YMANECON: PRELIMS ✓ Reported on the firm’s income statement.

• Economic profit
CHAPTER 1: The Fundamentals of Managerial Economics
Learning Objectives
1. Summarize how goals, constraints, incentives,
and market rivalry affects economic decisions.
2. Distinguish economic versus accounting profits
and costs.
3. Explain the role of profits in a market economy.
4. Apply the five forces framework to analyze the
sustainability of an industry’s profits.
5. Apply marginal analysis to determine the optimal
level of a managerial control variable.
6. Identify and apply six principles of effective
managerial decision making.
The Manager
A person who directs resources to achieve a stated goal.
• Directs the efforts of others.
• Purchases inputs used in the production of the firm’s
output.
• Directs the product price or quality decisions.
The difference between total revenue and cost opportunity cost.
✓ Total revenue minus total opportunity cost.
✓ Opportunity cost
The explicit cost of a resource plus the implicit cost of giving up its best
alternative.
• Accounting Costs
✓ The explicit costs of the resources needed to
produce produce goods or services.
✓ Reported on the firm’s income statement.
• Opportunity Cost
✓ The cost of the explicit and implicit resources
that are foregone when a decision is made.
• Economic Profits
✓ Total revenue minus total opportunity cost.
• The role of profits
✓ Profits are a signal to resource holders where
resources are most highly valued by society.
✓ Resources will flow into industries that are most
highly valued by society.

Economics
The science of making decisions in the presence of scarce Five Forces and Industry Profitability
resources. Sustainable Industry Profits
• Resources are anything used to produce a good or • Entry
service, or achieve a goal. ✓ Entry Costs
• Decisions are important because scarcity implies ✓ Speed of adjustment
trade-offs. ✓ Sunk costs
✓ Economies of scale
Managerial Economics ✓ Network effects
The study of how to direct scarce resources in the way that ✓ Reputation ✓ Switching costs ✓ Government
most efficiently achieves a managerial goal. restraints.
• Should a firm purchase component – like disk drives • Power of Input Suppliers
and chips – from other manufacturers or produce ✓ Supplier concentration
them within the firm? ✓ Price/productivity of alternative inputs
• Should the firm specialize in making one type of ✓ Relationship-specific investments
computer or produce several different types? ✓ Supplier switching costs
• How many computers should the firm produce, and ✓ Government restraints
at what price should you sell them?
• Power of Buyers
ECONOMICS OF EFFECTIVE MANAGEMENT ✓ Buyer concentration
Basic principles comprising effective management: ✓ Price/value of substitute products or services
1. Identify goals and constraints ✓ Relationship-specific investments
2. Recognize the nature and importance of profits ✓ Customer switching costs-
3. Understand incentives ✓ Government restraints
4. Understand markets
5. Recognize the time value of money • Industry Rivalry
6. Use marginal analysis ✓ Concentration
✓ Price, quantity, quality, or service competition
1. Identify Goals and Constraints ✓ Degree of differentiation
• Well-defined goals ✓ Switching costs
• Firm’s overall goal is to maximize profits ✓ Timing of decisions
• Constraints make it difficult to achieve goals ✓ ✓ Information
✓ Government restraints
Available technology
✓ Prices of inputs used in production

2. Recognize the Nature and Importance of Profits

• Accounting profit • Substitutes and Complements
✓ Price/value of surrogate products or services
Total amount of money taken in from sales (total revenue)
✓ Price/value of complementary products or
minus the dollar cost of producing goods or services.
services
✓ Total revenue (sales) minus dollar cost of producing
✓ Network effects
goods or services.
 ✓ Government Restraints
3. Understand Incentives
• Changes in profits provide an incentive to how
resource holders use their resources.
• Within a firm, incentives impact how resources are
used and how hard workers’ work.
benefits equal marginal costs. This level of the managerial
control variable corresponds to the level at which marginal net
benefits are zero; nothing more can be gained by further
changes in that variable.
Net Benefit
Net Benefits = Total Benefits - Total Costs
Profits = Revenue – Costs

Marginal Benefit (MB)

Change in total benefits arising from a change in the control
variable, Q:

Slope (calculus derivative) of the total benefit curve.

