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Managerial Economics
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The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.
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Basic principles of effective management
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1. identify goals and constraints
2. recognize the nature and importance of profits
3. understand incentives
4. understand markets
5. recognize the time value of money
6. use marginal analysis
2. recognize the nature and importance of profits
3. understand incentives
4. understand markets
5. recognize the time value of money
6. use marginal analysis
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Recognizing the nature and importance of profits
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- The nature of profits: economic profits, not accounting profits.
- To calculate accounting profits, we minus dollar cost of producing goods or services from total revenue.
- To calculate economic profits, we minus total opportunity cost from total revenue.
- The difference between those two concepts comes from the implicit cost.
- To calculate accounting profits, we minus dollar cost of producing goods or services from total revenue.
- To calculate economic profits, we minus total opportunity cost from total revenue.
- The difference between those two concepts comes from the implicit cost.
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The importance of profits
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- Profits are signals of resource allocation.
If an industry has a negative profit, resources will move out of the industry.
If an industry has a positive profit, resources will move in the industry.
If an industry has a negative profit, resources will move out of the industry.
If an industry has a positive profit, resources will move in the industry.
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Recognize the time value of money
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- Present value for an amount received in the future
- Present value for a series of future payments
- Present value of indefinitely-lived assets
- Present value for a series of future payments
- Present value of indefinitely-lived assets
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Present Value (PV) for an amount received in the future
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The amount that would have to be invested today at the prevailing interest rate to generate the given future value.
PV = (FV) / (1+i)^n
FV: Future Value
i: interest rate
n: number of periods
PV = (FV) / (1+i)^n
FV: Future Value
i: interest rate
n: number of periods
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Present Value for a series of future payments
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Present value of a stream of future amounts (FVt) received at the end of each period for "n" periods:
PV = (FV1) / (1+i)^1 + (FV2) / (1+i)^2 ...
PV = (FV1) / (1+i)^1 + (FV2) / (1+i)^2 ...
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Net Present Value
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Suppose that by spending C, dollars into a project today, a firm will generate FV, one year in the future, FV, two years in the future, and so on for n years.
NPV = (FV1) / (1+i)^1 + (FV2) / (1+i)^2 ... - C0
NPV < 0: Reject
NPV > 0: Accept
NPV = (FV1) / (1+i)^1 + (FV2) / (1+i)^2 ... - C0
NPV < 0: Reject
NPV > 0: Accept
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Present Value of indefinitely-lived assets
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PV = (CF) / (1+i) + (CF) / (1+i)^2 + (CF) / (1+i)^3 ... = (CF) / i
CF: Cash Flow
CF: Cash Flow
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Firm Valuation
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The value of a firm equals the present value of current and future profits.
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Use marginal analysis
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A manager to compare the marginal benefits with the marginal costs of a decision.
When we talk about marginal value, we are talking about the marginal value of a control variable.
When we talk about marginal value, we are talking about the marginal value of a control variable.
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Control variable
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A variable that is within the manager's control. It's the variable that a manager makes choice on.
Ex. Price: how much to charge
Quantity of production: how much to produce
Advertising spending: how much to spend on advertising
Ex. Price: how much to charge
Quantity of production: how much to produce
Advertising spending: how much to spend on advertising
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Type of Control Variable: Discrete Case
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The manager can only use integer values of control variable, not fractional units.
Ex. A manager can choose to produce 3 cars, but not 3.5 cars.
Ex. A manager can choose to produce 3 cars, but not 3.5 cars.
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Type of Control Variable: Continuous Case
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The control variable is infinitely divisible.
Ex. A manager can choose to produce 1 gallon of water, or 0.2 gallons, or 0.0013 gallons
Ex. A manager can choose to produce 1 gallon of water, or 0.2 gallons, or 0.0013 gallons
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Type of Control Variable: Incremental Case
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"Yes-or-No" decision.
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Marginal Benefit (MB)
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the change in total benefits arising from a change in the control variable
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Marginal Cost (MC)
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the change in total costs arising from a change in the control variable
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Marginal Net Benefit (MNB)
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the change in net benefits that arise from a one-unit change in control variable Q.
MNB = MB(Q) - MC(Q)
MNB = MB(Q) - MC(Q)
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Marginal Principle
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To maximize net benefits, the managerial control variable should be increased up to the point where MC = MC.
