Managerial Economics

Santanu Gupta
Managerial Economics

Decision Making by a Firm

Session Objectives

Define Marginal Revenue and Marginal Costs

Explain Policy Options

Learn the impact of price models

Describe the impact of price ceiling above and below the market price

Explain elasticity and oligopoly

Distinguish between Free Market And A Monopolistic Situation

Use Game Theory to Model Collusion

The Market as a Whole

We have till now only looked at aspects concerning the household,

namely how they decide how much to earn, how much to save, and that
they decide to spend on.

In all these decisions, price was an important variable, but that was
given from outside the system.

We now concentrate on how prices are determined within the system.

That depends on not only the decisions of the household, but also that
of the firm, so we need to look into firm behavior.
Decision Making by a Firm

Primary objective of a firm

The firm has to decide on how much of inputs to buy

and how much to produce, given inputs as well as
output prices.
• Maximize Profits
• Profits = Revenues – Costs
How would a firm respond to a rise in output prices?
Some Concepts

Marginal Revenue
• Increase in total revenue when an extra unit of the output is produced and sold.

Marginal Costs
• Increase in total costs when an extra unit of the output is produced.

Entrepreneurs maximize profits at an output level at which

marginal revenue is equal to or greater than marginal costs.
Output Price Revenue Costs Profit Marginal Marginal
Revenue Cost

0 4 2

1 4 4 2 2 4 3

2 4 8 5 3 4 4

3 4 12 9 3 4 5
4 4 16 14 2 4 6
5 4 20 20 0

Output Price Revenue Costs Profit Marginal Marginal

Revenue Cost

0 5 2

1 5 5 2 3 5 3
2 5 10 5 5 5 4
3 5 15 9 6 5 5
4 5 20 14 6 5 6
5 5 25 20 5
Change of Supply With Price

Therefore as the output price rises, the output at which

a producer maximizes profit increases. So with an
increase in output prices an individual producer will
supply more.
Price Market Supply

4 20
5 30

Let there be 10 identical suppliers. The market supply at

different prices will be
 Supply of Food

Producer P Producer Q Market Supply

Pf Pf
Pf

0
0 x P
Food
0
x Q
f Food x Pf  x Qf Food
f
Effect of a Fall in Fertilizer Prices

• Demand for food unaffected

• Supply of food is more at any given price

Pf Pf Pf

Food Food Food

Equilibrium

S
Pf

Pf*

x* Food

Similarly we can determine the equilibrium price

of clothing
Markets are Interlinked: A Shock in One Spreads to The Others

Example:- Drought:-
S1 S
Food supply is less, the supply curve shifts from S to
Pf
S1
P1
Farmers incomes are less, therefore they buy less P
clothes from the weaver

D1 D
Weaver’s demand for food falls
F1 F Food

Equilibrium quantity traded drops.

 Please select one design
Policy Options

If it is a closed economy, any

shock in the domestic market
affects all other sectors.
If suppliers of clothing, export a
large chunk of their product,
they are not affected much by
the domestic drought.
Policy Options

If it is a closed economy, any shock in the

domestic market affects all other sectors.

If suppliers of clothing, export a large chunk of

their product, they are not affected much by the
domestic drought.
Policy Options

Prices reveal relative scarcity or abundance of a commodity, if markets are not

allowed to operate freely, society may end up using resources in not the best way.

• Example: Fixed exchange rates

• The rupee was overvalued vis a vis the dollar, so that importers had to pay less to import machinery to
help in the country’s industrialization. However, we ended up choosing capital intensive techniques of
production instead of labor intensive ones, and so ended up with a lot of unemployment.

In India we use domestic labor to wash and clean homes rather than washing
machines and dish washers since domestic help is so much cheaper to buying or
renting these machines.
• A lot of water and electricity subsidies to farmers result in them choosing crops which require lots of
water, and not suited to the climatic condition of that place. Example: sugarcane in Maharashtra and
rice in Punjab.
Policy Options

Taxes also distort the relative prices between different goods consumed. For example taxes
distort the relative choice between consumption and leisure.

