MANAGERIAL

ECONOMICS

Dr. Utpal Chattopadhyay

Associate Professor, NITIE

1
 Introduction: What is
Economics?
Economics is the study of how
people allocate scarce
resources among alternative
uses
Economics studies production,
distribution and consumption of
goods and services
The word originates from
Greek words oikon (house)
and nomos (customs or law),
hence meaning rules of the
house(hold).

2
 Important Economic
Terms

Scarcity: A condition in which

resources are not available to
satisfy all the needs and wants
of a specified group of people
Resources:
Land
Labour
Capital
Entrepreneurship &
management skills

3
 Fundamental Questions
in Economics

What goods and services be

produced and in what quantities?
The product decision

How should these goods and

services be produced?
The hiring, staffing, procurement and capital
budgeting decisions

For whom should these goods and

services be produced?
The Market segmentation decision

4
 Branches of Economics

Microeconomics refers to the analysis

of scarcity and choice problems faced
by a single economic unit e.g. a
producer or a consumer (supply&
demand, pricing of output, production
& cost etc.)
Macroeconomics is study of the
aggregate economy (GDP,
employment, fiscal & monetary policy,
trade among nations etc.)
Positive Vs. Normative Economics
What is vs. what ought to be

5
 What is Managerial
Economics?

Managerial economics is the use of

economic analysis to make business
decisions involving the best use
(allocation) of an organizations
scarce resources

Managerial economics is (mostly)

applied microeconomics (normative
microeconomics)

Managerial Economics deals with

How decisions should be made by
managers to achieve the firms goals -
in particular, how to maximize profit.

6
 Relationship between
Managerial Economics and
Related Disciplines

Management
Decision Problems

Decision
Economic
Sciences
Concepts

Managerial
Economics

Optimal Solutions to Managerial

Decision Problems
7
Management Decision
Problems

Product Price and Output

Make or Buy
Production Technique
Stock Levels
Advertising Media and Intensity
Labour Hiring and Training
Investment and Financing

8
 Goals of a Firm

What is a firm?
A firm is a collection of resources that
is transformed into products
demanded by consumers

Economic Goals:
Maximizing or Satisficing
1. Profit
2. Market share
3. Revenue growth
4. Return on investment
5. Technology
6. Customer satisfaction
7. Shareholder value
9
 Goals of a Firm (contd..)

Non-economic Objectives:
1. A good place for our employees to
work
2. Provide good products/services to
our customers
3. Act as a good citizen in our
society
Is there any conflict between profit
maximization and non-economic
objectives?
No
Satisfied workers tend to be more productive
Satisfied customers tend to be more loyal
Social goals will create good wills and ultimately
potential sales
10
Profit Maximization by
Firms: The Principal-Agent
Problem

Separation of management from

ownership : Firms are owned by
stockholders (principals), but
managed by professionals
(managers, also called agents)
Conflict of interests between owners
and the management may arise
How to tackle?
Tying managers rewards to firms
performance
ESOP

11
 Constraints faced
by Firms

Resource constraints (non-availability

of essential raw materials, paucity of
fund, shortages of skills , insufficient
space etc.)
Legal Constraints (min. wage law,
health & safety standards, pollution
emission norms, business laws like
Competition Act etc.)
Constraints arising out of Govt.
Regulations/Policies (licensing, price
regulation, social welfare e.g.
backward area development,
reservation etc.)

12
Questions that a Manager
Must Answer

Should our firm be in this business?

If so, what price and output levels
achieve our goals?
How can we maintain a competitive
advantage over our competitors?
Cost-leader?
Product Differentiation?
Market Niche?
Outsourcing, alliances, mergers,
acquisitions?
International Dimensions?

13
 Questions that a Manager
Must Answer-Contd..

What are the economic conditions in

a particular market?
Market Structure?
Supply and Demand Conditions?
Technology?
Government Regulations?
International Dimensions?
Future Conditions?
Macroeconomic Factors?

14
 Role of a Manager

Practically in all managerial

decisions the task of the manager is
the same i.e. optimization.

A manager attempts either to

maximize or minimize some objective
function (e.g. maximize profits or
minimize costs), generally subject to
some constraint (e.g shortages of
capital, labour, raw materials etc.).

The optimal decision in managerial

economics is one that brings the firm
closest to its goal

15
Economic Vs. Accounting
Profit

Accounting Profit
Total Revenue- Total Cost
(What is typically reported to the manager by the
firms accounting dept.)
Economic Profit

Total Revenue-Total opportunity Cost

o Opportunity cost of using a resource
includes both the explicit cost of the resource
and the implicit cost of giving up the next-best
alternative use of the resource

16
 Why Economic Profits
exist?

Innovation
Risk
Monopoly Power

17
Managerial Economics-
Basic Principles

Opportunity Cost Principle

Discounting & Compounding
Principle
Marginal or Incremental
Principle
Equi-marginal Principle
Time Perspective Principle

18
 Marginal Analysis

As long as the marginal benefit

of an activity exceeds its
marginal cost, its better to
increase that activity.

The total net benefit is

maximized when marginal
benefit equals marginal cost.

19
Marginal Analysis- contd..

A firm maximizes its profit

when MR = MC
MR= Marginal Revenue
(change in total revenue per
unit change in output or sales)
MC= Marginal Cost (change in
total cost per unit change in
output)

20
 Equi-marginal Principle

A rational decision maker would allocate

resources in such a way that the ratio of
marginal returns and marginal cost of
various uses of a given resource or of
various resources in a given use is the
same

For a consumer to maximize his/her utility

(satisfaction):
MU1/MC1=MU2/MC2=....=MUn/MCn

MU= Marginal Utility (extra utility derived

from consumption of one additional unit
of a good)
MC=Marginal Cost (extra amount spent for
buying one additional unit of a good)

21
 Cetiris Paribus
Assumption

Frequently used in economic

literature
A Latin phrase meaning all
other things being equal
Helps in measuring
relationship between two key
economic variables, keeping
values of all other variables as
constant

22
Demand Analysis

23
 Meaning of Demand

Effective Demand has to fulfill

three basic characteristics

Desire to buy
Willingness to pay
Ability to pay
Demand for a commodity has
always reference to:
A Price
A Period of time
A Place

