Managerial Economics Compiled Reports

8/12/2019 Managerial Economics Compiled Reports

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MODULE 1: THE FUNDAMENTALS OF MANAGERIAL ECONOMICS

MANAGERIAL ECONOMICS

Manager A person who directs resources and design incentive schemes to achieve a stated goal. (A manager plays man

other roles, such as leadership, identifying problems and solving problemsbut these are not the focus of this course.)

Economics The science of making decisions in the presence of scarce resources.

Managerial Economics The study of how a manager may achieve a stated goal within a given set of resource

constraints.

IDENTIFYING GOALS AND CONSTRAINTS

ound decision making involves having well definedgoals! e.g.

"hat to ma#imi$e or minimi$e% for instance ma#imi$e profits by minimi$ing operational e#penses, otherw

ma#imi$e its profits or minimi$e losses.

To be specific to increase &' in the ne#t calendar year

To enter in new product market

To have international ventures

ther goals relating to market share, revenue growth, profit margin, return on investment.

*ence, there are also +oals ther than rofit which we termed as -on conomic b/ectives such as! rovide a good place for employees to work

rovide good products0services to our customers

Act as a good citi$en in our society.

1n striving to achieve a goal, we often faceConstraints, that such 2onstraints are a result of scarcity. #ample can be!

3imited hours per day, week and year that an employee can work on any one goal4

2ost of money to devote to marketing, sales and operations.

NATURE OF ROFITS

ro!i" is defined as gain. The e#cess of returns over e#penditure, the compensation to entrepreneur resulting from th

assumption of risk, the e#cess returns from a business, advantage, benefits. (from "ebster 5ictionary)


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Economic #s$ Acco%n"ing ro!i"s

Accounting rofits

% Total revenue (sales) minus dollar cost of producing goods or services.

% 6eported on the firm7s income statement.

conomic rofits

% Total revenue minus total opportunity cost

Accounting 2osts

% The e#plicit costs of the resources needed to produce goods or services.

% 6eported on the firm7s income statement.

pportunity 2ost

% The cost of the e#plicitand implicit resources that are foregone when a decision is made.

ro!i"s as a Signal

rofits signal to resource holders where resources are most highly valued by society.

% 6esources will flow into industries that are most highly valued by society.

UNDERSTANDING INCENTI&ES AND MAR'ET

Incen"i#eis any factor that enables or motivates particular course of action, or count as a reason for preferring one choi

to the alternatives. 1t is an e#pectation that encourages people to behave in a certain way.

Incen"i#es in"o ( )roa* Classes:

&. 6emunerative 1ncentives

- Are said to e#ist where an employee can e#pect some form of material reward.

8. 2oercive 1ncentives

- Are said to e#ist where a person can e#pect that a failure to act in a particular way will result in physical fo

being used against them by others in the community.

9. :oral 1ncentives

- Are said to e#ist where a particular choice is widely regarded as the right thing to do.

eo+le Res+on* "o Incen"i#es:


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;ecause people make decisions by comparing costs and benefits, their behaviour may change when the costs or

benefits change.

Incen"i#e ro)lems:

- 1ncentive structures are notoriously trickier than they might appear to people who set them up.

- eople offering incentives are often unable to predict all of the ways that people will respond to them.

UNDERSTANDING MAR'ETS

Mar,e" is a mechanism that allows people to buy and sell financial securities such as stocks, bonds, commodities and oth

fungible items of value. The aggregate possible buyers and sellers of a certain good or service and transaction betwe

them. :arket is an actual place where buyers and sellers could engage in face to face bargaining.

( SOURCES OF RI&ALRY:

&. 2 -


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TIME &ALUE OF MONEY

- 6efers to the fact that the value of a dollar0peso to be received at different future dates will not be the same

today.

- Therefore, it is necessary to develop techni?ues for measuring the value today(i.e. the present value)of

dollar0peso to be received or paid at different points in the future.

Time &al%e o! Mone. /A++lica"ions0Uses

&. To pro/ect future dollar0peso amounts such as cash flows, incomes, prices.

8. To estimate e?uivalent current%period values based on pro/ected future values.

9. To evaluate business decisions where at least some of the cash flows occur in the future.

Essen"ial "erms in a++l.ing "ime #al%e o! mone. +rinci+les:

Ann%i".2A series of e?ual payments per period for a specified length of time. @or e#ample! the repayment of a loan by

making B monthly payments of C8DDE is a form of annuity.

Amo%n"2A specific number of dollars0peso to be paid or received on a specific date.

resen" &al%e / & 2The value today of an amount or an annuity, taking into consideration that interest can be earned.

F%"%re &al%e /F& 2The value of an amount or an annuity, at a specified future date, taking into consideration that interest

can be earned.

Time &al%e o! Mone. /3asic Conce+"

A dollar0peso is worth more (or less) the sooner (later) it is received or paid due to the ability of money to earn

interest.

present value

F interest earned

G future value

r

future value

% interest lost


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G prese

The e?uation for the future value

E4am+le /F%"%re &al%e o! an amo%n"


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"hat is the present value of CI&,

Selec"e*

erio*s

8%

1 D.I8'I

2 D.B'J9

3 D.JI9B

4 D.J9'D

6 D.H9D8

8 D.' D9

10 D. H98

The process of reducing future v

interest rate used in present value proble

MARGINAL ANALYSIS

- 1mplies /udging the impact of a u

- #amines how the costs and ben

- "eighing the benefits out of the

& D in ten years if the discount rate is B percent p

resen" &al%e In"eres" Fac"ors

In"eres" Ra"e

10% 12%

D.IDI& D.BI8I

D.B8H D.JIJ8

D.J'&9 D.J&&B

D.HB9D D.H9''

D.'H ' D.'DHH

D HH' D. D9I

D.9B'' D.988D

lues to their present values is often referred to as

ms is sometimes referred to as adiscount rate .

it change in one variable on the other. :arginal g

efits change in response to incremental changes i

ost.

6

er yearK

discounting . 1n this conte#t, the

enerally refers to small changes

in actions.


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- :arginal revenue is change in total revenue per unit change in output sold. :arginal cost refers to change in total

costs per unit change in output produced ("hile incremental cost refers to change in total costs due to change in

total output).

- Analysis of Lmarginal7 costs and Lmarginal7 benefits due to a change.

- :arginal G additional or incremental.

- 2osts and benefits that are constant (i.e. fi#ed, don7t change) are e#cluded from the analysis.

- 2hanges occurring at Lthe margin7 are all that matter.

- Two important dimensions of change! direction, magnitude.

E4am+le

Ho%r Ho%rl. 5age

(:arginal

+ain0;enefit)

&al%e o! Time

(:arginal 2ost)

Ne" Gain03ene!i"

*our & C&D C8 CB

*our 8 C&D C8 CB

*our 9 C&D C9 CJ

*our C&D C9 CJ

*our ' C&D C CH

*our H C&D C' C'

*our J C&D CH C

*our B C&D CB C8

*our I C&' CI CH

*our &D C&' C&8 C9

*our && C&' C&B C%9

*our &8 C&' C8D C%'

This marginal analysis suggests that rational maximizing behavior is to or! "or 10 hours#

ro*%c"ion ossi)ili". C%r#e0 ro*%c"ion ossi)ili". Fron"ier / F


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% The trade%offs facing a society c

% The production possibilities curv

limited resources to the fullest e#

% 6epresents the point at which an

allocating its resources in the be

.

MODULE 6: DEMAND AND SU

DEMAND

5emand chedule Table that shows dif

different time.

n be illustrated in a graph known as the productio

shows the ma#imum ?uantity of goods and servi

tent possible.

economy is most efficiently producing its goods a

t way possible.

LY

ferent ?uantities of goods that consumers are willi

8

n possibilities curve.

es that can be produced using

nd services and, therefore,

ng to buy at different pri$es at


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5emand 2urve plotted diagram showing the relationship between the price and ?uantity demanded at a given time.

H

'

6129

8

&

D&D 8D 9D D 'D HD

M 5 :A-5 5

3aw of 5emand states that ?uantity demanded moves in the opposite direction of price (all the other things held consta

and this effect is observed in the downward slope of the demand curve.

De"erminan"s o! Deman*:

1ncome an increase in income shifts the demand curve of normal goods to the right.

rices of 6elated +oods

o ubstitutes an increase in the price of a substitute product increases demand, shifting

the demand curve to the right.

o 2omplements an increase in the price of a complement reduces demand, shifting the

demand curve to the left

rice Muantity5emanded

' &D

&J

9 8H

8 9B

& '9


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Advertising and 2onsumer Taste a favourable customer preference and a wide and effective advertisin

can increase the demand, shifting demand curve to the right.

opulation an increase in population or market si$e shifts the demand curve to the right.

2onsumer #pectations an e#pectation of pri$e changes can change the demand in anticipation of the

change effects.

