Chapter 1 INTRODUCTION TO MANAGERIAL ECONOMICS

 Managerial economics provides a systematic & logical way of analyzing

business decisions which focuses on economic forces that shape both day
to day short-run decisions and long-run planning decisions
 Managerial Economics applies economic tools and techniques for improving
Management Decision Making. The objective is to help business students become
architects of business strategy.
 Managerial Economics helps managers decide on what prices to charge, which
products to produce and what costs to consider.
 It helps managers decide the best hiring policy and the most effective style of
organization.
 Managerial economics powerful tools are used to make the managers more
effective by more effectively and efficiently collecting, organizing and analyzing
information.
 Effective management involves an integration of the accounting, finance,
marketing, personnel and production functions of a firm, considering it as a unified
whole rather than a series of unrelated parts.
 Economic Profit versus Accounting Profit
 Economic profit is the amount by which TR exceeds total economic
cost, where total economic cost is the sum of the opportunity costs of each and
every resource used by a firm(explicit & implicit costs).
 Businesses generally utilize 2 kinds of resources:
 1) resources owned by others (such as labor services or skilled and
unskilled workers, raw material purchased from commercial suppliers and capital
equipment rented or leased from equipment suppliers) and
 2)resources owned by the firm (such as labor services provided to the
firm by its owners, money provided to the business by its owners and any land,
buildings or capital equipment owned and used by the business).
 The opportunity cost of using resources owned by others is the dollar
amount paid to the resource owners.
 These payments made to resource owners are called explicit costs.
 The opportunity costs of using resources owned by the firm are called
Implicit costs.
 For the resources used by the firm that are owned by the firm, the
opportunity cost is the largest payment that the owner could have received if those
resources that it owns had been leased or sold instead of being held by the firm
for its own use.
 These opportunity costs of using a firm’s own resources are called
implicit costs since the firm makes no monetary payment to use its own
resources.
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 Both kinds of opportunity costs of using resources must be subtracted
from Total Revenue to get Economic Profit.
 Economic Profit = Total Revenue (TR) – Total economic costs
= TR – Explicit costs – Implicit costs.
 Accounting Profit then differs from economic profit because
accounting profit does not subtract from TR the implicit costs of using resources.
 Accounting Profit = TR – Explicit costs.
 Thus economic profit is smaller than accounting profit by the amount of
the firm’s implicit costs.
 Even though accountants are required to ignore most kinds of implicit
costs business owners of course bear all costs of using resources both the explicit
and the implicit costs.
 Economists frequently refer to the opportunity cost of using the
owner’s own resources as normal profit.
 Normal profit is just another name for the implicit cost that a firm
incurs when it employs owner supplied resources.
 It represents the payment that business owners must receive for using
their own resources in their own business.
 Normal profit is simply the implicit part of total economic costs.
Economic Profit = TR – Explicit costs – Normal profit.

 THEORY OF THE FIRM is defined as a basic model of business.

 Richer versions of the theory assumes that the firm tries to maximize its
wealth or value of the firm.
 The value of the firm is defined as the present value of its expected future
cash flows or profits. It takes into account the time value of money.
 Thus in an equation form the value of the firm equals:

π1 π2 πn
- PV of expected future profits =-------- + ------- + + -------
(1 + i) (1 + i)2 (1 + i)n

n
=∑ __πt
t= 1 (1 + i)t Figure 1.1
πt = profit in year t
i = interest rate
t = goes from 1 to n last year in planning horizon
Because profits equal TR – TC. This equation can be written as:
N TRt - TCt
PV of future profits = ∑ (1 + I)t
t=1 Equation 1.2
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Where TRt = total revenue in year t
TCt = total cost in year t.
 This expanded equation can be used to examine how the expected value
maximization model relates to a firm’s various functional departments.
 The marketing department often has primary responsibility for promotion and
sales(TR); the production department has primary responsibility for development
costs(TC); and the finance department has primary responsibility for acquiring
capital and, hence for the discount factor (i) in the denominator.
 e.g. Ford Motor Co-Marketing managers & sales reps work hard to increase
Total Revenue,
 Production managers & manufacturing engineers strive to reduce its Total
Cost,
 financial managers play a major role in obtaining capital,
 R & D invent new products & processes that increase Total Revenue &
decrease Total Cost.
 All these diverse groups affect value of the firm i.e. Present Value(PV) of
expected future profits of the firm.
 Relation The value of a firm is the price for which it can be sold, and that price
is equal to the PV of the expected future profits of the firm.

