Chap 1, 2, 3

Chapters
• Chapter No. 1 Introduction to
Managerial Economics
• Chapter No. 2 Basic
Training/Economic
Optimization
• Chapter No. 3 Demand Theory and
Analysis
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Javaid Dars (MBA, M.Phil) 1

• Reviewed & Compiled by Javaid Dars from the
publications of Mark Hirschey and H. Craig Petersen
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Introduction
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Introduction of the subject
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4Javaid Dars (MBA, M.Phil)

What is Economics?
• A social science that studies choice with
scarcity of resources.
• Economics = Oikos + Nomos (Law of
Households)
• Microeconomics:
1. Theory of Individual/Market Demand
2. Theory of Production and Cost
3. Theory of Markets and Price
4. Theory of Profit.
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What is Economics?
• Macroeconomics:
Theory of total output and employment.
General Price level.
Theory of Inflation
Theory of trade cycles
Economic Growth
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Economics v. Managerial
Economics
• Comprehensive and
wider scope.
• Micro and Macro in
approach.
• Normative and
Positive Science.
• Formulation of
Theories and
Principles.
• Narrow and limited
scope.
• Essentially Micro in
approach.
• Normative Science.
• Application of
Theories and
Principles.
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Overview of Course outline
1. Objectives of Firm
2. Theories of Profit
3. Demand Analysis and Forecasting
4. Production and Cost Analysis
5. Pricing Decision.
6. Profit Management
7. Capital Management
8. Market Structure
9. Inflation and Economic Conditions
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What is Managerial Economics?What is Managerial Economics?
• Managerial economics is concerned with the applicationManagerial economics is concerned with the application
of economic concepts and economics tools andof economic concepts and economics tools and
techniques to the problems of formulating rationaltechniques to the problems of formulating rational
decision making – (decision making – (Mansfield)Mansfield)
• Managerial economics applies the principals andManagerial economics applies the principals and
methods of economics to analyze problems faced by themethods of economics to analyze problems faced by the
management of a business, or other types ofmanagement of a business, or other types of
organizations and to help and to help find solutions thatorganizations and to help and to help find solutions that
advance the best interests of such organizations –advance the best interests of such organizations –
((Davis & Chang)Davis & Chang)
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Why do business manager need toWhy do business manager need to
know economics?know economics?
Business decisions are taken under uncertainty and riskBusiness decisions are taken under uncertainty and risk
which arises due to following aspects:which arises due to following aspects:
1.1. Behavior of market forcesBehavior of market forces
2.2. Changing business environmentChanging business environment
3.3. Emergence of competitors with highly competitiveEmergence of competitors with highly competitive
productsproducts
4.4. Government PolicyGovernment Policy
5.5. External influence on domestic on domestic marketExternal influence on domestic on domestic market
6.6. Social and political changesSocial and political changes
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Areas of decision makingAreas of decision making
• Production related issuesProduction related issues
• Sale prospects and problemsSale prospects and problems
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Production related issuesProduction related issues
1.1. Available techniques of productionAvailable techniques of production
2.2. Cost of production associated with each productionCost of production associated with each production
techniquetechnique
3.3. Supply position of inputs required to produce theSupply position of inputs required to produce the
planned commodityplanned commodity
4.4. Price structure of InputsPrice structure of Inputs
5.5. Cost structure of competitive productsCost structure of competitive products
6.6. Availability of foreign exchange if inputs are tp beAvailability of foreign exchange if inputs are tp be
importedimported
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Sale Prospects and problemsSale Prospects and problems
1.1. General market trendsGeneral market trends
2.2. Trends in the industry to which the planned productsTrends in the industry to which the planned products
belongbelong
3.3. Major existing and potential competitors and theirMajor existing and potential competitors and their
respective market sharesrespective market shares
4.4. Prices of competing productsPrices of competing products
5.5. Pricing strategy of the prospective competitorsPricing strategy of the prospective competitors
6.6. Market structure and degree of competitionMarket structure and degree of competition
7.7. Supply position of complimentary goodsSupply position of complimentary goods
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The Nature and Scope
of Managerial Economics
Chapter No. 1
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Theory of the Firm
1. Firm combines and organizes resources for
the purpose of producing goods and/or
services for sale.
2. Internalizes transactions, reducing
transactions costs/time.
3. Resource owners use the income generated
from the sale of their services/resources, to
purchase goods and services produced by
firms. Circular flow of economic activity is
thus completed.
4. Primary goal is to maximize the wealth or
value of the firm.
