MAGECO – Prelim • Situation: You are able to open a pizza shop in

a building that you own. During the year Uncle

Chapter 1 - The Fundamentals of Managerial Vinnie offers you a job with his pizza shop (he
Economics wants to eliminate the competition) which will
pay $30,000 and Aunt Judy offers you
The Manager $100,000 to rent the building for a year for her
• A person who directs resources to achieve a new hair salon. You decide to continue with
stated goal. your pizza shop. At the end of the year you
– Directs the efforts of others. calculate the following on your income
– Purchases inputs used in the statement.
production of the firm’s output. – Revenue = $100,000
– Directs the product price or quality – Cost of Supplies = $20,000
decisions. • Did you make a good decision???
Economics
• The science of making decisions in the Did you???
presence of scarce resources.
– Resources are anything used to • Accounting profit
produce a good or service, or achieve a – 100,000 - 20,000 = 80,000
goal. – Looks like you did!!!
– Decisions are important because – Economic profit
scarcity implies trade-offs. – 100,000 – 20,000 – 30,000 – 100,000 =
-$50,000
Managerial Economics – You could have done better by taking
• The study of how to direct scarce resources in them up on their offers
the way that most efficiently achieves a
managerial goal. Recognize the Nature and Importance of Profits
– Should a firm purchase components – • The role of profits
like disk drives and chips – from other – Profits are a signal to resource holders
manufacturers or produce them within where resources are most highly
the firm? valued by society.
– Should the firm specialize in making
one type of computer or produce Five Forces and Industry Profitability
several different types?
– How many computers should the firm
produce, and at what price should you
sell them?

Economics of Effective Management

• Basic principles comprising effective
management:
– Identify goals and constraints
– Recognize the nature and importance
of profits
– Understand incentives
– Understand markets
– Recognize the time value of money
– Use marginal analysis Understand Incentives
• Changes in profits provide an incentive to how
Identify Goals and Constraints resource holders use their resources.
• Well-defined goals • Within a firm, incentives impact how resources
• Firm’s overall goal is to maximize profits are used and how hard workers work.
• Constraints make it difficult to achieve goals – One role of a manager is to construct
– Available technology incentives to induce maximal effort
– Prices of inputs used in production from employees.

Recognize the Nature and Importance of Profits Understand Markets

• Accounting profit • Two sides to every market transaction: buyer
– Total amount of money taken in from and seller
sales (total revenue) minus the dollar • Bargaining position of consumers and
cost of producing goods or services. producers is limited by three rivalries in
• Economic profit economic transactions:
– The difference between total revenue – Consumer-producer rivalry
and cost opportunity cost. – Consumer-consumer rivalry
– Opportunity cost – Producer-producer rivalry
• The explicit cost of a resource • Government and the market
plus the implicit cost of giving
up its best alternative. Market Interactions
Why use opportunity cost?
 • Consumer-Producer Rivalry • The present value of the income stream
– Consumers attempt to locate low generated by a project minus the current cost
prices, while producers attempt to of the project:
charge high prices. FV 1 FV 2 FV n
• Consumer-Consumer Rivalry NPV = 1
+ 2
+ …+ −C 0
– Scarcity of goods reduces the (1+i ) ( 1+i ) ( 1+i )n
negotiating power of consumers as
they compete for the right to those Present Value of Indefinitely Lived Assets
goods. • Present value of decisions that indefinitely
• Out-bid or under-bid generate cash flows:
• Producer-Producer Rivalry CF 1 CF 2 CF 3
– Scarcity of consumers causes PV Asset =CF 0 + 1
+ 2
+ +…
producers to compete with one another ( 1+i ) ( 1+ i ) (1+i )3
for the right to service customers. • Present value of this perpetual income stream
• Better customer service, higher when the same cash flow is generated
quality, perks…
• The Role of Government
(CF ¿ ¿1=CF 2=…=CF)¿:
– Disciplines the market process. CF
– Firms “tell on each other” to try to get
PV Perpetuity =
i
the government to intervene
Examples of Assets with Perpetual Stream of
Recognize the Time Value of Money Identical Cash flows
• Often a gap exists between the time when
costs are borne and benefits received. 1. perpetual bonds and
– Managers can use present value 2. preferred stocks.
analysis to properly account for the Each of these assets pay the owner a fixed amount at
timing of receipts and expenditures. the end of each period, indefinitely.
In order to make decisions in the future you A perpetual bond pays the owner $100 at the end of
need to know what the future holds…. each year with the interest rate is fixed at 5%. Solve
Is a dollar today worth the same as a dollar in three for Present Value of the perpetual bond.
years??
PV perpetual bond = CF
= $100
= $2,000
i .05
Present Value Analysis 1
• Present value of a single future value
– The amount that would have to be Present Value and Profit Maximization
invested today at the prevailing
interest rate to generate the given • Profit maximization
future value: – Maximizing profits means maximizing
FV the value of the firm, which is the
PV = present value of current and future
( 1+i )n ¿ profits.
¿
* The present value (PV) of future value (FV) received FUTURE VALUE
n years in the future, where i is the rate of interest
– Present value reflects the difference
FV= I x ( 1+ i )n
between the future value and the FV= Future Value
opportunity cost of waiting: I= Investment
i= interest
PV =FV −OCW n= term
Present Value Analysis II
• Present value of a stream of future values Use Marginal Analysis
FV 1 FV 2 FV n • How can the manager maximize net benefits?
PV = + + …+ • Use marginal analysis
( 1+i )1 (1+i )2 ( 1+ i )n – Marginal benefit: MB ( Q )
or,
n • The change in total benefits
FV t
PV =∑ arising from a change in the
managerial control variable, Q .
t =1 ( 1+i )t
– Marginal cost: MC ( Q )
• The change in the total costs
arising from a change in the
managerial control variable, Q .

