ES-301 Managerial Economics 05.05.10

IILM Institute for Higher Education

Course ManualMANAGERIAL ECONOMICS

ES301

PGP 201012

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http://mail.google.com/a/iilm.edu/?attid=0.1&disp=inline&view=att&th=11366cc17f8cae97

MANAGERIAL ECONOMICS

PGP Batch [201012]

I. Course Facilitators

Facilitator Emailid

Ms. Rakhi Singh [email protected]. Abhijit Mukhopadhyay [email protected]. Deepa Bhaskaran [email protected]

II. Course Overview

Managerial Economics can be viewed as an application of that part of microeconomics that focuses on topics like demand, production, cost, pricing and market structure. The objective of the course is to facilitate the learning of basic microeconomic theory and tools with an emphasis on applications to business problems and decision making in the real world.

III. Course Topics:

a. Introductionb. Optimization techniques and New Management toolsc. Demand Analysisd. Production Theorye. Cost Theoryf. Market Structure

IV. Learning Outcome

1. Develop an understanding of key microeconomic concepts, theories and tools.2. Develop skills for rigorous economic analysis of different market structures.3. Understand basic economic issues and principles and develop economic reasoning

for formulation of effective business policies at firm level.

V. Books and References:

Main Textbook:

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mailto:[email protected]



Dominik Salvatore (Adapted by Ravikesh Srivastava) : Managerial Economics, Principles and Worldwide Applications, Sixth Edition, Oxford University Press.

Additional Readings

1. Hirschey: Economics for Managers, Thomson, 1st Indian Ed., 20072. Satya P. Das: Microeconomics for Business, Sage India, 20073. Dean, Joel: Managerial Economics, PHI4. Keat , Paul G. & Philip K.Y.Young,: Managerial Economics, Pearson Education,

4th Ed., 20035. Boyes, William: New Managerial Economics, 1ST Ed., 2005, Biztantra6. Steven Levitt and Stephen J. Dubner: Freakonomics, William Morrow, 2005.

VI. Assessment (Total 100 Marks)

Sl. No. Components Weightage1 MidTerm Test 202 Continuous Assessment 203 EndTerm Test 60

Total 100

VII. Session Plan

Sessions Topics Readings/ Cases Chapters

Module 1: Introduction

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• The scope of Managerial Economics

• The basic process of decision making

• The theory of firm• The nature and function of profit

Case Study 12 : The Management RevolutionCase Study 13 : Profits in the Personal Computer Industry

Dominic Salvatore , Chapter no.1

Module 2: Optimization techniques and New Management tools

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http://en.wikipedia.org/wiki/William_Morrow_and_Company

http://en.wikipedia.org/wiki/Stephen_J._Dubner

http://en.wikipedia.org/wiki/Steven_Levitt

2• Methods of expressing

Economic Relationships• Total, Average and

Marginal Relationships• Optimization Analysis

Case Study 21 : Optimal Polution Control


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• Constrained Optimization• New Management tools for

Optimization• New Management Tools

and Functional Specialization

Case Study 23 : Benchmarking at Xerox, Ford and MobilCase Study 24 : Total Quality Management in Real World


Module 3: Demand Analysis

4• The Demand for a

Commodity • Price Elasticity of Demand

Case Study 31 : The Demand for Big MacsCase Study 32 : Price Elasticities of Demand in the Real World


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• Income Elasticity of Demand

• CrossPrice Elasticity of Demand

Case Study 33 : Income Elasticities of Demand in the Real WorldCase Study 34 : CrossPrice Elasticities of Demand in the Real WorldCase Study 35 : Substitution between Domestic and Foreign Goods


6• Using Elasticities in

Managerial Decision Making

Case Study 36 : Gillet Introduces the Sensor and Mach 3 Razors—Two Truly Global ProductsCase Study 37 : Ford’s World Car(s)


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7• Demand Forecasting –

Qualitative ForecastsCase Study 51 : Forecasting the number of McDonald's Restaurants Worldwide


8 • TimeSeries Analysis Case Study 52 : Forecasting Demand of Industrially Produced Tea in India with Time series analysis


9 Guest Lecture

Module 4: Production Theory

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• The Organization of Production and the Production Function

