commodities and productive factors on one hand
and the quantities of these commodities and productive factors that are produced on the other hand.

Concept
Production is a process of combining various inputs to produce an output for consumption. It is the act of creating
output in the form of a commodity or a service which contributes to the utility of individuals.
In other words, it is a process in which the inputs are converted into outputs.

Function
The Production function signifies a technical relationship between the physical inputs and physical outputs of the firm,
for a given state of the technology.

Q = f (a, b, c, . . . . . . z)

Where a,b,c ....z are various inputs such as land, labor ,capital etc. Q is the level of the output for a firm.

If labor (L) and capital (K) are only the input factors, the production function reduces to −

Q = f(L, K)

Production Function describes the technological relationship between inputs and outputs. It is a tool that analysis the
qualitative input – output relationship and also represents the technology of a firm or the economy as a whole.

Production Analysis
Production analysis basically is concerned with the analysis in which the resources such as land, labor, and capital are
employed to produce a firm’s final product. To produce these goods the basic inputs are classified into two divisions −

Variable Inputs
Inputs those change or are variable in the short run or long run are variable inputs.

Fixed Inputs
Inputs that remain constant in the short term are fixed inputs.

Cost Function
Cost function is defined as the relationship between the cost of the product and the output. Following is the formula
for the same −

C = F [Q]

Cost function is divided into namely two types −

Short Run Cost

Short run cost is an analysis in which few factors are constant which won’t change during the period of analysis. The
output can be changed ie., increased or decreased in the short run by changing the variable factors.

Following are the basic three types of short run cost −

Long Run Cost
Long-run cost is variable and a firm adjusts all its inputs to make sure that its cost of production is as low as possible.

Long run cost = Long run variable cost

In the long run, firms don’t have the liberty to reach equilibrium between supply and demand by altering the levels of
production. They can only expand or reduce the production capacity as per the profits. In the long run, a firm can
choose any amount of fixed costs it wants to make short run decisions.

Law of Variable Proportions

The law of variable proportions has following three different phases −

 Returns to a Factor
 Returns to a Scale
 Isoquants
In this section, we will learn more on each of them.

Returns to a Factor
Increasing Returns to a Factor

Increasing returns to a factor refers to the situation in which total output tends to increase at an increasing rate when
more of variable factor is mixed with the fixed factor of production. In such a case, marginal product of the variable
factor must be increasing. Inversely, marginal price of production must be diminishing.

Constant Returns to a Factor

Constant returns to a factor refers to the stage when increasing the application of the variable factor does not result in
increasing the marginal product of the factor – rather, marginal product of the factor tends to stabilize. Accordingly,
total output increases only at a constant rate.

Diminishing Returns to a Factor

Diminishing returns to a factor refers to a situation in which the total output tends to increase at a diminishing rate
when more of the variable factor is combined with the fixed factor of production. In such a situation, marginal product
of the variable must be diminishing. Inversely the marginal cost of production must be increasing.

Returns to a Scale
If all inputs are changed simultaneously or proportionately, then the concept of returns to scale has to be used to
understand the behavior of output. The behavior of output is studied when all the factors of production are changed in
the same direction and proportion. Returns to scale are classified as follows −

 Increasing returns to scale − If output increases more than proportionate to the increase in all inputs.
 Constant returns to scale − If all inputs are increased by some proportion, output will also increase by the same
proportion.
 Decreasing returns to scale − If increase in output is less than proportionate to the increase in all inputs.

For example − If all factors of production are doubled and output increases by more than two times, then the situation
is of increasing returns to scale. On the other hand, if output does not double even after a 100 per cent increase in
input factors, we have diminishing returns to scale.

The general production function is Q = F (L, K)

Isoquants
Isoquants are a geometric representation of the production function. The same level of output can be produced by
various combinations of factor inputs. The locus of all possible combinations is called the ‘Isoquant’.

Characteristics of Isoquant

 An isoquant slopes downward to the right.

 An isoquant is convex to origin.
 An isoquant is smooth and continuous.
 Two isoquants do not intersect.
Types of Isoquants

The production isoquant may assume various shapes depending on the degree of substitutability of factors.

Linear Isoquant
This type assumes perfect substitutability of factors of production. A given commodity may be produced by using only
capital or only labor or by an infinite combination of K and L.

Input-Output Isoquant

This assumes strict complementarily, that is zero substitutability of the factors of production. There is only one method
of production for any one commodity. The isoquant takes the shape of a right angle. This type of isoquant is called
“Leontief Isoquant”.

Kinked Isoquant

This assumes limited substitutability of K and L. Generally, there are few processes for producing any one commodity.
Substitutability of factors is possible only at the kinks. It is also called “activity analysis-isoquant” or “linear-
programming isoquant” because it is basically used in linear programming.

