Chapter 1 INTRODUCTION TO MANAGERIAL ECONOMICS

Managerial economics provides a systematic & logical way of analyzing business decisions which focuses on economic forces that shape both day to day short-run decisions and long-run planning decisions Managerial Economics applies economic tools and techniques for improving Management Decision Making. The objective is to help business students become architects of business strategy. Managerial Economics helps managers decide on what prices to charge, which products to produce and what costs to consider. It helps managers decide the best hiring policy and the most effective style of organization. Managerial economics powerful tools are used to make the managers more effective by more effectively and efficiently collecting, organizing and analyzing information. Effective management involves an integration of the accounting, finance, marketing, personnel and production functions of a firm, considering it as a unified whole rather than a series of unrelated parts. Economic Profit versus Accounting Profit Economic profit is the amount by which TR exceeds total economic cost, where total economic cost is the sum of the opportunity costs of each and every resource used by a firm(explicit & implicit costs). Businesses generally utilize 2 kinds of resources: 1) resources owned by others (such as labor services or skilled and unskilled workers, raw material purchased from commercial suppliers and capital equipment rented or leased from equipment suppliers) and 2)resources owned by the firm (such as labor services provided to the firm by its owners, money provided to the business by its owners and any land, buildings or capital equipment owned and used by the business). The opportunity cost of using resources owned by others is the dollar amount paid to the resource owners. These payments made to resource owners are called explicit costs. The opportunity costs of using resources owned by the firm are called Implicit costs. For the resources used by the firm that are owned by the firm, the opportunity cost is the largest payment that the owner could have received if those resources that it owns had been leased or sold instead of being held by the firm for its own use.
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These opportunity costs of using a firms own resources are called implicit costs since the firm makes no monetary payment to use its own resources. Both kinds of opportunity costs of using resources must be subtracted from Total Revenue to get Economic Profit. Economic Profit = Total Revenue (TR) Total economic costs = TR Explicit costs Implicit costs. Accounting Profit then differs from economic profit because accounting profit does not subtract from TR the implicit costs of using resources. Accounting Profit = TR Explicit costs. Thus economic profit is smaller than accounting profit by the amount of the firms implicit costs. Even though accountants are required to ignore most kinds of implicit costs business owners of course bear all costs of using resources both the explicit and the implicit costs. Economists frequently refer to the opportunity cost of using the owners own resources as normal profit. Normal profit is just another name for the implicit cost that a firm incurs when it employs owner supplied resources. It represents the payment that business owners must receive for using their own resources in their own business. Normal profit is simply the implicit part of total economic costs. Economic Profit = TR Explicit costs Normal profit. In other words the owners are making just enough accounting profit to pay themselves an amount equal to what they could have earned by using their resources in their alternative use.

THEORY OF THE FIRM is defined as a basic model of business. Richer versions of the theory assumes that the firm tries to maximize its wealth or value of the firm. The value of the firm is defined as the present value of its expected future cash flows or profits. It takes into account the uncertainty & time value of money. Thus in an equation form the value of the firm equals:

1 2 - PV of expected future profits =-------- + ------- + (1 + i) (1 + i)2 n = __t

n + ------(1 + i)n

t= 1

(1 + i)t

Figure 1.1

t = profit in year t i = interest rate t = goes from 1 to n last year in planning horizon Because profits equal TR TC. This equation can be written as: N TRt - TCt PV of future profits = (1 + I)t t=1 Equation 1.2 Where TRt = total revenue in year t TCt = total cost in year t. This expanded equation can be used to examine how the expected value maximization model relates to a firms various functional departments. The marketing department often has primary responsibility for promotion and sales(TR); the production department has primary responsibility for development costs(TC); and the finance department has primary responsibility for acquiring capital and, hence for the discount factor (i) in the denominator. e.g. Ford Motor Co-Marketing managers & sales reps work hard to increase Total Revenue, Production managers & manufacturing engineers strive to reduce its Total Cost, financial managers play a major role in obtaining capital, R & D invent new products & processes that increase Total Revenue & decrease Total Cost. All these diverse groups affect value of the firm i.e. Present Value(PV) of expected future profits of the firm. Relation The value of a firm is the price for which it can be sold, and that price is equal to the PV of the expected future profits of the firm.