 What is Economics?
 Economics is the study of how scarce or limited resources are used to
satisfy unlimited wants and needs; the study of decision making in a world
of scarcity.
 Resources or factors of production are persons and things used to produce
goods and services limited in amount.
 Wants are what people would buy if their incomes were unlimited.
 Needs are food shelter and clothing.
 Scarcity is the result of not enough goods and services to satisfy all wants and
needs or when the ingredients (resources) for producing things that people desire
are insufficient to satisfy all wants.
 Microeconomics is the study of decision making by individuals and by firms
which are the individual segments of the economy.
 It’s the study and analysis of the behavior of individual consumers, workers,
owners of resources, individual firms, industries & markets for good & services
 Macroeconomics is the study of the behavior of the economy as a whole and
the interactions of the major groups called a)household, b)government & c)foreign
sector in the economy.
 It includes such topics as a)inflation, b)taxes & govt. spending,
c)unemployment & d)money & banking.

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 Economic System describes how a particular society distributes its resources
to produce G&S.
 It’s the institutional means through which resources are used to satisfy human
wants.
 What is a Market?
 A market is composed of firms & individuals who are in touch with each other in
order to buy or sell some goods or services.
 Its any arrangement through which buyers and sellers exchange final goods or
services, resources used for production, or anything of value.
DEMAND
 Demand is the various quantities of good or service that people are willing &
able to purchase at various prices during a specified period of time (week, month,
year) when all non-price factors are held constant(income, tastes, expectation,
prices of related goods, population).
 It is very important to note that since price is part of what we call demand a
change in the price cannot change the demand, but results in a change in the
quantity demanded for that product.
 Law of Demand Quantity demanded of a good is inversely related to price
assuming all non-price factors held constant.
 Market Demand Schedule is a table showing a list of possible product prices
and corresponding quantities demanded by consumers during a specified period
of time.
 Market Demand Curve is a graph showing the relation between quantity
demanded and price charged when all other variables influencing quantity
demanded are held constant (income, tastes, expectations of future prices,
income & product availability, price of related goods, population).
 Market Demand Function for a product is a statement of the relation between
the aggregate quantity demanded and all determinants that affect this
quantity(Price, tastes, income, price of related goods, expectations, population).
 Change in Demand – is a leftward or rightward shift from one demand curve to
another demand curve when one or more of the non-price determinants of
demand function change.
 1.Increase in demand is a change in demand function that causes an increase
in quantity demanded at every price and is reflected by a rightward shift in the
demand curve.
 2.Decrease in demand is a change in demand function that causes an
decrease in quantity demanded at every price and is reflected by a leftward shift in
the demand curve.
 The Non Price Determinants of Demand
 1. Income - normal goods & inferior goods(mobile homes, used cars, generic
food products).
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 2. Tastes & Preferences – Journal of Medicine writes higher incidence of
cancer found among persons who regularly eat bacon
 3. The Price of Related Goods – Complements are cameras & films, lettuce &
salad dressing, baseball games & hotdogs. Substitutes are wheat & corn, beef &
pork.
 4. Expectations – Future prices (when auto industry announces price
increases of next year’s models), income, product availability.
 5. Population – Florida during tourist season has increase in demand.
 Changes in Demand Vs Changes in Quantity Demanded
 A change in one or more of the non-price determinants will lead to a change
in demand. This is a shift of the curve.
 A change in a good’s own price leads to a change in quantity demanded.
This is a movement along the same demand curve.
SUPPLY
 SUPPLY The various quantities of a good or service sellers are willing &
able to supply for sale at various prices during a specified period of time (week,
month, year) when all other nonprice determinants are held constant(input costs,
technology & productivity, taxes & subsidies, price expectations, number of firms
in the industry).
 Law of Supply The price of a product or service and the quantity supplied
are directly related.
 This law states that holding non-price factors constant the quantity of a good
or service that a supplier is willing to offer on the market relates directly to price.
 Take campus tutoring as an example. If you were offered a job in the
Economics Tutoring Center for $3/hour how many hours a week would you be
willing to work?
 How many hours would you be willing to work if the wage were $10/hr?
$20/hr?
 Supply Schedule is a table showing a list of possible product prices &
corresponding quantities supplied by all firms or producers.
 Market Supply Curve is a graph showing the relation between quantity
supplied & price charged when all other variables influencing quantity supplied are
held constant (input costs, technology & productivity, taxes & subsidies, price
expectations, number of firms in the industry).
 Market Supply Function for a product is a statement of the relation between
the aggregate quantity supplied and all determinants that affect this quantity(input
costs, technology & productivity, taxes & subsidies, price expectations, number of
firms in the industry ).
 Shift in Supply A rightward or leftward shift from one supply curve to
another supply curve when one or more of the non-price determinants of supply
change.
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 1. Increase in supply is a change in the supply function that causes an
increase in quantity supplied at every price and is reflected by a rightward shift in
the supply curve.
 2. Decrease in supply is a change in the supply function that causes a
decrease in quantity supplied at every price and is reflected by a leftward shift in
the supply curve.

