Managerial Economics

Supply and Demand Homework

Lecture Notes in Power Point

Lecture I and II
Production and Costs
Profit Maximization
Perfect Competition & Monopoly
Monopolistic Competition and Oligopoly
Monopolistic Competition and Oligopoly II

Introduction

Orientation/Introduction

What is managerial economics?

Managerial economics is applied microeconomics; making use of the tools of

statistics, mathematics, and decision sciences, managerial economics applies
economic models and tools of analysis to (decision making) problems faced by the
managers of business firms, not-for-profit organizations and government agencies.

Consider the following cases:

o Trying to make her sales goals of the month a department store manager needs to
decide on a strategy to increase her sales. Should she have a sale on the overstocked
merchandise or should she raise the prices on some of the more popular items?

o In an attempt to increase the market share of his company the CEO of a major beer
company has to decide whether to expand the production capacity of an existing plant
or to build a new plant at another location.

o The CEO of a small accounting firm wishes to decide whether to upgrade the firm's
computer system or to hire more accountants.

o A regional sales manager wants to decide whether to hire more sales persons or
offer greater incentives to her existing sales staff.

o The marketing manager of a computer software company wants to determine the

price of an upgrade of one of the company's popular software products.
o A pharmaceutical company wants to determine the price of a new patented cancer
drug it has just had approved by FDA.

o A local moving company is trying to decide whether it should increase the size of its
fleet or replace some of its older trucks with new ones.

o A school board wants to decide whether to buy more computers or hire more
teachers.

o In reaction to an increase in the cost of claims an insurance company wants to

decide whether it should raise its premiums or it should reduce benefits.

o The director of a charity organization wants to decide between two fund-raising

schemes: (1) Direct mail to a large number of households whose addresses can be
obtained at no charge from public sources; (2) direct mail to a select number of
households whose names and addresses can be purchased from a commercial mailing
list company at a relatively high price.

These are some examples of the types of managerial problems that managers in
different organizational settings face every day. Note that in all cases the managers are
faced with alternative choices. Good decision-making practices often require
(appropriately) precise evaluation of alternatives. The need for some level of precision
in managerial decisions calls for precision instruments of measurement and analysis.
Aided with mathematical and statistical tools, economic models provide us with such
instruments.

A simple example should make the above point more clear. Suppose the sales
manager of an auto dealership wishes to increase the monthly sales revenue of the
dealership by $100,000. She can try to achieve this goal by offering discounts and
hoping to sell more cars. Alternatively, she can raise the prices on certain models and
hope that there won't be any reduction in the number of cars sold. Or, she can spend
more money on advertisement. Unless she knows, nearly exactly, how each of these
schemes affects her sales there is no way for her to identify and choose the best one.

Let's suppose that based on her experience, she decides to go with the discount
scheme. Now the next decision that she has to make is the size of the discount. Will a
10 percent discount on some models do it or should she offer a much larger discount?
For her to be able to make these decisions with some degree of confidence she needs
to know the demand for her cars. In other words, she needs to be able to make
predictions about how different factors affect the demand for her cars. We shall come
back to this example later in this lecture.
Most managerial decisions involve making a choice from among alternative courses
of action or alternative options in order to achieve a certain objective. A manager
would want to choose the best option among the possible alternatives.

Optimization
Optimization is the process by which a desired outcome is achieved through the most
efficient course of action. In production a manager optimizes the use of a given
amount of inputs to produce the greatest amount of output possible. In consumption, a
consumer with a given amount of income purchases the mix of goods that provides
him or her with greatest level of satisfaction (utility). In a not-for-profit setting, a
manager might want to accomplish a certain task at a lowest possible cost. Or,
alternatively, a manager may wish to provide the maximum amount of service with a
given amount fund.

Constrained Optimization
Often managerial decisions have to be made subject to some constraints. Managers
operate under a variety of constraints including technological, financial, legal and
contractual. For instance, a manager that is trying to cut his labor costs (or optimize
the size of his labor force) may be constrained by a union contract limiting his ability
to lay off workers. A farmer who wants to take advantage of good market conditions
and increase the size of his crop is limited by the amount of land that he has available.

Furthermore, managerial decisions are not made in a vacuum. Economic and market
conditions constantly change and managers must make their decisions in accordance
with the dynamics of the business environment. Especially for business firms,
changing economic/market conditions present major challenges, as their managers
need to constantly make adjustments in their plans in response to changing
economic/market conditions.

Economics and Management

What does economics have to do with management? Economics, as a discipline, is
divided into two branches: microeconomics and macroeconomics.

