MBA –MEC 605

(Lecture Notes)

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Definition
 Managerial economics is the analysis of major
management decisions using tools of economics
Decision Making
 Decision making lies at the heart of most important business and
government problems
 Range is vast, but basic steps are the same
 Six steps in decision making:

•Defining the problem

•Determining the objectives
•Exploring the alternatives
•Predicting the consequences
•Making a choice
•Performing sensitivity analysis (how an optimal decision would
change if the key economic facts and conditions were changed)
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Private and Public decisions:
Firm:
 Maximize profits
 Satisfying behavior
 Maximize sales
Public Sector:

 Maximize social welfare (cost-benefit analysis)

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Role of profits in the Market
Economy:
 Signal for resource allocation
 Profits essential for the viability of business
 Examples: computers/mobile phones
 Profits reward for efficiency and innovations

 Profits are ‘normal’ under competitive conditions

 Profits are ‘excessive’ due to monopoly, technological
edge( innovations), high risk, transitory phase of
structural adjustment, managerial efficiency, etc

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Some basic concepts:
 Business Profits vs. Economic Profits
 Implicit and Explicit Costs
 Private vs. Public Goods
 Business Ethics- prescribes business behavior the
firms should not engage in.
 Globalization and the rise of global corporation-
globalization of consumption, production, and
competition. Proportion of sales abroad is an index of
‘trans-nationality’. Global firm is a stateless
corporation. R&D & production are internationalized
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Demand and Supply/Equilibrium
Price:
 Demand curve (defines relationship between price and
quantity sold)
 Supply curve (shows the relationship between price
and output supplied)
 Shifts in Demand and Supply
 Equilibrium price
 Price control, taxes and subsidies (market dynamics)

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Demand, Supply and Market
Equilibrium
 Demand Side:
 Demand Curve (constant income, tastes and price of substitutes) -
 Law of Demand – inverse realtionship between price and
quantity demanded
 Shift in D- Curve (change in income, taxes, or price of substitutes)

 Supply Side:
 Supply Curve (constant technology and resource (L,K,L)
prices) – positive relationship between price and quantity
supplied
 Shift in S-curve (change in technology and prices inputs)

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 Equilibrium Price: Price at which the market demand
equals market supply

D Excess S
Supply

Pe

Excess
S Demand D

Qe

 Equilibrium Price: Price at which D=S

 Shift in D-Curve and the equilibrium price changes
 Shift in S-Curve and the equilibrium price changes
 Shift in D and S and the price of PCs – an example
 Impact of taxes, subsidies and price control- dynamics
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Optimization Rules (Profit Maximization)
o MR=MC ( Concept, Revenue, cost , Profit Table)
o Use of calculus in finding optimal output and price
o Example
o TR = 200Q – Q 2

o TC = Q 2+ 100 Q + 50
Marginal Revenue (MR)
dTR = 200 – 2Q
dQ
Marginal cost (MC)
= 2Q + 100
dTR
dQ
Profit s maximum, when MR = MC
So, 200-2Q=2Q+100 or -4Q=-100
Thus, optimal output is Q=25
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Elasticity of Demand:
• Elasticity of Demand -> responsiveness in the quantity demanded of
a commodity to a change in its price)
• Methods of Measurement:

EP = = • (Point elasticity)

EP =
• (Arc elasticity)

EP =
• (Using derivatives)

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 Price Elasticity, Total Revenue, Marginal Revenue
TR = P×Q
MR = or MR = P(1 + )

 Factors affecting Price elasticity of Demand (type of

good, share in budget, degree of substitution, time
factor)
 Demand elasticity and Price Discrimination –
 Purpose is to maximize revenue
 Market segmentation
 Conditions for effective price-discrimination

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 Mark-up Rule
P= MC

Example: MC=$200
Price Elasticity = -5
Price = [ ] $200

P= $200 = $250

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 Demand-based Pricing
Examples: Hotels/resorts (season-based)
 Airlines: Business class/economy,
 Hotels: Season/peak time
 Service: Quality-based
 Interdependent Demand (cross effects not ignored)
MTRA = MTRB
 Using Elasticities in Managerial Decision Making –
changing prices and formulating business strategy

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Estimating Demand:
Many methods are available to estimate D. However, the problem of
identification has to be watched out. Data on P and Qd may hide the
impact of non- price factors, such as changes in income, tastes and
price of other goods. Regression analysis can help to isolate the ‘effect’
of different variables.

