CHAPTER 1

• The word economy comes from a Greek word Oikonomos which means “one who manages a
household.”

• Economics is the study of how society manages its scarce resources.

• Microeconomics and Macroeconomics

• Microeconomics focuses on the individual parts of the economy.

– How households and firms make decisions and how they interact in specific markets

• Macroeconomics looks at the economy as a whole.

– Economy-wide phenomena, including inflation, unemployment, and economic growth

The Diverse Fields of Economics

Examples of microeconomic and macroeconomic concerns

Production Prices Income Employment

Microeconomics Production/Output in Price of Individual Distribution of Employment by

Individual Industries Goods and Income and Wealth Individual
and Businesses Services Businesses &
  Industries
 Price of
 How much steel medical care  Wages in the auto Jobs in the steel
 How many offices  Price of industry industry
 How many cars gasoline  Minimum wages Number of
 Food  Executive salaries employees in a firm
prices  Poverty
 Apartme
nt rents
Macroeconomics National Aggregate Price National Income Employment and
Production/Output  Level Unemployment in
 Total wages the Economy
 Total  Consume and salaries  
Industrial Output r prices  Total Total number of
 Gross  Producer corporate profits jobs
Domestic Product Prices Unemployment rate
 Growth of  Rate of
Output Inflation

Fundamental Economic Problem

• There are three fundamental economic problems for every human society. It is immaterial
whether it is centrally planned, mixed or advanced industrial society.
 • They are what commodities are produced, how these goods are made and for whom they are
produced.

• What: Whether produce one good more and other less.

• How: how goods are produced; choice of technologies; division of labor who will do what.

• For whom: for whom are goods produced? Distribution of products among household; what
pattern it takes; where the income goes.

Economic System
1. Market, Command and Mixed System

– We have indicated three fundamental problems in the previous section. One can solve
those problems in different way. It is a question of organization that what, how and for
whom can be dealt with. The three available systems try to address those problems
under their respective market system.

– A market economy is one in which individuals private firms market the major decisions
about production and consumption. A system of prices, market, of profits and losses, of
incentives and rewards determines what, how and for whom. In extreme case the
economy is seen practicing laissez-faire which means non-interference from the
government side in economic decision making.

2. In a command economy the extreme opposite happens where the government takes all
decision about the economy.

3. Mixed economy consists of the elements of command and market. Most prevalent one.

Society can not have everything. In must decide through Input-Output relationship. It
must choose the technology. Inputs: land, labor, capital, and entrepreneurship. Out is the
commodity produced by these inputs.

Lionel Robbins

Economics is the science which studies human behavior as a relationship between ends and
scarce means which have alternative uses
INTRODUCTION OF MANAGERIAL ECONOMICS

What is Managerial Economics

 Douglas - “Managerial economics is .. the application of economic principles and methodologies
to the decision-making process within the firm or organization.”
 Pappas & Hirschey - “Managerial economics applies economic theory and methods to business
and administrative decision-making.”
 Salvatore - “Managerial economics refers to the application of economic theory and the tools of
analysis of decision science to examine how an organisation can achieve its objectives most
effectively.”
 Howard Davies and Pun-Lee Lam - “It is the application of economic analysis to business
problems; it has its origin in theoretical microeconomics.”
 From these ideas it can be concluded managerial economics is the discipline, which deals with
the application of economic theory to business management. Thus it lies on the borderline
between economics and business management and serves as a bridge between these two
disciplines.
 It is an application of that part of microeconomics that focuses on
a. Risk
b. Demand
c. Production
d. Cost
e. Pricing, and
f. Market Structure.
 It helps rational decision making through MODEL BUILDING

