Managerial Economics

MBA ZC 416

BITS Pilani
Pilani Campus
 BITS Pilani
Pilani|Dubai|Goa|Hyderabad

Managerial Economics
Introduction - Part 1
Agenda

• Introductions

• Course objectives

• Textbooks/ Resources

• Evaluation scheme

• Overview of Managerial Economics

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Textbook/ Resources

Text Book(s) T1 “Managerial Economics: Economics tools for today’s decision makers”By Paul G.
Keat, Philip K.Y. Young, Stephen E. Erfle and Sreejata Banerjee, Pearson Paperback,
7th edition, 2018

Reference Book(s) & other resources

R1 Truett & Truett, "Managerial Economics", John Wiley & Sons, 8th edition, Singapore, 2004
R2 Samuelson &Nordhus, "Economics", Tata McGraw-Hill Edition, 16th edition, New Delhi, 1998
R3 Petersen, Lewis and Jain, “Managerial Economics”, Pearson Education, New Delhi, 2006.
R4 Hirschey, “Economics for Managers”, Thompson, New Delhi, 2006
R5 Suma Damodaran, "Managerial Economics", Oxford University Press, 2006
R6 H L Ahuja “Managerial Economics: Analysis of managerial decision making” S. Chand, 9th edition, 2017

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Evaluation Scheme

No Name Type Duration Weight

EC-1 Quiz-I Online - 10%

Quiz-II Online - 10%

Assignment Online - 10%

EC-2 Mid-Semester Test Closed Book 2 hours 30%

EC-3 Comprehensive Exam Open Book 3 hours 40%

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

 Evaluation Scheme

No Name Type Duration Weight Day, Date, Session, Time

Quiz-I/ Assignment-I Online - 5% September 1-10, 2024
EC-1 Quiz-II Online 5% October 10-20, 2024
Experiential Learning Online 15% November 1-10, 2024
EC-2 Mid-Semester Test EC 2 Closed Book 2 hours 30% Saturday, 21/09/2024 (FN)
EC-3 Comprehensive Exam EC 3 Open Book 2½ hours 45% Saturday, 30/11/2024 (FN)

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Introduction

Fundamental Questions
–What is Managerial Economics?
–Why Managerial Economics?
–What kind of issues does it help
address?
–How can it help managers to make
better decisions?

Managerial Economics (MBAZC416)

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
 Fundamental economic problems
• Three questions that managers face:
– What to produce?
– How to produce?
– How to distribute?
• Scarcity of resources
• How does economics answer these questions?

Managerial Economics (MBAZC416)

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Imagine

• Imagine a car manufacturer producing only one model of car (Model T) priced at US
10,000 at which they were able to find 5000 customers.
• For selling additional volumes they have to start giving freebies (additional warranty,
0% finance, free services)
• For selling more they have to initiate price-cuts. After the given volume they would
be able to sell by lowering price.
• At the same time their costs would also change (material cost would go down
because of bulk discounts, service and repair costs would go up etc.). There would
be an ideal level of production where they would be able to make maximum profit.
• How many Model Ts should I produce? Should I develop new models with my spare
resources?
• The concept applies equally well to your neighborhood burgher joint or dosa seller.

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Managerial economics
Definition
Managerial Economics: the
application of economic theory and
methods to business decision-making.

Business: Any situation where there is a

transaction between two or more
parties
Managerial Economics (MBAZC416)
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Managerial Economics: How is it useful?
• While economics attempts to describe how the economy
works, managerial economics deals with its impact on
businesses and how managers can handle them for the
benefit of their firms as well as the society.
• It prescribes rules for improving managerial decisions
• It helps managers recognize how economic forces
affect organizations
• It links economic concepts with quantitative methods to
develop vital tools for managerial decision making

Managerial Economics (MBAZC416)

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Scope of marketing what is a market?

• The word market traditionally refers to the market place –

the location or area where buyers and sellers meet.
• In economics, market is described as a collection of
buyers and sellers who transact over a particular product
or product class.
• In marketing the word “market” is used to describe various
grouping of customers. For example while referring to the
automobile market we mean the set of people interested
in buying an automobile.

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Relationship with economic theory
• Microeconomics
– Focuses on individual consumers and firms
– Theory of the firm
– Theory of consumer behaviour (demand)
– Production and cost theory (supply)
– Price theory
– Market structure and competition theory
• Macroeconomics
– Aggregate variables such as GDP, GNP,
Unemployment, Inflation, etc.
Managerial Economics (MBAZC416)
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Economic systems

• Traditional Economy
• People centric
• Little division of labor
• Limited Resources
• Little Surpluses and Little wastages
• RURAL ECONOMY

• Command Economy
• Dominant central authority (Government) takes production decisions
• Many Resources
• Works well under enlightened leadership
• Rigid, slow to change and hence prone to crises.
• COMMUNIST SOCIETY

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Economic systems

• Market Economy
• Little Government regulation
• Regulation through supply and demand
• Growth Oriented
• Unequal distribution of economic power
• Prone to recessions
• CAPITALISM

• Mixed System
• Combines the characteristics of market and command economies
• Most industries are private while public services (law and order, health, education etc.) are under government
control.
• Economy is REGULATED (not controlled) by the Government
• Challenges of right balance between the Government and market forces.
• GLOBAL NORM (Most countries in the world follow this system)

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Agenda

1. Managerial Economics – Scope

2. Market Environment
3. Factors of Production
4. Market Function
5. Approaches used in Economics
6. Types of Profit
7. Theories of Profit
8. Types of Enterprises

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Managerial Economics: a Tool for
Improving Management Decision Making

Managerial Economics (MBAZC416) BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
What is the best “choice”
• Understand the economic environment in which firms operate
– We will be exploring several case studies throughout the course
• Consider alternatives
• Make optimal choices to maximize (objective)
◆ Profit

◆ Market share = Sale/ Market Size

◆ Managerial interests
◆ Brand Value, Check the competition, Employee Retention
◆ Government influence
◆ National interests
◆ Providing employment, Inflation under check.
◆ Social and environmental benefits
Managerial Economics (MBAZC416)
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Market Environment

Monopoly
• One dominant player (Indian Railways)
• No substitute
• High Barriers of entry
• Seller is price maker (seller decides the price)
• Firm can charge any price to its customer without giving any notice.
Oligopoly
• A few sellers but many buyers (Steel Companies, Oil companies,
Ecommerce)
• High Entry Barrier
• Firms set price collectively (cartelization)

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Market Environment

Monopolistic competition
• Many sellers who offer similar but not substitute products (products are
differentiated)
• Low Entry Barriers
• Firms are price makers
• Overall business decision of one company does not affect the competition
• Restaurants
Monopsony
Many sellers, but one or only a few buyers
Armament industry, Tobacco farmers

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Market Environment

Perfect Competition
• Many firms produce identical products
• Sellers and buyers have all relevant information to make rational decisions
about the product being bought or sold.
• Many buyers are available to buy a product and many sellers to sell a
product.
• Firms can enter and exit the market without any restrictions.
• The neighborhood vegetable vendor.

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Characteristics of perfect competition
markets
• Firms are price takers. They have to take (accept) the market price. Else they
would lose customers.
• The price is decided by supply and demand.
• A firm in a perfect competition market would be small to the point its output
would not affect the overall supply or impact the prevailing price.
• In the long run, perfect competition firms would react to profits by increasing
production and losses by decreasing it.
• In the long run equilibrium conditions would prevail (here firms are not
increasing decreasing supply) when the firms are making zero profits or
losses.

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Factors of Production

• Land
• Labor
• Capital
• Entrepreneurs

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Market Operation

Resources Resource Money

(Land, Labour,
Resources
Money Capital)
Resources Money
Services Services
Manufacturer Government Consumer
(Producer)
Goods, Taxes Taxes
Services Goods, Taxes
Money Money
Intermediary
(Retailer)
Goods, services Goods, services
The Decision-Making Process

Managerial Economics (MBAZC416)

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 Summary
• Managerial Economics helps business leaders and policy
makers to make optimal decisions
• Leverages economic analysis for concepts such as
demand, cost, production, profit and competition
• Bridges the gap between theory and practice
• Provides tool sets to make optimal decisions

Managerial Economics (MBAZC416)

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Application of concepts using Case Studies
• Multinational production and pricing
– How does Ford or GM decide where to produce its cars
(multinational factory locations) and where to sell
(multinational markets)
• Market Entry
– How do major bookstores decide where to set up shop,
assess demand and profitability, assess and react to
threats from online stores
• R & D Decisions
– How does a pharma company decide whether to invest
in traditional biochemistry based research or to pursue
biogenetic approaches (such as gene splicing)
Managerial Economics (MBAZC416)
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Positive and Normative economics
• This is also referred to as is/ought distinction
• Positive statements
– Factual statements
– It can be verified by empirical study or logic
– Based on a study of 500 firms, it can be inferred that
private owned enterprises are more profitable than state
owned ones.
• Normative statements
– Value judgements
– It can’t be verified by empirical study or logic
– We should focus on growth through state owned companies
are private firms lead to concentration of wealth which is
detrimental to democracy.
• Relevance of the distinction to the study of managerial
economics Managerial Economics (MBAZC416)
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Behavioural Economics

The study of psychology as it relates to the economic decision making

processes of individuals and institutions.
Rational Choice Theory
When individuals are presented with various choices under condition of scarcity
they choose the option that maximizes their individual satisfaction.
It assumes that human beings are capable of rational decisions.
Behavioural Economics explains that is not often the case. Individuals often get
swayed by extraneous factors to make “irrational” decisions.
A man struggling with weight problems should avoid sugar-rich food. The same
person would get swayed by a television ad and consume carbonated soft
drinks.

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Opportunity costs
• Scarcity and choice are central to the
economics discipline
• In the face of scarcity, we make many
decisions
• Follow one course of action and forgo some
other course of action

Opportunity cost is the highest valued

alternative forgone whenever a choice is
made
Managerial Economics (MBAZC416)
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Illustration Opportunity Cost

1. Ram chose to start a business ignoring two job offers. The first one would
have offered a salary of Rs. 100,000 per month. The figure for the second
one is Rs. 150,000 per month. What is his opportunity cost of starting the
business?
Answer: Rs. 150,000 per month
2. Dr. Usha started her clinic for which she had to vacate a part of her
residential premise from which she was getting a rent of Rs. 20000 per
month. She also chose to quit her job at a local hospital where she was
getting a salary of Rs. 100,000 per month. What is her opportunity cost?
Ans: Rs. 120,000 per month
Opportunity cost is the highest valued alternative forgone
whenever a choice is made

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Definitions of Profit
• Business or Accounting Profit: Total revenue minus the
explicit or accounting costs of production.
• Economic Profit: Total revenue minus the explicit and
implicit costs of production.
• Opportunity Cost: Implicit value of a resource in its best
alternative use.
FUNDAMENTAL EQUATION OF BUSINESS: PROFIT = REVENUE - COST

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 Explicit and Implicit Costs

Basis Explicit Cost Implicit Cost

Definition The cost that involves The cost that does not
outflow of cash due to use involve any cash outlay.
of one or more factors of (Opportunity Cost)
production (Land, Labour,
Capital)
Nature Out of pocket expense Imputed (projected) costs
Occurrence Actual Implied
Recording and Reporting Yes No
Impact Objective Subjective
Example Salaries, Rent, Return on owner’s capital,
Advertisement, Bank Cost of owner’s work, Rent
Interest of owner’s premises

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Illustration

At the end of the year, Dr. Usha found that she has made a revenue of Rs. 10 Lakh. Her
expenses on electricity, consumable and the salary of one assistant is Rs. 6 lakh. What her
accounting profit / loss? What is her economic profit or loss?
Ans: Revenue =
Explicit Cost =
Implicit (Opportunity) Cost = Rent + Salary = 20000*12+100000*12 = 14.4 L
Accounting Profit = Revenue – Explicit Cost = 10L – 6L = 4L
Economic Profit = Revenue – Implicit cost-Explicit Cost = 10L – 14.4L – 6L = -10.4L

Dr. Usha started her clinic for which she had to vacate a part of
her residential premise from which she was getting a rent of Rs.
20000 per month. She also chose to quit her job at a local
hospital where she was getting a salary of Rs. 100,000 per
month. What is her opportunity cost?

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Theories of Profit
• Risk-Bearing Theories of Profit
– Firms make profit because they take risks.
• Frictional Theory of Profit
– Firms make profit because the perfect competition equilibrium is never reached.
• Monopoly Theory of Profit
– Firms make profit when they enjoy monopoly.
• Innovation Theory of Profit
– Firms make profit when they innovate on products or costs.
• Managerial Efficiency Theory of Profit
– Firms make profit by managing their businesses well, eliminating wastages etc.

Managerial Economics (MBAZC416)

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Social Function of Profit
• Profit is a signal that guides the allocation of society’s
resources.
• High profits in an industry are a signal that buyers want
more of what the industry produces.
• Low (or negative) profits in an industry are a signal that
buyers want less of what the industry produces.

Managerial Economics (MBAZC416)

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 1. Making decisions
• The role of the managers is to make
decisions
– Business firms come in all sizes
– No firm has unlimited resources
– Short-run and long-run decisions
• Managerial Economics: How to make
decisions that make sense for the
operation of the firm

37 Managerial Economics (MBAZC416)

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 2. Decisions are among alternatives
• Choices are always among alternatives
• Example-buying a new computer
• A job can be done by many, but some may
be better at it than others-cost differs

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 3. Decision alternatives have costs and benefits

• Working Vs. Pursuing further studies

• What we consider when making our decisions?
• Benefits: benefit gained from studying – enhanced knowledge
and capabilities, which lead to better career opportunities in
the future
• Cost - cost of giving up short term promotions and increments
• Choosing to study- additional benefit gained from further
studies exceeds the additional cost
• Opportunity cost

39 Managerial Economics (MBAZC416)

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 4. Objective of management is to
increase the firm’s value
• Profit is the difference between TR (Total Revenue) and TC (Total Cost)
• Different types of organizations/ firms
– Proprietorship Firms
• Sole proprietorship
– One owner
• Partnership Firms
– More than one owner
– Joint Stock Firms
• Private Limited Firms
– Shares are in private hands and not publicly traded.
• Public Limited Firms
– Shares are registered at stock exchanges and available for public trading
• Problem - Managers attempt to maximize own interest while shareholders increase
own benefit
• Principal –agent problem

40 Managerial Economics (MBAZC416)

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5. The firm’s value is measured by
its expected profit

• Example: consider two companies using different

production process
• Which one would be the better company?
• This can be easily evaluated based on excepted profits
• Present value of the expected future profit stream
Total Profit = Total Revenue – Total Cost

Managerial Economics (MBAZC416)

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6. Firm’s sales revenue depends on
demand for its product

• Some goods are highly price sensitive while other goods

are less price sensitive
• Demand for a product is a function of a number of factors
in addition to price

Managerial Economics (MBAZC416)

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7. Firm must minimize cost for each
level of output

• Total Profit (TP) = Total Revenue (TR) – Total Cost (TC)

• Important factors:
– Technology of production
• Labour Intensive, Capital Intesive
– Input prices
– Factors of production
– Different levels of technologies

Managerial Economics (MBAZC416)

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8. Firm must develop a strategy consistent
with its market

• We will study the various market structures and the

appropriate strategy for each of these situations
• Selling identical products
• Differentiated products
• Example - airline industry, software industry, etc.

Managerial Economics (MBAZC416)

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 Value of the Firm

The present value of all expected future profits

Managerial Economics (MBAZC416)

45
9. Firm’s growth depends on
rational investment
• Decision to invest in new plant or equipment or develop a
new product
• The process of evaluating new investments of the firm-
capital project analysis or capital budgetting
• Capital project - calculating the expected stream of
benefits it will produce for the firm

Managerial Economics (MBAZC416)

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10. Successful firms deal rationally and
ethically with laws and regulations

• Various business laws and regulations

• Case of Enron or closer hope the collapse of Satyam
highlight the consequences of unethical behaviour

Managerial Economics (MBAZC416)

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Course Objectives

No Course Objectives
CO1 Gain insights into the scientific and analytical methods, techniques
and tools of economics.

CO2 Gain basic understanding of the underlying concepts and building

blocks related to managerial Economics.

CO3 Understand the application of these concepts in business and

economic policy using suitable examples, case studies, simulation,
etc.

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Expectations

• Replay prerecorded digital content before class

• Attend all “live” classes else replay recordings

• Review the relevant chapters from textbook before and after

class

• Do the homework and assignments in a timely manner

• Make sure you have access to laptop/ computer with Excel;

we will need it for experiential learning components in
subsequent classes. (Excel 2007 or later versions preferred.)

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Seven Habits of Successful Students

1. Concise Thinker
2. Problem Solver
3. Focus
4. Ability to correlate
1. Across subjects (economics to finance, physics to chemistry)
2. Real Life

5. Discipline
6. Enjoy
7. Inspiration

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 Managerial Economics
MBA ZC 416

BITS Pilani
Pilani Campus
 BITS Pilani
Pilani | Dubai | Goa | Hyderabad

Managerial Economics

Theory of the Firm

and Related Concepts – Part 1
Agenda

• Introduction
• Nature of the firm
• Forms of Business Organizations
• Motivations
• Major theories of the firm
• The Basic Profit-maximising model
• The Agency problem
• Measurement of Profit
• Enron case study

Managerial Economics (MBA ZC416) BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Agenda

• Elementary Laws of Economics

• Diminishing marginal utility, productivity

• Cost and Quantity Relationships

• Law of Demand and Supply
• Revenues and Costs

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Theory of the firm: Introduction
• Managerial Economics is primarily concerned with the application of
microeconomic principles for the effective management of business
firms

• In order to do this in an effective manner we need an overarching

“Theory of the Firm” that explains why firms exist, their structure, how
they behave, and what their goals are, etc.

• Firms are complex organizations that are difficult to model but as with
any modelling the key is to focus on the important factors and
eliminate the unimportant factors

• There are a number of theories (i.e. models) that attempt to model the
business enterprise and we shall review the key ones in this segment

Managerial Economics (MBA ZC416) BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
The Nature of the firm
• Two fundamental questions:
– What are organizations?
– Why do they exist?
• Economic organizations
– Organizations occur at many different levels
• Business organizations
– Sole proprietorships
– Partnerships
– Joint stock company

Managerial Economics (MBA ZC416) BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
 Forms of Business Organizations

Sole Partnership Company or Joint

Proprietorship Stock Company

Managerial Economics (MBA ZC416)

7
Why do such organizations exist?
• Firms exist as an alternative to the market price mechanism
• Possible motivations:
– Benefits of Cooperation
– Specialization
• Business organizations are independent legal identities
• They can enter into binding contracts
• Firm contract bilaterally with suppliers, distributors, workers,
managers, investors, and customers
• Alchian and Demsetz - firm is a nexus of contract, wherein extra
output is provided by team production
– The contracts bring in predictability.
– Team production brings in specialization and benefits of cooperation
through synergy and economy of scale.

Managerial Economics (MBA ZC416) BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
The nature of the firms: areas of economic theories
• Transaction cost theory
– Cost associated with undertaking transactions in different ways
– One of the first theories developed in this area
– Ronald Coase proposed this in 1937
• Information theory
– Concept of bounded rationality, asymmetric information
• Motivation theory
– This examines the underlying factors that cause people to behave in certain
ways
• Agency theory
– Conflict between Principal and Agent
• Property rights theory
– This examines the nature of ownership, and its relationship with incentives to
invest and bargaining power
• Game theory
– The strategic interaction of different agents

Managerial Economics (MBA ZC416) BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Transaction
• An exchange of goods or services (Transaction)
• It can be performed in three different ways
– Trading in spot markets
– Long-term contracts
– Internalizing the transaction within the firm
• Transactions costs refer to the costs that are not directly
associated with the actual transaction but rather enable the
transaction to take place
– Acquiring information about a good or service (e.g., price,
availability, durability, servicing, safety) are transaction costs
• Minimize the external and internal transaction costs

Managerial Economics (MBA ZC416) BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Transaction cost theory
• According to this theory the major goal of the firm is to have lower
costs than the market
• Related to the problem of co-ordination and motivation
• Co-ordination costs (Coasian costs)
– Search costs - Both buyers and sellers have to search for the relevant
information before completing transactions
– Bargaining costs - costs required to come an acceptable agreement
– Contracting costs - costs associated with drawing up contracts (managerial
time and legal expenses)
• Motivation costs (Agency costs)
– Hidden information - in a transaction, one or several parties may have more
information than others (example second-hand car market)
– Hidden action - when contracts are completed the parties involved often
have to monitor the behaviour of other parties

Managerial Economics (MBA ZC416) BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
The Agency Problem
• Agency theory examines situations where agents are
charged with carrying out the desires of principals
• Maximize their own individual utilities
• A conflict of interest between principal and agent
• There is a misalignment of incentives
• Agency theory is concerned with designing incentives
so as to correct in the most efficient manner
• Two aspects
– The nature of contracts
– The problem of bounded rationality

Managerial Economics (MBA ZC416) BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Contracts and bounded rationality
• Contracts - method of conducting transactions

• Complete contracts - eliminate the agency problem

• Impractical to draw up a complete contract. To make a complete

contract, we need the following
– Foreseeing all the possible eventualities
– The eventualities must be accurately and unambiguously specified
– No desire to renegotiate the terms of the contract
– Observe freely the behaviour of other parties to ensure that the terms of the
contract are being met
– The parties must be willing to enforce the contract if the terms are not met

Managerial Economics (MBA ZC416) BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Nature of contract in reality

• Pragmatically, contracts tend to be incomplete, because of

bounded rationality

• Bounded rationality: people cannot solve problems perfectly,

costlessly and instantaneously

• The disadvantages of incomplete contract

– Hidden information: one party to a transaction has more information
regarding the past that is relevant to the transaction than the other
party or parties
– Adverse selection: only the products or customers with the worst
quality characteristics are able to have or make transactions and
others are driven from the market

• Hidden action (the problem of moral hazard):the behaviour of a

party cannot be reliably or costlessly observed after entering a
contract

Managerial Economics (MBA ZC416) BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Law of diminishing marginal utility

• Utility is the total satisfaction derived from consuming a particular good or a

service.
• Marginal Utility is the added satisfaction that a consumer gets from having
one more unit of a good or service.
• Imagine a thirsty person drinking water. Marginal Utility is the utility derived from each additional glass of water.

