MANAGERIAL ECONOMICS

PRELIMS
MARKET INTERACTIONS:
MANAGER CONSUMER-PRODUCER RIVALRY
- A person who directs resources to achieve a stated goal. Consumers attempt to locate low prices, while producers
ECONOMICS attempt to charge high prices.
- the science of making decisions in the presence of scare
resources. CONSUMER-CONSUMER RIVALRY
MANAGERIAL ECONOMICS Scarcity of goods reduces the negotiating power of
- the study of how to direct scarce resources in the way that consumers as they compete for the right to those goods.
most efficiently achieves a managerial goal.
PRODUCER-PRODUCER RIVALRY
GOAL Scarcity of consumers causes producers to compete with one
- Sound decision making involves having well-defined goals. another for the right to service customers.
- Leads to making the “right” decisions.
THE ROLE OF GOVERNMENT
CONSTRAINTS Disciplines the market process.
- In striking to achieve a goal, we often face constraints.
- Constraints are an artifact of scarcity. TIME VALUE OF MONEY
Present value (PV) of a future value (FV) lump-sum amount to
ACCOUNTING PROFITS be received at the end of “n” periods in the future when the
- Total revenue (sales) minus dollar cost of producing goods per-period interest rate is “i”:
or services.
- Reported on the firm’s income statement. FV
PV 
ECONOMIC PROFITS 1  i  n
- Total revenue minus total opportunity cost.
The present value (PV) reflects the difference between the
ACCOUNTING COSTS future value and the opportunity cost of waiting (OCW).
- The explicit costs of the resources needed to produce goods Succinctly,
or services. PV = FV – OCW
- Reported on the firm’s income statement. If i = 0, note PV = FV.
As i increases, the higher is the OCW and the lower the PV.
OPPORTUNITY COSTS
- The cost of the explicit and implicit resources that are PRESENT VALUE OF A SERIES
foregone when a decision is made. Present value of a stream of future amounts (FVt) received at
the end of each period for “n” periods:
ECONOMIC PROFITS
FV 1 FV 2 FV n
- Total revenue minus total opportunity cost.
PV    . . .
PROFIT SIGNAL
1  i  1
1  i  2
1  i  n
n
- Profits signal to resource holders where resources are most FV t
highly valued by society. PV =∑
- Resources will flow into industries that are most highly
t =1 ( 1+ i )t
valued by society.
NET PRESENT VALUE
FIVE FORCES BY MICHAEL PORTER
Suppose a manager can purchase a stream of future receipts
1. Suppliers
(FVt ) by spending “C0” dollars today. The NPV of such a
2. Substitutes & Complements
decision is
3. New Entrants
FV 1 FV 2 FV n
4. Buyers NPV    . . .  C
5. Industry / Rivalry 1  i  1
1  i  2
1  i  n 0

INCENTIVES play an important role within the firm. PRESENT VALUE OF A PERPETUITY
Incentives determine: An asset that perpetually generates a stream of cash flows
- How resources are utilized. (CFi) at the end of each period is called a perpetuity.
- How hard individuals work. The present value (PV) of a perpetuity of cash flows paying
- Managers must understand the role incentives play in the the same amount (CF = CF1 = CF2 = …) at the end of each
organization. period is
- Constructing proper incentives will enhance productivity
and profitability.
 CF CF CF To maximize net benefits, the managerial control variable
PV Perpetuity = + + +. . .
( 1+i ) ( 1+i )2 ( 1+i )3 should be increased up to the point where MB = MC.
CF - MB > MC means the last unit of the control variable
=
i increased benefits more than it increased costs.
- MB < MC means the last unit of the control variable
increased costs more than it increased benefits.
FIRM VALUATION AND PROFIT MAXIMATION
The value of a firm equals the present value of current and SUPPLY AND DEMAND ANALYSIS
future profits (cash flows). - Tool that managers can use to visualize the “big picture.
π1 π2 ∞ πt - Advantage of having this tool
PV Firm =π 0 + + +.. .=∑
( 1+i ) ( 1+i ) t=1 ( 1+i )t MARKET DEMAND CURVE
- A common assumption among economist is that it is the Shows the amount of a good that will be purchased at
firm’s goal to maximization profits. alternative prices, holding other factors constant.
- This means the present value of current and future profits, Law of Demand
so the firm is maximizing its value. The demand curve is downward sloping.