Net Present Value

– MNB ( Q )
Marginal net benefits:
MNB ( Q )=MB (Q )−MC (Q )
Use Marginal Analysis
• Marginal principle
– To maximize net benefits, the manager
should increase the managerial control
variable up to the point where marginal
benefits equal marginal costs. This
level of the managerial control variable
corresponds to the level at which
marginal net benefits are zero; nothing
more can be gained by further changes
in that variable.

Determining the Optimal Level of a Control

Variable : The Discrete Case
In the context of a production decision, Q may be the
number of gallons of soft drink produced. The manager
must decide how many gallons of soft drink to produce
(0,1, 2, and so on), but cannot choose to produce
fractional units (for example, one pint). Column 2 of
Table 1–1 provides hypothetical data for total benefits;
column3 gives hypothetical data for total costs.
Suppose the objective of the manager is to maximize
the net benefits which represent the premium of total
benefits over total costs of using Q units of the
managerial control variable, Q.

Incremental Decisions
• Incremental revenues
– The additional revenues that stem from
a yes-or-no decision.
• Incremental costs
– The additional costs that stem from a
yes-or-no decision.
• “Thumbs up” decision
– MB> MC .
• “Thumbs down” decision
– MB< MC .
Learning Managerial Economics
• Practice, practice, practice …
• Learn terminology
– Break down complex issues into
manageable components.
– Helps economics practitioners
communicate efficiently.

Chapter 2 - Market Forces: Demand and Supply

Demand
 • Market demand curve – Inferior good
– Illustrates the relationship between the • Prices of related goods
total quantity and price per unit of a – Substitute goods
good all consumers are willing and able – Complement goods
to purchase, holding other variables • Advertising and consumer tastes
constant. – Informative advertising
• Law of demand – Persuasive advertising
– The quantity of a good consumers are • Population
willing and able to purchase increases • Consumer expectations
(decreases) as the price falls (rises). • Other factors
– Price and quantity demanded are
inversely related. Advertising and the Demand for Clothing

Market Demand Curve

Shift in Quantity Demanded versus a Shift in The Demand Function

Demand • The demand function for good X is a
• Changing only price leads to changes in mathematical representation describing how
quantity many units will be purchased at different prices
• demanded. for X, the price of a related good Y, income and
– This type of change is graphically other factors that affect the demand for good
represented by a movement along a X.
given demand curve, holding other
factors that impact demand constant. The Linear Demand Function
• Changing factors other than price lead to A linear demand function is a mathematical
changes in demand. representation of the relationship between the quantity
– These types of changes are graphically demanded of a good or service and its price, typically
represented by a shift of the entire expressed in the form of a linear equation. It usually
demand curve. takes the following form:
Qd = a - bP
Changes in Demand
Where:
( Qd ) = Quantity demanded
( P ) = Price of the good or service
( a ) = Intercept (the quantity demanded when the
price is zero)
( b ) = Slope of the demand function (indicating how
much the quantity demanded changes with a change
in price
The linear demand function assumes a constant rate of
change in quantity demanded for every unit change in
price, which simplifies analysis in economics.

Demand Shifters Linear demand function with income

• Income
– Normal good The inclusion of income in the demand function
allows for a better understanding of how changes in
consumer income levels affect the quantity demanded • The supply function for good X is a
of a good. This is particularly useful for analyzing mathematical representation describing how
demand for normal goods (where demand increases as many units will be produced at alternative
income increases) and inferior goods (where demand prices for X, alternative input prices W, and
decreases as income increases). alternative values of other variables that affect
Qd = a - bP + cI the supply for good X.

