Transcript BUSINESS ECONOMICS - Kwabena Darfor Nkansah

BUSINESS ECONOMICS
Origin of Business Economics
• Business Economics emerged in 1951 with the publication of
Managerial Economics by Joel, Dean, to bridge the gap between the
theory and practice of economics.
What is Economics?
• Science of wealth. Some earlier economists defined Economics as
follows:
“An inquiry into the nature and causes of the wealth of the nations’’
(Adam Smith)
- Science which deals with wealth" (J.B. Say)
• Science of material well-being.
• "Economics is a study of mankind in the ordinary business of life. It
examines that part of individual and social action which is most closely
connected with the attainment and with the use of the material
requisites of well-being. (Alfred Marshall).
What is Economics Cont’d?
• Science of material well-being.
• "Economics is a study of mankind in the ordinary business of life. It
examines that part of individual and social action which is most closely
connected with the attainment and with the use of the material requisites
of well-being. (Alfred Marshall).
• Science of choice making. Robbins gave a more scientific definition of
Economics.
• "Economics is the science which studies human behaviour as a relationship
between end and scarce means which have alternative uses".
What is Economics cont’d?
• Science of dynamic growth and development.
• - "Economics is the study of how men and society choose, with or without the
use of money, to employ scarce productive resources which could have
alternative uses, to produce various commodities over time and distribute them
for consumption now and in the future amongst various people and groups of
society. It analyses the costs and benefits of improving the patterns of resource
allocation". (Paul A. Samuelson)
What is Economics cont’d?
• From the above definitions, it is clear that:
• an important problem faced by each and every nation of the world is the creation
and distribution of wealth
• Since the problems of poverty, unemployment etc. can be solved to a greater
extent when wealth is produced and is distributed equitably
• How to maximise individual welfare
• Economics is a science; it studies economic human behaviour scientifically. It
studies how humans try to optimise (maximize or minimize) certain objective
under given constraints.
• Human ends (wants) are Unlimited
• Means (resources) are scarce
What is Economics cont’d?
• Since resources (natural productive resources, man-made capital goods,
consumer goods, money and time etc.) are limited economic problem arises.
• Resources have alternative uses
• Resources are simply anything used to produce a good or services or, more
generally, to achieve a goal.
• Making a choice involves a cost, an alternative foregone ( an opportunity cost)
• Economic resources - physical, human, financial are not fixed and can be
increased by human ingenuity, exploration, exploitation and development.
• Economics is the science of making decisions in the presence of scarce resources.
• Economics is a science of management of limited resources given unlimited
wants of economic agents. It is concerned with the allocation of scarce resources
among alternative uses. These are the main issues confronted regularly by
business firms
What is Business?
• The term business refers to a system created to satisfy society’s needs and
desires.
• It is an organized effort of enterprises to produce or distribute goods and
services.
• The goods and services are limited and have alternative uses.
• These are used to satisfy human wants which are unlimited.
• In short, business includes all activities connected with production, trade,
banking, insurance, finance, agency, advertising, packaging and other several
related activities.
What is Business Economics?
• Business economics is "the integration of economic theory with business practice
for the purpose of facilitating decision-making and forward planning by
management". (Spencer and Siegelman)
• "Business economics deals with the use of economic modes of thought to
analyse business situation" (Mc Nair and Meriam)
• The purpose of business economics is show how economic analysis can be used
in formulating business policies (Joel Dean)
• Business economics is primary concerned with the applicability of economics
concepts and analyses to decisions made by businesses (Collberg)
• From the above definitions, business economics can be said to be a discipline
which deals with the application of economic principles, theory and methodology
in the management of business.
What is Business Economics?
It helps a business manager in:
• decision making (i.e. selecting from alternative options/ making informed
choices) to achieve the desired results.
• planning in advance for the future. For example, demand forecasting, pricing,
type of competition envisaged, etc.
• analyzing and solving business problems
Typically all firms have different departments or units:
• (1) production and operations
• (2) marketing
• (3) finance and accounting and
• (4) human resources.
What is Business Economics?
• An important characteristic of business economics is that it is normative or
prescriptive in nature rather than positive or descriptive
• It is, therefore, concerned with “what ought to be” rather than “what is” and
cannot be neutral about ends. It deals with how decision should be made by the
business executives to achieve the goals of the business.
• As a normative science, business economics gives suggestions regarding the best
possible way to achieve the goals of the firm. It passes value judgments on the
actions of the business manager.
This involves two aspects:
• (1) it tells the aims and objectives a firm or manager should pursue and
• (2) it shows how best to achieve these aims in a particular situation.
What is Business Economics?
• Thus, business economics is concerned with “what should happen” rather than
“what does happen”. Instead of explaining what a firm is doing, it explains what a
firm should do to make it s decision effective.
The Economic Problems and the Firms
• The problem of allocation (what to produce and in what quantity?)This is the
first concern of every potential business firm. What to produce to satisfy the
wants of people? This problem directly arises from the problem of scarcity of
resources.
• The problem of choice of production method (how to produce?). I.e. what
production methods are employed for the production of the various goods and
services?
• The problem of distribution (to whom to produce?). Who should have how much
of what has been produced and by what means should they acquire the good?
• The problem of Efficiency (Are the use of productive resources economically
efficient? Given that resources are scarce, it is prudent to ensure that resources
are put to the most efficient utilization. A firm that is operating efficiently is
operating on its production possibility frontier ( this concept is explained in
subsequent session)
The Economic Problems and the Firms
• The problem of full employment of resources. Are resources being fully utilized?
This question is important in that it helps to determine whether there exist
underutilsation of resources in the firm.
• The problem of growth/expansion (is the productive capacity of the firm
increasing, declining or remaining static over time?). Growth is important for
every economy and also for business firms. If a firm grows, it is able to expand its
capacity or scale of production.
Production Possibility Frontier
Definition
• A graph that shows the alternatives production capabilities of an economy or a
production unit.
• It shows the maximum combination of two goods that a production unit can
produce when it utilizes all the available resources, given technology.
• As the productive capacities of the firm/economy are limited, a choice must be
made among quantities of different goods. This demands a decision on how
much resource should be allocated among the different possible goods. for
example, how
Production Possibility Frontier cont’d
Assumptions
• There are given amount of productive resources and remain fixed
• Resources can be shifted from the production of one commodity to the other
• Resources are being used fully and with utmost technical efficiency. i.e. resources
are neither unemployed, underemployed nor inefficiently utilized
• Technology is constant. i.e. does not undergo changes
Production Possibility Frontier cont’d
Production Combinations Cocoa (tonnes)
Gold (Ounces)
A
350
0
B
330
10
C
300
20
D
250
30
E
150
40
F
0
50
Production Possibility Frontier cont’d
400
350
Cocoa (Metric
Tonnes)
A
B
C
300
.Z
D
250
200
.X
150
E
100
50
F
0
0
10
20
30
40
50
Gold (Ounces)
Illustrating the Basic Economic Questions
The problem of scarcity, choice and resource allocation
• the limit provided by the possibility curve illustrates scarcity
• all the wants of the firm cannot be satisfied because of scarcity
• The firm cannot increase the production of both goods
• However, different combinations can be produced ( choice)
• If the firm can produce more of one product only by reducing the quantity of the
other. This means that it has to withdraw resources from the production of one
to the other( resource allocation and cost)
The problem of Unemployment and under employment
• Discuss attainable and unattainable points
• Discuss points below the possibility frontier
• There will be full employment aggregate demand is large enough to buy
the total ouput produced by full employment
• Increase in AD leads to increase employment and thereby a reduction in
unemployment
• The problem of growth
• The combination of consumer goods ( x-axis) and capital goods(
y-axis)
• Allocating more resources to capital goods and less for consumer
goods. capital accumulation increases the productive capacity of
the firm
• The principle of increasing opportunity cost
• Why opportunity cost increases? Resources are not perfectly
substitutable. i.e. not equally efficient in the production of all
goods.
THE COMPETITIVE MARKET MODEL
• For many firms, prices are determined not by them but by the market.
• The market dominates a firm’s activities.
• The more competitive the market, the greater this domination
becomes.
• In the extreme case, the firm may have no power at all to change its
price
• In competitive markets, consumers are price takers
• So how does a competitive market work?
• For simplicity we will examine the case of a perfectly competitive
market
• In a competitive market, we have too main forces: the forces of
Demand and Supply
The structure of the demand and supply model.
Households
• Who attempt to maximize utility, they face diminishing marginal utility,
and are subject to a budget constraint.
Firms
• Attempt to maximize profits. Firms face cost constraints, and are
subject to the law of diminishing returns in production.
What is Demand?
• it refers to the quantities that people are or would be willing to buy at different
prices during a given time period, assuming that other factors affecting these
quantities remain the same.
This definition incorporates 3 important concepts:
• It involves three parameters – price, quantity and time.
• It refers to quantities in the plural, therefore a whole relationship, not a single
quantity.
• It involves the ceteris paribus (other things being equal) assumption, which is a
very common one in making statements in economics.
Tables, graphs and equations
Tables
• These are the simplest method of representation. The table shows the general
‘law of demand’, that less is demanded at higher prices.
Price of Coke (pesewa Quantity sold (cans
per can)
per day)
30
120
40
100
50
80
60
60
70
40
• Tables are not very useful for analytical purposes.
Tables, graphs and equations Cont’d
Graphs/Demand Curve
• These are much more useful for analysis. The demand relationship in this case is
both inverse and linear.
80
70
60
50
40
30
20
10
0
40 47 54 61 68 75 82 89 96 103 110 117
Demand Curve
Quantity
(Cans per day)
Tables, graphs and equations Cont’d
• the concepts of demand and quantity demanded is illustrated:
• the former relates to the whole demand curve whereas the latter
relates to a single point on the curve.
• it is mainly limited to examining two-variable relationships.
• Demand relationships often involve many variables and although the
effects of these can be shown on a graph, as seen in subsequent
sections, they are difficult to measure.
Tables, graphs and equations Cont’d
• Equations
• These are the most useful method of representation for analytical purposes since
they explicitly show the effects of all the variables affecting quantity demanded,
in a concise form that at the same time reveals important information regarding
the nature of the relationship.
• The general form of the demand function in terms of price and quantity
demanded is:
Q  f (P)      (2.1)
• This is the most general way of describing the relationship since it does not
involve any specific mathematical form
Tables, graphs and equations Cont’d
• This can be expanded by including any number of variables that might affect
quantity demanded on the right hand side of the equation, for example:
Q  f (P, A, Y , Ps ,...)      (2.2)
• A represents advertising expenditure, Y represents average income of the market
and Ps represents the price of a substitute product.
• In the two-variable case the demand function can be expressed in a linear form:
Q  a  bP        (2.3)
• The coefficients a and b can then be calculated for the demand schedule in Table
above
Tables, graphs and equations Cont’d
• One way of doing this is to use simultaneous equations and substitute any two
pairs of values in the table to solve for a and b.
• it is more insightful to calculate the value of b first, using the mathematical
concept that b represents
Q / P
• Again any two pairs of values can be used to establish that
• if the first two pairs of values are taken
b  2
b  20 /10  2.
Q  180  2P      (2.4)
Interpretation of equations
• The value of ‘a’ represents the maximum sales that will occur if the price is zero
• ‘b’ represents marginal effect of price on quantity demanded
Q  a  bP  cY        (2.6)
• the value of c represents the marginal effect of Y (income) on Q
• Sometimes the demand function may be non-linear such as equation (2.7) this
demand function is in the power form
b
Q  aP        (2.7)
As with the linear form, the function can be extended to include other variables; in
this case the function is multiplicative
Q  aP Y        (2.8)
b
c
The Demand Function
• A general equation representing the demand curve
Qxd = f(Px , PY , M, H,)
• Qxd = quantity demand of good X.
• Px = price of good X.
• PY = price of a related good Y.
• Substitute good.
• Complement good.
• M = income.
• Normal good.
• Inferior good.
• H = any other variable affecting demand.
Inverse Demand Function
• Price as a function of quantity demanded.
• Example:
• Demand Function
• Qxd = 10 – 2Px
• Inverse Demand Function:
• 2Px = 10 – Qxd
• Px = 5 – 0.5Qxd
Determinants of Demand
Change in Quantity Demanded
Price
A to B: Increase in quantity demanded
10
A
B
6
D0
4
7
Quantity
Change in Demand
Price
D0 to D1: Increase in Demand
6
D1
D0
7
13
Quantity
Consumer Surplus
• The demand curve reveals the amount of a product consumers will buy at a
given price.
• Consumer surplus is the value consumers get from a good but do not have
to pay for.
• This concept is important to managers because it tells how much extra
money consumers would be willing to pay for a given amount of a
purchased product.
• Geometrically, consumer surplus is the area above the price paid for a good
but below the demand curve
Consumer Surplus cont’d
Price
Price
5
Consumer Surplus
4
3
2
P0
1
0
1
2 3
(a)
4
D
5
Qty
D
0
Q0
(b)
Qty
I got a great deal!
• That company offers a lot
of bang for the buck!
• Dell provides good value.
• Total value greatly exceeds
total amount paid.
• Consumer surplus is large.
I got a lousy deal!
• That car dealer drives a hard
bargain!
• I almost decided not to buy
it!
• They tried to squeeze the
very last cent from me!
• Total amount paid is close to
total value.
• Consumer surplus is low.
THE THEORY OF INDIVIDUAL BEHAVIOUR
Overview
Consumer Behaviour
• Indifference Curve Analysis.
• Consumer Preference Ordering.
II. Constraints
• The Budget Constraint.
• Changes in Income.
• Changes in Prices.
III. Consumer Equilibrium
IV. Indifference Curve Analysis & Demand
• Individual Demand.
• Market Demand.
Curves
Consumer Behaviour
• Consumer Opportunities
• The possible goods and services consumer can afford to consume.
• Consumer Preferences
• The goods and services consumers actually consume.
• Given the choice between 2 bundles of goods a consumer either:
• Prefers bundle A to bundle B: A  B.
• Prefers bundle B to bundle A: A  B.
• Is indifferent between the two: A  B.
Indifference Curve Analysis
Indifference Curve
• A curve that defines the
combinations of 2 or
more goods that give a
consumer the same level
of satisfaction.
Marginal Rate of Substitution
• The rate at which a
consumer is willing to
substitute one good for
another and maintain the
same satisfaction level.
Good Y
III.
II.
I.
Good X
Consumer Preference Ordering Properties
•Completeness
•More is Better
•Diminishing Marginal Rate of Substitution
•Transitivity
Complete Preferences
• Completeness Property
• Consumer is capable of
expressing preferences (or
indifference) between all possible
bundles. (“I don’t know” is NOT
an option!)
• If the only bundles available
to a consumer are A, B, and C,
then the consumer
• is indifferent between A
and C (they are on the
same indifference curve).
• will prefer B to A.
• will prefer B to C.
Good Y
III.
II.
I.
A
B
C
Good X
More Is Better!
• More Is Better Property
• Bundles that have at least as much
of every good and more of some
good are preferred to other
bundles.
• Bundle B is preferred to A since B
contains at least as much of good Y
and strictly more of good X.
• Bundle B is also preferred to C since B
contains at least as much of good X
and strictly more of good Y.
• More generally, all bundles on ICIII are
preferred to bundles on ICII or ICI. And
all bundles on ICII are preferred to ICI.
Good Y
III
II
I.
100
A
B
C
33.33
1
3
Good X
Diminishing MRS
MRS
• The amount of good Y the consumer is
willing to give up to maintain the same
satisfaction level decreases as more of
good X is acquired.
• The rate at which a consumer is willing to
substitute one good for another and
maintain the same satisfaction level.
• To go from consumption bundle A to B
the consumer must give up 50 units of
Y to get one additional unit of X.
• To go from consumption bundle B to C
the consumer must give up 16.67 units
of Y to get one additional unit of X.
• To go from consumption bundle C to D
the consumer must give up only 8.33
units of Y to get one additional unit of
X.
Good Y
III.
II.
I.
100
50
33.33
25
A
B
C
D
1 2 3 4
Good X
Consistent Bundle Orderings
• Transitivity Property
• For the three bundles A, B,
and C, the transitivity
property implies that if C 
B and B  A, then C  A.
• Transitive preferences along
with the more-is-better
property imply that
• indifference curves will
not intersect.
• the consumer will not
get caught in a perpetual
cycle of indecision.
Good Y
III.
II.
I.
100
75
50
A
C
B
1 2
5
7 Good X
The Budget Constraint
• Opportunity Set
• The set of consumption
bundles that are affordable.
• PxX + PyY  M.
• Budget Line
• The bundles of goods that
exhaust a consumers income.
• PxX + PyY = M.
• Market Rate of Substitution
• The slope of the budget line
• -Px / Py.
Y
The Opportunity Set
Budget Line
M/PY
Y = M/PY – (PX/PY)X
M/PX
X
Changes in the Budget Line
• Changes in Income
• Increases lead to a parallel,
outward shift in the budget
line (M1 > M0).
• Decreases lead to a parallel,
downward shift (M2 < M0).
• Changes in Price
• A decreases in the price of
good X rotates the budget
line counter-clockwise (PX0 >
PX1).
• An increases rotates the
budget line clockwise (not
shown).
Y
M1/PY
M0/PY
M2/PY
Y
M0/PY
X
M2/PX M0/PX M1/PX
New Budget Line for a
price decrease.
M0/PX0
M0/PX1 X
Consumer Equilibrium
• The equilibrium consumption
bundle is the affordable bundle
that yields the highest level of
satisfaction.
• Consumer equilibrium occurs
at a point where
MRSxy = PX / PY.
• Equivalently, the slope of the
indifference curve equals the
budget line.
Y
M/PY
Consumer
Equilibrium
III.
II.
I.
M/PX
X
Price Changes and Consumer Equilibrium
• Substitute Goods
• An increase (decrease) in the price of good X leads to an increase
(decrease) in the consumption of good Y.
• Examples:
• Coke and Pepsi.
• Verizon Wireless or AT&T.
• Complementary Goods
• An increase (decrease) in the price of good X leads to a decrease
(increase) in the consumption of good Y.
• Examples:
• DVD and DVD players.
• Computer CPUs and monitors.
Complementary Goods
Pretzels (Y)
When the price of good X
falls and the consumption
of Y rises, then X and Y are
complementary goods.
(PX1 > PX2)
M/PY1
B
Y2
II
A
Y1
I
X1
X2
M/PX2
Beer (X)
Income Changes and Consumer Equilibrium
• Normal Goods
• Good X is a normal good if an increase (decrease) in
income leads to an increase (decrease) in its
consumption.
• Inferior Goods
• Good X is an inferior good if an increase (decrease) in
income leads to a decrease (increase) in its
consumption.
Normal Goods
Y
An increase in
income increases
the consumption of
normal goods.
(M0 < M1).
M1/Y
B
Y1
M0/Y
II
A
Y0
I
0
X0 M0/X
X1
M1/X
X
Decomposing the Income and Substitution Effects
Initially, bundle A is consumed. A
decrease in the price of good X
expands the consumer’s opportunity
set.
Y
The substitution effect (SE) causes the
consumer to move from bundle A to B.
C
A higher “real income” allows the
consumer to achieve a higher
indifference curve.
A
II
B
The movement from bundle B to C
represents the income effect (IE). The
new equilibrium is achieved at point C.
IE
0
SE
X
Individual Demand Curve
Y
• An individual’s demand
curve is derived from
each new equilibrium
point found on the
indifference curve as
the price of good X is
varied.
II
I
X
$
P0
P1
D
X0
X1
X
Market Demand
• The market demand curve is the horizontal
summation of individual demand curves.
• It indicates the total quantity all consumers would
purchase at each price point.
$
Individual Demand Curves
$
Market Demand Curve
50
40
D1
1 2
D2
DM
Q
1 2 3
Q
Limitations of the Theory of Individual Behaviour
Concentration on price
Search costs:-Consumers have to obtain information regarding price, quality and
availability of products and there is a cost attached to this.
Rationality:-It is sometimes argued, particularly by behaviourists, that humans
rarely make the relevant computations that are necessitated by the neoclassical
model, particularly with practical time constraints
ESTIMATING THE DEMAND FUNCTION
• The Regression Equation is given as:
Y  a  bX      (1)
• The Estimated Regression Equation is given as:
ˆ
Y  aˆ  bX      (2)
Demonstration of Demand Estimation Cont’d
•

bcan
be derived by the formula:
xy

b
x

2
Where x  X  X and y  Y  Y
X is the mean of X and Y is the mean of Y



a can be derived by the formula: a  Y  b X
Demonstration of Demand Estimation Cont’d
Given the data on quantity demanded and Price in Table 1
Observation
1
2
3
4
5
6
7
8
9
10
Quantity
180
590
430
250
275
720
660
490
700
210
Price (GHC)
475
400
450
550
575
375
375
450
400
500
Demonstration of Demand Estimation Cont’d
• The data above can be described by the regression equation
Q  a  bP      (3)
• The estimated regression line can be represented as:


Q  a  b P    (4)
pq

b
p

2


a  Q bP
..\Documents\Managerial Econs\data on demand and regression analysis.xlsx
SUPPLY
• What is Supply?
The supply of a commodity refers to the various quantities of that commodity that
producers are willing and able to sell at various prices during a given period of time.
Important elements in the definition
a. Schedule of intentions: An estimate
b. Price/Quantity relationship: Price is the most important determinant of quantity.
c. Ready, willing and able: Defines the market of relevant suppliers.
Ready: Has access to market.
Willing: Is a reasonable use of resources,
Able: Has productive means
d. Per unit of time: Time must be specified
e. other things constant.
f. Up-sloping due to the law of diminishing returns
SUPPLY CONT’D
The Law of Supply
• The law of supply asserts that quantity supplied of a good or service is directly
(positively) related to the selling price, ceteris paribus.
• Symbolically, the law of supply may be summarized as follows:
Qs  g ( P)      (2.16a)
dQs
 0      (2.16b)
dP
• Equation (2.16a) states that the quantity supplied QS of a good or service is
functionally related to the selling price P. Inequality (2.16b) asserts that quantity
supplied of a product and its price are directly related.
The Supply Curve
• This relationship is illustrated in the diagram below
Price
B S
P2
P1
0
A
Q1
Q2
Quantity Supplied
The Supply Function
The supply function of a good describes how much of the good will be
produced at alternative prices of the good, alternative prices of inputs,
and alternative values of other variables that affect supply.
Q  f (Px , Pr ,W , H )    (2.17)
s
x
Where Px is the price of the good, Pr is the price of technologically
related goods, W is the price of an input and H is the value of some other
variable that affects supply (such as existing technology, the number of
firms in the market, taxes, or producer expectations).
The Supply Function Cont’d
• The coefficients i ' s represent given numbers that that have been estimated by
the firm’s research department or an economic consultant.
Numerical Example
The research department of Ama and Co. Ltd estimated that the supply function
for their television sets is given by
Q  2000  3Px  4Pr  Pw
s
x
Where Px is the price of TV sets, Pr represents the price of a computer monitor, and
Pw is the price of an input used to make televisions. Suppose TVs are sold for
GH¢400 per unit, computer monitors are sold for GH¢100 per unit, and the price of
an input is GH¢2000. How many television sets are produced?
The Supply Function Cont’d
Solution
To find out how many television sets are produced, we insert the given values of
the prices into the supply equation to get
Qxs  2000  3(400)  4(100)  1(2000)  800
The information summarized in a supply function can be used to graph a supply
curve.
Since a supply curve is the relationship between price and quantity, a
representative supply curve holds everything but price constant.
This means one may obtain the formula for a supply curve by inserting given values
of the supply shifters into the supply function, but leaving Px
• If we do this for the supply function in example above, (where Pr = GH¢100 and
Pw = GH¢2000), we get
The Supply Function Cont’d
Q  2000  3Px  4(100) 1(2000)
s
x
Which simplifies to
Q  3Px  400
s
x
Since we usually graph this relation with the price of the good on the vertical axis,
it is useful to represent the new equation with price on the left-hand side and
everything else on the right-hand side.
This is known as the inverse supply function. In this particular case, the inverse
supply function is
400 1 s
Px 
 Qx
3
3
This equation is graphed below
Producer Surplus
• The supply curve reveals the amount producers will be willing to produce at a
given price.
Price
Producer Surplus
A
GH¢400 ∙
B
S
∙
C
GH¢400/3∙
Quantity
800
0
• Geometrically, producer surplus is the area above the supply curve but below the
market price of the good.
Producer Surplus Cont’d
• Producer surplus is the amount of money producers receive in excess of the
amount necessary to induce them to produce the good.
• For example, the supply curve in the figure above indicates that a total of 800
units will be produced when the price is GH¢400
• The area ABC, is the producer surplus when the price is GH¢400. Mathematically,
this area is one-half of 800 times GH¢266.67, or GH¢106,668.
Supply Shifters
• Input prices
• Technology or government regulations
• Number of firms
• Entry
• Exit
• Substitutes in production
• Taxes
• Excise tax
• Ad valorem tax
• Producer expectations
The Market Mechanism: The Interaction Of Demand
And Supply
P
Excess Supply
D
P*
S
E
S
Excess Demand
Q*
D
Q
The Interaction Of Demand And Supply cont’d
Example
• Suppose you are the special assistant to a member of parliament on the Foreign
affairs committee of parliament. The Togolese government plans to privatize an
industry, and you have been asked to help the committee determine the market
price and quantity that would prevail in the Togolese market if competitive forces
were allowed to equilibrate the market. The best estimates of the market
demand and supply for the Togolese good (in Ghana cedi equivalent prices) are
given by Qd = 10 – 2P and Qs = 2+2P, respectively. Determine the competitive
equilibrium price and quantity.
• Soln
In equilibrium Qd = Qs.
10 – 2P = 2+2P; 8 = 4P; Pe = 2
Qe = 10 – 2(2) = 6.
Price Restrictions
• Price Ceilings
• The maximum legal price that can be charged.
• Examples:
• Gasoline prices in the 1970s.
• Housing in New York City.
• Proposed restrictions on ATM fees.
• Price Floors
• The minimum legal price that can be charged.
• Examples:
• Minimum wage.
• Agricultural price supports.
Impact of a Price Ceiling
Price
S
PF
P*
P Ceiling
D
Shortage
Qs
Q*
Qd
Quantity
Full Economic Price
• The dollar amount paid to a firm under a price ceiling, plus the
non-pecuniary price.
PF = Pc + (PF - PC)
• PF = full economic price
• PC = price ceiling
• PF - PC = nonpecuniary price
An Example from the 1970s in the US
• Ceiling price of gasoline: $1.
• 3 hours in line to buy 15 gallons of gasoline:
• Opportunity cost: $5/hr.
• Total value of time spent in line: 3  $5 = $15.
• Non-pecuniary price per gallon: $15/15=$1.
• Full economic price of a gallon of gasoline: $1+$1=2.
Impact of a Price Floor
Price
Surplus
S
PF
P*
D
Qd
Q*
QS
Quantity
Comparative Static Analysis
• How do the equilibrium price and quantity change when a
determinant of supply and/or demand change?
Applications: Demand and Supply Analysis
• Event: The WSJ reports that the prices of PC components are
expected to fall by 5-8 percent over the next six months.
• Scenario 1: You manage a small firm that manufactures PCs.
• Scenario 2: You manage a small software company.
Use Comparative Static Analysis to see the Big
Picture!
• Comparative static analysis shows how the equilibrium price
and quantity will change when a determinant of supply or
demand changes.
Scenario 1: Implications for a Small PC Maker
• Step 1: Look for the “Big Picture.”
• Step 2: Organize an action plan (worry about details).
Big Picture: Impact of decline in component prices on
PC market
Price
of
PCs
S
S*
P0
P*
D
Q0
Q*
Quantity of PC’s
Big Picture Analysis: PC Market
• Equilibrium price of PCs will fall, and equilibrium quantity of
computers sold will increase.
• Use this to organize an action plan:
•
•
•
•
•
contracts/suppliers?
inventories?
human resources?
marketing?
do I need quantitative estimates?
Scenario 2: Software Maker
• More complicated chain of reasoning to arrive at the “Big
Picture.”
• Step 1: Use analysis like that in Scenario 1 to deduce that lower
component prices will lead to
• a lower equilibrium price for computers.
• a greater number of computers sold.
• Step 2: How will these changes affect the “Big Picture” in the
software market?
Big Picture: Impact of lower PC prices on the
software market
Price
of Software
S
P1
P0
D*
D
Q0 Q1
Quantity of
Software
Big Picture Analysis: Software Market
• Software prices are likely to rise, and more software will be sold.
• Use this to organize an action plan.
Conclusion
• Use supply and demand analysis to
• clarify the “big picture” (the general impact of a current event on equilibrium
prices and quantities).
• organize an action plan (needed changes in production, inventories, raw
materials, human resources, marketing plans, etc.).
Elasticity
Overview
The Elasticity Concept
•
•
•
•
Own Price Elasticity
Elasticity and Total Revenue
Cross-Price Elasticity
Income Elasticity
II. Demand Functions
• Linear
• Log-Linear
III. Regression Analysis
The Elasticity Concept
• How responsive is variable “G” to a change in variable “S”
The Elasticity Concept
• How responsive is variable “G” to a change in variable “S”
EG , S
%G

%S
If EG,S > 0, then S and G are directly related.
If EG,S < 0, then S and G are inversely related.
If EG,S = 0, then S and G are unrelated.
The Elasticity Concept Using Calculus
• An alternative way to measure the elasticity of a function G = f(S)
is
EG , S
dG S

dS G
If EG,S > 0, then S and G are directly related.
If EG,S < 0, then S and G are inversely related.
If EG,S = 0, then S and G are unrelated.
Own Price Elasticity of Demand
EQX , PX
%QX

%PX
d
• Negative according to the “law of demand.”
Elastic:
EQ X , PX  1
Inelastic: EQ X , PX  1
Unitary:
EQ X , PX  1
Perfectly Elastic & Inelastic Demand
Price
Price
D
D
Quantity
PerfectlyElastic(EQX ,PX  )
Quantity
PerfectlyInelastic( EQX , PX  0)
Own-Price Elasticity
and Total Revenue
• Elastic
• Increase (a decrease) in price leads to a decrease (an increase) in total
revenue.
• Inelastic
• Increase (a decrease) in price leads to an increase (a decrease) in total
revenue.
• Unitary
• Total revenue is maximized at the point where demand is unitary elastic.
Elasticity, Total Revenue
and Linear Demand
P
100
TR
0
10
20
30
40
50
Q
0
Q
Elasticity, Total Revenue
and Linear Demand
P
100
TR
80
800
0
10
20
30
40
50
Q
0
10
20
30
40
50
Q
Elasticity, Total Revenue and Linear Demand
P
100
TR
80
1200
60
800
0
10
20
30
40
50
Q
0
10
20
30
40
50
Q
Elasticity, Total Revenue and Linear Demand
P
100
TR
80
1200
60
40
800
0
10
20
30
40
50
Q
0
10
20
30
40
50
Q
Elasticity, Total Revenue and Linear Demand
P
100
TR
80
1200
60
40
800
20
0
10
20
30
40
50
Q
0
10
20
30
40
50
Q
Elasticity, Total Revenue
and Linear Demand
P
100
TR
Elastic
80
1200
60
40
800
20
0
10
20
30
40
50
Q
0
10
20
Elastic
30
40
50
Q
Elasticity, Total Revenue
and Linear Demand
P
100
TR
Elastic
80
1200
60
Inelastic
40
800
20
0
10
20
30
40
50
Q
0
10
Elastic
20
30
40
Inelastic
50
Q
Elasticity, Total Revenue
and Linear Demand
P
100
TR
Unit elastic
Elastic
Unit elastic
80
1200
60
Inelastic
40
800
20
0
10
20
30
40
50
Q
0
10
Elastic
20
30
40
Inelastic
50
Q
Demand, Marginal Revenue (MR) and Elasticity
• For a linear inverse
demand function,
MR(Q) = a + 2bQ,
where b < 0.
• When
P
100
Elastic
Unit elastic
80
60
Inelastic
40
20
0
10
20
40
MR
50
Q
• MR > 0, demand is
elastic;
• MR = 0, demand is unit
elastic;
• MR < 0, demand is
inelastic.
Factors Affecting the
Own-Price Elasticity
• Available Substitutes
• The more substitutes available for the good, the more elastic
the demand.
• Time
• Demand tends to be more inelastic in the short term than in the
long term.
• Time allows consumers to seek out available substitutes.
• Expenditure Share
• Goods that comprise a small share of consumer’s budgets tend
to be more inelastic than goods for which consumers spend a
large portion of their incomes.
Cross-Price Elasticity of Demand
EQX , PY
%QX

%PY
d
If EQX,PY > 0, then X and Y are substitutes.
If EQX,PY < 0, then X and Y are complements.
Predicting Revenue Changes
from Two Products
Suppose that a firm sells to related goods. If
the price of X changes, then total revenue
will change by:
 


R  RX 1  EQX , PX  RY EQY ,PX  %PX
Income Elasticity
EQX , M
%QX

%M
d
If EQX,M > 0, then X is a normal good.
If EQX,M < 0, then X is a inferior good.
Uses of Elasticities
• Pricing.
• Managing cash flows.
• Impact of changes in competitors’ prices.
• Impact of economic booms and recessions.
• Impact of advertising campaigns.
• And lots more!
Example 1: Pricing and Cash Flows
• According to an FTC Report by Michael Ward,
AT&T’s own price elasticity of demand for long
distance services is -8.64.
• AT&T needs to boost revenues in order to meet
it’s marketing goals.
• To accomplish this goal, should AT&T raise or
lower it’s price?
Answer: Lower price!
• Since demand is elastic, a reduction in price will
increase quantity demanded by a greater
percentage than the price decline, resulting in
more revenues for AT&T.
Example 2: Quantifying the Change
• If AT&T lowered price by 3 percent, what would
happen to the volume of long distance
telephone calls routed through AT&T?
Answer: Calls Increase!
Calls would increase by 25.92 percent!
EQX , PX
%QX
 8.64 
%PX
d
%QX
 8.64 
 3%
d
 3%   8.64  %QX
d
%QX  25.92%
d
Example 3: Impact of a Change in a
Competitor’s Price
• According to an FTC Report by Michael Ward,
AT&T’s cross price elasticity of demand for long
distance services is 9.06.
• If competitors reduced their prices by 4 percent,
what would happen to the demand for AT&T
services?
Answer: AT&T’s Demand Falls!
AT&T’s demand would fall by 36.24 percent!
EQX , PY
%QX
 9.06 
%PY
%QX
9.06 
 4%
d
 4%  9.06  %QX
d
%QX  36.24%
d
d
Interpreting Demand Functions
• Mathematical representations of demand curves.
• Example:
QX  10  2PX  3PY  2M
d
• Law of demand holds (coefficient of PX is negative).
• X and Y are substitutes (coefficient of PY is positive).
• X is an inferior good (coefficient of M is negative).
Linear Demand Functions and Elasticities
• General Linear Demand Function and Elasticities:
QX  0   X PX  Y PY  M M  H H
d
P
EQX , PX   X X
QX
Own Price
Elasticity
EQX , PY
PY
 Y
QX
Cross Price
Elasticity
M
EQX , M   M
QX
Income
Elasticity
Example of Linear Demand
• Qd = 10 - 2P.
• Own-Price Elasticity: (-2)P/Q.
• If P=1, Q=8 (since 10 - 2 = 8).
• Own price elasticity at P=1, Q=8:
(-2)(1)/8= - 0.25.
Log-Linear Demand
• General Log-Linear Demand Function:
ln QX d  0   X ln PX  Y ln PY  M ln M  H ln H
Own PriceElasticity:  X
Cross PriceElasticity:  Y
IncomeElasticity:
M
Example of Log-Linear Demand
• ln(Qd) = 10 - 2 ln(P).
• Own Price Elasticity: -2.
Graphical Representation of Linear and
Log-Linear Demand
P
P
D
Linear
D
Q
Log Linear
Q
Regression Analysis
• One use is for estimating demand functions.
• Important terminology and concepts:
•
•
•
•
•
•
Least Squares Regression model: Y = a + bX + e.
Least Squares Regression line:
Yˆ  aˆ  bˆX
Confidence Intervals.
t-statistic.
R-square or Coefficient of Determination.
F-statistic.
An Example
• Use a spreadsheet to estimate the following
log-linear demand function.
ln Qx  0   x ln Px  e
Summary Output
Regression Statistics
Multiple R
0.41
R Square
0.17
Adjusted R Square
0.15
Standard Error
0.68
Observations
41.00
ANOVA
df
Regression
Residual
Total
Intercept
ln(P)
SS
1.00
39.00
40.00
MS
F
3.65
18.13
21.78
Coefficients Standard Error
7.58
1.43
-0.84
0.30
3.65
0.46
t Stat
5.29
-2.80
Significance F
7.85
0.01
P-value
0.000005
0.007868
Lower 95%
Upper 95%
4.68
10.48
-1.44
-0.23
Interpreting the Regression Output
• The estimated log-linear demand function is:
• ln(Qx) = 7.58 - 0.84 ln(Px).
• Own price elasticity: -0.84 (inelastic).
• How good is our estimate?
• t-statistics of 5.29 and -2.80 indicate that the estimated coefficients are
statistically different from zero.
• R-square of 0.17 indicates the ln(PX) variable explains only 17 percent of the
variation in ln(Qx).
• F-statistic significant at the 1 percent level.
Conclusion
• Elasticities are tools you can use to quantify the
impact of changes in prices, income, and
advertising on sales and revenues.
• Given market or survey data, regression analysis
can be used to estimate:
• Demand functions.
• Elasticities.
• A host of other things, including cost functions.
• Managers can quantify the impact of changes in
prices, income, advertising, etc.
The Production
Process and Costs
Overview
I. Production Analysis
•
•
•
•
Total Product, Marginal Product, Average Product.
Isoquants.
Isocosts.
Cost Minimization
II. Cost Analysis
• Total Cost, Variable Cost, Fixed Costs.
• Cubic Cost Function.
• Cost Relations.
III. Multi-Product Cost Functions
Production Analysis
• Production Function
• Q = F(K,L)
•
•
•
•
Q is quantity of output produced.
K is capital input.
L is labor input.
F is a functional form relating the inputs to output.
• The maximum amount of output that can be produced with
K units of capital and L units of labor.
• Short-Run vs. Long-Run Decisions
• Fixed vs. Variable Inputs
Production Function Algebraic Forms
• Linear production function: inputs are perfect
substitutes.
Q  F K , L  aK  bL
• Leontief production function: inputs are used in
fixed proportions.
Q  F K , L  minbK, cL
• Cobb-Douglas production function: inputs have a
degree of substitutability.
Q  F K , L  K a Lb
Productivity Measures:
Total Product
• Total Product (TP): maximum output produced with given amounts of
inputs.
• Example: Cobb-Douglas Production Function:
Q = F(K,L) = K.5 L.5
• K is fixed at 16 units.
• Short run Cobb-Douglass production function:
Q = (16).5 L.5 = 4 L.5
• Total Product when 100 units of labor are used?
Q = 4 (100).5 = 4(10) = 40 units
Productivity Measures: Average Product of an
Input
• Average Product of an Input: measure of output produced per unit of
input.
• Average Product of Labor: APL = Q/L.
• Measures the output of an “average” worker.
• Example: Q = F(K,L) = K.5 L.5
• If the inputs are K = 16 and L = 16, then the average product of labor is APL = [(16)
0.5(16)0.5]/16 = 1.
• Average Product of Capital: APK = Q/K.
• Measures the output of an “average” unit of capital.
• Example: Q = F(K,L) = K.5 L.5
• If the inputs are K = 16 and L = 16, then the average product of capital is APK =
[(16)0.5(16)0.5]/16 = 1.
Productivity Measures: Marginal Product
of an Input
• Marginal Product on an Input: change in total
output attributable to the last unit of an input.
• Marginal Product of Labor: MPL = Q/L
• Measures the output produced by the last worker.
• Slope of the short-run production function (with respect to
labor).
• Marginal Product of Capital: MPK = Q/K
• Measures the output produced by the last unit of capital.
• When capital is allowed to vary in the short run, MPK is the
slope of the production function (with respect to capital).
Increasing, Diminishing and Negative
Q
Marginal Returns
Increasing
Marginal
Returns
Diminishing
Marginal
Returns
Negative
Marginal
Returns
Q=F(K,L)
AP
L
MP
Guiding the Production Process
• Producing on the production function
• Aligning incentives to induce maximum worker effort.
• Employing the right level of inputs
• When labor or capital vary in the short run, to maximize profit a
manager will hire:
• labor until the value of marginal product of labor equals the wage: VMPL = w,
where VMPL = P x MPL.
• capital until the value of marginal product of capital equals the rental rate: VMPK
= r, where VMPK = P x MPK .
Isoquant
• Illustrates the long-run combinations of inputs (K,
L) that yield the producer the same level of
output.
• The shape of an isoquant reflects the ease with
which a producer can substitute among inputs
while maintaining the same level of output.
Marginal Rate of Technical Substitution
(MRTS)
• The rate at which two inputs are substituted while
maintaining the same output level.
MRTSKL
MPL

