Jess Econ Notes

7/30/2019 Jess Econ Notes

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MANAGERIAL ECONOMICS

TEXTBOOK NOTES

Demand Theory

- Elements effecting demand:o Priceo Price of substitute productso Price of complementary productso State of the economyo Disposable personal incomeo Advertising expenditureso Etc

- Managers want to understand the impact of exogenous (out of control) variables on the product, so thathe or she can make decisions on endogenous variable and plan a reactive strategy to changes inexogenous variables

- Elasticity tells us how percentages of quantity change given a small percentage change in one of thelisted variables

o When the changed variable is the firms price, the elasticity also tells us how total revenuechanges

- Having estimates of elasticities can help managers make decisions about how to price their products andhow to anticipate quantity and revenue changes when uncontrollable variables change

The Market Demand Curve

- Market demand schedule: a table that shows the total quantity of the good that would be purchased ateach price

- Market demand curve: a plot of the market demand schedule on a graph Horizontal axisquantity of the good demanded per unit of time Vertical axisprice per unit of the good

- Factors effecting shape and curve of market demand curve:o Most demand curves slop downward to the right

In the laptop example, the quantity of laptops demanded increases as the price fallso Any demand curve pertains to some time period, and its shape and position depend on the length

and other characteristics of this periodo If consumers show an increasing preference for a product, the demand curve shifts to the right

At each price, the consumer wants to buy more than they did previously, and for eachquantity, consumers are willing to pay a higher price

Opposite if there is a decrease in demando Level of consumer income

Depending on the product, the curve shifts to the right or left if the per capita incomerises

in the laptop example, an increase in per capita income shifts the curve to the righto level of other prices

in the laptop example, the quantity of laptops demanded would increase if the price ofsoftware decreased

o size of the population in the relevant market an increase in population could mean an increase in demand


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Industry and Firm Demand Functions

- market demand function (for a product): relationship between the quantity demanded of the productand the various factors that influence this quantity

- Quantity demanded of good X= Q= f (price of X, incomes of consumers, tastes of consumers, prices ofother goods, population, advertising expenditures, etc)

-

more specifically- Q= b1P + b2I + b3S + b4A, where Q is the number of laptop computers demanded in a particular year, Pis the average price of laptops that year, I is per capita disposable income, S is the average price, and Ais the amount spent on advertising by producers of laptops

- assumption that this is a linear equation- necessary for managers and analysts to obtain numerical estimates of the values of b- ifQ= -700P + 200I + 500S + 0.01A, then a $1 increase in the price of a laptop results in a decrease in

the quantity demanded of 700 units per year- the market demand curve shows the relationship between Q and P when all other relevant variable are

held constant

The Price and Elasticity of Demand

- for some goods, a small change in price results in a big change in quantity demanded, while for othergoods, a big change in price results in a small change in quantity demanded

- price elasticity of demand: the percentage change in quantity demanded resulting from a 1 percentchange in price

o a measure to indicate how sensitive quantity demanded is to changes in price ()

o E.g. suppose a 1% reduction in the price of cotton shirts results in a 1.3 percent increase in thequantity demanded in the United States. If so, the price elasticity of demand for cotton shirts is

-1.3o The price of elasticity of demand generally varies from one point to another on a demand curve

For instance, the price of elasticity of demand may be higher in absolute value when theprice of cotton shirts is high than when it is low

o Price elasticity of demand for a product must lie between zero and negative infinity If it is zero, it is a vertical line and it is unaffected by price If it is negative infinity, the demand curve is a horizontal line and an unlimited amount

can be sold at a particular price

Point and Arc Elasticities

-

If we have a market demand schedule showing the quantity of a commodity demanded in the market atvarious prices, how can we estimate the price elasticity of market demand? Let P be a change in theprice of a good and Q be the resulting change in its quantity demanded. If P is very small, we cancompute the point elasticity of demand:

- To avoid large differences in results, compute the arc elasticity of demand, which uses the average

values of P and Q:


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or

Using the Demand Function to Calculate the Price and Elasticity of Demand

- The price elasticity of demand is() () ( ) ( )

- If the demand curve is linear, the price elasticity approaches zero as P gets very small and approachesnegative infinity as Q gets very small

Price Elasticity and Total Money Expenditure

- In simpler words, demand for a product can be said to be very inelastic if consumers will pay almost anyprice for the product, and very elastic if consumers will only pay a certain price, or a narrow range ofprices, for the product. Inelastic demand means a producer can raise prices without much hurting

demand for its product, and elastic demand means that consumers are sensitive to the price at which a

product is sold and will not buy it if the price rises by what they consider too much.

o Drinking water is a good example of a good that has inelastic characteristics in that people willpay anything for it (high or low prices with relatively equivalent quantity demanded), so it is not

elastic. On the other hand, demand for sugar is very elastic because as the price of sugar

increases, there are many substitutions which consumers may switch to.

- When the demand for the product price is elastic, the price elasticity of demand is less than -1. The totalamount of money spent by consumers on the product equals the quantity demanded times the price perunit. Here, is the price is reduced; the percentage increase in quantity demanded is greater than the

percentage reduction in price. A price reduction must lead to an increase in the total amount spent byconsumers on the commodity. Similarly, if the demand is price elastic, a price increase leads to areduction in the amount of money spent on the commodity.

- If the demand for the product is price inelastic, the price elasticity of demand is greater than -1. A pricedecrease leads to a reduction in the total amount spent on the commodity and a price increase leads to anincrease in the amount spent on the commodity.

- If the demand is of unitary elasticity, the price elasticity of demand equals -1. An increase or decrease inprice has no effect on the amount spent on the commodity.

Total Revenue, Marginal Revenue, and Price Elasticity

- To its producers, the total amount of money spent on a product equals their total revenue- Suppose the demand curve for a firms product is linear

P = a - bQ- Firms total revenue equals

TR = PQ= (a-bQ)Q=aQbQ2

- Marginal revenue


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- Comparing the demand curve and the marginal revenue curve, we see that both have the same intercepton the vertical axis (this intercept being a) but the marginal revenue curve has a slope that is twice thatof the demand curve

- The price elasticity of demand ( ) ( )

- Therefore, whether is greater than, equal to, or less than -1 depends on whether Q is greater than,equal to or less than a/2b

- Elastic if Qa/2b- Unitary elasticity if Q = a/2b- Inelastic if Qa/2b- At quantities where marginal revenue is positive, increase in quantity result in higher total revenue- At quantities where marginal revenue is negative, increases in quantity result in lower total revenue- This is expected because marginal revenue is the derivative of total revenue with respect to quantity

o So if marginal revenue is positive (negative), increases in quantity must increase (decrease) totalrevenue

- At quantities where price is elastic, marginal revenue is positive- At quantities where it is of unitary elasticity, marginal revenue is zero- At quantities where price is inelastic, marginal revenue is negative

(

)

- -1, marginal revenue must be positive- -1, marginal revenue must be negative- = -1, marginal revenue must be zero

Using Price Elasticity of Demand: Application to Philip Morris

- 1993 Philip Morris cut cigarette prices by 18%- Quantity sold increase by 12.5%- Profits fell by 25% as a result of bad pricing strategy- Estimate of the elasticity of demand

o (%Q/P) is 12.5%/-18%=-0.694 it is inelastico

Cutting the price when demand is inelastic decreases total revenueso Since output increased by 12.5%, total cost increased

Using Price Elasticity of Demand: Public Transit

- The price elasticity for public transportation service in the US is about -0.3 (fairly inelastic)- All transit systems in the US lose money and keeping the deficit under control is difficult because of

subsidizers- How does the general manager of a transit system raise needed revenues?

o With an inelastic demand, raising fares increases revenueso Raising fares decreases ridership, hence, decreasing the cost


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Determinants of the Price Elasticity of Demand

