Managerial Economics Semester of Notes
Managerial Economics Semester of Notes B ECON 300
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BECON3OO Notes 112 Ch6 Elasticity and Demand Price elasticity of demand E the percentage change in quantity demanded divided by the percentage change in price E is always a negative number because P and Q are inversely related Elastic segment of demand for which Egt1 Inelastic segment of demand for which Elt1 Unitary elastic segment of demand for which El Total Revenue TR the total amount paid to producers for a good or service Price effect the effect on total revenue of changing price holding output constant Quantity effect the effect on total revenue of changing output holding price constant To determine the direction of movement in TR information about the relative strengths of the price effect and output effect must be known TR always moves in the same direction as the variable P or Q having the domiant effect If demand is elastic percentage change in Q gt P Quantity effect always dominates the price effect when demand is elastic Demand Inelastic price effect dominates the quantity effect Demand Unitary elastic neither the price effect nor the quantity effect dominates You can only say that a demand curve is elastic or inelastic over a particular price range 3 factors that make the demand for some products more elastic than the demand for other products 1 availability of substitutes by far the most important determinant of price elasticity of demand a the better the substitutes for a given goodservice the more elastic the demand for that good service b rather elastic fruit corporate jets and life insurance c rather inelastic wheat salt and gasoline the definition of the market for a good greatly affects the number of substitutes and thus the good s price elasticity of demand 2 the percentage of the consumer s budget that is spent on the commodity a ex demand for refrigerator probably more price elastic than the demand for toasters bc the expenditure required to purchase a refrigerator would make up a larger percentage of the budget of a typical consumer 3 Time period of adjustment a In general longer the time period of measurement the larger more elastic the price elasticity will be in absolute value Calculating Price Elasticity of Demand Multiply the slope of demand times the ratio of price divided by quantity PQ If point change is relatively small a point measure is generally suitable When the price change spans a sizable arc along the demand curve E2 interval measurement of elasticity provides a better measure of consumer responsiveness than the point measure Computation of elasticity over an interval Interval or arc elasticity price elasticity calculated over an interval of a demand curve use average values of P and Q over the interval Point elasticity a measurement of demand elasticity calculated at a point on a demand curve rather than over an interval For linear demand functions Q a bP the price elasticity of demand can be computed using either of two equivalent formulas E bPQ PPA Where P and Q are the values of price and quantity demanded at the point of measure on demand and A a b is the priceintercept of demand For curvilinear demand functions the price elasticity at a point can be computed using either of 2 equivalent formula E changeQchangeP PQ PPA P and E vary directly along a linear demand curve higher price more elastic is demand No general rule about the relation price and elasticity as there is for linear demand in curved demand EXCEPT when Q aP b elasticity is constant along the demand curve and equal to b 2 Marginal revenue MR the addition of total revenue attributable to selling one additional unit of output the slope of total revenue Marginal revenue equals price only for the rst unit sold Inframarginal units units of output that could have been sold at a higher price had a firm not lowered its price to sell the marginal unit MR Price Revenue lost by lowering price on the inframarignal units Marginal revenue must be less than price for all units sold after the first b c the price must be lowered in order to sell more units Marginal revenue positive ea TR increases when quantity increases when demand is elastic Marginal revenue negative E2 TR decreases when quantity increases when demand is elastic Marginal revenue 0 when TR is maximized price elasticity of demand is unitary When inverse demand is linear marginal revenue is also linear intersects the vertical axis at the same point demand does and is twice as steep as the inverse demand function The equation of the linear marginal revenue curve is MR A 2BQ MR P1 1E for linear or curvilinear demands Income elasticity a measure of the responsiveness of quantity demanded to changes in income holding all other variables in the general demand function constant Crossprice elasticity a measure of the responsiveness of quantity demanded to changes in the price of a related good when all the other variables in the general demand function remain constant EM Change Q Change M MQ EM Change Q Change M Avg M Avg Q interval EM cMQ point measure Income elasticity is positive for normal goods EXR change QX change PR PRQX EXR change Q change PR Average PR Average Q interval EXR dPRQ BECON3OO Notes 12 Ch1 Managers Pro ts and Markets Firm s primary goal usually the maximization of pro t The economic way of thinking about business decisions and strategies provide all managers with a powerful and indispensible set of tools and insights for furthering the goals of their rms or organizations Managerial economics microeconomics and industrial organization E2 create systematic logical way of analyzing business practices or tactics to get the most pro t as well as sustainingprotecting it Microeconomics study of individual behavior of consumers business rms and markets and it contributes to our understanding of business practices and tactics Business practices or tactics routine business decisions managers must make to eam the greatest pro t under the prevailing market conditions facing the rm Marginal analysis key Industrial organization branch of microeconomics focusing on the behavior and structure of rms and industries Strategic decisions business actions taken to alter market conditions and behavior of rivals in ways that increase andor protect the strategic rm s pro t do not accept the existing conditions of competition as xed Strategic decisions can create greater pro ts and in some cases protect and sustain the pro ts into the future Economic forces that promote longrun pro tability 39 Few close substitutes Strong entry barriers Weak rivalry within market Low market power of input suppliers Low market power of consumers Abundant complementary products Limited harmful govemment intervention Economic Costs of Using Resources Economic cost of using resources OC to the owners of the rm using those resources Opportunity cost what a rm s owners give up to use resources to produce goods or services Market supplied resources resources owned by others and hired rented or leased in resource markets Ex labor services raw materials capital equipment rented Ownersupplied resources resources owned and used by a rm 3 most important types are 1 money provided to the business by its owners 2 time and labor service provide by the rm s owners 3 any land buildings or capital equipment owned and used by the rm total economic cost sum of OC of marketsupplied resources OC of owner supplied resources OC of marketsupplied resources out of pocket monetary payments explicit costs Explicit costs monetary OC of using marketsupplied resources OC of owner supplied resources best retum the owners of the rm could have received had