1d - Topic 1 Class Slides

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MICROECONOMICSDecision-making in a Market Economy

26-6-2015

ARIJIT SENM Calcutta | Term I, 2015 1

The three over-arching issues in Economics

1. Individuals make choices to improve economic well-being

People make economic choices all the time (about human capitalacquisition, occupation, financial portfolios)

- Businesses make economic choices all the time about what to sellhow much to sell, who to sell to)- Governments make economic choices all the time (about taxes,money supply, interest rates)

2. Individual choices interact to generate aggregate outcomes

- what kinds of goods and services are produced (production)

-- and who consumes what (consumption)

3. Given scarcity of resources, individual choices and aggregateoutcomes reflect fundamental trade-offs

- economic policy aims to influence/control these trade-offs

The ambit of Economics

[1] Studying the principles of economic decision-making

[2] Understanding economic outcomes generated by the aggregationof individual decision-making

[Individual decisions are affectedby the economic environment, while

- Robinson Crusoe had to worry about [1] given scarcity of resources

but not about [2]- Our advantage over Crusoe is that we can reap the benefits of

specialization / division of labour

- But how much benefit we can reap depends on the functioning of our

- The functioning of these institutions are affected by issues ofcompetition / coordination / and incentives

Economics studies these issues with a major focus on the questions:When does the market mechanism work well, and when does it not?When it does not, what policy interventions can improve matters?


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The Progression of Economic Analysis

Consumers& Firms

The Market

The National Economy

The Global Economy

Microeconomics: Studies decision-making of buyers and sellers,

an ow t ese ec s ons ge to generate mar et outcomes Macroeconomics: Studies levels and fluctuations of aggregate

economic variables: GNP, employment, inflation, interest rates

International Economics: Studies trading relations between nationsand the interactions among national macro-economies

Substantive assumptions about motivation and behaviour

Neo-classical Economics makes the following assumptions:

(1) All decision-makers are rational, and

(2) every individual and collective entity abides by the rule of law.

Rational decision-makingis the process of making decisions bysolving constrained optimization problems in which each

decision-maker maximizes a well-specified objective function subjectto a comprehensively specified set of constraints that she faces(constraints arising from a combination of limited resources, limitedoptions, limited time, and limited computing ability).


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Cost-Benefit Analysis An Example

At 9 am on 1/1, I have Rs. 1000,000 to invest for TWO years, andhave THREE indivisible & mutually exclusive ventures available:

Venture 1: Invest entire amount in bank Fixed Deposits (FDs)

Venture 2: Invest Rs. 480,000 in 2-yr ProjectA & remainder in FDs

u : nves s. , n -yr ro ec rema n er n s

Interest rate on bank FD: 10% per year (compounded) this is the market risk-free interest rate [there is no inflation]

Return structure of the 2-yr projects (I can predict the future perfectly):

ProjectA ProjectB

- - , , , ,

Net earnings at the end of two years from each of the ventures:

Venture 1: 1.21 1000,000 = 1210,000

Venture 2: {1.21520,000} + {(1.1200,000) + (800,000)} = 1649,200

Venture 3: {1.21500,000} + {(1.1500,000) + (500,000)} = 1655,000

Net Present Value (NPV) Analysis

NPV of projectA: 480,000 + [200,000/1.10] + [800,000/(1.10)2]

= 480,000 + {842,980} = 362,980

NPV of projectB: 500,000 + [500,000/1.10] + [500,000/(1.10)2]

= 500,000 + {867,770} = 367,770

NPV of Venture 1: zero

NPV of Venture 2: 362,980

NPV of Venture 3: 367,770

Net Present Value Rule of Investment: Among a set of indivisibleand mutually exclusive ventures, invest in that specific venture Vthathas the hi hest non-ne ative NPV.