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The higher the interest rate:
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The smaller the present value of a future amount.
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If the interest rate is 10% and cash flows are $1,000 at the end of year one and $2,000 at the end of year two, then the present value of these cash flows is:
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$2,562
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If the interest rate is 5%, what is the present value of ten dollars received one year from now?
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$9.52
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The difference between marginal benefits and marginal costs are the:
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Marginal net benefits
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Given the cost function C(Y) = 3+6Y2, what is the marginal cost?
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12Y
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Law of Demand
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Price and quantity demanded are inversely related.
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Change in Quantity Demanded
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Caused by changes in the price of a good. This corresponds to a movement along a given market demand curve.
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Change in Demand
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Caused by changes in variables other than the price of a good. This corresponds to a shift of the entire demand curve.
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Demand Shifters
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Variables other than the price of a good that influence demand.
- Income
- Prices of related goods
- Advertising and consumer taste
- Population
- Consumer expectations
- Income
- Prices of related goods
- Advertising and consumer taste
- Population
- Consumer expectations
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Income
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Normal good: a good for which an increase in income leads to an increase in the demand for that good. Ex. housing
Inferior good: a good for which an increase in income leads to a decrease in the demand for that good. Ex. lottery
Inferior good: a good for which an increase in income leads to a decrease in the demand for that good. Ex. lottery
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Prices of Related Goods
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Substitutes: goods for which an increase in the price of one good leads to an increase in the demand for the other good. Ex. Pepsi and Coca-Cola
Complements: goods for which an increase in the price of one good leads to a decrease in the demand for the other good. Ex. left shoe and right shoe
Complements: goods for which an increase in the price of one good leads to a decrease in the demand for the other good. Ex. left shoe and right shoe
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Population
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Size: the larger the size of population, the higher the demand
Composition.
Ex. As the percentage of old people in the US population increase, the demand for health care will increase.
Composition.
Ex. As the percentage of old people in the US population increase, the demand for health care will increase.
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Demand Function
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A function that describes how much of a good will be purchased at alternative prices of that good and related goods, alternative income levels, and alternative values of other variables affecting demand.
Or quantity demanded is a function of other variables.
Or quantity demanded is a function of other variables.
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Demand Function
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Qxd = quantity demand of good X.
Px = price of good X.
PY = price of good Y.
M = income.
H = any other variable affecting demand.
Px = price of good X.
PY = price of good Y.
M = income.
H = any other variable affecting demand.
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Inverse Demand Function
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In an inverse demand function, price is a function of other variables, or price is on the left-hand side and everything else on the right-hand side.
Px = 2020 - (1/3)Q d:x
Px = 2020 - (1/3)Q d:x
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Consumer Surplus
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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 product.
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Law of Supply
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As the price of a good rises and other things remain constant, the quantity supplied of the good rises.
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Change in Quantity Supplied
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caused by changes in the price of a good. this corresponds to a movement along a given supply curve.
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Change in Supply
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caused by changes in variables other than the price of a good. this corresponds to a shift of the entire supply curve.
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Supply Shifters
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Variables that affect the position of the supply curve.
- Input prices
- Technology or government regulations
- Number of firms
- Substitute in production
- Taxes
- Producer expectations
- Input prices
- Technology or government regulations
- Number of firms
- Substitute in production
- Taxes
- Producer expectations
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Input Prices
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As the price of an input rises, supply decreases.
As the price of an input falls, supply increases.
As the price of an input falls, supply increases.
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Technology and Government Regulations
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Changes that make producing a given output at a lower cost will increase supply.
Changes that make producing a given output at a higher cost will decrease supply.
Changes that make producing a given output at a higher cost will decrease supply.
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Substitute in Production
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Suppose product x and y use the same production technologies and input. If the price of y increases, the supply of x will decrease.
An example: When the price of cars rises, General Motors can convert a truck assembly plant into a car assembly plant.
An example: When the price of cars rises, General Motors can convert a truck assembly plant into a car assembly plant.
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Taxes
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An increase in taxes decreases supply.
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Producer Expectations
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Two effects working on opposite directions:
If firms expect prices to be higher in the future and the product is durable, producers can hold back output and supply today will decrease.
If prices are expected to be higher in the future, additional firms may enter the industry.
