Managerial Economics - unext.in 2012-2(VC)/M E/Session 2 Managerial... · •Managerial Economics...

Managerial Economics

Session II

Definition

• Managerial economics is the science of directing scarce resources to manage cost effectively. It consists of three branches: competitive markets, market power, and imperfect markets. A market consists of buyers and sellers that communicate with each other for voluntary exchange. Whether a market is local or global, the same managerial economics apply.

• A seller with market power will have freedom to choose suppliers, set prices, and use advertising to influence demand. A market is imperfect when one party directly conveys a benefit or cost to others, or when one party has better information than others.

• Typically, a model focuses on one issue, holding other things equal.

Application

• Managerial economics applies to:

• (a) Businesses (such as decisions in relation to customers including pricing and advertising; suppliers; competitors or the internal workings of the organization), nonprofit organizations, and households.

The Managerial Decision-Making Process

• Managerial Economics – applies economic theory and methods to business and administrative decision making.

• Specifically managerial economics

– prescribes rules for improving managerial decisions.

– indicates how one can achieve organizational objectives efficiently

– allows one to recognize how economic forces affect organizations

– describes the economic consequences of managerial behavior.


• Manager

– A person who directs resources to achieve a stated goal.

• Economics

– The science of making decisions in the presence of scare resources.

• Managerial Economics

– The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.

Douglas - “Managerial economics is .. the application of economic principles and methodologies to the decision-making process within the firm or organization.”

Pappas & Hirschey - “Managerial economics applies economic theory and methods to business and administrative decision-making.”

Salvatore - “Managerial economics refers to the application of economic theory and the tools of analysis of decision science to examine how an organisation can achieve its objectives most effectively.”

Howard Davies and Pun-Lee Lam -

“It is the application of economic analysis to business problems; it has its origin in theoretical microeconomics.”

1. Analysis based on the theory of the firm

2. Analysis based upon management sciences

3. Analysis based upon industrial economics

Related to, but not the same as management science and industrial economics.

These Definitions Cover a Number of Different Approaches

10

Why Managerial Economics?

• A powerful “analytical engine”.

• A broader perspective on the firm.

• what is a firm?

• what are the firm’s overall objectives?

• what pressures drive the firm towards profit and away from profit

• The basis for some of the more rigourous analysis of issues in Marketing and Strategic Management.

Management Decision Problems

Economic Concepts

Theory of the Consumer

Theory of the Firm

Theory of Market Structure

Decision Sciences

Numerical Analysis

Statistical Estimation

Forecasting

Optimization


Use of economic concepts and decision science methodology to solve managerial decision problems


• Managerial economics, meaning the application of economic methods in the managerial decision-making process, and it is a fundamental part of any business.

This is happening for several reasons

It is becoming more important for managers to make good decisions and to justify them, as their accountability either to management or to shareholders increases.

Number and size of multinationals increases, the costs and benefits at stake in the decision-making process are also increasing.

In the age of plentiful data it is more imperative to use quantitative and rationally based methods, rather than ‘intuition’.

The pace of technological development is increasing

with the impact of the ‘new economy’. There is an increased need for economic analysis because of the greater uncertainty and the need to evaluate it.

Improved technology has also made it possible to

develop more sophisticated methods of data analysis involving statistical techniques. Modern computers are adept at ‘number-crunching’, and this is a considerable aid to decision-making that was not available to most firms until recent years.

Relationship between Economics & Management

Economics theory Business Management

Decision Problems

Optimal Solutions to Business problems

Managerial Economics- Application of Economics

to solving business problems

Difference

Managerial Economics Economics

Involves application of economic

principles to problems of the firm.

Economics deals with the body of

the principles itself.

Scope is not wide Scope is wider

Micro in character Both micro and macro

Deals only with the firm and

not with individual’s

economic problem

Deals with both

Modifies models and

enlarges them

Simplifies models

More complex , introduces

certain feedbacks

Simple , makes

assumptions

What is Utility?