Marginal Cost (MC)

✓ One role of a manager is to construct incentives to Change in total costs arising from a change in the control
induce maximal effort from employees. variable, Q:

4. Understand Markets
• Two sides to every market transaction: buyer and
seller
• Bargaining position of consumers and producers is
limited by three rivalries in economic transactions:
✓ Consumer-producer rivalry
✓ Consumer-consumer rivalry Slope (calculus derivative) of the total cost curve.
✓ Producer-producer rivalry
• Government and the market Marginal Principle
To maximize net benefits, the managerial control variable
5. Use Marginal Analysis Control should be increased up to the point where MB = MC.
Variable Examples:
✓ Output MB > MC means the last unit of the control variable increased
✓ Price benefits more than it increased costs.
✓ Product Quality
MB < MC means the last unit of the control variable increased
✓ Advertising
costs more than it increased benefits.
✓ R&D
Basic Managerial Question: How much of the control variable
should be used to maximize net benefits?
• Given a control variable, 𝑄, of a managerial
objective, denote the
✓ total benefit as 𝐵 (𝑄)
✓ total cost as 𝐶 (𝑄)
• Manager’s objective is to maximize net benefits:
𝑁 𝑄 = 𝐵 (𝑄) – 𝐶 (Q)

• How can the manager maximize net benefits?

• Use marginal analysis
✓ Marginal benefit: 𝑀𝐵 (𝑄)
The change in total benefits arising from a change in the
managerial control variable, 𝑄.
✓ Marginal cost: 𝑀𝐶 (𝑄) The
change in the total costs arising from a change in the
managerial control variable, 𝑄.
✓ Marginal net benefits: 𝑀𝑁𝐵 (𝑄)
𝑀𝑁𝐵 (𝑄) = 𝑀𝐵 (𝑄) − 𝑀𝐶 (Q)
✓ Marginal principle
To maximize net benefits, the manager should increase the
managerial control variable up to the point where marginal
 • Goods offered for sale are all exactly the same •
Buyers and sellers are so numerous
✓ No single buyer or seller has any influence
over the market price
✓ Price takers
• At the market price
✓ Buyers can buy all they want
✓ Sellers can sell all they want

Monopoly
• The only seller in the market
• Sets the price
Other markets
• Between perfect competition and monopoly
DEMA
ND
Quantity demanded
• Amount of a good that buyers are willing and able to
purchase

Law of demand
• Other things equal
• When the price of a good rises, the quantity
demanded of the good falls
• When the price falls, the quantity demanded rises

Demand
• Relationship between the price of a good and
quantity demanded
CHAPTER 4: The Market Forces of Supply and Demand • Demand schedule: a table • Demand curve: a graph
✓ Price on the vertical axis
MARKETS AND COMPETITION
Supply and demand
✓ Quantity on the horizontal axis
• Words economists use most often Individual demand
• The forces that make market economies work • An individual’s demand for a product
• Refer to the behavior of people as they interact
with one another in competitive markets

Market
• A group of buyers and sellers of a particular good
or service
✓ Buyers as a group
Determine the demand for the product
✓ Sellers as a group
Determine the supply of the product

Markets take many forms

✓ Highly organized
Markets for many agricultural commodities
✓ Less organized Market demand
Market for ice cream in a particular town • Sum of all individual demands for a good or service

Competitive market Market demand curve

• Market in which there are many buyers and many
sellers
• Each has a negligible impact on market price
• Price and quantity are determined by all buyers
and sellers
✓ As they interact in the marketplace
• Sum the individual demand curves horizontally •
Total quantity demanded of a good varies
✓ As the price of the good varies ✓ Other
things constant

Perfectly competitive market

 ✓ Other things constant
✓ An increase in income leads to a decrease in
demand

Prices of related goods

• Substitutes, two goods
✓ An increase in the price of one
✓ Leads to an increase in the demand for the
other
• Complements, two goods
✓ An increase in the price of one
✓ Leads to a decrease in the demand for the
other
Tastes
• Change in tastes: changes the demand Expectations
about the future
• Expect an increase in income
✓ Increase in current demand
• Expect higher prices
✓ Increase in current demand

Number of buyers, increases

• Market demand increases

Shifts in the demand curve

• Increase in demand
✓ Any change that increases the quantity
demanded at every price
✓ Demand curve shifts right
• Decrease in demand
✓ Any change that decreases the quantity
demanded at every price
✓ Demand curve shifts left

TWO WAYS TO REDUCE THE QUANTITY OF SMOKING

DEMANDED
1. Shift the demand curve for cigarettes and other tobacco
products
2. Try to raise the price of cigarettes
“What is the best way to stop this?”
1. Shift the demand curve for cigarettes and other tobacco products
– Public service announcements
– Mandatory health warnings on cigarette packages
– Prohibition of cigarette advertising on television
• If successful
– Shift demand curve to the left
Variables that can shift the demand curve 2. Try to raise the price of cigarettes
• Income – Tax the manufacturer: higher price – Movement
• Prices of related goods along demand curve
• Tastes • 10% ↑ in price → 4% ↓ in smoking
• Expectations • Teenagers: 10% ↑ in price →
• Number of buyers 12% ↓ in smoking
Income • Demand for cigarettes vs. demand for
• Normal good marijuana
✓ Other things constant – Appear to be complements
✓ An increase in income leads to an increase
in demand
• Inferior good
 Market supply
• Sum of the supplies of all sellers for a good or service