Microeconomics is a study of the behavior of individual microeconomic units such

business firms and consumers. Macroeconomics, on the other hand, studies the
economy as whole and deals with issues like inflation, unemployment and economic
growth. Managerial decisions involve identifying problems and opportunities,
examining alternative courses of actions, and making optimal choices. As complex
as managerial problems may appear, often their relevant (important) elements can
nicely be fitted into microeconomic models. That is why managerial economics is also
called "applied microeconomics." Microeconomic models help us convert seemingly
complex managerial problems and solution options into manageable forms to which
quantitative tools of analysis can be applied. For example, the profit-maximizing
objective of a business firm is nicely described in the microeconomic theory of the
firm. This model provides a very good framework for analyzing many cost/revenue
related managerial questions.

A manager operates in two environments, internal and external. The internal

environment is made up of those factors over which he has at least some degree of
control. What technology to use, how many workers to hire, what method of
advertisement to use are some examples of internal factors. The external environment,
however, is influenced by factors beyond a manager's control. The state of the
economy, interest rates, inflation, exchange rates and laws and regulations are among
the factors that affect the external environment for a manager.

Macroeconomics is relevant to managers as managers are often interested in knowing

(and sometimes in predicting) the state of the economy and the direction of
macroeconomic measures such as interest rates and inflation. Such knowledge is
essential in their evaluation of opportunities and of the options they face. In the
increasingly globalized economic environment of today, accurately reading (and
predicting) macroeconomic measures such as inflation rates, interest rates, and
exchange rates could be the key to making effective managerial decisions.

Scope of the Course

Managerial economics is a growing and evolving field. It would be unrealistic for us
to expect to learn all the methods and analytical tools of managerial economics in one
undergraduate course. In this course we will attempt to learn about the application of
some of the more basic microeconomic models to managerial problems. We will start
our discussion with a look at the roles and the objectives of managers and
then move on to a review of the supply and demand model. Next we will turn to the
concept of elasticity.

Following a brief review of the consumer theory, through which we will learn about
the concept of optimization, we will start our discussion of the theory of the firm. It
is within the framework of that model that we will address the issue of profit
maximization and discuss the behavior of business firms under different market
structures.

In MBA 531 (our graduate version of this course) we would also contain a review of
regression analysis and forecasting methods as well as topics related to factor markets
and decision making under uncertainty. In this course we will omit most these topics.
We shall try, however, to address the issue of uncertainty, only to a limited extent, in
the context of our discussion of market structures.
Although many of the analytical tools of managerial economics are as useful to the
managers of government agencies and not-for-profit organizations as they are to the
managers of business firms, in this course we will do most of our analyses with
business firms in mind.

What You Should Expect to Learn

One course in managerial economics is not going to make you a professional
economist or a managerial economist, for that matter. Upon successfully completing
this course, however, you should expect to have learned how relatively simple
economic models and tools of analysis can be utilized to analyze (and sometimes to
solve) rather complex managerial problems. The course will sharpen your analytical
skills, enabling you to identify the relevant elements of a problem, fit it into a
manageable (economic) framework, and apply simple analytical tools to it to analyze
and solve it.

DOCUMENT by: Said Atri

Subject: 2.1 Managerial Objectives Lecture

Managerial Objectives

Business Firms and their Functions

Before we address the objectives of a business firm let us make sure that we all know
what economists mean by a business firm. Economists define a firm as an economic
unit engaged in the production of one or more goods (or services) for the purpose of
selling and making profits. It is generally assumed that the goals of the managers of a
firm are consistent with the economic function of the firm. In other words, managers
make their decisions in accordance with the profit-maximizing objective of the firm.

The economic definition of a business firm covers all sorts of business firms. IBM,
GM, Microsoft, Sears, and Walmart are all business firms as are your corner service
station and your favorite pizza restaurant. All these firms produce products or services
to sell in the market and make profits.

Profit Maximization and the Value of a Firm

What determines the value of a business firm? Although business firms often own
some physical (or intellectual; e.g. copy rights) assets (as well as liabilities), and the
net worth of their assets may have some effects on their values, the real value of a
business firm is likely to be more dependent on its (expected) future profitability. In
other words the value of a firm is the presented value of its expected future
profits. Thus a managerial decision that is expected to have a positive effect on the
firm's future profits would increase the value of the firm. Conversely, an event or a
decision by the firm that is perceived to have a negative effect on the firm's future
profits would like cause its value to go down.

Marginal Analysis: A Precursor

Economic profit is defined as the difference between the firm’s total revenue and its
total economic cost of production:

Profit = TR – TC

Both TR and TC change as the firm changes the quantity of its output (product). In
other words, TR and TC are both a function of the quantity of output (Q). Thus we
write:

TR = f (Q)
TC = g(Q)
Profit = TR-TC = h (Q)

Where f, g, and h denote functional relationships.

