Lesson 1: Introduction to Managerial Economics PDF

LESSON 1: INTRODUCTION TO MANAGERIAL ECONOMICS Total Economic Cost OUTLINE - This is the sum of the opportunity costs of both...

LESSON 1: INTRODUCTION TO MANAGERIAL ECONOMICS Total Economic Cost OUTLINE - This is the sum of the opportunity costs of both market-supplied resources and owner-supplied Making Decisions resources. Economic Way of Thinking about Business Understanding Economic Cost Types of Costs: Economic Profit VS Accounting Profit 1. Explicit Costs Market Structure ○ These are out-of-pocket payments made for market-supplied resources. ○ Example: Apple purchasing an Intel chip for $310. This cost is explicit because it involves MAKING DECISIONS a direct monetary payment. The rational-actor paradigm is a way of thinking that suggests people always make decisions in a logical, efficient, and 2. Implicit Costs self-serving way. They respond to incentives to achieve the best ○ These are the non-monetary opportunity outcome for themselves. costs of using owner-supplied resources. ○ Even though no cash payment is made, the In business, the main goal is to make as much profit as possible. cost is real and reflects what the owners forgo by using their resources within the business. ECONOMIC WAY OF THINKING ABOUT BUSINESS Opportunity Cost of Equity Capital: The opportunity cost of cash invested by the owners. Accountants refer “That’s okay is not good” means always aiming for better. to this as the cost of equity capital. For example, if $20 million could earn 12% annually elsewhere, Useful Concepts: that's the implicit cost of using it in the business the 12%. Microeconomics: Studies individual behavior of consumers and firms, helping with decisions like: Opportunity Cost of Using Land or Capital Owned ○ Maximizing profit through pricing and by the Firm: If a firm owns its land or buildings, the production levels opportunity cost is the rent or income it could earn by ○ Minimizing production costs leasing them out. ○ Allocating production across plants For instance, Alpha Corp. rents its building, so it has higher explicit costs than Beta Corp., which owns its building. Routine business decisions are called business practices or tactics. These are everyday decisions managers make to Opportunity Cost of the Owner’s Time: This is the maximize profit based on current market conditions. value of the owner's time and effort if they were employed elsewhere or engaged in other activities. Industrial Organization: A branch of microeconomics that examines firm and industry behavior and structure. It helps with strategic decisions, which aim to change market conditions and rival behavior to boost or protect ECONOMIC PROFIT VS ACCOUNTING PROFIT profits. It also helps analyze and understand the nature, motivations, and impacts of strategic actions that firms might consider. Economic Profit ○ The difference between total revenue and total Unlike routine decisions, strategic ones aim to change the economic cost. competitive landscape rather than just accepting it as it is. UNDERSTANDING ECONOMIC COSTS Accounting Profit Businesses use various resources like labor, capital, land, and ○ The difference between total revenue and explicit materials to produce goods and services. The economic cost of costs. using these resources is their opportunity cost, which is what the business owners give up by using the resources in their own firm instead of elsewhere. MARKET STRUCTURE Inputs: Market-Supplied Resources ○ These are resources owned by others that the firm Market: Any arrangement where buyers and sellers exchange hires, rents, or leases. For example, Apple goods, services, or resources. This can be a physical place, like purchasing an Intel chip for $310 is an explicit cost a store, or a virtual place, like a website. because it involves an actual payment. Market Structure: The characteristics of a market that define Owner-Supplied Resources the economic environment for firms, including: ○ These include money, time, and assets provided by Number and size of firms in the market. the business owners themselves. The opportunity Degree of product differentiation among firms. cost here is what the owners could have earned if Barriers to entry for new firms. they had used these resources differently.  LESSON 1: INTRODUCTION TO MANAGERIAL ECONOMICS Types of Market Structures: Perfect Competition ○ Many small firms sell identical products. No barriers to new firms entering the market. ○ Firms are price-takers (they accept the market price) and adjust their production to maximize profit based on market supply and demand. ex. Agricultural markets, like a local farmers' market where multiple farmers sell identical fruits and vegetables. No single farmer can influence the market price. Monopoly: ○ A single firm controls the entire market and offers a unique product with no close substitutes. Protected by barriers to entry. ○ The firm sets the price and has significant market power. The higher the price, the more consumers seek substitutes, which limits the monopolist's ability to raise prices without losing customers. ex. Utility companies like water or electricity providers in some regions. They are often the sole provider due to high barriers to entry, such as infrastructure requirements. Monopolistic Competition: ○ Many firms sell differentiated products without significant barriers to entry. ○ Firms have some market power due to product differentiation but are still subject to competition. They can set prices within limits but are not price-takers. ex. Fast-food restaurants, such as McDonald's and Burger King. They sell similar but differentiated products (e.g., different burger recipes) and face competition from other fast-food chains. Oligopoly: ○ A few firms dominate the market, and each firm's actions significantly affect the others. ○ Firms are interdependent, meaning the pricing and production decisions of one firm can impact the sales and profits of other firms in the market. ex. The airline industry. A few major airlines, like Delta, United, and American Airlines, dominate the market, and their pricing and service decisions significantly impact one another.  