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Managerial Economics
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The application of economic theory and the tools of decision science to examine how an organization can achieve its aims or objectives most efficiently.
- Business context, not just tools
- Business context, not just tools
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The form of economics most relevant to managerial decision making within the firm is
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Microeconomics
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Managerial Economics enables managers to
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- Select direction
- allocate efficiently the resources available
- Respond effectively to tactical issues
- allocate efficiently the resources available
- Respond effectively to tactical issues
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Managerial Economic decision making seeks to
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1.Identify the alternatives,
2.Select the choice that accomplishes the objective(s) in the most efficient manner,
3.Taking into account the constraints,
4.And the likely actions and reactions of rival decision-makers.
2.Select the choice that accomplishes the objective(s) in the most efficient manner,
3.Taking into account the constraints,
4.And the likely actions and reactions of rival decision-makers.
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What is crucial to improve performance?
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Management
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Managers in a capitalist economy are motivated to
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Monitor teamwork because of their overarching goal to maximize returns to owners of the business:
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Shareholder Wealth
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- Measured by the market value of the a firm's common stock,
- Which is equal to the present value of all expected future cash flows to equity owners discounted at the shareholder's required rate of return, plus a value for the firm's embedded real options
- Which is equal to the present value of all expected future cash flows to equity owners discounted at the shareholder's required rate of return, plus a value for the firm's embedded real options
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In the shareholder wealth calculation, the value of a firm's stock is equal to the present value of all expected future __________, discounted by the shareholder's __________.
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profits; required rate of return
This question refers to the definition of shareholder wealth. The fact that shareholder wealth takes into account future profits (rather than just current profit) and risk (through the required rate of return) makes it a more "comprehensive" objective for the firm.
This question refers to the definition of shareholder wealth. The fact that shareholder wealth takes into account future profits (rather than just current profit) and risk (through the required rate of return) makes it a more "comprehensive" objective for the firm.
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Theories of Profit
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1. Risk-Bearing Theories of Profit: Investors need to be compensated for high risk firm in form of higher rate of return ex. petroleum vs water utilities
2. Friction Theory of Profit: Firms may earn above or below long-run normal return level due to shock in various sectors of the economy LR vs SR, disequilibrium
3. Monopoly Theory of Profit: One firm is able to dominate the market and earn above-normal rates of return (economies of scale - large firm can produce additional units at lower costs than smaller firms) Market power
4. Innovation Theory of Profit: Above-normal profits are the reward for successful innovation
5. Managerial Efficiency Theory of Profit: Above-normal profits can arise because of the exceptional managerial skills of well-managed firms Reflection of lower costs
2. Friction Theory of Profit: Firms may earn above or below long-run normal return level due to shock in various sectors of the economy LR vs SR, disequilibrium
3. Monopoly Theory of Profit: One firm is able to dominate the market and earn above-normal rates of return (economies of scale - large firm can produce additional units at lower costs than smaller firms) Market power
4. Innovation Theory of Profit: Above-normal profits are the reward for successful innovation
5. Managerial Efficiency Theory of Profit: Above-normal profits can arise because of the exceptional managerial skills of well-managed firms Reflection of lower costs
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American Business Model
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- Maximizing value of the firm, subject to the constraints it faces
- Shareholder supremacy defined by Financial - Accounting Standards Board in NY
Involved tools and language
- Quarterly reports for transparency with stockholders; goals, strategy to achieve successes and failures
*Gives shareholders a good idea as to what the firm is doing, goals, and strategy
- Not perfect but only business model that has been shown to work
- Shareholder supremacy defined by Financial - Accounting Standards Board in NY
Involved tools and language
- Quarterly reports for transparency with stockholders; goals, strategy to achieve successes and failures
*Gives shareholders a good idea as to what the firm is doing, goals, and strategy
- Not perfect but only business model that has been shown to work
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What are some model to help improve firm performance?
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1. Business Model
2. Porter's Five Forces
3. Economics of the Firm
** NOT mutually exclusive
2. Porter's Five Forces
3. Economics of the Firm
** NOT mutually exclusive
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How do we Intend to Do Business and make a Profit?
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Business Model
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What are the Forces that should drive our Business Strategy?
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Porter's Five Forces
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What are the Technical "Nuts and Bolts" underpinnings of our Firm?
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Economics of the Firm
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Economic Profit
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Total Revenue - explicit costs - implicit costs (opportunity costs)
- Includes a "normal" rate of return on the capital contributions of the firm's partners
- Zero Economic profit = positive accounting profit
Π = TR - EC - IC
- Includes a "normal" rate of return on the capital contributions of the firm's partners
- Zero Economic profit = positive accounting profit
Π = TR - EC - IC
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Business or Accounting profit
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Total Revenue - explicit costs (in books)
Π = TR - EC
Π = TR - EC
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Opportunity Costs
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Implicit value of a resource in its best alternative use
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The rent a business owner forgoes by using his building for his current production process, rather than closing his business and renting out the building to someone else, is considered
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- An implicit cost of production
- The forgone rent is the cost of the next best alternative to using the building for this owner's business, making it an opportunity or implicit cost.
- The forgone rent is the cost of the next best alternative to using the building for this owner's business, making it an opportunity or implicit cost.