A change in a firm’s profit results from a change in its total revenue or a change in its
total cost or a combination of the two. That is:

Change in Profit = Change in TR - Change in TC

In mathematics very small changes in a variable (at the margin) are called marginal
changes. A marginal change in a variable could be positive or negative.

Thus, mathematically speaking, marginal profit is equal to the difference between

“marginal revenue” and “marginal cost”.

Simply put, "marginal revenue" is the change in total revenue resulting from selling
one additional unit of output. Likewise, "marginal cost" is the change in the cost of
production resulting from producing one additional unit of output. By the same token,
"marginal profit" can be defined as the change in profit resulting from a one-unit
change in the output. As long as its marginal profit is positive (greater than zero) a
firm can increase its (total) profit by producing more output. The firm's profit reaches
its maximum level when its marginal profit becomes zero. Thus, a firm can find the
profit maximizing level of its output (product) by setting its marginal profit equal to
zero (and solving for Q).

Marginal Profit = MR – MC = 0
Alternatively, the firm can find the profit maximizing level of its output by setting its
MR equal to its MC.

Note that when a firm sells its product at a given market price, irrespective of how
much it produces and offers to the market, its marginal revenue is simply the market
price. That is because each additional unit that it sells will increase the firm’s revenue
by an amount equal to the market price of the good.

An exercise:

TC = 400 + 70 Q + .002 Q^2

MC = 70 + .004 Q

TR = 250 Q
MR = 250

MR = MC

250 = 70 + .004 Q

.004 Q = 180

Q = 45,000

Note: The marginal value of a function (relative to a given variable) can be obtained
by taking the derivative of the function (with respect to that variable). that is:

This subject will be addressed in more detail in future lectures.

The Concept of Present Value

Because assets have potentials to generate either benefits or income (if invested) for
their owners, an economically "rational" person would prefer a present asset to a
future asset of the same value. If you were offered a television set as a gift and are
given the choice of either having it now or having it a year from now, chances are that
you would want to have it now. If you were to wait a year, you would deprive
yourself from its benefit for a whole year. The difference between the value of a
present asset and a future asset of the same value may be more clearly observed in the
case of financial assets. If you won a lottery and were given the option of receiving
your prize in full now or a year from now, you would definitely demand that it be
given to you now. That is because if you waited a year you would lose the opportunity
to invest your prize money and earn interest from it. That is why in some lottery
games players are offered the option of either receiving their prize money in
installments over a period of time or receiving the discounted value of the future
installments in cash. Thus we can say the present value of a future asset is equal to its
discounted value. Alternatively, the future value of a present asset, say two years from
now, is its present value plus the interest that would accrue over two years. So we can
write:

Future value of an asset in two years = Its present value (1 + interest rate )2

From this we can generalize and write:

FVA = PVA (1+ r) n

where FVA stands for future value of asset A, PVA is the present value of asset A, r
represents the interest (discount) rate, and n is the number of years into the future.

It is easy enough to rearrange the above equation to define the present value of a
future asset. We simply divide both sides of the equation by (1+ r) n .

PVA = FVA/ (1 + r) n

A simple example would make this concept more clearer. Let us suppose that when
you were born, say in 1980, your Uncle Ben gave you a 2010 zero-coupon bond with
a face value of $10,000.(Note: Zero coupon bonds were actually introduced in mid-
1982. Zero coupon bonds, as their name suggests, have no "coupons," or periodic
interest payments. Instead, the investor receives one payment (at maturity) that is
equal to the principal invested plus the interest earned, compounded semiannually. In
other words, when a zero coupon bond matures, the holder of the bond receives the
full face amount of the bond.) Uncle Ben told your parents that they did not have to
wait till year 2010 to cash the bond. He said they could go to a bank (or a brokerage
firm) any time they wished and cash the bond. That made your parents very happy and
they wondered how much they could get for it if they were to cash it then, although
they really did not intend to do so. On your mother's insistence, your father calls his
banker friend to find out. Your father was disappointedly surprised when his friend
gave him the present value of your $10,000 zero-coupon bond. He said if they were to
cash it then they would get about $575. When your mother heard that she said: "I
knew my brother could not have become so generous all of a sudden!"
Now let see how the banker figured that out. What he did was simply calculate the
present value of $10,000 for 30 years. Those days (in late 1970s and early 1980s) the
interest rates were rather high. The prime rate (the interest commercial banks charge
their most creditworthy customers) reached as high as 18 percent. Thirty-year
government bonds paid (or were discounted by) as much 13 percent (annually). Now
let us say that your father's banker friend used a 10 percent discount rate to determine
the value of your $10,000 zero-coupon bond. The future value of your 30-year zero-
coupon bond on its maturity day was $10,000., as indicated right on its face. So we
write:

PVA = 10,000/ (1 +.10 )^30 = 573.0855

In other words, if your uncle had given you $575 in cash and your parents had
invested it for you for 30 years at a fixed interest rate of 10 percent, by the year 2010
your $575 would have grown to about $10,000. That is the power of compounding
interest!