LESSON 2: DEMANDS OUTLINE Income An increase in income can cause the amount of a commodity Quantity Demand consumers purchase either to increase or to decrease. Direct Demand Inverse Demand If an increase in income causes consumers to demand more of a good, when all other variables in the general demand function are held constant, we refer to such a QUANTITY DEMAND commodity as a normal good. ○ Normal goods or services for which an increase (decrease) in income causes Quantity demanded (QD) is the amount of a good or service consumers to demand more (less) of the consumers are willing and able to purchase during a given good, holding all other variables in the period of time (week, month, etc.). general demand function constant. If goods and services for which an increase in income Demand relations: would reduce consumer demand, other variables held General demand functions – show how QD is related constant, the good must be inferior good. to product price and five other factors that affect ○ Inferior goods or services for which an demand. increase (decrease) in income causes consumers to demand less (more) of the Direct demand functions – show the relation good, all other factors held constant. between QD and the price of the product when all other Normal Goods: Increase in income = increase in demand. variables affecting demand are held constant at Normal goods are also called necessary goods. specific values Inferior Goods: Increase in income = decrease in demand. When people have less money, they tend to buy these Inverse demand functions – give the maximum kinds of products. prices buyers are willing to pay to obtain various amounts of product. Substitutes and Complements Goods are substitutes if one good can be used in the The general demand function place of the other. If two goods are substitutes, an QD = f(P, M, PR, T, PE, N); increase in the price of one good will increase the QD = a + bP + cM + dPR + eT + fPE + gN) demand for the other good holding all other factors constant. where f means “is a function of” or “depends on,” and Goods are said to be complements if they are used in QD = quantity demanded of the good or service conjunction with each other. Similarly, two goods are complements if an increase in the price of one of the P = price of the good or service goods causes consumers to demand less of the other M = consumers’ income (generally per capita) good, all other things constant PR = price of related goods or services T = taste patterns of consumers Substitutes: Increase in price of one = increase in demand for PE = expected price of the good in some future period the other. N = number of consumers in the market Complements: Increase in price of one = decrease in demand for the other. Price Taste - change of a good while holding the other variables Consumer tastes are not directly measurable (as are constant the other variables in the general demand function), - Consumers are willing and able to buy more of a good you may wish to view the variable as an index of the lower the price of the good and will buy less of a consumer tastes; taste takes on larger values as good the higher the price of the good. consumers perceive a good becoming higher in quality, more fashionable, more healthful, or more desirable in any way. A decrease in taste corresponds to a change Price and quantity demanded are negatively in consumer tastes away from a good or service as (inversely) related because when the price of a good consumers perceive falling quality, or displeasing rises, consumers tend to shift from that good to other appearance, or diminished healthfulness. goods that are now relatively cheaper. Conversely, when the price of a good falls, consumers Consequently, when all other variables in the general tend to purchase more of that good and less of other demand function are held constant, a movement in consumer tastes toward a good or service will increase goods that are now relatively more expensive. demand and a movement in consumer tastes away Price and quantity demanded are inversely related from a good will decrease demand for the good. when all other factors are held constant. Positive change in taste = increase in demand. Law of Demand: Lower price = higher QD; higher price = lower Negative change in taste = decrease in demand. QD. Price and QD: Inversely related, holding other factors constant. Expectations Refers to the future price of a commodity can change their current purchasing decisions. If consumers expect the price to be higher in a future period,  LESSON 2: DEMANDS demand will probably rise in the current period. On the other hand, expectations of a price decline in the future will cause some purchases to be postponed—thus demand in the current period will fall. Expected price increase = current demand rise. Expected price decrease = current demand fall. Numbers of Consumer An increase in the number of consumers in the market will increase the demand for a good, and a decrease in the number of consumers will decrease the demand for a good, all other factors are held constant. Increase in consumers = increase in demand. Decrease in consumers = decrease in demand. General demand function QD = a + bP + cM + dPR + eT + fPE + gN Where a,b,c,d,e,f,g are called parameters a = is the intercept parameter b,c,d,e,f,g = slope parameters; Slope parameters Calculated as ∆𝑄 / ∆𝑃 Negative value In income, if c is positive the goods are normal; and inferior if the value is negative d parameters measure the change in the amount consumers want to buy per unit change in PR; hence, if an increase in PR will rise the sales, the goods are substitutes and d is positive. But if the increase will make the sales fall, the two goods are complements and d is negative. Taste, Expectations and Number of consumers are directly related to the amount purchased, the parameters e, f, and g are all positive. The simplified linear demand function is expressed: QD = a + bP + cM + dPR INVERSE DEMAND Inverse Demand Function is the demand function when price is expressed as a function of quantity demanded: By switching, the inverse demand function: DIRECT DEMAND Although demand is generally interpreted as indicating the amount that consumers will buy at each price, sometimes Direct Demand Functions is the relation between price and managers and market researchers wish to know the highest quantity demanded per period of time, when all other factors that price that can be charged for any given amount of the product. affect consumer demand are held constant. Demand function Henceforth, every point on a demand curve can be interpreted in are showed with the use of equation, schedule or graph. either of two ways: The maximum amount of a good that will be purchased if a given price is charged or Equation The maximum price that consumers will pay for a Schedule or table - shows a list of several prices and specific amount of a good. the quantity demanded per period of time at each of the prices, again holding all variable other than price Movements along Demand constant. Law of demand refers to the quantity demanded increases when Demand curve - a graph showing the relation between price falls, and quantity demanded decreases when price rises, quantity demanded and price when all other variables other things held constant. influencing quantity demanded are held constant.  LESSON 2: DEMANDS Change in quantity demanded is the movement along a given demand curve that occurs when the price of the good changes, all else constant. Shifts in Demand When any one of the five variables held constant when deriving a direct demand function from the general demand relation changes value, a new demand function results, causing the entire demand curve to shift to a new location. Increase in demand - a change in the demand function that causes an increase in quantity demanded at every price and is reflected by a rightward shift in the demand curve. Decrease in demand - a change in the demand function that causes a decrease in quantity demanded at every price and is reflected by a leftward shift in the demand curve. Determinants of demand - variables that change the quantity demanded at each price and that determine where the demand curve is located: M, PR, T, PE, and N. Change in demand - a shift in demand, either leftward or rightward, that occurs only when one of the five determinants of demand changes  LESSON 2: SUPPLY Number of firms (F) - if the number of firms in the industry Quantity supplied ( ) is the amount of a good or service increases or if the productive capacity of existing firms offered for sale during a given period of time (week, month, etc.). increases, more of the good or service will be supplied at each price. Six major variables 1. The price of the good itself. 2. The prices of the inputs used to produce the good. The general supply function in linear functional form: 3. The prices of goods related in production. 4. The level of available technology. 5. The expectations of the producers concerning the future price of the good. 6. The number of firms or the amount of productive Where h is an intercept parameter, and k, l, m n, r, and s are capacity in the industry. slope parameters. The General Function Direct supply function A direct supply function (also called simply “supply”) shows the relation between Qs and P holding the determinants of supply (PI , PR , T, PE , and F) constant. Once a direct supply function QS = f(P) is derived Whereas from a general supply function, a change in quantity supplied QS is determined not only by the price of the good or service (P) can be caused only by a change in price. but also by the prices of the inputs used in production (PI), the prices of goods that are related in production (PR), the level of available technology (T), the expectations of producers concerning the future price of the good (PE), and the number of firms or amount of productive capacity in the industry (F). Price (P) - the effect of a change in the price of a good, the higher the price of the product, the greater the quantity firms wish to produce and sell, all other things being equal. Conversely, the lower the price, the smaller the quantity firms will wish to produce and sell. Producers are motivated by higher prices to