Module 2

Managerial Economics
MBA ZC 416
Sidharth Mishra
Associate Professor, Management – Off-campus
Email: Sidharth.mishra@pilani.bits-pilani.ac.in
BITS Pilani
Pilani Campus
BITS Pilani
Pilani | Dubai | Goa | Hyderabad
Theory of the Firm
and Related Concepts – Part 1
Agenda
• Introduction
• Nature of the firm
• Forms of Business Organizations
• Motivations
• Major theories of the firm
• The Basic Profit-maximising model
• The Agency problem
• Measurement of Profit
• Enron case study
Managerial Economics (MBA ZC416) BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Agenda
• Elementary Laws of Economics

• Diminishing marginal utility, productivity
• Cost and Quantity Relationships
• Law of Demand and Supply
• Revenues and Costs
4 BITS Pilani, Deemed to be University under Section 3, UGC Act

Theory of the firm: Introduction
• Managerial Economics is primarily concerned with the application of
microeconomic principles for the effective management of business
firms
• In order to do this in an effective manner we need an overarching

“Theory of the Firm” that explains why firms exist, their structure, how
they behave, and what their goals are, etc.
• Firms are complex organizations that are difficult to model but as with
any modelling the key is to focus on the important factors and
eliminate the unimportant factors
• There are a number of theories (i.e. models) that attempt to model the
business enterprise and we shall review the key ones in this segment
The Nature of the firm
• Two fundamental questions:
– What are organizations?
– Why do they exist?
• Economic organizations
– Organizations occur at many different levels
• Business organizations
– Sole proprietorships
– Partnerships
– Joint stock company
Forms of Business Organizations
Sole Partnership Company

CompanyororJoint
Joint
Sole Partnership
Proprietorship Stock
StockCompany
Company
Proprietorship
Managerial Economics (MBA ZC416)

7
Why do such organizations exist?
• Firms exist as an alternative to the market price mechanism
• Possible motivations:
– Benefits of Cooperation
– Specialization
• Business organizations are independent legal identities
• They can enter into binding contracts
• Firm contract bilaterally with suppliers, distributors, workers,
managers, investors, and customers
• Alchian and Demsetz - firm is a nexus of contract, wherein
extra output is provided by team production
– The contracts bring in predictability.
– Team production brings in specialization and benefits of cooperation
through synergy and economy of scale.
The nature of the firms: areas of economic theories
• Transaction cost theory
– Cost associated with undertaking transactions in different ways
– One of the first theories developed in this area
– Ronald Coase proposed this in 1937
• Information theory
– Concept of bounded rationality, asymmetric information
• Motivation theory
– This examines the underlying factors that cause people to behave in certain
ways
• Agency theory
– Conflict between Principal and Agent
• Property rights theory
– This examines the nature of ownership, and its relationship with incentives to
invest and bargaining power
• Game theory
– The strategic interaction of different agents
Transaction
• An exchange of goods or services (Transaction)
• It can be performed in three different ways
– Trading in spot markets
– Long-term contracts
– Internalizing the transaction within the firm
• Transactions costs refer to the costs that are not directly
associated with the actual transaction but rather enable the
transaction to take place
– Acquiring information about a good or service (e.g., price,
availability, durability, servicing, safety) are transaction costs
• Minimize the external and internal transaction costs
Transaction cost theory
• According to this theory the major goal of the firm is to have lower
costs than the market
• Related to the problem of co-ordination and motivation
• Co-ordination costs (Coasian costs)
– Search costs - Both buyers and sellers have to search for the relevant
information before completing transactions
– Bargaining costs - costs required to come an acceptable agreement
– Contracting costs - costs associated with drawing up contracts (managerial
time and legal expenses)
• Motivation costs (Agency costs)
– Hidden information - in a transaction, one or several parties may have more
information than others (example second-hand car market)
– Hidden action - when contracts are completed the parties involved often have
to monitor the behaviour of other parties
The Agency Problem
• Agency theory examines situations where agents are
charged with carrying out the desires of principals
• Maximize their own individual utilities
• A conflict of interest between principal and agent
• There is a misalignment of incentives
• Agency theory is concerned with designing incentives
so as to correct in the most efficient manner
• Two aspects
– The nature of contracts
– The problem of bounded rationality
Contracts and bounded rationality
• Contracts - method of conducting transactions
• Complete contracts - eliminate the agency problem
• Impractical to draw up a complete contract. To make a complete

contract, we need the following
– Foreseeing all the possible eventualities
– The eventualities must be accurately and unambiguously specified
– No desire to renegotiate the terms of the contract
– Observe freely the behaviour of other parties to ensure that the terms of the
contract are being met
– The parties must be willing to enforce the contract if the terms are not met
Nature of contract in reality
• Pragmatically, contracts tend to be incomplete, because of

bounded rationality
• Bounded rationality: people cannot solve problems perfectly,

costlessly and instantaneously
• The disadvantages of incomplete contract

– Hidden information: one party to a transaction has more information
regarding the past that is relevant to the transaction than the other
party or parties
– Adverse selection: only the products or customers with the worst
quality characteristics are able to have or make transactions and
others are driven from the market
• Hidden action (the problem of moral hazard):the behaviour of a

party cannot be reliably or costlessly observed after entering a
contract
Law of diminishing marginal utility
• Utility is the total satisfaction derived from consuming a particular good or a

service.
• Marginal Utility is the added satisfaction that a consumer gets from having
one more unit of a good or service.
• Imagine a thirsty person drinking water. Marginal Utility is the utility derived from each additional glass of water.
• Law of diminishing marginal utility states that all else remaining equal, as
consumption increases the marginal utility (the added satisfaction
consequent to the incremental unit of consumption) declines.
• Exceptions: Hobbies (stamp collection, coin collection etc.), Addictions, Money