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Business Model
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- Describes the process through which a firm hopes to earn profits
*Not a strategy model - does not factor in competition
A good business model answers the following questions:
1. Who is the customer What does the customer value? 2. How do we make money in this business?
3. What is the underlying logic that explains
4. How we can deliver value to customers at an appropriate cost?
Focus on customer
*Not a strategy model - does not factor in competition
A good business model answers the following questions:
1. Who is the customer What does the customer value? 2. How do we make money in this business?
3. What is the underlying logic that explains
4. How we can deliver value to customers at an appropriate cost?
Focus on customer
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Business Model - Building Blocks
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1. Customer Segments (CS)
2. Value Propositions(s) (NP)
3. Channels (CH)
4. Customer Relationships (CR)
5. Revenue Stream (RS)
6. Key Resources (KR)
7. Key Activities (KA)
8. Key Partnerships(KP)
9. Cost Structure (CS)
2. Value Propositions(s) (NP)
3. Channels (CH)
4. Customer Relationships (CR)
5. Revenue Stream (RS)
6. Key Resources (KR)
7. Key Activities (KA)
8. Key Partnerships(KP)
9. Cost Structure (CS)
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Customer Segments (CS)
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The consumers for whom the company creates value
- an organization serves one or several CSs
**VALUE
- an organization serves one or several CSs
**VALUE
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Value Propositions (VP)
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Firm seeks to solve customer needs with ______(s) (quant or qualit)
________ solve customer problems and satisfy customer needs.
________ may be quantitative (e.g. price, speed of service) or qualitative (e.g. design, customer experience).
VALUE & EFFCIENCY **
________ solve customer problems and satisfy customer needs.
________ may be quantitative (e.g. price, speed of service) or qualitative (e.g. design, customer experience).
VALUE & EFFCIENCY **
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Whats the difference between Value and Efficiency in Business Model Canvas?
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- Value: customers, demand, price, and revenue
- Efficiency: production, costs, inputs
- Efficiency: production, costs, inputs
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Why is Value Proposition under Value and Efficiency?
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- It can be considered both qualitative and quantitative
- Qualitative: side could describe service of customers which would fall upon the value segment
- Quantitative: side could be described as low cost or production that would fall upon the efficiency segment
- Qualitative: side could describe service of customers which would fall upon the value segment
- Quantitative: side could be described as low cost or production that would fall upon the efficiency segment
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Channels (CH)
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________ describe how a company communicates with and reaches its Customer Segments to deliver a Value Proposition. Generally communication, distribution, and sales comprise a company's ________.
____s are delivered to customers through communication, distribution, and sales CH
VALUE
____s are delivered to customers through communication, distribution, and sales CH
VALUE
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Customer Relationships
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________ is established and maintained with each CS
Communication with customers to encourage them to become loyal to the business and its products.
VALUE
Communication with customers to encourage them to become loyal to the business and its products.
VALUE
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Revenue Stream (RS)
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_____ results from VP(s) successfully offered to customers
VALUE
VALUE
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Key Resources (KR)
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______ are assets required to offer and deliver the above elements (RS, KR, CR)
EFFCIENCY
EFFCIENCY
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Key Activities (KA)
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performance by KRs
________ are the most important actions a company must take to operate successfully. They are required to create and offer a Value Proposition, reach markets, maintain Customer Relationships, and earn revenues.
EFFCIENCY
________ are the most important actions a company must take to operate successfully. They are required to create and offer a Value Proposition, reach markets, maintain Customer Relationships, and earn revenues.
EFFCIENCY
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Key Partnerships (KP)
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-Some activities are outsourced and some are acquired outside the enterprise
________ describe the network of suppliers and partners that make the business model work. Companies create ________ to optimize their business models, reduce risk, or acquire resources.
EFFCIENCY
________ describe the network of suppliers and partners that make the business model work. Companies create ________ to optimize their business models, reduce risk, or acquire resources.
EFFCIENCY
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Cost Structure
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- The business model elements result in a____
- The relative proportion of each type of cost in an organization
EFFCIENCY
- The relative proportion of each type of cost in an organization
EFFCIENCY
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Business Model Canvas
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- "A business model describes the rationale of how an organization creates, delivers, and captures value."
- 1, 2, 3, 4, 5 = Value (customer, demand, price, revenue)
- 2, 6, 7, 8, 9 = Efficiency (Production/cost inputs)
- 1, 2, 3, 4, 5 = Value (customer, demand, price, revenue)
- 2, 6, 7, 8, 9 = Efficiency (Production/cost inputs)
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Business Model vs Business Plan
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- Business model is the foundation, Business plan is a structure
- Business Model: the process by which the company generates its profits
--Central element of a firm's strategic plan
- Business Plan: a document that presents the company's strategy and expected financing performance for the future
Both are Dynamic and Changing
- Business Model: the process by which the company generates its profits
--Central element of a firm's strategic plan
- Business Plan: a document that presents the company's strategy and expected financing performance for the future
Both are Dynamic and Changing
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Porter's Five Forces Analysis
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- A framework for analyzing the level of competition within an industry and business strategy development.
- What are the forces that should drive our business strategy?
- Understanding competitive forces & underlying causes and profit potential + develop strategy to compete
- Provides sources of current profitability situation
- Provides framework for anticipating and influencing competition over time
- What are the forces that should drive our business strategy?
- Understanding competitive forces & underlying causes and profit potential + develop strategy to compete
- Provides sources of current profitability situation
- Provides framework for anticipating and influencing competition over time
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Porter's Five Forces
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1. Firms
- Objective: cost, revenue, profits, sustainability, etc - Mgmt tools; demand estimation & forecasting, production; pricing
2. Bargaining power of suppliers
- Cost of inputs
3. Threat of New Entrants
- Competition, monopoly, monopolistic competition, oligopoly, game theory and strategy; pricing
4. Threat of Substitutes
- Competition, monopoly, monopolistic competition, oligopoly, game theory and strategy; pricing
5. Bargaining Power of Buyers
- Demand, market structure, pricing
More Competition = less profits
Less Competition = more profits
- Objective: cost, revenue, profits, sustainability, etc - Mgmt tools; demand estimation & forecasting, production; pricing
2. Bargaining power of suppliers
- Cost of inputs
3. Threat of New Entrants
- Competition, monopoly, monopolistic competition, oligopoly, game theory and strategy; pricing
4. Threat of Substitutes
- Competition, monopoly, monopolistic competition, oligopoly, game theory and strategy; pricing
5. Bargaining Power of Buyers
- Demand, market structure, pricing
More Competition = less profits
Less Competition = more profits
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Industrial Organization Analysis
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Core issues of Competition and Monopoly:
1. Structure → Conduct → Performance (low cost, max profits= profitability)
2. Firms seek higher MS (market share) to realize higher πs (profitability)
3. Firms activities (rivalry) can counter one another; keeps prices low, foster innovation, etc.
1. Structure → Conduct → Performance (low cost, max profits= profitability)
2. Firms seek higher MS (market share) to realize higher πs (profitability)
3. Firms activities (rivalry) can counter one another; keeps prices low, foster innovation, etc.
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Industrial Organization Model
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1. Structure: Number & Size of Firms (Market Shares, Concentration) Product Differentiation Entry Barriers Vertical Integration Conglomerateness
2. Conduct: Pricing Behavior Product Strategy, Advertising Research and Development Plant Investment Legal Tactics
3. Performance: Efficiency - Allocative, cost of production, profitability, production, Productive, X, etc. Technological Progress, Growth Full Employment Equity
2. Conduct: Pricing Behavior Product Strategy, Advertising Research and Development Plant Investment Legal Tactics
3. Performance: Efficiency - Allocative, cost of production, profitability, production, Productive, X, etc. Technological Progress, Growth Full Employment Equity
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Economic Model of a Firm
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- What are the technical "nuts and bolts" underpinning of our firm?
1. Production: Q=f(Labor,Kapital,Fuel)
Efficiency: maximizing output produced (Q) given L,K,F
- Qp= output
2. Total Cost: TC=f(Qp, PL, PK, PF)
Efficiency efficiently maximizing Qp AND choosing combination of L,K,F (given PL,PK,PF) that minimizes Total Cost
3. Demand: Qd=f(P, Psub, Pcomp, INC, ADVertising, etc
4. Total Revenue: TR=P*Qd
TR depends on Price (P) charged and Quantity Sold (Qd)
Price depends on customers and competition/rivalry
5. Profit: Π=TR-TC=PQd-ACQp
Profit depends on competition, pricing, ability of new firms to enter (barriers to entry), management practices, etc.
1. Production: Q=f(Labor,Kapital,Fuel)
Efficiency: maximizing output produced (Q) given L,K,F
- Qp= output
2. Total Cost: TC=f(Qp, PL, PK, PF)
Efficiency efficiently maximizing Qp AND choosing combination of L,K,F (given PL,PK,PF) that minimizes Total Cost
3. Demand: Qd=f(P, Psub, Pcomp, INC, ADVertising, etc
4. Total Revenue: TR=P*Qd
TR depends on Price (P) charged and Quantity Sold (Qd)
Price depends on customers and competition/rivalry
5. Profit: Π=TR-TC=PQd-ACQp
Profit depends on competition, pricing, ability of new firms to enter (barriers to entry), management practices, etc.
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Effective Competition in "Real World" Rule of Thumb
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- At least 5 comparable competitors
- No firm is dominant, No firm has more than 40% MS (market share), each 5 has at least 10%
- Easy entry into market
- No firm is dominant, No firm has more than 40% MS (market share), each 5 has at least 10%
- Easy entry into market
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Production - Economic Model fo a Firm
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- Maximizing output produced (Qp) given land, capital,
Q=f(L,K,F)
Q=f(L,K,F)
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Total Cost - Economic Model of a Firm
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- Maximizing Qp AND choosing combination of L,K,F (given PL,PK, PF) that minimizes TC
TC=f(Qp, PL, PK, PF)
TC=f(Qp, PL, PK, PF)
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Demand - Economic Model of a Firm
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Qd=f(P, Psub, Pcomp, INC, ADV, etc
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Total Revenue - Economic Model of a Firm
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- Depends on Price (P) charged and Quantity Sold (Qd)
- price depends on customers and competition/rivalry
TR=P*Qd
- price depends on customers and competition/rivalry
TR=P*Qd
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Profit - Economic Model of a Firm
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- Profit depends on competition, pricing, ability of new firms to enter (barriers to entry), management practices, etc.
Π=TR-TC=PQd-ACQp
Π=TR-TC=PQd-ACQp
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What are indicators of Firm Success?
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1. Profitability
- Net Income After Taxes
- Rate of Return on equity
2. Stock prices
- Net Income After Taxes
- Rate of Return on equity
2. Stock prices
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Function of Profit
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- Profit is a signal that guides the allocation of society's resources.
- High profits in an industry are a signal that buyers want more of what the industry produces.
- Low (or negative) profits in an industry are a signal that buyers want less of what the industry produces.
- High profits in an industry are a signal that buyers want more of what the industry produces.
- Low (or negative) profits in an industry are a signal that buyers want less of what the industry produces.
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Methods of Managerial Economics
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Scarcity is Central to Economic and Business Problems
•Resources
-Land (Rent): Land, Forests, Minerals
-Labor (Wage): Human Mental/Physical Resources
-Capital (Interest): Tools, Machines, Buildings, etc.; Financial Capital, Stocks, Bonds, etc.
-Entrepreneurship (Profit): People who Combine Resources to Produce Goods and Services
•Scarcity Requires Choice
•Choice Implies Opportunity Cost
-Value of Benefits Foregone by Choosing One Alternative Over Another; Retained Earnings vs Alternative Investments.
•Resources
-Land (Rent): Land, Forests, Minerals
-Labor (Wage): Human Mental/Physical Resources
-Capital (Interest): Tools, Machines, Buildings, etc.; Financial Capital, Stocks, Bonds, etc.
-Entrepreneurship (Profit): People who Combine Resources to Produce Goods and Services
•Scarcity Requires Choice
•Choice Implies Opportunity Cost
-Value of Benefits Foregone by Choosing One Alternative Over Another; Retained Earnings vs Alternative Investments.
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Economic vs Business Model
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- Business: process by which the company generates its profits.
o Focused on the customers
- Economic: What are the technical "nuts and bolts" underpinning of our firm?
o Focus on most important determinants of economic behavior - cause and effect
o Focused on the customers
- Economic: What are the technical "nuts and bolts" underpinning of our firm?
o Focus on most important determinants of economic behavior - cause and effect
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Methodology of Economics
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1. Observe Economic Facts/Events
> Pricing (cost, etc.) varies across business firms.
2. Discern Patterns
> Prices vary across firms - Price links to ____?
3. Form Economic Theories
> Ownership form, (In)Efficiencies, management, marketing, regulation, etc. affect prices.
4. Test Economic Theories
> Gather actual firm/market data, test theory.