If profits grow at a constant rate (g < i) and current period LAW OF DEMAND
profits are po, before and after dividends are: As the price of a good rises (falls) and all other things remain
1 i constant, the quantity demanded of the good falls (rises
PVFirm   0 before current profits have been paid out as dividends;
ig
1 g
Ex  Dividend
PVFirm  0 immediately after current profits are paid out as dividends. PRICE AND DEMAND
ig
Price and quantity demanded are inversely related
Provided that g < i.
That is, the growth rate in profits is less than the interest rate
MARKET DEMAND CURVE
and both remain constant.
The straight line connecting those points, called the market
demand curve, interpolates the quantities consumers would
MARGINAL (INCREMENTAL) ANALYSIS
be willing and able to purchase at prices not explicitly dealt
- Control Variable Examples:
with in the market research
- Output
- Price
- Product Quality
- Advertising
- R&D

NET BENEFITS
Net Benefits = Total Benefits - Total Costs
Profits = Revenue - Costs DETERMINANTS OF DEMAND:
Income
MARGINAL BENEFIT - Normal good
Change in total benefits arising from a change in the control - Inferior good
variable, Q: Prices of Related Goods

ΔB
- Prices of substitutes
- Prices of complements
MB= Advertising and consumer tastes

ΔQ Population
Consumer expectations
Slope (calculus derivative) of the total benefit curve.
DEMAND SHIFTERS
MARGINAL COST Variables other than the price of a good that influence
Change in total costs arising from a change in the control demand are known as demand shifters.
variable, Q:
CHANGE IN QUANTITY DEMANDED
ΔC changes in the price of a good lead to a change in the

MC= quantity demanded of that good. This corresponds to a

ΔQ
movement along a given demand curve.

CHANGE IN DEMAND
Slope (calculus derivative) of the total cost curve changes in variables other than the price of a good, such as
income or the price of another good, lead to a change in
demand. This corresponds to a shift of the entire demand
curve.
MARGINAL PRINCIPLE
INCOME Price as a function of quantity demanded.
Because income affects the ability of consumers to purchase
a good, changes in income affect how much consumers will Example:
buy at any price. Demand Function
Qxd = 10 – 2Px
NORMAL GOOD Inverse Demand Function:
A good whose demand increases (shifts to the right) when 2Px = 10 – Qxd
consumer incomes rise Px = 5 – 0.5Qxd

INFERIOR GOOD COSUMER SURPLUS

A good for which an increase (decrease) in income leads to a The value consumers get from a good but do not have to pay
decrease (increase) in the demand for that good for.
- Consumer surplus will prove particularly useful in marketing
and other disciplines emphasizing strategies like value pricing
PRICES OF RELATED GOODS: and price discrimination.
SUBSTITUES
Goods for which an increase (decrease) in the price of one MARKET SUPPLY CURVE
good leads to an increase (decrease) in the demand for the The supply curve shows the amount of a good that will be
other good. produced at alternative prices.
COMPLEMENTS Law of Supply
Goods for which an increase (decrease) in the price of one The supply curve is upward sloping.
good leads to a decrease (increase) in the demand for the
other good. SUPPLY SHIFTERS
- Input prices
INFORMATIVE ADVERTISING - Technology or government regulations
Advertising often provides consumers with information about - Number of firms
the existence or quality of a product, which in turn induces Entry
more consumers to buy the product. Exit
- Substitutes in production
PERSUASIVE ADVERTISING - Taxes
Advertising that promotes the latest fad in clothing may Excise tax
increase the demand for a specific fashion item by making Ad valorem tax
consumers perceive it as “the” thing to buy. -Producer expectations

