Managerial Economics is the science of cost-
effective management of scarce resources.
Wherever resources are scarce, managers can
make more cost-effective decisions by applying
the discipline of managerial economics. The
decisions may regard customers, suppliers,
competitors, or the internal working of the
organization.
Three (3) branches of Managerial Economics:
Competitive markets
Market power
Imperfect markets
Scope of Managerial Economics
•study of individual economic
Microeconomics
behavior where resources are costly
Managerial • application of microeconomics to
Economics managerial issues
• focuses on aggevate economics
Macroeconomics
variables
Methodology
Economic Model – Concise description of behavior
and outcomes.
Assumptions in Managerial Economics
1. Ceteris Paribus - assertion in economic theory
that in the analysis of the relationship between
two variables, all other variables are assumed to
remain unchanged.
2. Ockham’s Razor - principle that, other things
being equal, the simplest explanation tends to be
the correct explanation.
Difference in Stocks and Flow
 Stock - Quantity at a specific point in time
 Flow - Change in a stock over some period
of time
Two Type of Economic Model
a) Static Model - Describes behavior at a single
point in time.
b) Dynamic Model - Explicitly focuses on the
timing and sequence of actions
and payments.
Basic Equation of Managerial Economics:
Value Added = Buyer benefit-Seller cost
= Buyer surplus+ Seller economic
profit
 The above equation states that value
added is the only extent that the business
deliver benefit to the buyers that exceeds
the cost of production that they create
value.
 Anyone who delivers benefit which is less
than the cost of production.
 The buyer gets some part of the value
added in buyer surplus, which is the
difference between buyer’s benefit and
their expenditure.
 The sellers gets the other part of the value
added in economic profit, which is the
difference between the revenue that the
seller receives(equal to the buyer
expenditure) and the cost of the
production.
Average Value
The total value of variable divided by total
quantity of the measure
Marginal value
Anchoring
The change in the variable associated with
a unit increase in measure.
Sunk Cost Fallacy
 Sunk cost refers to money that has
already been spent and which cannot be
recovered. It is excluded from future
business decisions because the cost will
remain the same regardless of the
outcome of a decision.
 The sunk cost fallacy is when we continue
an action because of our past decisions
(time, money, resources) rather than a
rational choice of what will maximise our
utility at this present time. For example,
Suppose you take out a 12-month gym
membership, costing $40 a month. You
have committed to spending 12*$40 =
$480. Once you have signed your contract,
you have effectively committed to $480. It
is now a sunk cost – you can’t get it back.
Whether you go to the gym or not, makes
no difference to the sunk cost.
Status Quo Bias
 is an emotional bias; a preference for
the current state of affairs. The
current baseline (or status quo) is
taken as a reference point, and any
change from that baseline is perceived
as a loss. For example, When offered
several sandwich options for lunch,
individuals often choose a sandwich
they have eaten before. This
phenomenon is called regret
avoidance: in seeking to avoid a
potential regrettable experience
(choosing a new sandwich and
disliking it), individuals opt to stick
with the status quo (the sandwich
with which they are already familiar).
 is the use of irrelevant information,
such as the purchase price of a
security, as a reference for evaluating
or estimating an unknown value of a
financial instrument.
 is a behavioral finance term to
describe an irrational bias towards a
psychological benchmark.
 For examples,In one instance, traders
are typically anchored to the price at
which they bought a security. For
example, if a trader bought stock ABC
for $100, then she will be
psychologically fixated on that price
for a sale or further purchases of the
same stock, regardless of ABC's actual
value based on an assessment of
relevant factors affecting it.
In another, analysts may become
anchored to the value of a given index
at a certain level instead of
considering historical figures. For
example, if the S&P 500 is on a bull
run and has a value of 10,000, then
analyst propensity will be to predict
values closer to that figure rather than
considering standard deviation of
values, which have a fairly wide range
for that index.
Discounting
 A procedure to transform future
dollars into an equivalent number of
present dollars.
Outsourcing
 The purchase of services or supplies
from external sources.
Market
Buyers and sellers who communicate with
one another for voluntary exchange.
Industry
Businesses engaged in production or
delivery of the same or similar items.
Competitive markets are characterised by:
 Many firms as opposed to a small number
 Low barriers to entry and exit. –
Contestable market
 Low profits of incumbent firms
 Relatively low prices.
Market Power
The ability of a buyer or a seller to
influence market conditions.
Imperfect Markets
- when one directly parties directly
conveys a benefit or cost to others, or
-when one party has better information.
Managers of business in imperfect markets need
to think strategically. For instance, a residential
mortgage lender may require all loan applicants to
pay for a credit evaluation, with the lender
refunding the cost, if the credit evaluation is
favorable. The lender might reason that would not
be willing to pay for the credit evaluation because
they would fail the check. Good borrowers,
however, would pay for the evaluation because
the would their money back from the lender.
Hence, the credit evaluation requirement will
screen out the bad borrowers. This is an example
of strategic thinking in an imperfect market.
DEMAND
Determinants of Demand
1. Income - A rise in individual’s income will lead
to an increase in demand in
normal products. While goods whose demand
varies inversely with income are called inferior
goods.
Normal goods
- Demand is positively related to buyer’s income
- When economy is growing and income are rising,
the demand fornormal products will rise
- The demand for normal products is relatively
higher in richer
countries
- These are the products with longer life span
usually more than 3
Years
Inferior products
- Demand is negatively related to buyer’s income
- The demand for inferior products is relatively
higher in poorer
countries
- When economy is in recession and incomes are
falling, the demand for normal products will fall
while the demand for inferior
products will rise
2. Consumer Preferences - favourable changes
lead to an increase in demand, unfavourable
change lead to a decrease. The individual decides
how much he or she wants to buy at each possible
price.
3. Price of related goods
Substitute goods
- Those that can be used to replace each other
- An increase in the price of one causes an
increase in the demand
for the other
- Price of substitute and demand for the other
good are directly related (ex: if the price of coffee
rises, the price of tea also increase)
Complement goods
- Those that can be used together
- An increase in the price of one causes an
increase in the demand
for the other.
- Price of complement and demand for the other illustrates the law of demand- the inverse relationship between price
and quantity demanded.
good are inversely
related (ex: if the price of ice cream rises, the
Marginal Benefit is the benefit provided by an
demand for ice
additional item. The principle of
cream toppings will decrease)
marginal benefit states that each additional unit of
4. Expectations - when people expect that a price
consumption provides less benefit than the
of a commodity will increase, they demand for
preceding unit.
more of it
5. Number of buyers in the market - As more
Buyer Surplus is the difference between a buyer’s
buyers enter the market, demand rises
total benefit from some
consumption and the actual expenditure.
Law of Demand – states that all other variables
Formula:
equal, as the price of product
Buyer Surplus = Total Benefit-Actual Expenditure
increases, the demand decreases.
Sample Problem:
Demand Schedule – is a table that shows the
relationship between the price of
goods and the amount of goods consumers are
willing and able to pay for them
at the price.

1. Calculate the Total Benefit from 8 movies a

month.
Table 1. Price and Quantity Demanded of Gasoline Area 0bcd = ½($8x8) + $12x8 = $128
2. Calculate the Buyer Surplus
Demand Curve – is a graph showing how the Total Benefit - $128 - 0bcd
demand for a commodity varies Actual Expenditure - (96) - 0bca
with changes in price. Buyer Surplus - $ 32 - acd

Two Types of Pricing Policies

Figure1. Demand Curve for Gasoline. The demand schedule shows
that as a price rises, quantity demanded decreases and vice versa.
These points are then graphed, and the line connecting them is the
demand curve (D). the downward slope of the demand curve again
*used by banking, car rentals, telecommunication, and
Internet access
1. Package-deal Pricing
- pricing scheme comprising a fixed payment for a
fixed quantity of consumption.
- effective if there is no alternative
Example: If the mobile telephone provider charges
a price of 10 cents per minute,
Lea will make 100 minutes of calls a month.
Suppose that the mobile provider
offers Lea a package deal of 100 minutes of calls at
$29 with no alternative.
Elasticity
Elasticity – Measure of the responsiveness of one
variable to changes in another
variable. The concept of elasticity is essential in
gauging the impact of changes in
prices, incomes and other factors on demand,
consumer’s expenditure and seller’s
revenue.
Percentage by which the quantity demanded will
change if the price of the item
rises by 1%.

Formula:
Percentage change in quantity demanded
____Percentage change in price
Compute for: Total Benefit and Buyer Surplus - 30
and 1 Types of Elasticies
1. Perfectly Elastic Demand – when
2. Package-deal Pricing demand for a product changes even when there is
- pricing scheme comprising a fixed payment and a no change in price.
charge based on
consumption.
Example: If the mobile telephone provider charges
a price of 10 cents per
minute, Lea will make 100 minutes of calls a
month. Suppose that the mobile
provider offers a two-part plan comprising a $19
monthly charge and an airtime charge of 10 cents
a minute.
Payment: A total of $19 + ($.10x100) = $29

MARKET DEMAND

Market Demand Curve

- graph that shows the quantity that all buyers will
purchase at every
possible price.
- slopes downward. 2. Perfectly Inelastic Demand – When a
- with lower price, market as a whole will buy a demand for commodity shows no response to
larger quantity. change in price.

Factors that Affect Market Demand

1. Buyers’ Income
2. Prices of related products
3. Advertising
 3. Relatively Elastic Demand - When
proportionate change in demand is more than the
proportionate change in price.
4. Relatively Inelastic Demand – When
proportionate change in demand is
less than the proportionate change in price.
5. Unitary Elastic Demand – When
proportionate change in demand is equal
to proportionate change in price.
Factors Affecting Price Elasticity
1. Available substitutes
The more substitutes available for the
good, the more elastic the demand for it. When
there are few close substitutes for a good, demand
tends to be relatively inelastic.
2. Buyer’s prior commitment
Once users have invested time and effort
to learn one program, they become
“locked in” for future upgrades. Whenever there is
such “locked in”, demand
is less elastic.
3. Benefit/costs of economizing
Buyers have limited time to spend on searching
better prices so they focus attention on items that
account for larger expenditures. Goods that
comprise a relatively small share of consumer’s
budgets tend to be more inelastic than goods for
which consumers spend a sizeable portion of their
incomes.
4. Time
Demand tends to be more inelastic in the short
term than the long term. The more time
consumers have to react to a price change, the
more elastic the demand for the good.
Other Elasticities
These are elasticities to measure the
responsiveness of demand to changes in other
factors such as buyer’s income, prices of
complementary and substitute items and sellers’
advertising.
a) Income Elasticity – Measures the impact on
demand to changes in buyers’ income.
• Increase in advertising = increase in
demand
Elasticity of Supply
Measures the responsiveness of the quantity
supplies to a change in the price of a goods, with
all other factors remaining the same.
Law of Supply – the elasticity of supply is
always positive because the law of supply says
that keeping other factors constant, an increase in
price results in an increase in quantity supplied.
If the supply is elastic, producers can increase
output without a rise in cost or a time delay. If the
supply is inelastic, firms find it hard to change
production in a given time period.