[as FD rate is risk-free rate, any inv in FD is a 0-NPV inv]

Relating theNPV rule to the concept of maximizing economic profits:

The opportunity costof engaging in Venture 3is the foregone NPV in the next best alternative: 362,980 in Venture 2

Long-term economic profits from engaging in Venture 3

= NPV of Venture 3 opportunity cost of Venture 3 = 4,790


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After starting Venture 3 at 9 am on 1/1, at 12 noon I realize thatBsannual returns will be 400,000. Should I continue withB at 12 noon or

pull out and get intoA (if I can costlessly break pre-invested FDs)?- Determine how much ofBs up-front investment cost is recoverable i.e. how much of the cost can be recovered when ullin out ofB

Continuation NPV

- If recoverable amt isX, continuation NPV of Venture 3 (at 12 n) is:

X+ {[400,000/1.10] + [400,000/(1.10)2]} = 694,220 X

- So, I should pull out ofB and get intoA at 12 noon if and only if:

NPV of V2 (362,980) > continuation NPV of V3 (694,220 X)

Decision: If X > 331,240, then switch toA, otherwise continue withB

Sunk costs are start-up costs that are not recoverable once made- In our example: upfront investment X [ifX= 350K then sunk costs= 150K]

- sunk costs are to be ignored in making current/future decisions

At any point in time, an already-initiated project should be continuedif and only if the amount of past investments that is recoverable (i.e.,non-sunk) is smallerthan a critical value

Opportunity Costs and Sunk Costs

The opportunity cost of using up a resource is the return that theresource would generate in its next best alternative use

Sunk costs are those irrecoverable past investment costs that are tobe ignored in deciding whether to continue with a project

, ,and get wrongly influenced by the magnitude of sunk costs

Ignored opportunity costs: The Generally Accepted AccountingPractices (GAAP) allows the deduction of cost of debt fromaccounting profits to determine taxable profits

but does not allow deduction of the cost of equity

Sunk Costs Fallacy: We often decide to continue in a previouslystarted project only because we have already sunk a lot of resourcesin the project


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Optimal Decisions and Marginal Analysis

Some decisions can be changed in increments (volume, price, portfolio)

I have 5 mill. of which I can invest Z mill. in a divisible 2-yr projectwhich would generate end-of-yr returns: [1.1

Z] & [1.21

Z], andput the remaining money in bank FDs giving 10% risk-free intt.

arg na na ys s: n at t e marg n t oug t exper ment to eterm neif a proposed {Z} is optimal, and if not, then to find the optimalZ*

(I) If I increase project investment by from {Z} to {Z+ } more project earnings generating marginal benefit of 2[(Z+ ) Z]

and less FD earnings generating marginal cost of

(II) If I decrease project investment by from {Z} to {Z} more FD earnin s eneratin mar inal benefit of

and less project earnings generating marginal cost of 2[

Z

(Z)]

Decision to invest {Z*} in the divisible project will be optimal only if:marginal benefit marginal costat {Z*} in (I) as well as (II)

If the maximand is globally concave then the unique optimaldecision is attained where marginal benefit = marginal cost- this condition characterizes the peak of the profit hill

Active Firms [Industry]

a retail consumer market has...many small price-takers

Customers

Markets / Industries

range from price-takersto price-makers

Input Suppliers commodity suppliers are..........small price-takers

Market: triadic relation between firms, customers & input suppliers

Market boundary depends mainly on (a) range of products relatedin consumption/production, (b) geography, and (c) time.

or two pro ucts to e n t e same mar et, re at ve pr ce c anges

should lead to substantial change in relative demand and/or supply

Market Structure is composed of (i) demand structure (many smallor few large buyers), (ii) input supply structure, and

(iii) industry structure size distribution of firms (i.e., the number of

active firms in the market and their sizes)


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Industry Structure and Market Power

Two extreme firm size distributions:

Perfectly competitive industry numerous small firms with negligible

power to affect input or output prices [fully fragmented industry withfirms having miniscule market shares]

ve etable mkts commodities mkts secondar stock markets ??

