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Foundations of Managerial
Economics
What is Economics?
What to produce How to produce How to distribute
Managerial Economics
Households
Inputs demand
Factor costs
Invisible Hand
Furthering selfish interest
Algebraic Solution
P = 300 Qd P = 60 + 2Qs
a = 300; b = 1; c = 60; d = 2
300 Q = 60 + 2Q
Q* = 80 P* = 220
Q P TR MR
6 4 24 -1 7 3 21 -3 8 2 16 - 5 9 1 9 -7
Concept of Margin
Rate of Change
Derivative- Calculus
Chapter 2
Household as a Consumer
Preference set
Constraints
Optimal decision
Assumptions
Completeness Transitivity Non satiation
Optimization
Optimization Rule 2:
When only one good is consumed and is available for a price: Consume till MUx = Pricex
Optimization Rule 3:When more than one good is consumed and the goods prices are different: Consume till MUx/Px = MUy/Py = MUz/Pz
Managerial Economics Oxford University Press, 2006
Opportunity Set
Defined by Budget Constraint. 6x + 3y = 60 Given Px = 6 and Py = 3 Graphically,
Y
20
10
Managerial Economics Oxford University Press, 2006
x At e slope of the budget line is equal to the slope of the Indifference curve.
Managerial Economics Oxford University Press, 2006
Consumers Equilibrium
Slope of the budget line: - Px/Py
Slope of Indifference curve: MUx/MUy Equilibrium : MUx/MUy = Px/Py or MUx/Px = MUy/Py
Managerial Economics Oxford University Press, 2006
The analysis which enables us to arrive at new optimal decisions when underlying assumptions change
Changes in equilibrium
Joining all these points of tangency gives the Price Consumption Curve. (PCC)
Y
PCC
Price of X is falling.
X
Managerial Economics Oxford University Press, 2006
Demand Curve
Every point on the PCC gives the price of X and quantity demanded/consumed of X Thus,
Px
Qx
Managerial Economics Oxford University Press, 2006
Changes in equilibrium
Joining all these points of tangency gives the Income Consumption Curve (ICC)
Y ICC
X
Managerial Economics Oxford University Press, 2006
Giffen good
Income effect Price effect + Substitution effect Substitution effect is inversely related to price. Income effect can be inversely related to changes in income Inferior Good Income effect can be positively related to income-Superior good
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Giffen Good
If income effect is inverse and large enough to offset the substitution effect, then it is a Giffen Good The Demand curve for Giffen Good will have a positive slope
Elasticity
Price Elasticity: Proportionate change in quantity demanded due to a proportionate change in price - Qx/ Px * Px/Qx - negative for normal goods - negative sign is ignored while making comparisons among normal goods
Managerial Economics Oxford University Press, 2006
Elasticity
Pe Greater than1 (ignoring sign): Elastic Pe Equal to 1 (ignoring sign) : Unit Elastic Pe Less than 1 ( ignoring sign): Inelastic Price Elasticity and Expenditure: - Pe less than 1 a fall in price lower exp - Pe equal to 1 a fall in price exp constant - Pe greater than 1 a fall in price higher exp
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Elasticity
Income Elasticity Qx/I * I/Qx Could be negative or positive: Negative for Inferior goods Positive for Superior goods
Elasticity
Cross Price Elasticity: Qx/Py * Py/Qx Could be negative or positive - Negative for complements - Positive for substitutes
Method of Estimation
Method of Ordinary Least Square( OLS) - minimizes the sum of the squared deviations of each of the points from the mean.
Coefficient of Determination
Regression Sum of Squares (RSS) / Total Sum of Squares (TSS) is R2 Coefficient of Determination If R2 = 1, the best fit. If R2 = 0.4, 40% of the total deviations is explained by the regression
Managerial Economics Oxford University Press, 2006
Graphical Representation
R2 = 1
R2 = 0
Forecasting Techniques
Opinion polls and market research Expert opinion Surveys Economic indicators Projection Techniques Econometric Models
Creation of a firm
To minimize Transaction costs One entity takes the responsibility to bring all the factors together required for production
Marginal Analysis
Used to arrive at the profit-maximizing output level Uses the concepts of Marginal revenue and Marginal Cost Marginal revenue is the change in total revenue due to an additional unit of output Marginal cost is the change in total cost due to an additional unit of output
Managerial Economics Oxford University Press, 2006
Profit-maximizing Rules
Rule- The level of output at which MR = MC Should this level of output be produced at all? - Shut Down Rule: If at the optimal level of output, Average Revenue is less than Average (economic) Cost, then, SHUT DOWN.
