Managerial Economics

A Definition:
The application of mathematical, statistical and decision-science tools to economic models to solve managerial problems Some managerial problems: What product to produce What price to charge Where/how to get financing Where to locate How to advertise What method of production to use Whether or not to invest in new equipment

Managers¶ Objectives
‡ Maximizing the value of the firm (Through profit maximization) ‡ Alternative objectives: =>Market share maximization =>Growth Maximization =>Maximizing their own benefits =>Stisfice vs. optimize

Decision Making Process ‡ Identifying the problem or the decision to be made Abstraction: Identifying the relevant factors in the problem and formulating the problem into a manageable set of questions/problems (while abstracting from irrelevant factors) ‡ Identifying alternative solutions to each problem ‡ Using relevant data to evaluate alternative solutions ‡ Choosing the best solution consistent with the firm¶s objective .

Market Conditions Economic Conditions Factor Prices Managerial Problems Managerial Decision Company¶s Performance Market Conditions .

expects shortfall in third quarter.S.8 percent. ‡ U. ‡ The International Monetary Fund will cut its global economic growth forecast for this year to 2. consumers lost confidence in August. may be preparing to acquire the Nantucket Nectars line of juice and tea products..Consider the following news headlines: ‡ Gateway cuts jobs: PC maker to trim 15 percent of staff. . in the fast-growing alternative drinks market. facing a stiff challenge from its arch rival PepsiCo Inc. analysts said Tuesday. ‡ Coca-Cola Co.

The ups and downs: MSFT IBM Mot AT&T GM KFT MCD WMT High 31 101 26 37 36 36 45 52 Low 21 72 17 24 19 28 31 42 Last 30 99 19 36 32 34 43 47 PE 24 16 13.4 18.3 19 NA 17.14 .9 15.

Microeconomics and and Managerial Decision Making .Macroeconomics.

Profitt TRt . Q TC = g(Q ) Value = .= --------------(1 + i )t (1 + i )t ‡ Functional Relationship TR = f (Q ) = P.Optimization and Value Maximization ‡ The value of a firm is the sum of the discounted future profits of the firm.TCt -------.

Linear Relations Y = f (X) = a + b X Y f(X) a Slope = dX/dY = b = Constant 0 Y a b<0 b>0 X f(X) X .

Nonlinear Relations ‡ Y = f (x) ‡ Standard nonlinear forms: Quadratic. Cubic Y Y 0 X 0 X .

Profit Function $ TC TR ‡ Linear TR ‡ Quadratic TC Q $ ‡ Quadratic Profit Q Profit .

Profit Function ‡ Linear or Quadratic TR ‡ Cubic TC $ $ TC TR Q ‡ Cubic Profit Q Profit .

P S P D 0 Q Q .

ceteris paribus ‡ Quantity demanded: The quantity of a good a buyer (or buyers) would be willing and able to buy at a specific price.Demand : A definition ‡ Demand: A quantity of a good or service a buyer (or buyers) would buy under a certain set of conditions ‡ Demand curve is a curve showing the quantities of a good or service a buyer (or buyers) would buy at various prices. ceteris paribus .

ceteris paribus .Supply: A definition ‡ Supply: A quantity of a good or service a producer (or producers) would be willing to produce and offer to the market for sale under a given set of conditions ‡ Supply curve: A curve showing the quantities of a good or service a producer (or producers) would produce and offer to the market for sale at various prices ‡ Quantity supplied: The quantity of a good or service a producer (or producers) would produce and offer for sale to the market at a specific price.

realizing that the value of a firm is function of its (expected) future profits. Profit = TR .Q ==> What are the factors that determine p and Q? ==> What are the elements determining a firm¶s costs? .Why do we study supply and demand? We assume. generally. firms are value maximizers.TC TR = P.

