Managerial Ecconomics - Lecture Notes

1
NATIONAL UNIVERSITY OF SCIENCE

AND TECHNOLOGY

MANAGERIAL ECONOMICS
Peter Nkala
PhD Candidate

University of Natural Resources and Applied Life Sciences (BOKU), Gregor
Mendel Strasse 33, A-1180 Vienna, Austria, Europe, Phone: ++43(1) 47 654-
3785, Fax: ++43(1) 47 654-3792,E-mail: peter.nkala@boku.ac.at
E-mail: pedronkala@yahoo.co.uk

Master of Business administration (MBA)
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BACKGROUND TO MANAGERIAL ECONOMICS
Davies H, - Chapter 1
Managerial economics is generally concerned with
resource allocation decisions that are made by
managers in both the private and public sectors of the
economy using applications of economic theory
principles and methodologies to decision making
under conditions of risk and uncertainty.
Economic concepts, models and analytical techniques
of economics are used to study and analyze business
decisions or operations and types of decisions
managers face, thereby getting a better understanding
of the business environment and the making of quality
decisions.

3
Managerial economics applies economic tools
and techniques to business and administrative
decision-making.
Managerial economics uses tools and techniques
of economic analysis to solve managerial
problems.
Managerial economics links traditional economics
with decision sciences to develop vital tools for
managerial decision making.
4
Managerial economics is the application of economic
analysis to business problems and this definition is
wide ranging covering a number of very different
appr oaches t o t he subj ect ( Davi es, 1991)

Managerial economics has its origins in theoretical
microeconomics particularly theory of demand,
theory of the firm, optimizing and advertising
expenditures and the impact of market structure on
the firms behaviour are all studied using the
economist tool kit of model building and testing
5
Economic Concept framework
for decision, theory of consumer
behavior, theory of markets and
pricing
Management decision problem product, price and output, make or buy,
production technique, inventory level, advertising intensity and media, labor
hiring and training, investment and financing
Decision Tools tools and technical
analysis, numerical analysis,
statistical estimation, forecasting,
game theory, optimization
Managerial economics the use of economic concepts and decision
science methodology to solve managerial decision problems
Optimal solutions to managerial decision problems
Source: Hirschey M. and Pappas J. L. (1996): Managerial Economics, 8th edition, the Dryden press, Illinois, USA
6
Managerial economics is important in making strategic
managerial decisions of high quality because the world
has not been endowed with ubiquitous resources; a
need arises to make the best use of such resources in
which firms are faced and guided by the profit motive
rather than sustainability in the exploitation of these
resources
Resources are limited or insufficient hence the need to
use them efficiently.
Managerial economics therefore emphasizes on the
practical applications rather than theoretical
underpinnings of economics, on making quality
economic decisions drawing heavily on
microeconomics analysis.
There is need to follow this up with examples where
practical managerial economics decisions were taken
and organizations turned around.
7
METHODOLOGY OF MANAGERIAL ECONOMICS
Definitions and assumptions about phenomenon to be modeled
Theoretical analysis
Predictions
Predictions tested against data
If predictions are tested and
not supported by data, model
is amended or discarded
If predictions are
supported by the data, the
model is valid for the
moment until proven
otherwise
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BUILDING AND TESTING ECONOMIC MODELS
The issue of building and testing models cuts across all disciplines as
approaches to different types of investigations.
For example engineers will build prototypes or computerized simulations in
order to examine their behaviour, meteorologists will use computer models
of weather patterns in order to make weather forecasts.
The first step involves establishing a set of definitions and a set of
assumptions about the entity to be modelled which could be an individual
household, market for an individual product, national economy as a whole
or individual firm.
Theoretical analysis or logical deduction or the process of following
through the and identifying implications of the function follows the first step
and it is the most challenging aspect of the process of model building and
are very sensitive to the changes in the model assumptions.
The model has very little value unless it has been tested against data.
If the model is able to explain the phenomenon being modelled better than
the alternatives it then becomes a useful means of predicting behaviour
which has been modelled.
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MANAGERIAL ECONOMICS AND RELATED DISCIPLINES

MANAGERIAL ECONOMICS - emphasizes on the firm, the
general business or economic environment and business
decisions
INDUSTRIAL ECONOMICS - focuses on the whole industry
views the firm as a component
MANAGEMENT SCIENCE - concerned with techniques that
can be applied to improve decision making and is entirely
normative, using operational research, linear
programming, goal programming, queuing theory and
forecasting all inform the subject matter of management
science
The study of industrial economics follows the famous structure-
conduct-performance approach which is driven largely by the
structure of the industry, which is considered as an exogenous
variable.
10
STRUCTURE-CONDUCT-PERFORMANCE APPROACH
STRUCTURE - generally has a number of dimensions
including the level of concentration, the height of
barriers to entry, degree of product differentiation, the
extent of vertical product differentiation and the extent of
diversification.
CONDUCT - of an industry refers to the type of behaviour
engaged in by its component firms which include
company objectives, collusive versus competitive
behaviour, pricing policies, advertising policies and
competitive strategies.
PERFORMANCE - of an industry refers to its results
focusing on profitability, growth, productivity increases,
and export performance and international
competitiveness.
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THE FIRM AND ITS ENVIRONMENT

Managerial economics analyses the activity of the
firm without any explicit reference to the legal and
organizational forms which the firm may take.
Textbooks on company or commercial law and we
should bear in mind that the legal framework that
governs various companies varies from country
to country.
In this study of managerial economics will
however deal with the general issues that are
common in most economies based on free private
enterprise.
This includes sole proprietorship, partnership,
Joint Stock Company, cooperatives, public
corporations, and private corporations.
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BUSINESS OBJECTIVES AND MODELS
OF THE FIRM
Different models of the firm based on
different assumptions on the firms basics
objective.
The theory of the firm is the centrepiece of
managerial economics
The basic model is the neoclassical model
while others are just reactions to this model
and suggestions on how it can be
improved.

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A firm is any organization that combines and
organizes resources to produce goods and
services.
Firms are autonomous and different from the
people who own it.
Theory of the firm is that firms exist in order to
make profits but sometimes firms sacrifice
short-term profits for long terms gains or
increases in long term profits.
It should also be noted that both the short and
long term profits are important and as a result
the firm would want to maximize the wealth or
value of the firm.
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WEALTH OF THE FIRM
) 1 ( ) 1 ( ) 1 (
.. ..........
2
2
1
1
r r r
n
n
PV
+ + +
+ + + =
t t t
PV is the present value of expected future profits of the firm, t1,
t2, ------, tn, represent the profits in any of the n years
considered and r, is the appropriate discount rate that could be
used to find the expected present value of future profits.
+
=
=
n
t
t
t
r
PV
1
) 1 (
t
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WEALTH OF THE FIRM
=
=
n
t
t
t
r
TC TR
f irm Valueof the
1
) 1 (
) (
This means that the value of the firms is
determined by profits generated which
are the difference between revenue and
costs.

This equation unifies theme for analysis
of managerial decision making and
indeed the whole subject matter of
managerial economics
16
THE NEOCLASSICAL MODEL OF THE FIRM
The neoclassical model is the anvil of the theory of the firm found in
elementary textbooks.
There are three basic assumptions about model of the firm

- are centred on profit maximization
- costs and output
- demand conditions in the market

The objective of the firm is to maximize profits which are essentially the
difference between revenue and costs without reference to the period or time
over which profits are to be maximized.

(TR TC = t)

This assumption is bridged by dividing the periods into the short run and the
long run.
Another complex version which established a multi-period setting for the
model is to assume that the objective of the firm is to maximize the wealth of
the shareholders, measured by the discounted value of expected future net
cash flows of the firm.

17
This requires that the firm makes a decision on its investment criteria about
the size and type of plant to operate and the most profitable use of that set of
plant equipment

When profits in the short-term and long term are not related then consistency
in the two periods is possible but if these profits are interrelated in the two
periods then, the situation becomes more complicated

The simple neoclassical model does not consider complications of this nature
about the maximization of short and long run profits

The firm is seen as a single entity which can be said to have its own
objectives and can make own decisions, in this case it is seen as being
holistic

Remember that the behavioural model argues that only human beings can
make decisions and not firms

The firm seeks to optimize, that is seen to want to achieve the best possible
performance rather than just simple performance meeting certain minimum
criteria.

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The firm produces a single, perfectly divisible and standardized product
for which production costs are known with certainty and the short run
average costs curve is U-shaped as shown in the figure below

The costs per level of output will decrease as they are spread over large
number of units during the period the firm will be experiencing increasing
returns to scale but these will increase beyond a certain level when the
firm starts experiencing diminishing returns to scale

The model generally focuses on the short run or the period during which
the firm is constrained by a plant of a particular size facing a particular
short run cost curve

The model is also based on the assumption that the firm has full
knowledge about the demand and output conditions in the market and the
volume that can be sold at each given price

Demand essentially depends on the behaviour of consumers and
structure of the industry in which the firm is operating and the behaviour
of rival firms.