 Source of Information
 Qualitative Forecasts- survey of economic intentions can reveal and be
used to forecast future purchases of capital equipment, inventory changes
and consumer expenditure. Decisions are taken before expenditure is
made. Opinion surveys/plans. Main problem is taking representative
samples

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 Consumer Interviews/surveys – problems are the nature
and relevance of the sample; reporting bias; reliability;
high cost.
 Market experiments – Controlled experiments.
Consumer response could be artificial, expensive and
risky
 Uncontrolled Market Data – Plenty of market data,
showing changes over time and space. Statistical
methods can isolate the effect of various factors
affecting demand.

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Regression Analysis:
 Regression Analysis
 Scatter diagram
 Specification of the estimating equation
 Evaluating the significance of the equation

 Simple Regression
Yi =A + BXi + ei
 Main assumption is that e1 are independent and their mean value in zero
 Example Page 5-7 of the module (Appendix to Chapter 2)

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 Interpretation
R2 (coefficient of determination the goodness of fit of regression line.
Adj. for the # of variables. Variance explained in Y divided by the total
variance in Y

t- Statistics (standard error of the coefficient) – error square divided by

(df x variance of X) and square root, av. Standard deviation of errors
F- statistic (ratio of av. explained variance in Y to av. unexplained
variance)
 Problems in Regression Analysis
 Multicollinearity (when independent variables are highly correlated)
 Heteroscedasticity ( size of the error may rise or fall with the size of an
independent variable.

 Serial correlation (error term is not independent, instead they are serially
correlated - Durbin – Watson test.

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Business Forecasting:
Forecasts of sales and profits is very important. Most problems in managerial
economics involved forecasting.

 Survey Techniques – Respondent’s forecast/belief/opinion. Reliability of the

forecast determined by the root- means squared forecast error.
 Time Series – based on the quantitative analysis of economic time series.
Trend, seasonal variation, cyclical variation and irregular variation.
Trend: Yt = A + Bt
b=

a= -b
Nor – linear trend
yt = A + B1 t + B2 t2
or yt = a Bt
Take logs and it will become a linear function

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 Seasonal Variation – Use dummy variables
 Cyclical variation – Phases
 Excel Program for Regression
Open EXCEL, click tools- look for data analysis and regression

Other Methods:
 Moving averages/smoothing techniques
 Barometric methods/leading economic indicators-stock
market(expectations)
 Consumer spending(consumer sentiment), money supply(M2).
Composite/diffusion index.
 Econometric Models – GDP, air travel . single equation, multiple
equation and reduced form equation model
 Input-output forecasting- recognizes interdependence(input/output
tables)

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Market Environment of the Firm
Five Components
 Demand analysis – definition and determinants
 Supply analysis – definition and determinants
 Market equilibrium – D and S interaction
 Elasticity of D
 Market Structure
 Market Demand – summation of individual D
 Individual Demand – negative relationship between P
and Q
 Determining factors – revenue, taxes, prices related
goods of consumers
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Supply Analysis:
 Supply – firms are willing to produce/sell at different prices
at a given time.
 Supply Curve – Upward slopping
 Market Supply - Summation of individual producers

 Elasticity of supply
Es = % ∆ in Q Supplied = ∆Qs x P
% ∆ in Price ∆P Qs
∂Qs . P
∂P QS

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 Determinants of supply – Technology, price of resources, price of
alternative goods, producer expectations, # of producers. Changes in
technology, prices of resources and other factors can cause shift in the
supply curve.
 Short-run supply- U shaped. Variable and fixed inputs. Law of
diminishing returns. Stages of production.
 Long-run supply curve- economies of scale. Factors contributing to
economies of scale. L shaped. Cobb-Douglas production functions.
 New economies of globalization – outsourcing of inputs and overseas
production, immigration of skilled labour and attracting world’s best
students, supply chain management.
 Estimation of Supply Curve- engineering data, cross section and
historical data, survival data( relative share of large and small firms)
 Cost- Volume Analysis- break-even output.

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Market Equilibrium:
 Price determination – D and S interplay
 Equilibrium price – Which equate D and S. Any other price leads to excess D or
excess S forcing the market price to converge to the equilibrium price. Price
Fixation/control—leads to the problem of balancing D and S.
 Price floor: Minimum legal price below which a good and service cannot be sold.
(Government sets it for Produces/farmers). Excess supply
 Price Ceiling: Maximum legal price above which a good and service cannot be sold.
Excess D
 Price clasticity of demand - Price responsiveness of D to price changes
 Price clasticity of D and TR
TR = P x Q, Relationship between Ed and TR.
With a price fall.
Ed = 1, TR Unchanged
Ed > 1, TR Increases
Ed < 1, TR Decreases

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 Market Structure: market structure and degree of competition (competitive
environment.). Process of price & output determination are strongly influenced by the
market structure.