they taken their own resource to market instead of using it themselves Implicit costs nonmonetary OC of using ownersupplied resources 3 most important types of implicit costs 1 OC of cash provided to a rm by its owners equity capital a Equity capital money provided to business by the owners 2 OC of using land or capital owned by the rm 3 OC of the owner s time spent managing the rm or working for the rm in some other capacity Ex Regardless of whether the pmt is explicit or implicit the OC of using the building resource is the same for both rms Economic profit difference between total revenue and total economic cost Economic pro t Total Revenue Total Economic Cost Economic pro t Total Revenue Explicit costs Implicit costs Accounting pro t the difference between total revenue and explicit costs Accounting pro t Total Revenue Explicit costs Value of a firm the price for which the rm can be sold which equals the PV of future pro ts Risk premium an increase in the discount rate to compensate investors for uncertainty about future pro ts When today s decisions affect pro ts in future time periods price output decisions that maximize pro t in each time period will not maximize the value of the rm but it is generally the case that there is little difference between the conclusions of single period pro t maximization and PV maximization a2 single period pro t maximization is generally the rule for managers to follow when trying to maximize the value of a rm MLB broke MV rising Past pro t doesn t matter Never increase output simply to reduce average costs marginal costs are the one important Pursuit of market share usually reduces pro t except network effects Focusing on pro t margin wont maximize total pro t Maximizing total revenue reduces pro t Cost plus pricing formulas don t produce pro tmaximizing prices Separation of ownership and control PrincipalAgent Problem the con ict that arises when the goals of mgmt agent do not match the goals of the owner principal Moral hazard exists when either party to an agreement has an incentive not to abide by all provisions of the agreement and one party cannot cost effectively monitor the agreement Most managers should ignore market share except for few industries such as network effect Corporate Control Mechanisms Equity ownership is considered one of the most effective mechanisms for corporate control so much so that some professional money managers and large institutional investors refuse to invest in f1r1ns whose managers hold little or no equity stake in the firms they manage Agency problem can arise between directors and shareholders Corporate policy on debt financing policy that emphasizes financing corporate investmetns w debt rather than equity can further the interests of sh in several ways 1 debt financing makes bankruptcy possible 2 managers face less pressure to generate revenues to cover the cost of investments if the payments are dividends to sh which they can choose to defer or neglect altogether rather than if the pmts are installments on a loan 3 lenders have an incentive to monitor managers of f1r1ns that borrow money from them corporate takeovers also an important possible solution to the con ict between sh and managers Market structure and managerial decision making Price taker a firm that cannot set the price of the product it sells since price is determined strictly by the market forces of demand and supply demand curve facing a pricetaking f1r1n is horizontal at the price determined by market forces Price setting rm a f1r1n that can raise its price wout losing all of its sales Market power ability to raise price wout losing all sales Market any arrangement through which buyers and sellers exchange anything of value Transaction costs costs of making transaction happen other than the price of the good or service itself Market structure market characteristics that determine the economic environment in which a firm operates Structure of a market governs the degree of pricing power possessed by a manager both in the short run and in the long run List of economic characteristics to describe market 39 The number and size of the f1r1ns operating in the market Degree of product differentiation among competing producers Likelihood of new f1r1ns entering a market when incumbent firms are earning economic profits Perfect competition large number of relatively small rms sell an undifferentiated product in a market with no barriers to the entry of new rms price takers with no market power EX commodities and agricultural goods Monopoly market single rm protected by some kind of barrier to entry produces a product for which no close substitutes are available price setting rm Monopolistic competition large number of rms that are small relative to the total size of the market produce differentiated products wout the protection of barriers to entry differentiation a market power E2 price setters In each of these 3 markets managers do not need to consider the reaction fo rival rms to a price change 39 Oligopoly market just a few rms produce most or all fo the market output so any one rm s pricing policy will have a signi cant effect on the sales of other rms in the market Globalization of markets economic integration of markets located in nations around the world Globalization E2 business can reduce their costs and hundreds of thousands of workers in lowincome nations can eam higher wages Ch2 Demand Supply and Market Equilibrium Demand Quantity demanded the amount of a good or service consumers are willing and able to purchase during a given period of time week month etc 6 factors considered suf ciently important to be included in most studies of market demand 1 general demand functions show how quantity demanded is related to product price and ve other factors that affect demand 2 direct demand functions show the relation between quantity demanded and the price of the product when all other variables affecting demand are held constant at speci c values referred as demand functions or demand 3 inverse demand functions give the maximum prices buyers are willing to pay to obtain various amount of product direct demand functions are derived from general demand functions and inverse demand curves are derived from direct demand curves General Demand Function 6 principal variables that in uence the quantity demanded of a good service 1 the price of the good or service 2 the incomes of consumers 3 the prices of related goods and services 4 the tastes or preference patterns of consumers 5 the expected price of the product in future periods 6 the number of consumers in the market General demand function the relation between 6 quantity demanded and the 6 factors that affect quantity demanded QdfPMPrTPeN Qd quantity demanded of the good service P Price of the good service inverse negative M consumer s income generally per capita a direct for normal goods positive b inverse for inferior goods negative Pr price of related goodsservices a direct for substitute goods positive b inverse for complement goods negative T Taste pattems of consumers direct positive Pe expected price of the good in some future period direct positive N number of consumers in the market direct positive The general demand function shows how all 6 variables jointly determine the quantity demanded Whenever we speak of the effect that a particular variable has on quantity demanded we mean the individual effect holding all other variables constant Price and quantity inversely related holding other factors constant Normal good a goodservice for which an increase decrease in income causes consumers to demand more less of the good holding all other variables in the general demand function constant Inferior