Supply The Linear Supply Function

• Market supply curve A linear supply function is a mathematical
– A curve indicating the total quantity of representation of the relationship between the quantity
a good that all producers in a of a good that producers are willing to supply and the
competitive market would produce at price of that good. It typically takes the form:
each price, holding input prices, Qs= c + dP
technology, and other variables
affecting supply constant. where:
• Law of supply - \( Qs\) is the quantity supplied,
– As the price of a good rises (falls), the - \( P \) is the price of the good,
quantity supplied of the good rises - \( c \) is the intercept (the quantity supplied when the
(falls), holding other factors affecting price is zero),
supply constant. - \( d \) is the slope of the supply curve (indicating how
much the quantity supplied changes with a change in
Changes in Quantity Supplied versus Changes in price).
Supply
• Changing only price leads to changes in Producer Surplus
quantity supplied. • Producer surplus: the amount producers
– This type of change is graphically receive in excess of the amount necessary to
represented by a movement along a induce them to produce the good.
given supply curve, holding other
factors that impact supply constant. Consumer Surplus
• Changing factors other than price lead to Marketing strategies – like value pricing and price
changes in supply. discrimination – rely on understanding consumer value
– These types of changes are graphically for products.
represented by a shift of the entire – Total consumer value is the sum of
supply curve. the maximum amount a consumer is
willing to pay at different quantities.
Changes in Supply – Total expenditure is the per-unit
market price times the number of units
consumed.
– Consumer surplus is the extra value
that consumers derive from a good but
do not pay extra for.

Market Equilibrium
• Competitive Market Equilibrium
– Determined by the intersection of the
market demand and market supply
curves.
– A price and quantity such that there is
no shortage or surplus in the market.
– Forces that drive market demand and
market supply are balanced, and there
is no pressure on prices or quantities to
change.
Supply Shifters
– The equilibrium price is the price that
• Input prices
equates quantity demanded with
• Technology or government regulation
quantity supplied
• Number of firms
– Entry
– Exit
• Substitutes in production
• Taxes
– Excise tax: a tax on each unit of
Market Equilibrium
output sold, where tax revenue is
collected from the supplier
– Ad valorem tax: percentage tax
• Producer expectations

The Supply Function

 Comparative Statics

• Comparative static analysis

– The study of the movement from one
equilibrium to another.
• Competitive markets, operating free of price
restraints, will be analyzed when:
– Demand changes
– Supply changes
– Demand and supply simultaneously
Market Equilibrium in Action change

• Consider a market with demand and supply

functions, respectively, as
d s
Q =10−2 P and Q =2+2 P
• A competitive market equilibrium exists at a
price, P
e
Qd ( P e ) =Qs ( Pe ). That is,
, such that
10−2 P=2+2 P
8=4 P
e
P =$ 2
Qe =10−2 ( $ 2 ) =6 and Q =2+2( $ 2)=¿6
e

e
Q =6 units
Price Restrictions and Market Equilibrium
• In a competitive market equilibrium, price and
quantity freely adjust to the forces of demand
and supply.
• Sometime government restricts how much
prices are permitted to rise or fall.
– Price ceiling
– Price floor

Price Ceiling in Action

• Consider a market with demand and supply
functions, respectively, as
d s
Q =10−2 P and Q =2+2 P
• Suppose a $1.50 price ceiling is imposed on
the market.
– Q d =10−2 ( $ 1.50 )=7 units.
s
– Q =2+2($ 1.50)=5 units.
– Since Q d > Q s a shortage of 7−5=2
units exists.

Price Floor in Action

• Consider a market with demand and supply
functions, respectively, as
d s
Q =10−2 P and Q =2+2 P
• Suppose a $3.50 price floor is imposed on the
market.
– Q d =10−2 ( $ 3.50 )=3 units
s
– Q =2+2( $ 3.50)=9 units
– Since Q s >Q d a surplus of 9−3=6
units exists
 Chapter 3 - Quantitative Demand Analysis

Elasticity
– Measures the responsiveness of a
percentage change in one variable
resulting from a percentage change in
another variable.
• You measure the percent change in
• quantity demanded when price changes

How do I measure a percent change in quantity?