Law of diminishing marginal productivity
Productivity: It measures the output per unit input such as labor, capital or any
other resource.
Labor Productivity = Productivity Curve
30
25
Sales productivity = 20
15
10
Change in Ratio* (Marginal 5
labour Input Output output Productivity)
(manhours) (units) Change in input (hours) (units) (unit/hour) 0
0 10 20 30 40
0 0
10 10 10 10 1
Output (units) Change in input (hours)
20 17 10 7 0.7 Change in output (units) Ratio (unit/hour)
30 22 10 5 0.5
40 26 10 4 0.4
*Ratio = Marginal Productivity =Change in output / Change in input

Costs and Profits
Explicit Costs : These are out-of-pocket expenses like rent, wages, ram materials, electricity etc.
Implicit Costs : Opportunity costs (The highest value alternative forgone when a choice is made.)
Accounting Profit = Total Revenue – Explicit Costs
Economic Profit = Total Revenue – (Explicit Costs + Implicit Costs)
Example
Dr. Manisha is employed at Kailash Hospital as a consultant on a salary of Rs. 100,000 per
month. She is planning to leave her job and devote herself full time to her own private practice.
The place she has chosen for her clinic would cost her Rs. 20,000 per month as rent. Other
miscellaneous expenditure (electricity, telephone, stationery etc.) would total Rs. 15000 per
month. She would need an office attendant at a salary of Rs. 10000 per month. Her
consultation fee is Rs. 500 per patient and she expects to see 15 paying patients on a day.
Assume there are 25 working days in a month. Calculate the accounting and the economic
profits.

Solution
Accounting Profit = Total Revenue – Explicit Costs
Total Revenue (per month) = (Consultation fee/patient)*(Patients/day)(Working days/month) = 500*15*25 = 187500
Explicit Costs = Rent + Wage+ Miscellaneous Expenses = 20000+10000+15000 = Rs. 45000
Accounting Profit = 187500 – 45000 = Rs. 142500
Economic Profit = Total Revenue – (Explicit Costs + Implicit Costs)
Implicit Cost = Opportunity Costs = Rs. 100,000
Economic Profit = 187500 – (45000+100000) = Rs. 42500
18
Marginal Cost
Marginal cost is the change in total costs that arises when the quantity
produced changes by one unit.
MARGINAL COST
It is the cost of producing the next car in an automobile factory, the cost
of tutoring the next student at a coaching center or the cost of treating
the next patient at a hospital.
Marginal Cost (MC) = (Change in total cost)/(Change in output)

OUTPUT
Cost Schedule
=
Marginal Cost for nth item, MCn = TCn – TCn-1 Units produced Total Cost Marginal Cost
MC2 = TC2 – TC1 1 10 10

2 18 8
Restaurant – Idlis 3 25 7
Total Cost1 = Rs. 10 4 31 6
Total Cost2 = Rs. 18 5 38 7

19 Marginal Cost of the Idli2 =(TC2-TC1)/ 2-1 = ΔTC/ΔQ = (18-10)/(2-1) = 8 BITS Pilani, Deemed to be University under Section 3, UGC Act
Marginal Cost of production
• Marginal Cost is the change in total cost of production that comes from producing one
additional unit.
Examples
1) A match box maker incurs a fixed cost of U$ 10,000 per month in his factory. The cost of wood and chemicals per
match box is U$ 0.05. Find the marginal cost of production if he is producing 100,000 match boxes in a month.
Solution: Total Cost = 10000+ 0.05*100000 = U$ 15000 (TC1), Total Production = 100,000, Marginal Cost =15000/100000 = U$ 0.15
2) The matchbox maker plans to increase production by 50000 match boxes. For this he has to build a new factory
shed and buy new machines which would require an additional investment of U$ 6,000 per month. The cost of wood
and chemicals remain unchanged. What is the marginal cost of production for the second lot of match boxes
(50,000)?
Solution: New total cost = 10000 + 6000+ 0.05*150000 = U$ 23500 (TC2)
Change in Total Cost = 23500 – 15000 = 8500 = TC2-TC1, Change in output = 150000 – 100000=50,000
Marginal Cost of Production = 8500/50000 = U$ 0.17
The entrepreneur may worry about this increased marginal cost of production. Usually, new factories would employ the latest
technology and their marginal cost should be less.
• We shall shortly see that the Marginal Cost should be equal to marginal revenue for optimal production.

Total Costs
Total Costs include all economic costs of production.
They have fixed and variable components. We also have
opportunity costs.
• Fixed Costs are accounting costs which do not change with

the level of output.
Example: Lease Rentals, Furniture and fittings
• Variable costs change with the level of production.