good a goodservice for which an increase decrease in income causes consumers to demand less more of the good all other factors held constant ex mobile homes shoe repair services generic food products and used cars Commodities may be related in consumption in either of 2 ways substitutes or as complements Substitutes 2 goods are substitutes if an increase decrease in the price of one of the goods causes consumers to demand more less of the other good holding all other factors constant Complements 2 goods are complements if an increase decrease in the price of one of the goods causes consumers to demand less more of the other good all other things held constant When all other variables in the general demand function are held constant a movement in consumer tastes toward a good service will increase demand and a movement in consumer tastes away from a good will decrease demand for the good ex change in taste New England J oumal of Medicine publish research findings that show higher incidence of cancer for people regularly eating bacon Expectation also in uence consumer s decision to purchase goods service if consume expects price to be higher in future ea current period demand will probably rise QdabPcMdPreJfPegN Slope parameters parameters in a linear function that measure the effect on the dependent variable Qd of changing one of the independent variables P M Pr T Pe and N while holding the rest of these variables constant Normal goods positive Inferior goods negative Simpli ed version Qd a bP cM dPr Direct demand functions Qd fP Direct demand function a table a graph or an equation that shows how quantity demanded is related to product price holding constant the ve other variables that in uence demand Qd fP Intercept parameter amount of the good consumers would demand if price is zero Although not all demand functions are linear linear form frequently used Demand schedule a table showing a list of possible product prices and the corresponding quantities demanded Demand curve a graph showing the relation between quantity demanded and price when all other variables in uencing quantity demanded are held constant Qd horizontal axis P vertical axis Inverse demand function the demand function when price is expressed as a function of quantity demanded P fQd Choke price consumers demand zero units of the good Every point on a demand curve can be interpreted in either of 2 ways 1 the maximum amount of good that will be purchased if a given price is charged 2 the maximum price that consumers will pay for a speci c amount of a good demand price maximum price consumers will pay for a speci c amount of a good service can be interpreted as the economic value Movement along demand law of demand quantity demanded increases when price falls and quantity demanded decreases when price rises other things held constant change in quantity demanded a movement along a given demand curve that occurs when the price of the goo changes all else constant Shifts in Demand When any one of the ve variables held constant when deriving a direct demand function from the general demand relation changes value a new demand function results causing the entire demand curve to shift to a new location Increase in demand a change in the demand function that causes an increase in quantity demanded at every price and is re ected by a rightward shift in the demand curve Decrease in demand a change in the demand function that causes a decrease in quantity demanded at every price and is re ected by a leftward shift in the demand curve Determinants of demand variables that change the quantity demanded at each price and that determine where the demand curve is located M Pr T Pe and N Change in demand a shift in demand either leftward or rightward that occurs when one of the ve determinants of demand changes Supply Quantity supplied the amount of a good or service offered for sale during a given period of time week month etc In general economists assume that the quantity of a good offered for sale depends on 6 major variables 1 the price of the good itself 2 the prices of the inputs used to produce the good the prices of goods related in production the level of available technology the expectations of the producers conceming the future price of the good the number of firms or the amount of productive capacity in the industry 39gt general supply function the relation between quantity supplied and the 6 factors that jointly affect quantity supplied Qs fP Pi Pr T Pe F Substitutes in production goods for which an increase in the price of one good relative to the price of another good causes producers to increase production of the now higher priced good and decrease production of the other good Complements in production goods for which an increase in the price of one good relative to the price of another good causes producers to increase production of both goods Technology the state of knowledge conceming the combination of resources to produce goods and services Expectation about future price of the good affect supply If the number of firms in the industry increases or if the productive capacity of existing firm increases more of the good service will be supplied at each price QshkPlPImPrnTrPesF Direct supply functions Q fP Direct supply function a table a graph or an equation that shows how quantity supplied is related to product price holding constant the ve other variables that in uence supply Qs fP Determinants of supply variables that cause a change in supply ie a shift in the supply curve Change in quantity supplied a movement along a given supply curve that occurs when the price of a good changes Supply schedule a table showing a list of possible product prices and the corresponding quantities supplied Supply curve a graph showing the relation between quantity supplied and price when all other variables in uencing quantity supplied are held constant Inverse supply function the supply function when price is expressed as a function of quantity supplied P fQs A point on the supply schedule indicates either 1 the maximum amount of a good or service that will be offered for sale at a specific price or 2 the minimum price necessary to induce producers to offer a given quantity for sale supply price the minimum price necessary to induce producers to offer a given quantity for sale change in quantity supplied a movement along a given supply curve that occurs when the price of the good changes all else constant Shift in supply Increase in supply a change in the supply function that causes an increase in quantity supplied at every price and is re ected by a rightward shift in the supply curve Decrease in supply a change in the supply function that causes a decrease in quantity supplied at every price and is re ected by a leftward shift in the supply curve BECON3OO Notes 122 Ch4 Basic Estimation Techniques Parameters coefficients in an equation that determine the exact mathematical relation among the variables Parameter estimation the process of nding estimates of the numerical values of the parameters of an equation Regression analysis a statistical technique for estimating the parameters of an equation and testing for statistical significance Dependent variable the variable whose variation is to be explained Explanatory variables the variables that are thought to cause the dependent variable to take on different values In the simpler linear regression model the dependent variable Y is related to only one explanatory variable X Y a bX Intercept parameter the parameter that gives the value of Y at the point where the regression line crosses the Yaxis Slope parameter the slope of the regression line b change Y change X or the change in Y associated