Managerial EconomicsManagerial Economics

DouglasDouglas - “Managerial - “Managerial economics is .. the application of economics is .. the application of economic principles and economic principles and methodologies to the decision-methodologies to the decision-making process within the firm making process within the firm or organization.”or organization.”

SalvatoreSalvatore - “Managerial - “Managerial economics refers to the economics refers to the application of economic theory application of economic theory and the tools of analysis of and the tools of analysis of decision science to examine how decision science to examine how an organisation can achieve its an organisation can achieve its objectives most effectively.”objectives most effectively.”

Positive Economics:-Positive Economics:- Derives useful theories with Derives useful theories with

testable propositions about testable propositions about WHAT IS.WHAT IS.

Normative Economics:-Normative Economics:- Provides the basis for value Provides the basis for value

judgements on economic judgements on economic outcomes.WHAT SHOULD BEoutcomes.WHAT SHOULD BE

Scope of Managerial Scope of Managerial EconomicsEconomics

Utility analysisUtility analysis Demand and supply analysisDemand and supply analysis Production and cost analysisProduction and cost analysis Market analysisMarket analysis PricingPricing Investment decisionsInvestment decisions Game theory Game theory

Basic problems of an Basic problems of an economyeconomy

What to produce( Choice)What to produce( Choice) How to produce ( Technology)How to produce ( Technology) Whom to produce ( Distribution)Whom to produce ( Distribution)

Fundamental ConceptsFundamental ConceptsManagerial EconomicsManagerial Economics

Marginal PrincipleMarginal Principle Opportunity cost principleOpportunity cost principle Incremental PrincipleIncremental Principle Discount PrincipleDiscount Principle Time PerspectiveTime Perspective

Demand AnalysisDemand Analysis

Demand – Demand –

Desire + ability to pay + Desire + ability to pay + willingness to paywillingness to pay

Demand is relative term –Demand is relative term –

PricePrice

TimeTime

PlacePlace

Determinants of demandDeterminants of demand

PricePrice IncomeIncome Taste, preference and fashionTaste, preference and fashion Prices of related goodsPrices of related goods Government policyGovernment policy Custom and traditionCustom and tradition AdvertisementAdvertisement

Law of demandLaw of demand

If other things remain constant, If other things remain constant, when price increases demand when price increases demand contracts and when price contracts and when price decreases demand expands. Price decreases demand expands. Price and demand are inversely and demand are inversely proportionate.proportionate.

D = a - bPD = a - bP

Why demand curve slopes Why demand curve slopes downwardsdownwards

Law of diminishing marginal Law of diminishing marginal utilityutility

Income effectIncome effect Substitution effectSubstitution effect Multiplicity of usesMultiplicity of uses

Market Demand CurveMarket Demand Curve

Shows the amount of a good that will Shows the amount of a good that will be purchased at alternative prices.be purchased at alternative prices.

Law of DemandLaw of Demand The demand curve is downward sloping.The demand curve is downward sloping.

Quantity

D

Price

Exception to the law of Exception to the law of demanddemand

Giffen GoodsGiffen Goods Prestigious goodsPrestigious goods Buyers illusionsBuyers illusions Necessary goodsNecessary goods Brand loyaltyBrand loyalty

ElasticityElasticity

Elasticity is a measure of Elasticity is a measure of responsiveness of one variable to responsiveness of one variable to another variable.another variable.

Can involve any two variables.Can involve any two variables. An An elastic elastic relationship is relationship is

responsive.responsive. An An inelasticinelastic relationship is relationship is

unresponsive.unresponsive.

Types of Elasticity of Types of Elasticity of demanddemand

Price Elasticity of demandPrice Elasticity of demand Income elasticity of demandIncome elasticity of demand Cross Elasticity of demandCross Elasticity of demand Promotional Elasticity of demandPromotional Elasticity of demand

Price elasticity: Price elasticity: pp==%%Q/%Q/%PP

Causality: denominator numerator!Causality: denominator numerator! An An elasticelastic response is one where response is one where

numerator is greater than denominator.numerator is greater than denominator. i.e., i.e., %%Q>%Q>%P so P so EEpp

Imagine extreme example.Imagine extreme example.

An An inelasticinelastic response is one where response is one where numerator is smaller than denominator.numerator is smaller than denominator. i.e., i.e., %%Q<%Q<%P so P so EEpp

Again, imagine extreme example.Again, imagine extreme example.