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Value of the Firm
1 2
1 2
1(1 ) (1 ) (1 ) (1 )
n
n t
n t
t
PV
r r r r
π ππ π
=
= + + + =
+ + + +
∑L
1 1(1 ) (1 )
n n
t t t
t t
t t
TR TC
Valueof Firm
r r
π
= =
−
= =
+ +
∑ ∑
•Managerial economics, begins by postulating a theory
of the firm, which is then used to analyse managerial
decision making. The theory of the firm is based on the
assumption that the goal of the firm is to maximise
profit. However, firms are observed to sacrifice short-
term profits for long term profits. Hence, its is
appropriate to postulate that the objective of the firm
is to maximise the wealth of value of the firm.
• The value of the firm is, present value of all expected future
profits:
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Alternative Theories of the firm
• Sales maximization(William Baumol)
– Adequate rate of profit to satisfy share holders; assuming
this, maximise sales, even by sacrificing some profits.
• Management utility maximization (Oliver Williamson)
– Principle-agent problem: managers try to maximise
their benefits like salaries, fringe benefits, stock options,
staff size, lavish offices, etc. This can be resolved by
linking managers’ rewards to firm’s performance
compared to similar firms in the industry.
• Satisficing behavior( not maximising) with reference
sales, profits, growth, mkt.. Share etc.
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Different Concepts of Profit
• Business Profit: Total revenue minus the
explicit or accounting costs of production.
• Economic Profit: Total revenue minus the
explicit and implicit costs of production.
• Opportunity Cost: Implicit value of a
resource in its best alternative use.
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Theories of Profit
• Frictional Theory of Economic Profits:
Abnormal profits observed following unanticipated
changes in demand or cost conditions.
• Monopoly Theory of Economic Profits:
Above normal profits caused by barriers to entry that limit
competition.
• Innovation Profit Theory:
Above normal profits that follow successful invention or
modernization.
• Compensatory Profit Theory:
Above normal rates of return that reward efficiency.
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Function of Profit
• Profit is a measurement that guides the
allocation of society’s resources.
• High profits in an industry are a
measurement that buyers want more of
what the industry produces.
• Low (or negative) profits in an industry
are a measurement that buyers want
less of what the industry produces.
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The Changing Environment of
• Globalization of Economic Activity
– Goods and Services
– Capital
– Technology
– Skilled Labor
• Technological Change
– Telecommunications Advances
– The Internet and the World Wide Web
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Economic Optimization
Chapter No. 2
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Chapter 2
OVERVIEW
• Economic Optimization Process
• Expressing Economic Relations
• Marginals as the Derivatives of Functions
• Marginal Analysis in Decision Making
• Incremental Concept in Economic
Analysis
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Chapter 2
KEY CONCEPTS
• optimal decision
• table
• spreadsheet
• graph
• equation
• dependent variable
• independent variable
• marginal
• marginal revenue
• marginal cost
• marginal profit
• derivative
• inflection point
• second derivative
• profit maximization
• breakeven point
• revenue maximization
• average cost
minimization
• multivariate optimization
• constrained optimization
• Lagrangian technique
• Lagrangian multiplier, λ
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Economic Optimization Process
• Optimal Decisions
– Best decision helps achieve objectives most
efficiently.
• Maximizing the Value of the Firm
– Value maximization requires serving
customers efficiently.
• What do customers want?
• How can customers best be served?
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Expressing Economic Relations
• Tables and Equations
– Simple graphs and tables are useful.
– Complex relations require equations.
• Total, Average, and Marginal Relations
– Total increases when marginal is positive.
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Revenue per time period ($)
$9 8 7 6 5 4
3 Total revenue = $1.50 ´ output 2 1
0 1 2 3 4 5 6 7 8 9 Output
per time period (units)
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Maximization occurs when marginal
switches from positive to negative.
• If marginal is above average, average is
rising.
• If marginal is below average, average is
falling.
• Graphing Total, Marginal, and Average
Relations
– Deriving Totals from Marginal and Average
Curves
– Total is sum of marginals.
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Marginals as the Derivatives of
Functions
• Concept of a Derivative
– Derivative is a marginal relation.
• Derivatives and Slope
– Derivative of total revenue is marginal
revenue.
– Derivative of total cost is marginal cost.
– Derivative of total profit is marginal profit.
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Marginal Analysis in Decision
Making
• Finding Maximums or Minimums
– Maximum and minimum points occur where marginal
is zero.
• Distinguishing Maximums from Minimums
– Maximum is where first derivative is zero, second
derivative is negative.
– Minimum is where first derivative is zero, second
derivative is positive.
• Maximizing the Difference Between Two
Functions
– Maximum profit requires MR = MC.
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Incremental Concept in Economic
Analysis
• Marginal v. Incremental Concept
– Marginal relates to one unit of output.
– Incremental relates to one managerial
decision.
• Multiple units of output is possible.