You take the difference between the two

quantities and divide by the original number
For example, if there is an increase from 3 units to 5
units, what is the percentage increase? Why is the demand curve for oil more inelastic?
The percent increase is 67%  oil is a necessity
How do I know this? The difference between  oil has few substitutes
the two numbers is 2 and the original number is 3 Why is the demand curve for ice cream more elastic?
So …  Ice cream is a luxury
2/3 = .67%  ice cream has many substitutes
If there is a decrease from 5 units to 3 unit, what is the Measure the price elasticity of demand for a
percent decrease? good:
2/5 = .40
Price elasticity of demand is the percentage change in
quantity demanded divided by the percentage change
How to calculate price elasticity of demand in price

change in quantity demanded

sum of quantities/2
___________________________________
change in price
Examples: If UNO-R raises tuition, what happens sum of prices/2
to total revenue?

 If demand is elastic - revenue goes down

 If demand is inelastic - revenue goes up

When price increases what two things happen?

 more money is made per unit
 fewer units are sold
Remember that;
I. When price increases and there is a net loss in
revenue, the demand curve is price elastic, >
1
II. When price increases and there is a net gain in
revenue, the demand curve is price inelastic,
<1
What do inelastic demand curves look like: What is the Price Elasticity of Demand for bananas?
Inelastic demand curves are more vertical than
elastic
demand curves
Total Revenue Test
• When demand is elastic:
– A price increase (decrease) leads to a Cross-Price Elasticity
decrease (increase) in total revenue. • Cross-price elasticity is important for firms
• When demand is inelastic: selling multiple products.
– A price increase (decrease) leads to an – Price changes for one product impact
increase (decrease) in total revenue. demand for other products.
• When demand is unitary elastic: • Assessing the overall change in revenue from a
– Total revenue is maximized. price change for one good when a firm sells
two goods is:
Extreme Elasticities
[
∆ R= R X ( 1+ EQ X
d
, PX ) + RY E Q Y
d
, PX ] ×% ∆ P X

Cross-Price Elasticity in Action

• Suppose a restaurant earns $4,000 per week in
revenues from hamburger sales (X) and $2,000
per week from soda sales (Y). If the own price
elasticity for burgers is EQ X , PX =−1.5 and the
cross-price elasticity of demand between sodas
and hamburgers is EQ Y ,P X =−4.0, what would
happen to the firm’s total revenues if it
reduced the price of hamburgers by 1 percent?
∆ R=[ $ 4,000 ( 1−1.5 )+ $ 2,000 (−4.0 ) ] (−1% )=$ 100
– That is, lowering the price of
Factors Affecting the Own Price Elasticity hamburgers 1 percent increases total
revenue by $100.
• Three factors can impact the own price elasticity of
demand:
– Availability of consumption substitutes. Income Elasticity
– Time/Duration of purchase horizon. • Income elasticity
– Expenditure share of consumers’ budgets. – Measures responsiveness of a percent
change in demand for good X due to a
Cross-Price Elasticity percent change in income.
d
% ΔQX
• Cross-price elasticity EQ , M = d

– Measures responsiveness of a percent

X
%ΔM
change in demand for good X due to a – If EQ , M >0 , then X is a normal good.
d

percent change in the price of good Y. X

d – If EQ , M <0 , then X is an inferior good.

% ΔQX
d
X

EQ d
, PY
=
X
% Δ PY Income Elasticity in Action
– If EQ d >0 , then X and Y are • Suppose that the income elasticity of demand
, PY
X for transportation is estimated to be 1.80. If
substitutes. income is projected to decrease by 15 percent,
– If EQ d
, PY
<0 , then X and Y are • What is the impact on the demand for
X