produce and sell more, while lower prices tend to discourage production. Thus price and quantity supplied are, in general, directly related. Figure 1 Summary of General (Linear) Supply Function Inputs used in Production (PI) If the cost rises, the good Supply schedule – is a table showing a list of possible product becomes less profitable and producers will want to supply a prices and the corresponding quantities supplied. smaller quantity at each price Supply curve - is a graph showing the relation between quantity Price of goods related in production (PR) - changes in the supplied and price, when all other variables influencing quantity prices of goods that are related in production may affect supplied are held constant. producers in either one of two ways, depending on whether the goods are substitutes or complements in production. Two goods, X and Y, are substitutes in production if an increase in the price of good X relative to good Y causes producers to increase production of good X and decrease production of good Y. Two goods, X and Y, are complements in production if an increase in the price of good X causes producers to supply more of good Y. Technology (T) - is the state of knowledge concerning how to combine resources to produce goods and services. An improvement in technology generally results in one or more of the inputs used in making the good to be more productive. Expectations (PE) - if firms expect the price of a good they produce to rise in the future, they may withhold some of the good, thereby reducing supply of the good in the current period.  LESSON 2: SUPPLY Figure 2 Supply Curve Inverse supply function – is the supply function when price is expressed as a function of quantity supplied: P= f(Qs). Supply price – is the minimum price necessary to induce producers to offer a given quantity for sale. Shift in supply A shift in supply occurs only when one of the five determinants of supply (PI , PR , T, PE , F) changes value. Figure 3 Shifts in Supply Increase in supply is a change in the supply function that causes an increase in quantity supplied at every price, and is reflected by a rightward shift in the supply curve. Decrease in supply is a change in the supply function that causes a decrease in quantity supplied at every price, and is reflected by a leftward shift in the supply curve.  LESSON 2: MARKET EQUILIBRIUM OUTLINE Market Equilibrium Shortage or Surplus Equilibrium Principle MARKET EQUILIBRIUM The marketplace leads to market equilibrium as demand shows how buyers respond to changes in price and other variable that determines the quantities buyers are willing and able to purchase; while supply shows how sellers respond to changes in price and other variables that determine quantities offered for sale. Equilibrium is a situation in which, at the prevailing price, consumers can buy all of a good they wish and producers can sell of the good they wish. EQUILIBRIUM PRINCIPLE Equilibrium Principle: The equilibrium price is that price at which Qd = Qs quantity demanded is equal to quantity supplied. When the current price is above the equilibrium price, quantity supplied In equilibrium, the price is called equilibrium price and the exceeds quantity demanded. The resulting excess supply quantity sold is called equilibrium quantity. induces sellers to reduce price in order to sell the surplus. Equilibrium Price If the current price is below equilibrium, quantity demanded The price at which Qd = Qs exceeds quantity supplied. The resulting excess demand causes the unsatisfied consumers to bid up price. Since prices below Equilibrium Quantity equilibrium are bid up by consumers and prices above The amount of a good bought and sold in market equilibrium. equilibrium are lowered by producers, the market will converge to the equilibrium price–quantity combination. SHORTAGE OR SURPLUS Excess supply or a surplus exists when the quantity supplied exceeds the quantity demanded. A situation in which quantity demanded exceeds quantity supplied is called excess demand or a shortage. Equilibrium price is sometimes called the market clearing price. Market Clearing Price The price of a good at which buyers can purchase all they want and sellers can sell all they want at that price. This is another name for the equilibrium price.  LESSON 3: ELASTICITY AND REVENUE Time period of adjustment OUTLINE Elasticity and Demand E = b(P/Q) - Point elasticity is a measurement of demand elasticity calculated at a point on a demand curve rather than ELASTICITY AND DEMAND over an interval. Price elasticity of demand (E) is the percentage change in Point elasticity when demand is linear quantity demanded, divided by the percentage change in price. (E) is always a negative number because P and Q are inversely related. Suppose a 10 percent price decrease %∆𝑃 = − 10% causes Marginal Revenue, Demand, and Price Elasticity consumers to increase their purchases by 30 percent Marginal revenue (MR) The addition to total revenue attributable %∆𝑄 = 30% − 30% The price elasticity is equal − 3 = ( −10% ) in to selling one additional unit of output; the slope of total revenue. this case. The smaller (absolute) value of E indicates less sensitivity on the part of consumers to a change in price. MR indicates the change in total revenue from an additional unit Elasticity of demand is always negative, so we typically drop the of sales. native sign and use absolute value instead. Interpretation: Elastic / E />1 greater than 1 Inelastic | E /