Eco 26 Aug08

Economics Analysis for Managerial Applications -Taught By: Ms.Dimple, Assistant Professor FMS Department, NIFT Delhi

The Basic Decision-Making Units A firm is an organization that transforms resources (inputs) into products (outputs). Firms are the primary producing units in a market economy. An entrepreneur is a person who organizes, manages, and assumes the risks of a firm, taking a new idea or a new product and turning it into a successful business. Households are the consuming units in an economy.

The Circular Flow of Economic Activity The circular flow of economic activity shows the connections between firms and households in input and output markets.

Input Markets and Output Markets Output, or product, markets are the markets in which goods and services are exchanged. Input markets are the markets in which resources—labor, capital, and land—used to produce products, are exchanged. Payments flow in the opposite direction as the physical flow of resources, goods, and services (counterclockwise).

Input Markets Input markets include: The labor market , in which households supply work for wages to firms that demand labor. The capital market , in which households supply their savings, for interest or for claims to future profits, to firms that demand funds to buy capital goods. The land market , in which households supply land or other real property in exchange for rent.

Determinants of Household Demand The price of the product in question. The income available to the household. The household’s amount of accumulated wealth . The prices of related products available to the household. The household’s tastes and preferences . The household’s expectations about future income, wealth, and prices. A household’s decision about the quantity of a particular output to demand depends on:

Quantity Demanded Quantity demanded is the amount (number of units) of a product that a household would buy in a given time period if it could buy all it wanted at the current market price.

Demand in Output Markets A demand schedule is a table showing how much of a given product a household would be willing to buy at different prices. Demand curves are usually derived from demand schedules.

The Demand Curve The demand curve is a graph illustrating how much of a given product a household would be willing to buy at different prices. Rs

The Law of Demand The law of demand states that there is a negative, or inverse, relationship between price and the quantity of a good demanded and its price. This means that demand curves slope downward. Rs

Other Properties of Demand Curves Demand curves intersect the quantity ( X )-axis, as a result of time limitations and diminishing marginal utility. Demand curves intersect the ( Y )-axis, as a result of limited incomes and wealth.

Income and Wealth Income is the sum of all households wages, salaries, profits, interest payments, rents, and other forms of earnings in a given period of time. It is a flow measure. Wealth , or net worth , is the total value of what a household owns minus what it owes . It is a stock measure.

Related Goods and Services Normal Goods are goods for which demand goes up when income is higher and for which demand goes down when income is lower. Inferior Goods are goods for which demand falls when income rises.

Related Goods and Services Substitutes are goods that can serve as replacements for one another; when the price of one increases, demand for the other goes up. Perfect substitutes are identical products. Complements are goods that “go together”; a decrease in the price of one results in an increase in demand for the other, and vice versa.

Shift of Demand Versus Movement Along a Demand Curve A change in demand is not the same as a change in quantity demanded . In this example, a higher price causes lower quantity demanded . Changes in determinants of demand, other than price, cause a change in demand , or a shift of the entire demand curve, from D A to D B .

A Change in Demand Versus a Change in Quantity Demanded When demand shifts to the right, demand increases. This causes quantity demanded to be greater than it was prior to the shift, for each and every price level.

A Change in Demand Versus a Change in Quantity Demanded To summarize : Change in price of a good or service leads to Change in quantity demanded ( Movement along the curve ). Change in income, preferences, or prices of other goods or services leads to Change in demand ( Shift of curve ).

The Impact of a Change in Income Higher income decreases the demand for an inferior good Higher income increases the demand for a normal good

The Impact of a Change in the Price of Related Goods Price of hamburger rises Demand for complement good (ketchup) shifts left Demand for substitute good (chicken) shifts right Quantity of hamburger demanded falls

From Household to Market Demand Demand for a good or service can be defined for an individual household , or for a group of households that make up a market . Market demand is the sum of all the quantities of a good or service demanded per period by all the households buying in the market for that good or service.

From Household Demand to Market Demand Assuming there are only two households in the market, market demand is derived as follows:

Supply in Output Markets A supply schedule is a table showing how much of a product firms will supply at different prices. Quantity supplied represents the number of units of a product that a firm would be willing and able to offer for sale at a particular price during a given time period.

The Supply Curve and the Supply Schedule A supply curve is a graph illustrating how much of a product a firm will supply at different prices.

The Law of Supply The law of supply states that there is a positive relationship between price and quantity of a good supplied. This means that supply curves typically have a positive slope.

Determinants of Supply The price of the good or service. The cost of producing the good, which in turn depends on: The price of required inputs (labor, capital, and land), The technologies that can be used to produce the product, The prices of related products.