If firms expect prices to be higher in the future and the product is durable, producers can hold back output and supply today will decrease.
If prices are expected to be higher in the future, additional firms may enter the industry.
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Supply Function
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A function that describes how much of a good will be supplied at alternative prices of that good, alternative input prices, and alternative values of other variables affecting supply.
Or quantity supplied is a function of other variables.
Or quantity supplied is a function of other variables.
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The Supply Function
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QxS = f(Px , PR ,W, H)
QxS = quantity supplied of good X.
Px = price of good X.
PR = price of a related good.
W = price of inputs (e.g., wages).
H = other variable affecting supply.
QxS = quantity supplied of good X.
Px = price of good X.
PR = price of a related good.
W = price of inputs (e.g., wages).
H = other variable affecting supply.
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Inverse Supply Function
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In a supply function, quantity supplied is a function of other variables, or quantity supplied is on the left-hand side and everything else on the right-hand side.
Ex: Q s:x = 3Px - 400
In an inverse supply function, price is a function of other variables, or price is on the left-hand side and everything else on the right-hand side.
Ex: Px = (400/3) + (1/3) Q s:x
Ex: Q s:x = 3Px - 400
In an inverse supply function, price is a function of other variables, or price is on the left-hand side and everything else on the right-hand side.
Ex: Px = (400/3) + (1/3) Q s:x
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Producer Surplus
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The amount producers receive in excess of the amount necessary to induce them to produce the good.
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Market Equilibrium
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Supply = Demand
Q s:x = Q d:x
Graphically, it's the intersection of market supply and demand for the good.
Q s:x = Q d:x
Graphically, it's the intersection of market supply and demand for the good.
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Price Ceiling
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The maximum legal price that can be charged in a market.
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Price Floor
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The minimum legal price that can be charged in a market.
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Full Economic Price
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The dollar amount paid by a consumer under a price ceiling, plus the non pecuniary price.
pF = pC + (pF - pC)
pF = full economic price
pC = price ceiling
pF - pC = non pecuniary price
pF = pC + (pF - pC)
pF = full economic price
pC = price ceiling
pF - pC = non pecuniary price
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Comparative Statistics
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The study of the movement from one equilibrium to another.
Comparative: comparing one equilibrium with another.
Static: not dynamic, as we assume other things do not change. Otherwise, we'll not be able to compare different equilibria in a meaningful way.
Comparative: comparing one equilibrium with another.
Static: not dynamic, as we assume other things do not change. Otherwise, we'll not be able to compare different equilibria in a meaningful way.
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Changes in Demand
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Increase in demand will increase equilibrium price and quantity.
Decrease in demand will decrease equilibrium price and quantity.
Decrease in demand will decrease equilibrium price and quantity.
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Changes in Supply
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Increase in supply will decrease equilibrium price and increase quantity.
Decrease in supply will increase equilibrium price and decrease quantity.
Decrease in supply will increase equilibrium price and decrease quantity.
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Simultaneous Change in Supply and Demand
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A. supply increases, demand increases.
B. supply decreases, demand increases.
C. supply increases, demand decreases.
D. supply decreases, demand decreases.
B. supply decreases, demand increases.
C. supply increases, demand decreases.
D. supply decreases, demand decreases.
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In a competitive market, the market demand is Qd = 60 - 6P and the market supply is Qs = 4P. A price ceiling of $3 will result in a
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Shortage of 30 units
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In a competitive market, the market demand is Qd = 60 - 6P and the market supply is Qs = 4P. The full economic price under a price ceiling of $3 is
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8
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If A and B are complements, an increase in the price of good A would:
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Lead to a decrease in demand for B
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Suppose the demand for good X is given by QdX= 100 + aXPX + aYPY + aM M. From the law of demand we know that aX will be:
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Less than zero
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Suppose the demand for good X is given by QdX= 100 + aXPX + aYPY + aMM. If aM is negative, then good y is:
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An inferior good
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Suppose both supply and demand decrease. What effect will this have on price?
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It may rise or fall
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Suppose the demand for X is given by QXd = 100 - 2PX + 4PY + 10M + 2A, where PX represents the price of good X, PY is the price of good Y, M is income and A is the amount of advertising on good X. If advertising on good X increases by $10,000, then the demand for X will
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Increase by $20,000
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