5. Apply to Business Decisions
> Alter input choices, pricing, etc.
> Pricing (cost, etc.) varies across business firms.
2. Discern Patterns
> Prices vary across firms - Price links to ____?
3. Form Economic Theories
> Ownership form, (In)Efficiencies, management, marketing, regulation, etc. affect prices.
4. Test Economic Theories
> Gather actual firm/market data, test theory.
5. Apply to Business Decisions
> Alter input choices, pricing, etc.
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Economic Theory
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Principles, Laws, Models, Theories
-Bring order and meaning to facts;
-Put facts into correct relationship with one another;
-Generalize relationships.
Ceteris Paribus - "Other Things Equal"
-Graphs, Regression Analysis, Calculus and Partial Derivative
Demand, Cost, Production, Pricing, Advertising, etc.
-Bring order and meaning to facts;
-Put facts into correct relationship with one another;
-Generalize relationships.
Ceteris Paribus - "Other Things Equal"
-Graphs, Regression Analysis, Calculus and Partial Derivative
Demand, Cost, Production, Pricing, Advertising, etc.
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Pitfalls in Managerial Economics
answer
• Bias and Preconceptions
○ Social vs Private Views
○ Both are Important to Business
○ Social vs Private Views
○ Both are Important to Business
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Key Economic Questions
answer
1. What is to be produced?
2. How is it to be produced?
3. For whom is it to be produced?
2. How is it to be produced?
3. For whom is it to be produced?
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Competitive Market
answer
1. Many small buyers and sellers
2. No barriers to Entry/Exit
3. Homogeneous product
4. Perfect information
5. Independence - no collusion
*Note - market is an institution or mechanism that brings together buyers (demanders) and sellers (suppliers or particular goods and services
2. No barriers to Entry/Exit
3. Homogeneous product
4. Perfect information
5. Independence - no collusion
*Note - market is an institution or mechanism that brings together buyers (demanders) and sellers (suppliers or particular goods and services
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Demand
answer
- Relationship showing the various amounts of commodity that buyers are willing and able to purchase at various possible prices during a given time period
Q=f(P) changeP ---- change Qd (dep), ceteris paribus
Q=f(P) changeP ---- change Qd (dep), ceteris paribus
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Law of Demand
answer
- Inverse relationship between price and quantity demanded
- Consumers buy more of a good when its price decreases and less when its price increases
- Change in prices causes a movement along with demand curve (change in quantity demanded)
- Consumers buy more of a good when its price decreases and less when its price increases
- Change in prices causes a movement along with demand curve (change in quantity demanded)
question
Law of Demand - why?
answer
1. Income Effect: As P change, consumers real incomes changes "purchasing power increases"
-P increase, income decrease
- P decreases, income increases
2. Substitution Effect: As P changes, consumers substitute goods
3. Diminishing Marginal Utility: Consumers will purchases more only if prices falls, since the additional utility falls with consumption
-P increase, income decrease
- P decreases, income increases
2. Substitution Effect: As P changes, consumers substitute goods
3. Diminishing Marginal Utility: Consumers will purchases more only if prices falls, since the additional utility falls with consumption
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Changes in Demand
answer
- Shifts of the demand curve due to changes in determinants
1. Taste and preferences
2. # of buyers
3. Income
- Normal good: income increase, demand increase Ex. Car, fresh fruits
- Inferior good: income increase, demand decrease Ex. Potatoes, ramen noodles
4. Price of related goods
- Substitutes: price of substitutes increase, demand for product x increase (direct)
- Complements: price increase of complementary goods, demand for product x decreases (inverse)
5. Expectations
6. Others Factors
- Ex. Age, demographics
1. Taste and preferences
2. # of buyers
3. Income
- Normal good: income increase, demand increase Ex. Car, fresh fruits
- Inferior good: income increase, demand decrease Ex. Potatoes, ramen noodles
4. Price of related goods
- Substitutes: price of substitutes increase, demand for product x increase (direct)
- Complements: price increase of complementary goods, demand for product x decreases (inverse)
5. Expectations
6. Others Factors
- Ex. Age, demographics
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Supply
answer
- Relationship showing the various amounts of commodity that sellers are willing and able to produce, sell, provide at variable possible prices during a given time
- Q=f(P) changeP ----- changeQs, ceteris paribus
- Q=f(P) changeP ----- changeQs, ceteris paribus
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Law of Supply
answer
- Direct relationship between price and quantity demanded
- Sellers produce, sell, provide more of a good when its price increases and less when its price decreases
- Change in prices causes a movement ALONG with Supply curve (change in quantity supplied)
- Sellers produce, sell, provide more of a good when its price increases and less when its price decreases
- Change in prices causes a movement ALONG with Supply curve (change in quantity supplied)
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Law of Supply - Why?
answer
- Higher prices induce suppliers to produce and sell more.
- Price incentive; Coverage of Higher Costs.
Firm
1. Profit Motive - More Revenue as P
2. Increased costs
a. More Intensive Use of Resources.
b. Increasing Marginal Costs of Production. [Law of diminishing returns]
- Price incentive; Coverage of Higher Costs.
Firm
1. Profit Motive - More Revenue as P
2. Increased costs
a. More Intensive Use of Resources.