Example: Cost of Raw material, packaging etc.
We have already examined opportunity costs.
• Total Cost = Total Fixed Cost (TFC)+ Total Variable Cost (TVC)
Petrol pump
Lease Rental : Rs 100,000 per month
Cost of Electricity = Rs. 10000 per month
Cost of manpower = Rs. 40000 per month
Cost of petrol = Rs. 100 per liter. Find the fixed, variable and total costs if the pump is selling 10000 litres of petrol per month.

Marginal Product, Marginal Cost Law of Variable proportions
Land (in Labour Output Marginal Land Unit cost of Incremental Marginal
acres) (units) (Quintals) Product Rent manpower Total Cost Cost Cost
1 0 0 0 10000 5000 10000 Not Defined
1 1 2 2 10000 5000 15000 5000 2500
1 2 6 4 10000 5000 20000 5000 1250 Marginal Cost Declines
1 3 12 6 10000 5000 25000 5000 833.3333333
1 4 16 4 10000 5000 30000 5000 1250
Marginal Cost Increases
1 5 18 2 10000 5000 35000 5000 2500
1 6 18 0 10000 5000 40000 5000 Not Defined
1 7 14 -4 10000 5000 45000 5000 Not Defined
1 8 8 -6 10000 5000 50000 5000 Not Defined
Marginal Product (Marginal Output)2 = (Total Output)2 – (Total Output)1

Marginal Product (Marginal Output)n = (Total Output)n – (Total Output)n-1
Some of the reasons for the initial decline in Marginal Cost
Source: toppr/com
1. Synergy 2. Experience Curve 3. Volume Discounts
Average Total Cost
Average Total Cost (ATC) is the Total Cost divided by the number of goods produced (or output quantity Q).
Average Total Cost = Total Cost / Q = [Total Fixed Cost (TFC)+ Total Variable Cost (TVC)] /Q
ATC = (TFC+ TVC)/Q = TFC/Q + TVC/Q
ATC influences price and hence is an important constituent of the supply curve.
Costs in a Rice Store
Rice Total Average
Fixed Cost Purchased Rice Sold Rice Cost Variable Total Total Selling Total
Month (Rent) (kg) (kg) (kg) Cost Cost Cost Price Profit/kg Profit Remarks
Cost
1 10000 1020 1000 30 30600 40600 40.6 45 4.4 4400 2% wastage
wastage down with
experience, volume
2 10000 1515 1500 28 42420 52420 34.9 45 10.1 15080 discount
wastage up with
volume, volume
3 10000 2020 2000 27 54540 64540 32.3 45 12.7 25460 discount continues
wastage up, scarcity

4 10000 3045 3000 28 85260 95260 31.8 45 13.2 39740 sets in volume premium



Agenda
• Cost Analysis
• ATC, MC, AVC (Average Variable Cost) etc. change.
• Demand Supply Curve
• Revenue Analysis
• Profit Maximization

Cost trends Variable, Marginal and Total Cost
• Marginal cost first reduces with increase in volume (volume discounts) and then increases (law of diminishing marginal returns).
• Marginal Cost curve touches the ATC and the AVC curves at their lowest points.
Units FC AVC TVC TC ATC MC

1 100 50 50 150 150
2 100 40 80 180 90 30
3 100 45 135 235 78.3 55
4 100 52 208 308 77 73
P 5 100 60 300 400 80 92
6 100 69 414 514 85.7 114
P’ * Marginal Cost at output 1 = 150 – 100 =50
Units = Output Units

ATC3 = (2*ATC2 + MC3)/3
If MC3 = ATC2, ATC3 = ATC2
25 If MC3 > ATC2, ATC3 > ATC2
General Proof MC,ATC,AVC
MC Curve crosses the ATC and AVC curves at their lowest

points.
ATCn+1 = TCn+1 / (n+1) = (TCn + MCn+1 )/(n+1)
= (n*ATCn + MCn+1 )/(n+1) = [((n+1)-1)ATCn + MCn+1]/(n+1)
= [(n+1)ATCn - ATCn +MCn+1 ]/(n+1)
= (n+1)ATCn/ (n+1) + (MCn+1 – ATCn)/n+1
= ATCn + (MCn+1 – ATCn )/n+1
If MCn+1 > ATCn the term on the right would be +ve.

ATCn+1 > ATCn
26
Variable, Marginal and Total Cost Example
The Average Total Cost of production of 10 items is Rs. 5. The marginal cost of production of the 11 th item is Rs. 6.
What is the average total cost of production of 11 items?
MC11 = TC11 – TC10 ATC11 = TC11 / 11
Solution
TC11 = TC10 + MC11 = TC10 + 6
ATC10 = Rs. 5
TC10 = 5*10 = 50
TC10 = ATC10 * 10 (ATC = TC/ Q; ATC10 = TC/10)
MC11 = 6
= 5*10 = 50
TC11 = TC10 + MC11 = 50+6 = 56
TC11 = 50+6 =56
ATC11 = TC11 / 11 = 56/11 = 5.09
ATC11 = 56/11 = 5.09
ATCn+1 = (TCn + MCn+1 )/(n+1)
27
Illustration Minimum ATC
Note that ATC goes on the increasing mode after MC exceeds it.
25
Average Total
Output Fixed Cost Marginal Cost Total Cost Cost
0 20000 0 20000 NA 20
1 20000 5000 25000 25000
2 20000 4500 29500 14750
3 20000 4300 33800 11267 15
This illustrates how the ATC curve
Average Total Cost