• Incremental Profits
– Profits tied to a managerial decision.
• Incremental Concept Example
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Concept of the Derivative
•The derivative of Y with respect to X
is equal to the limit of the ratio ∆Y/∆X
as ∆X approaches zero.
0
lim
X
dY Y
dX X∆ →
∆
=
∆
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Rules of Differentiation
1. Constant Function Rule: The
derivative of a constant, Y = f(X) = a,
is zero for all values of a (the
constant).
( )Y f X a= =
0
dY
dX
=
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2. Power Function Rule: The
derivative of a power function,
where a and b are constants, is
defined as follows.
( ) b
Y f X aX= =
1bdY
b aX
dX
−
= ⋅
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3. Sum-and-Differences Rule: The
derivative of the sum or difference of
two functions U and V, is defined as
follows.
( )U g X= ( )V h X=
dY dU dV
dX dX dX
= ±
Y U V= ±
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4. Product Rule: The derivative of
the product of two functions U and
V, is defined as follows.
( )U g X= ( )V h X=
dY dV dU
U V
dX dX dX
= +
Y U V= ⋅
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5. Quotient Rule: The derivative of
the ratio of two functions U and V,
is defined as follows.
( )U g X= ( )V h X=
U
Y
V
=
( ) ( )
2
dU dVV UdY dX dX
dX V
−
=
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6. Chain Rule: The derivative of a function
that is a function of X is defined as
follows.
( )U g X=( )Y f U=
dY dY dU
dX dU dX
= ⋅
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Optimization With Calculus
Find X such that dY/dX = 0
•Second derivative rules:
1.If d2
Y/dX2
> 0, then X is a
minimum.
2.If d2
Y/dX2
< 0, then X is a
maximum.
> In Cost functions, we attempt to find the minimum value.
> In Profit functions, we attempt to find the maximum value.
> Hence the objective is to minimize costs and maximize
profits or optimize profit.
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Demand and Supply
Chapter 3
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Chapter 3
OVERVIEW
• Basis for Demand
• Market Demand Function
• Demand Curve
• Basis For Supply
• Market Supply Function
• Supply Curve
• Market Equilibrium
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Chapter 3
KEY CONCEPTS
• demand
• direct demand
• utility
• derived demand
• demand function
• demand curve
• change in the quantity
demanded
• shift in demand
• Supply
• supply function
• supply curve
• change in the quantity
supplied
• shift in supply
• equilibrium
• market equilibrium price
• surplus
• shortage
• comparative statics
analysis
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Basis for Demand
• Direct Demand
– Demand is the quantity customers are willing
to buy under current market conditions.
– Direct demand is demand for consumption.
• Derived Demand
– Derived demand is input demand.
– Firms demand inputs that can be profitably
employed.
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Individual Consumer’s Demand
QdX = f(PX, I, PY, T)
1. QdX = Quantity demanded of commodity X
by an individual per time period
2. PX = Price per unit of commodity X
3. I =Consumer’s income
4. PY = Price of related (substitute or
complementary) commodity
5. T = Tastes of the consumer
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Individual Consumer’s Demand
∆QdX/∆PX < 0
____________
1.∆QdX/∆I > 0 if a good is normal
2.∆QdX/∆I < 0 if a good is inferior
3.∆QdX/∆PY > 0 if X and Y are substitutes
4.∆QdX/∆PY < 0 if X and Y are
complementsManagerial Economics
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Market Demand Function
• Determinants of Demand
– Demand is determined by price, prices of
other goods, income, and so on.
• Industry Demand Versus Firm Demand
– Industry demand is subject to general
economic conditions.
– Firm demand is determined by economic
conditions and competition.
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Market Demand Function
QDX = f(PX, N, I, PY, T)
1. QDX = Quantity demanded of commodity X
2. PX = Price per unit of commodity X
3. N = Number of consumers on the market
4. I = Consumer income
5. PY= Price of related (substitute or
complementary) commodity
6. T = Consumer tastes
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Demand Curve
• Demand Curve Determination
– Demand curve shows price and quantity
relation holding everything else constant.
• Change in Quantity Demanded
– Quantity demanded falls if price rises.
– Quantity demanded rises if price falls.
• Role of Non-Price Variables
– Change in non-price variables will define a
new demand curve.
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Relation Between the Demand
Curve and Demand Function
• Movements Along Demand Curve
– A rise in price causes upward movement
along a given demand curve.
– A price decline causes downward movement
along a given demand curve.
• Demand Curve Shifts
– Demand increases if a non-price change
allows more to be sold at every price.
– Demand decreases if a non-price change
causes less to be sold at every price.
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Basis For Supply
• Firms Offer Supply To Make Profits
– When prices rise, firms boost the quantity
supplied.