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EQUILIBRIUM CONDITIONS
Maximize $(q),
Where $(q) = R (q) C (q) where
- $(q) = profit,
- R (q) = revenue,
- C (q) = costs,
- q = units sold or
produced.
This means maximize profits defined as the
difference between revenue and costs and
where revenue and costs depend on the level of
output produced
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ELEMENTARY CALCULUS
0
$
=
c
c
c
c
=
c
c
q
C
q
R
q
q
C
q
R
c
c
=
c
c
q q
C R
c
c
c
c
)
2
2
2
2
CONDITION 1
CONDITION 2
CONDITION 1
This means that profit will be maximized if the firm produces a
level of output such that the marginal revenue ( )
q
R
c
c
equals marginal cost when the slope of the marginal cost curve
exceeds the slope of the marginal revenue curve.
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EQUILIBRIUM CONDITIONS
(diagrammatically)
$
Output
Marginal cost
curve
P
X
Demand / average
revenue curve
Marginal
revenue curve
Profit maximizing equilibrium Davies Howard (1990): Managerial Economics, for Business,
Management and accounting, 2nd edition, Pitman publishing, England.
Th e ma r g i n a l
Re v e n u e a n d
m a r g i n a l
C o s t c u r v e s
should intersect
and at the point of
equilibrium the
marginal revenue
c u r v e s h o u l d
a p p r o a c h t h e
ma r gi n a l c os t
curve from above
Both the diagram
and the equations
s h o w n a b o v e
identify the profit
m a x i m i z i n g
equilibrium for the
firm. The firm will
p r o d u c e t h e
indicated and the
firm is said to be in
equilibrium level of
output and sell it at
the indicated price.
If cost conditions
do not change the
f i r m h a s n o
incentive to change
its price or output
22
Applications of the simple model
Change in parameter

Impact on
Price Output
Demand increase + +
Demand falls - -
Increase in variable cost + -
Lump sum tax or cost increase 0 0
The purpose of the mainstream economic theory is to
predict the firms responses to business environmental
changes particularly demand, cost and tax structures and how
t h e n e w e q u i l i b r i u m wi l l b e e s t a b l i s h e d

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PROFITS IN THE LONG RUN: THE MAXIMIZATION OF
SHAREHOLDERS WEALTH

The firm has to make some investment
decisions which are essentially concerned
with the long run in which there are no fixed
costs. It is therefore not sufficient to
characterize the firms objective as profit
maximization which is defined by the
di f f e r e nc e be t we e n r e v e nue a nd
opportunity costs in a single period without
reference to a pattern of returns over time

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Comparative Static properties
of the profit maximizing
model

The model can also be used for normative
purposes in assisting managers on what they
o u g h t t o d o o r n o t t o d o .
For instance in supporting the traditional
management accounting thinking that firms
should always agree to accept business
decisions which bring in greater incremental
r e v e n u e t h a n i n c r e me n t a l c o s t
25
Managerial discretion models
of the firm
The neoclassical model of the firms has received a
lot of opposition from various authors in the late
fifties and sixties because in the modern day
economies ownership and control of firms lay with
different groups of individuals other than the real
owners.
The classical assumption that ownership and
control were unified in one person does not hold
anymore and this therefore implies two groups of
persons
Owners (shareholders)
Controllers (managers)
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of the firm
These two do not or may not necessarily share the
same interests.
Managers salaries for example may not entirely
depend on the firms profitability but may be tied to
organizational performance- remember the bonus or
profit-sharing schemes.
For this reason managers may therefore not pursue
profit maximization but follow other objectives but in
generally, the manager of a large normally
profitable company will earn a higher salary than
that of a small but highly profitable company.
27
of the firm
Berle and Means (1932) demonstrated that modern
enterprise had not only evolved in size but the
ownership and control of firms had changed
substantially.
Control lay in the hands of professional managers while
ownership rested with share holders and in the case
where the interests of managers and shareholders
differ, shareholders may not know the goings own in
firms that they own.
As long as shareholders have limited interest in what is
going on in the operations of the firms provided they
receive a good dividend, a lot of discretion is given to
managers who can exercise it to pursue personal
interests.
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of the firm
Some firms may aim at achieving a minimum
level of profits and once these are realized
- there is no incentive to increase profits,
- that is pressure for profits may be relaxed
although it may be possible to still earn
higher profits,
- this behaviour is known as satisficing as
according to Simon and others who
proposed an alternative to the profit
maximization behaviour.
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of the firm
It has been suggested therefore that firms in
oligopolistic markets do not necessarily pursue
the profit motive and this facilitated the
generation or search for newer models which
are based on different assumptions from those
espoused by the neoclassical model.
These models include the sales-revenue-
maximizing model by Baumol (1958), the
managerial utility maximizing model by
Williamson (1963), the multi-period profit-
maximizing rate of growth model by Baumol
(1967), the Marris model by Marris (1964) and
the integrative model by Williamson (1966).
30
The sales maximization model
$
Total cost
Total Revenue
Profit
Output
A D
B
E
C
31
Managers salaries, their status and
other perks are related to size of the
companies in which they work,
measured by sales rather than
profitability. Managers will therefore be
keen to increase size and other factors
to which their remuneration is tied
other than profits.
32
The assumption of maximization of sales rather than
profits therefore results in a different model from the
neoclassical model. Other assumptions of this model are:
Single product firm aims at a single objective
There is perfect information about cost and demand
conditions
The revenue maximizer will produce more and charge less
for the following reasons:
Marginal revenue = 0 for the revenue maximizer
Marginal revenue = marginal cost for the profit maximizer
Marginal cost must be positive and as such marginal
revenue must be greater than zero for the profit
maximizer.

33
The marginal revenue for a profit maximizer must be
greater than the marginal revenue for a revenue
maximizer.
As marginal revenue slopes downwards to the right
equilibrium output must be higher for a revenue maximizer
than for a profit maximizer.
Under this model the firm does make some profit like
espoused in the neoclassical model although this may not
satisfy the shareholders and in many cases revenue
maximization may imply incurring losses.
It is therefore necessary to introduce constraints into the
model to make it more realistic, so the model is also
known as the sales revenue maximization model subject
to meeting a minimum profit constraint and this model is
demonstrated in the figure below.

34
$
Total cost
Total Revenue
Profit
Output
A C
B
E
PC3
PC1
PC2
B
35
There are three possible scenarios demonstrated in this
model. In the first case represented by PC1 PC3.
For PC1 the constraint does not bite or seriously affect the
level of profits expected by the shareholders.
PC2 is another possible scenario where the at the revenue
maximizing level insufficient profit is being made and this
does not satisfy the shareholders and output is reduced
until that constraint is met at output level B.
For PC3 maximum profit required to satisfy the
shareholders is the same as that for the profit maximizing
firm and in this case output has to be reduced to level C.
This is despite the fact that the firm has set itself a
different objective.
36

The managerial utility maximization model

The relative efficiency of the firm compared
with the market depends on the extent to which
the interests of different parties within it
coincide,
That is the extent to which the principal-agent
problem exists and this is a general
phenomenon.
This occurs when the principal hires an agent
to act on his behalf but the agent may have
objectives totally different from those of the
principal,
Who may be unable to monitor whether his
instructions are being rigorously implemented.
37

Williamsons managerial-utility-maximizing model takes
account of wider range of variables by introducing the
concept of expense preferences and beginning with the
assumption that managers want to maximize their own
utility.
Expense preferences simply mean that managers get
satisfaction from using some of the firms potential profits
for unnecessary spending on items from which they
personally benefit and three major types of these
expenses are:
Amount managers spend on staff over and above those
needed to run the firms operations (S), including power,
prestige, status and satisfaction among other variables

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Additions to managers salaries and benefits in the
form of perks (M) including unnecessary luxury
company cars, extravagant entertainment and
clothing allowances, club subscriptions, palatial
offices, which may also be thought of as managerial
slack leading to X-inefficiency.
Discretionary profits (D), which are after tax profits
over and above the minimum required to satisfy the
shareholders which managers spend on pet projects
to further propagate their power, status, and
satisfaction. If the minimum profit required by
shareholders is equal to the maximum possible then
D will be zero, and managers may not have the liberty
to indulge their taste for perks and unnecessary
payments to staff.

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The managerial utility maximization
model
The basic form of the model is summarized as:
U = f(S,M,D) which can be interpreted as managerial utility
is a function of S, M, and D available to the individual
manager subject to the usual economic laws regarding
diminishing marginal utility. That is each additional units
of S, M and D yield less utility to the manager.
If R= Revenue, C= Costs and T=Taxes the actual profits
which are a difference between revenues and costs would
be given by:
Actual Profit = R-C-S
The manager will however report the following profits to
the shareholders:
Reported profits = R-C-S-M

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model
If shareholders require minimum
profits Z, after tax deductions, then
the Discretionary profits (D) will be
given by:
D= R-C-S-M-T-Z
41
model
MU MU MU
t D M S ) 1 (
= =
According to the equimarginal
principle managerial utility will be
maximized when the last pound
spent on S, M, and D yield the same
marginal utility such that:
42
model
If the demand declines then at every level of output
the discretionary profits (D) become less and less and
on the other hand the utility derived from D at the
margin increases that are MUD increases resulting in
a continuous disequilibrium.
The manager will then engage in a redistribution of
profits from S and M towards D resulting in serious
implications on costs.
On the other hand if tax on profits increases there will
be a redistribution towards S and M, given that taxes
do not yield utility to management resulting in an
increase in output as workers get more motivated to
perform and add more to output.
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model
While this model may be easy to understand it has some
complexities which make it difficult to grasp every detail
of it but it practical application comes in the explaining
high profits usually reported by take-overs or mergers.
New managers may have totally different ideas regarding
S and M they will seek to prune these in line with what
they believe is good for the organization.
This will result in high profits being reported than was the
case before.
This however depends on managements decision and
preparedness to earn less than maximum profits.
44
The Marris model
This is a dynamic model concerning itself
with growth rates but shares the same basic
assumptions as the managerial utility
maximizing model. However in this case the
utility derives from:
managers seeing reasonable growth of the
firm
job security which depends on satisfaction
of the shareholders interests
growth and profitability of the firm are
therefore key in this model
45
The Marris model
Growth in this model is characterized by
diversification into new products, rather than increase
in output per se. There are two dimensions to in the
relationship between profits and growth in this model,
first, supply growth which results from the profits
generated that are ploughed back as additional
investment into the firm or obtaining funds from the
capital market
Secondly, demand growth, which starts of as positive
at low levels and declines with time until it becomes
negative.
46
The Marris model
The rationale is that at low levels high profits
motivate management to work even harder
and are excited about growth being realized at
this level,
however as the organization experiences
more growth ,
managers are burdened with a larger team to
work with,
a feat that may be demotivating to managers.
This can also be explained in terms of the
diseconomies of scale setting in and retarding
growth.

