Managerial

Economics

Finals
 Unit III Production and Cost Analysis

A. Production Function
- Defines the maximum amount of output that can be produced with a given
set of inputs
determinant of available technology: decisions on R & D expenditures
Production process with two inputs:
K – capital [machineries & equipment]
L – labor [people]
Q – level of output
PF = Q = F(K,L)
Short-run versus Long-run decisions

Short Run {SR}

- The time frame in which there are fixed factors of production
Example: automakers
Fixed factors: inputs that cannot be adjusted in the SR
Variable factors: inputs that can be adjusted to alter production
Illustration: only two inputs [k,l] therefore, the SR production function is only
a function of labor
Q = f[L] = F[K*, L]
Table 5-1 p.157 for the illustration
Long Run
- The horizon over which the manager can adjust all factors of production
Example:
Measures of Productivity
- Used in evaluating the effectiveness of a production process or making input
decisions that maximize profits

1. Total Product [TP]

- The maximum level of output that can be produced with a given amount of inputs
Ex. Table 5-1 - 5units of L
2. Average Product [AP]
- A measure of the output produced per unit of input
AP = total product divided by the quantity used as input
APL = Q/L APQ = Q/K
3. Marginal Product
- The change in total output attributable to the last unit of an input
MPK - The change in total output divided by the change in capital
MPK = ΔQ/ΔK
MPL - The change in total output divided by the change in labor
MPL =ΔQ/ΔL
Ex. Table 5-1 ; assembly lines – specialized task
After 5 units of L – the same MP
Negative MP – the last unit of input reduced the TP
Graphical illustration – Fig 5-1 p.159
Points a - e describes the range of increasing marginal returns
Points e – j describes the decreasing marginal returns

Phases of Marginal Returns:

Increasing - decreasing - negative

ROLE of the Manager in the Production Process: Ensure that the firm
1. operates on the production function
2. Operates at the right point on the production function
1. the production function describes the maximum output that can be produced
with given inputs
Ex. L – incentives, PS, commission

2. Use the right level of inputs

- Determine the right number of units of labor
Basis: determine the benefit of hiring an additional worker
Ex. Price per product - $3
cost/ unit of labor $400
The benefit to the firm from each unit of labor = $3 X MPL
Product = called value marginal product [VMP] of labor
VMP - value of the output produced by the last unit of that input
VMPL = P X MPL
VMPK = P X MPK
Ex. Table 5-2 p.161
Profit-Maximizing Input Usage

Maximize profits – use inputs at levels at which

marginal benefit = marginal cost
Note: when the cost of each additional unit of labor is w, continue to
employ labor up to the point where VMPL = w in the range of
diminishing marginal product
The COST Function

C = cost function
- provides information to determine the profit-maximizing level of output

Short-Run Costs
- SR: The period over which the amounts of some inputs are fixed
- In the SR, you could alter variable inputs but is stuck with levels of fixed
inputs

Law of Diminishing Returns

- As we add more units of a variable input to fixed amounts of land and
capital, the change in total output will at first rise and then fall
- Total outputs will be increasing at a decreasing rate
Long-Run Production

Long-run: all factors of production are variable

Returns to Scale: how the output of a business responds to a
change in factor inputs
Occurs when:
a. Increasing returns to scale occur when the % change in output is
greater than % change in inputs
b. Decreasing returns to scale when the % change in output is less
than the % change in inputs
c. Constant returns to scale when the % change in output is the
same as the % change in inputs
Economies of Scale: expansion of output allows the firm to produce
at lower LR average cost

Diseconomies of Scale: further increases in output leads to increase

in average costs returns to scale

Constant returns to scale: when the technology allows a firm to

produce different levels of output at the same minimum average
cost
Total Cost of Producing Outputs in the SR
a. Cost of fixed inputs - FC
b. Cost of variable inputs – VC

FC - do not vary with output

VC - vary when output Is changed

Short-run Cost Function

- Summarizes the minimum possible cost of producing each level of
output when variable factors are being used in the cost-minimizing
way
Table 5.3 p177
Figure 5-11 - graph
Average fixed cost- fixed cost divided by the number of units of output
Average variable cost- variable costs divided by the number of units of
output
Marginal cost - the cost of producing an additional unit of output
MC = change in C / change in Q
- when only one input is variable, the MC is the price P of that
input divided by its marginal product
Relations Among Costs
- The shapes of the curves indicate the relation between the marginal and
average costs
a. MC curve intersects the ATC and AVC curves at their minimum
points
Implication: when MC is below an average cost curve, AC is
declining; when MC is above average cost, AC is rising

b. ATC and AVC et closer together as output increases

reason: the only difference between atc and avc is the afc;
average fixed cost decreases as output increases

Fixed and Sunk Costs

Sunk costs - a cost that is lost forever once it has been paid
amount of fixed cost that cannot be recouped
Ex. $10,00 lease to a railcar for a month
- considered as a FC whether it is used for whatever weight
Term: $6,000 refund if railcar is not needed
sunk cost - $4,000 of the $10,000 FC
- irrelevant to decision-making since it is lost forever but affect the
calculation of profits
Illustration:
- Lease of $10,000 for a mo. - after signing the contract, realized
that it is not needed
- Someone would like to sub-lease for $10,000 – declined since you
would lose $8,000 – reject
Decision: wrong - since the $10,000 was paid already and lost
forever
reason: enhance cash inflow
 2 3 4 5 6 7 8 9
K L Q FC VC TC AFC AVC ATC MC

FI VI O $1000 X [1] $400 x [1] [4] + [5] FC/Q VC/Q TC/Q cC/cQ
$ $ $
2 0 0 2000 0 2000
2 1 76 2000 400 2400 26.32 5.26 31.58
2 2 248 2000 800 2800 8.06 3.23 11.29
2 3 492 2000 1200 3200 4.07 2.44 6.50
2 4 784 2000 1600 3600 2.55 2.04 4.59
2 5 1100 2000 2000 4000 1.82 1.82 3.64
2 6 1416 2000 2400 4400 1.41 1.69 3.11
2 7 1708 2000 2800 4800 1.17 1.64 2.81
2 8 1952 2000 3200 5200 1.02 1.64 2.66
2 9 2124 2000 3600 5600 0.94 1.69 2.64
2 10 2200 2000 4000 6000 0.91 1.82 2.73
PREVIOUS
Relationship to the Decision Sciences
- The use of mathematical economics and econometrics
Mathematical Economics
 model of economics that utilizes math principles and methods to create
economic theories and to investigate economic quandaries; conduct
quantifiable tests and create models to predict future economic activity
 relies on statistical observations to prove, disprove and predict economic
behavior.
Econometrics
 the mixture of economic theory, mathematics and statistical inference can
quantify valuable economic phenomena
1.1 Economic Way of Thinking About Business Practices and Strategy

