Scarce Resources, Unlimited Wants: Economics

Acctg 1102 - Managerial Economics (Midterm)
MODULE 1 THE ECONOMIC PROBLEM: Scarce Resources,

Introduction to Basic Economics Unlimited Wants
• Economics is the study of how people use their

ECONOMICS is
scarce resources to satisfy their unlimited
greek word ‘economos’ which means the one who
wants.
manages the households.
• Economics is about making choices. The
❖ comes from two Greek words, 'eco' meaning problem is that wants or desires are virtually
home and 'nomos' meaning accounts unlimited while the resources available to
satisfy these wants are scarce.
• the ‘Study of allocation of scarce resources, o A resource is scarce when it is not
among alternative uses’. (Rao) freely available, when its price exceeds
• the social science that studies the behavior of zero. (when there is a value attached to
individuals, households, and organizations it)
(called economic actors, players, or agents), o Economics studies how people use
when they manage or use scarce resources, their scarce resources in an attempt to
which have alternative uses, to achieve desired satisfy their unlimited wants
ends. (Wikipedia)
SCARCITY
• a social science concerned with man’s problem
Scarcity occurs when the amount of people’s desire
of using scarce resources to satisfy human
exceeds the amount available at a price of zero.
wants. (Pagoso, et al)
• the study of people and choices o Goods and services that are truly free are not
the subject matter of economics.
❖ the famous economist, Alfred Marsh, defined ▪ Without scarcity, there would be no
economics as ‘A study of man in the ordinary economic problem and no need for
business of life’. prices.
o It inquires how he gets his income and o the tension between infinite wants and finite
resources.
how he uses it.
o Thus, it is on the one side, the study of 1. Resources are always scarce.
2. They are not only scarce, but also have
wealth and on the other and more
alternative uses
important side, a part of the study of 3. Optimum allocation is required.
4. It is about making of choices or decision-
man.
making.
❖ Allocation problems are faced by individuals,

organizations (Both profit making and non-
profit making) and nations also.
ECONOMICS DEALS WITH: Resources are divided into four categories:
1. How an individual consumer allocates his 1. Labor - the physical and mental effort used to
scarce resources among alternative uses? produce goods and services.
- in such a way that he always tries to get
2. Capital:
maximum satisfaction
- maximization of satisfaction/utility is the • Physical capital: Manufactured items (tools,
goal of an individual consumer. buildings) used to produce goods and services.
2. Similarly, an individual producer aims at least • Human capital: Knowledge and skills people
cost combination of inputs to get a given acquire to increase their labor productivity.
quantities of output.
3. Natural resources – all “gifts of nature” used to
o Efficiency. Getting more out of less.
produce goods and services; which includes bodies of
o Inputs – raw materials that are put into
water, trees, oil reserves, minerals, and animals.
process to develop a certain product or
service (output). • These can be renewable or exhaustible.
3. How an individual firm/Industry attains
4. Entrepreneurial ability – managerial and
equilibrium.
organizational skills needed to start a firm. The talent,
o A firm is said to be an equilibrium, if it
combined with the willingness to take risk of profit or
attain profit maximizing level of output.
loss. (could be innate or learn)
It tries to maximize Revenue, or
minimize Cost. • Entrepreneur – a profit-seeking decision maker
o Equilibrium = in the state of balance, a who starts with an idea, organizes an enterprise
point where buyers and sellers are to bring the idea to life, and assumes the risk of
equally satisfied. the operation.
4. How a country reach equilibrium: o An individual who decides to combine
o “Allocating limited resources in such a resources and produce.
way that the desired goals are PAYMENTS FOR RESOURCES

reached”. – The goal may be over all
• Wages – payment to resource owners for their
welfare of its people. (what is the
labor.
greater good)
• Interest - payment to resource owners for the
❖ Individuals/organizations (profit/non profit)
use of their capital.
/nations attain their goals, by optimum use of
• Rent - payment to resource owners for the use
limited resources.
of their natural resources.
RESOURCES • Profit – reward for entrepreneurial ability; sales
Resources: The inputs, or factors of production, used to revenue minus resource cost.
produce the goods and services that humans want. (sales revenue – resource cost)
GOODS AND SERVICES MARKETS
Resources are combined to produce goods and services. Market is a set of arrangements by which buyers and
sellers carry out exchange of mutually agreeable terms.
Good – a tangible product used to satisfy human wants.
The means by which buyers and sellers carry out
• A good is something we can see, feel, and touch
exchanges in markets.
(i.e., corn).
o It requires scarce resources to produce and is o Bring together buyers and sellers
used to satisfy human wants. o Determine price and quantity
Service – an activity, or intangible product, used to Product market – a market where goods and services
satisfy human wants. are sold or exchanged.
o A service is not tangible but requires scarce Resource market – a market in which a resource is
resources to produce and satisfies human bought and sold.
wants (i.e., haircut).
o Labor, capital, natural resources, and
entrepreneurial ability are exchanged in
ECONOMIC DECISION MAKERS resource markets.
There are four types of decision makers: THE MARKET

A market is a means of interactions between buyers and
1. Households (consumers)
sellers for trading or exchange.
2. Firms – the one producing goods and services
3. Governments – regulates, part of the system, The most common types of market:
provides service
1. goods market
4. The rest of the world
- Wet market
❖ Their interaction determines how an - Dry market
economy’s resources are allocated.
2. labor market – where workers offer their services,
and employers look for workers to hire
HOUSEHOLDS 3. stock market – where commodities traded consist of
• Consumers - Demand goods and services securities of corporations
• Resource owners - Supply resources o Philippine stock exchange – the one who
FIRMS, GOVERNMENTS, REST OF THE WORLD operates the stock market in the country.
• Demand resources A SIMPLE CIRCULAR-FLOW MODEL
• Produce goods and services Circular-flow model – a diagram that traces the flow of
resources, product income, and revenue among
economic decision makers.
• Flow of Rational Self-interest: Individuals try to maximize the

o Resources expected benefit achieved with a given cost or
o Products
maximize the expected cost of achieving a given
o Income
o Revenue benefit.
❖ Among economic decision makers
• Individuals are rational
• Interaction
o Make the best choice
o Households
o Firms o Given the available information
o Maximize expected benefit
▪ With a given cost
o Minimize expected cost
▪ For a given benefit
• The lower the personal cost of helping others,
the more help we offer
CHOICE REQUIRES TIME AND INFORMATION

Time and information are scarce and therefore
valuable.
ECONOMIC MODEL PRODUCTION
• Time and information – scarce; valuable
Rational decision makers acquire information as long as

the expected additional benefit from the information is
greater than its expected additional cost.
• Rational decision makers

o Willing to pay for information
• Improve choices
• Acquire information
o Additional benefit expected exceeds
the additional cost
RATIONAL SELF-INTEREST
o Economics assumes that individuals, in making ECONOMIC ANALYSIS IS MARGINAL ANALYSIS

choices, rationally select alternatives they Economic choice is based on a comparison of the
perceive to be in their best interests. expected marginal cost and the expected marginal
benefit of the action under consideration.
Rational refers to people trying to make the best
choices they can, given the available information. o Marginal means incremental, additional, or
extra.
o People try to minimize the expected cost of
achieving a given benefit or to maximize the
expected benefit achieved with a given cost.
A rational decision maker changes the status quo if the THE SCIENTIFIC METHOD
expected marginal benefit is greater than the expected
A process of theoretical investigation called scientific
marginal cost.
method consists of four steps:
(expected marginal benefit > expected marginal cost)
1. Identify the question and define relevant variables
2. Specify assumptions
MICROECONOMICS and MACROECONOMICS
• Other-things-constant assumption – when
Microeconomics: The study of economic behavior in
particular markets, such as that for computers or focusing on the relation among key economic
unskilled labor.
variables, that other variables remain
o the study of how consumers, workers, and
unchanged; in Latin, ceteris paribus.
firms interact to generate outcomes in specific
• Behavioral assumption – describes the
markets
expected behavior of economic decision
• Individual economic choices
makers – what motivates them.
• Markets coordinate the choices of
economic decision makers
3. Formulate the hypothesis
• Individual pieces of the puzzle
Macroeconomics: The study of the economic behavior • Hypothesis – a theory about how key variables
of entire economies
relate to each other (educated guess)
o the study of production, employment, prices,
• Variable – a measure, such as price or quantity,
and policies on a nationwide scale.
that can take on values at different times
• Performance of the economy as a whole
• Big picture 4. Test the hypothesis – evidence
Benigno Aquino & Gloria Arroyo - Economist
THE SCIENTIFIC METHOD: Step by Step
THE ROLE OF THEORY

An economic theory is a simplification of reality used to
make predictions about cause and effect in the real
world.
• An economic theory captures the important

elements of the problem under study.
❖ Economic theory/model NORMATIVE VERSUS POSITIVE
o Simplification of economic reality A positive economic statement concerns what is; it can
o Important elements of the problem be supported or rejected by reference to facts.
o Make predictions about the real world
• Assertion about economic reality
❖ Good theory
• Supported or rejected by evidence
o Guide • True or false
• ‘What is’
o Sort, save, understand information
A normative economic statement concerns what • The mistake of ignoring secondary effects:
should be; it reflects an opinion and cannot be shown (unintended consequences of policy)
to be true or false by reference to the facts. o Unintended consequences
(prescriptive in nature) o Train Law
• Opinion IF ECONOMIST ARE SO SMART,

• ‘What should be’
• Subjective WHY AREN’T THEY RICH?
• Prescriptive
GOALS OF A BUSINESS FIRM
PREDICTING AVERAGE BEHAVIOR SINGLE GOAL OR MULTIPLE OF GOALS

The task of an economic theory is to predict the impact
1. PROFIT MAXIMIZATION - Revenue maximization,
of an economic event on economic choices and, in turn,
Cost minimization. (maximize input to produce more
the effect of these choices on particular markets or on
output to maximize profit)
the economy as a whole.
2. WEALTH MAXIMIZATION - Value maximization.
• Economists focus on the average, or typical,
THE DEFINITION AND SCOPE OF MANAGERIAL
behavior of people in groups.
ECONOMICS
❖ Individual behavior WHAT IS MANAGERIAL ECONOMICS?

• Difficult to predict
• Random actions of individuals
1. “Managerial Economics is economics applied in
o Offset one another
decision making. It is a special branch of economics
❖ Average behavior of groups
bridging the gap between abstract theory and
• Predicted more accurately
managerial practice.”
PITFALLS OF FAULTY ECONOMIC ANALYSIS
2. “Managerial economics is the study of the allocation
• The fallacy that association is causation: The of scarce resources available to a firm or other unit of
fact that one event precedes another or that management among the activities of that unit” –
two events occur simultaneously does not Willian Warren Haynes, V.L. Mote, Samuel Paul
mean that one caused the other.
“It is the application of economic analysis to business
o Event A caused event B – associated in
problems; it has its origin in theoretical
time
microeconomics.” – Howard Davies and Pun-Lee Lam
• The fallacy of composition: The incorrect belief
that what is true for the individual, or the part, “Integration of economic theory with business practice
is true for the group, or the whole. for the purpose of facilitating decision-making and
o What is true for the individual is true forward planning” – Milton H. Spencer
for the group

“Price theory in the service of business executives is • The predictions are supported by the empirical
known as Managerial economics” – Donald Stevenson evidence
Watson
THESE DEFINITIONS COVER A NUMBER OF

THE USE OF ECONOMIC MODELS
DIFFERENT APPROACHES
POSITIVE ECONOMICS:
1. Analysis based on the theory of the firm
2. Analysis based upon management sciences Derives useful theories with testable propositions about
WHAT IS.
3. Analysis based upon industrial economics
❖ Related to, but not the same as management NORMATIVE ECONOMICS:
science and industrial economics.
Provides the basis for value judgments on economic
outcomes. WHAT SHOULD BE?
THE PROCESS OF MODEL-BUILDING MANAGERIAL ECONOMICS
• The economics ‘method’ • Economics in general takes a ‘positive’ and

- ‘illicit relationships with beautiful models’ predictive approach not prescriptive or
• The steps: the hypothetical-deductive ‘normative’
approach - trying to explain “what is” not what “should
- make assumptions about behaviour be”
- work out the consequences of those - the main objective is to understand how a
assumptions market economy works
- make predictions • Not very concerned about the descriptive
- test the predictions against the evidence realism of assumptions: “I assume X” does not
- PREDICTIONS SUPPORTED? The model is mean “I believe X to be true”
accepted as a good explanation (for the • Some real tension if the models are used for
moment) prescription
- PREDICTIONS REFUTED? Go back and re- - assume “perfect knowledge”: OK for
work the whole process model-building
Reference: Managerial Economics -- Howard Davies and Pun-Lee - cannot say to a manager: “behave AS IF you
Lam had perfect knowledge”
WHAT IS A “GOOD” MODEL? ECONOMIC ANALYSIS
• It allows us to make predictions and set • Comparative Statics

hypotheses o begin with an initial equilibrium
• The predictions can be tested against the position - the starting point
empirical evidence o change something
o identify the new equilibrium, e.g: in o for instance, the firm may be assumed
neo-classical model of the firm to behave “as if” its managers had
▪ When demand increases? perfect knowledge of its environment
▪ When costs rise?
• If the aim is to produce decision-rules which
▪ When a fixed cost increases?
o This is the main purpose of the model - can be applied by practising managers,
what it was designed to do unrealistic assumptions will produce decision-
• Normative prescriptions rules which are not operational
o it will cost me $30 per unit to supply o for instance, set output and price by
something which will give me $20 per MC=MR (marginal cost = marginal
unit in revenue – should I do it? – I must revenue)
pay $20 billion to set up in my industry.
HOW CAN MANAGERIAL ECONOMICS ASSIST
Should I charge higher prices to get
DECISION-MAKING?
that money back?
• Positive and normative are linked by “if?” 1. Adopt a general perspective, not a sample of one
o IF the aim of the firm is to maximise 2. Simple models provide stepping stone to more
complexity and realism
profit what will it do/what should it do?
3. Thinking logically has value itself and can expose
WHAT IS THE PURPOSE OF ECONOMIC ANALYSIS? sloppy thinking
WHY DO WE WANT TO APPLY ECONOMIC ANALYSIS TO

WHY MANAGERIAL ECONOMICS?
BUSINESS PROBLEMS?
• A powerful “analytical engine”.