Formula: __Percentage change in demand__

Percentage change in buyers’ income
• For a normal product = increase in income
= increase in demand = income elasticity is
positive
• For an inferior product= increase in
income = decrease in demand = income elasticity
is negative.

b) Cross Price Elasticity – Measures the

sensitivity of demand to changes in prices of
related products

Formula: Percentage change in demand

Percentage change in price of related item
• For substitutes= increase in price =
increase in demand = cross price elasticity is
positive
• For complements = increase in price =
decrease in demand = cross price elasticity is
negative

c) Advertising Elasticity – Measures the

sensitivity of demand to changes in sellers’
advertising expenditures

Formula: Percentage change in demand

Percentage change in sellers’ advertising
expenditure
Types of Elasticity

Cross Elasticity of Supply – Measures a

proportional change in the quantity supplied in
relation to the proportional change in the price.
Cross-price elasticity = %δ of qs of good a / %δ of
price of good b a change in the price of one good
can shift the quantity demanded for another good.
Example: complements in production (low fat
milk & cream) - positive substitute in production
(corn & soybeans) – negative

Determinants of Elasticity of Supply

• Long run vs short run: the supply is more

elastic in the long run (long time period).
• Availability of inputs: when the inputs are
easily available, the supply is more elastic. The
larger the number of close substitutes.
• Complexity of technology: if the
technology is simple, the supply will be more
elastic.
• Non-durable – the longer the time to
adjust, the bigger the response to a price change,
therefore more elastic in the long-run.
• Durables – the difference between short
and long-run elasticities of demand depends on a
balance between the need for time to adjust and
the replacement frequency effect.

Why it matters?
• tells how fast supply responds to quantity
demand and price increase.
• the higher the elasticity of supply, the
faster the supply will increase when demand and
price increases.
 SUPPLY
When economists talk about supply, they mean
the amount of some good or service a producer is
willing to supply at each price. Price is what the
producer receives for selling one unit of a good or
service. An increase in price almost always leads to
an increase in the quantity supplied of that good
or service, while a decrease in price will decrease
the quantity supplied.
Economists call this positive relationship
between price and quantity supplied—that a
higher price leads to a higher quantity supplied
and a lower price leads to a lower quantity
supplied—the law of supply. The law of supply
assumes that all other variables that affect supply
are held constant.
Supply Schedule and Supply Curve
Supply schedule is a table that shows the
quantity supplied at each price.
Supply curve is a graph that shows the quantity
supplied at each price. Sometimes the supply
curve is called a supply schedule because it is a
graphical representation of the supply schedule.
What are the determinants of supply?
• Production Costs
• Natural conditions
• New technology
• Government policies
• Number of Sellers
• Expectation of Future Prices
Costs in the Short Run
The short run is a period of time for which two
conditions hold:
◦ The firm is operating under a fixed factor
of production
◦ Firms can neither enter nor exit an
industry
All firms have costs that they must bear
regardless of their output. These are called Fixed
Costs.
1. Fixed Costs
- any costs that do not depend on the firm’s
level of output.
2. Variable Costs
- any costs that depends on the firm’s level
of output.
3. Average Fixed Costs
- is the total fixed costs divided by the
number of units of output.
4. Average Variable Costs
- total variable costs divided by the number
of units of output.
- Marginal cost is cost of additional one unit
while AVC is the aver-age variable cost per unit of
all the units being produced.
5. Marginal Costs
- is the increase in total cost that results
from producing one more unit of output.
- Reflects changes in Variable Costs.
Comparing Costs and Revenues To Maximize
Profit
The profit maximizing level of output for all the
firm is the output level where MR=MC
Break-Even Analysis in the Short Run
◦ Should the business continue in
operation?
◦ Compare profit from:
i) Continuing in production
ii) Shutting Down
Short Run Supply Curve
At any market price, the MC curve shows the
output level that maximizes profit. This is the
firm’s short run supply curve.
Long-Run Individual Supply
A long-run planning horizon is a time frame far
enough into the future that all inputs can be freely
adjusted. We have to analyze:
 • Long-run costs
• Revenue

Two key decision of management

1. Whether to continue in operation
2. How much to produce.

Let us analyze the LONG-RUN costs in the

context of LUNA PLYWOOD

The precise profit-maximizing production rate is

3,400. The marginal cost at a production rate of
3,400 is $7 per sheet.

Long-Run Individual Supply

Long-Run break-even condition is that the price

must cover the average cost.

We can maximize profits by:

• If the total revenue covers the total cost,
producing at the rate where the marginal cost
How much should the business produce in the equals the price.
long run? • If the total revenue does not cover the
Production Rate total cost, SHUTTING DOWN.
What is the general rule?

To maximize profits, business should produce

where
MARGINAL COST = MARGINAL REVENUE

Luna’s lowest average cost is $6.86. It attains cost at a

production rate of 3,000 sheets a week.
Hence, if the price of plywood falls below $6.86, then Luna
should GO OUT of the business.
 Individual Supply Curve
A seller maximizes profit by producing at the
rate where its long run marginal cost equals the
price of the output.
Short and Long Run
Why is the average cost of production being
higher in the short run than in long run?
Seller Surplus – is the difference between a
seller’s total revenue from some quantity of
production and the seller’s avoidable cost of
producing that quantity.
• In short run – seller surplus equals total
revenue less variable cost (as-suming that the
fixed cost is sunk)
• In long run – seller surplus equals total
revenue less total cost (assuming that the fixed
cost is avoidable.)
Price Elasticity – is the percentage by which the
quantity supplied will change if the price of the
item rises by 1%.
The percentage change in quantity supplied is 16%, while the
percentage change in price is 14.3%. Hence, the price elasticity
of supply is 16/14.3 = 1.12.
Intuitive Factors
• Available production capacity – One factor
is the available production capacity.
• Adjustment time – some inputs may be
costly or impossible to change.
Market Supply Curve – is a graph showing the
quantity that all sellers will sup-ply at every
possible price.
COMPETITIVE MARKET AND MARKET
EQUILIBRIUM
Market Structure
1. Perfect Competition
2. Pure Monopoly
3. Oligopoly
4. Monopolistic Competition
Characteristics of Competitive Market
Condition:
• Large number of buyers and sellers
• Large number of independent sellers in
the industry.
• Products are homogeneous or identical
• Products pricing are not dictated by any
one seller or buyer
• Buyers and sellers are “Price Takers”
• Freedom of entry and exit in the industry
• The demand curve of for the industry is
downward sloping while for a single firm, it is
perfectly inelastic
 MARKET EQUILIBRIUM – the price at which
quantity demanded is equal to quantity supplied
(Qd = Qs).

Demand Shift – The demand curve tells us how

much of a good or service people are willing to
buy at any given price. Change in demand is
represented graphically in a price vs. quantity
plane, and it is a result of more or fewer en-trants
into the market and changes in consumer
preferences. The shift can ei-ther be parallel or
nonparallel.

Parallel vs. Nonparallel Change in Demand

A parallel shift in demand means that there is
no change in the elasticity of demand for the given
market, but a nonparallel shift means there has
been a change in elasticity.

For example, if there is a perceived increase in

the price of gasoline, then there will be a decrease
in the demand for SUVs, ceteris paribus. This shift
is likely to be parallel, as those who are still in the
market for SUVs are still as sensitive to price
increases in the prices of SUVs as before the
perceived increase in gasoline prices occurred.

A nonparallel change in demand might occur

when, over time, a discretionary good is
considered a necessity.

Factors That Cause A Demand Curve to Shift
• Income of Buyers
• Trends and tastes of Consumers
• Prices of Goods and Services
• Expectations
• Size of the Population
Calculating Equilibrium Changes Using
Elasticities
Elasticity is a measure of a variable's sensitivity
to a change in another variable. In business and
economics, elasticity refers the degree to which
individuals, consumers or producers change their
demand or the amount supplied in response to
price or income changes.
Long-Run Equilibrium
LONG-RUN is a period of time in which all
factors of production and costs are variable. In the
long run, firms are able to adjust ALL COSTS.
In macroeconomics, the long run is the period
when the general price level, contractual wage
rates, and expectations adjust fully to the state of
the economy.
The equilibrium in the long-run is shown by the
intersection of the AD curve, the SAS curve, and
the Long-Run Aggregate Supply (LAS) curve. Since
LAS represents potential output, a shift in the AD
curve will only result in a change in price level: a
shift to the right increasing price level and a shift
to the left decreasing price level.

It is predominantly used to assess the change

in consumer demand as a result of a change in a
good or service's price.

How Elasticity Works?

• When the value of elasticity is greater
than ≥1 that demand for the good or service is
affected by the price. Therefore, it is ELASTIC.
• When the value of elasticity is less than <1
that demand is insensitive to price. Therefore, it is
INELASTIC.

Short-Run Equilibrium
Sample Problem: Yesterday, the price of
SHORT-RUN equilibrium firms face both
gasoline was Php 55.00/ liter, and Nico was willing
variable and fixed costs, which means that output,
to buy 10 liters. Today, the price has gone up to
wages and prices do not have full freedom to
Php 58.00/ liter, and Nico is now willing to buy 8
reach a new equilibrium.
liters. Is Nico's demand for gasoline elastic or
inelastic? What is Nico's elasticity of demand?
The equilibrium in the short-run is shown by
= (8-10) / (10)
the intersection of the Aggregate Demand (AD)
(55-58) / (55)
curve and the Short-Run Aggregate Supply (SAS)
= 0.036 or 0.04
curve. When either AD or SAS shifts, the
equilibrium point is changed.
Therefore, Nico’s demand for gasoline is
INELASTIC.