with a oneunit change in X True or actual relation the true or actual underlying relation between Y and X that is unknown to the researcher but is to be discovered by analyzing the sample data The regression equation shows only the average or expected level of sales when a rm spends a given amount on advertising Random error term an unobservable term added to a regression model to capture the effects of all the minor unpredictable factors that affect Y but cannot reasonably be included as explanatory variables Purpose of regression analysis is twofold 1 To estimate the parameters a and b of the true regression line and 2 To test whether the estimated values of the parameters are statistically significant Time series a data set in which the data for the dependent and explanatory variables are collected over time for a specific firm Crosssectional a data set in which the data on the dependent and explanatory variables are collected from many different f1r1ns or industries at a given point in time Scatter diagram a graph of the data points in a sample Population regression line the equation or line representing the true or actual underlying relation between the dependent variable and the explanatory variables Sample regression line the line that best fits the scatter of data points in the sample and provides an estimate of the population regression line Method of least squares a method of estimating the parameters of a linear regression equation by finding the line that minimizes the sum of the squared distances from each sample data point to the sample regression line Fitted or predicted value the predicted value of Y denoted Y associated with a particular value of X which is obtained by substituting that value of X into the sample regression equation Residual the difference between the actual value of Y and the tted or predicted value of Y YiY i Estimators the formulas by which the estimates of parameters are computed Statistically significant there is suf cient evidence from the sample to indicate that the true value of the coef cient is not 0 Hypothesis testing a statistical technique for making a probabilistic statement about the true value of a parameter Relative frequency distribution the distribution and relative frequency of values b can take because observations on Y and X come from a random sample Unbiased estimator an estimator that produces estimates of a parameter that are on average equal to the true value of the parameter ttest a statistical test used to test the hypothesis that the true value of a parameter is equal to O b O tratio the ratio of an estimated regression parameter divided by the standard error of the estimate tstatistic the numerical value of the tratio Larger the absolute value of the tratio the more probable it is that the true value of b is not equal to 0 Critical value of t the value that the tstatistic must exceed in order ot reject the hypothesis that b 0 Type I error error in which a parameter estimate is found to be statistically signi cant when it is not Level of significance the probability of nding the parameter to be statistically signi cant when in fact it is not Level of confidence the probability of correctly failing to reject the true hypothesis that bO equals one minus the level of signi cance Degrees of freedom the number of observations in the sample minus the number of parameters being estimated by the regression analysis nk pvalue the exact level of signi cance for a test statistic which is the probability of nding signi cance when none exists One minus the pvalue is the exact degree of con dence that can be assigned to a particular parameter estimate Coef cient of determination RA2 the fraction of total variation in the dependent variable explained by the regression equation R 2 is a widely used statistic but it is subjective in the sense of how much explained variation explained by the regression equation is enough to view the equation as being statistically signi cant Fstatistic a statistic used to test whether the overall regression equation is statistically signi cant Ch5 Theory of Consumer Behavior The basic model of consumer theory seeks to explain how consumers make their purchasing decisions when they are completely informed about all things that matter Consumption bundles a particular combination of specific quantities of goodsservices Complete consumers are able to rank all conceivable bundles of commodities Transitive consumer preferences are transitive if AgtB and BgtC then it follows that AgtC More is preferred to less nonsatiation Utility bene ts consumers obtain from the goods and services they consume Utility function an equation that shows an individual s perception of the level of utility that would be attained from consuming each conceivable bundle of goods U fXY Indifference curve a locus of points representing different bundles of goods and services each of which yields the same level of total utility Indifference curves are downwardsloping Indifference curves are convex Marginal rate of substitution MRS a measure of the number of units of Y that must be given up per unit of X added so as to maintain a constant level of utility Marginal utility addition of total utility that is attributable to the addition of one unit of a good to the current rate of consumption holding constant the amounts of all other goods consumed Budget line locus of all bundles of goods that can be purchased at given prices if the entire money is spent An increase decrease in money income causes a parallel outward backward shift in the budget line An increase decrease in the price of X causes the budget line to pivot backward outward around the original vertical intercept Marginal rate of substitution the absolute value of the slope of the indifference curve equals the price ratio the absolute value of the slope of the budget line A consumer maximizes utility subject to a limited money income at the combination of goods for which the indifference curve is just tangent to the budget line To obtain maximum satisfaction from a limited money income a consumer allocates money income so that the marginal utility per dollar spent on each good is the same for all commodities purchased and all income is spent The demand curve of an individual for a specific commodity relates utilitymaximizing quantities purchased to market prices holding constant money income and the prices of all other goods The slope of the demand curve illustrates the law of demand Quantity demanded varies inversely with price Market demand list of prices and the quantities consumers are willing and able to purchase at each price in the list other things being held constant The market demand curve is the horizontal summation of the demand curves of all consumers in the market It therefore shows how much all consumers demand at each price over the relevant range of prices For any particular quantity demanded the price on the vertical axis of the market demand curve measures two things 1 the maximum price consumers will pay to buy that quantity of the good and 2 the dollar value of the benefit to buyers of that particular unit of the good A market demand curve then gives the marginal bene t value individuals place on the last unit consumed The demand prices at various quantities along a market demand curve give the marginal bene t value of the last unit consumed for every buyer in the market and thus market demand can be interpreted as the marginal bene t curve for a good BECON3OO Notes 110 Ch3 Marginal Analysis for Optimal Decisions The manager should continue adjusting the activity level until no further net gains are possible which means the activity has reached its optimal value or