POPULATION INPUT PRICES

as the population rises, more and more individuals wish to As production costs change, the willingness of producers to
buy a given product, and this has the effect of shifting the produce output at a given price changes. In particular, as the
demand curve to the right price of an input rises, producers are willing to produce
less output at each given price
CONSUMER EXPECTATIONS:
STOCKPILING NUMBER OF FIRMS
If consumers expect future prices to be higher, they will As additional firms enter an industry, more and more output
substitute current purchases for future purchases and are available at each given price
generally occurs when products are durable in nature.
SUBSTITUTES IN PRODUCTION
DEMAND FUNCTION Many firms have technologies that are readily adaptable to
A general equation representing the demand curve several different products
Qxd = f(Px , PY , M, H,)
EXCISE TAX
Qxd = quantity demand of good X. is a tax on each unit of output sold, where the tax revenue is
Px = price of good X. collected from the supplier
PY = price of a related good Y. - At any given price, producers are willing to sell less gasoline
Substitute good. after the tax than before. Thus, an excise tax has the effect of
Complement good. decreasing the supply of a good.
M = income.
Normal good. AD VALOREM TAX
Inferior good. is a percentage tax
H = any other variable affecting demand.
PRODUCER EXPECTATIONS
If firms suddenly expect prices to be higher in the future and
the product is not perishable, producers can hold back output
today and sell it later at a higher price
INVERSE DEMAND FUNCTION SUPPLY FUNCTION
An equation representing the supply curve: A measure of the responsiveness of one variable to changes
QxS = f(Px , PR ,W, H,) in another variable; the percentage change in one variable
that arises due to a given percentage change in another
QxS = quantity supplied of good X. variable
Px = price of good X. - How responsive is variable “G” to a change in variable “S”
PR = price of a production substitute.
W = price of inputs (e.g., wages).
%ΔG
H = other variable affecting supply.
EG , S =
INVERSE SUPPLY FUNCTION
Price as a function of quantity supplied.
%ΔS
OWN PRICE ELASTICITY OF DEMAND
A measure of the responsiveness of the quantity demanded
Example:
of a good to a change in the price of that good; the
Supply Function
percentage change in quantity demanded divided by the
Qxs = 10 + 2Px
percentage change in the price of the good
Inverse Supply Function:
2Px = 10 + Qxs
Px = 5 + 0.5Qxs

PRODUCER SURPLUS
The amount producers receive in excess of the amount
necessary to induce them to produce the good.

MARKET EQUILIBRIUM
The Price (P) that Balances supply and demand
QxS = Qxd
No shortage or surplus
Steady-state

PRICE RESTRICTIONS:
PRICE CEILINGS
The maximum legal price that can be charged.
Examples:
Gasoline prices in the 1970s.
Housing in New York City.
Proposed restrictions on ATM fees.

PRICE FLOORS
- The minimum legal price that can be charged.
- Individuals may lobby for the government to legislate a
minimum legal price for a good.

Examples:
Minimum wage.
Agricultural price supports.

FULL ECONOMIC PRICE

The dollar amount paid to a firm under a price ceiling, plus
the nonpecuniary price.
PF = Pc + (PF - PC)
PF = full economic price
PC = price ceiling ELASTIC
PF - PC = nonpecuniary price Increase (a decrease) in price leads to a decrease (an
increase) in total revenue.
Use supply and demand analysis to: INELASTIC
- clarify the “big picture” (the general impact of a current Increase (a decrease) in price leads to an increase (a
event on equilibrium prices and quantities). decrease) in total revenue.
- organize an action plan (needed changes in production, UNITARY
inventories, raw materials, human resources, marketing Total revenue is maximized at the point where demand is
plans, etc.). unitary elastic.

FACTORS AFFECTING OWN PRICE ELASTICITY:

ELASTICITY CONCEPT
AVAILABLE SUBSTITUTES
PY
The more substitutes available for the good, the more elastic
EQ =α Y
X , PY
the demand.
QX
TIME INCOME ELASTICITY
Demand tends to be more inelastic in the short term than in
the long term. M
Time allows consumers to seek out available substitutes. EQ , M =α M
EXPENDITURE SHARE
Goods that comprise a small share of consumer’s budgets
X QX
tend to be more inelastic than goods for which consumers
spend a large portion of their incomes.

