MN12217 - Lecture 5 - Business Economics for Accountants PDF

MN12217 Business Economics for Accountants Lecture 5 Consumer theory (cont’d), Price Elasticity of Demand, and [email protected] first look at Dr Tim Wakeley production  RECALL… Changes in price can be broken down into two compone...

MN12217 Business Economics for Accountants Lecture 5 Consumer theory (cont’d), Price Elasticity of Demand, and [email protected] first look at Dr Tim Wakeley production  RECALL… Changes in price can be broken down into two components THE SUBSTITUTION THE INCOME EFFECT EFFECT measures the amount by measures the impact on which a consumer the amount of a good substitutes one good for consumed as a result of another, whilst the consequent change in maintaining the same real income levelthe it reflects of propensity utility of consumers to substitute between goods in response to a relative price change  Indifference curve analysis A A Substitution Quantity of A Income ’ Effect Potatoes B ’ Effect B A IC2 A’ IC1 0 Q1 Q2 Quantity of Bread  so what? The substitution effect always works in the same direction (i.e. when the price of a good - bread - falls it moves quantity demanded to the right) BUT… The income effect may not reinforce the substitution effect INFERIOR GOODS a good is defined as inferior if its consumption falls as income is increased (and vice versa)  the strongly inferior good… A A Substitution Quantity of A ’ Income Effect Potatoes B ’ Effect This implies an B upward sloping IC2 demand curve! Q A A’ IC1 Sir Robert Giffen (1837 – 1910) 0 Q2 Q1 Quantity of Bread Price Elasticity of Demand 6  Price Elasticity of Demand The demand curve of a normal good tells us that when price falls the quantity demanded will increase (and vice versa) The important question is, ‘by how much?’ Example 1: a 20% cut in the price of widgets leads to a 10% increase in quantity demanded Example 2: a 20% cut in the price of widgets leads to a 30% increase in quantity demanded  Price Elasticity of Demand “A unit-free measure of how much the quantity demanded of a good changes in response to a change in the price of that good.” & very useful very useful information for information for managers of firms government to have (e.g. if they officials to have want to change the (e.g. when they set prices of their various taxes & 8  Price Elasticity of Demand The formula: proportionate (percent)change in quantity demande PED = Proportionate (percent) change in price There are three ways of calculating this… 9  Price Elasticity of Demand £ ‘Rough & ready’ method: [ΔQ/Q0 ] x 100 100 PED = [ΔP/P0] x 100 [(40 – 20) ÷ 20] ×100 = ×100 [(30 – 40) ÷ 40] 50 A 100% = = -4 40 B -25% 30 Demand curve 1 “a 25% price cut leads to a 100% increase in sales quantity.” 0 20 40 50 100 Q 10  Price Elasticity of Demand £ Mid-point method [ΔQ/Qaverage] x 100 100 PED = [ΔP/Paverage] x 100 [(40 – 20) ÷ 30] x 100 = [(30 – 40) ÷ 35] x 100 [20/30] x 100 50 = A [-10/35] x 100 40 B 66.6% = 30 Demand curve 1 -28.6% = -2.33 0 20 40 50 100 Q 11  Price Elasticity of Demand £ Point-elasticity method dQ/Q 100 PED = dP/P Which rearranges to: dQ P PED = dP. Q 50 A Where, Q = 100 – 2P 35 B so,dQ = – 2 Demand curve 1 dP ‫؞‬PED =– 2x 35 30 = -2.33 0 30 50 100 Q 12  Price Elasticity of Demand We focus on the absolute value when we talk about the magnitude of PED i.e. we ignore the negative sign! when the absolute when the absolute value value of the % change of the % change in in quantity is larger quantity is smaller than than the absolute the absolute value of the value of the % change % change in price, this in price, this means means the absolute the absolute value value of PED is < 1 of PED is > 1 ‘INELASTIC ‘ELASTIC  Price Elasticity of Demand We are about to discover… 1. PED varies along the length of a given downward sloping demand curve & 2. Flatter demand curves are elastic relative to steeper demand curves  Price Elasticity of Demand PED varies along the length of a given downward sloping demand curve £ Total revenue (TR) 100 = P x Q & this also ELASTIC varies along the 8 PEDPORTION = TR = length of a given 0 4 £1600 demand curve PED TR = 50 =1 £2500 INELASTIC PORTION PED = TR = 2 ¼ £1600 0 Deman d 0 2 50 8 100 Q 0 0 15  Price Elasticity of Demand Flatter demand curves are relatively elastic compared to steeper £ demand curves Demand Curve 1 £ Demand Curve 2 100 100 25% price cut leads 25% price cut leads to 100% increase in to 16.7% increase in sales quantity sales quantity Note the contrasting 50 50 implications A A’ of the price 40 B 40 B’ cut for 30 30 revenue 