 Perfectly Competitive Market (5 conditions). Firms are price takers. Short-term

Long- term. MR = AR = P = MC Long –run only normal profits. Zero economic
profits means that total revenue just cover all costs(explicit and
implicit).Global competition, import price and exchange rate plays an important
role.
 Monopoly – MR =MC Sole producer/seller. No AC minimum. Monopoly profits if
no close substitute and entry is blocked. Natural monopoly, legal monopoly,
Economic factors. Is monopoly bad? Not always—infrastructure, technology, etc
Consumer surplus and deadweight loss under monopoly.
 Oligopoly – Competition among the few. Action – reaction. Strategic pricing. Four
models – Cournot, Cartel, Kinked D curve, price leadership, etc. Game theory a
useful tool in analysing oligopoly markets. Non-price competition, product
differentiation.
 Monopolistic competition – competition with some market power. Differentiated
product and advertising expenses are common features. Common in retail and
service sectors. Clothing, food industry are some examples.

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 Special Pricing Practices

 Price discrimination
 Cost plus pricing
 Dumping
 Transfer pricing
 Tying, bundling, others(prestige pricing, skimming, price lining, auction
pricing)
 Information goods

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Fundamentals of the Economy
 Macroeconomics :
Output produced by an entire nation,
macroeconomics deal with aggregates - people’s
welfare, economy’s performance – Three important
topics (a) economic growth (real GDP), (b)
fluctuations in GDP growth, and employment levels,
(c) Price level and changes. In addition – (a) what
determines r, (b) B/P , and (c) value of the Ringgit.

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 National income:
GDP – Total dollar value of final goods and services
produced by any country over a period of one year.
GNP – economy as the citizen of a nation
GDP Measurement – Three approaches:
 Ouput approach (take value added and avoid double
counting)
 Expenditure approach -> C+I+G+(X-M)
 GDP = Employee Compensation + Proprietors Income +
Rents + net Interest + Corporate Profits + Indirect
Business Taxes + Capital Consumption – Income
approach

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 Uses of GDP - Measure of material well being
(GDP/per capita) –Country comparisons with price
adjustments.
 Limitations – Omitted items (Voluntary work,
negative GDP items treated as value items.
 Personal Income – National income – net interest-
undistributed corp. profits – Corp. taxes - Social
security taxes + personal interest income.
 Disposable Income – personal income – personal
income tax- property tax

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 Aggregate D and Multiplier
Total output = Aggregate Demand
Aggregate D = C + I + G + (X-M)
Multiplier:

b = marginal propensity to consumer

Same with Gi , change in government spending
Same with x, change in exports

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 . Unemployment
Definition
Unemployment rate – indicator of the under-
utilization of resources. Unemployed – all persons
who were without work and had actively looked for
work during the past 4 weeks
 Types of unemployment – seasonal, frictional,
structural, cyclical

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Price Index, Inflation and Business Cycle
 Nominal value – in money terms
 Real variable – in constant prices (in terms of goods and services)
 Price index -> Facilitates comparisons of average prices prevailing in the
economy at different time periods. ‘Bundle’ of goods.

CPI – Consumer Price Index

PPI – Producer Price Index
GDP – Deflator – to make GDP in constant prices

 CPI – Fix the basket, find prices, compute the basket cost. By keeping the
basket same, compute the cost for another year. Base year.
 PPI – for various sectors. For Mfg. it is widely used.
 GDP deflator – It takes goods and services produced (unlikely CPI which
takes goods and services consumed)
 Real GDP = (GDP at current price/ GDP deflator) x 100

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Inflation:

 Definition – Increase in the general price level

Rate of change is measured from the CPI
 Causes :
 Demand – Pull: result of excess aggregate D
 Cost- Push: factors which raise production costs. (wage increase,
increase in the prices of resource inputs)

 Impact: Inflation hurts those whose incomes are fixed. With

inflation, incomes also rise for some. Hence, overall purchasing power
may not decline. People shift to other assets with inflation. Firms
may have to change prices more frequently. Inflation causes arbitrary
income redistribution. The real value of the debt will change -creditors
lose.

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Business Cycle:

 Definition
Recurring and fluctuating level of economic activity that an
economy may experience over a long period of time.
Expansion -> Recession – Expansion
Fluctuations in aggregate economic activity

 Business Cycle -> Business do well in boom and poor in recession.

