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PROF. B. S. PATIL
ECONOMICS
MANAGERIAL ECONOMICS
-Application of economic theory & Decision
Science tools to solve managerial
decision problem
OPTIMAL SOLUTION
TO
MANAGERIAL DECISION PROBLEMS
M. E refers to the application of economic theory and decision science tools to find the
optimal solution to business decision problems
SCOPE OF MANAGERIAL ECONOMICS
The subject matter of business economics has been divided into two
parts
1. Micro - Economics
2. Macro - Economics
Micro Economics:
In micro economics we make a microscopic study of the economy. It
should be remembered that micro economics does not study the
economy in its totality.
Theory
Theory
Of Wages Rent Interest Profits
Of
Production
Demand
&
Costs
SCOPE OF MANAGERIAL ECONOMICS
Macro Economics:
Macro economics analyses the behaviour of the
whole economic system in totality.
It studies the bahaviour of the large aggregates
such as total employment, the national product
or income, the general price level in the
economy.
Therefore, macro economics is also known as
aggregative economics.
SCOPE OF MANAGERIAL ECONOMICS
Theory of General
Theory of Income The Theory of
Price level &
and Employment Economic Growth
Inflation
Entrepreneurship and Profits
DEMAND ANALYSIS
PA A
D
0
QA
Quantity demanded (per unit of time)
2 B
Price (per unit)
Change (Contraction) in
quantity demanded
(a movement along the curve)
A
1
D1
0
100 200
Quantity demanded (per unit of time)
Change (decrease) in
demand
2
Price (per unit)
B A
1
D0
D1
100 200 250
Quantity demanded (per unit of time)
A
PA
0
QA
Quantity supplied (per unit of time)
A B
15 A to B
Shift (Increase) in
Supply
(a shift of the curve)
1,250 1,500
Quantity supplied (per unit of time)
B
Price (per unit)
A to B
Change (expansion) in
A quantity supplied
15
(a movement along the
curve)
1,250 1,500
Quantity supplied (per unit of time)
G
2.50 F
2.00 E
1.50 D
1.00 C
0.50 B CA
0 A
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Quantity of DVDs supplied (per week)
3.50 A
3.00
2.50 E
2.00 C
1.50
Excess demand
1.00 D
1 2 3 4 5 6 7 8 9 10 11 12
Quantity of DVDs supplied and demanded
B
2.50 Excess demand
A
2.25 B1
D0 D1
0 8 9 10
Quantity of DVDs (per week)
S0
C
2.50 Excess demand
B
2.25 A
D0
0 8 9 10
Quantity of DVDs (per week)
Principles of Microeconomics
© R. Larry Reynolds
Elasticity
· Elasticity is a concept borrowed from physics
· Elasticity is a measure of how responsive a
dependent variable is to a small change in an
independent variable(s)
· Elasticity is defined as a ratio of the percentage
change in the dependent variable to the
percentage change in the independent variable
· Elasticity can be computed for any two related
variables
Q1 = 3 Q2 = 5 Qx/ut
Fall '97 Economics 205Principles of Microeconomics Slide 7
.
∆-2
Q [-2/5 = -.4]
% ∆Q = -40%
ep = 5Q1 =
% ∆P = 40%
= -1 [this is called “unitary elasticity]
∆+2P
P51 [+2/5 = .4]
When the price increases from Rs.5 to Rs.7, the ep = -1 [“unitary”]
1 9 -.11 ∆P 3
2 8 -.25 at a price of 7, Q = 3
3 7 -.43
4 6 -.67 Calculate ep at P = 9
-1. Q=1
ep = (-1) 9
5 5
= -9
6 4 -1.5 1
7 3 -2.3 Calculate ep for all other
8 2 -4. price and quantity
9 1 -9 combinations.
10 0 undefined
Fall '97 Economics 205Principles of Microeconomics Slide 11
Notice that at higher prices
the absolute value of the price
For a simple demand function: Q = 10 - 1P elasticity of demand, ⏐ep⏐, is
greater.
price quantity ep Total
Revenue
Total revenue is price times
$0 10 0 0 quantity; TR = PQ.
$1 9 -.11 9 Where the total revenue [TR]
16 is a maximum, ⏐ep ⏐ is equal
$2 8 -.25
to 1
$3 7 -.43 21
In the range where ⏐ep ⏐< 1, [less
$4 6 -.67 24
than 1 or “inelastic”], TR increases as
$5 5 -1. 25 price increases, TR decreases as P
$6 4 -1.5 24 decreases.
$7 3 -2.3 21 In the range where ⏐ep ⏐> 1,
$8 2 -4. 16 [greater than 1 or “elastic”], TR
$9 1 -9 9 decreases as price increases, TR
$10 0 undefined 0 increases as P decreases.
∆Q P1 12
+ P2 D
ep = -1
* = - 1.5
∆P Q1 8+ Q2
The average ep between $5 and $7 is -1.5 3 5 Qx/ut
Fall '97 Economics 205Principles of Microeconomics Slide 13
Calculate the point ep at each
Given: Q = 120 - 4 P
price on the table.
Price Quantity e p TR
Calculate the TR at each price
on the table.
$ 10
Calculate arc ep at between
$ 20 $10 and $20.
$ 25 Calculate arc ep at between
$ 28 $25 and $28.
If the price elasticity of demand for air travel was estimated at -2.5, what
effect would a 5% decrease in price have on quantity demanded ?
%∆Q
-2.5 = = +12.5% change in quantity demanded
% ∆P
- 5%
If the price elasticity of demand for wine was estimated at -.8, what
effect would a 6% increase in price have on quantity demanded ?
%∆Q
-.8 = = -4.8% decrease in quantity demanded
%+6%
∆P
When |ep| > 1, demand is “elastic.” This means that the ⎢% ∆ Q⎢ > ⎢% ∆ P⎢.
When the % price decrease is less than the % increase in Q,
TR [TR = PQ] will increase.
When |ep| > 1, a price decrease will increase TR;
a price increase will
decrease TR, price and TR “move in opposite directions.” [elastic demand
wrt price]
eeyyy ≡ %%∆%
∆Q∆xxQx
Q
the more responsive buyers +
are to a change in their incomes. %∆Y
+- %%∆ Y∆ Y
When the value of ey is greater than 1, it is called a “superior good.”
The |% ∆ Qx| is greater than the |% ∆ Y|.
% ∆ Qx
Buyers are very responsive to changes in
income. Sometimes “superior goods” are
ey ≡
%∆Y
called “luxury goods.”
. Fall '97
. Economics 205Principles of Microeconomics Slide 31
Income Elasticity
[inferior goods]
eyy ≡=
x
An increase in income reduces -e %+∆Y
∆Y
the amount that individuals P
are willing to buy at each price
of the good. Income elasticity
decreases
is negative: - ey demand
P1
The greater the absolute value
of - ey, the more responsive buyers D1
- %∆Q x
D2
are to changes in income
Q2 Q1 Q/ut
.
. Fall '97 Economics 205Principles of Microeconomics Slide 32
Income Elasticity
[inferior goods]
%∆Y
the income elasticity of demand -∆Y
is negative
When the price of pork increases, it will tend to increase the demand
for beef. People will substitute beef, which is relatively cheaper, for
pork, which is relatively more expensive.
[price of beef]
is purchased. Pb is purchased.
Pp price of pork increases at Pb = $2 more
increase beef will be bought
The quantity demanded
demand to substitute for
2 of pork decreases.
2 the smaller
for an increase quantity of
1.50
in Ppork, pork.
Dp
demand for
beef increases
Db Db ’
-∆Qp
The cross elasticity of the demand for beef with respect to the
price of pork, ebeef-pork or ebp can be calculated:
+Q
%∆ ∆Q
ofb beef An increase in the price of pork,
+ebp
ebp = “causes” an increase in the demand
positive %∆P+of
∆Ppork
p for beef.
cross elasticity is positive
%∆ -Q ∆of
Qbeef
b A decrease in the price of pork,
+eebpbp = “causes” a decrease in the demand
positive %∆P of pork
- ∆Pp for beef.
If goods are substitutes, exy will be positive. The greater the
coefficient, the more likely they are good substitutes.
· cross elasticity
· measure the shift of a demand function for a good associated
with the change in the price of a related good
· [compliment/substitute]
Order Processing.
Master
Production
Planning
Forecasting Horizons.
Short Term (0 to 3 months): for inventory
management and scheduling.
Medium Term (3 months to 2 years): for
production planning, purchasing, and
distribution.
Long Term (2 years and more): for capacity
planning, facility location, and strategic
planning.
Principles of Forecasting
Forecasts are almost always wrong.
Every forecast should include an estimate of
the forecast error.
The greater the degree of aggregation, the
more accurate the forecast.
Long-term forecasts are usually less
accurate than short-term forecasts.
Forecasting Methods
Qualitative methods are subjective in nature since
they rely on human judgment and opinion.
Quantitative methods use mathematical or
simulation models based on historical demand or
relationships between variables.
Some Qualitative Methods
¾ Jury of Executive Opinion (opinions of a small group of
high-level managers is pooled).
¾ Sales Force Composite (aggregation of salespersons estimate
of sales in their territory).
www.stmartin.edu
Expectations
www.stmartin.edu
The Long Run Versus the Short Run
Marginal
product
Total
Increasing Diminishing
TP marginal returns marginal returns
5800
4700
1300
3500 1200 MP
1100
1000
2200
1000
0 1 2 3 4 5 0 1 2 3 4 5
Labor input Labor input
Law of diminishing marginal returns
Marginal product
Total product
TP1
TP0
MP1
MP0
Average
total cost
Costs
Total cost
Total
Cost
Total
Average
variable
variable
cost
cost
Total Marginal
50
fixed cost cost
z Financial
z Managerial
z Risk Bearing
Economies of Scale
Scale A 5 3 4 100
Scale B 10 6 8 300
z Internal: Technical
z Specialisation – large organisations
can employ specialised labour
z Indivisibility of plant – machines can’t be
broken down to do smaller jobs!
z Increased dimensions – bigger containers
can reduce average cost
Economies of Scale
Indivisibility of Plant/Machines:
z Some machineries available in large and
lumpy size-cannot be broken and used in
small production
Economies of Scale
z Commercial
z Large firms can negotiate favourable
prices as a result of buying in bulk
z Financial
z Large firms able to negotiate cheaper
finance deals
z Large firms able to be more flexible
about finance – share options, etc.
z Large firms able to utilise skills of
merchant banks to arrange finance
Economies of Scale
z Managerial
z Useof specialists – accountants,
marketing, lawyers, production,
human resources, etc.
