Managerial Economics Undergraduate (1) JAGA

Managerial Economics
Undergraduate Program, MGMT 2171.

Department of Management
College of Business and Economics
Addis Ababa University.
Chapter One
Introduction to Managerial Economics
Contents:
1.1 Definition, Managerial Issues, Decision Making
1.2 Scopes of Managerial Economics
1.3 The nature of the firm
1.4 Goals and Constraints
1.5 The circular flow of economic activity
1.6 The concept of profits

CHAPTER III
THEORY OF DEMAND AND ITS APPLICATION
3.1. Meaning of Demand, Types of Demand, Demand function
3.2. Elasticities of Demand, Importance of Elasticity Concept.
3.3. Measuring Demand Elasticities.
3.4. Elasticity applications.
Introduction to Economics:
Economics is a study of human activity both at
individual and national level.
Any activity involved in efforts aimed at earning
money and spending this money to satisfy our
wants such as food, Clothing, shelter, and others
are called “Economic activities”.
Introduction to Economics:
It was only during the eighteenth century that Adam Smith, the
Father of Economics, defined economics as the study of nature and
uses of national wealth‟.
Definition:
Dr. Alfred Marshall, one of the

greatest economists of the nineteenth
century, writes “Economics is a study
of man’s actions in the ordinary
business of life: it enquires how he gets
his income and how he uses it”.
Definition:
Prof. Lionel Robbins defined Economics as “the science, which
studies human behavior as a relationship between ends and
scarce means which have alternative uses”.
Microeconomics
1)The study of an individual consumer or a firm is

called microeconomics.
2)Micro means „one millionth‟.
3)Microeconomics deals with behavior and problems
of single individual and of micro organization.
4)It is concerned with the application of the concepts
such as price theory, Law of Demand and theories of
market structure and so on.
Macroeconomics:
1)The study of „aggregate‟ or total level of economic activity in a

country is called macroeconomics.
2)It studies the flow of economics resources or factors of
production (such as land, labor, capital, organization and
technology) from the resource owner to the business firms and
then from the business firms to the households.
3)It is concerned with the level of employment in the economy.
4)It discusses aggregate consumption, aggregate investment,
price level, and payment, theories of employment, and so on.
MANAGERIAL ECONOMICS
Managerial Economics refers to the firm‟s decision

making process. It could be also interpreted as
“Economics of Management” or “ Industrial economics
“ or “Business economics”.
Normative economics: focuses on the value of economic fairness, or what the economy "should be" or "ought to be.
Managerial Issues
1.Decreased performance levels 9.Skepticism
2.Being understaffed 10.Difficult employees
3.Lack of communication 11.Transition from coworker to
4.Poor teamwork manager
5.Pressure to perform 12.Weak workplace culture
6.Absence of structure
7.Time management
8.Inadequate support
OPERATIONAL ISSUES
Operational issues refer to those, which are within the business organization
and they are under the control of the management. Those are:
1. Theory of demand and Demand Forecasting
2. Pricing and Competitive strategy
3. Production cost analysis
4. Resource allocation
5. Profit analysis
6. Capital or Investment analysis
7. Strategic planning
1. Demand Analyses and Forecasting:
Factors that influence the demand for a
product.
Helps to manipulate demand.
It studies price elasticity and income
elasticity, cross elasticity as well as the
influence of advertising expenditure.
2. Pricing and competitive strategy:
Pricing decisions is part of managerial economics.

Price theory helps to explain how prices are
determined under different types of market conditions.
Competitions analysis includes the anticipation of the
response of competitions the firm‟s pricing,
advertising and marketing strategies.
Product line pricing and price forecasting occupy an
important place here.
3. Production and cost analysis:
Production analysis is in physical terms.

Cost analysis is in monetary terms cost
concepts and classifications, cost-output
relationships, economies and diseconomies
of scale and production functions are some
of the points constituting cost and
production analysis.
4. Resource Allocation:
Managerial Economics is the traditional economic theory
that is concerned with the problem of optimum allocation of
scarce resources.
Marginal analysis is applied to the problem of determining
the level of output, which maximizes profit.
In this respect linear programming techniques has been used
to solve optimization problems. In fact lines programming is
one of the most practical and powerful managerial decision
making tools currently available.
5. Profit analysis:
Managerial economics deals with techniques of
averting of minimizing risks. Profit theory guides in
the measurement and management of profit, in
calculating the pure return on capital, besides future
profit planning.
6. Capital or investment analyses:
The major issues related to capital analysis are:
1.The choice of investment project
2.Evaluation of the efficiency of capital
3.Most efficient allocation of capital. Knowledge of
capital theory can help very much in taking
investment decisions. This involves, capital budgeting,
feasibility studies, analysis of cost of capital etc.
7. Strategic planning:
Strategic planning provides a long-term

