Econ Prelim Week 3 and 4

MANAGERIAL ECONOMICS
BENEFITS ,COSTS AND

DECISIONS
• Objective:
• H ow t o u s e b e n e f i t c o s t a n a l y s i s n o t o n l y t o s p o t
m i s t a ke s but also to identify profitable decisions
t h a t s h o u l d h ave b e e n m a d e i n st ea d .
• Knowing h ow costs var y w i t h output allows

you to compute the c o s t s associated w i t h the
consequence of a decision that changes
output.
• Cost behavior analysis –refers to
m a n a g e m e n t ’s a t t e m p t t o u n d e r s t a n d h o w
operating c o s t s change in relation to a
c h a n g e i n a n o r g a ni z at i on’s l eve l o f a c t i v i t y.
These c o s t s may include dir ect materials,
dir ect labor, and overhead c o s t s that are
i n c u r r e d f r o m d eve l o p i n g a p r o d u c t .
Types of cost by
behavior
• 1. Fixed-remains constant regardless of a c t i v i t y level
• 2.variable cost- change propor tionatel y w i t h o u tpu t
• 3. mixed c o s t –are combination of both.
• Cost behavior i s af fected by a number of factor s,
including volume, price, ef ficiency, sales m i x and
production changes
NOTES
• Total Cost i s not quite the same as the total
ex p e n d i t u r e o f t h e f i r m . E x p e n d i t u r e a n d c o s t a r e
not equal because c o s t to an economist m u s t
include oppor tunity cost.
• Average Cost (AC) i s also called a unit c o s t that
• Is: AC=TC/quantity
• To deter mine MC, we m u s t kn ow w hat would happen

t o TC i f o u t p u t w e r e t o i n c r e a s e b y o n e u n i t .
• Once we kn ow a f i r m ’s TC, for i t s various output, we
can calculate i t s AC and MC
• The AC cur ve and MC cur ve are both shown to be
shaped roughly like letter U
quantity TC MC AC
0 0
1 210
2 270
3 306
4 360
5 425
6 516
7 700
Short –run profit

maximization
• Each f i r m tr i e s to maximize economic profit. Fir m
t h a t i g n o r e t h i s s t r a t e g y d o n o t s u r v i ve fo r long.
What are the costs?

1.Total Cost-summation of all the c o s t s or expenditures
incurred by the f i r m .
FC+VC= TC
2. Variable Cost-increases as the volume of production
increases. They can be varied quickl y to change the output
r at e . TC-FC=VC
3. Fixed Cost remains constant regardles of production.
TC-VC=FC
Graphical Illustration
• Total c o s t VC and FC chapter 3
How does the fir m use

these costs to
maximize economic
profit?
• The f i r m maximizes economic profit by finding the quantity at

w h i ch total revenue exceeds total c o s t by the greatest amount.
• To t al Reven ue =pri ce x q u a n t i t y
• I f TR>TC= profit
• I f TR<TC= loss
• I f TR=TC= n o r m a l p r o f i t /no l o s s n o p r o f i t
Graphical illustration
of TC and TR
• Output can be changed in the shor t run by

a d j u s t i n g v a r i a b l e r e s o u r c e s , b u t t h e size, o r
scale of the f i r m i s fixed in the shor t run.
• I n t h e l o n g r un, a l l r e s o u r c e s c a n b e vari ed.
Short run i s a period during w h i ch at least one of

a f i r m ’s r e s o u r c e s i s f i x e d
• Long run a period during w hi ch all resources
u n d e r t h e f i r m ’s c o n t r o l a r e vari a ble.
notes
• AFC gets smaller and smaller as output increases
because , w i t h TFC constant, AFC=TFC/quantity
h o w eve r AFC c a n n eve r r e a c h zero (0)
• AFC cur ve goes lower and lower as output increases
moving closer to the horizontal ax is but never
crossing it.
• Labor would not be considered a fixed c o s t unless

t h e c o m p a n y w o u l d ke e p t h e w o r ke r s o n p a y r o l l
regardless of whether the par t w a s produced
inter nally or exter nally.
seatwork
• Suppose that you are the manager of a candy
f a c t o r y. To p r o d u c e cand y, w h a t d o yo u need?
• You need to:

• -build a f a c t o r y o r r e n t
• -purchase ingredients
• -buy equipments
• -hir e e m p l o ye e s
• Suppose your factor y’s capital cost=1 million per

ye a r
• Employees hired = 50,000 each
• I n g r e d i e n t s cost= .50 p e r c a n d y b a r
• Assume you produce I,000 candy bars in a year,

a n d yo u n e e d t o h i r e 1 0 e m p l oyee s .
How much is your

production cost?
answer
• 1 million for your factor y
• 500,000 c o s t fo r e m p l oye e
• 500 for c o s t on ingredients
• P r o d u c t i o n c o s t o f 1,500,500.00
seatwork
• How much i s your total c o s t i f you produce 2,000
bar s?
• Identify your Fixed Cost and Variable Cost
• I l l u s t r a t e t h e d i f f e r e n t t y p e o f c o s t i n a g r aph.
The Marginal Analysis