- Allows people to gain insights into complicated problems using simplifying

assumptions to remove confusion
- Makes predictions & explanations valid in the real world though it ignores
many characteristics of the real world
- Reduces business problems to their most essential components
Figure 1.1 Economic Forces that Promote Long-Run Profitability

Few close substitutes

Strong entry barriers

Weak rivalry within market

Long Run
Low market power of input Profitability
suppliers

Low market power of

consumers
Abundant complementary
products

Limited harmful government

interventions
Thomas 1.2 Measuring and Maximizing Economic Profit

Manager’s decision: creates higher or lower profits

Revenues >Opportunity Cost = profit
Revenues < opportunity cost = negative profit - signal owners that they are ?
Goal: maximize economic profit [ determinant of the value of a business and
wealth of its owners]

- The economic cost to the owners of the firm using resources to produce a
good or service Love
as if each
day is
your last
Economic Cost of Using Resources
Productive Inputs:
a. Capital – land building
b. Raw materials
c. Energy
d. Financial resources
e. Managerial resources
Opportunity Cost
- The economic cost of using resources to produce a good or service
- Can either be explicit costs or implicit costs
Methods of Measuring Opportunity Costs:
a. Market-supplied resources
- Resources owned by others and hired, rented, leased by the firm
- Monetary payments made to the owners of resources; explicit costs
b. Owner-supplied resources
- Resources owned and used by the firm
- Money provided to the business, time and labor services, land, buildings,
capital equipment by the firm’s owners
- No cash payment for using owner’s resources
- OC is the best return the owners of the firm could have received had they
taken the resource to market instead of using them; implicit costs
Opportunity cost of owner-supplied resources - not zero; equal to zero if market value
is zero [ no other firms would be willing to pay anything for the use of the resource]
Most important type of implicit costs:
a. OC of cash provided to a firm [equity capital] – returns that it could earn if invested
in the same comparable risk
Ex. $20M in venture capital market @ 12%
$20M @.12 = $2.4M
b. OC of using land or capital
Ex. Alpha – rents the bldg.
Beta – inherited the bldg.
c. OC of owner’s time spent managing the firm or working for the firm in the same
capacity
Note:
- the OC of using owner-supplied inputs may not bear any relation to the
amount the firm paid to acquire the input;
- Reflects the current market value of the resource
Ex. LAND:
Firm paid $1M for a plot of land two years ago; market value fell to $500K,
implicit cost: [not the amount that the resource could be sold for] the best
return that could be earned if the land is sold for $500K not $1M & invested at
6%
$500k x .06 = $30K p.a.
Ex.2 firm owner’s time spent managing the firm
- The salary that could be earned in an alternative occupation
Principle:
Total Economic Costs
- The sum of opportunity cost of market-supplied and owner-supplied resources
Economic Profit = Total revenue – Total economic cost
Total revenue – explicit cost – implicit cost
Accounting Profit = Total revenue – explicit cost
Owners must cover all the costs of resources used by the firm. Thus maximizing
economic profit rather than accounting profit is the objective
Maximizing the Value of the Firm

Note: maximizing the economic profit is also maximizing the value of the firm
Value of the firm: the price for which it can be sold
Example:
Jan 1 – buy a business
Dec 31 – sell the business
Economic profit for the year: $50K then pay no more than $50k [in monthly
payments matching the flow of profits] to own the firm for that year
- Future profit is not known with certainty, value is based on the expected future
profit earned
Note: the greater the variation in possible future profits, the less a buyer is
willing to pay for those risky future profits
Risk premium:
 what is accounted for the risk associated with not knowing future profits
of a firm
 added to the [riskless] discount rate
 increases the discount rate thereby reducing the PV of profit received
in the future to compensate investors for the risk of not knowing with
certainty the future value of profits
 the more uncertain the future profits [the larger the risk associated with
future profits], the higher the risk-adjusted discount rate in valuing a firm &
the more heavily future profits will be discounted
–  
Example: Golf digest
Specific annual profit - $480K every year
Profit stream continues - T
Risk-adjusted rate – 10% p.a.
$480,000
Value of golf course = -------- ------------ = $4,800,000
r .10
- An investor who likes to earn 10% pa would be willing to pay $4.8M
- An investor who requires greater returns, 16% would be willing only to pay
$3M
The Equivalence of Value Maximization and Profit Maximization

Principle: equivalence of single period profit maximization

 If cost & revenue conditions in any period are independent of decisions made
in other time periods, maximize the value of a firm [PV] by making decisions
that maximize expected profit in each period
Examples:
a. A firm’s employees become more productive in future periods
b. Current production has the effect of increasing cost in the future
Thus:
 If increasing current output has a positive effect on future revenue and profit,
value-maximizing manager selects an output level that is greater than the
level that maximizes profit in a single time period
 If current production has the effect of increasing cost in the future
maximizing the value of the firm requires a lower current output than
maximizing single-period profit

Common Mistakes Managers Make

a. Never increase output simply to reduce average costs
- It is the marginal cost of production that matters in decision-making
b. Pursuit of market share reduces profit
- Simply gaining MS does not create higher profits
Network effects: arise when the value each consumer places on your product
depends on the number of other consumers who also buy your
products
Best action: charge a low initial price to dominate the market & charge higher
prices in later periods
Note: pursuing MS is consistent with profit-maximization only when network
effects are present
c. Focusing on Profit margin won’t maximize total profit
Profit margin - the difference between the price you charge for each unit
and the AC of producing the units
- average profit per unit [ex. $15 - $9 = $6]
Note: total profit is not maximized at the output and price level where profit
margin or unit profit is greatest

d. Maximizing Total Revenue reduces profit

- The point on a firm’s demand curve that maximizes profit will not be the price
and quantity that maximizes total revenue
e. Cost-plus pricing formulas don’t produce profit-maximizing prices
1.4 Market Structure and Managerial Decision-making
Price-taker
- A firm that cannot set the prices of the product it sells since price is
determined by the market forces
Price-setting firm
- A firm that can raise its price without losing is sales
Market power
- The ability to rise price without losing all sales
Market
- Any arrangement through which buyers & sellers exchange anything of value
Market Structure:
Economic characteristics to describe a market:
1. The number & size of firms operating in the market
2. Degree of product differentiation among competing producers
3. Likelihood of new firms entering a market when incumbent firms are earning
economic profits
Globalization of Markets
- The process of integrating markets located in nations around the world is a
process that brings opportunities and challenges to business manager An
- opportunity to sell more goods & services to foreign buyers & find new and
cheaper sources of economic resources
- it poses a threat of intensified competition
#2 Demand, Supply and Market Equilibrium