goals and objectives and selects the
strategies to achieve the same.
Strategic planning has given rise to be
new area of study called corporate
economics.
B. Environmental or External Issues:
They refer to general economic, social and political atmosphere within which
the firm operates. A study of economic environment should include:
The type of economic system in the country.
a. The general trends in production, employment, income, prices, saving
and investment.
b. Trends in the working of financial institutions like banks, financial
corporations, insurance companies
c. Magnitude and trends in foreign trade;
d. Trends in labor and capital markets;
e. Government’s economic policies viz. industrial policy monetary policy,
fiscal policy, price policy etc.
B. Environmental or External Issues:
The social environment refers to social structure as well as
social organization like trade unions, consumer‟s co-operative
etc.
The Political environment refers to the nature of state
activity, chiefly states‟ attitude towards private business,
political stability etc.
The environmental issues highlight the social objective of a
firm i.e.; the firm owes a responsibility to the society. Private
gains of the firm alone cannot be the goal.
Artefact-based Requirements Engineering
The Circular Flow of Economic
Activity
• The flow of payments in an economy is a circular flow.
• Individuals--people living in households--work for
businesses, rent their property (or their capital) to
businesses, and manage and own the businesses.
The Circular Flow
Describe how you have been
involved in the flow over the last
week of your life.
Activity
• All these activities generate incomes--flows of payments
from businesses to households.
• But households then spend their incomes--on
consumption goods, in taxes paid to governments, and on
assets like stock certificates and bank CDs that flow
through the financial sector.
Activity
• The two flows--of incomes and of expenditures--are equal:
all expenditures on products are ultimately someone's
income, and every piece of total income is also expended
in some way
Group work Assignment
1. Consider yourself as a Manager of a Firm and discuss how
managerial economics helps you in important decision making
process. (Individual) 20 Marks.
2. Explain how the Internal, External and Global Environments, plays
an important role in the conduct of business of your choice.
(Group) 20 Marks.
CHAPTER TWO & THREE
CHAPTER I - THEORY OF DEMAND AND ITS APPLICATION (6 hours)
2.1. Meaning of Demand, 2.2 Types of Demand, 2.3. Demand function
3.2. Elasticities of Demand, Importance of Elasticity Concept. Measuring
Demand Elasticities
3.3. Elasticity applications
Contents
CHAPTER II & III –
THEORY OF DEMAND AND ITS APPLICATION
• 2.1. Meaning of Demand,
• 2.2. Types of Demand,
• 2.3. Demand function
 3.1. Elasticities of Demand,
 3.2. Importance of Elasticity Concept.
 3.3. Measuring Demand Elasticities.
 3.4. Elasticity applications
Supply & Demand
Economics
DEMAND
The desire, ability,
and willingness to
buy a product or service
Do You Demand These?
Desire? Ability? Willingness?
Demand Schedule
A listing that shows the quantity demanded at all
Price Per CD # of CDs
Demanded prices.
$1 300
$2 162
$3 94
$4 58
$5 37
$6 25
$10 18
$15 13
$20 10
Demand Schedule Example
Price Per CD # of CDs
Demanded 30
$27 10
25
$24 13
$21 18 20
$18 25 15
$15 37
$12 58 10
$9 94
5
$6 162
0
$3 300 0 100 200 300
Law of Demand
P= Price QD= Quantity Demanded
P QD
P QD 
Item on sale, price mark up, etc.
The Law of Demand Graph
Price
Quantity Demanded
Change in Quantity Demanded
Price
Quantity Demanded
Non-Price Determinants of Demand
1) Buyer’s Income
2) Price of Substitutes
3) Market Size
4) Consumer Tastes
5) Consumer Expectations
6) Complement Goods
1) Buyer’s Income
Income  Demand
Income  Demand
Examples:
- Minimum wage increases
- Economic Recession
- The Great Depression
2) Price of Substitute Goods
Goods or services that can be used instead of other goods
or services, causing a change in demand.
3) Market Size
Market Size  Demand 
Market Size  Demand 

Examples:
• Immigration
• Detroit after collapse of auto industry
4) Consumer Tastes
The popularity of a good or service has a strong effect on the demand for
it, and in the marketplace, popularity can change quickly.
5) Consumer Expectations
What you expect prices to do in the future
can influence your buying habits today.
Examples:
HD TV’s
PS3
Gasoline
Homes
Automobiles
6) Complement Goods
When the use of one product increases
the use of another product.
Supply
The desire, ability, and willingness to offer products
for sale
*Anyone who offers an economic product for sale is a supplier
*When you work at your job, you are offering your services for
sale. Your economic product is labor. You would probably
supply more for a higher wage.
Law of Supply
P= Price QS= Quantity Supplied
P QS 
P QS 
Super bowl commercial

The Law of Supply Graph
Price
Quantity Supplied
Q: What causes a change in quantity supplied?
A: Price
Price
Quantity Supplied
Non-Price Determinants of Supply
1) Number of Products
2) Input Costs
3) Labor Productivity
4) Technology
5) Government Action
6) # of sellers
7) Producer Expectations
1) Number of Products
A successful new product or service always brings out competitors who initially raise
overall supply.
2) Input Costs
Input costs, the collective price of resources that go into producing a

good or service, affect supply directly
Examples
Minimum Wage increases
Cost of cotton increases, supply of t-shirts decreases
3) Labor Productivity
Better trained or more-skilled workers are usually more productive. Increased

productivity decreases costs and increases supply.
4) Technology
By applying scientific advances to the production process, producers have

learned to generate their goods or services more efficiently.
5) Government Action
Government actions, such as taxes or subsidies, can

have a positive or negative effect on production costs.
6) # of Sellers
# of sellers increases, supply increases