• Law of diminishing marginal utility states that all else remaining equal, as
consumption increases the marginal utility (the added satisfaction
consequent to the incremental unit of consumption) declines.
• Exceptions: Hobbies (stamp collection, coin collection etc.), Addictions, Money

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Law of diminishing marginal productivity

Productivity: It measures the output per unit input such as labor, capital or any
other resource.
Labor Productivity = Productivity Curve
30

25

Sales productivity = 20

15

10
Change in Ratio* (Marginal
labour Input Output output Productivity)(uni 5
(manhours) (units) Change in input (hours) (units) t/hour) 0
0 0 0 10 20 30 40

10 10 10 10 1 Output (units) Change in input (hours)

20 17 10 7 0.7 Change in output (units) Ratio (unit/hour)

30 22 10 5 0.5
40 26 10 4 0.4

*Ratio = Marginal Productivity =Change in output / Change in input

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Costs and Profits
Explicit Costs : These are out-of-pocket expenses like rent, wages, ram materials,
electricity etc.
Implicit Costs : Opportunity costs (The highest value alternative forgone when a choice
is made.)
Accounting Profit = Total Revenue – Explicit Costs
Economic Profit = Total Revenue – (Explicit Costs + Implicit Costs)
Example
Dr. Manisha is employed at Kailash Hospital as a consultant on a salary of Rs. 100,000
per month. She is planning to leave her job and devote herself full time to her own
private practice. The place she has chosen for her clinic would cost her Rs. 20,000
per month as rent. Other miscellaneous expenditure (electricity, telephone,
stationery etc.) would total Rs. 15000 per month. She would need an office
attendant at a salary of Rs. 10000 per month. Her consultation fee is Rs. 500 per
patient and she expects to see 15 paying patients on a day. Assume there are 25
working days in a month. Calculate the accounting and the economic profits.

17 BITS Pilani, Deemed to be University under Section 3, UGC Act

 Solution
Accounting Profit = Total Revenue – Explicit Costs

Total Revenue (per month) = (Consultation fee/patient)*(Patients/day)(Working days/month) = 500*15*25 = 187500

Explicit Costs = Rent + Wage+ Miscellaneous Expenses = 20000+10000+15000 = Rs. 45000

Accounting Profit = 187500 – 45000 = Rs. 142500

Economic Profit = Total Revenue – (Explicit Costs + Implicit Costs)

Implicit Cost = Opportunity Costs = Rs. 100,000

Economic Profit = 187500 – (45000+100000) = Rs. 42500

18
 Marginal Cost

Marginal cost is the change in total costs that arises when the quantity

MARGINAL COST
produced changes by one unit.

It is the cost of producing the next car in an automobile factory, the cost
of tutoring the next student at a coaching center or the cost of treating
the next patient at a hospital.

Marginal Cost (MC) = (Change in total cost)/(Change in output)

OUTPUT
Cost Schedule
=

Marginal Cost for nth item, MCn = TCn – TCn-1 Units produced Total Cost Marginal Cost
MC2 = TC2 – TC1 1 10 10
2 18 8

Restaurant – Idlis 3 25 7

Total Cost1 = Rs. 10 4 31 6

Total Cost2 = Rs. 18 5 38 7

19 Marginal Cost of the Idli2 =(TC2-TC1)/ 2-1 = ΔTC/ΔQ = (18-10)/(2-1) = 8 BITS Pilani, Deemed to be University under Section 3, UGC Act
Marginal Cost of production

• Marginal Cost is the change in total cost of production that comes from
producing one additional unit.
Examples
1) A match box maker incurs a fixed cost of U$ 10,000 per month in his factory. The cost of wood and
chemicals per match box is U$ 0.05. Find the marginal cost of production if he is producing 100,000
match boxes in a month.
Solution: Total Cost = 10000+ 0.05*100000 = U$ 15000 (TC1), Total Production = 100,000, Marginal Cost
=15000/100000 = U$ 0.15

2) The matchbox maker plans to increase production by 50000 match boxes. For this he has to build a
new factory shed and buy new machines which would require an additional investment of U$ 6,000
per month. The cost of wood and chemicals remain unchanged. What is the marginal cost of
production for the second lot of match boxes (50,000)?
Solution: New total cost = 10000 + 6000+ 0.05*150000 = U$ 23500 (TC2)
Change in Total Cost = 23500 – 15000 = 8500 = TC2-TC1, Change in output = 150000 –
100000=50,000
Marginal Cost of Production = 8500/50000 = U$ 0.17
The entrepreneur may worry about this increased marginal cost of production. Usually, new factories would
employ the latest technology and their marginal cost should be less.
• We shall shortly see that the Marginal Cost should be equal to marginal revenue for optimal production.
20 BITS Pilani, Deemed to be University under Section 3, UGC Act
Total Costs
Total Costs include all economic costs of production.
They have fixed and variable components. We also have
opportunity costs.

• Fixed Costs are accounting costs which do not change with

the level of output.
Example: Lease Rentals, Furniture and fittings

• Variable costs change with the level of production.

Example: Cost of Raw material, packaging etc.

We have already examined opportunity costs.

• Total Cost = Total Fixed Cost (TFC)+ Total Variable Cost (TVC)
Petrol pump
Lease Rental : Rs 100,000 per month
Cost of Electricity = Rs. 10000 per month
Cost of manpower = Rs. 40000 per month
Cost of petrol = Rs. 100 per liter. Find the fixed, variable and total costs if the pump is selling 10000 litres of petrol per month.

21 BITS Pilani, Deemed to be University under Section 3, UGC Act

Marginal Product, Marginal Cost Law of Variable proportions

Land (in Labour Output Marginal Land Unit cost of Incremental Marginal
acres) (units) (Quintals) Product Rent manpower Total Cost Cost Cost
1 0 0 0 10000 5000 10000 Not Defined
1 1 2 2 10000 5000 15000 5000 2500
1 2 6 4 10000 5000 20000 5000 1250 Marginal Cost Declines
1 3 12 6 10000 5000 25000 5000 833.3333333
1 4 16 4 10000 5000 30000 5000 1250 Marginal Cost Increases
1 5 18 2 10000 5000 35000 5000 2500
1 6 18 0 10000 5000 40000 5000 Not Defined
1 7 14 -4 10000 5000 45000 5000 Not Defined
1 8 8 -6 10000 5000 50000 5000 Not Defined

Marginal Product (Marginal Output)2 = (Total Output)2 – (Total Output)1

Marginal Product (Marginal Output)n = (Total Output)n – (Total Output)n-1
Some of the reasons for the initial decline in Marginal Cost
Source: toppr/com
1. Synergy 2. Experience Curve 3. Volume Discounts
22 BITS Pilani, Deemed to be University under Section 3, UGC Act
 Average Total Cost

Average Total Cost (ATC) is the Total Cost divided by the number of goods produced (or output quantity Q).
Average Total Cost = Total Cost / Q = [Total Fixed Cost (TFC)+ Total Variable Cost (TVC)] /Q
ATC = (TFC+ TVC)/Q = TFC/Q + TVC/Q
ATC influences price and hence is an important constituent of the supply curve.
Costs in a Rice Store
Rice Total Average
Fixed Cost Purchased Rice Sold Rice Cost Variable Total Total Selling Total
Month (Rent) (kg) (kg) (kg) Cost Cost Cost Price Profit/kg Profit Remarks

Cost
1 10000 1020 1000 30 30600 40600 40.6 45 4.4 4400 2% wastage
wastage down with
experience, volume
2 10000 1515 1500 28 42420 52420 34.9 45 10.1 15080 discount
wastage up with
volume, volume
3 10000 2020 2000 27 54540 64540 32.3 45 12.7 25460 discount continues

wastage up, scarcity

4 10000 3045 3000 28 85260 95260 31.8 45 13.2 39740 sets in volume premium

wastage up, scarcity

5 10000 3570 3500 29 103530 113530 32.4 45 12.6 43970 sets in volume premium

wastage up, scarcity

6 10000 4090 4000 30 122700 132700 33.2 45 11.8 47300 sets in volume premium

23 BITS Pilani, Deemed to be University under Section 3, UGC Act

Agenda

• Cost Analysis
• ATC, MC, AVC (Average Variable Cost) etc. change.

• Demand Supply Curve

• Revenue Analysis
• Profit Maximization

24 BITS Pilani, Deemed to be University under Section 3, UGC Act

 Cost trends Variable, Marginal and Total Cost
• Marginal cost first reduces with increase in volume (volume discounts) and then increases (law of diminishing marginal returns).
• Marginal Cost curve touches the ATC and the AVC curves at their lowest points.

Units FC AVC TVC TC ATC MC

1 100 50 50 150 150
2 100 40 80 180 90 30
3 100 45 135 235 78.3 55
4 100 52 208 308 77 73
P 5 100 60 300 400 80 92
6 100 69 414 514 85.7 114
* Marginal Cost at output 1 = 150 – 100 =50
P’
Units = Output Units
ATC3 = (2*ATC2 + MC3)/3
If MC3 = ATC2, ATC3 = ATC2
25
If MC3 > ATC2, ATC3 > ATC2
 General Proof MC,ATC,AVC

MC Curve crosses the ATC and AVC curves at their lowest

points.
ATCn+1 = TCn+1 / (n+1) = (TCn + MCn+1 )/(n+1)
= (n*ATCn + MCn+1 )/(n+1) = [((n+1)-1)ATCn + MCn+1]/(n+1)
= [(n+1)ATCn - ATCn +MCn+1 ]/(n+1)
= (n+1)ATCn/ (n+1) + (MCn+1 – ATCn)/n+1
= ATCn + (MCn+1 – ATCn )/n+1

If MCn+1 > ATCn the term on the right would be +ve.

ATCn+1 > ATCn

26
 Variable, Marginal and Total Cost Example

The Average Total Cost of production of 10 items is Rs. 5. The marginal cost of production of the 11th item is Rs. 6.
What is the average total cost of production of 11 items?
MC11 = TC11 – TC10 ATC11 = TC11 / 11

Solution
TC11 = TC10 + MC11 = TC10 + 6
ATC10 = Rs. 5
TC10 = ATC10 * 10 (ATC = TC/ Q; ATC10 = TC/10)
TC10 = 5*10 = 50
= 5*10 = 50
MC11 = 6
TC11 = 50+6 =56
TC11 = TC10 + MC11 = 50+6 = 56
ATC11 = 56/11 = 5.09
ATC11 = TC11 / 11 = 56/11 = 5.09

ATCn+1 = (TCn + MCn+1 )/(n+1)

27
 Illustration Minimum ATC

Note that ATC goes on the increasing mode after MC exceeds it.
25

Average Total
Output Fixed Cost Marginal Cost Total Cost Cost
0 20000 0 20000 NA 20
1 20000 5000 25000 25000
2 20000 4500 29500 14750
3 20000 4300 33800 11267 15
This illustrates how the ATC curve

Average Total Cost

4 20000 4500 38300 9575
5 20000 4700 43000 8600 reaches its minimum precisely
6 20000 5000 48000 8000 10
7 20000 5200 53200 7600
where the MC curve interests it.
8 20000 5800 59000 7375
9 20000 6500 65500 7278 5
10 20000 7200 72700 7270
11 20000 8000 80700 7336
12 20000 9000 89700 7475 0
13 20000 10000 99700 7669 Quantity of production

28
 The Costs MC, AVC, AFC, ATC
Example
The monthly cost structure of a firm is given. Monthly costs of a firm
VC
(variable TC (total Output MC=
FC Labour cost) cost) ΔTC (kgs) ΔQ ΔTC/ΔQ AVC AFC ATC
5000 1 2000 7000 2000 10 10 200 200 500 700
5000 2 6000 11000 4000 25 15 267 240 200 440
5000 3 9000 14000 3000 45 20 150 200 111 311
5000 4 12000 17000 3000 58 13 231 207 86 293
5000 5 15000 20000 3000 65 7 429 231 77 308
5000 6 18000 23000 3000 70 5 600 257 71 329

ATC = total cost/output, AFC = total fixed cost/output, AVC = total variable cost/output
*Also referred to as the Marginal Productivity of Labor (MPL). We shall cover this in greater details Ref: Khan Academy
while studying production.

29
 Law of Demand and Supply
Law of Demand: If all other factors remain equal, the higher the price of a product, the less people would demand it.
Exceptions : Veblen Goods (exclusive, high quality, prestige value items), Giffen Goods (Low price goods with few substitutes)
Law of Supply: If all other factors remain equal, higher the price, the higher the quantity supplied.

The Supply and Demand Curves shown in this

diagram are straight lines which can be
represented by simple equations like
P = 60 – 0.01*Q where P = Price, Q = Demand

The equation gives the mathematical relation

between the two elements (variables) price and
demand so that if you know one you can work out
E the other.
For example, if asked to find the price corresponding
to a demand of 4000 units, you can simply plug in
the numbers to the equation and get P = 60 – 0.01*4000
= 20.
The general equation is P = a-b*Q where a and b are
30
constants.
Please note that a real life demand curve would be influence
 Effect of shifts in demand and supply

Shifts in demand:
Demands shifts refer to changes in demand caused by factors other than the price of the good. (The change
caused by the price of the good is referred to as movement along the demand curve). Any of the following factors
or there are combination can cause a demand shift.
1. Change in customer income 2. Change in prices of related goods (substitutes or complements)
3. Change in customer tastes or preferences.

Shifts in supply
Improvement in production techniques, Fall in prices of factors of production, reduction of taxes, Acts of God.

In the following slides we shall study two cases of such shifts and their impact on equilibrium price and quantity
demanded.

14/02/2016 MBA ZC416

Case –I Supply decrease, demand increase.

Sf

Si S and D represent the original supply and demand curves. A

Ef
Pf decrease in supply pushes the supply curve to the
left while an increase in demand shifts the demand curve
Price

Ei to the right (from D to D1) causing a change in the position

Pi E
Of the equilibrium point from E to E1. Consequently, equilibrium
Df
price rises from OP to OP1 while demand increases marginally
Di
From OQ to OQ1.
Q Q1
O Quantity

14/02/2016 MBA ZC416

 Case II Supply increase, demand increase

S S1
P E
A big increase in supply is accompanied by a relatively lower
P1 E1 Increase in demand as shown in the accompanying diagram.
D1 The supply curve (S) moves by a long distance to the left (to S1) as
shown in the figure while the demand curve moves by a smaller distance
D The equilibrium point shifts from E to E1 leading to a fall in
equilibrium price from OP to OP1. The demand increases from OQ to OQ1.
O Q Q1 X

14/02/2016 MBA ZC416

 Law of Demand and Supply
• Demand Curve is sloped downwards as we move from left to right (negatively sloped) while supply curve is sloped upwards.
Supply Curve is sloped upwards as we move from left to right.
• Demand Curve meets the price axis at P1 and the quantity axis at P2. P1 represents the maximum price (choke price) beyond
which there would be no demand for the product. P2 represents the maximum demand possible at zero price. P1 is determined
by the limits on income and wealth of consumer while P2 is caused by the limits of time and the law of diminishing marginal utilit

P1

B
Q
Product: Face Mask
C

S2 D2

A
34 P2
 Demand Curve
P = 60 – 0.01Q, P in U$, Q in P = 60 – 0.01Q Toothbrushes
units
P1 (60) P = Rs. 40 , Demand/ month = ?
Q=0, P = 60 (choke price) P = 60 – 0.01Q
P=0, Q = 6000 units P = 40
(saturation demand) 40 = 60 – 0.01Q
0.01Q = 60 – 40 = 20
Demand Equation Q = 20/0.01 = 2000 units
P = a-bQ
Q=0, P = a
P=0, Q=a/b (saturation Demand Line
demand)
Marginal Revenue
MR = a-2bQ
Q=0, MR=a ( = choke price)
MR=0, Q= a/2b (half of Q1 = 6000
saturation demand)
35
Revenues

• Total Revenue (TR) = Output (Q)* Price (P)

• Average Revenue (AR) = TR/Q = (PQ)/Q = P(see example to understand Price)
• Marginal Revenue is the increase in revenue that results from the sale of one additional unit
of output. This is dealt in more detail in the following slide.
• MRn = TRn – TRn-1 MCn = TCn – TCn-1
• Example

Output(units Price Revenue Curves

) (per unit)TR MR AR 15 12 12
10 10
1 6 6 6 6 10 6 5
4 4

Price
2 5 10 4 5 5 2 3 2
0
3 4 12 2 4 0 -2
1 2 3 4 5
4 3 12 0 3 -5
Quantity of output
5 2 10 -2 2
Price TR MR

36 BITS Pilani, Deemed to be University under Section 3, UGC Act

Marginal Revenue

• Marginal Revenue is the increase in revenue that results from the sale of one
additional unit of output.

• Marginal Revenue (MR) = =

• Examples
• A firm sells 100 items at a price of U$ 10 each to a buyer. What is the marginal revenue of the 80 th product? On one
instance, the firm made a mistake and shipped 101 units to the buyer. The buyer refused to accept the 101 st product at
the same price citing storage problems at his end and offered U$ 9.99 for the whole consignment instead. The slight
change in price, the buyer argues would help rent him a temporary shed to store the products? For the 101st piece?
a. The marginal revenue of the 80 the product is the additional revenue resulting from the sell of the 80th product in
the original batch which is equal to U$ 10.
• MRn = TRn – TRn-1 MR80 = TR80 – TR79 = 10*80 – 10*79 = 800-790 = 10
b. A firm generally produced in batches of 100 items which they sold to the customer for U$ 10 per piece for the whole
produce. On one occasion they produced a batch of 101 items. However the customer said the would accept the whole
batch at U$ 9.99 per piece only. What is the marginal revenue at the production of the 101 st piece?
Additional Revenue generated by the 101st piece = 9.99*(101) – 10*100 = U$ 8.99
• MR101 = TR101 – TR100 = 9.99*101 – 10*100 = U$ 8.99

37 BITS Pilani, Deemed to be University under Section 3, UGC Act

 The Basic Profit - Maximizing Model

• The most common objective of the firm

– Basic profit-maximizing model: MC=MR Profit = π
– We start by defining, Profit (π) = R – C MR = CA
– Pi is at a maximum when its first derivative with respect to Q is equal to zero MC = CB
– d(π)/dQ => dR/dQ – dC/dQ = 0
– => dR/dQ = dC/dQ Marginal Profit = CA- CB = AB
– => MR = MC
– Intutively, if MC is higher than MR it means the cost of producing the additional unit Marginal Cost
exceeds the revenue that unit is going to fetch. This is a loss making proposition A
and the firm would not produce that extra unit.
– If MC is lower than MR, every additional product would fetch a profit and the P F

Cost/Revenue
company would go on producing. The company would stop producing when MR =
MC. Marginal Revenue
• Assumptions of basic profit-maximising model E
– The firm has a single decision-maker. B
– The firm produces a single product.
– The firm produces for a single market.
– The firm produces and sells in a single location C D
– All current and future costs and revenues are known with certainty. O Quantity of output
– Price is the most important variable in the marketing mix
– The firm operates in a perfect competition market

38
Managerial Economics (MBA ZC416) BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
 Demand and Marginal Revenue Curves

P = 60 – 0.01Q, P in U$, Q in P1 (60)

units MR = a-2bQ
Q=0, P = 60 (choke price) Q=0, MR=a ( = choke price)
P=0, Q = 6000 units MR=0, Q= a/2b (half of saturation demand)
(saturation demand)
MR = 60-0.02Q
Demand Equation Q=0, MR=60
P = a-bQ Demand Line MR=0, Q=60/0.02 = 3000
Q=0, P = a
P=0, Q=a/b (saturation
demand) Marginal Revenue

Q1 = 6000

39
 How to find MR equation if demand equation is given.

Demand Equation is P = 60 – 0.01Q a=60, b=0.01 P= a-bQ a=60, b=0.01 MR Equation : P = a-2bQ
MR Equation is P = 60 – 2*0.01Q = 60 – 0.02Q

60 Pchoke = a , Qsaturation = a/b

P = a – bQ ------- Demand Equation
50 MR = a – 2bQ
P = a-bQ
MR = a – 2bQ 40 P = 60-0.01Q
MR= 60 – 2*0.01Q = 60 – 0.02Q
Q =0, MR = a 30 Demand Line
MR=0, Q = a/2b Q = 40 – 20P - Demand Equation
Price

MR = 0 20 MR Line Q = 40- 2*20P = 40 -40P (This is wrong.)

a-2bQ = 0 20P = 40-Q
Q = a/2b P = (40-Q)/20 = 2 – 0.05Q ---
10
MR = 2-2*0.05Q = 2-0.1Q
OP2 = OP1/2 P2 P1
40 O 1000 2000 3000 4000 5000 6000
Quantity
Revenue and Demand curve

• Demand Line : P = a – bQ (At Q=0 choke price = a, At P=0, Q= a/b)

• Total Revenue TR = PQ = (a – bQ)*Q = aQ-bQ2
• Marginal Revenue = d(TR)/dQ = d(aQ-bQ2)/dQ = a-2bQ (At Q =0, MR = choke
price = a, At P=0, MR = a/2b) (We shall derive it without using calculus in example)
This proves that the MR curve cuts the demand axis at the half way point of the
demand line.

• For maximum total revenue, d(TR)/dQ= marginal revenue = 0 which occurs at Q =

a/2b
• The maximum total revenue = a2/4b (obtained by substituting Q = a/2b in the
TR expression.
For revenue maximization, MR=0. Profit maximization, MR = MC

41 BITS Pilani, Deemed to be University under Section 3, UGC Act

 Cost and revenue curves
Average Total Cost = Total Cost / Quantity of Production. (Q)

Y’
P’

Z’ Y

W Z

O Q’ O P2
Note: At the profit maximization point MC = MR
which means d(TC)/dQ = d(TR)/dQ
OA = OB/2 Slopes of the tangent to the total cost curve and the
Total revenue curve would be equal. This means they
42 would be parallel to each other.
 Cost and revenue curves
Points to be noted
1. OP1 = ½ OP2. The MR line intersects
the x-axis at a point half way
down the distance where the demand
Line cuts it. K
2. TR is an inverted parabola with its L
maximum value at the level of output Y
Maximum Total Revenue
where MR = 0. TR = 0 when demand is 0.

Price/cost

Points to be noted
3. Marginal cost curve cuts the ATC line at
O P1 P2 the latter’s lowest point.
output 4. Profit it maximum at the output level
(Q1) where the MC curve cuts the MR line.
5. As a profit maximizing monopoly firm seeks to
Equal MC with MR (price), the MC and
the supply curve would be identical.
43
 Example-1 Profit Maximization
Question: On a particular day, a carpenter sits down to make chairs. The marginal cost and market prices at different level
of production is given in the following table. Find out his profits (marginal as well as cumulative) with each level of productio
How many chairs should he produce to maximize his profit? Does it prove the MR=MC conclusion?