Concept of Managerial Economics

 Managerial economics is by nature goal oriented and prescriptive which may be viewed as
economics applied in decision making at the level of firm. Like an individual most of the
problems of the firm emerge in allocation of scarce resources.
 We can trace different ideas given by scholars in this subject.
 “Managerial economics is the price theory in service of business executive.”
-D.J. Watson
 “Managerial economics can be viewed as an application of that part of microeconomics that
focuses on such topics as risk, demand, production, cost, pricing, and market structure.”
-Petersen and Lewis
 “Managerial economics is concerned with the ways in which managers should make decisions in
order to maximize the effectiveness or performance of the organizations they manage.”
- Edwin Mansfield
 Following diagram shows how does the managerial economics provide the link between
traditional economics and decision sciences
 Optimal Decision
OPTIMAL SOLUTIONS
TO
MANAGERIAL DECISION
PROBLEMS
Distinction between Managerial Economics and Traditional Economics
There are some differences between managerial economics and traditional economic theory
because managerial economics seeks the help of other disciplines such as statistics, mathematics,
accounting, management to get optimal solution to the managerial decision-making problems.

 Managerial economics concerns with the application of economic principles to the problems
of the firm but the traditional economics deals with the body of principles itself.
 Managerial economics is highly microeconomics in character. It studies the problems of a firm
but does not study the macroeconomic phenomenon. But traditional economics consist of
both micro and macro economics.
 Traditional economics is a study of both firm and an individual, whereas managerial
economics is a study of the problem of a firm only.
 Managerial economics focuses its attention in the study of profits because it has great
influence primarily on entrepreneurial decision and value theory of the firm. In traditional
economics, the microeconomics is a branch under which all the theories of factor pricing such
as rent, wages, interest and profit are studied.
 Traditional economics studies human behavior on the basis of certain assumptions, but these
assumptions may not be true in managerial economics because managerial economics is
concerned with practical problems.
Scope of Managerial Economics
Microeconomics Applied to Operational Issues:
Operational issues of firms are of internal nature. Internal issues include all those problems which
arise within the business organization and fall within the control of the management. Some of the basic
internal issues are:
a) Choice of business and the nature of products, that is, what to produce,
b) Choice of size of the firm, that is, how much to produce,
c) Choice of technology, that is, choosing the factor-combination (technique of production)
d) Choice of price, that is, how to price the commodity,
e) How to promote sales,
f) How to face competition,
g) How to decide on new investments,
h) How to manage profit and capital,
 i) How to manage an inventory, that is, stock of both finished goods and raw materials.

Microeconomics deals with such questions confronted by managers. The following

microeconomic theories deal with most of these questions.

a) Demand Analysis and Forecasting: - An understanding of the forces behind demand is a

powerful tool for managers. Such knowledge provides the background needed to make pricing
decisions, forecast sales and formulate marketing strategies. A forecast of future sales is
essential before employing resources.
b) Theory of Production and Production Decisions: - Production theory explains the relationship
between inputs and output. It also explains under what conditions costs increase or decrease;
how total output behaves when use of inputs is changed; and how can output be maximized
from a given quantity of resources. Thus, it helps the managers in determining the size of the
firm, and the amount of capital and labour to be employed keeping in view the objectives of the
firm.
c) Market Structure and Pricing Theory: - Price theory explains how prices of outputs and inputs
are determined under different market conditions; when price discrimination is desirable,
feasible and profitable; and to what extent advertising can be helpful in expanding sales in a
competitive market. Hence, price theory can be helpful in determining the price policy of the
firm.
d) Analysis of Cost: - Estimates of cost are essential for planning purposes. The factors determining
costs are not always known or controllable which gives rise to cost uncertainty. Factors of
production are scarce and they have alternative uses. Factors of production may be allocated in
a particular way to get maximum output. Thus the analysis of costs and their links to output are
also importance in managerial economics.
e) Profit and Capital Management (Investment Decisions): - Profit provides the index of success of
a business firm. Profit analysis is difficult, because the uncertainty of expectations makes
realization of profit planning and measurement difficult and these areas are covered in the study
of managerial economics.
Capital management means planning and control of capital expenditures. Hence, it is very
important for a firm to manage required capital through proper investment planning. The main
topics covered are: cost of capital, types of investment decisions, and evaluation and selections
of investment projects.
f) Inventory Management: - Inventory refers to a stock of raw materials or finished goods which a
firm keeps. Management of inventory is very important for a firm to keep intact of its current
production and supply capacity and to meet the challenges arising from change in market and
other conditions. In this regard, a major question that arises is: how much of the inventory is the
ideal stock? If it is high, capital is unproductively tied up, and that might be useful for other
productive purposes if the stock of inventory is reduced. On the other hand, if the level of
inventory is low, production will be hampered. Hence, managerial economics uses different
methods which are helpful in minimizing the inventory cost.
 The Process of Model-building
• The economics ‘method’
• The steps: the hypothetical-deductive approach
1. make assumptions about behaviour
2. work out the consequences of those assumptions
3. make predictions
4. test the predictions against the evidence
5. PREDICTIONS SUPPORTED? The model is accepted as a good explanation (for the
moment)
6. PREDICTIONS REFUTED? Go back and re-work the whole process