For the academic economist: to understand, to make
predictions about firm’s behavior • A broader perspective on the firm.
o what is a firm?
o The “positive” approach to theory: What is? o what are the firm’s overall objectives?
o what pressures drive the firm towards
For the businessperson: “to assist decision-making”, to profit and away from profit
• The basis for some of the more rigorous
provide decision-rules which can be applied
analysis of issues in Marketing and Strategic
Management.
o The “normative” approach to theory: What
LINKS BETWEEN MANAGERIAL ECONOMICS
should be?
AND INDUSTRIAL ECONOMICS
❖ These purposes are different, they can lead to o In managerial economics, the emphasis is upon
misunderstanding, and economists are not the firm, the environment in which the firm
always honest about the limitations of their finds itself, and the decisions which individual
approach for practical purposes. firms have to take.
o In industrial economics (or industrial
WHAT ARE THESE LIMITATIONS?
organization), the emphasis is (or was) upon
• If the aim is prediction, unrealistic assumptions
are acceptable and may be needed;
the behavior of the whole industry, in which the Conduct: the behavior of firms in the market, e.g.
firm is simply a component. pricing behavior advertising, innovation.
Performance: a judgment about the results of

market behavior, e.g. efficiency, profitability,
WHAT IS INDUSTRIAL ORGANIZATION?
fairness/income distribution, economic growth.
o It studies how the performance of an industry
How can the government improve the performance
is related to its structure, that is, to the number
in an industry?
and size of firms it contains.
o It is the study of markets for goods and of the
firms which produce them.
o It is the study of industry.
o It is more concerned with why markets
are structured the way they are and
behave the way they do.
Question Asked In Industrial Organization:

LINKS BETWEEN MANAGERIAL ECONOMICS
o Why are some markets monopoly-like while AND MANAGEMENT SCIENCE
others are competitive?
MANAGERIAL ECONOMICS: is often concerned with
o How can industry performance and structure
finding optimal solutions to decision problems.
be measured or analyzed?
o How does the performance of individual firms o However, the primary purpose of using models
affect the structure and performance of the is to predict how firms will behave, not to
industry in which they operate? advise them what ought to do.
o If industry performance seems deficient but o Managers are assumed to find the optimal
remediable, which government policies are solutions for themselves and that is how
likely to help more than they cost? predictions are made
THE STRUCTURE-CONDUCT-PERFORMANCE MANAGEMENT SCIENCE: is essentially concerned with

PARADIGM: techniques for the improvement of decision-making
and hence it is essentially normative; firms are not
Basic Conditions: factors which shape the market of
assumed to find the optimal solutions for themselves.
the industry, e.g. demand, supply, political factors
o They are found by the researchers who then
Structure: attributes which give definition to the
present them as prescriptions for what the firm
supply-side of the market, e.g. economies of scale,
should do
barriers to entry, industry concentration, product
differentiation, vertical integration. 1. Managerial economics is the application of economic
theory (particularly microeconomic theory) to practical
problem solving.
2. Managerial economics can be used to make better

management decisions.
3. Managerial economics pertains to decision making

about the optimal allocation of scare resources to
competing activities both the private & public sectors.
4. Managerial economics incorporates elements of both

micro and macro economics. It uses both descriptive
and prescriptive models and the analytical tools of
mathematical economics and econometrics
(prescriptive models).
❖ The rapid internationalization of the

marketplace makes the decision-making tools
of managerial economics more valuable than
ever.
MODULE 2 Problem: Over-Bidding Ovi Gas Tract

Introduction: What This Book is About A young geologist was preparing a bid recommendation
for an oil tract in the Gulf of Mexico.
SUMMARY OF MAIN POINTS

o The geologist knew the productivity of nearby
Problem solving requires two steps: tracts also owned by the company.
o Knowing this, he recommended a bid
1) figure out what’s causing the problem
of $5 million.
2) figure out how to fix it
o Senior management bid $20 million –
• For both steps, predict how people behave
far over the next highest bid of
• rational-actor paradigm: assumes that people
$750,000.
act rationally, optimally, and self-interestedly.
What, if anything, is wrong?
• Simply put, people respond to incentives.
o is a set of external (rather than Problem Solving
intrinsic) motivators that explain
people's choices. o The goal of this text is to provide tools to help
identify and solve problems like this.
❖ Good incentives come from rewarding good
Two distinct steps:
performance.
o Ex: commission on sales 1) Figure out what’s wrong
• A well-designed organization aligns employee • i.e., why overbidding occurred

incentives with organizational goals. 2) Figure out how to fix it
o Specifically, employees have enough
information to make good decisions, MODEL OF BEHAVIOR
and the incentive to do so. • Both steps require a model of behavior
Three questions to find the source of the problem: o Why are people making mistakes?
o What can we do to make them change?
1) Who is making the bad decision?
• Economists use the rational-actor paradigm to
2) Does the decision maker have enough information to
make a good decision? model behavior.
3) Does the decision maker have the incentive to make • The rational actor paradigm states:
a good decision? o People act rationally, optimally, self-
Answers to these questions will suggest solutions: interestedly
1) Letting someone with better information or o Meaning, they respond to incentives – to
incentives make the decision change behavior you must change
2) Giving the decision maker more information incentives.
3) Changing the decision maker’s incentives.
Answer the three questions: Problem-Solving Algorithm
1) Senior management made the bad decision to 1) Who is making the bad decision?
overbid.
o The mechanic recommended unnecessary
2) They had enough information to make the right repairs.
decision.
2) Does the decision maker have enough information
3) They didn’t have the incentive to do so. to make a good decision?
A bonus system created incentives to over-bid. o Yes, in fact, the mechanic is the only one
with enough information to know whether
• Senior managers were rewarded for acquiring repairs are necessary.
reserves regardless of their profitability. 3) Does the decision maker have the incentive to make
• They had the young geologist “do what he a good decision?
could” to increase the size of estimated
o No, the mechanic is evaluated based on the
reserves. amount of repair work he does, and receives
bonuses or commissions tied to the amount of
• Bonuses also created an incentive to
repair work.
manipulate the reserve estimate
NAR Solution
Solution to Overbidding Problem
There was an incentive issue
Now that we know what is wrong, how do we fix it?
o NAR tried two solutions
• Let someone else decide? NO
• Change information flow? NO 1) reorganized into two division – led to colluding
• Change incentives? YES
o Collusion – backdoor agreement
❖ Change performance evaluation metric
o non-competitive, secret, and
• Ex: Increased profitability as
sometimes illegal agreement between
measurement of success instead of
rivals which attempts to disrupt the
increased acquired reserves
market's equilibrium
❖ Reward scheme
o conspire to work together to gain an
• Ex: Make bonuses tied to profitability,
unfair market advantage.
not acquired reserves
2) adopted flat pay (fixed pay) – led to less incentive to
NAR Problem work hard
In 2006, a TV reporter was sent into a National Auto o Suggested resolution: add an additional
Repair (NAR) shop with a perfectly good car performance evaluation metric to original
commission scheme
o The reporter came out with a new muffler and
▪ Ex: Sporadically send in “secret
transmission – and a bill for over $8,000
shoppers” like the news reporter
o The news story badly hurt NAR’s profits
❖ This shows the trade-offs you face when
How do you solve this problem? creating solutions (one thing increases, and
another must decrease)
ETHICS AND ECONOMICS
• The rational-actor paradigm can make students

uncomfortable
o It seems to disregard personal ethics the
guide behavior.
• You have to understand why unethical behavior
occurs to fix it though
o Be able to anticipate opportunistic behavior
to know how to avoid it
o In a business, the goal is to maximize profit
o Sometimes, interest and greed
comes in. People tend to resort to
opportunistic or unethical
behavior.
o We have certain legal policies that
are deemed unethical or
sometimes not acceptable to the
social standard (norms).
VALUE SYSTEM
• Debates about ethics and economics really are

about different value systems
Two different value system:
• Deontologists: actions are good or ethical if

they conform to a set of principles (ex: The
Golden Rule)
o Deviation with the ethical behaviour,
social norms and standard that’s not
acceptable.
• Consequentialists: actions are judged based on
whether they lead to a good consequence
o Whatever it takes as long as it would
lead to a better result
• Economics is more consequentialist
o Uses analysis to understand the
consequences of different solutions
MODULE 2 Apartments
The One Lesson of Business
Suppose you want to move from Detroit to Nashville.
First, you would try a two-way trade. Failing that, you’d
o Voluntary transactions create wealth by
try a three-way connection with another city.
moving assets from lower- to higher-valued
uses. o Need to find correct trades with correct timing
• Anything that impedes the movement = difficult!
of assets to higher-valued uses, like o Like with kidney transplants, compatibility
taxes, subsidies, or price controls, problems lead to inefficiency.
destroys wealth. CAPITALISM 101

o Economic analysis is useful to business for
To identify money-making opportunities, you must first
identifying assets in lower-valued uses.
understand how wealth is created (and sometimes
• The art of business consists of
destroyed).
identifying assets in low-valued uses
and devising ways to profitably move • Key note: Wealth is created when assets are
them to higher-valued ones. moved from lower to higher-valued uses
o A company can be thought of as a series of • Value = willingness to pay
transactions.
Desire + Income = you want something + you can pay
• A well-designed organization rewards
for it
employees who identify and
consummate profitable transactions or • Key note: Voluntary transactions, between
who stop unprofitable ones. individuals or firms, create wealth.

o Meaning, people create wealth by
pursuing self-interest.
Kidney Transplants
o There’s healthy movement of asset
Two prominent hospitals recently refused patients for from one place to another
kidney transplants because the organs were from o As they say, a country is judge to be
“directed donations.” productive if the interaction and
production in markets are good.
o The kidneys were meant for specific people
• Example: Barter
Demand for organs is high – far exceeding supply – and
many never receive them.
Despite high demand and low supply, buying and selling

organs is illegal. Why?
Housing Example Discussion: How do you create wealth?
A house is for sale: Do Mergers Create Wealth?
The buyer values the house at $130,000 Do mergers follow the wealth-creating engine of
o This is the buyer’s top dollar – willingness to pay capitalism? Do they move assets to a higher-valued
The seller values the house at $120,000 use?
o This is the seller’s bottom line – won’t accept o Our largest and most valuable assets are
less
corporations.
The buyer and seller must agree to a price that “splits”
o Merger - there is an accounting entity, there is
surplus between buyer and seller. Here, $128,000.
a surviving entity
SURPLUS o Example: A acquired B, the surviving
company is A. The resulting company is
The buyer and seller both benefit from this transaction:
A.
BUYER SURPLUS = buyer’s value minus the price
o For business consolidation: A and B. The
(market equilibrium) resulting company is C.
$130,000 - $128,000 = $2,000 buyer surplus