Illustration – Sequential Production* Illustration – Batch Production*

Output Marginal Marginal Marginal Marginal
(no of Cost Cumulative Revenue(MR) Cumulative Profit = MR- Cumulative Marginal Cost Cumulative Total Marginal Profit = Total
chairs) (MC) Cost Mkt Price =Mkt Price Revenue MC Profit Output (MC) Cost Mkt Price Revenue Revenue MR-MC Profit
1 1000 1000 1500 1500 1500 500 500 1 1000 1000 1500 1500 1500 500 500
2 900 1900 1400 1400 2900 500 1000 2 900 1900 1400 2800 1300 400 900
3 875 2775 1275 1275 4175 400 1400 3 875 2775 1275 3825 1025 150 1050
4 925 3700 1125 1125 5300 200 1600 4 925 3700 1187.5 4750 925 0 1050
5 985 4685 985 985 6285 0 1600 5 985 4685 985 4925 175 -810 240
6 1100 5785 800 800 7085 -300 1300 6 1100 5785 800 4800 -125 -1225

* The carpenter produces one chair after the other • The carpenter plans for the total output and produces in
one go.

44
 Example -2 Profit Maximization

Total
Variable Variable Average Total Cumulative
Fixed Cost Patients Cost Cost Total Cost Total Cost Price Revenue Profit Profit

50000 100 100 10000 60000 600 1000 100000 40000 40000

0 100 90 9000 15000 150 900 90000 75000 115000

0 100 200 20000 20000 200 800 80000 60000 175000

0 100 300 30000 30000 300 700 70000 40000 215000

0 100 400 40000 40000 400 600 60000 20000 235000

0 100 500 50000 50000 500 500 50000 0 235000

0 100 600 60000 60000 600 400 40000 -20000 215000

45
 Consumer and Producer Surplus

D1 Consumer Surplus
D’ = Area of triangle D1FE MC = d(TC)/dQ
S2 TC = ʃ MC*dQ = Integrand+ K
D3

Price
The integrand represents the Total
F F1 Variable Cost, K is the fixed cost.
F2 E
Producer Surplus=
S
Area of triangle S1EF 1 D2

O G
Total Cost of Quantity
production = OGES1

D1 D2 is the demand line. S1 S2 is the supply line which also represents the marginal cost of production.
Area under the supply curve is the Total (variable) cost of production.
46
 Inefficient Market Deadweight Loss

(Price)

47
 Profit Maximization Farmer’s Agitation

Minimum Support Price (MSP)

is the price at which the
P MC = d(TC)/dQ
Central Government sources
TC = integration of MC*dQ
select food grains (paddy, wheat)
Demand Line
from farmers which are stored
In Food Corporation of India A B H
Warehouses. Price
I

MR MC
E C

O D G Output F

48
 Example
Question: The demand curve for a product is given by the equation Q = 100 – P. Draw the demand, marginal revenue and
the total revenue curves. Determine the marginal revenue at a production levels of 40 and 60 units. Find the production level at
which total revenue is maximum?

Solution1: Q = 100-P, P=100-Q, TR= Q*(100-Q)= 100Q-Q2 For max revenue, d(TR)/dQ = 0, d/dQ(100Q-Q2) = 100-2Q =0
Q = 50, TR =100*50-502 = 2500
Solution2: (You can straight use the formula that if demand equation is P=a-bQ, MR = a-2bQ.
Q = 100-P (given)
P= 100-Q, Marginal Revenue = ΔTR/ΔQ
Total Revenue at production Q (TR) = P*Q = (100-Q)*Q = 100Q-Q2 – (1) Maximum Total Revenue
Total Revenue at production(Q+ΔQ) (TR+ΔTR)= 100(Q+ΔQ) – (Q+ΔQ)2 Total Revenue = 100Q-Q2
= 100Q+100ΔQ – (Q + 2QΔQ+ ΔQ )
2 2
= 2*50Q-Q 2
= 100Q-Q2 + (100 – 2Q)ΔQ – (2) = 2500 – 2500+2*50Q – Q2
2
(ΔQ is ignored) = 2500 – (50 2- 2*50Q+Q2)
Change in Total Revenue (ΔTR) = (2) – (1) ΔQ =0.1, ΔQ2 = 0.12 = 0.001 = 2500 – (50-Q)2
= (100 – 2Q)ΔQ
Marginal Revenue Δ(TR)/ΔQ = 100 – 2Q
Marginal Revenue at 40 production = 100-2*40 = 20 This is a non-negative number
Marginal
49 Revenue at 60 production = 100-2*60 = -20 as a square and has its minimum value at
Q = 50
 Example Costs

1.Total Fixed Cost is U$ 100. Complete the following table.

Marginal Cost Average Total

Output (Units) (MC) Total Cost (TC) Cost (ATC)
1 20
2 30
3 15

Hints
1. TC1 = Total Cost for producing the first unit = Total Fixed Cost + Marginal Cost1

2. TCn = Tcn-1 + MCn

50
 Question-2
The following table shows the total cost of production of a firm at different levels of output. Fill up the blank table based
on information given below.
Output (Units) 0 1 2 3
Total Cost (U$) 60 100 130 150

Average Output TC TFC TVC AVC MC

Variable
0 60 60 0 NA NA
Total Cost Total Fixed Total Variable Cost Marginal
Output (Units) (U$) Cost(TFC) Cost (TVC) (AVC) Cost (MC) 1 100 60 40 40 40
0
1 2 130 60 70 35 30
2
3 150 60 90 30 20
3

Hint1 : TFC0 = TFC1 = TFC2 =….TFCn

Hint2: TCn = TFCn+ TVCn

Hint3: MCn = TCn – TCn-1

51
52
THANK YOU

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

 Managerial Economics
MBA ZC 416

BITS Pilani
Pilani Campus
 BITS Pilani
Pilani | Dubai | Goa | Hyderabad

Managerial Economics

Theory of the Firm

and Related Concepts – Part 2
Measurement of profit

• Two problems associated with the measurement of profit

– Ambiguity in measurement
– Restriction to a single time period
• Bankruptcy of Enron in 2001 highlights these issues
• Restating their earnings
• Accounting profit is an ambiguous term
– gross profit
– net profit
– operating profit
– earnings before interest
– depreciation and tax
• The above definitions involve estimates rather than precise
measures for a number of reasons relating to GAAP

56
Managerial Economics (MBA ZC416) BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Manipulation

• Scope for managers to manipulate the firm’s accounts

– boost the share price
– personal earnings of the managers (CEO and CFO)
• It is difficult for shareholders to comprehend easily
• an agency problem combined with moral hazard
• Auditing: protect shareholders and potential investors
• Restriction to a single time period
– It is more appropriate to consider the long-term profits of a firm
– The stream of profits over some period of time
– Value of the expected future cash flows
– Discounting

57
Managerial Economics (MBA ZC416) BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
 Enron: The Fall Of A Wall Street Darling

Managerial Economics (MBA ZC416)

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BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Elasticity measures
• Price Elasticity
– Already defined in the previous slide. [ΔQ/Q]/[ΔP/P] = (P/Q)ΔQ/ΔI . [dQ/Q]/[dI/I] = (I/Q)dQ/dI
– If the demand curve is exponential and given by Q=aP-b , price elasticity would be constant and
shall be equal to –b.
– It has been empirically observed that price elasticity is different for price increases and price
decreases.
• Income Elasticity
– Defined as [ΔQ/Q]/[ΔI/I] = (I/Q)ΔQ/ΔI = (I/Q)dQ/dI
– As consumer income increases demand shifts for better quality or “superior” products.
– Superior products show income elasticity greater than one while those with elasticity less than zero
are referred to as inferior products.
– Normal products have income elasticity between 0 and 1.
• Cross price Elasticity
– Defined as (dQx / dPy)(Py/Qx) where x and y refer to different goods [dQx / Qx ]/[dPy / Py ]
– If positive, price increase of good y leads to an increase in demand of good x. hence x and y are
substitute goods (rice and wheat). If negative they are complementary goods (cars and petrol)
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
 The rise of Enron: a brief history
It was founded by Kenneth Lay, former CEO of Houston Natural Gas
Transporting and selling gas
In 1990, Lay hired Jeffrey Skilling, a consultant with McKinsey & Co., to
lead a new division -- Enron Finance Corp.
Skilling was made president and chief operating officer of Enron in 1997
From the pipeline sector, Enron began moving into new fields
In 1999, the company launched its broadband services unit and Enron
Online, the company's website for trading commodities, which soon
became the largest business site in the world.

Managerial Economics (MBA ZC416)

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BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
 Growth of Enron
Growth for Enron was rapid.

In 2000, the company's annual revenue reached$100

billion US.

It ranked as the seventh-largest company on the

Fortune 500

And the sixth-largest energy company in the world.

The company's stock price peaked at $90 US.

Managerial Economics (MBA ZC416)

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 Enron: Revenue

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Managerial Economics (MBA ZC416) BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
 Fall of Enron
Cracks began to appear in 2001

In August of that year, Jeffrey Skilling announced his departure

Lay resumed the post of CEO

Chief financial officer Andrew Fastow was replaced. Many new entities were
created, and debts were kept separate from Enron's books

In October 2001, Enron reported a loss of $618 million— its first quarterly
loss in four years

Managerial Economics (MBA ZC416)

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BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
 Enron’s stock price

Managerial Economics (MBA ZC416)

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BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
 Enron: Stock price falls

Managerial Economics (MBA ZC416)

65
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
 Bankruptcy of Enron
Tried to negotiate with its rival Dynegy

The negotiations failed

The company was left with no choice

On Dec. 2, 2001, it filed for bankruptcy protection

More than 4,000 people were laid off at Enron's Houston headquarters

Arthur Andersen, who had a large portion of their revenue coming from
Enron’s audit and consulting fee, was tempted to ignore the issues

Managerial Economics (MBA ZC416)

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Multiproduct strategies

• In practice, firms produce multiple products

• This complicates the analysis because:

– Demand and Cost interactions

• How to firms maximize profits given these interactions?

– Product line profit maximization
– Product mix profit maximization

• PC World case study highlights the underlying challenges

and issues in a multiproduct strategy

67
Managerial Economics (MBA ZC416) BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
THANK YOU

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

 Demand Analysis
and Elasticity of Demand
MBA ZC416, Managerial Economics
Agenda
• Introduction
• Circular Flow of Economy
• Concept and Definition of Demand
• Law of Demand and its Exceptions
• Concept and Definition of Supply
• Elasticity of Demand and its types
• Factors affecting elasticity of demand
• Measurement of elasticity
• Significance of elasticity of demand

• Consumer Theory
 Focus Areas
• Demand and Supply
• Elasticities of Demand
– Price Elasticity of Demand
– Income Elasticity
– Cross Elasticity
• Consumer Choice
– Budget Line
– Consumer Satisfaction Curves (Indifference Curves)
– Law of Choice (Law of Equi-marginal Utility)
The Circular Flow of Economic Activity

Labor services supplied by households

flow to firms, and goods and services
produced by firms flow to households.

Payment for goods and services flows

from households to firms, and payment
for labor services flows from firms to
households.
Input Markets and Output Markets:
The Circular Flow
• Input and output markets are connected through the behavior of both firms
and households.

• Firms determine the quantities and character of output produced and the
types and quantities of input demanded.

• Households determine the types and quantities of products demanded and

the quantities and types of inputs supplied.
Demand in Product/Output Markets
A household’s decision about what quantity of a particular
output, or product, to demand depends on a number of
factors, including:
▪ The price of the product in question.
▪ The income available to the household.
▪ The household’s amount of accumulated wealth.
▪ The prices of other products available to the household.
▪ The household’s tastes and preferences.
▪ The household’s expectations about future income,
wealth, and prices.
Quantity Demanded ?

• The amount (number of units) of a product that a

household would buy in a given period if it could buy all it
wanted at the current market price.
Changes in Quantity Demanded vs.
Changes in Demand

• The most important relationship in individual markets is that

between market price and quantity demanded.
Changes in Quantity Demanded vs.
Changes in Demand
• Changes in the price of a product affect the quantity demanded per period.

• Changes in any other factor, such as income or preferences, affect demand.

• Thus, we say that an increase in the price of Coca-Cola is likely to cause a

decrease in the quantity of Coca-Cola demanded.

• However, we say that an increase in income is likely to cause an increase in

the demand for most goods.
What is Demand ?

• A relation showing the quantities of a good that

consumers are willing and able to buy at various prices
per period, other things constant.
Demand for commodity implies

• Desire to acquire it

• Willingness to pay for it

• Ability to pay for it

Types of Demand
• Consumer goods vs. Producer goods
• Firm vs. Industry
• Autonomous vs. Derived
• Durable vs. Perishable
• Short-term vs. Long-term
Representation
• The general ‘law of demand’
• Demand table or schedule
• Demand graph
• Equations
– Q = f (P)
– Q = f (P, A, Y, Ps,...)
• A linear demand function Q= a+bP
LAW of DEMAND

Law of demand As price rises, quantity

demanded decreases. As price falls,
quantity demanded increases.

It is reasonable to expect quantity demanded to fall when price rises, ceteris paribus,
and to expect quantity demanded to rise when price falls, ceteris paribus. Demand
curves have a negative slope.
Demand Schedule

TABLE Anna’s Demand Schedule

for Telephone Calls
QUANTITY DEMANDED
PRICE (PER CALL) (CALLS PER MONTH)
Demand schedule A table
$ 0 30
showing how much of a .50 25
given product a household 3.50 7
would be willing to buy at 7.00 3
different prices. 10.00 1
15.00 0
Demand Curve

Tan 1200 = -1.73

A graph illustrating how

much of a given product a
household would be willing
to buy at different prices.

FIGURE Anna’s Demand Curve

P
1200
Factors determining demand
 Alex’s Demand Curve

Alex’s Demand Schedule for Gasoline

Price Quantity Demanded

(per unit) (Good X)
8.00 0
7.00 2
6.00 3
5.00 5
4.00 7
3.00 10
2.00 14
1.00 20
0.00 26

The relationship between price (P) and quantity demanded

(q) presented graphically is called a demand curve.
Demand curves have a negative slope, indicating that lower
prices cause quantity demanded to increase.
CALCULATING TOTAL REVENUE

In any market, P x Q is total revenue (TR) received by producers:

TR = P x Q
total revenue = price x quantity

Profit = Revenue - cost

MARGINAL REVENUE
• It is the additional revenue added by an additional unit of
output.

• In other words marginal revenue is the extra revenue that an

additional unit of product will bring a firm.

• Marginal revenue is the derivative of total revenue with respect

to demand.
Example
• TR = 100Q−Q^2
• MR = d(TR)/dQ = 100-2Q
• When Q = 60, MR = -20
Demand curves slope downward
• Law of Demand: The negative relationship between price and quantity
demanded: As price rises, quantity demanded decreases. As price falls,
quantity demanded increases.

• It is reasonable to expect quantity demanded to fall when price rises,

ceteris paribus, and to expect quantity demanded to rise when price
falls, ceteris paribus.
Other Properties of Demand Curves

1. They have a negative slope.

2. They intersect the quantity (X) axis, as a result of time limitations and
diminishing marginal utility.

3. They intersect the price (Y) axis, as a result of limited income and wealth.

The actual shape of an individual household demand curve whether it is

steep or flat, whether it is bowed in or bowed out depends on the unique
tastes and preferences of the household and other factors.
Classification of goods
Normal goods Goods for which demand goes up when income is higher
and for which demand goes down when income is lower.

Inferior goods Goods for which demand tends to fall when income rises.

Substitutes Goods that can serve as replacements for one another; when
the price of one increases, demand for the other increases.

Complements or Complementary goods Goods that “go together”; a

decrease in the price of one results in an increase in demand for the other
and vice versa.
Shift vs. Movement along a Demand Curve

Income rises

Price rises
Quantity demanded falls Demand for substitutes shifts right

Demand for complements shifts left

Supply of Product
Firms build factories, hire workers, and buy raw materials because they believe they can sell
the products they make for more than it costs to produce them.

Profit The difference between revenues and costs.

Quantity supplied The amount of a particular product that a firm would be willing and
able to offer for sale at a particular price during a given time period.

Supply schedule A table showing how much of a product firms will sell at alternative
prices.

Law of supply The positive relationship between price and quantity of a good
supplied: An increase in market price will lead to an increase in quantity supplied, and
a decrease in market price will lead to a decrease in quantity supplied.
Supply of Product

A producer will supply more when the price

of output is higher.

The slope of a supply curve is positive.

Supply is determined by choices made by

firms.

P – price of soya beans per bushel

Q – Bushels of soya beans produced per

year
Determinants of Supply
Assuming that its objective is to maximize profits, a firm’s decision
about what quantity of output, or product, to supply depends on:
1. The price of related products.
2. The cost of producing the product, which in turn depends on:
■ The price of required inputs (labor, capital, and land).
■ The technologies that can be used to produce the product.
Shift of Supply versus Movement Along a Supply Curve

Shift of Supply Schedule for Soybeans

following Development of a New
Disease-Resistant Seed Strain

Schedule S0 Schedule S1
Quantity Supplied Quantity Supplied
Price (Bushels per Year (Bushels per Year
(per Bushel) Using Old Seed) Using New Seed)
1.50 0 5,000
1.75 10,000 23,000
2.25 20,000 33,000
3.00 30,000 40,000
4.00 45,000 54,000
5.00 45,000 54,000

Shift of the Supply Curve for Soybeans following

Development of a New Seed Strain

When the price of a product changes, we move along the supply

curve for that product; the quantity supplied rises or falls.
When any other factor affecting supply changes, the supply
curve shifts.
Market Equilibrium
Market equilibrium is achieved when consumers are willing to buy the same quantity of goods the
producers are willing to sell.

When quantity demanded exceeds quantity supplied, price tends to rise.

When the price in a market rises, quantity demanded falls and quantity supplied rises until
an equilibrium is reached at which quantity demanded and quantity supplied are equal.
 Point of Equilibrium

PA
A
L2 Supply Consumer and Producer surplus

Pe
Area of triangle APPe P
Price Area of triangle APPe = Consumer Surplus
Area of triangle BPPe = Producer Surplus
= ½ PPe * APe (1/2 base* height)
PbB Demand
Area of triangle BPPe =
L1
½ PPe * Bpe = producer surplus Qe
O
Quantity demanded or supplied

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ECONOMICS Session 3
 Profit Motive Deadweight Loss

Producer Surplus = CKMN

Consumer Surplus = ANM A D
E Overall economic surplus =
Overall Economic Surplus
Consumer Surplus + Producer Surplus
= Area of CKMN + Area of ANM
Area of triangle ABP + Area of triangle CP
= Area of AMKC
M = Area of triangle ACP
N
(Price)

B P MC = d(TC)/dQ
F
D(TC) = MCdQ
K TC = ʃ(MC)dQ from 0 to L

J
C

O I L G 32
 Tax Regimes Deadweight Loss

Initial Supply Curve: p = a+bQ

Tax Imposed = T (payable by supplier)

Example: A manufacturer was selling his proudct at

Rs. 200 per kg. A flat tax of Rs. 10/ kg was imposed which
the suppliers chose to absorb and not pass on to the
Customer. (Had they passed on it would have affected the
Demand curve).
P
Part of the price retained by supplier = p-T
New Supply Curve p-T = a+bQ
p = a+T+bQ
The new supply curve would be pushed up by T as shown
in accompanying diagram.

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ECONOMICS Session 3
Demand and Supply in Product Markets: A quick recap

• A demand curve shows how much of a product a household would buy if it could
buy all it wanted at the given price. A supply curve shows how much of a product a
firm would supply if it could sell all it wanted at the given price.

• Quantity demanded and quantity supplied are always per time period—that is, per
day, per month, or per year.

• The demand for a good is determined by price, household income and wealth,
prices of other goods and services, tastes and preferences, and expectations.
Demand and Supply in Product Markets: A quick recap

• The supply of a good is determined by price, costs of production, and prices of

related products. Costs of production are determined by available technologies
of production and input prices.

• Be careful to distinguish between movements along supply and demand curves and
shifts of these curves. When the price of a good changes, the quantity of that good
demanded or supplied changes—that is, a movement occurs along the curve. When
any other factor changes, the curve shifts, or changes position.

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ECONOMICS Session 3
Demand and Supply in Product Markets: A quick recap

• Market equilibrium exists only when quantity supplied equals quantity

demanded at the current price.
Elasticity of Demand

• It allows us to analyze demand with greater precision.

• It is a measure of how much buyers and sellers respond to

changes in market conditions.
Elasticity of Demand
• Elasticity of Demand measures the degree of responsiveness
of the quantity demanded of a commodity to a given change in
any of the determinants of demand.

•
%A
elasticity of A with respect to B =
%B
Types of Elasticity of Demand
• Price elasticity of demand

• Income elasticity of demand

• Cross elasticity of demand

PRICE ELASTICITY OF DEMAND
SLOPE AND ELASTICITY

FIGURE 1 Slope Is Not a Useful Measure of Responsiveness

PRICE ELASTICITY OF DEMAND

price elasticity of demand The ratio of

the percentage of change in quantity
demanded to the percentage of change
in price; measures the responsiveness
of demand to changes in price.

% change in quantity demanded

price elasticity of demand =
% change in price
 Example
In a market, the demand for rice went up from 100 ton to 150 ton when the price fell from Rs. 50/kg to Rs. 40/kg.
Calculate the price elasticity of demand.

Price Elasticity of Demand = % change in demand / % change in price

% change in demand = (Final Demand – Initial Demand)/ initial Demand = (150-100)/100 = 50%
% change in price = (Final Price – Initial Price)/Initial price = (40-50)/50 = -10/50 = -20%
Price Elasticity of Demand = 50%/(-20%) = 50/(-20) = -2.5
Price Elasticity of Demand is expressed as a positive number. Price Elasticity = 2.5 (-2,5).
(-)2.5

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ECONOMICS Session 3
Price Elasticity of Demand
• Elasticity of Demand

• Quantity demanded of a commodity in

response to a given change in price

• Always negative

• Relationship between the price and the

demand is inverse
PRICE ELASTICITY OF DEMAND

FIGURE 2 Perfectly Elastic and Perfectly Inelastic Demand Curves

% change in quantity demanded

price elasticity of demand =
% change in price
Degree of Price Elasticity of Demand

• Inelastic Demand (e<1): Quantity demanded does not respond

strongly to price changes.