A Change in Supply Versus a Change in Quantity Supplied A change in supply is not the same as a change in quantity supplied . In this example, a higher price causes higher quantity supplied , and a move along the demand curve. In this example, changes in determinants of supply, other than price, cause an increase in supply , or a shift of the entire supply curve, from S A to S B .

A Change in Supply Versus a Change in Quantity Supplied When supply shifts to the right, supply increases. This causes quantity supplied to be greater than it was prior to the shift, for each and every price level.

A Change in Supply Versus a Change in Quantity Supplied To summarize : Change in price of a good or service leads to Change in quantity supplied ( Movement along the curve ). Change in costs, input prices, technology, or prices of related goods and services leads to Change in supply ( Shift of curve ).

From Individual Supply to Market Supply The supply of a good or service can be defined for an individual firm, or for a group of firms that make up a market or an industry. Market supply is the sum of all the quantities of a good or service supplied per period by all the firms selling in the market for that good or service.

Market Supply As with market demand, market supply is the horizontal summation of individual firms’ supply curves.

Market Equilibrium The operation of the market depends on the interaction between buyers and sellers. An equilibrium is the condition that exists when quantity supplied and quantity demanded are equal. At equilibrium, there is no tendency for the market price to change.

Market Equilibrium Only in equilibrium is quantity supplied equal to quantity demanded. At any price level other than P 0 , the wishes of buyers and sellers do not coincide.

Market Disequilibria Excess demand , or shortage, is the condition that exists when quantity demanded exceeds quantity supplied at the current price. When quantity demanded exceeds quantity supplied, price tends to rise until equilibrium is restored.

Market Disequilibria Excess supply , or surplus, is the condition that exists when quantity supplied exceeds quantity demanded at the current price. When quantity supplied exceeds quantity demanded, price tends to fall until equilibrium is restored.

Increases in Demand and Supply Higher demand leads to higher equilibrium price and higher equilibrium quantity. Higher supply leads to lower equilibrium price and higher equilibrium quantity.

Decreases in Demand and Supply Lower demand leads to lower price and lower quantity exchanged. Lower supply leads to higher price and lower quantity exchanged.

Relative Magnitudes of Change The relative magnitudes of change in supply and demand determine the outcome of market equilibrium.

Relative Magnitudes of Change When supply and demand both increase, quantity will increase, but price may go up or down.

Law of Demand Demand slopes downward according to the law of demand. The law is demand is caused in part by the substitution effect. The substitution effect of a price change, which occurs when a lower price on a good causes a person to buy more of that good instead of alternative goods. Likewise, the substitution effect of increasing the price of a good would drive consumers to buy more of the substitute good instead of the good with the increased price.

For a normal good , the income effect of a price change will also cause demand to slope down. The income effect occurs when the price change affects consumer purchasing power, termed real income , and thus leads to a change in quantity demanded. A higher price reduces real income, while a lower price increases real income. Law of Demand

UTILITY AND CONSUMER SATISFACTION Consumers buy in order to obtain utility , which is the satisfaction received from the consumption of a good. The utility that people gain from their purchases is subjective, varying from person to person. Utility is not measurable, since satisfaction is not measurable. Utility does not imply that a good is useful.

Total and Marginal Utility Although utility is not measurable, it can be modeled as though it were, using the util as its unit of measure. Total utility equals the sum of the utils a person receives from consuming a specific quantity of a good. Marginal utility equals the increments to total utility from changes in consumption.

Marginal Utility = Total and Marginal Utility Change in total utility_______ Change in number of units consumed

0 50 100 150 Utils First Slice Second Slice Pizza Marginal utility Total Utility Total and Marginal Utility

Diminishing Marginal Utility The law of diminishing marginal utility decrees that the first unit of a good is most satisfying, after which additional units provide progressively less and less additional utility. There is a satiation point , beyond which additional consumption actually reduces utility.

When marginal utility is negative we say that a good provides disutility, which occurs beyond the satiation point. The total utility curve rises as long as marginal utility is a positive number. When marginal utility equals zero, the total utility curve peaks because total utility is at its maximum value. The total utility curve turns downward when marginal utility becomes negative. Diminishing Marginal Utility

Total and Marginal Utility Utility Utility Satiation point Satiation point Marginal utility Total utility Total Utility is maximized when marginal utility is zero.

You are given a box of donuts to eat and are asked to record how much utility you receive from eating each one. It is likely that the marginal utility you receive: Increases with each additional donut you eat Stays constant with each additional donut you eat C) Decreases with each additional donut you eat

So wanna come with me for lunch? Q. Did you ever see an “eat as much as you want” restaurant? A. They live on disutility and on that you reach your satiation point before they lose money on you. Q. If you went to such a restaurant, did you have a stomachache later? Q. What does that mean?