Quantity demanded
- The amount of a good or service consumers are willing and able to purchase in
a given period of time
Three types of demand relations:
a. general demand function
b. direct demand function
c. inverse demand function
The General demand function
Qd = f [P, M, PR, T, PE, N]
P = price of the good or service
M = consumer’s income [ general per capita]
Pr = price of related good or service
T = taste patterns of consumers
Pe = expected price of the good in some future period
N = number of consumers in the market
Price and quantity demanded - negatively related [inversely]
Income & Qd - an increase in income would either increase or decrease
purchases
Normal good - a decrease in income causes consumers to demand less of
the good or service and vice versa
Inferior good - an increase in income would reduce consumer demand;
falling income would cause consumers to demand more
Ways where commodities are related in consumption:
a. As substitutes - one good can be used in the place of the other
- An increase in the price of one good will increase the demand for the other
good
b. Complements - goods used in conjunction with the other
- Demand for one good increases when the price of the other good decreases or an
increase in the price of one good causes consumers to demand less of the other

Linear form of the general demand function:

Qd = a+ bP + cM + dPr + eT + fPe + gN
a …. g are slope parameters
- Measure the effect on the amount of the good purchased of changing one of the
variables
- Slope parameter of a specific variable is positive – directly related; negative – inversely
related
The intercept parameter a shows the value of Qd when the variables P, M, Pr, T, Pe and N
are equal to zero
Summary of the general demand function:
variable Relation to Quantity Demanded Sign of slope parameter

P inverse B=

PR

PE
Direct demand Functions:
- Obtained by holding all other variables constant; expressed in a form of linear demand
equation
Qd = f (P)
Qd = f(P, M, Pr ) = f (P)
Where the bar above the variables M and Pr are held constant at some specified amount
whatever is the value of the product price takes
Ex. Qd = 3,200 – 10P + .05M – 24Pr
Suppose: consumer income is $60,000; price of related good is $200
= 3, 200 – 10P + .05(60,000) – 24(200)
= 3,200 – 10P + 3,000 – 4,800
= 1,400 – 10P
Meaning: intercept parameter 1,400 is the amount of the good consumers buy if the P is zero
At each P, the equation gives the amount that consumers would purchase at
that price:
Ex. P = $60 P = $40
= 1,400 – 10P = 1,400 – 10(40)
= 1,400 – 10(60) = 800 = 1,000

Inverse Demand Function

P = f(Qd) price as a function of quantity demanded; mathematical
inverse of the direct demand function
P = 140 – 1/10Qd
Decision: managers want to know the highest price that can be charged for any
given amount of the product
Interpretation at every point on a demand curve:
a. The maximum amount of a good that will be purchased if a given price is
charged
b. The maximum P that consumers will pay for a specific amount of a good

Therefore: the inverse demand function gives the demand P for any specific
quantity of the product or service
Note: columns 2 & 3 depicts an increase in demand
column 4 depicts a decrease in demand
2.2 SUPPLY
- The amount of a good or service offered for sale in a market during a given
period of time: Qs

Variables that Affect Supply

1. Price of the good itself
2. Prices of the inputs used to produce the good
3. Prices of goods related in production
4. Level of available technology
5. The expectations of the producers concerning the future price of the good
6. The number of firms or the amount of productive capacity in the industry
The General Supply Function
Qs = f (P, Pi, Pr, T, Pe, F)
1. Q and S have a direct relationship; P is high – they produce more; P is low –
discourage production
2. Increase in the P of inputs increase the cost of production; cost rises, good
becomes less profitable, producers supply less and vice versa
3. Changes in the P of goods related in production may affect producers in two ways:

X & Y - substitutes in production

Increase in the P of Good X relative to good Y causes increase in production of good Y
Ex. P of corn increases, wheat constant, farmers would grow corn and less wheat
would be supplied
Manufacturing goods: firms switch resources from the production of one good
to the production of a substitute good when P of substitute rises
Complements:
An increase in the P of good X causes producers to supply more of good Y
Ex. Crude oil & natural gas – by product for each
P of crude oil rises, petroleum firms produce more oil so output of natural gas
increases

4. Improvement in technology results in some inputs to be more productive;

increased productivity allows firms to make more of a good with the same or
fewer inputs
5. Increase in the number of firms or productive capacity, more would be
supplied
Linear Functional Form of the General Supply Function
Qs = h + kP + IPi + mPr + nT + rPe + sF
h = intercept parameter
k,l, m, n, r, s = slope parameters
Pi = prices of inputs
Pr = prices of goods that are related in production
T = level of technology
Pe = expectations of producers about the future P of the good
F = the number of firms or amount of productive capacity in the industry
Direct Supply Function ( simply supply)
Qs = f (P) [ a change in P causes a change in Qs]
- Expresses quantity supplied as a function of product P only
- Derived from the general supply function by holding all the variables in the general
supply function constant except P
- Shows the relation between Qs and P holding the determinants of supply
[ Pi, Pr, T, Pe, F] constant
Qs = f (P, Pi, Pr, T, Pe, F] = f (P) : bar means he determinants of supply are held
constant at some specified value
- A change in quantity supplied is caused only by a change in P
- Graph: a change in P causes a movement along a supply curve from one P to
another P
Illustration:
Qs = 100 + 20P – 10Pi + 20F [Pr and Pe are omitted to simplify]
Ex. P of an input = $100
F = 25 [ producing the product]
Supply Function
Qs = 100 + 20P – 10(100) + 20(25)
= -400 +20P
 The linear S function gives the quantity supplied for various product prices
holding constant the other variables
Example: P of product = $40 P = $100
= -400 + 20(40)= 400 = -400 + 20(100) = 1,600
Inverse Supply Function
P = f(Qs)
P = 20 + 1/20Q
Slope of this inverse S function [fig 2.3] = ΔP/ ΔQs = 1/20
and is the reciprocal of the slope parameter k (= ΔQs/ΔP = 20)
Based from fig 2.3 - $20 - lowest P for which production will occur
Supply equation describes supply only over P $20 or greater = [P ≥ $20]