• Elastic Demand (e>1): Quantity demanded responds strongly

to changes in price.
Degree of Price Elasticity of Demand
• Perfectly Inelastic: Quantity demanded does not respond
to price changes.

• Perfectly Elastic: Quantity demanded changes infinitely

with any change in price.

• Unitary Elastic (e=1): Quantity demanded changes by the

same percentage as the price.
% change in quantity demanded
price elasticity of demand =
% change in price
Price Elasticity: Impact on Revenue
Elastic (e>1) Unitary Elastic Inelastic (e<1)
Price rises TR falls No change in TR rises
TR
Price falls TR rises No change in TR falls
TR

TR = P*Q
d(TR)/dP = d(PQ)/dP = Q+PdQ/dP
e = [d(Q)/Q]/[d(P)/P] = -Pd(Q)/QdP
Pd(Q)/dP = -eQ
d(TR)/dP = Q-eQ = Q(1-e)
As you can see if e >1 (elastic), TR would fall with increase in P. If e=1 (Unitary elastic), TR is unchanged.
If e<1 (inelastic), TR would rise with increase in price.
Price elasticity of Demand
Urban India Short Run Long Run
Butter 1.478 2.78
Petrol 0.3 0.9
Tea 0.718 1.14
Coffee 0.292 0.685
Burger 1.49 2.79
Clothing 1.1 2.88
Price elasticity of Demand

Goods/Services Price Elasticity

Brinjals 3.5
Cabbage 2.8
Health insurance 1.9
Public transport 1.0
Electricity for domestic 0.5
purpose
CALCULATING ELASTICITIES
CALCULATING PERCENTAGE CHANGES

To calculate percentage change in quantity demanded

using the initial value as the base, the following formula is
used:

change in quantity demanded

% change in quantity demanded = x 100%
Q1

Q2 - Q1
= x 100%
Q1
CALCULATING ELASTICITIES
We can calculate the percentage change in price in a similar way. Once again, let us use the
initial value of P—that is, P1—as the base for calculating the percentage. By using P1 as the
base, the formula for calculating the percentage of change in P is simply:

change in price
% change in price = x 100%
P1

P2 - P1
= x 100%
P1
CALCULATING ELASTICITIES
ELASTICITY IS A RATIO OF PERCENTAGES

Once all the changes in quantity demanded and price have been converted into percentages,
calculating elasticity is a matter of simple division. Recall the formal definition of elasticity:

% change in quantity demanded

price elasticity of demand =
% change in price
CALCULATING ELASTICITIES Arc Elasticity
THE MIDPOINT FORMULA
midpoint formula
A more precise way of calculating percentages using the value halfway between P1 and P2
for the base in calculating the percentage change in price, and the value halfway between
Q1 and Q2 as the base for calculating the percentage change in quantity demanded.

change in quantity demanded

% change in quantity demanded = x 100%
(Q1 + Q2 ) / 2

Q2 - Q1
= x 100%
(Q1 + Q2 ) / 2
CALCULATING ELASTICITIES
Using the point halfway between P1 and P2 as the base for
calculating the percentage change in price, we get

change in price
% change in price = x 100%
( P1 + P2 ) / 2

P2 - P1
= x 100%
( P1 + P2 ) / 2
CALCULATING ELASTICITIES

TABLE 5.2 Calculating Price Elasticity with the Midpoint Formula

First, Calculate Percentage Change in Quantity Demanded (%QD):
change in quantity demanded Q2 - Q1
% change in quantity demanded = x 100% = x 100%
(Q1 + Q2 ) / 2 (Q1 + Q2 ) / 2

By substituting the numbers from Figure 1(slide 32): PRICE ELASTICITY COMPARES THE
PERCENTAGE CHANGE IN QUANTITY
10 − 5 5 DEMANDED AND THE PERCENTAGE
% change in quantity demanded = x 100% = x 100% = 66.7% CHANGE IN PRICE:
(5 + 10) / 2 7.5
%QD 66.7%
=
Next, Calculate Percentage Change in Price (%P): %P - 40.0%
= 1.67
change in price P2 - P1 = PRICE ELASTICITY OF DEMAND
% change in price = x 100% = x 100%
( P1 + P2 ) / 2 ( P1 + P2 ) / 2 DEMAND IS ELASTIC

By substituting the numbers from Figure 1(slide 32):

2−3 -1
% change in price = x 100% = x 100% = - 40.0%
(3 + 2) / 2 2.5
Problem
• You are given market data that says when the price of pizza is
Rs. 4, the quantity demanded of pizza is 60 slices and the
quantity demanded of cheese bread is 100 pieces. When the
price of pizza is Rs. 2, the quantity demanded of pizza is 80
slices and the quantity demanded of cheese bread is 70 pieces.

a. Can the PED be calculated for either good? Why?

b. If so, what is the PED?
Solution
• In order to calculate PED we need two (quantity, price) pairs
for one good (two points along a certain good’s demand
curve). We are given this information for pizza. We are not
given this information for cheese bread.
• We have two (quantity, price) pairs for pizza. Specifically, (QD1 ,
P1 ) = (60, $4) and (QD2 , P2 ) = (80, $2) .
• PEDpizza = [Q2 – Q1]/Q1*P1/[P1 – P2] = [80-60]/60*4/[4-2] = 0.67
CALCULATING ELASTICITIES
ELASTICITY AND TOTAL REVENUE
In any market, P x Q is total revenue (TR) received by producers:

TR = P x Q
total revenue = price x quantity

When price (P) declines, quantity demanded (QD) increases.

The two factors, P and QD, move in opposite directions:

Effects of price changes P → QD 

on quantity demanded: and
P → QD 
Determinants of Price Elasticity of Demand
• Nature of Commodity

• Availability and proximity of Substitutes

• Proportion of Income spent on the Commodity

• Time frame

• Durability of the Commodity

Income elasticity of Demand

• Income elasticity measures the responsiveness of quantity

demanded to changes in income, holding the price of the good
& all other demand determinants constant.
Income elasticity of Demand

• Positive for a normal good

• Negative for an inferior good

• Zero for a neutral good

Income elasticity of Demand
• Luxury goods: Income elasticity is greater than 1

• Normal goods: Income elasticity is between 0 and 1

• Inferior goods: Income elasticity is negative

Cross elasticity of Demand

• Cross-price elasticity of demand (EXY) measures the

responsiveness of quantity demanded of good X to changes in the
price of related good Y, holding the price of good X & all other
demand determinants for good X constant
Cross-price elasticity of demand in the real world

Positive : Two goods are substitutes

Negative: Two goods are complements

Commodity X Commodity Y Cross-price elasticity

Tea (India) Coffee (India) 0.0385
Tea (India) Coffee (India) 0.3457 (long run)
Entertainment (US) Food (US) -0.72
Margarine (US) Butter (US) 1.53
 Consumer Choice

A consumer is one who takes decisions about what to buy for satisfaction of wants, both as an individual and as a
Member of household, is called a consumer.

A consumer is considered to be rational which means he is someone who seeks to maximise his/her satisfaction
(utility) in spending his/her income.

Equilibrium is a state of rest when the entity concerned (for example the consumer or the producer) achieve their
objective and stop further action.

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ECONOMICS Session 3
 The Study of Choices
• We shall see how a consumer with a limited budget chooses
between two goods X and Y to maximize his/her satisfaction
(utility).
HOUSEHOLD CHOICE IN OUTPUT MARKETS
Every household must make three basic decisions:

1. How much of each product, or output, to

demand

2. How much labor to supply

3. How much to spend today and how much

to save for the future
HOUSEHOLD CHOICE IN OUTPUT MARKETS
THE BUDGET CONSTRAINT

Information on household income and wealth,

together with information on product prices, makes
it possible to distinguish those combinations of
goods and services that are affordable from those
that are not.

budget constraint The limits imposed on

household choices by income, wealth,
and product prices.
HOUSEHOLD CHOICE IN OUTPUT MARKETS

TABLE Possible Budget Choices of a Person Earning $1,000 Per Month After Taxes
MONTHLY OTHER
OPTION RENT FOOD EXPENSES TOTAL AVAILABLE?
A $ 400 $250 $350 $1,000 Yes
B 600 200 200 1,000 Yes
C 700 150 150 1,000 Yes
D 1,000 100 100 1,200 No

choice set or opportunity set The set of options that is

defined and limited by a budget constraint.
HOUSEHOLD CHOICE IN OUTPUT MARKETS
THE EQUATION OF THE BUDGET CONSTRAINT

In general, the budget constraint can be

written:

PXX + PYY = I,

where PX = the price of X, X = the

quantity of X consumed, PY = the price of
Y, Y = the quantity of Y consumed, and I
= household income.
 Budget Line Example
A consumer has gone to the market to buy apples and oranges.Oranges are selling at Rs. 100 per kg and apples for Rs.
200 per kg. His budget is Rs.1000. Draw the budget line and graphically represent it. How would the graph change if
the price of apple increased to Rs. 250 per kg. A
10

X and Y stand for consumption of apples and oranges respectively.

PX = Price of Apple = Rs. 200 per kg
8 PXX + PYY = I,

ORANGES
PY = Price of Orange = Rs.100 per kg
Budget Line Equation is PX X+ Py Y = B 6
200X+100Y = 1000 P (2 g of apples, 5 kg of oranges)
5
X=0, 100Y = 1000, Y=10. The consumer can invest his/her full budget in Budget Line
buying oranges alone. S/he would get 10 kg of oranges. 4
Y=0, 200X = 1000, X=5. The consumer uses the full budget to buy
apples and gets 5 kg of apples.

New Budge Line 250X+100Y=1000 2 Choice set

B
30/1/2016 MBA ZC416 MANAGERIAL
ECONOMICS Session 3
APPLES 1 2 3 4 5 7 9
HOUSEHOLD CHOICE IN OUTPUT MARKETS
The Budget Constraint More Formally

FIGURE Budget Constraint and Opportunity Set for Ann and Tom
 Explanation

B = Budget
Px = Price of item X
Py = Price of item Y
X = Consumption of X
Y = Consumption of Y

Money spent on X = XPx

Money remaining = B – XPx = Money spent on Y = YPy
Hence XPx + YPy = B

30/1/2016 MBA ZC416 MANAGERIAL

ECONOMICS Session 3
HOUSEHOLD CHOICE IN OUTPUT MARKETS
Budget Constraints Change When Prices Rise or
Fall

FIGURE The Effect of a Decrease in

Price on Ann and Tom’s
Budget Constraint

The budget constraint is defined by income, wealth, and prices. Within those limits, households are
free to choose, and the household’s ultimate choice depends on its own likes and dislikes.
THE BASIS OF CHOICE: UTILITY

utility The satisfaction, or reward, a product yields

relative to its alternatives. The basis of choice.
THE BASIS OF CHOICE: UTILITY
DIMINISHING MARGINAL UTILITY
marginal utility (MU) The additional satisfaction gained by
the consumption or use of one more unit of something.
MC = d(TC)/dQ
total utility The total amount of satisfaction obtained from MU = d(TU)/dQ
consumption
of a good or service.

law of diminishing marginal utility The more of any one

good consumed in a given period, the less satisfaction
(utility)
generated by consuming each additional (marginal) unit of
the same good.
THE BASIS OF CHOICE: UTILITY
TABLE Total Utility and Marginal
Utility of Trips to the Club
Per Week
TRIPS TOTAL MARGINAL
TO CLUB UTILITY UTILITY
1 12 12
2 22 10
3 28 6
4 32 4
5 34 2
6 34 0

FIGURE Graphs of Frank’s Total

and Marginal Utility
 Trade off Example

Change in Change in
Chocolates Balloons chocolates Balloons

10 0

9 1 1 1

8 3 1 2

7 6 1 3

law of diminishing marginal utility The more of any one good consumed in a
given period, the less satisfaction (utility)
generated by consuming each additional (marginal) unit of the same good.
30/1/2016 MBA ZC416 MANAGERIAL
ECONOMICS Session 3
THE BASIS OF CHOICE: UTILITY
DIMINISHING MARGINAL UTILITY AND DOWNWARD-SLOPING DEMAND

FIGURE Diminishing Marginal Utility and

Downward-Sloping Demand
INCOME AND SUBSTITUTION EFFECTS
THE INCOME EFFECT

When the price of something

we buy falls, we are better
off. When the price of
something we buy rises, we
are worse off.
INCOME AND SUBSTITUTION EFFECTS
THE SUBSTITUTION EFFECT

Both the income and the substitution effects imply a negative relationship
between price and quantity demanded—in other words, downward-sloping
demand. When the price of something falls, ceteris paribus, we are better off,
and we are likely to buy more of that good and other goods (income effect).
Because lower price also means “less expensive relative to substitutes,” we are
likely to buy more of the good (substitution effect). When the price of something
rises, we are worse off, and we will buy less of it (income effect). Higher price
also means “more expensive relative to substitutes,” and we are likely to buy less
of it and more of other goods (substitution effect).
Customer Satisfaction (Indifference) Curves -
Assumptions
1. We assume that consumers have the ability to choose among the combinations of goods and
services available.

2. We assume that consumer choices are consistent with a simple assumption of rationality (to
maximize his satisfaction).

Change in Change in
Chocolates Balloons chocolates Balloons

10 0

9 1 1 1

8 3 1 2

7 6 1 3
Deriving Customer Satisfaction (Indifference)
Curve

An indifference curve is a
1,9
set of points, each point
representing a combination
3,8 of goods X and Y, all of
chocolates
which yield the same total
6,7 satisfaction (utility).

Change in Change in
Chocolates Balloons chocolates Balloons
10 0
9 1 1 1
Balloons 8 3 1 2
7 6 1 3
FIGURE An Indifference Curve
 Consumer Satisfaction Curve
• I went to the market to buy apples and oranges. I was fourth in
the queue. The seller asked me how many of each I wanted
and I replied “ 1 kg apples and 5 kg oranges.” (1,5)
• There was a shortage of oranges. After the first customer, the
seller told me over the queue that he probably be able to give
only 4 kg oranges (as the previous buyer has presumably
bought 1 kg oranges). “Sir” he shouts “I shall give you one
extra kg of apples.” I say “Yes.” (2,4)

30/1/2016 MBA ZC416 MANAGERIAL

ECONOMICS Session 3
 Consumer satisfaction Curve
• After the second customer he says “ Sorry, Can give you only 3
kg oranges. May I add one extra kilo apple?”
• What do I do with so many apples? I came here for only 1 kg
apples?
• “Sir, please take 1.5 kg apples instead.” I accept. (3.5,3)
• Finally when I am at his counter, he says “Sir, I can only give
you 2 kg oranges. To compensate for this 1 kg (of oranges), I
shall give you 2 kg apples extra apples instead. (5.5,2)
 Customer Satisfaction (Indifference) Curve
• (1,5), (2,4), (3.5, 3) and (5.5, 2) represent four points of equal
satisfaction for the consumer. A curve connecting the four
points is the consumer satisfaction curve or the indifference
curve. The customer is indifferent to the four options before
him.
Consumer Satisfaction (Indifference) Curves -
Properties

1. It slopes downwards from left to right

2. It is convex to the origin

3. It cannot intersect with another indifference curve

 Indifference Curves
Indifference Curves are convex to origin (that is they bulge towards the origin.)

30/1/2016 MBA ZC416 MANAGERIAL

ECONOMICS Session 3
 Indifference Curves
They occur in a series with higher curves representing higher levels of consumer satisfaction.

orange

P3

P1
P
apple
30/1/2016 MBA ZC416 MANAGERIAL
ECONOMICS Session 3
 Indifference Curves
They curves DO NOT intersect each other.

oranges

apples

30/1/2016 MBA ZC416 MANAGERIAL

ECONOMICS Session 3
 Indifference Curves
Indifference Curves DO NOT touch the axes.

30/1/2016 MBA ZC416 MANAGERIAL

ECONOMICS Session 3
Consumer Equilibrium
CONSUMER CHOICE

FIGURE: Consumer Utility-Maximizing

Equilibrium
I/Py’ D

I/Px’

As long as indifference curves are convex to the origin, utility maximization will take place at the
point at which the indifference curve is just tangent to the budget constraint.
THE BASIS OF CHOICE: UTILITY
THE UTILITY-MAXIMIZING RULE

In general, utility-maximizing consumers spread out their

expenditures until the following condition holds:

MU X MUY
utility - maximizing rule : = for all pairs of goods
PX PY
 Law of Equi-marginal utility
• Let us say Mux / Px > Muy / Py
• This means Mux > Px * Muy / Py
• If the consumer buys 1 unit of X he gets additional utility Mux
and pays a price of Px. With Py he could have got one unit of Y
and enjoyed a utility of Muy; a utility per rupee of Muy / Py.
• After spending Px with X he forgoes the utility of Px *Muy / Py.
• If Mux > Px*Muy / Py he is better off buying 1 unit of X.
 Consumer Choice
• I am choosing between rice and wheat.
• Price of rice = Rs. 40/kg, Price of wheat = Rs. 50/ kg
• Marginal utility for rice = Murice ( utility of 1 kg of rice)
• Marginal utility for wheat = Muwheat (utility of 1 kg of wheat)
With Rs. 40, I buy 1 kg of rice = Murice
With same Rs. 40, 40/50 kg of wheat = 0.8 kg of wheat =
0.8Muwheat
If Murice > (40/50) Muwheat Murice / 40= Price > Muwheat / 50 = Pwheat
 Law of Equi-Marginal Utility
• Indifference Curve equation : TUx + TUy = constant
• d(TUx)/dx+ d(TUy)/dx = 0
• Mux + Muy (dy/dx) =0 d(Tuy)/dx = d(Tuy)/dy*dy/dx =
Muy*dy/dx
• Mux/Muy = - dy/dx = Px/Py
• Mux/Px = Muy/Py d(Tuy)/dx =
d(Tuy)/dy*dy/dx = Muy*dy/dx

PXX + PYY = I,
 Practice Question -1

Use consumer theory to explain the law of demand.

Law of demand states increase in price leads to decrease in demand.

Law of Equimarginal utility, Mux / Px = Muy / Py for equilibrium of consumption in a situation of choice.

Px increases. Equilibrium is disturbed.

Left hand side (LHS) is lower in value. As a consequence, the customer consumer more of item y, ignoring
Item X.

The demand for X goes down with its increase in price.

30/1/2016 MBA ZC416 MANAGERIAL

ECONOMICS Session 3
 Practice Question-2
The customer challenged the fruit-seller. “Man, you just cheated the previous customer. You charged him higher for
apples. The standard rate of apples is Rs. 200 per kg. You charged him Rs. 250. This is unfair business practice.”
The fruit-seller angrily retorted “Gentleman, you might have put on expensive clothes. But you seem to know nothing
economics. You probably did not notice that I sold him oranges at a lower price. The market is running short of apples.
By altering the prices, I changed his Budget line and delivered his intended total satisfaction. His position might have
changed, but he still stayed on the same Indifference curve. Go figure.”

B/Papple Original Budget Line

Papple *Qapple + Porange * Qorange = B

Apples P1

P2

B/Porange
Oranges
30/1/2016 MBA ZC416 MANAGERIAL
ECONOMICS Session 3
THANK YOU
 Managerial Economics
MBA ZC 416

BITS Pilani
Pilani Campus
 BITS Pilani
Pilani|Dubai|Goa|Hyderabad

Managerial Economics
Demand Estimation and Forecasting
Agenda

• Estimation Methods

• Data

• Regression Analysis

• Correlation

• Time Series Analysis

• Trend Projection

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Demand Forecasting –
Estimation Methods

4
Managerial Economics (MBA ZC416)
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Demand Forecasting –
Estimation Methods

5
Managerial Economics (MBA ZC416)
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Demand Forecasting –
Data

6
Managerial Economics (MBA ZC416)
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Regression analysis
• In the next few slides we will attempt to understand the assumptions and principles
behind regression analysis and how it may be leveraged in demand forecasting and other
types of business decision making

• Applications include projections of demand, sales, earnings, risk, etc.

• Regression analysis is a way to find the relationship between a dependent variable and
one or more independent variables based on the historical trend or relationship
– Dependent variable is the one whose value is being forecasted or predicted
– Independent variables are the underlying drivers which cause the dependent variable to change

• Scatter plot
– Shows the strength of the relation between two variables in a graphical manner
– If the points on the scatter plot cluster together in a straight line then the two variables can be said
to have strong linear relationship
14

12

10

Y 8

0
0 2 4 6 8 10 12

X
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Regression analysis
• Steps for regression analysis:
– Specify the dependent variable (Y) and identify the independent variable (X)
– Obtain historical values of the independent variables and respective dependent variables
– Draw a scatter plot for visual evaluation
– Identify or fit a mathematical relationship based on the visual observation
• Linear: Y = b(0) + b(1).x1 + b(2).x2
• Logarthmic: Y = a* b^x
• Polynomial: Y = a + bX + cX^2+……
– Typically the method chosen to fit the data to the chosen model is the least squares principle
• Fits the data to the model such that the sum of the squared deviations of the historical data from the
theoretical model values are minimized
• Simple bi-variate linear regression model
– Y = b(0) + b(1)X + e
– Here b(0) = y intercept; the value of Y when X = 0
– X = independent variable
– Y = dependent variable
– b(1) is the regression co-efficient
• Measures how much the dependent variable changes per unit of change in the independent variable
• b(1) = delta(y)/delta(x); also known as the slope

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Regression analysis
• Assumptions underlying a classical normal linear regression model are as
follows:
– Linear relationship exists between the independent variable and the dependent
variable
– Independent variable is not random
– Expected value of the error term is 0
– The variance of the error term is the same for all observations (homoskedasticity)
– The error term is independent across observations
– The error term is normally distributed

• The co-efficient of variation measures the fraction of the total variance in the
dependent variable that is explained by the independent variable.
– The simplest way to calculate the co-efficient of determination is to square the
correlation of the dependent and the independent variables
– Also R^2 = (Explained variation)/(Total Variation) = 1 – (unexplained)/(total)

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Correlation
• Correlation analysis attempts to measure the strength of the
relationship (or goodness of fit) between the dependent variable and
the independent variables.
– The key measure of goodness of fit is the coefficient of determination:

R(yx)^2 = [n∑XY –(∑X)(∑Y)]^2]/[n∑ x^2 –(∑X)^2] [n∑ Y^2 –(∑Y)^2]

• The correlation coefficient is the square root of the coefficient of

determination

• Covariance between two variables is defined as:

COV(yx) = ∑(X – X(bar))(Y – Y(bar)/ N = E(XY) – E(X)*E(Y)

= ∑XYP(XY) - ∑XP(X)VYP(Y)

• Correlation is related to covariance by: r(yx) = COV(yx)/ y x

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Demand Forecasting –
Time Series Analysis

11
Managerial Economics (MBA ZC416)
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Demand Forecasting –
Sources of Variation

12
Managerial Economics (MBA ZC416)
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Trend Projection

• A short run forecasting technique

• Projecting the past trend by fitting a straight line to the data using regression
analysis

• Assuming that a variable (such as sales) depends on the passage of time.