Your uncle Ben might not have been too generous, but he was a smart investor. In a
few years in mid and late 1980's, the interest rate had dropped significantly. For
example in 1990 the 20-year interest rate was around 8 percent. In that year the
present value of your $10,000 bond, which was to mature in 20 years now, was
$2145, almost 4 times what it was 10 years earlier; that means a little less than 300
percent growth in ten years.

Present Value and the Value of a Business Firm

One way to put a value on a firm is to multiply the market value of a share of its stock
by the number of its outstanding shares. Outstanding shares are share issues held by
investors. This value is referred to as the market value of the company. In other words
that is the value that investors put on the company when they trade its share. When
you buy a share of a company, in theory, you are buying a piece of the net asset or the
equity of the company that could include some bolts and nuts and maybe a few bricks.
But that is not really why you buy a share of a company's stock. As a small
shareholder you can hardly hope to have a say in the business of the company let
alone claiming your share of the bolts and nuts that the company owns. You (directly
or through your investment agent) evaluate and buy a stock much the same way you
would buy a bond issue. In other words, to an investor the value of a stock is a
function of its (expected) future earnings. A stock is a piece of paper that gives its
holder a right to a portion of the company's future profits. It is then the future profits
of the company that give value to the stocks of a company. More precisely, the value
of a business firm is the present value of the company's expected future profits. Using
the present value formula we can write
where PV t is the value of the firm in time t, r is the interest (discount) rate, and n is
the number of years following time t that the firm is expected to be in operation and
produce profits. Theoretically a business firm could have an infinite lifetime. One can
assume a case where an investor would buy a stock with the intention of selling it
after a certain period of time. In that case the last "earning" of that stock would be the
market value of the stock at the time the investor intends to sell it. An investor could
speculate about the value of a stock in the future and make his or her investment
decision accordingly. Note that the market value of a stock at some point in the future
would also depend on its expected profits from that point on. To make sure that the
relationship between future profitability and the present value of a stock is well
understood, let us use a simple example.

Suppose that you are considering buying a stock that is expected to yield $15 dividend
(profit) per share for the next three years after which you intend to sell the stock. You
also expect that at the end of year three the market value of this stock will be $200.
Let us also assume that there are no transaction costs (no fees or commissions). We
further assume that, considering the risk factor associated with investment in stocks,
you expect at least 12 percent return on this investment. Utilizing the above present
value formula, we write:

PVt = 15/ (1+ .12)1 + 15/ (1+.12)2 + 15/ (1+.12)3 +200/ (1+.12)3 = 13.39+ 11.95 +
10.68 + 142.35 = 178.38

Based on your expected rate of return on this kind of investment, the present value of
the expected future earnings (including the market value of the stock a the end of your
intended investment period) is $178.38; that is the value you would put on this stock
at this time. Note that in this simple case we assume that you adjust your expected rate
of return (discount rate) for the risk you perceive in this investment, the higher the
perceived risk the higher the discount rate. There are more sophisticated ways to deal
with uncertainty and risk in investment decisions. At this point, however, the subject
of risk management is not within the scope of our discussion.

The purpose of an investor (or an owner of a business firm) is to realize income or

profit from his or her investment. As demonstrated above, there is a direct relationship
between the (expected) future profits of a firm and its value. In other words, firms that
are expected to be more profitable in the future would have higher market values. It is
therefore expected that the manager of a firm who is supposed to act as an agent of the
shareholders (owners) make his or her decisions in

accordance with shareholders’ interest which is to have the value of the firm
maximized.
Note: A commonly used market indicator of the expected profitability of a stock
(based on its past history) is the price/earning (P/E) ratio, published daily in the W-S
Journal and some other investment publications. The P/E ratio is in fact the reciprocal
of the (ex post) current rate of return on the stock. For example, a P/E ratio of 20
indicates 5% return on the investment. (Visit www.buffettsecrets.com/price-earning-
ratio.htm)

Generally, stocks with high P/E ratios are considered “growth stocks.” The investor is
willing to pay a higher price for a growth stock with the expectation (or in the hope)
that it will perform better in the future and, thus, its market value will increase.

If you have any questions about this material, please click on the ASK A QUESTION
link below. Now go to the next document to continue this module.