Theoretical analysis, predictions, predictions tested against data

Economic Laws
Idea, hypothesis, theory, law
Economic Policy
Criteria for judging economic outcomes:

• Efficiency, or allocative efficiency. An efficient economy is one that produces what people want
at the least possible cost.

• Equity, or fairness of economic outcomes.

• Growth, or an increase in the total output of an economy.

• Stability, or the condition in which output is steady or growing, with low inflation and full
employment of resources.

The circular flow diagram

Assumptions
  Assumption: The economy composed of households and firms only
 Households: own factors of production, consume goods and service
 Firms: hire factors of production to produce goods and services

The Circular Flow of Economic Activity

 The diagram above represents the transactions between firms and households in a simple
economy.
 In the upper loop, the arrow emanating from firms to households represents the sale by firms of
goods and services to households. On the other hand, the arrow from households to firms
represents the payments.
 In the lower loop, the arrow originating from the households to the firms shows that firms hire
labor and capital from households in order to produce goods and services. The arrow
emanating from the firms indicates their payments for the use of the factors of production.
 Prices of outputs and inputs are determined in these markets and guide the decisions of all
market participants,
 The firm, an entity, organizes factors of production to produce goods and services,
 The prices of product and factor of production guide interaction between individual and firms.

The Production Possibilities Frontier

The production possibilities frontier is a graph that shows the combinations of output that the
economy can possibly produce given the available factors of production and the available production
technology.

Theory of a Firm
• Expected Value Maximization
– Owner-managers maximize short-run profits.
– Primary goal is long-term expected value maximization.
• Constraints and the Theory of the Firm
– Resource constraints. Ex. Issue to supplier
– Social constraints – ex. Negative feedback from customer
• Limitations of the Theory of the Firm
– Alternative theory adds perspective. – additional strategies
– Competition forces efficiency. – affordability of the product
– Hostile takeovers threaten inefficient managers. -

Firm includes:
1. Society
2. Investors
3. Employees
4. Customers
5. Management
6. Suppliers

Profit Measurement
 • Business Versus Economic Profit
– Business (accounting) profit reflects explicit costs and revenues.
– Economic profit.
• Profit above a risk-adjusted normal return.
• Considers cash and noncash items.
• Variability of Business Profits
– Business profits vary widely.

Why Do Profits Vary Among Firms?

• Disequilibrium Profit Theories
– Rapid growth in revenues.
– Rapid decline in costs.
• Compensatory Profit Theories
– Better, faster, or cheaper than the competition is profitable.

Role of Business in Society

• Why Firms Exist
– Business is useful in satisfying consumer wants.
– Business contributes to social welfare
• Social Responsibility of Business
– Serve customers.
– Provide employment opportunities.
– Obey laws and regulations.