b. Increasing Marginal Costs of Production. [Law of diminishing returns]
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Changes in Supply
answer
- Shifts of the supply curve due to changes in determinants
1. Technology/productivity of inputs
2. Resource prices (wages, price of raw materials, etc)
Cost = resource price/ productive
- As cost decreases (increases), supply increases (decrease)
3. P's of related goods in productions As Pmaize increases, rice supply decreases Relative profitability have changes
4. # of sellers
5. Expectations
6. Taxes & subsidies
7. Other Factors - war, weather, regulation
1. Technology/productivity of inputs
2. Resource prices (wages, price of raw materials, etc)
Cost = resource price/ productive
- As cost decreases (increases), supply increases (decrease)
3. P's of related goods in productions As Pmaize increases, rice supply decreases Relative profitability have changes
4. # of sellers
5. Expectations
6. Taxes & subsidies
7. Other Factors - war, weather, regulation
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Market-Clearing Price/Equilibrium
answer
The price at which the quantity supplied is equal to the quantity demanded
question
Market Shortage
answer
- Price is below equilibrium
- Qd > Qs
- Buyers compete with each other
- Qd > Qs
- Buyers compete with each other
question
Market Surplus
answer
- Price is above equilibrium
- Qs > Qd
- Sellers compete with each other
- Qs > Qd
- Sellers compete with each other
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Price Floor
answer
- A legal minimum on the price at which a good can be sold
- Price can't go below the floor
- Price above equilibrium: causes surplus
Qs > Qd
- Price can't go below the floor
- Price above equilibrium: causes surplus
Qs > Qd
question
Price Ceiling
answer
- A legal maximum on the price at which a good can be sold
- Price can't go above the ceiling
- Price below equilibrium: causes shortage
Qd > Qd
- Price can't go above the ceiling
- Price below equilibrium: causes shortage
Qd > Qd
question
Changes in BOTH Supply and Demand
answer
- Supply ⬆️ & Demand ⬆️ : Quantity increase, price ??
- Supply ⬇️ & Demand ⬇️: Quantity decrease, price ??
- Supply ⬆️ & Demand ⬇️ : price decrease, quantity ??
- Supply ⬇️ & Demand ⬆️: price increase, quantity ??
- Supply ⬇️ & Demand ⬇️: Quantity decrease, price ??
- Supply ⬆️ & Demand ⬇️ : price decrease, quantity ??
- Supply ⬇️ & Demand ⬆️: price increase, quantity ??
question
If hog is an input to pork production, then a change in the price of hog influences the equilibrium price of pork (all else equal). Suppose the price of hog increases. An increase in the price of hog will
answer
decrease the supply of pork, causing a shift inward of the supply curve for pork.
Since hog is an input to pork, an increase in the price of hog makes pork production more expensive. This will decrease the supply of pork, shift its supply curve inward, and cause equilibrium price to rise and equilibrium quantity to fall.
Since hog is an input to pork, an increase in the price of hog makes pork production more expensive. This will decrease the supply of pork, shift its supply curve inward, and cause equilibrium price to rise and equilibrium quantity to fall.
question
Which of the following will likely increase the equilibrium price of CDs?
a. A decrease in the price of iPods
b. A decrease in the cost of raw materials needed to produce CDs
c. The release of a medical report, indicating that listening to music recorded on CDs
has health benefits
d. An increase in the price of CDs
a. A decrease in the price of iPods
b. A decrease in the cost of raw materials needed to produce CDs
c. The release of a medical report, indicating that listening to music recorded on CDs
has health benefits
d. An increase in the price of CDs
answer
c. The release of a medical report, indicating that listening to music recorded on CDs
has health benefits
An announcement of the health benefits associated with listening to music recorded on CDs will increase the demand for CDs, shift the demand curve for CDs outward, and increase both equilibrium price and quantity.
has health benefits
An announcement of the health benefits associated with listening to music recorded on CDs will increase the demand for CDs, shift the demand curve for CDs outward, and increase both equilibrium price and quantity.
question
If the cross-price elasticity of demand measured for goods A and B is positive, the two products are referred to as
answer
substitutes
question
An own-price elasticity of demand of -1.5 indicates that for a __________ increase in price, quantity demanded will __________ by __________.
answer
one percent; decrease; 1.5%
The solution to this question comes from the fact that own-price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. In this scenario, when we normalize the change in price to 1%, quantity demanded must change in the opposite direction (because of the law of demand) by 1.5%.
The solution to this question comes from the fact that own-price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. In this scenario, when we normalize the change in price to 1%, quantity demanded must change in the opposite direction (because of the law of demand) by 1.5%.
question
Performance Indications
answer
- Rate of return on equity
- Debt to equity
- Interest coverage
- Price-Earnings (PE) ratio
- Earnings per share (EPS)
- Debt to equity
- Interest coverage
- Price-Earnings (PE) ratio
- Earnings per share (EPS)
question
Financial Markets
answer
- Firms need financial resources (capital)
- Suppliers (hhs) use savings for return
- Financial markets bring them together
- Financial markets - stocks, bonds, loans, etc
- HHs - bank account, CDs, money market, mutual funds, bonds, stocks, housing, gold
- Suppliers (hhs) use savings for return
- Financial markets bring them together
- Financial markets - stocks, bonds, loans, etc
- HHs - bank account, CDs, money market, mutual funds, bonds, stocks, housing, gold
question
Stocks
answer
- Ownership
- Issued after initial success in start up
- Insufficient profits to expand the business - IPO
- (+) financial resources generated do not have to be repaid
- (-) issuance of additional stock means future earnings spread over more investors
- Key performance indicators (KPIs): PE ratio, EPS, RoR Equity - stockholders expect return
- Issued after initial success in start up
- Insufficient profits to expand the business - IPO
- (+) financial resources generated do not have to be repaid
- (-) issuance of additional stock means future earnings spread over more investors
- Key performance indicators (KPIs): PE ratio, EPS, RoR Equity - stockholders expect return
question
Bonds
answer
- Debt owned to lenders
- (+) can issue as long as investor will lend
- (+) no effect on ownership
- (+) many options, including long-term or short-term
- (+) often cheaper than bank loans
- (-) must met interest payments or default, fixed costs
- KPIs: interest coverage, debt to equity ratio
- (+) can issue as long as investor will lend
- (+) no effect on ownership
- (+) many options, including long-term or short-term
- (+) often cheaper than bank loans
- (-) must met interest payments or default, fixed costs
- KPIs: interest coverage, debt to equity ratio
question
Stocks vs Bonds - Investor perspective
answer
Stocks: are shares (ownership) in the company
-Ownership, compensation is in the form of dividends from profits
- Riskier due to lac/variability of profits, but higher long-run returns
- Payout ratio = % of NI paid in dividends
Bonds: are debt for the company
- Loan to the company, less risky, steadier income, usually paid back full amount of principal at maturity
- Lower long-run return
-Ownership, compensation is in the form of dividends from profits
- Riskier due to lac/variability of profits, but higher long-run returns
- Payout ratio = % of NI paid in dividends
Bonds: are debt for the company
- Loan to the company, less risky, steadier income, usually paid back full amount of principal at maturity
- Lower long-run return
question
Quantity Demanded for Stocks
answer
Ps = stock price; reflects estimates of company's future profits. Consider P/E.