- Price elasticity depends heavily upon the number and closeness of the substitutes availableo If a product has a lot of close substitutes, its demand is likely to be price elastic consumers

will choose the cheapest choiceo As the definition of a product becomes narrower and more specific, the product would be

expected to have more close substitutes, and its demand would be more price elastic The demand for a particular brand of gasoline is likely to be more price elastic than the

overall demand for gasoline- The price elasticity of demand for a product may depend on the importance of the product on the

consumers budgets,

o e.g. the demand for rubber bands may be quite small since the consumer spends a small fractionof his or her income on such goods

o e.g. for products that bulk larger in the typical consumers budget, like major appliances, theelasticity of demand may tend to be higher, since consumers may be more conscious of andinfluenced by price changes in the case of goods that require larger outlays

- the price elasticity of demand for a product is likely to depend on the length of the period to which thedemand curve pertains

o demand is likely to be more elastic or less inelastic over a long period of time than over a shortperiod of time, because the longer the period of time, the easier it is for consumers and firms tosubstitute one good for another

o e.g. if the price of oil should decline relative to other fuels, the consumption of oil in that dayafter the decline would probably increase very little. Over a period of several years, peoplewould have an opportunity to take account of the price decline in choosing the type of fuel to beused in new houses, etc.

in the longer period of several years, the price decline would have greater effect on theconsumption of oil than in the shorter period of one day

Uses of the Price of Elasticity and Demand

- managers pay close attention to the price elasticity of demand of their products because it is useful whenit comes to the pricing of their goods

- no manager interested in maximizing profit will set the price at a point where the demand for his or herproduct is price inelastic

o marginal revenue must be negative if demand of price is inelastico if marginal revenue is negative, a firm can increase its profit by raising its price and lowering its

output because its total revenue will increase if it sells less (this is what it means to say thatmarginal revenue is negative

Price Elasticity and Pricing Policy

- marginal revenue equals marginal cost if a firm is maximizing profit, which means that if ( )Then, So,

( )When solving for P,


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- suppose the marginal cost of a shirt is $10 and its price elasticity of demand equals -2, the optimal price

is

- the central point to note is that the optimal price depends heavily on the price elasticity of demand- holding constant the value of marginal cost, a products optimal price is inversely related to its price

elasticity of demand- therefore, if the shirts price elasticity of demand were -5 rather than -2, its optimal price would be

The Income Elasticity of Demand

- a factor besides price influencing demand is the level of money income among the consumers in themarket

- Income elasticity of demand: the percentage change in quantity demanded resulting from a 1 percentchange in consumers income. It equals

( ) ( )- Where Q is quantity demanded and I is consumers income- For some products, the income elasticity of demand is positive, indicating that increases in consumers

money income result in increases in the amount of the good consumedo E.g. luxury items like gourmet food are expected to have positive income elasticities

- Other goods have negative income elasticities, indicating that increases in money income result indecreases in the amount of the good consumed

o E.g. inferior grades of vegetables and clothing might have negative income elasticities- In calculating the income elasticity of demand it is assumed that prices of commodities are held constant- E.g. if the income elasticity of demand for milk is 0.5, it means that a 1% increase in disposable income

is associated with about a 0.5% increase in the quantity demanded for milk- E.g. if the income elasticity of demand for bread is -0.17, it means that a 1% increase in disposable

income is associated with about a 0.17% decrease in the quantity demanded for bread

Using the Demand Function to Calculate the Income Elasticity of Demand

- Calculating income elasticity of demand- Demand function for good X is

- Q is the quantity demanded of good X, Px is the price of the good X, Py is the price of good Y and I is

per capita disposable income- The income elasticity of demand is


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( ) ( )( )

- If I=10,000 and Q=1,600

( )

- The income elasticity of demand equals 0.25, which means that a 1% increase in per capita disposableincome is associated with a 0.25 percent increase in the quantity demanded of good X

Cross Elasticities of Demand

- Price of other commodities also affects demand- When the price of the product is held constant and allowing the prices of other products to vary shows

important effects on the quantity demandedo By observing these effects we can classify commodities as substitutes or complements and we

can measure how close the relationship is- Cross elasticity of demand: the percentage change in the quantity demanded of good X resulting from

a 1 percent change in the price of good Y

() ()- X and Y are substitutes if the cross elasticity of demand ispositive

o E.g. an increase in the price of wheat when the price of corn remains constant tends to increasethe quantity of corn demanded. is positive and they are substitutes

- X and Y are complements if the cross elasticity of demand is negativeo E.g. an increase in the price of software may tend to decrease the purchase of personal computers

when the price of personal computer remains constant. is negative and they are complementsThe Advertising Elasticity of Demand

- Advertising elasticity: the percentage change in the quantity demanded of the product resulting from a1% change in advertising expenditure

() ()The Constant-Elasticity Demand Function

- A mathematical form frequently used is constant-elasticity demand function- If quantity demanded Q depends only on the products price P and consumer income I, this

mathematical form is

- An important property of this demand function is that the price elastic of demand equalsb1, regardlessof the value of P or I

o To see this let us differentiate Q with respect to price

- Therefore


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() () - The price elasticity of demand equalsb1, a constant whose value does not depend on P or I- Differentiate Q with respect to income

- Therefore

( ) ( ) - Income elasticity of demand equals b2, another constant whose value does not depend on P or I- Constant-elasticity demand function is often used by managers and managerial economists:

o In contrast to the linear demand function, this mathematical form recognizes that the effect ofprice on quantity depends on the level of the price

The multiplicative relationship is often more realistic than the additive oneo The constant-elasticity demand function is relatively easy to estimate If we take logarithms of both sides,

Since the equation is linear in logarithms, the parameters (a, b1 and b2) canreadily be estimated by regression analysis


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Consumer Behaviour and Rational Choice

- We assume the consumer is rational and wishes to maximize his or her well-being- Well being is a function of the goods one consumes- The amount of goods he or she can consume is constrained by income- A consumers demand curve is derived from the rational behavior of an individual who maximizes his or

her well-being given the prices of goods, personal tastes and preferences for goods and income

Indifference Curves

- Here we only look at food and clothing as commodities- Indifference curve: contains point representing market baskets among which the consumer is

indifferent- Certain market baskets (certain combinations of food and clothing) are equally desirable for a consumer

o The consumer may be indifferent between a market basket containing 50 pounds of food and fivepieces of clothing and a market basket containing 100 pounds of food and 2 pieces of clothing (2different points on a curve)

oWhen all of the points are connected, we get a curve that represents market baskets that areequally desirable to the consumer

- Important things to note about any consumers indifference curve:o A consumer has many indifference curves, not just one

We will assume, however, that consumers prefer market baskets on higher indifferencecurves than markets on lower indifference curves because consumers will prefer to morefood and clothing

o Every indifference curve must slope downward and to the right, so as long as the consumerprefers more of each commodity to less

If one market basket has more of one commodity than a second market basket, it washave less of the other commodity, assuming that the two market baskets yield equal

satisfaction to the consumero Indifference curves cannot intersect If they did, it would contradict the assumption that more of a commodity is preferred to

less

The Marginal Rate of Substitution

- Different consumers value different things. One consumer might be willing to give up a lot for one moreunit of a certain commodity, while another might give up very little

- Marginal rate of substitution: number of units of good Y that must be given up if the consumer, afterreceiving an extra unit of good X, is to maintain a constant level of satisfaction

o The larger the number of units of good Y that the consumer is willing to give up to get an extraunit of good X, the more important good X is, relative to good Y, to the consumer

o To measure the marginal rate of substitution, take the slope of the consumers indifference curveand multiply this slope by -1

This gives us the number of units of good Y that the consumer is willing to give up for anextra unit of good X

High marginal rate of substitutionindifference curves are steep, slope is large Low marginal rate of substitutionindifference curves are flat, slope is small

The Concept of Utility

- Indifference curves are representative of a consumers tastes


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- Given all the indifference curves of a consumer we attach a number, a utility to each of the marketbaskets that might confront him or her

o The utility indicates the level of enjoyment or preference attached by this consumer to thismarket basket

Summarized preference ranking of market baskets Since all market baskets in a given indifference curve yield the same amount of

satisfaction, they would have the same utility Market baskets on higher indifference curves would have higher utilities than marketbaskets on lower indifference curves