Ex: Dell-Alienware merger:
SELLER SURPLUS = the agreed-on price minus the

In 2006, Dell purchased Alienware, a manufacturer of
seller’s value
high-end gaming computers.
$128,000 - $120,000 = $8,000 seller surplus

o Dell left design, marketing, sales and support in
TOTAL SURPLUS = buyer + seller surplus = difference in Alienware’s hands.
values o Dell took over manufacturing though, using its

expertise to build Alienware’s computers at a
$2,000 + $8,000 = $10,000 --> $130,000 - $120,000 =
much lower cost
$10,000
$10,000 are the gains from trade o However, many mergers and acquisitions do
not create value
Wealth-Creating Transactions
o If they do, value creation is rarely so
Which assets do these transactions move to higher-
clear
valued uses?
o To create value, the assets of the acquired firm
o Factory Owners must be more valuable to the buyer than to the

o Real Estate Agents seller
o Insurance Salesman
o Corporate Raiders
o Investment Bankers
Discussion: How does eBay create wealth?
Discussion: Which individual has created the most
wealth during your lifetime?
Does Government Create Wealth? o Business person’s solution is to try to make

money on the inefficiency
What’s the government’s role is wealth creation?
The One Lesson of Business
o Enforcing property rights and contracts legal
tools that facilitate wealth creating transactions Inefficiency implies the existence of unconsummated,
o Ensures that buyers and sellers keep gains from wealth-creating transactions
trade
The One Lesson of Business: The art of business consists
o Key important role of the government: enforce
of identifying assets in lower valued uses and devising
existing laws, rules, and regulation.
ways to profitably moving them to higher valued uses.
o To intervene
o In other words, make money by identifying
Why are some countries so poor?
unconsummated wealth-creating transactions
o No property rights and devise ways to profitably consummate
o No rule of law
them.
Much of the justification for government intervention
Destroying Wealth
comes from the assertion that markets have failed.
Anything that stops assets from moving to higher
o One money manager scoffed at this idea.
valued uses is destroying wealth.
o “The markets are working fine, but they’re
giving people answers that they don’t like, so • Taxes Destroy Wealth:
people cry market failure.” o By deterring wealth-creating
transactions – when the tax is larger
The One Lesson of Economics
than the surplus for a transaction.
An economy is efficient if all assets are employed in
o Taxes – defined by law as the lifeblood
their highest-valued assets.
of our economy
• This is an unattainable, but useful benchmark • Subsidies Destroy Wealth:

o Example: flood insurance encourages
The One Lesson of Economics: The art of economics
people to build in areas that they
consists in looking not merely at the immediate but at
otherwise wouldn’t
the longer effects of any act or policy; it consists in
o A subsidy is a government payment
tracing the consequences of that policy not merely for
given to individuals or businesses
one group but for all groups. – Henry Hazlitt
designed to offset cost to advance a
o Must look at the intended and unintended specific public goal.
effects of policies to understand their efficiency o Economists argue that any form of
o The economist’s solution to inefficient government assistance distorts the
outcomes is to argue for a change in public market, resulting in unintended
policy. consequences.
• Price Controls Destroy Wealth: • They buy raw materials (capital, labor, etc.) and
o Example: rent control (price ceiling) in create and sell higher-valued goods and
New York City deters transactions services
between owners and renters • Can equate market-level problems (taxes,
o Government could set the legal subsidies and price controls) with organization-
minimum amount and maximum level goal alignment problems
amount. o Ex: The overbidding from the oil
o Department of Trade and Industry company = “subsidy” paid to
Which assets end up in lower-valued uses? management for acquiring oil reserves
• Allows us to use the same analysis
Price ceiling – When the government sets a maximum
price for a specific goods or services
Stossel on Vanderbilt's GREED
- The lower the price celling, the more the
deadweight loss and inefficiency
- Only has an effect on the market when it’s Vanderbilt got so rich by pleasing lots of people.
below the equilibrium price
o He did that by making travel and shipping
Price floor – is a law that sets a minimum price in a cheaper
specific market • He used bigger and faster ships
• Served food on board
- The idea is to help by keeping the price
artificially high and not allowing the price to o All this lowered his cost so much that he caught
fall down equilibrium the New York to Hartford fare from $8 to $ 1
Rockefeller got rich selling oil.

Profiting from Inefficiency
Taxes create a profit opportunity o Competitors and the government called him a
monopolist
o Discussion: 1983 Sweden tax
o He had to persuade people by offering oil for a
Subsidies create opportunity
lesser price
o Discussion: health insurance
• Working-class people could now afford
Price-controls create opportunity
fuel for their lanterns
o Discussion: Regulation Q. & euro dollars
o Discussion: What about ethics?
❖ Their greed did more than make them rich. It
gave the rest of us good things.
Wealth Creation in Organizations
Companies = a collection of transactions

MODULE 3 The hidden-cost fallacy occurs when you ignore

Benefits, Costs, and Decisions relevant costs.
❖ Rational economics decisions require the
o A common hidden-cost fallacy is to ignore the
evaluation of costs and benefits
opportunity cost of capital when making
- Significantly depend on different
investment or shutdown decisions.
alternatives.
EVA® is a measure of financial performance that makes
Costs are associated with decisions, not activities.
visible the hidden cost of capital.
• The opportunity cost of an alternative is the
o Rewarding managers for increasing economic
profit you give up to pursue it.
profit increases profitability, but evidence
• OPPORTUNITY COST is whatever you give up to
suggests that economic performance plans
do something. (value of the next best alt.)
work no better than traditional incentive
calculating the total opportunity cost is: what you pay + compensation schemes based on accounting
what you give up = total measures
In computing costs and benefits, consider all costs and Big Coal Power Company
benefits that vary with the consequences of a decision
Big Coal Power Co. switched to an 8400 coal when the
and only those costs and benefits that vary with the
price fell 5% below the price of 8800 coal
consequences of the decision.
o 8400 coal generates 5% less power than 8800
o These are the relevant costs and benefits of a
o The manager was compensated based on the
decision.
average cost of electricity, and expected this
Fixed costs do not vary with the amount of output. move to save money
o Instead – company profit reduced
• Regardless whether you produce or not these
costs are being incurred Why? What happened?
Big Coal Solution
Variable costs change as output changes.
Use our three questions for analysis
o Decisions that change output will change only
variable costs. 1) Who is making the bad decision?
Accounting profit does not necessarily correspond to • The plant manager made the switch to the
real or economic profit. lower-priced 8400 coal.
The fixed-cost fallacy or sunk-cost fallacy means that 2) Did he have enough information to make a good
you consider irrelevant costs. decision?
o A common fixed-cost fallacy is to let overhead • Yes, presumably he knew that this would reduce
or depreciation costs influence short-run his output.
decisions.
3) Did he have the incentive to make a good decision? o Payments to your accountants to prepare your
tax returns. (fixed)
• No, because he was evaluated based on the o Electricity to run the candy making machines.
(variable)
average cost of electricity produced at his plant. o Fees to design the packaging of your candy bar.
(fixed)
Lesson From Coal Problem o Costs of material for packaging. (variable,
depends on the no. of production and materials
• The plant manager should have considered all to be used)
the costs of switching to the lower Btu coal
o Namely, the lost electricity Real Example: Cadbury (Bombay)
• Average costs can be a poor measure of plant Beginning in 1978, Cadbury offered managers’ free
performance housing in company owned flats to offset the high cost
• Need to align incentives of a business unit with of living. (stay in)
the goals of the parent company
o In 1991, Cadbury added low-interest housing
Background: Types of Costs loans to its benefits package.
o Definition: Fixed costs do not vary with the o Managers moved out of the company housing
amount of output. (no changes) and purchased houses.
o Definition: Variable costs change as output o The empty company flats remained on
changes. (increases as you produce more) Cadbury’s balance sheet for 6 years.
In 1997, Cadbury adopted Economic Value Added

(EVA)® (performance metric, a measure)
• Charges each division within a firm for the

amount of capital it uses
• Provides an incentive for management to
Total cost = combination of total fixed cost and total reduce capital expenditures if they do not cover
variable cost. (total FC + total VC) costsSenior managers then decided to sell the
unused apartments after seeing the implicit
Example: A Candy Factory
cost of capital.
o The cost of the factory is fixed.
o Employee pay and cost of ingredients are
variable costs.
Are these costs fixed or variable?

Cadbury Accounting Profit • potential benefit that an individual, business

organisation or investor misses out when
Accounting profit recognizes only explicit costs
choosing an alternative option over another
• Does not consider implicit costs
Identifying Costs
Typical income statements include explicit costs:
Whenever you get confused by costs, step back and ask,
• Costs paid to its suppliers for product inputs “What decision am I trying to make?”
• General operating expenses, like salaries to
• If you start with costs, you will always get
factory managers and marketing expenses
confused
• Depreciation expenses related to investments in
• If you start with a decision, you will never get
buildings and equipment
confused
• Interest payments on borrowed funds
Apply it to Cadbury:
Cadbury Accounting Profit vs. Economic Profit
• The cost of the company of holding onto the
What’s missing from Cadbury’s statements are implicit
apartments was the forgone opportunity to
costs:
invest capital in the company’s organization to
• Payments to other capital suppliers earn a higher return.
(stockholders)
Cadbury’s Costs
• Stockholders expect a certain return on their
money (they could have invested elsewhere) Holding on to the flats cost the company £600,000 each
• “Profit” should recognize whether firm is year
generating a return beyond shareholders

• Unless the benefits to the company of holding
expected return
onto the apartments were at least £600,000,
the capital was not employed in its highest-
❖ Economic profit recognizes these implicit costs;
valued use.
accounting profit recognizes only explicit costs
• The cost of the company of holding onto the
Opportunity Costs & Decisions apartments was the forgone opportunity to
invest capital in the company’s organization to
The opportunity cost of an action is what you give up
earn a higher return.
(forgone profit) to pursue it.
• By selling the flats, the company moved the
• Costs imply decision-making rules and vice- capital to a higher-valued use.
versa
• The goal is to make decisions that increase
profit
• If the profit of an action is greater than the
alternative, pursue it (benefit > cost)
Relevant Costs and Benefits Example: Football game (again)
When making decisions, you should consider all costs You buy a ticket for $20. Scalpers are selling tickets for
and benefits that vary with the consequence of a $50 because your team is playing cross-state rivals
decision and only costs and benefits that vary with the
o You go to the game, saying, “These tickets cost
decision.
me only $20.” WRONG
o These are the relevant costs and relevant o The tickets really cost you $50 because you give
benefits of a decision. up the opportunity to scalp them by going
o Unless you value them at $50, you are sitting on
You can make only two mistakes
an unconsummated wealth-creating
o You can consider irrelevant costs transaction
o You can ignore relevant ones
Example: Should You Fire an Employee?
Definition: The fixed-cost/sunk-cost fallacy means you
The revenue he provides to the company is $2,500 per
make decisions using irrelevant costs and benefits
month
Fixed-Cost/Sunk-Cost Fallacy Examples
o His wages are $1,900 per month
Football game: o His office could be rented out $800 per month
You pay $20 for a ticket. At halftime, you’re team is o YES, you are only making $600 a month from
losing by 56 points. You say you’ll stay to get your this employee but could make $800 a month
money’s worth, but you can’t get your money’s worth! from renting his office
o The ticket price does not vary whether you stay Subprime Mortgages
or leave – it’s a sunk cost and irrelevant. The subprime mortgage crisis of 2008 is a good example
Launching a new product: of the hidden-cost fallacy.
You are in a new products division and will be able to Credit-rating agencies failed to recognize the higher
distribute a new product through your existing sales costs of loans made by dubious lenders.
force. You will be forced to pay for a portion of the sales o Example: Long Beach Financial
force. o Gave loans out to homeowners with bad credit,
o If you believe this “overhead” is big enough to asked for no proof of income, deferred interest
deter an otherwise profitable product launch, payments as long as possible.
then you’ve committed the sunk-cost fallacy Credit ratings didn’t reflect the hidden costs of risky
Hidden-Cost Fallacy loans
Definition: ignoring relevant costs (costs that vary with o As a result, many Wall Street investors
the consequences of your decision) when making a purchased packaged risky loans and eventually
decision went bankrupt when the debtors defaulted.