Two Ways of Interpretation for any Particular Combination of P & Qs

a. The maximum amount of a G or S offered for sale at a specific P
b. The minimum P necessary to induce producers to offer a given Q for sale
Shifts in Supply
- Occurs only when one of the five determinants of supply changes value
Illustration from table 2.6
Ex. Input P = $60
Qs = 100 + 20P – 10(60) + 20(25)
Qs = 20P [new supply function]
Ex. Nu. Of firms = 10
Qs = 100 + 20P – 10(100) + 20(10)
Qs = -700 + 20P
2.3 Market Equilibrium
- The interaction of buyers and sellers in the market
- A situation in which, at the prevailing price, consumers can buy all of a good
they want and producers can sell all the good they wish
- P level – Qd = Qs
Excess supply/surplus - exists when the Qs exceeds the Qd [table 2.9]
$60: above – surplus below – shortage
Note: excess demand & excess supply equal zero only in equilibrium
- Clearing of the market – equilibrium P is also called market clearing price
Illustration:
D equation: Qd = 1,400 – 10P S equation: Qs = -400 + 20P
Equilibrium: Qd = Qs
1,400 – 10P = -400 + 20P
To solve for PE: 1800 = 30P
Equilibrium P: $60
Qd= 1,400 – 10(60) Qs = -400 + 20(60)
= 800 = 800
P: $80
Qd= 1,400 – 10(80) Qs = -400 + 20(80)
= 600 = 1,200
Measuring he Value of Market Exchange

Economic Value
- The maximum amount a buyer is willing to pay for the unit which is measured by
the demand price for the unit of the good?
Ex. Value of the property is only as high as some buyer in the market is willing and
able to pay regardless of how much the current owner paid for the home or how
much was spent for the improvement
Economic value = demand P for the unit
= maximum amount buyers are willing to pay
Consumer Surplus
- The difference between the economic value of a good [demand price] and the price
[market price] of the good is the net gain to the consumer
Ex. $2,000 – how much you’re willing to pay for a 40-yeard line NFL season ticket
$1,200 – purchase price
------------
$800 consumer surplus
Fig. 2.6 p65

Producer Surplus
- For each unit supplied, the difference between the market price received and the
minimum price producers would accept to supply the unit
Social Surplus
- The sum of consumer surplus and producer surplus generated at that specific
level of output
- The net gain to society as a whole from any specific level of output
2.5 Changes in Market Equilibrium
Note:
Variables held constant when deriving demand and supply curves change;
Result: D and S shift, equilibrium price & quantity change
managers make forecasts using D and S
Qualitative forecast
- Predicts only the direction in which an economic variable ]price or quantity]
will move
Quantitative forecast
- Predicts both the direction and magnitude of the change in an economic
variable
Ex. Congress is considering a tax cut, D&S analysis enables you to forecast
whether the price or sales of a particular product will increase or decrease
Forecast: price will rise and sales will fall - qualitative forecast
with sufficient data on the exact nature of D & S, you could predict that P
will rise by $1.10 and sales will fall by 7,000 units - quantitative forecast
Task: predicting the effect on MP of changes in the variables that determine
the position of D&S curves

Changes in Demand [Supply Constant]

Illustration: figure 2.7
Principle:when D increases and S is constant, Pe and Qe both rise
when D decreases and S constant, Pe and Qe both fall
Changes in Supply [Demand Constant]
Illustration: figure 2.8
Principle:when S increases and D is constant, Pe falls and Qe rises
when S decreases and D is constant, Pe rises and Qe falls
Note: changes in D & S holding the other constant, effect on equilibrium price
and quantity can be predicted

Simultaneous Shifts in Demand and Supply

Note: both D and S shift, it is possible to predict either the direction in which price
changes or the direction in which quantity changes
Indeterminate - the term for the change in the variable when it is not possible
to predict the direction of change in a variable [equilibrium P or Q]
Fig. 2.9
Both D & S increase
Principle: a small increase in supply relative to D causes P to rise while large
increase in S relative to D causes P to fall
Both D & S shift together
Principle:
a. Change in Q can be predicted & the change in P is indeterminate
b. Change in Q is indeterminate & the change in P can be predicted
Fi. 2.10
Predicting the Direction of Changes in Airfares: A Qualitative Analysis
News: two events that will affect the airline industry in 2017:
a. A number of new, small airlines have recently entered the industry and others are
expected to enter next year
b. Broadband internet videoconferencing is becoming a popular, cost-effective
alternative to business travel for many UC corporations. The trend is expected to
accelerate next year as telecommunications firms begin cutting prices on
teleconferencing rates
Fig. 2.11

Qualitative: videoconferencing & air travel are substitutes

Analysis Dec in D with the increase in S leads you to predict a fall in airfares
but you cannot predict whether Qe will rise or fall
change in Q is indeterminate
Advertising and the Price of Milk: A Quantitative Analysis

American Dairy Association estimates next year’s D&S functions for milk in the US: Qd=
410 - 25P
Qs = -40 + 20P
Q - Measured in billion pounds of milk per year
P - wholesale P measured in $ per hundred pounds of milk
1st – predict the P & Q of milk next year
Pe:Qd= Qs
410 – 25P = -40 + 20P
450 = 45P
10 = P [constant] - the predicted Pe of milk next year is $10 per hundred pounds
Predicted equilibrium output of milk is determined by substituting the market P
into either the D and S function to get Q
Qd = Qs = Q [constant]
410 – [25 x 10] = -40 + [20 x 10] = 160
Thus: output equilibrium is 160B pounds next year
Promotion: inform consumers of its nutritional benefits
MT#3 Marginal Analysis for Optimal Decisions

Concepts and Terminology:

Optimal decisions: managers analyze benefits and costs
Objective function:
Manager: usually profit which is to be maximized
Consumer: maximize satisfaction derived from consumption of goods
Maximization problem: an optimization problem that involves maximizing the
objective function
Minimization problem: an optimization problem that involves minimizing the
objective function
RULE:
objective function measures a benefit - the decision-maker seeks to maximize
this benefit: solving a maximization problem
objective function measures a cost - the decision-maker seeks to minimize
the this cost: solving a minimization problem

Value of the objective function: determined by one or more activities or choice

variables
Ex. Value of profits depends on the no. of units produced and sold
production of the units - activity
Activities or choice variables
- variables that determine the value of the objective function
Ex. The value of profit depends on the number of units of output produced and
sold
- Production of units of the good – the activity that determines the value of the
objective function [profit]
Decision-maker: controls the value of the objective function by choosing the
levels of the activities or choice variables [vary either:]
a. Discrete choice variables
- a choice variable that can take only specific integer values
Ex.1,2,3, … or 10, 20, 30
- Arise when benefit and cost data are presented in tables
b. Continuous choice variable
- Can take on any value between two end points
Ex. Vary between 0 and 10 - may take one of the values on the value of 2.3,
4.5, 7.39, 8.9 or any one of the infinite number of values between the two
limits
presented graphically but are sometimes shown by equations

Marginal Analysis
- Analytical technique for solving optimization problems that involves changing
values of choice variables by small amounts to see if the objectives function can
be further improved [maximization problems] or further decreased
[ minimization problems]
Unconstrained Maximization
[considered only one activity or choice variable to influence net benefit]
DM - choose the level of activity to obtain the maximum net benefit
Net Benefit [NB]:
- associated with a specific amount of activity [A]
- the difference between total [TB] and total cost [TC] for the activity
Objective Function: NB = TB – TC
amount of activity A: represents the choice variable [continuous
variable]
- choose any level of activity they wish from zero to infinity, either
discreet or continuous units
Optimal Level of Activity
Total Benefit and Total Cost Curves
Fig 3.1
Optimal level of activity
- The level of activity that maximizes net benefit
- With an asterisk*

Two observations about A* in Unconstrained Maximization Problems:

1. The optimal level of activity does not generally result in maximization of
total benefits; occurs at a point where revenues are not maximized
2. The optimal level of activity does not result in minimization of total cost
Total benefit – total cost = net benefit curve
Graphical derivation of net benefit: define & describe the optimal level of
activity; it does not explain why net befit rises, falls, reaches its peak
Alternative:marginal Analysis
- Focuses only on the changes in total benefits and total costs
- Explains the forces causing the net benefit to change
- Does not consider irrelevant information: fixed costs, sunk costs, average
costs in the decision-making process
- Uses information only about the benefits and costs at the margin to
construct TB, TC, NB
- Ex in fig. 3.1,info about benefits and costs is only needed from 200 -351 units
if the DM is at 199 units of level of activity
Marginal Benefit and Marginal Cost

Marginal benefit [MB]

- The change in total benefit caused by an incremental change in the level of
activity
MB = change in total benefit/ change in activity = ΔTB/ΔA
Marginal cost
- The change in total cost caused by an incremental change in the level of an
activity
MC = change in total cost/change in activity = ΔTC/ ΔA
Principle:
marginal benefit [marginal cost] is the change in total benefit [total cost] per
unit change in the level of activity. The marginal benefit [marginal cost] of
a particular unit of activity can be measured by the slope of the line tangent
total benefit [total cost] curve at that point of activity
Finding Optimal Activity Levels with Marginal Analysis
Method of M.A.- involves comparing marginal benefit and marginal cost to
see if net benefit can be increased by making an incremental change in activity
level
Note: when MB > MC, it indicates the activity should be further increased –
continues until MB and MC are exactly equal at the peak of NB curve
Ref.: figure 3.2 p.96
Principle:
If, at a given level of activity, a small increase or decrease in activity causes net
benefit to increase then this level of the activity is not optimal. The activity must
then be increased [if MB exceeds MC] or decreased [if MC exceeds MB] to reach
the highest net benefit. The optimal level of the activity – the level that
maximizes net benefit [NB] – is attained when no further increases in net benefit
[NB] are possible for any changes in the activity which occurs at the activity level
for which marginal benefit [MB] equals marginal cost [MC]

Note: when decision-makers wish to maximize the net benefit [NB] from
several activities, the same principle applies: The firm maximizes the NB when
the MB from each activity equals the MC of that activity [equate simultaneously]
Ex. DM chooses the levels of two activities A and B to maximize net benefit
then values for A and B must satisfy two conditions at once: MB a = MCa and
MBb = MCb

Maximization with Discrete Choice Variables

DM: will not usually be able to adjust the level of activity to the point where
MB exactly equals MC
RULE: Optimal decisions: DM must increase activity until the last level of
activity is reached for which MB exceeds MC
Reference: table 3.2 p100
Principle [applied to table 3.2 analysis p.101] discrete choice of variables
When a decision maker faces an unconstrained maximization problem and must
choose among discrete levels of an activity, the activity should be increased if
MB > MC and decreased if MB < MC. The optimal level of activity is reached -
net benefit [NB] is maximized – when the level of activity is the last level or
which marginal benefit [MB] exceeds marginal cost [MC]

Note: this principle cannot be interpreted to mean “choose the activity level
where MB and MC are as close to equal as possible
Illustration: table 3.2 at four units of activity – MB $8 much closer to MC $9
than at the optimal level 3 – MB $10 & MC 5
Sunk Costs, Fixed Costs, Average Costs Are Irrelevant
[ should be ignored in finding the Optimal Level of Activity]
1. Sunk Costs
- costs that have previously been paid and cannot be recovered
2. Fixed Costs
- Costs that are constant and must be paid no matter what level of an activity is
chosen
Relevant Decision Variables [ not affected by the levels of sunk or fixed costs]
a. marginal cost
b. marginal revenue
Example of sunk cost: advertisement paid in full $2.0M @ $250k per 30-sec
spot
choose between 24th and 25th : $270K or $210k additional sales
respectively
discovered that the firm paid not $2M but $3M
Example of fixed cost: instead of paying one time the $2M –
sign a 30-month contract leasing the rights to use the TV ad for a
lease payment of $10K. This a fixed payment and must be paid no matter
how matter how many times the co. run the ad even if it chooses never to
run the ad
Question: do you need to call another meeting to recalculate the optimal
number of times to run the ad?
3. Average or unit cost
- Cost per unit of activity [ total cost / number of units of activity ]
- Decision makers should not be concerned about whether the decision will push
average cost up or down
Reason: the impact on net benefit of making an incremental change in activity
depends only on MB and MC
optimal decisions are made at the margin not on the average
Ex. Table 3.2
Principle:
DM wishing to maximize the NB of an activity should ignore any sunk costs, fixed
costs and average costs associated with the activity because none of these costs
affect the MC of the activity and so are irrelevant for making optimal decisions
Constrained Maximization