4 20000 4500 38300 9575
5 20000 4700 43000 8600 reaches its minimum precisely
6 20000 5000 48000 8000 10
7 20000 5200 53200 7600
where the MC curve interests it.
8 20000 5800 59000 7375
9 20000 6500 65500 7278 5
10 20000 7200 72700 7270
11 20000 8000 80700 7336
12 20000 9000 89700 7475 0
13 20000 10000 99700 7669 Quantity of production
28
The Costs MC, AVC, AFC, ATC
Example
The monthly cost structure of a firm is given. Monthly costs of a firm
VC
(variable TC (total Output MC=
FC Labour cost) cost) ΔTC (kgs) ΔQ ΔTC/ΔQ AVC AFC ATC
5000 1 2000 7000 2000 10 10 200 200 500 700
5000 2 6000 11000 4000 25 15 267 240 200 440
5000 3 9000 14000 3000 45 20 150 200 111 311
5000 4 12000 17000 3000 58 13 231 207 86 293
5000 5 15000 20000 3000 65 7 429 231 77 308
5000 6 18000 23000 3000 70 5 600 257 71 329
ATC = total cost/output, AFC = total fixed cost/output, AVC = total variable cost/output
*Also referred to as the Marginal Productivity of Labor (MPL). We shall cover this in greater details Ref: Khan Academy
while studying production.
29
Law of Demand and Supply
Law of Demand: If all other factors remain equal, the higher the price of a product, the less people would demand it.
Exceptions : Veblen Goods (exclusive, high quality, prestige value items), Giffen Goods (Low price goods with few substitutes)
Law of Supply: If all other factors remain equal, higher the price, the higher the quantity supplied.
The Supply and Demand Curves shown in this

diagram are straight lines which can be
represented by simple equations like
P = 60 – 0.01*Q where P = Price, Q = Demand
The equation gives the mathematical relation

between the two elements (variables) price and
demand so that if you know one you can work out
E the other.
For example, if asked to find the price corresponding
to a demand of 4000 units, you can simply plug in
the numbers to the equation and get P = 60 – 0.01*4000
= 20.
The general equation is P = a-b*Q where a and b are
30
constants.
Please note that a real life demand curve would be influence
Effect of shifts in demand and supply
Shifts in demand:
Demands shifts refer to changes in demand caused by factors other than the price of the good. (The change
caused by the price of the good is referred to as movement along the demand curve). Any of the following factors
or there are combination can cause a demand shift.
1. Change in customer income 2. Change in prices of related goods (substitutes or complements)
3. Change in customer tastes or preferences.
Shifts in supply
Improvement in production techniques, Fall in prices of factors of production, reduction of taxes, Acts of God.
In the following slides we shall study two cases of such shifts and their impact on equilibrium price and quantity
demanded.
14/02/2016 MBA ZC416

Case –I Supply decrease, demand
increase.
Sf
Si S and D represent the original supply and demand curves. A

Ef
Pf decrease in supply pushes the supply curve to the
left while an increase in demand shifts the demand curve
Price
Ei to the right (from D to D1) causing a change in the position

Pi E
Df Of the equilibrium point from E to E1. Consequently, equilibrium
Di price rises from OP to OP1 while demand increases marginally
From OQ to OQ1.
Q Q1
O Quantity
14/02/2016 MBA ZC416

Case II Supply increase, demand increase
S S1
P E
A big increase in supply is accompanied by a relatively lower
P1 E1 Increase in demand as shown in the accompanying diagram.
D1 The supply curve (S) moves by a long distance to the left (to S1) as
shown in the figure while the demand curve moves by a smaller distance
D The equilibrium point shifts from E to E1 leading to a fall in
equilibrium price from OP to OP1. The demand increases from OQ to OQ1.
O Q Q1 X
14/02/2016 MBA ZC416

Law of Demand and Supply
• Demand Curve is sloped downwards as we move from left to right (negatively sloped) while supply curve is sloped upwards.
Supply Curve is sloped upwards as we move from left to right.
• Demand Curve meets the price axis at P1 and the quantity axis at P2. P1 represents the maximum price (choke price) beyond
which there would be no demand for the product. P2 represents the maximum demand possible at zero price. P1 is determined
by the limits on income and wealth of consumer while P2 is caused by the limits of time and the law of diminishing marginal utili
P1
B
Q
Product: Face Mask
C
S2 D2
A
34 P2
Demand Curve
P = 60 – 0.01Q, P in U$, Q in P = 60 – 0.01Q Toothbrushes
units
P1 (60) P = Rs. 40 , Demand/ month = ?
Q=0, P = 60 (choke price) P = 60 – 0.01Q
P=0, Q = 6000 units P = 40
(saturation demand) 40 = 60 – 0.01Q
0.01Q = 60 – 40 = 20
Demand Equation Q = 20/0.01 = 2000 units
P = a-bQ
Q=0, P = a
P=0, Q=a/b (saturation Demand Line
demand)
Marginal Revenue
MR = a-2bQ
Q=0, MR=a ( = choke price)
MR=0, Q= a/2b (half of Q1 = 6000
saturation demand)
35
Revenues
• Total Revenue (TR) = Output (Q)* Price (P)