24
 Types of Demand

Demand for Consumers &

Producers Goods
Demand for Perishable & Durable
Goods
Autonomous & Derived Demand
Individual & Market Demand
Firm & Industry Demand
Short-term & long-term Demand
Domestic & Overseas Demand

25
 Factors affecting
Demand

Price of goods:
o Own Price
o Prices of related products
Prices of substitute goods
Prices of complementary goods

Income of consumers
Consumers tastes & preferences
Future Expectations
o Income
o Price
No. of consumers
Distribution of consumers

26
 Demand Function

A Typical demand function:

Dx= f (Px,Py, I, T,E,C,u)

Dx= Demand for good X

Px= Price of good X
Py= Price of other goods
I= Income
T= Tastes & preferences
E= Future expectations
C= No. of consumers & their distribution
u=residual factors

A simplified version:
Dx= f (Px)
with ceteris paribus assumption

27
 Demand Curve

A Demand curve shows the amount of the

commodity buyers would like to purchase at
different prices. It depends on prices (own
as well as related commodities), income,
tastes and no. of consumers.
D = F (P) with tastes, incomes, prices
of other goods and no. of consumers etc.
Price held constant.

Law of Demand says More (less) will

D
bought at lower (higher) price.
P1

P2 Demand

P3

D
Quantity
Q1 Q2 Q3

28
 Supply Curve

A Supply curve shows the amount of the

commodity sellers would like to offer at
various prices. It depends on product price,
input prices and technology.
S = F (P) with input prices and
technology held constant.

Price S
Supply
P1

P2 Quantity supplied
increases as the
price increases
P3

Quantity
Q1 Q2 Q3

29
 Equilibrium Price

Equilibrium price is that price where the quantity

demanded equals the quantity supplied (market
clearing price). In the short run market price may not
equal equilibrium price. But in the long run market
price approximates the equilibrium price

Price

S
D

Pe Equilibrium Price

S D
Quantity
Qe

30
 Market Mechanism

When market price (Pm1) is above equilibrium price

(Pe) there is Excess Supply (or Surplus). Producers
reduce price. Quantity demanded increases and
quantity supplied decreases. Market continues to
adjust until Pe is reached.

Price When Pm2 < Pe,

S there is Excess
Demand (or
D Excess Supply shortages) in the
Pm1
market. This puts
upward pressure
Pe on price and it
continues to rise
Pm2 till price reaches
to Pe.
Excess Demand D
S
Quantity
Qe

31
 Stability of Equilibrium

Walarasian Vs. Marshallian Stability

Stability of a market based on price adjustment
is called Walrasian Stability, while the one based
on quantity adjustment is called Marshallian
Stability

Price

D S At Q1, demand price

(Pd) exceeds supply
Pd price (Ps). Thus more
of the commodity will
Pe Market Equilibrium be made available in
the market until Q
reaches Qe. This is
Ps Marshallian Stability.

S D
Quantity
Q1 Qe

32
 Change in Demand

Extension/contraction in
demand (movement along a
demand curve)
caused by changes in own
price
Increase/ decrease in demand
(shift in demand curve)
caused by changes in other
determinants of demand

33
 Movement along a
Demand Curve

Impact of change in own

Price price on demand

Dx

P3

P1

P2

Dx

Quantity
D3 D1 D2

Income and Substitution Effects

of a (own) price change

34
 Shifts in Demand Curve

An rightward/upward (leftward/downward)
shift in demand curve results in an increase
(decrease) in equilibrium price.

Factors affecting shifts in

Demand
Price Income
D2 Price of related goods
D1 S
Consumers tastes &
preferences
D3
P2
Expectations
P1
Others (bandwagon effect )
P3
D2
D1
S D3
Quantity
Q3 Q1 Q2

35
 Change in Income &
Demand

For normal (superior) goods, if

income increases demand also
increases

For inferior goods, demand falls

when income increases (why?)

What is a Giffen good?

An inferior good for which a rise in its price makes
people buy even more of that good
This is because for such goods a strong income
effect outweighs the substitution effect of a price
change
Law of Demand does not hold good in case of
Giffen goods (Other exceptions to the Law include:
luxury/ status goods, expectations on future prices
etc.)

36
 Engel Curve

Named after the 19th century German

Statistician Ernst Engel
It shows how the quantity demanded of a
good changes with change in consumers
income level
It states that the lower a familys income, the
greater is the proportion of it spent on food
The conclusion was based on a budget study
of 153 Belgian families
For normal goods, the Engel curve has a
positive slope. That is, as income increases,
the quantity demanded increases. For inferior
goods , the Engel curve has a negative
slope, meaning that as a consumer earns
more income, he/she will be able to buy
better goods and thus stop buying the inferior
goods

37
 Change in Prices of
Related Goods & Demand

For substitute goods, if price of

one good (say X) increases
demand for the other (say Y)
also increases

In case of complementary
goods, if price of one good
(say A) increases demand for
the other (say B) falls

38
 Shifts in Supply

An rightward (leftward) shift in supply curve

results in an decrease (increase) in
equilibrium price.
Factors affecting shifts in
supply
Input Prices
Price Technology
S3
Price of substitutes
D1 S1
Taxes
S2
P3 Market speculation

P1 No. of firms
P2 Others (e.g. weather for
agricultural products)
S3
D1
S1
S2 Quantity
Q3 Q1 Q2

39
 Simultaneous Shifts in
Demand and Supply

A hypothetical case where both

demand and supply shift rightward.

D2
S1
D1 S2

P1
E1
P1 E2
P1

D2
S1
D1
S2
Q1 Q1 Q1 Q2

40
Elasticity of Demand

41
 How price changes affect
Consumers Equilibrium

An increase in price of good X led to a

decrease in consumption of X (and Y).

Good Y

Y1

Y2 I1
I2

X2 X1 Good X

42
 Price Change & Market
Demand

A price rise (from P1 to P2) leads to a decline in

total quantity demanded ( from Q1 to Q2).

How much of demand would decline when price

is raised by say 10%?