• The Production Function with One Variable Input

• Optimal Use of the Variable Input

Case Study : SAIL – Distribution Strategy for nonurban markets


11 • The Production Function with Two Variable Inputs


12 • Optimal Combination of Inputs

Case Study 61 : Substitutability between Gasoline Consumption and Driving Time


13 • Returns to Scale Case Study 62 : Returns to

Scale in U.S. Manufacturing IndustryCase Study 63 : Bajaj Auto Limited : Small is Better


• Empirical Production Case Study 64 : Output Dominic

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14 Function (CobbDouglas Production Function)

Elasticity in U.S. Manufacturing Industry

Salvatore , Chapter no.6

15 Midterm

16 Guest Lecture

Module 5: Cost Theory

17 • The Nature of Costs• Short Run Cost Functions


18 • Long Run Cost Curves• Relationship between short

run and long run cost curves

Case Study 71 : The Long Run Average Cost Curve in Electricity Generation


19• Plant Size and Economies of

Scale• Learning Curves

Case Study 72 : The Shape of the Long Run Average Cost CurveCase Study 73 : To Reduce Costs, Firms Often Look Far Afield


20 • CostVolumeProfit Analysis and Operating Leverages

Case Study 76 : Breakeven Analysis for Tata Motor’s Nano Car


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Guest Lecture

Module 6: Market Structure

22 • Market Structure and Degree of Competition

Case Study 81 : Competition in the Stock Market


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• Perfect Competition

23 • Monopoly Case Study 84 : Barriers to Entry and Monopoly by AlcoaCase Study 85 : Monopoly in the Mumbai City Taxi Industry


24 • Monopolistic Competition Case Study 86 : The Monopolistically Competitive Restaurant MarketCase Study 87 : Advertiser Competition in India


2526 • Oligopoly Case Study 91 : Brands : Thrive or DriveCase Study 92 : Industrial Concentration for TwoWheeler Industry in India Case Study 93 : The Organisation of Petroleum Exporting Countries (OPEC)Cartel


27 • Pricing of Multiple Product

• Price Discrimination

Case Study 111 : Optimal Pricing and Output by GilletteCase Study 112 : Price Discrimination by BSES India


VIII. Session Details

Session 1 In this introductory session, we will introduce the students to the subject and make them understand its importance in the current economic environment. This session

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provides the students with the basic tool kit that aids understanding of the nature and process of decision making by a manager.a. Question for discussion in the class − What is the importance of Managerial Economics?b. Case Discussion − Case Study 12 : The Management Revolution− Case Study 13 : Profits in the Personal Computer Industryc. Learning Outcomes− As an introductory session, the objective is help the students understand the meaning of managerial Economics and its role in the business decision making.d. Chapter Dominic Salvatore , Chapter no.1

Session 2 In this session we will make students understand the logic of optimization and its importance in decision making.

a. Question for discussion in the class − What are the tools for expressing economic relationships?b. Case Discussion − Case Study 21 : Optimal Polution Controlc. Learning Outcomes− The objective is to help the students understand the different ways to express economic relationships and their use in understanding optimisation techniques.d. Chapter Dominic Salvatore , Chapter no.2

Session 3 – In this session, we will introduce the tools designed to increase the effectiveness by providing the analytical framework used by managers. Thus emphasis is placed on optimization techniques.

a. Question for discussion in the class − How is a firm's profit maximisation level of output determined?b. Case Discussion − Case Study 23 : Benchmarking at Xerox, Ford and Mobil− Case Study 24 : Total Quality Management in Real Worldc. Learning Outcomes− The students will understand the constraints the firms face in their optimisation decisions. Also they will learn the new management tools introduced during the past two decades.d. Chapter Dominic Salvatore , Chapter no.2

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Session 4 – This session will cover demand and elasticity of demand. We will start with introduction to the concept of demand which is the force that drives all business. Without a demand for its goods or services, a firm cannot survive. Then we will go a step further and discuss the importance of elasticities as measures of the responsiveness of one item to change in another item. This session will focus on Price Elasticity of demand.

a. Question for discussion in the class − Discuss the relationship between price elasticity of demand and total revenue?b. Case Discussion − Case Study 31 : The Demand for Big Macs− Case Study 32 : Price Elasticities of Demand in the Real Worldc. Learning Outcomes− The students will understand the meaning of demand, elasticity of demand , the relationship between price elasticity of demand and total revenue and its importance as a manager.d. Chapter Dominic Salvatore , Chapter no.3

