MANAGERIAL ECONOMICS Opportunity Cost

- the cost of choosing the use

What is Economics? resources for one purpose measured by
• Economics is a study of human activity both at the sacrifice of the next best alternative
individual and national level. for using those resources.
• It was only during the eighteenth century that The Fundamental Economic Problem
Adam Smith, the Father of Economics, defined 1. What Goods and Services should be
economics as the study of nature and uses of produced?
national wealth’. 2. How should these Goods and Services be
produced?
“Economics is a study of man’s actions in the 3. For whom should these Goods and Services be
ordinary business of life: it enquires how he gets his produced?
income and how he uses it”. - Dr. Alfred Marshall, POSITIVE ECONOMICS
Positive economics is a stream of economics that
“The science, which studies human behavior as a focuses on the description, quantification, and
relationship between ends and scarce means which explanation of economic developments,
have alternative uses”. - Prof. Lionel Robbins expectations, and associated phenomena.
Ex: "Government-provided healthcare increases
MICRO vs MACRO ECONOMICS public expenditures."
• Microeconomics studies individuals and business NORMATIVE ECONOMICS
decisions, while macroeconomics analyzes the Normative economics focuses on the ideological,
decisions made by countries and governments. opinion-oriented, prescriptive, value judgments,
• Microeconomics focuses on supply and demand, and "what should be" statements aimed toward
and other forces that determine price levels, economic development, investment projects, and
making it a bottom-up approach. scenarios
• Macroeconomics takes a top-down approach and Ex: "The government should provide basic
looks at the economy as a whole, trying to healthcare to all citizens.
determine its course and nature. NORMATIVE OR POSITIVE?
• Investors can use microeconomics in their • The desired rate of return on gambling stocks are
investment decisions, while macroeconomics is an higher compared to others
analytical tool mainly used to craft economic and • No individuals should be entitled to inheritances
fiscal policy. as it belongs to society
• Monopolies have proved to be inefficient
TERMS IN ECONOMICS • Since the price of oil is likely to rise in the future,
Scarcity we should develop more nuclear energy.
-refers to the condition wherein most things
that people want are available only in limited Nature of Managerial Economics
supply. 1. Close to microeconomics:
- the imbalance between our desires and Managerial economics is concerned with finding
means of satisfying those desires. the solutions for different managerial problems of a
particular firm. Thus, it is more close to
Economic Good microeconomics.
-anything which yields utility and which could
command a price if bought or sold in the market. 2. Operates against the backdrop of
Wants macroeconomics: In other words, the managerial
-refer to a person’s desires or economist has to be aware of the limits set by the
preferences for specific ways to satisfying a basic macroeconomics conditions such as government
need. industrial policy, inflation and so on.
3. Offers scope to evaluate each alternative: TC=TFC+ TVC
• Managerial economics provides an
opportunity to evaluate each alternative in terms of
its costs and revenue.
4. Interdisciplinary:
The contents, tools and techniques of
managerial economics are drawn from different
subjects such as economics, management,
mathematics, statistics, accountancy, psychology,
etc.

Scope of Managerial Economics:

a. The selection of product or service to be
produced.
b. The choice of production methods and resource
combinations.
c. The determination of the best price and quantity
combination
d. Promotional strategy and activities.
e. The selection of the location from which to
produce and sell goods or service to consumer
The scope of managerial economics covers two
areas of decision making
• Operational or Internal issues
• Environmental or External issues
CHAPTER 2
REVENUE
• The total monetary value of the goods or services
sold is called revenue.
EXAMPLE
• The difference between the revenue and cost
(found by subtracting the cost from the revenue) is
• TFC = $16000
called the profit. When costs exceed revenue, there
• TVC = 0.3X 36000
is a negative profit, or loss.
= $10800
• TC =FC+ VC
Short-Run Production Costs
=$ 26800
In the short run, the firm has two types of costs:
Fixed cost: the cost of the production facility, which
• Profit = R-C
is independent of the amount of output produced
=54000-26800
in it.
=$ 27200
Variable costs: the costs of labor and materials
Economic Cost
associated with producing output.
• In economics, the notion of a firm's costs is based
Total Cost
on the notion of economic cost.
• The key principle underlying the computation of
• The sum of total fixed costs and total variable
economic cost is opportunity cost.
costs:

PRINCIPLE of Opportunity Cost

The opportunity cost of something is what you
sacrifice to get it.
Accounting versus Economic Cost set in relation to the variable costs of production
• An accountant's notion of costs involves only the (i.e. ignoring fixed costs and overheads).
firm's explicit costs: • The objective is to achieve a desired
Explicit costs: the firm's actual cash payments "contribution" towards fixed costs and profit.
for its inputs. • Contribution per unit can be defined as: SELLING
• An economist includes the firm's implicit costs: PRICE less VARIABLE COSTS
Implicit costs: the opportunity costs of non • So, P= 1.5-0.3= 1.2
purchased inputs. The opportunity Cost in the
example is $30,000 Average cost
Economic cost: the sum of explicit and implicit • The average cost is calculated by dividing the total
costs. cost by the quantity. The relationship between
Accounting Economic average cost and quantity is the average cost
Approach Approach function. For the ice cream bar venture, the
Explicit Cost (purchased inputs) $ 60,000 $ 60,000
equation for this function would be
Implicit: oppprtunity cost of entrepreneur's time $ 30,000
Implicit: oppprtunity cost of funds $ 10,000
• AC=C/Q = ($40,000 + $0.3Q)/Q = $0.3 +
Total Cost $ 60,000 $ 100,000 $40,000/Q.
Revenue, Cost, and Profit Functions
There is a relationship between quantity created
and sold and the resulting impact on revenue, cost,
and profit. These relationships are called the
revenue function, cost function, and profit function.
Revenue function
• Revenue is the product of the price per unit times
the number of units sold.
• If we assume ice cream bars will be sold for $1.50
apiece, the equation for the revenue function will
be R = $1.5 Q
• where R is the revenue and Q is the number of
units sold.

Cost function Essentially the average cost function is the variable

• The cost function for the ice cream bar venture cost per unit of $0.30 plus a portion of the fixed
has two components: the fixed cost component of cost allocated across all units. For low volumes,
$40,000 that remains the same regardless of the there are few units to spread the fixed cost, so the
volume of units and the variable cost component of average cost is very high. However, as the volume
$0.30 times the number of items. The equation for gets large, the fixed cost impact on average cost
the cost function is becomes small and is dominated by the variable
cost component.
• FC=16000+30,000=46000
• FC=46000-6000=40,000
• C= $40,000 + $0.3 Q.
• where C is the total cost. Note we are measuring
economic cost, not accounting cost.
Profit functions
• Since profit is the difference between revenue
and cost, the profit functions will be
• π =R-C = $1.2 Q-$40,000. Here π is used as the
symbol for profit marginal cost pricing
• With variable (or marginal cost) pricing, a price is
 margins to cover the economic fixed cost of
Breakeven point $40,000. So the breakeven level would be
• From the graph we can see the breakeven point is • Q= fixed cost/(price per unit - variable cost per
slightly less than 35,000 units. If the students can unit) $40,000/($1.50-$0.30)=33.333.3 or 33.334
sell above that level, which the prior operator did, it units.
will be worthwhile to proceed with the venture. If
they are doubtful of reaching that level, they should law of demand
abandon the venture now, even if that means losing • Demand curves generally follow a pattern called
their nonrefundable deposit levels where revenues the law of demand, whereby increases in price
exceed economic costs. result in decreases in the maximum quantity that
• The volume level that separates the range with can be sold.
economic loss from the range with economic profit • The law of demand says that quantity demanded
is called the breakeven point. varies inversely with price, other things constant.
Thus, the higher the price, the smaller the quantity
demanded