Hidden cost of capital • Interpretations

o Selection bias?
Recall that accounting profit does not necessarily
▪ NO, cheaper to use existing
correspond to economic profit.
plans
Discussion: Economic Value Added o Goal alignment, YES.
o EVA® = net operating profit after taxes minus • EVA® is no better or worse
the cost of capital times the amount of capital o Rival EPP’s
utilized o Bonus plans

o Discussion: WHY?
(net operating profit after taxes – cost of capital)*amount of
capital utilized Psychological Biases
o Makes visible the hidden cost of capital Not enough information or bad incentives are not the
only causes for business mistakes.
The major benefit of EVA is identifying costs. If you
cannot measure something, you cannot control it. • Often psychological biases get in the way of
rational decision making.
o Those who control costs should be responsible
for them. Definition:
Incentives and EVA® o endowment effect means that taking

ownership of item causes owner to increase
Goal alignment: “By taking all capital costs into account,
value she places on the item.
including the cost of equity, EVA shows the dollar
o attachment
amount of wealth a business has created or destroyed
o loss aversion – individuals would pay more to
in each reporting period. … EVA is profit the way
avoid loss than to realize gains.
shareholders define it.”
o confirmation bias – a tendency to gather
Discussion: can you make mistakes using EVA?
information that confirms your prior beliefs,
• Does it help avoid the hidden cost fallacy? and to ignore information that contradicts
• Does it help avoid the fixed cost fallacy? them.

o anchoring bias – relates the effects of how
Does EVA® work?
information is presented or “framed”
• Adopting companies of EPP’s (+ four years) o overconfidence bias – the tendency to place
o ROA from 3.5 to 4.7% too much confidence in the accuracy of your
o operating income/assets from 15.8 to analysis
16.7%
• Indistinguishable from non-adopters
o Bonuses increase 39.1% for EVA® firms
o But 37.4% for control group
In class problem (1) o The company, however, decided to sell off

these “underperforming businesses”
You won a free ticket to see an Eric Clapton concert
(which has no resale value). Bob Dylan is performing on Why?
the same night and is your next-best alternative activity.
At the time, soft drink division was earning 16 percent
o Tickets to see Dylan cost $40. On any given day, return on capital
you would be willing to pay up to $50 to see
o The “opportunity cost” of investing in
Dylan.
aquaculture and wine is the foregone profit
o Assume there are no other costs of seeing
that could have been earned by investing in soft
either performer. Based on this information,
drinks
what is the opportunity cost of seeing Eric
o A dollar invested in aquaculture and wine is a
Clapton?
dollar that was not invested in soft drinks
A. $0 B. $10 C. $40 D. $50 o Divisions sold off and proceeds invested in core
soft drink business
You won a free ticket to see an Eric Clapton concert
(which has no resale value). Bob Dylan is performing on
the same night and is your next-best alternative activity. Cost-Benefit Analysis
o Tickets to see Dylan cost $40. On any given day,

Explicit benefits – monetary benefits that can be easily
you would be willing to pay up to $50 to see
quantified
Dylan.
Implicit benefits – harder to quantify but they are
o Assume there are no other costs of seeing valuable
either performer. Based on this information, ❖ Total benefits form the metric ‘utility’ for
what is the minimum amount (in dollars) you consumers and total revenue for firms
would have to value seeing Eric Clapton for you Total net benefits = total benefits – total costs,
maximized at optimal choice
to choose his concert?
❖ Rational agents consider opportunity costs,
A. $0 B. $10 C. $40 D. $50 whether implicit or explicit, when calculating
the total
Alternate intro anecdote
Coca-Cola in the 1980s had very little debt, preferring

to raise equity capital from its stockholders
o The company had a diversified product line,

including products like aquaculture and wine.
• These other businesses generated
positive profits, earning a ten percent
return on capital invested.
MODULE 3 (Chapter 3) • Case 2: use $40,000 of your savings (assuming

Supplemental Accounting vs Economic the interest you may earn in the bank is also
Profit 5%), borrow the other $60,000
Accounting Vs Economic Profit o explicit cost = $3000 (5%) interest on
In this chapter, look for the answers to these the loan
questions:
o implicit cost = $2000 (5%) foregone
• What is Profit? interest you could have earned on
• What is Implicit and Explicit Cost? How do they
• differ? your $40,000
• What is Accounting Profit and Economic In both cases, total (exp + imp) costs are $5000
Profit? How do they differ?
Economic Profit vs. Accounting Profit
Total Revenue, Total Cost, Profit
• Accounting profit = total revenue minus total
• We assume that the firm’s goal is to maximize
profit. explicit costs
Profit = Total revenue – Total cost • Economic profit = total revenue minus total
costs (including explicit and implicit costs)
❖ Total revenue - the amount a firm receives
from the sale of its output
❖ Accounting profit ignores implicit costs, so it’s
❖ Total cost - the market value of the inputs a
higher than economic profit.
firm uses in production
ACTIVE LEARNING 2
Costs: Explicit vs. Implicit
Economic profit vs. accounting profit
• Explicit costs require an outlay of money, e.g.,
The equilibrium rent on office space has just increased
paying wages to workers. (recorded in the
by $500/month. (The rent on office space increases
accounting records) $500/month)
• Implicit costs do not require a cash outlay, e.g., Compare the effects on accounting profit and economic
the opportunity cost of the owner’s time. profit if:
Remember one of the Ten Principles: a. you rent your office space
• Explicit costs increase $500/month.
The cost of something is what you give up to get it
• Accounting profit & economic profit
• This is true whether the costs are implicit or
each fall $500/month.
explicit. Both matter for firms’ decisions.
b. you own your office space
Explicit vs. Implicit Costs: An Example • Explicit costs do not change, so

accounting profit does not change.
You need $100,000 to start your business. The interest
• Implicit costs increase $500/month
rate is 5%.
(opp. cost of using your space instead
• Case 1: borrow $100,000 (debt, borrowing) of renting it), so economic profit falls by
o explicit cost = $5000 interest on loan $500/month.
MODULE 4 US Financial Crisis

Extent (How Much) Decisions
The financial crisis began in the subprime housing
Do not confuse average and marginal costs.
market, where government policies encouraged
• Average cost (AC) is total cost (fixed and lenders to extend credit to low-income borrowers (by
variable) divided by total units produced. lowering lending standards)
o Average cost is irrelevant to an extent
• These high-risk loans, or mortgages, were being
decision
packaged into securities by lenders and sold to
TC / total units produced investors.
• If the risk had been recognized investor
• Marginal cost (MC) is the additional cost
demand would have been low, but rating
incurred by producing and selling one more
agencies were too liberal with AAA ratings,
unit.
increasing demand for loans.
• Marginal revenue (MR) is the additional
• The result? A credit “bubble”
revenue gained from selling one more unit.
• How did this lending crisis arise?
❖ Credit rating is very important when it comes to
❖ Sell more if MR > MC; sell less if MR < MC.
financial markets or institutions
o If MR = MC, you are selling the right amount
o The better rating we could have, the
(maximizing profit!).
better also our country is performing
o Reach the profit maximizing point
o Adding more units will no longer Average Cost Caution!
produce profit but rather it would
Memorial Hospital’s CEO conducted performance
eventually decrease.
reviews of the hospital departments.
• The relevant costs and benefits of an extent • During this process, the chief of obstetrics
decision are marginal costs and marginal proposed an increase in the number of babies
revenue. being delivered in his department.
o If the marginal revenue of an activity is • The CEO wondered why since the cost of
larger than the marginal cost, then do delivering babies was higher than the revenues
more of it. MR > MC brought in.
• An incentive compensation scheme that • The CEO’s mistake: He began with the costs
increases marginal revenue or reduces instead of the decision.
marginal cost will increase effort. o He committed the fixed-cost fallacy by
o Fixed fees have no effects on effort looking at average cost, which include
• A good incentive compensation scheme links costs that do not vary with the decision.
pay to performance measures that reflect o If he had ignored fixed costs, he would
effort. have seen that increasing the number

of deliveries would increase profit.
Background: Average Cost Marginal Cost & Marginal Revenue
Average cost (AC) is simply the total cost (TC) of Marginal cost is the additional cost to make and sell
production divided by the number of units produced one additional unit of output (Q)
(Q).
MC = TCQ+1 – TCQ
AC = TC/Q
MC = change in total cost/change in quantity
• Average costs often decrease as quantity
• Marginal cost is often lower than average cost
increases due to presence of fixed costs (FC)
(due to fixed costs) but not always
o AC = (VC + FC)/Q
• Marginal costs are what matter in extent
o FC does not change as Q increases
decisions
• Key note: Average costs are not relevant to
extent decisions Marginal revenue (MR) is the additional revenue
gained from producing and selling one more unit.
Extent Decisions
Examples of extent decisions:
• Should you change the level of advertising?

• Should you increase the quality of service?
• Is your staff big enough, or too big?
• How many parking spaces should you lease?
For extent decisions, we break the decision into small

steps
Memorial Hospital Revisited • If taking a step provides more benefit than

cost, take a step forward. If not, step backward
Memorial made 500 deliveries originally
Extent (How Much?) Decisions
• Fixed cost: $1,000,000
• Variable cost: $3,000/delivery • This analysis tells you direction of change but
• Total cost: $1,000,000 + ($3,000 x 500) not the distance

o You can only measure MR and MC at
• Average cost: total costs/# of deliveries
the current level of output – make a
($5,000)
change and re-measure
Average costs fall as you increase output, but the
• If the benefits of selling another unit (MR) are
variable costs remain constant
bigger than the costs (MC), then sell another
o Marginal cost is only $3,000 at Memorial unit.
Hospital
Maxim: Competing Strategies & Marginal Analysis
o Produce more when MR > MC Example: Compare TV advertising to telephone

o Produce less when MR< MC solicitation
o Profits are maximized when MR = MC
• The opportunity cost of spending one more $ on
Memorial Hospital Marginal Analysis TV advertising is the forgone opportunity to
spend $ on telephone solicitation
As we mentioned, the MC of a delivery was $3,000
• Say you recently cut telephone (PH) budget by
• The MR was $5,000 $10,000 and lost 100 customers
• Therefore, MR>MC so the hospital was not
Estimated MCPH = $100 = ($10,000/100)
delivering enough babies
• This explains why the CEO was wrong • So, to get one more customer costs $50 for TV
and $100 for phone
Advertising Extent Decision Example
MCPH > MCTV so shift ad dollars from phone to TV
Answering the “How much advertising?” question
Advice: make changes one-at-a-time to gather
• A $50,000 increase in the TV ad budget brings
valuable information about marginal effectiveness
in 1,000 new customers
of each medium
• Estimated MCTV is $50 (the cost to get one
more customer) Textile Production Example
$50,000 /1,000 = $50 estimated marginal cost • A textile company with manufacturing plants in
Latin America uses SAH=“Standard Absorbed
If the marginal revenue generated by this customer is
Hours” a measure of textile factory output
greater than $50, do more advertising.
o Allows managers to compare factories
Advertising Extent Decision Example (cont.) making different items, e.g. t-shirt = 1 SAH
• You know the direction (do more), but you do while dress = 3 SAH
not know how far to go • Suppose Factory A has costs of $30 per SAH
• You have to take a step and re-compute while Factory B has cost of $20 per SAH. How
marginal cost and benefit to see if you should can you profitably use this information?
continue in the direction your analysis originally • Should you move production to cheaper
pointed you in factory?
• Also, even if we do not know the marginal o Make sure you are not including fixed
revenue, we can still use marginal analysis to costs in the analysis
make extent decisions o Marginal costs matter, not average
o by comparing marginal effectiveness of costs!
different media
o If the $20 and $30 rates are good MC o The landowner receives less money
proxies, shift some production from since the logger only harvests one type
Factory A to Factory B of tree
o Royalties deter some wealth-creating
Incentive Pay
transactions as fir trees are not
Royalty rates vs. fixed fee contracts harvested
How hard to work is an extent decision so you can Sales Commission Example
design incentives to encourage hard work by using
Motivating salespeople:
marginal analysis
• Expected sales level: 100 units @ $10,000/unit
• Example: You receive two bids to harvest 100
= $1M
trees on your land
o Option 1: 10% commission
o $150/tree or $15,000 for the right to
o Option 2: 5% commission + $50,000
harvest all the trees.
salary
o On your tract there are pines (worth
▪ Hint: consider incentives for
$200) and fir (worth $100).
salespeople
o Which offer should you accept?
• Use Option 1 because MR = $1000/sale >
▪ Hint: consider the effects of
$500/sale, the MR under Option 2
the two bids on the incentives
• The sales force responds to larger marginal
of the logger.
benefits of selling with more effort
Tree Harvesting Answer o Lower sales effort under option 2 is
The bids have the same face value, but are very called “shirking”
different in terms of logger’s incentives

Tie Pay to Performance
• Fixed fee: the logger will ignore the $15,000 A consulting firm COO received a flat salary of $75,000
because it doesn’t vary with the decision to cut
• After learning about the benefits of incentive
down trees.
pay in class, the CEO changed COO
o The logger will end up cutting down all
compensation to $50K + (1/3)* (Profits-$150K)
trees that are profitable to cut down,
• Profits increased 74% to $1.2 M
MR>MC
• Compensation increased $75K -> $177K
• Royalty Rate: The logger will only cut down
trees that generate profit of $150, Discussion: What are the disadvantages to incentive
MR>MC+150 pay?
o Mix of $200- and $100-value trees –
• Some argues that it creates a gap between
logger will harvest only the $200
employees because you are not allocating the
incentive fairly to all.
Title? How to Calculate

Total Cost, Marginal Cost, Average
American Express offers a Platinum Card to affluent
Variable Cost, and Average Total Cost
customers
In 2001, there were approximately 2,000 Platinum

Theory of Cost
cardholders in the Japanese market. Numbers had been
limited to ensure high quality customer service
With customer service technology advances, the

company considered expanding number of card holders
• How many more should be added?