Economies of Scale
z Risk Bearing
z Diversification
z Product ranges
z R&D
ECONOMIES OF SCALE
Y
AC
E>D E<D
AC E=D
X
O Large Scale Production
Diseconomies of Scale
• Benefits
• Defining Page
• Getting Started
• Break-even Analysis
– Break-even point
– Comparing variables
• Algebraic Approach
• Graphical Approach
Benefits and Uses:
• The evaluation to determine
necessary levels of service or
production to avoid loss.
• FC = Fixed Costs
• OI = Operating Income
• TR = Total Revenue
• TC = Total Cost
(USP – UVC) x Q = FC + OI
Q = FC + OI
UMC
Q = 25,000 + 0
5
Q = 5,000
What quantity needs sold to make 1,000?
Q = 25,000 + 1,000
5
Q = 5,200
Graphical analysis:
Rs
70,000
60,000 Total Cost
Line
50,000
40,000
30,000
20,000
Total Revenue
10,000 Line Break-even point
0
1000 2000 3000 4000 5000 6000
Quantity
Graphical analysis:
Cont.
Dollars
70,000
60,000
Profit zone
Total Cost
Line B
50,000
40,000
30,000
20,000 Loss zone
Total Revenue
10,000 Line Break-even point
0
1000 2000 3000 4000 5000 6000
Quantity
Scenario 1:
Break-even Analysis Simplified
TC = TR
Summary:
• Break-even analysis can be an
effective tool in determining the cost
effectiveness of a product.
• Where: V = FC
SP - VC
Break-even analysis:
Part 1, Cont.
Machine A:
v = $3,000
$10 - $5
= 600 units
Machine B:
v = $8,000
$10 - $2
= 1000 units
Part 1: Comparison
• Compare the two results to
determine minimum quantity sold.
• Part 1 shows:
– 600 units are the minimum.
– Demand of 600 you would choose
Machine A.
Part 2: Comparison
Finding point of indifference between
Machine A and Machine B will give
the quantity demand required to
select Machine B over Machine A.
Machine A = Machine B
FC + VC = FC + VC
$3,000 + $5 Q = $8,000 + $2Q
$3Q = $5,000
Q = 1667
Part 2: Comparison
Cont.
(USP x Q) – (UVC x Q) – FC = OI
$30Q - $10Q – $100,00 = $ 0.00
$20Q = $100,000
Q = 5,000
Exercise 2:
• Company DEF has a choice of two
machines to purchase. They both
make the same product which sells
for $10.
• Machine A has FC of $5,000 and a per
unit cost of $5.
• Machine B has FC of $15,000 and a
per unit cost of $1.
Machine A = Machine B
FC + VC = FC + VC
$5,000 + $5 Q = $15,000 + $1Q
$4Q = $10,000
Q = 2500
ECN101
Professor Grob
www.stmartin.edu
Expectations for Chapter 5
15
• Describe how a perfectly competitive firm
1415
1314
maximizes profits or minimizes losses.
1213
1112
• Explain how a perfectly competitive firm achieves
1011
910
economic efficiency in the long run.
89
78
• Identify factors that contribute to monopoly.
67
56
• Develop a model that illustrates profit
45
34
maximization and loss minimzation for a monopoly.
23
12
• Assess the advantages and disadvantages of a
01
perfectly
00
0 competitive firm and a2,800,000
monopoly.
1,400,000
1,400,000 2,800,000
Quantity of fish (lbs.)
Quantity of fish (lbs.)
Continuum of market structures
#producers or sellers
1 2 5 30+
Many
Duopoly Perfect
Monopoly Competition
Oligopoly Monopolistic
competition
Chapter 5 deals with the extremes
#producers or sellers
1 Many
Perfect
Monopoly Competition
Market equilibrium facing a competitive firm
Price 15
14
13
12 Market supply
11
10
9
8
7
6
5
4
3
2 Market demand
1
0
0 1,400,000 Quantity
2,800,000
Quantity of fish (lbs.)
Some characteristics of market structures
0.00 0.00
0 500 1000 1500 2000 2500 3000 3500 0 700 1600 3000
Quantity of fish (lbs.) Quantity of fish (lbs.)
Long-run adjustments for a competitive firm: effects of
market entry
S0
7 7
S1
Demand0 = Price0
6 6
LRATC
A
5 5
Demand1 = Price1
D0
4 4
0 0 500
Quantity of fish (lbs.) Quantity of fish (lbs.)
Perfect Competition
S1
6 6
LRATC
S2
A
5 5
Demand1 = Price1
4 4
Demand2 = Price2
D0
3 3
0 0 500
Quantity of fish (lbs.) Quantity of fish (lbs.)
Monopoly
Monopoly
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Monopoly
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Why Monopolies Arise
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Why Monopolies Arise
Barriers to entry have three sources:
Ownership of a key resource.
Ê This tends to be rare. De Beers is an example
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Economies of Scale as a Cause of
Monopoly...
Cost
Average
total
cost
0 Quantity of Output
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Monopoly versus Competition
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Demand Curves for Competitive and
Monopoly Firms...
Demand
Demand
0 Quantity of 0 Quantity of
Output Output
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A Monopoly’s Revenue
Total Revenue
P x Q = TR
Average Revenue
TR/Q = AR = P
Marginal Revenue
∆TR/∆Q = MR
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A Monopoly’s Marginal Revenue
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A Monopoly’s Total, Average, and
Marginal Revenue
(Rs)
Average
Quantity Price Total Revenue Revenue Marginal Revenue
(Q) (P) (TR=P x Q) (AR=TR/Q) (MR= ∆TR / ∆Q )
0 11.00 0.00
1 10.00 10.00 10.00 10.00
2 9.00 18.00 9.00 8.00
3 8.00 24.00 8.00 6.00
4 7.00 28.00 7.00 4.00
5 6.00 30.00 6.00 2.00
6 5.00 30.00 5.00 0.00
7 4.00 28.00 4.00 -2.00
8 3.00 24.00 3.00 -4.00
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A Monopoly’s Marginal Revenue
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Demand
Marginal
cost
Marginal revenue
0 QMAX Quantity
Comparing Monopoly and
Competition
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A Monopoly’s Profit
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Monopoly E B
price
M pro
Average
total cost D C
Demand
Marginal revenue
0 QMAX Quantity
The Monopolist’s Profit
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Public Policy Toward Monopolies
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Price Discrimination
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Price Discrimination
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Monopolistic
Competition
The Four Types of Market Structure
Number of Firms?
Many
firms
One Type of Products?
firm Few
firms Differentiated Identical
products products
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Types of Imperfectly
Competitive Markets
Monopolistic Competition
Many firms selling products that are similar
but not identical.
Oligopoly
Only a few sellers, each offering a similar or
identical product to the others.
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Monopolistic Competition
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Attributes of Monopolistic
Competition
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Many Sellers
There are many firms competing for the
same group of customers.
Product examples include books, CDs,
movies, computer games, restaurants,
piano lessons, furniture, bath soaps etc.
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Product Differentiation
Each firm produces a product that is
at least slightly different from those
of other firms.
Rather than being a price taker,
each firm faces a downward-sloping
demand curve.
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Free Entry or Exit
Firms can enter or exit the market
without restriction.
The number of firms in the market
adjusts until economic profits are
zero.
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Monopolistic Competitors in
the Short Run...
(a) Firm Makes a Profit
Price
MC
ATC
Price
Average
total cost
Profit Demand
MR
0 Profit-
Quantity
maximizing quantity
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Monopolistic Competitors in
the Short Run...
(b) Firm Makes Losses
ATC
MC
Price
Losses
Average
total cost
Price
Demand
MR
0 Loss- Quantity
minimizing
quantity
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Monopolistic Competition in
the Short Run
Short-run economic profits encourage new
firms to enter the market. This:
Increases the number of products offered.
Reduces demand faced by firms already in the
market.
Incumbent firms’ demand curves shift to the
left.
Demand for the incumbent firms’ products fall,
and their profits decline.
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Monopolistic Competition in
the Short Run
Short-run economic losses encourage firms
to exit the market. This:
Decreases the number of products offered.
Increases demand faced by the remaining
firms.
Shifts the remaining firms’ demand curves
to the right.
Increases the remaining firms’ profits.
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The Long-Run Equilibrium
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A Monopolistic Competitor
in the Long Run...
Price
MC
ATC
P=ATC
Demand
MR
0
Profit-maximizing Quantity
quantity
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Two Characteristics of Long-
Run Equilibrium
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Two Characteristics of Long-
Run Equilibrium
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Monopolistic versus Perfect
Competition
There are two noteworthy
differences between monopolistic
and perfect competition—excess
capacity and markup.
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Excess Capacity
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Excess Capacity
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Excess Capacity...
(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm
Price Price
MC MC
ATC ATC
P
P = MC P = MR
Excess capacity (demand
curve)
Demand
Quantity Quantity
Quantity Efficient Quantity= Efficient
produced scale produced scale
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Markup Over Marginal Cost
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Markup Over Marginal Cost
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Markup Over Marginal Cost...
(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm
Price Price
Markup MC MC
ATC ATC
P
P = MC P = MR
(demand
Marginal curve)
cost
MR Demand
Quantity Quantity
Quantity Quantity
produced produced
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Monopolistic versus Perfect
Competition...
(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm
Price Price
MC MC
Markup ATC ATC
P
P = MC P = MR
Marginal (demand
cost curve)
MR Demand
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Monopolistic Competition and
the Welfare of Society
There is the normal deadweight loss of
monopoly pricing in monopolistic
competition caused by the markup of
price over marginal cost.
However, the administrative burden of
regulating the pricing of all firms that
produce differentiated products would be
overwhelming.
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Monopolistic Competition and
the Welfare of Society
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Monopolistic Competition and
the Welfare of Society
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Monopolistic Competition and
the Welfare of Society
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Advertising
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Advertising
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Advertising
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Advertising
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Brand Names
Economists have argued that brand
names may be a useful way for
consumers to ensure that the goods they
are buying are of high quality.
providing information about quality.
giving firms incentive to maintain high
quality.
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Summary
A monopolistically competitive market is
characterized by three attributes: many
firms, differentiated products, and free
entry.
The equilibrium in a monopolistically
competitive market differs from perfect
competition in that each firm has excess
capacity and each firm charges a price
above marginal cost.
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Summary
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Summary
The product differentiation inherent
in monopolistic competition leads to
the use of advertising and brand
names.
Critics of advertising and brand names
argue that firms use them to take
advantage of consumer irrationality and to
reduce competition.
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Summary
Defenders argue that firms use
advertising and brand names to inform
consumers and to compete more
vigorously on price and product quality.
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Graphical
Review
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Monopolistic Competitors in
the Short Run...
(a) Firm Makes a Profit
Price
MC
ATC
Price
Average
total cost
Profit Demand
MR
0 Profit-
Quantity
maximizing quantity
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Monopolistic Competitors in
the Short Run...