MAXIMIZING UTILITY SUBJECT TO A BUDGET CONSTRAINT The budget constraint , a consumer’s income, curbs the amount of total utility that can be obtained. Consumers must choose, while striving to spend their incomes so as to obtain the greatest satisfaction from their incomes. Consumers maximize utility subject to their budget constraint. Utility maximization is achieved when the consumer’s choices provide the greatest amount of total utility for a specific amount of time.

Spending at the Margin When marginal utility is divided by the prices of goods and services, the result is called marginal utility per dollar. The rule of utility maximization is… To maximize utility, a consumer adjusts spending until the marginal utility from the last rupee spent on each good is the same.

Algebraic Statement of the Utility Maximizing Rule Marginal Utility of X Price of X Marginal Utility of Y Price of Y, = If the marginal utility per dollar of product X is greater than the marginal utility per rupee of product, consumers should purchase more of product X. Conversely, if the marginal per rupee of product Y is greater than the marginal utility of product Y, consumers should purchase more of product Y. for all goods X and Y

Utility Maximization and Demand When consumers maximize utility their individual demand curves for a good are downward sloping. In other words, the quantity demanded of a good will change in the opposite direction to a change in its price. The law of diminishing marginal utility is another explanation for the downward sloping demand curve.

Have you ever picked up an item in a store or taken a piece of clothing off a store’s rack and then looked at the price tag and decided it wasn’t worth it? YES B) NO

Maximizing Utility – Do We Want What We Choose? Consumers account for some 70% of total spending in the Indian economy. Predicting consumer’s choice is difficult as since they are determined by numerous considerations. Time has utility. People try to allocate their time to attain the greatest satisfaction, taking into account time’s opportunity cost.

Good Choice, Bad Choice Information also has utility. The last rupee spent on information should have a marginal utility per rupee equal to the marginal utility per rupee of the last rupee spent on the consumer’s other purchases. Impulse buyers make purchases on the spur of the moment without consulting information sources. Advertising is intended to affect consumer’s choices, generally with the goal of getting us to buy something now. A rupee saved can provide more satisfaction than a rupee spent.

Addictive Behavior Some people make choices that appear to be bad to others. Binging behavior like overeating, smoking, binging on alcohol, drugs, shopping, etc., are examples. One aspect of addiction problems is that we are unable to rationally control the things that give us utility. A second aspect is “utility in hindsight”, where immediate gratification comes now, but the disutility comes later. The further into the future the disutility, the more we are inclined to brush it aside.

Addictive Behavior: Utility in Hindsight Utility Disutility Quantity of binge purchases Marginal utility perceived at the time Marginal utility perceived later Point where all money has been spent

Terms Along the Way substitution effect income effect Utility util total utility marginal utility disutility law of diminishing marginal utility satiation point marginal utility per rupee substitution effect income effect utility util total utility marginal utility disutility

Test Yourself When the price of a normal good decreases the income and substitute effects both prompt the consumer to purchase more of the good. the income and substitute effects both prompt the consumer to purchase less of the good. the income effect prompts the consumer to purchase less of the good, but the substitution effect prompts the consumer to purchase more. the income effect prompts the consumer to purchase more of the good, but the substitution effect prompts the consumer to purchase less.

Test Yourself 2. Which of the following best describes the concept of utility? Utility is measurable. The utility of a good must rise the more useful it is. Utility is subjective. The utility provided by any particular good will be the same for most consumers.

Test Yourself 3. The util is unrelated to the concept of utility. measurable with highly sensitive electronic equipment. used by economist to to illustrate diminishing marginal utility . a special kind of money used in economic experiments.

Test Yourself 4. Marginal utility will be negative when the total utility curve is rising. falling. at its maximum. in the negative range.

Test Yourself 5. Consumer equilibrium requires the consumer to maximize total utility. maximize marginal utility. purchase amounts of each good so that their marginal utilities are equal. ignore the price of a good in deciding how much to consume and consider only the utility of a purchase. 5. Consumer equilibrium requires the consumer to maximize total utility. maximize marginal utility. purchase amounts of each good so that their marginal utilities are equal. ignore the price of a good in deciding how much to consume and consider only the utility of a purchase.

Test Yourself 6. The marginal utility per rupee of a good equals the goods marginal utility multiplied by Rs.1. divided by Rs.1. divided by the price of the good. multiplied by the price of the good.

What is forecasting? Forecasts translate business plans and decisions into actions: Forecasts are needed in every step of the supply chain (e.g. for controlling purchasing, production and inventory) Plans can be definite, but forecasting always involves an element of uncertainty Market view Plans and decisions Forecast Actions

Forecasting-related challenges Producing the forecast Creating an accurate and timely forecast Using the forecast Managing forecast uncertainty

Eco 26 Aug08

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Eco 26 Aug08