Supply and Demand Schedule Price Supply Demand
$ 0.00 1.00 1.25 1.50 1.75 2.00 2.25 2.50 ---210 290 370 450 530 610 690 670 470 420 370 320 270 220 170

Supply and Demand Equations
‡ Demand: Qd = 670 -200 P P = 3.35 -.005 Qd ‡ Supply: Qs = - 110 + 320 P P = .34375 + .003125 Qs

Supply and demand plotted:
P 3.35 S

1.50

D -110 0 370 670

Q

2 Age .5 Wage + 30 Price Income = 2000 Age = 30 Wage = $8 . Income. X1. Wn ) Qs = -40 . ««Xn) Qd = 20 + .1 Income . ««.50 Price Qs = g( Price. W1.An algebraic approach to supply and demand: Qd = f ( Price. X2. W2.

5 Wage + 30 Price ( $8) Qs = .2 .666 + .2 Age .80 + 30 P P = 2.50P P = 3.50 Price ($2000) (30) Qd = 160 .02 Qd Qs = -40 ..Supply and demand curves Qd = 20 + .1 Income .0333 Q .

Shifts in supply and demand curve: ‡ A change in any non-price factor in the demand function would result in a shift in the curve: changes in the intercepts. . ‡ A change in any non-price factor in the supply function would result in a shift in the curve: changes in the intercepts.

..02Q). TR = 3.Q Or.02 Q.2 Q . we can write: TR = (3.Q If P = f (Q) = 3.Demand and Revenue ‡ Recall that: TR = Price x Quantity = P .02 Q2 (a quadratic function) .2 -.2 .

MR 3.2 MR 0 TR D 160 Q Q 0 .P.

Q 0 Q .The case of a horizontal demand curve: P Price D 0 TR TR Q TR = P.

02 Q2 TR AR = -----..2 . Q = 3.2 .Marginal versus Average Recall: TR = P.= 3..04 Q (Q dQ .02 Q = P Q ( TR d TR MR = ------.= ------.= 3.2 Q ..

.2 P = 3.02 Q MR = 3.2 . MR 3.04 Q MR 0 TR D 160 Q MR = Slope of TR TR = 3.P.02 Q 2 TR 0 Q 80 .2 ...2 Q .

P. TR = P.Q 0 ==> P = MR .The case of a horizontal demand curve: P Price D In this case the price. is a constant.= P dQ dQ Q 0 TR TR Q TR = P.= --------.Q) MR = -----. Q dTR d(P.

Why is the demand curve generally downward-sloping? The Consumer theory : ‡The indifference curve ‡The Budget line .

The Consumer Theory ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ The concept of ³utility´ Cardinal measurement of utility Ordinal measurement of utility Marginal utility The principle of diminishing marginal utility Marginal utility and consumer choice Consumers¶ optimizing behavior The Consumer¶s optimizing rule >> the cardinal approach >> the ordinal approach .

over a certain span of time.Utility The satisfaction or pleasure a consumer derives from the consumption or possession of a good (or service) or an activity (or lack thereof). . or an activity that brings on harm or displeasure to a consumer. A consumer derives utility from having an economic ³bad´ reduced or eliminated. a condition. Note: An economic ³bad´ is an object.

Diminishing Marginal Utility U U = f (X) X .

Marginal Utility MU Change in U U MU x = -------------------.= ----------Change in X X 0 X .

to maximize her total utility a consumer allocates her income among different goods in such a way that the utility derived from the last dollar spent on each good would be equal to that each of the other goods. .Consumer Choice Constrained by her income.

beyond a certain level.The principle of diminishing marginal utility: ‡ As a consumer consumes more and more of a good. beyond a certain level. each additional unit of that good becomes less dear to him/her . the utility of each additional unit of it (marginal utility) begins to decrease. ‡ As a consumer consumes more and more of a good.

reflecting the principle of diminishing marginal utility. ‡ The slope of an indifference curve measures the marginal rate of substitution. MRS. ‡ An indifference curve is convex to the origin. .An Indifference Curve: Definition ‡ An indifference curve is a curve showing all the quantity mixes of two goods from which the consumer derives the same level of utility.

Conc Msc.Utility and Indifference Curves A INDIFFERENCE SCHEDULE Lv.CDs 10 2 9 3 8 5 7 8 6 12 5 18 4 26 3 36 2 50 1 70 Music CDs 80 70 60 50 40 30 20 10 0 0 5 10 U4 U3 U1 U2 Liv e 15 Concerts .

reflecting diminishing marginal utility ‡ Two indifference curves cannot cross ‡ Special case: a positively sloped indifference curve . reflecting marginal rate of substitution ‡ Convex to the origin.Properties of an indifference curve ‡ Generally. negatively sloped.