47
The Marris model
The optimal combinations of supply and demand
growth would be where the two curves depicting the
two combinations of growth intersect.
The Marris model is shown in the diagram below.
As can be seen the combination of profits and growth
chosen is not where the profits are necessarily
maximized.
The desire by managers to seek more growth results
in them being more incensed with growth than profits
but the extent to which they do this is governed by
their concern for job security subject to constraints
placed on them by shareholders who want to see their
wealth being maximized.
48
The Marris model
Demand
Growth
Supply
Growth
A
B
X
Profit
Rate
Growth rate
SG1
49
The Marris model
A high retention ratio, that is percentage of profits
paid out in dividends is too high, will realize lower
levels of growth as there will be limited finance for
further expansion.
In this case the supply growth curve will be very
steep as shown by SG1 and equilibrium at A depicts
a situation where growth is low and less than
maximum profits are being realized.
If the retention ration rises then the equilibrium
combination of growth and profitability also rises
until it reaches point like B where profits earned are
maximum.
50
The Marris model
Up to point B managers have no fears for their
job security as the combination of growth and
profits must meet with approval of the
shareholders.
Going beyond B without the firms share price
falling is also possible but when the threat of
takeover becomes great the managers would
then be more concerned with job security than
other issues.
If the threat of takeover is weak, manager will
not be concerned and will be more concerned
with growth of the firm rather than job security
and will therefore adopt retentions policies
ensuring more growth but reduced profits.
51
The integrative model

This model combines single period profit and
sales maximization with growth maximization
and the maximization of present value of
future sales.
In the upper quandrant the relationship
between the rate of growth and current sales
revenue is shown.
The lower quandrant shows the total cost,
total revenue and profit in a single period with
a constraint as depicted in Baumols model.
52
Growth of sales is directly related to profits so that
growth is maximized when profits are maximum and
growth is zero when profits are zero.
A single period growth maximizer and profit
maximizer will both produce output level Q1
A single period revenue maximizer subject an
externally imposed constraint will produce output
level Q2
However a firm which aims to maximize the present
value of future sales will seek the combination of
current revenue and growth rate which gives that
maximum and this is obtained by constructing iso-
present-value curves joining all points which have
the same present value.
53
The iso-present-value lines must
therefore be negatively sloped as
shown by the lines PV1 PV3.
The properties of indifference
curves still apply in this case, that
is the further away from the origin is
the iso-present-value line, the
higher the present value at that
level.
54
Behavioral model of the firm
Managerial discretion models came about as a result of
the criticism of the neoclassical or traditional model of the
firm driven by the understanding that where ownership
and control are not in the hands on one person,
Many firms compete in relatively comfortable oligopolistic
conditions, managers are able to pursue own objectives
and direct resources to their own ends.
Cyert R. M. and March J. G. in their book A Behavioral
Theory of the Firm argue that the modern firm is a
coalition of individual interests, whereby the interests of
managers and shareholders may diverge with the third
group in the organization,
The labour force may pursue interests different from those
of the other two, and the 4th group or suppliers and
customers interests may also influence the firms
operations.
55
Behavioural model of the firm
However most of the assumptions of the orthodox model
still hold and the only underlying principle in this model is
that firms cannot be regarded as single entities because
they are a conglomeration of many people coming from
various backgrounds and with own set of objectives.

In essence the behavioral model is different from the
neoclassical and discretion models because of the
rejection of the concept of the holistic firm.

The model does not emphasize so much on optimization
and does not assume certainty as information is seen as a
scarce commodity.
56
Behavioural model of the
firm
The key elements of this model are that the firm
hardly exists as a single entity but consists of a
group of people who form coalitions and
alliances amongst themselves based on
common group and individual interests. Each
individual will have own objectives based on
their historical background, preferences, and
position within the firm.
This therefore implies that the firm will have
multiple objectives which are in conflict with
each other which cannot be reconciled in a
single utility function.

57
Decision-making therefore acknowledges a score or
average that allows group and individual interests to be
considered and taken care of.
Decision makers exhibit satisficing behaviour rather than
an optimizing one. There is no minimization or
maximization of anything in this firm, the incentive is just
not there to do so.
Organizational costs will therefore not be kept to a
minimum but instead there is organizational slack
associated with higher than normal costs in all aspects of
operational activities.
Departments in an organization may have own set of
agendas which may not necessarily be in tandem,
accounts, human resources, marketing, etc may all be
having objectives which are in conflict with each other.

58
If one of the multiple organizational objectives is not
met there will be problem oriented search using rule of
thumb to ensure that this is met.
The problem is that this search will be fairly narrow
probably concentrating on this one objective not met
and ignoring other issues which may be equally
important. Past experience and individuals concerned
assist in this rule of thumb problem oriented search.
Organizational learning helps change the individual and
group aspirations and if aspirations are met during the
first level of problem search these increase and more
aspirations come about which will need another round
of search but eventually a point will be reached when
everyone achieves a satisficing level in respect of
individual objectives.
59
However where a solution does not seem
anyway in sight the level of aspirations is
reduced.
Overall, there is the process known as
quasi-resolution of conflict which is
the process whereby organizational
objectives are met by negotiation and
bargaining between differing sectional
interests.

60
Critique of the model
It is a very realistic model which depicts
a lot of commonalities in terms of how
organizations are run, so it is
descriptively more realistic
Model does not offer insights into how
organizations responds to changes in the
environment because it is too inward
looking
Model does not fully address the
question on what firms should do to meet
their objectives

61
If all the stakeholders share a common
objective which is very unlikely, the process of
organizational learning may lead the firm
towards profit maximization.
Decision making takes time if all suggestions of
this model are followed and for this reason it is
of limited use in managerial economics.
However the model still offers an alternative
way that fosters democratization in
organization that allows participation by all and
if properly applied this may yield positive
benefits to the firm.

62
THEORY OF CONSUMER BEHAVIOUR AND DEMAND
The individual is important in economics as
a consumer, supplier of productive services
and as an active participant in the political
process.
The study of consumer behaviour proceeds
by looking at consumer preference
relations which essentially analyze how
consumers make choices under the
assumption that consumers are rational
and would want to maximize utility subject
to the budget constraint.
63
THEORY OF CONSUMER BEHAVIOUR AND
DEMAND
Preference relations are formal descriptions
of the consumers capabilities and
inclinations when faced with choice
making.
There are basically three categories of
preference relations namely the strict
preference relation, weak preference
relation and indifference preference relation
(~)

64
THEORY OF CONSUMER BEHAVIOUR AND DEMAND-
Consumer preferences and Choice

The consumer makes choices in the consumption space
which is defined as the non-negative Euclidian n-orthant
(where n is a finite integer, R+).
The properties of the consumption space are as follows:
Set X is not a null set
Set X is a closed set
Set X is bound from below
Zero is an element of set X
X is a convex set(based on the assumption that goods are
divisible)
B is a subset of X or B is an alternative choice
consumption plans both conceivable and realistically
obtainable.
65

THEORY OF CONSUMER BEHAVIOUR AND DEMAND- Utility
analysis

The utility function is a formal way of
consolidating preference relations and can be
defined as a real valued function and there are
three approaches to the utility function namely,
cardinal measurement, ordinal measurement and
revealed preference.
The utility function is drawn under the following
general assumptions; preference relations hold,
utility is continuous, utility is differentiable, utility
is a regular and strictly quasi-concave function,
and utility is invariant to positive monotonic
transformation of the function.
66

ASSUMPTIONS OF THE CARDINALIST MEASUREMENT

Rational consumer
Cardinal utility or the fact that utility
can be measured in cardinal units
The measurement assumes constant
utility of money
Diminishing marginal utility
Total utility depends on the number of
commodities in the consumption
basket

67
Critique of the cardinalist
approach
The assumption of cardinal utility is
extremely doubtful
Satisfaction derived from various
commodities cannot be measured
objectively
Constant utility of money is extremely
doubtful and unrealistic
Axiom of diminishing marginal utility has
been established from introspection, is only
a psychological law which must be taken
for granted

68
Ordinal Utility
Assumptions of ordinal utility
Rationality
Utility is ordinal
Diminishing marginal rate of substitution
Total utility depends on the quantities of
commodities consumed
Consistency and transitivity of choice

69
Critique of the ordinalist
approach
Assumptions less stringent than those of the cardinalist
Made it possible for framework of consumer surplus
which is important in welfare economics and government
policy to be measured
Makes possible the classification of goods into
substitutes, complements, neutrals and bads, etc
Axiomatic assumptions of existence and convexity of the
indifference curves does not either establish existence or
shape of the indifference curves
It is doubtful whether consumers can really order their
preferences, precisely and rationally as assumed

70
Critique of the ordinalist
approach
Consumer ordering works through a lot of influences,
like advertising, availability of commodities, etc
Theory inherits weaknesses of the cardinalist approach
with strong assumption of rationality and the concept of
marginal utility in the definition of marginal rate of
substitution.
Does not analyze effects of advertising, habit
persistence, etc
Rules out the speculative demand and random
behaviour and these are important in pricing decisions
of the firm

71
Revealed preference
hypothesis Paul Samuelson
This dismisses outright the existence and need of
indifference curves in the study of consumer behaviour
and derivation of demand curves.
Assumptions of the revealed preference hypothesis
Rational consumer
Consistency in consumer decision making
Transitivity of choice
Revealed preference axiom - When the consumer chooses
a particular bundle of commodities they are revealing their
preference for that and other bundles and the chosen
bundle being the one that maximizes utility
72
Revealed preference
hypothesis Paul Samuelson
Critique of the Revealed Preference Hypothesis
A major contribution by Paul Samuelson to the theory of
consumer behaviour
Provides a direct way of deriving the demand curve not
requiring the concept of utility
Can prove existence and convexity of indifference curves
under the weaker assumptions than the earlier theories
Has made possible construction of index numbers of the
cost of living and their use for judging consumer welfare
in situations where prices remain constant
73
The indirect utility function
A utility function that expresses the utility obtained from a
set of goods as being determined by the prices of goods
and level of income, that is
The properties of such a function are:
is a homogeneous function of degree zero in prices and
income
It is a non increasing function in prices, consumer
reduces consumption and this leads to a reduction in
utility.
is an increasing function in income
is continuous in both income and prices
is demand generating where the first part shows the
Marshallian demand function and the whole equation is
called Roys identity

74
Consumer tastes indifference curve
analysis

Consumer preferences are explained by the three
approaches to consumer choice described below of which
the most common is the indifference curve approach.
The indifference curve is defined as the locus of
combinations of amounts of two goods, say X and Y such
that the consumer is indifferent between consuming any
one combination or basket of commodities.
Properties of indifference curves are as follows:
They are negatively sloped showing the inverse
relationship between increase or decrease in quantity
consumed of each of X and Y.
higher indifference curves yield more utility and hence are
preferred
indifference curves will not intersect
indifference curves are convex to the origin

75
Consumer income and price constraints
The budget constraint also called the consumer
possibility line, income line, wealth constraint or the
price line is given by the following equation: where =
price; = quantity and = income.
The budget constraint is based on the following
assumptions:
Consumers have a given budget
Consumers operate in a market where prices are given
Prices of all commodities are strictly positive
Consumer purchases non-negative amounts of n-
commodities
Expenditure on the ith commodity is a product of
quantity and price

76
Properties of the budget set
The budget line is a set of bundles that cost
exactly
It is a subset of the consumption space
Is a closed, convex, compact set
The set is bound from below
Properties of the expenditure function
This is a minimum value function stated as min
subject to to attain level of utility U. .
The specific properties of the utility function
include:
It is an increasing function in U, meaning that
higher levels of expenditure are required for
greater utility to be realized.