Break even level

• There are a number of ways to determine a Marginal Analysis
precise value for the breakeven level algebraically.
One is to solve for the value of Q that makes the • The marginal revenue measures the change in
economic profit function equal to zero: revenue in response to a unit increase in production
• π=R-C = $1.2 Q- $40,000 level or quantity.
• 0=$1.2 Q-$40,000 • The marginal cost measures the change in cost
• or Q$40,000/$1.2 = 33,334 units. corresponding to a unit increase in the production
level.
• Another way to assess the breakeven point is to • The marginal profit measures the change in profit
find how large the volume must be before the resulting from a unit increase in the quantity
average cost drops to the price level. In this case,
we need to find the value of Q where AC is equal to
$1.50.
• A fourth approach to solving for the breakeven
level is to consider how profit changes: as the
volume level increases.
• Each additional item sold incurs a variable cost
per unit of $0.30 and is sold for a price of $1.50. The
difference, called the unit contribution margin,
would be $1.20. For each additional unit of volume,
the profit increases by $1.20. In order to make an
overall economic profit, the business would need to
accrue a sufficient number of unit contribution
 consumer plans her purchases, the timing of those
Most profitable production level purchases, and borrowing and saving so as
maximize the satisfaction she and her household
• Most profitable production level will be at a level unit will experience from consumption of goods and
where marginal profit equals zero. services
• The most profitable production level is where • In this theory, consumers are able to compare any
marginal revenue is equal to marginal cost. MR=MC two patterns of consumption, borrowing, and
• If marginal revenue is greater than marginal cost saving and deem that either one is preferred to the
at some production level and the level can be second or they are indifferent between the two
increased, profit will increase by doing so. patterns.
• If marginal cost is greater than marginal revenue
and the production level can be decreased, again Two effects of theory of consumer to price changes
the profit can be increased.
Substitution effect
Shut Down point is the consumer’s response to a changing price to
• Shut-down point is the minimum market price at restore balance in the ratios of marginal utility to
which a company would prefer t to close down its price. As the result of price changes and
operation rather than manufacture anything. substitution, the consumer’s overall utility may
• A point of operations where a firm is indifferent increase or decrease
between continuing operations and shutting down Income effect
temporarily. Consequently, the consumer may experience the
• If the selling price per unit is at least as large as equivalent of an increase or decrease in wealth, in
the average variable cost per unit, the firm should the sense that it would have required a different
continue to operate for at least a while; otherwise, level of wealth to just barely afford the new
the firm would be better to shut down operations consumption pattern under the previous set of
immediately. prices
Example
• FC=80 Is the theory of customer realistic?
• VC=100 • Herbert Simon proposed a theory of bounded
• TC = 180 rationality that states that humans do behave
• If the P=100, Loss would be 80 rationally with a limited range of options. So if
• If the P=90, Loss would be 90 consumers focus on a modest set of important
• The concept of shut-down point is used to goods and services, they may be able to achieve
understand and analyze and understand the way something close to the theoretical optimum in
companies take decision on the product level terms of overall utility.
• Output level at which total revenue equals total • Simon also observed that human beings may not
variable costs, and the product price equals its optimize so much as they “satisfice,” meaning that
average variable cost. they work to meet a certain level of consumption
satisfaction rather than the very best pattern of
Chapter 3 Demand and pricing consumption.
Theory of consumer • If someone else, either by active choice or by
• A consumer is someone who makes consumption accidental discovery, is experiencing greater
decisions for herself or for her household unit. satisfaction under similar circumstances of wealth
• Consumers are limited in how much they can and income, their friends and neighbors will detect
consume by their wealth. it and start to emulate their consumption patterns.
• Consumption decisions may be planned into the Determinants of demand
future, taking account of the expected changes in
wealth over time. • Price is also the key determinant of demand in the
• The theory of the consumer posits that a theory of the consumer.
• If a consumer is regarded as deciding how to Department of Commerce for that month.
allocate his wealth across available goods and
services, in order for your product to be included as Forecasting demand
a candidate in that choice, the consumer has to be • Identifying the key determinants of demand and
aware that your product or service exists. developing demand functions gives a business