• Satisfaction, happiness, benefit

Util

• A unit of measure of utility

Total Utility

•The amount of satisfaction obtained by consuming specified amounts of a product per period of time.

Marginal Utility

•The change in total utility (TU) resulting from a one unit change in consumption (X).

•MU = TU/ X

Diminishing Marginal Utility

• Each additional unit of a product contributes less extra utility than the previous unit.

Introduction to Utility

• In economics, we are not try to explain why people get utility from certain goods. We take that as a given.

• Example:

• Some people like jazz, others hate it.

• Economists say given an individual’s preferences about jazz, how many jazz music CD’s might they purchase.

Utility

The concept of utility can be looked upon from two angles—from the commodity angle and from the consumer’s angle. Looked at it from a commodity angle, utility is the want-satisfying property of a commodity. Looked at it from a consumer’s angle, utility is the psychological feeling of satisfaction, pleasure, happiness or well-being which a consumer derives from the consumption, possession or the use of a commodity.

Total Utility

Assuming that utility is measurable and additive, total utility may be defined as the sum of the utilities derived by a consumer from the various units of goods and services he consumes. Suppose a consumer consumes four units of a commodity, X, at a time and derives utility as u1, u2, u3 and u4. His total utility (TUx) from commodity X can be measured as follows.

• TUx = u1 + u2 + u3 + u4

Marginal Utility

Marginal utility is another most important concept used in economic analysis. Marginal utility may be defined may be defined as the addition to the total utility resulting from the consumption (or accumulation) of one additional unit. Marginal Utility (MU) thus refers to the change in the Total Utility (i.e., ΔTU) obtainedobtained from the consumption

of an additional unit of a commodity. It may be expressed as MU = ^TU/^Q where TU = total utility, and ÄQ = change in quantity

consumed by one unit. Another way of expressing marginal utility (MU), when the

number of units consumed is n, can be as follows. MU of nth unit = TUn – TUn–1

Total and Marginal Utility

• Total Utility (TU) - relates consumption of a good to the utility derived from consuming a good. (This could be many units of a good)

• Marginal Utility (MU) - the change in total utility when consumption of a good changes by one unit.

• MU = TU / Q consumed of a good

Diminishing marginal utility

The law of diminishing marginal utility is one of the fundamental laws of economics. This law states that as the quantity consumed of a commodity increases, the utility derived from each successive unit decreases, consumption of all other commodities remaining the same. In simple words, when a person consumes more and more units

of a commodity per unit of time, e.g., ice cream, keeping the consumption of all other commodities constant, the utility which he derives from the successive units of consumption goes on diminishing. This law applies to all kinds of consumer goods— durable and non-durable sooner or later.

Law of Diminishing Marginal Utility

• Law of Diminishing Marginal Utility - eventually, a point is reached where the marginal utility obtained by consuming additional units of a good starts to decline, ceteris paribus.

Law of Diminishing Marginal Utility

• Example

• If I’m really hungry, I get a lot of satisfaction from first slice of pizza.

• If I keep eating pizza, the satisfaction from the 8th slice would be much less than that of the first slice.

Law of Diminishing MU

Notes about the Law of Diminishing MU

• Time period must be specified for law.

• Law tells us that eventually the marginal utility curve will be downward sloping.

• Law tells us that eventually the total utility curve will become “flatter.” • Slope of the total utility curve is equal to marginal

utility

Marginal Utility

MU

Q MU

Shape of MU

• Eventually downward sloping

• Law of diminishing marginal utility

• Positive always

• Rational behavior

• Consumer only purchases a good if they get some positive utility from it.

Assumptions

The law of diminishing marginal utility holds only under certain conditions. These conditions are referred to as the assumptions of the law. The assumptions of the law of diminishing marginal utility are listed below.

First, the unit of the consumer good must be a standard one, e.g., a cup of

tea, a bottle of cold drink, a pair of shoes or trousers, etc. If the units are excessively small or large, the law may not hold.

Second, the consumer’s taste or preference must remain the same during the period of consumption.