In Graph 1, a shift to the right of the AD curve
will cause the equilibrium output as well as the
price level to increase.
ECONOMIC EFFICIENCY
Understanding economic efficiency is
fundamental since it points to opportunities to
increase value added and profit. Whenever the
allocation of resources is not economically
efficient, there is a way to add value and make
profit by solving the inefficiency.
An allocation of resources is economically
efficient if no reallocation of resources can make
one person better off without making another
person worse off. Economic efficiency as a
concept have benefits such as:
• A guide to managing resources within an
organization and across entire economies.
• Identifies opportunities for profit (there is
a way to make money by resolv-ing an economic
inefficiency).
• A way to assess government intervention.
• It assesses resource allocation
Conditions for Economic Efficiency
These are the conditions for economic
efficiency that are based on user’s benefits and
supplier’s costs:
• Same marginal benefit for all users
• Same marginal costs for all suppliers
• Marginal benefit equals marginal cost
Scenario:
Company: Moonlight Paper
Nature of Business: production and delivery of
wood
Users: paper mills
Suppliers: forests
Economic Efficiency Condition:
1. Same marginal benefit - If one paper mill
gets more profit than another, the company
should switch some wood supplies to the higher
profit mill. Buyer surplus will increase. The
company’s overall profit will be higher.
2. Same marginal cost - If one forest can
produce wood at a lower marginal cost than
another, then the company should direct the
lower cost forest to produce more and the higher
cost forest to produce less. Seller surplus will
increase. The company’s overall profit will be
higher.
3. Marginal benefit = marginal cost - If the
marginal benefit of wood to the paper mills is less
than the marginal cost of production wood, the
compa-ny should cut back production. The
reduction in benefit would be less than the
reduction of cost. The company’s overall profit will
be higher. The sum of buyer and seller surplus will
increase.
Consumer Sovereignty – is the theory that
consumer preferences determine the production
of goods and services. This means consumers can
use their spending power as ‘votes’ for goods. In
return, producers will respond to those
preferences and produce those goods.
The concept of economic efficiency assesses
resource allocation in terms of individual user’s
evaluation of benefit. An example would be in an
economy where some consumers like heavy metal
but which produces only opera is not efficient and
vice versa.
Technical Efficiency - is the provision of an item
at the minimum possible cost. However, it does
not imply scarce resources are being well used.
The concept of economic efficiency extends
beyond technical efficiency wherein the
production of the items must be that the marginal
benefit equals the marginal cost.
Adam Smith’s Invisible Hand
In a competitive market, buyers and sellers
each acting independently and selfishly will
channel scarce resources into economically
efficient use. The invisible hand that guides buyers
and sellers is the market price.
Market prices allocate scarce resources in an
economically efficient way. Prices lead to an
efficient allocation of resources by providing
information and incentives:
• Users buy until marginal benefit equals
price (to maximize benefit);
• Producers supply until marginal cost
equals price (to maximize profit);
• Users and producers face same price.
Decentralized Management
The concept of economic efficiency applies not
only across the economy but also within the
organization.
• If there is a competitive market for an
item, the transfer price (i.e., a price charged for
the sale of an item within an organization) should
be set equal to the market price.
• Right of outsourcing: consuming units
within an organization should be allowed to
outsource (i.e., purchase services or supplies from
external sources).
• Producing unit should be able to sell the
product to outside buyers.
• The 3 conditions for economic efficiency
are satisfied. The internal mar-ket will be
integrated with the external market.
Scenario
Company: Moonlight Paper
Nature of Business: production and delivery of
wood
Users: paper mills. Every mill maximizes profit
and is permitted to buy wood at the market price
(up to the point where marginal benefit balances
market price) from any supplier, whether
Moonlight’s forests or an outside source. Since all
mills face the same market price, their marginal
benefits will be equal.
Suppliers: forests. Managers of every forest
maximize profit and sell wood at the market price
(up to the point where marginal cost balances the
market price) to either Moonlight’s own paper
mills or outside buyers. Since all forests face the
same market price, their marginal costs will be
equal.
Since the mills and the forests face the same
market price, marginal benefit equals marginal
cost.
Intermediation
Intermediation is a function which brings
together seekers and providers of goods,
information, money, etc. Need for intermediation
occurs due to the imperfect nature of markets and
everyday situations where the complete
knowledge about providers and seekers (and
about what they seek) is not available to
everyone. It is important in the demand-supply
function to understand the impact of the costs of
retailing, distribution, transportation, brokerage
and other forms of intermediation on the market
for the final food or service.
One of the common considerations is whether
to include the costs of shipment in the price to the
customer. There are two pricing methods that
may have exactly the same impact on the
manufacturer and customer:
• Freight-Inclusive Pricing – the price
includes the cost of delivery to the buyer
• Free on-Board Pricing – the price does not
include the cost of delivery to the buyer
Scenario:
Some online retailers include free shipping wile
others charge for shipping. In November 2014, RT
Edwards offered Samsung 65-inch high definition
LED TV for $4238 with free shipping, while Exeltek
offered the same TV for $4095 with a shipping
charge of $145 to Perth, Western Australia.
 Minimum Wage Equilibrium
Demand-supply analysis predicts that, whether
online retailers charge for shipping or provide free
shipping, the net price to consumers would be the
same. In the above scenario, Exeltek’s price plus
shipping was $4240, which is almost identical to
RT Edward’s price.

Rent Equilibrium

Deadweight Loss

Deadweight Loss
• Sellers willing to provide item at price that
buyers willing to pay, but provi-sion doesn’t occur.
• Lost gains from trades caused by a market
inefficiency

Price Elasticity
• demand more inelastic > larger loss Price Elasticity
• supply more elastic > larger loss • supply more inelastic > larger loss
• demand more elastic > larger loss

Taxes
• “the only two sure things in life are death
and taxes”
• buyer’s price - tax = seller’s price
• payment vis-à-vis incidence (US: airlines
pay tax; Asia: passengers pay)
 consumers allocate and spend their income
among all the different goods and services.

Utility
It is an economic term used to represent
satisfaction or happiness from consuming a good
or service. The economic utility of a good or
service is important to understand because it will
directly influence the demand, and therefore
price, of that good or service.

Marginal Utility
It is the additional utility gained from the
consumption of one additional unit of a good or
service. For example, if the utility of the first slice
of pizza is 10 utils and the utility of the second
slice is 8 utils, the marginal utility of eating the
second slice of pizza is 8 utils. Moreover, if the
utility of a third slice is 2 utils, the marginal utility
of eating the third slice of pizza is 2 utils.

Total Utility
It is defined as the total amount of satisfaction
that a person can receive from the consumption of
all units of a specific product or service. For
example, if a person can only consume three slices
of pizza and the first slice of pizza consumed yields
10 utils, the second slice of pizza consumed yields
8 utils and the third slice yields 2 utils, the total
utility of pizza would be 20 utils. The total utility is
simply the sum of all the marginal utilities of the
individual units.

Total Utility Maximization

Economic theory regarding consumer activities
suggests that the primary goal of the consumer is
to achieve the largest amount of utility for the
least amount of cost. This is partly due to the
limited amount of funds a person may possess, as
well as a desire to achieve as much satisfaction
THEORY OF CONSUMER BEHAVIOR AND from the consumption of goods and services as
UTILITY MAXIMIZATION possible.

Theory of Consumer Behavior Law of Diminishing Marginal Utility

It tells how consumers purchase diverse It states that all else equal, as more of a single
products and considers how a consumer uses his good or service is consumed, the additional
income in order to accomplish the most fulfillment satisfaction, referred to as marginal satisfaction,
or utility. In other words, it deals with how drops. Or in other words, all else equal as
consumption increases the marginal utility derived
from each additional unit declines.
Indifference Curve Analysis
Indifference Curve
This is a curve that represents all the
combinations of goods that give the same
satisfaction to the consumer. It is also known as
‘equal satisfaction curve’ since all the
combinations give the same amount of
satisfaction to the consumer.
For example, if Peter has 1 unit of mango and
14 units of oranges, indifference curve will
determine how many units of orange a consumer
is willing to give up in exchange for an additional
unit of mango so that his level of satisfaction
remains unchanged.
Properties of the Indifference Curve
Indifference curve slopes downward to the
right
This is an important feature of an indifference curve. An
indifference curve can neither be horizontal line nor an
upward sloping curve. When a consumer wants to have more
of a commodity, he/she will have to give up some of the other
commodity, given that the consumer remains on the same
level of utility at constant income. This is essential for the level
of satisfaction to remain the same on an indifference curve.
Indifference curve always convex to the origin
The concept of indifference curve is based on
the properties of diminishing marginal rate of
substitution. The rate gives a convex shape to the
indifference curve.
It is worthy to note that two goods can never
perfectly substitute each other. Therefore, the
rate of decrease in a commodity cannot be equal
to the rate of increase in another commodity.
Thus, indifference curve is always convex (neither
concave nor straight).
 Indifference curves never intersect each other
Each indifference curve is a representation of
particular level of satisfaction. In the above image,
IC1 and IC2 are two indifference curves and C is
the point where both the curves intersect.
According to indifference curve theory,
satisfaction at point C = satisfaction at point A.
Also, satisfaction at point C = satisfaction at point
B.
But, satisfaction at point B ≠ satisfaction at
point A. The level of satisfaction of consumer for
any given combination of two commodities is
same for a consumer throughout the curve. Thus,
indifference curves cannot intersect each other.
4. Higher indifference curve = higher
satisfaction
A higher IC indicates a higher level of
satisfaction as compared to a lower IC. This
means, any combination of two goods on the
higher curve give higher level of satisfaction to the
consumer than the combination of goods on the
lower curve.
Marginal Rate of Substitution
This is the rate at which a consumer is
prepared to exchange a good X for Y. This is the
amount of a good that a consumer is willing to
give up for another good, as long as the new good
is equally satisfying.
For example, a consumer initially gives up 6
units of orange to get an extra unit of mango.
Hence, the MRS is 6. Therefore, MRS of X for Y is
the amount of Y whose loss can be compensated
by a unit gain of X, keeping the satisfaction the
same. Interestingly, as a consumer accumulates
more units of mango, the MRS starts falling –
meaning he is prepared to give up fewer units of
orange for mango.
Diminishing Marginal Rate of Substitution
An important principle of economic theory is
that marginal rate of substitution of X for Y
diminishes as more and more of good X is
substituted for good Y. In other words, as the
consumer has more and more of good X, he is
prepared to forego less and less of good Y.
The Budget Constraint
A consumer always tries to maximize his
satisfaction. But, in this pursuit, he is hampered by
his limited money income, or budget. In order for
a consumer to attain the highest possible level of
satisfaction, he has to buy more goods and has to
work under the following two constraints: (1) he
has to pay the price for the goods and (2) his
income is limited, restricting the availability of
money for purchasing these goods.
 Budget Constraint
This occurs when a consumer is limited in
consumption patterns by a certain income. It
describes the different amount of two
commodities that a consumer can afford.

Budget Line
It shows all possible combinations of two goods
that a consumer can buy within the funds
available to him at the given prices of the goods.

b. Decrease in Income
If a consumer’s income falls, there will be a
corresponding parallel shift to the left to represent
a fall in the potential combination of the two
goods that can be purchased. A decrease in
income makes the purchase of less of either one
or both items possible.

In the diagram, A and B are the two extreme

points. By joining these two points we obtain the
budget line AB which is a straight downward
sloping line. All combinations that are within a
consumer’s reach lie on the budget line. A point
outside the line (point D) represents a
combination beyond the financial reach of the
consumer. On the other hand, a point inside the
line (point C) represents under-spending by the
consumer.

Change in Consumer Income The Budget Constraint

a. Increase in Income
If a consumer’s income increases, then the
consumer will be able to purchase higher
combinations of goods. Hence an increase in
income will result in a shift to the right in the
budget line. An increase in income makes the
purchase of more of either or both items possible.
In economics, a budget constraint represents
all the combinations of goods and services that a
consumer may purchase given current prices
within his or her given income. Consumer theory
uses the concepts of a budget constraint and a
preference map to analyze consumer choices.
 Budget Constraint: Change in the Price of
Goods
 Increase in price of one commodity

Table . The Budget Constraint

Table shows that an individual has a total
income of P500.00 and spent his income on 2
commodities A & B, and the price of A & B are • Decrease in price of one commodity
P100.00 & P50.00 respectively.