Let there be an electrician and a carpenter, the electrician does his own job in 12 hours and a
carpenters job in 20 hours. A carpenter does his own job in 12 hours and a electrician’s job in
20 hours. The wage rate for both is 10 units an hour. If both need each other, then they
would work for 12 hours to pay for the others services.

If however a 50% income tax were imposed, the carpenter would prefer to the electrician’s
job himself, rather than hire a plumber since that would mean working for 24 instead of 20
hours and vice versa.
The Impact of Price Controls

Free market prices that come through interaction of demand and supply may
be too high or too low to be desirable for society at large.

If it be an essential good like housing, the government might to for a rent

ceiling act as was the case in India.

If prices be too low as will be the case with a bumper harvest, the government
may specify a floor price below which the good cannot be sold.
The Economics of Dowry and Bride Price

Siwan Anderson wrote a very interesting paper on the economics of dowry and the bride price.

Bride price is more common in societies with heavy involvement of women in agriculture.

Dowry is more common in societies involving heavy plough agriculture where women’s outside role is limited.

Bride price is more common in polygamy and also with a high possibility of divorce.

In contrast, monogamy is the norm and divorce is rare in dowry paying societies.

Bride price is usually determined by the expected number of children a women could bear.

Dowry is a means to attract a husband of good social and economic standing, therefore men who are well qualified would
receive good dowry.
The Economics of Dowry and Bride Price

The economic explanation of dowry is that there is a

marriage squeeze that occurs due to men marrying
younger women and due to population growth, more
women than men enter the marriage market.

Dowry is also seen as inheritance payment, women receive

dowry and men receive bequests.

The very skewed sex ratio in south Asian countries is

attributed to the existence of dowry payments.
Government Intervention: Impact of Price Ceiling Above The Market Price

No impact on the market

S
Pf
In this case the maximum price is set
above the equilibrium price Pf*. So it is
Pf*
ineffective since the equilibrium price
Pf* can still be charged.

q D
f
q *f q Sf Food
Government Intervention: Impact of Price Ceiling Below The Market Price

Shortages created

S
Pf

At a ceiling price below the

equilibrium price, demand is more
Pf*
than supply and shortages are
P Shortage created.
D

Food
q S
f
q *f q Df
Rent Control and Mechanisms to Counter Housing Shortage

In India under the rent control act, rent was set below the market rate to make housing affordable to people. That
resulted in shortage.

In cities with rent control, landlords use various mechanisms to ration housing.

Some have long waiting lists. Some give preference to couples without children.

Still others discriminate on grounds of race.

Some apartments are allocated to those willing to offer under the table payments to building superintendents. In
essence, these bribes bring the total price of an apartment (including the bribe) closer to the equilibrium price.
Contrast Between Free Market and a Monopolistic Situation

In the discussion till now prices

were not in the control of either
producers or consumers, it was
essentially determined by the
However, if there is only one
market given the demand and
seller, he has the power to set It is here that the concept of
supply situation. We have
prices, he will set a price that elasticity becomes important.
therefore discussed a
maximizes his profits.
competitive situation where
there are large number of
producers and no one has the
power to influence prices.
Price Setting With Only Fixed Costs

The costs to a producers can be of two types, fixed costs and variable costs. Fixed costs are those which do
not vary with the level of output like rent. However costs like fuel costs might increase as one goes for
more production and these are variable costs.

Running a show in a movie hall may be thought of having only fixed costs, the electricity and other costs
are the same irrespective of the number of people.

In such a situation maximizing revenues which is price times quantity, may be equivalent to maximizing
profits.

However as price increases, demand declines, so we are not sure of whether the product will increase or
decline, and that is where the concept of elasticity becomes important.
Price Setting With Only Fixed Costs

If with a one percent increase in price, demand falls by more than one
percent, total revenue will fall, so it is best to decrease prices.