How to Read and Understand Graphs

• Each point on the Cartesian plane is a combination of

(X,Y) values.

• The relationship between X and Y is causal. For a given

value of X, there is a corresponding value of Y, or X
causes Y.

Reading Between the Lines

• A line is a continuous string of points, or sets of (X,Y)

values on the Cartesian plane.

• The relationship between X and Y on this graph is

negative. An increase in the value of X leads to a
decrease in the value of Y, and vice versa.

Positive and Negative Relationships

 An upward-sloping line
describes a positive
relationship between X and Y.

A downward-sloping line
describes a negative
relationship between X and Y.

Chapter 2

 Revenue : the money that comes into the firm from the sale of their goods
• Profit: The money that business makes: (Revenue minus Cost; plus or loss)
• Cost: the expense that must be incurred in order to produce goods for sale

“Cost” is not a simple concept. It is important to distinguish between different

types for example:

• Fixed Costs: costs of production that we cannot change (ex. the rent)
• But, some cost elements are related to the volume of sales; that is, as sales go
up, the expenses go up.
• Variable Costs: costs of production that we can change(ex. raw materials)

Economic Versus Accounting Measures of Cost and Profit

• The discipline of accounting provides guidelines for the measurement of revenue,

cost, and profit that analyses based on generally accepted principles.

For example:
• Corporation: the financial Statement produced which help investors and
creditors to asses the health of the corporation.
• Individuals and businesses must produce tax return to determines a fair
measures of their income (taxation purposes).

• In economic perspective the costs is relevant to decision making which may not
considered as a costs from perspective of accounting standards, for example:
 • The owner/operator of a firm invests time and effort in operating a
business.
These would typically not be treated as expenses on the proprietorship’s
tax return but are certainly relevant to the owner in deciding how to manage his self-run
business.

• Opportunity Cost: The value of the next best alternative forgone (ex. A
warehouse).
• Sunk Cost: Money that has been spent in the past and should not be taken into
account in the current decision (ex. training, R&D…etc).

• An economic perspective, ignoring sunk costs and including opportunity costs,

you can conclude that a venture is worth pursuing if it results in an economic
profit of zero or better.
• This opportunity cost could be estimated and included in the economic cost. If
the resulting profit is zero or positive after netting out the opportunity cost of
capital, the investor’s participation is worthwhile

• Accounting Profit: A The difference between Revenue and Accounting costs.

• Economic Profit: The difference between Revenue and Economic costs.
• Accounting Cost: Only those costs that must be explicitly paid by the owner of a
business ($10000-$5000)=$5000
• Economic Cost: The sum of variable cost, fixed cost, and the value of the next
best alternative use of the money involved in a business. ($10000-($4000+
$1000+$2000))=$3000

•
Revenue, Cost, and Profit Functions
• Functions a relationship between the volume or quantity created and sold and
the resulting impact on revenue, cost, and profit. These relationships are
expressed in functions

• Revenue function: The product of the price per unit times the number of units
sold; R = P*Q.
• Cost function: The sum of fixed cost and the product of the variable cost per unit
times quantity of units produced, also called total cost; C = F + V*Q.
• Profit function: The revenue function minus the cost function; in symbols π = R -
C = (P*Q) - (F + V*Q).
• Average cost function: The total cost divided by the quantity produced; AC =
C/Q.

Break-even analysis
• Breakeven point: The volume of business that separates economic loss from
economic profit; the quantity at which the revenue function and the cost function
are equal. BE= (R = TC)
Revenue would equal or exceed costs.
Average cost per unit is equal to the price.

Unit contribution margin: The difference between the price per unit and the variable
cost per unit; price per unit - variable cost per unit. Q = FC/(P− VC)
($40,000/($1.5-$0.30))= 33,333 Units

The Impact of Price Changes

• Demand curve: The relationship between the price charged and the maximum
• unit quantity that can be sold.