The Budget Line

- The consumer would like to maximize his or her utility, which means that he or she wants to achieve thehighest possible indifference curve

- Whether a particular indifference curve is attainable depends on the consumers income and commodityprices

- Budget line:shows the market baskets that he or she can purchase, given the consumers income andprevailing market prices

o If one makes $600 per week and a pound of food costs $3 and a piece of clothing $60, there aremultiple combinations of food and clothing the consumer can purchase this line when graphedis the budget line

o Where Y is the amount of food she buys, X is the amount of clothing she buys, Pf is the price offood, Pc is the price of clothing, and I is her income

The left-hand side of the equation represent what she spends on food and clothing andhere we assume she saves nothing

o Rearrange to get the equation of the budget line

o A shift occurs in the consumers budget line if changes occur in the consumers money incomeor commodity prices

Increase in income means the budget line rises and a decrease in income means it falls Moves parallel to the original line because change in income doesnt alter slope

Change in price of commodity alters the slope Slope of the budget line equalsPc/Pf

The Equilibrium Market Basket

- Given the consumers indifference curves and budget line, we are in a position to determine theconsumers equilibrium market basket the basket that:

oThe consumer can purchase

o Yields the maximum utility- Graph the consumers indifference curves and budget line on the same graph- Choose the market basket on the budget line that is on the highest indifference curve the equilibrium

market basket

Maximizing Utility: A Closer Look

- Since the slope of the indifference curve equals -1 times the marginal rate of substitution of clothing forfood and the slope of the budget line isPc/Pf,


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- Where MRS is the marginal rate of substitution of clothing for foodo E.g. if the marginal rate of substitution is 4, the consumer is willing to give up 4 pounds of food

to obtain one more piece of clothing- Pc/Pf is the rate at which the consumer is able to substitute clothing for food

o E.g. if Pc/Pf is 3, he or she mustgive up 3 pounds of food to obtain one more piece of clothing- This equation is saying: the rate at which the consumer is willing to substitute clothing for food (holding

satisfaction constant) must equal the rate at which he or she is able to substitute clothing for food.Otherwise it is always possible to find another market basket that increases satisfaction. And this meansthat the present market basket is not the one that maximizes consumer satisfaction.

- When the marginal rate of substitution (4) exceeds the price ratio (3), she can increase satisfaction bysubstituting clothing for food

- If the marginal rate of substitution is less than the price ratio, she can increase satisfaction bysubstituting food for clothing

- When the marginal rate of substitution equals the price ratio, her market basket maximizes her utilityCorner Solutions

- Budget line will not always be tangent to the indifference curveo Consumers may consume none of some goods because even tiny amounts of them are worth less

to the consumer than they cost E.g. even if one can afford Beluga caviar, she may not buy it

- In figure 4.8, she would maximize her utility by choosing a market basket that contains all pizza and nocaviar

o It maximizes her utility because it is on a higher indifference curve than any other market basketon the budget line

o It is a corner solution, in which the budget line touches the highest achievable indifferencecurve along an axis

Representing the Process of Rational Choice

- The economists model of consumer behavior can help people and organizations where to allocate theirfunds

- This is much more than a theory of consumer behavior; it is a theory of rational choiceDeriving the Individual Demand Curve

- A consumers individual demand curve shows how much he or she would purchase of the good inquestion at various prices of this good (when the other prices and the consumers income are held

constant)- If you look at a certain consumers individual demand curve for food, you would find two different

market baskets if the price of food changed from $3 per pound to $6 per pound

o To obtain more points on her individual demand curve for food, allow the price of food to varyand hold the price of clothing and her income constant The individual demand curve for food shows the amount of food she would buy at

various prices

Deriving the Market Demand Curve

- to derive the market demand curves, we obtain the horizontal sum of all of the individual demand curveso to find the total quantity demanded in the market at a certain price, we add up the quantities

demanded by all the individual consumers at that price

Consumer Surplus


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- consumers reservation price: the price value for each number of units demanded- consumer surplus: the difference between what an individual is willing to pay and what that individual

has to pay for a goodo it is the actual price paid subtracted from the reservation price

- when a market price is determined, the last individual/set of individuals to purchase the good is theindividual whose reservation price just equals the market price

-

all other purchasers have reservation prices which exceeds the market price and have therefore gainedconsumer surplus since they were willing to pay more for the good than they actually did- when you total all the individuals consumer surpluses, we have the consumer surplus for the good at

that priceo consumer surplus is the area below the demand curve but above the price charged


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Introduction

Introduction

- managerial economics uses formal models to analyze managerial actions and their effect on firmperformance

- differs significantly from microeconomics focus of analysis is differento many times the analysis if microeconomics is at market level, not firm level

- the focus of managerial economics is on behaviouro managerial describes behaviour as micro would describe the environment

The Theory of the Firms

- little variance in the goals of managers from around the globe- choose actions they believe will increases the value of their organization- managers in profit-oriented organizations try to increase the net present value of expected future cash

flows

- where is the expected profit in year t, i is the interest rate, and t goes from1 (next year) to n (the lastyear)

- what complicates the managerial life or the operating constraints managers faceo most resources are scarceo legal or contractualo must pay taxes in accord with federal, state and local lawso managers must comply with contract with customers and suppliers

What is Profit?

- Profit:when economists speak of profit, they mean profit over and above what the owners labour andcapital employed in the business could earn elsewhere

- Accountant is concerned with controlling the firms day to say operations- Economist is concerned with decision making and rational choice among strategies

Reasons for the Existence of Profit

- Fertile profit-generating areas used by managers risk, operation, power- Product innovations push the frontier relative to existing products in terms of functionality, technology

and style

o E.g. iPhone, 787 Dreamliner from Boeing (plane)- A hallmark of managerial decision making is the need to make risky choices

o Profit is the reward for those who bear risk wello Managers also earn profit by exploiting market inefficiencies


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o Good managers understand how to create inefficiencies to give their firm a sustainablecompetitive advantage

Managerial Interests and the Principal-Agent Problem

- Managers have goals besides a profit that might enhance a firms long term valueo i.e. building market share, establishing a brand name

besides long-term value might be increasing managerial compensation- some managers take the selfish route when making the choice to maximize a firms value or increase the

payoffs to a single manager or management team

- self-interest is of growing importance because the separation between ownership and management offirms is continuing to increase on a global scale

o owners have little detailed knowledge on the firms operationo lots of freedom to managerso

firm behaviour may be driven by nonowner management groups- principal agent problem: when managers pursue their own objectives, even though this decreases, the

profit of the owners

o managers are shareholders or principals- to deal with this problem, owners often use contracts to converge their preferences and those of their

agents

o E.g. rewards for firm success or ability to purchase shares at less than market priceDemand and Supply

- Market: a group of firms and individuals that interact with each other to buy or sell a good- A market exists when there is an economic exchange... multiple parties enter binding contracts- All markets follow general principles

The Demand Side of a Market

- Every market has demanders and suppliers- Manager needs to know how potential customers value a product or service and must be able to estimate

the quantity or goods demanded at various prices

- One goal of a manager is to maximize a firms profit- Revenue is the number of units sold (Q) multiplied by the price (P)... TR=P x Q- Association of price and quantity demanded depends on many variables income, taste, price of

substitutes and complements, advertising dollars, product quality, governmental fiat

- Demand function: quantity demanded relative to price, holding other possible influences constant- Demand curves for commodities usually slop downward to the right

o An increase in a goods price results in a smaller quantity demanded- Influences like tastes and incomes are held constant, but if they were to change then the demand curve

would shift

The Supply Side of a Market


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- Graph shows how many units of a commodity sellers will offer at any price- Higher prices provide an incentive to suppliers to produce more of the good to sell- We assume that the cost of technology (if lower cost production technology is developed) is held

constant, or else supply curve shifts

- Supply curve for a product is affected by the cost of production inputso When production costs go down, managers realize lower production costs and are willing to

supply a given amount at a lower price

- Decrease in cost of inputs causes supply curve to shift to the right- Increase in costs of inputs causes supply curve to shift to the left

Equilibrium Price

- We can determine market behaviour at various prices when we overlap supply and demand curves- You can see areas of excess supply and demand- A price is sustainable when the quantity demanded equals the quantity supplied at that price- Equilibrium: when the market is in balance because everyone who wants to purchase the good can and

every seller who wants to sell the good cano Where the two curves intersect

Actual Price

- In general economists assume the actual price approximates the equilibrium price, which seemsreasonable because the actual forces at work tend to push the actual price toward the equilibrium price

o Therefore, if conditions remain fairly stable, the actual price should move toward the equilibriumprice

- As long as the actual price is greater than the equilibrium price, there is downward pressure on price-

As long as the actual price is less than the equilibrium price, there is upward pressure on priceo Always a tendency for the actual price to move toward the equilibrium price

Speed varies- Invisible hand: when no governmental agency is needed to induce producers to drop or increase their

prices

What if the Demand Curve shifts?