• Marginal analysis i s used to answer the question,
“ s h o u l d I s e l l m o r e ” ? W her e m a r g i n a l a n a l y s i s
applies to both c o s t s and revenues.
What is the Marginal

Revenue?
Marginal Revenue
• MR i s the f i r m ’s change in Total Revenue fr om selling
an additional unit or
• MR i s the additional revenue gained fr om selling one
more unit.
• MR i s a l s o t h e m a r k e t p r i c e
What is Marginal Cost?

Marginal Cost
• MC i s the additional c o s t incur red by producing
a n d s e l l i n g o n e m o r e u ni t .
• MC i s the f i r m ’s change in Total c o s t f r om
p r o d u c i n g a d d i t i o n a l u n i t o f good.
What is the
relationship of MR and
MC?
• I f the benefit of selling another unit (MR) i s bigger

t h a n (MC) o r
• MR>MC then sell another unit
• I f MR> MC sell more

• MC> MR s e l l l e s s
• MR=MC you are selling the right amount; pr ofit i s
maximized
A d ve r t i s i n g MR MC Listeners P r of it
10,000 21 5.00 2,000 32,000
20,000 21 3,386 51,112
40,000 10.00 21 4,773 60,224
42,000 20.00 21 4,870 60,724
44,000 21.00 4,963 60,227
21 22.00
• What i s the best choice?

Golden rule of profit

maximization
• To maximize pr ofit or minimize loss, a f i r m should
p r o d u c e t h e q u a n t i t y a t w h i c h MR=MC. T his r u l e
holds tr ue for all m a r ke t str uctur es.
Take note
• Marginal analysis points you in the right direction
b u t i t d o e s n o t t e l l yo u h o w f a r t o go.
Graphical illustration
• page 126 to 127 Micr oeconmics by W illiam
M cEacher n
Sample seat wor k

Total Revenue 105,000.00
Less E xp l i ci t Cost
-assistant’s salar y 21,000
-material /equipt 20,000
EQUAL ACCTG. PROFIT 64,000
Less i m p l i c i t c o s t
-Lily’s forgone salar y 50,000
-forgone interest savings 1,000
-forgone garage rental 1,200
EQUALS ECONOMIC PROFIT 11,800.00
note
Therefore:
✓ Nor m al Profit i s where TR=TC for perfectl y
competitive m ar ke t
✓ Accounting Cost - I m p l i c i t Cost=Economic Profit
✓ Negative economic profit means that the f i r m i s earning less

than shareholders expect.
✓ The oppor tunity c o s t of an alter native i s w hat you give up to

pursue it.
• Fi r ms may show accounting pr ofit w hile

ex p e r i e n c i n g e c o n o m i c loss.
• Accounting profit i s higher than economic profit.

Sunk cost
• A c o s t that has already been incurred, cannot be
r e c ove r e d a n d t h u s i s i r r e l ev a n t fo r p r e s e n t a n d
future economic decisions.
Proverbs where sunk

cost is applied
• Let bygones be bygones
• Don’t c r y ove r a s p i l l e d m i l k
• All sunk c o s t s are fixed c o s t s but not all fixed

costs are sunk costs
Take note!
• T he o p p o s i t e o f s u n k c o s t i s i n ve s t m e n t
• The hidden c o s t fallacy occur s when you ignore

relevant costs.
• Ex. A c o m m o n h i d d e n c o s t f a l l a c y i s t o i g n o r e t h e
oppor tunity c o s t of capital when making investment or
shutdown decisions.
Economic Cost
• Economic c o s t includes both: accounting c o s t (explicit
c o s t ) and oppor tunity c o s t ( i m p l i c i t cost)
• E x p l i c i t c o s t s - a r e a c t u a l c a s h p a y m e n t s fo r r e s o u r c e s
• I m p l i c i t costs-are the oppor tunity c o s t of using resources
owned by the f i r m or provided by the f i r m ’s owner
• L i ke e x p l i c i t c o s t s , i m p l i c i t c o s t s a r e o p p o r t u n i t y c o s t .
• Unlike ex p l i c i t costs, i m p l i c i t c o s t s require no cash
payment and no entr y in the f i r m ’s accounting statement,
w h i c h r e c o r d s i t s r eve n u e s , e p l i c i t c o t s a n d a c c o u n t i n g
profit.
Production in the short

run
• Fixed resources –resources that can not be altered
easily
• Variable resources they can be changed qu ickl y to

change the output.
• When considering the t i m e required to change the

q u a n t i t y o f r e s o u r c e s e m p l oye d , s h o r t r u n o r l o n g r u n
are used to distinguish.
• Resources are priced and these are called costs:

• ATC or average total c o s t =TC/number of units produced
• AVC or average variable cost=TVC/number of units
produced
• AFC or Average Fixed cost= TFC/number of units
produced
The Law of Diminishing

Returns
• The l a w s t a t e s t h a t a s m o r e o f a v a r i a b l e
resource i s combined w i t h a given amount of
another fixed resource, Marginal Product
eventually eventually declines and could become
negative.
• Increasing Marginal Returns i s attained when

M ar ginal P r o d u c t i n c r e a s e s b r o u g h t a b o u t b y
increasing marginal retur ns f r om labor.
• Diminishing Marginal Returns- as more input i s

u s e d (labor) a n d a p p l i e d t o a f i x e d i n p u t (land) t h e
marginal product may decrease and finall y
become negative.
Total and Marginal

Product curves
• When Marginal retur ns increases, Marginal Product increases
• W ith Marginal Product increasing, Total Product increases
• Once Mar gina l Re t u r n s d e c r e a s e s , M ar gin al P r o d u c t d e cl i n e s .
• As long as Marginal Product i s positive, Total Product increases.
• Marginal Product =to the change in Total Product

t h at occur s w hen the use of a par ticular resource
increases by one unit all other resources
constant,
• MP=change in TP/change in input.

Costs in the short run

• How the c o s t of production varies as output varies:
the Fixed Cost and the Variable costs.
• Fixed c o s t s pays for fixed resources and Variable c o s t
for variable resources.
• I f o u t p u t i s zero, v a r i a b l e c o s t i s zero
• Marginal Cost i s the change in total Cost resulting fr om a

one unit change in output.
• MC= change in TC/change in Quantity of output
• The s l o p e o f t h e TC c u r v e a t e a c h r a t e o f o u t p u t e q u a l s t h e
Marginal Cost at the rate of output.
• Marginal c o s t indicates how much total c o s t increases i f one
more unit is produced or h ow much total cost drops if
production declines by one more unit.
• I t i s considered the key to economic decisions.
Some behaviors of
managers making bias
1 . O ve r con f i de nc e E f fe c t - i s a w e l l e s t a b l i s h e d b i a s
in w h i ch a person’s subjective confidence in his or
her judgements i s reliably greater than the objective
accur acy of those judgement especially when
confidence i s r elativel y high.
2. Loss Aversion refer s to people’s tendency to

p r e fe r avo i d i n g l o s s e s t o a c q u i r i n g e q u i v a l e n t gains.
I t i s better to not loss P100 than to find P100.
3. Confir mation Bias-it i s the tendency to search for,

i n t e r p r e t , f avo r a n d r e c a l l i n f o r m a t i o n i n a w a y t h a t
confi r ms or strengthens one’s prior personal beliefs
or hypothesis
4. Anchoring or Focalism Cognitive Bias where an

i n d i v i d u a l d e p e n d s t o o h e av i l y o n a n i n i t i a l p i e c e o f
infor mation offered when making decisions.
• 5. Endowment Ef fect- i s the finding that people

a r e m o r e l i ke l y t o r e t a i n a n o b j e c t t h e y o w n t h a n
acquire that same object when they do not own it.
What level of sales tax w i l l

result in unconsummated
transaction?
• Consumer surplus/ buyer surplus i s derived whenever
the price a consumer actually are prepared or willing
t o pay.
• I f the price offered to the consumer i s greater than
w hat he i s willing to pay, no transaction takes place
(unconsummated transaction)
• The choice of the level of t a x should move the price

a b ove w h a t t h e c o n s u m e r i s w i l l i n g t o p a y w i l l r e s u l t
in unconsummated transaction. This would mean that
the buyer i s no longer willing to buy because the price
becomes higher because of the percentage of sales
t a x that i s added. A high t a x would more l ikel y make
the consumer not willing to purchase.
• For example:
I f a consumer values a car at 40,000 and a

p r o d u c e r v a l u e s t h e s a m e c a r a t 30,000and
transaction i s completed at P34,000 .
choosing between 40% and 20% sales ,w hich
would r esult to unconsummated transaction?
• Say 40%
• Tax o n c o s t o f t h e car=40/100X P34,000=P13,600.
• Price +the sales tax=34,000+13,600= P47,600.00
• The final price(price +sales tax)=P47,600.00 w h ich i s
g reater than w h a t the consumer is willing to pay
P40,000 thus transaction w i l l not take place or
unconsummated
• i f you choose lower t a x say 15% w i l l i t be s t i l l