C-ange in 7%an"i". Deman*e* % A change in ?uantity demanded is a change from one price%?uantity pair on an e#ist

demand curve to a new price%?uantity pair on the A: demand curve. 1n other words, this is a movement along th

demand curve. A change in ?uantity demanded is caused by a change in price.

C-ange in Deman* % A change in demand is a change in the -T16 demand relation. This means changing, moving, and

shifting the entire demand curve. The entire set of prices and ?uantities is changing. 1n other words, this is a shift ofdemand curve. A change in demand is caused by a change in the five demand determinants.

Cons%mer S%r+l%s % The difference between the ma#imum price that consumers are willing to pay for a good and market price that they actually pay for a good.

2*A-+ 1- 5 :A-5!

A shift of the demand curve caused by a change in one of the demand determinants. A change in demand i

caused by any factor affecting demand N2 T price. A related, but distinct, concept is a change in ?uantity demanded.

A change in demand is a change in the entire price%?uantity relation that makes up the demand curve. 1t means t

a different ?uantity demanded is paired with a given demand price or that a different demand price is paired with a g

?uantity demanded. The result of this repairing of prices and ?uantities is a repositioning, or a shift, of the demand curve


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The five demand determinants (buyersO income, buyersO preferences, other prices, buyersO e#pectations

number of buyers) are responsible for causing a change in demand. 1n fact, the only thing that 5 - T cause a change

in demand is the demand price.

Deman* an* 7%an"i". Deman*e*

To set the stage for an understanding of this difference, take note of two related concepts!

5emand! 5emand is the range of ?uantities that buyers are willing and able to buy at a range of demand prices. 1t

A33 points that make up a demand curve. Muantity 5emanded! Muantity demand is a specific ?uantity that buyers are willing and able to buy at a spec

demand price. 1t is but - point on a demand curve.

Ma,ing C-anges

o what happens when the phrase Pchange inP is placed in front of each termK

2hange in 5emand! A change in demand is a change in the -T16 demand relation. This means changing,

moving, and shifting the entire demand curve. The entire set of prices and ?uantities is changing. 1n other wor

this is a shift of the demand curve. A change in demand is caused by a change in the five demand determinants. 2hange in Muantity 5emanded! A change in ?uantity demanded is a change from one price%?uantity pair on

e#isting demand curve to a new price%?uantity pair on the A: demand curve. 1n other words, this is a movemenalong the demand curve. A change in ?uantity demanded is caused by a change in price.

2hanging 5emand

A change in demand is a shift of the demand curve. A change in ?uantity demanded is a movement along a giv

demand curve. These alternatives can be illustrated with the negatively%sloped demand curve presented in this e#hibit.

demand curve captures the specific one%to%one, law of demand relation between demand price and ?uantity demanded

five demand determinants are assumed to remain constant with the construction of this demand curve.


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A 2hange in 5emand! A change in demand, which is triggered by a change in any of the five demand determinan

is a shift of the demand curve.

A 2hange in Muantity 5emanded! A change in ?uantity demanded, which is only triggered by a change in dema

price, is a movement along the demand curve.

An Im+or"an" Di!!erence

"hy is this difference so importantK The answer is as simple as cause and effect. The demand curve is used (togethe

with supply) to e#plain and analy$e market e#changes. The se?uence of events follows a particular pattern.

@irst, a demand (or supply) determinant changes. econd, this determinant change causes the demand curve (or supply curve) to shift. Third, the change in demand (or supply) causes either a shortage or a surplus imbalance in the market. The mark

is in a temporary state of dise?uilibrium. @ourth, the shortage and surplus imbalance causes the price of the good to change.

@ifth, the change in price causes a change in ?uantity demanded (and supplied). i#th, the change in ?uantity demanded (and supplied) eliminates the shortage or surplus and restores market

e?uilibrium.

The key conclusion is that demand (and supply) determinants, which induce changes in demand (and supply), are t

source of instability in the market. The change in price, which induces a change in ?uantity demanded (and supplied) is

means of eliminating the instability and restoring e?uilibrium.

A Change in Demand


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CONSUMER SURPLUS

The difference between the mathat they actually pay for a good is ref

illustrated in @igure & , which depicts th

The market price is C', and th

curve reveals that consumers are willin

the third unit, and CH for the fourth unit.

*owever, they can purchase

purchased is therefore CI % C' G C . i

C9, C8, and C&, respectively. These su

these surpluses is the$onsumer sur lu

The value C&D, however, is onl

consumer surplus is given by the ar

#imum price that consumers are willing to payrred to as thecons%mer s%r+l%s$ The deter

e market demand curve for some good.

Figure 1 Calculation of consumer surplus

e e?uilibrium ?uantity demanded is ' units of

g to pay at least CI for the first unit of the goo

' units of the good for /ust C' per unit. T

imilarly, their surpluses from the second, third,

pluses are illustrated by the vertical bars dra

s&

a crude appro#imation of the true consumer s

a below the market demand curve and abo

13

for a good and the market priceination of consumer surplus is

the good. The market demand

d, CB for the second unit, CJ for

eir surplus from the first unit

and fourth units purchased are

n in @igure & . The sum total of

urplus in this e#ample. Thetrue

e the market price. This area


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consists of a triangle with base of length ' and height of length '. Applying the rule for the area of a triangleQon

half the base multiplied by heightQone finds that the value of the consumer surplus in this e#ample is actually &8.

SU LY

upply, is the amount of some product producers are willing and able to sell at a given price all other factors bei

held constant.


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Deman*

A relationship between two variables, price and ?uantity demanded, with all other factors that could affect dem

being held constant.

Fac"ors A!!ec"ing Deman*

&. +oodOs own price

8. rice of related goods

9. 1ncome

. Tastes or preferences

'. 2onsumer e#pectations about future prices and income

MAR'ET E7UILI3RIUM

:arket e?uilibrium, is the point at which total supply and demand within a market are e?ual, shown by the interceof a demand curve and a supply curve when both are graphed on the same a#is.

E9%ili)ri%m

"hen supply and demand are e?ual (i.e. when the supply function and demand function intersect) the economy i

said to be at e?uilibrium. At this point, the allocation of goods is at its most efficient because the amount of goods be

supplied is e#actly the same as the amount of goods being demanded. Thus, everyone (individuals, firms, or countries

satisfied with the current economic condition. At the given price, suppliers are selling all the goods that they have prod

and consumers are getting all the goods that they are demanding.

S%r+l%s an* s-or"age

% 1f the market price is above the e?uilibrium price, ?uantity supplied is greater than ?uantity demanded, creatin

surplus. :arket price will fall.

% 1f the market price is below the e?uilibrium price, ?uantity supplied is less than ?uantity demanded, creatin

shortage. The market is not clear. 1t is in shortage. :arket price will rise because of this shortage.


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C-anges in e9%ili)ri%m +rice an* 9%an"i".

?uilibrium price and ?uantity are determined by the intersection of supply and demand. A change in supply,

demand, or both, will necessarily change the e?uilibrium price, ?uantity or both. 1t is highly unlikely that the change

supply and demand perfectly offset one another so that e?uilibrium remains the same.

RICE CEILINGS AND RICE FLOORS

rice ceiling and price floor is setting a price on a certain good.

rice Ceilings

The ma#imum legal price that can be charged.

rice ceiling puts a ma#imum price limit the price canOt go higher than the price you have set.

An effective price ceiling is where e?uilibrium price is above the price ceiling. 3etOs say the ma#imum price set

but the e?uilibrium price is C'. This creates a shortage because the suppliers will supply when price is at C8 amany people will demand the good. This creates a shortage.

E4am+les:

+asoline prices in the &IJDs.

*ousing in -ew >ork 2ity.

roposed restrictions on AT: fees.


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rice Floors The minimum legal price that

rice floors sets a minimum

An effective price floor is wh

even though e?uilibrium pric

E4am+les:

:inimum wage.

Agricultural price supports.

These pricing limits can create s

demand meet (e?uilibrium).

rice floor above e?uilibrium Gs%r+l%s

rice floor below e?uilibrium Gno e!!ec"

COM ARATI&E STATICS: CHANGES I

Com+ara"i#e S"a"ic Anal.sis

can be charged.

rice limit that means the price canOt go lower than

re e?uilibrium price is below the price floor this c

is ' for e#ample the minimum price it can go &D.

hortages and surpluses or it may have no effect

rice ceiling above e?uilibriumGno e!!ec

rice ceiling below e?uilibrium Gs-or"ag

N DEMAND AND SU LY

18

it possibly can.

auses a surplus. This is because

This will create a surplus.

depending on where supply and

"

e


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A common method of econ

change$

hows how the e?uilibrium

A !orm o! sensi"i#i". or 8-

A++lica"ions o! Deman* an* S%++l. A

E#en": The 'S( reports that the

months.

Scenario 1: >ou manage a small fir

Scenario 6: >ou manage a small s

Use Com+ara"i#e S"a"ic Anal.sis "o seScenario 1: Im+lica"ions !or a Small

tep &! 3ook for the R;ig icture.S

tep 8! rgani$e an action plan (wor

3ig ic"%re Anal.sis: C Mar,e"

?uilibrium price of 2s will fall, and e?ui


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marketingK

do 1 need ?uantitative estimatesK

Scenario 6: So!"8are Ma,er

:ore complicated chain of reasoning to a

tep &!


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*ow responsive is variable R+S (?uantity demanded or ?uantity supplied) to a change in variable R S (price).

1f) *+S D, thenS and * are directly related.

1f +, U D, then and + are inversely related.

1f +, G D, then and + are unrelated.

RICE ELASTICITY OF DEMAND

The law of demand states that as price increases, less ?uantity is demanded. This is why the demand curve slope

down to the right. ;ecause price and ?uantity move in opposite directions on the demand curve, the price elasticity demand is always negative.

Elas"ic: Inelas"ic: Uni"ar.:

+enerally, a curve iselas"ic i! i" is !la" and more inelas"ic i! i" is more #er"ical. *owever, this can be a little

misleading. ven on a linear (straight) demand or supply curve, the elasticity is not constant for the whole curve. The reas

for this is that we are measuring the percentage change in both price and ?uantity. As you move along a linear curve a

approach one of the a#es, the percentage changes in that a#is variable (either price or ?uantity) get smaller and smaller an

the percentage changes of the opposite a#is get bigger and bigger.

ELASTICITY; TOTAL RE&ENUE AND MARGINAL RE&ENUE

1t is now time to develop some technical concepts that will be useful in later analysis. The first of these is

concept ofelasti$ity . X X PQ E 1, < X X PQ E 1, = X X PQ E


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ince dividing by a number is e?uivalent to multiplying by its reciprocal we can rewrite the above e?uation as

9. X G ( VM 0 M ) ( 0 V ) G ( VM 0 V ) ( 0 M )

ince the slope of the demand curve is e?ual to the change in price divided by the change in ?uantity, the term( VM 0 V ) in the above e?uation is the reciprocal of the slope. Then we can write ?uation 9 as

. X G ( VM 0 V )( 0 M ) G ( & 0 W )( 0 M )

T-e elas"ici". is "-e reci+rocal o! "-e slo+e m%l"i+lie* ). "-e ra"io o! +rice o#er 9%an"i".$ All this is illustrated

in @igure 8 where the elasticity of demand is measured relative to the initial price%?uantity combination ( D,MD ) . 1t turns out

that the elasticity will not be constant as we move along the curve. As should be clear from ?uation , given a constan

slope,"-e elas"ici". 8ill *ecline as 0 7 *eclines as 8e mo#e *o8n "o "-e rig-" along "-e s"raig-"2line *eman*c%r#e222a" "-e #er"ical a4is 8-ere 7 is


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cons"an" as 8e mo#e %+ along a s"raig-"2line s%++l. c%r#e %nless "-a" line +asses "-ro%g- "-e origin; in 8-ic-

case )o"- "-e slo+e an* "-e ra"io 0 7 8ill )e cons"an"$

The total revenue to the seller of a commodity, or total e#penditure by the purchaser, is obtained by multiplying

price by the ?uantity. 1t appears in @igure as the area of a rectangle whose bottom left corner is the origin and top ri

corner is a point on the demand curve. The top left and bottom right corners e?ual price and ?uantity respectively. T

shaded rectangle in @igure , for e#ample, gives the total revenue at pointc on the demand curve%%%the product of the

price D and the ?uantity MD. The total revenue at pointa is the rectangle & a M& =.


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:arginal revenue for each ?uantity sold is given in @igure ' as the distance between the thick line and the

hori$ontal a#is at that ?uantity. This distance is e?ual to the slope of the total revenue curve at that ?uantity.A" "-e +oin" o!

ma4im%m "o"al re#en%e m "-e slo+e o! "-e "o"al re#en%e c%r#e is


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gg producers like this arrangement because it enables them to sell their eggs to consumers at a price above the

cost of production, yielding a profit indicated by the shaded area in @igure H. The problem faced by the :arketing ;o

acting on their behalf, is to determine the ?uantity level that will ma#imi$e that profit. At a lower output ?uota there is a

from a higher price, but the ?uantity producers sell will be less.

The profit is the e#cess of total revenue, given by the area & a M& =, over total cost, given by the area 2D )

M&D. At every ?uota level the ;oardOs problem is to decide whether to increase the output ?uota by one unit. 1t will do

the additional revenue from selling another unit to consumers%%%themarginal revenue%%%is greater than the additional to total

cost from producing another unit%%%called themarginal $ost .

The marginal revenue is given by the thick line in @igure H. The marginal cost is given simply by the hori$

supply curve%%%each additional unit produced adds= 2D to total cost.S"ar"ing !rom


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the reduction in the ?uota not worthwhile. rofits are ma#imi$ed by ad/usting the ?uantity sold to e?uali$e marginal cost

marginal revenue.

Economis"s -a#e a con#en"ion o! re!erring "o "-e elas"ici". o! *eman* as +osi"i#e n%m)er e#en "-o%g- i" is

in !ac" nega"i#e$ "hen they talk about an elasticity of demand greater than & they really mean that the elasticity of demanis less than %&.5-a" "-e. are re!erring "o is "-e a)sol%"e #al%e o! "-e elas"ici". o! *eman*$ The absolute value of %8 is

8, whereas its algebraic value is %8. "e obtain a numberOs absolute value by simply ignoring its sign.So 8-en economis"s

sa. "-a" "-e *eman* is -ig-l. elas"ic "-e. mean "-a" "-e elas"ici". is a large n%m)er 8i"- a nega"i#e sign a""ac-e*$

1t is test%time again. :ake sure that you think up an answer of your own before looking at the one provided.

The following definitions apply to calculations of price elasticity!

&)I! E+ > 1, 5emand is elastic. The percentage change in price will produce a greater percentage in ?uantity demanded. 1f

the price goes up, then total revenues will go down. 1f the price goes down, then total revenues willincrease.

8) I! E+ ? 1, 5emand is inelastic. The percentage change in price will produce a lower percentage in ?uantity demanded. 1

the price goes up, then total revenues will go up. 1f the price goes down, then total revenues will decrease.

9) I! E+ @ 1, 5emand has unitary elasticity. A percentage in price will produce the e#act same percentage change in?uantity. Therefore, changes in price will no have effect on total revenues.

5-. Economis"s Use Elas"ici".

conomists want to compare apples and oranges all the time. 1s oil market demand more price sensitive than wheat demandK (no) 1s the labor supply of women more wage sensitive than the labor supply of menK (yes)

An elasticity is a unit%free measure. ;y comparing markets using elasticities it does not matter how we measure the price or the ?uantity in the tw

markets. lasticities allow economists to ?uantify the differences among markets without standardi$ing the units

measurement.

E4am+les o! Uni"2!ree Com+arisons

+asoline and /ewelry


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o 1t doesnOt matter that gas

o "e compare the deman

o +old /ewelry demand is

aintings and meato 1t doesnOt matter that cla

by the pound for about C

o "e compare the supply

o ;eef supply is more pric

Inelas"ic Economic Rela"ions

"hen an elasticity is small (betw 1nelastic demand means that the 1nelastic supply means that the ?

Elas"ic Economic Rela"ions

"hen an elasticity is large (great

lastic demand means that the ? lastic supply means that the ?u

Si


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FACTORS AFFECTING RICE ELASTICITY

5-a" De"ermines rice Elas"ici". o! Deman*

T-e n%m)er o! close s%)s"i"%"es !or a goo* 0 %ni9%eness o! "-e +ro*%c" the more close substitutes in the

market, the more elastic is the demand for a product because consumers can more easily switch their demand

the price of one product changesrela"i#e to others in the market. The huge range of package holiday tours and

destinations make this a highly competitive market in terms of pricing many holiday makers are price sensitive T-e cos" o! s8i"c-ing )e"8een *i!!eren" +ro*%c"s there may be significant"ransac"ions cos"s involved in

switching between different goods and services. 1n this case, demand tends to be relatively inelastic. @or e#am

mobile phone service providers may include penalty clauses in contracts or insist on &8%month contracts btaken out

T-e *egree o! necessi". or 8-e"-er "-e goo* is a l%4%r. goods and services deemed by consumers to be

necessities tend to have an inelastic demand whereas lu#uries will tend to have a more elastic demand because

consumers can make do without lu#uries when their budgets are stretched. 1.e. in an economic recession we c

cut back on discretionary items of spending T-e B o! a cons%mer s income alloca"e* "o s+en*ing on "-e goo* goods and services that take up a high

proportion of a household7s income will tend to have a more elastic demand than products where large prchanges makes little or no difference to someone7s ability to purchase the product.

T-e "ime +erio* allo8e* !ollo8ing a +rice c-ange demand tends to be more price elastic, the longer that we

allow consumers to respond to a price change by varying their purchasing decisions. 1n the short run, the dema

may be inelastic, because it takes time for consumers both to notice and then to respond to price fluctuations 5-e"-er "-e goo* is s%) ec" "o -a)i"%al cons%m+"ion when this occurs, the consumer becomes much less

sensitive to the price of the good in ?uestion. #amples such as cigarettes and alcohol and other drugs come into

this category ea, an* o!!2+ea, *eman* % demand tends to be price inelastic at peak times a feature that suppliers can take

advantage of when setting higher prices. 5emand is more elastic at off%peak times, leading to lower prices

consumers. 2onsider for e#ample the charges made by car rental firms during the course of a week, or the cheape

deals available at hotels at weekends and away from the high%season. Train fares are also higher on @riday

peak day for travelling between cities) and also at peak times during the day


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T-e )rea*"- o! *e!ini"ion o! a goo* or ser#ice if a good is broadly defined, i.e. the demand for petrol or meat,

demand is often fairly inelastic. ;ut specific brands of petrol or beef are likely to be more elastic following a p

change.

CROSS RICE ELASTICITY OF DEMAND

:easures the responsiveness of demand for +ood N following a change in the price of +ood > (a related good).

2 e5 G change in ?ty demand of +ood N change in price of +ood >

2alculating the ercentage 2hange in Muantity 5emanded of +ood N

ZM5emand(- ") % M5emand( 35)[ 0 M5emand( 35)[

2alculating the ercentage 2hange in rice of +ood >

rice/NE5 2 rice/OLD 0 rice/OLD

SU3STITUTE0 COM LEMENT GOODS:

1f two goods are substitutes, we should e#pect to see consumers purchase more of one good when the price of i

substitute increases. imilarly if the two goods are complements, we should see a price rise in one good cause the deman

for both goods to fall.

lasticity of 5emand (2 ed) F G ubstitutes

2ross lasticity of 5emand (2 ed) % G 2omplements

ubstitutes!

"ith substitute goods such as brands of soda, an increase in the price of one good will lead to an increase

in demand for the rival product

"eak substitutes inelastic 2 ed

2lose substitutes elastic 2 ed

2 e5 G change in ?ty demand of +ood N G 'D G .'D G '.'H change in price of +ood > I .DI


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change in ?ty demand of +ood N( 1)ZM5emand(- ") % M5emand( 35)[ 0 M5emand( 35)[Z&'DD &DDD[0 &DD[ G 'D

change in price of +ood > (2 \ )Z rice(- ") % rice( 35)[ 0 rice( 35)[Z &8%&&[0&8 G I

Subst i tu tesPr ice o f

G ood

Y ( C O K E

Q u an t i ty d em an d ed o f

G o o d X (P E P S I)

D e m a n d

Tw o Clos e Su b s ti tu tes

P1

P2

G o o d s C O K E a n d P EP S I a reclose subst i tu tes

A rise in the pr ice of Good Yleads to a h igher r ise in t hed ema n d fo r g o o d X

Th e c ro ss p r ice e las t ic i ty o fd ema n d w i l l b e p o s i t ive

P E P S I & C O K E. 5 0 = 5 . 5 6. 0 9

+


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SubstitutesPrice of

Good

Y(COKE

Quantity demanded of

Good X(RC)

Demand

Two Weak Substitutes

P1

P2

Goods COKE and RC are weaksubstitutes

A rise in the price of COKE leadsto a small rise in the demand forRC

The cross price elasticity ofdemand will be positive but thecoefficient of elasticity will be lessthan one

RC & COKE0.02 = 0.220.09

+

Cross rice Elas"ici". o! Deman* /C e* 2 @ Com+lemen"s

Com+lemen"s:

+oods that are in complementary demand

"eak complements inelastic 2 ed

2lose complements elastic 2 ed


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ComplementsPrice of

Good X


Good Y

Deman

d

Two Close Complements

P2

P1

Goods X and Y are closecomplements

A fall in the price of good Xleads to a large rise in thedemand for good Y

The cross price elasticity ofdemand will be negative andthe coefficient of elasticity willbe more than one

Complements are said to bein JOINT DEMAND

Boracay& Air Flights!A 12%fall in the price of air faresleads to a 30%rise in the demand forBoracay+30/-12 = -2.5

-


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Goods with zero cross-price elasticity ofdemand INDEPENDENT

Price of

Good A


Good B

Demand

P1

P2

P3

Goods A and B have norelationship.

A fall in the price of good Aleads to no change in thedemand for good B

Therefore the cross-priceelasticity of demand is zero

Apples andgloves!

INCOME ELASTICITY OF DEMAND

This measures the responsiveness of demand to a change in income.

e.g. if your income increase by ' and your demand for mobile phones increased 8D then the

> 5 G 8D0 ' G .

> 5 G change in M.5 change in 1ncome

7 ) 9 *99: This occurs when an increase in income leads to a fall in demand. Therefore > 5UD.

.g. clothes from charity shops, cheap bread.

"hen your income increase you buy better ?uality goods.


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79 ;/< *99:

This occurs when an increase in income leads

To an increase in demand for the good, Therefore > 5 D

= ? *99:

This occurs when an increase in demand causes a bigger increase in demand, therefore > 5 &.

3u#ury goods will also be normal goods and we can say RThey will be income lasticS

1ncome inelastic, this means an increase in income leads to a smaller increase in demand. Therefore D

> 5 U&

@irms will make use of > 5 by producing more lu#ury goods during periods of economic growth, simil

there will be less demand for inferior goods.

Positive Income Elastic DemandDiagram

ote the a!es are DI""E#E $%


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Elastic or Inelastic & 'eD

Elastic goods ( are seenas LUXURIES )#SUPERIOR %

Inelastic goods ( are seenas NORMAL orNECESSITIES.

egative Income Elasticity Diagram *Inferior

ote the different a!es labels


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+ero Income Elasticity

$his occurs when achange in income has) effect on thedemand for goods,

rise of ./ income ina rich country willleave the Demand fortoothpasteunchanged%

@ 6 NA: 3 !

>ed G % D.H!

+ood is anin!erior goo* butinelas"ic

a rise in income of &D would lead to demand falling by H >ed G F D. !

+ood is anormal goo* butinelas"ic

a rise in incomes of &D would lead to demand rising by

>ed G F &.H!

+ood is anormal goo* and elas"ic

a rise in incomes of &D would lead to demand rising by &H

>ed G % 8.&!

+ood is anin!erior goo* and elas"ic

a rise in incomes of &D would lead to a fall in demand of 8&

Signi!icance o! Income Elas"ici". o! Deman*

*igh 1ncome lasticity


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o 5emand is sensitive to changes in real incomes

o 5emand is thereforec.clical in an economic e#pansion, demand will grow strongly. 1n a recession demand

may fall

o 2an be difficult for businesses to accurately forecast demand and make capital investment decisions

3ow 1ncome lasticity

o 5emand ismore s"a)le *%ring !l%c"%a"ions in the economic cycle

o ver time, the share of consumer spending on inferior goods and normal necessities"en*s "o *ecline

o 3ong run businesses need to invest in 0 focus on products with a higher income elasticity of demand if th

want to increase total profits

OTHER ELASTICITIES

rice Elas"ici"ies

O8n rice Elas"ici".

The Plaw of demand,P namely that the higher the price of a good, the less consumers will purchase, has been term

the Pmost famous law in economics, and the one that economists are most sure of. To predict consumer behavio

economists use well%defined techni?ues evaluating the sensitivity of consumers to changes in price.

Cross rice Elas"ici".

An economic concept that measures the responsiveness in the ?uantity demand of one good when a change in pric

takes place in another good. The measure is calculated by taking the percentage change in the ?uantity demanded of on

good, divided by the percentage change in price of the substitute good! 2ross elasticity of demand is synonymous to Pcr

price elasticity of demandP. The cross elasticity of demand for substitute goods will always be positive, because the dem

for one good will increase if the price for the other good increases.

DEMAND FUNCTIONS

In"er+re"ing Deman* F%nc"ions

The degree to which a demand or supply curve reacts to a change in price is the curveOs elasticity. lasticity var

among products because some products may be more essential to the consumer. roducts that are necessities are more


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insensitive to price changes because consumers would continue buying these products despite price increases. 2onversel

a price increase of a good or service that is considered less of a necessity will determine more consumers because th

opportunity cost of buying the product will become too high.

Linear Deman* F%nc"ions

A linear demand function e#presses the demand as a linear function of the unit price.

E4am+le o! Linear Deman*

] MdG &D %8 .

] wn% rice lasticity! (%8) 0M.

] 1f G&, MGB (since &D %8 G B).] wn price elasticity at G&, MGB!

(%8)(&)0BG %D.8'.

A linear demand function e#presses the demand ? (for e#ample annual sales) as a linear function of the unit price p. 1t

the form

? G mp F b.

E4am+le!

The annual sales of your computer game P2yber 6aptorP is given by ? G % Dp F B,DDD, where p is the price you cha

game. Thus, if you charge C9' per unit, you can e#pect to sell

? G % D(9') F B,DDD G H,HDD games this year.

Log2Linear Deman*

"hen price and ?uantity observations are spread over a wide range of values, elasticities are likely to vary, and

linear specification with its varying elasticities is usually a more appropriate specification of demand. Alternatively,

sample data are clustered over a narrow price (and ?uantity) range, a constant%elasticity specification of demand, such

log%linear model, may be a better choice than a linear model.

E4am+le o! Log2Linear Deman*


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] ln(Md) G &D %8 ln( ).

] wn rice lasticity! %8

Concl%sion!

lasticities are tools you can use to-uanti"y the impact of changes in prices, income, and advertising on sales and

revenues.

MODULE (: COSTS OF RODUCTION AND THE ORGANI ATION OF THE FIRM

THE RODUCTION FUNCTION

1n economics, theCo)) Do%glas functional form of+ro*%c"ion !%nc"ions is widely used to represent the

relationship of an output to inputs. 1t was proposed by \nut "icksell (&B'&&I8H), and tested against statistical evidenc

2harles 2obb and aul 5ouglas in &IDD&I8B.

@or production, the function is

? G /< ^@ _,

where!

? G total production (the monetary value of all goods produced in a year) < G labor input @ G capital input / G total factor productivity ^ and _ are the output elasticities of labor and capital, respectively. These values are constants determined by

available technology.


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utput elasticity measures the responsiveness of output to a change in levels of either labor or capital used in

production, ceteris paribus. @or e#ample if ^ G D.&', a & increase in labor would lead to appro#imately a D.&' increas

output.

@urther, if!

^ F _ G &,

the production function has constant returns to scale. That is, if 3 and \ are each increased by 8D , > increases by

8D . 1f

^ F _ U &,

returns to scale are decreasing, and if ^ F _ & returns to scale are increasing. Assuming perfect competition and ^ F _ G

^ and _ can be shown to be labor and capitalOs share of output.

2obb and 5ouglas were influenced by statistical evidence that appeared to show that labor and capital shares o

total output were constant over time in developed countries4 they e#plained this by statistical fitting least%s?uares regre

of their production function. There is now doubt over whether constancy over time e#ists.

THE ROFIT2MA IMI ING LE&EL OF AN IN UT

1n economics,+ro!i" ma4imi


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:arginal cost and revenue, dep

change in cost or revenue as each additi

output. 1t may also be defined as the a

taking the first definition, if it costs a firm

si#th unit is appro#imately BD dollars, alt

linear interpolation. 2alculus is capable o

To"al re#en%e 2 "o"al cos" me"-

ro!i" Ma4imi


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Marginal re#en%e2marginal co

ro!i" ma4imi


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Ma4imi


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A & & &DD : T 6

; 8 &D &DD : T 6

2 9 J &DD : T 6

5 ' &DD : T 6 ' &DD : T 6

1n the table given above, it is shown that a producer employs two factors of production N and > for producing

output of &DD meters of cloth. There are five combinations which produce the same level of output (&DD meters o

The factor combination A using & unit of factor N and & units of factor > produces &DD meters of cloth. The combin

using 8 units of factor N and &D units of factor > produces &DD meters of cloth. imilarly combinations 2, < anemploying 9 units of N and J units of >, units of N and ' units of >, ' units of N and units of > produce &DD units

output, each. The producer, here., is indifferent as to which combination of inputs he uses for producing the same amoun

output. The alternative techni?ues for producing a given level of output can be plotted on a graph.

The figure &8.& shows y the &DD units iso?uant plotted to 1 product schedule. The five factor combinations

and > are plotted and are shown by points a, b, c, d and e. if we /oin these points, it forms an Oiso?uantO. An iso?

therefore, is the graphic representation of an iso%product schedule. 1t may here be noted that all the factor combinations

and > on an iso product curve are technically efficient combinations. The producer is indifferent as to which combinatio

uses for producing the same level of output. 1t is in this way that an iso product curve is also called Oproduction indiff


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curveO. 1n the figure &8.&, 1 product 1 curve represents the various combinations of the two inputs which produc

same level of output (&DD meters of cloth).

Iso9%an" Ma+

An iso?uant map shows a set of iso product curves. ach iso?uant represents a different level of output. A highe

iso?uant shows a higher level of output and a lower iso?uant represents a lower level of output.

1n the figure &8.8, a family of three 1so product curves which produce various level of output is shown. Th

product 1M& yields &DD units of output by using ?uantities of inputs N and >. o is also the case with iso?uant 1M9 yielding

9DD units of output. "e conclude that an iso?uant map includes a series, of /so%product curves. ach iso?uant represents

different level of output. The higher the iso?uant output, the further right will be the iso?uant.

ro+er"ies o! Iso9%an"

The main+ro+er"ies o! "-e iso?uants are similar to those of indifference curves. These properties are now

discussed in brief.


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/i An Iso9%an" slo+es *o8n8ar* !rom le!" "o rig-":

This implies that the 1so?uant is a negatively sloped curve. This is because when the ?uantify of factor \ (capital)

increased, the ?uantity of 3 (labor) must be reduced so as to keep the same level of output. The figure (&8.9) depicts

an iso?uant 1 is negatively sloped curve. This curve shows that as the amount of factor \ is increased from one unit to units, the units of factor 3 are decreased from 8D to &' only so that output of &DD units remains constant.

/ii An Iso9%an" "-a" lies a)o#e an* "o "-e rig-" o! ano"-er re+resen"s a -ig-er o%"+%" le#el:

1t means a higher iso?uant represents higher level of output. The figure &8. represents this property. 1t shows t

greater output

can be secured by increasing the ?uantity combinations of both the factors N and >. The producer increases the output fro

&DD units to 8DD units by increasing the ?uantity combination of both the N and >. The combination of 2 of capital a

of labor

yield &DD units of production. The production can be increased to 8DD units by increasing the capital from 2 to 2& and

labor from 3 to 3.


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/iii Iso9%an"s canno" c%" eac- o"-er:

The two iso?uants cannot intersect each other. 1f two iso?uant are drawn to intersect each other as is shown in th

figure &8.', then it is a negation of the property that higher 1so?uant represents higher level of output to a lower 1so?u

The intersection at point shows that the same factor combination can produce &DD units as well as 8DD units. ;ut th

?uite absurd. *ow can the same level of factor combination produce two different levels of output, when the techni?u

production remains unchanged. *ence two iso?uants cannot intersect each other.

/i# T-e iso9%an"s are con#e4 "o "-e origin: This property implies that the marginal significance of one factor in terms of another factor diminishes along an

product curve. 1n other words, the iso?uants are conve# to the origin due to diminishing marginal rate of substitution, 1

figure &8.H :6\3 diminishes from '!& to !& and further to 9!&. This shows that as more and more units of capital (\) a

employed to produce &DD units of the product, lesser and lesser units of labor (3) are used. *en

diminishing marginal rate of technical substitution is the reason for the conve#ity of an iso?uant.

/# Eac- iso9%an" is o#al s-a+e*:


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The iso product curve, is elliptical. This means that the firm produces only those segments of the iso%pro

curves which are conve# to the origin and lie between the ridge lines. This is the economic region of production.

ISOCOST LINE

A firm can produce a given level of output using efficiently different combinations of two inputs. @or choefficient combination of the inputs, the producer selects that combination of factors which has the lower cost of produc

The information about the cost can be obtained from the isocost lines.

3et us e#amine a firm which wishes to spend C&DD on a combination of two factors labor and capital for produ

given level of output. "e suppose further that the price of one unit of labor is C' per day. This means that the firm can h

8D units of labor. n the other hand if the price of capital is C&D per unit, the firm will purchase &D units of capital. 1n

&8.J, the point A shows &D units of capital used whereas point T shows 8D units of labor are hired at the given price

/oin points A and T, we get a line AT. This AT line is called isocost line or outlay line. The isocost line is obtained w

outlay of C&DD.

3et us assume now that there is no change in the market prices of the two factors labor and capita ;ut, the firm

increases the total outlay to C&'D. The new price line ;\ shows that with an outlay of C&'D, the producer can purchase

units of capital or 9D units of labor. The new price line ;\ hifts upward to the right. 1n case the firm reduces the outlay

C'D only, the isocost line 25 shifts downward to the left of original isocost line and remains parallel to the original price


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MINIMI ING COST

The firm minimi$es its cost at the point ReS where the iso?uant M is tangent to the isocost line A;. The opt

combination of factors is \ and 3. The optimal combination takes place at the point Le7 where the given output can b

produced at the least cost. oints below OeO are desirable but are not attainable for output M. oints above OeO are on

iso%cost lines and they show higher costs. *ence, the point OeO is the least cost point and it is the lowest cost combina

factors for producing the output M. 1t is produced by \ amount of capital and 3 amount of labour. At the point o

tangency, that is, at point OeO, the slope of isocost line is e?ual to the slope of the iso?uant. This is the first condition f

e?uilibrium. The second condition is that the iso?uant should be conve# to the origin at the point of e?uilibrium. Thus apoint ReS the ratio of marginal product of two factors is e?ual to the ratio of their factor prices.

COST MINIMI ATION

The assumption that any enterprise will try to produce its output at the lowest possible cost. This is clearly desira

for a profit%ma#imi$ing firm. 1t is likely to appeal to public bodies also, as a saving of cost in any one pro/ect will eith

lower ta#es, or free resources for other desirable uses. 2ost minimi$ation does however have to be taken with somprovisos.

1t is a$om etitive strategythat is based on producing goods and services more cheaper than competitor firms.

According to many commentators, cost minimi$ation is the dominant strategy within


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The process or goal of incurring the least possible opportunity cost in the pursuit of a given activity. 2o

minimi$ation is comparable to other ob/ectives, including utility ma#imi$ation and profit ma#imi$ation. This goal, how

generally used when circumstances constrain a decision. @or e#ample, a government agency has been assigned the task

building a bridge. 1t must now do so at the lowest cost possible.

ROFIT MA IMI ATION

A process that companies undergo to determine the best output and price levels in order to ma#imi$e its return. T

company will usually ad/ust influential factors such as production costs, sale prices, and output levels as a way of reach

its profit goal.

1t is the ability for company to achieve a ma#imum profit with low operating e#penses. rofit ma#imi$ation is a g

thing for a company, but can be a bad thing for consumers if the company starts to use cheaper products or decides

raise prices.

ro*%c" Ma4imi


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Ma4imi


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organi$ation is performing and where it stands. A look at the last three or four year financial statement will give an ave

of an organi$ationOs financial standing. 2alculating all the key indices will show where the linkages are, and the contr

of the linkages.

;y the time the analysis is complete, the following review would have been taken! labor cost, administratiooperations, overhead, break%even utili$ation, sales and marketing, cash flow management, ta# planning, web site, mat

cost, productivity, incentives, cost controls, material flow, organi$ation re%engineering, possibility of e#pansion

globali$ation if applicable. These areas will give a snap%shot of how the organi$ation could be improved.

valuation will be performed to determine the problems and the cost associated (soft and hard problem costs) wi

them. Again, these potential problem costing areas will need to be calculated! productivity, pricing, safety, advertis

?uality control, communication, meetings, training, employee turnover, compensation, incentives, depreciation, pro

financing, purchasing, overtime, margin mi#, material wastes, cash management, billing procedures, collection proced

and sweep account. At the end, focus will include the following! lost profits4 lost income4 e#cess inventory4 scrap,

rework4 productivity4 debt load4 attrition4 and hidden cost.

THE COST FUNCTION

A mathematical formula created for the purpose of estimating a cost, e.g. the cost of making an observation whenvaries from stratum to stratum of a collection of data.

ratio o" total $ost to -uantity rodu$ed

1t is derived from the production function, which describes the efficient method of production at any given time.

A cost function may be either linear or nonlinear. The general formula for a linear relationship is y Ga F b#,

. @a J )4

aG intercept


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LONG2RUN OF COSTS ECONOMIES OF SCALE

De!ini"ion o! Termsconomies

- 1t is all about effectiveness.

cale

- 1t is all about the benefits gained by the production of large volume of a product.

cope

- 1t is linked to the benefits gained by producing a wide variety of products by efficiently utili$ing to s

operations.

ECONOMIES OF SCALE

The advantages of large scale production that result in lower (average cost) (cost per unit)

Average 2ost G Total 2ost0 Muantity


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conomies of cale spreads total costs over a greater range of output

6efer to the situation in which the cost of producing an additional unit of output (i.e., themarginal

$ost ) of a product (i.e., a good or service) decreases as the volume of output (i.e., thes$ale of

production) increases

1t could also be defined as the situation in which an e?ual percentage increase in all inputs results in a great

percentage increase in output.

The increase in efficiency of production as the number of goods being produced increases. Typically, a compa

that achieves economies of scale lowers the average cost per unit through increased production since fi#ed cos

are shared over an increased number of goods.

conomies of scale are production efficiencies reali$ed when per%unit costs are reduced as the ?uantity produc

increases. 1n business, scale is si$e, and in many business situations, as a company produces more output, the averag

cost of that output declines. conomies of scale are the result of efforts that improve efficiency.

The basic notion behind economies of scale is well known! As a plant gets larger and volume increases, the avera

cost per unit of output is e#pected to drop. This is partially because relative operating and capital costs decline, sinc

piece of e?uipment with twice the capacity of another piece does not cost twice as much to purchase or operate. 1f aver

unit production cost G variable costs F fi#ed costs0output, one can see that as output increases the fi#ed costs0output fi

decreases, resulting in decreased overall costs.

n addition to s e$ialization and the division o" labor+ ithin any $om any there are various in uts that may result in the

rodu$tion o" a good andAor servi$e#

Lo8er in+%" cos"s: "hen a company buys inputs in bulk % for e#ample, potatoes used to make @rench fries at

fast food chain % it can take advantage of volume discounts. (1n turn, the farmer who sold the potatoes could als

achieving if the farm has lowered its average input costs through, for e#ample, buying fertili$er in bulk at

volume discount.)

Cos"l. in+%"s: ome inputs, such as research and development, advertising, managerial e#pertise and skilled

labor are e#pensive, but because of the possibility of increased efficiency with such inputs, they can lead to

decrease in the average cost of production and selling. 1f a company is able to spread the cost of such inputs ov

an increase in its production units, can be reali$ed. Thus, if the fast food chain chooses to spend more money

on technology to eventually increase efficiency by lowering the average cost of hamburger assembly, it would a

have to increase the number of hamburgers it produces a year in order to cover the increased technology

e#penditure.


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S+eciali


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3arge firms can negotiate favourable prices as a result of buying in bulk

3arge firms may have advantages in keeping prices higher because of their market power

Financial

3arge firms able to negotiate cheaper finance deals

3arge firms able to be more fle#ible about finance share options, rights issues, etc.

3arge firms able to utilise skills of merchant banks to arrange finance

Ris, 3earing

5iversification

:arkets across regions0countries roduct ranges

6 5

E4"ernal Economies

The advantages firms can gain as a result of the growth of the industry normally associated with a particular are upply of skilled labour

6eputation

3ocal knowledge and skills

1nfrastructure

Training facilities

o"en"ial Limi"s "o Economies o! Scale

:arket demand may be insufficient for businesses to fully e#ploit the scale economies.

@alling demand in a recession % capital will be under%utilised leading to e#cess capacity and rising averag

costs.

R-iche marketsS allow smaller%scale producers to supply at higher cost because consumers are willing to pa

higher price.


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ome large units of fi#ed capital may not be transferable to other uses if there is a sudden switch in consume

demand.

A business may e#pand beyond the optimal si$e in the long run and e#perience diseconomies of scale.

Diseconomies o! Scale

This occurs when production is less than in proportion to inputs. "hat this means is that there are inefficienci

within the firm or industry resulting in rising average costs.

They could stem from inefficient managerial or labor policies, over%hiring or deteriorating transportation net

(e#ternal 5 ). @urthermore, as a companyOs scope increases, it may have to distribute its goods and services progressively more dispersed areas. This can actually increase average costs resulting in diseconomies of scale.

ECONOMIES OF SCO E

The average total cost of production decreases as a result of increasing the number of different goods produced

conomies of scope e#ist if a firm can produce several product lines at a given output level more cheaply than

combination of separate firms each producing a single product at the same output level.

conomies of scope occur where it is cheaper to produce a8i*er range o! +ro*%c"s rather than speciali$e in /ust

a handful of products.

conomies of scope can also operate through distribution efficiencies.

conomies of scope occur when there are cost%savings arising from by%products in the production process.

Diseconomies o! Sco+e

:ulti%product production by a single firm that is less efficient than having separate firms each speciali$ing in

production of a single product.

/t some oint+ additional advertising ex enditure on ne rodu$ts may start to be less e""e$tive

METHODS OF ROCURING IN UTS


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2ostly

TRANSACTION COSTS cost associated with ac?uiring an input that are in e#cess of the amount paid to the input supplier such as!

The cost of searching for a supplier willing to sell a given input.

The costs of negotiating a price at which the input will be purchased. This maybe in terms of cost of time and le

fees,

ther investment and e#penditures re?uired to facilitate e#change. #ample ! if the input supplier re?uires you t

furnish your own truck and driver to pick up the input with a unit cost of C&D.DD. The price of the input is C

the cost of the truck and the driver.

*owever, there are transaction costs that are less obvious. "e call it hidden cost. *idden costs are sometimes general

in nature or specific to a particular trading relationship. The key to this distinction is the notion of a R pecial1nvestment.S

S+eciali


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"hen substantial speciali$ed investments are re?uired to facilitate e#change and the cost of writing a contract i

less rather than the transaction costs associated with spot e#change, it is optimal to ac?uire the input through a contract.

this case the optimal contract length is determined by the intersection of the marginal cost and marginal benefits of writi

longer contract.

@inally, when substantial speciali$ed investments are re?uired and the desired input has comple# characterist

that are difficult to specify in a contract or it is very costly to write into a contract all the clauses needed to protect the pa

from changes in future conditions, the manager should integrate vertically to minimi$e the cost of ac?uiring inputs nee

for production%provided the cost of integration is not too high.

MANAGERIAL COM ENSATION AND THE RINCI AL2AGENT RO3LEM

1n separating ownership from control, the owner usually will hire a manager to oversee the business. The owne

not around to monitor the manager, to get him to do what is in the best interest of the owner. The manager on the oth

hand likes to earn income, but he also likes to consume leisure. This is where the rincipal%Agent problem emerges.

1ndeed, there is a similar problem between the manager and the employees she or he supervises.

Sol%"ions "o "-e rinci+al2Agen" ro)lem

1ncentive 2ontracts such as stock options and bonuses

#ternal 1ncentives demonstrate to other firms that managers have the managerial skills needed to ma#imi$

profits

Takeovers

Sol%"ions "o "-e Manager25or,er rinci+al2Agen" ro)lem rofit haring

6evenue haring

iece 6ate

Time 2locks and pot 2hecks


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MODULE K: MAR'ET STRUCTURES: RICING AND OUT UT DECISIONS

THE NATURE OF INDUSTRY

*ow does market mechanism workK @irms and consumers are too small to affect the price in perfect competit

:ost industries are imperfectly competitive and are classified in three ma/or features of different market structure

monopoly, oligopoly, and monopolistic competition. 1mperfect competition prevails in industry whenever individual

can affect the price of their output.

TY ES OF MAR'ET STRUCTURES

STRUCTURE

N%m)er o!

ro*%cers an*

*egree o! +ro*%c"

*i!!eren"ia"ion

ar" o! econom.

8-ere +re#alen"

Firm s

*egree o!

con"rol o#er

+rice

Me"-o*s o!

Mar,e"ing

6@ 2T2 : T1T1 -

:any producers4identical products

@inancial markets

and agriculturalproducts -one

:arket

e#change orauction

1: 6@ 2T

2 : T1T1 -

:onopolistic

2ompetition

:any producers4

many real or

perceived differences 6etail trade

ome

Advertising

and ?uality

rivalry4


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e#ample, at a market price of C D per unit, the firm can sell all it wants at C D. 1f it decides to sell &D& units rather th

units, its revenue goes up by e#actly C D.

C-arac"eris"ics o! er!ec" Com+e"i"ion

&. There are many small firms, each producing an identical product and each too small to affect the market price.

8. The perfect competitor faces a completely hori$ontal demand (55) curve.

9. The e#tra revenue gained from each e#tra unit sold is therefore the market price.

5 5

igure 8,1 Borizontal demand or :: $urve

Com+e"i"i#e S%++l. 5-ere Marginal Cos" E9%als rice

7 TC MC0Uni" AC TR ROFIT

D 9D,DDD

&,DDD 9',DDD ' 9'.DD D.DD D,DDD ',DDD

8,DDD HD,DDD 8' 9D.DD D.DD BD,DDD 8D,DDD

9,DDD ID,DDD 9D 9D.DD D.DD &8D,DDD 9D,DDD

9,III &'I,IHD JD D.DD D.DD &'I,IHD D

,DDD &HD,DDD D D.DD D.DD &HD,DDD %

,&DD &H',DDD 'D D.8 D.DD &H ,DDD (&,DDD.DD)

',DDD 8&D,DDD 'D 8.DD D.DD 8DD,DDD (&D,DDD)

P

Q


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The ma#imum profit comes at that output where marginal cost e?uals price. That is at C D at ?uantity of ,DDD u

The firm selling at &,DDD%8,DDD units will gain a positive profit because :2


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An oligopoly is a market dominated by a few large suppliers. The degree of market concentration is very high (i.e

large of the market is taken up by the leading firms). The important feature of oligopoly is that each individual firm can

affect the market price. #amples! 1n the airline industry, the decision of a single airline to lower fares can set off a price

which brings down the fares charged by all its competitors.

MONO OLY

ure monopoly e#ists when a single firm is the sole producer of a product for which there are no close substitute

single seller with complete control over an industry. They are very desirable from the point of view of a company

usually, not very desirable for consumers.

:ono% +reek word for RoneS olist% +reek word for RsellerS

T-ree c-arac"eris"ics *e!ine +%re mono+ol.:

&. There is a single seller.

8. There are no close substitutes for the firm7s product.

9. There are barriers to entry.

"hereas the er"e$tly $om etitive "irm was a price taker, themono olisti$ "irm is a +rice ma,er . That is, it has

control over the price.

#amples of monopoly are public utilities such as gas, electric, water, cable T=, and local telephone servic

companies, professional sports teams, 5e;eers, and Alcoa.

Also, monopolies may e#ist at the local level because of geographic location. ;arriers to entry are the main line

defense for incumbent monopolies and may be of different types.)$onomies o" s$ale $onstitute one ma or barrier . They

occur where decreases in unit costs depend on output si$e. 1n this case, because a large firm with a large market share

most efficient, new firms cannot afford to enter the market and gain market shares. ublic utilities are known as natu

monopolies because they possess such economies of scale. ;arriers to entry also e#ist in legal forms as patents or

licenses. atents grant the inventor the e#clusive right to produce a product for 8D years (new worldwide patent per

established with a &II' +ATT agreement). 3icenses are granted by the government and allow only one or few firms

operate in a given market. @inally, barriers to entry may arise from the e#clusive ownership or control of essential resou


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ince there is only one company, the monopolist is a price maker. That is, the company controls output or price

though not both. ven the monopolist has to deal with its market conte#t.


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0 1 2 3 4 5 6 7 8 9 10

2learly, the price elasticity of demand plays a crucial role in monopoly price setting. As long as demand is elas

total revenue will rise when the monopoly lowers its price, but this will not be true when demand becomes inela

Therefore, the monopolist will e#pand output only in the elastic portion of its demand curve.

A monopolist, like any other company, does not care about charging the highest price it can get, it cares abo

selling as close as possible to the ?uantity of output that ma#imi$e its profits. @inally, remember that, in monopoly, locan occur. They are, in fact, relatively common in regulated monopoly where the government subsidi$es low per unit p

(e.g. utilities). 1f monopoly creates substantial economic inefficiency and appears to be long%lasting, antitrust laws c

used to break up the monopoly (:icrosoft). @igure 8 illustrates loss minimi$ation under monopoly.

Fig%re 6Loss Minimization under Monopoly

P

D

200

175

150

125

100

75

50

25

MC

ATC

MR

Loss

MR = MC

LossPer Unit

AVC

Q

D

200

175

150

125

100

75

50

25

MC

ATC

MR

P

Profit


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0 1 2 3 4 5 6 7 8 9 10

Ho8 Mono+olies can *e#elo+

Hori


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conomies of scale. 1ncreased output will lead to a decrease in average costs of production. These can be passed on t

consumers in the form of lower prices.

1f a monopoly produces at output M&, average costs (A2 &) are much lower than if a competitive market had firms prod

at M8 (A2 8).

1nternational 2ompetitiveness. A domestic firm may have :onopoly power in the domestic country but face effect

competition in global markets. .g. ;ritish teel

A firm may become a monopoly through being efficient and dynamic. A monopoly is thus a sign of success not ineffici

@or e#ample % +oogle

A :onopolist is a price maker because he does not face any competitors.

Disa*#an"ages o! a Mono+ol.


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+reen area G upernormal rofit (A6%A2) M

ink area G 5eadweight welfare loss (combined loss of producer and consumer surplus) compared to competitive market

*igher rice and 3ower utput than under erfect 2ompetition. This leads to a decline in consumer surplus and a

deadweight welfare loss

Allocative 1nefficiency. A monopoly is allocatively inefficient because in monopoly the price is greater than :2. :2. 1n

competitive market the price would be lower and more consumers would benefit

roductive 1nefficiency A monopoly is productively inefficient because it is not the lowest point on the A2 curve.

N % 1nefficiency. % 1t is argued that a monopoly has less incentive to cut costs because it doesnOt face competition fro

firms. Therefore the A2 curve is higher than it should be.

upernormal rofit. A :onopolist makes upernormal rofit Mm (A6 A2) leading to an une?ual distribution of income.