- Supply and demand curves are not statico Shift in reaction to changes in the environment

- Managers need to anticipate and forecast changes in price- A rightward shift in the demand curve results in an increase in equilibrium price- A leftward shift in the demand curve results in a decrease in the equilibrium price

What if the Supply Curve shifts?

- A leftward shift in the supply curve results in an increase in the equilibrium price- A rightward shift in the supply curve results in a decrease in the equilibrium price


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Optimization Techniques

- Virtually all the rules we study about optimal behaviour of firms and individuals are driven by theconcept of marginal analysis

- Differentiation tells us what changes will occur in one variable (the dependent variable) when a small(marginal) change is made in another variable (the independent variable)

- We also look at constrained optimizationo Maximization and minimization i soften subject to constraints

Functional Relationships

- Relationship between the number of units sold and the price... Q=f(P)o Number of units sold is the dependent variable and price is the independent variable

- How the number of units depends on price... Q=200-5PMarginal Analysis

- Marginal value: the change in the dependent variable associated with a one-unit change in a particularindependent variable

- Marginal profit: the change in the total profit associated with a one-unit change in output- E.g. if output increases from 0 to 1 unit, total profit increases from $0 to $100, a $100 increase.

Therefore, the marginal profit equals $100 if the output is one unit

- Central point about a marginal relationship of this sort the dependent variable, in this case total profit,is maximized when its marginal value shifts from positive to negative

o This is therefore useful to managers- Average profit: the total profit divided by output

o if managers want to maximize profit, they should not choose the output level with the highestaverage profit... want to pick the one where marginal profit shifts from positive to negative

- it is important to understand the relationship between average and marginal valueso marginal value represents the change in the totalo average value must increase if the marginal value is greater than the average valueo average value must decrease if the marginal value is less than the average value

Relationships among Total, Marginal and Average Values

- the relationship between average profit and output is relatively simple to deriveo Take any output level. At this output level, the average profit equals the slope of the straight line

from this origin to the point

- Deriving the relationship between marginal profit and output is also relatively simpleo Take and output level. At this output level, the marginal profit equals the slope if the tangent to

the total profit curve

- Marginal profit is defined as the extra profit resulting from a very small increase in outputo If were trying to find the marginal profit, we are finding the slop between two points. If these

points are extremely close together, the slope of the tangent is a good estimate of the slop

between these two close points

- Sometimes you are given the average profit curve but not that total profit curve


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o Total profit equals average profit times output Pg. 603 paragraph 2

- If the slope of the total profit curve increases as we move away from the origin, the marginal profitincreases as the output level rises

o Because marginal profit equals the slope of this tangent, it must increase as the output level risesfrom 0

- If the slope of the total profit curve decreases as the input level increases, the marginal profit decreasesand the output level rises

- The average profit curve must be rising if it is below the marginal profit curve, and it must be falling if itis above the marginal profit curve

The Concept of a Derivative

- If Y is the dependent variable and X is the independent variable... Y=f(X)- The marginal value of Y can be estimated by

- The relationship between Y and X can be represented in a straight line- The value of is related to the steepness or flatness of a curve

o If the curve is steep small change in X results in a large change in Y is relatively large

o If the curve is flat large change in X results in a small change in Y is relatively small

- The derivative of Y with respect to X is defined as the limit of as delta X approaches zero

- Graphically, the derivative of Y with respect to X equals the slope of the curve showing Y (on thevertical axis) as a function of X (on the horizontal axis)

- Clearly, in the limit, as X approaches zero, the ratio is equal to the slope of the lineHow to Find a Derivative

Derivatives of Constants

- Always zeroDerivatives of Powers

Derivatives of Sums and Differences

Derivatives of Products

- The derivative of the product of two terms is equal to the sum of the first term multiplied by thederivative of the second plus the second term times the derivative of the first

Derivatives of Quotients


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- The derivative of the quotient of two terms equals the denominator times the derivative of the numeratorminus the numerator times the derivative of the denominator

Derivatives of a Function of a Function (the Chain Rule)

- Suppose Y=f(W) and W=g(X)... the derivative of Y with respect to X is... ( ) ( )Using Derivatives to Solve Maximization and Minimization

- the central point is that a maximum or minimum point can only occur only if the slope of the curveshowing Y on the vertical axis and X on the horizontal axis equals zero... slope of the tangent on thispoint equals 0

- to find the value of X that maximizes or minimizes Y, we must find the value of X where this derivativeequals zero

- the second derivative measures the slope of the curve showing the relationship between dY/dX- second derivative is important because:

o always negative at a point of maximizationo always positive at a point of minimization

Marginal Cost Equals Marginal Revenue and the Calculus of Optimization

- for profit maximization, set marginal cost equal to marginal revenue- as long as the slope of the total revenue curve (which equals marginal revenue) exceeds the slope of total

cost curve (which equals marginal cost), profit will continue to rise as output increaseso when these slopes become equal (when marginal revenue equals marginal cost) profit will no

longer rise but be at a maximum

Partial Differentiation and the Maximization of Multivariable Functions

- in many cases, a variable depends on a number of other variables- to find the value of each independent variables that maximizes the dependent variable, we need to know

the marginal effect of each independent variable on the dependent variable, holding constant the effectof all other independent variables

- here we need to know the marginal effect of Q1 on when Q2 is held constant and we need to know themarginal effect of Q2 on

when Q1 is held constant

- we obtain the partial derivative of with respect to Q1 and the partial derivative of with respect to Q2o set the partial derivatives equal to 0Constrained Optimization

- maximize/minimize with constraints, such as Q1+Q2 cannot equal less than 30Lagrangian Multipliers

- do we need to know this?


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Comparing Incremental Costs with Incremental Revenues

- if a firm is considering adding a new product line, they should compare the incremental cost of adding it(the extra cost resulting from its addition) with the incremental revenue (the extra revenue resulting fromits addition)

oif the incremental revenue exceeds the incremental cost, the new product line will add to thefirms profits

- marginal costs is the extra cost from a very small increase in output- incremental output: the extra cost from an output increase that may be substantial- incremental revenue: the extra revenue from an output increase that may be substantial


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Production Theory

- managers must choose an optimal method to produce- efficiency requires an understanding of the production process- a production process explains how scarce resources (inputs) are sued to produce a good or service

(output)o production function precisely specifies the relationship between input and outputs

- understanding the production process is fundamental to gaining insight into cost analysiso control of costs along with understanding of demand, is required for managers to optimize profit

The Production Function with One Variable Input

- Production function table, graph or equation showing the maximum product output achieved from anyspecific set of inputs

- Production is dynamico Methods, designs and factor costs change

- Say a process uses two inputs. If X1 is the level of the first input and X2 is the level of the second input,the production function is

- Where Q is the firms output rate- Simplest case:

o One input with fixed quantitiyo One input whose quantity is variable

- time needed to change an asset is the beginning of what is called the long term- fixed inputs often require capital (buildings, machinery, land)- variable inputs can be changed in the short run, e.g. labour- in the long run, all inputs are variable- E.g. an entrepreneur own 5 machines and wants to know the effect on annual output if he were to hire

various number of machinistso He produces more parts by hiring more machinistso Numbers in the table are produced by a production function (equation)o he is interested in knowing how output changes as the number of machinists varies