– When prices fall, firms cut the quantity
supplied.
• Everything That Affects Marginal
Production Costs Affects Supply
– If MC falls, supply rises.
– If MC rises, supply falls.
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Market Supply Function
• Determinants of Supply
–Supply is determined by price, prices of
other goods, technology, and so on.
• Industry Supply Versus Firm Supply
–Firm supply is determined by economic
conditions and competition.
–Industry supply is the sum of firm
supply.
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Supply Curve
• Supply Curve Determination
– Supply curve shows price and quantity relation
holding everything else constant.
• The Price-quantity Supplied Relation
– A rise in price will increase the quantity
supplied.
– A fall in price will decrease the quantity
supplied.
• Along a supply curve, all non-price
variables are held constant
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Relation Between Supply Curve
and Supply Function
• Movements Along Supply Curve
– A rise in price causes upward movement along a
given supply curve.
– A price decline causes downward movement along a
given supply curve.
• Supply Curve Shifts
– Supply increases if a non-price change allows more to
profitably produced and sold.
– Supply decreases if a non-price change causes less
to be profitably produced and sold.
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Market Equilibrium
• Demand and Supply Balance
–Equilibrium exists if perfect balance
exists in the quantities demanded and
supplied.
–Equilibrium reflects productive and
allocative efficiency.
• Surplus and Shortage
–Surplus is excess supply.
–Shortage is excess demand.
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Comparative Statics
• Changes in Equilibrium
– Equilibrium exists when there is no economic
incentive for change in demand or supply.
– Changing demand or supply affects
equilibrium.
• Comparative Statics
– Study of how equilibrium changes with
changing demand or supply.
– Change continues until a new equilibrium is
established.
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Price Elasticity of Demand
/
/
P
Q Q Q P
E
P P P Q
∆ ∆
= = ⋅
∆ ∆
Linear Function of Elasticity of Demand
Point Elasticity of Demand
1P
P
E a
Q
= ⋅
It is the % change in quantity demanded of a good
due to a % change in price of a good.
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Price Elasticity of Demand
Arc Elasticity of Demand 2 1 2 1
2 1 2 1
P
Q Q P P
E
P P Q Q
− +
= ⋅
− +
It gives elasticity over a range of observations (values) over the
given time period.
The measure of elasticity does not change over the range i.e.
from point A to B, elasticity will be same from A to B or from B
to A.
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MR and Price Elasticity of Demand
PX
QX
MRX
1PE >
1PE <
1PE =
On a straight
line of demand
curve, the
price elasticity
decreases
along with the
curve i.e. low
price & high
quantity; high
price & low
quantity.
(If Demand Curve is Linear)
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Marginal Revenue, Total
Revenue, and Price Elasticity
TR
QX
1PE <
MR<0MR>0
1PE >
1PE = MR=0
TR is
maximum
when Ep = 1
and MR is
equal to 0.
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Determinants of Price Elasticity
of Demand
Demand for a commodity will be more
elastic if:
1.It has many close substitutes
2.It is narrowly defined
3.More time is available to adjust to a
price change
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Determinants of Price Elasticity
of Demand
Demand for a commodity will be less
elastic if:
1.It has few substitutes
2.It is broadly defined
3.Less time is available to adjust to a
price change
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Income Elasticity of Demand
Linear Function of Point Income Elasticity of Demand
Point Income Elasticity of Demand /
/
I
Q Q Q I
E
I I I Q
∆ ∆
= = ⋅
∆ ∆
3I
I
E a
Q
= ⋅
It is the % change in quantity demanded of a good
due to a % change in income of the consumer.
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Income Elasticity of Demand
Arc Income Elasticity of Demand
2 1 2 1
2 1 2 1
I
Q Q I I
E
I I Q Q
− +
= ⋅
− +
•Normal Good •Inferior Good
0IE > 0IE <
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Cross-Price Elasticity of Demand
Linear Function of Cross Elasticity of Demand
Point Cross Elasticity of Demand /
/
X X X Y
XY
Y Y Y X
Q Q Q P
E
P P P Q
∆ ∆
= = ⋅
∆ ∆
4
Y
XY
X
P
E a
Q
= ⋅
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Cross-Price Elasticity of Demand
Arc Cross Elasticity of Demand
Substitutes Complements
2 1 2 1
2 1 2 1
X X Y Y
XY
Y Y X X
Q Q P P
E
P P Q Q
− +
= ⋅
− +
0XYE > 0XYE <
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Next Chapters
• Chapter No. 4 Regression Techniques
and Demand Estimation
• Chapter No. 5 Business and Economic
Forecasting
• Chapter No. 6 Production Theory and
Analysis
MBA

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