(Expenditure on promotion) manager a better understanding of his customers. A
• Being able to quantitatively assess how benefit of that understanding is an improved
consumption changes by location or time is a accuracy in forecasting the demand levels for their
powerful tool in deciding where and when to sell products and services in an upcoming period.
your product. Some businesses decide to serve • Businesses need to have an adequately sized
broad geographical regions; others target specific operation, have a sufficient staff in terms of size
locations. Some businesses sell most or all times of and training, and obtain any necessary resources for
the day and days of the year; others limit their production.
operations to a restricted number of hours or • Without some concrete estimate of what level of
periods within a year. demand will result after these planning, designing,
and production activities, a business may find itself
• The selection of price, promotional activities, with an excess of unused capacity or unable to
location, and channel are generally in the control of serve the demand that follows.
the business concern. • Excess capability is costly because idle resources
• Different goods and services can be strongly have an opportunity cost but do not contribute to
related in another way called a complementary sales or revenue, especially when the unused
relationship. Consumption of some goods and resources spoil and cannot be used at a later time.
services can necessitate greater consumption of • Businesses can improve demand forecasting with
other goods and services. their demand functions using the future values of
• Demand is also affected by the demographics of determinant variables in those demand functions.
the population of eligible customers. How many • If the business has a record of data for these
people live in a region, their ethnic and uncontrollable variables, they can apply
socioeconomic composition, and age distribution quantitative forecasting techniques like time series
can explain variations in demand across regions and analysis or develop casual models that relate these
the ability to forecast in the future as these factors to other variables that can be forecast.
demographics change. • Although the future will almost certainly not
conform exactly to any single scenario, the exercise
Modeling consumer demand prepares them to monitor for changes in these
• To develop a formal model of consumer demand, factors and be ready to make a prompt response
the first step is to identify the most important whenever a similar scenario emerges.
determinants of demand and define variables that
measure those determinants. Elasticity of demand
• Suppose a business is selling broadband services • Another use of a mathematical demand function
in a community. The managers of the business have is measuring how sensitive demand is to changes in
identified four key determinants of demand: (a) the the level of one of the determinants.
price they charge for the service, (b) their • An alternative approach to measuring the
advertising expenditure, (c) the price charged by the sensitivity of demand to its determinant factors is to
competition, and (d) the disposable income of their assess the ratio of percentage change in demand to
potential customers. the percentage change in its determinant factor.
• P = the price per month of their service, in dollars, • This type of measurement is called an elasticity of
A = advertising expenditure per month, in dollars, demand.
CP = the price per month of the competitor’s • Assessing the elasticity of demand relative to
service, in dollars, DIPC = the disposable income per changes in the price of the good or service being
capita, in dollars, as measured by the U.S. consumed is called the own-price elasticity or
usually just the price elasticity. Consumption decisions in the short and long run
• Since the law of demand states that quantity • A consumer decision is considered short run when
demanded will drop when its price increases and her consumption will occur soon enough to be
quantity demanded will increase when its price constrained by existing household assets, personal
decreases, price elasticities are usually negative commitments, and know-how. Given sufficient time
numbers to remove these constraints, the consumer can
• Goods and services are categorized as being price change her consumption patterns and make
elastic whenever the price elasticity is more additional improvements in the utility of
negative than –1. consumption.
• In this category, the percentage change in • Decisions affecting consumption far enough into
quantity will be greater than the percentage change the future so that any such adjustments can be
in price if you ignore the negative sign. When the made are called long-run decisions.
computed price elasticity is between 0 and –1, the • Short-run demand curves are easier to develop
good or service is considered to be price inelastic. because they estimate demand in the near future
and generally do not require a long history of data
• Another important class of elasticities is the on consumption and its determinant factors.
response of demand to changes in income, or the Because long-run demand must account for