The variable may follow a trend (decrease, increase or stay flat over time).

• We can measure linear secular trends (leveraging regression analysis):

– Linear regression analysis: Y(t) = b(0) + b(1)t
– Y(t) is the value of the time series at time = t
– b(0) is the intercept or the value of Y(t) at time t = 0
– b(1) is the regression co-efficient or the slope of the line

• Using least squares method we can determine these parameters

– b(1) = [(n*sigma(tY)) – (sigmaY)*sigma(t)]/[(n*sigma(t^2))-(sigma(t)^2)]
– b(0) = Ybar – b*tbar

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Example: Electricity Demand

Period Time Electricity (million kwh)

Q1FY12 1 11
Q2FY12 2 15
Q3FY12 3 12
Q4FY12 4 14
Q1FY13 5 12 Please see Excel sheet for detailed
Q2FY5 6 17 solution; however I encourage
Q3FY5 7 13
each of you to first attempt to
Q4FY5 8 16
solve this by yourself, based on
Q1FY6 9 14
the discussion in class and then
Q2FY6 10 18
check my excel sheet to verify.
Q3FY6 11 15
Q4FY6 12 17
Q1FY7 13 15
Q2FY7 14 20
Q3FY15 15 16
Q4FY15 16 19

14 Managerial Economics (MBA ZC416)

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Example: Electricity Demand
Regression output

Electricity (million kwh) y = 0.3941x + 11.9

R² = 0.5335
25

20

15

10

0
0 2 4 6 8 10 12 14 16 18

15 Managerial Economics (MBA ZC416)

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Example: Electricity Demand
Interpreting the results
• The regression equation is as follows:
• Y(t) = 11.90 + 0.394t

• The regression suggests that if “t” changes by 1 unit (i.e. 1

quarter) then Y (i.e. Electricity demand) changes by 0.394
million units

• R^2 = 53% ➔ 53% of the total variation is explained by the

regression equation

• We can develop forecasts based on this regression

equation

16 Managerial Economics (MBA ZC416)

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Homework problem: Bicycle
Demand

Sales
Year (in millions)

2006 61.63
Experiential Learning – Homework Problem
2007 67.97

2008 69.63 1) Using the data for bicycle sales in the table
2009 71.49
besides, first create a scatter plot in excel
2) Draw the trend line and estimate the
2010 89.01
regression equation as also the R squared
2011 96.61 3) Interpret your results
2012 108.62 4) Project the bicycle demand for 2016 based
2013 111.53 on your regression model
2014 115

2015 119.6

17 Managerial Economics (MBA ZC416)

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
 Thank You

18
 Managerial Economics
MBA ZC 416

BITS Pilani
Pilani Campus
 BITS Pilani
Pilani | Dubai | Goa | Hyderabad

Managerial Economics
Production Analysis - Part 1
AGENDA
• Production Function
• Key relationships: Total, Average and marginal products
• The law of diminishing returns
• The three stages of production function
• Isoquants and Isocosts
• Economic Region of Production
• Returns to Scale
• Empirical production function
Production Process

• The organization of production

– Inputs
• Fixed inputs
• Variable inputs
• Transformation of inputs into output
The Three Decisions That All Firms Must Make

Firm: An organization that comes into being when a

person or a group of people decides to produce a good
or service to meet a perceived demand.
All firms must make several basic decisions to
achieve what we assume to be their primary
objective—maximum profits.

Profit Maximizing Principle Capital vs. Labour How much capital to be employed?
Marginal Cost = Marginal Revenue How much labour?
The Behavior of Profit-Maximizing Firms

Optimal method of production - The production method that

minimizes cost.
Short-run vs. Long-run decisions • Land
• Labor
Short run: • Capital
• Entrepreneurship
At least one of the inputs (labor or capital) is fixed.
❖ The firm is operating under a fixed scale (fixed factor) of production, and
❖ Firms can neither enter nor exit an industry.
❖The firm has fixed and variable costs.
❖Example: A hospital with a fixed number of beds with lease contracts (with
the land lord) and employment contracts (doctors, paramedics, technicians
and support staff) for a period of 1 year.

Long run:
That period of time for which there are no fixed factors of production:
❖ Firms can increase or decrease the scale of operation, and
❖ New firms can enter and existing firms can exit the industry.
❖There is no fixed cost.
Production function
• Production function with two inputs:
• Q = f (K, L)
– Output = Number of the units of commodity
– Labour = Number of workers employed
– Capital = Amount of equipment used in the
production
• Assumption: both L and K are homogeneous
• This principle can apply to firms using more
than two inputs and delivering more than one
output
Examples of functions: Q = 2K+3L , Q=KL2
The Production Process

Production technology The quantitative

relationship between inputs and outputs.
Labor-intensive technology that relies
heavily on human labor instead of capital.

Capital-intensive technology: Technology

that relies heavily on capital instead of
human labor.
While choosing the most appropriate
technology, Firms choose the one that
minimizes the cost of production.
Total, average and marginal
product
• Total product- The total amount of output produced
• Marginal Product (MP) of labour is the change in total product or extra output per unit changes in
labour used
TP
MPL = TP = Total Product = Output (Q)
L = ΔQ/ΔL
• Average product (AP) of labour: total product divided by the quantity of labour used
TP
APL =
• L = Q/L
• Output elasticity of labour: percentage change in output divided by the percentage change in the
quantity of labour used

• %Q =
EL =
%L
• This can also be written as:
% change in demand/ % change
= (delQ/Q)/del(P)/P
MPL
EL = MPL = APL EL =1 Price elasticity of demand
APL
Production function with one
variable input
Labour Total Product Marginal Average Output
(Number of (TP) Product (MP) Product (AP) elasticity of
workers) labour

0 0 - - Output Elasticity at Labour =3

1 3 3 3 1 Output Elasticity = [ΔQ/Q]/[ΔL/L]
2 8 5 4 1.25 = [(12-8)/8]/[(3-2)/2
=1
3 12 4 4 1 ]
4 14 2 3.5 0.6 TP
MPL =
L
5 14 0 2.8 0
6 12 -2 2 -1

MP1 = TP1– TP0

Average Product = Q/L
 (Numb Produc al e elastici
er of t Produc Produc ty of
worker (TP) t (MP) t (AP) labour
s)

TP, MP, AP of labour curves 0

1
0
3
-
3
-
3 1
2 8 5 4 1.25
3 12 4 4 1
4 14 2 3.5 0.6
5 14 0 2.8 0
6 12 -2 2 -1
Three Stages of Production
• Graphical relationship between TP, MP, and AP vs. units of labour
• It helps firms set production schedules and make staffing decisions
• The slope of TP curve rises up to some point, and then becomes zero at some point, and
is negative thereafter 2

• Three stages of production

• In the first stage – increasing marginal return
• AP of labour is maximum
• TP is increasing
• In the second stage – law of diminishing returns sets in
– AP of labour declines
– MP of labour is zero
– TP is maximum
• In the third stage – marginal returns become negative
– Adding more resources becomes counter productive
Output (production)
Three Stages of Production

TP
Points on TP Marginal Product Average Product Stages of
curve (MP) (AP) Total Product Production
Increases and
reaches a maximum
O to G* at point B Increases Increses at an increasing rate
TP increases. Increases at a
O to H MP> AP AP increases decreasing rate after point B. I
H to J MP< AP AP decreases TP increses at a decreasing rate II
J onwards MP turns negative AP decreases TP decreases III

*In some books. O to G is defined as phase I.

Correction: Point G, not B in the marginal product column.
Law of diminishing returns

• As we use more and more units of the variable

input with a given amount of the fixed input,
after a point we get diminishing returns from the
variable input
Thank You

16
 Managerial Economics
MBA ZC 416

BITS Pilani Sidharth Mishra

Pilani Campus Associate Professor, Management
Email: sidharth.mishra@pilani.bits-pilani.ac.in
 BITS Pilani
Pilani | Dubai | Goa | Hyderabad

Managerial Economics
Production Analysis - Part 2
Optimal use of labour
• Marginal revenue product of labour (MRPL)-the extra revenue generated by
the use of an additional unit of labour. This equals
MRPL = ( MPL )( MR ) MR MPL

MRPL = Extra Revenue / Extra Labour = ΔR/ΔL= (ΔR/ΔQ)*(ΔQ/ΔL)

ΔR = ΔQ* (ΔR/ΔQ) = ΔQ*(Marginal Revenue (MR))
MRPL = ΔQ*MR/ΔL = (ΔQ/ΔL)*MR = MPL * MR

• Marginal resource cost of labour (MRC of labour)-the extra cost of hiring an

additional unit of labour, which equals to
TC/ L
• Condition: (Labour will be hired until) The extra revenue generated from the
sale of output by employing additional unit of labour equals the extra cost of
hiring the labour
• Example: additional revenue Rs. 30 and extra cost is Rs. 20
 Optimal use of labour-
Graphical representation

MRCL = Marginal
P Resource Cost of
Revenue/ Labour
Cost
MRPL = Marginal
Revenue Product of
labour
Units of
labour used
Restaurant
Kitchen – 1 cook
 Isoquants and Isocosts

Isoquant: shows all the combinations of capital and labor that can be used to produce a given
amount of output.
Isocost: shows all the combinations of capital and labor available for a given total
cost

Iso-constant, Isobar = curve that joins all places with same pressure, isotherms= all

Note the similarity with consumer choice theory.

The indifference curves, curves all points on which represent constant total satisfaction are conceptually similar
to the isoquant, all points on which represent the same level of output.

The Budget Line is similar to the iso-cost all lines on which refer to a constant cost (budget).
 Isoquants
Production function withand
twoIsocosts
inputs

Alternative Combinations of Capital (K)

and Labor (L) Required
to Produce 50, 100, and
150 Units of Output ISO-QUANT: Constant Production Curve
QX = 50 QX = 100 QX = 150
K L K L K L
A 1 8 2 10 3 10
B
C
2
3
5
3
3
4
6
4
4
5
7
5
Z
D 5 2 6 3 7 4
E 8 1 10 2 10 3
Y
X

Isoquant that shows all the combinations of

capital and labor that can be used to produce a
given amount of output.

Note: The above curves only show portions of

isoquants. We shall see fuller representation in a
later slide.
MRTS
Slope of isoquant:

K MPL MPL = ΔQ/ΔL

=− MPK = ΔQ/ΔK
L MPK
B Marginal rate of technical substitution The rate at
A
which a firm can substitute capital for labor and
hold output constant.

As we move towards the right, labor increases, the

magnitude of MRTS decreases. With relatively less
The magnitude of the Slope of an Isoquant Is Equal capital, it is possible to substitute more labor.
to the Ratio of MPL to MPK The reverse happens as we move to the left.
Isocosts

(0, TC/Pk)
Isocost line A
graph that shows all
the combinations of PL * L + PK*K = Constant (TC)
capital and labor
available for a given Slope = -PL / PK
total cost.

( TC/PL, 0)

PL = 2

Capital
PK = 3 FIGURE Isocost Lines Showing the
Budget Equation: Combinations of Capital and Labor
Available for $5, $6, and $7
2L+3K = 10 (if the budget is U$10)
Labour
1 Labour,
2 labout
Isocosts

FIGURE Isocost Line Showing All

Combinations of Capital and
Labor Available for $25 L = Labour used
K= Capital used
Total Cost of Labour = 5L:
Total Cost of Capital = 1K
Slope of isocost line: PL = U$5
PK = U$1
K TC / PK PL Total Cost of production
=− =− = Total Cost of Labor + Total
L TC / PL PK Cost of Capital = 5L+1K = 25
Isoquants and Isocosts

Finding the Least-Cost Technology with Isoquants and Isocosts

Profit-maximizing firms will
Finding the Least-Cost minimize costs by producing
Combination of Capital and their chosen level of output
Labor to Produce 50 Units with the technology
of Output represented by the point at
which the isoquant is tangent
E to an isocost line.

Here the cost-minimizing

technology—3 units of capital
and 3 units of labor—is
represented by point C.

Conceptually this is similar to indifference curves (constant total satisfaction curves) and budget line. The
Corresponding slide has been reproduced for easy understanding.
Consumer Equilibrium
CONSUMER CHOICE

FIGURE: Consumer Utility-Maximizing

Equilibrium
I/Py’

I/Px’

As long as indifference curves are convex to the origin, utility maximization will take place at the
point at which the indifference curve is just tangent to the budget constraint.
Isoquants and Isocosts

The Cost-Minimizing Equilibrium Condition

At the point where a line is just tangent to a

curve, the two have the same slope. At each
point of tangency, the following must be true:
MPL P
slope of isoquant = − = slope of isocost = − L
MPK PK

MPL PL
Thus, =
MPK PK

Dividing both sides by PL and

multiplying both sides by MPK, we get
MPL MPK Cost-minimizing
=
PL PK equilibrium
condition

This is similar to the concept of equi-marginal utility which states MUx/Px = MUy/Py
Economic Region of
Production

• Economic region of production is given by the negatively sloped segment of

isoquants between ridge lines

ISO-QUANTS
Slope = ΔK/ΔL
A Negative Slope means capital requirement
Reduces with increasing labor and vice versa: Econo
Region

Positive Slope means capital requirement

O Increases with increasing labor and vice versa.
Wasteful Region
Ridge lines
• Ridge lines separate the relevant from irrelevant
portions of the isoquants
• Isoquants have zero slope(horizontal) or infinite
slope (vertical) where ridge line joins on the
various isoquants
• Ridge line OV-the isoquants are negatively sloped
to the left and positively sloped to the right
• The isoquants are negatively sloped to the right
of the ridge line (OZ) positively sloped to the left
 Return to Scale

• Return to scale is the change in output achieved when the input factors are changed
by the same proportions.
– Constant Return to scale
• The output changes by the same proportion as input factors.
– Increasing return to scale
• The output change is more than the proportionate change in input factors.
– Decreasing return to scale
• The output change is less than the proportionate change in input factors.
– Example (capital and labour are considered the input factors)
• If the output doubles when capital and labour are doubled, it is a case of constant return to scale.
• If the output MORE than doubles when capital and labour are doubled, it is a case of increasing return to
scale.
• If the output is LESS than double in the above case, it is decreasing return to scale.

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Empirical Production function
• Cobb-Douglas empirical function

Q refers to the qty of output Q = AK a Lb

K-capital
L-Labour
A, a and b are parameters to be estimated empirically, a and b would lie between 0 and
1.
Cobb-Douglas Production function-Properties
❖ The MP of capital and MP of labour depend on the quantity of capital and quantity
of labour used in the production which diminish with increasing input of the
corresponding factor of production (capital or labor).
❖ The exponents of K and L (a and b) represent the output elasticity of capital and
labour and sum of the exponents measures the returns to scale.
❖
❖
a+b =1; constant return to scale.
a+b >1; increasing return to scale. Q = AK L a b

❖ a+b <1, decreasing return to scale.

❖ Cobb-Douglas production function can be estimated by regression analysis by
transforming into
ln Q = ln A + a ln K + b ln L
❖ Cobb-Douglas production function can be extended to deal with more than two
inputs
Logarithm base 10.
Ln = loge Logarithm base e.

Euler’s number e = 2.7

 Cobb Douglas Function - Properties
• Marginal Productivity (MP)
– MPL (Marginal productivity of Labour) = dQ/dL = d(Aka Lb)/dL = bAka Lb-1 (Differentiation at constant K)
– b-1 is negative as b<1 and hence as L increases, dQ/dL would decrease.
– You can do the same analysis for MPk (Marginal productivity of Capital).
• Output Elasticity
Q = AK L
a b

– Labour Output Elasticity = (% change in production)/% change in labour input = (dQ/Q)/(dL/L)

= (L/Q)(dQ/dL) = (L/Aka Lb)(bAka Lb-1 ) = b(Aka Lb / Aka Lb) = b
– Capital output of elasticity = a
– Return to Scale
– For constant return to scale, the output should double if the input factors (capital and labour)
are doubled.
– 2Q = A(2k)a (2L)b = 2a+b (Aka Lb) = 2a+bQ; 2=2a+b ; a+b =1
– Similarly it can be proven that a+b>1 and <1 for increasing and decreasing returns to scale
respectively.
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
 Problem -1

Calculate AP and MP from the following table.

Units of
input TP (units) AP(units) MP(units)
1 12 12 12
2 25 12.5 13 MP >= AP : Stage I of production
3 35 11.67 10 MP < AP Stage II
4 35 8.75 0 MP < 0 Stage III
5 30 6 -5

13/02/2016 MBA ZC416 Session 07

 Problem -2

Complete the following table.

Variable
Input
(Units) TP AP MP
0
1 20
2 26
3 66
4 19
5 4

13/02/2016 MBA ZC416 Session 07

 Solution – Problem 2

Variable
Input
(Units) TP AP MP
0 0 0 0
1 20 20 20
2 46 23 26
3 66 22 20
4 76 19 10
5 80 20 4

Correction: AP for input 5 = 16

13/02/2016 MBA ZC416 Session 07

 Solved Example-3

• The production function for a firm is Q=8K0.6 L0.4. Calculate the firm’s outputs if it
employs 30,40,50 and 60 hands for labour if 25 units of capital is used. What is the
firm’s return to scale? Q = AK a Lb
• Solution:
Q = 8(25)0.6 (30)0.4 = 215 units. Outputs at other levels can be calculated accordingly.
As a+b =0.6+0.4 =1, the firm would display constant return to scale.

change in Marginal
Capital Labour Output output Productivity
25 30 215
25 40 241 26 2.6
25 50 264 23 2.3
25 60 284 20 2

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

 Solved Example-4

• A young doctor started a clinic in a new town. After experimenting for sometime she could estimate
that at an investment of Rs. 1 lakh and with one attendant she is able to handle 10 patients per day. The
corresponding numbers (patients handled per day) with (Rs. 2 lakh,2 employees) and (Rs. 5 lakh, 4
employees) are 18 and 35 respectively. How much capital does she need to invest if she does not want
to increase the number of employees but wants to increase the capacity of her clinic to handle 50
patients per day? Assume the Cobb Douglas production function and the unit of capital as Rs. Lakh.
• Solution is on the next slide.

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

 Solution
lnQ = lnA+ alnK+ blnL - Eqn 1 Cobb Douglas Function in log format.

The three production situations mentioned in the question have been represented in the accompanying table.
Output(Q) Capital (K) Labour(L)
10 1 1
18 2 2
35 5 4

Putting the figures for the three production situation into the equation we obtain
ln10 = lnA+ aln1 + bln1 –Eqn 2
ln18 = lnA+ aln2+bln2 - Eqn 3
ln35 = lnA+aln5+bln4 - Eqn 4

Substituting the log values in the equations (ln1 =0, ln2 = 0.7, ln4 = 1.4 and ln5 = 1.6, ln10 =2.3,ln18=2.9,ln35=3.6)
2.3 = lnA
2.9 = lnA+0.7a+0.7b
3.6 = lnA+1.6a+1.4b
The above equations can be solved to give A =10, a=0.5, b=0.357
The Cobb Douglas function can now be written as lnQ = ln10+0.5lnK+0.357lnL
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
 Solution (continued)

We need to find out the capital required when Q=50 and L=4
Using the Cobb-Douglas equation
lnQ = ln10+0.5lnK+0.357lnL
Ln50 = ln10+0.5lnK+0.357ln4

Substituting the logarithm values,

3.9= 2.3+0.5lnK+0,357*1.4 ln50 = 3.9. ln10=2.3, ln4=1.4
lnK = 2.21
K = e2.21 = Rs. 9.1 lakh.
The doctor has to employ a capital of Rs. 9.1 Lakh to get the output of 50 patients per day with four labour hands.