Lecture Outline

Examples of managerial problems:

What product to produce
What price to charge
Where/how to get financing
Where to locate
How to advertise
What method of production to use
Whether or not to invest in new equipment

Managers’ Objectives
a. Maximizing the value of the firm (Profit maximization)
b. Possible alternative objectives:
=>Market share maximization
=>Growth Maximization
=>Maximizing their own benefits

Decision Making Process

Identifying the problem or the decision to be made

Abstraction: Identifying the relevant factors

in the problem and formulating the problem into a manageable
set of questions/problems
Identifying alternative solutions to each problem
Using relevant data to evaluate alternative solutions
Choosing the best solution consistent with the firm’s objective

Consider the following news headlines:

 AOL Time Warner plans to cut more than 2000 jobs as part of a move to
streamline its operation.
 Lucent cuts 10,000 jobs.
 Exxon Mobil profit soars.
 A key gauge of U.S. economic activity fell sharply in December, signaling
continued weakness in the U.S. economy.
 The Bank of England rate-setting committee came within one vote of cutting
interest rates.

The ups and downs:

High Low Last PE
MSFT 118 40 62 33
IBM 134 80 109 24
Lucent 77 12 19 50
Mot 61 15 23 40
AT&T 61 16 23 14
GM 94 48 54 8
RJR 52 15 51 13

Macroeconomics and Microeconomics and Managerial Decision Making

Microeconomics: Production and cost models, price, revenue and profit, market
conditions
Macroeconomics: Economic conditions: Business cycles; unemployment, inflation,
recession and economic growth and expansion

Demand and Supplied Reviewed

 Exxon sets profit record: Company logs $17.7B income, most of any
corporation. Sales at the company rose 17 percent in the quarter to $64.1 billion
from $54.6 billion a year earlier.
 What has been happening in the oil market in recent months?
 How can we use supply and demand analysis to better understand the oil
market?
Demand : Definitions

 Demand: A quantity of a good or service a buyer (or buyers) would buy under a
certain set of conditions
 Demand curve is a curve showing the quantities of a good or service a buyer
(or buyers) would buy at various prices, ceteris paribus
 Quantity demanded: The quantity of a good a buyer (or buyers) would be
willing and able to buy at a specific price, ceteris paribus

Supply: Definitions

 Supply: A quantity of a good or service a producer (or producers) would be

willing to produce and offer to the market for sale under a given set of
conditions
 Supply curve: A curve showing the quantities of a good or service a producer
(or producers) would produce and offer to the market for sale at various prices
 Quantity supplied: The quantity of a good or service a producer (or producers)
would produce and offer for sale to the market at a specific price, ceteris
paribus

Supply and Demand Schedule

Price Supply Demand
$ 0.00 ---- 670
1.00 210 470
1.25 290 420
1.50 370 370
1.75 450 320
2.00 530 270
2.25 610 220
2.50 690 170

Why do we study supply and demand?

We assume, generally, firms are value maximizers, realizing that the value of a firm is
a function of its (expected) future profits.
Profit = TR - TC
TR = P.Q
==> What are the factors that determine P and Q?
==> What are the elements determining a firm’s costs?
Supply and Demand Equations
Demand:
Qd = 670 -200 P
P = 3.35 -.005 Qd
Supply:
Qs = - 110 + 320 P
P = .34375 + .003125 Qs

Supply and demand plotted:

An algebraic approach to supply and demand:

Qd = f ( Price, Income, X1, X2, ……Xn)
Qd = 20 + .1 Income - 2 Age - 50 Price

Qs = g( Price, W1, W2, ……. Wn )

Qs = -40 - 5 Wage + 30 Price

If
Income = 2000
Age = 30
Wage = $8
==>Supply and demand curves:
Qd = 20 + .1 Income - 2 Age - 50 Price
($2000) (30)
==> Qd = 160 - 50P

Qs = -40 - 5 Wage + 30 Price

( $8)
==> Qs = - 80 + 30 P

Shifts in supply and demand curve:

 A change in any non-price factor in the demand function would result in a shift
in the curve: changes in the intercepts.
 A change in any non-price factor in the supply function would result in a shift
in the curve: changes in the intercepts.

Demand and Revenue

Recall that:
TR = Price x Quantity = P .Q
If P = f (Q) = 3.2 - .02 Q,
we can write: TR = (3.2 -.02Q).Q

Or, TR = 3.2 Q - .02 Q2

The case of a horizontal demand curve:
Marginal versus Average
Recall: TR = P. Q = 3.2 Q - .02 Q2
TR
AR = ------ = 3.2 - .02 Q = P
Q

Change in TR d TR
MR = ---------------- = ------- = 3.2 - .04 Q
Change in Q dQ
Demand and Revenue
Supply and demand: An exercise

(ANSWERS)
1. Plot the following supply and demand equations in a diagram measuring price
on the vertical axis and quantity on the horizontal
axis.