77
Properties of the budget set
is non-decreasing in prices and the resulting
Hessian demand function is demand
generating.
where is known as the Hessian matrix.
is homogeneous of degree 1 in prices
is concave in prices such that where HD is the
Hessian matrix

78
Consumer choice

Good Y
Good X
IC
1

IC
2

IC
3

79
Consumer choice
Other effects that managers need to understand
about consumer choice include the Bandwagon,
Snob and Veblen effects because they have a
different impact on demand for the commodity.
A bandwagon effects exists in the market when
consumers for one reason or another would want
to identify with the crowd and suddenly exhibit an
increased demand for the commodity, much more
than was originally anticipated.
This is very common with fad items.
80
Changes in income

Consumers incomes do not remain constant but change
over time resulting in an outward shift of the budget line.
This essentially means that the consumer is now able to
purchase more of one or both commodities given their
new increase in income.
On each new income constraint line there will be a new
equilibrium established and if these points are joined they
result in a curve known as the income expansion path.
The shape or direction of the income expansion path
helps explain the consumers perception about the
commodity.
That is, for normal goods the income expansion path
tends to be a straight line from the origin out into the
consumption space.
81
Changes in income

Good Y
Good X
Income consumption curve
Good Y inferior to X
Income consumption curve
Normal goods
IC
3

IC
2

IC
1

82
Changes in income
Understanding of this concept helps managers
define their products and price them
appropriately knowing fully well how consumers
will react to changes in incomes.
Each individual manager need to determine
through some market analysis whether their
product is perceived to be a normal good or
otherwise with reference to changes in
consumers incomes.
However most of the time managers assume a
positive relationship between income and the
demand for their product although this
assumption may not necessarily be true.
83
Substitution and income effects

For normal goods the substitution and income
effects of a price change are both positive and
reinforce each other in leading to greater
quantities of the product being purchased. For
inferior goods the income effect moves in the
opposite direction from the substitution effect.
That is when the price of an inferior good falls,
the substitution effect continues to operate as
before to increase the quantity purchased of the
goods.
Increase in purchasing power or real income
resulting from the price decline leads consumers
to purchase less of the inferior good.
84
However since the substitution effect is
usually larger than the income effect, the
quantity demanded of the inferior good
increases when its price falls and the demand
curve is still negatively sloped.
The diagram below shows the relationship
between the income and substitution effects
of a price curve and the corresponding
demand curves in the case of normal, inferior
and giffen goods.
The net effect of the income and substitution
effect is called the price effect.
85
Substitution
effect
Income effect
Good
X
Good
Y
Q
2
Q
3
Q
1

1
Q
2
Q
3

Giffen
good
Normal and
other inferior
goods
Quantit
y
Price
Q
86
Note the upward sloping nature of the demand
curve in the case of the giffen good implying that
the income effect more than offsets the
substitution effect to the extent that quantity
demanded of the commodity is far less than was
the case before the price change.
This analysis is very useful in explaining whether
consumers will and always respect the law of
demand or there are situations during which this
is violated?
87
Substitution between domestic and
foreign goods

The substitution between domestic and foreign goods
has risen sharply in recent years due to more liberal
approaches to international trade.
Other reasons for this increase are a decrease in
transportation costs for most products, increased
knowledge of foreign products due to the international
information revolution, global operations of
multinational corporations, explosion of international
travel and rapid convergence of tastes globally.
For most products like computers, fibre optics,
television sets, automobiles, soft drinks and other
specialized machinery substitutability between domestic
and foreign products is apparent and has not
encountered any major problems.
Managers should note that a small shift in prices of the
domestic product may lead to customers shifting totally
from the consumption of local brands to international
brands.

88
Substitution between domestic and
foreign goods

Managers should note that a small shift in prices of the
domestic product may lead to customers shifting totally
from the consumption of local brands to international
brands.
Consumers will spend their incomes on foreign and
domestic goods until the marginal utility per dollar derived
from each is equalized.
For this reason again the multinational companies are
forced more and more by international competition to
equalize costs in production and components as well as
sales revenues between domestic and foreign markets.
The modern manager must therefore have a good
understanding of this substitutability between foreign and
domestic goods for them to be current and relevant and
the study of managerial economics needs to acknowledge
this phenomenon.
89
Further application of indifference
curve analysis

Governments in developing countries have a
major role to play in ensuring that the vulnerable
are protected through sustainable social safety
nets and the options open to government or other
institution involved with the same are either
providing cash or providing food stamps.
Each of the approaches has its own merits and
demerits which every manager of such a
programme needs to think seriously about.
90
curve analysis
Food
Money for nonfood items (Mt)
Food
F
1

B
II

F
B
B
I

91
curve analysis
The fundamental question is whether it is better to give an
equal amount of subsidy in cash to poor families. In the
diagram above we assume that each family has an
average income which it spends entirely on food and non-
food items as shown by the lower budget line.
This budget line changes with free food stamps that
require the family to purchase food and becomes the solid
inverted L-shaped curve above the original budget line
intersecting with it on the vertical axis.
Where government gives cash instead of food stamps the
budget line become the straight line above the original
budget line and touches both axes.
92
curve analysis
Indifference curves shown represent the familys
utility maximization points for example point B is
one such point before family receives assistance
and this is a family that has strong preference for
non-food items. Another family with strong
preference for food will maximize utility at a point
like F but on the same budget line. These families
will move upwards and enjoy utility at BI or FI with
either cash or food stamps. A family with more
preference for non-food items will however move to
a higher indifference curve from the food axis to
purchase more of non-food items if given cash
instead of cash.

93
curve analysis
We note that in both cases individual
households are better off but cash allows
households to have more liberty to purchase
other items other than food.
The reasons why governments however may
continue to give this assistance in terms or
food-stamps or food per se is because there is
a deliberate need to improve nutrition status
which objective may not be achieved if cash
instead was given.

94
Market demand for a commodity

The market demand curve for a commodity is the
horizontal summation of demand curves for all individuals
in the market.
Thus the market demanded quantity at each price is the
sum of the individual demand quantities at that price.
Assume two individuals in the market and assume that
each individual is demanding a certain amount of the
commodity at that price.
The market demanded quantity will therefore be the sum
total of the quantities demanded by these individuals and
nothing more.
However we need to note that the market demand curve
generally is flatter than the individual demand curve, but
still maintains the downward sloping nature of the demand
curve, ceteris paribus.
95
Market demand for a
commodity

When drawing the market demand curve for a
commodity we hold the income, prices of substitutes
and complements and the number of consumers in
the market constant.
A change in any one of these will lead to a shift in the
in the market demand curve for the commodity.
It is also important to note that the market demand
curve will be a horizontal summation of individual
demand curves if consumption decisions are
independent but we know that this is not always the
case.
96
Market demand for a
commodity

There are effects like the band wagon effect, that is keep
up with the Joneses such that the greater the number of
people purchasing the commodity in the event of a price
change others follow suit so that they do not get left out.
This results in much flatter market demand curve than
would be the case.
On the other hand the Snob effect will result in some
consumers disassociating themselves from the product
resulting in a much steeper market demand curve.
Veblens will demand more of the commodity the more
expensive it is in order to impress other people.
This postulation was developed by Thorstein Veblen who
observed that the slope of the market demand curve is not
always what we expect it to be.

97
Price elasticity of market demand
Decisions taken have to be sensitive to the elasticity of
demand, whether quantity or price.
Elasticity is nothing but the responsiveness of quantity
demanded to a change in any of the variables that affect
demand.
Demand for a commodity can exhibit either elastic or
inelastic demand and managers have to understand the
nature of commodities that they are dealing with in terms
of the elasticity concept so that they can price them
appropriately.
Further governments also need to understand elasticity
and use that understanding in determining what would
be appropriate taxes to charge on certain commodities to
either encourage or discourage their consumption.
98
Price elasticity of market
demand
Price
Quantity
Unitary elasticity
Elastic region
Inelastic region
99
A normal price and quantity diagram would
exhibit three elasticity regions that is unitary
elasticity, elastic and inelastic regions.
These are defined in terms of how consumers
behave in each region is there is a change in the
price of the commodity.
For example the region below unitary elasticity is
said to be inelastic because changes in price
result in less than proportionate changes in
quantity demanded.
One major reason for this is that prices are still
fairly low in this region and any marginal
increases will not result in an outcry from
consumers.
100
For example take a commodity like salt which are
lowly priced in most economies, a change in the
price of salt will not be quickly reacted to by the
consumers because the commodity cost very
little anyway compared to the other commodities
in the consumption basket.
However in the region above the quantity tends to
be highly price elastic because any small changes
in price tend to be noticed and reacted to by
consumers.