Session 5 – In this session the other two types of elasticities of demand will be covered, namely Income elasticity of demand and CrossPrice elasticity of demand.

a. Question for discussion in the class − How will you use the information regarding cross price elasticity of demand for your product?b. Case Discussion Case Study 33 : Income Elasticities of Demand in the Real World Case Study 34 : CrossPrice Elasticities of Demand in the Real World Case Study 35 : Substitution between Domestic and Foreign Goodsc. Learning Outcomes− The students will understand the importance and use of the concepts of income and cross price elasticity of demand of the products and services.d. Chapter Dominic Salvatore , Chapter no.3

Session 6 – In this session we will make the students understand the use of different elasticities of demand in the real world by taking cases of real business situations and also by giving them some situation and asking for a solution bases on Elasticity concept.

a. Question for discussion in the class − How will you use the concept of elasticity of demand as a manager?b. Case Discussion

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Case Study 36 : Gillet Introduces the Sensor and Mach 3 Razors—Two Truly Global Products Case Study 37 : Ford’s World Car(s) c. Learning Outcomes− The students will understand the importance and use of the concepts elasticity of demand in real world.d. Chapter Dominic Salvatore , Chapter no.3

Session 7 This session will help the students in understanding the importance of demand forecasting in the business decisions. It will introduce them to qualitative methods of demand forecasting.

a. Question for discussion in the class − What is the importance of demand forecasting?b. Case DiscussionCase Study 51 : Forecasting the number of McDonald's Restaurants Worldwide c. Learning Outcomes− The students will understand the importance of the concepts of demand forecasting in the business decision making. Also they will learn about the qualitative methods for the same.d. Chapter Dominic Salvatore , Chapter no.5,

Session 8 In this session students will be introduced to the most frequently used forecasting method – Time Series Analysis which attempts to forecast future values of the time series by examining past observations of the data only.

a. Question for discussion in the class − How do you make a trend line?b. Case Discussion Case Study 52 : Forecasting Demand of Industrially Produced Tea in India with Time series analysisc. Learning Outcomes− The students will understand to use the time series data for demand forecasting for the products.d. Chapter Dominic Salvatore , Chapter no.5

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Integration Plan: In this particular lecture, faculty of MR will also be there in the class to explain the Demand Forecasting techniques and students will get indepth knowledge about the Forecasting techniques

Session 9 – Guest Lecture

Session 10 – This session begins with a discussion of the production function which summarizes the engineering and technological possibilities open to the firm. This general discussion is extended to the specific case where there is a single variable input or resource and examines how much of the variable input a firm should employ to maximize profit.

a. Question for discussion in the class − What is the importance of supply for a producer?b. Case Discussion Case Study : SAIL – Distribution Strategy for nonurban marketsc. Learning Outcomes− With the help of the case study students will understand the role of supply and maximization of resources in production.d. Chapter Dominic Salvatore , Chapter no.6

Integration Plan : Common case on SAIL to be discussed in ME and Physical Distribution & Channel Management. From ME perspective, this case will highlight the importance of supply for creating demand for a product in an untapped market. From Marketing perspective, this case will stress upon the fact that many organisations are forced to choose alternative or additional marketing strategies based on competitions' activities. Also it will highlight the distribution channels available and chosen by SAIL and would take care of Physical Distribution and Channel Management.

Session 11 – In this session we will examine the production function when there are two variable inputs. The difference between short run and long run is explained from an economist’s perspective.

a. Question for discussion in the class − What is the difference between short run and long run production?b. Learning Outcomes− Students will understand the process of production in short run as well as in the long run.c. Chapter Dominic Salvatore , Chapter no.6,

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Session 12 In this session we will explain the students how the production function and its building blocks are analysed from a managerial perspective. Also the students will understand how a profitmaximising firm will choose an optimal combination of inputs based on input prices.

a. Question for discussion in the class − What are the conditions for profit maximization?b. Case Discussion Case Study 61 : Substitutability between Gasoline Consumption and Driving Timec. Learning Outcomes− Students will understand how the maximization of output and minimization of cost by choosing an optimal combination takes place..d. Chapter Dominic Salvatore , Chapter no.6,