D1 = demand for stocks; owner of share of stock is an owner of company and expects profit (dividend). Expected future profit plays important role in determining value of stock. Future profit is uncertain.
Demand is downward sloped. At lower price for stocks, quantity demanded increases since future profits do not have to be as high to justify purchase. Also, there is the possibility of reselling at a higher price for a positive return.
D1 = demand for stocks; owner of share of stock is an owner of company and expects profit (dividend). Expected future profit plays important role in determining value of stock. Future profit is uncertain.
Demand is downward sloped. At lower price for stocks, quantity demanded increases since future profits do not have to be as high to justify purchase. Also, there is the possibility of reselling at a higher price for a positive return.
question
Demand for Stocks (Determinants of Demand for stocks)
answer
1.State of Economy (+)
2.Expected Profits (+)
3.Interest Rates (-)**
- What would happen to demand if interest rates lower? Demand for stocks will increase (interest rates are related to bonds NOT stocks)
4.Announcement of Actual Corporate Profits (+)
5.Demographics - planning for retirement (+)
6.Firm announcements - moving into new product line (+)
7.Trade agreement, peace (+)
2.Expected Profits (+)
3.Interest Rates (-)**
- What would happen to demand if interest rates lower? Demand for stocks will increase (interest rates are related to bonds NOT stocks)
4.Announcement of Actual Corporate Profits (+)
5.Demographics - planning for retirement (+)
6.Firm announcements - moving into new product line (+)
7.Trade agreement, peace (+)
question
Quantity Supplied for Stock
answer
Ps = stock price; reflects estimates of company's future profits.
S1 = supply of stocks; though number of shares is fixed at any point in time, S is not vertical but slopes upward since it shows how many shares (quantity supplied) current owners are willing to sell at each price.
Supply is upward sloped. At higher price for stocks, quantity supplied increases since current owners of shares can obtain a positive return by selling the stock.
S1 = supply of stocks; though number of shares is fixed at any point in time, S is not vertical but slopes upward since it shows how many shares (quantity supplied) current owners are willing to sell at each price.
Supply is upward sloped. At higher price for stocks, quantity supplied increases since current owners of shares can obtain a positive return by selling the stock.
question
Supply of Stock (Determinants of Supply for Stock)
answer
1. Initial Public Offerings (IPOs) (+)
2. Issue New Shares (+)
3. Spinoffs** by Existing Companies (+)
2. Issue New Shares (+)
3. Spinoffs** by Existing Companies (+)
question
Quantity Demanded for Bonds
answer
Pb = bond price.
D1 = investors demand for bonds; shows relationship between price and quantity demanded of bonds, ceteris paribus.
Demand is downward sloped. At lower price for bonds, quantity demanded increases since investors pay a lower price for bonds. As Pb falls, the market interest rate rises, making bonds more attractive
D1 = investors demand for bonds; shows relationship between price and quantity demanded of bonds, ceteris paribus.
Demand is downward sloped. At lower price for bonds, quantity demanded increases since investors pay a lower price for bonds. As Pb falls, the market interest rate rises, making bonds more attractive
question
Demand for Bonds (Determinants of Demand for Bonds)
answer
1.Change in Wealth - State of the Economy (+)
2. Decrease in expected returns on investments; expectation of lower future interest rates will cause investors to buy now. Buy at low price (high i) and resell bonds in future at higher price as market interest falls.
3.Decrease in expected inflation. Inflation reduces value of stocks and bonds, deflation does the opposite.
4.Decrease in risk of default on bonds.
5. Decrease in information costs. Information costs for large corporations are low, making demand for their bonds high.
6. Increase in liquidity of bonds. Government bonds are typically highly liquid.
2. Decrease in expected returns on investments; expectation of lower future interest rates will cause investors to buy now. Buy at low price (high i) and resell bonds in future at higher price as market interest falls.
3.Decrease in expected inflation. Inflation reduces value of stocks and bonds, deflation does the opposite.
4.Decrease in risk of default on bonds.
5. Decrease in information costs. Information costs for large corporations are low, making demand for their bonds high.
6. Increase in liquidity of bonds. Government bonds are typically highly liquid.
question
Quantity Supplied for Bonds
answer
Pb = bond price.
S1 = business & government supply of bonds; shows relationship between price and quantity supplied of bonds, ceteris paribus.
Supply is upward sloped. At a higher price for bonds, quantity supplied increases since businesses borrow more at a lower market interest rate, making bonds a more attractive source of financial resources.
S1 = business & government supply of bonds; shows relationship between price and quantity supplied of bonds, ceteris paribus.
Supply is upward sloped. At a higher price for bonds, quantity supplied increases since businesses borrow more at a lower market interest rate, making bonds a more attractive source of financial resources.
question
Supply for Bonds (Determinants of Supply for Bonds)
answer
1.Rise in expected profits. Businesses issue more bonds if optimistic about future profits.
2.Decrease in business taxes; businesses expand if taxes fall.
3.Increase in expected inflation. Inflation reduces value of the dollar, making repayment of loans cheaper.
4.Increase in government borrowing. US government has issued more debt using bonds, increasing the supply of bonds.
2.Decrease in business taxes; businesses expand if taxes fall.
3.Increase in expected inflation. Inflation reduces value of the dollar, making repayment of loans cheaper.
4.Increase in government borrowing. US government has issued more debt using bonds, increasing the supply of bonds.
question
Price Elasticity of Demand
answer
The percentage change in quantity demanded relative to a percentage change in price
question
Price Elasticity of Demand Example
answer
Ex: Suppose price is cut by 2% and quantity demanded rises by 4%.