Price To quantify this we need to

know Elasticity of Demand
D

E2
P2
E1
P1

Quantity
Q2 Q1

43
 Elasticities of Demand

How responsive is Demand (D) to a

change in Price (P)
E = % change in Quantity Demanded
% change in Price
E is very important for pricing
decisions
Different Types of Elasticities:
1. Price Elasticity
Own Price Elasticity
Cross Price Elasticity
2. Income Elasticity

44
 Own Price Elasticity of
Demand

%QX
d
EQX , PX =
%PX
EQx,Px is Negative according to the
law of demand

Elastic: (sensitive) EQX , PX > 1

Inelastic: (insensitive) EQX , PX < 1
Unitary: EQX , PX = 1
45
 Perfectly Elastic &
Inelastic Demand

Price
Price (E = 0)
D

(E = )

Quantity Quantity

Perfectly Perfectly
Elastic Inelastic

46
 Point & Arc Price
Elasticities of Demand

Point Elasticity is the elasticity

at a given point on the demand
curve. It is measured by:
E= (P/Q)*(Q/ P)
Arc Elasticity is the elasticity
between two points on the
demand curve. It is measured
by:
E=(P2+P1)/2 *(Q/ P)
(Q2+Q1)/2

= (P2+P1) * (Q2-Q1)
(Q2+Q1) (P2-P1)

47
 Price Elasticity at different
points on a Demand Curve

E= (Px/Qx)(Qx/ Px)
Along the dd Qx/ Px= constant.
Price
Thus E >1 if Px > Qx
A(E= ) E = 1 if Px = Qx
d
E < 1 if Px < Qx
E>1
C (E=1)

Px
E<1
B (E=0)
Quantity
Qx d

48
 Cross Price Elasticity of
Demand

%QX
d
EQX , PY =
%PY

When EQx, Py is + ve : X & Y are Substitutes

-ve : X & Y are Complements

49
Price Elasticity, Total &
Marginal Revenue

Total Revenue (TR)= Unit price X

Quantity (no.) sold
TR = P *Q
AR = TR/Q = PQ/Q= P
MR= TR/ Q
Alternatively
MR = d(TR)/dQ=d/dQ(PQ)
=P+Q(dP/dQ)
i.e. MR=P(1+Q * dP)
P dQ
=P(1+1/E)
E= elasticity of demand
=(P/Q)(dQ/dP)

50
 Total & Marginal Revenue
Curves

Price
Demand is price
elastic

Demand is price
inelastic

Quantity

Revenue MR

TR
Quantity

51
 Impact of Price Change
on Total Revenue

MR =P(1+1/E)

If E<-1 ; MR > 0 E=-2 P=4 MR=4(1+1/-2)=2

If E>-1 ; MR < 0 E=-0.5 P=4 MR=4(1+1/-0.5)=-4
If E=-1 ; MR = 0 E=-1 P=4 MR=4(1+1/-1)=0
Elasticity Price change Total Revenue
Elastic (E >1) Rises Falls
-do- Falls Rises
Inelastic (E <1) Rises Rises
-do- Falls Falls
Unitary Elastic Rises/ Falls No change
(E=1)

52
Determinants of Price
Elasticity
Availability of Substitutes
The more substitutes available for the good, the
more elastic the demand.
Product Definition
How the product in question has been defined-
narrowly (jeans) or broadly (cloth)
Time
Demand tends to be more inelastic in the short
term than in the long term.
Time allows consumers to seek out available
substitutes.

Expenditure Share
Goods that comprise a small share of consumers
budgets tend to be more inelastic than goods for
which consumers spend a large portion of their
incomes.
Individual Habits

53
 Income Elasticity

%QX
d
EQX , M =
%M

When EQx,M is + ve : X is a Normal Good

-ve : X is Inferior Good

54
 Price & Income Elasticity
Estimates- A Few Examples

Product/service Price Elasticity Study

Non-cereal Food 0.804 Meenakshi & Ray (1999)
India (urban + rural)

Clothing 0.560 -do-

India (urban + rural)

Electricity, India 0.32 (winter) Filippini &

(urban) 0.39 (monsoon) Pachauri (2002)
0.16 (summer)

High-speed internet 1.08 to 1.79 Kridel, Rappoport &

Access Th. Cable modems Taylor (2000)
US (residential)

Income Elasticity

White Maize 0.15 Rosegrant,

Phillipines Agcaoili- Sombila
& Perez (1995)

Source: Das, Satya P.(2007)

55
 Uses of Elasticities

Pricing
Managing cash flows
Impact of changes in competitors
prices
Impact of economic booms and
recessions
Impact of advertising campaigns

56
Price Elasticity & Pricing
Policy
MR =P(1+1/E)
For profit maximization by a firm
MR =MC
Thus MC =P(1+1/E)
P= MC ( 1 )
(1+1/E)

Optimal price of product depends on its

marginal cost and its price elasticity of
demand. Holding MC constant, price is
inversely related to its price elasticity of
demand.

57
Production and Costs
Analysis

58
 Overview

I. Production Analysis
Total Product, Marginal
Product, Average Product
Isoquants
Isocosts
Cost Minimization
II. Cost Analysis
Total Cost, Variable Cost,
Fixed Costs
Cubic Cost Function
Cost Relations
III. Multi-Product Cost
Functions 59
 Production Analysis

Production Function
Q = F(K,L)
The maximum amount of
output (Q) that can be
produced with a given set of
inputs, say Capital (K) and
Labour (L).
Short-Run vs. Long-Run
Decisions
Fixed vs. Variable Inputs

60
 Production Analysis

Short run is a time period where at least

one factor of production is fixed (e.g. it
takes time to build a production plant).

In the long run, all factors are variable.

Variable factors are the inputs a manager

can adjust to alter production.

The short run production function is

essentially a function of labour, since
capital is fixed.
Q = F(K*,L); K* = Fixed amt. of K

Productivity of Inputs
Total Product
Average Product
61
Marginal Product
 Total Product

Total Product (TP) is max.

level of output that can be
produced with given input
usage .
Example: Q = F(K,L) = 50+4L
Here K is fixed at 50 units.
Production when 100 units of
labor are used?
Q = 50+4 (100) = 450 units

62
 Total Product Curve
(with labour as variable input)

Output

Total Product

63
Labour
 Average & Marginal
Products

Average Product is output

produced per unit of input, e.g.
APL = Q/L.
Marginal Product measures the
output produced by the last
unit of input,
e.g. MPL = Q/L.