Third, there must be continuity in consumption. Where a break in continuity is necessary, the time interval between the consumption of two units must be appropriately short.

Fourth, the mental condition of the consumer must remain normal during the period of consumption.

Given these conditions, the law of diminishing marginal utility holds universally

Total Utility

TU

Q

TU

TU

Q

TU Q

Shape of TU

• Positive slope

• Consumer only purchases a good if gets some positive amount of utility (rational behavior)

• Slope gets flatter as Q increases • Law of diminishing marginal utility

Consumer Surplus

• Consumer Surplus - the difference between the price buyers pay for a good and the maximum amount they would have paid for the good.

• Example:

• I’m willing to pay $6 for a case of soda

• Soda is on sale for $5 a case

• Consumer surplus = $1

Consumer Surplus

S

D Q

P

0

$5

3 1 2

$9

$7

This is the Consumer

Surplus for the

second case of soda

Consumer Surplus

Here is the generally

accepted method of finding the

total Consumer Surplus in

a market

Consumer Surplus

S

D Q

P

0 Q*

P*

The area of this

triangle is the total

Consumer Surplus

The Theory of Consumer Behavior

The principle assumption upon which the theory of consumer behavior and demand is built is: a consumer attempts to allocate his/her limited money income among available goods and services so as to maximize his/her utility (satisfaction).

Theories of Consumer Choice

• The Cardinal Theory

– Utility is measurable in a cardinal sense

• The Ordinal Theory

– Utility is measurable in an ordinal sense

Cardinal Utility vs. Ordinal Utility

• Cardinal Utility: Assigning numerical values to the amount of satisfaction

• Ordinal Utility: Not assigning numerical values to the amount of satisfaction but indicating the order of preferences, that is, what is preferred to what

The Cardinal Approach

Nineteenth century economists, such as Jevons, Menger and Walras, assumed that utility was measurable in a cardinal sense, which means that the difference between two measurement is itself numerically significant.

UX = f (X), UY = f (Y), …..

Utility is maximized when:

MUX / MUY = PX / PY

The Ordinal Approach

Economists following the lead of Hicks, Slutsky and Pareto believe that utility is measurable in an ordinal sense--the utility derived from consuming a good, such as X, is a function of the quantities of X and Y consumed by a consumer.

U = f ( X, Y )

Assumptions of the Ordinal Utility Approach

• Complete Ordering;

• More is Preferred to Less;

• Transitivity or Consistency;

• Substitutability or Continuity; and

• Optimality

Tools of the Ordinal Approach

• The Budget Line – Budget line illustrates the consumer’s income

constraint by showing all of the combinations of quantities of X and Y that the consumer can buy.

• The Indifference Curves – Indifference curves reveal consumer’s

preferences for X and Y by identifying the combinations of X and Y which yield the same level of total utility.

Indifference Curve Analysis

Sophie’s Choice

• Sophie eats chocolate bars and drinks soda.

• She wants to maximize her utility given a budget constraint.

Graphing the Budget Constraint

• Chocolate bars cost $1 and sodas cost 50 cents each.

• Sophie has $10 to spend.

• She can buy 10 chocolate bars or 20 sodas or some combination of each.


• The slope of the budget constraint is the ratio of the prices of the two goods.

The slope changes when the prices

change.

Graphing the Indifference Curve

• Indifference curve – a curve that shows combinations of goods among which an individual is indifferent.

• The slope of the indifference curve is the ratio of marginal utilities of the two goods.


• The absolute value of the slope of an indifference curve is called the marginal rate of substitution.


• Marginal rate of substitution – the rate at which one good must be added when the other is taken away in order to keep the individual indifferent between the two combinations.


• Indifference curves are downward sloping and bowed inward.


• Law of diminishing marginal rate of substitution – as you get more and more of a good, if some of that good is taken away, then the marginal addition of another good you need to keep you on your indifference curve gets less and less.

A Group of Indifference Curves

• Sophie will have a whole group of indifference curves, each representing a different level of happiness.