 Non Price Determinants of Supply

 1. Cost of Inputs – labor, capital, raw materials.
 2. Technology & Productivity is society’s pool of knowledge regarding
industrial arts. New processes make it possible to produce commodities more
cheaply.
 3. Taxes & Subsidies.
 4. Price Expectations If firms expect price to increase in the future they may
withhold some of the good reducing supply in current period.
 5. Number of Firms in the Industry If number of firms increase more of a
good will be supplied at each price, e.g. supply of air travel between NY & Hong
Kong increased because more airlines begin servicing this route.
 When sellers leave a market supply decreases.
 Changes in Supply Vs Changes in Quantity Supplied
 A Change in one or more of the non-price determinants will lead to a change
in supply.
 This is a shift of the curve.
 A Change in a good’s own price leads to a change in quantity supplied. This
is a movement along the curve.
 Determination of Market Equilibrium
 In a free market economic system, price is determined by demand and
supply.
 If we superimpose the demand and supply curves developed in the earlier
analysis, we can determine a market equilibrium price and quantity.
 Competitive market equilibrium occurs when the quantity of the product
demanded equals the quantity supplied at a specified price.
 Equilibrium price is the price at which quantity demanded equals quantity
supplied and the quantity traded is called equilibrium quantity
 Shortage: A market situation in which the quantity demanded exceeds the
quantity supplied, at a price below the equilibrium level and will exert an upward
pressure on price.
 Surplus: A market situation in which the quantity supplied exceeds the
quantity demanded, at a price above the equilibrium level and will exert a
downward pressure on price.
 a)Find the equilibrium Price & Quantity
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 P=12.4-4Qd
 P=-2.6+2Qs
 b)Must actual price be equal to equilibrium price? Why or why not?
TEXT
 Demand and Supply: A First Look
 Market can be defined as a group of firms and individuals that are in touch
with each other in order to buy or sell some goods.
 The Demand Side of a Market
 See Figure 1.4
 The Demand Side of a market can be represented by a market demand
curve showing the amount of the commodity buyers would like to purchase at
various prices.
 Consider figure 1.4 which shows the demand curve for copper worldwide in
1990s. The figure shows:
 At $1 price quantity demanded is 11.7 million metric tons, at $1.10/lb price
11 million metric tons and at $1.20/lb price 10.3 million metric tons.
 Pertains to a particular period of time & shape & position depends on length
of period.
 Demand Curve for copper slopes downward to the right showing quantity of
copper demanded increases as price falls.
 This is true of demand curves of most commodities.
 They almost always slope to the right.
 Assuming of course the tastes, incomes, number of consumers and prices of
other commodities are held constant.
 Any change in one of these elements will shift the commodity’s demand
curve to the right or left.
 The Supply Side of a Market
 See Figure 1.5 shows the supply curve for copper worldwide in 1990s
based on estimates made informally by industry experts.
 The supply side of the market can be represented by a market supply curve
that shows the amount of commodity that sellers would offer at various prices.
 Lets continue with the case of copper’s worldwide supply curve in the 1990s.
 At $1/lb price, 9.5 million metric tons would be supplies per year, at price
$1.10/lb, 11 million metric tons and at price $1.20/lb, 12.5 million metric tons.
 Supply curve of copper slopes upward to the right because quantity of
copper supplied increases as the price increases since there is more incentive for
firms to produce copper & offer it for sale.
 Equilibrium Price
 See Figure 1.6