Control Mechanisms
Principal Agency Cost Therefore CONTROL MECHANISMS Internal -board of Directors - ESOPs External - Takeovers
Production function
A production function is a functional specification that provides the most efficient combination of input with which a chosen target level of output can be produced It is specific to each industry and technology
Isoquants
Graphical representation of production function A curve drawn through the technically feasible combinations of inputs to produce a target level of output
Map of Isoquants
K
Properties of Isoquants
They are downward sloping
They are convex to the origin They do not intersect
Production Elasticity
Q / X * X / Q = MPx * 1 / APx
Returns to Scale
Increasing Returns to Scale When output increases by a proportion greater than the proportionate increase in all inputs. Decreasing returns to scale Constant returns to scale
Concepts of costs
Economic costs Relevant costs defined in terms opportunity costs Sunk costs Expenditures that are irrelevant for decision making during the concerned period Normal Profit this is as much a component of costs as wages, interest, etc. It is a payment for entrepreneurship
Cost Functions
Polynomial Function: - Cubic Fn: TC = a + bQ - cQ2 +dQ3 - Quadratic Fn: TC = a + bQ + cQ2 - Linear Fn: TC = a + bQ Logarithmic Function: - ln TC = a + b ln Q
Breakeven Analysis
Qb = TFC / ( P AVC) P AVC is Contribution Quantity at which a target profit can be earned: Q = TFC + Profit Target / Contribution
MC
AEC (Avg Eco. Cost AR=MR=P
Every point above B on the MC curve is a point on the Short run supply curve
Managerial Economics Oxford University Press, 2006
Elasticity of supply
Ess = % change in quantity supplied / % change in price Flatter the supply curve , larger the elasticity
Long run
SS A B DD
Monopoly
A single firm faces the entire demand - Price Maker No role for strategy No substitutes No entry
MR
AR
Q
Managerial Economics Oxford University Press, 2006
Regulation of Monopoly
Regulation of prices Antitrust Policies to prevent the monopolist from exercising Monopoly Power. In India , we had the MRTP Act of 1969 We now have the competition Act 2002 Patent Policy
Price Discrimination
Practice of charging different prices in different markets for the same product The seller should be a price maker Price elasticity of demand has to be different for different market segments The different market segments should be insulated
Features of Oligopoly
Few sellers Interdependence Intense rivalry Strategy plays a dominant role. Barriers to entry; Natural and Strategic
Equilibrium in Oligopoly
Cournot Equilibrium Bertrand Equilibrium Stackelberg Equilibrium The kinked demand model Cartel Collusion Price Leadership
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remote without areas H remote areas 40,70 35,55 C L With remote areas Managerial Economics Oxford University Press, 2006 30,60
A Game Tree
Rs 4000,4000
high Atlas high low high
Rs 6000,1000 Rs 1000,6000
low
Hero
low Atlas
Rs 3000,3000
Strategies
Maximin Strategy Dominant Strategy Dominated Strategy Pure and mixed Strategy
Different Games
Entry Game Games of imperfect and incomplete information Prisoners Dilemma Games Sequential Games Repeated Games Finitely repeated Games
Managerial Economics Oxford University Press, 2006
Economic rent
In the context of factor markets, the excess of payment over the minimum required to buy the use of the factor is economic rent. Economic Rent earned varies with supply elasticity
Bilateral Monopoly
A monopolist seller meets a monopsonist buyer
Each would bargain and the price gets fixed
Chapter 12
Discounting
The process of bringing the future stream of revenues to the present Choice of the discount rate is important The discount rate should reflect the opportunity cost of capital to the firm
Risk
A decision making situation in which the possible outcomes can vary and the probability of occurrence of each outcome is known
Incorporation of Risk
Subjective approach Utility function approach Decision tree approach Risk adjusted discount rate approach
Interest Rates
Interest rate is the price of funds - Prime lending rate - Commercial paper rate - Discount rate or Bank rate - T- Bill rate
Chapter 13
Economics of Information
Imperfect Information
Incomplete Information - where both sides to a transaction do not possess complete information Asymmetric Information - where one of the parties to a transaction has more information than the other
Signalling
Ways of conveying and getting information on hidden characteristics (e.g. airlines offering various Packages)
Adverse Selection
an outcome of asymmetric information wherein you select precisely the ones you should not (e.g. the unhealthy and weak taking up health insurance) this is due to asymmetric information on some hidden characteristics
Hidden Action
Characterized by: - one side of the transaction not being able to observe the action taken by the other. - The unobservable action affects the other side. - no agreement on whether the action should be taken or not. * The result of hidden Action is Moral Hazard
Managerial Economics Oxford University Press, 2006
Externalities
The effect of an economic activity that is not incorporated into or reflected in the market price is called an Externality Externality if negative, imposes a cost unaccounted for Externality if positive, gives rise to a benefit not accounted for
Externalities (contd..)