- one common measure used by many managers is output per workero average product (AP): common measuring device for estimating the units of output, on average

per input unit- when varying machinists, output per worker is

( ) - tells us how many units of output, on average, each machinist is responsible for- if he wants better metric to estimate efficiency,

o marginal product (MP):metric for estimating the efficiency of each input in which the inputsMP is equal to the incremental change in output created by a small change in the input:

( ) - he wants to know how much his output will change as input changes by one machinist- Q(L) total output with L units of labour per year- Q(L)/Laverage product- marginal product of labour MP, when between L and (L-1) units of labour per year is Q(L)-Q(L-1)


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- Quant option:o The marginal product of an input is the derivative on output with regard to the quantity of the

input. That is, if Q is the output and x is the quantity of the input, the marginal product of theinput equals dQ/dx is the quantities of all other inputs are fixed

- Marginal profit equals the average product when the latter reaches a maximum- Marginal product exceeds average product when average product is increasing-

Marginal product is less than the average product when average product is decreasing

The Law of Diminishing Marginal Returns

- The law of diminishing returns: a well-known occurrence where managers add equal increments of aninput while holding other input levels constant, the incremental gains to output actually get smaller

o if pushed to the extreme, can be counterproductive- e.g. if he hires 8 machinists he will counterproductive because he only had 5 machines. As more people

are hired, they will have to ration machines or new hires will be assigned to less important tasks- choosing the optimal input is difficult because managers cannot hold all but one input constant

The Production Function with Two Variable Inputs

- with a longer time horizon, the formerly fixed input of 5 machines becomes variable- the production surface shows the amount of total output that can be obtained from various combinations

of machine tools and labouro we measure output for any input bundles as height on the surfaceo dropping a perpendicular down from a point on the surface to the floor defined the

corresponding input bundle

Isoquants

- isoquant: a curve showing all possible (efficient) input bundles capable of producing a given outputlevel

o the surface is not meant to represent the numerical values in Table 4.3 but is a generalrepresentation of how a production surface of this sort is likely to appear

- an isoquant is composed of all the points having the same height in the production surface- an isoquant shows all the combinations of X1 and X2 such that f(X1, X2) equals a certain output- the farther the isoquant from the origin, the greater the output it represents- because we assume continuous production functions, we can draw an isoquant for any input bundle- each isoquant represents and infinite number of possible input combinations- Isoquants are always down-sloping and convex to the origin

The Marginal Rate of Technical Substitution

- Generally a particular output can be produced with a number of input bundles- As we move along the isoquant, the marginal rate of technical substitution (MRTS): shows the rate at

which one input is substituted for another (with output remaining constant)- If the output produced is the function of two inputs, Q=f(X1,X2),

- Given that Q, output, is held constant- The marginal rate of technical substitution is -1 times the slope of the isoquant, which makes sense

because

measures the slope, which is downward or negative


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- Useful for managers to think of MRTS as the ratio of marginal products, MP1/MP2 for inputs 1 and 2- The marginal product metric shows the incremental effect on output of the last unit of input- Managers want to increase the use of inputs with relatively high marginal products, though they must

also consider the cost of inputs- Rate of substitutability between inputs varies:

o One type of labour is easily substituted for anothero

Specialized inputs are requiredo No substitution among input is possible; to produce a unit of output, a fixed amount of each input

is required and inputs must be used in fixed proportions (extreme cases) Graph is right angles

- With perfect substitutability of inputs, isoquant are straight lines connecting the two axes- Figure 4.6:

o Two isoquant slopes are positive Increases in both capital and labour are required to maintain a specified output rate Marginal product of one or the other input is negative Above 0U, the marginal product of capital is negative so output increases is less capital is

used while the level of labour is held constant

Below 0V, the marginal product of labour is negative so output increases if less labour isused while the amount of capital is held constant 0U and 0V are ridge lines: the lines that profit-maximizing firms operate within, because

outside of them, marginal products of inputs are negative- If managers want to maximize profit, they cannot use input bundles outside the ridge lines- No-profit managers will operate at a point outside the ridge lines because they can produce the same

output with less input

The Optimal Combination of Inputs

- Managers must consider costs because inputs are scarce- A manager who wants to maximize profit will try to minimize the cost of producing a given output or

maximize the output derived from a given level of cost- Example: what combination of capital and labour should the manager choose to maximize the output

derived from the given level of cost:o Inputs: capital and labouro Price of labour: Plo Price of capital: Pk o And

o Represented by a straight line

Isocost curve: curve showing all the input bundles that can be purchased at a specificcost

o If we superimpose the isocost curve on the isoquant map we see the input bundle that maximizesoutput for a given cost (curve and line touch)

o Pick the point on the isocost curve that is tangent to the highest-valued isoquanto Choose the curve that MPl/Pl=MPk/Pk

- To determine the input the maximizes production costs:o Moving along the isoquant of the specified output level, we find the point that lies on the lowest

iscost curve Ones below the isoquant are cheaper but dont produce desired output


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o To minimize the cost of producing a given output or to maximize the output from a given costoutlay, the firm must make MPl/Pl=MPk=Pk

Corner Solutions

- Corner solutions optimal input bundles with just one input deployedo

In the two-input case, just one input is used to produce the product in the least expensive way- For cases where just capital is used, MPk/Pk>MPl/Pl- For cases where just labour is used, MPk/Pk1, means increasing returns to scaleo =1, means constant returns to scaleo


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o logQ=loga+blogL+clogK- managers can easily estimate returns to scale using this- if the sum of exponents (b+c) exceeds 1, increasing returns to scales are indicated- if the sum of exponents equals 1, constant returns to scale prevail- if the sum of exponents is less than 1, decreasing returns to scale are indicated- this is true because if the Cobbs-Douglas production function prevails, the output elasticity equals the

sum of exponents


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The Analysis of Costs

Opportunity costs

- producing a particular product as the revenue a manager could have received if she had used herresources to produce the next best alternative product or services

- opportunity costs: the revenues forgone if resources (inputs) are not optimally usedo managers need to reduce opportunity costs

- opportunity cost doctrine: the inputs values (when used in their most productive way) together withthe production costs (the accounting costs of producing a product) determine the economic cost ofproduction

- opportunity costs of an input may not equal its historical cost: the money that managers actually paidfor an input

- managers concerned with two types of costs:o explicit costs: the ordinary items accountants include as the firms expenseso implicit costs: the forgone value of resources that managers did not put to their best use

- Ex: the cost per year of attending Wharton is $90,000. Many students work beforehand and make$70,000. According to an accountant, the average yearly cost of attending Wharton is $90,000, whereasan economist would say $160,000.

- sunk costs: resources that are spent and cannot be recoveredo the difference between what a resource costs and what it is sold for in the futureo Ex: if a company builds a plant for $12 million and disposes of it for $4 million, it incurs sunk

costs of $8 million

Short-run costs functions

- cost function: function showing various relationships between input costs and output rate- short-run so short that a manager cannot alter the quantity of some inputs- as the length of time increases, more inputs become variable- short run: the time span between where the quantity of no input is variable and one where the quantities

of all inputs are variable- in the short run we say that it is so brief that managers cannot alter the quantities of plant and equipment- fixed inputs: when the quantities of plant and equipment cannot be altered

o they determine the firms scale of plant: this scale is determined by fixed inputs- variable inputs: inputs that a manager can vary in quantity in the short run- short run cost concepts:

o fixed total fixed cost (TFC): the total cost per period of the time incurred for fixed inputs

o variable total variable cost (TVC): the total cost incurred by managers for variable inputs increase as output rises because greater output requires more inputs and higher variable

costs up to a particular output rate, total variable costs rise at a decreasing rate; beyond that

output level, they increase at an increasing rate... follows law of diminishing returnso total

total cost (TC): the sum of total fixed and total variable costs total fixed cost + total variable cost