(b) Firm Makes Losses
ATC
MC
Price
Losses
Average
total cost
Price
Demand
MR
0 Loss- Quantity
minimizing
quantity
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A Monopolistic Competitor
in the Long Run...
Price
MC
ATC
P=ATC
Demand
MR
0
Profit-maximizing Quantity
quantity
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Excess Capacity...
(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm
Price Price
MC MC
ATC ATC
P
P = MC P = MR
Excess capacity (demand
curve)
Demand
Quantity Quantity
Quantity Efficient Quantity= Efficient
produced scale produced scale
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Markup Over Marginal Cost...
(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm
Price Price
Markup MC MC
ATC ATC
P
P = MC P = MR
(demand
Marginal curve)
cost
MR Demand
Quantity Quantity
Quantity Quantity
produced produced
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Monopolistic versus Perfect
Competition...
(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm
Price Price
MC MC
Markup ATC ATC
P
P = MC P = MR
Marginal (demand
cost curve)
MR Demand
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Imperfect Competition
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Types of Imperfectly
Competitive Markets
Oligopoly
Only a few sellers, each offering a
similar or identical product to the
others.
Monopolistic Competition
Many firms selling products that are
similar but not identical.
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The Four Types of Market Structure
Number of Firms?
Many
firms
One Type of Products?
firm Few
firms Differentiated Identical
products products
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Characteristics of an Oligopoly
Market
Few sellers offering similar or identical
products
Interdependent firms
Best off cooperating and acting like a
monopolist by producing a small quantity of
output and charging a price above marginal
cost
There is a tension between cooperation and
self-interest.
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Competition, Monopolies, and
Cartels
The Oligopolists may agree on a
monopoly outcome.
Collusion
The two firms may agree on the quantity
to produce and the price to charge.
Cartel
The two firms may join together and act
in unison.
P1
Industry D ≡ AR
Industry MR
O Q1 Q
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Oligopoly
Tacit collusion
Ê price leadership: dominant firm
Ê price leadership: Low Cost firm
Collusion and the law
The breakdown of collusion
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Oligopoly
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Kinked
Kinked demand
demand for
for aa firm
firm under
under oligopoly
oligopoly
Rs
P1
O Q1 Q
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Oligopoly
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
£
The MR
The MR curve
curve
P1
MR
a
D = AR
O Q1 Q
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Stable
Stable price
price under
under conditions
conditions of
of aa
kinked
kinked
£ demand
demand curve
curve
MC2
P1 MC1
a
D = AR
b
O Q1 Q
MR
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Oligopoly
Non-collusive oligopoly: the kinked
demand curve theory
Êassumptions of the model
Êthe shape of the demand curve
Êstable prices
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Oligopoly
Ê advantages
• countervailing power
• supernormal profits may allow higher R&D
• greater choice for consumers
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Summary of Equilibrium for an
Oligopoly
Possible outcome if oligopoly firms
pursue their own self-interests:
Joint output is greater than the monopoly
quantity but less than the competitive
industry quantity.
Market prices are lower than monopoly
price but greater than competitive price.
Total profits are less than the monopoly
profit.
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
How the Size of an Oligopoly
Affects the Market Outcome
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Pricing Methods and Policies
Context and concepts
• Learning outcomes
Going rate
Competition-based
pricing Seal bid
Competitive reaction
Price
Rapid Slow
penetration penetration
Low
New product launch pricing strategies
Cost/Benefit Analysis
Two Broad Categories
• Benefit Measurement Methods
• Mathematical Models
Mathematical Models
Also known as Algorithms
(Constrained Optimization Methods, PMBOK® 2000 Edition)
Linear Programming
Non Linear Programming
Dynamic Programming
Integer Programming
Multi-objective Programming
Mathematical Models
Also known as Algorithms
(Constrained Optimization Methods, PMBOK® 2000 Edition)
Linear Programming
Non Linear Programming
Dynamic Programming
Integer Programming
Multi-objective Programming
Mathematical Models
Linear Programming
A mathematical approach to obtaining the
best or optimal solution to a complex
problem with:
(a) A specified objective (such as maximization of
profits)
(b) Quantifiable constraints or limitations.
Copyright: Vail Training Associates 56 9
4.1.2.1 Project Selection Methods
Mathematical Models
Also known as Algorithms
(Constrained Optimization Methods, PMBOK® 2000 Edition)
Linear Programming
Non Linear Programming
Dynamic Programming
Integer Programming
Multi-objective Programming
• Benefit/Cost Ratio
• Payback Period
• Discounted Cash Flow
– Net Present Value
• Internal Rate of Return (IRR)
• Benefit/Cost Ratio
• Payback Period
• Discounted Cash Flow
• Net Present Value
• Internal Rate of Return (IRR)
Copyright: Vail Training Associates 56 20
Cost/Benefit Analysis
Benefit Measurement Methods
Economic Models
• Benefit/Cost Ratio
Simply put it is the financial value of the
benefit divided by the financial cost.
$Benefit
$Cost
• Benefit/Cost Ratio
• Benefit/Cost Ratio
• Payback Period
• Discounted Cash Flow
– Net Present Value
• Internal Rate of Return (IRR)
• Payback Period
• Payback Period
Initial Project Expense = Rs.5,000
Payback Rs Rs
Year 1 1,000 (4,000)
Year 2 2,000 (2,000)
Year 3 2,000 0
Year 4 2,000 2,000
Future Value
And
Present Value
Concepts
• Future Value
FV = PV (1+interest rate)
raised to the (number of years)
power.
• Future Value
Lets say we have Rs.1,000 invested at 6% for three
years.
FV = Rs.1,000 (1+.06) to the third power.
FV = Rs.1,000 * (1.1910)
FV = Rs.1,191
• Present Value
• Present Value
• Present Value
For example:
Rs.100 invested at 6% will amount to Rs.106
at the end of one year (this is a future value).
Therefore:
• Present Value
• Present Value
Lets say we have Rs.1,000 being sent to us 3years
from now and the inflation rate is at 3%.
PV = Rs.1,000 * 1/((1+.03) to the third power).
PV = Rs.1,000 * (.9151)
FV = Rs.915.10
• Benefit/Cost Ratio
• Payback Period
• Discounted Cash Flow
– Net Present Value
• Internal Rate of Return (IRR)
• Benefit/Cost Ratio
• Payback Period
• Discounted Cash Flow
– Net Present Value
• Internal Rate of Return (IRR)
• Benefit/Cost Ratio
• Payback Period
• Discounted Cash Flow
– Net Present Value
• Internal Rate of Return (IRR)
Years 2% 3% 6% 10%
1 1.0200 1.0300 1.0600 1.1000
Hurdle Rate
The minimum acceptable
return on investment.
Dictionary of Accounting, Ralph Estes
Second Edition, MIT Press, 1995
Copyright: Vail Training Associates 56 52
Cost/Benefit Analysis
Benefit Measurement Methods
Economic Models
Hurdle Rates
High Tech Companies tend to very
high “hurdle rates”.
Less competitive organizations tend to
have much lower “hurdle rates”.
• Benefit/Cost Ratio
• Payback Period
• Discounted Cash Flow
–Net Present Value
• Internal Rate of Return (IRR)
Copyright: Vail Training Associates 56 54
End of Cost-Benefit Analysis
Cost-benefit analysis can be much more complex that we will present here. Real
work problems frequently have benefits to multiple groups, i.e. the recipients of
the service and society at large. For example, a person cured of substance abuse
could show his or her wages as a personal benefit. Society would also gain
because this individual now pays taxes, does not steal to pay for the drug habit,
etc.
Cost Benefit
Principles Analysis, Slide 2 Ch. 20
of Macroeconomics: Second Canadian Edition
Cost-Benefit Analysis - 2
In many cases, benefits to one group may be costs to another group. For
example, welfare reform may save the government money, but reduce the
income of merchants who own the stores where welfare recipients shop.
Cost Benefit
Principles Analysis, Slide 3 Ch. 20
of Macroeconomics: Second Canadian Edition
Example 1: East Stockton Urban Renewal Project - 1
The objective and social benefits of urban renewal are (1) superior pattern of
resource allocation, (2) social benefits of the removal of blight, and (3) improved
local financial position. Although there may be a number of alternative uses for
land being redeveloped, we are here considering the more aggregate alternatives,
either urban renewal or no urban renewal in a particular section of the city. This
is the level of evaluation appropriate for cost-benefit analysis. The alternatives
would then be the particular urban renewal projects that should or should not be
undertaken.
Among the constraints active on urban renewal is the legal requirement that a
redevelopment agency must provide former residents of an urban renewal area
with decent, safe, and sanitary housing that is conveniently located and within
the means of the residents. Note that it is not implicitly assumed that relocation
results in housing facility improvement for the residents,
Cost Benefit
Principles Analysis, Slide 4 Ch. 20
of Macroeconomics: Second Canadian Edition
Example 1: East Stockton Urban Renewal Project - 2
The costs include those for relocation, survey and planning, administration,
public improvements, demolition, and the value of improvements demolished.
Benefits include those specifically associated with the stated objectives as well
as non-economic negative effects of relocation and possible land value write-
down. In urban renewal there are, of course, tangible and intangible benefits; in
this exercise, our goal is to determine what level of intangible benefits would
decision makers have to substantiate in order to justify the project from a cost-
benefit perspective.
The East Stockton, California, Urban Renewal Project was officially approved
by the federal government in July 1959. The workbook, “Urban Renewal.xls”,
which can be downloaded from the course download web page, displays the
various costs associated with the renewal project and the time at which they
occurred. Most of the costs were actually incurred over an interval of time; in
such cases the center of the interval is used as the date of the cost.
Cost Benefit
Principles Analysis, Slide 5 Ch. 20
of Macroeconomics: Second Canadian Edition
Example 1: East Stockton Urban Renewal Project - 3
The cost of the land is not included in the list of costs since land purchases were
later resold. In the East Stockton renewal project, the land was purchased for
$669,129 over a period roughly centered at June 30, 1960. After clearing and
renewal, the land was subsequently sold for $1,200,000 over a period roughly
centered at June 30, 1965. Employing a discount rate of 6 percent, the selling
price was discounted to June 30, 1960, yielding a present value of $896,760;
hence, the redevelopment agency had a “profit” of $227,631 on the project area
land. This amount is included in the list of tangible benefits in the
“UrbanRenewal” workbook.
Other tangible benefits were not quite so easily estimated. The increase in the
property value in the project area was the result of three factors: inflation,
growth in real income and population, and urban renewal. To isolate the
increase due to urban renewal, a comparison was made between increases in the
project area and increases near the project area. The comparison led to an
estimate of $415,500 as the increase in the value of the neighborhood properties.
Public improvements such as schools and parts were estimated at a value equal
to their cost.