CROSS PRICE ELASTICITY OF DEMAND

%ΔQ X d

EQ , P =
X Y %ΔP Y
PREDICTING REVENUE CHANGES FROM TWO PRODUCTS
Suppose that a firm sells to related goods. If the price of X
changes, then total revenue will change by:
ΔR= R X ( 1+ EQ
( )+ RY E Q ) ¿ %ΔP
X, PX Y , PX X

INCOME ELASTICITY

%ΔQ X d

EQ ,M=
X %ΔM
USES OF ELASTICITIES:
- Pricing.
- Managing cash flows.
- Impact of changes in competitors’ prices.
- Impact of economic booms and recessions.
- Impact of advertising campaigns.

INTERPRETING DEMAND FUNCTIONS

Mathematical representations of demand curves.
Example:
Q d =10−2 P X +3 PY −2 M
X

Law of demand holds (coefficient of PX is negative).

X and Y are substitutes (coefficient of PY is positive).
X is an inferior good (coefficient of M is negative).

LINEAR DEMAND FUNCTION AND ELASTICITIES

General Linear Demand Function and Elasticities:
Q d =α 0 +α X P X +α Y PY +α M M +α H H
X

OWN PRICE ELASTICITY

PX
EQ =α X
X , PX QX

CROSS PRICE ELASTICITY MIDTERMS

 - is the added satisfaction that a consumer gets
Chapter 4: The Theory of Individual Behavior from having one more unit of a good or service.
The concept of marginal utility is used by
CONSUMER economists to determine how much of an item
- an individual who purchases goods and services consumers are willing to purchase.
from firms for the purpose of consumption.
- Interested in who purchase our products? CONSISTENT BUNDLE ORDERINGS
TRANSITIVE PROPERTY
CONSUMER OPPORTUNITIES - Transitive preferences along with the more-is-
- The possible goods and services consumer can better property imply that
afford to consume. - indifference curves will not intersect.
- the consumer will not get caught in a perpetual
CONSUMER PREFERENCES cycle of indecision.
- The goods and services consumers actually
consume.
CHAPTER 5: THE PRODUCTION PROCESS AND COSTS
INDIFFERENCE CURVE TECHNOLOGY
- An indifference curve, with respect to two - The feasible means of converting raw inputs, such as
commodities, is a graph showing those steel, labor, and machinery, into an output such as
an automobile
combinations of the two commodities that
leave the consumer equally well off or equally PRODUCTION PROCESS
satisfied—hence indifferent—in having any
combination on the curve.

COMPLETE PREFERENCES ORDERING PROPERTIES

COMPLETE PROPERTY
- Consumer is capable of expressing preferences
(or indifference) between all possible bundles.
(“I don’t know” is NOT an option!)

MORE IS BETTER PROPERTY

- Bundles that have at least as much of every
good and more of some good are preferred to • Two inputs: Capital & Labor
other bundles. • K denote the quantity of capital (machines)
DIMINISHING MARGINAL RATE OF SUBSTITUTION • L the quantity of labor
- The rate at which a consumer is willing to • Q the level of output produced in the production
substitute one good for another and maintain process.
the same satisfaction level.
PRODUCTION ANALYSIS
• Production Function
TRANSITIVITY
 Q = F(K,L)
INDIFFERENCE CURVE
 Q is quantity of output produced.
- A curve that defines the combinations of 2 or  K is capital input.
more goods that give a consumer the same  L is labor input.
level of satisfaction  F is a functional form relating the
inputs to output.
INDIFFERENCE MAP  The maximum amount of output that can
be produced with K units of capital and L
units of labor.
• Short-Run vs. Long-Run Decisions
• Fixed vs. Variable Inputs

SHORT-RUN
- the time frame in which there are fixed factors
of production

MARGINAL UTILITY
 - total cost / output
- total cost per unit
- >>> AC = TC / q

AVERAGE FIXED COST

- When output increase, Fixed Cost constant,
Average Fixed Cost decline
- AFC + TFC / q