# of sellers decreases, supply decreases
Examples:
• McDonald’s Plans to Open 1,000 new stores in 2010
• All Circuit City stores in America went out of business
7) Producer Expectations
The amount of a product that producers are willing and able to supply may
be influenced by whether they believe prices will go up or down.
SUPPLY
Price
(The entire line --

ALL Prices & ALL Quantities)
Quantity Supplied
QUANTITY Supplied
Price
(POSITIVE SLOPE)
Quantity Supplied
Market Equilibrium
Situation in which prices are relatively stable and the quantity of goods or
services supplied is equal to the quantity demanded.
QS = QD
Equilibrium Price – the price that “clears the
market.” No Shortage or Surplus.
10
9
8
7
Equilibrium Price
6 Equilibrium Price
5
Equilibrium Quantity
Price
4
3
2
1
0
0 500 1000 1500 2000
Quantity
Surplus
Situation in which the quantity supplied is greater than the quantity
demanded at a given price.
QS > QD
P
Note: If there is a surplus, prices generally fall
At $8 there is a surplus of 700
10 Surplus of 700
9
8
7
6
5
Price
4
3
2
1
0
0 500 1000 1500 2000
Quantity
Shortage
The situation in which the quantity demanded is greater than the quantity
supplied.
QD > QS
P
Note: If there is a shortage, prices generally rise
A price of $3 causes a shortage of 900 units.
10
9
8
7
6
5
Price
4
3
2
1 Shortage of 900
0
0 500 1000 1500 2000
Quantity
Demand Elasticity
A term used to indicate the extent to which changes in price cause

changes in quantity demanded.
Elastic Demand
Occurs when a relatively small change in price causes a relatively large
change in the quantity demanded.
Inelastic Demand
Occurs when a change in price causes a relatively smaller change in the
quantity demanded.
Estimating Elasticity of Demand
Yes = Elastic No = Inelastic
Can purchase be delayed?

Are there adequate substitutes?
Does purchase use a large portion of income?
2 or more yes’s = elastic

2 or more no’s = inelastic
Elastic or Inelastic?
Necessity
The more necessary a good is, the lower the elasticity, as people will
attempt to buy it no matter the price, such as the case of insulin for
those that need it.
Marginal Analysis
• Marginal analysis is the process of breaking down a decision into a

series of 'yes or no' decisions. More formally, it is an examination of
the additional benefits of an activity compared to the additional costs
incurred by that same activity. If benefits > costs, this is the right
choice for a rational thinker.
The Time Value of Money
• The time value of money (TVM) is the concept that a sum of money is
worth more now than the same sum will be at a future date due to its
earnings potential in the interim. The time value of money is a core
principle of finance. A sum of money in the hand has greater value
than the same sum to be paid in the future.
Equilibrium - Meaning & Definition
 The term ‘equilibrium’ has often to be used in economic analysis. Equilibrium
means a state of balance.
 Modern economics sometimes called as equilibrium analysis.
 The word ‘equilibrium’ is derived from the Latin word ‘aequilbrium’ that means equal balance.
 According to Prof. Stigler “an equilibrium is a position from which there is no

tendency to move, we say net tendency to emphasize the fact that it is not
necessarily a state of sudden inertia but may instead represent the cancellation
of power forces”.
Types of equilibrium
Stable equilibrium
There is a stable equilibrium, when the object concerned, after having been
disturbed, tends to resume its original position.
Thus, in the case of a stable equilibrium, there is a tendency for the object to revert to
the old position.
According to Piguo, a ship with a heavy keel is in stable equilibrium. Another famous
simile is that of a bowl and a ball given by Schumpeter.
A ball that rests in a bowl is in stable equilibrium because if disturbed it will eventually
come to rest in its initial position after moving back and forth.
Stable Equilibrium
The below figure represents stable equilibrium at the point ‘P’ where MR=MC.
 When in equilibrium at P. The producer produces an output OM and maximizes his
profit.
In case the producer increases his output to OM2 or decreases it to OM1, the size of his
profits is reduced, this automatically bring forces tend to establish equilibrium again at P.
Unstable equilibrium
On the other hand, the equilibrium is unstable when a slight disturbance evokes
further disturbance, so that the original position is never restored.
 In the words of Prof. Marshall “As an egg if balanced on one of its ends would at
the smallest shake fall down, and lie length ways”.
If the bowl is inverted and the ball is perched on its top, it will be in unstable
equilibrium.
For once the ball is pushed, it falls off the top of the bowl to the ground and does
not return to its original position.
• The below figure represents the unstable equilibrium.
• Initially the producer is in equilibrium at point P. where MR=MC and he is producing amount OM of
output and maximizing his profits.
• If now he increases his output to OM1, he would be in equilibrium output at P1, where he will obtain
higher profits, since, at this output, marginal revenue is greater than marginal cost.
• Thus, there is no tendency to return to the original position at P.
Neutral equilibrium
It is neutral equilibrium when the disturbing forces neither bring it
back to the original position nor do they drive it further away from it.
It rests where it has been moved.
 Thus, in the case of a neutral equilibrium, the object assumes once-
for-all a new position after the original position is disturbed.
According to Prof. Piguo “An egg lying on its side is in neutral
equilibrium”.
Neutral equilibrium
The below figure represents the neutral equilibrium. In this case, MR=MC at all levels of output so that
the producer has no tendency to return to the old position and every time a new equilibrium point
is obtained, which is as good as the initial one.
Partial equilibrium
Partial or particular equilibrium analysis, also known as microeconomics, is the study of