13/02/2016 MBA ZC416 Session 07

THANK YOU
 Managerial Economics
MBA ZC 416

BITS Pilani
Pilani Campus
 BITS Pilani
Pilani | Dubai | Goa | Hyderabad

Managerial Economics
Cost of Production
 Agenda
• Short Run Cost Analysis
• Long Run Cost Analysis
• Demand and Supply
Cost Analysis-Outline
Basic principles of relevant costs
Short-run cost analysis
Relationship between cost and output
Long-run cost analysis
Relationship between cost and output
Economies of scale and economies of scope
Learning Curve
International Considerations
Cost Analysis-the context?
• Harley Davidson – motor cycle company
• Stiff competition from Japanese in the 1980’s
• Due to decreasing market share and lower profits, Harley Davidson introduced a
number of steps to increase manufacturing efficiency and reduce costs
• Instead of machining parts in house it began to purchase ready made parts from
suppliers using just in time principles
• This reduced work-in-process inventory by $24 million thereby saving significant
costs
• If we assume an interest rate of say 15% then the annual cost savings from interest
expense would amount to 15% x $24 Mil = $3.6 Million
Metric 1985 1995
Net Sales $288 Million $1.35 billion
Net Income $3 Million $112 Million
Earnings per Share $0.09 $1.50
Cost Analysis - significance
• In order to make wise decisions on how much to produce and
what price to charge, managers need to understand the
relationship between a firm’s output rate and its costs.
• Cost has multiple impacts:
– Current level of profitability
– Competitive advantages
– Expansion of output
• Determining the level of output (frequently pose questions)
– What would be the cost of increasing production by 25%
– What is the impact on cost of rising input prices?
– What production changes can be made to reduce costs?
• Output and costs are interrelated
Air Asia India-Low cost airline
• Air Asia –Perhaps world’s best low-cost airline
• Started in February 2013
• Foreign direct investment -49%
– Joint venture –Tata Sons
– Focuses on the southern part of India
– Headquarters in Chennai
• Major focus of the airline: keep costs low and increase
revenue
– Counted the number of papers that they print –reduced
significantly
– The number of coffee cups that they use in their offices-
Reduced
– Charge for extra luggage
Air Asia’s Model: Features
• Single class, no-frills
– Passengers do not receive meals, entertainment, amenities such as
pillows
– Cabins were designed to minimize the wear and tear, cleaning time,
and cost
• High aircraft utilization and Efficient operations
– Reduced the overhead and fixed costs associated with the aircraft
– Absence of in-flight services (loading of food and drinks)
• Low distribution costs (via e-ticketing)
• Negotiations and contracts
– Staff and training needs reduced
– Better purchase terms
– The new A-320 would lower fuel usage by about 12 per cent (fuel
costs -50 % of the total operating costs)
– Low lease rates for its aircraft (outcome of negotiation)
Boeing: Rising marginal cost of 747’s
• Boeing 747s, 767s, and 777s had 60 – 70% of the market share for wide body jets
• With a backorder running to almost 1,000 planes in the mid-1990s, Boeing boosted
production from 180 to 560 jets per year
• At its main plant in Everett, Washington production was increased from 15 planes
to 21 planes per month
• This required: (a) splitting bottlenecked assembly stations into parallel processes (b)
additional assembly workers (c) massive overtime
• Additionally Boeing also contracted out more subassemblies
• These changes led to substantial increase in variable costs
• In the late 1990s, wide body prices did not rise due to competition from Air-bus
• Due to which for a period of time in the 1990’s, 747 – price was less than the
marginal costs , i.e. negative gross profit margins
• Eventually (by 2000) Boeing refused such orders and reduced production back to 15
wide body jets per month (at Everett) and thereby returned to profitability
 Short Run and Long Run
• Output of a firm is dependent on the capital (K) and Labor (L) employed.
• In short run analysis at least one of the factors (usually capital K) is considered to be
fixed.
– Costs of a 50 bed hospital
– Costs of a steel plant with a production capacity of 4 Million Tons of steel per
year.
– Costs have fixed and variable components
– Costs are expressed as a function of the quantity of production C = f(Q)
• In the long run, all factors are variable.
– Entrepreneur is looking at setting up a hospital or a plant. He/she needs to
decide on the capacity of the firm.
– All costs are variable in nature.
Relevant costs
• Types of cost
– Explicit costs-explicit payments (wages and salaries, material costs)
– Implicit costs-costs of using firm-owned resources
• Accounting Profit and Economic Profit
• Short-run costs functions (fixed and variable costs)
– Fixed costs- do not vary with respect to different courses of action
under consideration (example-annual license fee of a restaurant)
– Variable costs
– Total costs = FC+VC
• Per-unit cost functions
– Average fixed costs
– Average variable costs
– Average total costs
• Marginal costs
• Sunk costs-unrecoverable costs (R&D expenditure)
 Short Run Costs
• Fixed Costs
– Salaries of Admin Staff
– Depreciation (wear and tear) of machine
– Depreciation of Buildings and the cost of repairs
– Land Maintenance
– Interest on Loans
• Variable Costs
– Raw Material
– Direct Labour
– Fuel, Lubes and other consumables
Short-run costs
Output Fixed Variable Total AFC AVC ATC MC
(qty) costs costs costs
0 270 0.0 270.0 - - -
5 270 157.5 427.5 54 31.5 85.5 31.5
10 270 330.0 600 27 33 60 34.5
15 270 517.5 787.5 18 34.5 52.5 37.5
20 270 720.0 990.0 13.5 36 49.5 40.5
25 270 937.5 1207.5 10.8 37.5 48.3 43.5
30 270 1170.0 1440.0 9 39 48 46.5
35 270 1417.5 1687.5 7.7 40.5 48.2 49.5
40 270 1680.0 1950.0 6.75 42 48.8 52.5
45 270 1957.5 2227.5 6 43.5 49.5 55.5
50 270 2250.0 2520.0 5.4 45 50.4 58.5
55 270 2557.5 2827.5 4.9 46.5 51.4 61.5
60 270 2880.0 3150.0 4.5 48 52.5 64.5
 Short Run costs

Cost Curves ATC and MC

90

80

70

60 Average Total Cost (ATC) Curve is U-shaped.

ATC and MC

50 It falls initially and then rises.

40

30
Marginal Cost curve crosses the ATC curve at its
20
Lowest point.
10

0
0 10 20 30 40 50 60 70
Quantity

Average Total Cost curve is in blue. Marginal Cost is in red.

14/02/2016 MBA ZC416 Session 08

Short-run costs

Patients served
SAC = Short Run Average Cost
SMC = Short Run Marginal Cost
Short-run costs
• What factors drive the firm’s increasing short-run marginal costs?
– The law of diminishing returns
• Behaviour of short-run average costs (SAC)
– When output is low, total costs mainly consists of fixed costs. AC is high
as output is divided by a small number of units (spread over)
• The firm’s marginal costs curve intersects its average cost curve at the
minimum point of SAC
• The cost function can be represented in equation form
C = C ( Q ) = 270 + (30Q + .3Q 2 )

SAC = 270 / Q + (30 + .3Q)

SMC=dC/dQ = 30 + .6Q
• See the Excel sheet for derivation of the equation (using regression analysis)
Long-Run Cost Curves
❖ Firm can freely vary all of its inputs (all costs are variable)
❖ Two aspects:
❖ Firm can produce at lower costs in the long run than in the
short-run
❖ Shape of the long-run cost curve depends on returns to scale
❖Constant returns to scale –average cost is constant
❖Increasing returns to scale –average cost falls as output
increases

• Long-Run Total Cost = LTC = f(Q)

• Long-Run Average Cost = LAC = LTC/Q
• Long-Run Marginal Cost = LMC = LTC/Q
Short-run versus Long-Run Cost
❖ Firm produces output using two inputs, labour and capital
❖ If we know that production exhibits constant returns to scale
❖ In other words, the firm’s long-run average cost (LAC) is constant
❖ LAC = C/Q = 4 (long-run marginal cost (LMC) is also 4 per unit)
❖ Three possible plants of varying sizes
❖ The firm’s plant represents the total capital input
❖ The left curve is for a 9,000-square-foot plant, and so on
❖ If we plan to produce twice the level of output (144,000 units), we need to use a
plant twice the size (18,000 square foot)
❖ Build a plant of the proper scale and apply the right proportion of labour
❖ Once the plant is in place, any change in planned output must be achieved by a
change in labour
 Short Run Average Cost Behaviour

Why does Average Total Cost (AC)

Reach its minimum at the
Point where the Marginal Cost
ATC/AC Cur
Curve intersects it? (Short Run)

Cost per unit

Once the MC curve exceeds the
AC curve, AC starts heading
Upwards. P

Min Cost Output

output
Experience Curve

14/02/2016 MBA ZC416 Session 08

 Long Run Average Cost

Long-run average cost is the unit cost of producing a certain output when all inputs, even physical
capital, are variable. The behavioral assumption is that the firm will choose that combination of
inputs that produce the desired quantity at the lowest possible cost. The Long Run Average Cost is
the unit minimum cost of producing a certain quantity of a given item in the long run.
Application
A Burger chain is planning to set up eateries at different locations with differing demands. The firm needs
to decide on the scales of the restaurants they would build at these different locations for minimum unit cost
production.
Scale Decision
Locations Demand (Burger/day) Capacity Load
A 1000
B 2000
C 1500
D 3000
E 500
F 1200

14/02/2016 MBA ZC416 Session 08

Short-run versus Long-Run Cost
 Returns to scale
• Long Term Average Cost (LAC) is the envelope of short term average cost
curves (SAC).
• P represents minimum cost of production. The firm must aim to operate at
this capacity.

un Cost Analysis = Existing production unit

un Cost Analysis 50 beds
90 beds
A 70 beds SAC4
maternity hospital – Short Run Analysis B Q
hould be the capacity of the hospital I build?
P
un costs
Returns to scale
• Returns to scale determine the shape of LAC
• Declining average cost –Constant Average cost-
Increasing average cost

A SAC4
B

Increasing
Constant Return to Scale Decreasing Return to Scale
Return to Scale
 Long Term Marginal Cost Curve
Envelope

It is the curve joining the red dots shown in the diagram below.

14/02/2016 MBA ZC416 Session 08

Three examples of LAC

Traditional U shaped LAC

LAC falls with increasing plant capacity and

stabilizes at Qmin.

LAC falls continuously.

 Business Implications
• Unique Minimum Point (U-shaped curve), High Demand
– Washing Machine Plant with minimum cost production at 10,000 units a year.
– If the total demand is 10,00,000 units, we would have 100 manufacturing
facilities
• Flat bottom Curve
– If min cost production is from 5000 to 10,000 units we would have
manufacturing facilities of different sizes.
• Unique Minimum Point Low Demand
– Minimum cost production is 10,000 units, demand is 7000 units. Monopoly.

14/02/2016 MBA ZC416 Session 08

 Economies of Scale
• Reasons for Economies of Scale
– Better Utilization of Labour, machine and building
– Ability to afford specialized labour, machine and technology
– Price discounts on volume purchase
• Reasons for Diseconomies of Scale
– Lack of sufficient management skill
– Need to hire, train and supervise large labour force.
– Disperse over a large geographical area.
Long-Run average Cost-empirical evidence
❖A sample of 114 firms generating electricity in the US in 1970
❖The LAC is lowest at the output level about 32 billion kilowatt-hours
❖LAC is nearly L-shaped
❖Source: Christensen and H Green (1976), Economies of Scale in US
Power Generation, Journal of Political Economy
Economies of Scope
• Economies of scope are present if it is cheaper for a single
firm to produce various products jointly than for separate
single product firms to produce the products independently
• Sources of economies of scope
– Know-how-Soft drink companies launching multiple flavours
– Demand related – selling a piece of office equipment also offers
installation service
• Emergence of e-commerce and retail outlets
• Economies of scale in distribution
– Taking orders online
– Holding inventories in centralized facilities
– Shipping direct to customers
The Learning Curve
Minimizing Costs Internationally
• There has been a sharp increase in international
trade
• Global nature of industries-highly connected
• Foreign Sourcing of Inputs-a requirement to remain
competitive
• Some real world example
– $625 of the $860 total cost of producing an IBM PC was
outsourced
– Major components going into the production of a Boeing
777 are made abroad
– US firms now spend more than $100 billion on
outsourcing
– By doing so, they are able to cut costs by 10-15%
 Effect of shifts in demand and supply

Shifts in demand:
Demands shifts refer to changes in demand caused by factors other than the price of the good. (The change
caused by the price of the good is referred to as movement along the demand curve). Any of the following factors
or there are combination can cause a demand shift.
1. Change in customer income 2. Change in prices of related goods (substitutes or complements)
3. Change in customer tastes or preferences.

In the following slides we shall study two cases of such shifts and their impact on equilibrium price and quantity
demanded.

14/02/2016 MBA ZC416 Session 08

 Case –I Supply decrease, demand increase.

S1

S S and D represent the original supply and demand curves. A

E1
P1 decrease in supply pushes the supply curve to the
left while an increase in demand shifts the demand curve
Price

P to the right (from D to D1) causing a change in the position

E
Of the equilibrium point from E to E1. Consequently, equilibrium
D1
price rises from OP to OP1 while demand increases marginally
D
From OQ to OQ1.
Q Q1
O Quantity

14/02/2016 MBA ZC416 Session 08

 Case II Supply increase, demand increase

S S1
P E A big increase in supply is accompanied by a relatively lower
P1 E1 Increase in demand as shown in the accompanying diagram.
D1 The supply curve (S) moves by a long distance to the left (to S1) as
shown in the figure while the demand curve moves by a smaller distance
D The equilibrium point shifts from E to E1 leading to a fall in
equilibrium price from OP to OP1. The demand increases from OQ to OQ1.
O Q Q1 X

14/02/2016 MBA ZC416 Session 08

THANK YOU
 Managerial Economics
MBA ZC 416

Sidharth Mishra
BITS Pilani Associate Professor, Management (Off-campus)
Pilani Campus
Email: k.bindumadhavan@pilani.bits-pilani.ac.in
 BITS Pilani
Pilani | Dubai | Goa | Hyderabad

Managerial Economics
Profit Analysis
Topics of Discussion
• Profit Maximization
– Mathematical Understanding
– Numerical Examples
• Shut-Down Point
• Breakeven Analysis
• Incremental Profit Analysis
• Long Term Cost Analysis
Rules for Profit Maximization

Profit
Profit = Total Revenue – Total Costs
maximization
dP/dQ = 0
d(R-C)/dQ = 0 dR/dQ = DC/dQ

total revenue
(TR) and total MR=MC
costs (TC)
 C B
Profit = Revenue - Cost A
MC
5
• Total Profit = Total Revenue – 4.5
$ TC Q
Total Cost 4

3.5
B
• Total profit for small and large 3

2.5
P
TR
P is the point of maximum
profit where the SLOPES
quantity production is 2 A
of the total cost curve and
1.5
negative with two zero 1 the total revenue curve
crossings. 0.5

0
are equal.
Q
• Total profit is maximum when
0 5 10 15 20 25 30 35

1
$
the slopes of both TR and TC 0.5
T A horizontal line has a slo
curves are equal and parallel 0
0 5 A 10 15 20 25 B 30 35
Slope of a vertical line = i
-0.5
Q Two lines whose slopes a

MR = MC -1
Parallel to each other and

-1.5

-2
 Tan A = slope of the curve at point P

Total Revenue (Rs.)

B
P

A Quantity
MR = MC
• Marginal Revenue dR/dQ

◼ Marginal Cost dC/dQ

◼ Marginal Profit dπ/dQ

M = MR − MC
◼Maximum Profit does
not occur at Maximum
Marginal Profit but at
zero.

Y
X
 Revenue, Cost and Profits
5
0.2

4.5 0.1
4 0
3.5 0 5 10 15 20 25 30 35
-0.1
3

2.5
TC -0.2

2 -0.3
1.5 -0.4
1
-0.5
0.5 Marginal Profit
-0.6
0
0 5 10 15 20 25 30 35

1
0.5
0.5
0.4
MC
0
0.3
0 5 10 15 20 25 30 35
0.2 -0.5

-1
Total Profit
0.1

0 -1.5
0 5 10 15 20 25 30 35 MR
-0.1 -2

20/02/2016 MBA ZC416 Session 09

Using Calculus
T = TR − TC
• Maximum Profit occurs when the derivative of T is zero,
dT dTR dTC
= − = MR − MC = 0
dQ dQ dQ

d 2T dMR dMC

2
= − 0
dQ dQ dQ
• and the second derivative is negative.
Profit Maximization: in brief
• Slope of the TR curve is equal to the slope of the TC curve
– Slope of the TR curve = Marginal curve
– Slope of the TC curve = Marginal cost
• When both are equal, slope of the total profit is zero
• This can be stated in another way
– MR-MC = 0 so that MR = MC
• It states that additional revenue generated from a unit of
output must be equal to the additional costs of producing it
 Profit maximization Rule: Example
• Marginal Revenue decreases as quantity (Q) increases.
• Marginal Cost first decreases and then increases in keeping with its hockey stick nature.
• Profit is negative (loss) at lower as well as higher values of Q. It is maximum at Q=35 where Arc MR = Arc MC

Q P TR TC T Arc MR Arc MC Arc M

0 200 0 200 -200
5 190 950 1200 -250 190 200 -10 Representative Calculation
10 180 1800 2050 -250 170 170 0 Arc MR for Q=15 = (TR15 – TR10)/5
15 160 2400 2450 -50 120 80 40 = (2400-1800)/5 =600/5 = 120
20 140 2800 2700 100 80 50 30
Arc MC = (TC15 – TC10)/5 =
25 120 3000 2850 150 40 30 10 (2450-2050)/5 = 400/5 = 80
30 105 3150 2950 200 30 20 10
35 93 3255 3055 200 21 21 0
40 80 3200 3180 20 -11 25 -36
MR-MC Rule: Example
• Marginal revenue from producing another TV set is Rs. 200 and
marginal cost is Rs. 100. in this transaction, the firm will add
Rs. 100 to the profit
• Even if MR is Rs. 175 and MC is Rs. 174, the firm will add Rs. 1
to the total profit
• If the firm produces an additional unit when MR is Rs. 160 and
MC is Rs. 180, then profit will decrease by Rs. 20.
• The condition is that marginal profit is zero, profit is
maximized
 Shutdown point

Business Decisions:

• A firm should shut down operation if the realisable price (per unit) is less than its variable cost (per unit).
• MR < AVC

• A firm may consider continuing with the operation if the realisable price is higher than the variable cost even though
it is not high enough to cover the fixed cost and there is a hope that the price would recover.
MR< AFC+AVC … not a condition for shutting down.
Illustration
Consider a retailer selling 150 mobile phones per month at Rs. 10,000 per piece. He sources the mobile phone
at Rs. 9000 per piece.The fixed cost of his retail shop (shop rent, electricity, stationary, salaries etc.) is Rs. 100,0
What shouldhe do if his competitor suddenly starts selling the same phone at (i) Rs. 8500 per piece (ii) Rs. 950
Business Situation
If the retailer is selling 150 phones per month, his cost can be allocated in the following manner.
Cost of phone = Unit Variable Cost + Fixed Cost / Sales Volume = 9000+100000/150 = Rs. 9667
Unit Profit Made per phone = Rs. 10000 –Rs. 9667 = Rs. 333. Total profit of retailer = Rs. 333* 150 = Rs 50,000
20/02/2016 MBA ZC416 Session 09
 Shutdown Point (contd..)
Business Situation

You can do the same calculation in the following way

Total Revenue = Price* Quantity = 10000*150 = Rs. 15,00,000
Total Variable Cost = 9000*150 = Rs. 13,50,000
Total Contribution = 15,00,000 – 13,50,000 = 1,50,000
Fixed Cost = 100,000
Total Profit = 150,000 – 100,000 = 50,000

What happens if the market price falls to Rs. 9500 due to competition? The retailer might think the price is below his
cost (Rs. 9667) and try to hold on to his old price and see his sales drop to zero. If the sales drops to zero he would
Incur a loss of Rs. 100,000 (the fixed cost of his business). Instead, if he chooses to follow the market, he would set
his price at Rs. 9500, and revisit his old sale of 150 units per month. In which case, he would incur a lesser loss of Rs
25000 (please do the calculation). In due course of time, the market would warm up to the lower price and respond
with higher sales volume. The cost would also readjust to the new situation.

Such periods of transition occur very frequently in the consumer electronics and other businesses.
20/02/2016 MBA ZC416 Session 09
 Solution
(I) Let us say he brings down his price to Rs. 8500 to meet the competitor’s price and as a result is able to sell
x mobile phones in a month.
Total Revenue = 8500x
Total Cost = Variable cost+ Fixed Cost = 9000x+100000
Total Profit = Total Revenue – Total Cost = 8500x – 9000x-100000 = -500x -100,000
The sell of x mobile phones has only made the loss worse. The retailer should stop selling mobile phones and wait
for the prices to go up.

(ii) Let us say he brings down his price to Rs. 9500.

Total Profit = 9500x – 9000x- 100000 = 500x-100000.
The sell of x mobile phones would contribute towards offsetting the fixed costs.
Please note that if x< 200 units, the retailer would still make a loss. But it would make some sense for him to stay
the course if there is hope that the price challenge would blow over.

20/02/2016 MBA ZC416 Session 09

Shut down point
• Example: the fixed costs of a restaurant is Rs. 4000, average price is
Rs. 4, average variable cost Rs. 4.50 for each meal. The total sales
revenue would be Rs. 40,000 if the restaurant sells 10,000 meals
per month. But the total variable cost will be Rs. 45000. What
should the firm do?

• If the firm continues to produce then the loss would be Rs. 9,000

• If the firm does not produce then the loss would only be Rs. 4000
per month (fixed cost)

• Hence, the option for the firm is to shut down its operation
temporarily
Shut down point
• In the short-run
– If the average price of a meal is Rs. 4.60 and average
variable cost is Rs. 4.40 and firm sells 9000 meals, then the
total revenue would be Rs. 41,400, and total cost would be
Rs. 39,600.
– Without considering the fixed cost, the profit would be Rs.
1,800. If fixed cost are included, the loss would be Rs. 2,200.
– In the short-run, the firm would rather continue its
operation as long as it covers variable cost and some part of
fixed costs.
• In the long-run, the firm should try to recover all of its costs, if
it wants to stay in business. (few exceptions to this rule) .
Breakeven Analysis
• Breakeven: relationship among the total revenue, total costs,
and total profits of the firm at various levels of output
• A firm breaks even when TR = TC
• The firm incurs losses at smaller outputs and earns profits at
higher output levels
• Often used by business executives
• Real world examples
– Nano: Took four years to break even with an estimate of 8
lakh units
– Air Asia-(February 2013), Initially, it was expected to break
even by May or June (Original break even was in November
last year) (Source: Live Mint, Air Asia India to break even by
May June, Says CEO, 20th August 2015)
Breakeven Analysis
PROFIT

• Product Cost is U$ 3.60 200 TR

TC
• Product Price is U$ 6.00
P
• Total Fixed Costs are Rs. 150
TVC
60,000/mo.