Cost Benefit
Principles Analysis, Slide 6 Ch. 20
of Macroeconomics: Second Canadian Edition
Example 1: East Stockton Urban Renewal Project - 4
The questions we will answer in this exercise are: what level of intangible
benefits need to be identified in order for this project to satisfy the minimum cost
benefit ratio of 1.0? Does a higher or lower discount rate substantially change
our answer?
Cost Benefit
Principles Analysis, Slide 7 Ch. 20
of Macroeconomics: Second Canadian Edition
Tangible costs/benefits of urban renewal project
The
Thetangible
tangiblecosts
costsand
andbenefits
benefitsforforthe
theproject
projecthave
have
been entered in a workbook called UrbanRenewal.xls
been entered in a workbook called UrbanRenewal.xls
which
whichcan canbebedownloaded
downloadedfrom fromaacourse
courseweb
webpage.
page. All
All
ofofthis information is given in the chapter by McKenna.
this information is given in the chapter by McKenna.
Note
Notethatthatthe
theworksheet
worksheetincludes
includesthetheDate
Dateofofthe
the
expense
expensebecause
becausenotnotall
allexpenses
expensesoccurred
occurredatatregular
regular
annual intervals. Excel has another worksheet function
annual intervals. Excel has another worksheet function
to
tosupport
supportcalculations
calculationsofofnet
netpresent
presentvalue
valuewhen
whenthe
the
stream
stream of payments occur in different time periods,the
of payments occur in different time periods, the
XNPV function.
XNPV function.
Cost Benefit
Principles Analysis, Slide 8 Ch. 20
of Macroeconomics: Second Canadian Edition
The discount rate
First,
First,we
weenter
enterthe
thediscount
discount
rate stated in the problem
rate stated in the problem
6%
6%ininthe
thecell
cellD2
D2ofofthe
the
Cost-benefit analysis
Cost-benefit analysis
worksheet.
worksheet.
Cost Benefit
Principles Analysis, Slide 9 Ch. 20
of Macroeconomics: Second Canadian Edition
Use XNPV function to calculate value of tangible costs
First,
First,select
selectthe
thecell
cellininwhich
whichwe
we
Excel
Excelto
toreturn
returnthe
thepresent
presentvalue
valueofof
the
thetangible
tangiblecosts,
costs,cell
cellB14
B14ononthe
the
Cost-benefit analysis worksheet.
Cost-benefit analysis worksheet.
Second,
Second,select
selectthe
the
Function command
Function command
from
fromthe
theInsert
Insertmenu.
menu.
Unlike
Unlikethe
the‘NPV’
‘NPV’function,
function,
the
the‘XNPV’
‘XNPV’function
functiondoes
does
not make the assumption
not make the assumption
that
thatthe
theseries
seriesofofcosts
costs
occurs at regular, annual
occurs at regular, annual
intervals.
intervals. XPNV
XPNVpermits
permits
us
usto
toassociated
associateddates
dates
with each cost item.
with each cost item.
Cost Benefit
Principles Analysis, Slide 10 Ch. 20
of Macroeconomics: Second Canadian Edition
Locate the XNPV function
We
Wewill
willsearch
searchforforthe
theXNPV
XNPV
function.
function.First,
First,type
typeXNPV
XNPVininthe
the
Search
Search for text box, and clickon
for text box, and click on
the Go button.
the Go button.
The
TheXNPV
XNPVfunction
functionname
namewillwillappear
appearinin
the
theSelect
Selectaafunction
functionlist
listbox.
box.Click
Clickon
onthe
the
OK button access the dialog box where
OK button access the dialog box where
the
thefunction
functionarguments
argumentsare areentered.
entered.
Note:
Note:the
theXNPV
XNPVfunction
functionisispart
partofofthe
the
Analysis Toolpak that we used for
Analysis Toolpak that we used for
Data
DataAnalysis.
Analysis.IfIfExcel
Exceldoes
doesnotnotfind
find
it,
it,check
checkto
tomake
makesuresurethe
theAnalysis
Analysis
Toolpak
ToolpakAdd-in
Add-inhas
hasbeen
beeninstalled.
installed.
Cost Benefit
Principles Analysis, Slide 11 Ch. 20
of Macroeconomics: Second Canadian Edition
The arguments to the XNPV function
The
Thefirst
firstargument
argumentto to
the
theXNPV
XNPVfunction
functionisisthe
the
discount rate, which we
discount rate, which we
put
putinincell
cellD2.
D2.
The
Thesecond
secondargument
argument
to
to the XNPV functionisis
the XNPV function
the
thecells
cellscontaining
containingthe
the
The tangible costs, B2:B12.
Thethird
thirdargument
argumentto to tangible costs, B2:B12.
the XNPV function is the
the XNPV function is the
cells
cellscontaining
containingthe
the
dates
datesthe
thetangible
tangiblecosts
costs
occurred, C2:C12.
occurred, C2:C12.
With
Withthe
thearguments
arguments
entered,
entered, clickon
click on
the
theOK
OKbutton.
button.
Cost Benefit
Principles Analysis, Slide 12 Ch. 20
of Macroeconomics: Second Canadian Edition
Net present value of tangible costs
Excel
Excelcomputes
computesthethe
net
netpresent
presentvalue
valuefor
for
the series of costs for
the series of costs for
this
thisproject.
project.
Cost Benefit
Principles Analysis, Slide 13 Ch. 20
of Macroeconomics: Second Canadian Edition
The table of tangible benefits - 1
The
TheXPNV
XPNVfunction
functiondiscounts
discountsthethestream
streamofofcosts
costsororbenefits
benefits
back
back to the first date in the series. For costs, the entryfor
to the first date in the series. For costs, the entry for
‘Survey
‘Surveyand
andplanning’
planning’waswasdated
datedto tooccur
occuratatthe
thestart
startofofthe
the
project. Since this item was listed first, it could be used for
project. Since this item was listed first, it could be used for
the
thedate
date(12-31-58)
(12-31-58)to towhich
whichall
allother
othercosts
costswere
werediscounted.
discounted.
Cost Benefit
Principles Analysis, Slide 14 Ch. 20
of Macroeconomics: Second Canadian Edition
The table of tangible benefits - 2
The
Thetable
tableofoftangible
tangiblebenefits
benefitswas
wascopied
copied
from the McKenna text, except for the
from the McKenna text, except for the
entry
entryononrow
row18 18which
whichwas
wasadded
addedasasaa
requirement
requirementofofthetheXNPV
XNPVfunction.
function.
InInthe
thecase
caseofofbenefits,
benefits,there
therewas,
was,quite
quitenaturally,
naturally,nonobenefit
benefit
totobe
berealized
realizedatatthe thestart
startofofthe
theproject.
project. ToTosatisfy
satisfythe
theExcel
Excel
XPNV function, I added a dummy entry to the table,
XPNV function, I added a dummy entry to the table,
‘Immediate
‘Immediatebenefits’
benefits’with
withaavalue
valueofof$0
$0totobe
berealized
realizedatatthe
the
start
start of the project on 12-31-58. Since this entry was forzero
of the project on 12-31-58. Since this entry was for zero
dollars, it will not affect our benefit calculations. The date
dollars, it will not affect our benefit calculations. The date
entry
entryinincell
cellC18
C18meets
meetsthetherequirement
requirementofofthetheXNPV
XNPVfunction
function
for an initial date to which all other benefits are discounted.
for an initial date to which all other benefits are discounted.
Cost Benefit
Principles Analysis, Slide 15 Ch. 20
of Macroeconomics: Second Canadian Edition
Use XNPV to calculate value of tangible benefits
First,
First,select
selectthe
thecell
cellininwhich
whichwewe
Excel
Excelto
toreturn
returnthe
thepresent
presentvalue
valueofof
the
thetangible
tangiblebenefits
benefitscell
cellB26
B26on
onthe
the
Cost-benefit analysis worksheet.
Cost-benefit analysis worksheet.
Second,
Second,select
selectthe
the
Function command
Function command
from
fromthe
theInsert
Insertmenu.
menu.
Cost Benefit
Principles Analysis, Slide 16 Ch. 20
of Macroeconomics: Second Canadian Edition
Locate the XNPV function
We
Wewill
willsearch
searchforforthe
theXNPV
XNPV
function.
function.First,
First,type
typeXNPV
XNPVinin
the
theSearch
Searchforfortext
textbox,
box,and
and
click on the Go button.
click on the Go button.
The
TheXNPV
XNPVfunction
functionname
namewillwillappear
appearinin
the
the Select a function list box. Clickon
Select a function list box. Click onthe
the
OK
OKbutton
buttonaccess
accessthe
thedialog
dialogbox
boxwhere
where
the
thefunction
functionarguments
argumentsare areentered.
entered.
Note:
Note:thetheXNPV
XNPVfunction
functionisispart
part
ofofthe
theAnalysis
AnalysisToolpak
Toolpakthat
thatwewe
used for Data Analysis. If Excel
used for Data Analysis. If Excel
does
doesnotnotfind
findit,
it,check
checktotomake
make
sure
surethetheAnalysis
AnalysisToolpak
ToolpakAdd-in
Add-in
has been installed.
has been installed.
Cost Benefit
Principles Analysis, Slide 17 Ch. 20
of Macroeconomics: Second Canadian Edition
The arguments to the XNPV function
The
Thefirst
firstargument
argumentto to
the
theXNPV
XNPVfunction
functionisisthe
the
discount rate, which we
discount rate, which we
put
putinincell
cellD2.
D2. The
Thesecond
secondargument
argumentto to
the
theXNPV
XNPVfunction
functionisisthe
the
cells
cellscontaining
containingthe
thetangible
tangible
benefits, B18:B24.
benefits, B18:B24.
The
Thethird
thirdargument
argumentto tothe
theXNPV
XNPV
function is the cells containing
function is the cells containing
the
thedates
datesthethetangible
tangiblebenefits
benefits
occurred, C18:C24.
occurred, C18:C24.
With
Withthe
thearguments
arguments
entered,
entered, clickon
click on
the OK button.
the OK button.
Cost Benefit
Principles Analysis, Slide 18 Ch. 20
of Macroeconomics: Second Canadian Edition
Net present value of tangible benefits
Excel
Excelcomputes
computesthe thenet
net
present
present value for theseries
value for the series
ofofbenefits
benefitsfor
forthis
thisproject.
project.
Cost Benefit
Principles Analysis, Slide 19 Ch. 20
of Macroeconomics: Second Canadian Edition
Compute the required intangible benefits
The
Theproblem
problemstatement
statementwanted
wanted
us
usto
tofind
findthe
theminimum
minimumlevellevelofof
In
intangible
intangible benefits that wouldbe
benefits that would be Incell
cellB28,
B28,enter
enterthe
theformula
formula
necessary for computing the difference
necessaryto tomeet
meetthetheminimum
minimum for computing the difference
between
benefit-cost
benefit-costratio
ratioofof1.0.