64
 Average & Marginal Product
Curves
(with labour as variable input)

Output/unit of
labour

Average Product

Marginal Product

Labour
65
 Law of Diminishing
Marginal Returns
If equal increments of an input
are added with quantities of
other inputs held constant, total
output decreases beyond
some point, i.e. marginal
product of the (variable ) input
diminishes.
Its an empirical generalization
Assumes fixed technology
Assumes that qty. of at least one input is
being held constant

66
 An Illustration

(1) (2) (3) (4) (5) (6)

K L (Var. L TP MPL APL [(4)/
(Fixed Input) [(2)] [ (4)/(2)] (2)]
Input)
2 0 -- 0 -- --
2 1 1 76 76 76
2 2 1 248 172 124
2 3 1 492 244 164

2 4 1 784 292 196

2 5 1 1100 316 220
2 6 1 1416 316 236
2 7 1 1708 292 244
2 8 1 1952 244 244
2 9 1 2124 172 236
2 10 1 2200 76 220
2 11 1 2156 -44 196

67
 Different Production Functions

Linear Production Function

assumes perfect linear relationship
between all inputs and total output.
Q = F(K, L)= a K+b L
Leontief Production Function
assumes that inputs are used in
fixed proportions: Q = F(K, L)= Min.
(bK, cL)
Cobb-Douglas Production Function
some degree of substitutability
between the inputs: Q = F(K, L)= Ka
Lb

68
Marginal Product for Linear & Cobb-
Douglas Production Functions

For a liner function: Q= a K+b L

MPK= Q/ K=a; MPL= Q/ L=b

For Cobb-Douglas Production: Q = Ka Lb

MPK= aKa-1 Lb; MPL=bKaLb-1

For a linear production function, MP of an

input is independent of the qty. of input is
used in production, implying non-
compliance of the Law of Diminishing
Marginal Product

69
 Three Stages of
Production

TP, AP & MP
Increasing Diminishing Negative
Marginal Marginal Marginal
Returns Returns Returns

TP

APL
70
L
MPL
 Isoquant

The combinations of inputs

(K, L) that yield the producer
the same level of output.
The shape of an isoquant
reflects the ease with which
a producer can substitute
among inputs while
maintaining the same level L
of output.

71
 Properties of an Isoquant
Capital

Q3>Q2>Q1

Q3
Q2
Q1
Labour

They are falling

Higher isoquants represent
higher levels of output
They dont intersect with each
other
They are convex from below
72
 Linear Isoquants

Capital and
labor are
perfect
substitutes K
Increasing
Output

Q Q2 Q3
L
1

73
 Leontief Isoquants

Q
Capital and K
Q
labor are perfect 3

Q 2
complements Increasi
1 ng
Capital and Output
labor are used
in fixed-
proportions

74
 Cobb-Douglas
Isoquants
Inputs are not
perfectly K
Q
substitutable 3
Increasing
Diminishing Q
Output
2
marginal rate of Q
technical 1

substitution
Most
production
processes have
isoquants of
this shape
L

75
 Isocost
K

The combinations Equation: wL + rK =C

of inputs that cost w = wage rate

the producer the r= rental rate

same amount of
money C C1
0 L
For given input
prices, isocosts K
farther from the New Isocost
Line for a
origin are decrease in the
associated with wage (price of
higher costs. labor).

Changes in input
prices change the
slope of the L
isocost line
76
 Cost Minimization

Marginal product per rupee spent

should be equal for all inputs i.e.:

MPL/w = MPK/r
Stated differently, for cost
minimization a firm should employ
inputs such that marginal rate of
technical substitution is equal to
ratio of input prices; i.e.

MRTS=MPL/MPK =w /r

77
 Least-Cost Input
Combinations

Point of Cost
Minimization
Slope of
Isocost
=
F
Slope of
Isoquant

KE
E
D

L
LE

78
Input Substitution

K
l

f
When wage rate increases, a
more capital-intensive mode
C2
K2 of production will be adopted
to minimize cost

K1 C1

g
L2 L1h l`
L

79
Optimal Input combinations
with a given Cost

KE
E

Q3
D Q2
Q1
L
LE

80
 Production decisions over
time

OE is the Expansion Path : It is the locus of

the least-cost input combinations for various
K
output levels.

Economic Region
R1
E

R2

Q4
Q3
Q2
Q1

L
C1 C2 C3 C4
O 81
 How Output responds
to change in scale ?
In the long run all inputs are
variable

Suppose the firm increases the

amount of all inputs by same
proportion, what would happen
to output?

To measure this we need to

know a concept called Returns
to Scale

82
 Returns to Scale

Returns to scale is the degree by which

output changes as a result of a given
change in all inputs
The production function:
Q = F(K,L)
Now both inputs increased by b times and
as a result output increases by times,
then
Q = F( bK, bL)

Then if > b : Increasing returns to scale

< b : Decreasing returns to scale
= b : Constant returns to scale

Returns to scale can be measured by

Output Elasticity, which is defined as the
percentage change in output resulting
from a one percent increase in all inputs
83
 Cost Analysis

Types of Costs
Fixed costs (FC)
Variable costs (VC)
Total costs (TC)
Sunk costs

84
 Different Types of Costs

Fixed Cost (FC): C

Costs that do not
change as output C(Q) = VC + FC
changes

Variable Cost (VC): VC(Q)

Costs that vary with
output

Sunk Cost: A cost

that is forever lost
after it has been paid FC

Total Cost: C(Q)

=VC+FC Q
85
 Average & Marginal Costs
Average Total
Cost
ATC = AVC +
C
AFC
MC ATC
ATC = C(Q)/Q
AVC
Average Variable
Cost
AVC =
VC(Q)/Q

Average Fixed
Cost
AFC = FC/Q
AFC

Marginal Cost
MC = C/Q Q
86
 Fixed Cost

Q0(ATC-AVC) MC
C
= Q0 AFC ATC

= Q0(FC/ Q0) AVC

= FC

ATC
AFC Fixed Cost
AVC

Q0 Q

87
 Variable Cost

Q0AVC MC
C
= Q0[VC(Q0)/ ATC
Q0]
AVC
= VC(Q0)