income elasticity. changes in consumption styles, it requires longer
• When income elasticity of a product is greater histories of data and greater sophistication.
than one, we call the product a cyclic good. The • Elasticities of demand in the short run can differ
adjective “cyclic” suggests that this demand is substantially from elasticities in the long run.
sensitive to changes in the business cycle and will • Long-run price elasticities for a product are
generally change more on a percentage basis than generally of higher magnitude than their short-run
income levels. Luxury goods that customers can do counterparts because the consumer has sufficient
without in hard economic times often fall in this time to change consumption styles.
category. • There is so much uncertainty about long-run
• When income elasticity is between zero and one, consumption that these analyses are usually limited
we call the product a noncyclic good. to academic and government research.
• The demand for noncyclic goods tends to move up Short-run analyses, on the other hand, are feasible
and down with income levels, but not as strongly on for many analysts working for the businesses that
a percentage basis. Most of the staple goods and must estimate demand in order to make production
services we need are noncyclic decisions.
• When income elasticity is negative, we call the Price discrimination
product a counter cyclic good. • Sellers may wish they were able to charge
• When elasticities are calculated to measure the customers the maximum amount they are willing to
response of demand to price changes for a different pay, which would result in more revenue and no
good or service, say either a substitute product or added cost. In economics, the term for charging
complementary product, we call the calculated different prices to different customers is called price
value a cross-price elasticity. discrimination.
• Cross- price elasticities tend to be positive for • Economists have actually defined multiple types
substitute goods and negative for complementary of price discrimination, called first-degree price
goods. discrimination, second-degree price discrimination,
• Some elasticities, like price elasticities and and third-degree price discrimination.
advertising elasticities, tend to reflect greater • First-degree price discrimination is an attempt by
sensitivity to changes in the factor when an the seller to leave the price unannounced in
elasticity is calculated for a single business than advance and charge each customer the highest
when assessed for the total demand for all sellers in price they would be willing to pay for the purchase.
a market. • A business may benefit by offering different prices
to those who purchase in larger volumes because
either they can increase their profit with the
increased volume sales or their costs per unit
decrease when items are purchased in volume.
• Businesses can create alternative pricing methods
that distinguish high-volume buyers from low-
volume buyers. This is second-degree price
discrimination.
• Third-degree price discrimination is differential
pricing to different groups of customers. One
justification for this practice is that producing goods
and services for sale to one identifiable group of
customers is less than the cost of sales to another
group of customers.
Long run average cost and scales
Chapter 4 Cost and production
• A long-run time frame was of sufficient length
Average cost curves
that the consumer had the ability to alter her
• Average cost reflects the cost on a per unit basis.
lifestyle and technology and to improve her
A portion of the average cost is the amount of
understanding, so as to result in improved utility of
variable costs that can be assigned to the
consumption.
production unit. The other portion is the allocation
• In the long run, businesses have sufficient time to
of fixed costs (specifically those fixed costs that are
expand, contract, or modify facilities.
not sunk), apportioned to each production unit
in the long run, since the firm has the flexibility to
• The average cost generally varies as a function of
change anything about its operations (within the
the production volume per period.
scope of what is technologically possible and they
• Fixed costs do not increase with quantity
can afford), all costs in long-run production
produced, at least in the short run where
decisions can be regarded as variable costs.
production capabilities are relatively set, the
In the long run, the firm is able to make decisions
portion of the average cost attributable to fixed
that alter its capacity point by resizing operations to
cost is very high for small production volume but
where the firm expects to have the best stream of
declines rapidly and then levels off as the volume
profits over time.
increases.
The production level at which the long-run average
• The portion of average cost related to the variable
cost curve flattens out is called the minimum
cost usually changes less dramatically in response to
efficient scale.
production volume than the average fixed cost.
• Economists called the production volume where
average cost is at the lowest value the capacity of
the operation.