Concept for Solving Constrained Optimization Problems:

- Concept of MB per dollar spent on an activity
Marginal Benefit per Dollar Spent on an Activity:
“more value for your money”
- customers will get more for their money or more value for each dollar spent on the
product
- A particular activity yields the highest MB per dollar
Example
Mgr. for an expanding law firm; you need an extra copy machine in the office; current copier
is overworked;
three choices/brands:
A’s machine - $2,500 production - 500,000 copies
- MB is 500,000 [Mba = 500,000]
- Pa = 2,500
MBa/Pa = 500,000 copies / 2,500 dollars
= 200 copies / dollar
B’s machine
MBb / Pb= 600,000 copies / 4,000 dollars
= 150 copies / dollar
MBc / Pc = 580,000 copies / 2,600 dollars
= 223 copies / dollar
Constrained Maximization
- Manager must chose the levels of two or more activities to maximize a total benefit [objective ] function subject
to a constraint: budget [restricts the amount that can be spent]
Example
Two activities: cost to undertake
Activity A - $4
Activity B - $2
Constraint [budget] - $100 between activities A and B
Purpose: the combined TB from both activities is maximized
Choices: activity A - 20 units
activity B - 10 units
20A and 10B = [$4 x 20] + [$2 x 10] = $100
Suppose: marginal benefit - A40 ; B10= MB/Pa = 40/4 = 10 > 10/2 = 5
Meaning: spending an additional dollar on Activity A increases TB by 10 units
-do- Activity B increases TB by 5 units
Decision of manager:
- Can increase activity A by one unit and decrease activity by two units
Activity A - 21 units = B - 8 units
= [$4 x 21units] + [$2 x 8 units] = $100
Meaning: purchasing one more unit of A causes TB to rise by 40 units
decreasing two units of B causes TB to fall by 20 units
total combined benefits of A and B: rises by 20 units [ 40 – 20 = 20]
New combination of activities: A = 21 B = 8
Decision:continue to increase spending on activity A and reduce spending on
activity B as long as MBa/Pa exceeds MBb/Pb
- MB declines as activity increases
Principle:
To maximize TB subject to a constraint on the levels of activities, choose the level
of each activity so that the MB per dollar spent is equal for all activities

Optimal Advertising Expenditures: Example of Constrained Maximization

Ex.
Maximize the effectiveness [in total sales] of the firm’s weekly advertising
budget of $2,000; estimates of the impact on the retailer’s sales of varying levels
of advertising in the two different media.
Price of TV ad - $400 radio - $300
Objective: maximize the number of units sold
1 2 3 4 5
MBtv MBradio
Number of Ads MBtv Ptv MB radio Pradio
1 400 1.0 360 1.20
2 300 .75 270 .90
3 280 .70 240 .80
4 260 .65 225 .75
5 240 .60 150 .50
6 200 .50 120 .40
Decision: allocation of first ad – radio

decision MB/P Ranking of MB/P Cumulative

expenditures
Buy radio Ad 1 360/300 = 1.20 1 $300
Buy TV ad 1 400/400 = 1 2 700
Buy radio ad 2 270/300 = .90 3 1,000
Buy radio ad 3 240/300 = .80 4 1,300
Buy TV ad 2 300/400 = .75 1,700
Buy radio ad 4 225/300 = .75 5 [tie] 2,000

Decision: select two TV ads and four radio ad , sales is maximized subject to the
constraint that only $2,000 can be spent on advertising activity
Constrained Minimization

- Involve minimizing a total cost function [the objective function] subject to a constraint that
the levels of activities be chosen such that a given level of TB is achieved
Example:
Minimize the total cost of two activities A and B subject to the constraint that 3,000 units of
benefit are to be generated
Activity A - $5 per unit Activity B - $20 per unit
Current use: 100 units of activity A 60 units of activity B TB = 3,000
MB of the last unit of Activity A – 30
MB ---- Activity B – 60
MBa/Pa = 30/ 5 = 6 > 3 = 60/20 = MBb/Pb
Note: MB per dollar spent on activity A exceeds the MB spent on activity B; activity A gives
more money
To take advantage of Activity A:
Reduce activity B by one unit causing TB to fall by 60 units and reducing cost by $20
Increase activity A by two units with a MB of 30 each; TC to rise by $10
Result: reduces TC by $10 [ $20 - $10] without reducing TB
Note: As long as MBa/Pa > MBb/Pb the manager will continue to increase activity A and
decrease activity B at the rate that holds TB constant until
MBa/ Pa = MBb/Pb
if there are more than two activities in the objective function, the condition is expanded to
require that the MB / $ spent be equal for all activities

Principle:
To minimize TC subject to a constraint on the levels of activities, choose the level of each
activity so that the MB per dollar spent is equal for all activities
#5 Theory of Consumer Behavior

Basic Assumptions of Consumer Theory

Premise: all individuals make consumption decisions while maximizing their total
satisfaction from consuming various G&S subject to the constraint that their
spending on goods exactly equals their incomes
Model of consumer theory: explain how consumers make their purchasing
decisions when they are
 completely informed about all things
 Know the full range of P&S available
 The capacity of each product to provide utility
 Know the P of each good & their incmes
Properties of consumer Preferences

Consumption bundle:
A particular combination of specific quantities of G&S
Ref. Figure 5.1 p.161
Complete preference ordering:
- For any given pair of consumption bundles, consumers must be able to rank the
bundles acc. To the level of satisfaction they would enjoy from consuming the
bundles
Possible Responses: for consumers confronted with bundles A and B
1 prefer bundle A to bundle B [denoted as A>B]
I prefer bundle B to bundle A [ B>A]
I am indifferent between bundles A and B [the same level of satisfaction]
Transitive preference ordering
- Consumers are consistent in the following way:
If bundle A is preferred to bundle B and bundle B is preferred to bundle C then
bundle A must be preferred to bundle C
A > B, B > C then A > C

Why transitivity is necessary?