$(1000's)
Q
◼ Total Variable Cost 100
◼ Total Cost = TFC+TVC = 60000+3.6Q
TFC
60
◼ Total Revenue = 6Q
◼ Break-even point:
50 R
◼ TR = TC, 6Q = 60000+3.6Q, Q=25000
BEP
◼ Break-even point at 25,000 products /
month 0 TR = PriceXQuantity
S
◼ Profit at higher sales volumes grows 0 10 20 30 40
without bound
Q(1000's)
Breakeven - Algebraically
TR = TC
TR = ( P )(Q ) AVC = Average Variable Cost
TC = TFC + ( AVC )(Q )
( P )(QB ) = TFC + ( AVC )(QB ) QB = Quantity at Break Even Point

( P )(QB ) − ( AVC )(QB ) = TFC

(QB )( P − AVC ) = TFC Selling Price = Rs. 10,000
Buying Price = Rs. 9000
TFC
QB = Unit Contribution Margin = Price – Variable Cost = 1
P − AVC
This is different from profit.
Profit = Unit contribution margin*Quantity of Sale –
(P - AVC) is known as the unit contribution margin
Sale = 500 phones in a month
Profit = 1000*500 – 100000 = 500000-100000 = Rs
Breakeven - Algebraically
• Suppose, if a firm wishes to earn a specific
profit and wants to estimate the quantity it
must sell to earn that profit
• Determine the target output (Q) at which a
target profit can be achieved

TFC +  T
QT =
P − AVC
Incremental Profit Analysis
• To determine the effect on total profit that will result
from a particular action, given that the firm is already
generating a certain level of profit (based on its
existing business)
– Open a new territory or business
– Sell on credit
– New technology or Equipment change, etc.
• Identify the relevant costs and revenues for the
various options being considered
• Analyze whether these activities contribute more to
total revenue than to total cost
THANK YOU
 Break Even Analysis-1
• The price of a product is Rs. 100. The variable cost for
manufacturing and marketing the product is Rs. 80. If the fixed
cost involved is Rs. 10 lakh find the break even volume (BEV) in
terms of units. What is break even sales revenue?
• Solution:
100*BEV = 10,00,000 + 80*BEV
hence (100-80)*BEV = 10,00,000
BEV = 10,00,000/20 = 50,000 units.
BEV Sales Revenue = Price* BEV units = 100*50000 = Rs. 50 lakh.
 1588
James Watt
R
V
F’ C’
P

F C

O Q R

20/02/2016 MBA ZC416 Session 09

 Break Even Sales -II
• The variable cost for manufacturing and marketing the product
is Rs. 80. If the fixed cost involved is Rs. 10 lakh and the
production of the factory is limited to 40000 units, find the
minimum price at which the unit can break even?
• Solution:
Let us say the price = p
The minimum price for break even would happen at the maximum
volume of production here which is equal to 40000 units.
P*40000 = 10,00,000+80*40000 = 42,00,000
P = 4200000/40000 = Rs. 105.
 Break Even Sales-III
• A company is planning to launch a gadget in the market. The
company is sourcing the gadget from the china at Rs. 1000 per
piece and does not incur any other variable cost. The only fixed
cost components involved for the company are the costs of sales
force which is Rs. 2 crore (Rs. 20 million) per month and the cost of
advertising. The company has planned an ad campaign costing Rs. 1
crore for the month. Find the Break even sales units if the company
proposes a price of Rs. 1500 per piece for the gadget.
• Solution
1500*BEP = 300,00,000+1000*BEP
BEP = 300,00,000/(1500-1000) = 60,000 units.
 Break Even sales – IV Multiple models
• Let us say the firm in the previous question was sourcing 2 gadgets in place
of 1. The variables costs of Model1 and Model2 are Rs. 1000 and Rs. 1500
respectively. They account for 60% and 40% of total sale and their sale
prices are Rs. 1500 and Rs. 2000 respectively. Find the total combined
volume of sales for the business to break even if the fixed cost is Rs. 3
crore.
• Take weighted averages (WA) for prices and variable costs with weights as
per their sales. And use the standard method for finding break even point.
For the above case, the WA prices and variable costs are
1500*0.6+2000*0.4 = 1700 and 1000*0.6+1500*0.4=1200 respectively.
• 1700*BEP = 1200*BEP+300,00,000
BEP = 300,00,000/ (1700-1200) = 600,000 units.
 Managerial Economics
MBA ZC 416

BITS Pilani Krishna M

Hyderabad Campus Associate Professor
Email: krishna@pilani.bits-pilani.ac.in
 BITS Pilani
Pilani | Dubai | Goa | Hyderabad

Managerial Economics
Perfect Competition and Monopoly
 Topics of Discussion
• Perfect Competition
• Monopoly Market
 Market Structure

1.Perfect Competition
More Competitive

Less Competitive
2.Monopolistic
Competition
3.Oligopoly
4.Monopoly
Perfect competition: Everything
is worth what its purchaser
will pay for it.

~Anonymous
 Cost trends Variable, Marginal and Total Cost
• Marginal cost first reduces with increase in volume (volume discounts) and then increases (law of diminishing margina
• Marginal Cost curve touches the ATC and the AVC curves at their lowest points.

Mathematical proof: (ATC curve rises as MC > ATC)

ATCn+1 = [n*ATCn + MCn+1] / n+1

= [(n+1-1)ATCn + MCn+1] / n+1
= [(n+1) ATCn – ATCn + MCn+1 ]/ n+1
= ATCn + (MCn+1 – ATCn)/ n+1
If MCn+1 > ATCn; ATCn+1 > ATCn
This proves that as MC exceeds ATC, the ATC
Keeps increasing and the ATC curve rises.

Ref: Slide 21, Module 2

6
 Cost and revenue curves
Points to be noted
1. OP1 = ½ OP2. The MR line intersects
the x-axis at a point half way
down the distance where the demand Maximum Total Revenue
Line cuts it.
2. TR is an inverted parabola with its
maximum value at the level of output
where MR = 0. TR = 0 when demand is 0.

Points to be noted
3. Marginal cost curve cuts the ATC line a
O P1 P2 the latter’s lowest point.
4. Profit it maximum at the output level
(Q1) where the MC curve cuts the MR line
Ref: Slide 26, Module 2 5. As a profit maximizing firm seeks to
Equal MC with MR (price), the MC and
the supply curve would be identical.
7
 Industry Supply and Demand

• Total Industry demand

Price of the product ($)

SURPLUS
ΣSi
◼ Total Industry supply

▪ Equilibrium Point Pe
▪ Surplus SHORTAGE ΣDi

Qe
▪ Shortage Quantity sold or bought (units)
 Perfect competition
• Large number of buyers and sellers
• Homogeneity in the products
• Free enterprise
– Any one can enter the market as a buyer or a seller.
• Perfect knowledge
– Buyers and sellers have perfect knowledge about the product.
• Free entry and exit
– Sellers can enter and exit the market without incurring any cost or encountering and barrier.
• Example: Vegetable Vendor, Stock market
• In perfect competition, suppliers can only make “normal” (bare minimum) profit.
Normal profit is that necessary for the firm to be willing to produce its product
over the long run, and is considered a cost of production
Perfect Competition: Stock
market
• The market for stocks traded on the stock exchanges
• The price of a particular stock is determined by the market
forces
• Individual buyers and sellers of the stock have an insignificant
effect
• All stocks within each category are more less homogeneous
• Information on prices and quantities traded is readily available
• Price of a stock-reflects all the publically known information
about the present and expected future profitability of the
stock
• However, the stock market is known to show “erratic
behavior” with wide swings in prices. This happens due to
herding behavior and lack of perfect (forecast) information.
Equilibrium Price and demand level
faced by a perfectly competitive firm
Perfect Competition: Price
Determination

QD = 625 − 5P QD = QS QS = 175 + 5P

625 − 5P = 175 + 5P
450 = 10P
P = $45
QD = 625 − 5P = 625 − 5(45) = 400
QS = 175 + 5P = 175 + 5(45) = 400
Short-run analysis of a perfectly
competitive firm

1. If the profit is high, it would attract more suppliers

which would push the price line down, the cost curve u
and reduce Profits.

1. Cut costs, hope the prices would increase.

2. Exit business.
3. If sufficiently large number of suppliers leave the
market, the price would rise, costs would go down
And profits would improve.
Long-run equilibrium of the
perfectly competitive firm
 Monopoly: the earnings of
many in the hands of one.

~Eugene Debs
 Monopoly

• Single seller and many buyers

• No close substitutes for product
• Significant barriers to resource mobility
– Control of an essential input
– Patents or copyrights
– Economies of scale: Natural monopoly
– Government franchise: Post office
Price and Output Decisions in
Pure Monopoly Markets
Marginal Revenue and Market Demand

Marginal Revenue Facing a Monopolist

(1) (2) (3) (4)
Quantity Price Total Marginal
Revenue Revenue
0 11 0 –
1 10 10 10
2 9 18 8
3 8 24 6
4 7 28 4
5 6 30 2
6 5 30 0
7 4 28 −2
8 3 24 −4
9 2 18 −6
10 1 10 −8
Short-run price and output
determination
Profit = Total Revenue –
total cost A firm would
produce at the level
Maximum profit is where MC = MR
at an output of 5 Q
Quantity produced
units per period
and a price of $6.

At 5 units, TR =
PmAQm0, TC = P
CBQm0, and profit
M D
= PmABC. O
 Long Run Average Cost
• Long Term Average Cost (LAC) is the envelope of short term average cost
curves (SAC).
• P represents minimum cost of production. The firm must aim to operate at
this capacity.

It looks counterintuitive that we would

SAC1, SAC2, SAC3 represent produce at point A when the firm is
the short run costs of firms (factories, A1
designed for a capacity shown by point
SAC4
Hospitals, retail shops etc.) of different A B and hence would operate at the lowe
capacities. C1
Cost at that point.
Capacity of a steel plant is defined in C P Please note that we are at the planning
terms of production ( million tons of steel stage here.
Produced per annum). Capacity of a If we wanted to produce at a quantity
Hospital in in terms of beds (100 bedded corresponding to point B, we are more
Hospital) etc. cost effective by operating at B’.
 Long Run Average Cost (LRAC) Curve

It looks counterintuitive that we would

produce at point A when the firm is
designed for a capacity shown by point B L
and hence would operate at the lowest cost R
at that point. Unit -3
Unit -1
Please note that we are at the planning stage here.
If we wanted to produce at a quantity corresponding to A1
A
point B, we Unit -2
are more cost effective by operating at B’. C1
 Long Run Marginal Cost Curve

No of Beds: 50 beds, 60 beds,

P2 70 beds and so on.
LRAC = Long Run Average (Total) Cost
SRAC = Short Run Average (Total) Cost
LRMC = Long Run Marginal Cost
A2 1. Min Cost occurs at P. Qm
2. 50
A1
P
Av Cost
ost P1
Q

Q’ 70
50
P
No of patients

t Run Average Cost and Marginal Cost of a hospital with a fixed rated capacity (70 beds)
 Long-run price and output
determination

What should be the capacity

of my plant?

F
The Social Costs of Monopoly (Deadweight Loss)
MC reflects the marginal
cost of the resources
needed.

The triangle ABC roughly

measures the net social
gain of moving from
2,000 units to 4,000 units
(or the loss that results
when monopoly
decreases output from
4,000 units to 2,000 Inefficiency and Consumer Loss
units).
 Profit Motive Deadweight Loss

$ 30
A D Monopoly Firm profit maximization
E Mode would have a social cost.

Consumer Surplus, Producer Surplus

N M
4 $ 10 (Price)
Supply Curve

B P
F MR (P) = MC
X $40 , 2000 units
Price K
plus = Buyer Surplus Price = Marginal Revenue
Surplus = CKMA J MR = MC
C
Price = MC
MC = d(TC)/dQ
Surplus = CPB O TC = Integration (MC*dQ)
24 I L (4) G
plus = ABP
 Summary

Points of Comparison Perfect Competition Monopoly

Relationship between AR AR = MR AR > MR
and MR
Profit in the long run Normal profits Supernormal profits
Number of sellers Large Single
Barriers to entry and exit Free entry and exit Strong barriers
Control on Price The seller is only the price Monopolist is the price
taker maker
Nature of demand curve Perfectly elastic Inelastic
Relationship between firm Each firm is a part of the Firm and industry are one
and industry industry and the same
THANK YOU
 Managerial Economics
MBA ZC 416

BITS Pilani Krishna M

Hyderabad Campus Associate Professor
Email: krishna@pilani.bits-pilani.ac.in
 BITS Pilani
Pilani | Dubai | Goa | Hyderabad

Managerial Economics
Monopolistic Competition
Introduction
• A blend of competition and monopoly
• Many sellers of differentiated (similar but not identical) products
– May be real or imaginary (same ingredients)
• Limited monopoly power
• Downward-sloping demand curve
• Increase in market share by competitors causes decrease in
demand for the firm’s product
• Most common in the retail and service sectors
Characteristics of Different Market
Structures
The Monopolistically Competitive Firm in the Short Run

• Each firm faces a downward-sloping demand curve

• The monopolistically competitive firm follows the
monopolist's rule for maximizing profit
– It chooses the output level where MR is equal to MC
– It sets the price using the demand curve to ensure that
consumers will buy the amount produced
• We may compare price and average total cost to decide
whether a firm is making a profit or loss
– If P > ATC , the firm is earning a profit
– If P < ATC , the firm is earning a loss
– If P = ATC , the firm is earning zero economic profit
Price/Output Determination in the Short Run

P
The Monopolistically Competitive Firm in the Long-run

• When firms make profit, new firms have an incentive to enter the market
– This increases the number of products from which consumers can
choose
– Thus, the demand curve faced by each firm shifts to the left

• When firms are incurring losses, firms in the market will have an incentive
to exit
– Consumers will have fewer products from which to choose
– Thus, the demand curve for each firm shifts to the right

• The process of exit and entry continues until firms are earning zero profit

• This means that the demand curve and the average total cost curve are
tangent to each other.
Price/Output Determination in the Long Run

Q’
Q

As new firms enter a monopolistically competitive industry in search of profits, the demand
curves of existing profit-making firms begin to shift to the left, pushing marginal revenue
with them as consumers switch to the new close substitutes.

This process continues until profits are eliminated, which occurs for a firm when its
demand curve is just tangent to its average total cost curve.
 Characteristic of monopolistic competition firms

• Product Differentiation
• Selling and advertising costs
• Excess Capacity
• Unemployment
• Price inefficiency
• Cross Transport

05/03/2016 MBA ZC416 Session 11

Advertising
• The Critique of Advertising
– Manipulate people's tastes
– Advertising reduces competition because it increases the
perception of product differentiation
• The Defence of Advertising
– Firms use advertising to provide information to consumers.
– Advertising increases competition because it allows
consumers to be better informed about all of the firms in
the market.
– Advertising is a complementary good. Advertising increases
the pleasure one gets from purchasing a good
Long-run Equilibrium of the monopolistically competitive firm
with selling expense

B*
Price

Quantity
THANK YOU
 Managerial Economics
MBA ZC 416
BITS Pilani Sidharth Mishra
Hyderabad Campus Associate Professor, Management - Finance
Email: Sidharth.mishra@pilani.bits-pilani.ac.in
 BITS Pilani
Pilani | Dubai | Goa | Hyderabad

Managerial Economics
Oligopoly Part 1
 Agenda
• Oligopoly
• Cournot’s model
• Bertrand’s Model
• Edgeworth Contract Curve
• Cartels
• Porter’s Five Forces

05/03/2016 MBA ZC416 Session 11

What is Oligopoly?

Oligopoly: A form of industry (market)

structure characterized by a few dominant
firms. Products may be homogenous or
differentiated.

They compete with one another not only in

price but also in developing new products,
marketing and advertising those products,
and developing complements to use with the
products.
Oligopoly: Characteristics

• Few sellers of a product

• Non-price competition
• Barriers to entry
• Duopoly: Two sellers
• Pure oligopoly: Homogeneous product
• Differentiated oligopoly: Differentiated
product
Market Structure in an Oligopoly
Five Forces model: A model developed by Michael Porter helps us
understand the five competitive forces that determine the level of competition
and profitability in an industry.
 Cournot Model

• Proposed by Augustin Cournot (more than 160 years ago)

• Interdependence that exists among oligopolistic firms (even though they do not
actually recognize it)
• Behavioral assumption
– Firms maximize profits under the assumption that market rivals will not change
their rates of production.
• Bertrand Model
– Firms assume that their market rivals will not change their prices.
 Cournot Model

• Assumptions
–Two firms (duopoly)
–Identical products (spring water)
–Marginal cost is zero
–Initially Firm A has a monopoly and then Firm B enters
the market
Cournot Model
• Firm A is the only firm in the market
• Point A is the monopoly situation and TR is maximum
• Firm B enters the market and assume that A will
continue to sell six units
• Adjustment process
– Entry by Firm B reduces the demand for Firm A’s product
– Firm A reacts by reducing output, which increases demand
for Firm B’s product
– Firm B reacts by increasing output, which reduces demand
for Firm A’s product
– Firm A then reduces output further
– This continues until equilibrium is attained
 The Cournot Model

Marginal Cost is zero. So the MC line coincides with the quantity

axis (x-axis).

Firm A would initially operate at point A where production (Q) is 6

and price is also 6. This point on the demand curve corresponds
to the point where MR = MC. A represents ½ of full demand. U
Remember that MC=0.

At point A the portion of the market to its left (customers who can
pay upwards of $6) is served. Firm B chooses to cater to the A’
remaining customers. The demand line for him is 6-6 and he
operates at B where his MC=MR. B represents ¼ of full demand
which is half the unserved demand when A was a monopoly. The
unserved demand was 1-1/2 = ½

Firm A would assume that B would stay at the capacity of 3 units

(1/4th fo full demand) and would react by targeting the remaining
3/4th of unserved demand. It would operate at 1/2.*3/4 = 3/8 of
full demand. And so on.

REMEMBER THAT IF THE DEMAND CURVE IS A STRAIGHT LINE, THE MARGINAL REVENUE CURVE IS ALSO
A STRAIGHT LINE THAT CUTS THE QUANTITY AXIS (x-axis) HALFWAY BETWEEN ORIGIN AND DEMAND LINE.
 Action-Reaction of competing firms
Fractions of full demand

Stage Firm A Firm B

Stage1 ½ ¼=1/2(1-1/2)
Stage2 3/8 = ½(1-1/4) 5/16= ½(1-3/8)
Stage3 11/32=1/2(1-5/16) 21/64= ½(1-11/32)

Note that the production of Firm A keeps decreasing while that of B keeps increasing.
The productions of individual firms can be written as an infinite geometrical series which would sum to 1/3.*
In the long run, both firms would produce the same quantity (equal to 1/3 of full demand) and operate at
1/3rd the maximum price (12 in the case given on previous slide).

So 2/3rd of the full market demand would be catered to. And the firms would operate at the price point of 4 which
is lower than the monopoly price point of 6 but higher than the perfect competition price (zero in this case.).
Remember that market price in perfect competition is equal to marginal cost.

*Proof in the appendix

06/03/2016 MBA ZC416
The Cournot Model

• Equilibrium
– Firms are maximizing profits simultaneously
– The market is shared equally among the firms
– Price is above the competitive equilibrium and
below the monopoly equilibrium
– Cournot duopoly outcome of P=4 and Q=8 lies
between the monopoly equilibrium (P=6 and
Q=6) and competitive equilibrium (P=0 and
Q=12)
 Isoprofit

Firm B 60
Firm A affordable pricey
50
sale total 45 Profit = 10
price price cost unit profit sale (litres) total profit price cost unit profit (litres) profit PA
Profit = 800
60 30 10 20 50 1000 60 10 50 20 1000
30
50 35 10 25 40 1000 50 10 40 25 1000
20
40 38 10 28 35.7 1000 45 10 35 28.6 1000

30 40 10 30 33.33 1000 40 10 30 33.33 1000

PB
30 35 60

06/03/2016 MBA ZC416

Bertrand’s and Edgeworth’s
Theories
• Cournot was criticized by several economists
even in his own time, notable among them
being:
– Bertrand: each of the duopolists would assume
that the other’s price would not change (not
quantity); each will cut price to steal customers
until ultimately the price falls to zero
– Edgeworth: based on productive capacity (limited
capacity); in this model price will be cut by one
firm and in reaction the other will increase it
slightly and this will continue ad infinitum
 Bertrand’s Theory Isoprofit
• Iso-profits are constant profit lines of a firm vis-à-vis the prices
of the competing firm.
Iso-profit lines for Firm A Iso-profit lines for Firm B

Prices of Firm B
Prices of Firm B

PA3 Prices of Firm A

Π stands for profit

06/03/2016 MBA ZC416

 Price and Profits in a duo-poly
Iso – profit for Firm A (not for firm B, not for firm A and B)

A’s response to B’s price moves

PB1 π1 Profit of firm A is constant. = 2500

Price of

PB = Rs. 100
firm B

PB2
PB3 PB = Rs. 80
PB4
PB5

PA4 PA1 =50 PA3 PA3 PA2 = 150

Price = Rs. 30 Price of Firm A
Cost = 25 Price = Rs. 50 Price = Rs. 150
Unit profit = 5 Cost = Rs. 25 Cost = Rs. 25
No of cust = 500 Profit = Rs. 25 Profit – Rs. 125
Total Profit = 2500 No of customers = 100, 90,83 No of customers = 20
Price = 55 Total Profit = 125*20 =2500
Profit = 30
 Firm B PB

PB2

PA
Firm A

06/03/2016 MBA ZC416

 Iso-Profits Competition between two firms A and B

Firm B’s prices

PB1 = Rs.1
Iso-profit for Firm A

PA1 PA2
Firm A’s prices

Price of firm B
= Rs. 50 =Rs. 150
• Iso-profit for Firm A would Cost = 25 Rs. 25
Reaction Line Profit = 25
Be convex (bulge towards) Rs. 125
A’ (As Firm B increases price, Firm A would adjust its price along
Firm A’s price axis. PB A
this line)
• The optimal Price (PAO) shifts P’B A1 A1’
to the right as PB increases. PB min Firm B : Rs. 50
PA’ PAO PA’
Cost: Rs. 10
Firm A : Rs. 30, Margin: 20 No of customers
Price of Firm A Firm A: Rs. 60, Margin: 50 No of customers

06/03/2016 MBA ZC416

Bertrand’s Theory

• The Firms A and B would operate at the equilibrium point e with the corresponding prices PAe and Pbe.
• The equilibrium point is at the intersection of the reaction lines of the two firms.
• Any deviation from this price by one competitor would set off a price rivalry pushing the price to the equilibrium point

D
B

A
C

06/03/2016 MBA ZC416

 Edgeworth’s Contract Curve
Firms make sub-optimal choice by assuming that the competitor would not react of price front and operating at e.
They are better off (in terms of individual and joint profit) at point c,f and d (see diagram). At point c, firm B makes the
Same profit as point e while firm A
makes higher profit (follow the
respective isoprofits). At d, the reverse
occurs. At f, both make higher profits than
What they would make at point e

06/03/2016 MBA ZC416

Chamberlin and Duopoly
Theory
• Cournot, Bertrand, and Edgeworth theories are all
based on the assumption of naive behaviour on the
part of the firms.
• Chamberlin argued that the duopolists would
recognize their interdependence and settle on a
price that confirms to the monopolists price and split
the profits between them.
• He stated that an explicit agreement is not required
since the firms would recognize that any other
strategy would lead to worse outcomes.
 Appendix Cournot’s production

Stage 2 production for Firm A = ½(1-1/4) = ½[1-1/2(1-1/2)] = ½- (1/2)2 + (1/2)3 ….

This is an infinite series with initial term (a) ½ and common ratio (r ) (-1/2).