unconsummated? The answer i s NO.
• Tax on c o s t of the car=15/100X34,000=P5,100
• Price +sales tax=34,000+5,100= P39,100.00
• T he f i n a l p r i c e ( pr ic e + s a l e s tax)=P39, 1 0 0 . 0 0 i s l o w e r
than w hat the consumer i s willing to pay (40,000.00)
thus transaction took place or consummated.
• Take note:
• I f yo u b e g i n w i t h t h e c o s t , yo u w i l l a l w a y s g e t
confused; but i f you begin w i t h the decision, you
w i l l n eve r g e t c on f u sed .
What are incentives

• Incentives have to pieces
• 1. a w a y o f m e a s u r i n g p e r f o r m a n c e
• 2. compensation scheme to reward good ( or
p u n i s h bad) p e r fo r m a n c e .
What is a well
designed incentive?
• * employee incentives are aligned w i t h
o r g a n i z at i o n a l g o a l t h i s m e a n s t h a t e m p l oy e e s
have enough infor mation to make good and
incentive to do so.
Suggestions for better

decision;
• 1. Let someone make the decision, someone w i t h
b e t t e r i n f o r m a t i o n o r i n c e n t i ve
• 2. provide the decision maker enough infor mation
• 3. c h a n g e t h e d e c i s i o n m a ke r ’s i n c e n t i ve
Ratioanal –Actor
PARADIGM
• I t i s a model of behavior that w h i ch assumes that
p e o p l e a c t r at i o n a l l y, o p t i m a l l y a n d s e l f
interestedly, that i s they respond to incentives.
Examples of value
systems
• Deontologists-judge actions as good or ethical by
w h e t h e r t h e y c o n f o r m t o a s e t o f p r i n c i p l e s l i ke
Ten commandments or golden Rule.
• *they object on principle t o the pr actice of raising
prices in t i m e s of shortage.
• 2. consequentialists- judge actions by their

consequences. If the consequences of their
actions are good, then their actions i s deemed
good or moral.
• *they make rational calculations to make rational

ch o i c e s .
• * they are concerned about their sur vival,
p r o s p e r i t y o r s t r e n g t h a n d m a ke c a l c u l a t i o n s o n
the basis of these concer ns
• *they maximize the u t i l i t y of their decisions.

Econ Prelim Week 3 and 4

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Econ Prelim Week 3 and 4

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MANAGERIAL ECONOMICS

BENEFITS ,COSTS AND

• Knowing h ow costs var y w i t h output allows

• To deter mine MC, we m u s t kn ow w hat would happen

Short –run profit

What are the costs?

How does the fir m use

• The f i r m maximizes economic profit by finding the quantity at

• Output can be changed in the shor t run by

Short run i s a period during w h i ch at least one of

• Labor would not be considered a fixed c o s t unless

• You need to:

• Suppose your factor y’s capital cost=1 million per

• Assume you produce I,000 candy bars in a year,

How much is your

The Marginal Analysis

What is the Marginal

What is Marginal Cost?

• I f the benefit of selling another unit (MR) i s bigger

• I f MR> MC sell more

• What i s the best choice?

Golden rule of profit

Sample seat wor k

✓ Accounting Cost - I m p l i c i t Cost=Economic Profit

✓ Negative economic profit means that the f i r m i s earning less

✓ The oppor tunity c o s t of an alter native i s w hat you give up to

• Fi r ms may show accounting pr ofit w hile

• Accounting profit i s higher than economic profit.

Proverbs where sunk

• All sunk c o s t s are fixed c o s t s but not all fixed

• The hidden c o s t fallacy occur s when you ignore

Production in the short

• Variable resources they can be changed qu ickl y to

• When considering the t i m e required to change the

• Resources are priced and these are called costs:

The Law of Diminishing

• Increasing Marginal Returns i s attained when

• Diminishing Marginal Returns- as more input i s

Total and Marginal

• Marginal Product =to the change in Total Product

• MP=change in TP/change in input.

Costs in the short run

• Marginal Cost i s the change in total Cost resulting fr om a

2. Loss Aversion refer s to people’s tendency to

3. Confir mation Bias-it i s the tendency to search for,

4. Anchoring or Focalism Cognitive Bias where an

• 5. Endowment Ef fect- i s the finding that people

What level of sales tax w i l l

• The choice of the level of t a x should move the price

I f a consumer values a car at 40,000 and a

• i f you choose lower t a x say 15% w i l l i t be s t i l l

What are incentives

Suggestions for better

• 2. consequentialists- judge actions by their

• *they make rational calculations to make rational

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