• Law of demand: Increases in price result in decreases in the maximum quantity

that can be sold.

Demand curve, is generally downward sloping because As quantity goes down price per
unit increases, As quantity goes up, price per unit decreases

Marginal Analysis
In economics, marginal = additional
• Marginal measurement: The change in a function in response to a small change
in quantity; used to determine the optimal level of planned production.
• Marginal revenue: The additional revenue from selling each additional unit of the
good. Δ R ÷ Δ QSold
• Marginal cost: The additional cost of producing each additional good produced.
ΔTC ÷ ΔQ
• Marginal profit: The change in profit resulting from a unit increase in the quantity
sold.
 • As long as marginal revenue is greater than or equal to marginal cost, a firm will
continue to produce. MR ≥ MC
• If marginal revenue is less than marginal cost, a firm will not produce. MR < MC

The Shutdown Rule

•Shutdown rule: When all fixed costs are regarded as sunk for the next production
period, a firm should continue to operate only as long as the selling price per unit
is at least as large as the average variable cost per unit. Otherwise, the firm
better to shutdown operations immediately.
Selling price per unit ≥ AVC

• Economists would say that a business should make decisions that maximize the
value of the firm, meaning the best decisions will result in larger economic profits
either now or later.
• The overall goal of a firm is to maximize its value.
• The value of the firm: The collective worth of all economic profits into the future
and the amount the owners would expect to receive if they sold the business; for
a corporation, the equity on a company's balance sheet.
• Recommended to evaluate anticipated total costs to total expected potential
benefits in order to determine whether the proposed implementation of project is
worthwhile (Cost-Benefit-Analysis).

Chapter 3
• Demand of commodity refers to the quantity of a commodity which a consumer is
willing to buy at a given price, and time.
• Demand Function: Demand Function is the functional relationship between demand
and factors affecting demand. Dx = f (Px, Po, Y, T, E)
• Individual demand Function shows how demand for a commodity, demanded by
individual consumer in the market. It is related to its various determinants: -Dx = f ( Px,
Pr, Y, T E )

Factors affecting demand

• Price of Commodity: When the price of commodity rises demand of commodity will decrease
andviceversa.
• Price of other related commodity: Price of other commodity affect the demand of
commodity in two ways:
1) Substitute Goods:- In the case of substitute goods, the demand for a commodity rises
with a rise in the Price and fall with the fall in price.
Example- Tea and coffee
2) Complementary Goods:- In case of complementary goods, the demand for a
commodity rises with fall in the Price and decreases with the rise in the price of
complementary goods. Example: Car and Petrol, Ink and Pen, Bread and Butter.
• Income of Consumer:- When the Income of Consumer rises the demand of normal goods
increases and if the income decreases the demand of normal good decreases. In case of
Inferior good the demand will decrease with rise in income and increase with decrease in
income.
• Taste and Preference: - If the taste and preference of consumer develop for a commodity
the demand will rise.
• Expectation: - If the consumer expects that price in future will rise the demand will rise and
vice-versa
• Population:- More population, more demand, less population less demand.
• Climate: - The demand of commodity changes according to the climate.

Market Demand Function

• Market Demand: Market Demand refers to the sum total of the quantities demanded
by
all the individual households in the market at various prices in given time.
Mkt. Dx = f ( Px, Pr, Y, T, E, P, D )

Law of Demand
• Other things are equal, the demand for a good rises with a decrease in price and
decreases with increase in price.

Assumption of law of demand

1) Price of related goods should not be change.
2) Income of the consumer should not change.
3) Taste and preferences should not be change.
4) No change in price in future.

EXCEPTIONS OF LAW OF DEMAND.

1) Inferior good or Giffen goods.
2) Goods become scarce in future.
3) Articles of social distinctions.
4) Necessities
5) Ignorance.
6) Emergency.

• Demand curve upward When Law of demand fails.