the equilibrium position of an individual, a firm, an industry or group of
industries.
 It is a market process for the determination of product prices and factor prices in which
one or two variables are discussed, keeping all others constant.
In the words of professor Stigler “A partial equilibrium is one which is based on only a
restricted range of data, a standard example is price of a single product, the prices of
all other products being held fixed during the analysis”.
There are two types of problems that the partial equilibrium analysis can deal
with:
In the first category fall those problems, which pertain to some specific facets of
economic behaviour of certain individual, firm or industry.
For instance, it may limit itself to the market for a single product where its
price, the technique of production, and the amount of factors used in its
production are taken into consideration, while all other factors affecting it are
assumed to be constant.
Secondly, it studies only the first-order consequences of the economic events it
analyses.
It ignores the effects on the prices of other commodities brought about by the
product being analysed and in turn secondary influences of the former on the
product.
A consumer, a firm, an industry and a factor is said to be equilibrium under the
following conditions:
A consumer is in equilibrium when he spends his money income on the different

goods and services in such a way that he gets the maximum
satisfaction.
It is assumed that his tastes and preferences, money income and the price of the
goods he wants to buy are given and constant.
Industrial Equilibrium
An industry is in equilibrium when all its firms are earning normal profits and there is no
tendency for the existing firms to leave or for new firms to enter it.
 In the market for a single product, as it is called, only one price rules in the market at a
time, at which the quantity the consumers wish to buy exactly equals the quantity
being produced by the different firms.
Each firm in the industry sells at the ruling market price and produces that level of
output where its marginal cost equals marginal revenue.
In the short run, it can produce even at a price less than its average costs of production,
but in the long run the price must equal its minimum average costs of production.
Equilibrium of Firm
A firm is in equilibrium when it has no tendency to change its output. In the short run, it
equalizes its marginal revenue with marginal cost and in the long run it satisfies the
conditions of full equilibrium,
MC=MR=LAC
(i.e. Marginal Cost = Marginal Revenue = Long Run Average Cost) at its minimum.
Thus, it earns only normal profits and has no tendency to leave the industry.
In the analysis of the firm the given data are the techniques of production, the prices of
its products and of the factors.
Importance of partial equilibrium
Partial equilibrium analysis helps us in analysing the causes of a
change in the price of a product or service.
Similarly the causes of a change in the behaviour of an individual, a
firm or an industry can also be understood.
This helps in predicting the consequences of changes in the
behaviour and plans of the market participants.
That is, for an understanding of the general working of the
economic system, which involves the interdependence of
economic variables, partial equilibrium analysis acts as a
stepping stone.
Finally, it is an indispensable tool of analysis for the solution
of practical problems.
By concentrating on a limited and narrow range of economic
subjects and by reducing the field of enquiry to one or two
variables, it makes the economic problems simple and
understandable.
Marginal Revenue
Marginal Revenue (MR) is the extra revenue that an additional unit of product will
bring.
It is the additional income from selling one more unit of a good; sometimes equal to
price.
It can also be described as the change in total revenue/change in number of units sold.
Marginal revenue is equal to the change in total revenue over the change in quantity,
when the change in quantity is equal to one unit (or the change in output in the bracket
where the change in revenue has occurred)
Marginal Revenue
This can also be represented as a derivative. (Total revenue) = (Price demanded) times
(Quantity) or
TR = P * Q .
Concept of MR (Marginal Revenue). It is made clear with the following equation.
MR = dTR / dQ = dP / dQ * Q + dQ / dQ * P
= dP / dQ * Q + 1* P
= dP / dQ * Q + P
For a firm facing perfectly competitive markets, price does not change with quantity
sold dP / dQ = 0. So, marginal revenue is equal to price.
Marginal Revenue
For a monopoly, the price received will decline with quantity sold dP / dQ < 0.
So marginal revenue is less than price.
This means that the profit-maximizing quantity, for which marginal revenue is
equal to marginal cost, will be lower for a monopoly than for a competitive firm,
while the profit-maximizing price will be higher.
 When marginal revenue is positive, Price elasticity of demand [PED] is elastic,
and when it is negative, PED is inelastic.
When marginal revenue is equal to zero, price elasticity of demand is equal to -1.
Maximizing profits using MR
Regardless of market structure firm maximized profit by producing where MR = MC.

There are exceptions.
If variable costs are zero or nominal the firm should seek to maximize revenue rather
than follow the profit-max rule (MR = MC).
The Discounting Concept:
The discounting principle is based on the recognition of the time value of

money.
It is our common experience that a Birr tomorrow is worth less than a Birr today.
Whenever we compare the present and future values of money, we always
discount the future value to make it comparable with the present value.
In investment decisions, the discounting principle is highly useful.
 It is used to measure the relative worth of different project proposals.
A simple exposure to DCF & NDCF
methodologies
• DCF methodologies
• It is called the discounted cash flow method.