Consumer Equilibrium

Graph 1: Budget Line The state of balance achieved by an end user of

Budget Line is a graphical representation of all products that refers to the amount of goods and
possible combinations of two goods which can be services they can purchase given their present
purchased with given income and prices, such that level of income and the current level of prices.
the cost of each of these combinations is equal to Consumer equilibrium allows a consumer to
the money income of the consumer. obtain the most satisfaction possible from their
income.
A budget set or opportunity set includes all
possible consumption bundles that someone can
afford given the prices of goods and the person's
income level. The budget set is bounded above by
the budget line.

A consumer is said to be in equilibrium when

he feels that he “cannot change his condition
either by earning more or by spending more or by
changing the quantities of thing he buys”. A
rational consumer will purchase a commodity up
to the point where price of the commodity is
equal to the marginal utility obtained from the
thing.

PRODUCTION AND PROCESS COST

Fixed and Variable Costs

• Fixed costs are those that do not vary with
output and typically include rents, insurance,
depreciation, set-up costs, and normal profit. They
are al-so called overheads.
• Variable costs are costs that do vary with
output, and they are also called direct costs.
Examples of typical variable costs include fuel, raw
materials, and some labour costs.
A. Total fixed costs
Example: The total fixed costs, TFC, include
Given that total fixed costs (TFC) are constant
premises, machinery and equipment needed to
as output increases, the curve is a horizontal line
construct boats, and are £100,000, irrespective of
on the cost graph.
how many boats are produced. Total variable
costs (TVC) will increase as output increases.
B. Total variable costs
OUTPUT TOTAL TOTAL TOTAL The total variable cost (TVC) curve slopes up at
FIXED VARIABLE COST an accelerating rate, reflecting the law of
COST COST diminishing marginal returns.
100 50 150
C. Total costs
2 100 80 180 The total cost (TC) curve is found by adding
total fixed and total variable costs. Its position
3 100 100 200 reflects the amount of fixed costs, and its gradient
4 100 110 210 reflects variable costs.

5 100 150 250 D. Average fixed costs

6 100 220 320 Average fixed costs are found by dividing total
fixed costs by output. As fixed cost is divided by an
7 100 350 450 increasing output, average fixed costs will
continue to fall.
8 100 640 740
 TOTAL
AVERAGE E. Average variable costs
OUTPUT FIXED
FIXED COST Average variable costs are found by dividing
COST
total fixed variable costs by output.
1 100 100
TOTAL AVERAGE
2 100 50 OUTPUT VARIABLE VARIABLE
COST COST
3 100 33.3
4 100 25 1 50 50

5 100 20 2 80 40

6 100 16.6 3 100 33.3

7 100 14.3 4 110 27.5
8 100 12.5
5 150 30

6 220 36.7

7 350 50

8 640 80

The average fixed cost (AFC) curve will slope down

continuously, from left to right.

The average variable cost (AVC) curve will at first slope

down from left to right, then reach a minimum point, and rise
again.
 AVC is ‘U’ shaped because of the principle of
variable Proportions, which explains the three
phases of the curve:
• Increasing returns to the variable factors,
which cause average costs to fall, followed by:
• Constant returns, followed by:
• Diminishing returns, which cause costs to
rise.

F. Average total cost

Average total cost (ATC) is also called average
cost or unit cost. Average total costs are a key cost
in the theory of the firm because they indicate
how efficiently scarce resources are being used.
Average variable costs are found by dividing total
fixed variable costs by output.
AVERA
AVERA AVERA Average total cost (ATC) can be found by
OUTP GE
GE FIXED GE TOTAL adding average fixed costs (AFC) and average
UT VARIABLE
COST COSTS variable costs (AVC). The ATC curve is also ‘U’
COST
shaped because it takes its shape from the AVC
1 100 50 150 curve, with the upturn reflecting the onset of
diminishing returns to the variable factor.
2 50 40 90

3 33.3 33.3 67 Areas for total costs

Total Fixed costs and Total Variable costs are
4 25 27.5 52.5 the respective areas under the Average Fixed and
Average Variable cost curves.
5 20 30 50

6 16.6 36.7 53.3

7 14.3 50 64.3

8 12.5 80 92.5
 G. Marginal costs Law of Diminishing Returns
Marginal cost is the cost of producing one extra " As additional units of a variable input are
unit of output. It can be found by calculating the combined with a fixed input, at some point the
change in total cost when output is increased by additional output (i.e., marginal/ product) starts to
one unit. diminish."
TOTAL MARGINAL
OUTPUT The Significance of Marginal Cost
COST COST
The marginal cost curve is significant in the
theory of the firm for two reasons:
1 150 0
1. It is the leading cost curve, because
changes in total and average costs are derived
2 180 30
from changes in marginal cost.
3 200 20 2. The lowest price a firm is prepared to
supply at is the price that just covers marginal
4 210 10 cost.

5 250 40 ATC and MC

Average total cost and marginal cost are
6 320 70 connected because they are derived from the
same basic numerical cost data. The general rules
7 450 130 governing the relationship are:
1. Marginal cost will always cut average total
8 740 290 cost from below.
2. When marginal cost is below average total
cost, average total cost will be falling, and when
marginal cost is above average total cost, average
total cost will be rising.
3. A firm is most productively efficient at the
lowest average total cost, which is also where
average total cost (ATC) = marginal cost (MC).

Total Costs and Marginal Costs

Marginal costs are derived exclusively from

variable costs and are unaffected by changes in
fixed costs. The MC curve is the gradient of the TC
curve, and the positive gradient of the total cost
curve only exists because of a positive variable
It is important to note that marginal cost is cost. This is shown below:
derived solely from variable costs, and not fixed
costs. The marginal cost curve falls briefly at first,
then rises. Marginal costs are derived from
variable costs and are subject to the theory of Law
of Diminishing Returns.