• Economies of scope and joint products

Most businesses provide multiple goods and
services; in some cases, the number of goods and simultaneously.
services is quite large. • In situations where a firm excels in some
• Whereas the motivation for providing multiple components of its operations, there may be an
products may be driven by consumer expectations, opportunity for improved profitability by
a common attraction is the opportunity to reduce recognizing these key areas, sometimes called core
per unit costs. When a venture can appreciate such competencies in the business strategy literature,
cost savings, the opportunity is called an economy and then determining what kinds of goods or
of scope. services would best exploit these capabilities. This is
• suppose we have a company that expands the resource approach to the planning of
from selling one product to two similar products. production.
The administrative functions for procurement, • The cost approach is often easier to conduct,
receiving, accounts payable, inventory particularly for a firm that is already in a particular
management, shipping, and accounts receivable in line of business and can make incremental
place for the first product can usually support the improvements to reduce cost.
second product with just a modest increase in cost. The resource approach encourages more out-of-
• If multiple goods and services require the same the-box thinking that may lead a business toward a
raw materials, the firm may be able to acquire the major restructuring.
raw materials at a smaller per unit cost by Marginal Revenue Product and Derived Demand
purchasing in larger volume.
In some cases, two or more products may be • The marginal product of a production input is the
natural by-products of a production process. For amount of additional output that would be created
example, in refining crude oil to produce gasoline to if one more unit of the input were obtained and
fuel cars and trucks, the refining process will create processed.
lubricants, fertilizers, petrochemicals, and other For example, if an accounting firm sells
kinds of fuels. accountant time as a service and each hired
• As with economies of scale, the opportunities for accountant is typically billed to clients 1500 hours
economies of scope generally dissipate after per year, this quantity would be the marginal
exploiting the obvious combinations of goods and product of hiring an additional accountant.
services. • The marginal revenue product of a production
• At some point, the complexity of trying to input is the marginal revenue created from the
administer a firm with too many goods and services marginal product resulting from one additional unit
will offset any cost savings, particularly if the goods of the input. The marginal revenue product would
and services share little in terms of production be the result of multiplying the marginal product of
resources or processes. the input times the marginal revenue of the output.
• However, sometimes firms discover scope the marginal revenue will change as output is
economies that are not so obvious and can realize increased, usually declining as output levels
increased economic profits, at least for a time until increase. Correspondingly, the marginal revenue
the competition copies their discovery. product will generally decrease as the input and
Cost Approach Versus Resource Approach to corresponding output continue to be increased. This
Production Planning phenomenon is called the law of diminishing
• The conventional approach to planning marginal returns to an input.
production is to start with the goods and services
that a firm intends to provide and then decide what • One difficulty in comparing marginal revenue
production configuration will achieve the intended product to the marginal cost of an input is that the
output at the lowest cost. This is the cost approach mere increase in any single input is usually not
to production planning. enough in itself to create more units of output
• Another option is to use sophisticated computer
models that determine the optimal output levels
and minimum cost production configurations
 available on short notice.
Productivity and the Learning Curve
• This measure reflects how productive an
additional unit of that input would be in creating
additional output. However, for some inputs, there
are differences in marginal productivity across units.
• For example, in agriculture an acre of land in one
location may be capable of better yields than an
acre in another location.
• One means of doing this is using the measure of
average productivity, which is a ratio of the total
number of units of output divided by the total units
of an input. An alternative measure of average
Marginal Cost of Inputs and Economic Rent productivity would be the total dollars in revenue or
profit divided by the total units of an input.
• In cases where inputs are in high supply at the • In retail stores, a key resource is the amount of
current market price and the market for inputs is floor space. The productivity of a store could be
competitive, the marginal cost of an input is roughly measured by the total revenue over a period
equal to the actual cost of acquiring it divided by the available square footage.
• In this situation, the marginal cost of inputs may • The productivity of firms may change over time. In
be higher than the price to acquire an additional the case of labor, the productivity of individual
unit because the resulting price increase for the workers will rise as they gain experience and new
additional unit may carry over to a price increase of workers can be trained more effectively.
all units being purchased. • These productivity gains from experience and
• Suppose the salary required to hire a new improved knowledge are sometimes called learning
accountant will be higher than what the firm is by doing
currently paying accountants with the same ability. • The relationship between cumulative production
Once the firm pays a higher salary to get a new experience and average cost is called the learning
accountant, they may need to raise the salaries of curve.
the other similar accountants they already hired • The doubling rate is the reduction in average cost
just to retain them. that occurs each time cumulative production
• The difference between the amount the provider doubles.
of the limited input supply is able to charge and the
minimum amount that would have been necessary
to induce the provider to sell the unit to the firm is
called economic rent.
• Suppose a contracting firm was hired to do
emergency repairs to a major bridge. Due to the
time deadline, the firm will need to hire additional
construction workers who are already in the area.
Normally, these workers may have been willing to
work for $70 per hour. However, sensing the
contracting firm is being paid a premium for the
repairs, meaning the marginal revenue product of
labor is high, and there are a limited number of
qualified workers available, the workers can insist
on being paid as much as $200 per hour for the
work. The difference of $130 would be economic
rent caused by the shortage of qualified workers