• Here we give value to the time.
• The money received as profits during a period of time like first year, second year…… 10th
year are reckoned as of today.
• This is called discounting method.
• Study the following table.
Time value of money
When you give a value to the time, the 1,00,000 going to be received during all the
above period, is not the same as Birr 1,00,000 you receive today.
It would be less than 1,00,000 . Net result, the total would be less than 1,00,000.
In the other case, when you adopt NDCF methodology, you are not giving any value to
the time.
 It means the 1,00,000 that you receive today & you receive after 10 years, are the same,
without any difference in their intrinsic values.
Time Value of Money
Money available today is worth more than the same amount of
money in the future, based on its earning potential.
Birr.20,000 after 3 years or Birr.20,000 now.
The formula for compound interest:
Compound amount = Principal (1 + r)n
Or, we can write Principal = compound amount/(1 + r)n
Or, Present value of money = Future value x Present value factor
where present value factor (PVF) = 1/ (1 + r)n
R = Discounting factor
N = No. of periods
Time value of money terms
Present value: Any value that occurs at the beginning of
the problem is a present value.
Future value: The last cash flow is generally called
future value. It can be understood as the cash transaction
taking place after certain duration of time.
Annuity payment: An annuity payment means the yearly payment
that occurs every year for more than one year. But in financial
terms, the duration may not be yearly, it may be less as well, say
quarterly, monthly, weekly, etc., but the duration between two
successive payments remains constant.
Each payment, if taken alone, is a future value, but together they
make an annuity.
It is important that annuity value is the sum of present values for
the interest rate for n years and it starts from the first year.
Discounting factor (r): Discounting factor is the expected returns
per unit period over the life of the project or investment. It is
necessary to understand that if annuity is for quarterly payments or
transactions, the annual expected return should be reduced to one
quarter for computational purpose. Similarly, if transactions are
made monthly, the annual expected return should be adjusted to
1/12th.
Number of periods (n): The total number of periods in any
annuity is very important as they define the value of any annuity.
It should again be noted that if transactions are done yearly, it is
the number of years, but in the situation of quarterly payments,
the number of periods should be quadrupled the number of
years.
Example
Mr. Roy wishes to invest some money for future need of Birr. 2
million after 5 years. How much should he deposit in the bank if
the bank, is offering an interest rate of 9% per year? What
should be the invested amount if interest is paid semi annually?
Solution
Present value of money = Future value x Present value factor
Where present value factor (PVF) = 1/(1 + r)n
PVF = 2000000/(1+.09)5
= 2000000/ 1.5386239549 = 1,299862.8
PVF = 2000000/(1+.045)10 = 1,287855.4
If interest is paid semi-annually, n = 10 and r = 4.5%.
CHAPTER 4
DECISION MAKING UNDER RISK AND UNCERTAINITY
4.1 The Nature of Decision Making

4.2 Meaning and Measurement of Risk
4.2.1. The Meaning of Risk
4.2.2. Risk and Probability Distributions
4.2.3. Risk and Expected values of an Investment
4.3. Approaches of incorporating Risk into Decision Making Process
4.4. Decision Making Under Uncertainty
CHAPTER FIVE
Production and Cost analysis
5.1. Theory of production
5.2 Theory of cost
5.3. Economies and diseconomies of scale
5.4. Economies of scope
Theory of Production and Cost
• Short and Long run production functions
• Behavior of Costs
• Law of Diminishing Returns
• Law of Returns to scale in the theory of production
• Fixed Costs and Variable Costs
• Explicit Costs and Implicit Costs
What are Costs?
• “The Market Value of the inputs a firm uses in production”
• Total Revenue – the amount a firm receives for the sale of its outputs.
• Eg: Each Ice-Cream takes Birr. 10 to make and it is sold at Birr. 25 – Nelum
sells 2000 ice-creams
Economic Cost
• This is different to accounting cost
• What is accounting cost?
• Remember Nelum? – She made Birr. 30000 profit making ice-cream. Assume Nelum was an amazing
programmer and she could earn Birr. 80000 a month programming.
• Her Opportunity cost = 80000 – 30000 = Birr. 50000
• Which means she is losing Birr. 50000 by making ice-cream.
Implicit and Explicit Costs
• Explicit Costs – input costs that require an outlay of money by the
firm.
• Implicit costs – input costs that do not require an outlay of
money by the firm.
• Accounting Profit = TR – Explicit Costs
• Economic Profit = TR – (Implicit Costs+ Explicit Costs)
No other investment yields as great a return as the investment in education.
An educated workforce is the foundation of every community and the future
of every economy.
Brad Henry
35
30
25 10
20 20
Profit Implicit Cost
15 10 30
10
Explicit Cost
5 10 10
0
Economic Profit Total Revenue Accounting Profit
The production functions
Two Assumptions
Short Run
Size of Nelum’s factory is fixed
She can only vary the amount of ice-cream by increasing workers
Long run – She can build a new factory.
The production function