• Average Revenue (AR) = TR/Q = (PQ)/Q = P(see example to understand Price)
• Marginal Revenue is the increase in revenue that results from the sale of one additional unit
of output. This is dealt in more detail in the following slide.
• MRn = TRn – TRn-1 MCn = TCn – TCn-1
• Example
Output(units Price Revenue Curves

) (per unit) TR MR AR 15 12 12
10 10
1 6 6 6 6 10
6 5
Price
4 4 3
2 5 10 4 5 5 2 2
0
0 -2
3 4 12 2 4 1 2 3 4 5
-5
4 3 12 0 3
Quantity of output
5 2 10 -2 2
Price TR MR

Marginal Revenue
• Marginal Revenue is the increase in revenue that results from the sale of one additional
unit of output.
• Marginal Revenue (MR) = =

• Examples
• A firm sells 100 items at a price of U$ 10 each to a buyer. What is the marginal revenue of the 80 th product? On one instance,
the firm made a mistake and shipped 101 units to the buyer. The buyer refused to accept the 101 st product at the same price
citing storage problems at his end and offered U$ 9.99 for the whole consignment instead. The slight change in price, the
buyer argues would help rent him a temporary shed to store the products? For the 101st piece?
a. The marginal revenue of the 80 the product is the additional revenue resulting from the sell of the 80th product in the
original batch which is equal to U$ 10.
• MRn = TRn – TRn-1 MR80 = TR80 – TR79 = 10*80 – 10*79 = 800-790 = 10
b. A firm generally produced in batches of 100 items which they sold to the customer for U$ 10 per piece for the whole produce.
On one occasion they produced a batch of 101 items. However the customer said the would accept the whole batch at U$ 9.99
per piece only. What is the marginal revenue at the production of the 101 st piece?
Additional Revenue generated by the 101 st piece = 9.99*(101) – 10*100 = U$ 8.99
• MR101 = TR101 – TR100 = 9.99*101 – 10*100 = U$ 8.99

The Basic Profit - Maximizing Model
• The most common objective of the firm
– Basic profit-maximizing model: MC=MR Profit = π
– We start by defining, Profit (π) = R – C MR = CA
– Pi is at a maximum when its first derivative with respect to Q is equal to zero MC = CB
– d(π)/dQ => dR/dQ – dC/dQ = 0 Marginal Profit = CA- CB = AB
– => dR/dQ = dC/dQ
– => MR = MC
– Intutively, if MC is higher than MR it means the cost of producing the additional unit
Marginal Cost
A
exceeds the revenue that unit is going to fetch. This is a loss making proposition and the
firm would not produce that extra unit. P F
Cost/Revenue
– If MC is lower than MR, every additional product would fetch a profit and the company
would go on producing. The company would stop producing when MR = MC. Marginal Revenue
E
• Assumptions of basic profit-maximising model B
– The firm has a single decision-maker.
– The firm produces a single product.
– The firm produces for a single market. C D
– The firm produces and sells in a single location O Quantity of output
– All current and future costs and revenues are known with certainty.
– Price is the most important variable in the marketing mix
– The firm operates in a perfect competition market
38
Demand and Marginal Revenue Curves
P = 60 – 0.01Q, P in U$, Q in P1 (60)

units MR = a-2bQ
Q=0, P = 60 (choke price) Q=0, MR=a ( = choke price)
P=0, Q = 6000 units MR=0, Q= a/2b (half of saturation demand)
(saturation demand)
MR = 60-0.02Q
Demand Equation Q=0, MR=60
P = a-bQ Demand Line MR=0, Q=60/0.02 = 3000
Q=0, P = a
P=0, Q=a/b (saturation
demand) Marginal Revenue
Q1 = 6000
39
How to find MR equation if demand equation is given.
Demand Equation is P = 60 – 0.01Q a=60, b=0.01 P= a-bQ a=60, b=0.01 MR Equation : P = a-2bQ
MR Equation is P = 60 – 2*0.01Q = 60 – 0.02Q
60 Pchoke = a , Qsaturation = a/b

P = a – bQ ------- Demand Equation
50 MR = a – 2bQ
P = a-bQ
MR = a – 2bQ 40 P = 60-0.01Q
MR= 60 – 2*0.01Q = 60 – 0.02Q
Q =0, MR = a 30 Demand Line
MR=0, Q = a/2b Q = 40 – 20P - Demand Equation
MR = 0
Price
20 MR Line Q = 40- 2*20P = 40 -40P (This is wrong.)

a-2bQ = 0 20P = 40-Q
Q = a/2b P = (40-Q)/20 = 2 – 0.05Q ---
10
MR = 2-2*0.05Q = 2-0.1Q
OP2 = OP1/2 P2 P1
40 O 1000 2000 3000 4000 5000 6000
Quantity
Revenue and Demand curve
• Demand Line : P = a – bQ (At Q=0 choke price = a, At P=0, Q= a/b)