• If she prefers more to less, she is better off with the indifference curve that is farthest to the right.

Why Indifference Curves Cannot Cross

• If indifference curves crossed, it would violate the “prefer-more-to-less” principle.

Indifference Curves and Budget Constraints

• Sophie will maximize her utility by consuming on the highest indifference curve as possible, given her budget constraint.


• The best combination is the point where the indifference curve and the budget line are tangent.


• The best combination is the point where the slope of the budget line equals the slope of the indifference curve.

S

S

C

C

C

S

C

S

P

MU

P

MU that so

MU

MU

P

P

Deriving a Demand Curve from the Indifference Curve

• Demand is the quantity of a good that a person will buy at various prices.


• The point of tangency of the indifference curve and the budget line gives the quantity that a person would buy at a given price.


• By varying the price of one of the goods while holding the price of other constant, the points of tangency will change.

This gives alternative price/quantity

combinations.

Characteristics of Indifference Curves

Indifference Curves are:

• Continuous and Everywhere Dense;

• Negatively Sloped;

• Convex from the Origin; and

• Indifference Curves Do Not Intersect.

Preference Theory

The main merit of the revealed preference theory is that the ‘law of demand’ can be directly derived from the revealed preference axioms without using indifference curves and most of the restrictive assumptions.

What is needed is simply to record the observed behaviour of the consumer in the market. The consumer reveals his behaviour by the basket of goods a consumer buys at different prices

Assumptions

1. Rationality. The consumer is assumed to be a rational being. In his order of

preferences, the prefers a larger basket of goods to the smaller ones.

2. Transitivity. Consumer’s preferences are assumed to be transitive. That is,

given alternative baskets of goods, A, B and C, if he considers A > B and B > C, then he considers A > C.

3. Consistency. It is also assumed that during the analysis consumer’s taste

remains constant and consistent. Consistency implies that if a consumer, given his circumstances, prefers A to B he will not prefer B to A under the same conditions.

4. Effective Price Inducement. Given the collection of goods, the consumer can

be induced to buy a particular collection by providing him sufficient price

incentives. That is, for each collection, there exists a price line which makes it

attractive for the consumer.

The Elasticity of Demand

The Concept of Elasticity

• Elasticity is a measure of the responsiveness of one variable to another.

• The greater the elasticity, the greater the responsiveness.

Price Elasticity

• The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.

price in change Percentage

demanded quantity in change Percentage=ED

Sign of Price Elasticity

• According to the law of demand, whenever the price rises, the quantity demanded falls. Thus the price elasticity of demand is always negative.

• Because it is always negative, economists usually state the value without the sign.

What Information Price Elasticity Provides

• Price elasticity of demand and supply gives the exact quantity response to a change in price.

Classifying Demand and Supply as Elastic or Inelastic

• Demand is elastic if the percentage change in quantity is greater than the percentage change in price.

E > 1

Classifying Demand and Supply as Elastic or Inelastic

• Demand is inelastic if the percentage change in quantity is less than the percentage change in price.

E < 1

Elastic Demand

• Elastic Demand means that quantity changes by a greater percentage than the percentage change in price.

Inelastic Demand

• Inelastic Demand means that quantity doesn't change much with a change in price.

Defining elasticities

• When price elasticity is between zero and -1 we say demand is inelastic.

• When price elasticity is between -1 and - infinity, we say demand is elastic.

• When price elasticity is -1, we say demand is unit elastic.

Elasticity Is Independent of Units

• Percentages allow us to have a measure of responsiveness that is independent of units.

• This makes comparisons of responsiveness of different goods easier.

Calculating Elasticities

• To determine elasticity divide the percentage change in quantity by the percentage change in price.

The End-Point Problem

• The end-point problem – the percentage change differs depending on whether you view the change as a rise or a decline in price.