AVC
Variable Cost

Q0 Q

88
 Total Cost

Q0ATC MC
C
ATC
= Q0[C(Q0)/ Q0]

= C(Q0) AVC

ATC

Total Cost

Q0 Q

89
 An Example

Total Cost: C(Q) = 60 + Q +2Q2

Fixed Costs : FC = 60
Variable cost function:
VC(Q) = Q + 2Q2
Variable cost of producing 10 units:
VC(10) = 10 + 2(10)2 = 210
Total costs of producing 10 units :
TC= FC +VC= 60+210=270
Marginal cost function:
MC(Q) = 1 + 4Q
Marginal cost of producing 10 units:
MC(10) = 1 + 4(10) = 41

90
 Long Run Costs
C
LRAC
ATC1

C2
ATC0

C1
ATC2
C`2
C0

C`1

Q
Q0 Q1 Q2
LRAC defines the min. average cost of producing alternative levels
of output, allowing for optimal selection of both fixed and variable
91
inputs.
 Economies of Scale

A firm reaps economies of scale when

C its long run total cost increases less than
proportionately with increase in output
or when its LRAC falls as output is
expanded.
LRAC

Economies Diseconomies
of Scale of Scale

Output

92
Sources of Scale Economies

Due to large plant

Specialization
Indivisibility
Productivity/ price
Equipment maintenance

Due to large firm

Quantity discounts
Funds raising
Sales promotion
Innovation
Management

93
 Multi-Product Cost
Function

C(Q1, Q2): Cost of producing

two outputs jointly
Q1 = No. of units produced of
Product 1
Q2 = No. of units produced of
Product 2
Cost depends on how much of
each product is produced

94
 Economies of Scope

C(Q1, Q2) < C(Q1, 0) + C(0, Q2)

It is cheaper to produce the
two outputs jointly instead of
separately.

95
 Cost Complementarity

The marginal cost of producing

product 1 declines as more of
product 2 is produced:
MC1/Q2 < 0.

96
 Multi-Product Cost Function

C(Q1, Q2) = f + aQ1Q2 + Q1 2 + Q2 2

MC1(Q1, Q2) = aQ2 + 2Q1
MC2(Q1, Q2) = aQ1 + 2Q2
Cost complementarity: a<0
Economies of scope: If C(Q1, 0)
+C(0 ,Q2) > C(Q1, Q2)

C(Q1 ,0) + C(0, Q2 ) = f + Q1 2 + f + Q22

C(Q1, Q2) = f + aQ1Q2 + Q1 2 + Q2 2

Thus economies of scope are

realized when f > aQ1Q2

97
 A Numerical Example

C(Q1, Q2) = 90 - 2Q1Q2 + (Q1 )2 +

(Q2 )2
Cost Complementarity?
Yes, since a = -2 < 0
MC1(Q1, Q2) = -2Q2 +
2Q1
Economies of Scope?
Yes, since 90 > -2Q1Q2

Implications for Merger?

98
Break-Even Analysis

99
 The Concept

Break-even analysis examines the

cost tradeoffs associated with
demand volume.

Its a process of finding the Break-

even (B-E) Point.

A B-E point is one where total

revenue equals total cost (both
fixed & variable).

100
 How B-E Point could be
Derived?

Three Alternative Approaches:

Mathematical Equation
Contribution Margin
Cost-Volume-Profit (C-V-P) Graph
It can be expressed by
Sales (Physical) Units
Sales (Rupee) Value

101
 Mathematical Equation

Sales Revenue = Variable cost + Fixed cost+ Net

income

Example:
Fixed Costs: Rs. 2,000
Variable costs: Rs. 3/ unit
Selling Price: Rs. 5/ unit

If Q is no. of units sold:

Sales (value)= Rs. 5Q
Variable cost= Rs. 3Q

At B-E point: Net income =0, thus

5Q=3Q+2000+0
5Q-3Q= 2000
Q= 1000 units

B-E sales value (in Rs.) =Rs. 5*1000

= Rs. 5000

102
 Contribution Margin
Technique

At B-E point contribution

margin (CM) must equal total
fixed costs
CM is amount of revenue
remaining after covering
variable costs : CM=Total
Revenues- Variable Costs
B-E point can be computed by
CM per unit (in units)
CM Ratio (in rupees)

103
 B-E in Units

B-E Point=Fixed Costs/ CM

per unit
CM per unit=(Selling Price
Variable Costs per unit)
Example: Fixed Costs: Rs. 15,000
Variable costs: Rs. 3/
unit
Selling Price: Rs. 6/
unit
B-E Point=(15000)/(6-3)=5000
units

104
 B-E in Rupees

B-E Point=Fixed Costs/ CM Ratio

CM Ratio= (Sales ValueVariable
Costs)/ Sales Value
Example: Fixed Costs: Rs. 3,000
Variable costs: Rs. 6,000
Sales: Rs. 10,000
CM Ratio =(10000-
6000)/10000
= 0.40

B-E Point=(3000)/(0.40)= Rs. 7500

105
 The C-V-P Approach

Its a graphical approach- most

frequently used by managers
It depicts costs, volumes and
profits together in a single
graph
B-E point is determined at the
intersection of the total cost
line and the total revenue line

106
 The B-E Chart

Sales
Revenue/
Cost
Total
Revenue
Profit Area
Total Cost

B-E
Point
Variable
(Rs)
Cost

Fixed Cost
Loss
Area

B-E Point Sales

(Units) (Units)

107
 Break-even Analysis
Simplified

When total revenue is equal to

total cost the process is at the
break-even point.

TC = TR

108
 Uses of B-E Analysis

Determine safety margin

Achieve target profit
Decide price changes
Guard against cost increases
Capacity expansion
Make or buy decisions
Product promotion strategies
Equipment selection
Improving profit margins

109
 B-E & Product Prices

Total revenue (TR) is determined by

price charged and quantity sold

The lower (higher) the price, less

(more) steep is the total revenue
curve
If the firm chooses to set higher
price for its product, the TR curve
would be steeper & they would not
have to sell as many units to break
even
If the firm chooses to set a lower
price, it would need to sell more units
before covering its costs

110
 Effect of Price Changes

Revenue/ TR
Cost P1>Po & P2 < Po
p1
TRP0
TR
p2

TC

FC

Q1 Q0 Q2 Quantity

111
 Important to
Remember

A higher price or lower price

does not mean that break even
will never be reached!
The B-E point depends on the
number of sales needed to
generate revenue to cover
costs the B-E chart is NOT
time related!