3ower rices to uppliers % A monopoly may use its market power and pay lower prices to its suppliers. .g. upermarke

have been critici$ed for paying low prices to farmers.

5iseconomies of cale % 1t is possible that if a monopoly gets too big it may e#perience diseconomies of scale. % h

average costs because it gets too big

"orse products% 3ack of competition may also lead to improved product innovation.

2harge higher prices to suppliers. :onopolies may use their supernormal profits to charge higher prices to suppliers.


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MONO OLISTIC COM ETITION

5-a" Does Monopolistic Competition

A type of competition within an industry

&. All firms produce similar yet not perfect

8. All firms are able to enter the industry i

9. All firms are profit ma#imi$ers.

. All firms have some market power, whi

:onopolistic competition differs

ossible $ost . ;ecause of this, firms ar

produce differentiated products.Di!!er

computers for e#ample, have differing

;ecause computers are differentiated, th

The classic case of monopolistic

though it charges slightly more, becauseabove the competition, you might switch t

So%rces o! Mar,e" Im+er!ec"ions

"hy do some industries display nea

cases of imperfect competition can be tra

Mean

here!

ly substitutable products.

f the profits are attractive.

ch means none are price takers.

from perfect competition in that rodu$tion do

left withex$ess rodu$tion $a a$ity# 1n this sit

en"ia"e* +ro*%c"sare ones whose importan

characteristics such as speed, memory, hard

y can sell at slightly different prices.

competition is the retail gasoline market. >ou m

it is on your way to work. ;ut if the price at helo the other station a short distance away.

%perfect competition while others are dominated

ced to two principal causes!

74

es not ta!e la$e at the lo est

ation, a large number of sellers

t characteristics vary. ersonal

disk, modem, si$e, and weight.

ay go to local hell station, even

l raises more than a few pennies

by a handful of large firmsK :ost


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&. 2osts and :arket 1mperfection. 1ndustries tend to have fewer sellers when there are significant economies of large

scale production and decreasing costs.


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ome economists have argued that the distance between products is often phony, that firms differentiate product

to fool consumers. Their argument is surely correct in many cases. 1n other cases, however, product differentiation e#

because it reflects differences in peopleOs tastes. Again, there is a cost to deciding whether in each case produ

differentiation manipulates buyers or caters to them. 1t is not clear that any government policy that tries to eliminate P

differentiation will have benefits that e#ceed its costs.

"hen the cost of correcting a problem e#ceeds the possible gain from the correction, is there any real welfare los

by allowing the problem to continueK The model of monopolistic competition shows that real market systems fall sh

theoretical constructs that assume away the problems of information and of making agreements among people. ;ut an

real%world system looks bad compared to theory that assumes away problems.

@inally, the theory developed above does have at least one interesting use in e#plaining the real world. "he

traveling costs are reduced, people become more price%sensitive, which means that the demand curve facing each se

gets more elastic. As a result, the marginal revenue curve shifts upward and will intersect the marginal cost curve a

higher ?uantity (or greater distance). @or individual firms to e#pand sales when the industry sales are constant re?u

some firms to disappear. 6educing traveling costs reduces the number of firms, and development of the automobile and t

highway system drastically cut traveling costs in the


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+overnments also impose entry restrictions on many industries. Typically, utilities, such as telephone, electric

distribution, and water are given"ran$hise mono oliesto serve an area. 1n these cases, the firm gets an e#clusive

right to provide a service, and in return the firm agrees to limit its prices and provide universal service in its reg

even when some customers might be unprofitable.

6$ Hig- Cos" o! En"r.$This is the economic barrier. 1n some industries the price of entry simply may be very hig

Take the commercial%aircraft industry, high cost of designing and testing new airplanes serves to discoura

potential entrants into the market. 1t is likely that only two companies ;oeing and Airbus% can afford the C&D

billion that the ne#t generation of aircraft will cost to develop. 1n addition, companies build up intangible for

investment, and such investments might be very e#pensive for any potential new entrant to match. 2onsider th

software industry.

($ A*#er"ising an* ro*%c" Di!!eren"ia"ion$ometimes it is possible for companies to create barriers to entry for

potential rivals by using advertising and product differentiation. Advertising can create product awareness aloyalty to well%known brands. @or e#ample, epsi and 2oca% 2ola spend hundreds of millions of dollar per

advertising their brands, which makes it very e#pensive for any potential rivals to entry the cola market.

Mono+ol. 3e-a#ior

"hat do monopolists doK 1f the monopolist is a private firm, generally we assume that it chooses the level of output to ma#imi$e profits.

an accounting matter, profits ( 6) are e?ual to total revenue (T6) minus total costs (T2)! 6 G T6 T2. @orany firm, not /ust a monopolist, it can beshown that profit will be ma#imi$ed at the ?uantity where marginal revenue is e?ual to marginal cost! :6 G :2

"hat makes a monopolist different from a competitive firm is that it faces a downward sloping demand curve! it knows that it will have to

cut its price in order to sell more output. As a result, its :6 curve will slope down rather than being flat like competitive firms.

ro!i" Ma4imi


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9BD.DD 8 '.DD IBD.DD 9'.DD 8&'.DD I'.DD 8 '.DD HDD.DD

' 8'.DD 89'.DD &,&J'.DD '.DD &I'.DD B'.DD 89'.DD J'D.DD

H BD.DD 88'.DD &,9'D.DD ''.DD &J'.DD BD.DD 88'.DD BJD.DD

J ' '.DD 8&'.DD &,'D'.DD H'.DD &''.DD JJ.BH 8&'.DD IHD.DD

B H8D.DD 8D'.DD &,H D.DD J'.DD &9'.DD JJ.'D 8D'.DD &,D8D.DD

I JD'.DD &I'.DD &,J''.DD B'.DD &&'.DD JB.99 &I'.DD &,D'D.DD

&D BDD.DD &B'.DD &,B'D.DD I'.DD I'.DD BD.DD &B'.DD &,D'D.DD

&& ID'.DD &J'.DD &,I8'.DD &D'.DD J'.DD B8.8J &J'.DD &,D8D.DD

&8 &,D8D.DD &H'.DD &,IBD.DD &&'.DD ''.DD B'.DD &H'.DD IHD.DD

&9 &,& '.DD &''.DD 8,D&'.DD &8'.DD 9'.DD BB.DB &''.DD BJD.DD

& &,8BD.DD & '.DD 8,D9D.DD &9'.DD &'.DD I&. 9 & '.DD J'D.DD

&' &, 8'.DD &9'.DD 8,D8'.DD & '.DD %'.DD I'.DD &9'.DD HDD.DD

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Monopoly Behavior

P

MR

MC


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Assumptions!dis$uss details and ro$esses

&. roduction is twice itself thus M 8

8. A2 and A6 is divided at average M thus no need to 8

9. eller reached its ma#imum profit at M%&D

. rice is dropping and yet profit is getting lower. "hyK This is to sell more M (eco. inefficiency), to sell

e#cess production price should be lower

'. eller produced higher M due to hedging (discuss hedging speculation activities of investor)

H. 5iscuss theory of investorOs speculation vs law of demand supply

J. 5iscuss concept of Ospot marketO ! 3ondon%based 1nternational etroleum #change (1 ) and the -ew

>ork :ercantile #change (->: N)

;ut why is the oil crisis a global crisisK 1s it really beyond the government controlK

The hilippines, like many other nations, buys the oil at the spot market. ;y PspotP is meant, that one buys the oil

a market only 8 to B hours before one takes physical (spot) delivery, as opposed to buying it &8 or more months in

advance. 1n effect, the spot market inserted a financial middleman into the oil patch income stream.

Today, the oil price is largely set in the two futures markets! 3ondon%based 1nternational etroleum #change (1

and the -ew >ork :ercantile #change (->: N). *ere, traders or investors buy or sell certain commodities like oil at a

certain date in the future, at a specified price. ;asically, traders invest in the futures market by buying futures contracts

called Ppaper oilP or simply paper claim against oil. The very purpose of buying oil is not to wait for the actual delivery

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Monopoly- Proft and Loss

Profit

TR

TC


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5-. Go#ernmen" Tolera"es Mono+olies

&. 1t is difficult to break up monopolies.

8. +overnments can implement regulation of :onopolies e.g. @"AT regulates the prices of water companies

9. :onopolies can be more efficient because of the advantages from economies of scale. This is particularly importanfor firms operating in a natural monopoly. @or e#ample, it wouldn7t make sense to have many small companies

providing tap water. The large scale infrastructure makes it more efficient to /ust have & firm

. @irms with monopoly power are not necessarily bad. +oogle has monopoly power on search engines but can w

say +oogle is an inefficient firm who don7t seek to innovateK

Does Microso!" -a#e "oo m%c- mono+ol. +o8er

At one stage the < ustice 5epartment had nearly succeeded in getting :icrosoft broken up into 9 smaller companies.

They argued that :icrosoft had abused its monopoly power to engage in illegal activities.

The

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