101
Price elasticity of market
demand
Unitary elasticity results when percentage changes in
price result in an equal percentage change in quantity
demanded.
That is, when the price of the commodity changes, that
does not change overall consumer expenditure and the
quantity purchased of the commodity does not change as
well.
As a policy principle it is not advisable to reduce the price
when the commodity is of unitary elasticity. For luxuries it
is advisable to reduce the price in order to boost demand.
However the concept of unitary elasticity, although very
reasonable, does not exist in practice because the
commodities will either exhibit elastic or inelastic demand.
102
Factors that affect elasticity of
demand
Factors that drive the elasticity of demand of commodities include (1)
how the commodity is defined, (2) relative expenditure on the good,
(3) availability of substitutes, (4) geographical location and (5) time.
Basic commodities tend to be very much price inelastic because
consumers are given no choice because they need the commodities
anyway while on the other hand luxuries tend to on average exhibit
elastic demand because consumers can easily go without them.
If a commodity takes a larger chunk of the household budget, it tends
to exhibit elastic demand because consumers are quick to notice any
price changes of such commoditities.
Prices that are high tend to be more elastic than low ones. Further
commoditities that have many close substitutes are more price elastic
than those that have not close substitutes.
The question however is why is it that salt has no close substitutes
but is generally lowly priced?
103
Factors that affect elasticity of
demand
Geographical location of the commodity also affects the
elasticity of demand because the relative importance of a
commodity varies as you move from one country to the next.
For example, blankets in Lesotho and Tanzania because of
the differences in weather conditions will tend to exhibit
inelastic demand.
Sometimes consumer tastes and preferences change over
time. For example the way consumers perceived the first
Honda car was so negative that it did not sell.
However, manufacturers were able to transform this car
model to one that could compete very well with other cars in
the market. However this took a long time to accomplish and
a lot of resource ploughed into research and development.
104
Income and cross elasticity of demand

Own elasticity of demand if the ratio of
percentage change in quantity demanded to
percentage change in the price of the
commodity or the product of the ratio of
change in quantity to change in price and
ratio of price and quantity.
That is,
od iceofthego changeinpr percentage
nded antitydema changeinqu percentage
= q
quantity
price
ice changeinpr
antity changeinqu
* = q
105

Q
P
P
Q
*
c
c
= q
For the downward sloping demand curve own price elasticity will
always take negative values because price and quantities change in
opposite directions.
We also talk about arc and point elasticity of demand where arc
elasticity refers to elasticity over an interval along the demand
curve and this takes different values depending on the direction of
change in values that would be considered at any point in time. We
therefore define arc elasticity as the average of the two different
values although this raises a lot of ambiguity, so we should be
satisfied that arc elasticity will take on different values depending
on the direction of change being considered.
106


As the distance between the two points
under consideration is reduced the
difference between the two values for the
arc elasticity becomes smaller and at this
point we discuss point elasticity which in
elementary calculus it is defined as:
Q
P
P
Q
*
c
c
= q
107
Income and cross elasticity of
demand

This makes the whole ambiguity about arc elasticity
disappear. Curves depicting different elasticities of
demand will always take on different shapes, that is
where the demand curve is a vertical line elasticity
will be equal to zero, where it is a horizontal line
elasticity will be negative infinity and for the normal
convex demand curve the elasticity will be negative
unity at all points.
This is where the demand curve is a rectangular
hyperbola and the product of price and quantity at
any one point would be negative one.
108
Price elasticities of demand
Examples given here are unlikely to be met in practice but
are important to understand the elasticity concept for
purely academic purposes.
At the point where the curve meets the price axis elasticity
is negative infinity and at the point where it meets the
quantity axis it is zero.
Elastic and inelastic demand is also terms generally used
to describe the type of responsiveness that is being
considered.
When elasticity is less than 1 demand is generally said to
be inelastic and if the absolute value of elasticity is
greater than 1 then that is considered as being elastic.
In situations where elasticity is either infinity or zero, then
it is described as infinitely or perfectly elastic and where it
is equal to one it is said to be unitary.
109
Marginal revenue and elasticity
As elasticity measures the responsiveness of
demand to changes in price, it is also proper
to think about a link as existing between
elasticity and revenue.
This link is as follows, in the elastic region a
fall in the price leads to a more than
proportionate increase in quantity demanded
thereby leading to an increase in revenue
generated.
If demand is inelastic a fall in the price will
lead to a less than proportionate increase in
the volume of demand and revenue will fall.
110
Marginal revenue and elasticity

In short in the elastic region revenues and elasticity move in different
directions but in the inelastic region revenues and elasticity move in
the same direction.
This is shown in the figure below:
X
Y
Z
Marginal revenue
Priceric
e
Between X and Y where
demand is elastic the
marginal revenue is
positive and between Y
and Z where demand is
inelastic the marginal
revenue in negative. We
can explain the later
case as meaning that in
order to sell one
additional unit of output
the proportionate
change in price is so
large that revenue falls.
111
Income elasticity of demand
While in economic theory we often talk
about price elasticity of demand income
elasticity of demand is another very
important concept because demand is
also sensitive to changes in income
which can be expressed as:
come nsumer changeinco percentage
nded antitydema changeinqu percentage
sin '
= q
112
This can be expressed as both arc
income elasticity and point income
elasticity and each on of them will be
expressed as follows:
manded quantityde
income consumers
come nsumer changeinco
nded antitydema changeinqu '
*
sin '
= q
Q
Y
Y
Q
*
c
c
= q
(point income elasticity)
arc income elasticity
113
The size and sign of the income elasticity of
demand depends to a great extent upon the
nature of the product in question and the
level of income which the consumers will
have reached.
At any level of income consumers will
purchase commodities in certain quantities
and these quantities are likely to increase as
the level of income increases.
Remember that total utility depends on the
total amount of commodities in the
consumption basket
114
The Engel curve which shows the relationship between
income and demand for the product will be relatively
flat in the case of necessities.
For luxuries the Engel curve will be upward sloping
indicating that at higher levels of income the
consumers want to purchase more of the luxury good
than they would at low levels of income.
For inferior goods consumers will purchase less as
their income increases and the opposite is true for
normal goods.
These scenarios can be explained in the figures below:
115
Quantity demanded Quantity demanded Quantity demanded
Income Income
(a) Necessities (b) Luxuries (c)Inferior for income
levels above X
0

Income
The Engel curve has also been used to explain welfare. The greater the proportion of income spent on food
the lesser will be the standard of living in any particular country. This means that consumers in that country
are more preoccupied with working just to buy food and cannot afford other non-food items. Managers need
therefore to understand the proportion of money that consumers spend on food in their respective target
markets and business environments. Where the Engel curve shows that a greater proportion of income is
spent on food, those businesses selling non-food items should therefore be cautious about how they go
about their day to day business as demand is depressed for them.
116
Cross price elasticities of
demand
This is the third most discussed elasticity
concept which indicates the responsiveness of
quantity demanded to changes in prices of
other goods which may either be substitutes or
compliments. We summarize the point cross
elasticity of demand as:
P
P
P
Q
A
B
B
A
*
c
c
= q
where QA and QB are quantities and PA and PB are prices. In looking at this elasticity concept
it is important to pay particular attention to the sign of that type of elasticity. A positive sign
means that the two commodities in question are substitutes and a negative sign means they
are compliments. For commodities that are not related the cross elasticity of demand will be
zero.
117
Cross price elasticities of
demand
The magnitude of the cross elasticity figure obtained if
very important in decision making as it indicates the
degree of industrial competition that exists.
A low magnitude indicates low levels of competition or
the degree of industrialization and high magnitudes
indicates still competition and more industrialization.
The question now is how big is big, we are talking about
magnitudes of 6 and above.
Practical application of the cross elasticity of demand is
in finding the appropriate definition of a market or
industry, that is an industry is a group of firms producing
goods which are close substitutes or have high positive
cross elasticities of demand.
118
Constant Elasticity of
demand
Demand functions take various forms ranging
from multiplicative to additive demand
functions.
Given that quantity demanded is a function of
many independent variables and assuming an
addictive demand function of the form:
+ + + + = . .......... 2 5 5 , 1 100 A Pc Ps P
Q
d
119
demand
Where Qd = quantity demanded
P = own price of the product
Ps = price of substitute good
Pc = price of complementary good
A = Advertising expenditure
= error term
For a multiplicative demand function we shall
assume a Cobb Douglas type of demand function
which is expressed as:
A Y aP
Q
b b b
d
3 2 1
=
120
demand
Where Qd = quantity demanded
P = own price of the product
Y = Incomes of consumers
A = Advertising expenditure
a = coefficient
The powers in such a demand function
represent the elasticities of demand with
respect to each of the variables to which they
are attached. Note that the elasticity of
demand in the case of price is negative and
that with respect to income and Advertising
are positive.
121
demand
We can prove that the powers indeed
represent the elasticities by solving
this function as follows:
) 1 (
2 1
=

Y aP
Q
b b
d
) 2 ( *
c
c
=
Q
P
P
Q
q
This shows us that in such a multiplicative demand function of the Cobb Douglas form power
of the variables represent the elasticities of demand with respect to each of those variables
and there are two important issues to take note of in this case. You can also demonstrate that
b2 is the elasticity of demand with respect to income Y, by differentiating this function with
respect to the income variable.
122
demand
The marginal effect of each of the independent variables
depends on the value of all other independent variables
unlike is the case with the additive model where the
impact of each variable does not depend on other
variables.
This latter assertion does not make any realistic sense
because in reality everything depends on everything
else, there is no way we can think of variables as totally
unrelated.
For example it is erroneous to assume constant taste
because these are likely to change with price.
Constant elasticity of demand is important because it
tells us that there is uniform decision making within the
firm and that there are no variations among individual
tastes within the group.
123
demand
It is also possible to convert this Cobb
Douglas multiplicative model into a linear-
log function as follows :
In this case the coefficients of the logs
give the elasticities of demand in this
function.