MPK
Linear Isoquants
• Capital and labor are perfect
substitutes
• Q = aK + bL
• MRTSKL = b/a
• Linear isoquants imply that inputs are
substituted at a constant rate,
independent of the input levels
employed.
K
Increasing
Output
Q1
Q2
Q3
L
Leontief Isoquants
• Capital and labor are perfect
K
complements.
• Capital and labor are used in
fixed-proportions.
• Q = min {bK, cL}
• Since capital and labor are
consumed in fixed proportions
there is no input substitution
along isoquants (hence, no
MRTSKL).
Q3
Q2
Q1
Increasing
Output
L
Cobb-Douglas Isoquants
• Inputs are not perfectly
substitutable.
• Diminishing marginal rate
of technical substitution.
• As less of one input is used in
the production process,
increasingly more of the other
input must be employed to
produce the same output level.
K
Q3
Q2
Q1
Increasing
Output
• Q = KaLb
• MRTSKL = MPL/MPK
L
Isocost
• The combinations of inputs that
produce a given level of output
at the same cost:
wL + rK = C
• Rearranging,
K= (1/r)C - (w/r)L
• For given input prices, isocosts
farther from the origin are
associated with higher costs.
• Changes in input prices change
the slope of the isocost line.
K
C1/r
New Isocost Line
associated with higher
costs (C0 < C1).
C0/r
C0
C0/w
C1
C1/w
L
K
C/r
New Isocost Line for
a decrease in the
wage (price of labor:
w0 > w1).
C/w0
C/w1
L
Cost Minimization
• Marginal product per dollar spent should be equal for all inputs:
• But, this is just
MPL MPK
MPL w



w
r
MPK r
MRTS KL
w

r
Cost Minimization
K
Slope of Isocost
=
Slope of Isoquant
Point of Cost
Minimization
Q
L
Optimal Input Substitution
• A firm initially produces Q0 by
employing the combination of
inputs represented by point A
at a cost of C0.
• Suppose w0 falls to w1.
• The isocost curve rotates
counterclockwise; which
represents the same cost level
prior to the wage change.
• To produce the same level of
output, Q0, the firm will produce
on a lower isocost line (C1) at a
point B.
• The slope of the new isocost line
represents the lower wage
relative to the rental rate of
capital.
K
A
K0
B
K1
Q0
0 L0
L1 C0/w0
C1/w1
C0/w1 L
Cost Analysis
• Types of Costs
• Short-Run
• Fixed costs (FC)
• Sunk costs
• Short-run variable
costs (VC)
• Short-run total costs
(TC)
• Long-Run
• All costs are variable
• No fixed costs
Total and Variable Costs
C(Q): Minimum total cost of
producing alternative levels of
output:
$
C(Q) = VC + FC
VC(Q)
C(Q) = VC(Q) + FC
VC(Q): Costs that vary with
output.
FC
FC: Costs that do not vary with
output.
0
Q
Fixed and Sunk Costs
FC: Costs that do not change as $
output changes.
Sunk Cost: A cost that is forever
lost after it has been paid.
Decision makers should ignore
sunk costs to maximize profit or
minimize losses
C(Q) = VC + FC
VC(Q)
FC
Q
Some Definitions
Average Total Cost
ATC = AVC + AFC
ATC = C(Q)/Q
$
MC
ATC
AVC
Average Variable Cost
AVC = VC(Q)/Q
MR
Average Fixed Cost
AFC = FC/Q
Marginal Cost
MC = DC/DQ
AFC
Q
Fixed Cost
Q0(ATC-AVC)
$
= Q0 AFC
= Q0(FC/ Q0)
MC
ATC
AVC
= FC
ATC
AFC
Fixed Cost
AVC
Q0
Q
Variable Cost
$
Q0AVC
MC
ATC
= Q0[VC(Q0)/ Q0]
AVC
= VC(Q0)
AVC
Variable Cost
Minimum of AVC
Q0
Q
Total Cost
Q0ATC
$
= Q0[C(Q0)/ Q0]
= C(Q0)
MC
ATC
AVC
ATC
Minimum of ATC
Total Cost
Q0
Q
Cubic Cost Function
• C(Q) = f + a Q + b Q2 + cQ3
• Marginal Cost?
• Memorize:
MC(Q) = a + 2bQ + 3cQ2
• Calculus:
dC/dQ = a + 2bQ + 3cQ2
An Example
• Total Cost: C(Q) = 10 + Q + Q2
• Variable cost function:
VC(Q) = Q + Q2
• Variable cost of producing 2 units:
VC(2) = 2 + (2)2 = 6
• Fixed costs:
FC = 10
• Marginal cost function:
MC(Q) = 1 + 2Q
• Marginal cost of producing 2 units:
MC(2) = 1 + 2(2) = 5
Long-Run Average Costs
$
LRAC
Economies
of Scale
Diseconomies
of Scale
Q*
Q
Multi-Product Cost Function
• C(Q1, Q2): Cost of jointly producing two outputs.
• General function form:
CQ1, Q2   f  aQ1Q2  bQ  cQ
2
1
2
2
Economies of Scope
• C(Q1, 0) + C(0, Q2) > C(Q1, Q2).
• It is cheaper to produce the two outputs jointly instead of separately.
• Example:
• It is cheaper for Time-Warner to produce Internet connections and Instant
Messaging services jointly than separately.
Cost Complementarity
• The marginal cost of producing good 1 declines as more of good two
is produced:
MC1Q1,Q2) /Q2 < 0.
• Example:
• Cow hides and steaks.
Quadratic Multi-Product Cost Function
• C(Q1, Q2) = f + aQ1Q2 + (Q1 )2 + (Q2 )2
• MC1(Q1, Q2) = aQ2 + 2Q1
• MC2(Q1, Q2) = aQ1 + 2Q2
• Cost complementarity: a < 0
• Economies of scope:
f > aQ1Q2
C(Q1 ,0) + C(0, Q2 ) = f + (Q1 )2 + f + (Q2)2
C(Q1, Q2) = f + aQ1Q2 + (Q1 )2 + (Q2 )2
f > aQ1Q2: Joint production is cheaper
A Numerical Example:
• C(Q1, Q2) = 90 - 2Q1Q2 + (Q1 )2 + (Q2 )2
• Cost Complementarity?
Yes, since a = -2 < 0
MC1(Q1, Q2) = -2Q2 + 2Q1
• Economies of Scope?
Yes, since 90 > -2Q1Q2
Conclusion
• To maximize profits (minimize costs) managers
must use inputs such that the value of marginal of
each input reflects price the firm must pay to
employ the input.
• The optimal mix of inputs is achieved when the
MRTSKL = (w/r).
• Cost functions are the foundation for helping to
determine profit-maximizing behavior in future
chapters.