1.0. betweentangible
tangiblecosts
costsinincell
cell
B14
B14andandtangible
tangiblebenefits
benefitsinin
cell
The
The‘Required
‘Requiredintangible
intangiblebenefits’
benefits’ cellB26:
B26:=B14-B26.
=B14-B26.
are equal to the difference
are equal to the difference
In
between
betweentangible
tangiblecosts
costsand
and Inorder
orderto tosatisfy
satisfybenefit-cost
benefit-cost
criteria,
criteria, the projectplanners
tangible benefits. the project
tangible benefits. planners
would
wouldhave
haveto toidentify
identifyand
and
document $1,062,932 in
document $1,062,932 in
intangible
intangiblebenefits.
benefits.
Cost Benefit
Principles Analysis, Slide 20 Ch. 20
of Macroeconomics: Second Canadian Edition
What if the discount rate were different
The
Theproblem
problemstatement
statementalso
also
wanted us to determine whether
wanted us to determine whether
or
ornot
notaahigher
higheror
orlower
lowerdiscount
discount
rate
rate substantially changesour
substantially changes our
answer.
answer.
In
Inorder
orderto tosee
seethe
theresults
resultsofofthe
the
testing
testingdifferent
differentdiscount
discountrates,
rates,
we
wesplit
splitthe
thescreen
screenatatrow
row24
24and
and
arrange the panes as shown.
arrange the panes as shown.
Cost Benefit
Principles Analysis, Slide 21 Ch. 20
of Macroeconomics: Second Canadian Edition
Test a higher discount rate
Enter
Enter7%7%inincell
cellD2
D2
to
to test the effect ofaa
test the effect of
higher
higherdiscount
discountrate.
rate.
Excel
Excelhas
hasrecalculated
recalculatedthe
the
required
requiredintangible
intangiblebenefits
benefits
needed
neededtotobe
behigher
higherby
by
about $15,000
about $15,000
($1,077,691-$1,062,932).
($1,077,691-$1,062,932).
For
Forthis
thissize
sizeofofthe
theurban
urban
renewal project, I would
renewal project, I would
not
notconsider
considerthis
thisaa
substantial
substantialdifference
difference
Cost Benefit
Principles Analysis, Slide 22 Ch. 20
of Macroeconomics: Second Canadian Edition
Test a lower discount rate
To
Totest
testaalower
lowerdiscount
discountrate,
rate,
enter
enter 5% in cell D2 to testthe
5% in cell D2 to test the
effect of a higher discount rate.
effect of a higher discount rate.
Excel
Excelhas
hasrecalculated
recalculatedthe
the
required intangible benefits
required intangible benefits
needed
neededtotobe
belower
lowerby
byabout
about
$16,000 ($1,046,037-
$16,000 ($1,046,037-
$1,062,932).
$1,062,932).
For
Forthis
thissize
sizeofofthe
theurban
urban
renewal
renewalproject,
project,I Iwould
wouldnot
not
consider this a substantial
consider this a substantial
difference
difference
WeWehave
haveanswered
answeredall
all
ofofthe questions stated
the questions stated
ininthe
theproblem.
problem.
Cost Benefit
Principles Analysis, Slide 23 Ch. 20
of Macroeconomics: Second Canadian Edition
Example 2: A Highway Expansion Project
This example was adapted from a problem presented in Public Policy Analysis:
Applied Research Methods by Theodore H. Poister, pages 397-400.
For this problem, we will present in detail how the benefits and costs are
derived. The sheet, column, and row labels have been entered into the workbook,
HighwayProject.xls.
Cost Benefit
Principles Analysis, Slide 24 Ch. 20
of Macroeconomics: Second Canadian Edition
The benefit of travel time saved by the proposed
highways
The
Theaverage
averagetime
timespent
spentperpertrip
tripdeclines
declinesdramatically
dramatically
with
with the expansion to the 4-lane highway,and
the expansion to the 4-lane highway, andthen
then
modestly
modestlyas aswewemove
moveto tothe
the6-lane
6-lanehighway
highway
expansion.
expansion. Average
Averagedriving
drivingtimetimeperpertrip
tripon
onthe
the
existing
existinghighway
highwayisisestimated
estimatedto tobe
be3030minutes.
minutes. IfIf
the
thehighway
highwayisisexpanded
expandedto to4-lanes,
4-lanes,thetheaverage
averagetrip
trip
time drops to 18 minutes. If the highway is
time drops to 18 minutes. If the highway is
expanded
expandedto to6-lanes,
6-lanes,the
theaverage
averagetrip triptime
timedrops
dropsan
an
additional two minutes to 16 minutes.
additional two minutes to 16 minutes.
Cost Benefit
Principles Analysis, Slide 25 Ch. 20
of Macroeconomics: Second Canadian Edition
Computing the time cost per trip
Setting
Settingthe
thevalue
valueofofthe
thedriver’s
driver’stime
time atat$2.00
$2.00
per
perhour,
hour,the
thetime
timecost
costper
pertrip
tripisiscomputed
computedbyby
dividing the number of minutes in the average
dividing the number of minutes in the average
trip
tripby
by60
60and
andthen
thenmultiplying
multiplyingby by$2.00.
$2.00.
In
Incell
cellB3,
B3,enter
enterthetheformula
formula
=B2/60*2.
=B2/60*2. In cell C3,enter
In cell C3, enterthe
the
formula
formula=C2/60*2.
=C2/60*2.In Incell
cellD3,
D3,
enter
enterthe
theformula
formula=D2/60*2.
=D2/60*2.
Cost Benefit
Principles Analysis, Slide 26 Ch. 20
of Macroeconomics: Second Canadian Edition
Total cost per trip
Other
Othertrip
tripcosts
costsincrease
increaseslightly
slightlyatatthe
thefirst
firstexpansion
expansionlevel
level
(from $1.75 to $1.90), because of higher and less efficient
(from $1.75 to $1.90), because of higher and less efficient
operating
operatingspeeds,
speeds,andandthen
thendecrease
decreaseslightly
slightlyatatthe
thesecond
second
expansion level (from $1.90 to $1.85) because of improved
expansion level (from $1.90 to $1.85) because of improved
maneuverability
maneuverabilityinindispersed
dispersedtraffic.
traffic.Enter
Enter$1.75
$1.75inincell
cellB4,
B4,
$1.90
$1.90inincell
cellC4,
C4,and
and$1.85
$1.85inincell
cellD4.
D4.
Total
Totalvariable
variablecostcostper
pertrip
tripisis
computed
computed by adding ‘Timecost
by adding ‘Time cost
per
pertrip’
trip’and
and‘Other
‘Othercosts
costsper
per
trip’.
trip’.Enter
Enter=B3+B4
=B3+B4inincell
cellB5,
B5,
=C3+C4 in cell C5, and
=C3+C4 in cell C5, and
=D3+D4
=D3+D4inincell cellD5.
D5.
Cost Benefit
Principles Analysis, Slide 27 Ch. 20
of Macroeconomics: Second Canadian Edition
Cost savings per trip
The
Thecost
costsavings
savingsper
pertrip
tripwhen
when
expanding
expandingto tothe
the4-lane
4-lanehighway
highway
isisthe
thedifference
differencebetween
betweenthe the
total variable costs for the
total variable costs for the
existing
existinghighway
highway($2.75)
($2.75)andand
the 4-lane highway ($2.50)
the 4-lane highway ($2.50)
which
whichequals
equals$.25.
$.25.Enter
Enterthe
the
formula =B5-C5 in cell
formula =B5-C5 in cell C6.C6.
The
Thecost
costsavings
savingsper
pertrip
tripwhen
when
expanding to the 6-lane highway
expanding to the 6-lane highway
isisthe
thedifference
differencebetween
betweenthethe
total
total variable costs for the4-
variable costs for the 4-
lane
lane highway ($2.50) and the6-
highway ($2.50) and the 6-
lane
lanehighway
highway($2.38)
($2.38)which
which
equals
equals$.12.
$.12.Enter
Enterthe
theformula
formula
=C5-D5
=C5-D5inincell
cellD6.
D6.
Cost Benefit
Principles Analysis, Slide 28 Ch. 20
of Macroeconomics: Second Canadian Edition
Computing cost savings on current trips
First,
First,weweenter
enterthe
thesame
samenumber
numberofoftrips tripsper
peryear
year
for each highway condition, 1 million trips per year
for each highway condition, 1 million trips per year
inincells
cellsB8,
B8,C8,
C8,and
andD8.
D8. ItItisislikely
likelythat
thatthe
the
number
numberofoftrips
tripswould
wouldincrease
increasebecause
becauseofof
improved
improvedtravel.
travel. Estimating
Estimatingsavings
savingsbased
basedononthe
the
existing number of trips is, therefore, a
existing number of trips is, therefore, a
conservative
conservativeestimate
estimateofofthe
theprobable
probablesavings.
savings.
Second,
Second,to tocompute
computethe thecost
cost
savings for all trips, we multiply
savings for all trips, we multiply
the
thecost
costsavings
savingsperpertrip
tripon
onrow
row
66by the number of trips per
by the number of trips per
year
yearononrow
row8.8.Enter
Enter=C6*C8
=C6*C8inin
cell
cellC9
C9and
and=D6*D8
=D6*D8inincellcellD9.
D9.
Cost Benefit
Principles Analysis, Slide 29 Ch. 20
of Macroeconomics: Second Canadian Edition
Projected savings worksheet
First,
First,copy
copythe
thecost
costsavings
savingsfor
foreach
eachofofthe
the
expansion
expansion projects from cells C9 throughD9
projects from cells C9 through D9
on the ‘Cost-benefit Analysis’ worksheet and
on the ‘Cost-benefit Analysis’ worksheet and
Paste
PasteSpecial
Specialthe
theValues
Valuesinto
intocells
cellsB2
B2through
through
C2 on the ‘Projected Savings’ worksheet.
C2 on the ‘Projected Savings’ worksheet.
Second,
Second,fill fillthe
theannual
annualsavings
savings
down
downforforaatwenty-five
twenty-fiveyear
yeartime
time
period. For this problem, the
period. For this problem, the
present
presentvalue
valueofofthethebenefits
benefits
stream is computed by
stream is computed by
assuming
assumingthat thatthethesame
sameamount
amount
ofofbenefit
benefitwill
willaccrue
accruefor
foreach
eachofof
25
25years
yearsinto
intothethefuture.
future.
Highlight
Highlightcells
cellsB2
B2through
throughC26
C26
and select the Fill > Down
and select the Fill > Down
command
commandfromfromthetheEdit
Editmenu.
menu.