If with a one percent increase in price, demand falls by less than one
percent, total revenue will rise, so it is best to increase prices.

Profits will therefore be maximized when with a one percent increase in price,
demand falls by exactly one percent and therefore profits remain the same.
Elasticity: Definition

Elasticity:
Percentage change in quantity demanded from a one
percent change in price.

Therefore in a situation with fixed costs in a monopoly,

profits are maximized when the elasticity of demand is
equal to one.
In symbols the definition of
Categories of Elasticity
elasticity is:

• Relative elasticity of demand: EP

q / q pq >1
  • Relative inelasticity of demand:
0 < EP < 1
p / p qp • Unitary elasticity of demand: EP
=1
• Perfect elasticity: EP = ∞
• Perfect inelasticity: EP = 0
• Problem of calculating elasticities between two points on a demand curve (arc elasticity).
• Point A: Price = Rs. 4 Quantity = 120 kgs
• Point B: Price = Rs. 6 Quantity = 80 kgs

Going from Point A to Point B, price rises by 50% and quantity falls by 33%, so the price elasticity is 33/50 or 0.66. By contrast, going
from point B to point A, price falls by 33% and quantity rises by 50%, indicating that the price elasticity is 50/33 or 1.5. Therefore
computation of elasticities is path dependent. On way to get over this problem is to compute elasticities by the midpoint method.

Q2  Q1 P2  P1
Ep  
(Q1  Q2 ) / 2 ( P1  P2 ) / 2

By the mid-point method, price rises by 40% and quantity falls by 40%. In both directions price elasticity equals one.
Policy Options

If the government
wants to raise tax
revenues, it should
tax goods for which
demand is inelastic.
People cannot
avoid buying these
items and tax
revenues will rise.
Supply Demand and Elasticities: Application

Why did OPEC fail to keep oil prices high?

From 1973 to 1974 price of oil (adjusted for overall inflation rose more than 50%. Price of oil rose by 14% in 1979, followed by 34% in 1980, and
another 34% in 1981.

Between 1982 to 1985, the price of oil steadily declined at about 10% per year. In 1986 cooperation amongst OPEC countries completely broke
down, and the price of oil plunged 45%.

In 1990 the price of oil (adjusted for overall inflation) was back to where it began in 1970, and it stayed at the low level throughout most of the
1990’s.

Both demand and supply behave differently in the short run and the long run. In the short run both demand and supply are relatively inelastic.
Supply is inelastic because the quantity of known oil reserves and the capacity for oil extraction cannot be changed quickly. Demand is inelastic
because buying habits do not respond immediately to changes in price. Over time consumers attempt for conservation by shifting to more fuel
efficient cars.
 Price of Oil
Price of Oil S1
S0 S1
S0
P1
P1
P0 P0

Demand Demand

Quantity of Oil Quantity of Oil

The oil market in the short run The oil market in the long run

In the short run when demand and supply are both inelastic, a shift in the supply from
S0 to S1 causes a large increase in price. The same shift in the long run causes a small
increase in price.
Does banning drugs lead to more drug related crime?

For drug addicts, the demand for drugs is highly inelastic.

Banning drugs would lead to a hike in its price, and drug addicts would have to pay more for the same
amount of drugs consumed.

Addicts who already had to steal to support their habits would have an even greater need for quick cash, so
thefts and drug related crimes might increase.

Therefore some policy planners feel that it is a better decision to go for drug education, which reduces the
demand and price of drugs. Expenses on drugs decrease, and so would drug related crime over time.
Policies to Reduce Illegal Drugs: Drug Interdiction versus Drug Education

Price of Price of
S1 Drugs D D D1
Drugs
S0
1 0
Supply

P1
P0 P0
P1

Demand

Q1 Q0 Quantity of Drugs Q1Q0 Quantity of Drugs

Drug Interdiction Drug Education
Drug interdiction reduces the supply of drugs and raises the price of drugs . If demand is inelastic,
expenditures of drug users increase. Addicts who were already stealing to support their habits might steal
more now. So drug interdiction might increase drug related crime. In contrast drug education reduces drug
usage and expenses of drug users and should lead to a reduction in drug related crime.
Similar Problems in India

Lawlessness runs over many districts in India where Maoists have taken
control.