The relationship between the quantity of inputs used to make a good and the
quantity of outputs for that good.
Output per Marginal Cost of factory Cost of workers Total Cost
Hour product of (FC) (VC) Number of
labour Workers
0 0 0 30 0 30
1 50 50 30 10 40
2 90 40 30 20 50
3 120 30 30 30 60
4 140 20 30 40 70
5 150 10 30 50 80
6 155 5 30 60 90
Production Function
Output per Hour
Output per Hour
6, 155
5, 150
4, 140
3, 120
2, 90
1, 50
0, 0
0 1 2 3 4 5 6 7
Total Cost Curve
• Marginal Product
• The increase in output that arises from an additional unit of
output
• Diminishing Marginal Product
• The property whereby the marginal product of an input
declines as the quantity of the input increases.
Total Cost
100
90
80
70
60
50
Total Cost
40
30
20
10
0
0 20 40 60 80 100 120 140 160 180
Fixed and Variable Costs
Fixed Costs
Costs that do not vary with the quantity of output produced
Variable Costs
Costs that vary with the quantity of output produced.
Average Total Cost – Total cost divided by the quantity of output
Average Fixed Cost – Fixed cost divided by the quantity of output
Average Variable Cost – Variable cost divided by the quantity of
output
Marginal Cost – The increase in total cost that arises from an extra
unit of production.
Cups Per
Hour Total Cost Fixed Cost Variable Cost Average Fixed Cost Average Variable Cost Average Total Cost Marginal Cost
0 300 300 0 0 0 0
1 330 300 30 300 30 330
2 380 300 80 150 40 190
3 450 300 150 100 50 150
4 540 300 240 75 60 135
5 650 300 350 60 70 130
6 780 300 480 50 80 130
7 930 300 630 43 90 133
8 1100 300 800 38 100 138
9 1290 300 990 33 110 143
10 1500 300 1200 30 120 150

350
300
250
200
150
100
50
0
0 1 2 3 4 5 6 7 8 9 10
Average Fixed Cost Average Variable Cost Average Total Cost

Observations
• Rising Marginal Cost
• MC rises with the quantity of output produced. This reflects the
property of diminishing marginal product.
• U-Shaped Average Total Cost
• Average fixed costs always reduces
• Average variable costs typically rises as output increases
because of diminishing marginal product
The bottom of the U shaped curve occurs at the quantity that
minimizes average total cost
Long run costs curves
• In the short term you cannot increase the number of factories,
only the number of workers
• In the long run this is not an issue.
• Economies of Scale – (Specialization) – When long run average

total costs falls as the quantity of output increases
• Diseconomies of Scale – (Coordination Issue) – When LRATC
increase as the output increases
• Constant returns of scale – When LRATC stays the same as the
quantity of output changes.
Unit 6
PRICING STRATEGIES AND PRACTICES
6.1 Introduction
6.2 Pricing strategies
Chapter 6
The Price Strategy
6.1 Considering Price Strategy
6.2 Calculating and Revising Prices

6.1
• Identify factors that affect price strategy.

• Explain the marketing objectives related to pricing.
• Describe the components that go into making price strategy decisions.
Section 11.1 Considering Price Strategy

6.1
Developing an effective price strategy is an important part of a marketing

plan.
It enables you to set prices consistent with your objectives and appropriate
for your target market.

6.1
fixed penetration pricing

variable psychological pricing
price gouging prestige pricing
price fixing odd/even pricing
resale price maintenance price lining
unit pricing promotional pricing
bait-and-switch multiple-unit pricing
return on investment bundle pricing
price skimming discount pricing

Factors Affecting Price
costs and supply and

expenses demand
$
technological consumer
trends perceptions
government competition
regulations
Section 11.1 Considering Price Strategy 204

Costs and Expenses
Fixed costs and expenses, such as rent, fixed costs and expenses that are not
utilities, and insurance premiums, affect subject to change depending on the
price. number of units sold

Costs and Expenses
Variable costs and expenses, such as the variable costs and expenses that are
cost of goods or services, sales subject to change depending on the
commissions, delivery charges, and number of units sold
advertising, also affect price.

Costs and Expenses
If you are selling goods, their costs are affected by the pricing structure in
the channel of distribution.
Each channel member has to make a profit to make handling the goods
worthwhile. Their cost and profit together is your cost.

Supply and Demand
The law of supply and demand also affects price.
When the demand for a product is high and supply is low, you can
command a high price.
When the demand for a product is low and supply is high, you must set
lower prices.

Consumer Perceptions
The price of your products helps create your image in the minds of
customers.
If your prices are too low, customers may consider your products
inferior.
If your prices are too high, you may turn some customers away.

Competition
Competition can affect pricing when the target market is price conscious
because competitors’ pricing may determine your pricing.
Businesses can charge higher prices than competitors if they offer added
value, such as personal attention, credit, and warranties.