Economics is the study of how scarce or limited resources are used to satisfy unlimited wants and needs; the study of decision making in a world of scarcity. Resources or factors of production are persons and things used to produce goods and services limited in amount. Wants are what people would buy if their incomes were unlimited. Needs are food shelter and clothing. Scarcity is the result of not enough goods and services to satisfy all wants and needs or when the ingredients (resources) for producing things that people desire are insufficient to satisfy all wants.
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What is Economics?

Microeconomics is the study of decision making by individuals and by firms which are the individual segments of the economy. Its the study and analysis of the behavior of individual consumers, workers, owners of resources, individual firms, industries & markets for good & services Macroeconomics is the study of the behavior of the economy as a whole and the interactions of the major groups called a)household, b)government & c)foreign sector in the economy. It includes such topics as a)inflation, b)taxes & govt. spending, c)unemployment & d)money & banking. Economic System describes how a particular society distributes its resources to produce G&S. Its the institutional means through which resources are used to satisfy human wants. What is a Market? A market is composed of firms & individuals who are in touch with each other in order to buy or sell some goods or services. Its any arrangement through which buyers and sellers exchange final goods or services, resources used for production, or anything of value.

DEMAND
Demand is the various quantities of good or service that people are willing & able to purchase at various prices during a specified period of time (week, month, year) when all non-price factors are held constant(income, tastes, expectation, prices of related goods, population). It is very important to note that since price is part of what we call demand a change in the price cannot change the demand, but results in a change in the quantity demanded for that product. Law of Demand Quantity demanded of a good is inversely related to price assuming all non-price factors held constant. Market Demand Schedule is a table showing a list of possible product prices and corresponding quantities demanded by consumers during a specified period of time. Market Demand Curve is a graph showing the relation between quantity demanded and price charged when all other variables influencing quantity demanded are held constant (income, tastes, expectations of future prices, income & product availability, price of related goods, population). Market Demand Function for a product is a statement of the relation between the aggregate quantity demanded and all determinants that affect this quantity(Price, tastes, income, price of related goods, expectations, population). Change in Demand is a leftward or rightward shift from one demand curve to another demand curve when one or more of the non-price determinants of demand function change.
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1.Increase in demand is a change in demand function that causes an increase in quantity demanded at every price and is reflected by a rightward shift in the demand curve. 2.Decrease in demand is a change in demand function that causes an decrease in quantity demanded at every price and is reflected by a leftward shift in the demand curve.

The Non Price Determinants of Demand

1. Income - normal goods & inferior goods(mobile homes, used cars, generic food products). 2. Tastes & Preferences Journal of Medicine writes higher incidence of cancer found among persons who regularly eat bacon 3. The Price of Related Goods Complements are cameras & films, lettuce & salad dressing, baseball games & hotdogs. Substitutes are wheat & corn, beef & pork. 4. Expectations Future prices (when auto industry announces price increases of next years models), income, product availability. 5. Population Florida during tourist season has increase in demand. Changes in Demand Vs Changes in Quantity Demanded A change in one or more of the non-price determinants will lead to a change in demand. This is a shift of the curve. A change in a goods own price leads to a change in quantity demanded. This is a movement along the same demand curve.

SUPPLY
SUPPLY The various quantities of a good or service sellers are willing & able to supply for sale at various prices during a specified period of time (week, month, year) when all other nonprice determinants are held constant(input costs, technology & productivity, taxes & subsidies, price expectations, number of firms in the industry). Law of Supply The price of a product or service and the quantity supplied are directly related. This law states that holding non-price factors constant the quantity of a good or service that a supplier is willing to offer on the market relates directly to price. Take campus tutoring as an example. If you were offered a job in the Economics Tutoring Center for $3/hour how many hours a week would you be willing to work? How many hours would you be willing to work if the wage were $10/hr? $20/hr? Supply Schedule is a table showing a list of possible product prices & corresponding quantities supplied by all firms or producers. Market Supply Curve is a graph showing the relation between quantity supplied & price charged when all other variables influencing quantity supplied are
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held constant (input costs, technology & productivity, taxes & subsidies, price expectations, number of firms in the industry). Market Supply Function for a product is a statement of the relation between the aggregate quantity supplied and all determinants that affect this quantity(input costs, technology & productivity, taxes & subsidies, price expectations, number of firms in the industry ). Shift in Supply A rightward or leftward shift from one supply curve to another supply curve when one or more of the non-price determinants of supply change. 1. 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. 2. 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.