AVERAGE VARIABLE COST

- AVC = TVC / q

FIXED COST
- costs that do not change with the amount
produced
- costs that incurred even if the firm is producing
nothing
- no fixed cost in long run
- sunk cost is a type of fixed cost (but not
recoverable)
- Fixed costs are not permanently fixed; they will
change over time, but are fixed, by contractual
obligation, in relation to the quantity of PRODUCTION FUNCTION – CONCEPTS
production for the relevant period. - Whether or not the quantity of an input is fixed
- there are no fixed costs in the long run, because depends on the time
the long run is a sufficient period of time for all
short-run fixed inputs to become variable. Short run – time period in which at least one input is
Investments in facilities, equipment, and the fixed
basic organization that cannot be significantly Long run – time period in which all inputs can be
reduced in a short period of time are referred changed
to as committed fixed costs. - There are no fixed inputs in the long run
- Discretionary fixed costs usually arise from - The long run is defined as the horizon over
annual decisions by management to spend on which the manager can adjust all factors of
certain fixed cost items. production. If it takes a company three years to
acquire additional capital machines, the long
run for its management is three years, and the
VARIABLE COST short run is less than three years.
- costs that do change with the amount
produced MEASURE OF PRODUCTIVITY
TOTAL PRODUCT
- depend on production
- is simply the maximum level of output that can
- VC=VC (q)
be produced with a given amount of inputs
TOTAL COST
AVERAGE PRODUCT
- fixed costs plus variable costs
- A measure of the output produced per unit of
- sum of fixed and variable costs input.
- TC = TFC + TVC - The average product (AP) of an input is defined
as total product divided by the quantity used of
MARGINAL COST
the input.
- additional cost of one additional output
- MC = ΔTC /Δq
- Additional cost of producing one more unit of
output

AVERAGE COST
 - Costs that vary with output.
Fixed Cost
- Costs that do not vary with output.
MARGINAL PRODUCT
- The change in total output attributable to the
last unit of an input.
FIXED AND SUNK COST
Fixed Cost
- Costs that do not change as output changes.
Sunk Cost
- A cost that is forever lost after it has been paid.
- Decision makers should ignore sunk costs to
INCREASING, DIMINISHING AND NEGATIVE MARGINAL
maximize profit or minimize losses
RETURNS
Average Total Cost
ATC = AVC + AFC
ATC = C(Q)/Q

Average Variable Cost

AVC = VC(Q)/Q

Average Fixed Cost

AFC = FC/Q

GUIDING THE PRODUCTION PROCESS Marginal Cost

• Producing on the production function MC = DC/DQ
 Aligning incentives to induce maximum
worker effort.
• Employing the right level of inputs FIXED COST
 When labor or capital vary in the short
run, to maximize profit a manager will
hire
 labor until the value of
marginal product of labor
equals the wage: VMPL = w,
where VMPL = P x MPL.
 capital until the value of
marginal product of capital
equals the rental rate: VMPK =
r, where VMPK = P x MPK .

COST ANALYSIS
• Types of Costs
VARIABLE COST
 Short-Run
 Fixed costs (FC)
 Sunk costs
 Short-run variable costs (VC)
 Short-run total costs (TC)
 Long-Run
 All costs are variable
 No fixed costs

TOTAL AND VARIABLE COSTS

C(Q): Minimum total cost of producing alternative
levels of output:
C(Q) = VC(Q) + FC
Variable Cost (Q)
TOTAL COST Budget Line
- The bundles of goods that exhaust a
consumer’s income

Opportunity Cost
- The value of the next best alternative that
you had to forego when you made a choice

Market Rate of Substitution

- The rate at which one good can be
exchanged for another at current market
prices . The Market Rate of Substitution for
X with Y is : The amount of Y which must be
LONG-RUN AVERAGE COSTS
given up in order to get one more unit of X,
given a fixed budget and market prices .
-
Optimization
- Optimisation occurs when consumers are
able to reach the highest indifference curve
possible, for their given level of income

Market Value

Budget Constraints
- Restricts consumer behavior by forcing the Personal Valuation
consumer to select a bundle of goods that
is affordable.

Factors
Tangent
- In geometry, the tangent line to a plane
curve at a given point is the straight line
that "just touches" the curve at that point.

Intersects
- When two or more lines cross each other in
a plane, they are called intersecting lines.
The intersecting lines share a common
point, which exists on all the intersecting
lines, and is called the point of intersection

Budget Set
- The bundles of goods a consumer can
afford