complements. transportation?
d
% ΔQX
1.8=
Cross-Price Elasticity in Action −15
• Suppose it is estimated that the cross-price – Demand for transportation will decline
elasticity of demand between clothing and food by 27 percent.
is -0.18. If the price of food is projected to • Is transportation a normal or inferior good?
increase by 10 percent, by how much will – Since demand decreases as income
demand for clothing change? declines, transportation is a normal
d good.
% ∆ Q Clothing d
−0.18= ⇒ % ∆ Q Clothing =−1.8 Other Elasticities
10
– That is, demand for clothing is • Own advertising elasticity of demand for good
expected to decline by 1.8 percent X is the ratio of the percentage change in the
when the price of food increases 10 consumption of X to the percentage change in
percent. advertising spent on X.
• Cross-advertising elasticity between goods X
and Y would measure the percentage change in
the consumption of X that results from a 1
percent change in advertising toward Y.
 d d
EQ =β R =3. So, E % ∆ QX % ∆ QX
d
,R QX
d
,R
= ⇒ 3= .
X
%∆R 10
A 10 percent increase in rainfall will lead to a 30
percent increase in the demand for raincoats.
Elasticities for Linear Demand Functions
• From a linear demand function, we can easily
compute various elasticities. Regression Analysis
• Given a linear demand function: • How does one obtain information on the
d
Q X =α 0 +α X P X + α Y P Y + α M M +α H PH demand function?
– Published studies.
PX – Hire consultant.
– Own price elasticity: α X d. – Statistical technique called regression
QX analysis using data on quantity, price,
PY income and other important variables.
– Cross price elasticity: α Y d.
QX Regression Line and Least Squares Regression
M • True (or population) regression model
– Income elasticity: α M d. Y =a+bX + e
QX
– a unknown population intercept
Elasticities for Linear Demand Functions In parameter.
Action – b unknown population slope parameter.
• The daily demand for Invigorated PED shoes is – e random error term with mean zero
estimated to be
d
and standard deviation σ.
Q X =100−3 P X + 4 PY −0.01 M + 2 P A X
• Least squares regression line
Suppose good X sells at $25 a pair, good Y sells at $35, Y = a^ + b^ X
the company utilizes 50 units of advertising, and
average consumer income is $20,000. Calculate the
– a^ least squares estimate of the
own price, cross-price and income elasticities of unknown parameter a.
demand. – b^ least squares estimate of the
– unknown parameterb .
d
Q X =100−3 ( $ 25 ) +4 ( $ 35 )−0.01 ( $ 20,000 )+ 2 ( 50 )=65
• The parameter estimates a^ and b^ , represent
units. the values of a and b that result in the smallest
25 sum of squared errors between a line and the
– Own price elasticity: −3 =−1.15.
65 actual data.
35
– Cross-price elasticity: 4 =2.15. Excel and Least Squares Estimates
65
– Income elasticity:
20,000
−0.01 =−3.08.
65
Elasticities for Nonlinear Demand Functions
• One non-linear demand function is the log-
linear demand function:
d
ln Q X = β0 + β X ln P X + β Y ln PY + β M ln M + β H ln H
– Own price elasticity: β X .
– Cross price elasticity: β Y .
– Income elasticity: β M .

Elasticities for Nonlinear Demand Functions Evaluating Statistical Significance

In Action • Standard error
• An analyst for a major apparel company – Measure of how much each estimated
estimates that the demand for its raincoats is estimate varies in regressions based on
given by the same true demand model using
d
ln Q X =10−1.2 ln P X +3 ln R❑−2 ln A Y different data.
• Confidence interval rule of thumb
where R denotes the daily amount of rainfall and AY
the level of advertising on good Y. What would be the – a^ ± 2 σ a^
impact on demand of a 10 percent increase in the daily – b^ ± 2 σ b^
amount of rainfall?
• t-statistics rule of thumb
 – When |t |>2, we are 95 percent • Lower p-values are associated
confident the true parameter is in the with better overall regression
regression is not zero. fit.

Excel and Least Squares Estimates Excel and Least Squares Estimates

Regression for Nonlinear Functions

and Multiple Regression
• Regression techniques can also be applied to
the following settings:
– Nonlinear functional relationships:
• Nonlinear regression example:
Evaluating Overall Regression Line Fit: R- Square
• R-Square ln Q=β0 + β p ln P+e
– Also called the coefficient of determination. – Functional relationships with multiple
– Fraction of the total variation in the variables:
dependent variable that is explained by the • Multiple regression example:
d
regression. Q X =α 0 +α X P X + α M M + α H P H + e
2 Explained Variation SS Regression or
R= = d
Total Variation SSTotal ln Q X = β0 + β X ln P X + β M ln M + β H ln P H +e
– Ranges between 0 and 1.
• Values closer to 1 indicate “better” Excel and Least Squares Estimates
fit.

Evaluating Overall Regression Line Fit:

Adjusted R-Square

• Adjusted R-Square
– A version of the R-Square that penalize
researchers for having few degrees of
freedom.
n−1
R =1−( 1−R )
2 2
n−k
– n is total observations.
– k is the number of estimated coefficients.
– n−k is the degrees of freedom for the
regression. • Elasticities are tools you can use to
quantify the impact of changes in prices,
income, and advertising on sales and
Evaluating Overall Regression Line Fit: F- revenues.
Statistic • Given market or survey data, regression
• A measure of the total variation explained by analysis can be used to estimate:
the regression relative to the total unexplained – Demand functions.
variation. – Elasticities.
– The greater the F-statistic, the better – A host of other things, including
the overall regression fit. cost functions.
– Equivalently, the P-value is another • Managers can quantify the impact of
measure of the F-statistic. changes in prices, income, advertising,
etc.