Non Price Determinants of Supply

1. Cost of Inputs labor, capital, raw materials. 2. Technology & Productivity is societys pool of knowledge regarding industrial arts. New processes make it possible to produce commodities more cheaply. 3. Taxes & Subsidies. 4. Price Expectations If firms expect price to increase in the future they may withhold some of the good reducing supply in current period. 5. Number of Firms in the Industry If number of firms increase more of a good will be supplied at each price, e.g. supply of air travel between NY & Hong Kong increased because more airlines begin servicing this route. When sellers leave a market supply decreases.

Changes in Supply Vs Changes in Quantity Supplied

A Change in one or more of the non-price determinants will lead to a change in supply. This is a shift of the curve. A Change in a goods own price leads to a change in quantity supplied. This is a movement along the curve.

Determination of Market Equilibrium

In a free market economic system, price is determined by demand and supply. If we superimpose the demand and supply curves developed in the earlier analysis, we can determine a market equilibrium price and quantity. Competitive market equilibrium occurs when the quantity of the product demanded equals the quantity supplied at a specified price.
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Equilibrium price is the price at which quantity demanded equals quantity supplied and the quantity traded is called equilibrium quantity Shortage: A market situation in which the quantity demanded exceeds the quantity supplied, at a price below the equilibrium level and will exert an upward pressure on price. Surplus: A market situation in which the quantity supplied exceeds the quantity demanded, at a price above the equilibrium level and will exert a downward pressure on price. a)Find the equilibrium Price & Quantity P=12.4-4Qd P=-2.6+2Qs b)Must actual price be equal to equilibrium price? Why or why not? TEXT

Demand and Supply: A First Look

Market can be defined as a group of firms and individuals that are in touch with each other in order to buy or sell some goods. The Demand Side of a Market See Figure 1.4 The Demand Side of a market can be represented by a market demand curve showing the amount of the commodity buyers would like to purchase at various prices. Consider figure 1.4 which shows the demand curve for copper worldwide in 1990s. The figure shows: At $1 price quantity demanded is 11.7 million metric tons, at $1.10/lb price 11 million metric tons and at $1.20/lb price 10.3 million metric tons. Pertains to a particular period of time & shape & position depends on length of period. Demand Curve for copper slopes downward to the right showing quantity of copper demanded increases as price falls. This is true of demand curves of most commodities. They almost always slope to the right. Assuming of course the tastes, incomes, number of consumers and prices of other commodities are held constant. Any change in one of these elements will shift the commoditys demand curve to the right or left. The Supply Side of a Market See Figure 1.5 shows the supply curve for copper worldwide in 1990s based on estimates made informally by industry experts. The supply side of the market can be represented by a market supply curve that shows the amount of commodity that sellers would offer at various prices. Lets continue with the case of coppers worldwide supply curve in the 1990s.
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 At $1/lb price, 9.5 million metric tons would be supplies per year, at price $1.10/lb, 11 million metric tons and at price $1.20/lb, 12.5 million metric tons. Supply curve of copper slopes upward to the right because quantity of copper supplied increases as the price increases since there is more incentive for firms to produce copper & offer it for sale. See Figure 1.6 The two sides of a market, demand and supply, interact to determine the price of a commodity. Putting demand and supply curves for copper together will help us determine equilibrium price of copper. Equilibrium price is a price that can be maintained. Any price that is not an equilibrium price cannot be maintained for long, since there are fundamental factors at work to cause a change in price. Lets see what would happen if various prices were established in the market. At price $1.20/lb demand is 10.3 million metric tons supply 12.5 million metric tons, there is a mismatch between the quantity supplied and the quantity demanded per year. Supply > Demand. Excess supply of 2.2 million metric tons will have inventory build up. Suppliers will cut prices to get rid of unwanted inventories & price of $1.20/lb could not be maintained for long. So $1.20/lb is not an equilibrium price. At price $1.00/lb demand is 11.7 million metric tons supply is 9.5 million metric tons. Again we find a mismatch between quantity Demand & Supply per year. Demand > Supply. Excess demand of 2.2 million metric tons will have inventory shortage. Some consumers turned away empty handed. Given this shortage suppliers increase price and competition among consumers will bid price up. Thus a price of $1/lb could not be maintained for long. So $1/lb is not an equilibrium price. The equilibrium price must be the price where the quantity demanded equals the quantity supplied and there is no mismatch and consequently the only price that can be maintained for long. In the figure that price is $1.10/lb where quantity supplied equals the quantity demanded. i.e. the point where demand curve intersects the supply curve and equilibrium quantity demanded and supplied is 11 million metric tons. Actual Price The price we are really interested in is actual price which is the price that actually prevails, not the equilibrium price.
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Equilibrium Price