Least Cost Combination of Inputs

A given level of output can be produced using many different combinations of two variable inputs. In choosing between
the two resources, the saving in the resource replaced must be greater than the cost of resource added. The principle
of least cost combination states that if two input factors are considered for a given output then the least cost
combination will have inverse price ratio which is equal to their marginal rate of substitution.

Marginal Rate of Substitution

MRS is defined as the units of one input factor that can be substituted for a single unit of the other input factor. So MRS
of x2 for one unit of x1 is −

= 

Number of unit of replaced resource (x 2) Number of unit of added resource (x 1)

Price Ratio (PR) = 

Cost per unit of added resource Cost per unit of replaced resource

= 

Price of x1 Price of x2

Therefore the least cost combination of two inputs can be obtained by equating MRS with inverse price ratio.

x2 * P2 = x1 * P1

7. FORCASTING USING LEAST SQUARE REGRESSION METHOD

What is the 'Least Squares Method'
The least squares method is a form of mathematical regression analysis that finds the line of best fit for a dataset,
providing a visual demonstration of the relationship between the data points. Each point of data is representative of the
relationship between a known independent variable and an unknown dependent variable.

BREAKING DOWN 'Least Squares Method'

The least squares method provides the overall rationale for the placement of the line of best fit among the data points
being studied. The most common application of the least squares method, referred to as linear or ordinary, aims to
create a straight line that minimizes the sum of the squares of the errors generated by the results of the associated
equations, such as the squared residuals resulting from differences in the observed value and the value anticipated
based on the model.

This method of regression analysis begins with a set of data points to be graphed. An analyst using the least squares
method will be seeking a line of best fit that explains the potential relationship between an independent variable and a
dependent variable. In regression analysis, dependent variables are designated on the vertical Y axis and independent
variables are designated on the horizontal X axis. These designations will form the equation for the line of best fit, which
is determined from the least squares method.

Example of Least Squares Method

For example, an analyst may want to test the relationship between a company’s stock returns and the index returns for
which the stock is a component. In this example, the analyst seeks to test the dependence of the stock returns on the
index returns. To do this, all of the returns are plotted on a chart. The index returns are then designated as the
independent variable, and the stock returns are the dependent variable. The line of best fit provides the analyst, with
coefficients explaining the level of dependence.

Line of Best Fit Equation

The line of best fit determined from the least squares method has an equation that tells the story of the relationship
between the data points. Computer software models are used to determine the line of best fit equation, and these
software models include a summary of outputs for analysis. The least squares method can be used for determining the
line of best fit in any regression analysis. The coefficients and summary outputs explain the dependence of the variables
being tested.

Break-Even PointWHAT IT IS:

In economics, the break-even point is the point at which revenues equal expenses. Ininvesting, the break-even point is
the point at which gains equal losses.

HOW IT WORKS (EXAMPLE):

The basic idea behind break-even point is to calculate the point at which revenues begin to exceed costs.

The first step is to separate a company's costs in to those that are variable and those that are fixed. Fixed costs are costs
that do not change with the quantity of output. Examples of Fixed cost include rent, insurance premiums,
or loan payments. Variable costs are costs that change with the quantity of output. They are zero when production is
zero. Examples of common variable costs include labor directly involved in a company's manufacturing process and raw
materials.

For example, at XYZ Restaurant, which sells only pepperoni pizza, the variable expenses per pizza are:
  Fixed Costs Variable Costs
 General Labor $1,500  Flour $0.50
 Rent $3,000  Yeast $0.05
 Insurance $200  Water $0.01
 Advertising $500  Cheese $3.00
 Utitilies $450  Pepperoni $2.00
 Total $5,650  Total $5.56

Based on the total variable expenses per pizza, we now know that XYZ Restaurant must price its pizzas at $5.56 ($0.50 +
$0.05 + $0.01 + $3.00 + $2.00) or higher just to cover those costs. But if the pizzeria charges $10 for the finished product,
then it receives $4.44 per pizza to contribute to the fixed costs and ultimately the restaurants overall profits.

How many pizzas does XYZ Restaurant need to sell at $10 each to cover all those fixed monthly expenses?  First we must
add up all the fixed expenses ($1,500 + $3000 + $200 + $500 + $450) which the total comes to $5,650. And then we
simply dividendthis amount by the $4.44 left over after the variable costs are covered. ($5,650 / $4.44 = 1,272)  XYZ
must sell 1,272 pizzas in order to break even for the month. Each pizza sold after that contributes to the bottom-line.

It is important to note that some fixed costs increase "stepwise," meaning that after a certain level of revenue is
reached, the fixed cost changes. For example, if XYZ Restaurant began selling 5,000 pizzas per month rather than just
2,000, it might need to hire a second manager, thus increasing labor costs.

WHY IT MATTERS:

The break-even point helps business owners determine when they'll begin to turn aprofit and assists them with the
pricing of their products. Typical vaisinble and fixed costs differ widely among industries. This is why comparison of
break-even points is generally most meaningful among companies within the same industry, and the definition of a
"high" or "low" break-even point should be made within this context.