• Total Revenue TR = PQ = (a – bQ)*Q = aQ-bQ2
• Marginal Revenue = d(TR)/dQ = d(aQ-bQ2)/dQ = a-2bQ (At Q =0, MR = choke
price = a, At P=0, MR = a/2b) (We shall derive it without using calculus in example)
This proves that the MR curve cuts the demand axis at the half way point of the
demand line.
• For maximum total revenue, d(TR)/dQ= marginal revenue = 0 which occurs at Q =

a/2b
• The maximum total revenue = a2/4b (obtained by substituting Q = a/2b in the
TR expression.
For revenue maximization, MR=0. Profit maximization, MR = MC

Cost and revenue curves
Average Total Cost = Total Cost / Quantity of Production. (Q)
Y’
P’
Z’ Y
W Z
O Q’ O P2
Note: At the profit maximization point MC = MR
which means d(TC)/dQ = d(TR)/dQ
OA = OB/2 Slopes of the tangent to the total cost curve and the
Total revenue curve would be equal. This means they
42
would be parallel to each other.
Cost and revenue curves
Points to be noted
1. OP1 = ½ OP2. The MR line intersects
the x-axis at a point half way
down the distance where the demand
Line cuts it.
K
2. TR is an inverted parabola with its L
maximum value at the level of output
Y
Maximum Total Revenue
where MR = 0. TR = 0 when demand is 0.
Price/cost
Points to be noted
3. Marginal cost curve cuts the ATC line at
O P1 P2 the latter’s lowest point.
output 4. Profit it maximum at the output level
(Q1) where the MC curve cuts the MR line.
5. As a profit maximizing monopoly firm seeks to
Equal MC with MR (price), the MC and
the supply curve would be identical.
43
Example-1 Profit Maximization
Question: On a particular day, a carpenter sits down to make chairs. The marginal cost and market prices at different level
of production is given in the following table. Find out his profits (marginal as well as cumulative) with each level of productio
How many chairs should he produce to maximize his profit? Does it prove the MR=MC conclusion?
Illustration – Sequential Production* Illustration – Batch Production*

Output Marginal Marginal Marginal
(no of Cost Cumulative Revenue(MR) Cumulative Profit = MR- Cumulative Marginal
Marginal Cost Cumulative Total Marginal Profit = Total
chairs) (MC) Cost Mkt Price =Mkt Price Revenue MC Profit Output (MC) Cost Mkt Price Revenue Revenue MR-MC Profit
1 1000 1000 1500 1500 1500 500 500 1 1000 1000 1500 1500 1500 500 500
2 900 1900 1400 1400 2900 500 1000 2 900 1900 1400 2800 1300 400 900
3 875 2775 1275 1275 4175 400 1400 3 875 2775 1275 3825 1025 150 1050
4 925 3700 1125 1125 5300 200 1600 4 925 3700 1187.5 4750 925 0 1050
5 985 4685 985 985 6285 0 1600 5 985 4685 985 4925 175 -810 240
6 1100 5785 800 800 7085 -300 1300 6 1100 5785 800 4800 -125 -1225
* The carpenter produces one chair after the other • The carpenter plans for the total output and produces in
one go.
44
Example -2 Profit Maximization
Total
Variable Variable Average Total Cumulative
Fixed Cost Patients Cost Cost Total Cost Total Cost Price Revenue Profit Profit
50000 100 100 10000 60000 600 1000 100000 40000 40000
0 100 90 9000 15000 150 900 90000 75000 115000
0 100 200 20000 20000 200 800 80000 60000 175000
0 100 300 30000 30000 300 700 70000 40000 215000
0 100 400 40000 40000 400 600 60000 20000 235000
0 100 500 50000 50000 500 500 50000 0 235000
0 100 600 60000 60000 600 400 40000 -20000 215000
45
Consumer and Producer Surplus
D1 Consumer Surplus
D’ = Area of triangle D1FE MC = d(TC)/dQ
S2 TC = ʃ MC*dQ = Integrand+ K
D3
The integrand represents the Total
Price
F F1 Variable Cost, K is the fixed cost.
F2 E
Producer Surplus=
S
Area of triangle S1EF 1 D2
O G
Total Cost of Quantity
production = OGES1
D1 D2 is the demand line. S1 S2 is the supply line which also represents the marginal cost of production.
Area under the supply curve is the Total (variable) cost of production.
46
Inefficient Market Deadweight Loss
(Price)
47
Profit Maximization Farmer’s Agitation
Minimum Support Price (MSP)