 Economists simply assume that the actual price will approximate the equilibrium price since the basic forces at work tend to push the actual price toward equilibrium price assuming conditions remain fairly stable for a time. Managers need to know the direction in which a price will change. If actual price is $1.20/lb there is a downward pressure. If actual price is $ 1.00/lb there will be upward pressure on price. So long as the actual price is > than the equilibrium price, there will be a downward pressure on price. Similarly so long as the actual price is less than the equilibrium price, there will be an upward pressure on price. Thus there is always a tendency for the actual price to move toward the equilibrium price. But this movement may not be fast. All that can be said safely is that the actual price will move toward the equilibrium price. But of course this information is of great value, since frequently all that a manager needs to know is the direction in which a price will change. ________________________________________________________________

Problem 1
Suppose that the demand and supply functions for good X are Qd = 50 8P Qs = -17.5 + 10P a) What are the equilibrium price and quantity? b) What is the market outcome if price is $2.75? What do you expect to happen and why? c)What is the market outcome if price is $4.25? What do you expect to happen and why?d) What happens to equilibrium price & quantity if the demand function becomes Qd = 59 8P? e) What happens to equilibrium price and quantity if the supply function becomes Qs = -40 + 10P ( Qd = 50 8P)?

Answer
a) At equilibrium Qd = Qs i.e quantity demanded is = quantity supplied. So 508P=-17.5+10P or -10P-8P=-17.5-50 or -28P= -67.50 or P = $3.75. Market Equilibrium point Qe is where Qd=Qs. Substitute the value of P=$3.75 in any one of the values and you will get Qe=50- 8(3.75) = 20. so equilibrium price is $3.75 and equilibrium quantity is 20 units. b) When P=$2.75, Qd = 50 8(2.75) = 28 and Qs=-17.5+10(2.75) = 10. There is a shortage of 18 units. Due to excess demand consumers will bid up the price, decreasing quantity demanded and increasing quantity supplied. Consumers will bid up price until it reaches $3.75, the price at which Qd=Qs. c) When P= $4.25, Qd= 16 and Qs = 25(calculate as shown in b) there is a surplus of 9 units. Producers will lower price in order to avoid accumulating
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unwanted inventories. The price will fall (reducing the excess supply) until equlibrium is attained at a price of $3.75. d) At equilibrium, 59 8P = -17.5 +10P; thus Pe=$4.25 & Qe=25. e) At equilibrium, 50 8P = - 40 +10P; thus Pe=$5 & Qe=10.