Session 13 – In this session we will discuss the concept of Returns to Scale where all the inputs are variable. The three types of Returns to scale : Constant , Increasing and Decreasing will be explained in detail with the use of different examples from the real world.

a. Question for discussion in the class − What is Returns to scale?b. Case Discussion Case Study 62 : Returns to Scale in U.S. Manufacturing Industry Case Study 63 : Bajaj Auto Limited : Small is Betterc. Learning Outcomes− Students will understand the concept of returns to scale and its possibility in the production process.d. Chapter Dominic Salvatore , Chapter no.6,

Session 14 This session will explain the most commonly used production function which is known as CobbDouglas Production function. We will also make the students understand several useful properties this production function has.

a. Question for discussion in the class − Examine the use of CobbDouglas production function.b. Case Discussion Case Study 64 : Output Elasticity in U.S. Manufacturing Industryc. Learning Outcomes− Students will understand the use of the famous CobbDouglas production function in the production process.

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d. Chapter Dominic Salvatore , Chapter no.6,

Session 15 – Midterm


Session 17 In this session, we will shall discuss some important cost concepts that are relevant for managerial decisions. We analyse the basic difference between these cost concepts and also, examine how accountants and economists differ on treating different cost concepts. We will cover all the short run cost curves in this session.

a. Question for discussion in the class − What is the difference between accounting cost and Economics cost?b. Learning Outcomes− Students will understand different concepts of cost and their relevance in business decision making.c. Chapter Dominic Salvatore , Chapter no.7,

Session 18 This session will continue the cost concept and will focus on the derivation of long run total, average and marginal cost curves. We then show the relationship between the firm’s long run average cost curve and the firm’s short run average cost curves.

a. Question for discussion in the class − Why long run average cost curve is called an envelope to short run cost curves?b. Case Discussion Case Study 71 : The Long Run Average Cost Curve in Electricity Generationc. Learning Outcomes− Students will understand the working of the cost in the long run and the relationship between short run and long run cost curves.d. Chapter Dominic Salvatore , Chapter no.7,

Session 19 – In this session we will examine the plant size, economies of scale, diseconomies of scale, economies of scope and learning curves. These concepts and analysis have a lot of applications in real world decision making process.

a. Question for discussion in the class − How does the economies of scale take place in the production process?b. Case Discussion

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Case Study 72 : The Shape of the Long Run Average Cost Curve Case Study 73 : To Reduce Costs, Firms Often Look Far Afieldc. Learning Outcomes− Students will understand the difference between economies and diseconomies of scale and their impact on the shape of long run average cost curves.d. Chapter Dominic Salvatore , Chapter no.7,

Session 20 – This session will examine costvolumeprofit analysis (often called breakeven analysis) and operating leverage. These simple analytical techniques are frequently used in managerial decision making and can be quite useful when applien under a proper set of circumstances.

a. Question for discussion in the class − How does the economies of scale take place in the production process?b. Case Discussion Case Study 76 : Breakeven Analysis for Tata Motor’s Nano Carc. Learning Outcomes− Students will understand the concept and relevance of the break even analysis for a firm.d. Chapter Dominic Salvatore , Chapter no.7,


Session 22 – One of the most important decision made by managers is setting the price of the firm’s product. If the price set is too high, the firm will be unable to compete with other suppliers in the market. On the other hand, if the price is too low, the firm may not be able to earn a normal rate of profit.. Pricing is thus a crucial decision area, which needs much of managerial attention. The process by which price and output are determined in the real world is strongly affected by the structure of the market. We will make the students understand the meaning of market structure which refers to the competitive environment in which the buyers and the sellers of a particular product operate. Then we will distinguish between four types of markets. And finally we will explain the equilibrium conditions for a firm and the industry in a perfectly competitive situation.

a. Question for discussion in the class Is there any example of perfectly competitive market structure today?b. Case Discussion Case Study 81 : Competition in the Stock Marketc. Learning Outcomes

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− Students will understand the concept of market and will be able to analyse the perfectly competitive market’s working.d. Chapter Dominic Salvatore , Chapter no.8,

Session 23 – In this session we shall analyse the behaviour of a firm under monopoly, examine how the monopolist determines the best level of output and price in the short run and in the long run, and compare monopoly with perfect competition.