0 20 40 50 100 Q 0 30 35 50 100 Q Demand Curve 2 is described as being ‘relatively inelastic’ with respect to 16  Price Elasticity of Demand There are two extreme types of Price demand curve: Price PED = 0 PED = ∞ 0 Quantity 0 Quantity The perfectly elastic The perfectly inelastic demand curve demand curve A change in price leads A change in price to an infinitely large leads to no change in change in quantity quantity  Price Elasticity of Demand What determines PED? availability of substitutes PED is higher… 1. When there are more competing products 2. For specific brands rather than broad categories 3. For things that aren’t necessities 4. When consumers search more 5. When there’s more time to adjust 18  Price Elasticity of Demand Do you think demand is elastic or inelastic for the following goods? A. Flowers on Valentine’s day B. Healthcare C. Walker’s crisps D. Electricity E. Apple iPads  Elastici ty How do you think incorporating PED into our model of supply and demand might impact outcomes? Other measures of elasticity you will come across include… PRICE CROSS(PRI INCOME ELASTICIT CE) ELASTICIT Y OF ELASTICIT Y OF SUPPLY Y OF DEMAND DEMAND  Price elasticity of supply Percent change in quantity supplied PES = percent change in price What determines PES? the flexibility firms possess to increase or decrease the quantity supplied it is a measure of how responsive firms are to price changes  Price elasticity of supply PES is higher… 1. For firms that store inventories 2. When inputs are easily available 3. For firms with extra capacity 4. When firms can easily enter and exit a market 5. When there’s more time to adjust  Cross elasticity of demand Percent change in quantity demanded of good X CED = percent change in price of good Y CED is positive for substitutes e.g. Coke and Pepsi CED is negative for complements e.g. printers and ink cartridges CED is near zero for unrelated goods e.g. Coke and trainers  Income elasticity of demand Percent change in quantity demanded IED = percent change in income IED is positive for normal goods e.g. restaurant mealsfor inferior goods e.g. IED is negative processed fruit and vegetables The theory of production and costs 25  The theory of production and costs We now turn our attention to firms – our aim here is to build the foundations of a deeper understanding of the economics of business activity and the competitive environment… Our point of departure is this observation… “Firms create value, for themselves and their customers, by combining factor inputs in particular ways in order to produce saleable outputs” Let us see where this takes us…  Theory of Production in order to be able to produce a good/service an entrepreneur must hire/buy factors of production LAND CAPITAL e.g. raw e.g. materials, a LABOUR buildings, plot of e.g. production line machinery, land… workers, managers… computers … 28  Theory of Production it follows that, a firm’s costs are driven by: (i) the (ii) the way in which quantity of the entrepreneur factor inputs & organises & the incentivises these entrepreneur factors to work hires/buys together as a unit » productivity  Theory of Production in essence, an entrepreneur faces a two-stage problem She/he needs to She/he then needs to identify the possible choose which production production technique techniques that could to invest in (a be used (a pecuniary problem) e.g.technological 20,000 widgets a e.g. given the cost of month problem) can be produced machines and the costs by using either 2,000 of labour, option 1 costs machines & 50 units of £50 million while option labour or 500 machines & 2 costs £45 million 3,000 units of labour 30  Theory of Production once the entrepreneur’s firm has made its strategic choice about which production technique to invest in (e.g. what type of plant/factory to build) it then needs to work within the constraints this choice placesTHE on LONG it RUN THE SHORT RUN “a decision-making “a decision-making period during which the period during which the quantities of all of the quantities of some of the factors of production factors of production used by the firm can be used by the firm cannot changed” be changed” i.e. the firm is constrained by its long run decision about the quantity employed of firms in different lines ofsome business will have factors of short-run decision periods of different duration 31  The short run theory of Production & Costs A simplified illustrative example Samantha Pinewood decides to leave her current career as a teacher to become an entrepreneur… She was earning £150 per week as a teacher, and she would be able to return to this career at any time. she starts up ‘Tables 4U’ to produce flat-pack coffee tables each flat-pack contains: (1) a simple (unstained, unvarnished) wooden table- top; (2) four wooden legs; (3) a small packet of screws and glue that can be used by the final customer to assemble the table. 