Cost Benefit
Principles Analysis, Slide 30 Ch. 20
of Macroeconomics: Second Canadian Edition
Compute NPV of savings for 4 lane expansion
First,
First,select
selectthe
thecell
cellininwhich
whichwe
we
Excel to return the present value
Excel to return the present value
ofofthe
thesavings,
savings,cell
cellC10
C10ononthe
the
Cost-benefit Analysis worksheet.
Cost-benefit Analysis worksheet.
Second,
Second,select
selectthe
the
Function command
Function command
from
fromthe
theInsert
Insertmenu.
menu.
Cost Benefit
Principles Analysis, Slide 31 Ch. 20
of Macroeconomics: Second Canadian Edition
Locate the NPV function
We
Wewill
willsearch
searchforforthe
theNPV
NPV
function.
function.First,
First,type
typeNPV
NPVinin
the
theSearch
Searchforfortext
textbox,
box,and
and
click on the Go button.
click on the Go button.
The
TheNPVNPVfunction
functionname
namewillwill
appear in the Select a function
appear in the Select a function
list
listbox.
box.Click
Clickon
onthe
theOK OKbutton
button
access
accessthethedialog
dialogbox
boxwhere
wherethe
the
function arguments are entered.
function arguments are entered.
Cost Benefit
Principles Analysis, Slide 32 Ch. 20
of Macroeconomics: Second Canadian Edition
The arguments to the NPV function
The
Thefirst
firstargument
argumentto tothe
the
NPV function is the
NPV function is the
discount
discountrate,
rate,which
whichwewe
will
willenter
enterdirectly
directlyas
as8%.
8%.
The
Thesecond
secondargument
argumenttotothe
theNPV
NPVfunction
functionisisthe
thecells
cells
containing the projected savings for 4 lane expansion,
containing the projected savings for 4 lane expansion,
'Projected
'ProjectedSavings'!B2:B26.
Savings'!B2:B26.
Remember
Remembertotoenter
enterthe
thequote
quotemarks
marksaround
aroundthethename
nameofofthe
the
worksheet
worksheetProjected
ProjectedSavings
Savingsbecause
becauseititcontains
containsaaspace.
space.
With
Withthe
thearguments
arguments
entered,
entered, clickon
click on
the OK button.
the OK button.
Cost Benefit
Principles Analysis, Slide 33 Ch. 20
of Macroeconomics: Second Canadian Edition
NPV for projected savings for 4 lane expansion
The
TheNPV
NPVfunction
functionreturns
returnsthe
the
present
presentvalue
valueofofthe
theprojected
projected
savings
savingsfor
for44lane
laneexpansion,
expansion,
$2,668,694.05.
$2,668,694.05.
Cost Benefit
Principles Analysis, Slide 34 Ch. 20
of Macroeconomics: Second Canadian Edition
Compute NPV of projected savings for 6 lane
expansion
First,
First,select
selectthe
thecell
cellininwhich
whichwe
we
Excel
Exceltotoreturn
returnthe
thepresent
presentvalue
value
ofofthe
thesavings,
savings,cell
cellD10
D10ononthe
the
Cost-benefit Analysis worksheet.
Cost-benefit Analysis worksheet.
Second,
Second,select
selectthe
the
Function command
Function command
from
fromthe
theInsert
Insertmenu.
menu.
Cost Benefit
Principles Analysis, Slide 35 Ch. 20
of Macroeconomics: Second Canadian Edition
Locate the NPV function
We
Wewill
willsearch
searchforforthe
theNPV
NPV
function.
function. First, type NPVinin
First, type NPV
the
theSearch
Searchforfortext
textbox,
box,
and click on the Go button.
and click on the Go button.
The
TheNPVNPVfunction
functionname
namewillwill
appear in the Select a function
appear in the Select a function
list
listbox.
box.Click
Clickon
onthe
theOK OKbutton
button
access
accessthethedialog
dialogbox
boxwhere
wherethe
the
function arguments are entered.
function arguments are entered.
Cost Benefit
Principles Analysis, Slide 36 Ch. 20
of Macroeconomics: Second Canadian Edition
The arguments to the NPV function
The
Thefirst
firstargument
argumentto tothe
the
NPV function is the
NPV function is the
discount
discountrate,
rate,which
whichwewe
will enter directly as 8%.
will enter directly as 8%.
The
Thesecond
secondargument
argumenttotothe
theNPV
NPVfunction
functionisisthe
thecells
cells
containing
containingthe
theprojected
projectedsavings
savingsfor
for66lane
laneexpansion,
expansion,
'Projected
'ProjectedSavings'!C2:C26.
Savings'!C2:C26.
Remember
Remembertotoenter
enterthe
thequote
quotemarks
marksaround
aroundthe
thename
nameofofthe
the
worksheet Projected Savings because it contains a space.
worksheet Projected Savings because it contains a space.
With
Withthe
thearguments
arguments
entered,
entered, clickon
click on
the OK button.
the OK button.
Cost Benefit
Principles Analysis, Slide 37 Ch. 20
of Macroeconomics: Second Canadian Edition
NPV for projected savings for 6 lane expansion
The
TheNPV
NPVfunction
functionreturns
returnsthe
the
present
presentvalue
valueofofthe
theprojected
projected
savings
savingsfor
for66lane
laneexpansion,
expansion,
$1,245,394.11.
$1,245,394.11.
Cost Benefit
Principles Analysis, Slide 38 Ch. 20
of Macroeconomics: Second Canadian Edition
The costs of the highway projects - 1
The
Theexpansion
expansiontotoaa4-lane
4-lanehighway
highway
will cost $2,000,000 in construction
will cost $2,000,000 in construction
costs.
costs.Enter
Enter$2,000,000
$2,000,000inincell
cellC13.
C13.
Similarly,
Similarly,the
theexpansion
expansionto to66lanes
lanes
will cost an additional $2,000,000.
will cost an additional $2,000,000.
Enter
Enter$2,000,000
$2,000,000inincell
cellD13.
D13.
Cost Benefit
Principles Analysis, Slide 39 Ch. 20
of Macroeconomics: Second Canadian Edition
The costs of the highway projects - 2
The
Theannual
annualmaintenance
maintenancecostscostsfor
forboth
both
the
theexisting
existinghighway
highwayandandeach
eachofofthe
the
alternatives
alternativesisisentered
enteredininthe
theworksheet.
worksheet.
Enter
Enter$20,000
$20,000inincell
cellB14,
B14,$30,000
$30,000inin
cell
cell C14, and $50,000 in cellD14.
C14, and $50,000 in cell D14.
Cost Benefit
Principles Analysis, Slide 40 Ch. 20
of Macroeconomics: Second Canadian Edition
The costs of the highway projects - 3
The
Theincrease
increaseininmaintenance
maintenancecosts
costsare
are
computed
computed by subtracting the existingroadway
by subtracting the existing roadway
maintenance
maintenancecosts
costsfrom
fromthe
the4-lane
4-laneexpansion
expansion
maintenance
maintenancecosts
costsand
andsubtracting
subtractingthethe4-lane
4-lane
expansion maintenance costs from the 6-lane
expansion maintenance costs from the 6-lane
maintenance
maintenancecosts.
costs.
Second,
Second,enterenterthe
the
formula
formula =D14-C14inin
=D14-C14
cell
cellD15
D15totocompute
compute
the
the increaseinin
increase
First,
First,enter
enterthe
theformula
formula maintenance
maintenancecostscosts
=C14-B14
=C14-B14inincellcellC15
C15to
to associated
associatedwithwithadding
adding
compute the increase in two
two additional lanesto
compute the increase in additional lanes
maintenance to
maintenancecostscosts the
the44lane
lanehighway.
highway.
associated
associatedwith
withthethe
expansion to 4 lanes.
expansion to 4 lanes.
Cost Benefit
Principles Analysis, Slide 41 Ch. 20
of Macroeconomics: Second Canadian Edition
Annual Maintenance worksheet
First,
First,copy
copythe
theincrease
increaseininmaintenance
maintenance
costs
costs for each of the expansionprojects
for each of the expansion projects
from
fromcells
cellsC15
C15through
throughD15 D15on onthe
the‘Cost-
‘Cost-
benefit Analysis’ worksheet and Paste
benefit Analysis’ worksheet and Paste
Special
SpecialthetheValues
Valuesinto
intocells
cellsB2
B2through
throughC2 C2
on
onthe
the‘Annual
‘AnnualMaintenance’
Maintenance’worksheet.
worksheet.
Second,
Second,fillfillthe
theannual
annualmaintenance
maintenance
cost
costincreases
increasesdowndownforforaatwenty-five
twenty-five
year time period. For this problem,
year time period. For this problem,
the
thepresent
presentvalue
valueofofthe
thecost
coststream
stream
isiscomputed
computed by assuming thatthe
by assuming that the
same amount of maintenance costs
same amount of maintenance costs
will
willbe
beincurred
incurredfor foreach
eachofof2525years
years
into the future.
into the future.
Highlight
Highlightcells
cellsB2B2through
throughC26
C26and
and
select
select the Fill > Down commandfrom
the Fill > Down command from
the
theEdit
Editmenu.
menu.
Cost Benefit
Principles Analysis, Slide 42 Ch. 20
of Macroeconomics: Second Canadian Edition
Compute NPV of increased maintenance for 4 lane
expansion
First,
First,select
selectthe
thecell
cellininwhich
whichwe
we
Excel to return the present value
Excel to return the present value
ofofthe
theincreased
increasedmaintenance,
maintenance,
cell C16 on the Cost-benefit
cell C16 on the Cost-benefit
Analysis
Analysisworksheet.
worksheet.
Second,
Second,select
selectthe
the
Function command
Function command
from
fromthe
theInsert
Insertmenu.
menu.
Cost Benefit
Principles Analysis, Slide 43 Ch. 20
of Macroeconomics: Second Canadian Edition
Locate the NPV function
We
Wewill
willsearch
searchforforthe
theNPV
NPV
function.
function.First,
First,type
typeNPV
NPVininthe
the
Search
Search for text box, and clickon
for text box, and click on
the Go button.
the Go button.
The
TheNPVNPVfunction
functionname
namewillwill
appear in the Select a function
appear in the Select a function
list
listbox.
box.Click
Clickon
onthe
theOK OKbutton
button
access
accessthethedialog
dialogbox
boxwhere
wherethe
the
function arguments are entered.
function arguments are entered.
Cost Benefit
Principles Analysis, Slide 44 Ch. 20
of Macroeconomics: Second Canadian Edition
The arguments to the NPV function
The
Thefirst
firstargument
argumentto tothe
the
NPV
NPVfunction
functionisisthe
the
discount
discountrate,
rate,which
whichwewe
will enter directly as 8%.
will enter directly as 8%.