Average and Marginal Costs


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- three average cost functions corresponding to the three total cost functions:o average fixed cost (AFC): the total fixed cost divided by output

declines with increases in output rectangular hyperbola total fixed cost (TFC): the total cost per period of the time incurred for fixed inputs

oaverage variable cost (AVC): the total variable cost divided by output the variable cost, on average, of each unit of output

initially, increasing output results in decreases in AVC, however, as output increases, atsome point of increased production, AVC rises, this increasing the average variable costper unit

total variable cost divided by number of units produced, where U is the number of inputunits used and W is the cost per unit of input

inverse of average product times the cost per unit of input because of their inverse relationship, AVC mirrors the behaviour of AP when AP increase, AVC decreases; when AP decreases, AVC increases we expect AVC to initially decrease, hit a minimum, and then increase

o Average total cost (ATC): the total cost divided by output AFC + AVC takes a similar shape to AVC but higher at all output levels due to fixed costs ATC reaches its minimum at output levels relatively higher than AVC because increases

in average variable cost are for a time more than offset by decreases in average fixed cost(which must decrease as output increases)

o Marginal Cost (MC): the incremental cost of producing an additional unit of output at low output levels, MC may decrease with increases in output, but after reaching a

minimum, it increases (like AVC) with additional output

but is zero because fixed costs cant vary, therefore

consequently,

and

hence we can define MC as

the behaviour of MP is inverse to that of MC as MP increases, MC decreases; when MP decreases, MC increases


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we saw that the behaviour of marginal product is to increase, attain a maximum, and thendecline with increases in output; marginal cost normally decreases, attains a minimum,and then increases

marginal cost always equals average variable cost when the average variable cost is at aminimum (because MP=AP when AP is maximized)

Long Run Cost Functions

- in the long run, all inputs are variable and there are no fixed costs because no inputs are variable- long-run average cost function (LAC): function showing the minimum cost per unit of all output

levels when any desired size plant is built- Any point on the long run average cost function is also a point on the short-run average cost function... it

is a point on the lowest-cost short-run cost function for the given output level- when given the freedom, managers want to choose the plant scale that minimizes average cost- Fig 5.4 pg. 141

o the minimum average cost of producing all outputs is given by the long-run AC functiono each point is also a point on a short-run AC functiono

at that output level, it is a point on the lowest-cost short-run AC function; it is the best andefficient manager can doo the two functions are tangent at that point

- long run total cost of production= long run average cost x output- long-run total cost function: the relationship between long-run total cost and output- long-run marginal cost function: function representing how varying output affects the cost of

producing the last unit if the manager has chosen the most efficient input bundle- shows behaviour similar to average costs- long-run marginal cost < LAC, when LAC is decreasing- long-run marginal cost = LAC, when LAC is at a minimum- long-run marginal cost > LAC when LAC is increasing

Managerial Use of Scale Economies

- economies of scale:when the firms average unit cost decreases as output increases- managers use many sources of scale economies to create competitive advantages

o e.g. UPS use them in their distribution network to decrease costso e.g. larger cruise ships have lower cost per passenger

- however, increasing size eventually causes diseconomies of scale: when the average costs per unit ofoutput increase (usually because of the complexity of managing and coordinating all of the necessaryactivities

Managerial Use of Scope Economies

- economies of scope: exist when the cost of jointly producing two (or more) products is less than the costof producing one

- this is a cost efficiency strategy for managers- simple way for managers to estimate the extent of their scope economies is to use:

- S is the degrees of economies of scope, C(Q1) is the cost of producing Q1 units of the first product

alone, C(Q2) is the cost of producing Q2 units of the second product alone and C(Q1+Q2) is the cost ofproducing Q1 units of the first product in combination with Q2 units of the second product


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- if there are economies of scope, S is greater than zero because the cost of producing both productstogether, C(Q1+Q2), is less than the cost of producing each alone, C(Q1) + C(Q2)

- the larger the value of S, the greater are the scope economies- managers use scope economies to create cost advantages by producing multiple products rather than just

one... often these cost savings arise because the products share either processes (like distribution) orresources (such as components)

-

also diseconomies of scope

Managerial Use of Break-Even Analysis

- managers use it to estimate how possible pricing changes affect firm performance- break-even point: the output level that must be reached if managers are to avoid losses

o intersection of the cost and revenue functions- can be modelled with both linear and curvilinear

Profit Contribution Analysis

-

profit contribution analysis: break-even analysis to understand the relationship between price andprofit- profit contribution is the difference between total revenue and total variable cost; on a per unit basis, it is

equal to price minus average variable cost


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Perfect Competition

- a dominant constraint in pricing decisions is the structure of the market- market structure is important because it largely determines the potential pricing power of managers- classify markets based on degree of pricing power... perfectly competitive market (managers have no

market power)monopoly market (managers face no competition and possess plenty of market power)

- managers are price takers: they accept the decisions of the aggregate marketo managers with no market power have no control over price

still face supply side challenges of efficient production and cost control from the demand side, managers must choose the profit-maximizing output when the

price is given... in all other markets, managers can vary both output and price- in perfectly competitive markets, managers cannot overrule the price set by the interaction of the

aggregate market demand and supply curveso ex: farmers who do not control price but control quantity... prices may change as conditions

influencing demand (taste, income) and supply (weather, crop disease) change

Market Structure

- the situation of the price-taking producer is one of the four general categories of market structure weinvestigate:

o perfect competition: when there are many firms that are small relative to the entire market andproduce similar products

no control over price firms produce identical products barriers to entry (barriers that determine how easily firms can enter an industry,

depending on the market structure) are low no nonprice competition

o monopolistic competition: when there are many firms and consumers, just as in perfectcompetition; however, each firm produces a product that is slightly different from the productsproduced by the other firms

less control over price than monopolist and more control over price than a manager in aperfectly competitive market

firms produce somewhat different products low barriers to entry considerable emphasis placed on managers using nonprice competition

much of the nonprice competition centers around the ability of managers todifferentiate their products; this differentiation gives managers the power tooverrule the market price

o monopoly: markets with a single seller barriers to entry are blocked (once entry occurs, monopoly no longer exists) nonprice competition in advertising

o oligopoly: markets with a few sellers most prevalent category in present-day business less control over price than monopolist and more control over price than a manager in a

perfectly competitive market firms sometimes produce identical products

e.g. in steel/aluminum they do but in cars they do not considerable barriers to entry


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managers of oligopoly that produce differentiated products also tend to rely heavily onnonprice competition, whereas managers from oligopolies that produce nondifferenitatedproducts do not

- see table 6.1Market Price in Perfect Competition

- in a perfectly competitive industry, market price is determined by the intersection of market demand andsupply curves

- individuals managers cannot always affect priceo sometimes, even with great increases in output, price change is minisculeo this means that managers in this market essentially face a horizontal demand curve...no matter

how many units one manager sells, the market price remains the same

Shifts in Supply and Demand Curves

- shifts in the supply and demand curves result in price changes-

two of the major factors causing shifts in supply curves:o technological advancementsshift curve to the righto changes in input pricesshift curve to the left

The Output Decision of a Perfectly Competitive Firm

- managers cannot affect market price of producto must sell output within their capabilities at the market price

- relationship between total revenue, cost and outputo distance between total revenue and total cost curves is the profit at the corresponding outputo total revenue curve is a straight line through the origin with a slope equal to the fixed priceo slope of total revenue is always the market price

- and it follows that - is the firms marginal revenue... the firms total revenue is PQ, therefore, marginal revenue is

so the firms marginal revenue is the products price- in the case of a price taker, the price of a condition reads P=MR, therefore, P=MC... this is why

managers want to avoid these markets: the nature of competition is to grind the price down to marginalcost... competitive pressure is relentless

- there is no above normal economic profit (except in the short run)- managers should never produce output where MC is greater than MR- because the manager takes the price as given, it is constant for all output levels

o marginal revenue curve is also the firms demand curve, which is horizontal- central pointmanagers maximize profit at the output where price (or marginal revenue equals the

marginal cost

Setting the Marginal Cost Equal to the Price

- if managers want to maximize firm value, they should set price equal to marginal cost when marginalcost is increasing