= C = 4%/2% = 2
*Ignore the negative sign
Explanation:
- 1% change in price will cause 2% change in quantity demanded
-2% change in price will cause 4% change in quantity demanded
= C = 4%/2% = 2
*Ignore the negative sign
Explanation:
- 1% change in price will cause 2% change in quantity demanded
-2% change in price will cause 4% change in quantity demanded
question
Perfectly Inelastic
answer
Quantity does not respond at all to changes in price (Ed=0)
- Given % change In price = 0% change in QD
Ex. Healthcare/ Prescription drugs
- Given % change In price = 0% change in QD
Ex. Healthcare/ Prescription drugs
question
Inelastic Demand
answer
An increase or a decrease in price will not significantly affect demand for the product (Ed<1)
- Given % change in price = smaller % change in Qd
Ex. cigarettes, gasoline, and coffee.
- Given % change in price = smaller % change in Qd
Ex. cigarettes, gasoline, and coffee.
question
Unitary Demand
answer
The percentage change in price is identical to the percentage change in quantity demanded so that sales revenue remains the same (Ed=1)
*Maximize total revenue
*Maximize total revenue
question
Elastic Demand
answer
Changes in price have large effects on the amount demanded (Ed>1)
- 1% change in price = larger % change in Qd
Ex. Products that have an elastic demand are airline travel, fresh fish, and new cars
Get coupon, rush out to get it
- 1% change in price = larger % change in Qd
Ex. Products that have an elastic demand are airline travel, fresh fish, and new cars
Get coupon, rush out to get it
question
Perfectly Elastic Demand
answer
The case where the quantity demanded is infinitely responsive to price and the price elasticity of demand equals infinity (E= infinity)
- 1% change in price = infinity % change in Qd
*individual competitive firm
- 1% change in price = infinity % change in Qd
*individual competitive firm
question
Arc Elasticity of Demand: Midpoints
answer
Defines consumer responsiveness over a segment or arc of the demand curve
- KEEP negative signs (always negative)
-1% change in price will cause ____% increase or decrease in quantity demanded
*Not holding everything else constant
- KEEP negative signs (always negative)
-1% change in price will cause ____% increase or decrease in quantity demanded
*Not holding everything else constant
question
Elastic Demand & Total Revenue
answer
- Price decrease, Qd increase--Increase Total Revenue (people will buy more at lower price)
- Price increase, Qd decrease--Decrease Total Revenue
- Quantity OVER powers price
- Ed>1
- Price increase, Qd decrease--Decrease Total Revenue
- Quantity OVER powers price
- Ed>1
question
Inelastic Demand & Total Revenue
answer
- Price increase, Qd increase--Increase Total Revenue (people will buy same quantity)
- Price decrease, Qd decrease--Decrease Total Revenue
- Price OVER power quantity
- Ed<1
- Price decrease, Qd decrease--Decrease Total Revenue
- Price OVER power quantity
- Ed<1
question
Unitary Demand & Total Revenue
answer
- Price increase or decreases, revenue will stay the same
- Ed=1
- Ed=1
question
Point Price Elasticity of Demand (Linear)
answer
A measurement of the price elasticity of demand at a particular price
Demand: Qx = α + β1Px + β2PS + β3I + β4ADV etc
- (P/Q)(change in q/change in p)
- Slope is constant but elasticity is not
Demand: Qx = α + β1Px + β2PS + β3I + β4ADV etc
- (P/Q)(change in q/change in p)
- Slope is constant but elasticity is not
question
Point Price Elasticity of Demand - Example (Linear)
answer
Let demand be Q = 50 - 2P + .5INC.
Let INC = 20. Then,
Q = 50 - 2P + .5(20) = 60 - 2*P.
P=f(Q), P = 30 - .5*Q.
TR = PQ = (30- .5Q)Q = 30Q - .5*Q2.
MR = ΔTR/ΔQ; using Calculus MR = dTR/dQ = 30 -1*Q
Point Ed= -2 * P/Q
Let INC = 20. Then,
Q = 50 - 2P + .5(20) = 60 - 2*P.
P=f(Q), P = 30 - .5*Q.
TR = PQ = (30- .5Q)Q = 30Q - .5*Q2.
MR = ΔTR/ΔQ; using Calculus MR = dTR/dQ = 30 -1*Q
Point Ed= -2 * P/Q
question
Point Price Elasticity (Multiplicative)
answer
A popular demand specification is multiplicative.
Q = αP^β1INC^β2
Suppose Q = 2000P^-2.5INC^.3. Let INC = 1,000. Find the price elasticity of Demand.
The price elasticity of demand is constant:
Ed = β1 = -2.5.
**- Elasticity is constant but slope is not
Q = αP^β1INC^β2
Suppose Q = 2000P^-2.5INC^.3. Let INC = 1,000. Find the price elasticity of Demand.
The price elasticity of demand is constant:
Ed = β1 = -2.5.
**- Elasticity is constant but slope is not
question
Determinants of Price Elasticity
answer
Demand is more elastic when
- A good faces a LARGER number of close substitutes More options (more options)
- A good makeup LARGER % of total budget
o Ex. Furniture vs salt
- A good is regarded as LUXURY rather than NECESSITY - Time period under consideration INCREASES
- A good faces a LARGER number of close substitutes More options (more options)
- A good makeup LARGER % of total budget
o Ex. Furniture vs salt
- A good is regarded as LUXURY rather than NECESSITY - Time period under consideration INCREASES
question
Income Elasticity
answer
% change in quantity demanded / % change in income
- Normal Good: As income increase, you will spend more on normal goods (Ei>0)
- Inferior Good: As income increases, you demand less of inferior goods (Ei<0)
o Ex. ramen noodles
- Normal Good: As income increase, you will spend more on normal goods (Ei>0)
- Inferior Good: As income increases, you demand less of inferior goods (Ei<0)
o Ex. ramen noodles
question
Arc Elasticity of Income
answer
- Defines consumer responsiveness to changes in income over a segment or arc of the demand curve
- KEEP negative signs (always negative)
-1% change in income will cause ____% increase or decrease in quantity demanded
*Not holding everything else constant
- KEEP negative signs (always negative)
-1% change in income will cause ____% increase or decrease in quantity demanded
*Not holding everything else constant
question
Point Income Elasticity
answer
A measurement of the income elasticity of demand at a particular price
Demand: Qx = α + β1Px + β2PS + β3I + β4ADV etc
Ei= (I/Q)(change in q/change in I)
- Slope is constant but elasticity is not
Demand: Qx = α + β1Px + β2PS + β3I + β4ADV etc
Ei= (I/Q)(change in q/change in I)
- Slope is constant but elasticity is not
question
Point Elasticity - Example
answer
Ei= (I/Q)(change in q/change in I)
Ei=829∗I/Q
Qjb = -672,663 - 7,173,333Pjb + .58PASS - 542,737PNATL + 829GDP - .54*ADV
Example: If GDP = 14,500, Qjb = 2,006,296, ceteris paribus.