The sum of the series is a/(1-r) = (1/2)/[1-(-1/2)] = (1/2)/(3/2) = 1/3

Infinite geometric series, if the initial number is a, common ratio r, sum is a/1-r. 1

06/03/2016 MBA ZC416

THANK YOU
 Managerial Economics
MBA ZC 416
BITS Pilani Krishnamurthy Bindumadhavan, CFA, FRM
Hyderabad Campus Associate Professor, Management - Finance
Email: k.bindumadhavan@pilani.bits-pilani.ac.in
 BITS Pilani
Pilani | Dubai | Goa | Hyderabad

Managerial Economics
Oligopoly Part 2
Barriers to Entry

• Conditions that make it difficult for new firms to

enter an industry or market where existing firms
have long-run interests
• Examples:
– Entry limit pricing
– Building excess capacity and economies of scale
– Huge Capital requirements
– Product differentiation
– Others
Contestable Markets
• Baumol and others advanced this theory
which focused on entry.
• Contestable markets are markets with few
sellers but characterized by free entry.
• This theory predicts that oligopolies in such
markets will price at perfectly competitive
levels and therefore will be able to enjoy only
normal profits in the long run.
• Heavily criticized
Kinked Demand Curve Model
• Proposed by Paul Sweezy

• If an oligopolist raises price, other firms will not follow, so customers will be
lost

• If an oligopolist lowers price, other firms will follow leading to a price war
and few new customers

• In either case profit is likely to fall and hence it is better to stick to the
prevailing price

• This leads to a “kinked” demand curve that consists of an elastic range for
price increases and a less elastic (or inelastic) range for price decreases

• The “kink” leads to a discontinuity in the MR curve, due to which

oligopolists will be unable to change their price even when marginal costs
change
Tacit collusion and Price
Leadership
• Collusion: Cooperation among firms to restrict
competition in order to increase profits
• Implicit Collusion
• Although collusion is illegal implicit collusion is
difficult to prove
• Price Leader (Barometric Firm)
– Largest, dominant, or most efficient firm in the
industry
– When the leader sets the price , other members of the
group shortly follow suit
Price Leadership: Efficient Firm

• In this example, Firm A is the

efficient firm
• If the firms agree to split the
market equally then demand
curve becomes D’ for each
firm Y
• Firm A will establish the price
X
Pa, which maximizes profit
• Firm B has maximum profit at
Pb but must adjust to Pa else
risk going out of business
Perfect Collusion and
Cartel
• Cartel: A formal organization of producers of
a commodity with an agreement to manage
operations so as to maximize group profits
• Centralized cartel
– Formal agreement among member firms to set
a monopoly price and restrict output
• Market sharing cartel
– Collusion to divide up markets
The Centralized Cartel

The marginal cost curves of the two firms are summed to obtain the sigmaMC curve.
The cartel establishes the price such that sigmaMC = MR and allocates output to each firm at
the quantity where SMC = MR
 Combined Marginal Cost

Firm-1 Firm-2 Combined MC

150

Marginal Cost
Marginal Cost
Marginal Cost

100 100 100

100

Qa Qa1 Quantity Qb Qb1 Quantity Quantity Qa +Qb Qa1 +Qb1

MC1 = a1+b1Q, MC2 = a2 +b2 Q , MCcombined = (b1 b2 )Q / (b1 + b2) + (a1 b2 + a2 b1) / (b1 + b2)
For example
MC1 = 1+2Q and MC2 = 2+3Q, MCcombined = (2*3)Q/(2+3)+ (1*3+2*1)/(2+3) = 6Q/5+ 1

06/03/2016 MBA ZC416

Example: OPEC
• The OPEC –Petroleum exporters
• It was founded in Baghdad, Iraq (1960)
• Aim: increase the petroleum earnings of its members
• The organization has a total of 12 member countries
• Founder members: Islamic Republic of Iran, Iraq, Kuwait, Saudi
Arabia and Venezuela
• Four major problems
– Difficult to organize if there are more than a few producers
– How to allocate output and profits when firms face different cost curves
– There is a strong incentives for each firm to remain outside the cartel or
cheat on the cartel by selling more than its quota at the high prices
resulting from the limited output of the other cartel members
– Monopoly profits are likely to attract other firms into industry and
undermine the cartel agreement
Market Sharing cartel
• Each member firms agree only on how to
share the market.
• Each firm then operates in only one area or
region agreed upon without encroaching on
the others’ territories
• Example: Du Pont (American) and Imperial
Chemical (English) made an agreement in the
early part of this century
Summary

Type of Market Number of Product Rival Barriers Long-Run

Sellers Differentiation Reactions to Entry Profit Greater
Than Normal
Perfect Competition Many None None None No
Monopolistic Many Some None None No
Competition
Oligopoly Few Yes or No Yes Yes Possible
Monopoly One Yes or No No Yes Possible
THANK YOU
 Managerial Economics
MBA ZC 416

Sidharth Mishra
Associate Professor, Management – Off Campus
Email: sidharth.mishra@pilani.bits-pilani.ac.in
BITS Pilani
Pilani Campus
 BITS Pilani
Pilani|Dubai|Goa|Hyderabad

Managerial Economics
Games, Information, and Strategy - Part 1
Agenda

• Introduction to Macro Economics

• National Income Measurement

• Introduction to Game Theory

• Strategy

• Dominant Strategy

• Nash Equilibrium

• First Mover Advantage

• Prisoner’s Dilemma

• Cooperative/ Repeated Games

• Trees and Sequential Games

• Economics of Information

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

 Introduction to Macroeconomics
• Macroeconomics is the study of economic aspects of the
country as a whole. The studies concerning gross domestic
product, national income, government budget, balance of
payment etc. fall under the ambit of macroeconomics.

Microeconomics
 Economic Territory
• An economic territory is a geographic territory administered by a government within
which persons, goods and capital freely circulate.
– Political frontiers including territorial waters and airspaces.
– Embassies, consulates, military bases located abroad but excluding the foreign
ones located within its own political frontiers.
– Etc.
• A Resident is a person or an institution whose centre of economic interest lies in the
economic territory of the country which he lives of is located.
– The resident lives or is located within the economic territory of the country.
(Indian nationals settled in US, Non-Resident Indians)
– The resident carries out the basic economic activities from that location.
 National Income Aggregates
• Domestic Aggregates
– Measures of the value of production activity being carried out by
production units located within the economic territory of the
country.
• Gross Domestic Product (GDP), Net Domestic Product
• National Aggregates
– Measure of the contribution of residents of a country to production
inside and outside the economic territory of the country.
• Gross National Product(GNP), Net National Product
 Gross Domestic Product (GDP)
• GDP at market prices
Gross Domestic Product at market prices is the value of
contribution to production by all the production units located
within the economic territory of a country, undiminished by the
Fertilizer subsidy: low price
consumption of fixed capital and indirect tax and
Rs. 100/kg, without
Rs. 60/kg, Rs. 40/kgadding
Govt.
subsidies. A: 100 carsX 5 lakh = Rs. 5 crore
B : 200 TV X Rs. 50000 = Rs. 1 crore
• GDP at Factor Costs* Rs. 6 crores
GST 10% Car : 5 lakh - !0%* 5 lakh = 450,000*100
– GDPfc = GDPmp – Indirect Taxes (GST) + Subsidies* TV: 50000 + 10000 = 60000 * 200 = 1.
5.7 cro
*Factor Costs: Costs incurred in terms of various factors (land, labour, capital) which have played a part in production and are exclusive of tax)
*Subsidies are a financial advantage granted to an individual, group or institution usually by the Govt.
 Example

Two products. Cars, Fertilizer.

Production : 10,000 cars @ Rs 500,000 per car. 200,000 kg of fertilizer at Rs. 100 per kg.
GDP at market price = 10000 * 500,000 + 200000*100 = 502 Cr. (market prices)

1. GST is applicable only on cars @ 18%, Total GST = 10000*500,000*18% = 90 crore

2. Govt Subsidy on fertilizer is Rs. 20 per kg. Total subsidy = 200,000* 20 = Rs. 0.4 crore

GDP at factor cost = GDP at market price – GST+ Subsidy = 502 cr – 90 cr + 0.4 cr = 412.4 cr.

06/03/2016 MBA ZC416 Session 12

 Net Domestic Product (NDP)
• NDP = GDP – Depreciation (Consumption of fixed capital)
• Depreciation is the fall in the value of fixed capital goods (like
building, machinery etc.) due to normal wear and tear and
obsolescence
• NDPmp = GDPmp – Depreciation (mp is market prices, fc: factor
cost)
• NDPfc = GDPfc – Depreciation = GDPmp – Indirect Taxes (GST) +
Subsidies - Depreciation = NDPmp – Indirect Taxes (GST)+
Subsidies
National Aggregates Gross National Product
• Measure of the contribution of residents to production both
inside and outside the economic territory of the country.
• (Gross/Net) National Product = (Gross/Net) Domestic Product –
Factor income paid to non-residents+ factor income received
from abroad by residents = (Gross/Net) Domestic Product+ Net
Factor income Received from Abroad (NFIA)
GNPmp/fc = GDPmp/fc + NFIA,
NNPmp/fc = NDPmp/fc + NFIA
*Factor income is flow of income derived from factors of production (Land – Rent, Labor – Wage, Capital – Profit)
 Solved Example
• Calculate NDPfc and NNPfc with the following data.
• GNPmp = Rs. 200 crore, NFIA = -4 (minus 4), Depreciation
(Consumption of fixed capital) = 10, GST: 20 crore, Subsidies : 4
crore.
• NDPfc = GDPfc – Depreciation = GDPmp – GST+ Subsidies –
Depreciation = GNPmp – NFIA – GST+ Subsidies – Depreciation =
200-(-4)-(20)+4-10 = 200+4-10-20+4 = Rs. 178 crore
• NNPfc = NDPfc + NFIA = 178+(-4) = Rs. 174 crores
 Real GDP and Nominal GDP
• Nominal GDP (GDP at current prices) of a particular year is
calculated using the current market values of goods.
• Real GDP (GDP at constant prices) is calculated with reference
to the base year. The nominal GDP is divided with a price index
(calculated using the base year prices as reference) to give Real
GDP which removes the influence of inflation from Nominal
GDP.
Real GDP of year 2 = (Nominal GDP of year 2/Price index of year 2)*100
 Per capita real GDP
• Per capita Real GDP = Total Real GDP / Total population
• Per capita real GDP is a measure of the per capita availability of
goods and services to the people of the country
 Per capita GDP and Welfare
• Per capita GDP is a measure of the amount of goods and services made available to
the people of the country. In a materialistic way, a high per capita GDP is considered
to be a good sign.
• However it is not a perfect measure of economic welfare for the following reasons.
– Many goods and services are not included in calculation of GDP.
• Items for self consumption ( a parent teaching a child, a mother or housewife’s inputs)
– Changes in distribution of income may affect welfare
• Inequality of income and consumption.
– All products may not contribute equally to welfare.
• Medicines, Entertainment services
– Some of the products may have negative impact on welfare.
• Tobacco
– Externalities not considered.
Strategy

 A distinguishing characteristic of rivalrous market structures is that

individual firm managers need to take into consideration the
reactions of rival firms before making key decisions relating to
pricing or profitability of the firm.
 This is particularly important in an Oligopoly, since there are only a
few firms in the industry, and the actions of a particular firm can
potentially adversely impact the other firms
 Strategic Behavior: the plan of action or behavior of an oligopolist,
after taking into consideration all possible reactions of its
competitors
 Strategies: changes to product pricing, quantity of product
produced, level of advertising, etc.

Managerial Economics (MBA416)

Game Theory
 Game Theory: the study of decision making in the context of
Oligopoly is known as Game Theory
 Players: decision makers whose behavior we are trying to explain
 Strategy: the choice made by a decision maker by sacrificing other
options
 Payoff: benefit of choosing a particular strategy
 Payoff matrix: analysis of the payoff from various choices

Managerial Economics (MBA416)

Types of games

 Zero-sum games: Gain of one

player is exactly equal to the loss of
the other player

 Nonzero-sum games: gains or

losses of one firm do not come at the
expense of or provide equal benefit to
other firms
Managerial Economics (MBA416)
Dominant strategy - Identification

 We will now discuss the process by which players choose the

optimal strategy that maximizestheirpayoff
 Let us take the example of thesimplest type of game in an
industry
 Letusassumethatthereare twofirms named Firm A and Firm B
 Each firm has a choice of two strategies: to advertise or not
to advertise
 The actual level of profits of firm A depends on whether firm
B advertise sornot and vice versa for Firm B

Managerial Economics (MBA416)

 Game Theory Pay-Off Matrix

• The market size for a product is 1 million units where two firms
are competing with each other. The price of the product is $
20. If firm A launches an ad campaign spending U$ 5 million it
would have a market share of 70% with the remaining staying
with Firm B and vice versa. If both of them spend U$ 1 million,
the market gets equally divided them between them. With
Advertising and not advertising as the strategic alternatives,
draw up the pay-off matrix. The gross margins are 40% and
50% for firms A and B.
 Game Theory Pay-off Matrix
B
Ad No ad
Alternative 1: Both A and B are doing Ads.
(3,4)
A’s case: Business : 500,000 units Ad (4.6, ---)
Revenue = 500,000*20 = U$ 10 Million
Gross Margin @ 40% = U$ 10 Million*40% = U$ 4 Million A
Ad Expense = U$ 1 Million
Net Margin = 4 M – 1M = U$ 3 M
B’s Business = 500,000 units No ad
Revenue = 500,000*20 = U$ 10 Million
Gross Margin@50% = 10 Million*50% = U$ 5 Million
Ad Expense = U$ 1 Million
Net Margin = 5-1 = 4 Million

Alternative 2: A –Ad, B- No Ad
A: 70% Market Share = 700,000 units = U$ 14 M dollar
Gross Margin @ 40% = 14*0,4 = U$ 5.6 M
Ad Expanse = 1 M
Net Margin = 5.6 -1 = 4.6M
Advertising Example 1
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)

What is the optimal strategy for Firm A if Firm B chooses to advertise?

Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)
Managerial Economics (MBA416)
Advertising Example 1
What is the optimal strategy for Firm A if Firm B chooses
to advertise?
If Firm A chooses to advertise, the payoff is 4. Otherwise, the
payoff is 2. The optimal strategy is to advertise.

Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)

Managerial Economics (MBA416)

Advertising Example 1
What is the optimal strategy for Firm A if Firm B chooses
not to advertise?
If Firm A chooses to advertise, the payoff is 5. Otherwise, the
payoff is 3. Again, the optimal strategy is to advertise.
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)

Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)
Managerial Economics (MBA416)
Advertising Example 1
Regardless of what Firm B decides to do, the optimal strategy for Firm
A is to advertise.The dominant strategy for Firm A is toadvertise.

Dominant strategy is a strategic choice that is the best for a given firm
irrespective of the choice made by the rival firm

Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)

Managerial Economics (MBA416)

Advertising Example 1
What is the optimal strategy for Firm B if Firm A chooses to advertise?

Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)

Managerial Economics (MBA416)

Advertising Example 1
What is the optimal strategy for Firm B if Firm A chooses
to advertise?
If Firm B chooses to advertise, the payoff is 3. Otherwise, the
payoff is 1. The optimal strategy is to advertise.

Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)

Managerial Economics (MBA416)

Advertising Example 1
What is the optimal strategy for Firm B if Firm A chooses not to
advertise?

Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)

Managerial Economics (MBA416)

Advertising Example 1
• What is the optimal strategy for Firm B if
Firm A chooses not to advertise?
• If Firm B chooses to advertise, the payoff is 5.
Otherwise, the payoff is 2. Again, the optimal
strategy is to advertise.

Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)
Managerial Economics (MBA416)
Advertising Example 1
Regardless of what Firm A decides to do, the optimal strategy for Firm
B is to advertise.The dominant strategy for Firm B is toadvertise.

Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)

Managerial Economics (MBA416)

Advertising Example 1
The dominant strategy for Firm A is to advertise and the
dominant strategy for Firm B is to advertise. The Nash
equilibrium is for both firms is to advertise.

Nash Equilibrium is a game outcome in which each

player obtains the best possible result given the strategy
of the rival firm.

Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)

Managerial Economics (MBA416)

THANK YOU
 Managerial Economics
MBA ZC 416

Krishnamurthy Bindumadhavan, CFA, FRM

Associate Professor, Management - Finance
Email: k.bindumadhavan@pilani.bits-pilani.ac.in
BITS Pilani
Pilani Campus
 BITS Pilani
Pilani|Dubai|Goa|Hyderabad

Managerial Economics
Games, Information, and Strategy - Part 1
Agenda

• Strategy

• Game Theory

• Dominant Strategy

• Nash Equilibrium

• First Mover Advantage

• Prisoner’s Dilemma

• Cooperative/ Repeated Games

• Trees and Sequential Games

• Economics of Information

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Nash equilibrium

 Not all games have a dominant strategy for each

player
 In the real world, one or both players may not have
a dominant strategy
 In the example that follows, Firm B has a
dominant strategy, but firm A does not have a
dominant strategy
 If at least one of the players has a dominant
strategy then a Nash equilibrium can still occur (as
we will see in this example)
Managerial Economics (MBA416)
Advertising Example 2
What is the optimal strategy for Firm A if Firm B chooses to advertise?

Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (6, 2)

Managerial Economics (MBA416)

Advertising Example 2
What is the optimal strategy for Firm A if Firm B chooses
to advertise?
If Firm A chooses to advertise, the payoff is 4. Otherwise, the
payoff is 2. The optimal strategy is to advertise.

Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (6, 2)

Managerial Economics (MBA416)

Advertising Example 2
What is the optimal strategy for Firm A if Firm B chooses not to
advertise?

Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (6, 2)

Managerial Economics (MBA416)

Advertising Example 2
What is the optimal strategy for Firm A if Firm B chooses
not to
advertise?
If Firm A chooses to advertise, the payoff is 5. Otherwise, the
payoff is 6. In this case, the optimal strategy is not to
advertise.
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (6, 2)

Managerial Economics (MBA416)

Advertising Example 2
The optimal strategy for Firm A depends on which strategy is chosen by
Firms B.
In other words, FirmA does not have a dominant strategy.

Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (6, 2)

Managerial Economics (MBA416)

Advertising Example 2
What is the optimal strategy for Firm B if Firm A chooses to advertise?

Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (6, 2)

Managerial Economics (MBA416)

Advertising Example 2
What is the optimal strategy for Firm B if Firm A chooses
to advertise?
If Firm B chooses to advertise, the payoff is 3. Otherwise, the
payoff is 1. The optimal strategy is to advertise.

Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (6, 2)

Managerial Economics (MBA416)

Advertising Example 2
What is the optimal strategy for Firm B if Firm A chooses not to
advertise?

Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (6, 2)

Managerial Economics (MBA416)

Advertising Example 2
• What is the optimal strategy for Firm B if
Firm A chooses not to advertise?
• If Firm B chooses to advertise, the payoff is 5.
Otherwise, the payoff is 2. Again, the optimal
strategy is to advertise.

Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (6, 2)
Managerial Economics (MBA416)
Advertising Example 2
Regardless of what Firm A decides to do, the optimal strategy for Firm
B is to advertise.The dominant strategy for Firm B is toadvertise.

Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (6, 2)

Managerial Economics (MBA416)

Advertising Example 2

The dominant strategy for Firm B is to advertise. If Firm B

chooses to advertise, then the optimal strategy for Firm A is
to advertise. The Nash equilibrium for both firms is to
advertise.
This example illustrates the use of a iterative dominance
strategy (by firm A) that is arrived at after considering the
possible game outcomes and identifying the dominated rival
strategies.
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (6, 2)
Managerial Economics (MBA416)
First Mover Advantage
In this example (from textbook, page 424) there is more than
one Nash equilibrium.
If play is simultaneous then the results are unpredictable,
however if we assume that one of the firms makes the entry
first then we can indeed predict what the other firm will do
once it is able to observe the action of the rival.
This example illustrates the first mover advantage that
accrues to the player who makes the first strategic choice in a
sequential game.
Firm B
Enter Do not enter
Firm A Enter (7, 7) (10, 8)
Do not enter (8, 10) (7, 7)
Managerial Economics (MBA416)
Prisoners’ Dilemma
Two suspects are arrested for armed robbery.
They are immediately separated.
However, the evidence is not sufficient to convict them of
more than the crime of possessing stolen goods, which
carries a sentence of only 1 year.

Managerial Economics (MBA416)

Cooperative Games
 Situation where decisions are made collectively by two or more
players

 However in most countries antitrust laws prohibit collusion in

decisions relating to pricing, market share, etc.

 But the OPEC cartel is an example of a cooperative game where there

is explicit collusion

Managerial Economics (MBA416)

Repeated Games
 In many business situations games are not one shot games but rather
played over and over again

 This is particularly true in advertising and pricing decisions

 In situations where the game may be repeated over and over again
(infinitely), a form of collusion called “tacit collusion” may
spontaneously occur

Managerial Economics (MBA416)

Repeated Games - Pricing
In this example (from textbook, page 428) the Nash
equilibrium (one shot) is for both firms to charge a low price
However if both agree to charge a High price then they will
make huge profits (this cannot be done explicitly)
However there is an incentive to defect but since the game is
repeated the defector will be penalized in the next period due
to the presence of a credible threat

Firm B
High Price Low Price
Firm A High Price (20, 20) (-20, 60)
Low Price (60, -20) (0, 0)
Managerial Economics (MBA416)
Trees and Sequential Games
 Sequential games are typically analyzed using a decision tree analysis
method

 A decision tree is a diagram that maps out the strategy (or game) in
the form of a tree with decision nodes and branches

 Backward induction is used to identify the optimal decisions by

working backwards through the tree starting from the best outcome
for each player.

Managerial Economics (MBA416)

Economics of Information
 Information is typically neither free nor complete
 Search costs are the economic costs associated with searching,
obtaining and analyzing information before we make a decision
 The tools of marginal analysis can be applied to optimize search costs
 Asymmetric Information is the situation where one party to a
transaction has more information than the other
 Adverse Selection is the situation where the information relating to a
transaction attracts undesirable customers
 Moral Hazard is the phenomenon of engaging in risky behavior by
one party of a transaction to the detriment of the counter party
 Asymmetry and Moral Hazard typically occur when one party has
private information that is relevant but unavailable to the counterparty
 Monitoring Costs are costs incurred to ensure compliance to the
terms of the agreement
 Signaling is an alternative way of communicating otherwise
unobservable information
Managerial Economics (MBA416)
 Joint Product Pricing
• Joint Products that are interdependent in production and one
necessarily results in the production of the other. The product
with higher economic value is called the main product while
the one with lower economic value is called the by-product.
– Steel – Cement
– Rice – Straw (Paddy cultivation)
– Wool-Meat (Sheep rearing)
– The by-product may come in a fixed proportion or a variable
proportion.
06/03/2016 MBA ZC416 Session 12
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