Government Regulations
Be fair to customers and familiarize yourself with federal and state laws
that address pricing, including:
price gouging: *an act or instance of charging customers too high a price for goods or services, especially when demand is high and supplies are limited:
price fixing: * an agreement (written, verbal, or inferred from conduct) among competitors to raise, lower, maintain, or stabilize prices or price levels.
resale price maintenance: *an agreement between a manufacturer and a wholesaler or retailer not to sell a product below a specified
price.
unit pricing: * the price for one item or measurement, such as a pound, a kilogram, or a pint, which can be used to compare the same type of goods
sold in ...
bait-and switch advertising: * a deceptive pricing technique that involves promoting a product at a surprisingly low price

A company that engages in price price gouging an

gouging or price fixing is violating illegal practice in which competing
federal and state laws. companies agree, formally or
informally, to restrict prices within a
specified range
price fixing pricing above the market

when no other retailer is available

Resale price maintenance is illegal. resale price maintenance price fixing

imposed by a manufacturer on wholesale
or retail resellers of its products to deter
price-based competition
Unit pricing is required by law.

unit pricing the pricing of goods on
the basis of cost per unit of measure,
such as a pound or an ounce, in
addition to the price per item

Unethical practices, such as bait and bait and switch a deceptive method
switch, are not only illegal but also of selling in which a customer,
unfair to customers. attracted to a store by a sale-priced
item, is told either that the advertised
item is unavailable or that it is inferior
to a higher-priced item that is available

Technological Trends
The Internet and technological trends affect price strategy.
Adapting to technological changes can give an entrepreneur a

competitive edge; not adapting can cause some businesses to become
obsolete.

Technological Trends
Before setting prices, consider the following objectives:
obtaining a target return on investment

obtaining market share
social and ethical concerns
meeting the competition’s prices and establishing an image
survival
sometimes maintaining the status quo
Pricing Strategy Decisions
Consider your target market as you make these pricing strategy decisions:
Set a price based on the

Select a basic approach to Determine your pricing
stage of the product life
pricing. policy.
cycle.

Setting a Basic Price
There are three basic approaches to pricing
cost-based
demand-based pricing competition-based pricing
pricing

Pricing Policies
Establishing a pricing policy frees you from making the same pricing
decisions over and over again and lets employees and customers know
what to expect.

Pricing Policies
A flexible-price policy is one in which customers pay different prices for

the same type or amount of merchandise.
A one-price policy is one in which all customers are charged the same
price for all the goods and services offered for sale.

Product Life Cycle Pricing
All products move through the four-stage life cycle:
1 Introduction
2 Growth
3 Maturity
4 Decline

Price skimming is commonly used when price skimming the practice of

introducing a product. charging a high price on a new product
or service in order to recover costs and
maximize profits as quickly as possible;
the price is then dropped when the
product or service is no longer unique

Penetration pricing is also commonly penetration pricing a method used to

used when introducing a product. build sales by charging a low initial
price to keep unit costs to customers as
low as possible

Pricing Techniques
Once you have introduced your new psychological pricing

product through penetration pricing or a pricing technique, most often used by
price skimming, you need to adjust your retail businesses, that is based on the
belief that customers’ perceptions of a
prices so they are more attractive to product are strongly influenced by
customers by using psychological pricing. price; it includes prestige pricing,
odd/even pricing, price lining,
promotional pricing, multiple-unit
pricing, and bundle pricing

Psychological Pricing Techniques
prestige odd/even
pricing pricing
bundle Psychological
price
pricing Pricing lining
Techniques
multiple-unit promotional
pricing pricing

Pricing Techniques
A business may use prestige pricing to prestige pricing a pricing technique in

foster a high-end image. which higher-than-average prices are
used to suggest status and prestige to
the customer

Pricing Techniques
When a business uses odd/even pricing, odd/even pricing a pricing technique

customers may think they are getting a in which odd-numbered prices are
bargain. used to suggest bargains, such as
$19.99

Pricing Techniques
A store that sells all its jeans at $20, $40, price lining a pricing technique in
and $60 is using price lining. which items in a certain quality
category are priced the same

Pricing Techniques
A new restaurant that offers “1950s prices promotional pricing a pricing

for three days only” is using promotional technique in which lower prices are
pricing, a temporary pricing technique. offered for a limited period of time to
stimulate sales

Pricing Techniques
When a store sells three pairs of socks multiple-unit pricing a pricing

for $10, it is using multiple-unit pricing. technique in which items are priced in
multiples, such as 3 items for 99 cents

Pricing Techniques
Businesses that sell computer hardware bundle pricing a pricing technique in

often use bundle pricing to sell which several complementary products
software that may not have sold are sold at a single price, which is lower
than the price would be if each item
otherwise. was purchased separately

Pricing Techniques
Discount pricing is used by all types of discount pricing a pricing technique

businesses to encourage customers to buy. that offers customers reductions from
the regular price; some reductions are
basic percentage-off discounts and
others are specialized discounts

6.1
1. Identify factors that affect price strategy.
Factors that affect price strategy include costs, expenses, supply and demand, consumer
perceptions, the competition, government regulations, and technological trends.

6.1
2. Explain the marketing objectives related to pricing.
Marketing objectives related to pricing include obtaining a target return on

investment, obtaining market share, considering social and ethical issues, meeting the
competition’s prices, and establishing an image. They may also include surviving and
maintaining the status quo.

6.1
3. Describe the components that go into making price strategy

decisions.
To determine a pricing strategy, (1) select a basic approach to pricing (cost-based, demand-
based, or competition-based), (2) determine your pricing policy (flexible-price policy or one-
price, (3) set a price based on the stage of the product life cycle (introduction, growth, maturity,
or decline) using an effective pricing technique (psychological pricing or discount pricing).

6.2
• Carry out a break-even analysis.