Case: a Walmart shopper can purchase any one of three bundles of goods, A, B
or C each of which costs exactly the same amount. Suppose the consumer’s
preferences violate the transitivity: A > B, B > C, C > A
- The consumer will never be able to make up his mind which he prefers
Assumptions for Consumer Theory:
a. Completeness and transitivity
b. Consumers always prefer to have more of a good rather than less of the good

The Utility Function

Utility: benefits consumers obtain from the goods and services they consume
Utility function: an equation that shows an individual’s perception of the level of
utility that would be attained from consuming each conceivable bundle of goods
U = f (X, Y)
X and Y - amount of goods X and Y consumed
F - a function of , depends on
U - the amount of utility the person receives from each combination X & Y
- utility depends on the quantities consumed of X and Y
- Numbers assigned to the levels of utility are arbitrary
Example:
Preferred combination: 20X and 30Y to 15X and 32Y meaning:
U = f (20,30) > U = f (15,32)

Indifference Curves
- A set of points representing different combinations of G&S each of which
provides an individual with the same level of utility
- Downward sloping: consumer obtains utility from both goods, when more X is
added, some Y is deducted to maintain the same level of utility
- Are convex: a convex shape means that as consumption of X is increased
relative to consumption of Y, the consumer is willing to accept a smaller
reduction in Y for an equal increase in X to stay at the same level of utility
Marginal Rate of Substitution

- Measures the number of units of Y that must be given up per unit of X added
to maintain a constant level of utility
- Consumer is indifferent between combinations: points A to B
ΔY 60 – 40 20
--- = ---------- = - ----- = - 2
ΔX 10 – 20 10
- MRS is 2 meaning: the consumer is willing to give up two units of Y for each
unit of X added.
For the movement from C to D, MRS is:
(20 - 15) 5 1
= - ---------------- = --------- = ----
(40 - 50) 10 2
Meaning: the consumer is willing to give up only ½ unit of Y per additional unit
of X added
- MRS diminishes along an indifference curve
Rule: when consumers have a small amount of X relative to Y, they are willing
to give up a lot of Y to gain another unit of X
when they have less Y relative to X they are willing to give up less Y to gain
another unit of X
Marginal Utility Interpretation of MRS

Marginal Utility
- The addition to total utility that is attributable to consuming one more unit of
a good holding constant the amounts of all other goods consumed
MU = ΔU / ΔX X – qty. of the good
Assumption: as the assumption of a good increases, the MU from an
additional unit of the good diminishes
Note: the change in TU that results when both X and Y change by small amounts
is related to the MU of X and Y
ΔU = (MUx X ΔX) + (MUy X ΔY)
Example:
Increase of consumption X by two units ( Δ = 2)
Decrease of consumption Y by one unit ( Δ = -1 )
MU of X is 25 for each additional unit of X; MU of Y is 10
ΔU= (25 x 2 ) + (10 x -1) = 40
Meaning:consuming 2 more X and 1 less Y causes TU to rise by 40 units

Consumer’s Budget Constraint

- Are constrained as to what bundles of goods they can purchase based on
market determined prices of the goods and on their incomes
Budget Lines
Problem: how to spend the limited income in a way that gives the maximum
possible utility
Graphical illustration: figure 5.6 p.170-171
sample data:
Fixed income - $1,000 maximum amount of two goods in a given period
price of X - $5 per unit X = ($5 x X)
price of Y - $10 per unit Y = ($10 x Y)
= $1,000
$5X + $10Y = $1,000
Solve Y in terms of X: Y= $1,000/$10 - $5/$10X = 100 – 1/2X
ex. C - 40X and 80Y = ( 80 x $10) + (40 x $5) = $1,000
D - 120X and 40Y = (40 x $10) + ( 120 x $5) = $1,000

Slope of the budget line: - ½ (= ΔY/ ΔX )

- indicates the amount of Y that must be given up if one
more unit of X is purchased
Illustration: bundle D to bundle E
Note: the rate at which the consumer can trade-off Y for one more unit of X
is----- to the price of good X ($5) divided by the price of good Y ($10)
slope of the BL = -Px/Py [prices] = -1/2 = -$5/$10
Relation between Income [M] and the amount of goods X and Y
M = PxX + PyY

Utility Maximization
Indifference Map
- shows the preference ordering of all conceivable bundles of goods

Maximizing Utility Subject to a Limited Income

Illustration: Johnson is an overworked, underpaid management trainee.
Johnson’s monthly food budget is $400 which because she works such long
hours, is spent on pizzas and burgers. The P of a pizza is $8 and a burger is $4.
Johnson’s task is to determine the combination of pizzas and burgers yields the
highest level of utility possible from the $400 food budget at the given prices
Ref. Fig. 5.8 p.174

Indifference curves I thru IV - represent a portion of Johnson’s Indifference map

between pizzas (vertical axis) and burgers [horizontal axis]
Absolute value of the budget line: Pburgers/Ppizza = $4/$8 = ½
meaning: it indicates that to consume one additional $4 burger,
Johnson must give up half of an $8 pizza;
to consume one more $8pizza, give up $4 burger
#6 Elasticity and Demand

Note: When managers lower price to attract more buyers, revenues may either rise
or fall
Determinant: how responsive consumers are to a price
Managers: need to know how a price decrease or increase is going to affect the
quantity sold and revenues;
- useful for price-setting firms
- useful for price-taking firms [in competitive markets] – prices are
determined by the intersection of demand and supply
- knowledge of price elasticity of demand predicts the effect of changes in
market price on total industry sales and total consumer expenditures in the industry
Price Elasticity of Demand
- The percentage change in quantity demanded divided by the percentage
change in price
- E is always negative: price and quantity are inversely related
E = % ΔQ / % ΔP
- Calculated for movements along a given demand curve
- E>1 elastic demand
- E< 1 inelastic demand
- E=1 unitary elastic
Predicting the Percentage Change in Quantity Demanded

Price elasticity: -2.5 [ a certain product]