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- managers in perfectly competitive markets often accrue negative profits (figure 6.5 pg. 181)o if the price is at a certain level, short-run average total costs may exceed the price at all possible

outputso because the short run is too short to permit the manager to alter the scale of a plant, all she can so

is product at a loss or discontinue the producto for any output where price exceeds average variable costs, managers should produce, even

thought the price does not cover average total costso if there is no output rate where the manager is able to exceed the average variable costs, the

manager is better off shutting the plant however, the fixed costs still stand so if the loss of producing is smaller than the fixed

costs, the manager would be more profitable without shutting down the planto managers want TR to exceed VC by as much as possible, thus maximizing controllable cash flow

if VC exceeds TR do not produce because controllable cash flow is negativeo P = MC and P > AVCo shutdown point: when the price equals the minimum average variable cost

price is equal to marginal cost because it intersects with average variable cost at this point at this price, the manager loses money equal to fixed cost if he produces or he loses that

money if he shuts down... any price below this, the manager shuts down the marginal cost curve (above the average variable cost) is the supply curve for the firmAnother Way of viewing the price equals marginal cost profit-maximizing rule

- marginal revenue product (MRP): the amount an additional unit of the variable input adds to thefirms total revenue

- Marginal expenditure (ME) is the amount of additional unit of labour adds to the firms total cost- to maximize profit, managers should use labour (a variable input) where its marginal revenue product

equals its marginal expenditure... MRP = ME- to maximize profit... MR=MC- in the case of perfect competition, MR = P- rule becomes... P x MPL = MEL = PL- managers should continue to hire more labour as long as P x MPL > PL and should not hire labour if P x

MPL < PL- the stopping rule to maximizing is P x MPL = PL... dividing both sides by MPPL gives P = PL/MPL and as

was shown in Chapter 5, MC = PL/MPLo therefore to maximize profit in a perfectly competitive market, P = MC

Producer Surplus in the Short Run

- producer surplus: the difference between the market price and the price the producer is willing toreceive for a good or service (the producers reservation price)

- to arrive at producers surplus, managers subtract the only available cost from total revenue, hence thevariable-cost profit is larger than the profit is larger than profit (by the level of fixed cost), and producersurplus and variable-cost profit are the same

- because the perfectly competitive firms marginal cost represents its supply curve, we can view producersurplus, we can view producer surplus as the difference between the supply curve and the price receivedfor the good

- market supply is the horizontal summation of individual firms supply curves dor the product- refer to figure 6.7 pg 188- the market equilibrium price of P* yields a consumer surplus of A and a producer surplus of B


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- the sum of A and V, the total surplus, is the economists measure of social welfare at the price P* andthe quantity Q*

- for consumers, the total amount they are willing to pay for goods are areas A, B and C or the area belowthe demand curve and to the left of the equilibrium quantity

- for producers, the total variable cost of supplying quantity Q* is the area beneath the supply curve and tothe lest of the equilibrium quantity or area C

-

in the market consumers pay and producers receive P*, yet P* is less than the total benefit and greaterthan the variable cost of the goods- the market exchange generates value for participants, represented by consumer, producer and total

surplus- in this case, the difference between what the demanders are willing to spend (A, B and C) and what the

suppliers are willing to receive (C) is the measure of social welfare... A + B- a more gently sloped demand curve reduces consumer surplus and a more gently sloped supply curve

reduces producer surplus

Long-run equilibrium of the firm

-

the long-run equilibrium of the firm is at the point where its long-run average total cost curve equals theprice- if price exceeds the average total cost, economic profit is earned and new firms enter the industry

o this increases supply, thereby driving down price and hence profit- if the price is less than the average total costs for any firm, the firm will exit the industry

o as firms exit, supply falls, causing price and profit to riseo when economic profit is zero (long-run average cost equals price), a firm is in long-run

equilibrium- economic profit is above what the owners could obtain elsewhere from the resources they invest in the

firmo long-run equilibrium occurs when owners receive no more and no less than they could obtain

elsewhere from these resources- the price must be the lowest value of the long-run average total cost

o if managers maximize their profit, they must operate where price equals long-run marginal costo also must operate where price equals long-run average costo therefore, long-run average cost must equal long-run marginal cost... this is at a point where

long-run average cost is a minimum

The Long-run Adjustment process: A constant-cost Industry

- assume that this industry is a constant-cost industry, meaning that expansion of the industry does notincrease input prices

- assume the industry is in long-run equilibrium with the result that the price equals the minimum value ofthe long-run and short-run average cost

- a constant-cost industry has a horizontal long-run supply curve- if the demand curve shifts to the right with the number or firms fixed...

o the product price riseso each firm expands its outputo each firm makes economic profit because the new price exceeds the short-run average costs of

the firm when the output increaseso firms enter the industry, the supply curve shifts to the right

- in a constant-cost industry, entrance of new firms does not influence the cost of existing firms


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- the inputs used by this industry are used by other industries as well and new firms in this industry do notbid up the price of inputs and hence raise the costs of existing firms

- neither does entry of new firms reduce existing firms costs- a constant cost industry has a horizontal long run supply curve- as long as the industry remains in a state of constant costs, its output can be increased indefinitely- industry output can be raised or lowered, in accord with demand conditions, without changing this long-

run equilibrium price

The long-run adjustment process: an increasing-cost industry

- increasing cost industryindustry expansion increases input prices- the original position (of the equilibrium) is one of the long-run equilibrium because price equals the

minimum value of long run and short-run average cost- if the demand curve shifts to the right, the product price goes up and the firms earn economic profit,

attracting new entrantso more inputs are needed by the industry and in an increasing-cost industry, the prices of the inputs

rise with the amount used by the industryo

the cost of inputs increases for established firms as well as entrants and the average cost curvesare pushed up- if each firms marginal cost curve is shifted to the left by the increase in input prices, the industry supply

curve tends to shift to the lefto this tendency is more than counterbalanced by the increase in the number of firms, which shifts

industry supply curve to the righto without offsetting, there would be no expansion in total industry outputo this process of adjustment must go on until a new point of long-run equilibrium is reached

- an increasing-cost industry has positively sloped long-run supply curve- after long-run equilibrium is achieved, increases in output require increases in the price of the product- in constant-cost industries, new firms enter in response to an increase in demand until the price returns

to original level- in increasing-cost industries, new firms enter until the minimum point on the long-run average cost

curve has increased to the point where it equals the new higher price- also decreasing-cost industries, where their long-run supply curves are negatively slopes

How a Perfectly Competitive Economy Allocates Resources

- important for managers to understand how a competitive economy allocates resources- simple case: consumers become more favourably disposed toward corn and less favourably disposed

toward rice than n the pasto rising demand for corn increases its price and results in some increase in the output of corno corn output cannot be increased substantially because the capacity of the industry cannot be

expanded in the short-runo falling demand of rice reduces its price and results in some reduction in the output of riceo output of rice cannot be limited greatly because firms continue to produce as long as they can

cover their variable costso because of the increased price of corn and the decreased price of rice, corn producers earn

economic profit and rice producers show economic losso producers reallocate resources to correct this imbalanceo when short-run equilibrium is achieved in both the corn and rice industries, the reallocation of

resources is not yet complete because there has not been enough time for producers to build newcapacity or liquidate old capacity


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o neither industry operates at minimum average costo corn producers may operate at greater than the output level where average cost is a minimum and

the rice producers may operate at less than the output level where average cost is a minimumo long-run:

shift in consumer demand curve from rice to corn results in greater adjustments in outputand smaller adjustments in price than in the short run

existing firms can leave rice production and new firms can enter corn production as firms leave rice production, the supply curve shifts to the left, causing the price to riseabove its short-run level

the transfer of resources out of rice production ceases when the price has increased andcosts have decreased to the point where loss no longer occurs

o whereas rice production loses resources, corn production gains themo the short-run profit in corn production stimulates the entry of new firmso the increased demand for inputs raises input prices and cost curves in corn production and the

price of corn is depressed but he movement to the right of the supply curve because of new entryof new firms

o entry stops when economic profit is more is no longer being earnedo

at that point, when long-run equilibrium is achieved, more firms and more resources are used inthe corn industry than in the short run