level Managers face 2 general types of decisions 1 routine business practice 2 tactical decisions and strategic decisions that can alter the rm s competitive environment marginal analysis builds the essential foundation for making everyday business decisions Strategic decision relies heavily on concepts from game theory it nevertheless depends indirectly on optimal decision making Objective function the function the decision maker seeks to maximize or minimize Usually pro t which is to be maximized For consumer it is the satisfaction derived from consumption of goods Maximization problem an optimization problem that involves maximizing the objective function Minimization problem an optimization problem that involves minimizing the objective function Activities or choice variables variable that determine the value of the objective function Discrete choice variable a choice variable that can take only speci c integer values Continuous choice variable a choice variable tha can take any value between two end points Unconstrained optimization an optimization problem in which the decision maker can choose the level of activity from an unrestricted set of values Constrained optimization an optimization problem in which the decision maker chooses value for the choice variables from a restricted set of volumes Marginal analysis analytical technique for solving optimization problems that involves changing values of choice variables by small amounts to see if the objective function can be further improved Unconstrained Maximization Net benefit the objective function to be maximized NB TB TC Optimal level of activity the level of activity that maximizes net bene t l optimal level of activity does not generally result in maximization of total bene ts 2 optimal level of activity in an unconstrained maximization problem does not result in minimization of total cost marginal bene t MB the change in total bene t caused by an incremental change in the level of an activity marginal cost the change in total cost caused by an incremental change in the level of an activity marginal bene t and marginal costs are also slopes of total bene t and total cost curves respectively To make optimal decision for discrete choice variables decision makers must increase activity until the last level of activity is reached for which marginal bene t exceeds marginal cost Sunk costs costs that have previously been paid and cannot be recovered Fixed costs costs that are constant and must be paid no matter what level of the activity is chosen Average unit cost cost per unit of activity computed by dividing total cost by the number of units of activity To maximize total bene ts subject to a constraint on the levels of activities choose the level of each activity so that the marginal bene t per dollar spent is equal for all activities BECON3OO Notes 215 Ch8 Production and Cost in the Short Run Production the creation of goods and services from inputs or resources Production function a schedule or table or mathematical equation showing the maximum amount of output that can be produced from any speci ed set of inputs given the existing technology Technical efficiency production of the maximum level of output that can be obtained from a given combination of inputs Economic efficiency production of a given amount of output at the lowest possible total cost Variable input input for which the level of usage may be readily varied to increase or decrease output Fixed input an input for which the level of usage cannot readily be changed and which must be paid even if no output is produced Quasi fixed input a lumpy or indivisible input for which a fixed amount must be used for any positive level of output and none is purchased when output is zero Short run a time span of production during which at least one input is a fixed input Long run time period just far enough in the future that all fixed inputs become variable inputs The longrun production period is also called the firm s planning horizon rms operate in the short run and plan for the long run Planning horizon the collection of all possible shortrun situations a firm may face a unique one for every possible level of the fixed input Sunk cost in production payment for an input that once made cannot be recovered should the firm no longer wish to employ that input Only the nonrecoverable portion of input pmt is a sunk cost Avoidable costs input costs the firm can recover or avoid paying if it decides to produce no output Variable proportions production production in which a given level of output can be produced with more than one combination of inputs Fixed proportions production production in which one and only one ratio or mix of inputs can be used to produce a good Average product of labor total product output divided by the number of workers AP QL Marginal product of labor MP The additional output attributable to using one additional Worker with the use of all other inputs xed Average product first rises and then falls When average product is increasing marginal product is greater than average product after the rst worker at which they are equal When average product is decreasing marginal product is less than average product This occurs for any production function for which average product rst increases then decreases When marginal product is increasing total product increases at an increasing rate When marginal product begins to decrease after 2 workers total product begins to increase at a decreasing rate When marginal product becomes negative 10 workers total product declines Law of diminishing marginal product the principle that as the number of units of the variable input increases other inputs held constant a point will be reached beyond which the marginal product decreases Total fixed cost TFC The total amount paid for xed inputs Total xed cost does not vary with output Total variable cost TVC The amount paid for variable inputs Total variable cost increases with increases in output Total cost TC The sum of total xed cost and total variable cost Total cost increases with increases in output TC TFC TVC Average fixed cost AFC Total xed cost divided by output AFC TFCQ Average variable cost AVC Total variable cost divided by output AVC TVCQ Average total cost ATC Total cost divided by output or the sum of average xed cost plus average variable cost ATC TCQ AVC AFC Shortrun marginal cost SMC The change in either total variable cost or total cost per unit change in output When SMC is less than AVC average variable cost is falling When SMC is greater than AVC average variable cost is rising SMC must equal AVC at the minimum point on AVC Exactly the same reasoning can be used to show that SMC crosses at ATC at the minimum point on the latter curve When marginal product average product is increasing marginal cost average variable cost is decreasing When marginal product average product is decreasing marginal cost average variable cost is increasing When marginal product equals average product at maximum AP marginal cost equals average variable cost at minimum AVC A typical set of shortrun cost curve is characterized by the following features 1 AFC decreases continuously as output increases 2 AVC is Ushaped ATC is Ushaped SMC is Ushaped and crosses both AVC and ATC at their minimum points SMC lies below above both AVC and ATC over the output range for which these curves fall rise SMC wMP and AVC wAP When MP AP is increasing SMC AVC is decreasing When MP AP is decreasing SMC AVC is increasing When MP AP at AP s maximum value SMC AVC at AVC s minimum value Similar but not identical relations hold when more than one input is variable 39gt BECON3OO Notes 15 Ch 2 Cont d Market Equilibrium Market