Movement in demand curve

Change in quantity demanded
1) Extension in demand - Caused by decrease in own price of the commodity. Downward
movement along the demand curve)
 Extension of demand also called expansion in demand. Movement along the
demand curve refers to extension and contraction in demand. Both are caused by change in
own price of the commodity.

2) Contraction in demand -Caused by increase in own price of the commodity

Contraction in demand refers to decrease in quantity demanded due rise in own
price of the commodity.

Shift in demand curve - Caused by change in factors other than own price of the commodity.
1) Demand Curve shift to left ) – when there’s a Decrease in demand or Backward shift in
demand curve
2) Demand Curve shift to Right – when there’s an Increase in demand or Forward shift in
demand curve

Change in Demand - It is also called shift in demand curve. When quantity of commodity
changes due to change in factor other than price. It has two types: -
1. Rightward shift in demand.
2. Leftward shift in demand.
RIGHTWARD SHIFT IN DEMAND. – or Increase in demand.
It means that quantity demanded of a commodity increases even than price of the
commodity remains constant OR When quantity of a commodity increases due to other factors
and price of the commodity remains constant.

FACTORS SHITING DEMAND RIGHTWARD.

1) When income of the consumer increases.
2) When price of substitute good increase.
3) When price of complementary good falls.
4) When taste of the consumers shifted in favour of the commodity due to change in
fashion and climate.

LEFTWARD SHIFT IN DEMAND

FACTORS SHIFTING DEMAND CURVE LEFTWARD.
1) When income of the consumer’s falls.
2) When price of the substitute goods decrease.
3) When price of the complementary goods increases.
4) When taste of the consumer shifts against the commodity due to change in fashon or
climate

Elasticity of Demand - The elasticity of demand measures the responsiveness of the quantity
demanded due to change in price of the commodity

Measurement of elasticity of demand

Total Expenditure Method/Total outlay method

• If no change in total expenditure as change in price than Ed=1
• If total expenditure and price changes in opposite direction Ed>1
• If total expenditure and price changes in same direction Ed<1

Proportionate or Percentage Method

Under this method elasticity of demand is measured by the ratio of the percentage
change in quantity demanded to the percentage in price.

Ed = Percentage change in Quantity Demanded

Percentage change in Price

Geometric Method/ Point Elasticity Method

If elasticity of demand is to be measured on the point of demand curve following
formula is to be used.

ed = Lower segment from the point

Upper segment from the point
Factors effecting elasticity of Demand
• Nature of Goods
• Availability of Substitutes
• Postponement of Consumption
• Number of Uses
• Time period
• Habit of consumer

Price did not change, as demand increases

As the price increases, the demands remain the same

As the price decreases, the quantity demanded increases

Price - This is the only element in the marketing mix that brings in the revenues. All the rest
are costs. Price communicates the value positioning of the product.

A firm must set a price for the first time when

• It develops a new product
• It introduces its regular product into a new distribution channel or geographical area
• It enters bids on new contract work ( as in Industrial Sale )
• A company must set its price in relation to the value delivered and perceived by the
customer

Company misses potential profit = Higher price + lower perceived value

Company fails to harvest potential profit = lower price + lower perceived value

Price = Cost + profit

Pricing policy (Factors)

1) Selecting the pricing objective
2) Determining demand
3) Estimating costs
4) Analyzing competitors – costs, prices, offers
5) Selecting a pricing method
6) Selecting the final price

Pricing objectives
The company first decides where it wants to position its market offering. The objective
could be :-
 Survival
 Maximize current profit
 Maximize market share
 Maximize market skimming
 Product - quality leadership