a. Question for discussion in the class How does a firm under monopoly work?b. Case Discussion Case Study 84 : Barriers to Entry and Monopoly by Alcoa Case Study 85 : Monopoly in the Mumbai City Taxi Industryc. Learning Outcomes− Students will understand the working of a firm under monopoly .d. Chapter Dominic Salvatore , Chapter no.8,

Session 24 In this session we will discuss the meaning and importance of monopolistic competition, show how the equilibrium price and quantity are determined in the short run and in the long run, explain the concept of product differentiation with special reference to monopolistic competition.

a. Question for discussion in the class Give 5 examples of firms working under monopolistic competition.b. Case Discussion Case Study 86 : The Monopolistically Competitive Restaurant Market Case Study 87 : Advertiser Competition in Indiac. Learning Outcomes− Students will understand the working of a firm under monopolistic competition and will be able to relate it to the real world.d. Chapter Dominic Salvatore , Chapter no.8,

Session 2526 – In these session we will examine oligopoly, study oligopoly models and apply these models of oligopoly behaviour to real world situations.

a. Question for discussion in the class Take 2 examples of oligopoly market and analyse the working.b. Case Discussion Case Study 91 : Brands : Thrive or Drive

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Case Study 92 : Industrial Concentration for TwoWheeler Industry in India Case Study 93 : The Organisation of Petroleum Exporting Countries (OPEC)Cartelc. Learning Outcomes− Students will understand the working of a firm under oligopoly and with the help of real examples will be able to relate it to the business world.d. Chapter Dominic Salvatore , Chapter no.9,

Session 27 – Most modern firms produce a variety of products rather than a single product. In this session we will expand our simple pricing rule and examine the firm’s pricing of multiple products. We will also examine the optimal pricing of a product sold by the firm in multiple markets. We will explain the meaning of Price Discrimination and examine the conditions under which it arises.

a. Question for discussion in the class Is price discrimination possible? If yes, under what conditions?b. Case Discussion Case Study 111 : Optimal Pricing and Output by Gillette Case Study 112 : Price Discrimination by BSES Indiac. Learning Outcomes− Students will understand the conditions under which there is a possibility of price discrimination.d. Chapter Dominic Salvatore , Chapter no.11,

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STUDY MATERIAL OF MANAGERIAL ECONOMICS

Preliminary Ideas of Demand and Supply

The relationship between demand and price

Why does the demand for a given good increase when prices are falling? The demand curve illustrates the relationship between price and quantity demanded.

The law of demand states that other things remaining same, the quantity of a good demanded falls as the price rises and rises as the price falls.

Demand FunctionThe demand function for a product in a market can be written as follows:D = f (P1, P2,…,Pn, Y, T, P, E)Where:P1 = Price of the good itselfP2,…,Pn = Prices of other goods – e.g. prices of Substitutes and ComplementsY = Consumer’s incomeT = Tastes and preferences of consumerP = The level and agestructure of the populationE = Price expectations of consumers for future time periods

Other Determinants of Demand

• Change in the income of consumers• Change in tastes and preferences• Population and age distribution• Price expectations• Product quality

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Movements along and shifts in the demand curve

When a determinant of demand other than price changes there is a shift in demand curve. When there is a change in price there is a movement along the demand curve.

Supply

The law of supply states that all other things remaining same, when the price of a good rises, the quantity supplied will also rise, and vice versa. Supply curves generally slope upwards.

Other Determinants of Supply • Costs of production • Profitability of alternative products (substitutes in supply)

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• Profitability of goods in joint supply • Nature and other random shocks • Aims of producers • Expectations of producers

Movements along and shifts in the supply curve

A movement along the supply curve is caused when there is a change in the price of the commodity itself. An increase in the price of the commodity leads to increase in quantity supplied, while a decrease in price causes a contraction in quantity supplied.A shift in the supply curve takes place when there is a change in any nonprice determinant of supply. The curve can shift to the right or left. In the diagram given below a rightward shift represents an increase in the quantity supplied S1 to S2, whilst a leftward shift represents a decrease in the quantity supplied S1 to S3.