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Monopoly and Monopolistic Competition

- equilibrium price sent by the intersection of the supply and demand curves is rarely seen- do not have to consider actions of market rivals because there are none - monopolies have no intramarket competition and firm demand is equal to market demand- downward sloping demand curve- firms decide price an quantity (no longer passive price takers)- higher economic profit- although monopolies may have no direct substitutes, cross elasticities can tell us what goods, locations

and time are substitutes for a monopoly producto must consider product, spatial and temporal competition

- the higher the profit, the more others will test your market defences and try to enter your market- if companies are doing too good a job, authorities may try to regulate actions- still produce where marginal revenue equals marginal cost- monopolistic competitive markets:

o market managers still have market power but they must deal with intramarket rivalso lack of entry barriers allows others into the market

Price and Output Decisions in Monopoly

- monopolist maximizes profit by choosing the price and output where the difference between totalrevenue and total cost is the largest

- maximize profit if they set output at the point where marginal cost equals marginal revenue- note that with a linear demand curve, the marginal revenue curve has twice the slope of the demand

curve- unlike firms in a perfectly competitive market, the firms marginal revenue is no longer constant, nor is

it equal to price- recall

[ ()] [ ( ||)]

( ||)- where MR is marginal revenue, P is price and isthe price elasticity of demand- because < 0, the marginal revenue equals price minus ||

o marginal revenue is price minus something positive, so price must exceed marginal revenueo no rational manager produces where marginal revenue is negative (producing another unit

decreases total revenue)- if managers are to produce where marginal revenue equals marginal cost, a negative marginal revenue

implies a negative marginal cost- total costs increase (not decrease) when managers increase production- if marginal revenue is positive, then < -1 (that is ||> 1), which implies an elastic demand

o a monopolist will not produce in the inelastic range of the demand curve if maximizing profit- also true that price must exceed average variable cost if managers are to maximize profit

o if not, the monopolist is not covering variable cost and should shut the operation to reduce lossesto only fixed cost


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- figure 7.4 (pg 206) produce output Q where:o marginal cost curve intersects that of marginal revenueo demand curve slopes downward to the right (not like the horizontal demand curve of perfectly

competitive market)o profit per unit of P-ATC (multiplied by Q to get shaded area)o P>AVCo

relative to managers in perfectly competitive markets, monopolists choose a higher price andlower output... allows them to charge a higher price than marginal cost and hence generateeconomic profit

o output is limited under monopoly, price is increased, and profit is increased (compared toperfectly competitive markets)

- to see that monopolists price exceeds marginal costs, [ ( ||)] [ ( ||)]

[ ( ||)]

- because ||>1, it follows that ||


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o factory cost/unit= $2,300 (at production of 20,000)o 40% markup= $920o US list price= $3,220

- price is set without considering prices of rival products- pricing scheme works better when products are differentiated... Therma-Stent is unique in form and

structure

Cost-Plus Pricing at Internet Companies and Government-Regulates Industries

- many online companies seem to have adopted a cost-plus pricing scheme- some companies have structured a pricing policy called At Cost where they sell products based at the

wholesale price plus a fixed transaction fee (the markup)- many automobile dealers also use a cost-plus pricing scheme, though they tend to make it difficult for

consumers to accurately determine cost- government regulators also use cost-plus pricing in industries they regulate or control

o dangers of such pricing scheme in a government controlled industry is that, when profit isguaranteed, firm managers may lose the incentive to be cost efficient

othis tends to create a larger government regulatory bureaucracy to monitor costs

Can Cost-Plus Pricing Maximize Profit?

- we question how good a heuristic cost-plus pricing is for managers to use- it seems unlikely that cost-plus pricing will often maximize profit

o this pricing technique seems simple-minded in that it does not explicitly consider the extent ofdemand or the products price elasticity, including the pricing behaviour of rivals

- the possibility that cost-plus pricing is sometimes a good heuristic revolves around what factorsmanagers consider in determining the size of the percentage markup or the target rate of return

o in choosing markup to maximize profit, managers must understand how marginal cost and priceelasticity of demand are associated

- note the negative association between elasticity and markupo as the price elasticity of demand decreases (in absolute value), the optimal markup increases

if the quantity demanded is not very sensitive to price, obviously a high price should beset if you want to make the most amount of money possible

The Multiple-Product Firm: Demand Interrelationships

- more complex decisions for managers producing multiple products- change in the price or quantity sold of one product may influence the demand for other products- TR=TRX+TRY- marginal revenue from product X is

- marginal revenue from product Y is

- the last term in each of these equations represents the demand interrelationship between the two

products- in the first one, the last term shows the effect of an increase in the quantity sold of product X on the total

revenue from product Y


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o if X and Y are complements, this effect is positive because an increase in the quantity sold of oneproduct increases the total revenue from the other product

o if X and Y are substitutes, this effect is negative because an increase in the quantity sold of oneproduct reduces the total revenue of the other product

Pricing of Joint Products: Fixed Proportions

- in addition to being interrelated on the demand side, some products also have interrelated characteristics- ex: a bundle might be one hide and two sides of beef in the case of cattle because they are produced

from each animal- with such jointly produced products. there is no economically correct way to allocate the cost of

producing each bundle to the individual products- to determine the optimal price and output of such bundled product, managers need to compare the

marginal revenue generated by the bundle to its marginal cost of production- if the marginal revenue (sum of the marginal revenues obtained from each product package) is greater

than its marginal cost, managers should expand output- total marginal revenue curve: the vertical summation of the two marginal revenue curves for

individual products- Figure 7.5 page 217o 2 joint products, each with a demand curveo marginal cost for bundled product in the fixed proportion in which it is produced (produced in

the same place, therefore same cost)o profit maximizing output is Q (total marginal revenue equals marginal cost)o optimal price output for A is Pa and the optimal price output for B is Pbo total marginal revenue curve coincides with the marginal revenue curve for product A ar all

outputs beyond Qo managers should never sell product B at a level where its marginal revenue is negative

(negative marginal revenue means managers can increase revenue by selling fewer units) if total output exceeds Qo, managers shouls sell only part of product B produced... they

want to sell the amount corresponding to an output of Qo product bundles if output Qo, total marginal revenue equals the marginal revenue of product A alone

o What if marginal cost curve intersects the total marginal revenue curve to the right of Qo? profit-maximizing output is Q1 where marginal cost and total marginal revenue curves

intersect all of product A produced is sold, but not all of product B is sold... amount sold is limited

to the amount of output Qo, so that the price of product B is Pb the surplus amount of product B (Q1-Qo) must be kept off the market to avoid

depressing its price

Output of Joint Products: Variable Proportions

- more realistic if the manager is considering a fairly long period- a firm produces 2 products each with an isocost curve: curve showing the amounts of goods produced at

the same total cost- isorevenue lines: lines showing the combinations of outputs of products that yield the same total

revenue- want to know how much of A and B to produce

o if an output combination is at a point where an isorevenue line is not tangent to an isocost curve,it cannot be the optimal output combination


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if an output combination is at a point where an isorevenue line is not tangent to an isocostcurve, it is possible to increase revenue without changing cost by moving to a point onthe same isocost curve where an isorevenue line is tangent to the isocost curve

o we find the optimal output combination by comparing the profit level at each tangency point andchoosing the point where the profit level is the highest

Monopsony

- monopsony: markets that consist of a single buyero controls price

- consider The Company in company town... when it wishes to hire another workers, because it employssuch a large proportion of the labour force, it will influence the wage

- demand for labour is labours marginal revenue product... marginal revenue multiplied by the marginalproduct of labour

o downward sloping... marginal revenue falls as output increases andbecause labours marginalproduct falls as more labour is employed

- labour supply curve: P=c+eQo

upward sloping...to hire another worker, The Company must increase the wage to entice aworker either into the workforce or away from another job- The Companys total expenditure on labour (total cost) is: C=PQ=(C+eQ)Q=cQ+eQ2- to maximize profit, managers will equate the marginal benefit of hiring another work with the marginal

expenditure (mar

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Jess Econ Notes