o As more members are acquired,
average spending per card member
decreases because the financial
threshold for membership is lowered
o Costs of customer service rise for each
additional member added, and Average Fixed Cost = fixed cost/output
growing beyond a certain point would
Average Variable Cost = variable cost/output
require building and operating an
additional call center Average Total Cost = total cost (fc+vc)/output
o After analyzing the costs and benefits,
Marginal cost = change in total cost/change in output
American Express realized that it
should expand its offering to only
15,000 more Platinum Card members
We call this an “extent” decision, because the company

needed to decide “how many” platinum cards to
provide. In this chapter, we show you how to make
profitable extent decisions.
Maximizing Profit Practice
output Variable Fixed Total Marginal Marginal

Cost Cost Cost Cost Revenue
0 0 20 20 - -
1 12 20 32 12 30
2 22 20 42 10 30
3 27 20 47 5 30
4 40 20 60 13 30
5 60 20 80 20 30
6 100 20 120 40 30
Given: Price = 30 = MR
• What is the profit maximizing quantity? 5

o MR>MC, MR is close as possible to MC
without the MC going over the
o The firm should produce 5 units
(outputs)
• What is the total revenue at the quantity?
o Total revenue = Price (marginal
revenue) * quantity (output)
o 30*5 = 150 (total revenue)
• How much is the profit?
o Profit = Total revenue – Total cost
o 150 – 80 = 70 (profit)
output Variable Fixed Total Marginal Marginal TR Profit

Cost Cost Cost Cost Revenue
0 0 20 20 - - - -
1 12 20 32 12 30 30 -2
2 22 20 42 10 30 60 18
3 27 20 47 5 30 90 43
4 40 20 60 13 30 120 60
5 60 20 80 20 30 150 70
6 100 20 120 40 30 180 60
MODULE 5 Break-even quantity = FC/contribution margin (price –

Investment Decisions: Look Ahead and marginal cost)
Reason Back
o If you expect to sell more than the break-even
quantity, then your investment is profitable
• Investments imply willingness to trade dollars o You are not earning, you’re not also losing
in the present for dollars in the future.
o Wealth-creating transactions occur • Avoidable costs can be recovered by shutting
when individuals with low discount down.
rates (rate at which they value future o If the benefits of shutting down (you
vs. current dollars) lend to those with recover your avoidable costs) are larger
high discount rates. than the costs (you forgo revenue),
• Companies, like individuals, have different then shut down.
discount rates, determined by their cost of o The break-even price is average
capital. avoidable cost.
o They invest only in projects that earn a
return higher than the cost of capital. • If you incur sunk costs, you are vulnerable to
post-investment hold-up.
• The NPV rule states that if the present value of o Anticipate hold-up and choose
the net cash flow of a project is larger than zero, contracts or organizational forms that
the project earns economic profit (i.e., the minimize the costs of hold-up.
investment earns more than the cost of
capital). • Once relationship-specific investments are
o Although NPV is the correct way to made, parties are locked into a trading
analyze investments, not all companies relationship with each other, and can be held
use it. up by their trading partners.
o Instead, they use break-even analysis o Anticipate hold-up and choose
because it is easier and more intuitive. organizational or contractual forms to
o However, break – even analysis is not give each party both the incentive to
so convincing as compared to the NPV. make relationship-specific investments
and to trade after these investments
• Break-even quantity is equal to fixed cost are made.
divided by the contribution margin.
o If you expect to sell more than the
break-even quantity, then your
investment is profitable
Title? o Individuals with low discount rates

would willingly lend to those with
In summer 2007, Bert Matthews was contemplating
higher discount rates.
purchasing a 48-unit apartment building.
o Discounting helps you figure out if
• The building was 95% occupied and generated future gains are larger than current
$550,000 in annual profit. sacrifice.
• Investors expected a 15% return on their capital
Compounding
• The bank offered to loan Mr. Matthews 80% of
the purchase price at a rate of 5.5% To understand discounting, let’s first look at
compounding:
Mr. Matthews computed the cost of capital as a
weighted average of equity and debt. (future value, k periods in the future) = (present value)
x (1 + r)K
0.2 (equity component)*(15%) + 0.8 (debt component)
*(5.5%) = 7.4% Example: If you invest $1 (present value) today at a 10%
(r), then you would expect to have $1.10 in one year
• Mr. Matthews could pay no more than
$550,000/7.4% = $7.4 million and still break • In two years, $1 becomes $1.21 = $1.10 x
even (1+0.1)
Mr. Matthews decided not to buy the building. A good A good compounding rule of thumb:
decision – one year later, the cost of capital was
“Rule of 72”: If you invest at a rate of return r, divide 72
10.125% and Mr. Matthews could offer only $5.4
by r to get the number of years it takes to double your
million for the building.
money
• This story illustrates both the effect of the

Discounting
bursting credit bubble on real estate valuations
Discounting (the inverse of compounding):
and, more importantly, the relevant costs and
benefits of investment decisions. Present value = (future value, k periods in the future) /
(1 + r)k
Background: Investment Profitability
Example: At a 10% r, $1 is worth:
All investments represent a trade-off between possible
future gain and current sacrifice. o Next year: ($1)/1.1 = $0.91
o Two years: ($0.91)/1.1 =$0.83
• Willingness to invest in projects with a low rate
of return, indicates a willingness to trade Discussion: If my discount rate is 10%, would I lend to
current dollars for future dollars at a relatively or borrow from someone with a discount rate of15%?
low rate.
o What does this say about behavior?
• Low risk, low return. High risk, high return.
The higher the discount rate, the lower the
o This is also known as having a low value of your money.
discount rate (r).
Example: Nashville Pension Obligations The NPV Rule: if the present value of the net cash flows
is larger than zero, then the project earns more than the
The city of Nashville uses discounting to decide how
cost of capital.
much to save for future pension obligations.
NPV > O, earns more than the costs of capital
For a pension that pays out $100,000 in 20 years, with
a discount rate of 8.25% Nashville must save: o Project is profitable if the value is greater than
zero
$100,000/(1.0825)20 =$20,485
The NPV Rule in Action
• If the city invests the $20,485 and e arns 8.25%,
then the savings will compound in 20 years – Consider two projects that each require an initial
unrealistic! investment of $100
• Somewhat of high savings rate that may not be
• Project 1 returns $115 at the end of the first
returned; however, a high savings rate means year
less current spending, which is politically • Project 2 returns $60 at the end of the first, and
$60 at the end of the second
popular • The company’s cost of capital is 14%
• A more realistic (but less popular) discount rate
would be 6.5%, which would lead to saving
$28,380 now.
Determining the Profitability of Investments

• Project 1 earns more than the cost of capital.
Remember the simple rule: discount the future benefits Project 2 does not
of an investment, and compare them to the current cost
• Companies use discount rates, which are NPV and Economic Profit
determined by cost of capital.
o Projects with a positive NPV create economic
o A company’s cost of capital is a blend of
profit.
debt and equity, its “weighted average
• Only positive NPV projects earn a
cost of capital” or WACC
return higher than the company’s cost
• Time is a critical element in investment
of capital.
decisions
o Projects with negative NPV may create
o Value of money might be different in
accounting profits, but not economic profit.
the future period – not the same as you
• In making investment decisions,
expect it.
choose only projects with a positive
o Cash flows to be received in the future
NPV
need to be discounted to present value
o IRR – you have to interpolate to arrive at the
using the cost of capital correct value
• Effective tool in making decisions
(project possibility study)
Another Method: Break-Even Quantities Deciding Between Two Technologies
The break-even quantity is the amount you need to sell In 1983, John Deere was in the midst of building a
to just cover your costs
Henry-Ford-style production line factory for large 4WD
o At this sales level, profit is zero
tractors
o Neither earning or incurring losses
o Unexpectedly, wheat prices fell dramatically
o If your break- even is lower, you could reach
reducing demand for large tractors
your goal a little bit earlier and then surpass
your break- even Deere decided to abandon the new factory and instead
purchased Versatile, a company that assembled
The break-even quantity is:
tractors in a garage using off-the-shelf components
Q=FC / (P-MC)
• Deere chose one manufacturing technology
FC - fixed costs P - price MC - marginal cost
over another
o (P-MC) is the “contribution margin” – what’s o A discrete investment decision – the
left after marginal cost to “contribute” to factory had big FC and small MC,
covering fixed costs Versatile had small FC but bigger MC
Break-Even Example: Nissan Truck John Deere: Right Decision?
Nissan’s popular truck model, the Titan, had only two Was purchasing Versatile the right choice?
years remaining on its production cycle. Redesigning

It depends… on how much John Deere expected to sell
the “Titan” would cost $400M
• Suppose the capital-intensive technology would
• Cost of capital was 12%, implying annual fixed
involve $100 FC and $10 MC
cost of $48M
• Suppose Versatile’s technology had $50 FC and
• Contribution margin on each truck is $1,500
$20 MC
• Break-even quantity is 32,000 trucks
• To determine break-even quantity (point of
• The decision to redesign or not came down to a indifference), solve for the quantity that
break-even analysis equates the costs: $150 for 5 unit
Nissan had a 3% share of the market, implying only • If you expect to sell less than 5 units, choose the
12,000 Titan sales per year – not enough to break even. low-MC technology
• If you expect to sell more than 5 units, choose
• Instead they decided to license the Dodge Ram
the low-FC technology
Truck, which would reduce the fixed cost of
redesign, and a lower break-even point. John Deere Lesson
• After the Government took over Chrysler, John Deere made the right decision by acquiring
Nissan reconsidered. Versatile; however, the Antitrust Division of he U.S.

Department of Justice challenged the acquisition as
anticompetitive.
• John Deere and Versatile were only two of 4 o Long-run: fixed costs become avoidable
firms selling 4WD tractors in North America. so they are included in the shutdown
price
Break-Even Advice
▪ Long run = longer timeline,
Remember this advice: Do not invoke break-even longer time period
analysis to justify higher prices or greater output. ▪ More than a year
• Managers sometimes believe they must raise o Short run: they are unavoidable and
prices to cover fixed costs or they must sell as should not be included in the shutdown
much as possible to make average costs lower price

▪ Short run = shorter time
• These are extent decisions though!
periods
o They require marginal analysis, not
▪ Less than a year
break-even
o NPV and IRR are still the best tool in
computing.
The Decision to Shut-Down
Shut-down decisions are made using break-even prices

rather than quantities.
• The break-even price is the average avoidable

• Unavoidable or sunk cost – cost already
cost per unit
incurred, not part of the decision
• Profit = (Rev-Cost)= (P-AC)(Q)
• Avoidable cost – fixed costs, avoidable in the
If you shut down, you lose your revenue, but you get
long run. Variable costs, avoidable in the short
back your avoidable cost.
run.
• If average avoidable cost is less than price, shut

down.
Sunk Costs and Post-Investment Hold Up
Determining avoidable c osts can be difficult.
Always remember the business maxim “look ahead and
• To identify avoidable costs firms use Cost reason back.” This can help you avoid potential hold up.
Taxonomy
• Before making a sunk cost investment, ask what
Cost Taxonomy you will do if you are held up.
Example: FC=$100, MC=$5, and you produce 100 • What would you do to address hold up?
units/year
• How low of a price before you shut down? IT

DEPENDS
• It depends on which costs are avoidable
Sunk Costs and Post-Investment Hold Up Contractual view of marriage

Example
• Long-term contracts induce higher levels of
National Geographic can reduce shipping costs by relationship specific investment
printing with regional printers.
o To print a high quality magazine, the printer

must buy a $12 million printing press. – sunk
cost if the company bought it already.
o Each magazine has a MC of $1 and the printer
would print 12 million copies over two years.
o The break-even cost/average cost is $7 = ($12M
/2M copies) + $1/copy
o BUT once the press is purchased, the cost is
sunk and the break-even price changes.
o Because of this the magazine can hold up the
printer by renegotiating the terms of the deal –
because the price of the press is unavoidable,
and sunk, the break-even price falls to $1, the
marginal cost
Vertical Integration
One possible solution to post-investment hold-up is

vertical integration.
Example: Bauxite mine and alumina refinery
• Refineries are tailored to specific qualities of ore

• The transaction options are:
o Spot-market transactions
o Long-term contracts
o Vertical integration
- Vertical integration refers to the common
ownership of two firms in separate stages
of the vertical supply chain that connects
h
raw materials to finished goods
Discussion: How is vertical integration a solution to hold

up?
If the business sells fewer than 50,000 units (the red

Break-even analysis area), then the contribution margin is lower than fixed
costs (CM < FC), and the business is loss making.
Break – even point – The sales volume where neither If the business sells more than 50,000 units (the green
profit nor loss is made area), then the contribution margin is higher than fixed
costs (CM > FC), the business makes a profit.
alternative way of saying the same thing: the break –
even point is the sales volume where Contribution
Margin = Fixed Cost
Break – Even Point Formula
Contribution Margin $ = Fixed Cost $