Reasons for movements in supply curve are:1. Changes in costs of production – An increase in the costs of production leads to declining profits and producers start producing less of it causing a leftward shift in the supply curve.2. Role of technology – With improved technology larger production takes place at less cost, making the supply curve shift to the right.

Equilibrium Price and Output DeterminationThe price of a commodity in a market is determined by the interaction of market supply and market demand. In the diagram given bellow the point at which the quantity demanded equals the quantity supplied is the equilibrium point. This point states the price of the good (P1) and the market quantity (Q1).The market forces maintain the equilibrium if there is no shift in either demand or supply curves. If prices rise and equilibrium is disturbed then the firms starts supplying more. At the same time the consumers will demand less. Thus supply outstrips demand in this case. The producers will thus not be able to sell what they produced at this price and they will have unsold stocks. Thus they will start selling stocks at a lower price thereby raising demand. This process continues until the supply and demand are again in equilibrium.

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Movement to a new equilibrium:If the position of either the demand and/or supply curve shifts, then the equilibrium price and quantity will change. For example, if the good is more in demand, then the demand curve will shift from D1 to D2.

The new equilibrium quantity and price will be Q2 and P2.

Concept of Elasticity

Defining ElasticityThe degree to which a demand or supply curve reacts to a change in price is the curve's elasticity. Elasticity varies among products because some products may be more essential to the consumer. Products that are necessities are more insensitive to price changes because consumers would continue buying these products despite price increases. Conversely, a price increase of a good or service that is considered less of a necessity will deter more consumers because the cost of buying the product will become too high.

To determine the elasticity of the supply or demand curves, we can use this simple equation: Elasticity = (% change in quantity divided by % change in price)

Alternatively, Elasticity, e = PPQQ

//

∂∂

= PQ

∂∂

. QP

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Demand Curves with different price elasticity of demand

If elasticity is greater than or equal to one, the curve is considered to be elastic. If it is less than one, the curve is said to be inelastic. As we mentioned previously, the demand curve is a negative slope, and if there is a large decrease in the quantity demanded with a small increase in price, the demand curve looks flatter, or more horizontal. This flatter curve means that the good or service in question is elastic. Meanwhile, inelastic demand is represented with a much more upright curve as quantity changes little with a large movement in price.

Percentage change in price

Percentage change in demand

Numerical calculations

Elasticity value

Description

10% 0% 0/10 η = 0 Perfectly inelastic

10% 5% 5/10 η < 1 Inelastic demand

10% 10% 10/10 η = 1 Unit elasticity

10% 20% 20/10 η > 1 Elastic demand

10% Infinitely large η = ∝ Perfectly elastic

Factors Affecting Demand Elasticity

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There are three main factors that influence price elasticity of demand:

1. The availability of substitutes This is probably the most important factor influencing the elasticity of a good or service. In general, the more substitutes, the more elastic the demand will be. For example, if the price of a cup of coffee went up by Rs. 1.00, consumers could replace their morning caffeine with a cup of tea. This means that coffee is an elastic good because a raise in price will cause a large decrease in demand as consumers start buying more tea instead of coffee.However, if the price of caffeine were to go up as a whole, we would probably see little change in the consumption of coffee or tea because there are few substitutes for caffeine. Most people are not willing to give up their morning cup of caffeine no matter what the price. We would say, therefore, that caffeine is an inelastic product because of its lack of substitutes. Thus, while a product within an industry is elastic due to the availability of substitutes, the industry itself tends to be inelastic. Usually, unique goods such as diamonds are inelastic because they have few if any substitutes.

2. Amount of income available to spend on the good If the price of a can of Coke goes up from Rs. 5 to Rs. 10 and income stays the same, the income that is available to spend on coke, which is Rs. 20, is now enough for only two rather than four cans of Coke. In other words, the consumer is forced to reduce his or her demand of Coke. Thus if there is an increase in price and no change in the amount of income available to spend on the good, there will be an elastic reaction in demand; demand will be sensitive to a change in price if there is no change in income.

3. Time If the price of cigarettes goes up Rs. 2 per pack, a smoker with very few available substitutes will most likely continue buying his or her daily cigarettes. This means that demand for tobacco is inelastic because the change in price will not have a significant influence on the quantity demanded. However, if that smoker finds that he or she cannot afford to spend the extra Rs. 2 per day and begins to kick the habit over a period of time, the price elasticity of cigarettes for that consumer becomes elastic in the long run.