Market supply curve

• Sum of individual supply curves horizontally •
Total quantity supplied of a good varies
✓ As the price of the good varies
✓ All other factors that affect how much
suppliers want to sell are hold constant

SUPPLY

Quantity supplied
• Amount of a good
• Sellers are willing and able to sell

Law of supply
• Other things equal
• When the price of a good rises, the quantity supplied
of the good also rises
• When the price falls, the quantity supplied falls as
well
Shifts in supply
Supply • Increase in supply
• Relationship between the price of a good and the ✓ Any change that increases the quantity
quantity supplied supplied at every price
• Supply schedule: a table • Supply curve: a graph ✓ Supply curve shifts right
✓ Price on the vertical axis • Decrease in supply
✓ Quantity on the horizontal axis ✓ Any change that decreases the quantity
supplied at every price
Individual supply ✓ Supply curve shifts left
• A seller’s individual supply

Variables that can shift the supply curve

 • Input prices
• Technology
• Expectations about future
• Number of sellers

Input prices
• Supply is negatively related to prices of inputs
• Higher input prices: decrease in supply

Technology
• Advance in technology: reduces firms’ costs:
increase in supply

Expectations about future

• Affect current supply Surplus
• Expected higher prices • Quantity supplied > Quantity demanded
✓ Decrease in current supply • Excess supply
• Downward pressure on price
Number of sellers, increases ✓ Movements along the demand and supply
• Market supply increases curves
✓ Increase in quantity demanded
✓ Decrease in quantity supplied
Shortage
• Quantity demanded > Quantity supplied
• Excess demand
• Upward pressure on price
✓ Movements along the demand and supply
curves
✓ Decrease in quantity demanded ✓ Increase
in quantity supplied

Equilibrium
• Various forces are in balance
• A situation in which market price has
reached the level were
✓ Quantity supplied = Quantity
demanded
• Supply and demand curves intersect

Equilibrium price
• Balances quantity supplied and quantity
demanded Law of supply and demand
• Market-clearing price • The price of any good adjusts
✓ To bring the quantity supplied and the
Equilibrium quantity quantity demanded for that good into
• Quantity supplied and quantity demanded balance
at the equilibrium price • In most markets
✓ Surpluses and shortages are temporary

Three steps to analyzing changes in equilibrium

1. Decide whether the event shifts the supply curve, the
demand curve, or, in some cases, both curves (Decide
whether the event shifts the supply or demand curve
(or perhaps both).
2. Decide whether the curve shifts to the right or to the
left (Decide in which direction the curve shifts.)
 3. Use the supply-and-demand diagram (Use the supply- 1. Heat wave shifts the demand curve; hurricane shifts
and demand diagram to see how the shift changes the supply curve
the equilibrium price and 2. Demand curve shifts to the right; Supply curve shifts
quantity.)
to the left
✓ Compare the initial and the new equilibrium
3. Equilibrium price raises
✓ Effects on equilibrium price and quantity
✓ If demand increases substantially while supply falls
just a little: equilibrium quantity rises
A change in market equilibrium due to a shift in demand
– One summer, very hot weather ✓ If supply falls substantially while demand rises just a
little: equilibrium quantity falls
– Effect on the market for ice cream?
1. Hot weather: shifts the demand curve (tastes )
2. Demand curve shifts to the right
3. Higher equilibrium price; higher equilibrium quantity

Shifts vs. movements along curves

• Shift in the supply curve
✓ Change in supply
• Movement along a fixed supply curve
✓ Change in the quantity supplied
• Shift in the demand curve
✓ Change in demand
• Movement along a fixed demand curve
✓ Change in the quantity demanded
Supply and demand together
A change in market equilibrium due to a shift in supply
– One summer, a hurricane destroys part of the • Determine the prices of the economy’s many different goods
and services
sugarcane crop: higher price of sugar
– Effect on the market for ice cream?
1. Change in price of sugar: supply curve
2. Supply curve: shifts to the left
3. Higher equilibrium price; lower equilibrium quantity

Prices
• Signals that guide the allocation of resources
• Mechanism for rationing scarce resources
Shifts in both supply and demand
– One summer: hurricane and heat wave
• Determine who produces each good and how much is
produced