The
Thesecond
secondargument
argumenttotothe
theNPV
NPVfunction
functionisisthe
thecells
cells
containing the increased maintenance for 4 lane expansion,
containing the increased maintenance for 4 lane expansion,
'Projected
'ProjectedSavings'!B2:B26.
Savings'!B2:B26.
Remember
Remembertotoenter
enterthe
thequote
quotemarks
marksaround
aroundthethename
nameofofthe
the
worksheet
worksheetAnnual
AnnualMaintenance
Maintenancebecause
becauseititcontains
containsaaspace.
space.
With
Withthe
thearguments
arguments
entered,
entered, clickon
click on
the OK button.
the OK button.
Cost Benefit
Principles Analysis, Slide 45 Ch. 20
of Macroeconomics: Second Canadian Edition
NPV for increased maintenance for 4 lane expansion
The
TheNPV
NPVfunction
functionreturns
returnsthe
the
present value of the increased
present value of the increased
maintenance
maintenancefor
for44lane
lane
expansion, $106,747.76.
expansion, $106,747.76.
Cost Benefit
Principles Analysis, Slide 46 Ch. 20
of Macroeconomics: Second Canadian Edition
Compute NPV of maintenance for 6 lane expansion
First,
First,select
selectthe
thecell
cellininwhich
whichwe
we
Excel to return the present value
Excel to return the present value
ofofthe
theincreased
increasedmaintenance,
maintenance,
cell D16 on the Cost-benefit
cell D16 on the Cost-benefit
Analysis
Analysisworksheet.
worksheet.
Second,
Second,select
selectthe
the
Function command
Function command
from
fromthe
theInsert
Insertmenu.
menu.
Cost Benefit
Principles Analysis, Slide 47 Ch. 20
of Macroeconomics: Second Canadian Edition
Locate the NPV function
We
Wewill
willsearch
searchforforthe
theNPV
NPV
function.
function. First, type NPVininthe
First, type NPV the
Search
Searchforfortext
textbox,
box,and
andclick
clickon
on
the Go button.
the Go button.
The
TheNPVNPVfunction
functionname
namewillwill
appear in the Select a function
appear in the Select a function
list
listbox.
box.Click
Clickon
onthe
theOK OKbutton
button
access
accessthethedialog
dialogbox
boxwhere
wherethe
the
function arguments are entered.
function arguments are entered.
Cost Benefit
Principles Analysis, Slide 48 Ch. 20
of Macroeconomics: Second Canadian Edition
The arguments to the NPV function
The
Thefirst
firstargument
argumentto tothe
the
NPV
NPVfunction
functionisisthe
the
discount
discountrate,
rate,which
whichwewe
will enter directly as 8%.
will enter directly as 8%.
The
Thesecond
secondargument
argumenttotothe
theNPV
NPVfunction
functionisisthe
thecells
cells
containing
containingthe
theincreased
increasedmaintenance
maintenancefor
for66lane
laneexpansion,
expansion,
'Projected Savings'!C2:C26.
'Projected Savings'!C2:C26.
Remember
Remembertotoenter
enterthe
thequote
quotemarks
marksaround
aroundthe
thename
nameofofthe
the
worksheet Annual Maintenance because it contains a space.
worksheet Annual Maintenance because it contains a space.
With
Withthe
thearguments
arguments
entered,
entered, clickon
click on
the OK button.
the OK button.
Cost Benefit
Principles Analysis, Slide 49 Ch. 20
of Macroeconomics: Second Canadian Edition
NPV for increased maintenance for 6 lane expansion
The
TheNPV
NPVfunction
functionreturns
returnsthe
the
present value of the increased
present value of the increased
maintenance
maintenancefor
for66lane
lane
expansion, $213,495.52.
expansion, $213,495.52.
Cost Benefit
Principles Analysis, Slide 50 Ch. 20
of Macroeconomics: Second Canadian Edition
Total project costs
The
Thetotal
totalproject
projectcosts
costsfor
forthe
the
two
two expansion projects arethe
expansion projects are the
sum
sumofofthe
thecapital
capitalcosts
costsand
and
the
theyearly
yearlymaintenance
maintenancecosts.
costs.
Sum
Sumtotal
totalproject
projectcosts
costsfor
forthethe44
lane expansion by entering the
lane expansion by entering the
formula
formula=C13+C16
=C13+C16inincellcellC17.
C17.
Sum
Sum total project costs for the66
total project costs for the
lane
laneexpansion
expansionbybyentering
enteringthe the
formula
formula=D13+D16
=D13+D16inincellcellD17.
D17.
Cost Benefit
Principles Analysis, Slide 51 Ch. 20
of Macroeconomics: Second Canadian Edition
Compute benefit-cost ratio for the two expansion plans
Second,
First, Second,compute
computethe
First,compute
computethe the
the benefit-cost
benefit-cost benefit-costratio
ratiofor
benefit-cost ratiofor
ratio for
for the
the the6-lane
6-laneexpansion
the4-lane
4-laneexpansion expansion
expansion by
by dividing thepresent
dividing the
by
bydividing
dividingthe thepresent present
present value
value valueofofsavings
savings(D10)
value of savings(C10)
of savings (D10)
(C10) by total project costs
by
bytotal
totalproject
projectcosts by total project costs
costs (D17),
(C17), (D17),displaying
displayingthe
(C17),displaying
displayingthe the
the result in cell D18.
result
resultinincell
cellC19. result in cell D18.
C19.
Cost Benefit
Principles Analysis, Slide 52 Ch. 20
of Macroeconomics: Second Canadian Edition
Results of the benefit-cost analysis
The
Thebenefit-cost
benefit-costratio
ratiofor
forthe
the4-lane
4-laneexpansion
expansion
isisover
over 1.0. Based on this analysis, the4-lane
1.0. Based on this analysis, the 4-lane
expansion is justified.
expansion is justified.
However,
However,the thebenefit-cost
benefit-costratio
ratiofor
forthe
the
additional
additional22lanes
lanestotocomplete
completeaa6-lane
6-lane
expansion
expansionisisless
lessthan
than1.0.
1.0.The
Theadditional
additional22
lanes
lanes to complete the 6-lane expansionisisnot
to complete the 6-lane expansion not
justified,
justified,based
basedononbenefit-cost
benefit-costanalysis.
analysis.
Cost Benefit
Principles Analysis, Slide 53 Ch. 20
of Macroeconomics: Second Canadian Edition
Example 3: Methadone Maintenance Treatment
Program - 1
This problem is from Quantitative Methods for Public Decision Making by
Christopher K. McKenna, page 162-163.
Cost Benefit
Principles Analysis, Slide 54 Ch. 20
of Macroeconomics: Second Canadian Edition
Example 3: Methadone Maintenance Treatment
Program - 2
In methadone treatment as in most social programs there are both tangible and
intangible benefits. Here the intangibles are not included in the calculations;
however, the decision maker must be aware of them when interpreting the results
of the analysis. The benefits of MMTP include decreases in private protection
expenditures, the costs of injury to crime victims, the negative value placed on
fear of attack by an addict, criminal justice expenditures, expenditures on heroin
by the addict, expenditures for narcotic-related illnesses, and increases in legal
earning. The last three are tangible benefits and are summarized on the
worksheet 'Benefits of the MMTP' worksheet in the 'MMTP.xls' workbook.
Your assignment is to determine the net present value of the MMTP, and to
compute and interpret its cost-benefit ratio.
Cost Benefit
Principles Analysis, Slide 55 Ch. 20
of Macroeconomics: Second Canadian Edition
Open the MMTP.xls workbook
The
TheMMTP.xls
MMTP.xlsworkbook
workbookcontains
contains
three worksheets: one
three worksheets: one
containing
containingthe
theannual
annualcosts
costsfor
for
the
the program, one containingthe
program, one containing the
annual
annualbenefits
benefitsfor
forthe
theprogram,
program,
and
andone
onefor
forcomputing
computingthethe
benefit-cost ratio.
benefit-cost ratio.
Cost Benefit
Principles Analysis, Slide 56 Ch. 20
of Macroeconomics: Second Canadian Edition
Costs in the first year
The
Thefirst-year
first-yearcosts
costs
are
arenot
notdiscounted.
discounted.
First,
First,enter
enteraa Second,
Second,enter
enterthe
the
label
label Costs, first year costs,
Costs, first year costs,
year
year 1 incell
1 in cellB9. $2,220,000,
B9. $2,220,000,inincell
cellC9.
C9.
Cost Benefit
Principles Analysis, Slide 57 Ch. 20
of Macroeconomics: Second Canadian Edition
Costs in the years two through six
The
Thetotal
totalcosts
costsfor
foryears
yearstwo
two
through
through six are discountedto
six are discounted to
the
thefirst
firstyear
yearusing
usingaa10%
10%rate.
rate.
First,
First,enter
enteraa
label NPV,
label NPV,
Costs,
Costs,year
year2-6
2-6
inincell B10.
cell B10. Second,
Second,select
select
cell
cell C10 andinsert
C10 and insert
the
theNPV
NPVfunction.
function.
Cost Benefit
Principles Analysis, Slide 58 Ch. 20
of Macroeconomics: Second Canadian Edition
Locate the NPV function
We
Wewill
willsearch
searchforforthe
theNPV
NPV
function.
function. First, type NPVininthe
First, type NPV the
Search
Searchforfortext
textbox,
box,and
andclick
clickon
on
the Go button.
the Go button.
The
TheNPVNPVfunction
functionname
namewillwill
appear in the Select a function
appear in the Select a function
list
listbox.
box.Click
Clickon
onthe
theOK OKbutton
button
access
accessthethedialog
dialogbox
boxwhere
wherethe
the
function arguments are entered.
function arguments are entered.
Cost Benefit
Principles Analysis, Slide 59 Ch. 20
of Macroeconomics: Second Canadian Edition
The arguments to the NPV function
The
Thefirst
firstargument
argumentto tothe
the
NPV
NPVfunction
functionisisthe
thediscount
discount
rate,
rate,which
whichwewewill
willenter
enter
directly as 10%.
directly as 10%.
The
Thesecond
secondargument
argumentto tothe
theNPV
NPVfunction
functionisisthe
thecells
cells
containing
containing the costs of the program in years 2 through6,
the costs of the program in years 2 through 6,
'Costs
'Costsofofthe
theMMTP'!D3:D7.
MMTP'!D3:D7.
Remember
Remembertotoenter
enterthethequote
quotemarks
marksaround
aroundthethename
nameofofthe
the
worksheet
worksheetCosts
Costsofofthe
theMMTP
MMTPbecause
becauseititcontains
containsspaces.
spaces.
With
Withthe
thearguments
arguments
entered,
entered, clickon
click on
the
theOK
OKbutton.
button.