equilibrium a situation in which at the prevailing price consumers can buy all of a good they wish and producers can sell all of the good they wish Qd Qs Equilibrium price the price at which Qd Qs Equilibrium quantity the amount of good bought and sold in market equilibrium Excess supply surplus exists when quantity supplied exceeds quantity demanded Excess demand shortage exists when quantity demanded exceeds quantity supplied Market clearing price the price of a good at which buyers can purchase all they want and sellers can sell all they want at that price This is another name for the equilibrium price Indeed every market where there is voluntary exchange creates value for all the buyers and sellers trading in that market Consumer surplus Economic value the maximum amount any buyer sin the market is willing to pay for the unit which is measured by the demand price for the unit of the good Consumer surplus the difference between the economic value of a good its demand price and the market price the consumer must pay Producer surplus for each unit supplied the difference between market price and the minimum price producers would accept to supply the unit its supply price Social surplus the sum of consumer surplus and producer surplus which is the area below demand and above supply over the range of output produced and consumed Qualitative forecast a forecast that predicts only the direction in which an economic variable will move Quantitative forecast a forecast that predicts both the direction and the magnitude of the change in an economic variable When demand increases and supply is constant equilibrium price and quantity both rise When a demand decreases and supply is constant equilibrium price and quantity both fall When supply increases and demand is constant equilibrium price falls and equilibrium quantity rises When supply decreases and demand is constant equilibrium price rises and equilibrium quantity falls Indeterminate term referring to the unpredictable change in either equilibrium price or quantity when the direction of change depends upon the relative magnitudes of the shifts in the demand and supply curves In the case Where both demand and supply increase a small increase in supply relative to demand causes price to rise while a large increase in supply relative to demand causes price to fall When both demand and supply shift together either 1 the change in quantity can be predicted and the change in price is indeterminate or 2 the change in quantity is indeterminate and the change in price can be predicted when demand and supply both shift simultaneously if the change in quantity price can be predicted the change in price quantity is indeterminate The change in equilibrium quantity or price is indeterminate when the variable can either rise or fall depending upon the relative magnitudes by which demand and supply shift Shortages and surpluses can occur after a shift in demand or supply but these shortages and surpluses are sufficiently short in duration that they can reasonably be ignored in demand and supply analysis Some shortages and surpluses that market forces do not eliminate a more permanent in nature and result from govemment interferences with the market mechanism Ceiling price the maximum price the govemment permits sellers to charge for a good When this price is below equilibrium a shortage occurs Floor price the minimum price the govemment permits sellers to charge for a good When this price is above equilibrium a surplus occurs When the govemment sets a ceiling price below the equilibrium price a shortage or excess demand results bc consumers wish to buy more units of the good than producers are willing to sell at the ceiling price If the govemment sets a oor price above the equilibrium price a surplus or excess supply results because producers offer sale more units of the good than buyers Wish to consume at the oor price BECON3OO Notes 225 Ch 11 Answer the following What two conditions determine a LR perfectly competitive equilibrium What then do these two conditions imply for the graph of a LR perfectly competitive equilibrium 114 Pro t Maximization in the Long Run Long run can also be viewed as the planning stage Entry of new rms which is possible only in the long run plays a crucial role in longrun analysis of competitive industries As long as price is greater than longrun average cost the rm can make a pro t Breakeven points price longrun average cost and economic pro t is 0 While the individual rm is in longrun pro tmaximizing equilibrium when MR LMC the industry will not be in longrun equilibrium until there is no incentive for new rms to enter or incumbent rms to exit The economic force that induces rm to enter into an industry or that drives rms out of an industry is the existence of economic pro ts or economic losses respectively New rms continue to enter the industry price continues to fall and existing rms continue to adjust their outputs until all economic pro ts are eliminated Longrun competitive equilibrium condition in which all rms are producing where P LMC and economic pro ts are zero P LAC Principle In longrun competitive equilibrium all rms are maximizing pro t P LMC and there is no incentive for rms to enter or exit the industry bc economic pro t is zero P LAC Longrun competitive equilibrium occurs because of the entry of new rms into the industry or the exit of existing rms from the industry The market adjusts so that P LMC LAC which is at the minimum point on LAC BECON3OO Notes 229 Ch 13 Strategic Decision Making in Oligopoly Markets In markets where a relatively small number of rms compete every kind of decision affecting any one rm s pro t such as decisions about pricing output and advertising as well as decisions about expanding production facilities or increasing spending on RampD also affects pro ts of every other rm in the market Interdependence requires strategic behavior Strategic behavior actions taken by rms to plan for and react to competition from rival rms Oligopoly a market consisting of a few relatively large rms each with a substantial share of the market and all recognize their interdependence Interdependence of rms pro ts the distinguishing characteristic of oligopoly markets arises when the number of rms in a market is small enough that every rm s price and output decision affects the demand and marginal revenue conditions of every other rm in the market Game theory an analytical guide or tool for making decisions in situations involving interdependence Game any decisionmaking situation in which people compete with each other for the purpose of gaining the greatest individual payoff Simultaneous decision games a situation in which competing rms must make their individual decisions without knowing the decisions of their rivals If you have information about what your rival has chosen to do before you make your decision then you are in a sequential decisionmaking game Payoff table a table showing for every possible combination of decisions players can make the outcomes or payoffs for each of the players in each decision combination Common knowledge a situation in which all decision makers know the payoff table and they believe all other decision makers also know the payoff table Dominant strategy a strategy or action that always provides the best outcome no matter what decisions rival make When a dominant strategy exists an action that always provides a manager with the best outcome no matter what action the manager s rival chooses to take a rational decision maker always chooses to follow its own dominant strategy and predicts that if its rivals have dominant strategies they also will choose to follow their dominant strategies