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 The two sides of a market, demand and supply, interact to determine the
price of a commodity.
 Putting demand and supply curves for copper together will help us
determine equilibrium price of copper.
 “Equilibrium price” is a price that can be maintained. Any price that is
not an equilibrium price cannot be maintained for long, since there are
fundamental factors at work to cause a change in price.
 Let’s see what would happen if various prices were established in the
market. At price $1.20/lb demand is 10.3 million metric tons supply 12.5 million
metric tons, there is a mismatch between the quantity supplied and the quantity
demanded per year.
 Supply > Demand. Excess supply of 2.2 million metric tons will have
inventory build up.
 Suppliers will cut prices to get rid of unwanted inventories & price of $1.20/lb
could not be maintained for long. So $1.20/lb is not an equilibrium price.
 At price $1.00/lb demand is 11.7 million metric tons supply is 9.5 million
metric tons.
 Again we find a mismatch between quantity Demand & Supply per year.
 Demand > Supply. Excess demand of 2.2 million metric tons will have
inventory shortage.
 Some consumers turned away empty handed.
 Given this shortage suppliers increase price and competition among
consumers will bid price up.
 Thus a price of $1/lb could not be maintained for long. So $1/lb is not an
equilibrium price.
 The equilibrium price must be the price where the quantity demanded
equals the quantity supplied and there is no mismatch and consequently the
only price that can be maintained for long.
 In the figure that price is $1.10/lb where quantity supplied equals the
quantity demanded. i.e. the point where demand curve intersects the supply curve
and equilibrium quantity demanded and supplied is 11 million metric tons.
 Actual Price
 The price we are really interested in is actual price which is the price that
actually prevails, not the equilibrium price.
 Economists simply assume that the actual price will approximate the
equilibrium price since the basic forces at work tend to push the actual price
toward equilibrium price assuming conditions remain fairly stable for a time.
 Managers need to know the direction in which a price will change.
 If actual price is $1.20/lb there is a downward pressure. If actual price is $
1.00/lb there will be upward pressure on price.

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 So long as the actual price is > than the equilibrium price, there will be a
downward pressure on price.
 Similarly so long as the actual price is less than the equilibrium price, there
will be an upward pressure on price.
 Thus there is always a tendency for the actual price to move toward the
equilibrium price.
 But this movement may not be fast.
 All that can be said safely is that the actual price will move toward the
equilibrium price.
 But of course this information is of great value, since frequently all that a
manager needs to know is the direction in which a price will change.
________________________________________________________________
Problem 1
 Suppose that the demand and supply functions for good X are
 Qd = 50 – 8P
 Qs = -17.5 + 10P
 a) What are the equilibrium price and quantity? b) What is the market
outcome if price is $2.75? What do you expect to happen and why? c)What is the
market outcome if price is $4.25? What do you expect to happen and why?d)
What happens to equilibrium price & quantity if the demand function becomes
Qd = 59 – 8P? e) What happens to equilibrium price and quantity if the supply
function becomes Qs = -40 + 10P ( Qd = 50 – 8P)?
Answer
a) At equilibrium Qd = Qs i.e quantity demanded is = quantity supplied. So 50-
8P=-17.5+10P or -10P-8P=-17.5-50 or -28P= -67.50 or P = $3.75. Market
Equilibrium point Qe is where Qd=Qs. Substitute the value of P=$3.75 in any one
of the values and you will get Qe=50- 8(3.75) = 20. so equilibrium price is $3.75
and equilibrium quantity is 20 units.
b) When P=$2.75, Qd = 50 – 8(2.75) = 28 and Qs=-17.5+10(2.75) = 10. There is a
shortage of 18 units. Due to excess demand consumers will bid up the price,
decreasing quantity demanded and increasing quantity supplied. Consumers will
bid up price until it reaches $3.75, the price at which Qd=Qs.
c) When P= $4.25, Qd= 16 and Qs = 25(calculate as shown in b) there is a
surplus of 9 units. Producers will lower price in order to avoid accumulating
unwanted inventories. The price will fall (reducing the excess supply) until
equlibrium is attained at a price of $3.75.
d) At equilibrium, 59 – 8P = -17.5 +10P; thus Pe=$4.25 & Qe=25.
e) At equilibrium, 50 – 8P = - 40 +10P; thus Pe=$5 & Qe=10.
Problem2
Fill in the blanks