Determining demand
Each price will lead to a different level of demand and have a different impact on a
company’s marketing objectives. Demand and price are inversely related i.e. Higher the price,
lower the demand
Company needs to consider :-
 Price sensitivity
 Price elasticity of demand
What influences price sensitivity
 Shared cost ( part of cost is borne by other party )
 Sunk investment (product used is required as a complement to earlier purchase )
 Inventory effect ( buyers cannot store the product )
 Items bought more frequently ( more sensitive ) / infrequently ( less sensitive )
 Unique value effect ( quality , prestige or exclusiveness )
 Substitute awareness by buyers
 Difficult comparison by buyers
 End benefit ( expenditure small part of total income )
 Total expenditure ( purchase cost is insignificant compared to the cost of end product )
 Low – cost items (less sensitive ) / high cost items ( more sensitive )

Price elasticity
This determines the changes in demand with unit change in price
 If there is little or no change in demand, it is said to be price inelastic.
 If there is significant change in demand, then it is said to be price elastic.

Demand is likely to be less elastic when:

 There are few or no substitutes

 Buyers readily do not notice the higher price
 Buyers are slow to change their buying habits
 Buyers think that the higher prices are justified

Price quality strategy

Estimating costs
 Fixed costs
 Variable costs
 Learning curve
 Activity based costing
 Target costing

Pricing Methods
 Markup pricing
 Target return pricing
 Perceived value pricing
 Value pricing
 Going rate pricing
 Sealed bid pricing

Psychological pricing
 It is used to lessen the impact of the actual pricing in the consumers mind
 It is used as a surrogate to indicate the product quality or esteem

New methods of pricing

 Group Pricing
 Gain and Risk sharing pricing

Geographical Pricing
 Different pricing at different locations
 Could be in terms of barter, countertrade and foreign currency

Discounts and allowances

 Early payment
 Off – season
 Bulk purchase
 Retail discount
 Cash discount
 Trade in allowance
Promotional pricing
 Loss leader pricing
 Special event pricing
 Cash rebate
 Low interest financing
 Longer payment terms
 Warranties and service contracts
 Psychological discounting

Discriminatory Pricing
 Customer segment
 Product form
 Image pricing
 Location pricing
 Time pricing

Preconditions
 Market must be segment able
 The lower price segment should not be able to resell the product to the higher price
segment
 The competitors must not be able to undersell the firm in the higher price segment
 Should not breed customer resentment and ill will
 Price discrimination should not be illegal

Product mix pricing

 Product line pricing
 Optional feature pricing
 Captive product pricing
 Two part pricing
 Byproduct pricing
 Product bundling pricing

Initiating Price cuts

 Excess plant capacity
 Competition
 Aggressive pricing

Initiating price increases

 When demand exceeds supply
 When costs go up
 Govt. policies
 Reduce/remove discounts and rebates

Indirect prices increases

 Shrinking pack size for same price
 Substituting less expensive raw materials
 Reducing product features
 Removing product services
 Using less expensive packaging material
 Reducing the no. of packs and sizes offered
 Creating new economy brands

Reaction to price changes

 Customer reaction
 Competitor reaction

Responding to competitors price changes

 Maintain price
 Maintain price and add value
 Reduce price
 Increase price and quality
 Launch a low price fighter
Chapter 4 Cost and Production
• Firm is an economic institution that transforms factors of production into consumer
goods.

 Organizes factors of production.

 Produces goods and services.
 Sells produced goods and services.

Forms of Business

Sole Propreietor Partnership Corporation

Advantages 1) Minimum 1) Ability to share 1) No personal
bureaucratic work and risks liability
hassle 2) Relatively easy to2) Increasing
2) Direct control by form ability to get funds
owner 3) Ability to
shed personal
income and gain
added expenses
Disadvatages 1) Limited ability to 1) Unlimited personal 1) Legal hassle
get funds liability (even for to organize
2) Unlimited partner’s blunder) 2) Possible
personal liability 2) Limited ability to double taxation of
get funds income
3) Monitoring
problems

The firm and the market

• Transaction costs — the costs of undertaking trades through the market.
• Profit is the difference between total revenue and total cost.
Profit = total revenue – total cost
• For an economist, total cost is explicit payments to factors of production plus the
opportunity cost of the factors provided by the owners of the firm, which is an implicit
cost.
• For an economist, Economic Profit = total revenue – (implicit and explicit cost)
• A long-run decision is a decision in which the firm can choose the least expensive method
of producing from among all possible production techniques.
• A short-run decision is one in which the firm is constrained by past choices in regard to
what production decision it can make.
• In the long run, all inputs are variable.