is the price at which the
P MC = d(TC)/dQ
Central Government sources
TC = integration of MC*dQ
select food grains (paddy, wheat)
Demand Line
from farmers which are stored
In Food Corporation of India A B H
Warehouses. Price
I
MR MC
E C
O D G Output F
48
Example
Question: The demand curve for a product is given by the equation Q = 100 – P. Draw the demand, marginal revenue and
the total revenue curves. Determine the marginal revenue at a production levels of 40 and 60 units. Find the production level at
which total revenue is maximum?
Solution1: Q = 100-P, P=100-Q, TR= Q*(100-Q)= 100Q-Q 2 For max revenue, d(TR)/dQ = 0, d/dQ(100Q-Q2) = 100-2Q =0
Q = 50, TR =100*50-502 = 2500
Solution2: (You can straight use the formula that if demand equation is P=a-bQ, MR = a-2bQ.
Q = 100-P (given)
P= 100-Q, Marginal Revenue = ΔTR/ΔQ
Total Revenue at production Q (TR) = P*Q = (100-Q)*Q = 100Q-Q2 – (1) Maximum Total Revenue
Total Revenue at production(Q+ΔQ) (TR+ΔTR)= 100(Q+ΔQ) – (Q+ΔQ)2 Total Revenue = 100Q-Q 2
= 100Q+100ΔQ – (Q2+ 2QΔQ+ ΔQ2) = 2*50Q-Q2
= 100Q-Q + (100 – 2Q)ΔQ – (2)
2
= 2500 – 2500+2*50Q – Q2
(ΔQ is ignored)
2
= 2500 – (502- 2*50Q+Q2)
Change in Total Revenue (ΔTR) = (2) – (1) ΔQ =0.1, ΔQ = 0.1 = 0.001
2 2
= 2500 – (50-Q)2
= (100 – 2Q)ΔQ
Marginal Revenue Δ(TR)/ΔQ = 100 – 2Q
Marginal Revenue at 40 production = 100-2*40 = 20 This is a non-negative number
Marginal
49 Revenue at 60 production = 100-2*60 = -20 as a square and has its minimum value at
Q = 50
Example Costs
1.Total Fixed Cost is U$ 100. Complete the following table.
Marginal Cost Average Total

Output (Units) (MC) Total Cost (TC) Cost (ATC)
1 20
2 30
3 15
Hints
1. TC1 = Total Cost for producing the first unit = Total Fixed Cost + Marginal Cost1
2. TCn = Tcn-1 + MCn
50
Question-2
The following table shows the total cost of production of a firm at different levels of output. Fill up the blank table based
on information given below.
Output (Units) 0 1 2 3
Total Cost (U$) 60 100 130 150
Output TC TFC TVC AVC MC

Average
Variable 0 60 60 0 NA NA
Total Cost Total Fixed Total Variable Cost Marginal
Output (Units) (U$) Cost(TFC) Cost (TVC) (AVC) Cost (MC) 1 100 60 40 40 40
0
1 2 130 60 70 35 30
2
3 150 60 90 30 20
3
Hint1 : TFC0 = TFC1 = TFC2 =….TFCn
Hint2: TCn = TFCn+ TVCn
Hint3: MCn = TCn – TCn-1

51
52
THANK YOU
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

MBA ZC 416
Sidharth Mishra, B.E, PGDM

Associate Professor, Management - Finance
Email: sidharth.mishra@pilani.bits-pilani.ac.in
BITS Pilani
Pilani Campus
BITS Pilani
Pilani | Dubai | Goa | Hyderabad
Theory of the Firm
and Related Concepts – Part 2
Measurement of profit
• Two problems associated with the measurement of profit

– Ambiguity in measurement
– Restriction to a single time period
• Bankruptcy of Enron in 2001 highlights these issues
• Restating their earnings
• Accounting profit is an ambiguous term
– gross profit
– net profit
– operating profit
– earnings before interest
– depreciation and tax
• The above definitions involve estimates rather than precise
measures for a number of reasons relating to GAAP
56
Manipulation
• Scope for managers to manipulate the firm’s accounts

– boost the share price
– personal earnings of the managers (CEO and CFO)
• It is difficult for shareholders to comprehend easily
• an agency problem combined with moral hazard
• Auditing: protect shareholders and potential investors
• Restriction to a single time period
– It is more appropriate to consider the long-term profits of a
firm
– The stream of profits over some period of time
– Value of the expected future cash flows
– Discounting
57
Enron: The Fall Of A Wall Street Darling

58
Elasticity measures
• Price Elasticity
– Already defined in the previous slide. [ΔQ/Q]/[ΔP/P] = (P/Q)ΔQ/ΔI . [dQ/Q]/[dI/I] = (I/Q)dQ/dI
– If the demand curve is exponential and given by Q=aP-b , price elasticity would be constant and
shall be equal to –b.
– It has been empirically observed that price elasticity is different for price increases and price
decreases.
• Income Elasticity
– Defined as [ΔQ/Q]/[ΔI/I] = (I/Q)ΔQ/ΔI = (I/Q)dQ/dI
– As consumer income increases demand shifts for better quality or “superior” products.
– Superior products show income elasticity greater than one while those with elasticity less than zero
are referred to as inferior products.
– Normal products have income elasticity between 0 and 1.
• Cross price Elasticity
– Defined as (dQx / dPy)(Py/Qx) where x and y refer to different goods [dQx / Qx ]/[dPy / Py ]
– If positive, price increase of good y leads to an increase in demand of good x. hence x and y are
substitute goods (rice and wheat). If negative they are complementary goods (cars and petrol)
The rise of Enron: a brief
history
It was founded by Kenneth Lay, former CEO of Houston Natural Gas
Transporting and selling gas
In 1990, Lay hired Jeffrey Skilling, a consultant with McKinsey & Co., to
lead a new division -- Enron Finance Corp.
Skilling was made president and chief operating officer of Enron in 1997
From the pipeline sector, Enron began moving into new fields
In 1999, the company launched its broadband services unit and Enron
Online, the company's website for trading commodities, which soon
became the largest business site in the world.