112
 B-E and Pricing Strategies

Penetration pricing high

volume, low price more
sales to break even
Market Skimming high price
low volumes fewer sales to
break even

But the likely impact on sales

depend on price elasticity of
demand

113
Importance of Price Elasticity of
Demand

Higher prices might mean

fewer sales to break-even but
those sales may take a longer
time to achieve.
Lower prices might encourage
more customers but higher
volume needed before
sufficient revenue generated to
break-even

114
 Limitations of B-E
Analysis
Data availability
Static in nature
Linear relationships (cost &
revenue curves)
Not effective for long range
planning
Ignores impact of other factors
e.g. technology, managerial
skills etc. on profitability

115
 Conclusion

Break-even analysis is easy to

understand.

It can be an effective tool in

determining the cost effectiveness
of a product.

Helpful for profit planning.

Can be used as a comparison tool

for making various managerial
decisions.

116
 Market Structure:
Perfect Competition &
Monopoly

117
 Market Structure

Four types of market:

Perfect Competition
Monopoly
Monopolistic Competition
Oligopoly

118
 Market Structure

Basis of market categorization

No. of sellers
A firms control over its
product price
Product differentiation
(identical or different)
Barriers to entry
Extent of non-price
competition (e.g. advertising)

119
 Characteristics of Market
Types

Number
Power of Barrie
Market of Type of Non-price
Examples firm over rs to
structure producer product competition
price entry
s

Parts of
Perfect agriculture
Standardize
competitio are Many None Low None
d
n reasonably
close
Monopolis
Advertising
tic Differentiat
Retail trade Many Some Low and product
competitio ed
differentiation
n

Standardize
Advertising
Computers, d or
Oligopoly Few Some High and product
oil, steel differentiate
differentiation
d

Public Unique Consider- Very

Monopoly One Advertising
utilities product able high

120
 Perfect Competition-
Basic Features
Large number of buyers and
sellers, each acting
independently
No buyer or seller is so large that
it can influence price
Homogeneous product
No barriers to entry or exit
No artificial restraint on prices
Perfect information
Profit maximizing firms
Perfect mobility of factors of
production
121
 Market Demand &
Supply
A perfectly competitive firm is a price
taker; the price is determined by the
intersection of the market demand and
supply curves

Price

S
D

Pe

S D
Quantity
Qe

122
 Individual demand
curve
Each seller is a price taker it can sell
any quantity it likes at the prevailing
price; but it sells none at prices above
this (market price). The demand curve
facing an individual firm is horizontal
(infinitely elastic)
Price

P
Demand

Quantity

123
 Price-Output Decisions:
Short Run
Since price is determined by the market and no
individual seller can influence it, the only decision
to be taken by the firm is how much to produce
and sell that would maximize his profit

Costs of production may be different for different

firms

In short run, some inputs are fixed

Goal of the firm is profit maximization

Profit is maximized at a point where MR= MC

For a perfectly competitive firm marginal revenue

(MR) is equal to its product price (P). Thus at profit
maximizing output:
P=MR=MC i.e. price equals marginal costs

124
 Perfect Competition:
Short Run Analysis

Price
MC

ATC

E
P*
Profit d=MR
C
D

Q* Quantity

125
 Perfect Competition:
Loss making Firm

Price ATC
MC

D
C
Loss E
P*
d=MR

Q* Quantity

126
 Perfect Competition:
Shut down Point

Price ATC
MC

D
C
Loss E d=MR
P*
AVC

H If price <AVC
better to shut
down

Q* Quantity
127
 Perfect Competition:
Long Run Analysis
In the long run
All inputs and costs of production are variable
and the firm can construct the optimum or
most appropriate scale of plant to produce the
best level of output.

Some new firms enter the industry and a

few existing firms leave the industry
leading to shifts the market supply curve to
the right (new firms enter) or to the left
(existing firms leave). This changes market
equilibrium.

All firms produce at the lowest point on

their long run av. cost curve (LRAC). Thus
long run equilibrium is found at a point
where
P=MR=MC=LRAC

128
 Long Run Equilibrium

In a perfectly competitive market, in the

long run equilibrium firms earn only normal
profit.
Price LRAC
MC

d=MR
P*

Q* Quantity
129
 Monopoly

Single seller and many

buyers
No close substitutes for
product
Significant barriers to entry

130
 Why Monopolies Arise

The fundamental cause of monopoly

is barriers to entry, that arises from
three sources:
Ownership of a key resource.
The government gives a single firm
the exclusive right to produce
some good.
Costs of production make a single
producer more efficient than a
large number of producers

Although exclusive ownership of a key

resource is a potential source of
monopoly, in practice monopolies
rarely arise for this reason.

131
 Why Monopolies Arise-
contd..

Governments may restrict

entry by giving a single firm the
exclusive right to sell a
particular good in certain
markets.

Patent and copyright laws

are two important examples
of how government creates
a monopoly to serve the
public interest.

132
 Natural Monopoly

An industry is a natural
monopoly when a single firm
can supply a good or service
to an entire market at a
smaller cost than could two or
more firms.
A natural monopoly arises
when there are economies
of scale over the relevant
range of output.

133
Figure: Economies of Scale as a
Cause of Monopoly

Cost

Average
total
cost

0 Quantity of Output
134
 Production and Pricing
Decisions under Monopoly

Monopoly
Is the sole producer
Faces a downward-sloping
demand curve
Is a price maker
Reduces price to increase
sales

135
A Monopolys Marginal
Revenue

A monopolists marginal revenue is

always less than the price of its good.
The demand curve is downward sloping.
When a monopoly drops the price to sell
one more unit, the revenue received from
previously sold units also decreases.

When a monopoly increases the amount it

sells, it has two effects on total revenue (P
Q).
The output effectmore output is sold,
so Q is higher.
The price effectprice falls, so P is
lower.