Ei = 829*(14,500/2,006,296) = 5.99
This means a 1% increase in Income (GDP) increases JB's demand by 5.99%.
Ei=829∗I/Q
Qjb = -672,663 - 7,173,333Pjb + .58PASS - 542,737PNATL + 829GDP - .54*ADV
Example: If GDP = 14,500, Qjb = 2,006,296, ceteris paribus.
Ei = 829*(14,500/2,006,296) = 5.99
This means a 1% increase in Income (GDP) increases JB's demand by 5.99%.
question
Advertising Elasticity
answer
- Measures the responsiveness of demand for a product following a change in the advertising spending on it
question
Advertising Arc Elasticity
answer
- Defines consumer responsiveness to changes in advertising over a segment or arc of the demand curve
- KEEP negative signs (always negative)
-1% change in advertising will cause ____% increase or decrease in demand
*Not holding everything else constant
- KEEP negative signs (always negative)
-1% change in advertising will cause ____% increase or decrease in demand
*Not holding everything else constant
question
Price Cross Elasticity
answer
- How our demand responds to changes in price of substitutes or compliments
question
Price Cross Elasticity - Substitute
answer
- The demand for a substitute good increases when the price of another product goes up.
- (Cross-price elasticity is always positive).
- NO ABSOLUTE VALUE * SAME DIRECTION* Example: coke vs pepis: coke price increases, demand for pepis increases
- (Cross-price elasticity is always positive).
- NO ABSOLUTE VALUE * SAME DIRECTION* Example: coke vs pepis: coke price increases, demand for pepis increases
question
Price Cross Elasticity - Complementary
answer
- The demand for complementary good decreases when the price of the complementary product goes up.
- (Cross-price elasticity is always negative). * INVERSE* - Example: must be used in combination: gas goes increases, demand of SUV decreases
- (Cross-price elasticity is always negative). * INVERSE* - Example: must be used in combination: gas goes increases, demand of SUV decreases
question
Arc Cross Price Elasticity of Demand
answer
- Change in price of good Y and change of quantity demanded for good X
Substitute: positive
complementary: negative
Explanation: 1% increase in price of good X will cause a __% increase/decrease in the demand for good Y
Substitute: positive
complementary: negative
Explanation: 1% increase in price of good X will cause a __% increase/decrease in the demand for good Y
question
Point Price Cross Elasticity of Demand - Example
answer
Qjb = -672,663 - 7,173,333Pjb + .58PASS - 542,737PNATL + 163,064PGAS + 829GDP - .54ADV
Ecross=163,064∗P_GAS/Q_JB
- If Pgas = 1.3 and Qjb = 2,372,658, Ecross = 163,064*(1.3/2,372,658) = .089.
- This means a 1% increase in price of gasoline will increase JB's demand by .089%. It does not appear that demand is very sensitive to gasoline price changes.
Ecross=163,064∗P_GAS/Q_JB
- If Pgas = 1.3 and Qjb = 2,372,658, Ecross = 163,064*(1.3/2,372,658) = .089.
- This means a 1% increase in price of gasoline will increase JB's demand by .089%. It does not appear that demand is very sensitive to gasoline price changes.
question
Price Elasticity of Supply
answer
The responsiveness of the quantity supplied to a change in price, measured by dividing the percentage change in the quantity supplied of a product by the percentage change in the product's price
- ALWAYS POSITIVE
Es > 1, supply is elastic
Es = 1, supply is unit elastic (rare)
Es < 1, supply is inelastic
- ALWAYS POSITIVE
Es > 1, supply is elastic
Es = 1, supply is unit elastic (rare)
Es < 1, supply is inelastic
question
Price Elasticity of Supply - Example
answer
Ex: Suppose price increase by 5% and quantity supplied rises by 20%.
= C = 20%/5% = 4
*ALWAYS POSITIVE
Explanation:
- 1% change in price will cause a 4% change in quantity supplied
-5% change in price will cause 20% change in quantity supplied
= C = 20%/5% = 4
*ALWAYS POSITIVE
Explanation:
- 1% change in price will cause a 4% change in quantity supplied
-5% change in price will cause 20% change in quantity supplied
question
Arc Price Elasticity of Supply
answer
- KEEP negative signs (always negative)
-1% change in price will cause ____% increase or decrease in supply
*Not holding everything else constant
-1% change in price will cause ____% increase or decrease in supply
*Not holding everything else constant
question
Point Price Elasticity of Supply
answer
Let Supply be: Qs = 11 + .5P
P = 11 + 1Qs
If P = 10, Qs = 16, Es = .5*(10/16) = .3125
Es=dQs/dP∗P/Qs=.5∗P/Q
Supply is more elastic the greater the time producers have to respond to a given change in price.
P = 11 + 1Qs
If P = 10, Qs = 16, Es = .5*(10/16) = .3125
Es=dQs/dP∗P/Qs=.5∗P/Q
Supply is more elastic the greater the time producers have to respond to a given change in price.
question
r^2 (coefficient of determination)
answer
- The percent of variation in the dependent variable from its mean is explained by independent variable
- Ex. 78% of variation in SW's Sales from its mean is explained by price, pass, adv, pcomp, income,.
- Ex. 78% of variation in SW's Sales from its mean is explained by price, pass, adv, pcomp, income,.
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