Qs = - 600 + 40 P
Qd = 1200 -50 P
a. Identify the price and quantity intercepts for each equation.
b. Determine the slope of each line.
c. Write each equations for price (P) in terms of quantity (Q).
d. Determine the equilibrium price and quantity.
e. Explain the market conditions when the price is set at $18
f. Explain the market conditions when the price is set at $ 25

The demand and supply functions for seats on a special shuttle flight to Orlando,
Florida, have been estimated as follows:

Qd = 900 -2 Price + .05 Income - 5 Weather + 1.25 Pc ( where Pc is the price

offered by the competition)

Qs = -20 - 5 Pf + 4 Price (where Pf is the fuel price)

Assuming: Income( I ) = 1000, Weather (W) = 70, Pc = $160, Pf =

$16

a. Write the equations for the demand curve and supply curve.
b. Carefully plot both supply and demand curves.
c. Determine the equilibrium price and quantity.
d. Determine and show on your diagram the effect of an increase in the weather
temperature (W)
from 70 to 80 on the equilibrium price and quantity.
e. Keeping the weather temperature (W) at 80, determine and show the effect of
an increase in
the price of the competition from $160 to $200 on the equilibrium price and
quantity.
f. Now keeping the weather temperature at 80, Pc at 200, and income at 1000, use
your demand
function to write the total
revenue ( TR ) equation.
g. Using the same demand function, also write and plot the marginal revenue
(MR) function.
h. Using the same demand function, determine at what price level the total
revenue from this shuttle
flight is maximized.
Try to show your work on a diagram.

Answers:
Q1: a) Supply: Qs = -600 + 40 P ; P = 15 + .025 Qs Demand: Qd = 1200 - 50
P ; P = 24 - .02 Q
 b) Slope of demand curve = -.02 Slope of supply curve = +.025
c) P = 15 + .025 Qs ; P = 24 -.02 Q
d) P = 20 ; Q = 200
e) Excess demand
f) Excess supply
Q2: a) Qd = 800 - 2 P ; Qs = -100 + 4 P
b) Demand: P intercept = 400 ; Q intercept = 800 Supply: P intercept =
25 ; Q intercept = -100
c) P = 150 ; Q = 500
d) Shift to the left (-50)
e) Shift to the right (+50)
f) TR = 400 Q -.5 Q2
g) MR = 400 - Q
h) Q = 400 ; P = 200

Elasticity
A general definition:
Elasticity is a standardized measure of the sensitivity of one (dependent) variable to
changes in another variable.

Price elasticity of demand:

A measure of the sensitivity of the quantity demanded a good to changes in the price
of that good.

Measuring Elasticity
Elasticity is measured by the ratio between the percentage change in on variable and
the percentage change in another variable:

Percentage change in Y
Elasticity = ------------------------------
Percentage change in X

Change in Y/ Y
= -----------------------------
Change in X/ X

Elasticity of Demand
The (market) demand for a good is affected by numerous factors: price, income, taste,
population, weather, expectations, population demographics, etc.
The degree of sensitivity or responsiveness of the demand to changes in any of the
factors affecting it can be measured in terms of “elasticity”.
percentage change in Qd
Ez = -------------------------------------
percentage change in X

Measuring a change in percentage terms:

Y2 –Y1 Y1 = 80
% change in Y = ------------------ Y2 =100
Y1

Y1 –Y2
= -------------
Y2

Y2 –Y1
Arc % change = -------------------
Y2 +Y1
-----------
2

Calculating Elasticity

Change in Qx
-------------------
Qx1
Ez = ---------------------
Change in Z
-------------
Z1
 Change in Qx
--------------
Qx1 + Qx2
(Arc)Ez = --------------------
Change in Z
--------------
Z1 + Z2

Arc Price Elasticity of Demand

Definition: A measure of the responsiveness of quantity demanded of a good to
changes in its price.
Qx2 – Qx1
------------
Qx1 + Qx2
Ep = -----------------------
P2 – P1
------------
P1 + P2

Using the "simple" elasticity formula, the price elasticity of the demand at two
different (price) ranges has been calculated. Here it is assumed that between points a
and b the price has changed from 10 to 8 and between c and d it has changed from 4 to
2.
To get the average elasticity between two points on a demand curve we take the
average of the two end points (for both price and quantity) and use it as the
initial value:
Q2-Q1 10
(Q1+Q2) 8+18
Ea = -------------- = --------------- = -3.49
P2-P1 -2
(P1+P2) 10+8
Production and Costs

Here again we start with our basic definition of profit:

Profit = TR – TC = P·Q – TC

In the previous lecture we studied the demand function to understand how the revenue
of a business firm is determined and how a firm’s decisions, particularly relative to
price, would affect the quantity demanded and thus its sales revenue. In this section
we are going to turn our attention to the firm’s decisions relative to production and
costs.