60
Growth of Enron
Growth for Enron was rapid.
In 2000, the company's annual revenue reached$100

billion US.
It ranked as the seventh-largest company on the

Fortune 500
And the sixth-largest energy company in the world.
The company's stock price peaked at $90 US.

61
Enron: Revenue
62
Fall of Enron
Cracks began to appear in 2001
In August of that year, Jeffrey Skilling announced his departure
Lay resumed the post of CEO
Chief financial officer Andrew Fastow was replaced. Many new entities were
created, and debts were kept separate from Enron's books
In October 2001, Enron reported a loss of $618 million— its first quarterly
loss in four years

63
Enron’s stock price

64
Enron: Stock price falls

65
Bankruptcy of Enron
Tried to negotiate with its rival Dynegy
The negotiations failed
The company was left with no choice
On Dec. 2, 2001, it filed for bankruptcy protection
More than 4,000 people were laid off at Enron's Houston headquarters
Arthur Andersen, who had a large portion of their revenue coming from
Enron’s audit and consulting fee, was tempted to ignore the issues

66
Multiproduct strategies
• In practice, firms produce multiple products
• This complicates the analysis because:

– Demand and Cost interactions
• How to firms maximize profits given these interactions?

– Product line profit maximization
– Product mix profit maximization
• PC World case study highlights the underlying challenges

and issues in a multiproduct strategy
67
THANK YOU

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Managerial Economics

• Elementary Laws of Economics

4 BITS Pilani, Deemed to be University under Section 3, UGC Act

• In order to do this in an effective manner we need an overarching

Sole Partnership Company

Managerial Economics (MBA ZC416)

• Complete contracts - eliminate the agency problem

• Impractical to draw up a complete contract. To make a complete

• Pragmatically, contracts tend to be incomplete, because of

• Bounded rationality: people cannot solve problems perfectly,

• The disadvantages of incomplete contract

• Hidden action (the problem of moral hazard):the behaviour of a

• Utility is the total satisfaction derived from consuming a particular good or a

15 BITS Pilani, Deemed to be University under Section 3, UGC Act

*Ratio = Marginal Productivity =Change in output / Change in input

16 BITS Pilani, Deemed to be University under Section 3, UGC Act

17 BITS Pilani, Deemed to be University under Section 3, UGC Act

Total Revenue (per month) = (Consultation fee/patient)*(Patients/day)(Working days/month) = 500*15*25 = 187500

Explicit Costs = Rent + Wage+ Miscellaneous Expenses = 20000+10000+15000 = Rs. 45000

Accounting Profit = 187500 – 45000 = Rs. 142500

Economic Profit = Total Revenue – (Explicit Costs + Implicit Costs)

Implicit Cost = Opportunity Costs = Rs. 100,000

Economic Profit = 187500 – (45000+100000) = Rs. 42500

Marginal Cost (MC) = (Change in total cost)/(Change in output)

MC2 = TC2 – TC1 1 10 10

Total Cost1 = Rs. 10 4 31 6

Total Cost2 = Rs. 18 5 38 7

20 BITS Pilani, Deemed to be University under Section 3, UGC Act

• Fixed Costs are accounting costs which do not change with

• Variable costs change with the level of production.

We have already examined opportunity costs.

21 BITS Pilani, Deemed to be University under Section 3, UGC Act

Marginal Product (Marginal Output)2 = (Total Output)2 – (Total Output)1

wastage up, scarcity

wastage up, scarcity

wastage up, scarcity

23 BITS Pilani, Deemed to be University under Section 3, UGC Act

24 BITS Pilani, Deemed to be University under Section 3, UGC Act

Units FC AVC TVC TC ATC MC

Units = Output Units

MC Curve crosses the ATC and AVC curves at their lowest

If MCn+1 > ATCn the term on the right would be +ve.

ATCn+1 = (TCn + MCn+1 )/(n+1)

Average Total Cost

The Supply and Demand Curves shown in this

The equation gives the mathematical relation

14/02/2016 MBA ZC416

Si S and D represent the original supply and demand curves. A

Ei to the right (from D to D1) causing a change in the position

14/02/2016 MBA ZC416

14/02/2016 MBA ZC416

• Total Revenue (TR) = Output (Q)* Price (P)

Output(units Price Revenue Curves

36 BITS Pilani, Deemed to be University under Section 3, UGC Act

• Marginal Revenue (MR) = =

37 BITS Pilani, Deemed to be University under Section 3, UGC Act

P = 60 – 0.01Q, P in U$, Q in P1 (60)

60 Pchoke = a , Qsaturation = a/b

20 MR Line Q = 40- 2*20P = 40 -40P (This is wrong.)

• Demand Line : P = a – bQ (At Q=0 choke price = a, At P=0, Q= a/b)

• For maximum total revenue, d(TR)/dQ= marginal revenue = 0 which occurs at Q =

41 BITS Pilani, Deemed to be University under Section 3, UGC Act

Illustration – Sequential Production* Illustration – Batch Production*

Total Revenue (per month) = (Consultation fee/patient)(Patients/day)(Working days/month) = 50015*25 = 187500