136
 Figure :Demand and Marginal-
Revenue Curves for a Monopoly

Price

10
9
8
7
6
5
4
3
Demand
2 Marginal
(average
1 revenue
revenue)
0
Quantity
1 1 2 3 4 5 6 7 8
2
3
4
137
Profit maximization by a
Monopolist

A monopoly maximizes profit

by producing the quantity at
which marginal revenue
equals marginal cost, i.e.
MR=MC.

It then uses the demand curve

to find the price that will
induce consumers to buy that
quantity.

138
 Figure :Profit Maximization for a
Monopoly

Costs and
2.and then the demand
Revenue 1. The intersection of the
curve shows the price
marginal-revenue curve
consistent with this quantity.
and the marginal-cost
curve determines the
profit-maximizing
B
Monopoly quantity . . .
price

Average total cost

Demand
Marginal
cost

Marginal revenue

0 Q QMAX Q 139
Quantity
 Figure : The Monopolists Profit

Costs and
Revenue

Marginal cost

MonopolyE B
price

Monopoly Average total cost

profit

Average
D C
total
cost
Demand

Marginal revenue

0 QMAX Quantity
140
A Monopolists Profits

The monopolist will receive

economic profits as long as
price is greater than average
total cost.

141
Comparing Monopoly
with Competition

Monopoly
Is the sole producer
Faces a downward-sloping
demand curve
Is a price maker
Reduces price to increase
sales
Competitive Firm
Is one of many producers
Faces a horizontal demand
curve
Is a price taker
Sells as much or as little at
same price
142
 Comparing Monopoly
with Competition

In contrast to a competitive firm, the

monopoly charges a price above the
marginal cost.
For a competitive firm, price equals marginal cost:
P = MR = MC
For a monopoly firm, price exceeds marginal cost: P
> MR = MC

From the standpoint of consumers,

this high price makes monopoly
undesirable.
However, from the standpoint of the
owners of the firm, the high price
makes monopoly very attractive.

143
 Price Discrimination

Price discrimination is the business

practice of selling the same good at different
prices to different customers, even though the
costs for producing for the two customers are
the same.
Price discrimination is not possible
when a good is sold in a competitive
market since there are many firms all
selling at the market price. In order to price
discriminate, the firm must have some
market power.
Examples:
Movie tickets
Airline prices
Discount coupons
Telecom tariffs
Quantity discounts

144
 A Discriminating
Monopolist
A Monopolist may charge different
prices to different customers for the
same product
Price discrimination can be
practiced in different degrees, such
as:

First degree price discrimination

Second degree price discrimination
Third degree price discrimination

145
 Price Discrimination-
various degrees

First degree (also called perfect price

discrimination): The monopolist charges
different price for each unit of his good;
highest price for the first unit and reducing
price for successive units

Second degree: The monopolist sets block

prices, under which price is the highest for
the first block of qty. bought and it is reduced
for successive blocks (e.g. electricity pricing)

Third degree: Different prices charged for the

same homogeneous good from different
customers depending upon various factors
like geographical locations, product use,
purchase time, customer profile (age, sex
etc).

146
 Welfare Aspects :
Monopoly Vs. Competition

Competition:
Efficient in Production - incentive
to produce at lowest possible cost
Efficiency in Allocation - right
amount of good is produced since
MC to produce equals marginal
willingness to pay equals price

147
Social Welfare under
Perfect Competition

Social surplus= Consumer

surplus + Producer surplus

148
 Inefficiency of Monopoly

Because a monopolist sets its price above

marginal cost, it places a wedge between the
consumers willingness to pay and the producers
cost. This wedge causes the quantity sold to
fall short of the social optimum.

The monopolist produces less than the

socially efficient quantity of output.

The deadweight loss caused by a monopolist is

similar to the deadweight loss caused by a tax.
The difference between the two cases is that the
government gets the revenue from a tax,
whereas a private firm gets the monopoly profit.

149
Figure : The Inefficiency of Monopoly

Price
D

Deadweight
loss

F
PM

EM EC LAC=LMC
PC

Demand

MR

0 QM QC Quantity

150
 Public Policy Toward
Monopolies

Government responds to the problem of

monopoly in one of four ways.
Making monopolized industries more
competitive.
Regulating the behavior of monopolies.
Turning some private monopolies into
public enterprises.
Doing nothing at all.

Important Antitrust Laws in

India
MRTP Act (1969)
Competition Act (2002)

151
MONOPOLISTIC
COMPETITION &
OLIGOPOLY

152
 Monopolistic
Competition

Many firms
Differentiated products (products are
close substitutes to each other, yet
somewhat different)
Producers have some control over
their price, but it is usually small
Demand curve not completely flat
A firm expects its actions to go
unheeded by its rivals and
unimpeded by possible retaliatory
moves on their part (because there
are so many firms)
Easy entry and exit
Examples: shirts, candy bars,
restaurants

153
 Behavior of
Monopolistically
Competitive firms

Firms producing similar products can

be organized under a product group
The demand curve facing each firm
slopes downward to the right
If a firm raises (lowers) its price it may
lose (gain) some but not all its
(competitors) customers
The firm seeks profit maximization
Marketing is important: firms want to
make their product unique, (advertising
plays an important role)

154
 Price Determination

For profit maximization, a firm sets its

price where
marginal revenue = marginal cost
Profits arise
This attrcts new firms (producing
similar products) into the market
Each firm competes for a percentage
of total demand, new entry means
demand for the individual firm must be
lower (shifts left/down)
Shift must be so far, that profits
disappear
Demand curve must finally be
tangential to long-run average cost
curve

155
Short-run equilibrium

156
 Long-run
equilibrium
Due to market
entry demand
shifted to the left
for the firm

Zero profit
condition met
(Revenue=Costs
)

Profit-
maximization
condition met
(MC=MR)

Problem:
production is not
cost-efficient
Long-run
average costs
not at minimum
157
cost of product
variety
 Perfect Competition Vs.
Monopolistic Competition

PC: price equal to long-run marginal

cost, in MonC price is always higher
as marginal cost
PC produces at minimum of long-run
average cost, MonC not at the
minimum

Trade-Off between efficiency (cost)

and variety
Long-run profit situation is alike,
because of entry.