Look at the ExtremesLook at the Extremes

Perfectly Elastic DPerfectly Elastic D

EEpp infiniteinfinite

Perfectly Inelastic Perfectly Inelastic DD

P

Q

P

Q

Ep 0

D

D

Relatively Elastic vs. Relatively Elastic vs. Inelastic Demand CurvesInelastic Demand Curves

Q1 Q2 Q2’

P1

P2

D’D

D’ is relatively more elasticthan D

P

Q

Point Elasticity FormulaPoint Elasticity Formula

Point elasticityPoint elasticity Point elasticity is Point elasticity is

responsiveness at a responsiveness at a point along the point along the demand functiondemand function

EEpp Q/QQ/Q1 1

P/PP/P11

simplifying:simplifying:EEpp

Q/Q/P)* PP)* P1 1 /Q/Q1 1

Price (Rs.)Price (Rs.)

QQ1

P1

D

Point Elasticity FormulaPoint Elasticity Formula

Point elasticityPoint elasticity Point elasticity is Point elasticity is

responsiveness at responsiveness at a point along the a point along the demand functiondemand function

EEpp Q/QQ/Q1 1

P/PP/P11

simplifying:simplifying:EEpp

Q/Q/P)* PP)* P1 1 /Q/Q1 1

Price (Rs.)Price (Rs.)

QQ1

P1

D

Example: Q=56-0.002*PExample: Q=56-0.002*P

Point elasticityPoint elasticityEEpp

Q/Q/P)* PP)* P1 1 /Q/Q11

SupposeSuppose P=17000P=17000 Q=56-0.002*17000Q=56-0.002*17000 Q=56-34=22Q=56-34=22 Plug into equation gives:Plug into equation gives:

EEpp -0.002)* 17000-0.002)* 17000

/22 /22 EEpp

=-34/22=-1.54=-34/22=-1.54

Price (Rs)Price (Rs)

Q22

17k

D

Arc ElasticityArc Elasticity

Briefly, arc elasticity is simply Briefly, arc elasticity is simply an average elasticity along an average elasticity along

a range of the demand a range of the demand curve.curve.

Arc Elasticity FormulaArc Elasticity Formula

Arc elasticity:Arc elasticity:

Responsiveness along a Responsiveness along a range of D. functionrange of D. function

EEpp Q/((QQ/((Q11++ QQ22)/2))/2)

P/((PP/((P11++ PP22)/2))/2)

simplifying:simplifying:EEppQ/Q/P)*((PP)*((P11+P+P22)/(Q)/(Q11+Q+Q22))))

Price ($)Price ($)

QQ2

P2

P1

Q1

Avg. responsiveness

D

Example Q=56-0.002*PExample Q=56-0.002*P

Arc elasticityArc elasticityEEpp

Q/Q/P)*((PP)*((P11+P+P22)/(Q)/(Q11+Q+Q22))))

Look atLook at P range 16k - P range 16k - 17k 17k

Q=56-0.002*17000Q=56-0.002*17000 Q=56-34=22Q=56-34=22 Plug into equation Plug into equation

gives:gives:EEpp

-0.002)*(33000/46)-0.002)*(33000/46)

EEpp =-66/46=-1.43=-66/46=-1.43

Price ($)Price ($)

Q22

17k

D

24

16k

Factors influence Price Factors influence Price elasticity of demandelasticity of demand

Nature of commodityNature of commodity Availability of substituteAvailability of substitute Multiplicity of usesMultiplicity of uses HabitHabit Proportion of income spentProportion of income spent Price rangePrice range

Managerial Applications of Managerial Applications of Price elasticity of demandPrice elasticity of demand

Pricing DecisionPricing Decision Fiscal policyFiscal policy Labour marketLabour market International tradeInternational trade

Income Elasticity of DemandIncome Elasticity of Demand

Recall demand function is:Recall demand function is:Q=f(P,Q=f(P,I,PI,Prelatedrelated,Tastes,Buyers,Expectations,Tastes,Buyers,Expectations......))

Change in I causes Change in I causes shiftshift in demand. in demand. Size of shift depends on income elasticity.Size of shift depends on income elasticity. EEI I Q/Q/II Focus again on point formula.Focus again on point formula. Value of EValue of EII determines type of good. determines type of good.