32  The short run theory of Production & Costs Tables 4U’s production facilities consist of a small workshop (100 square metres) with enough space to accommodate 3 workbenches; a lathe a 3 units of saw capital (K) a packing machine  The short run theory of Production & Costs Samantha cannot get hold of any more capital for at least 6 weeks she can easily hire labour on a daily basis her material suppliers are happy to supply wood and packets of screws and glue in any amount at any time an expert consultant tells her how many flat- packs she can expect to produce per week if she employs different numbers of workers… A PRODUCTION FUNCTION... a way of presenting the quantitative relationship between factor inputs and the maximum output attainable given the current state of technological knowledge 34 Short-run Production Function K L APL TP MPL 3 0 0 100 “increasing 3 1 100 100 marginal 150 3 2 125 250 returns” 200 (thanks to the 3 3 150 450 division of 100 labour) 3 4 137.5 550 “(the law of) 50 3 5 120 600 diminishing marginal -120 3 6 80 480 returns” 35  TP 600 TP Zone I underutilisation of 300 fixed factor inputs ZONE ZONE I IIZONE III 0 1 2 3 4 5 6 Zone II MP, AP No. of workers using fixed factor inputs ‘properly’ 200 Zone III 100 MP AP L L beyond the capacity ZONE I ZONE III of fixed factor inputs ZONE II 0 1 2 3 4 No.5 of 6 workers  The short run theory of Production & Costs now we use the information from the short-run production function in conjunction with a list of factor input prices to calculate the costs of producing different assumelevels of output the following for Tables 4U (1) rental of the workshop (100 square metres plus 3 workbenches inclusive of electricity costs) is » in £90other per words week capital costs £30 per unit per week (2) labour must be paid wages of £100 per person per week (3) cost of raw materials (wood, packets of glue and screws etc…) amounts to £2 per table 37 What is the economic cost of producing 450 flat-pack tables? 38  The short run theory of Production & Costs The concept of Marginal Cost if it costs a firm a total of £100 to produce 10 units of output and a total of £105 to produce 11 units of output, then the addition to total cost as a result of producing the 11th unit of output is… Q TC ATC MC £10 10 £10 0 £5 £10 £9.5 11 the marginal cost of the5 11th5 unit measures the extra costs generated by production of this extra unit only whereas the ATC (= £9.55) spreads the total costs of production across all 11 units of output 39  Thinking ‘at the margin’ – an operational decision your firm is already producing 10 units of output for its current customers (giving unit costs of £10). It sells each of these units for £10.50. One day, unexpectedly, an 11th customer turns up and asks you to supply them with one unit, but is only willing to pay £6 for it is it sensible (i.e. rational) to produce an 11th unit of output to satisfy this extra customer? 40  Short-run costs of Tables 4U with 3 (1 (2 (5) (6) workbenches (7) (9) (10) (11) (13) (14 (4) (8) ) ) (3) prod’n. fn Ent TFC÷Q (12) TFC TVC÷Q + TC÷Q ) ΔTC÷ op Wa Ra TVC Cos p t of cos w TF AF g- mat TV AV AT ΔQ K L Q K es TC MC t C C s C C C 3 0 0 90 150 24 - 0 0 0 0 240 - 0 + = + = 3.0 0 3 1 10 90 + 150= 24 2.4 10 + 200 = 300 3.0 540 5.4 0 0 0 0 0 0 + = + = 2.6 7 3 2 25 90 + 150= 24 0.9 20 500 = 700 2.8 940 3.7 + 0 0 6 0 0 6 2.5 + = + = 0 3 3 45 90 150 24 0.5 30 900 120 2.6 144 3.2 0 0 3 0 0 7 0 0 41  Short-run costs of Tables 4U with 3 £ workbenches 6 5 MC 4 These curves ATC underpin 3 AVC operational (short-run) 2 decision-making 1 AFC 0 Q 100 200 300 400 500 600 42  The short run theory of Production & Costs we classify costs as belonging to one of two types FIXED COSTS VARIABLE the sum of costs the the sumCOSTS of costs the firm firm will incur even if it will incur over & above produces nothing e.g. fixed costs as a result of cost of capital (£90), producing a non-zero entrepreneur’s level of output e.g. for opportunity cost 450 tables labour costs (£150) (£300), raw material costs (£900) these change as the quantity of output changes, so if output = 0, then variable costs = 0 The ratio of fixed costs to variable costs is called the firm’s ‘cost structure’ 43 To be continued…