That is the amount of good X needed to replace one unit of (lost) good Y to keep the consumer¶s level of satisfaction (utility) unchanged.Marginal Rate of Substitution ‡ Definition: The rate at which a consumer is willing to substitute one good for another good while remaining at the same level of satisfaction. ‡ MRS = Slope of the indifference curve .

=MRS X MU y . X and Y U = f ( X.---------. Y) As X increases => U will increase As Y increases => U will increase Recall: U U MU x = ---------MU y = -----------X Y Along any given indifference curve U= MU x X + MU y Y = 0 Y MU x Slope of an indifference curve= ---------.Again suppose a consumer consumes two goods.= .

Y U MRS MRS 0 X .

Income = 1200 CD intercept = 80 LC intercept = 10 . Qc + PL . QL Pc = 15 .Budget Line A line showing all combinations of the quantities of two goods a consumer can buy with a given amount of income (budget). PL = 120 . Income = Pc . Assuming a consumer is spending all her income on two (symbolic) consumer goods: CDs and live concerts.

= 8 15 LC 0 5 10 .CDs 80 PL Slope of budget line = .--------Pc 120 = -------.

= .-------.33 15 Pc = 80 Pc=240 Pc = 120 0 LC 5 10 .= -16 15 80 = .8 15 240 = .= .-------.--------Pc 120 = .-------.CDs 80 PL Slope of budget line = .5.

CDs 96 80 Income and the Budget Line Pc = 15 PL = 120 40 I= 600 I = 1200 I=1440 LC 0 5 10 12 .

--------Pc 120 = -------. E d f 0 g LC 5 10 .= 8 15 At E the slope of the indifference curve U4 is equal to the slope of the budget line.CDs 80 U1 a b c U2 U4 U5 U3 PL Slope of budget line = .

= .= MRS Pc MUc .--------Pc PL MUL At point E: .------.Utility Maximization Recall that: MUL Slope of the indifference curve = .--------.-------.= MRS MUc PL Slope of the budget line = .

Y Demand Curve Derivation PX1 > PX2 > PX3 1 2 X2 X3 3 X o X1 .

P P1 P2 P3 D Qx X1 X2 X3 .

.Elasticity A general definition: Elasticity is a standardized measure of the sensitivity of one (dependent) variable to changes in another variable. Price elasticity of demand: A measure of the sensitivity of the quantity demanded a good to changes in the price of that good.

Measuring Elasticity ‡ Elasticity is measured by the ratio between the percentage change in on variable and the percentage change in another variable: Percentage change in Y Elasticity = -----------------------------Percentage change in X Y/ Y = --------------------------X/ X .

population. weather.Elasticity of Demand ‡ The (market) demand for a good is affected by numerous factors: price. etc. taste. population demographics. income. expectations. ‡ The degree of sensitivity or responsiveness of the demand to changes in any of the factors affecting it can be measured in terms of ³elasticity´. percentage change in Qd Ez = ------------------------------------percentage change in X .

Measuring Elasticity Measuring a change in percentage terms: Y2 ±Y1 Y1 = 80 % change in Y = -----------------Y2 =100 Y1 Y1 ±Y2 = ------------------Y2 Y2 ±Y1 Arc % change = ------------------Y2 +Y1 ----------- 2 .

Measuring Elasticity Change in Qx ------------------------- Ez = Qx1 --------------------Change in Z ------------------------- Z1 Change in Qx -------------------------- Qx1 + Qx2 (Arc)Ez = -------------------Change in Z ------------------------ Z1 + Z2 .

Qx2 ± Qx1 --------------------------- Qx1 + Qx2 Ep = ----------------------P2 ± P1 --------------------------- P1 + P2 .Price Elasticity of Demand Definition: A measure of the responsiveness of quantity demanded of a good to changes in its price.