Values for Income Values for Income Elasticity (Elasticity ())

Sign indicates normal or inferiorSign indicates normal or inferior

EEII>0 implies normal good.>0 implies normal good.

EEII<0 implies inferior good.<0 implies inferior good. Normal goods may be Normal goods may be necessitynecessity or or

luxuryluxury.. If EIf EII>1 then this is luxury (responsive >1 then this is luxury (responsive

to income).to income). If 0<EIf 0<EII<1 then this is necessity <1 then this is necessity

(unresponsive to income).(unresponsive to income).

Cross Price Elasticity Cross Price Elasticity (E(EXYXY))

QQXX=f(P=f(PXX , ,I,PI,PYY,Tastes, Buyers,Expectations,Tastes, Buyers,Expectations......))

Change in Change in PPYY causes causes shiftshift in demand for X. in demand for X. Size of shift depends on cross-price elasticity.Size of shift depends on cross-price elasticity. EEXYXYQQXX / /PPYY

Sign indicates relationship between two Sign indicates relationship between two goodsgoods

EEXYXY>0 implies goods are substitutes. >0 implies goods are substitutes.

EEXYXY<0 implies goods are complements. <0 implies goods are complements.

OBJECTIVES OF SHORT TERM DEMAND OBJECTIVES OF SHORT TERM DEMAND FORECASTINGFORECASTING

Production planning Production planning Evolving sales policy Evolving sales policy Fixing sales targetsFixing sales targets Determining price policyDetermining price policy Inventory controlInventory control Determining short-term financial planningDetermining short-term financial planning

OBJECTIVES OF LONG-TERM DEMAND OBJECTIVES OF LONG-TERM DEMAND FORECASTINGFORECASTING

BUSINESS PLANNINGBUSINESS PLANNING

MANPOWER PLANNINGMANPOWER PLANNING

LONG-TERM FINANCIAL PLANNINGLONG-TERM FINANCIAL PLANNING

METHODS OF DEMAND FORECASTINGMETHODS OF DEMAND FORECASTING

Survey methodsSurvey methods:: Consumer interviewsConsumer interviews Opinion pollOpinion poll Experts opinionExperts opinion End-use methodEnd-use method

Statistical methods:Statistical methods: Trend AnalysisTrend Analysis Regression AnalysisRegression Analysis

Market Supply CurveMarket Supply Curve

The supply curve shows the amount The supply curve shows the amount of a good that will be produced at of a good that will be produced at alternative prices.alternative prices.

Law of SupplyLaw of Supply The supply curve is upward slopingThe supply curve is upward sloping

Price

Quantity

S0

Supply ShiftersSupply Shifters

Input pricesInput prices Technology or Technology or

government government regulationsregulations

Number of firmsNumber of firms Substitutes in Substitutes in

productionproduction TaxesTaxes Producer Producer

expectationsexpectations

The Supply FunctionThe Supply Function

An equation representing the supply An equation representing the supply curve:curve:

QQxxS S = f(P= f(Px x ,, PPR R ,W, H,),W, H,)

QQxxS S = quantity supplied of good X. = quantity supplied of good X.

PPx x = price of good X.= price of good X.

PPR R = price of a related good = price of a related good W = price of inputs (e.g., wages)W = price of inputs (e.g., wages) H = other variable affecting supplyH = other variable affecting supply

Change in Quantity Change in Quantity SuppliedSupplied

Price

Quantity

S0

20

10

B

A

5 10

A to B: Increase in quantity supplied

Price

Quantity

S0

S1

8

5 7

S0 to S1: Increase in supply

Change in SupplyChange in Supply

6

Producer SurplusProducer Surplus The amount producers receive in excess of the The amount producers receive in excess of the

amount necessary to induce them to produce the amount necessary to induce them to produce the good.good.

Price

Quantity

S0

Producer Surplus

Q*

P*

Market EquilibriumMarket Equilibrium

Balancing supply and Balancing supply and demanddemand QQxx

S S = Q= Qxxdd

Steady-stateSteady-state

Price

Quantity

S

D

8

Equilibrium Price and Equilibrium Price and quantity quantity

7

Price

Quantity

S

D

5

6 12

Shortage12 - 6 = 6

6

If price is too low...If price is too low...

7

Price

Quantity

S

D

9

14

Surplus14 - 6 = 8

6

8

8

If price is too high…If price is too high…

7