Price Elasticity: Supply

• Price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in

• This tells us exactly how quantity supplied responds to a change in price

ES =

• Elasticity is independent of units

% change in Quantity Supplied % change in Price

Price Elasticity: Supply

• Supply is elastic if the percentage change in quantity is greater than the percentage change in price

Elastic supply is when ES > 1 • Supply is inelastic if the percentage change in quantity is less

than the percentage change in price

Inelastic supply is when ES < 1

Calculating Elasticity

)PP(

PP

)QQ(

QQ

P%

Q% E

2121

12

2121

12

Perfectly inelastic demand curve

0 Quantity

Perfectly Inelastic Demand Curve

Perfectly elastic demand curve

Perfectly Elastic Demand Curve

0 Quantity

Demand Curve Shapes and Elasticity

• Perfectly Elastic Demand Curve – The demand curve is horizontal, any change in price can and

will cause consumers to change their consumption.

• Perfectly Inelastic Demand Curve – The demand curve is vertical, the quantity demanded is totally

unresponsive to the price. Changes in price have no effect on consumer demand.

• In between the two extreme shapes of demand curves are the demand curves for most products.

Demand Curve Shapes and Elasticity

Elasticity Along a Demand Curve P

rice

$10 9 8 7 6 5 4 3 2 1

0 1 2 3 4 5 6 7 8 9 10 Quantity

Elasticity declines along demand curve as we move toward the

quantity axis

Ed = 1

Ed = 0

Ed < 1

Ed > 1

Ed = ∞

The Price Elasticity of Demand Along a Straight-line Demand Curve

Substitution and Elasticity

• As a general rule, the more substitutes a good has, the more elastic is its supply and demand.

Substitution and Demand

• The less a good is a necessity, the more elastic its demand curve.

• Necessities tend to have fewer substitutes than do luxuries.


• Demand for goods that represent a large proportion of one's budget are more elastic than demand for goods that represent a small proportion of one's budget.


• Goods that cost very little relative to your total expenditures are not worth spending a lot of time figuring out if there is a good substitute.

• It is worth spending a lot of time looking for substitutes for goods that take a large portion of one’s income.


• The larger the time interval considered, or the longer the run, the more elastic is the good’s demand curve.

– There are more substitutes in the long run than in the short run.

– The long run provides more options for change.

Determinants of the Price Elasticity of Demand

• The degree to which the price elasticity of demand is inelastic or elastic depends on: – How many substitutes there are

– How well a substitute can replace the good or service under consideration

– The importance of the product in the consumer’s total budget

– The time period under consideration

Price Change: Income and Substitution Effects

THE IMPACT OF A PRICE CHANGE

• Economists often separate the impact of a price change into two components:

– the substitution effect; and

– the income effect.


• The substitution effect involves the substitution of good x1 for good x2 or vice-versa due to a change in relative prices of the two goods.

• The income effect results from an increase or decrease in the consumer’s real income or purchasing power as a result of the price change.

• The sum of these two effects is called the price effect.


• The decomposition of the price effect into the income and substitution effect can be done in several ways

• There are two main methods:

(i) The Hicksian method; and

(ii) The Slutsky method

THE HICKSIAN METHOD • Sir John R.Hicks (1904-1989)

• Awarded the Nobel Laureate in Economics (with Kenneth J. Arrrow) in 1972 for work on general equilibrium theory and welfare economics.

THE HICKSIAN METHOD

X2

X1

Ea

I1

xa

Optimal bundle is Ea, on indifference curve I1.

THE HICKSIAN METHOD

X2

X1

I1

xa

Ea

A fall in the price of X1

The budget line pivots out from P

P*

THE HICKSIAN METHOD

X2

X1

Eb

I1

I2

xa xb

Ea

The new optimum is Eb on I2.

The Total Price Effect is xa to xb

THE HICKSIAN METHOD

• To isolate the substitution effect we ask….

“what would the consumer’s optimal bundle be if s/he faced the new lower price for X1 but experienced no change in real income?”