H. Marginal Revenue
Is define as an increase in revenue by
producing one additional unit of a good or service.
Price
Quantity
Cost Function:
It is a mathematical formula used to chart how
production expenses will change at different
output levels. In other words, it estimates the
total cost of production given a specific quantity
produced.
Economies of Scale
Economies of scale are cost advantages reaped
by companies when production becomes efficient.
Companies can achieve economies of scale by
increasing production and lowering costs. This
happens because costs are spread over a larger
number of goods. Costs can be both fixed and
variable.
The size of the business generally matters
when it comes to economies of scale. The larger
the business, the more the cost savings.
Economies of scale can be both internal and
external. Internal economies of scale are based on
management decisions, while external ones have
to do with outside factors.
Reasons why economies of scale give rise to
lower per-unit costs:
1. Specialization of labor and more
integrated technology boost production volumes
2. lower per-unit costs can come from bulk
orders from suppliers, larger ad-vertising buys
(Cost Capital)
3. spreading internal function costs across
more units produced and sold helps to reduce
costs.
Types of Economies of Scale:
1. Internal Economies of Scale
 This happens when a company cuts costs
internally, so they're unique to that firm. This
may be the result of the sheer size of a
company or because of decisions from the
firm's management.
 This offers ,greater competitive advantage
because, external economies of scale is
shared among competitors
 2. External Economies of Scale
 This occurs outside of an individual
company but within the same industry.
External Economies of Scale are achieved
because of external factors, or factors that
affect an entire industry.
Diseconomies of Scale
Often cost don’t keep falling and falling in the
long run. Like production they of-ten level up and
this is called Constant Return Scale. This happens
when a company or business grows so large that
the costs per unit increases. Rather than
decreasing costs in every additional output, the
firm sees an increase in cost when output is
increase.
Diseconomies of scale specifically come about
due to several reasons, but all can be broadly
categorized as internal or external. Internal
diseconomies of scale can arise from technical
issues of production or organizational issues
within the structure of a firm or industry.
Types of Diseconomies of Scale:
1. External Diseconomies of Scale
 This arise due to constraints imposed by the
environment within which a firm or industry
operates. Essentially, diseconomies of scale are
the result of the growing pains of a company
after it's al-ready realized the cost-reducing
benefits of economies of scale.
2. Technical Diseconomies of Scale
 This involve physical limits on handling and
combining inputs and goods in process. These
can include overcrowding and mis-matches
between the feasible scale or speed of
different inputs and processes.
3. Organizational Diseconomies of Scale
 This happen for many reasons, but overall,
they arise because of the difficulties of
managing a larger workforce. Several problems
can be identified with diseconomies of scale.
Graphical Presentation of Economies and
Diseconomies of Scale:
Economies of Scope
This describe the situations in which the long
run average and marginal cost of a company,
organization, or economy decreases due to
production of some complementary goods and
services. An economy of scope means that the
pro-duction of one good reduces the cost of
producing another related good. While economies
of scope are characterized by efficiencies formed
by variety, economies of scale are characterized
by volume.
Economies of Scope are economic factors that
make the simultaneous manufacturing of different
products more cost effective than manufacturing
them on their own. This can occur because the
products are co-produced by the same process,
the production process are complementary, or the
inputs to production are shared by the products.
Ways to Achieve Economies of Scope:
1. Diversification of Products
 This is the most common way, the idea
that efficiency is gained through related
diversification. Products that share the
same in-puts that have complimentary
productive processes offer great op-
portunities.
2. Merger and Acquisition
 Horizontally merging with or acquiring
another company is anoth-er a way to
achieve economies of scope. Two regional
 retail chains, for example, may merge with
each other to combine different product
lines and reduce average warehouse costs.
Goods that can share common inputs like
this are very suitable for generating
economies of scope through horizontal
acquisitions.
Opportunity Cost & Sunk Cost
Opportunity costs represent the benefits an
individual, investor or business misses out on
when choosing one alternative over another.
While financial reports do not show opportunity
cost, business owners can use it to make educated
decisions when they have multiple options before
them.
Because by definition they are unseen,
opportunity costs can be easily overlooked if one
is not careful. Understanding the potential missed
opportunities foregone by choosing one
investment over another allows for better
decision-making.
Opportunity Cost Formula and Calculation:
Opportunity Cost=FO−CO
where:
FO=Return on best foregone option
CO=Return on chosen option
Key Takeaways
• Opportunity cost is the return of a
foregone option less the return on your chosen
option.
• Considering opportunity costs can guide
you to more profitable decision-making.
• You must assess the relative risk of each
option in addition to its potential returns.
Sunk Cost is a cost that has already been
incurred and cannot be recovered. A sunk cost
differs from future costs that a business may face,
such as decisions about inventory purchase costs
or product pricing. Sunk costs (past costs) are
excluded from future business decisions because
the cost will be the same re-gardless of the
outcome of a decision.
Opportunity Cost vs. Sunk Cost
The difference between an opportunity cost
and a sunk cost is the difference between money
already spent and potential returns not earned on
an investment because the capital was invested
elsewhere. Buying 1,000 shares of company A at
$10 a share, for instance, represents a sunk cost of
$10,000. This is the amount of money paid out to
make an investment, and getting that money back
requires liquidating stock at or above the purchase
price.
Production Possibility Curve
This curve illustrates the different possibilities
that two separate goods may produce when there
is fixed availability of resources that both item
require for manufacturing. Shifts in the PPC curve
are only caused by two factors (a) Change in the
quantity and quality of resources and (b) Change
in technology.
Two types of Production Possibility Curve
1. Constant Opportunity Cost Curve
A steady potential price to a business that
occurs when a company does not take
advantage of a feasible chance to earn
profits. An example of a constant
opportunity cost would be if funds and
 resources were allocated to one project,
but could have been allocated to a second
project instead.
2. Increasing Opportunity Cost
Law of increasing Opportunity Cost:
"When all resources are being used an increase
in the production of one good will lead to greater
forgone production of another good."
THE ORGANIZATION OF THE FIRM
Method of Procuring Inputs
a) Spot Exchange
This is an informal relationship between a
buyer and a seller in which neither party is
obligated to adhere to specific terms for
exchange. The buyer and seller are basically
anonymous and there is not a legal relationship
between the buyer and seller. This is your typical
purchasing of consumer goods and services.
b) Contracts
This is a formal and legal relationship between
a buyer and a seller that obligates both to
exchange at specified and agreed upon terms. The
agreement identifies what each party will be
responsible for and defines the time requirement,
and a contract is used for both tangible goods as
well as services rendered.
c) Vertical Integration
This occurs when a firm decides to produce not
only the final product but at least one of the
inputs that are needed for the product.
Transaction Costs
Incur costs in excess of the actual amount paid
to the input supplier, e.g. the cost of searching for
supplier willing to sell a given input, the cost of
negotiating a price at which the input will be
purchased, other investments and expenditures
required to facilitate exchange and alike.
Specialized Investments
Simply an investment in a particular exchange
that cannot be recovered in another trading
relationship.
Types of Specialized Investments
a) Site specificity occurs when the buyer and
the seller of an input must locate their plants close
to each other to be able to engage in exchange.
For example, electric power plants often locate
close to a particular coal mine to minimize the
transportation costs of obtaining coal; the output
(electricity) is less expensive to ship than the input
(coal). The cost of building the two plants close to
each other represents a specialized in-vestment
that would have little value if the parties were not
involved in exchange.
b) Physical-Asset Specificity refers to a
situation where the capital equip-ment needed to
produce an input is designed to meet the needs of
a particular buyer and cannot be readily adapted
to produce inputs need-ed by other buyers. For
example, if producing a lawn mower engine re-
quires a special machine that is useful only for
producing engines for a particular buyer, the
machine is a specific physical asset for producing
the engines.
c) Dedicated Assets are general investments
made by a firm that allow it to exchange with a
particular buyer. For example, suppose a
computer manufacturer opens a new assembly
line to enable it to produce enough computers for
a large government purchaser. If opening the new
assembly line is profitable only if the government
actually pur-chases the firm’s computers, the
investment represents a dedicated as-set.
d) Human Capital. In many employment
relationships, workers must learn specific skills to
work for a particular firm. If these skills are not
useful or transferable to other employers, they
represent a specialized investment.
Relationship-specific Exchange
• Tied Together
• Creates transaction costs due to sunk
nature of the specific investments.
Lead to Higher transaction Cost
• Costly Bargaining
• Underinvestment
• Opportunism and the hold-up problem.
Underinvestment
An underinvestment problem is an agency
problem between shareholders and debt holders
where a leveraged company foregoes valuable
investment opportunities because debt holders
would capture a portion of the benefits of the
project, leaving insufficient returns to
shareholders.
Hold- Up Problem
The hold-up problem is a situation where two
parties may be able to work most efficiently by
cooperating but refrain from doing so because of
concerns that they may give the other party
increased bargaining power, and thereby reduce
their own profits. When party A has made a prior
commitment to a relationship with party B, the
latter can 'hold up' the former for the value of that
commitment. The hold-up problem leads to severe
economic cost and might also lead to
underinvestment.
NATURE OF THE INDUSTRY
Factors that impact managerial decision:
A) Market Structure – refers to factors such as the
number of firms that compete in the market.
a. Firm Size – Considerable differences in the
size of largest firms in each industry
b. Industry Concentration - Are there many
small firms within an industry or only a few large
firms? It can be measure through the following
ratios:
Four-firm concentration ratio (C4)– provides a
crude measure of size structure of an industry
Or
Where:
Four-firm concentration ratio ranges from 0 to 1.
Ratio close to 0 – less concentrated, many small
firms, more competition
Ratio close to 1 – more concentrated, four or fewer
firms, less competition
Sample problem:
Suppose an industry is composed of six firms.
Four firms have sales of $10 each, and two firms
have sales of $5 each. What is the four-firm
concentration ratio for this industry?
Answer: 40/50 = 0.80, this means that the four
largest firms in the industry account for 80% of
total industry output.
• Herfindahl-Hirschman Index (HHI) -
commonly accepted measure of market
concentration
Where
Sample problem:
Suppose an industry is composed of three
firms. Two firms have sales of $10 each, and one
firms have sales of $30. What is the Herfindahl-
Hirschman Index for this industry?
Answer:
c. Technology
1. Some industries are labor intensive, some
are capital intensive, or both.
2. In some industries, firms have access to
identical technologies.
3. In other industries, one or two firms only
have access to a specific technology.
d. Demand and Market Conditions
1. Industries with relatively low demand vs.
industries with great demand.
2. Elasticity of demand for products and
services produced by the firms
3. Rothschild index (R) - measure of the
elasticity of industry de-mand for a product
relative to that of an individual firm.
where
is the elasticity of demand for the total
market
is the elasticity of demand for the
product of an individual firm.
Sample Problem:
The industry elasticity of demand for airline
travel is negative 3, and the elasticity of demand
for an individual carrier is negative 4. What is the
Rothschild index for this industry?
Answer:
When the index is 1, the individual firm faces a
demand curve that has the
same sensitivity to price as
the market demand curve.
When the firm's elasticity of
demand is much greater than of the market, the
index is close to 0.
e. Potential for Entry
1. Barriers to entry
2. Explicit costs - capital requirements
3. Economies of scale - new entrant may be
unable to enjoy the re-duced average costs
B) Conduct
a. Pricing Behavior – Firms in some industry
charge higher markups than firms in other
industries.
1. Lerner Index (L) – measures the difference
between price and marginal cost as a fraction of
the price of the product.
Or
where P is Price and MC is Marginal Cost
Sample problem
 A firm in the airline industry has a marginal
cost of $200 and charges a price of $300. What are D) The Structure-Conduct-Performance Paradigm
the Lerner index and markup factor? a. Causal View
Answer:

The higher the

Lerner Index, the
greater the firm's markup and vice versa.

b. Integration and Merger Activity

1. Vertical integration – situation where b. Feedback Critique
various stages in the production of a single
product are carried out in a single firm.
2. Horizontal integration – merging of the
production of similar products into a single firm.
3. Conglomerate mergers – involved the
integration of different product lines into a single
firm

c. Research and Development - Optimal

amount to spend on Research and Development
depend on the characteristics of the industry in
which the firm operates
d. Advertising - Various industries spend
much on advertising while oth-ers don't.
C) Performance – refers to the profits and social
welfare that result in a giv-en industry.
a. Profit - Big firms with big sales do not
always earn big profits.
b. Social Welfare - Defined as sum of
consumer and producer surplus generated in a
market. Dansby-Willig Performance Index - the
higher the index, the poorer the performance.
PRICE STRATEGIES OF FIRM WITH MARKET
POWER
Market Power
is a measure of the ability of a company to
successfully influence the pricing of its products or
services in the overall market.
Perfect Competition
multiple sellers sell a standardized product to
multiple buyers.
Monopolistic Competition
is a kind of imperfect competition wherein a
smaller number of sellers slightly differentiate
their products by branding or customization in
function. Because of such trait, the products in the
market are not perfect substitutes for each other,
and sellers can demand variable prices.
 Monopoly
single company is the sole seller of a distinct
type of product or service.
Price Discrimination
the practice of charging different prices to
consumers for the same good or service. Because,
there are some who would be willing to pay more
than others.
Two channels for Price Discrimination.
• Channel 1: Higher Prices for Some
Price discrimination can extract additional
consumer surplus from consumers who place a
high value on the good.
• Channel 2: Attract New Customers
Price discrimination can simultaneously sell to
new customers who would not be willing to pay
the profit-maximizing uniform price.
Price Discrimination
• 1st Condition, A Firm Must Have Market
Power
A monopoly, an oligopoly, or a monopolistically
competitive firm might be able to price
discriminate. A perfectly competitive firm cannot.
• 2nd Condition, A Firm Must Identify Groups
with Different Price Sensitivity
If consumers have different demands, a firm
must identify how they differ.
• 3rd Condition, A Firm Must Prevent Resale
If resale is easy, price discrimination doesn’t
work because of only low-price sales.
Types of Price Discrimination
a) First-degree discrimination/ Perfect Price
Discrimination – occurs when a company charges
the maximum possible price for each unit
consumed.
b) Second-degree price discrimination/
Nonlinear Price Discrimination – oc-curs when a
company charges a different price for different
quantities consumed, such as quantity discounts
on bulk purchases.
c) Third-degree price discrimination/ Group
Price Discrimination – occurs when a company
charges a different price to different consumer
groups.
How a Firm Perfectly Price Discriminates?
A firm with market power that can prevent
resale and has full information about its
customers’ willingness to pay price discriminates
by selling each unit at its reservation price—the
maximum amount any consumer would pay for it.
The maximum price for any unit of output is
given by the height of the demand curve at that
output level.
• Perfectly Price Discrimination: Price = MR
A perfectly price-discriminating firm’s marginal
revenue is the same as its price. So, the firm’s
marginal revenue curve is the same as its demand
curve
• Competitive, Single-Price, and Perfect
Price Discrimination Outcomes