If the fixed cost is $200,000 and the contribution margin
o Volume sold * CM$ per unit = Fixed Cost $
is $4 per unit, then the business need to sell 50,000
units to break even. Volume sold (Q)= Fixed Cost $/CM$ per unit
Contribution Margin = revenue minus variable cost (P- Volume sold (Q) = Fixed Cost $/ (Price per unit – Variable
MC or VC) cost per unit)
o what you sell the product for minus what it

costs you to make an incremental unit. Example:
o Contribution Margin - go up for every unit sold. $200,000 = $200,000
❖ The business need $200,000 in CM to cover
❖ Fixed Cost - do not vary with the number of that $200,000 in fixed costs
units sold
o Examples: rent, depreciation, and o 50,000 * $4= $200,000
research and development 50,000 = $200,000/$4
expenditures. 50,000 = $200,000/ ($10 – $6)
But what should a business owner do with this

information? Net Present Value (NPV)
❖ Present Value and Future Value are closely
related concepts.
FUTURE VALUE
Example of Future Value: How much money will I have

one year from now if I invest $100 at an expected 20%
annual return?
$100 * 1.2 = $120

o Sell as many units as possible, increase the
→
volume sold
o Reducing the fixed cost ❖ To get to the future value, you go from left to
o Increasing the price per unit right: 𝑷𝑽 𝒙 (𝟏 + 𝒓𝒂𝒕𝒆 𝒐𝒇 𝒓𝒆𝒕𝒖𝒓𝒏)𝒏 = 𝑭𝑽
o Reducing the variable cost per unit ❖ n = number of years of years
Work on all these variables at the same time, and the How much money will I have two years from now if I
break – even point becomes dynamic instead of static invest $100 at an expected 20% annual return?
$100 * 1.2 = $120 → $120 * 1.2 = $144
$100 ∗ (1.2)2 = $144
PRESENT VALUE
Example of Present Value: How much money do I

invest today to achieve $120 one year from now at an
expected 20% annual return?
$100 = $120/1.2
❖ To get to the present value, you go from left to

right: t: 𝑭𝑽/(𝟏 + 𝒓𝒂𝒕𝒆 𝒐𝒇 𝒓𝒆𝒕𝒖𝒓𝒏)𝒏 = 𝑷𝑽
❖ How much money do I invest today to achieve
$144 two years from now at an expected 20%
annual return?
$100 = $120/1.2 ← $120 = $144/1.2
$𝟏𝟎𝟎 = 144/(1.2)2
NET PRESENT VALUE (NPV) calculation Today

Benefits $333
What is the present value (PV) of all the cash inflows
Benefits $278
and cash outflows of the following project?
Benefits $231
today year 1 year 2 year 3 year 4
Benefits $193
Benefits $𝟑𝟑𝟑 $400
Investments ($1000)
Benefits $𝟐𝟕𝟖 $400
Benefits $𝟐𝟑𝟏 $400
Benefits $𝟏𝟗𝟑 $400 To get the NPV, simply add the amounts:
Investments ($1000) NPV = ($333 + $278 + $231 + $193) - $1000
Net Present Value = $35
o The project is expected to provide four years’ ❖ The word ‘Net’ in the term ‘Net Present Value’
worth of benefits of nominally $400 per year, means deducting the investment amount from
and an investment today of $1000 to launch the the present values of the future cash flows.
project
As the net present value of this project is positive, it is
o We take a fairly high WACC of 20% in this
worth pursuing.
calculation.
NPV > 0 Accept
What is the present value of a $400 benefit that we o Accept the project proposal as it creates value
expect one year from now? for the company.
𝑭𝑽/(𝟏 + 𝒘𝒆𝒊𝒈𝒉𝒕𝒆𝒅 𝒂𝒗𝒆𝒓𝒂𝒈𝒆 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒄𝒂𝒑𝒊𝒕𝒂𝒍)𝒏 = 𝑷𝑽 If the net present value of the project would have been
negative, it would not be worth pursuing.
$400/(1.2)1 = $𝟑𝟑𝟑
NPV < 0 Reject
$400/(1.2)2 = $𝟐𝟕𝟖, two years from now
o Reject the project proposal, as it does not
$400/(1.2)3 = $𝟐𝟑𝟏, three years from now
create value for the company.
4
$400/(1.2) = $𝟏𝟗𝟑, four years from now
The main idea of Net Present Value is very simple: time

is money!
❖ Weighted average cost of capital (or WACC) is a
calculation of a firm’s cost of capital in which o The net present value method takes the time
each category of capital is proportionately value of money into account, by translating all
weighted. future cash flows into today’s money, and then
adding up today’s investment and the present
What is the Net present value (NPV) of the project?
values of all future cash flows
Module 6 Four factors make demand more elastic:

Simple Pricing
o Products with close substitutes (or distant
complements) have more elastic demand.
Aggregate demand or market demand is the total o Demand for brands is more elastic than
number of units that will be purchased by a group of industry demand.
consumers at a given price. o In the long run, demand becomes more
elastic.
• Pricing is an extent decision.
o As price increases, demand becomes more
o Reduce price (increase quantity) if
elastic.
MR > MC.
o Increase price (reduce quantity) if Income elasticity, cross-price elasticity, and advertising
MR < MC. elasticity are measures of how changes in these other
o The optimal price is where factors affect demand.
MR = MC.
o It is possible to use elasticity to forecast
Price elasticity of demand: e = (% change in quantity changes in demand:
demanded) ÷ (% change in price)
%ΔQuantity ≈ (factor elasticity)*(%ΔFactor)
o Estimated price elasticity is used to estimate
Stay-even analysis can be used to determine the volume
demand from a price and quantity change
required to offset a change in costs or prices, which is
[(Q1 - Q2)/(Q1 + Q2)/2] ÷ [(P1 - P2)/ (P1 + P2)/2] how businesses often implement marginal analysis.
o If |e| > 1, demand is elastic; if |e| < 1, demand Hot Wheels

is inelastic.
Mattel introduced Hot Wheels in 1968. They kept price
%ΔRevenue ≈ %ΔPrice + %ΔQuantity below $1.00 for 40 years, even as production costs rose.
o Elastic Demand (|e| > 1): Quantity changes • Finally tested a price increase, experienced
more than price. profit increase of 20%
o Inelastic Demand (|e| < 1): Quantity changes
Why? Profit= (P-C) x Q
less than price.
• Businesses tend to focus on C and Q, neglect P
• In many instances, companies can make money
MR > MC implies that (P - MC)/P > 1/|e|; in words, if
by simply raising price
the actual margin is bigger than the desired margin,
reduce price
• Equivalently, sell more

Simple Pricing Consumer Surplus and Demand Curves

Example
In this chapter, we consider “simple pricing”:
Pizza consumer values first slice at $5, next at $4 . . . fifth
• A single firm selling a single product at a single
at $1
price
• Most firms sell: in competition with rivals;
multiple products, and at different prices, so
this is rare
• Important to understand simple pricing first
though • Note that if pizza slice price is $3, consumer will
• Simple pricing has become part of business purchase 3 slices
vernacular
Pizza Example (cont.)
o When your boss says that “demand is
elastic,” she often means that price is For the first slice, the total and marginal value are the
too high. same at $5
• For the second, the marginal value is $4, while
Background: Consumer Surplus and Demand the total value is $9 = $5 + $4
Curves
First Law of Demand - consumers demand more

(purchase more) as price falls, assuming other factors
are held constant.
• Consumers make consumption decisions using

marginal analysis, consume more if marginal
value > price
• But, the marginal value of consuming each Background: Aggregate Demand
subsequent unit diminishes the more you
Aggregate Demand: the buying behavior of a group of
consume.
consumers; a total of all the individual demand curves.
Law of Diminishing Marginal Returns – until your utility
• To construct demand, sort by value.
will be satisfied.
• Adding more and more becomes less satisfying.
Consumer surplus = value to consumer - price paid
• Definition: Demand curves are functions that

relate the price of a product to the quantity
demanded by consumers
Aggregate Demand (cont.) Marginal analysis of pricing
Demand curves describe buyer behavior and tell you Marginal analysis finds the profit increasing solution to
how much they will buy at a given price the pricing trade-off.
• It tells you which direction to go (to raise or

lower price), but not how far to go.
Definition: marginal revenue (MR) is change in total

revenue from selling another unit.
• If MR > 0, then total revenue will increase if you

sell one more.
• If MR > MC, then total profit will increase if you
sell one more.
• If something other than price causes an
Proposition: Profit is maximized when MR = MC
increase in demand, we say that “demand
shifts” to the right or “demand increases” such
that consumers purchase more at the same
Example: Find the Optimal Price
prices
Once you reach the 4th unit, total profit decreases by
%0.50 because the MR from the 4th unit is only $1,

Pricing Trade-Off
which is less than $1.50 MC
Pricing is an extent decision
o Therefore, the profit maximizing quantity is 3
Profit= Revenue - Cost
and we see that the price is $5.00 for 3 units to
Demand curves turn pricing decisions into quantity be sold
decisions:
• “what price should I charge?” is equivalent to

“how much should I sell?”
Fundamental tradeoff:
• Lower price → sell more, but earn less on each How Do We Estimate MR?
unit sold Price elasticity allows us to calculate MR

• Higher price → sell less, but earn more on each
Definition: price elasticity of demand (e)
unit sold
❖ Tradeoff created by downward sloping demand (%change in quantity demanded)
o There is always a trade-off between (%change in price)
two options. There is a corresponding
effect in every decision.
• If |e| is less than one, demand is said to be Price Elasticity Example

inelastic. (|e| < 1)
Mayor Marion Barry increased taxes on gasoline sales in
• If |e| is greater than one, demand is said to be
DC by 6%.
elastic. (|e| > 1)
• If |e| is equal to one, demand is said to be unit • Before the tax, gas station predicted that the
elastic. ((|e| = 1) increase in a sales tax would reduce quantity

demanded by 40%.
Mistake in 3rd Edition
• The gas station owners were indirectly arguing
The Correct Answer that gasoline revenue, and the taxes collected
out of revenues, would decline because
• Elastic Demand implies |e|>1
gasoline sales in DC has a very elastic demand.
• Inelastic Demand implies |e|<1
The following figures are mis-labled (The inequality in

parentheses should be reversed) Estimating elasticities
Arc (price) elasticity =
[(q1 -q2)/(q1+q2)]
[(p1 -p2)/(p1+p2)]
Discussion: Compute elasticity, when price changes
from $10 to $8, and quantity changes from 1 to 2? 3
Example: On a promotion week for Vlasic, the price of

Elastic Demand implies |e|>1
Vlasic pickles drops by 25% and quantity increases by
Price increase → Revenue decrease (decrease in Q is 300%.
bigger than increase in P)
o Is the price elasticity of demand -12?
Price decrease → Revenue increase (increase in Q is o HINT: could something other than price be
bigger than decrease in P) changing?
Inelastic Demand implies |e|<1 Intuition: MR and Price Elasticity
Price increase → Revenue increase (decrease in Q is Revenue and price elasticity are related by the following
smaller than increase in P) approximation.
Price decrease → Revenue decrease (increase in Q is %∆ Rev ≈ %∆ P + %∆ Q

smaller than decrease in P)
Elasticity tells you the size of |% P| relative to |% Q|
If demand is elastic
• If P then Rev
• If P then Rev
If demand is inelastic What Makes Demand More Elastic?
• If P then Rev 5 factors that affect demand elasticity and optimal

• If P then Rev pricing:
Formula: Elasticity and MR 1. Products with close substitutes have elastic

demand.
Proposition: MR = P(1-1/|e|)
2. Demand for an individual brand is more elastic
• If |e|>1, MR>0. than industry aggregate demand.
• If |e|<1, MR<0. 3. Products with many complements have less
elastic demand.
Discussion:
4. In the long run, demand curves become more
• If demand for Nike sneakers is inelastic, should elastic.
Nike raise or lower price? raise price 5. As price increases, demand becomes more
• If demand for Nike sneakers is elastic, should elastic.
Nike raise or lower price? lower price
Factor 1
1. Products with close substitutes have elastic demand.