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 1) During a year of operation, a firm earns total revenues of $175,000 and spends
$80,000 on raw materials, labor expense, utilities expense and rent expense. The
owners of the firm have provided $500,000 of their own money to the firm instead
of investing the money and earning a 14% annual rate of return.
a) The explicit costs of the firm are $___________ . The implicit costs are
$__________. Total economic cost is $_____________.
b) The firm earns economic profit of $__________. The firm’s normal
profit is $___________.
c) The firm’s accounting profit is $___________ .
d) If the firm’s total cost stay the same but its total revenue falls to
$____________, only a normal profit is earned.
e) If the owners could earn 20% annually on the money they have
invested in the firm, the economic profit of the firm would be $__________ when
total revenue is $175,000).
2) Over the next 3 years, a firm is expected to earn economic profits of $120,000
in the first year, $140,000 in the second year, & $100,000 in the third year. After
the end of the third year, the firm will go out of business.
a) If the risk-adjusted discount rate is 10% for each of the next 3 years, the value
of the firm is $__________. The firm can be sold today for a price of $________.
(check for present value tables in the appendix of the text book).
b) If the risk-adjusted discount rate is 8% for each of the next 3 years, the value of
the firm is $__________. The firm can be sold today for a price of $________.
(check for present value tables in the appendix of the text book).
3) a) Managers will maximize the values of firms by making decisions that
maximize ___________ in every single time period.
ANSWERS 1) a)$80,000; $70,000; $150,000. b) $25,000; $70,000. c) $95,000. d)
$150,000. e) -$5,000
2) a) $299,925; $299,925. b) $310,522; $310,522. 3) profit.
________________________________________________________________
Problem.3 The following relations describe demand and supply conditions in the
lumber products industry:
Qd = 40,000 – 10,000P (Demand)
Qs = -10,000 + 10,000P (Supply) where Q is quantity in thousands of
board feet and P is price in dollars. Set up a spreadsheet or table to illustrate the
effect of price(P) on the quantity supplied(Qs), quantity demanded(Qd), and the
resulting surplus(+) and shortage(-) as represented by the difference between the
Qs and Qd at various price levels. Calculate the value of each respective variable
based on a range for P from $1.00 to $3.50 in increments of 10 cents($1.00,
$1.10, $1.20…..$3.50)
Table
Surplus
Price Quantity Quantity (+)
Demanded Supplied Shortage (-)

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 $1 00 30,000 0 -30,000
$1.10 29,000 1,000 -28,000
$1.20 28,000 2,000 -26,000
$1.30 27,000 3,000 -24,000
$1.40 26,000 4,000 -22,000
$1.50 25,000 5,000 -20,000
$1.60 24,000 6,000 -18,000
$1.70 23,000 7,000 -16,000
$1.80 22,000 8,000 -14,000
$1.90 21,000 9,000 -12,000
$2.00 20,000 10,000 -10,000
$2.10 19,000 11,000 -8,000
$2.20 18,000 12,000 -6,000
$2.30 17,000 13,000 -4,000
$2.40 16,000 14,000 -2,000
EQUILIBRIUM PRICE &
EQUILIBRIUM $2.50 15,000 15,000 0 QUANTITY
$2.60 14,000 16,000 2,000
$2.70 13,000 17,000 4,000
$2.80 12,000 18,000 6,000
$2.90 11,000 19,000 8,000
$3.00 10,000 20,000 10,000
$3.10 9,000 21,000 12,000
$3.20 8,000 22,000 14,000
$3.30 7,000 23,000 16,000
$3.40 6,000 24,000 18,000
$3.50 5,000 25,000 20,000

Answer Equilibrium Price = $2.50 and Quantity(Qs=Qd) = 15,000

Determine the equilibrium price and quantity by using equations

Problem 4
If the market demand function is Qd = 340 -6P
and market supply function is Qs = 100+2P:
a) What is the equilibrium price? b)What is the equilibrium quantity?
ANSWERS
a)Qd=Qs or 340-6P=100+2P or -8P=-240 or P=$30
b) Qd = 340-6(30)=160 or Qs = 100+2(30)=160
-------------------------------------------------------------------------------------------------------------
Problem 5
If the demand and supply functions for widgets are Qd=100-16P and Qs=-35+20P
a) What is the equilibrium price ?
b) What is the equilibrium quantity?
c) What is the outcome if price is $2.75? What do you expect to happen? Why?
d) What is the outcome if price is $4.25? What do you expect to happen? Why?

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e) What happens to equilibrium price and quantity if the demand function changes
to Qd=118-16P?
f) What happens to equilibrium price and quantity if the supply function changes to
Qs=-80+20P while demand is Qd=100-16P?
Answers:
a)Equilibrium Price P=$3.75. (Qd= Qs or 100-16P =-35+20P)
b) Equilibrium Quantity Q=40.
c)When Price is $2.75 Qd=100-16(2.75)=56 & Qs=-35+20(2.75)=20. There is a
shortage of 36 units. Since there is excess demand, the price will be bid up by the
consumers, thereby decreasing quantity demanded and increasing quantity
supplied. The price will be bid up until it reaches $3.75. That is the price where
quantity demanded equals quantity supplied
d)If P=$4.25, Qd=100-16(4.25)=32 and Qs=-35+20(4.25)=50. There will be a
surplus of 18 units at this price. To avoid accumulating unwanted inventories
Suppliers will lower price and the price will fall thereby reducing the excess supply
until the equilibrium is attained at a price of $3.75.
e)At 118-16P=-35+20P, -36P=-153 or Equilibrium P=$4.25 & equilibrium Q=50.
f)At 100-16P=-80+20P, Equilibrium Price is -36P=-180=$5 & equilibrium Q=20.

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