Bilateral monopoly a single seller of a unique product withsubstantial power to affect both input and output prices [fullyconcentrated industry with a single firm having 100% market share](a pharma multinational selling a patented drug, a public utility ??)

The reality is in the middle: Most industries are oligopolies with a finite number firms (selling

close substitutes) that can affect/set both input and output prices- airlines, auto-makers, telecom, soft drinks, .

Question: Why are some oligopolies tight (closer to monopoly) whileothers are loose (closer to perfect competition)?

Answer related to market fundamentals nature of market demandand of production technologies (entry barriers and economies of scale)

The Structure, Conduct, Performance Theory

Our central aim is to uncover the systematic relationship between threesets of variables: (1) market fundamentals, (2) industry structure, and(3) market power of different market participants.

In the 1960s, Harvard economist Joseph Bain (and others) developed, ,

market performance:

Market fundamentals like higher entry barriers and scale economieslead to greater industry concentration (i.e., fewer and larger firms)Greater industry concentration leads to monopolistic firm behavior(i.e., firms exercising market power and enjoying greater margins)

Monopolistic firm behavior leads to larger firm profits and lowersocial efficiency

Critique: firm conduct & performance influence future industry structure

Missing markets and the role of entrepreneurshipSome markets do not operate in spite of positive consumer valuationsfor products, because sellers havent discovered profitable ways to serveconsumers - entrepreneurship is about finding such profitable ways


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Prices:

Prices determine allocation of goods and services, determine incomes/

profits, and convey information about profitable future investments

Two problems with nominal prices:

om na pr ce o a goo n a par cu ar geograp ca area m g no

precisely indicate the true value/expensiveness of the good

- We need to focus on the relative price: by deflating the nominalprice of the good by the appropriate price index of other goods inthat same geographical area

[comparing affordability of a good across space]

(2)Nominal price of a good at a specific point in time might not preciselyindicate the true value/expensiveness of the good

- We need to focus on the real price: by deflating the nominal priceof the good by the appropriate inflation index

[comparing affordability of a good over time]

Price Indices

Constructing the Consumer Price Index for Food (CPI-F) in India in2015 with respect to the base year 1984

Let food basket = {rice, wheat, chicken}

LetPR(Y),PW(Y), andPC(Y) denote the Rupee prices of rice, wheat,an c c en n year

LetR(X), W(X), and C(X) denote the total volume of rice, wheat, and

chicken bought in yearX Then the CPI-F in 2015 with base year 1984 [Laspeyres Index] =

PR(15)R(84) +PW(15)W(84) +PC(15)C(84)PR(84)R(84) +PW(84)W(84) +PC(84)C(84)

100

[Paasches Index will, in contrast, use the current year quantities]

A general Consumer Price Index (CPI) is constructed using arepresentative consumption basket of all major consumption goods

- Weights assigned to different components should be consistent

with actual consumption patterns


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Real price of goodA in 2015 in 1984 rupees (given base yr 2000) =

Year Nominal CPI Real Price in 1970 $

Evolution of real price of going to College in the US:

Using CPI to determine real prices & inflation rates

{Nominal price ofA in 15}{CPI in 84 w.r.t.00/ CPI in 15 w.r.t.00}

Price (base 1985)

1970 $2,530 38.8

1990 $12,018 130.7

2002 $18,273 181.0

$3,569$12,018*130.7

38.8

$3,917$18,273*38.8

$2,530$2,530*38.8

38.8

.