Decision: A. manager is considering decreasing the P by 8 percent
-2.5 = % Δ Q / -8%
% ΔQ = -2.5 X -8%= +20% [increase in sales if P is decreased by 8%]
B. Industry or market-level changes: an increase in industry supply is
expected to cause market price to fall by 8%; price elasticity of industry demand
is -2.5
% Δ = -2.5 x -8% = +20% [increase in industry output is 20%]
Predicting the Percentage Change in Price

Manager: A. wants to stimulate sales by 15 percent; up to what decrease in price

should be implemented to achieve the goal
Elasticity:-.5
-0.5 = +15% / %Δ P
% Δ P = 15% /-0.5 = -30% [ must lower price by 30% to increase sales by 15% ]
B. An increase in industry supply is expected to cause market output to rise by 15%;
Elasticity of industry demand is equal to -0.5
% Δ P = 15% / -0.5 = -30% [ market price is predicted to fall by 30%]
Application: How does a change in the P of the firm’s product affect the total revenue
received
Price Elasticity and Total Revenue
Concern of: how TR changes when there is a movement along the demand
curve
a. Firm managers
b. Industry analysts
c. Government policymakers
d. Academic researchers
Total Revenue
- Total amount paid to producers
- Equals the total expenditure by consumers on the commodity
- Price of the commodity times quantity demanded [ TR= P x Q ]
Law of demand: inversely proportional – price and quantity
change in P & change in Q have opposite effects on TR
Two EFFECTS
1. Price Effect
- The effect on total revenue of changing price, holding output constant
Increase - total revenue increases if quantity sold remained constant
TR = P x Q
Decrease - total revenue decreases if quantity sold remained constant
Note: if there is a price change and quantity sold does not remain constant, it
moves in the opposite direction
to determine the direction of TR, elasticity of D tells which effect is dominant
2. Quantity Effect
- The effect on total revenue of changing output holding price constant
Increase - increase in quantity by itself [after a P fall] would increase total
revenue if the price of the product remained constant
Decrease - decrease in quantity by itself [after a price increase] would
decrease total revenue if the price of the product remained constant
Note: price and quantity effects always push total revenue in opposite
directions; moves in the direction of the stronger of the two
two effects equally strong – no change in total revenue
Demand is elastic: greater than 1 - % change in Q [in absolute value] is greater
than the % change in P [in absolute value]
quantity effect dominates the price effect
Note:
P rises - TR falls
P falls - TR rises
Demand is inelastic: less than 1% - % change in Q [in absolute value] is greater
than the % change in P [ in absolute value]
price effect dominates the quantity effect
P rises - TR rises
P falls - TR falls
Demand is unitary elastic: E is equal to 1
neither the price effect nor the quantity effect dominates
the two effects offset each other - price changes have no effect on
TR
Relation:
The effect of a change in price on total revenue [TR = P x Q] is determined by
the price elasticity of demand. When D is elastic [inelastic], the Q [P] effect
dominates. TR always moves in the same direction as the variable [P or Q]
having the dominant effect. When D is unitary elastic, neither effect dominates
and changes in P leave TR unchanged
 ELASTIC UNITARY ELASTIC INELASTIC
%ΔQ > %ΔP %ΔQ = %ΔP %ΔQ < %ΔP

Price rises TR falls No change in TR TR rises

Price Falls TR rises No change in TR TR falls
Changing Price at Borderline Video Emporium: A Numerical Example
Quantity Effect dominates:
Fig. 6.1 p.203 P per week
1st decision $18 - Sales 600 DVDs
$16 800
Conclusion: lowering the P results in an increase in the Q of DVD’s sale
point A: TR = $18 x 600 = $10,800
point B: TR = $16 x 800 = $12,800
2nd decision $9 1,500
$7 1,700
Factors Affecting Price Elasticity of Demand
1. Availability of Substitutes
- The better the substitutes for a given good or service, the more elastic the
demand for that G or S
Increase in P – reduce consumption– shift to close substitutes
- less responsive - few/poor substitutes
Example: goods that are elastic
- fruits, corporate jets, life insurance
Example: goods considered as inelastic
Corn, pepper, diesel fuel
2. Percentage of Consumer’s Budget
- Price elasticity is directly related to the percentage of consumers’ budgets
spent on the good
Ex. D for ref is more elastic than D for toasters - why?

3. Time Period of Adjustment

- The length of time period in measuring the price elasticity affects the
magnitude of price elasticity
Longer the time period of measurement – the larger the P.E. ; the result of
consumers’ having more time to adjust to the price change
Ex. Milk: producers of milk to raise prices by 15% - effected the next week
Calculating Price Elasticity of Demand

E = % change in Q / % change in P
- or multiply the slope of demand times the ratio of price divided by the
quantity
- can be measured:
a. Over an interval [or arc] along the demand
b. At a specific point on the demand curve
- measures the sensitivity of consumers to changes in the price of the
commodity
Computation of Elasticity over an Interval

Interval [or Arc] Elasticity - elasticity calculated over an interval of a D curve

[ linear or a curvilinear demand ]
E = ΔQ / ΔP X average P/ average Q
Refer to ex. Fig 6.1 p.203
E ab = +200/-2 X 17/700 = -2.43
Ecd = +200/-2 X 8/1600 = -.50

Relation: when calculating the price elasticity of demand over an interval of

demand, use the interval or arc elasticity formula [above]
Computation of Elasticity at a Point

Point Elasticity
- a measurement of demand elasticity calculated at a point on a demand curve
rather than over an interval
- more appropriate to use when the price change covers only a small interval
of demand
Refer to fig. 6.1 p.203
Ea = -100 X 18/600 = -3
Eb = -100 X 16/800 = -2
–Point
  Elasticity when Demand is Linear
- Consider a general linear demand function of three variables: price [P],
income [M], price of a related good [Pr]
Q = a + bP + cM + dPr
[ass.: income & P of related good take on specific values & held constant]
Q = a’ + bP
Where: a’ = a + c + d
- Price elasticity at a point on a linear demand curve can be calculated as:
E = b P/Q
Slope parameter b – measures the rate of change in quantity demanded per unit
change in P: b = ΔQ/ΔP
–  
Ex. Borderline fig. 6.1
P - $9 per CD [panel B] - equation for the direct demand function:
Q = 2,400 – 100P so b = -100
E = -100 = = -0.6
Alternative point elasticity formula:
E = P/ P-A
P = price at the point on demand where elasticity is to be measured
A = price –intercept of demand
Note: