Economic TheoryMBA(IB), 2021-23

Microeconomics

Lecture 1

Papiya Ghosh

Introduction

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▪ Traditional economic theory broadly consists of:✓Microeconomics: deals with the behaviour of individual economic units like consumers,

workers, investors, business firms or any entity that plays a role in the functioning of an economy.

✓Macroeconomics: deals with aggregate economic quantities such as the level and growth rate of national output, interest rates, unemployment and inflation.

▪ Business economics draws heavily from microeconomics.

▪ It is an application of economic theory and its tools of analysis to management decision making- establish rules and techniques to arrive at certain kinds of outcomes or fulfil specified goals.

▪ It examines how an organization can achieve its aims and objectives most efficiently.

▪ To do that the general macroeconomic conditions of the economy within which the firms operates are also very important for any organizational decision.

Introduction

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▪ The key idea in Economics is that Goods are scarce, and that society must use its

resources efficiently.

▪ The three fundamental economic problems are:

What goods and services should be produced?

How should these goods and services be produced?

Who should get the goods and services that have been produced?

▪ These questions can be addressed by understanding the basic principles of

economics.

Introduction

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▪ An instance where Economics might be helpful for managers-It can answer questions like how many computers should computer manufacturers like IBM or Dell manufacture, how many staffs should they hire, how should they price their products etc.

▪ Business economics therefore offers powerful tools and approaches to facilitate decision making by the managers.

▪ (As you will soon see!) The concepts useful for managers are costs, demand, profit, competition, pricing strategy, market entry strategy and so on.

▪ Business economics uses formal models to understand these concepts and analyse their effect on firm performance.

▪ In doing so, it will enable the (prospective!) managers to better identify the consequences of alternative courses of action.

▪ In nutshell, this course will show you how to apply the economic principles to actual decision- making problems as managers.

Illustration 1: The Disney Corporation: Expansion of the Magic Kingdom

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▪ The Walt Disney Company is one of the world’s leading producers and providers of entertainment and information known for its superior quality creative content.

▪ Founded in 1923, the company went adrift for decades in 1966 after the death of one of its founder, Walt Disney.

▪ Even though the company retained the high brand recognition, its managers seemed unable to turn this recognition into increased sales and profits.

▪ It reached a stage in the early 80s when the company was at the verge of being taken over.

▪ Then was hired Michael Eisner as the new CEO who was successful in unlocking the value of the Disney brand and positioned the Magic Kingdom for the twenty-first century.

▪ In less than twenty years, Eisner’s team has increased revenues tenfold to over $23 billion in 1999. Disney, in 2001- 02, ranked as one of the 100 biggest global firms and the second largest global media company (behind Time-Warner).

HOW COULD HE DO IT?

▪ In expanding their Magic Kingdom, Eisner’s team has used analyses that are based on managerial economics !

What did he do?

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▪ Apart from investing in a series of successful advertising campaigns, Eisner’s team has

also shown its ability to use both simple and sophisticated pricing techniques to

improve firm performance.

➢When the Disney animated classic film Pinocchio was released on videocassette, it was

initially priced at $79.95 (as were most videocassettes). At this price only 1,00,000 copies

were sold in the first two months. As a simple price technique, Eisner’s team decided to

drop the price to $29.95, and promptly sold over 3,00,000 copies

➢Under Eisner’s leadership Disney also became a leader in using sophisticated pricing

strategies such as bundling. They have bundled together a Disney cruise with a stay at their

Disneyland theme park in Florida, a McDonald kid’s meal and several other such packaging.

They also practice price discrimination. Consumers who buy a Disney videocassette will

find coupons for merchandise at Disney retail stores.

▪ Such strategies of Eisner enabled Disney to give to its shareholders 20 % annual

earnings growth for 14 consecutive years and an annualized return on equity of 18.5%.

Illustration 2: Corporate Decision making: Ford’s SUV

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▪ In the 90s till early 2000s Ford Motors specialized in the manufacturing of SUVs

▪ In the period 2005- 2007, higher oil prices and increased environmental

awareness led to a dip in SUV sales and Ford’s profits turned into losses.

▪ In response Ford worked on developing new and smaller cars and also modified

its SUV models, making them lighter and more fuel efficient.

▪ The design and efficient production of the Ford’s SUV involved not only some

impressive engineering, but a lot of economics as well.

▪ Two things to consider: Revenue and cost

Ford’s SUV

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Firstly, Ford had to think carefully about how the public would react to the design and performance of this new product. How strong would demand be initially, and how fast would it grow? How would demand depend on the prices that Ford charges? Understanding consumer preferences and trade-offs and predicting demand and its responsiveness to price are essential to Ford and every other automobile manufacturer.

Secondly, Ford had to be concerned with the cost of manufacturing these cars. How high would production costs be? How would the cost of each car depend on the total number of cars produced each year? How would the cost of labourand the prices of steel and other raw materials affect costs? How much and how fast would costs decline as managers and workers gained experience with the production process? And to maximize profit, how many of these cars should Ford plan to produce each year?