• This amounts to returning the consumer to the original indifference curve (I1)

THE HICKSIAN METHOD

X2

X1

Eb

I1

I2

xa xb

Ea



THE HICKSIAN METHOD

X2

X1

I1

I2

xa xb

Ea

Eb

Draw a line parallel to the new budget line and tangent to the old indifference curve

THE HICKSIAN METHOD

X2

X1

Ec I1

I2

xa xc xb

Ea

Eb

The new optimum on I1 is at Ec. The movement from Ea to Ec (the increase in quantity

demanded from Xa to Xc) is solely in response to a change in relative prices

THE HICKSIAN METHOD

X2

X1

I1

I2

Substitution Effect

Ea

Eb

Ec

This is the substitution effect.

Xa Xc

THE HICKSIAN METHOD

• To isolate the income effect …

• Look at the remainder of the total price effect

• This is due to a change in real income.

THE HICKSIAN METHOD

X2

X1

I1

I2

Income Effect

Ea

Eb

Ec

The remainder of the total effect is due to a change in real income. The increase in real

income is evidenced by the movement from I1 to I2

Xc Xb

THE HICKSIAN METHOD

X2

X1

I1

I2

xa xc xb

Sub Effect IncomeEffect

Ea

Eb

Ec

THE SLUTSKY METHOD

• Eugene Slutsky (1880-1948)

• Russian economist expelled from the University of Kiev for participating in student revolts.

• In his 1915 paper, “On the theory of the Budget of the Consumer” he introduced “Slutsky Decomposition”.

THE SLUTSKY METHOD

X2

X1

Ea

I1

xa

Optimal bundle is Ea, on indifference curve I1.

THE SLUTSKY METHOD

X2

X1

I1

xa

Ea

A fall in the price of X1

The budget line pivots out from P

P*

THE SLUTSKY METHOD

X2

X1

Eb

I1

I2

xa xb

Ea



THE SLUTSKY METHOD • Slutsky claimed that if, at the new prices,

– less income is needed to buy the original bundle then “real income” has increased

– more income is needed to buy the original bundle then “real income” has decreased

• Slutsky isolated the change in demand due only to the change in relative prices by asking “What is the change in demand when the consumer’s income is adjusted so that, at the new prices, s/he can just afford to buy the original bundle?”

THE SLUTSKY METHOD

• To isolate the substitution effect we adjust the consumer’s money income so that s/he change can just afford the original consumption bundle.

• In other words we are holding purchasing power constant.

THE SLUTSKY METHOD

X2

X1

Eb

I1

I2

xa xb

Ea



THE SLUTSKY METHOD

X2

X1

Eb

I1

I2

xa xb

Ea

Draw a line parallel to the new budget line which passes through

the point Ea.

THE SLUTSKY METHOD

X2

X1

Eb

I3

I2

xa xb

Ea

The new optimum on I3 is at Ec. The movement from Ea to Ec is the

substitution effect

Ec

xc

THE SLUTSKY METHOD

X2

X1

Eb

I3

I2

xa

Ea

The new optimum on I3 is at Ec. The movement from Ea to Ec is the

substitution effect

Ec

xc

Substitution Effect

THE SLUTSKY METHOD

X2

X1

Eb

I3

I2 Ea

The remainder of the total price effect is the Income Effect.

The movement from Ec to Eb.

Ec

xc

Income Effect

xb

THE SLUTSKY METHOD for NORMAL GOODS

• Most goods are normal (i.e. demand increases with income).

• The substitution and income effects reinforce each other when a normal good’s own price changes.


X2

X1

Eb

I3

I2 Ea

The income and substitution effects reinforce each other.

Ec

xc xb xa

• Since both the substitution and income effects increase demand when own-price falls, a normal good’s ordinary demand curve slopes downwards.

• The “Law” of Downward-Sloping Demand therefore always applies to normal goods.


GIFFEN GOODS

• In rare cases of extreme inferiority, the income effect may be larger in size than the substitution effect, causing quantity demanded to rise as own price falls.

• Such goods are Giffen goods.

• Giffen goods are very inferior goods.

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