Cost Benefit
Principles Analysis, Slide 60 Ch. 20
of Macroeconomics: Second Canadian Edition
NPV for projected savings for MMTP
The
TheNPV
NPVfunction
functionreturns
returnsthe
the
present value of the costs for
present value of the costs for
years
years22through
through6,6,$5,247,308.
$5,247,308.
Cost Benefit
Principles Analysis, Slide 61 Ch. 20
of Macroeconomics: Second Canadian Edition
Total Project Cost
The
Thetotal
totalproject
projectcost
costisis
computed
computed by summingthe
by summing thefirst
first
year
yearcosts
costsand
andthe
thediscounted
discounted
costs
costsfor
foryears
yearstwo
twothrough
throughsix. six.
First,
First,enter
enterthe
the Second,
Second,sum sumthe
thecosts
costsbyby
label Total Project entering
label Total Project
Cost enteringthe
theformula
formula=C9+C10
=C9+C10
Costinincell
cellB11.
B11. inincell
cellC11.
C11.The
Thetotal
totalproject
project
cost is $7,467,308.
cost is $7,467,308.
Cost Benefit
Principles Analysis, Slide 62 Ch. 20
of Macroeconomics: Second Canadian Edition
Increased earnings benefit in the first year
Like
Likethe
thefirst-year
first-yearcosts,
costs,
the first-year benefits
the first-year benefits
are
arenot
notdiscounted.
discounted.
First,
First,enter
enter
aalabel
label Year
Year
11inincell
cellA9.
A9.
Second,
Second,enter
enteraaformula
formulato to
point to the first year benefits
point to the first year benefits
=B2
=B2inincell
cellB9.
B9.By Byusing
usingaa
formula,
formula, we can dragfill
we can drag fillthe
the
other
otherbenefit
benefitcolumns.
columns.
Cost Benefit
Principles Analysis, Slide 63 Ch. 20
of Macroeconomics: Second Canadian Edition
Increased earnings benefit in years two through six
The
Thetotal
totalbenefits
benefitsfor
foryears
yearstwo
two
through
throughsix sixare
arediscounted
discountedto to
the
thefirst
firstyear
yearusing
usingthe
thesame
same
10% rate we used for costs.
10% rate we used for costs.
First,
First,enter
enteraa
label
label Yr
Yr2-6
2-6
inincell
cellA10.
A10. Second,
Second,select
select
cell
cell B10 andinsert
B10 and insert
the
theNPV
NPVfunction.
function.
Cost Benefit
Principles Analysis, Slide 64 Ch. 20
of Macroeconomics: Second Canadian Edition
Locate the NPV function
We
Wewill
willsearch
searchforforthe
theNPV
NPV
function.
function. First, type NPVininthe
First, type NPV the
Search
Searchforfortext
textbox,
box,and
andclick
clickon
on
the Go button.
the Go button.
The
TheNPVNPVfunction
functionname
namewillwill
appear in the Select a function
appear in the Select a function
list
listbox.
box.Click
Clickon
onthe
theOK OKbutton
button
access
accessthethedialog
dialogbox
boxwhere
wherethe
the
function arguments are entered.
function arguments are entered.
Cost Benefit
Principles Analysis, Slide 65 Ch. 20
of Macroeconomics: Second Canadian Edition
The arguments to the NPV function
The
Thefirst
firstargument
argumentto tothe
the
NPV
NPVfunction
functionisisthe
the
discount
discountrate,
rate,which
whichwewe
will enter directly as 10%.
will enter directly as 10%.
The
Thesecond
secondargument
argumenttotothe
theNPV
NPVfunction
functionisisthe
thecells
cells
containing
containingthe
theincreased
increasedearnings,
earnings,'Benefits
'Benefitsofofthe
the
MMTP'!B3:B7.
MMTP'!B3:B7.
Remember
Remembertotoenter
enterthe
thequote
quotemarks
marksaround
aroundthe
thename
nameofofthe
the
worksheet Benefits of the MMTP because it contains a space.
worksheet Benefits of the MMTP because it contains a space.
With
Withthe
thearguments
arguments
entered,
entered, clickon
click on
the OK button.
the OK button.
Cost Benefit
Principles Analysis, Slide 66 Ch. 20
of Macroeconomics: Second Canadian Edition
NPV for increased earnings for MMTP
The
TheNPV
NPVfunction
functionreturns
returnsthe
the
present value of the increased
present value of the increased
earnings
earningsfor
foryears
years22through
through6,6,
$6,727,065.65.
$6,727,065.65.
Cost Benefit
Principles Analysis, Slide 67 Ch. 20
of Macroeconomics: Second Canadian Edition
Total Increased Earnings Benefit
The
Thetotal
totalfor
forthe
theincreased
increased
earnings
earnings benefit iscomputed
benefit is computedby by
summing the first year benefit
summing the first year benefit
and
andthe
thediscounted
discountedbenefits
benefitsfor
for
years two through six.
years two through six.
First,
First,enter
enter
the
the labelTotal
label Total
inincell
cellA11.
A11.
Second,
Second,sum sumthe
thecosts
costsbyby
entering the formula =B9+B10
entering the formula =B9+B10
inincell
cellB11.
B11.The
Thetotal
totalproject
project
cost is 7,141,065.65.
cost is 7,141,065.65.
Cost Benefit
Principles Analysis, Slide 68 Ch. 20
of Macroeconomics: Second Canadian Edition
Drag fill the other benefit columns
The
Thebenefits
benefitsattributed
attributedtotocriminal
criminal
justice
justicesavings
savingsand andreduced
reducedheroin
heroin
consumption
consumption are computed inthe
are computed in the
same way as increased earnings.
same way as increased earnings.
We
Wecancancomplete
completethesethesecalculations
calculations
by drag filling the columns.
by drag filling the columns.
First,
First,select
selectcells
cells
B9
B9through
throughD11.
D11.
Second,
Second,select
selectthe
the
Fill > Right command
Fill > Right command
from
fromthe
theEdit
Editmenu.
menu.
Cost Benefit
Principles Analysis, Slide 69 Ch. 20
of Macroeconomics: Second Canadian Edition
Total Project Benefits
The
Thetotal
totalbenefits
benefitsattributed
attributedto
to
the project are computed by
the project are computed by
summing
summingthe thetotal
totalbenefits
benefitsfrom
from
the three tangible sources.
the three tangible sources.
First,
First,select
selectcell
cellB13
B13
and enter the label
and enter the label
Total
Totalproject
projectbenefits.
benefits.
Second,
Second,select
selectcell
cellC13
C13
and enter the formula
and enter the formula
=B11+C11+D11.
=B11+C11+D11.
The
Thetotal
totalproject
projectbenefits
benefits
are
are$$39,352,844.66.
39,352,844.66.
Cost Benefit
Principles Analysis, Slide 70 Ch. 20
of Macroeconomics: Second Canadian Edition
The Benefit-cost Ratio
To
Tocompute
computethethebenefit
benefitcost
costratio
ratio
for
for the MMTP project, we enterthe
the MMTP project, we enter the
total
totalcosts
costsand
andtotal
totalbenefits
benefitson
on
the
theBenefit-cost
Benefit-costRatio
Ratioworksheet.
worksheet.
First,
First,inincell
cellB1,
B1,enter
enteraa
reference
referenceto tothe
thetotal
totalproject
project
costs ='Costs of the MMTP'!C11.
costs ='Costs of the MMTP'!C11.
Second,
Second,inincell
cellB2,
B2,enter
enteraareference
reference
to the total project benefits
to the total project benefits
='Benefits
='Benefitsofofthe
theMMTP'!C13.
MMTP'!C13.
Third,
Third,compute
computethe theratio
ratio
by entering the formula
by entering the formula
=B2/B1
=B2/B1inincell
cellB4.
B4.
The
Theratio
ratioofof5.27
5.27indicates
indicatesthat
that
the benefits clearly out weigh
the benefits clearly out weigh
the
thecosts.
costs. Using
Usingbenefit-cost
benefit-cost
criteria,
criteria,the
theMMTP
MMTPprogram
program
should be continued.
should be continued.
Cost Benefit
Principles Analysis, Slide 71 Ch. 20
of Macroeconomics: Second Canadian Edition
Chapter 20
The Influence of Monetary and Fiscal
Policy on Aggregate Demand
I0
Q0 Quantity of Money
Principles of Macroeconomics: Ch. 20 Second Canadian Edition
The Money Market
Interest
Rate Money Demand
I1
I0
Q0 Quantity of Money
Principles of Macroeconomics: Ch. 20 Second Canadian Edition
The Money Market
Interest
Rate Money Demand
I1
I0
Q1 Q0 Quantity of Money
Principles of Macroeconomics: Ch. 20 Second Canadian Edition
Equilibrium in the Money Market
Money Demand
IE
Money Demand
IE
Money Demand
IE0
Money Demand
IE0
Money Demand
IE0
Money Demand
IE0
IE1
Money Demand
AD1
Quantity of Output
Principles of Macroeconomics: Ch. 20 Second Canadian Edition
The Multiplier Effect
Price
Level An increase in
government
purchases initially
increases AD
AD2
AD1
Quantity of Output
Principles of Macroeconomics: Ch. 20 Second Canadian Edition
The Multiplier Effect
Price
Level The multiplier effect
can amplify the shift
in AD
AD3
AD2
AD1
Quantity of Output
Principles of Macroeconomics: Ch. 20 Second Canadian Edition
The Multiplier Effect of
Government Purchases
The formula for the multiplier is:
Multiplier = 1 ÷ (1 - MPC)
the MPC is the Marginal Propensity to Consume.
Peak
Peak
Real GDP
Recovery
Recession
Trough
0
0
Time
How do we predict a recession?
20%
15%
10%
5%
0%
13
21
29
37
45
53
61
69
77
85
93
01
19
19
19
19
19
19
19
19
19
19
19
20
-5%
-10%
-15%
Who wins & who loses from
inflation?
Loses Wins
z Savers (non z Debtors
interest bearing) z Home owners
z Fixed income
z Banks,leasing
(retirees, workers companies.
with no or small pay
raise)
Causes of inflation
z Demand pull
z Demand outpaces supply
z “Too much money chases too few goods”
z Cost push
z Businesses raise prices
z Workers demand higher wages to keep up
with inflation
z Prices of other inputs rises
Government Policy and
Market Failures
D = Marginal
social benefit
0 Q1 Q0 Quantity
0 Q0 Q1 Quantity
P1
Efficient tax
P0
Marginal social
benefit
0 Q1 Q0 Quantity
1.00
0.50
.80
.60 0.10 Market demand
.40 DB
0.60 0.40
0.50
.20
DA
0.10
1 2 3 Quantity
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Informational Problems
Perfectly competitive markets assume
perfect information.
Real-world markets often involve
deception, cheating, and inaccurate
information.