In attempting to increase the firm’s profit managers must pay attention to both the
revenue and the cost side of the profit function. Let us suppose a farmer can produce
wheat, barley, or corn, or a combination of them. The profitability of his operation
would depend on his decisions on what to produce, how much to produce and how to
produce. His revenue (P·Q) would be determined by the first two decisions (what and
how much) whereas his cost would be affected by all three decisions.

Business firms operate in dynamic environments. Their both external and internal
environments change all the time. Managers must adjust to their changing
environments by constantly evaluating their options relative to all three questions—
what, how much and how. In recent years, the emergence of new technologies, on the
one hand, and increases in international trade and investment opportunities, on the
other hand, have resulted in major changes in the way businesses operate. The
successes and failures of all business entities have depended upon how they have
reacted to their changing environments. Your textbook gives a number of examples of
the structural changes that some firms have gone through during the past two decades.
All of theses changes have some how affected their sales revenues or their costs or
both. As read about different cases in the book be sure to think about the impact of
each action that various firms have taken on their profitability.

Production Function

The production cost of the firm depends on (i) what the firm produces, (ii) how it is
producing it, and (iii) what quantity it is producing. The relationship between the
inputs used in the production of a good and the quantity of the output produced,
assuming that the firm is using the technology available to it efficiently, can be shown
in a production function. In other words a production function is a mathematical
expression that shows the maximum amount of output that can be produced from a
given mix of inputs.

What are inputs? Inputs are factors or materials used in the production—e.g., land,
labor, capital, materials, energy, etc.

What is output? Output is a quantitative measure of the good (or service) produced.
The production process, on the one hand, generates costs— as needed inputs are
purchased—and, on the other hand, generates output.

The relationship between output and cost (the cost function) is directly linked to the
production process—that is the production function. We will start our analysis with
the production function and then we’ll expand it to the cost function.

As said earlier the production function is a mathematical statement reflecting the

relationship between inputs and the quantity of output efficiently produced from them
given the available technology. For example, our farmer’s production function for
wheat can be written as follows:

Q = f (K, L, N, F,W), where K is capital, L is labor, N is land, F is fertilizer, and W is

whether.

This function generally implies that the quantity of the output of wheat is determined
by the quantitative (or qualitative) measures of capital, labor, land, fertilizer, and
weather. For example we expect the output to increase as more capital (tools and
machinery) is used in the production. Or, generally, more land would also increase the
output. The above function is of course in a general form—it does not show
specifically by much the output would change as any or all of the inputs would
change. Production functions can take different mathematical forms from simple
linear functions to complex nonlinear forms. To learn about the mechanics of a
production function let us use a simple two-input production function:

Q = f (K, L), assuming that K represents all capital goods and L labor.

Again this is a general production function. The following are some possible specific
forms of production functions:

Q = a Lb + c KL

Q = a Kb + c KL

Q = a Kb· Lc

where a, b, and c are parameters that determine the nature of the relationship between
the inputs and output.
For example, if for the first equation we a=1, b= 2 and c= 3, we can write:

Q = L2 + 3 KL

Now with 100 units of labor and 50 units of capital the output will be:

Q = (100) 2 + 3 ( 50 x 100) = 10000 + 15000 = 25000

*A simple exercise for you: Apply the same parameters and capital and labor quantity
to the third equation and determine the quantity of output. Then, double each input
and recalculate the output. What kind of observation can you make about the
relationship between the inputs and the output in this production function?

The production function is studied in the short run and in the long run. The long run is
the period of time that is long enough for a firm to change all of its inputs or factors of
production. In the short run, on the other hand, the firm can only increase or decrease
some of its inputs. In our simple two-input production function, for example, in the
short run labor could be considered the variable input while capital would remain
constant. That means in the short run the quantity of output would be simply a
function of labor.

Given K, Q = f( L); as L changes Q changes.

Let us use our farmer’s production function to examine the relationship between the
variable input and output more closely. Suppose our farmer’s variable input (in the
short run) is fertilizer. All other inputs, land, labor, capital, etc., remain constant. The
relationship between the amount of fertilizer and the annual size the output of wheat
has been tabulated in the table below.

Fertilizer (Kg) 0 50 100 150 200 250 300 350 400 450
Output of wheat 100 200 280 340 380 400 360 300 200 50

Note that the addition of the first fifty kilograms of fertilizer to the land would double
the annual output. As more and more fertilizer is applied the output increases, but at a
decreasing rate. It peaks at 400 and then starts to fall. This relationship is depicted in
the diagram below.
Diminishing Returns and Marginal Product of an Input
Most products are produced from a combination of inputs. In the wheat production
function in addition to fertilizer we have land, labor, capital, and weather conditions.
As more and more fertilizer is added to the same amounts of other inputs, beyond a
certain point, its effectiveness starts to decline, and, most likely, it will eventually
become negative. This phenomenon is referred to as the principle (or law) of
diminishing returns (to input.) Alternatively put, as more and more of a variable input
is added to fixed quantities of other inputs, beyond a certain point, the marginal
product of the variable input starts to fall.