Dominantstrategy equilibrium both players have dominant strategies and play them Cooperation is unlikely to occur bc there is an incentive to cheat A prisoners dilemma arises when all rivals possess dominant strategies and in dominant strategy equilibrium they are all worse off than if they had cooperated in making their decisions Decisions with One Dominant Strategy When a rm does not have a dominant strategy but at least one of its rivals does have a dominant strategy the rm s manager can predict with con dence that its rivals will follow their dominant strategies Then the manager can choose its own best strategy knowing the actions that will almost certainly be taken by those rivals possessing dominant strategies BECON3OO Notes 217 Ch 11 Managerial Decisions in Competitive Markets Managers of rms that are pricetakers look at price and cost conditions to answer 3 fundamental questions 1 should the rm produce or shut down 2 If the rm produces what is the optimal level of production 3 What are the optimal levels of inputs to employ Perfect competition a market structure that exists when 1 rms are pricetakers 2 all rms produce a homogeneous product and 3 entry and exit are unrestricted when a market is characterized by a large number of relatively small producers each producing a homogeneous product the demand curve facing the manager of each individual rm is horizontal at the price determined by the intersection of the market demand and supply curves Perfectly elastic demand horizontal demand facing a single pricetaking rm in a competitive market E in nity For a horizontal demand demand is said to be in nitely elastic or perfectly elastic Since marginal revenue price for a competitive rm the demand curve is also simultaneously the marginal revenue curve D MR The law of demand does apply to perfectly competitive markets The market demand for the product is downward sloping A manager must make 2 decisions in the short run 1 whether to produce or shut down during the period a shut down a rm produces zero output in the short run but must still pay for xed inputs b manager will choose to produce a positive amount of output only if doing so generates enough TR to cover the rm s avoidable total VC of production 2 choosing the optimal level of output profit margin the difference between price and average total cost P ATC when all units of output are sold for the same price pro t margin average pro t average profit total pro t divided by quantity pieQ Measures pro t per unit and is equivalent to pro t margin when all units sell for the same price pro t maximizing managers should ignore pro t margin when making their production decisions when a rm can make positive pro t in the short run pro t is maximized at the output level where MR P SMC Breakeven points output levels where P ATC and pro t equals zero points U and V in Figure 114 Manager choose to produce output where P SMC as long as TR gt TVC or Price gt AVC Firms should shut down and produce nothing when TR falls below TVC or equivalently when price falls below average variable cost When price average variable cost the loss is the same for either decision and the manager is indifferent between producing the output where P SMC or producing no output at all Shutdown price the price below which the rm shuts down in the short run minimum AVC Choosing the output level that minimizes average total cost ATC and maximizes pro t margin P ATC generally fails to maximizes pro t pie AVC does matter when deciding whether to produce but AVC is irrelevant for nding the positive optimal level of output Principle 1 average variable cost tells whether to produce the rm ceases to produce shuts down if price falls below minimum AVC 2 Marginal cost tells how much to produce if P gt minimum AVC the rm produces the output at which SMC P 3 Average total cost tells how much pro t or loss is made if the rm decides to produce pro t equals the difference between P and ATC average pro t or pro t margin multiplied by the quantity produced and sold Shortrun supply curve for an individual pricetaking rm is the portion of the rrn s MC curve above minimum AVC For market prices less than minimum AVC quantity supplied is O The shortrun supply curve for a competitive industry can be obtained by horizontally summing the supply curves of all the individual rms in the industry Shortrun industry supply is always upwardsloping and supply prices along the industry supply curve give the MC of production for every rm contributing to industry supply Producer surplus TR TVC gt economic pro t Relation Shortrun producer surplus is the amt by which total revenue exceeds total variable cost and equals the area above the shortrun supply curve below market price over the range of output supplied Shortrun producer surplus exceeds economic pro t by the amt of total xed costs Steps to nd the pro tmaximizing rate of production and the level of pro t the rm will eam Step 1 Forecast the price of the product Step 2 Estimate average variable cost AVC and marginal cost SMC Step 3 Check the shutdown rule Step 4 If P gt AVCmin nd the output level Where P SMC Step 5 Computation of pro t or loss Firm makes one of the following choices in the short run 1 produce a positive level of output and eam an economic pro t if P gt AVC and P gt ATC 2 produce a positive level of output and suffer an economic loss less than the amount of total xed cost if AVC lt P lt ATC 3 Produce zero output and suffer an economic loss equal to total xed cost if P lt AVC BECON3OO Notes 227 Ch 9 Production and Cost in the Long Run Businesses operate in the short run and plan for the long run Isoquant a curve showing all possible combinations of inputs physically capable of producing a given xed level of output Each point on an isoquant is technically efficient for each combination on the isoquant the maximum possible output is that associated w the given isoquant Isoquant map a graph showing a group of isoquants Marginal rate of technical substitution MRTS the rate at which one input is substituted for another along an isoquant For very small movements along an isoquant the marginal rate of technical substitution equals the ratio of the marginal products of the two inputs 2 forces are working to diminish labor s marginal product 1 less capital causes a downward shift of the marginal product of labor curve 2 more units of the variable input labor cause a downward movement along the marginal product curve For analogous reasons marginal product of capital increases as less capital and more labor are used Isocost curve line that shows the various combinations of inputs that may be purchased for a given level of expenditure at given input prices C wL rK K Cr wrL The slope of the isocost curve is equal to the negative of the relative input price ratio w r In general an increase in cost holding input prices constant leads to a parallel upward shift in the isocost curve At constant input prices w and r for labor and capital a given expenditure on inputs will purchase any combination of labor and capital given by the following equation called an isocost curve K Cr wrL Minimization problem chooses combination on the desired isoquant that costs the least Maximization problem choose the input combination on the isoquant curve that lies on the highest isoquant At the costminimizing input combination MRTS wr MRTS MPLMPk wr MPLw MPkr To produce a given level of output at the lowest possible cost when two inputs L and K are variable and the prices of the inputs are respectively w and r a manager chooses the combination of inputs for which MRTS MPLMPk wr Which implies that MPLW MPkr The isoquant associated w the desired level of output the slope of which