A study shows in US, expansion (29 monthly)
contractions (21 monthly) before 1945. After 1945,
expansions (57 monthly) and contractions (10 monthly)

 Management -> r, monetary policy, government budget. Managers should

understand macroeconomic events, and determine the
implications for his/her firm
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Monetary & Fiscal Policies
 Fiscal Policy
Fiscal policy can be used to promote economic growth, lower unemployment
rate and to eliminate recessionary gap. To do this, fiscal policy must change AD
or AS. Fiscal policy refers to changes in govt. expenditure and/ or taxes to
achieve a particular macro-economic goal (i.e. low unemployment, price
stability, economic growth). Budget surplus/deficit.

 Demand side policy - It affects AD (or C,I,G,M,E)

 Overheated economy: reduce govt. exp./increase taxes. Shift AD to left
 Recessionary gap: increasegovt.exp./reduce taxes. Deficit budget
 Neo-classical View: deficit budget – increased debt, less savings and higher
taxes later. It may also raise r when govt. borrows to finance the budget
deficit.
As long as the expansionary policy is translated into higher future taxes, there
will be no change in GDP, unemployment, price level, or interest rates.

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 Supply- side Policy- A lower marginal tax rate improves incentives. If
tax rate is lowered, what happens to tax revenues? Most people think-
it will reduce revenues. But Arthur Laffers says it may not be the case.
Incentives may improve and inv/production goes up and revenues
improve. The marginal tax rates, tax base, and the tax revenues are
related.

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 Monetary Policy
The goal is to stabilize price level, achieve low unemployment rate and promote
economic growth.

 Money market
 Demand for money- r is the price for holding money. Higher
the r, higher the cost of holding money.
 Supply of money- is vertical line as Central Bank determines it.
 Equilibrium- where D and r are balanced.
 Monetary policy tools- r discount rate, Reserve requirements, Open Market
operations. R has a salutary effect as well. Reserve ratios- change has effect
on credit creation. Open market operations is the most important tool.

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 Problems

Crowding out effect – negative influence

Time lags-data lag, wait n see lag, legislative lag, transmission lag, effectiveness
lag. By the time full impact comes, problem may disappear.
Incomplete Information - about multiplier and current level of GDP.

 Activist VS. Non-activist Debate

Discretionary policy not favoured. It should be rule-based. Activist policy may

not work or make matters worst. Some economists believe that the economy is
inherently unstable. So the government can play a useful role in stabilizing it

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Exchange Rates and Currencies
 International transactions involve one currency for another, i.e. foreign
exchange (FE)
 Exchange Rate:
Prices of one currency in terms of the other.
Convertible Currency -> which can legally be exchanged
Spot Rate: Rate applicable for delivery within two days
Forward Rates: Prices a good today for delivery at future days – 30, 60, 90 days
ahead
These are used for (a) Hedging, (b) Arbitrage , and (c)
Speculation
Hedging -> To guard against the risk of FE changes
Arbitrage -> A foreign currency is simultaneously bought spot and sold
forward
Allocation of funds in two centres.
Speculation To make Profits by taking risk - buys spot and sell later.

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 Balance of Payments:
Exports and imports of goods and services, capital flow – in and out
FDI, Capital outflows
Items are shown under 10 headings
 X and M of goods
 X and M of services
 Unilateral transfer (net) -, +
 Current Account balance
 Private Assets abroad (Direct individual, Portfolio individual)
 Foreign Assets in reporting country(net) Direct investment, Portfolio
investment
 Capital account (5+6)
 Change in F.E reserves
 Statistical discrepency
 Special Drawing Rights (+)
CA balance + Long term capital movement measures the fundamental
situation of B/P of a country.
B/P in always balanced if FE rate in allowed to float.
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 International Monetary Arrangement:

Gold Standard -> Currency value is expressed in gold equivalent.

FE Rates -> Changes have implication for X and M. Appreciating currency
hurts exporters and helps importers. Depreciating currency helps X
and hurts M.
Management -> Is a complex affair both at the firm and national levels.
Firm’s competitiveness is also affected with changes in FE rates.
Government intervention through r, monetary policy, and (AD
Management) and sale and purchase of FE.
A prudent manager will consider not only the exchange rate
movements itself, but also the macroeconomic phenomena
accompanying it.

Firm can protect itself from FE risk through hedging or forward

Contracts. Another way is to locate production facilities where sales
Are significant and minimize transfer of FE. Fourth is a trade off
between profit margin and market share.

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