The marginal product of an input (say input X), MPx, is the change in output resulting
from one additional unit of (variable) input.

?Q
MPx = ----------
?X
?Q
For the fertilizer in our wheat production function MPf = -----------
?F
Fertilizer (Kg) 0 50 100 150 200 250 300 350 400 450
Output of wheat 100 200 280 340 380 400 360 300 200 50
MPf 2 1.6 1.2 0.8 0.4 -0.8 -1.2 -2 -3

In the table above the relationship between the variable input (fertilizer) and output
are tabulated in discrete numbers. Therefore, each measure of marginal product is an
average (or approximation to) the marginal product between two levels of inputs.
Some textbooks call this measure arc marginal product. For example between 100 and
150 kilograms of fertilizer the marginal product (of one additional unit) of fertilizer is:

(340-280)/(150-100) = 60/50 = 1.2

That means, other things remaining constant, between 100 and 150 units of fertilizer,
on average, each kilogram of fertilizer would increase the output by 1.2 metric ton.
Note that at some point between 250 and 300 kilograms the marginal product reaches
zero. That is where the total product is maximized. The marginal product of
(additional) fertilizer beyond that point would be negative causing reductions in the
total output.

Average Product
Another commonly used measure of productivity of a variable input is the average
product. It is simply total output divided by total variable input. This measure, as its
name suggests, is the (overall) average output per unit of a variable input, again,
assuming all other inputs remain constant.
Q
AP f = -------
F

Fertilizer (Kg) 0 50 100 150 200 250 300 350 400 450
Output of wheat 100 200 280 340 380 400 360 300 200 50
MPf 2 1.6 1.2 0.8 0.4 -0.8 -1.2 -2 -3
Apf 4 2.8 2.27 1.9 1.6 1.2 0.86 0.5 0.11

The Marginal and Average Product: A closer Look

To understand the relationship between marginal product and average product let us
use a simple production function with capital and labor as inputs.

Q = KL2 – L3 where K is capital and L is labor.

Suppose in the sort run the capital, K, is constant at 16 units whereas labor, L, is
variable. The following table shows the output for varying levels of labor as well as
the marginal and average product measures corresponding to them.

Q = 16 L2 – L3 APL = Q/L MPL = ?Q/?

Labor 1 2 3 4 5 6 7 8 9 10 11 12
Output 15 56 117 192 275 360 441 512 567 600 605 576
MPL 15 41 61 75 83 85 81 71 55 33 5 -29
APL 15 28 39 48 55 60 63 64 63 60 55 48

We can make the following observations:

· Given K=16, as L increases Q will increase, first at an increasing rate and then at a
decreasing rate.
· The marginal product of labor peaks at about 6 units of labor at which point the law
of diminishing returns goes into effect.
· As long as the MPL is greater the APL, the APL increases, but as soon as the MPL
falls below the APL the APL stars to decline.
· The MPL intersects the APL at the point where the APL is at its maximum.
· Somewhere between 11 and 12 units of labor the MPL becomes zero. That is where
the total output reaches its maximum.

Before we move onto the long-run production function let us take advantage of the
above analysis and develop the short-run cost function.

The short-run cost of production in this simple case consists of two components:
capital cost and labor cost.

STC = Pk . K + W . L where Pk is the price of capital and W is wage.

In the short run where K is constant, given the price of capital, the capital cost would
be fixed. The cost of labor however would vary with the amount of labor that is
variable in the short run. Assuming the price of capital is $50 per unit and the wage is
$120, we write:

STC = TFC + TVC = 50x16 + 120 L

STC = Short-Run Total Cost

TFC = Total Fixed Cost
TVC = Total Variable Cost

In the table below these three cost measures have been calculated for the labor levels
1 through 11. Three other cost measures, average fixed cost, average variable cost,
average total cost, and marginal cost have also been calculated in this table.

AFC = TFC/Q AVC = TVC/Q ATC = TC/Q MC = ?TC/?Q

Note that all measures of cost are calculated relative to the quantity of output, not the
labor input. While the average cost measures are self-explanatory, the marginal cost
might need some explanation. The marginal cost is the cost producing one additional
unit of output. The marginal cost is determined by two factors: wage and the marginal
product of labor. For a small firm that has no influence on the wage and, thus, the
wage is given, the marginal cost is simply the wage (the change in the cost resulting
from hiring one additional unit of labor) divided by the marginal product of labor.

MC = W/MPL