Income Elasticity of Demand

In the second factor outlined above, we saw that if price increases while income stays the same, demand will decrease. It follows, then, that if there is an increase in income, demand tends to increase as well. The degree to which an increase in income will cause an increase in demand is called income elasticity of demand (EDy), which can be expressed in the following equation:

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If EDy is greater than one, demand for the item is considered to have a high income elasticity. If however EDy is less than one, demand is considered to be income inelastic. Luxury items usually have higher income elasticity because when people have a higher income, they don't have to forfeit as much to buy these luxury items.

Determinants of Income Elasticity of Demand– Degree of necessity of the good– The rate at which the desire for a good is satisfied as

consumption increases.– The level of income of consumers.

With some goods and services, we may actually notice a decrease in demand as income increases. These are considered goods and services of inferior quality that will be dropped by a consumer who receives a salary increase. An example may be the increase in the demand of DVDs as opposed to video cassettes, which are generally considered to be of lower quality. Products for which the demand decreases as income increases have an income elasticity of less than zero. Products that witness no change in demand despite a change in income usually have an income elasticity of zero these goods and services are considered necessities.

Crossprice elasticity of demandThe responsiveness of demand for one good to a change in the price of another is called Crossprice elasticity of demand.

Cross elasticity of demand =

B good of pricein change ateProportionA goodfor demandedquantity in change ateProportion

Determinants of cross price elasticity– Closeness of the substitute or complement.

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Theory of ProductionThe Organization of Production• Inputs

Labor, Capital, Land• Fixed Inputs• Variable Inputs• Short Run

At least one input is fixed• Long Run

All inputs are variableProduction Function with Two Inputs

Q = f(L, K)

Production Function with One Variable Input

Total Product TPL = Q = f(L)

Average Product APL = L

TPL

Marginal Product MPL = L

TP∆∆

Production or Output Elasticity EL = L

L

APMP

Production Function with One Variable Input

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K Q6 10 24 31 36 40 395 12 28 36 40 42 404 12 28 36 40 40 363 10 23 33 36 36 332 7 18 28 30 30 281 3 8 12 14 14 12

1 2 3 4 5 6 L

Total, Marginal, and Average Product of Labor, and Output Elasticity

L Q MPL APL EL

0 0 1 3 3 3 12 8 5 4 1.253 12 4 4 14 14 2 3.5 0.575 14 0 2.8 06 12 2 2 1

Three Stages of Production with One Variable Input

Production with Two Variable InputsIsoquants show all the combinations of two inputs that can produce the same level of output.Firms will only use combinations of two inputs that are in the economic region of production, which is defined by the portion of each isoquant that is negatively sloped.

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CobbDouglas Production Function

The widely used multiplicative form of production function which is known as CobbDouglas production function is of the following form.

Q = AKα Lβ where A is a constant and and α , β are fractions, i.e., lying between 0 and 1

It is widely used in economics because it has properties representative of many production processes.

Concepts of Revenue and Profit

RevenueRevenue

Defining total, average and marginal revenue

Revenue curves when firms are price takers (horizontal demand curve) • Average revenue (AR) • Marginal revenue (MR) • Total revenue (TR)

Revenue curves when price varies with output (downwardsloping demand curve) • Average revenue (AR) • Marginal revenue (MR) • Total revenue (TR) • Revenue curves and price elasticity of demand

Shifts in revenue curves

Profit MaximisationProfit Maximisation

Using total curves • Maximising the difference between TR and TC • The total profit curve

Using marginal and average curves • stage 1: profit maximised where MR = MC • stage 2: using AR and AC curves to measure maximum profit

Some qualifications • longrun profit maximisation

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• the meaning of profit

What if a loss is made? • loss minimising: still produce where MR = MC • shortrun shutdown point:

P = AVC • longrun shutdown point:

P = LRACTotal, Average, and Marginal Cost

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0

6 0

1 2 0

1 8 0

2 4 0

0 1 2 3 4Q

T C ($ )

0

6 0

1 2 0

0 1 2 3 4 Q

A C , M C ($ )AC

M C

ES-301 Managerial Economics 05.05.10

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Transcript of ES-301 Managerial Economics 05.05.10