• Apply formulas used in calculating markup and markup percentages.
• Employ formulas used to compute discounts.
• List considerations for updating the price strategy.
Section 6.2 Calculating and Revising Prices

6.2
Implementation of the price strategy requires an understanding of pricing

formulas.
Keeping your price strategy in tune with your market requires ongoing
review and revision.

6.2
break-even point markup

selling price markdown

Break-Even Analysis
To calculate the break-even point, you break-even point the point at which
divide fixed costs by the selling price the gain from an economic activity
minus your variable costs. equals the costs involved in pursuing it

Break-Even Analysis
Break-even analysis does not tell you what price you should charge for a
product, but it gives you an idea of the number of units you must sell at
various prices to make a profit.

Markup
Businesses that purchase or manufacture markup the amount added to the

goods for resale use markup pricing cost of an item to cover expenses and
based on the cost of the item. ensure a profit

Markdown
Entrepreneurs may use markdown markdown the amount of money

pricing to tempt shoppers to buy in order taken off an original price
to reduce inventory.

Discounts
A discount is a reduction in price to the customer.
multiply the item price by the discount percentage

then subtract the discount dollars from the price

Possible Changes to Pricing Strategy
Adjusting prices to maximize profit
Reacting to market prices
Revising terms of sale
Section 6.2 Calculating and Revising Prices 244

Adjusting Prices to Maximize Profit
Before you adjust prices to maximize profit,

ask yourself two questions:
Are your products’ prices elastic or

What are your competitors’ prices?
inelastic?

Reacting to Market Prices
As part of ongoing market research keep an eye on current market prices

for your products.
If competitors’ prices fall, you will lose customers if you do not lower
prices.
If competitors’ prices rise, it is important to your business’s financial

health to raise prices.

Revising Terms of Sale
Another way to change your pricing strategy is to revise the terms of sale,
such as
changing credit policies

introducing discounts
offering leasing
arranging financing

6.2
1. Explain how to Carry out a break-even analysis.
Divide fixed costs by the selling price minus variable costs.

6.2
2. Apply formulas used in calculating markup and markup

percentages.
Markup percentage on cost is determined by dividing markup by cost.

Markup percentage on selling price is determined by dividing markup by selling price.

6.2
3. Employ formulas used to compute discounts.
To compute discounts, the item price is multiplied by the discount percentage; then the
discount dollars are subtracted from the price. Series discounts are calculated in sequence.

6.2
4. List considerations for updating the price strategy.
Considerations for updating price strategy include a review of basic price strategies, pricing
policies, shifts in product life cycle, and pricing techniques. Another consideration is reviewing
the overall effectiveness of the price strategy. Adjustments to price strategy should reflect any
changes in objectives. These changes may lead to changes in the marketing plan.

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Managerial Economics

Undergraduate Program, MGMT 2171.

1.1 Definition, Managerial Issues, Decision Making

1.2 Scopes of Managerial Economics

1.3 The nature of the firm

1.4 Goals and Constraints

1.5 The circular flow of economic activity

1.6 The concept of profits

Dr. Alfred Marshall, one of the

1)The study of an individual consumer or a firm is

1)The study of „aggregate‟ or total level of economic activity in a

Managerial Economics refers to the firm‟s decision

Pricing decisions is part of managerial economics.

Production analysis is in physical terms.

Strategic planning provides a long-term

Market Size  Demand 

Market Size  Demand 

P= Price QS= Quantity Supplied

Super bowl commercial

Input costs, the collective price of resources that go into producing a

Better trained or more-skilled workers are usually more productive. Increased

By applying scientific advances to the production process, producers have

Government actions, such as taxes or subsidies, can

# of sellers increases, supply increases

(The entire line --

A term used to indicate the extent to which changes in price cause

Can purchase be delayed?

2 or more yes’s = elastic

• Marginal analysis is the process of breaking down a decision into a

 According to Prof. Stigler “an equilibrium is a position from which there is no

Partial or particular equilibrium analysis, also known as microeconomics, is the study of

A consumer is in equilibrium when he spends his money income on the different

Regardless of market structure firm maximized profit by producing where MR = MC.

The discounting principle is based on the recognition of the time value of

• It is called the discounted cash flow method.

4.1 The Nature of Decision Making

The production function

1 330 300 30 300 30 330

2 380 300 80 150 40 190

3 450 300 150 100 50 150

4 540 300 240 75 60 135

5 650 300 350 60 70 130

6 780 300 480 50 80 130

7 930 300 630 43 90 133

8 1100 300 800 38 100 138

9 1290 300 990 33 110 143

10 1500 300 1200 30 120 150

Average Fixed Cost Average Variable Cost Average Total Cost

• Economies of Scale – (Specialization) – When long run average

The Price Strategy

6.1 Considering Price Strategy

6.2 Calculating and Revising Prices

• Identify factors that affect price strategy.

Section 11.1 Considering Price Strategy

Developing an effective price strategy is an important part of a marketing

Section 11.1 Considering Price Strategy

fixed penetration pricing

Section 11.1 Considering Price Strategy

costs and supply and

Section 11.1 Considering Price Strategy 204

Section 11.1 Considering Price Strategy

Section 11.1 Considering Price Strategy

Section 11.1 Considering Price Strategy

The law of supply and demand also affects price.