The other implication is to say we need not
worry about these constants when making
decisions because these values are
constants
Y b P b a Q log log log log
2 1
+ + =
124
How to estimate and forecast
demand
The size of the market is very important to any business
and decision-making is better informed if the manager
knows the size of their market share relative to that of
other competitors.
Market demand estimation can be done using consumer
surveys, market experimentation, regression analysis or
moving averages.
There are different types of markets that we need to think
about as we try to estimate demand for our product.
There is the potential market, which is composed of a
group of households and other consumers who indicate
some interest in the product on offer without necessarily
having the ability to purchase the commodity.
125
demand
The available market is the group of consumers who
have the interest, the necessary income and access
to the product.
This is what is referred to in economics, as
consumers able to show effective demand and very
few companies are able to sell to every possible
consumer.
The market that suppliers will decide to focus on is
known as the served market but these may not all be
reached and those consumers that the company will
eventually settle for who will actually purchase the
product are the penetrated market.
126
demand
These markets can also be analyzed from the
viewpoint of industry market, which is the
market for the whole industry and the market
for the individual firm.
Markets also need categorization along the
product line, product form and market for an
individual product item.
Further markets can also be classified
according to geographical differences like the
local, regional, national , continental or global
and also in terms of the time factor such as
short-medium-long term.
127
Market surveys
This is one way of estimating and forecasting demand for a
product which proceeds by way of a questionnaire to establish
consumers intentions about a product within a specified future
period.
Market surveys may be used for a range of other purposes like
testing the consumers reactions to different product
configurations and packaging, identifying the link between
purchasing behavior and other variables like consumer incomes,
age, gender and social status.
A team of well-trained interviewers or scouts is sent out into the
market to ask consumers questions about how they feel about
certain products.
Some inherent problems of consumers surveys is that they may
be very expensive to carry out, some biased questions, sample
may be unrepresentative and answers may be associated with
these surveys and for these reasons some economists argue
that surveys may not necessarily be ideal for forecasting.
128
Market surveys
The success of consumer surveys also depends very
much on how clear consumers are about their attitudes
towards certain products because if buyers are
ambiguous or vague about their intentions they may not
be able to provide useful information to the researcher.
The cost-effectiveness of market surveys also depends
on the cost of identifying and contacting buyers, buyers
willingness to disclose certain information and the
buyers propensity to carry out their actions.
Market surveys are therefore useful for those products
where it is possible for consumers to plan ahead their
future demand and purchases of the product.
129
Market experiments or testing
When a new product is introduced into the
market there may be no data available to
compare or use for the analysis and in this
case direct questioning of potential
customers may be difficult as they have never
seen the product or its characteristics and
neither the sales force nor expert opinion will
be useful in this regard.
Market testing therefore becomes the only
option available to estimate the demand for
the product and it takes the following different
forms and techniques.
130
Market experiments or
testing
Sales-wave research approach consist of selecting a
group of consumers and supplying the product for
free to them and reoffering the product at reduced
cost to them and then determine the repeat purchases
of different brands.
Packaging can be varied to determine or monitor the
effect of variations on market demand for the product.
Market experiments generally proceed through
varying only one variable and keeping the others
constant in order to see the effect of changes in this
one variable on market demand for the product.
131
Market experiments or
testing
The other method of carrying out market experiments is known as
simulated store technique whereby a group of shoppers are shown a
number of advertising commercials including those on the product in
question then giving them small amounts of money that they can spend
on the product or other products or keep. Records are then taken on the
money spent on the product and that on other competing products and
shoppers are then reassembled and asked on their immediate reactions
to the product and other competing products and their reasons for
purchasing the product.
The problem with this approach is that it may be very expensive and
distorts consumer behavior since the consumers already know that they
are being watched and may not necessarily order their purchasing ideas
independently. For example some consumers will associate the money
given with the idea that they are suppose to buy products of that very
firm and not that from other firms and this need to be honest in itself
may not really give a true picture about the consumers preferences for
the product.
132
Market experiments or testing
Test marketing is another approach to establishing
market demand which actually involves selling the
product in different markets, in varied packaging or
promotional concepts.
This may be done on a very small scale or large scale
depending on the budget allocated to this exercise.
Test marketing may be very expensive and may not
necessarily give accurate forecasting information
because of certain shortcomings in the exercise itself or
the methodology used, e.g. markets in which testing is
done may not be representative.
Market testing however gives companys intentions to
competitors who may as well take any counter-
measures.
133
Sales force opinion

This approach does not focus on the consumers but on
the sales force who because of their closeness to the
consumers are asked to provide information on
consumers attitude and opinions on the product and
asking them to make projections about the future volumes
of sales quantities.
This relies very much on the knowledge of the sales force
such that if the sales force themselves are not well
informed about changes in the economy may not
necessarily provide reliable information.
The sales force may also provide biased information
because they may be pursuing different interests, such as
protecting their jobs, giving low forecasts so that they will
be able to sell everything without much effort.
134
Sales force opinion
This approach therefore should find ways of bring the
interests of the sales force and that of the company
together and these may include bonuses for providing
accurate forecasts.
Despite these inherent problems the sale force
opinion has advantages because if properly done the
sales force are closer to the customers and more
informed about their attitudes towards certain
products, may be able to spot the trends in demand
first before anyone else does, and should they be
involved in making these forecasts they may be more
committed and motivated to carry out the exercise.
135
Expert opinion
Experts directly involved with selling like dealers, distributors and
suppliers or other people whose interest is in forecasting such as
stockbrokers industry analysts, marketing consultants, trade
association officers all have valuable information about the
demand for the product and may be approached for their opinion
on how the future sales of the product will behave. Individuals give
their own independent opinion and as a result are not affected by
the group-think influences.
The Delphi technique is one such approach where individuals are
asked for their independent forecast and the forecasts then
discussed further with the participants who have no knowledge at
all about who gave what figures and each one asked to revise their
forecasts in line with what others had forecasted, with revisions
until some agreement is reached.
The problem however arises when some of the experts refuse to
change their views but it is true that iteration actually leads to a
convergence of ideas.
136
Regression Analysis
A relationship between two or more variables can be established
using statistical and econometric techniques including regression
analysis. This is based on the understanding that a relationship or
influence may exist among different variables, for example and
equation or model such as implies that X and Y are related as
given by this linear function or model.
Time series analysis is sometimes used to explain the variations in
the dependent variable and one popular method is known as
decomposition method which assumes that time series has or is
made up of various components. The first of these components is the
Trend (T) showing long run changes in the variable considered and
the second is the seasonal movements (S) in the variable which
acknowledges that demand for instance may exhibit seasonal
fluctuations. The third component is the irregular movement (I)
associated with non-predictable changes and finally the cyclical
movement associated with expansions over periods of a few years.
Time series analysis uses information from past values to make
forecasts of the future. The following model may then be used to
summarize this:
X Y o o 1 0
+
=
I S C T X t t t t t
+ + + =
137
Regression Analysis
Xt = observation at time t
Tt = trend value for period t
Ct = the cyclical component at period t
St = the seasonal component in period t
It = the irregular component in period t
This relationship may be multiplicative instead of being
linear but the essence of the model may be explaining
the same thing.
I S C T X
t t t t t
* * * =
The trend component may be isolated by calculating the moving average or by making a scatter
plot of the data at hand and inserting a trend line from the way the data is presenting itself or
appearance on the scatter plot. Take and example of sales figures for bicycles for company X from
1981 to 1985 shown in the table below, if we regress the raw observations against the time we
get the trend line as explained by Tt= 2787.9 +59.6t
Where Tt= trend values for sales and t = time period. This function helps us separate the seasonal
and the irregular components by finding the difference between the actual value and the
calculated value of Tt at any one point.
138
Regression Analysis
The relationship between Y and X is given
by the value of R2 or the adjusted R2 of the
regression equation.
The higher will be the value of R2 the better
because it means that the variations in the
dependent variable are well explained by the
independent variables.
Lower values of R2 imply that there may be
other variables that explain the dependent
variables which have not been captured in
the model.
139
Barometric forecasting
techniques

This uses indicators from present or current activity to forecast future
values and one such common approach uses leading indicators
where this is an indicator known to be correlated with the future
behaviour of the variable requiring to be forecasted.
For example if we want to forecast the number of MA graduates from
UCM in 10 years 2 years time, the number of currently registered
students studying for MA degree would be a good indicator to use.
Managers need to be able to forecasts future changes in economic
activity because this may mean a lot in terms of the survival of their
business or its failure.
Demand for new machinery and equipment may mean brighter future
in terms of economic performance, and performance of the stock
exchange may be used to point to the same.
140
Applications of market demand and
elasticity

Knowledge of the market demand and elasticity is very
useful and often necessary for government and
business managers to come up with the correct
decisions.
Tax department for example need an understanding of
the elasticity concept to be able to design tax systems
that will either encourage or discourage the
consumption of particular products.
Most governments are aware of social problems
associated with the consumption of alcohol, drugs and
other anti-social products so the taxes on such
commodities are very high.
141
Applications of market demand
and elasticity

Elasticity of demand concept is also
used to discourage imports of
certain products with the view to
protecting local industries
producing import substitutes.
Governments would charge very
high tariffs for those commodities,
which are demand inelastic to
achieve this objective.
142
Applications of market demand and
elasticity

Taxation is very important revenue base for most
governments and for government to maximize revenue
there is need to tax more those commodities which
exhibit inelastic demand and less those that are
demand elastic.
Pricing decisions in companies should also be driven
by the elasticity concept such that for those
commodities exhibiting inelastic demand the prices
charged should be relatively higher than those that are
demand elastic in order to maximize shareholders
wealth.
The elasticity concept can also be used to combat
crime if it is known that a relationship exists between
expenditures on crime prevention activities and a
decline in the crimes committed.

143
THEORY OF PRODUCTION
Production is the creation of any good or service
that has economic value to either consumers or
other producers.
Production economics focuses on the efficient
use of inputs to create outputs and the process
involves all of the activities associated with
providing goods and services.
Managerial economics essentially discussed
include: whether to produce or shut down, how
much to produce, what input combination to use,
what type of technology to use.
144
Examples of production would include:
physical processing or manufacturing of
material goods
production of transportation services
production of legal advice
production of education
production of research and development
production of bank loans
145

146
The theory of production essentially studies the relationship between
inputs and output of various products.
The study follows the analytical approaches as the study of consumer
theory but the objective in this case is maximization of profits at the
margin and not marginal utility as is the case in consumer theory and
the minimization of costs of production.
However both firms and consumers are maximizing entities.
The production function therefore is crucial in this case, and this can
be defined as a function describing the relationship between inputs
and output.
This theory also analyses how firms that are operating efficiently
make profits in both the short and the long run resulting in attainment
of economies of scale in production.
147
The profit maximization assumption provides the framework for
analyzing the behaviour of the firm in microeconomic theory
and it is this assumption that the behaviour of the firm will be
studied most fruitfully although we already know that this has
been challenged by recent managerial theories of the firm which
postulate multiple goals for the firm other than maximization of
profits.
The later postulate that after making satisfactory rather than
maximum profits modern enterprises (firms) seek to maintain or
increase market share, maximize sales or growth, maintain a
large staff of executives and lavish offices, minimize
uncertainty, create and maintain good public image as desirable
entities in the community which provide employment and
contribute through good corporate relations with other
stakeholders in the environment in which they operate.
Corporate social responsibility
148
Our study will therefore not discard
this theory because many of these
goals are indirect ways of earning
and increasing profits in the long
run hence we shall retain this very
important profit-maximization
assumption.
149
TECHNICAL EFFICIENCY
If an alternative process can produce the
same amount of output as process A but
process B uses less of one input and the
same amounts of all other inputs, then
process A is technically inefficient compared
to process B.
Process B is therefore the technically efficient
process compared to A.
150
ECONOMIC EFFICIENCY
When economists use production function they assume
that the maximum level of output is obtained from a given
combination of inputs, that is they assume that production
is technically efficient, but when producers are faced with
input prices, the problem is not one of technical efficiency,
but that of economic efficiency.
That is, the problem faced by producers is how to produce
a given amount of output at the lowest possible costs.
To be economically efficient, a producer must determine
the combination of inputs that solves this problem.
151
The nature, function and
theories of profits