• In the short run:

a) Flexibility is limited.
b) Some factors of production cannot be changed.
c) Generally, the production facility (“the plant”) is fixed.

Production Table
• Total product is the number of units of the good or service produced by different
numbers of workers.
• Production
• Marginal product is the additional output that will be forthcoming from an
additional worker, other inputs remaining constant.
• Average product is calculated by dividing total output by the number of workers
who produced it.

Number of Total Marginal Average

workers Output
0 0
1 4
2 10
3 17
4 23
5 28
6 31
7 32
8 32
9 30
10 25
Product product
4 0
6 4
7 5
6 5.7
5 5.8
3 5.6
1 5.2
0 4.6
-2 4.0
-5 3.3
2.5

Production Functions
• Production function – a curve that describes the relationship between the inputs
(factors of production) and output.
• The production function tells the maximum amount of output that can be derived
from a given number of inputs.

Diminishing Marginal Productivity

  Law of diminishing marginal productivity – as more and more of a variable input is
added to an existing fixed input, after some point the additional output one gets from
the additional input will fall.
 Fixed costs are those that cannot be changed in the period of time under consideration
regardless of output.
 In the long run there are no fixed costs since all costs are variable.
 In the short run, a number of costs will be fixed.
 Variable costs are costs that change as output changes, such as the costs of labour and
materials.
 The sum of the fixed costs and variable costs are total costs. TC = FC + VC

Average Costs
 Average total cost (often called average cost) equals total cost divided by the quantity
produced. ATC = TC/Q
 Average fixed cost equals fixed cost divided by quantity produced. AFC = FC/Q
 Average variable cost equals variable cost divided by quantity produced. AVC = VC/Q
 Average total cost can also be thought of as the sum of average fixed cost and average
variable cost. ATC = AFC + AVC

Marginal Cost
 Marginal cost is the increase in total cost of increasing the level of output by one unit,
MC = DTC/DQ
 In deciding how many units to produce, the most important variable is marginal cost.

The Cost of Producing Earrings

Output FC VC TC MC AFC AVC ATC
3 50 38 88 0 16.67 12.67 29.33
4 50 50 100 12 12.50 12.50 25.00
9 50 100 150 0 5.56 11.11 16.67
10 50 108 158 8 5.00 10.80 15.80
16 50 150 200 0 3.13 9.38 12.50
17 50 157 207 7 2.94 9.24 12.18
22 50 200 250 0 2.27 9.09 11.36
23 50 210 260 10 2.17 9.13 11.30
27 50 255 305 0 1.85 9.44 11.30
28 50 270 320 15 1.79 9.64 11.43

Relationship Between Productivity and Costs

  The shapes of the cost curves are mirror-image reflections of the shapes of the
corresponding productivity curves.

Relationship Between Marginal and Average Costs

 The marginal cost and average cost curves are related.
 When marginal cost exceeds average cost, average cost must be rising.
 When marginal cost is less than average cost, average cost must be falling.
 This relationship explains why marginal cost curves always intersect average cost
curves at the minimum of the average cost curve.
 To summarize:
If MC > ATC, then ATC is rising.
If MC = ATC, then ATC is at its minimum.
If MC < ATC, then ATC is falling.

 Marginal and average total cost reflect a general relationship that also holds for
marginal cost and average variable cost.
If MC > AVC, then AVC is rising.
If MC = AVC, then AVC is at its minimum.
If MC < AVC, then AVC is falling.