It is said that they have been able to lure common citizens, given the fact
that unemployed youths can be easily lured to terrorism.

Should the government try to curb terrorism in these districts by increasing

the police force or starting development works in these districts or both.
Agricultural Produce Marketing Committee (APMC) Act

The APMC Acts were enacted in order to free the farmer from the clutches of the
middlemen.

However, market monopoly given to the state was seen as preventing private
investments in agricultural markets and its restrictive legal provisions have
prevented new entrants from coming in, thus reducing competition.

Market Committees did not plough back the market fee collected into
developing infrastructure and these funds were siphoned off into government
accounts.

To address many of these issues a Model Act 2003 was framed.

The Effect of Minimum Wage Legislation

Minimum wage
legislations are common
worldwide and are done
with the intention of
providing a fair wage to
the working class.
On the flip side, it is
argued, that fixing a
minimum wage results in
involuntary
unemployment that is
people who want jobs at
the going wage rate but
are unable to get it.
A Labour Market with a Binding Minimum Wage

Wage Labour supply

Unemployment
Labour supply

Labour demand

Quantity Quantity Quantity of labour

demanded supplied
Nature of Government Interventions in Rice and Wheat Markets

Indian food grains policy can be traced back to World War II,
when a series of food price control measures were taken by
British to control rising food prices.

The Bengal famine of 1943 accelerated the scope of public

intervention
Instruments for administrative intervention

Minimum support prices

Input subsidies

Public Procurement

Price Stabilization through buffer stocks

Public Distribution System

Controls on private trade (on storage and transportation as well as controls on international trade)
Nature of Government Interventions in Rice and Wheat Markets

Restrictions on private
storage under Essential As regards restrictions
Commodities Act, 1955 on inter-state sale of Many states follow a
originated from the agricultural practice of collecting
general perception commodities, a tax on the entry of
that traders are number of states have commercial vehicle to
speculators who, by used entry permits their jurisdiction.
hoarding and without which goods These are impediments
artificially increasing are not allowed to to inter-state trade.
prices, make abnormal enter consuming state.
profits.
Nature of Government Interventions in Rice and Wheat Markets

Such restrictions along with harassment by officials,

corruption and bribery, slowed movement of grains
from surplus to deficit regions, increased price
variations across regions, added to cost of
marketing/trading thus rendering domestic prices
uncompetitive (NCAER, 2006)
Agricultural produce have been subjected to an ad-
hoc international trade policy, which increases
uncertainty and lower’s India’s dependability as an
exporter in the global platform. Restrictions were
imposed on the trade of food grains up to 1990’s.
Partial liberalization of food grain trade policies were
witnessed in the mid 1990’s.
Nature of Government Interventions in Rice and Wheat Markets

During the 1960’s India was facing

massive food shortages, necessitating
huge imports.

To steer the country out of the crisis

Commission of Agricultural Costs and
Prices were set up in 1985 and Food
Corporation of India were set up in
1965.

The government took upon itself the

task of procurement, storage and
distribution, by dominating the entire
market chain, with several self-serving
controls on the private sector over
both domestic and international trade.
Agricultural Produce Marketing Committee (APMC) Act

• Many state governments during the sixties and the

seventies introduced several mandatory regulations in
agricultural marketing.
• Under the APMC Act only state governments were
permitted to set up markets. Once a particular area is
declared as market area, it falls under the jurisdiction of
an APMC and this body governed the storage and
marketing of agricultural products in regulated markets.