Profits usually differ among different industries and even
more so among different firms and the theory of profits
attempts to explain or give a rationale for these
differences.
There are many such theories of profits including, risk
bearing, frictional theory, monopoly, innovation,
managerial efficiency theories.
The risk bearing theory of profits postulates that firms that
are involved in risky business like exploration for
petroleum, have to earn higher profits to remain in
business and the expected return on stocks for such
companies has to be higher to justify their continued
existence.
152
RISK BEARING THEORY OF PROFITS

Firms enter into risky areas of business because
they expect to make above normal returns so that
they can justify their continued existence in that
industry.
For example exploration for petroleum is one field
where there are above-normal risks but firms still
invest in those areas and the only logical
justification to do that is that expected profits
from that industry are very high and prices to
charged for these commodities have to reflect the
risk element involved.
153
Frictional theory of Profits
Movement away from equilibrium results in profits in the
short run because of the friction or disturbances of the
equilibrium otherwise in the long run firms are supposed
to make zero or normal profits on their investments.
However at any point in time firms are unlikely to be on
their long-run equilibrium hence they make profits.
When the industry makes profits in the short-run other
firms will be attracted into that industry and this tends to
drive profits to zero.
Some industries will start making losses and leave the
industry.
154
Innovation theory of profits
Profits are a result of introducing a successful
innovation such as was done by Steven Jobs
who introduced the Apple computer company
and becoming a millionaire in the course of a
few years in 1977.
Countries like the United States encourages and
protection of innovations through its patent
system.
However when other firms start producing
imitations of the innovation, profits will decline.
155
Case study
PROFITS IN THE PERSONAL-COMPUTER INDUSTRY STEVEN JOBS
In 1976, Steven Jobs, then 20 years, dropped out of college together with a friend
developed prototype desktop computer. With financing from an independent
inventor, the Apple Computer Company was born, which revolutionized the
computer industry. Sales of apple Computers jumped from $3 million in 1977 to
over $1.9 billion in 1986 with profits of over 150 million. The immense success of
Apple was not lost on potential competition and by 1984, more than 75 computer
companies had jumped onto the market. Even IBM which had originally chosen not
to enter the market soon put all its weight and muscle behind the development of
its own version of the personal computer the IBM PC. Because of increased
competition, and reduced profits, however many of the early entrants had dropped
out by 1986, and even the Apple Computer Company was under pressure and
faced leaner profits in 1985.
This is a classic example of the resource, function and importance of profits in a
managerial economics or the economy in general. While Jobs is not doing well
today as he did a few years ago (he actually resigned from the company in 1985
after a power struggle with the companys president, John Sculley), he is still a
multimillionaire. His huge rewards resulted from correctly anticipating, promoting
and satisfying and important type of market demand. Competitors, attracted by
the huge early profits were quick to follow thereby causing profits in the industry
to fall shapely. In the process however, more and more of societys resources were
attracted to the computer industry, which supplied consumers with rapidly
improving personal computers at sharply declining prices.
Adapted from Salvatore D (1986), Managerial Economics, McGraw-Hill, New York,
P18
156
Managerial efficiency theory of profits

Firms that are more efficient than others
will tend to generate more profits than
those firms that are less efficient otherwise
all firms should earn normal profits.
Managers operating above average tend
therefore to encourage maximum profits in
the organization.
157
Monopoly theory of profits
Firms in monopoly situations restrict output and
charge higher prices than would be the case
under perfect competition in order to earn
profits.
Because of barriers to entry these firms can
continue to make profits in the long-run and
monopoly power arises from the firms ability to
own and control the entire supply of raw
materials, scale economies, from ownership of
patents, or from government restrictions
prohibiting competition.
158
Function of Profits in
organizations

High profits are a good indicator that the firm is doing well and that
consumers want more of the product.
High profits provide an incentive for firms to expand output and for
more firms to enter the industry in the long-term.
For firms operating above average efficiency levels, profits act as a
reward for this efficiency.
Profits encourage industries to expand their output while it signals
for other industries that it is opportune for them to leave the industry
because they are making losses.
Finally profits are a signal for the firm to reallocate resources to
those areas where it is more lucrative to produce.
In situations where the profit motive exceeds its mandate
governments come in to regulate private enterprise for example
through introducing price controls on rent, minimum wages, cost of
electricity, etc.
In short government comes in to prevent exploitation of man by man
in pursuit of the profit motive and to reduce generation of
externalities.
159
Relating inputs to output

Production refers to the transformation of resources into
output of goods and services and it is important to
appreciate that output of a firm can either be a tangible
product or an intangible one.
The later would include such things as education,
banking, legal, accounting, communications services etc.
production is a flow concept meaning that it has a time
dimension, we thus therefore look at production in the
short run or the long run and this is the same view that
we have for our costs.
Firms should therefore be viewed as those organizations
which combine and organize resources for the purpose
of producing goods and services for sale at a profit
160
Relating inputs to output

Inputs, resources or factors of production
are the means of producing the goods and
services and can be broadly classified into
labor or human resources, capital, land or
natural resources and entrepreneurship.
Entrepreneurship is a special factor of
production and should be viewed differently
from human resources as it is associated
with individual risk takers who see the
opportunity to combine resources and
produce commodities and take the risk of
committing capital for the achievement of
this goal.
161
The production function and its
properties
The production function is simple a
mathematical model relating the maximum
quantity of output that can be produced
from given amounts of various inputs or a
schedule (table, equation) showing the
maximum amount of output that can be
produced from any specified set of inputs
given the existing technology or state of
the art.
162
properties
) , , ( ) , , , , ( T Y X f Q t j T L K f Q
or
= =
where Q = level of output
K = a measure of capital input
L = a measure of labor input
T = Technology
J = industry to which the firm belongs
t = time
163
properties
The production functions takes on
various forms but the most common and
useful is the Cobb-Douglas production
function which is a multiplicative
function of the form:
L K
A Q
b a
=
where A = a constant
a, b = positive fractions
The Cobb Douglas form of the production function allows direct calculation of output elasticities
and can be considered a first order arbitrary production function and it is also commonly
assumed that time (t) and industry (j) only result in multiplicative shifts in overall output, but
do not interact with any other inputs into the process.
164
properties
This results in the following equation:
L K
C
j
T Y
Q
it it
it
j
j t t
jt
3 2
) exp(
1
| |
|
+ =
Technology is another very important factor to consider
when thinking through the concept of production.
Certain industries have seen so much increase in
technology such that the costs of production have
drastically gone down and more machines are now
employed in the production process than was the case
before.
The coefficients |1-|3 represent production elasticities.
Other factors of production may be included depending
on what the researcher thinks influences production in a
big way.
165
properties
The production function by assumption has a number
of properties for example both capital and labours are
assumed to be infinitely divisible and independently
variable and the function is continuous in labour and
capital.
That is, output increases smoothly as either capital or
labour input or both is increased.
The marginal production of labour for example is the
rate at which output increases when the labour input is
increased.
From the concept of diminishing returns as more and
more of one factor of production is combined with fixed
quantities of another the point must be reached at
which this peaks and begins to decline.
166
properties
Marginal product of labour (MPL)
1
=
c
c
b a
L bAK
L
Q
The slope of the marginal product curve =
) 2
)( )( 1 (

=
b a
L
L AK b b
dL
dMP
and as b lies between zero and one, the slope
of this function always has to be negative.
This explains to us that the Cobb-Douglass
production function has the notion of a
downward sloping marginal product curve.
167
properties
If both factors of production are
increased the impact or level of output
depends on the returns to scale
exhibited by the production function.
Given the initial production function as
if we increase both capital and labour
by factor k we shall have
b a
K AK Q =

) (
) (
*
) ( ) (
b a
b a b a
b a
Qk
k L AK
kL kK A Q
+
+
=
=
=
168
properties
In the Cobb-Douglas production
function, if the factors of production are
changed by some factor k output will
change by factor .
If (a+b)>1, there are increasing returns to
scale but if this is less than one there are
decreasing returns to scale and if this
equals unity there are constant returns to
scale.
k
b a ) ( +
169
properties
Capital input Capital input Capital input
Labour input Labour input
Dcreasing returns to
scale
Constant returns to
scale
Increasing returns to
scale
As can be seen in the diagram for increasing returns to scale isoquants get
to be closer and closer together at higher level of output while at lower
level they remain more evenly spaced. For decreasing returns to scale they
get to be more widely spaced at higher levels of output. For constant
returns to scale isoquants are evenly spaced at all levels of output.
170
The production function and
isoquants
110 units of output
105 units of output
100 units of output
Labour input
Capital input
Isoquants are curves
connecting all
combinations of inputs
that give the same level
of output when
combined efficiently as
shown in the diagram.
171
isoquants
Labour intensive operation
Capital intensive operation
(IEP)
Capital input
Labour input
172
Properties of isoquants
they are convex to the origin or concave
upwards
their slope shows the rate at which one factor is
substituted for the other to maintain the level of
output constant
this slope is known as the marginal rate of
technical substitution
isoquants never intersect because this would
imply that the same level of output can be
produced by from different combinations of
factors of production
173
isoquants
In economics the production function
can also be seen to represent technology
which encompasses all known methods
of producing the commodity in question
and each point on the isoquant
represents some production technique,
represented at those combinations of
capital and labour.
174
Cost minimizing choice
technique
Isoquants provide a graphical means of
cost minimization in production.
Assuming a unit price for labour to be
W and r the cost of capital which is
generally defined in terms of the wage
rate and interest respectively.
The total cost of production will be
defined by
) )( ( ) )( ( K r L w TC + =
where L= units of labour employed
K= units of capital employed
175
technique
Cost minimization at output level Q* would be given
by the first derivative of the cost function at this
point with respect to each of the variables that are
affecting costs as shown in this diagram.
The function or curve describing costs would
therefore be a straight line whose slope gives the
price ratios of capital and labour. For a given level
of expenditure the combinations of capital and
labour that can be purchased is given by the isocost
line and higher levels of expenditure are given by
lines which are higher and further away from the
origin.
.
176
Cost minimizing choice technique
The optimal level of output Q* is produced at minimum
cost at which the firm can purchase combinations of
capital and labour which are sufficient to produce this
output level Q*.
Cost minimization depends very much on relative
prices of the two factor inputs.
If labour is relatively expensive the isocost lines will be
steeper and the production technique chosen will be
capital intensive.
It is logical to assume that a rational producer will tend
to use relatively cheap inputs compared to the first.
If labour is cheap then the isocost line will be less
steep, relatively flat, and the production technique will
be labour intensive
177
technique
Capital input
Labour input
Q*
L
3