Pollution is a negative externality; development of an area due to industrial units being set up is a positive externality
The result is that costs and benefits are either overestimated or underestimated
Internalizing Externalities
Governments response: - Taxes - Regulation - Effluent Fee - Transferable Emission Permits - Recycling
Internalizing Externalities
Markets Response - Mergers - Social Conventions - Property Rights
Public Goods
Public goods are Non Rival Public Goods are Non Excludable The result: no reason for the consumer to reveal his/her valuation of the good or service HENCE MARKETS FAIL
Macro Aggregates
Aggregate output levels Aggregate Price levels Aggregate Investment levels Aggregate Consumption levels Balance of Payments
Fundamental Identity
* Gross Domestic Product * Gross National Product * Net Domestic Product * Net National Product * PPP Gross Domestic Product National Income NNP at Factor Cost
Managerial Economics Oxford University Press, 2006
Price Indices
CPI (Also called Cost of living Index)
WPI (Wholesale Price Index) GDP Deflator
Price Indices
CPI : Weighted Average Retail Price of a specific basket of goods. WPI : Based on wholesale prices of a specific basket of goods ( different from CPIs basket both in composition and in weights). GDP Deflator: Ration of Nominal GDP to Real GDP.
Aggregate Consumption
Keynesian Consumption function - Concept of Marginal Propensity to consume Irving Fishers Hypothesis Life-Cycle Hypothesis Duesenberrys Hypothesis Random walk Hypothesis
Managerial Economics Oxford University Press, 2006
Investment
Investment as a function of changes in income(Y) - The Accelerator A relationship between Investment and the stock market is Tobins Q Investment as a function of Real Interest Rate
Managerial Economics Oxford University Press, 2006
Cost-Push
Inflation Demand- Pull
Phillips Curve
Inflation (Wage rate) and Unemployment are inversely related NAIRU: Non Accelerating Inflation Rate of Unemployment
w W is wage rate
Unemp rate
Managerial Economics Oxford University Press, 2006
Balance of Payment
Captures all transactions between any economy and the rest of the world. Current Account
Capital Account
Balance of Payment
Items keenly watched: - ratio of current account Deficit/surplus to GDP - ratio of Capital Account surplus/deficit to GDP - extent of intervention through reserves.
Business Cycles
Fluctuations in economic activity. - low level of economic activity: Recession - Peaking levels of economic activity: Boom Economic activity is measured by rate of change in GDP Policy interventions are called for to reduce the severity of fluctuations and to stabilize the economy
Managerial Economics Oxford University Press, 2006
Stabilization Policies
Reliance on Demand management Policies in the Short Run.
Fiscal Policies
Monetary Policies
Fiscal Policy
Instruments: Taxes and Government Spending
These two instruments dont work through the market. Both these are reflected in the Budget.
Monetary Policy
The central bank of a country is the sole authority.
Interest Rate is the instrument which is manipulated by changes in Money supply. Interest rate is the price of funds.
Money Supply
Is primarily determined by the central bank.
The banking sector plays a key role through the fractional reserve system and the multiple expansion of deposits.
Money Multiplier
Given by :
Cu /D + 1 ----------------------------Cu/D + RR/D + ER/D Where Cu is the currency, RR is Required reserves and ER is Excess Reserves.
Managerial Economics Oxford University Press, 2006
Devaluation
A reduction in the value of a currency.
Devaluation is done when: - a country cannot maintain the Fixed Exchange rate due to scarcity of Reserves. - a country chooses to consciously improve trade.
Exchange Rates
Nominal Exchange Rate: No correction for inflation. Real Exchange Rate: -Nominal rate * Foreign price level / Domestic Price level PPP (Purchasing Power Parity) rate is that rate which makes the dollar price of a commodity the same across all countries.
Managerial Economics Oxford University Press, 2006
Chapter 17
The New Economy
Definition
Outcome of the Information Revolution. It has 3 distinguishing characteristics: - it is leaning on intangibles - it is global - it is intensely interlinked The New Economy is thus a Network Economy.
Information Goods
These are digitized information. Eg. Encyclopedias, Directories Characteristics: - High fixed costs but very low variable costs of reproduction. - The above results in non excludability and market failure. - Pricing is Value based (since MC is near zero)
Managerial Economics Oxford University Press, 2006
Networks
Network Externality: The value to each user being in the network rises at a rate much higher than the rate of increase in the size of the network.
Ignoring the above led to the demise of Dot-All rights reserved Coms
Role of Government
Public policy to facilitate adoption and adaptation. Policy to actively promote innovation.