Group Price Discrimination
Conditions for Group Price Discrimination
a) Group price discrimination: potential
customers are divided into two or more groups
with different prices for each group (single price
within a group).
b) Consumer groups may differ by age,
location, or in other ways.
c) A firm must have market power, be able
to identify groups with different reservation
prices, and prevent resale.
Group Price Discrimination: A Graphic
Approach
If a firm can prevent resale between countries
and has a common MC, then it can maximize
profit by acting like a traditional monopoly in each
country separately.
In Figure next slide, resale between the U.S.
and the U.K. is not possible (different DVD
formats) and the common constant MC = m = $1.
Warner acts as a traditional monopoly in each
country. U.S. market: MRA=1, QA=5.8, pA=$29.
U.K. market: MRB=1, QB=2, pB=$39. Warner price
group discriminates and maximizes profit.
Group Pricing of the Harry Potter DVD
Effects on Total Surplus: Group Price
Discrimination vs. Perfect Competition
Consumer surplus is greater and more output is
produced with perfect competition than with
group price discrimination.
Group price discrimination transfers some of
the competitive consumer surplus to the firm as
additional profit and causes deadweight loss due
to reduced output.
Effects on Total Surplus: Group Price
Discrimination vs. Single-Price Monopoly
The closer the firm comes to perfect price
discrimination using group price discrimination
(many groups rather than just two), the more
output it produces, and the less production
inefficiency—the greater the total surplus.
Characteristics and Conditions
Many firms, with market power and no resale,
are unable to determine high reservation prices.
Such a firm can price discriminate by letting the
price each customer pays vary with the number of
units the customer buys (nonlinear price
discrimination).
Block Pricing
• A firm charges one price per unit for the
first block purchased and a dif-ferent price per
unit for subsequent blocks. Used by gas, electric,
water, and other utilities.
• When block pricing consumer surplus is
lower, total surplus is higher and deadweight loss
is lower. The firm and society are better off but
con-sumers lose.
• The more block prices that a firm can set,
the closer the firm gets to per-fect price
discrimination.
 Two-Part Pricing 20, where Valerie purchases 60 and Neal buys 80
units. It charges both the same access fee of 1,800
Characteristics and Conditions: = A1 , which is Valerie’s CS. π = 5,000
Two-part pricing: a firm charges each
consumer a lump-sum access fee for the
right to buy as many units of the good as
the consumer wants at a per-unit price.
A consumer’s overall expenditure for
amount q consists of two parts: an access
fee, A, and a per-unit price, p. Therefore,
expenditure is E = A + pq.
To do it, a firm must have market power,
know how individual demand curves vary
across its customers, and prevent resale.

a. Two Part Pricing with Identical Consumers

With identical customers, a firm can set a two-
part price that is efficient (p = MC) and all total
surplus goes to the firm (CS = 0).
Bundling and Types of Bundling – selling
multiple goods or services for a single price.
Most goods are bundles of many separate
parts. However, firms sometimes bundle even
when there are no production advantages and
transaction costs are small. Bundling allows firms
to increase their profit by charging different prices
to different consumers based on the consumers’
willingness to pay.

b. Two-Part Pricing with Different Consumers
Two-part pricing is more complex if consumers
have different demand curves. Having two
different demands implies consumers have
different consumer surpluses. Two-part pricing
would require the monopolist to charge different
access fees, and this may not be possible.
Example
In next slide, the monopoly faces two
consumers. Valerie’s demand curve is D1 in panel
a, and Neal’s demand curve is D2 in panel b.
If the monopoly can charge different prices, it
sets price for both customers at p = MC = 10 and
access fee of 2,450 to Valerie and 4,050 to Neal. π
= 6,500
If the monopoly cannot charge its customers
different access fees, it sets its per-unit price at p =
• Pure Bundling – only a package deal is
offered (a cable company sells a bundle of
Internet, phone, and television for a single price,
no service separately)
• Mixed – are available as a package or
separately.
Profitable Pure Bundling: Reservation Prices
Negatively Correlated
Tables 10.2 Negatively Correlated Reservation Prices
Table 10.2 shows the reservation prices for two
customers and two products. The reservation
prices are negatively correlated: the customer
who has the higher reservation price for one
product has the lower reservation price for the
other product.

If the firm sells the two products separately, it
maximizes its profit by charging $90 for the word
processor and selling it to both consumers and
selling the spreadsheet program for $50 to both
consumers. The firm’s total profit from selling the
programs separately is $280 (= $180 + $100).
If the firm sells the two products in a bundle, it
maximizes its profit by charging 160, selling to
both customers, and earning $320. Pure bundling
is more profitable.
Pure bundling is more profitable because the
firm captures more of the consumers’ potential
consumer surplus—their reservation prices.
Non-Profitable Pure Bundling: Reservation
Prices Positive Correlated
Table 10.3 Positively Correlated Reservation Prices
Table 10.3 shows the reservation prices for two
customers and two products. The reservation
prices are positively correlated: a higher
reservation price for one product is associated
with a higher reservation price for the other
product.
If the programs are sold separately, the firm
charges $90 for the word processor, sells to both
consumers, and earns $180. However, it makes
more charging $90 for the spreadsheet program
and selling it only to Carol. The firm’s total profit if
it prices separately is $270 (= $180 + $90).
If the firm uses pure bundling, it maximizes its
profit by charging $130 for the bundle, selling to
both customers, and making $260.
Because the firm earns more selling the
programs separately, $270, than when it bundles
them, $260, pure bundling is not profitable in this
example. As long as reservation prices are
positively correlated, pure bundling cannot
increase the profit.
Mixed Bundling
Under mixed bundling, consumers are allowed
to buy the pure bundle or to buy any of the
bundle’s components separately.
Table 10.4 Reservation Prices and Mixed Bundling
Table 10.4 shows the reservation prices of four
potential customers for two products. Aaron, a
writer, places high value on the word processing
program but has relatively little use for a
spreadsheet. Dorothy, an accountant, has the
opposite pattern of preferences. Brigitte and
Charles have intermediate reservation prices that
are negatively correlated.
If the firm prices each program separately, it
maximizes its profit by charging $90 for each
product and selling each to three customers. It
earns $540 total.
If the firm engage in pure bundling, it can
charge $150 for the bundle, sell to all four
consumers, and earns $600 total.
If the firm does mixed bundling, it can charge
$160 for the bundle to two consumers and $120
for each product separately to the other two
consumers. It earns $640 total.
Requirement Tie-In Sales
Requirement tie in sales is another form of
bundling: requires customers who buy one
product from a firm to make all concurrent and
subsequent purchases of a related product from
that firm.
This requirement allows the firm to identify
heavier users and charge them more per unit.
 Example:
If a printer manufacturer can require that ECONOMICS OF INFORMATION
consumers buy their ink cartridges only from the
manufacturer, then that firm can capture most of
the consumers’ surplus. Heavy users of the
printer, who presumably have a less elastic
demand for it, pay the firm more than light users
because of the high cost of the ink cartridges.
Printer firms such as Hewlett-Packard (HP) write
their warranties to strongly encourage consumers
to use only their cartridges and not to refill them.

Peak-Load Pricing

Mean – the expected value of average of a

random variable. It is computed as the sum of the
probabilities that different outcomes will occur
multiplied by the resulting payoffs, represented
by:

Where xi is payoff i, qi is the probability that

payoff I occurs, and q1 + q2 +…+qn = the mean of
a random variable thus collapses information
about the likelihood of different outcomes into a
single statistic.

It provides information about the average

value of a random variable but it yields no
information about the degree of risk associated
with the random variable.

Example:
Option 1: Flip a coin. If it comes up heads, you
receive $1; if it comes up tails, you pay $1.
Option 2: Flip a coin. If it comes up heads, you
receive $10; if it comes up tails, you pay $10.
How much is the expected value (mean) of
each of the options?
 Variance – a measure of risk. The sum of the
probabilities that different outcomes will occur
multiplied by the squared deviations from the
mean of the random variable:
Standard Deviation – the square root of the
variance. High variances (standard deviations) are
associated with higher degrees of risk.
Key Differences Between Variance and
Standard Deviation
a) Variance is a numerical value that
describes the variability of observations from its
arithmetic mean. Standard deviation is a measure
of dispersion of observations within a data set.
Variance is nothing but an average of squared
deviations. On the other hand, the standard
deviation is the root mean square deviation.
Variance is denoted by sigma-squared (σ2)
whereas standard deviation is labelled as sigma
(σ). Variance is ex-pressed in square units which
are usually larger than the values in the given
dataset. As opposed to standard deviation which
is expressed in the same units as the values in the
set of data. Variance measures how far individuals
in a group are spread out.
b) Conversely, Standard Deviation measures
how much observations of a data set differs from
its mean.
Illustration:
You manage a firm that is about to introduce a
new product that will yield $1000 in profits if the
economy does not go into a recession. However, if
a recession occurs, demand for your normal good
will fall and your company will lose $4000.
Economists project a 10% chance that the
economy will go into recession.
• What is the expected profit of introducing
the project?
• How risky is the introduction of the
project?
Mean:
E(X) = (90%) X (1000) + (10%) X (-4000) = 500
E(X) = 900 + -400
E(X) = 500
Variance:
• S2= [(90%) x (1000-500)2 ] + [(10%) x (-
4000-500)2]
• S2= [(90%X(500)2] + [10%X(-4500)2]
• S2= [90%(250,000)] + [10%(20,250,000)]
• S2=[225,000+2,025,000]
• S2=2,250,000
•
Standard Deviation:
• S=1,500
Attitude Towards Risk
• Risk Averse: An individual who prefers a
sure amount of $M to a risky prospect with an
expected value, E[x], of $M.
• Risk Loving: An individual who prefers a
risky prospect with an expected value, E[x], of $M
to a sure amount of $M.
• Risk Neutral: An individual who is
indifferent between a risky prospect where E[x] =
$M and a sure amount of $M.
Example of How Risk Aversion Influences
Decisions
• Product Quality A risk averse consumer
will not purchase a new product if it works just as
well as the old product. They prefer a sure thing to
an uncertain prospect of equal expected value.
How would your firm induce risk-averse
consumers to try new product?
• Lower the price below the existing
product
• Informative advertising (Expected quality
of new is higher than the certain quality of old)
• Free Samples (Lower the price to
compensate the risk)
• Guarantees
• Chain Stores Risk aversion explains why it
may be in a firm’s interest to become part of a
chain store is instead of remaining independent.
National hamburger chain vs. local diner. Retail
outlets, transmission shops etc.
 • Insurance Fact that consumers are risk
averse implies they are willing to pay to avoid risk.
Precisely why you decide to buy insurance on your
home, extended warranties on purchases etc.
Price Uncertainty and Consumer Search
Suppose consumers face numerous stores
selling identical products but charge different
prices. The consumer wants to purchase the
product at the lowest possible price, but also
incurs a cost, c, to acquire price information.
There is an assumption of free recall and with
replacement. Free recall means a consumer can
return to any previously visited store to purchase
the product.
The consumer’s reservation price, at which the
consumer is indifferent between purchasing and
continue to search, is R.
Consumer Search Rule
When should a consumer cease searching for
price information?
Consumer will search until
Therefore, a consumer will continue to search
for a lower price when the observed price is
greater than R and stop searching when the
observed price is less than R.
Reservation price is the price that a consumer is
indifferent between purchasing at that price and
searching for a lower price.
Example:
A risk neutral manager is attempting to hire a
worker. All workers in the market are of identical
quality but differ with respect to the wage at
which they are willing to work. Suppose half of the
workers in the labor market are willing to work for
a salary of $40,000 and half will accept a salary of
$38,000. The manager spends three hours
interviewing a given worker and values this time at
$300. The first worker the manager interviews
says he will work only if paid by $40,000. Should
the manager make him an offer, or interview
another worker?
Computation for the expected benefits:
EB = ½($40,000 – 38,000) + ½ ($40,000 –
40,000)
EB = $1,000
Since the EB is greater than the cost of $300,
the manager should not hire the worker but
instead search for a worker willing to work for
$38,000.
The Optimal Search Strategy
The Optimal Search Rule is such that the
consumer rejects prices above the reservation
price. Stated differently, the optimal search
strategy is to search for a better price when the
price charged by a firm is above the reservation
price and stop searching when price is below the
reservation price is found.
Summary:
Accept – p < R; Purchase the product.
Reject – p > R; Reject and continue to search.
Consumer Search Rule: Increased Search Costs