L
2

L
1

Cost minimizing production technique
178
technique
Having analyzed the isoquants and the isocost line, the
next important thing is to determine the point at which
production costs are minimized and this is the point at
which the isocost line will be tangential to the highest
possible isoquant.
This is the point at which the slope of the isocost curve is
equal to the slope of the isoquant.
This slope of the isoquant is equal to the marginal rate of
rate of technical substitution which can be expressed in
terms of the ratios of the marginal product of capital to the
marginal product of capital at any point in time.
179
technique
This may also be viewed to be equal to
the relative price ratios of the two
inputs, of labour and capital. That is,
MP
MP
r
w
k
L
=
or alternatively,
r
MP
w
MP
K
L
=
This should be interpreted to mean that the last dollar
spent on labour should be equal to the marginal
productivity of the last dollar spent on capital.
180
The economic region of
production
The firm does not operate on the positively
sloped sections of the isoquants because it
could produce the same quantity with less
capital and less labour.
181
Returns to scale constant, increasing and
decreasing returns
The word scale refers to the long run situation where all
inputs can be varied resulting in constant, increasing and
decreasing returns.
Constant returns to scale refers to a situation where
output changes by the same proportion as inputs.
For example if all inputs are increased by 15% output will
change by the same amount.
Increasing returns to scale implies a higher than
proportionate increase in output compared to changes in
the factor of production concerned.
Decreasing return are therefore the opposite of this
scenario where an increase in prices by a certain amount
would lead to a lesser than expected increases in output.
182
Returns to scale constant, increasing
and decreasing returns
The reasoning behind constant returns to scale is that we would
expect two similar workers using identical machines to produce as
much output as one worker operating under similar conditions.
One would expect also that the output of two identical plants
employing an equal number of workers of equal and comparable
skills to double output of a single plant.
Decreasing and increasing returns also make a lot of economic
sense as well.
Increasing returns arise because as the scale of operation
increases, a greater division of labour and specialization can take
place and more specialized productive machinery employed.
Division of labour allows each worker to continue doing a repetitive
task which they will then be able to do very well as they become
more proficient with whatever they are doing.
Higher productivity is therefore associated with increasing returns
to scale.
183
At higher levels of operation, more specialized and production
machinery, technology is employed and in addition some physical
features of the machinery also leads to increasing returns to scale.
Firms also need fewer supervisors, fewer spare parts, and smaller
inventories per unit of output as the scale of operation increases.
Decreasing returns to scale arises primarily because as the scale of
operation increases, it becomes more difficult to manager the firm
effectively, and coordinates all the various operations and divisions of
the firm.
The number of channels of communication increases and become
more complex, and the number of meetings, paper work and
telephone bills increase more than proportionately to increase the
scale of operation.
All this makes it difficult to ensure that the managers directives and
guidelines are properly carried out. Thus efficiency will decrease.
184
Decreasing returns to scale refers to the long-run situation where
as the diminishing returns is a short run situation.
Diminishing returns in the short run is consistent with constant,
increasing and decreasing returns in the long run.
In the real world the forces for increasing and decreasing returns
often operate side by side and forces for increasing returns to
scale usually prevail at small scale of operation.
The tendency for decreasing returns to scale may be balanced by
tendencies for decreasing returns to scale at intermediate scales
of operation.
Eventually forces for decreasing returns to scale at very large
scales of operation may be balanced by forces for decreasing
returns to scale.
185
Production elasticity
This is given by the marginal
product of labour divided by the
average product of labour, that is
AP
MP
L
L
Production elasticity =
186
If the production elasticity is greater than 1 that means
that when we increase the labour component, output
will increase rapidly.
This is an example of an elastic region and in this
region the firm is experiencing increasing returns to
scale.
That is if the labour component increases by 10%,
output increases by more than 10%.
When production elasticity is less than 1, this means
output is not responsive to changes in the labour input
and we are in the inelastic region.
Production in this region suffers from diminishing
returns to scale.
Increasing labour by 10% results in output increasing
by less than 10%.

187

188
189
An elasticity of production which is equal to
one means that theoretically everything
remains the same.
Changing labour by 10% results in a 10%
increase in output and the firm is
experiencing constant returns to scale.
However this position is very unlikely because
under any practical situations it may not be
easy to apportion output to a single variable
input because output depends on all the
inputs in question.

190
Costs of production
The resulting combination of a level of output and a figure
for total cost provides one point on the long run average
cost curve and if this exercise is repeated over and over
again we obtain the long run average cost curve.
The shape of this curve and the long run average cost
curve is consistent with the returns to scale represented
by the production function.
Costs of production in the short run remain fixed while in
the long run all costs are variable.
Fixed costs are associated with the fixed factors while
variable costs are associated with the variable factors in
the short run.
191
Costs of production
Variable
Cost
Output
AVC
ATC MC
AFC
Total
Cost
Fixed
Cost
Costs
(Mt)
Costs
(Mt)
II
I
II
I
192
Costs of production
As the figure shows fixed costs are constant at any
amount yielding the downward sloping curve for the
average fixed cost curve in the lower part of this
diagram.
Variable costs increase with a slope that first
decreases indicating decreasing marginal cost and
then increasing indicating increasing marginal cost
giving an average variable cost curve which falls and
then rises.
The combination of the fixed and variable costs give
the average total costs curve (ATC) which is U-shaped
and which is intersected by the marginal cost curve at
its lowest point.

193
Long-run cost curves
In the long run the firm is able to choose whichever
combinations of inputs it may consider to be profitable
and in the long run the firm is essentially concerned with
investment decisions and the shape of the cost curve at
this time depends on the extent to which economies of
scale exist. This is why the LRAC is also known as the
planning curve.
The long-run costs curve is constructed from the short-
run cost curves and each short-run cost curve shows the
behavior of costs when the firm has a fixed level of capital
input.
For this reason we may think of the long run as the period
in which the firm chooses which short-run curve to locate
on. This implies that each long-run cost curve is made up
of segments of short-run cost curves.
194
Costs
LRAC
SRAC
5

SRAC
2

SRAC
1

SRAC
3

SRAC
4

Output
Time (y
t
)
A B
195
Curves SRAC1-SARC5 are short-run average cost curves
for each of the known sets of plant and equipment in the
industry where the firm chooses to locate itself in the
short-run given its long run growth path or growth fire.
In situations where there is no relationship among the
short-run cost curves the long run cost curve will be
discontinuous but it is more prudent to think about growth
of the firm as a continuous process where the growth in
one period influences the level of growth in the other.
If we therefore remember each point on the long-run
average cost curve as defining a certain point on the short
run average cost curve then, we are able to picture this
curve as an envelope of the short-run cost curves.
196
Break-even analysis

Break-even analysis is concerned with the
point at which the firm is just able to
generate enough revenue to cover its costs
of production and there are various
methods or approaches used to solve
break-even problems of which the most
commonly used method is the graphical
method.
197
Break-even analysis
Break even revenue
Total Cost
Total Revenue
Output
(Mt)
X
Breakeven Point
Q
2

Actual revenue
198
Break-even analysis
This approach can be used to
calculate the level of sales that will
maximize revenue at any one time
or that level of sales that will ensure
that profits are maximized.
That is the margin of safety that the
firm will want to realize.
199
Margin of safety = actual sales
revenue- break-even sales
revenue
This can be followed up by analyzing the
margin of safety ratio which the
accountants would define as:
Margin of safety ratio = followed up by
analyzing the margin of safety ratio
which the accountants would define as:

This therefore becomes very important in
decision making where the firm has to
decide on various ways of ordering
operations in the production dep
AS
BESR ASR
s actualsale
inofsafety m

=
arg
200
MARKET STRUCTURES
In certain markets single monopoly markets tend to be protected by
high barriers to entry but in most industrial markets such protection
may not exist and as a result the potential for competition exist and
intermediate imperfect competition outcomes are most likely.
The basic paradigm of industrial economics dwells so much on the
link between the structures of the market, the conduct of firms in the
industry in shaping market performance resulting in the structure-
conduct-performance paradigm developed by Mason at Harvard
University during the 1930s.
The basic conditions of the s-c-p paradigm include among others the
costs, demand and technology faced by the firm.
Market structure focuses on market concentration, product
differentiation, and barriers to entry, vertical integration and
conglomerate diversification.
201
MARKET STRUCTURES
The analysis of this market structures
focuses on how the price is
determined, structural assumptions,
and the behavior of firms in the
industry.
Structural assumptions essentially
seek to define the nature or intensity of
competition, nature of product
differentiation, among other variables.
202
MARKET STRUCTURES

203
Pure monopoly

A monopoly in the strictest sense is the only supplier of a
homogeneous product for which there is no close
substitutes and many buyers exist in the monopolistic
market.
The firms demand curve is the market demand curve for
the product.
This market structure just as perfect or pure competition
does not exist in real life. The monopolist earns
supernormal profits in which revenue generated far
exceeds operating costs.
The term is also used to describe a situation where firms
are earning a return which exceeds minimum necessary to
induce them to remain within the industry they currently
occupy.
These are also called the mark up price over the marginal
average cost which is a function of elastic demand when
set up too high it will chase away customers.

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