158
 Summary-Monopolistic
Competition

Very common market form

No interaction between firms
Firm could reduce average cost by
producing more
Firms try to bind their costumers to the
firm:
Marketing, advertising plays a role
(not in perfect competition)
Make the product different from the
crowd

159
 Oligopoly

Few sellers of a product

(mutual interdependence)
Duopoly: Two sellers
Nonprice competition
Barriers to entry (entry is possible,
but not easy)
Pure oligopoly:
Homogeneous product
(cement, steel, aluminum etc.)
Differentiated oligopoly:
Differentiated product
(automobiles, cigarettes, soaps,
detergents, pharmaceuticals etc.)

160
 Sources of Oligopoly

Economies of scale
Large capital investment
required
Patented production
processes
Brand loyalty
Control of a raw material or
resource
Government franchise
Limit pricing (existing firms charge
price low enough to discourage entry into
the industry) 161
Measures of Oligopoly

Concentration Ratios (it

measures the degree by which an industry
is dominated by a few large firms)
4, 8, or 12 largest firms in an
industry
Herfindahl Index (H)
H = Sum of the squared
market shares of all firms in an
industry
Theory of Contestable
Markets
If entry is absolutely free and
exit is entirely costless then
firms will operate as if they are
perfectly competitive
162
 Price-Output Determination in
Oligopoly

Interdependence among firms

Actions of a firm affect the fortune of its rivals
directly, immediately, adversely and to a
significant extent
Interdependence is not limited to pricing alone,
but it acts in terms of rivals advertisement
budgets, quality & style of the rivals products
etc.

No general theory of price

determination, but many models.
Popular among these are:

Collusion Model (cartel)

Cournot Model
Bertrand Model
Stackelberg Model (Price Leadership)
Sweezy Model (Kinked demand curve)

163
 Perfect Collusion
(Cartel)

All firms in an industry voluntarily decide

to follow a common method of pricing
Example: The Organization of Petroleum Exporting
Countries (OPEC) for petroleum pricing
There will be one market demand
function (AR, MR) and many cost
functions (MCs)
The profit maximizing output and price
would be found at the intersection of the
MR curve and combined MC (CMC)
curve
The industry output would then be
distributed among the participating firms
Profits earned may not be same for all
firms
Perfect collusion has the obvious
advantage of avoiding price wars among
firms, but there always remains a threat
of breaking the cartel
164
 Perfect Collusion
(Cartel)

Firm Firm
Pric CMC MC1 II
e I MC2
ATC1

ATC2

P
* Profit

A
R

M
R
165

Q Q1 Q2 Quan
 Cournot Model

Proposed by French
Economist Augustin Cournot in
early 19th century
Behavioral assumption
Each firm decides how much to
produce and assumes that its
rival will not alter their level of
production in response
Total output of both firms equals
industry output

166
 Cournot Model

Example
Two firms (duopoly)
Identical products
Marginal cost is zero
Initially Firm A has a monopoly
and then Firm B enters the
market

167
 Cournot Model-
Adjustment process

Entry by Firm B reduces the

demand for Firm As product
Firm A reacts by reducing
output, which increases
demand for Firm Bs product
Firm B reacts by increasing
output, which reduces demand
for Firm As product
Firm A then reduces output
further
This continues until equilibrium
is attained

168
169
 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

170
 Bertrand Model

Cournots constant-output
assumption was criticized by
French mathematician &
economist Joseph Bertrand in
1881
Bertrand argued that each firm
sets the price of its product to
maximize profits and ignores
the price charged by its rivals

171
 Price Leadership

Tacit Collusion
Price Leader (Barometric Firm)
Largest, dominant, or lowest cost firm in
the industry
The price leader initiates a price change
and other firms follow it
The dominant firm sets the product price
that maximizes its total profits, allows all
other firms (followers) in the industry to
sell all they want at that price and then it
comes in to fill the market
Followers
Take market price as given and behave
as perfect competitors

172
Kinked Demand Curve Model

Proposed by Paul Sweezy

If an oligopolist raises price,
other firms will not follow, so
demand will be elastic
If an oligopolist lowers price,
other firms will follow, so demand
will be inelastic
Implication is that demand curve
will be kinked, MR will have a
discontinuity, and oligopolists will
not change price when marginal
cost changes
173
174
 Global Oligopolists

Impetus toward globalization

Advances in telecommunications
and transportation
Globalization of tastes
Reduction of barriers to
international trade

175
Worlds Largest Auto Producers
(2012)
12.00

10.10

9.28
10.00 9.25

7.12
8.00

5.59
6.00
4.88
4.11

4.00
2.87

2.00

0.00

Figures indicate no. of vehicles produced in million

Source: OICA (2014)

 Oligopoly - Game
Theory

Prisoner's Dilemma - Two

suspected criminals A and B are
arrested and put in separate cells
unable to communicate. If one
confesses while the other does
not, the one who confesses is
granted immunity and goes free
and the other goes to jail for 20
years. If both confess they both
go to jail for 5 years. If both are
silent, both go to jail for only one
year, for a lesser crime
(concealed weapons). The payoff
matrix looks like this:

177
 Oligopoly - Game
Theory

Mr. A Mr. B

Confesses Remains
Silent
Confesses [-5,-5] [0,-20]

Remains [-20,0] [-1,-1]

Silent

Whatever A does, B is better off

confessing. Whatever B does, A is better
off confessing. They are both better off if
they both remain silent.

178
 Duopolist's Dilemma

Firm A Firm B

Cut Price (Rs. Fix Price (Rs.

12) 18)
Cut Price (Rs. [720,720] [1440,0]
12)
Fix Price (Rs. [0, 1440] [810,810]
18)

Dominant Strategy is to cut price but

both firms are better off by fixing prices.

179
 Books

1) Salvatore, Dominick, Managerial

Economics Principles and Wold wide
Applications, Oxford University Press
2) Gupta, G.S., Managerial Economics,
Tata Mc Graw-Hill.
3) Allen WB, Dohetry N, Keith W and
Mansfield E, Managerial Economics
-Theory, Applications and Cases,
W.W. Norton & Co.
4) Baye, Michael R., Managerial
Economics and Business Strategy,
The McGraw-Hill Companies Inc.

180