Elasticity and Pricing
• Consumers respond to a price increase by
MR>MC is equivalent to switching to their next-best alternative.
• P(1-1/|e|)>MC • If their next-best alternative is a very close

• P>MC/(1-1/|e|) substitute, then it doesn’t take much change in
• (P-MC)/P>1/|e|
price for them to switch.
• When Mayor Barry raised the price of gasoline,
MR > MC means that (P-MC)/P > 1/|e| DC commuters began buying gasoline in nearby
Virginia and Maryland.
o The left side of the expression is the current
margin = (P-MC)/P Factor 2
o The right side is the desired margin, or the 2. Demand for an individual brand is more elastic than
inverse elasticity = 1/|e| industry aggregate demand.
• Rough rule of thumb: brand price elasticity is

❖ If the current margin is greater than the desired
approximately equal to industry price elasticity
margin, reduce the price because MR>MC and
divided by brand share
vice versa.
o Intuition: the more elastic demand Example:
becomes (1/|e| becomes smaller), the

• elasticity of demand for all running shoes = -0.4
less you can raise price over MC
• Market share of Nike running shoes is 20%
because you lose too many customers.
• Price elasticity of demand for Nike running Factor 5

shoes is -0.4/.20 = -2
5. As price increases, demand becomes more elastic.
• Using our optimal pricing formula, this would
give Nike a desired margin of 50% • Example: high-fructose corn syrup (HFCS)
o Primary use is a caloric sweetener in
Factor 3
soft drinks
3. Products with many complements have less elastic o Sugar is the perfect substitute for HCFS
demand. o Import quotas and sugar price supports
have raised the US domestic price of
• Products that are consumed as a larger bundle
sugar about twice that of HFCS.
of complementary goods have less elastic
▪ Bottlers have shifted to HFCS.
demand.
o Bottlers have no close substitute for
• Example: iPhones have less elastic demand
low-priced HFCS, although as the price
because of the number of apps run on them
of HFCS approaches that of sugar,
o If the price of an iPhone increases, you
demand for HFCS becomes very elastic.
are less likely to substitute to another
product due to the complementary Other Elasticities
apps
Income elasticity measures the change in demand
Factor 4 arising from a change in income
4. In the long run, demand curves become more elastic. (%change in quantity demanded) (%change in income)
• This can also be explain by the speed at which o Inferior goods (negative): as income increases,
price information is spread; or the ability of demand declines
consumers to find more substitutes in the long o normal goods (positive): as income increases,
run. demand increases
Example: ATM fees Cross-price elasticity of good one with respect to the
price of good two.
• At a selected number of ATMs, a bank raised
user fees from $1.50 to $2.00. (%change in quantity of good one) (%change in price of
o When informed of the fee increase, good two)
users typically completed the current o Substitute (positive): as the price of a substitute
transaction but avoided the higher increases, demand increases
priced ATMs in the future o Complement (negative): as the price of a
complement increase, demand decreases
Stay-Even Analysis Extra: Market Share Formula
Stay-even analysis tells you how many sales you need Proposition: The individual brand demand elasticity is
when changing price to maintain the same profit level approximately equal to the industry elasticity divided by
the brand share.
• How to implement marginal analysis of pricing
using stay-even quantity: • Discussion: Suppose that the elasticity of
demand for running shoes is –0.4 and the
%ΔQ = (%ΔP)
market share of a Saucony brand running shoe
(%ΔP + margin)
is 20%. What is the price elasticity of demand
Margin=40%, %ΔP=5%, then %ΔQ = 11.1%
for Saucony running shoes?
In other words, a 5% price increase would be profitable
if quantity went down by less than 11.1%. Proposition: Demand for aggregate categories is less-
elastic than demand for the individual brands in
• Use elasticity estimates or marketing surveys to
aggregate.
determine whether quantity would go down by
11.1% Title?
Cost-Based Pricing In 1994, the peso devalued by 40% in Mexico
Our expression for optimal pricing, MR=MC or • Interest rates and unemployment shot up
(PMC)/P= 1/|e|, takes into account the firm’s cost • Overall economy slowed dramatically and
structure and its consumer demand consumer income fell
• Often, the consumer side is ignored in pricing Concurrently, demand for Sara Lee hot dogs declined
decisions, leading to cost-based pricing. Why? • This surprised managers because they thought
• Often, firms do not have the demand picture demand would hold steady, or even increase,
• They need to invest in a market research since hot dogs were more of a consumer staple
division to take profitability seriously than a luxury item.
Extra: Quick and Dirty estimators • Surveys revealed the decline was mostly
confined to premium hot dogs
Linear Demand Curve Formula:
• And, consumers were using creative substitutes
𝑚𝑎𝑥
e = p / (𝑝 − p) • Lower priced brands did take off but were priced
too low.
Discussion:
Failure to understand demand and to price accordingly

o How high would the price of the brand have to
was costly.
go before you would switch to another brand of
running shoes?
o How high would the price of all running shoes
have to go before you should switch to a
different type of shoe?
Module 6 (Chapter 6) Definition:

Elasticity and its Application
Elasticity is a numerical measure of the responsiveness
A scenario…
of 𝑄 𝑑 or 𝑄 𝑠 to one of its determinants
You design websites for local businesses. You charge
$200 per website, and currently sell 12 websites per
month. Price Elasticity of Demand
o Your costs are rising (including the opp. cost of 𝑷𝒓𝒊𝒄𝒆 𝒆𝒍𝒂𝒔𝒕𝒊𝒄𝒊𝒕𝒚 𝒐𝒇 𝒅𝒆𝒎𝒂𝒏𝒅
your time), so you’re thinking of raising the 𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑸𝒅

=
price to $250. 𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑷
o The law of demand says that you won’t sell as
many websites if you raise your price.
Price elasticity of demand measures how much
How many fewer websites? How much will your
𝑄 𝑑 responds to a change in P
revenue fall, or might it increase?
o Loosely speaking, it measures the price -
• Law of Demand – there is an inverse
sensitivity of buyers’ demand.
relationship between price and
quantity demanded.
▪ As price increase, decrease in Example:
quantity demanded
▪ If price fell or decreases,
quantity demanded increases
• Law of Supply - there is a positive or
direct relationship between the price
and quantity supplied.
▪ If price increase, quantity
supply also increases
▪ If price decreases, quantity
supplied also decreases
15%
Price elasticity of demand equals = 1.5
Elasticity 10%
Basic idea: Elasticity measures how much one variable Along a D curve, P and Q move in opposite directions,
responds to changes in another variable. which would make price elasticity negative.
• One type of elasticity measures how much ❖ We will drop the minus sign and report all
demand for your websites will fall if you raise price elasticities as positive numbers.
your price. ❖ Take the absolute value

Calculating Percentage Changes From B to A,
Standard method of computing the percentage (%) P falls 20%, Q rises 50%, elasticity = 50/20 = 2.50
change:
Percentage Change $200−$250

P= $250
= −0.20 𝑜𝑟 20%,
𝑒𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 − 𝑠𝑡𝑎𝑟𝑡 𝑣𝑎𝑙𝑢𝑒 12−8
= 𝑥 100% Q= 8
= 0.50 𝑜𝑟 50%,
𝑠𝑡𝑎𝑟𝑡 𝑣𝑎𝑙𝑢𝑒
So, we instead use the midpoint method:
𝒆𝒏𝒅 𝒗𝒂𝒍𝒖𝒆 − 𝒔𝒕𝒂𝒓𝒕 𝒗𝒂𝒍𝒖𝒆

= 𝒙 𝟏𝟎𝟎%
𝒎𝒊𝒅𝒑𝒐𝒊𝒏𝒕
The midpoint is the number halfway between the start

& end values, also the average of those values.
o It doesn’t matter which value you use as the
Going from A to B, the % change in P equals: “start” and which as the “end” – you get the
same answer either way
($250–$200)/$200 = 25%
The problem with standard method:

Using the midpoint method, the % change in P equals
The standard method gives different answers
depending on where you start. $250 − $200
𝑥 100% = 𝟐𝟐. 𝟐%
$225
From A to B,
The % change in Q equals
P rises 25%, Q falls 33%, elasticity = 33/25 = 1.33
12 − 8
𝑥 100% = 𝟒𝟎. 𝟎%
10
$250−$200 The price elasticity of demand equals

P= $200
= 0.25 𝑜𝑟 25%,
8−12 40/22.2 = 1.8
Q=
12
= −0.3333 𝑜𝑟 33%,
A C T I V E L E A R N I N G 1:
Calculate an elasticity
Use the following information to calculate the price

elasticity of demand for hotel rooms:
if P = $70, 𝑄 𝑑 = 5000
if P = $90, 𝑄 𝑑 = 3000
Answers: • Rice Krispies has lots of close substitutes (e.g.,

Cap’n Crunch, Count Chocula), so buyers can
Use midpoint method to calculate % change in 𝑸𝒅
easily switch if the price rises.
Midpoint Method • Sunscreen has no close substitutes, so
𝑒𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 − 𝑠𝑡𝑎𝑟𝑡 𝑣𝑎𝑙𝑢𝑒 consumers would probably not buy much less if
= 𝑥 100%
𝑚𝑖𝑑𝑝𝑜𝑖𝑛𝑡
its price rises.
Lesson: Price elasticity is higher when close substitutes

5000 − 3000
4000
𝑥 100% = 𝟓𝟎% are available.
% change in P EXAMPLE 2:
$90 − $70 “Blue Jeans” vs. “Clothing”

𝑥 100% = 𝟐𝟓%
$80
The prices of both goods rise by 20%. For which good
The price elasticity of demand equals
does 𝑸𝒅 drop the most? Why?
50%/25% = 2.0
• For a narrowly defined good such as blue jeans,
there are many substitutes (khakis, shorts,
What determines price elasticity? Speedos)

• There are fewer substitutes available for
To learn the determinants of price elasticity, we look at
broadly defined goods. (Can you think of a
a series of examples. Each compares two common
substitute for clothing, other than living in a
goods.
nudist colony?)
In each example:
Lesson: Price elasticity is higher for narrowly defined
Suppose the prices of both goods rise by 20%.
goods than broadly defined ones.
• 𝒅
The good for which 𝑸 falls the most (in
EXAMPLE 3:
percent) has the highest price elasticity of
demand. Which good is it? Why? Insulin vs. Caribbean Cruises
What lesson does the example teach us about the The prices of both of these goods rise by 20%. For which
determinants of the price elasticity of demand? good does 𝑸𝒅 drop the most? Why?
EXAMPLE 1: • To millions of diabetics, insulin is a necessity. A

rise in its price would cause little or no decrease
Rice Krispies vs. Sunscreen
in demand.
The prices of both of these goods rise by 20%. For
• A cruise is a luxury. If the price rises, some
𝒅
which good does 𝑸 drop the most? Why?
people will forego it
Lesson: Price elasticity is higher for luxuries than for

necessities.
EXAMPLE 4: 5 Different classifications, from least to most

elastic.
Gasoline in the Short Run vs. Gasoline in the
Long Run “Perfectly inelastic demand” (one extreme
case)
The price of gasoline rises 20%. Does 𝑸𝒅 drop more in
the short run or the long run? Why? Price elasticity of demand
• There’s not much people can do in the short % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 𝟎%

= = 𝟎
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 𝟏𝟎%
run, other than ride the bus or carpool.
• In the long run, people can buy smaller cars or
live closer to where they work.
Lesson: Price elasticity is higher in the long run than the

short run.
The Determinants of Price Elasticity:
A Summary
The price elasticity of demand depends on:

D curve: vertical, Consumers’ price sensitivity: 0,
• the extent to which close substitutes are Elasticity: 0
available (the more close substitutes, the more
“Inelastic demand”
elastic)
• whether the good is a necessity or a luxury Price elasticity of demand
• how broadly or narrowly the good is defined % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 < 𝟏𝟎%
= =<𝟏
• the time horizon: elasticity is higher in the long % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 𝟏𝟎%
run than the short run.
The Variety of Demand Curves
• Economists classify demand curves according

to their elasticity.
• The price elasticity of demand is closely related
to the slope of the demand curve.
• Rule of thumb: The flatter the curve, the bigger D curve: relatively steep, Consumers’ price sensitivity:
the elasticity. The steeper the curve, the relatively low, Elasticity: <1
smaller the elasticity.
❖ People tend to be less responsive to the effect
of the price.
“Unit elastic demand” “Perfectly elastic demand” (the other

extreme)
❖ Equal change in the % change in quantity and
price Price elasticity of demand
Price elasticity of demand % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 𝒂𝒏𝒚 %

= = 𝑖𝑛𝑓𝑖𝑛𝑖𝑡𝑦
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 𝟎%
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 𝟏𝟎%
= = 𝟏
D curve: horizontal, Consumers’ price sensitivity:

extreme, Elasticity: infinity
D curve: intermediate slope, Consumers’ price
sensitivity: intermediate, Elasticity: 1
“Elastic demand” Elasticity of a Linear Demand Curve
Price elasticity of demand The slope of a linear demand curve is constant, but its
elasticity is not.
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 > 𝟏𝟎%
= =>𝟏
Price Elasticity and Total Revenue
Continuing our scenario, if you raise your price from