Problem2 Fill in the blanks

1) During a year of operation, a firm earns total revenues of $175,000 and spends $80,000 on raw materials, labor expense, utilities expense and rent expense. The owners of the firm have provided $500,000 of their own money to the firm instead of investing the money and earning a 14% annual rate of return. a) The explicit costs of the firm are $___________ . The implicit costs are $__________. Total economic cost is $_____________. b) The firm earns economic profit of $__________. The firms normal profit is $___________. c) The firms accounting profit is $___________ . d) If the firms total cost stay the same but its total revenue falls to $____________, only a normal profit is earned. e) If the owners could earn 20% annually on the money they have invested in the firm, the economic profit of the firm would be $__________ when total revenue is $175,000). 2) Over the next 3 years, a firm is expected to earn economic profits of $120,000 in the first year, $140,000 in the second year, & $100,000 in the third year. After the end of the third year, the firm will go out of business. a) If the risk-adjusted discount rate is 10% for each of the next 3 years, the value of the firm is $__________. The firm can be sold today for a price of $________. (check for present value tables in the appendix of the text book). b) If the risk-adjusted discount rate is 8% for each of the next 3 years, the value of the firm is $__________. The firm can be sold today for a price of $________. (check for present value tables in the appendix of the text book). 3) a) Managers will maximize the values of firms by making decisions that maximize ___________ in every single time period. ANSWERS 1) a)$80,000; $70,000; $150,000. b) $25,000; $70,000. c) $95,000. d) $150,000. e) -$5,000 2) a) $299,925; $299,925. b) $310,522; $310,522. 3) profit. ________________________________________________________________ Problem.3 The following relations describe demand and supply conditions in the lumber products industry: Qd = 40,000 10,000P (Demand) Qs = -10,000 + 10,000P (Supply) where Q is quantity in thousands of board feet and P is price in dollars. Set up a spreadsheet or table to illustrate the effect of price(P) on the quantity supplied(Qs), quantity demanded(Qd), and the resulting surplus(+) and shortage(-) as represented by the difference between the
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Qs and Qd at various price levels. Calculate the value of each respective variable based on a range for P from $1.00 to $3.50 in increments of 10 cents($1.00, $1.10, $1.20..$3.50) Table
Price Quantity Demanded 30,000 29,000 28,000 27,000 26,000 25,000 24,000 23,000 22,000 21,000 20,000 19,000 18,000 17,000 16,000 15,000 14,000 13,000 12,000 11,000 10,000 9,000 8,000 7,000 6,000 5,000 Quantity Supplied 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000 11,000 12,000 13,000 14,000 15,000 16,000 17,000 18,000 19,000 20,000 21,000 22,000 23,000 24,000 25,000 Surplus (+) Shortage (-) -30,000 -28,000 -26,000 -24,000 -22,000 -20,000 -18,000 -16,000 -14,000 -12,000 -10,000 -8,000 -6,000 -4,000 -2,000 0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 18,000 20,000 EQUILIBRIUM PRICE & QUANTITY

$1 00 $1.10 $1.20 $1.30 $1.40 $1.50 $1.60 $1.70 $1.80 $1.90 $2.00 $2.10 $2.20 $2.30 $2.40 EQUILIBRIUM $2.50 $2.60 $2.70 $2.80 $2.90 $3.00 $3.10 $3.20 $3.30 $3.40 $3.50

Answer

Equilibrium Price = $2.50 and Quantity(Qs=Qd) = 15,000

Determine the equilibrium price and quantity by using equations

Problem 4 If the market demand function is Qd = 340 -6P and market supply function is Qs = 100+2P: a) What is the equilibrium price? b)What is the equilibrium quantity? ANSWERS a)Qd=Qs or 340-6P=100+2P or -8P=-240 or P=$30 b) Qd = 340-6(30)=160 or Qs = 100+2(30)=160 ------------------------------------------------------------------------------------------------------------Problem 5
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If the demand and supply functions for widgets are Qd=100-16P and Qs=-35+20P a) What is the equilibrium price ? b) What is the equilibrium quantity? c) What is the outcome if price is $2.75? What do you expect to happen? Why? d) What is the outcome if price is $4.25? What do you expect to happen? Why? e) What happens to equilibrium price and quantity if the demand function changes to Qd=118-16P? f) What happens to equilibrium price and quantity if the supply function changes to Qs=-80+20P while demand is Qd=100-16P? Answers: a)Equilibrium Price P=$3.75. (Qd= Qs or 100-16P =-35+20P) b) Equilibrium Quantity Q=40. c)When Price is $2.75 Qd=100-16(2.75)=56 & Qs=-35+20(2.75)=20. There is a shortage of 36 units. Since there is excess demand, the price will be bid up by the consumers, thereby decreasing quantity demanded and increasing quantity supplied. The price will be bid up until it reaches $3.75. That is the price where quantity demanded equals quantity supplied d)If P=$4.25, Qd=100-16(4.25)=32 and Qs=-35+20(4.25)=50. There will be a surplus of 18 units at this price. To avoid accumulating unwanted inventories Suppliers will lower price and the price will fall thereby reducing the excess supply until the equilibrium is attained at a price of $3.75. e)At 118-16P=-35+20P, -36P=-153 or Equilibrium P=$4.25 & equilibrium Q=50. f)At 100-16P=-80+20P, Equilibrium Price is -36P=-180=$5 & equilibrium Q=20.

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