P 10 8 a b 4 2 8 18 c d 80 90 D Q Ep (a --.b) = (10/8)/(-2/10) = -6.25 Ep (c ---d ) = (10/80)/(-2/4) = -.25 .

Arc (Price) Elasticity Note that if we increased P the price. Ep = (-10/18)/(2/8) = -2. respectively. (from 8 to 10 or 2 to 4) the original P and Q would 10 8 be 2 and 8 and 18 and 90.22 Ep = (-10/90)/(2/2) = -.11 4 a b c 2 8 18 d D Q 80 90 .

49 .Arc Elasticity To get the average elasticity between two points on a demand curve we take the average of the two end points (for both price and quantity) and use it as the initial value: Q2-Q1 (Q1+Q2) Ea = P2-P1 (P1+P2) -2 10+8 10 8+18 = -3.

17 d D 80 90 .49.49 b 4 2 8 18 c E = -. |elasticity | increases.Elasticity and the Price Level Along a linear demand curve as the price goes up. 10 8 a E =-3.17. P | Ep | > 1 : | Ep | < 1 : | Ep | = 1 : Elastic Inelastic Unit-elastic Note that between points "a" and "b" the (arc) elasticity of the above demand curve is -3. whereas between "c" and "d" it is -.

. ------.= ------. = -----..Point Elasticity Q --------Q 1+Q2 Q P1+P2 Q P E = -----------.= ------. ----dP Q .. -----P P Q1+Q 2 P Q --------P1+P2 dQ P Or.

----.b P C 1 P = ----.-----..Q b b D MR 0 TR C Q C 2 MR = -----..MR |E|= 1 Q = C .Q b b Note: In the demand equation dQ/dP = -b That means Q 0 P E p = -b ----Q .P.

( ------. ----.Q .= -------..). TR (P.P = P.P Q Q dQ dQ dP Q P 1 = ( -----. P = f (Q ) Marginal Revenue = Change in TR resulting from producing (selling) one additional unit of output.= -----..A note about marginal revenue: Recall: TR = P.+ -----.Q) d P dQ MR = -----.+ 1 ) dQ P P E .Q + -----.

b P dQ ---.) E Slope= -1/b Slope=-2/b MR 0 D Q C . ( 1 + ---.b dp dQ P P E = ----.= .. MR 1 MR = P.Q = C .= -b . ----. -----dp Q Q P.

‡When demand is unit-elastic. ‡When demand is inelastic. .Important Observations ‡When demand is elastic. an increase (or a decrease) in price will not change the revenue (sales). a decrease in price will result is an increase in the revenue (sales). a decrease in price will result is a decrease in the revenue (sales).

What Determines Elasticity  Necessities versus luxuries Eating at restaurants Groceries  Availability of substitutes Chicken versus beef  How much of our income a good takes Salt versus Nike sneakers  The passage of time .

Other Elasticity Measures Recall: ³Elasticity´ is a (standard) measure of the degree of sensitivity ( or responsiveness) of one variable to changes in another variable.  Income Elasticity: a measure of the degree of sensitivity of demand for a good (or service) to changes in consumers¶ (buyers¶) income  Cross Price Elasticity: a measure of the degree of sensitivity of demand for a good (or service) to changes in the price of another good or service .

-----d I Q . ceteris paribus.Income Elasticity of Demand A measure of the degree of responsiveness of demand (for a good) to a change in income. (Shift of the demand curve) Q2-Q 1 Q2 +Q1 EI = I2 -I1 I1 +I2 d Q I = or = -----..

------d Py Qx .Cross (Price) Elasticity A measure of the degree of responsiveness of the demand for one good (X) to a change in the price of another good (Y): (Shift of demand curve) Qx2..Py1 Py1+Py2 or = d Qx Py ----------.Qx1 Qx2+Qx1 Ec = Py2.

I = 1000.5 (80/200) = .2 (95/200) = -.2 P + . Pc = 200 ==> Qd = 200 Ep = .5 .95 EI = .2 Epc = .05 I + .5 Pc P = 95.05 (1000/200) = . W = 80.5(200/200)= .An example: Qd = 200 .5 W + .25 Ew = .