Ford’s SUV

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Thirdly, Ford also had to design a pricing strategy and consider how competitors would react to it. Should Ford charge a relatively low price for a basic stripped-down version of the Explorer and high prices for individual options like leather seats? Or would it be more profitable to make these options “standard” items and charge a higher price for the whole package? Whatever pricing strategy Ford chose, how were competitors likely to react? Would Toyota or Nissan try to undercut by lowering the prices of its small cars, or rush to bring out their own hybrid cars at lower prices? Might Ford be able to deter Toyota and Nissan from lowering prices by threatening to respond with its own price cuts?

Finally, Ford had to consider both the risks (due to uncertainties over future price of petrol or wages it would have to pay its workers) and possible outcomes of its decisions.

Decision-making: Four Principles of Economics

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▪ A manager of a firm faces many decision problems.

➢One major task- resource allocation- because resources are scarce the management of

resources is important.

▪ The two fundamental decisions in business are “participation (which)” and “extent

(how much)”

▪ Economics tells us how to make wise decisions in face of scarcity. Following are the

four guiding principles of individual decision-making:

Principles

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Principle 1: People face trade-offs

▪ To get one thing that we like, we usually have to give up another thing that we like.

Making decisions requires trading off one goal against another.

Principle 2: The cost of something is what you give up

▪ Because of tradeoffs that people face, making decisions requires comparing the costs and

benefits of alternative courses of action.

▪ What should be counted as costs?

o Opportunity costs- The opportunity cost of an item is what you give up to get that item.

o There can be many items that one gives up to get a particular item! Do we consider all such

items? The answer is: The value of the next best opportunity that one has foregone is the one to

be considered for calculating the opportunity cost.

Explicit vs. Implicit Costs: An Example

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You need $100,000 to start your business.

The interest rate on both borrowing and lending is 5%.

Case 1: borrow $100,000

explicit cost = $5000 interest on loan

Case 2: use $40,000 of your savings, borrow the other $60,000

explicit cost = $3000 (5%) interest on the loan

implicit cost = $2000 (5%) foregone interest you could have earned on your $40,000.

In both cases, total (exp + imp) costs are $5000.

Quick Thinking

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Why do you think most sportspersons do not have a college or a professional

degree?

Principles(contd)

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Principle 3: Rational people think at the margin

▪ Such individuals make the best decisions by thinking at the margin, that is, the

impact of marginal or incremental changes to existing plan of action is what is

important and not anything else.

▪ Rational individuals often make decisions by comparing marginal benefits and

marginal costs - takes an action if and only if the marginal benefit of the action

exceeds the marginal cost.

Principle 4: People respond to incentives

▪ People’s behaviour may change when the incentives in terms of costs or benefits

change.

▪ Price acts as an incentive for both consumers and firms but quite differently!

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Quick thinking: How flexible should the flexi-fare system in the premium trains of

the Indian railways be?

Suppose the average cost of a seat in a Shatabdi Express is 2000/-. Suppose two

hours before departure not all seats are filled up and the Indian railways is offering

a ticket for 2400/-. Now here is a passenger who is willing to pay 1900/- for

reserving a seat. Should the Indian railways sell him a ticket at that price or let the

seat go empty?

The Theory of firm

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▪ The principal field of application of Business economics is firms.

▪ Hence it is based primarily on the theory of firm.

▪ Primary assumption about firms is that they are optimizers.

What do they optimize?

▪ At the very basic level, every firm tries to maximize profits.

▪ But not always!

▪ sales maximization or satisficing behaviour.

▪ maximization of management utility. (Principal- Agent Problem)

How Disney dealt with the Principal- Agent Problem

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When Walt Disney Company brought in Michael Eisner as CEO, the firm’s Board of Directors agreed to pay him a salary of $750000 plus a $750000 bonus for signing on, plus

an annual bonus equal to 2% of the dollar amount by which the firm’s net income exceeded a 9 per cent return on shareholders’ equity.

In addition he received options on 2 million shares of Disney stock, which meant he could purchase them from the firm at any time during the five-year life of the contract for only $14 per share.

These are incentives provided to Eisner to work hard to increase the firm’s profits.

Did it work?

A shareholder who invested $100 in Disney stock at the beginning of Eisner’s tenure would have seen its value rise to $1460 in 1994!

Profit

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▪ We would retain profit maximization as the basis for analyzing managerial

decisions.

▪ Note : Profits do not necessarily mean short-term profits ---- short-term profits

are often sacrificed for the sake of increasing long-term profits. It is the stream of

profits that matters! So both short-term and long-term profits are important.

▪ A richer version of the theory assumes that the firm tries to maximize its wealth or

value (to account for the dynamic elements of production).

▪ A firm’s value can be defined as the present value (PV) of its expected future

profits where, in any given period, Profit (π)= Total revenue (TR) –Total cost

(TC).

Value of a firm

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Constraints in optimizing

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▪ From the above expression it should be clear that a firm’s value can be influenced in three ways:

▪ By increasing revenue- marketing managers and sales personnel have a role to play here.

▪ By decreasing cost- production managers and manufacturing engineers and human resource managers play an important role here.

▪ By decreasing interest rate- financial managers have a role here

▪ But the managers on their part also operate under constraints. Constraints can be in the form of:

▪ Availability of inputs (particularly in the short run)

▪ Regulatory restrictions

▪ Various contracts and legal agreements

▪ Thus, the managers are in principle faced with constrained optimization problem.