is the MRTS is tangent to the isocost curve the slope of which is Wr at the optimal combination of inputs This optimization condition also means that the marginal product per dollar spent on the last unit of each input is the same In the case of 2 variable inputs labor and capital the manager of a firm maximizes output for a given level of cost by using the amounts of labor and capital such that the marginal rate of technical substitution MRTS equals the input ratio Wr In terms of a graph this condition is equivalent to choosing the input combination Where the slope of the given isocost curve equals the slope of the highest attainable isoquant This outputmaximizing condition implies that the marginal product per dollar spent on the last unit of each input is the same Expansion path the curve or locus of points that shows the cost minimizing input combination of each level of output with the inputprice ratio held constant It is the curve or locus along which the firm will expand output when input prices are constant The expansion path is the curve along which a rm expands or contracts output when input prices remain constant Each point on the expansion path represents an efficient least cost input combination Along the expansion path the marginal rate of technical substitution equals the constant input price ratio The expansion path indicates how input usage changes when output or cost changes Structure of the relation between output and cost is determined by the expansion path Longrun average cost LAC Longrun total cost divided by output LAC LTCQ Longrun marginal cost LMC The change in longrun total cost per unit change in output LMC Change LTC ChangeQ The shape of the curve depends exclusively on the production function and the input prices This curve re ects 3 of the commonly assumed characteristics of longrun total cost 1 bc there are no xed costs LTC is 0 when output is O 2 cost and output are directly related that is LTC has a positive slope 3 LTC first increases at a decreasing rate then increases at an increasing rate This implies that marginal cost first decreases then increases 1 Longrun average cost defined as LAC LTCQ first declines reaches a minimum and then increases 2 When LAC is at its minimum longrun marginal cost defined as LMC change LTC Change Q equals LAC 3 LMC rst declines reaches a minimum and then increases LMC lies over the range in which LAC declines it lies above LAC when LAC is rising Economies of scale occurs when longrun average cost LAC falls as output increases Diseconomies of scale occurs when longrun average cost LAC rises as output increases Strengths of scale of economies or diseconomies can be seen respectively as the reduction in unit cost over the range of scale economies or the increase in LAC above its minimum value LAC2 beyond Q2 2 things that cannot be reasons for rising or falling unit cost as quantity increases along the LAC curve changes in technology and changes in input prices these shifts or even changes shape in ways that will alter the range and strengths of existing scale economies and diseconomies probably the most fundamental reason for economies of scale larger scale rms have greater opportunities for specialization and division of labor specialization and division of labor dividing production into separate tasks allows workers to specialize and become more productive which lowers unit costs Second cause of falling unit costs arises when a rm employs one or more quasi xed inputs quasi xed inputs must be used in xed amounts in both the short run and long run A variety of technological factors constitute a third force contributing to economies of scale 1 when several different machines are required in a production process and each machine produces at a different rate of output the operation may have to be quite sizable to permit proper meshing of equipment 2 Costs of capital equipment the expense of purchasing and installing larger machines is usually proportionately less than for smaller machines 3 Might be the most important technological factor of all As the scale of operation expands there is usually a qualitative change in production process and type of capital equipment employed The rising portion of LAC is generally attributed to limitations to ef cient mgmt and organization of the rm Overall corporate ef ciency is sacri ced when lobbying by division managers results in a misallocation of resources among divisions Scale diseconomies then remain a fact of life for very largescale enterprises Constant costs neither economies nor diseconomies of scale occur thus LAC is at and equal to LMC at all output levels Instances of truly constant costs at all output levels are not common in practice but businesses frequently treat their costs as if they are constant even when their costs actually follow the more typical Ushape pattem Minimum efficient scale MES lowest level of output needed to reach minimum longrun average cost Decision makers should ignore average cost and focus instead on marginal cost when trying to reach the optimal level of any activity Economies of scope exist when the joint cost at producing two or more goods is less than the sum of the separate costs of producing the goods A multiproduct total cost function is derived from a multiproduct expansion path To construct a multiproduct expansion path for two goods X and Y production engineers must work with a more complicated production function one that gives technically ef cient input combinations for various pairs of output quantities XY Multiproduct total cost function LTCXY Gives the lowest total cost for a multiproduct rm to produce X units of one goods and Y units of another good Economies of scope exist when LTCXY lt LTCXO LTCOY In product markets where scope economies are strong managers should expect that new rms entering a market are likely to be multiproduct rms and existing singleproduct rms are likely to be targets for acquisition by multiproduct rms Economists have identi ed 2 situations that give rise to economies of scope l economies of scope arise bc multiple goods are produced together as joint products Joint products when production of good X causes one or more other goods to be produced as byproducts at little or no additional cost 2 one more common place than joint products arises when common or shared inputs contribute to the production of two or more goods or services Common or shared inputs inputs that contribute to the production of two or more goods or services When economies of scope exists 1 The total cost of producing goods X and Y by a multiproduct rm is less than the sum of the costs for specialized single product rms to produce these goods LTCXY lt LTCXO LTCOY and 2 Firms already producing good X an add production of good Y at lower cost than a singleproduct rm can produce Y LTCXY LTCXO lt LTCOY Economies of scope arise when rms produce joint products or when rms employ common inputs in production Sometimes a purchasing manager for an individual rm obtain lower input prices as the rm expands its production level Purchasing economies of scale large buyers of inputs receive lower input prices through quantity discounts causing LAC to shift downward at the point of discount Learning or experience economies when cumulative output increases causing workers to become more productive as they leam by doing and LAC shifts downward as a result While scale scope purchasing and leaming economies can all lead to lower total and average costs of supplying goods and services we must wam you that managers should not increase production levels solely for the purpose of chasing any one of these cost economies
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