The increase in search costs means that the consumer will
now find more prices acceptable and will search less
intrusively and vice versa.
Uncertainty and the Firm
Risk Aversion – Risk preferences
Are managers risk averse or risk neutral?
Diversification – Investing in multiple projects.
” Don’t pull all your eggs in one basket.”
Profit Maximization (Goal of a Risk Neutral
Manager)
When demand is uncertain, expected profits
are maximized at the point where expected
marginal revenue equals marginal cost: E[MR] =
MC.
In order for a Risk Neutral manager to
maximize expected profits, the manager should
equate expected marginal revenue (E[MR) and
marginal costs (MC) in selling output.
E[MR] = MC
If:
E[MR] > MC; Expand Output
E[MR] < MC; Decrease Output
Profit-Maximization in Uncertain
Environments
Example:
Suppose that economists predict that there is a
20% chance that the price in a competitive wheat
market will be $5.62 per bushel and an 80%
chance that the competitive price of wheat will be
$2.98 per bushel. If a farmer can produce wheat at
cost of C(Q)=20+0.01Q, how many bushels of
wheat should he produce? What are his expected
profits?
E[MR] = 0.2 X $5.62 + 0.8 X $2.98 = $3.508
In a competitive market firms produce where
E[MR] = MC. Or, 3.508 = 0.01Q,
Thus, Q=350.8 bushels
Expected profits = (3.508 x 350.8) – [20 +
0.01(350.8)] = 1230.61 – 20 – 3.508 = $1,207.10
Uncertainty can profoundly impact market’s
abilities to efficiently allocate resources.
Asymmetric Information – a situation that
exists when some people have better information
than others. Example, Insider Trading
Types of Asymmetric Information
1. Adverse Selection – When an individual has
hidden characteristics. Things one party to
a transaction knows about itself, but which
are unknown by the others party.
Examples:
Choice of medical plans or Auto insurance for
drivers with bad records.
2. Moral Hazard – When one party takes
hidden actions. Actions taken by one party
in a relationship that cannot be observed
by the other party.
Examples:
The principal-agent problem.
Care taken with rental cars.
Possible Solution
Signaling – an attempt by an informed party to
send an observable indicator of his or her hidden
characteristics to an uninformed party. To work,
the signal must not be easily mimicked by other
types. Example, Education
Screening – an attempt by an uninformed party
to sort individuals according to their
characteristics. Often accomplished through a self-
selection device – a mechanism in which informed
parties are presented with a set of options and the
options they choose reveals their hidden
 characteristics to an uninformed party. Example,
Price discrimination
Auctions:
Art
Treasury Bills
Spectrum rights
Consumer goods (eBay and other
internet auction sites)
Oil leases
Four Major Types of Auction:
 English - Most common auction. An
ascending sequential bid auction in
which bidders observe the bids of
others and decide whether or not to
increase the bid. The auction ends
when a single bidder remains; this
bidder obtains the item and pays the
auctioneer the amount of the bid. The
item is sold to the highest bidder.
 First-price, sealed-bid. – a simultaneous
move auction in which bidders
simultaneously submit bids on pieces
of paper. The auctioneer awards the
item to the highest bidder, who pays
the amount bid. The difference
between the First-price, sealed bid and
the English auction is that the bidders
do not know the bids of other players.
 Second-price, sealed-bid - A
simultaneous move auction in which
bidders simultaneously submit bids.
The auctioneer awards the item to the
high bidder, who pays the amount bid
by the second-highest bidder. The
same bidding process as a first-price,
sealed-bid auction. However, the
higher bidder pays the amount bid by
the 2nd highest bidder.
 Dutch - A descending price auction
started from the highest price that the
auctioneer is certain that no one will
buy. The bid decreases until one bidder
is willing to pay the quoted price.
Strategically equivalent to a first-price,
sealed-bid auction.
Information Structures
 Perfect Information - each bidder knows
exactly the items worth.
 Independent Private Values – bidders
know their own valuation of the item, but
not other bidders’ valuations. Bidders’
valuations do not depend on those of
other bidders.
 Affiliated (or correlated) value estimates –
bidders do not know their own valuation
of the item or the valuations of others.
Bidders use their own information to form
a value estimate. Value estimates are
affiliated: the higher a bidder’s estimate,
the more likely it is that other bidders also
have high value estimates. Common
values are the special case in which the
true (but unknown) value of the item is
the same for all bidders.
STRATEGIC THINKING
Strategic Situation – where the parties consider
interactions with one another in making decisions.
Strategy – a plan for action in a strategic
situation
Nash Equilibrium
Refers to a condition in which every participant
has optimized its outcome, based on the other
player’s expected decision.
It is a game theory concept that determines the
optimal solution n a non-cooperative game in
which each player lacks incentive to change
his/her initial strategy. Under a Nash equilibrium,
a player does not gain anything from deviat-ing
from the initially chosen strategy, assuming the
other players keep their strategies unchanged.
Competition or Coordination
• Zero-sum game – one party can be better
off only if another is worse
• Positive-sum game – one party can be
better off without another being worse off

Game in Extensive Form
A game in extensive form explicitly depicts the
sequence of moves and the corresponding
outcomes which consist of nodes and branches. A
node represents a point in which a party must
choose a move. Branches, on the other hand
represents the possible choices at the node.
Strategic Move
A strategic move is an action to influence
beliefs or actions of other parties in favorable way.
Example Situation
• You were driving your car when the police
officer pulls you over and asks to search for your
vehicle.
• The officer needs your permission because
he doesn’t have reasonable suspicion.
• You can either let him do it or call for a K-9
unit

Game in Extensive Form

Figure above depicts the analysis of Player 1 in

making a move. As seen in the above figure, 2
options were given: move A and move B. Both
moves have a set of possible moves to be taken by
Player 2. The judgment will be based on the
highest payoff considering the possible move of
player 2.

Backward Induction
What we did in analyzing the extensive form is
backward induction. It is a process of looking
forward to final nodes and reason backward
toward the initial node.
Equilibrium Strategy
What was portrayed was a sequence of best
actions, with each action decided at corresponding
node.
First Mover Advantage
In sequence games, a party gains advantage by
moving first and deciding the probable course of
action which can possible control the game.
This is a typical situation and can be analyzed
on figure 2 by the given nodes and possible pay
offs. If an additional scenario has been added, a
change of judgment will happen.
• Assuming the police officer states that a
quick search is better than the K-9 for both of you.
The statement said by the police officer may
have a great impact on your judgment and can be
classified as a strategic move.

Uncertain Consequences
One party may not be certain about the
consequences of the various actions of the other
party.
 Conditional Strategic Move
An action under specified conditions to
influence the beliefs or actions of other parties in
a favorable way.
Promise
Conveys benefits under specified conditions, to
influence the beliefs or actions of other parties in
favorable way.
• Suppose a promise has been said by the
police officer. This is a condi-tional strategic move
as it influences the judgment of the decision-
maker to let him conduct a quick search.
Threat
Imposes costs, under specified conditions, to
influence the beliefs or actions of other parties in
favorable way.
• Suppose a threat has been said by the
police officer. This is a conditional strategic move
as it influences the judgment of the decision-
maker to let him conduct a search regardless of
the outcome.
Repetition
Surely, many strategic interactions are
repeated and can be solved faster than before
considering the historical factors and previous
outcomes. Knowing the other players more can
help in assessing which of the actions should be
chosen to reach the Nash equilibrium of the
situation. This can be a great help in solving the
problem with strategic and conditional strategic
moves as credibility, and character is now being
considered before conducting a judgment.
INTERNATIONAL TRADE
INTERNATIONAL TRADE is the exchange of
goods and services between countries.
International Trade Theories
a) Classical or Country Based Theories
1. Mercatilism – this theory stated that a
country’s wealth was determined by the amount
of gold and silver holdings.
2. Absolute Advantage – focused on the
ability of a country to produce a good more
efficiently than another nation.
3. Comparative Advantage – occurs when a
country cannot produce a product more efficiently
than the other country; however, it can produce
that product better and more efficiently than it
does other goods.
4. Heckscher-Ohlin – also called the Factor
Proportions Theory, stated that countries would
produce and export goods that required resources
or factors that were in great supply, and therefore,
cheaper production factors.
b) Modern Firm Based Theories
1. Country Similarity – this theory states that
most trade in manufactured goods will be
between countries with similar per capita
incomes, and intra-industry trade will be common.
2. Product Life cycle – this theory stated that
a product life cycle has three distinct stages: 1)
New Product, 2) Maturing Product 3) Standardized
Product. The theory assumed that production of
the new product will occur completely in the
home county of its innovation.
3. Global Strategic Rivalry – this theory
focused on MNCs and efforts to gain a competitive
advantage against other global firms in industry.
4. Porter’s National Competitive Advantage –
this theory stated that a nation’s competitiveness
in an industry depends on the capacity of the
industry to innovate and upgrade.
 Differences in Domestic and International
Nature of International Trade Trade
• Human wants and countries’ resources do
not totally coincide
• Technological Advancement
• Factor endowments in different countries
differ
• Labor an entrepreneurial skill differs
• Factors of production are highly immobile
between countries

Advantages of International Trade

• Optimum Allocation
• Gains of Specialization
• Enhanced Wealth
• Larger Output
• Welfare Contour
• Cultural Values
• Better International Politics
• Dealing with Scarcity
• Language
• Advantageous Competition
• Larger size of Market • Differences Regarding Mobility of Labor
and Capital
Disadvantages of International Trade • Differences in Natural and Economic
Conditions
• Exhaustion of Resources
• Differences in Banking Systems and
• Blow to Infant Industry
Economic Policies
• Dumping
• Diversification of savings • Currency
• Declining Domestic Employment • Systems of Payment
• Over Interdependence • Distance
• Customs Duties and Import Quotas
• Competition
• Local Conditions

Protectionism Economic – is an economic

policy of restricting imports from other countries
through methods such as tariffs on imported
goods, import quota and variety of other
government regulations. A variety of policies have
been used to achieve protectionist goal. These
include:

• Protection of technologies, patents,

technical and scientific knowledge
• Prevent foreign investors from taking
control of domestic firms
• Tariffs
 • Import quotas
• Administrative barriers
• Anti-dumping legislation
• Direct Subsidies
• Export Subsidies
• Exchange rate control
• International patent systems
• Political Campaigns
• Preferential governmental spending
Trade Barriers – are government-imposed
restraint on the flow of International good or
services. Non-tariff barriers include:
• Licenses
• Import quotas
• Voluntary Export Restraints (VER)
• Local content requirement
Reasons Why Tariff are Imposed:
a) Protecting Domestic Employment
b) Protecting Consumers
c) Infant Industries
d) National Security
e) Retaliation
Tariffs and Modern Trade
The role of tariffs play in international trade
has declined in modern times. One of the primary
reasons for the decline is the introduction of
International organizations designed to improve
free trade such as the World Trade Organization
(WTO).
Who Benefits?
The benefits of tariffs are uneven. Because a
tariff is a tax, the government will see increased
revenue as imports enter the domestic market.
REGULATION
Regulation is broadly defined as imposition of
rules by government, backed by the use of
penalties that are intended specifically to modify
the economic behavior of individuals and firms in
the private sector. Various regulatory instruments
or targets exist. Prices, output, rate of return (in
the form of profits, margins or commissions),
disclosure of information, standards and
ownership ceilings are among those frequently
used.
Market power refers to the ability of a firm (or
group of firms) to raise and maintain price above
the level that would prevail under competition is
referred to as market or monopoly power. The
exercise of market power leads to reduced output
and loss of economic welfare.
A natural monopoly is a type of monopoly that
exists due to the high start-up costs or powerful
economies of scale of conducting a business in a
specific industry. A company with a natural
monopoly might be the only provider or a product
or service in an industry or geographic location.
Natural monopolies can arise in industries that
require unique raw materials, technology, or
similar factors to operate.
If a market is a natural monopoly, the
government should prohibit competition and
allow only a single supplier. This would establish
the conditions for production at the lowest
average cost. The monopoly, however, might
exploit its exclusive right to raise its price at the
expense of its consumers. Accordingly, to ensure
economic efficiency, the government must control
the monopoly which it can do it in two ways:
• The government itself can own the
business, and operate at the economically
efficient level
• Award a monopoly franchise to a
commercial enterprise and subject the monopoly
to regulation
Government ownership and operation is the
simplest and most direct way to ensure economic
efficiency. However, in practice, government-
owned enterprises tend to be relatively inefficient,
and so government ownership and operation fails
to achieve economic efficiency. Some of the
sources of inefficiency in government ownership
are:
 • Government-owned enterprises are prone
to be coopted by employees so that the enterprise
serves its employees rather than its customers.
• Government-owned enterprises depend
on the government for investment funds. A
government-owned enterprise must compete with
other priorities for an allocation from the budget
and may not be able to secure the economically
efficient level of investment
Due to the limitations of government
ownership and operation, a worldwide trend has
been to privatize government-owned enterprises.
Privatization occurs when a government-owned
business, operation, or a property becomes
owned by a private, non-government party. Note
that privatization also describes the transition of a
company from being publicly traded to becoming
privately held. This is referred to as corporate
privatization.
Privatization of specific government operations
happens in a number of ways, although generally,
the government transfers ownership of specific
facilities or business processes to a private, for-
profit company. Privatization generally helps
governments save money and increase efficiency.
In general, two main sectors compose an
economy—the public sector and the private
sector.
Price regulation refers to the policy of setting
prices by a government agency, legal statute or
regulatory authority. Under this policy, minimum
and/or maximum prices may be set. Under price
regulation, the government can implement the
following policies:
• Marginal cost pricing - the practice of
setting the price of a product to equal the extra
cost of producing an extra unit of output. By this
policy, a producer charges, for each product unit
sold, only the addition to total cost resulting from
materials and direct labor
• Average cost pricing - pricing strategy that
regulators impose on certain businesses to limit
what they are able to charge consumers for its
products or services to a price equal to the costs
necessary to create the product or service. This
implies that businesses will set the unit price of a
product relatively close to the average cost
needed to produce it
Rate of return regulation is a form of price
setting regulation where governments determine
the fair price which is allowed to be charged by a
monopoly. It is meant to protect customers from
being charged higher prices due to the monopoly's
power while still allowing the monopoly to cover
its costs and earn a fair return for its owners.
Rate of return regulation presents three
challenges in implementation:
• Rate of return – one challenge is to set the
allowed rate of return. There would be few
comparable businesses, so it would be difficult to
determine the appropriate rate of return
• Rate base – another challenge is to
determine what assets are needed to provide the
regulated service and should be counted in the
rate base
• Overinvestment –the franchise holder has
an incentive to invest beyond the economically
efficient level. By enlarging the rate base, the
allowed rate of return will be applied to larger
base thus the franchise holder can increase its
profit.
Potentially Competitive Market
A potentially competitive market is one where
economies of scale and scope are small relative to
market demand. With perfect competition, the
invisible hand will ensure economic efficiency. In
any potentially competitive market, the
government should promote competition.
Competition Law
The basic way in which governments promote
competition is through competition law, which is
also called antimonopoly or antitrust law.
The Philippine Competition Act (PCA) or R.A.
10667 is the primary competition policy of the
Philippines for promoting and protecting
competitive market. It will protect the well-being
of consumers and preserve the efficiency of and the allocation of resources will not be
competition in the marketplace. The PCA was economically efficient.
passed in 2015 after languishing in Congress for 24
years. It is a game changing legislation that is Consider for instance, the market for medical
expected to improve consumer protection and services. Patients rely on surgeons for advice as
help accelerate investment and job creation in the well as treatment. Owing to the asymmetry of
country, consistent with the national information between surgeon and patient, the
government’s goal of creating more inclusive surgeons are subject to moral hazard. Surgeons
economic growth. Enforcement of this law will may overprescribe treatment to increase their
help ensure that markets are open and free, income.
challenging anticompetitive business practices
while maintaining an environment where
businesses can compete based on the quality of
their work. A competitive market means a market
with multiple buyers and multiple sellers, driving
market prices lower and offering consumers more
choices. A truly competitive market encourages
efficiency and innovation, and forces businesses
to excel. The act reflects the belief that
competition:

• Promotes entrepreneurial spirit

• Encourages private investments
• Facilitates technology development and
transfer, and
• Enhances resource productivity
The graph above illustrates the market
equilibrium. The true demand is the patients’
Structural Regulation
marginal benefit if they had the same information
The fact that one market is a natural monopoly
as their surgeons. The inflated demand results
does not necessarily mean that related upstream
from asymmetry of information and exceeds the
or downstream markets are also natural
true demand to the extent that surgeons induce
monopolies. The government must consider how
patients to get excessive treatment.
to preserve the benefits of monopoly in one
market while fostering competition in the other.
The inflated demand crosses the supply of
medical services at point a. In the market
Under structural regulation, the regulator
equilibrium, the price is $140 per hour and the
stipulates the conditions under which a business
quantity of treatment is 210,000 hours a month.
may produce vertically related goods and services.
At that quantity, the true marginal benefit of
medical services is $50, which is the height of the
true demand curve. The marginal cost of medical
Asymmetry of Information
services is $140, the height of the supply curve at
Another situation in which the invisible hand
the equilibrium quantity. In equilibrium, the
may fail is where information about some
marginal cost exceeds the marginal benefit by $90.
characteristic or future action is asymmetric. If
This economic inefficiency results from asymmetry
the information asymmetry is not resolved, the
of information between surgeons and patients.
marginal benefit will diverge from marginal cost,
 In situation of asymmetric information, the
regulator might possibly resolve the asymmetry by
regulating the better-informed party’s
a. Disclosure of information
b. Conduct, and
c. Business structure.
In medical services, to the extent that the
regulation is effective, the inflated demand would
shift down towards the true demand. Then the
equilibrium would be closer to point b, where the
true marginal benefit equals the marginal cost.
Disclosure
The most obvious way to resolve asymmetric
information is to require the better-informed
party to disclose its information truthfully.
However, disclosure will resolve the asymmetry
only if the information can be objectively verifies.
In the case of surgery, the patient’s need is a
matter of professional judgment, hence,
disclosure may not resolve the information
asymmetry. Consider another situation of
asymmetric information: financial advisors hard-
selling risky investments. The regulator can
require financial advisors to disclose the riskiness
of investments. This might help to resolve the
information asymmetry if the client understands
the disclosure.
Conduct Regulation
Instead of directly resolving an information
asymmetry, an alternative is to regulate the
conduct of the better-informed party and so limit
the extent to which it can exploit informational
advantage. If parties with better information
cannot exploit their advantage, then the outcome
would be closer to the economically efficient level.
For example, the regulator of financial services
can stipulate that financial advisors must evaluate
their clients’ risk profile before marketing any
investment products. The regulator can also
stipulate a minimum ”cooling-off” period during
which an investor may withdraw from the
purchase of any investment without penalty. Such
regulations of conduct restrict the scope for a
financial advisor to pressure investors into buying
unsuitable investments.
Structural Regulation
Another way to limit the extent to which a
better-informed party can exploit an informational
advantage is to regulate the structure of the
industry. By enforcing separation of different
businesses, a regulator may reduce the
opportunities for exploiting superior information.
The market for medical services illustrates
structural regulation. In some countries, doctors
are limited to providing advice and treatment, and
are prohibited from selling medicines and medical
supplies. This regulation effectively dissuades
doctors from excessive prescription of medicines.
The market for financial services also illustrates
structural regulation. Following the subprime
financial crisis, various regulators have proposed
that commercial banks, which take deposits from
retail customers, should not be allowed to engage
in trading of derivatives and other securities. This
structural regulation limits the exposure of
commercial banks to risk.
Externalities
The invisible hand may fail in situations of
externalities, that is, when some benefit or cost
passes directly from source to recipient and not
through a market. In the absence of a market, the
invisible hand cannot work. There are no markets
for factory emissions or discharge of contaminated
water. Furthermore, pollution affects so many
entities that private action would probably not
resolve the externality. Government regulation
may be the only solution.
For economic efficiency, the level of an
externality would be such that marginal benefit
equals marginal cost. The benefit of emissions is
in allowing the sources to avoid the cost of clean
disposal. The cost of emissions is the harm to the
health of the victims.
The economically efficient rate is where the
marginal benefit equals the marginal cost to
society. How can this be achieved? Generally, To remedy the problem, the government can
there are two ways of regulating externalities: internalize the externalities by taxing goods that
a. User fees or taxes; have negative externalities and subsidizing goods
b. Standards or quotas that have positive externalities.

User Fee or Taxes

One method of regulation aims to mimic Adam
Smith’s invisible hand: allow all sources to emit as
much as they like provided that they pay the
appropriate user fee or tax. Consider an oil
refinery that emits pollutants. To maximize
profits, the refinery should buy emissions up to
the rate where the marginal benefit of emissions
balances to user fee. Negative externalities lead
markets to produce a large quantity than is
socially desirable. Manufacturers tend to just pay
taxes rather than stop producing products that
would harm the people.

Standards or Quotas
Although some activities impose costs on third
parties, other yield benefits. For example,
consider education. To a large extent, the benefit
of education is private: The consumer of
education becomes a more productive worker and
thus reaps much of the benefit in the form of
higher wages. Beyond these private benefits,
however, education also yields positive
externalities. One externality is that a more
educated population leads to more informed
voters, which means better government for
everyone. Another externality is that a more
educated population tends to mean lower crime
rates. A third externality is that a more educated
population may encourage the development and
dissemination of technological advances, leading
to higher productivity and wages for everyone.

However, government sponsored education is

not available for everyone, criteria have been set
and standards are established to determine the
cream of the crops who will be eligible for the
scholarship. Positive externalities lead markets to
produce a smaller quantity than is socially
desirable.