Note that the 20 year consumer inflation rate in the US between1970 and 1990: f(70-90) = (130.7 38.8)/38.8 = 236.85%

- and so, the real price of going to College in 1990 (in 1970 $) is:12,018/(1+f(70-90)) = 3,569

The Real Interest Rate

An interest rate is also a price: it is the relative price of current..consumption vis--vis future consumption

- when there is inflation, one has to distinguish between the real andthe nominal interest rate

1990 2004 2006 2008

Nominal interest rate p.a. 10% 5% 6% 9%Annual inflation rate 7% 3% 4% 9%

Real interest rate p.a. 2.8% 1.94% 1.92% 0%

Let i= nominal interest rate p.a. and = annual inflation rate

The real interest rate p.a. (r) is given by:(1 + r) = (1 + i)

(1 +f)

When iand f are quite small, r approximately equals (i f)


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Firms: Internal Structures and Objectives

The internal structure of a firm is either a proprietorship, or apartnership, or a privately held limited liability company, or apublicly held limited liability company

The objectives of a firm will depend on its internal structure

When there is separation of ownership and control (as in largecorporations), management might be more interested in its ownobjectives (of short-term returns / empire building) rather thanmaximizing long-term shareholder value

The main aim of corporate governance is to align managerialobjectives with shareholder objectives (through ESOPs etc.)

In most of Microeconomics, we will study firm behaviour under theprofit maximization hypothesis owners/managers take purposivedecisions to maximize long-term economic profits of a firm

We will have to define what we mean by long-term economic profits

Understanding Economic Profits

Annual Economic profits = Annual Revenues Annual Economic Costs

- Latter should include all explicit and implicit costs yet to be incurredand should not include any irrecoverable expenditure already spent.

Example: Monica will graduate on 31/12 and leave the country one yearater. e as to ec e w at to o n t e com ng year: s e can get a

call-centre job OR she can run a boutique in her garage.

She will have Rs. 2,00,000 on 1/1.Call-centre job will pay Rs.60,000 for the year.

She can also get Rs. 18,000 by renting out her garage.Boutique will need capital investment of Rs.1,00,000 on 1/1, ofwhich Rs.90 000 will be recou ed at ear-end.Annual expenditures in running the boutique will be Rs.40,000 on rawmaterials, Rs.25,000 on wages, and Rs.15,000 on advertising.Annual sales revenues from the boutique will be Rs.1,75,000.

All receipts and expenditures will happen at the end of the year.

Annual market interest rate is 10%, all incomes are taxed at 10% per

year, and there is no inflation.


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ARIJIT SEN

Economic Profits from Boutique at year end:

Sales revenues = 1,75,000

Explicit Costs Depreciation = 10,000

Raw materials = 40,000Wages = 25,000Advertising = 15,000

= ,

Taxes = 8,500 After-tax Accounting Profits = 76,500

After-tax implicit costs Foregone call-centre salary = 54,000Foregone interest income = 9,000Foregone garage rental = 16,200

79 200

Monicas Economic Profits from boutique = 2,700

Annual economic profits = Annual after-tax accounting profits net opportunity (implicit) costs of all resources used over the year

Monicas Economic Profits from call centre = 2,700

Conclusion: Monica should take the call centre option as that willgenerate super-normal economic profits for her

Long-term Economic Profits

Annual economic profits = annual sales revenue annual economiccosts [i.e., accounting (explicit) costs + opportunity (implicit) costs ofall resources used over the year]

Normal and super-normal profits: Normal profits earned over the yearwhen revenues e ual economic costs su ernormal rofits are earnedwhen revenues are greater than economic costs [in both cases,accounting profits (revenues accounting costs) are positive]

Let t(xt) be annual economic profits accruing to a firm at the end ofyear t, wherext is a set of managerial decision variables; and let rtbethe annual (compounded) interest rate or t-year deposits

Then the long-term economic profits of a firm on 1-1-tis thepresent discounted value of future profit stream as valued at 1-1-t:

t (xt)/(1+rt) + t+1 (xt+1)/(1+rt)(1+rt+1) + t+2 (xt+2)/(1+rt) (1+rt+1)(1+rt+2) +.

Where does this stream end?Should we use real or nominal values?

How should we account for the fact that the future is uncertain?

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1d - Topic 1 Class Slides