D curve: relatively flat, Consumers’ price sensitivity: $200 to $250, would your revenue rise or fall?
relatively high, Elasticity: > 1
Revenue = P x Q
❖ Consumer could easily switch from one product
to another in case of price changes
A price increase has two effects on revenue: If demand is inelastic, then price elastic of demand < 1
• Higher P means more revenue on each unit % change in Q < % change in P

you sell.
• The fall in revenue from lower Q is smaller than
• But you sell fewer units (lower Q), due to Law
the increase in revenue from higher P, so
of Demand.
revenue rises.
Which of these two effects is bigger? It depends on the • In our example, suppose that Q only falls to 10
price elasticity of demand. (instead of 8) when you raise your price to
$250.
𝑷𝒓𝒊𝒄𝒆 𝒆𝒍𝒂𝒔𝒕𝒊𝒄𝒊𝒕𝒚 𝒐𝒇 𝒅𝒆𝒎𝒂𝒏𝒅
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑸𝒅
=
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑷
Revenue = P x Q
• If demand is elastic, then price elastic of

demand > 1
% change in Q > % change in P
• The fall in revenue from lower Q is greater than
the increase in revenue from higher P, so
Now, demand is inelastic: elasticity = 0.82
revenue falls.
If P = $200, Q = 12 and revenue = $2400.
If P = $250, Q = 10 and revenue = $2500.
When D is inelastic, a price increase causes revenue to

rise.
A C T I V E L E A R N I N G 2:
Elasticity and expenditure/revenue

Elastic demand (elasticity = 1.8)
A. Pharmacies raise the price of insulin by 10%.
If P = $200, Q = 12 and revenue = $2400. Does total expenditure on insulin rise or fall?
If P = $250, Q = 8 and revenue = $2000 Expenditure = P x Q
❖ When D is elastic, a price increase causes Since demand is inelastic, Q will fall less than 10%, so
revenue to fall. expenditure rises.
B. As a result of a fare war, the price of a luxury Since demand for drugs is inelastic, P rises
cruise falls 20%. Does luxury cruise companies’ proportionally more than Q falls.
total revenue rise or fall?
Result: an increase in total spending on drugs, and in
Revenue = P x Q
drug-related crime
The fall in P reduces revenue, but Q increases, which
❖ Shifting of the curve is different from
increases revenue.
movement along the curve.
Since demand is elastic, Q will increase more than 20%, o Movement – the factor is price
so revenue rises. (price increases revenue to fall; o Shifting – other price factor, many
however, since price decreases and the quantity determinants.
increased by more than 20%, so revenue rises)
Policy 2: Education
APPLICATION: Does Drug Interdiction Increase

or Decrease Drug-Related Crime?
• One side effect of illegal drug use is crime:

Users often turn to crime to finance their habit.
• We examine two policies designed to reduce
illegal drug use and see what effects they have
on drug-related crime.
Education reduces the demand for drugs. P and Q fall.
• For simplicity, we assume the total dollar value
of drug-related crime equals total expenditure Result: A decrease in total spending on drugs, and in
on drugs. drug-related crime.
• Demand for illegal drugs is in elastic, due to

addiction issues.
Price Elasticity of Supply
Policy 1: Interdiction
𝑷𝒓𝒊𝒄𝒆 𝒆𝒍𝒂𝒔𝒕𝒊𝒄𝒊𝒕𝒚 𝒐𝒇 𝒔𝒖𝒑𝒑𝒍𝒚
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑸𝒔
=
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑷
Price elasticity of supply measures how much 𝑸𝒔

responds to a change in 𝑷
• Loosely speaking, it measures the price -

sensitivity of sellers’ supply.
• Again, use the midpoint method to compute
Interdiction reduces the supply of drugs. the percentage changes.
Example: 5 different classifications, from least to most

elastic
Price
“Perfectly inelastic” (one extreme)
Price elasticity of supply
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 𝟎%
= =0
𝟏𝟔%
elasticity of supply equals = 2.0
𝟖%
The Variety of Supply Curves
• Economists classify supply curves according to

their elasticity.
• The slope of the supply curve is closely related
to price elasticity of supply. S curve: vertical, Seller’s price sensitivity: 0, Elasticity: 0
Rule of thumb:
• The flatter the curve, the bigger the elasticity. “Inelastic”

• The steeper the curve, the smaller the
elasticity.
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 < 𝟏𝟎 %
• % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃
=
𝟏𝟎%
=<1
S curve: relatively steep, Seller’s price sensitivity:

relatively low, Elasticity: < 1
“Unit elastic” “Perfectly elastic” (the other extreme)
Price elasticity of supply Price elasticity of supply
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 𝟏𝟎 % % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 𝒂𝒏𝒚 %

= =1 = = 𝑖𝑛𝑓𝑖𝑛𝑖𝑡𝑦
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 𝟏𝟎% % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 𝟎%
S curve: horizontal, Seller’s price sensitivity: extreme,

Elasticity: infinity
S curve: intermediate slope, Seller’s price sensitivity:
intermediate, Elasticity: = 1
The Determinants of Supply Elasticity
“Elastic” • The more easily sellers can change the quantity

they produce, the greater the price elasticity of
supply.
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 > 𝟏𝟎 %
= =>1
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 𝟏𝟎% Easy change in quantity produce = greater price
elasticity of supply.
❖ if there is a change in price, they could increase

the volume of their production
Example: Supply of beachfront property is harder to

vary and thus less elastic than supply of new cars.
• For many goods, price elasticity of supply is

greater in the long run than in the short run,
because firms can build new factories, or new
S curve: relatively flat, Seller’s price sensitivity: relatively
firms may be able to enter the market.
high, Elasticity: = > 1
A C T I V E L E A R N I N G 3: How the Price Elasticity of Supply Can Vary
Elasticity and changes in equilibrium Supply often becomes less elastic as Q rises, due to
capacity limits.
The supply of beachfront property is inelastic. The
supply of new cars is elastic.
• Suppose population growth causes demand for

both goods to double (at each price, 𝑸𝒅
doubles).
For which product will P change the most? For which

product will Q change the most?
Other Elasticities
The income elasticity of demand measures the

response of 𝑸𝒅 to a change in consumer income
Formula:
𝑷𝒆𝒓𝒄𝒆𝒏𝒕 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑸𝒅
=
Answers 𝑷𝒆𝒓𝒄𝒆𝒏𝒕 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒊𝒏𝒄𝒐𝒎𝒆
When supply is inelastic, an increase in demand has a
Recall from chapter 4: An increase in income causes an
bigger impact on price than on quantity.
increase in demand for a normal good.
• Hence, for normal goods, income elasticity > 0.

• For inferior goods, income elasticity < 0.
❖ Negative income elasticity coefficient = Inferior

good
o If income increases, demand decreases
for an inferior good.
❖ Positive income elasticity coefficient = normal
good
o If income increases, demand increases
When supply is elastic, an increase in demand has a
for a normal good.
bigger impact on quantity than on price.
The cross-price elasticity of demand measures the CHAPTER SUMMARY

response of demand for one good to changes in the
• Elasticity measures the responsiveness of 𝑸𝒅 or
price of another good.
𝑸𝒔 to one of its determinants.
Formula: • Price elasticity of demand equals percentage
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑸𝒅 𝒇𝒐𝒓 𝒈𝒐𝒐𝒅 𝟏

change 𝑸𝒅 in divided by percentage change in
=
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒈𝒐𝒐𝒅 𝟐 P.
o When it’s less than one, demand is
“inelastic.”
• For substitutes, cross-price elasticity > 0
o When greater than one, demand is
“elastic.”
o E.g., an increase in price of beef causes
• When demand is inelastic, total revenue rises
an increase in demand for chicken.
when price rises. When demand is elastic, total
revenue falls when price rises.
• For complements, cross-price elasticity < 0
o E.g., an increase in price of computers

• Demand is less elastic in the short run, for
causes decrease in demand for
necessities, for broadly defined goods, or for
software.
goods with few close substitutes.
• Price elasticity of supply equals percentage
❖ If cross-price elasticity = 0, there is no
change in 𝑸𝒔 divided by percentage change in
relationship between the two goods.
P.
o Not related, there are nothing.
o When it’s less than one, supply is
“inelastic.”
o When greater than one, supply is
“elastic.”
• Price elasticity of supply is greater in the long
run than in the short run.
o The income elasticity of demand
measures how much quantity
demanded responds to changes in
buyers’ incomes.
o The cross-price elasticity of demand
measures how much demand for one
good responds to changes in the price
of another good.
Problem complements: you need gasoline to run a

(gasoline-powered) car like a Honda Civic.
According to a Honda press release on October 23,
o So the complementary relationship between
2006, sales of the fuel-efficient four-cylinder Honda
gas and cars implies that the cross-price
Civic rose by 7.1% from 2005 to 2006. Over the same
elasticity between them is negative.
period, according to data from the U.S. Energy
Information Administration, the average price of But a Honda Civic adds another dimension to the
regular gasoline rose from $2.27 per gallon to $2.57 per comparison: it is a fuel-efficient car, not a gas-guzzler.
gallon. And fuel-efficient cars and gas guzzlers are gross
substitutes.
o Using the midpoint method, calculate the
cross-price elasticity of demand between o So as gasoline prices rise, the demand for gas-
Honda Civics and regular gasoline. guzzling cars falls and the demand for fuel-
o According to your estimate of the cross-price efficient cars (such as the Honda Civic), which
elasticity, are the two goods gross are gross substitutes, rises.
complements or gross substitutes? Does your o So the substitute nature between gas-guzzlers
answer make sense? and Honda Civics implies a positive cross-price
elasticity between gas and Honda Civics.
SOLUTION
Answer to Question: An increase in price from $2.27 to
Which effect is stronger?
$2.57, using the midpoint method, is a percent increase
❖ Clearly it is the substitution effect that is
of
stronger, because the data show a positive
$2.57 − $2.27
𝑥 100 = 𝟏𝟐. 𝟒% cross-price elasticity
($2.57 + $2.27)/2
So the cross-price elasticity of demand is
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑸𝒅 𝑓𝑜𝑟 𝑔𝑜𝑜𝑑 1 7.1%

= = 𝟎. 𝟔
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑔𝑜𝑜𝑑 2 12.4%
SOLUTION
Since the cross-price elasticity of demand between

Honda Civics and regular gasoline is positive, your
estimate says that the two are gross substitutes.
o This answer might seem perplexing because

cars and gasoline are generally gross

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Acctg 1102 - Managerial Economics (Midterm)

MODULE 1 THE ECONOMIC PROBLEM: Scarce Resources,

• Economics is the study of how people use their

• the ‘Study of allocation of scarce resources, o A resource is scarce when it is not

individuals, households, and organizations it)

❖ Allocation problems are faced by individuals,

ECONOMICS DEALS WITH: Resources are divided into four categories:

equally satisfied. the operation.

4. How a country reach equilibrium: o An individual who decides to combine

o “Allocating limited resources in such a resources and produce.

way that the desired goals are PAYMENTS FOR RESOURCES

GOODS AND SERVICES MARKETS

There are four types of decision makers: THE MARKET

HOUSEHOLDS 3. stock market – where commodities traded consist of

• Consumers - Demand goods and services securities of corporations

• Demand resources A SIMPLE CIRCULAR-FLOW MODEL

• Flow of Rational Self-interest: Individuals try to maximize the

CHOICE REQUIRES TIME AND INFORMATION

Rational decision makers acquire information as long as

• Rational decision makers

o Economics assumes that individuals, in making ECONOMIC ANALYSIS IS MARGINAL ANALYSIS

THE ROLE OF THEORY

• An economic theory captures the important

• Opinion IF ECONOMIST ARE SO SMART,

PREDICTING AVERAGE BEHAVIOR SINGLE GOAL OR MULTIPLE OF GOALS

❖ Individual behavior WHAT IS MANAGERIAL ECONOMICS?

for the group

THESE DEFINITIONS COVER A NUMBER OF

THE PROCESS OF MODEL-BUILDING MANAGERIAL ECONOMICS

• The economics ‘method’ • Economics in general takes a ‘positive’ and

WHAT IS A “GOOD” MODEL? ECONOMIC ANALYSIS

• It allows us to make predictions and set • Comparative Statics

WHY DO WE WANT TO APPLY ECONOMIC ANALYSIS TO

• A powerful “analytical engine”.

Performance: a judgment about the results of

Question Asked In Industrial Organization:

THE STRUCTURE-CONDUCT-PERFORMANCE MANAGEMENT SCIENCE: is essentially concerned with

2. Managerial economics can be used to make better

3. Managerial economics pertains to decision making

4. Managerial economics incorporates elements of both

❖ The rapid internationalization of the

MODULE 2 Problem: Over-Bidding Ovi Gas Tract

SUMMARY OF MAIN POINTS

• A well-designed organization aligns employee • i.e., why overbidding occurred

Answer the three questions: Problem-Solving Algorithm

ETHICS AND ECONOMICS

• The rational-actor paradigm can make students

• Debates about ethics and economics really are

Two different value system:

• Deontologists: actions are good or ethical if

• Anything that impedes the movement = difficult!

of assets to higher-valued uses, like o Like with kidney transplants, compatibility

taxes, subsidies, or price controls, problems lead to inefficiency.

destroys wealth. CAPITALISM 101

who stop unprofitable ones. individuals or firms, create wealth.

Despite high demand and low supply, buying and selling

Housing Example Discussion: How do you create wealth?

A house is for sale: Do Mergers Create Wealth?

The seller values the house at $120,000 use?

$130,000 - $128,000 = $2,000 buyer surplus

SELLER SURPLUS = the agreed-on price minus the

$128,000 - $120,000 = $8,000 seller surplus

TOTAL SURPLUS = buyer + seller surplus = difference in Alienware’s hands.